UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT
TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended: September 30, 2005
Commission File Number: 000-31929
SONOMA VALLEY BANCORP
(Exact name of Registrant as specified in its charter)
California 68-0454068
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
202 West Napa Street Sonoma, California 95476
(Address of principal executive offices) (Zip Code)
(707) 935-3200
(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 of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes o No |_|
Indicate by a check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes |_| No o
The number of shares outstanding of the registrant's Common Stock, no par value,
as of November, 1, 2005 was 2,204,949.
INDEX
Part 1 Financial Information Page Number
Item 1. Financial Statements (Unaudited):
Consolidated Balance Sheets at September 30, 2005,
December 31, 2004 and September 30, 2004.............................3
Consolidated Statements of Operations for the
three months and nine months ended September 30, 2005 and 2004.......4
Consolidated Statements of Changes in Shareholders' Equity
for the nine months ended September 30, 2005,
and the years ended December 31, 2004 and 2003.......................5
Consolidated Statements of Cash Flows for the
nine months ended September 30, 2005 and 2004........................7
Notes to Consolidated Financial Statements...........................8
Average Balances, Yields and Rates Paid
for the nine months ended September 30, 2005 and 2004...............11
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations.......................12
Item 3. Quantitative and Qualitative Disclosure about Market Risk...........28
Item 4. Controls and Procedures.............................................28
Part II Other Information
Item 1. Legal Proceedings...................................................28
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.........29
Item 3. Default Upon Senior Securities......................................29
Item 4. Submission of Matters to a Vote of Security Holders.................29
Item 5. Other Information...................................................29
Item 6. Exhibits............................................................29
Signatures...................................................................30
Certifications...............................................................31
The information furnished in these interim statements reflects all adjustments
and accruals which are, in the opinion of management, necessary for a fair
statement of the results for such periods. The results of operations in the
interim statements are not necessarily indicative of the results that may be
expected for the full year.
Page 2
Part I - FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS The information furnished in these interim
statements reflects all adjustments and accruals which are, in the opinion of
management, necessary for a fair statement of the results for such periods. The
results of operations in the interim statements are not necessarily indicative
of the results that may be expected for the full year.
FINANCIAL STATEMENTS
SONOMA VALLEY BANCORP AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
September 30,2005 (Unaudited) and December 31, 2004 (Audited) and
September 30, 2004 (Unaudited)
September 30 December 31 September 30
ASSETS 2005 2004 2004
------------ ----------- ------------
Cash and due from banks $ 6,172,079 $ 5,471,669 $ 8,292,339
Federal funds sold 0 9,840,000 1,685,000
Interest-bearing due from banks 55,267 35,551 35,406
------------ ------------ ------------
Total cash and cash equivalents 6,227,346 15,347,220 10,012,745
Investment securities available-for-sale, at fair value 34,977,162 20,253,490 23,518,575
Investment securities held-to-maturity (fair
value of $17,066,000, $17,842,000and
$18,394,000, respectively) 16,789,147 17,418,303 17,794,884
Loans and lease financing receivables, net 159,344,237 150,732,087 144,537,306
Premises and equipment, net 1,250,525 1,364,879 1,369,688
Accrued interest receivable 1,294,295 1,138,607 1,159,065
Cash surrender value of life insurance 9,147,268 8,913,136 8,851,899
Other assets 3,596,711 3,079,740 3,457,580
------------ ------------ ------------
Total assets $232,626,691 $218,247,462 $210,701,742
============ ============ ============
LIABILITIES
Non interest-bearing demand deposits $ 48,746,030 $ 44,557,377 $ 45,379,582
Interest-bearing transaction deposits 34,139,432 34,912,205 31,214,138
Savings and money market deposits 73,459,066 70,254,926 65,398,770
Time deposits, $100,000 and over 26,890,840 25,307,661 26,505,608
Other time deposits 21,791,961 18,630,846 18,562,732
------------ ------------ ------------
Total deposits 205,027,329 193,663,015 187,060,830
Other borrowings 650,000 0
Accrued interest payable and other liabilities 4,509,919 3,903,287 3,756,149
------------ ------------ ------------
Total liabilities 210,187,248 197,566,302 190,816,979
SHAREHOLDERS' EQUITY
Common stock, no par value; 10,000,000 shares authorized; 2,204,949 shares at
September 30, 2005, 2,142,104 shares at December 31, 2004 and 2,142,104
shares at September 30, 2004 issued & outstanding 16,230,507 15,528,940 15,497,836
Retained earnings 6,494,016 5,295,732 4,470,003
Accumulated other comprehensive loss (285,080) (143,512) (83,076)
------------ ------------ ------------
Total shareholders' equity 22,439,443 20,681,160 19,884,763
------------ ------------ ------------
Total liabilities and shareholders' equity $232,626,691 $218,247,462 $210,701,742
============ ============ ============
Page 3
SONOMA VALLEY BANCORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
For the Three Months For the Nine Months
Ended September 30, Ended September 30,
2005 2004 2005 2004
------------ ------------ ------------ ------------
INTEREST INCOME
Loans and leases $ 3,060,940 $ 2,600,528 $ 8,727,198 $ 7,232,583
Taxable securities 277,861 199,716 782,668 626,080
Tax-exempt securities 155,884 167,272 472,752 493,306
Federal funds sold 332 12,663 45,792 77,231
Dividends 8,609 8,093 23,129 13,849
------------ ------------ ------------ ------------
Total interest income 3,503,626 2,988,272 10,051,539 8,443,049
INTEREST EXPENSE
Interest-bearing transaction deposits 14,183 13,397 42,999 37,354
Savings and money market deposits 231,021 109,155 586,123 312,162
Time deposits, $100,000 and over 221,459 164,582 600,855 498,011
Other time deposits 151,829 97,424 387,368 296,439
Other borrowings 20,019 0 81,821 0
------------ ------------ ------------ -----------
Total interest expense 638,511 384,558 1,699,166 1,143,966
------------ ------------ ------------ ------------
NET INTEREST INCOME 2,865,115 2,603,714 8,352,373 7,299,083
Provision for loan and lease losses 95,000 40,000 345,000 70,000
------------ ------------ ------------ -----------
NET INTEREST INCOME
AFTER PROVISION FOR
LOAN AND LEASE
LOSSES 2,770,115 2,563,714 8,007,373 7,229,083
NON-INTEREST INCOME 497,931 452,131 1,443,620 1,264,243
NON-INTEREST EXPENSE
Salaries and employee benefits 1,120,639 1,102,331 3,346,883 3,113,135
Premises and equipment 268,641 230,840 745,665 662,949
Other 578,003 533,372 1,792,276 1,629,757
------------ ------------ ------------- ------------
Total non-interest expense 1,967,283 1,866,543 5,884,824 5,405,841
------------ ------------ ------------- ------------
Income before provision
for income taxes 1,300,763 1,149,302 3,566,169 3,087,485
Provision for income taxes 453,212 404,574 1,217,381 1,005,594
------------ ------------ ------------- ------------
NET INCOME $ 847,551 $ 744,728 $ 2,348,788 $ 2,081,891
============ ============ ============ ============
NET INCOME PER SHARE $ .39 $ .35 $ 1.09 $ .97
============ ============ ============ ============
NET INCOME PER SHARE-
ASSUMING DILUTION $ .37 $ .32 $ 1.02 $ .89
============ ============ ============ ============
Page 4
SONOMA VALLEY BANCORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
For the nine months ended September 30, 2005
(Unaudited), and the years ended December 31, 2004
(Audited) and 2003 (Audited)
Accumulated
Other
Comprehensive Common Stock Retained Comprehensive
Income Shares Amount Earnings Income Total
------------- --------- ------------- -------------- ----------------- --------------
BALANCE AT
JANUARY 1, 2003 1,401,146 $ 12,936,225 $ 6,215,790 $ 88,295 $ 19,240,310
5% stock dividend 68,665 1,997,422 (1,997,422)
Fractional shares (14,193) (14,193)
