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| HTBK > SEC Filings for HTBK > Form 10-Q on 28-Oct-2009 | All Recent SEC Filings |
28-Oct-2009
Quarterly Report
The following discussion provides information about the results of operations, financial condition, liquidity, and capital resources of Heritage Commerce Corp and its wholly owned subsidiary, Heritage Bank of Commerce. This information is intended to facilitate the understanding and assessment of significant changes and trends related to our financial condition and the results of operations. This discussion and analysis should be read in conjunction with our consolidated financial statements and the accompanying notes presented elsewhere in this report. Unless we state otherwise or the context indicates otherwise, references to the "Company," "Heritage," "we," "us," and "our," in this Report on Form 10-Q refer to Heritage Commerce Corp and Heritage Bank of Commerce.
This Report on Form 10-Q contains various statements that may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or Exchange Act, and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Any statements about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and may be forward-looking. These forward-looking statements often can be, but are not always, identified by the use of words such as "assume," "expect," "intend," "plan," "project," "believe," "estimate," "predict," "anticipate," "may," "might," "should," "could," "goal," "potential" and similar expressions. We base these forward-looking statements on our current expectations and projections about future events, our assumptions regarding these events and our knowledge of facts at the time the statements are made. These statements include statements relating to our projected growth, anticipated future financial performance, and management's long-term performance goals, as well as statements relating to the anticipated effects on results of operations and financial condition.
These forward-looking statements are subject to various risks and uncertainties that may be outside our control and our actual results could differ materially from our projected results. In addition, our past results of operations do not necessarily indicate our future results. Please see our most recent Annual Report on Form 10-K for the year ended December 31, 2008 and our subsequent Quarterly Reports on Form 10-Q and the other information contained in this Report on Form 10-Q for a further discussion of these and other risks and uncertainties applicable to our business. The forward-looking statements could be affected by many factors, including but not limited to:
º •
º Our ability to attract new deposits and loans;
º •
º Local, regional, and national economic conditions and events and the
impact they may have on us and our customers;
º •
º Risks associated with concentrations in real estate related loans;
º •
º Increasing levels of classified assets, including nonperforming
assets, which could adversely affect our earnings and liquidity;
º •
º Market interest rate volatility;
º •
º Stability of funding sources and continued availability of borrowings;
º •
º Changes in legal or regulatory requirements or the results of
regulatory examinations that could restrict growth and constrain our
activities, including the terms of an anticipated written agreement to
be entered into by the Company and the Board of Governors of the
Federal Reserve System;
º •
º Changes in accounting standards and interpretations;
º •
º Significant decline in the market value of the Company that could
result in an impairment of goodwill;
º •
º Our ability to raise capital or incur debt on reasonable terms;
º •
º Regulatory limits on the Heritage Bank of Commerce's ability to pay
dividends to the Company;
º •
º Effectiveness of the Emergency Economic Stabilization Act of 2008, the
American Recovery and Reinvestment Act of 2009 and other legislative
and regulatory efforts to help stabilize the U.S. financial markets;
º •
º Future legislative or administrative changes to the U.S. Treasury
Capital Purchase Program enacted under the Emergency Economic
Stabilization Act of 2008;
º •
º The impact of the Emergency Economic Stabilization Act of 2008 and the
American Recovery and Reinvestment Act of 2009 and related rules and
regulations on our business operations and competitiveness, including
the impact of executive compensation restrictions, which may affect
our ability to retain and recruit executives in competition with other
firms who do not operate under those restrictions; and
º •
º Our success in managing the risks involved in the foregoing items.
We are not able to predict all the factors that may affect future results. You should not place undue reliance on any forward-looking statement, which speaks only as of the date of this Report on Form 10-Q. Except as required by applicable laws or regulations, we do not undertake any obligation to update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.
EXECUTIVE SUMMARY
This summary is intended to identify the most important matters on which management focuses when it evaluates the financial condition and performance of the Company. When evaluating financial condition and performance, management looks at certain key metrics and measures. The Company's evaluation includes comparisons with peer group financial institutions and its own performance objectives established in the internal planning process.
The primary activity of the Company is commercial banking. The Company's operations are located entirely in the southern and eastern regions of the general San Francisco Bay area of California in the counties of Santa Clara, Alameda and Contra Costa. The largest city in this area is San Jose and the Company's market includes the headquarters of a number of technology based companies in the region known commonly as Silicon Valley. The Company's customers are primarily closely held businesses and professionals.
Performance Overview
For the three months ended September 30, 2009, the net loss was $2.1 million. Net loss allocable to common shareholders was $2.7 million, or $(0.23) per common share for the quarter ended September 30, 2009, which included a $7.1 million provision for loan losses and $599,000 in dividends and discount accretion on preferred stock. In the quarter ended September 30, 2008, net income allocable to common shareholders was $2.4 million, or $0.21 per common share, including a provision for loan losses of $1.6 million and no dividends or discount accretion on preferred stock. The annualized returns on average assets and average equity for the third quarter of 2009 were -0.58% and -4.67%, compared to 0.65% and 6.78% for the third quarter of 2008.
For the nine months ended September 30, 2009, the net loss was $11.4 million. Net loss allocable to common shareholders was $13.2 million, or $(1.12) per common share, which included a
$28.3 million provision for loan losses and $1.8 million in dividends and discount accretion on preferred stock. In the nine months ended September 30, 2008, net income allocable to common shareholders was $1.1 million, or $0.09 per common share, including a provision for loan losses of $11.0 million and no dividends or discount accretion on preferred stock. The annualized returns on average assets and average equity for the first nine months of 2009 were -1.05% and -8.43%, compared to 0.10% and 0.95% for the first nine months of 2008, respectively.
The following are major factors impacting the Company's results of operations:
º •
º Net interest income decreased 11% to $11.6 million in the third
quarter of 2009 from $13.0 million in the third quarter of 2008,
primarily due to compression of the net interest margin and lower
average loans. Net interest income in the first nine months of 2009
decreased to $34.5 million, or 12% from $39.1 million in the first
nine months of 2008, primarily due to compression of the net interest
margin, partially offset by an increase in average loans.
º •
º The net interest margin decreased 21 basis points to 3.62% during the
third quarter of 2009, compared with 3.83% for the third quarter a
year ago, but increased 7 basis points from 3.55% for the second
quarter of 2009. The Company's net interest margin decreased to 3.51%
for the nine months ended September 30, 2009 compared to 4.04% for the
first nine months of 2008. The 7 basis point increase in the net
interest margin in the third quarter of 2009, compared to the second
quarter of 2009, was primarily due to lower cost of funds and higher
yields on loans. The decrease in the net interest margin from the
first nine months of 2008 was primarily the result of the 275 basis