Redemption and retirement
of stock (38,987) (361,296) (729,099) (1,090,395)
Stock options exercised and
related tax benefits 26,770 489,285 489,285
Net income for the year $ 2,911,007 2,911,007 2,911,007
Other comprehensive loss,
net of tax:
Unrealized holding losses
on securities available-
for-sale arising during
the year, net of taxes
of $45,274 (64,735)
-------------
Other comprehensive loss,
net of taxes (64,735) (64,735) (64,735)
------------- --------- ------------- -------------- ----------------- --------------
Total comprehensive income $ 2,846,272
=============
BALANCE AT
DECEMBER 31, 2003 1,457,594 15,061,636 6,386,083 23,560 21,471,279
Redemption and retirement
of stock (601) (6,218) (11,839) (18,057)
Stock options exercised and
related tax benefits 97,494 1,786,065 1,786,065
Redemption of stock
under tender offer (126,208) (1,416,223) (3,071,903) (4,488,126)
Cash dividend (906,732) (906,732)
Stock options granted 103,680 103,680
3 for 2 stock split 713,825
Fractional shares (7,498) (7,498)
Net income for the year $ 2,907,621 2,907,621 2,907,621
Other comprehensive loss,
net of tax:
Unrealized holding losses
on securities available-
for-sale arising during
the year, net of taxes
of $116,844 (167,072)
-------------
Other comprehensive loss,
net of taxes (167,072) (167,072) (167,072)
------------- --------- ------------- -------------- ----------------- --------------
Total comprehensive income $ 2,740,549
=============
Page 5
SONOMA VALLEY BANCORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
For the nine months ended September30, 2005
(Unaudited), and the years ended December 31, 2004
(Audited) and 2003 (Audited)
Accumulated
Other
Comprehensive Common Stock Retained Comprehensive
Income Shares Amount Earnings Income Total
----------------- --------- ------------ ------------- ------------- ------------
BALANCE AT
DECEMBER 31, 2004 2,142,104 $ 15,528,940 $ 5,295,732 $ (143,512) $ 20,681,160
Redemption and retirement
of stock (5,616) (41,165) (72,503) (113,668)
Cash dividends (1,078,001) (1,078,001)
Stock options granted 77,760 77,760
Stock options exercised and
related tax benefits 68,461 664,972 664,972
Net income for the period $ 2,348,788 2,348,788 2,348,788
Other comprehensive loss,
net of tax:
Unrealized holding losses
on securities available-
for-sale arising during
the year, net of taxes
of $ 99,007 (141,568)
-----------------
Other comprehensive loss,
net of taxes (141,568) (141,568) (141,568)
----------------- --------- ------------ ------------- ------------- ------------
Total comprehensive income $ 2,207,220
=================
BALANCE AT
September 30, 2005 2,204,949 $ 16,230,507 $ 6,494,016 $ (285,080) $ 22,439,443
========= ============ ============= ============= ============
Page 6
SONOMA VALLEY BANCORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
For the nine months ended September 30, 2005 and 2004
2005 2004
----------- -----------
OPERATING ACTIVITIES
Net income $ 2,348,788 $ 2,081,891
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses 345,000 70,000
Depreciation 230,659 227,462
Gain on sale of premise and equipment 0 (366)
Gain on sale of securities (5,094) 0
Amortization and other 124,933 105,667
Stock options granted 77,760 72,576
Net change in interest receivable (155,688) (252,107)
Net change in cash surrender value of life insurance (234,132) (1,121,299)
Net change in other assets (417,964) (94,540)
Net change in interest payable and other liabilities 606,632 235,907
----------- -----------
NET CASH PROVIDED BY OPERATING ACTIVITIES 2,920,894 1,325,191
INVESTING ACTIVITIES
Purchases of securities held-to-maturity (399,570) (2,519,972)
Purchases of securities available-for sale (15,014,860) (8,154,336)
Proceeds from maturing securities held-to-maturity 959,500 1,201,900
Proceeds from maturing securities available-for sale 0 4,550,000
Net change in loans (8,957,150) (24,773,318)
Purchases of premises and equipment (116,305) (282,789)
----------- -----------
NET CASH USED FOR INVESTING ACTIVITIES (23,528,385) (29,978,515)
FINANCING ACTIVITIES
Net change in demand, interest-bearing transaction and savings deposits 6,620,020 7,896,538
Net change in time deposits 4,744,294 (950,324)
Cash dividend paid (1,078,001) (906,732)
Net change in FHLB borrowings 650,000 0
Exercise of stock options 664,972 1,786,065
Stock repurchases (113,668) (4,506,183)
Fractional shares purchased 0 (7,497)
----------- -----------
NET CASH PROVIDED BY FINANCING ACTIVITIES 11,487,617 3,311,867
----------- -----------
NET CHANGE IN CASH AND CASH EQUIVALENTS (9,119,874) (25,341,457)
Cash and cash equivalents at beginning of period 15,347,220 35,354,202
----------- -----------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 6,227,346 $10,012,745
=========== ===========
SUPPLEMENTAL DISCLOSURES:
Cash paid during the period for:
Interest $ 1,678,070 $ 1,145,990
Income taxes 1,273,047 115,000
Change in unrealized gains and losses
on securities available-for-sale (240,575) (181,212)
Change in deferred income taxes on
unrealized holding gains and losses on securities 99,007 74,577
Page 7
SONOMA VALLEY BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2005
(Unaudited)
Note 1 - Basis of Presentation
In the opinion of Management, the unaudited interim consolidated financial
statements contain all adjustments of a normal recurring nature, which are
necessary to present fairly the financial condition of Sonoma Valley Bancorp
(the "Company") and Subsidiary at September 30, 2005 and results of operations
for the three and nine months then ended.
Certain information and footnote disclosures presented in the Company's annual
financial statements are not included in these interim financial statements.
Accordingly, the accompanying unaudited interim consolidated financial
statements should be read in conjunction with the consolidated financial
statements and notes thereto included in the Company's 2004 Annual Report on
Form 10- K. The results of operations for the three and nine months ended
September 30, 2005 are not necessarily indicative of the operating results
through December 31, 2005.
Note 2 - Consolidation
The consolidated financial statements include the accounts of Sonoma Valley
Bancorp and its wholly owned subsidiary Sonoma Valley Bank. All material
intercompany accounts and transactions have been eliminated in consolidation.
Note 3 - Commitments
The Company has no outstanding performance letters of credit at September 30,
2005 and September 30, 2004.
Note 4 - Net Income Per Common Share
Net income per share is calculated by using the weighted average common shares
outstanding. The weighted average number of common shares used in computing the
net income per common share for the period ending September 30, 2005 was
2,159,380 and for the period ending September 30, 2004 was 2,155,646.
Net income per share (diluted) is calculated by using the weighted average
common shares (diluted) outstanding. The weighted average number of common
shares (diluted) used in computing the net income per common share (diluted) for
the period ending September 30, 2005 was 2,299,258 and for the period ending
September 30, 2004 was 2,343,047.
Page 8
Note 5 - Stock Option Accounting
The Company has a stock-based employee and director compensation plan. Prior to
January 1, 2003, the Company accounted for this plan under the recognition and
measurement principles of APB Opinion No. 25, Accounting for Stock Issued to
Employees, and related Interpretations. No stock- based compensation cost is
reflected in net income for stock options granted prior to January 1, 2003, as
all options granted under those plans had an exercise price equal to the market
value of the underlying common stock on the date of grant. Effective January 1,
2003, the Company adopted the fair value recognition provisions of SFAS No. 123,
Accounting for Stock-Based Compensation, prospectively to all employee awards
granted, modified, or settled after January 1, 2003. No options were granted in
2003. Awards under the Company's plan vest over five years. The cost related to
stock-based employee compensation included in the determination of net income is
less than that which would have been recognized if the fair value based method
had been applied to all awards since the original effective date SFAS No. 123.
The following table illustrates the effect on net income and earnings per share
if the fair value based method had been applied to all outstanding and unvested
awards in each period.
For the Three Months For the Nine Months
Ended September 30 Ended September 30
2005 2004 2005 2004
------------ ------------ ----------- -----------
Net Income, as reported $ 847,551 $ 744,728 $ 2,348,788 $ 2,081,891
Deduct: Total stock-based
compensation expense determined
under fair value based method for all
awards, net of related tax effects (46,253) (138,759)
------------ ------------- ----------- -----------
Pro forma net income $ 847,551 $ 698,475 $ 2,348,788 $ 1,943,132
============ ============ =========== ===========
Net income per share:
Basic - As reported $ .39 $ .35 $ 1.09 $ .97
============ ============ =========== ===========
Basic - Pro forma $ .39 $ .32 $ 1.09 $ .90
============ ============ =========== ===========
Diluted - As reported $ .37 $ .32 $ 1.02 $ .89
============ ============ =========== ===========
Diluted - Pro forma $ .37 $ .30 $ 1.02 $ .83
============ ============ =========== ===========
Page 9
Note 6 - Employee Benefit Plans
The Bancorp provides retirement plans to its key officers and directors. The
plans are unfunded and provide for the Bancorp to pay the officers and directors
specified amounts for specified periods after retirement. The amount of pension
expense related to this plan, and the components of pension expense for the nine
months ended September 30, 2005 and 2004 are as follows:
Directors Officers
--------------------------- ---------------------------
2005 2004 2005 2004
----------- ----------- ----------- -----------
Service cost $ 27,273 $ 47,407 $ 86,432 $ 138,276
Interest cost on projected benefit 31,832 16,363 57,673 51,853
Amortization of unrecognized liability
at transition (7,126) 11,348 (22,644)
----------- ----------- ----------- -----------
Net periodic pension cost recognized $ 51,979 $ 63,770 $ 155,453 $ 167,485
=========== =========== =========== ===========
Page 10
SONOMA VALLEY BANCORP
AVERAGE BALANCES/YIELDS AND RATES PAID
For the nine months ended September 30, 2005 and 2004
2005 2004
---- ----
Average Income/ Yield/ Average Income/ Yield/
ASSETS Balance Expense Rate Balance Expense Rate
------------- ------------ ----- ------------- ------------ ------
Interest-earning assets:
Loans(2):
Commercial $ 107,098,464 $ 5,968,483 7.45% $ 95,539,374 $ 5,089,093 7.12%
Consumer 18,654,492 981,252 7.03% 13,667,086 680,820 6.65%
Real estate construction 20,648,462 1,166,398 7.55% 18,756,143 1,084,908 7.73%
Real estate mortgage 9,688,980 499,248 6.89% 4,438,653 245,014 7.37%
Tax exempt loans (1) 2,669,420 165,242 8.28% 3,055,176 191,748 8.38%
Leases 40,268 2,758 9.16% 32,775 6,195 25.25%
Tax exempt leases (1) 0 0 0.00% 1,160 0 0.00%
Unearned loan fees (477,560) (447,186)
------------- ------------ ------------- ------------
Total loans 158,322,526 8,783,381 7.42% 135,043,181 7,297,778 7.22%
Investment securities
Available for sale:
Taxable 33,163,279 774,306 3.12% 23,626,348 614,145 3.47%
Tax exempt(1) 0 0 0.00% 0 0 0.00%
Hold to maturity:
Taxable 373,045 7,652 2.74% 393,102 7,598 2.58%
Tax exempt (1) 16,697,603 716,292 5.74% 17,154,985 747,433 5.82%
------------- ------------ ------------- ------------
Total investment securities 50,233,927 1,498,250 3.99% 41,174,435 1,369,176 4.44%
Federal funds sold 2,589,245 45,791 2.36% 10,639,836 77,231 0.97%
Federal Home Loan Bank stock 796,622 23,129 3.88% 564,053 13,849 3.28%
Total due from banks/Interest-bearing 55,637 710 1.71% 193,904 4,337 2.99%
------------- ------------ ------------- ------------
Total interest-earning assets 211,997,957 $ 10,351,261 6.53% 187,615,409 $ 8,762,371 6.24%
============ ============
Noninterest-bearing assets:
Reserve for loan losses (2,634,249) (2,444,198)
Cash and due from banks 6,680,842 9,651,736
Premises and equipment 1,302,903 1,363,995
Other assets 12,673,007 12,038,029
------------- -------------
Total assets $ 230,020,460 $ 208,224,971
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Interest-bearing liabilities:
Interest-bearing deposits
Interest-bearing transaction 33,959,362 $ 42,999 0.17% $ 32,923,799 $ 37,355 0.15%
Savings deposits 74,005,285 586,122 1.06% 66,393,976 312,161 0.63%
Time deposits over $100,000 26,812,131 600,855 3.00% 25,446,133 498,011 2.61%
Other time deposits 19,829,702 387,368 2.61% 18,750,433 296,439 2.11%
------------- ------------ ------------- ------------
Total interest-bearing deposits 154,606,480 1,617,344 1.40% 143,514,341 1,143,966 1.06%
Federal Funds purchased 0 0 0.00% 0 0 0.00%
Other short term borrowings 3,479,004 81,822 3.14% 0 0 0.00%
------------- ------------ ------------- ------------ -----
Total interest-bearing liabilities 158,085,484 $ 1,699,166 1.44% 143,514,341 $ 1,143,966 1.06%
============ ============
Non interest-bearing liabilities:
Non interest-bearing demand deposits 46,256,797 40,293,157
Other liabilities 4,107,577 3,467,560
Shareholders' equity 21,570,602 20,949,913
------------- -------------
Total liabilities and shareholders' equity $ 230,020,460 $ 208,224,971
============= =============
Interest rate spread 5.13% 5.18%
==== =====
Interest income $ 10,351,260 6.53% $ 8,762,371 6.24%
Interest expense 1,699,166 1.07% 1,143,966 0.81%
------------ ---- ------------ ------
Net interest income/margin $ 8,652,094 5.46% $ 7,618,405 5.43%
============ ==== ============ ======
(1) Fully tax equivalent adjustments are based on a federal income tax rate of
34% in 2005 and 2004
(2) Non accrual loans have been included in loans for the purposes of the above
presentation. Loan fees of $259,262 and $224,508 for the nine months ended
September 30, 2005 and September 30, 2004, respectively, were amortized to
the appropriate interest income categories.
Page 11
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Forward Looking Statements
With the exception of historical facts stated herein, the matters discussed in
this Form 10-Q are "forward looking" statements that involve risks and
uncertainties that could cause actual results to differ materially from
projected results. Such "forward looking" statements include, but are not
necessarily limited to statements regarding anticipated levels of future
revenues and earnings from the operation of Sonoma Valley Bancorp's (the
"Company") wholly owned subsidiary, Sonoma Valley Bank (the "Bank"), projected
costs and expenses related to operations of the bank's liquidity, capital
resources, and the availability of future equity capital on commercially
reasonable terms. Factors that could cause actual results to differ materially
include, in addition to the other factors discussed in Sonoma Valley Bancorp's
Form 10-K for the year ended December 31, 2004, and subsequent periodic reports,
the following; (i) increased competition from other banks, savings and loan
associations, thrift and loan associations, finance companies, credit unions,
offerors of money market funds, and other financial institutions; (ii) the risks
and uncertainties relating to general economic and political conditions, both
domestically and internationally, including, but not limited to, inflation, or
natural disasters affecting the primary service area of the Bank or its major
industries; or (iii) changes in the laws and regulations governing the Bank's
activities at either the state or federal level. Readers of this Form 10-Q are
cautioned not to put undue reliance on "forward looking" statements which, by
their nature, are uncertain as reliable indicators of future performance. Sonoma
Valley Bancorp disclaims any obligation to publicly update these "forward
looking" statements, whether as a result of new information, future events, or
otherwise.
For the Nine Month Periods
Ended September 30, 2005 and 2004
Overview
The Company reported net income of $2,348,788 as of September 30, 2005 an
increase of $266,897 from $2,081,891 reported as of September 30, 2004. The
increase in net income is in part a result of loan growth of 10.4% compared to
the comparable period of 2004. This increase in loans contributed to the strong
earnings growth. Deposits have grown 9.6% in the same period, but due to
pressure to increase deposit rates this has reduced somewhat the benefit of the
growth in interest income. The Banco de Sonoma Office, although still showing a
year to date loss of $81,744 is on track to show profitability sooner than
anticipated. On a per share basis, net income equaled $1.09 compared with $.97
per share during the same period in 2004.
Return on average total assets on an annualized basis for the nine-month period
was 1.37% in 2005 and 1.34% in 2004. Return on average shareholders' equity on
an annualized basis for the same periods was 14.56% and 13.27%, respectively.
The higher return on equity is the result of the growth in income for the nine
month period of 2005 offset by the $621,000 increase in average equity from
$21.0 million in 2004 to $21.6 million in 2005.
Page 12
The Company continues to experience loan and deposit growth at the Banco de
Sonoma Office from $6.2 million in deposits and $653,462 in loans as of December
31, 2004 to $11.2 million in deposits and $1.8 million in loans as of September
30, 2005. For the first three or four years the costs associated with opening a
new office will have a negative effect on the Company's Consolidated Income
Statement. For the year 2005, it was anticipated that the additional expense
will approximate $200,000, but the branch seems to be progressing better than
anticipated, showing a loss of $81,744 as of September 30, 2005. The Bank's
branch is offering services to the Latino community in our market place.
Management identified this as a niche market which was underserved and an
opportunity for potential future growth and profitability. Most of the employees
at the branch are bilingual and the Bank offers full service banking. An
additional product which has been added is the ability for customers to effect
an immediate transfer of funds to Mexico. Management anticipates that the growth
in the branch will be slow and steady and profitable within three or four years.
Total shareholders' equity increased by $1.8 million or 8.5% for the nine months
ended September 30, 2005. At September 30, 2005, the Company reported net income
of $2.3 million. In March the Company paid out $537,842 for cash dividends
declared in February, 2005 and in August the Company paid out $540,159 for cash
dividends declared in July, 2005. In 2004 stock options were granted to senior
employees with a fifth of the options vesting each year over a five year period.
In 2005, 13,500 options vested which increased equity by $77,760 year to date.
The net income figure of $2.3 million also reflects an expense for the stock
options of $77,760, therefore the net effect of the stock option transaction
relative to equity was zero. Directors exercised 68,461 options which added
$532,635 to the capital accounts. The tax benefit of these options was $132,337,
which also increased equity. In September, 2005, the Company repurchased 5,616
shares which lowered equity by $113,668. The net effect of this activity was
capital of $22,439,443 as of September 30, 2005, compared to capital of
$20,681,160 as of December 31, 2004. See page 6 for detail of "Changes in
Shareholder Equity."
Section 404 of the Sarbanes-Oxley Act of 2002 requires the SEC to prescribe
rules requiring the establishment, maintenance and evaluation of an issuer's
internal control of financial reporting. Accordingly, in the annual report for
December 31, 2006, management was going to be required to include an assessment
on the effectiveness of the Company's internal controls over financial reporting
in accordance with standards set by the Public Company Accounting Oversight
Board. On September 21, 2005, the Securities and Exchange Commission (SEC)
extended for another year the deadline for non-accelerated filers to first
certify compliance with Section 404. This means that the Company will not have
to certify compliance until December 31, 2007, unless the Company's market cap
exceeds $75 million at June 30, 2006. The Company's external independent
auditors are required to attest to and report on management's assessment of
internal control over financial reporting. The Company's management and staff
are working diligently toward evaluating and documenting the internal control
systems in order to allow management to report on, and the Company's independent
auditors to attest to, the Company's internal control over financial reporting.
The Company has retained the services of a consulting firm to assist management
and staff with this process and to address any material weaknesses and plan
accordingly to maintain adequate processes. Even so, there can be no assurances
that the evaluation required by Sarbanes-Oxley will not result in the
identification of significant control deficiencies or that the Company's
auditors will be able to attest to the effectiveness of our internal controls
over financial reporting.
Page 13
RESULTS OF OPERATIONS
Net interest Income
Net interest income is the difference between total interest income and total
interest expense. Net interest income, adjusted to a fully taxable equivalent
basis, as shown on the table- Average Balance, Yields and Rates Paid, on page
11, is higher than net interest income on the statement of income because it
reflects adjustments applicable to tax-exempt income from certain securities and
loans ($300,000 in 2005 and $319,000 in 2004, based on a 34% federal income tax
rate).
The improvement in net interest income for the nine months ended September 30,
2005 (stated on a fully taxable equivalent basis) is a result of the net effect
of a $1.6 million increase in interest income offset by an increase in interest
expense of $555,000, the net effect being an increase of $1.0 million. The
increase in interest income is a result of the growth in the loan portfolio and
the 200 basis point increase in the prime lending rate since September, 2004.
Net interest income (stated on a fully taxable equivalent basis) expressed as a
percentage of average earning assets, is referred to as net interest margin. The
Company's net interest margin for 2005 increased to 5.46% from 5.43% for the
same period in 2004. The increase in the net interest margin is the result of
the 200 basis point increase in the prime lending rate, growth in loan volume
and the transition of assets from fed funds sold to loan products.
Interest Income
As previously stated, interest income (stated on a fully taxable equivalent
basis) increased by $1.6 million to $10.4 million in the nine months of 2005, an
18.1% increase over the $8.8 million realized during the same period in 2004.
The $1.6 million increase in interest income was the result of a $1.4 million
increase due to the growth in volume of average balances, together with a
$183,000 increase in income related to higher interest rates paid. The yield on
earning assets was 6.53% as of September, 2005 compared to 6.24% as of the same
period in 2004, a 29 basis point increase. The increase is primarily the result
of the $15.2 million or 10.4% growth in loans from $146.9 million as of
September, 2004 to $162.1 million in 2005.
Interest Expense
Total interest expense increased by $.6 million to $1.7 million for the 2005
period ending September compared to $1.1 million during the same period of 2004.
The average rate paid on all interest-bearing liabilities increased from 1.06%
in 2004 to 1.44% in 2005, a 38 basis point increase. Average balances increased
from $143.5 million to $158.1 million, a 10.2% gain in earning liabilities. Of
the increase in average interest bearing liabilities, $3.5 million was
borrowings at the Federal Home Loan Bank. The Company continues to experience
stronger loan growth than deposit growth, so the Company determined it is more
cost effective to satisfy its liquidity needs by borrowing at the Federal Home
Loan Bank.
The gain in volume of average balances was responsible for a $81,000 increase in
interest expense and the higher rates paid were responsible for a $474,000
increase in interest expense resulting in higher interest expense of $555,000.
Page 14
Individual components of interest income and interest expense are provided in
the table-Average Balances, Yields and Rates Paid on page 11.
Provision for Loan Losses
The provision for loan losses charged to operations as of September 30, 2005 was
$345,000 compared to $70,000 for the same period of 2004. The provision for loan
losses charged to operations is based on the Company's monthly evaluation of the
loan portfolio and the adequacy of the allowance for loan losses in relation to
total loans outstanding. The Company has experienced strong loan growth during
the first nine months of 2005. Management anticipates that loan growth will slow
somewhat allowing a lower charge to the provision for loan losses. There has
been a regulatory focus on concentrations of commercial real estate loans among
many financial institutions. The Company does have a concentration of commercial
real estate loans and although they are adequately collateralized, management
accounted for these loans in determining the adequacy of the provision. The
provision for loan losses at year end 2004 was $130,000.
The non-accrual portfolio was less than 1% of total loans during both the nine
months of 2005 and 2004. Non accrual loans were down 7.2% or $77,000 from the
level of non-accrual loans as of September, 2004. Loans charged-off were $37,000
and recoveries were $51,000 for the nine months of 2005 compared with $336,000
in charge-offs and $13,000 in recoveries for the same period in 2004. See page
19 for an analysis in the changes in allowance for loan losses including charge
offs and recoveries.
Non-interest Income
Non-interest income of $1.4 million increased 14.2% from the $1.3 million
recorded in the comparable period in 2004. Service charges on deposit accounts
increased $141,000 to $937,000 for the nine months of 2005 from $796,000 for the
same period of 2004, an increase of 17.7%. Other fee income grew 15.8% or
$35,000 from $222,000 in 2004 to $257,000 in 2005. Credit card merchant
processing fees were largely attributable for the increase.
Non-interest Expense
Total non-interest expense increased 8.9% to $5.9 million during the nine months
of 2005 from $5.4 million for the same period in 2004. Non-interest expense on
an annualized basis represented 3.42% of average total assets in 2005 compared
with 3.47% for the comparable period of 2004. The decline in the 2005 expense
ratio reflects managements' efforts to control expenses in 2005.
The expenses for salaries and benefits increased 7.5% from $3.1 million in 2004
to $3.4 million in 2005. The $234,000 increase in 2005 is largely the result of
normal merit and incentive increases and increases in employee benefits. At
September 30, 2005, total full time equivalent employees were 49 compared to 56
in 2004.
Expense related to premises and equipment increased 12.5% to $746,000 in 2005
from $663,000 in 2004. The $83,000 increase in expense in 2005 is a result of
additional lease expense for the new Finance Center and remodeling expense
required to make it serviceable, increased expenses related to maintenance and
repairs both for buildings and fixed assets, increases in property tax
Page 15
and increases in utility costs. The bank continues to emphasize security in its
computer operations. Equipment and software are monitored and upgraded as
appropriate to ensure confidentiality of customer and company data contributing
to additional increases in expense. The company continues to emphasize the
utilization of technology to accommodate customer and market demands.
Other operating expenses increased by 10.0% in 2005 to $1.8 million from $1.6
million in 2004. All categories of other operating expense remained level or
declined from the prior year except for professional fees and operational losses
and outages, which increased by 22.1% or $194,000 and 176.2% or $22,000,
respectively. The growth in professional fees is predominately the result of
additional accruals for expenses associated with the implementation of
Sarbanes-Oxley, Rule 404, regarding internal controls over financial reporting.
The delay in implementation could mitigate or spread out the ongoing expenses
relative to this process.
The increase in operational losses and outages is the result of losses
associated with check forgeries. The Company has a positive track record
relative to operational losses and has implemented additional training and
controls in an attempt to mitigate future losses.
Provision for Income Taxes
The provision for income taxes increased to an effective tax rate of 34.1% for
the nine months of 2005 compared with 32.6% for the nine months of 2004. The
higher effective tax rate is a reflection of the increase in taxable income when
compared with income derived from tax exempt investments. Income taxes reported
in the financial statements include deferred taxes resulting from timing
differences in the recognition of items for tax and financial reporting
purposes.
BALANCE SHEET ANALYSIS
Investments
Investment securities were $51.8 million at September 30, 2005, a 37.4% increase
from the $37.7 million at December 31, 2004 and a 25.3% increase from $41.3
million at September 30, 2004. The significant increase in the portfolio is
management's attempt to generate higher earnings by moving funds from Fed Funds
Sold to higher yielding investments. The Company purchases securities rated A or
higher by Standard and Poor's and or Moody's Investors Service. In the event a
security is downgraded, the Company will monitor the investment more closely or
sell if appropriate. Local tax-exempt bonds are occasionally purchased without
an A rating.
Securities are classified as held to maturity (HTM), if the Company has both the
intent and the ability to hold these securities to maturity. As of September 30,
2005, the Company had securities totaling $16.8 million with a market value of
$17.1 million categorized as held to maturity. Decisions to acquire municipal
securities, which are generally placed in this category, are based on tax
planning needs, pledge requirements and earnings.
Securities are classified as available for sale (AFS) if the Company intends to
hold these debt securities for an indefinite period of time, but not necessarily
to maturity. Investment securities which are categorized as available for sale
are acquired as part of the overall asset and liability management function and
serve as a primary source of liquidity. Decisions to acquire or dispose of
different investments are based on an assessment of various economic and
financial factors,
Page 16
including, but not limited to, interest rate risk, liquidity and capital
adequacy. Securities held in the available for sale category are recorded at
market value, which is $35.0 million compared to an amortized cost of $35.5
million as of September 30, 2005.
There were thirty Federal Farm Credit Bank, Federal Home Loan Bank, Federal Home
Loan Mortgage Corporation or Federal National Mortgage Association securities
with a fair value of $29.6 million and six U.S. Treasury securities of $5.4
million in the AFS portfolio and twenty two municipal securities with a fair
market value of $7.4 million in the HTM portfolio that are temporarily impaired
as of September 30, 2005. Of the above, there were nineteen Federal Farm Credit
Bank, Federal Home Loan Bank, Federal Home Loan Mortgage Corporation or Federal
National Mortgage Association securities of $16.6 million in the AFS portfolio
and seven municipal securities of $2.4 million in the HTM portfolio that have
been in a continuous loss position for 12 months or more as of September 30,
2005. The primary cause of the impairment of these securities is interest rate
volatility inherent in a rising rate environment which causes the market value
of the security to decline. Management understood the potential market risks at
the time of acquisition and determined that the benefit to the Company of the
higher interest rates received more than offset the potential deterioration in
value. It is the Company's intent to carry the securities to maturity date, at
which time the Company will receive face value for the securities at no loss.
Although the quoted market values fluctuate, investment securities are generally
held to maturity, and accordingly, gains and losses are recognized in the
accounts upon sale, or at such time as management determines that a permanent
decline in value exists. In the opinion of management, there was no investment
in securities at September 30, 2005 that constituted a material credit risk to
the Company. The lower market value to amortized costs was a result of the
increase in market interest rates and not an indication of lower credit quality.
Loans
The Company's loan portfolio was $162.1 million at September 30, 2005, or 79.1%
of total deposits. This compares with $153.2 million, or 79.1% of total
deposits, at December 31, 2004 and $146.9 million, or 78.5% of total deposits,
at September 30, 2004. A comparative schedule of average loan balances is
presented in the table on page 11; period-end and year-end balances are
presented in the following table.
September 30, Percentage December 31, Percentage September 30, Percentage
2005 of Total 2004 of Total 2004 of Total
------------ ---------- ------------ ---------- ------------ ----------
Commercial $114,451,600 70.4% $109,324,569 71.2% $107,850,150 73.1%
Consumer 19,670,435 12.1% 16,249,913 10.6% 15,147,103 10.3%
Real estate construction 15,279,749 9.4% 20,291,506 13.2% 17,483,054 11.9%
Real estate mortgage 13,148,765 8.1% 7,732,177 5.0% 6,857,318 4.7%
Leases 31,296 0.0% 47,717 0.0% 20,714 0.0%
------------ ----- ------------ ----- ------------ -----
162,581,845 100.0% 153,645,882 100.0% 147,358,339 100.0%
===== ===== =====
Deferred loan fees
and costs, net (450,329) (485,223) (439,618)
Allowance for loan
and lease losses (2,787,279) (2,428,572) (2,381,415)
------------ ------------ ------------
$159,344,237 $150,732,087 $144,537,306
============ ============ ============
Page 17
Risk Elements
The majority of the Company's loan activity is with customers located within
Sonoma County. Approximately 88.6% of the total loan portfolio is secured by
real estate located in the Company's service area. Significant concentrations of
credit risk may exist if a number of loan customers are engaged in similar
activities and have similar economic characteristics. The Company believes it
has policies in place to identify problem loans and to monitor concentrations of
credits.
Non Performing Assets
Management classifies all loans as non-accrual loans when they become more than
90 days past due as to principal or interest, or when the timely collection of
interest or principal becomes uncertain, if earlier, unless they are adequately
secured and in the process of collection.
A loan remains in a non-accrual status until both principal and interest have
been current for six months and meets cash flow or collateral criteria or when
the loan is determined to be uncollectible and is charged off against the
allowance for loan losses, or, in the case of real estate loans, is transferred
to other real estate owned. A loan is classified as a restructured loan when the
interest rate is materially reduced, when the term is extended beyond the
original maturity date or other concessions are made by the Company because of
the inability of the borrower to repay the loan under the original terms. As of
September 30, 2005 there were $835,000 in restructured loans.
There were $1.0 million of non-accrual loans and no loans 90 days or more past
due and still accruing at September 30, 2005. There were $1.1 million of
non-accrual loans and no loans 90 days or more past due and still accruing at
September 30, 2004. The decline in non- accrual loans is management's attempt to
recognize and handle problems early.
Allowance for Loan Losses
The allowance for loan losses is maintained at a level considered adequate to
provide for losses that can be reasonably anticipated. The allowance is
increased by provisions charged to operating expense and reduced by charge-offs,
net of recoveries. The allowance is based on estimates, and ultimate losses may
vary from the current estimates. These estimates are reviewed monthly and, as
adjustments become necessary, they are reported in earnings in the periods in
which they become known.
The review process is intended to identify loan customers who may be
experiencing financial difficulties. In these circumstances, a specific reserve
allocation or charge-off may be recommended. Other factors considered by
management in evaluating the adequacy of the allowance include: loan volume,
historical net loan loss experience, the condition of industries and geographic
areas experiencing or expected to experience economic adversities, credit
evaluations and current economic conditions. The allowance for loan losses is
not a precise amount, but based on the factors above, represents management's
best estimate of losses that may be ultimately realized from the current loan
portfolio.
Page 18
Worsening conditions in certain economic sectors and geographic areas could
adversely affect the loan portfolio, necessitating larger provisions for loan
losses than currently estimated. Based on its risk management review and a
review of its loan portfolio, management believes that its allowance for losses
for the quarter ending September 30, 2005, is sufficient to absorb losses
inherent in the loan portfolio. This assessment is based upon the best available
information and does involve uncertainty and matters of judgment. Accordingly,
the adequacy of the loan loss reserve cannot be determined with precision and
could be susceptible to significant change in future periods.
At September 30, 2005, the allowance for loan losses was $2.8 million, or 1.72%
of period-end loans, compared with $2.4 million, or 1.59% at December 31, 2004
and $2.4 million, or 1.62% at September 30, 2004.
An analysis of the changes in the allowance for loan losses, including
charge-offs and recoveries by loan categories, is presented below.
For the Nine For the Year For the Nine
Months Ended Ended Months Ended
9/30/05 12/31/04 9/30/04
Balance beginning of year $ 2,428,572 $ 2,634,625 $ 2,634,625
Charge-offs:
Commercial (20,198) (290,000) (290,000)
Consumer (16,738) (63,007) (46,369)
--------------- --------------- ---------------
Total charge-offs (36,936) (353,007) (336,369)
Recoveries:
Commercial 50,543 15,416 11,621
Consumer 100 1,538 1,538
--------------- --------------- ---------------
Total recoveries 50,643 16,954 13,159
Net (chargeoffs) recoveries 13,707 (336,053) (323,210)
Provision charged to operations 345,000 130,000 70,000
--------------- --------------- ---------------
Balance end of period $ 2,787,279 $ 2,428,572 $ 2,381,415
=============== =============== ===============
Ratio of net charge-offs (recoveries)
annualized to average loans -0.01% 0.24% 0.32%
Balance in allowance as a percentage 1.72% 1.59% 1.62%
of loans outstanding at period end
Page 19
Deposits
A comparative schedule of average deposit balances is presented in the table on
page 11; period end and year-end deposit balances are presented in the following
table.
September 30, Percentage December 31, Percentage September 30, Percentage
2005 of Total 2004 of Total 2004 of Total
------------ ------------ ------------ ---------- ------------ ----------
Interest-bearing
transaction deposits $ 34,139,432 16.7% $34,912,205 18.0% $31,214,138 16.6%
Savings deposits 73,459,066 35.8% 70,254,926 36.3% 65,398,770 35.0%
Time deposits,
$100,000
and over 26,890,840 13.1% 25,307,661 13.1% 26,505,608 14.2%
Other time deposits 21,791,961 10.6% 18,630,846 9.6% 18,562,732 9.9%
------------ ------ ------------ ----- ------------ ----
Total interest bearing
deposits 156,281,299 76.2% 149,105,638 77.0% 141,681,248 75.7%
Demand deposits 48,746,030 23.8% 45,557,377 23.0% 45,379,582 24.3%
------------ ------ ------------ ----- ------------ -----
Total deposits $205,027,329 100.0% $193,663,015 100.0% $187,060,830 100.0%
============ ====== ============ ===== ============ =====
Total deposits increased by $11.4 million, during the nine months of 2005, to
$205.0 million from $193.7 million at December 31, 2004 and $187.1 million as of
September 30, 2004. As of September 30, 2005, non interest demand showed the
strongest growth of $4.2 million or 9.4% to $48.7 million from $44.6 million as
of December 31, 2004. Savings deposits (including money market savings) showed
growth of $3.2 million or 4.6% to $73.5 million from $70.3 million as of
December 31 ,2004. Other time deposits were $21.8 million compared to $18.6
million an increase of 17.0% or $3.2 million and time deposits greater than
$100,000 showed growth of $1.6 million or 6.3% from $25.3 million as of December
31, 2004 to $26.9 million as of September 30, 2005. Interest bearing checking
was the only category of deposits which showed a decline from $34.9 million as
of December 31, 2004 to $34.1 million as of September 30, 2005, a 2.2% decline
or $773,000. This decline in interest bearing checking could be the result of
customers moving funds to higher yielding deposit accounts.
With the future of interest rates uncertain the Company cannot predict how
quickly rates may change on deposit accounts. In a rising rate environment
deposit rates could increase which would cause the net interest margin to
decline, resulting in lower net income. Already the Company has seen a 34 basis
point increase in the yield on deposits from 1.06% as of September 30, 2004 to
1.40% for the nine months ended September 30, 2005.
Although the Company has experienced strong deposit growth this year, loan
demand has exceeded expectations, therefore the Company has taken advantage of
its ability of borrow at the Federal Home Loan Bank. These short-term borrowings
are responsible for a 4 basis point increase in the yield of interest bearing
liabilities or 38 basis points over the prior year, as shown on the
table-Average Balance, Yields and Rates Paid, on page 11. The decision was made
by
Page 20
<page>
management that it was more cost effective to borrow instead of paying higher
rates of interest on long term deposits.
Risk-Based Capital
The Federal Deposit Insurance Corporation (FDIC) has adopted risk-based capital
guidelines which establish a risk-adjusted ratio relating capital to different
categories of assets and off- balance sheet exposures. Under current guidelines,
as of September 30, 2005, the Company was required to have minimum Tier I and
total risk-based capital ratios of 4% and 8%, respectively. To be well
capitalized under Prompt Corrective Action Provisions requires minimum Tier I
and total risk-based capital ratios of 6% and 10%, respectively.
The FDIC has also adopted new minimum leverage ratio guidelines for compliance
by banking organizations. The guidelines require a minimum leverage ratio of 4%
of Tier 1 capital to total average assets. Banks experiencing high growth rates
are expected to maintain capital positions well above the minimum levels. The
leverage ratio in conjunction with the risk-based capital ratio constitute the
basis for determining the capital adequacy of banking organizations.
The table below presents Tier 1 capital, total capital and total risk-weighted
assets at September 30, 2005, along with the related risk-based capital ratio
and leverage ratio.
(dollars in thousands)
Total
Risked-based TIER 1 TOTAL Leverage
Assets Capital Ratio Capital Ratio Ratio
------------ ------- ----- -------- ----- --------
$ 234,279 $21,662 10.76% $24,183 12.01% 9.25%
Off Balance Sheet Commitments
The Company's off balance sheet commitments consist of commitments to extend
credit of $38.2 million and standby letters of credit of $348,000. These
commitments are extended to customers in the normal course of business. The
Company also has contractual obligations consisting of operating leases for
various facilities and payments to participants under the Company's supplemental
executive retirement plan and deferred compensation plan.
Market Risk Management
Overview. Market risk is the risk of loss from adverse changes in market prices
and rates. The Company's market risk arises primarily from interest rate risk
inherent in its loan, investment and deposit functions. The goal for managing
the assets and liabilities of the Company is to maximize shareholder value and
earnings while maintaining a high quality balance sheet without exposing the
Company to undue interest rate risk. The Board of Directors has overall
responsibility for the interest rate risk management policies. Sonoma Valley
Bank has an Asset and Liability Management Committee (ALCO) that establishes and
monitors guidelines to control the sensitivity of earnings to changes in
interest rates.
Page 21
Asset/Liability Management. Activities involved in asset/liability management
include but are not limited to lending, accepting and placing deposits and
investing in securities. Interest rate risk is the primary market risk
associated with asset/liability management. Sensitivity of earnings to interest
rate changes arises when yields on assets change in a different time period or
in a different amount from that of interest costs on liabilities. To mitigate
interest rate risk, the structure of the balance sheet is managed with the goal
that movements of interest rates on assets and liabilities are correlated and
contribute to earnings even in periods of volatile interest rates. When interest
rates increase, the market value of securities held in the investment portfolio
declines. Generally, this decline is offset by an increase in earnings. When
interest rates decline, the market value of securities increases while earnings
decrease due to the bank's asset sensitivity caused by the variable rate loans.
Usually the Company is able to mitigate its risk from changes in interest rates
with this balance sheet structure. At the present time, the market is
experiencing an anomaly from historical norms. While short term rates have
increased over the past year as a result of the Federal Open Market Committee
increasing the Fed Funds target rate from 1.00% to 3.75%, the Company has
actually experienced a decline in long term interest rates from September, 2004,
following the market trend. The asset/liability management policy sets limits on
the acceptable amount of variance in net interest margin and market value of
equity under changing interest environments. The Company uses simulation models
to forecast earnings, net interest margin and market value of equity.
Simulation of earnings is the primary tool used to measure the sensitivity of
earnings to interest rate changes. Using computer-modeling techniques, the
Company is able to estimate the potential impact of changing interest rates on
earnings. A balance sheet forecast is prepared quarterly using inputs of actual
loans, securities and interest bearing liabilities (i.e. deposits/borrowings)
positions as the beginning base. The forecast balance sheet is processed against
five interest rate scenarios. The scenarios include 100 and 200 basis point
rising rate forecasts, a flat rate forecast and 100 and 200 basis point falling
rate forecasts which take place within a one year time frame. The net interest
income is measured during the year assuming a gradual change in rates over the
twelve- month horizon. The Company's 2005 net interest income, as forecast
below, was modeled utilizing a forecast balance sheet projected from September
30, 2005 balances. The following table summarizes the effect on net interest
income (NII) of +/-100 and +/-200 basis point changes in interest rates as
measured against a constant rate (no change) scenario.
Interest Rate Risk Simulation of Net Interest Income as of September 30, 2005
(In thousands)
Variation from a constant rate scenario $ Change in NII
+200bp $ (639)
+100bp (321)
-100bp (195)
-200bp (403)
The simulations of earnings do not incorporate any management actions, which
might moderate the negative consequences of interest rate deviations. Therefore,
they do not reflect likely actual results, but serve as conservative estimates
of interest rate risk.
Since the primary tool used by management to measure and manage interest rate
exposure is a simulation model, use of the model to perform simulations
reflecting changes in interest rates over a twelve month horizon enables
management to develop and initiate strategies for managing exposure to interest
rate risks. Management believes that both individually and in the aggregate
Page 22
its modeling assumptions are reasonable, but the complexity of the simulation
modeling process results in a sophisticated estimate, not an absolutely precise
calculation of exposure.
Interest Rate Sensitivity Analysis. Interest rate sensitivity is a function of
the repricing characteristics of the portfolio of assets and liabilities. These
repricing characteristics are the time frames within which the interest-bearing
assets and liabilities are subject to change in interest rates either at
replacement, repricing or maturity. Interest rate sensitivity management focuses
on the maturity of assets and liabilities and their repricing during periods of
changes in market interest rates. Interest rate sensitivity is measured as the
difference between the volumes of assets and liabilities in the current
portfolio that are subject to repricing at various time horizons. The
differences are known as interest sensitivity gaps.
A positive cumulative gap may be equated to an asset sensitive position. An
asset sensitive position in a rising interest rate environment will cause a
bank's interest rate margin to expand. This results as floating or variable rate
loans reprice more rapidly than fixed rate certificates of deposit that reprice
as they mature over time. Conversely, a declining interest rate environment will
cause the opposite effect. A negative cumulative gap may be equated to a
liability sensitive position. A liability sensitive position in a rising
interest rate environment will cause a bank's interest rate margin to contract,
while a declining interest rate environment will have the opposite effect. The
table above shows net interest income declining both when rates increase and
when rates decline. Although the Bank is usually asset sensitive which would
cause the Bank's net interest margin to expand, the negative change in net
interest income shows both in rising and declining rate environments. The
decline in the rising rate environment is a result of management's conservative
evaluation of the pressure to increase rates on deposits, which temporarily
causes the decline in the net interest margin.
The following table sets forth the dollar amounts of maturing and/or repricing
assets and liabilities for various periods. This does not include the impact of
prepayments or other forms of convexity caused by changing interest rates.
Historically, this has been immaterial and estimates for them are not included.
The Company has more liabilities than assets repricing during the next year.
Usually because the Company's asset rates change more than deposit rates, the
Company's interest income will change more than the cost of funds when rates
change. For the current quarter, the Company is making a more conservative
assumption. Historically, the Company has been able to raise deposit rates with
a lag to loan rate increases, however loan rates have remained flat and market
demands are creating pressure to raise interest rates. Therefore for a period of
time the Company has chosen to use the simulation to forecast deposits rates
rising quite rapidly. This causes the net interest margin to shrink and net
interest income to decline in both a rising and falling rate environment.
The Company controls its long term interest rate risk by keeping long term fixed
rate assets (longer than 5 years) less than its long term fixed rate funding,
primarily demand deposit accounts and capital. The following table sets forth
cumulative maturity distributions as of September 30, 2005 for the Company's
interest-bearing assets and interest-bearing liabilities, and the Company's
interest rate sensitivity gap as a percentage of total interest-earning assets.
The table shows $138.6 million in the over twelve month category, of that
amount, only $42.3 million has a maturity or repricing of over 5 years, compared
to demand deposits and capital of $70.1 million.
Page 23
September 30, 2005 Immediate Up to 3 4 to 6 7 to 12 Over 12 Totals
Reprice Months Months Months Months
(in thousands) ---------- ---------- ---------- ---------- ---------- ----------
Fed Funds Sold $ 55 $ 0 $ 0 $ 0 $ 0 $ 55
Securities + IBB 0 2,262 3,119 6,237 40,148 51,766
Loans 37,187 6,023 6,084 11,568 98,482 159,344
---------- ---------- ---------- ---------- ---------- ----------
Total RSA $ 37,242 $ 8,285 $ 9,203 $ 17,805 $ 138,630 $ 211,165
MMDA/NOW/SAV $ 108,608 $ 0 $ 0 $ 0 $ 0 $ 108,608
CDs < $100k 0 4,028 6,540 6,540 4,684 21,792
CDs > $100k 0 5,454 13,198 3,300 4,939 26,891
Borrowings 0 650 0 0 0 650
---------- ---------- ---------- ---------- ---------- ----------
Total RSL $ 108,608 $ 10,132 $ 19,738 $ 9,840 $ 9,623 $ 157,941
Gap (71,366) (1,847) (10,535) 7,965 129,007 53,224
Cumulative (71,366) (73,213) (83,748) (75,783) 53,224
% of Assets -30.70% -31.50% -36.00% -32.60% 22.90%
Market risk in securities. Market risk in securities shows the amount of gain or
loss (before tax) in the securities portfolio. Portfolio volume, sector
distribution, duration, and quality all affect market valuation. The adjusted
equity ratio is tier 1 capital adjusted for the market gain or loss less any
applicable tax effect divided by average total assets for leverage capital
purposes for the most recent quarter. The ratio is designed to show tier 1
capital if the securities portfolio had to be liquidated and all gains and
losses recognized. If the ratio remains strong after a +2% or +3% rate shock,
market risk is reasonable in relation to the level of capital. A bank has
flexibility and strength when the securities portfolio can be liquidated for
liquidity purposes without affecting capital adequacy.
The Bank has only moderate market risk in investments because the average
maturity in the portfolio is not very long, except for municipals, which are
held to maturity. The portfolio should decline in value only about 1.9% or $1.0
million for a 1% increase in rates. The gain in value if rates fall would be
somewhat less, because there are some callable bonds. Marking-to-market
available for sale securities when rates change would add only modest volatility
to a strong level of equity. This market risk acts to offset the interest rate
risk (i.e. if rates decline and NIM is squeezed, there would be a concurrent
gain in the value of securities).
For the Three Month Periods
Ended September 30, 2005 and 2004
Overview
The Company reported net income of $847,551 for the third quarter of 2005
compared with $744,728 for the third quarter of 2004. On a per share basis, net
income for the three months ended September 30, 2005 equaled $.39 per share
compared with $.35 per share during the same period in 2004.
Return on average total assets on an annualized basis for the three months ended
September 30, 2005 was 1.45% compared to 1.40% for the same period of 2004. The
increase in the return on
Page 24
assets is because earnings are growing faster than assets. Return on average
shareholders' equity on an annualized basis for the three months ended September
30, 2005 and 2004 was 15.33% and 15.14%, respectively. The increase in the
return on equity is a result of the strong growth in earnings experienced in the
third quarter of 2005 when compared to 2004. Net income showed an increase of
13.8% or $102,823 from $744,728 to $847,551.
RESULTS OF OPERATIONS
Net Interest Income
Net interest income, adjusted to a fully taxable equivalent basis, increased
$251,000 to $3.0 million for the three months ended September 30, 2005, from
$2.7 million during the comparable period of 2004. Net interest income on a
fully taxable equivalent basis, as shown on the table - Average Balances, Yields
and Rates Paid on page 27, is higher than net interest income on the statements
of income because it reflects adjustments applicable to tax-exempt income from
certain securities and loans ($98,000 in 2005 and $108,000 in 2004, based on a
34% federal income tax rate).
Net interest income (stated on a fully taxable equivalent basis) expressed as a
percentage of average earning assets, is referred to as net interest margin. The
Company's net interest margin for the third quarter of 2005 declined to 5.44%
from 5.62% for the comparable period in 2004. The decline in the net interest
margin is the result of the pressure to raise interest rates. For the three
months ended September 30, 2005, the yield on interest bearing liabilities
increased 54 basis points from 1.05% for the three months of 2004 compared to
1.59% for the three months period ended September 30, 2005. Although the prime
lending rate has increased 200 basis points since September 30, 2004, the long
term rates in the marketplace have remained flat which has caused borrowers to
want to refinance into lower yielding longer term loans. This has had some
effect on the net interest margin, although the refinancing was somewhat more
prevalent in earlier quarters of the year.
Interest Income
Interest income for the three months ended September 30, 2005 increased by
$505,000 to $3.6 million, a 16.3% increase over the $3.1 million realized during
the same period in 2004. The gain in volume of average balances was responsible
for a $379,000 increase in interest income and a $126,000 increase in income was
related to lower interest rates, resulting in a total increase in interest
income of $505,000.
Interest Expense
Total interest expense for the three months ended September 30, 2005 increased
by $254,000 to $639,000 compared with $385,000 in the same period of 2004. The
average rate paid on all interest-bearing liabilities for the third quarter of
2005 increased to 1.59% from 1.05% in the third quarter of 2004, and average
balances for the third quarter of 2005 increased to $159.2 million from $144.7
million in the same period of 2004, a 10.0% gain.
The gain in volume of average balances accounted for a $41,000 increase in
interest expense while a $213,000 increase was related to higher interest rates
paid, resulting in a $254,000 increase in interest expense for the third quarter
of 2005.
Page 25
Individual components of interest income and interest expense are provided in
the table - Average Balances, Yields and Rates Paid on page 27.
Provision for Loan Losses
The provision for loan losses was $95,000 during the third quarter of 2005
compared to the $40,000 provision for the third quarter of 2004. The increase in
the provision is the result of managements' evaluation and assessment of the
loan portfolio and the loan growth the Company has experienced.
Non-interest Income
Non-interest income of $498,000 for the third quarter of 2005 represented an
increase of $46,000, or 10.1%, from the $452,000 for the comparable period in
2004. Income from service charges on deposit accounts and credit card merchant
income were major contributors to the growth in income over 2004.
Non-interest Expense
For the third quarter of 2005, non-interest expense was $2.0 million compared
with $1.9 million for the same period in 2004, representing an increase of
$100,741, or 5.4%. The largest increase of non interest expense was premises and
equipment, which increased $38,000, or 16.4%, compared with the three months
ended September 30, 2004. The increase in expense in 2005 is a result of
additional lease expense for the new Finance Center and remodeling expense
required to make it serviceable, increased expenses related to maintenance and
repairs both for buildings and fixed assets, increases in property tax and
increases in utility costs.
Other non interest expense for the three months ended September 30, 2005
increased 8.4% to $578,000 compared to $533,000 in the same period in 2004. All
categories of other operating expense remained level or declined from the prior
year except for professional fees. This is predominately the result of
additional accruals for expenses associated with the implementation of
Sarbanes-Oxley, Rule 404, regarding internal controls over financial reporting.
The expenses for salaries and benefits increased 1.7% from $1.10 million in 2004
to $1.12 million in 2005. The $18,000 increase in 2005 is largely the result of
normal merit and incentive increases and increases in employee benefits. At
September 30, 2005, total full time equivalent employees were 49 compared to 56
in 2004.
Provision for Income Taxes
The provision for income taxes decreased to an effective tax rate of 34.8% in
the third quarter of 2005 compared with 35.2% for the comparable period in 2004.
Income taxes reported in the financial statements include deferred taxes
resulting from timing differences in the recognition of items for tax and
financial reporting purposes.
Page 26
SONOMA VALLEY BANCORP
AVERAGE BALANCES/YIELDS AND RATES PAID
For the three months ended September 30, 2005 and 2004
2005 2004
Average Income/ Yield/ Average Income/ Yield/
ASSETS Balance Expense Rate Balance Expense Rate
------------- ------------ ----- ------------- ------------ -----
Interest-earning assets:
Loans(2):
Commercial $ 109,771,367 $ 2,083,419 7.53% $ 101,190,073 $ 1,811,078 7.10%
Consumer 19,459,206 349,958 7.14% 14,382,185 234,110 6.46%
Real estate construction 18,689,755 361,262 7.67% 20,158,437 398,449 7.84%
Real estate mortgage 13,227,184 231,628 6.95% 6,592,958 113,383 6.82%
Tax exempt loans (1) 2,470,126 51,142 8.21% 3,031,016 63,895 8.36%
Leases 34,831 920 10.48% 25,010 1,337 21.21%
Tax exempt leases (1) 0 0 0.00% 0 0 0.00%
Unearned loan fees (475,465) (461,205)
------------- ------------ ------------- ------------
Total loans 163,177,004 3,078,329 7.48% 144,918,474 2,622,252 7.18%
Investment securities
Available for sale:
Taxable 35,032,300 274,973 3.11% 23,727,566 197,141 3.30%
Tax exempt(1) 0 0 0.00% 0 0 0.00%
Hold to maturity:
Taxable 368,083 2,496 2.69% 388,086 2,496 2.55%
Tax exempt (1) 16,571,431 236,188 5.65% 17,571,913 253,442 5.72%
------------- ------------ ------------- ------------
Total investment securities 51,971,814 513,657 3.92% 41,687,565 453,079 4.31%
Federal funds sold 39,570 332 3.33% 3,908,302 12,662 1.29%
Federal Home Loan Bank stock 857,852 8,609 3.98% 700,341 8,093 4.58%
Total due from banks/Interest bearing 105,109 392 1.48% 35,320 78 .88%
------------- ------------ ------------- ------------
Total interest-earning assets 216,151,349 $ 3,601,319 6.61% 191,250,002 $ 3,096,164 6.42%
============ ============
Noninterest-bearing assets:
Reserve for loan losses (2,755,188) (2,383,996)
Cash and due from banks 6,419,048 9,889,631
Premises and equipment 1,274,906 1,382,084
Other assets 12,947,311 12,388,286
------------- -------------
Total assets $ 234,037,426 $ 212,526,007
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Interest-bearing liabilities:
Interest-bearing deposits
Interest-bearing transaction $ 33,360,612 $ 14,183 0.17% $ 32,898,017 $ 13,398 0.16%
Savings deposits 75,362,401 231,020 1.22% 68,513,150 109,154 0.63%
Time deposits over $100,000 27,346,281 221,459 3.21% 24,853,002 164,582 2.63%
Other time deposits 21,009,015 151,829 2.87% 18,446,769 97,424 2.10%
------------- ------------ ------------- ------------
Total interest-bearing deposits 157,078,309 618,491 1.56% 144,710,938 384,558 1.05%
Federal Funds purchased 0 0 0.00% 0 0 0.00%
Other short term borrowings 2,118,002 20,020 3.75% 0 0 0.00%
------------- ------------ ------------- ------------
Total interest-bearing liabilities 159,196,311 $ 638,511 1.59% 144,710,938 $ 384,558 1.05%
============ ============
Non interest-bearing liabilities:
Non interest-bearing demand deposits 48,347,004 44,528,840
Other liabilities 4,375,790 3,608,892
Shareholders' equity 22,118,321 19,677,337
------------- -------------
Total liabilities and shareholders' equity $ 234,037,426 $ 212,526,007
============= =============
Interest rate spread 5.02% 5.37%
===== =====
Interest income $ 3,601,318 6.61% $ 3,096,164 6.42%
Interest expense 638,511 1.17% 384,558 0.80%
------------ ----- ------------ -----
Net interest income/margin $ 2,962,807 5.44% $ 2,711,606 5.62%
============ ===== ============ =====
(1) Fully tax equivalent adjustments are based on a federal income tax rate of
34% in 2005 and 2004
(2) Non-accrual loans have been included in loans for the purposes of the above
presentation. Loan fees of $93,883 and $84,700 for the three months ended
September 30, 2005 and September 30, 2004, respectively, were amortized to
the appropriate interest income categories.
Page 27
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Information regarding Quantitative and Qualitative Disclosures about Market Risk
appears on page 21 through 24 under the caption "Management's Discussion and
Analysis of Consolidated Financial Condition and Results of Operations - Market
Risk Management" and is incorporated herein by reference.
Item 4. CONTROLS AND PROCEDURES
Our management, with the participation and under the supervision of our Chief
Executive Officer and our Chief Financial Officer, reviewed and evaluated the
effectiveness of the design and operation of our disclosure controls and
procedures, as of the end of the fiscal quarter covered by this report, as
required by Securities Exchange Act Rule 13a-15, and concluded that our
disclosure controls and procedures are effective to ensure that information
required to be disclosed in our reports filed with the Securities and Exchange
Commission pursuant to the Securities Exchange Act of 1934 is accumulated and
communicated to management, including our Chief Executive Officer and Chief
Financial Officer. Based on this evaluation, our Chief Executive Officer and
Chief Financial Officer have concluded that as of the end of such period, our
disclosure controls and procedures are effective to ensure that we record,
process, summarize and report information required to be disclosed in the
reports we filed under the Securities Exchange Act of 1934 within the time
periods specified by the Securities and Exchange Commission's rules and
regulations.
During the quarter ended September 30, 2005, there have been no changes in our
internal control over financial reporting, or to our knowledge, in other
factors, that have materially affected or, are reasonably likely to materially
affect our internal controls over financial reporting.
Part II
Item 1. LEGAL PROCEEDINGS
From time to time the Company may be a party to legal proceedings arising in the
ordinary course of business. The Company is not currently a party to, nor is any
of its properties the subject of, any material pending legal proceedings.
Page 28
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following chart summarizes the Company repurchases of the Company's common
shares as part of the Company's publicly announced repurchase plan.
(a) (b) (c) (d)
Maximum Number (or
Total Number of Approximate Dollar
Shares (or Units) Value) of Shares (or
Total Number of Purchased as Part Units) that May Yet be
Shares (or Units Average Price Paid of Publicly Announced Purchased Under the Plans
Period Purchased per Share (or Unit) Plans or Programs or Programs
- ---------------- ----------------- ------------------- ---------------------- -------------------------
Month #7: 0 $ 0 0 $ 0
7/1/05 - 7/31/05
Month #8: 0 $ 0 0 $ 0
8/1/05 - 8/31/05
Month #9: 5,616 $ 20.24 87,517 $ 419,837
9/1/05 - 9/30/05
Total 5,616 $ 20.24 87,517 $ 419,837
----------------- ------------------- ---------------------- -------------------------
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
Exhibits
3.1 Sonoma Valley Bancorp Articles of Incorporation, filed as Exhibit 3.1
to the Registrant's Registration Statement on Form S-8 filed on June
5, 2001.
3.2 Sonoma Valley Bancorp By-laws, filed as Exhibit 3.2 to the
Registrant's Registration Statement on Form S-8 filed on June 5, 2001.
4.2 Agreement for the sale of Sonoma Valley Bank Stock dated September 23,
1992, filed as Exhibit 4.2 (formerly A-1) to the Form F-2 for the year
ended December 31, 1992.
31.1 Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley Act
31.2 Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley Act
32 Certification of CEO and CFO pursuant to Section 906 of the
Sarbanes-Oxley Act
Page 29
SIGNATURES
Under the requirements of the Securities Exchange Act of 1934, the Company
has duly caused this report to be signed on its behalf by the undersigned
thereunto duly authorized.
SONOMA VALLEY BANCORP
Registrant
Date: November 10, 2005 /s/ Mel Switzer, Jr.
--------------------------- -------------------------------------
Mel Switzer, Jr.
President and Chief Executive Officer
(Principal Executive Officer)
Date: November 10, 2005 /s/ Mary Dieter Smith
--------------------------- -------------------------------------
Mary Dieter Smith
Executive Vice President,
Chief Operating Officer and Chief
Financial Officer
(Principal Financial and Accounting
Officer)
Page 30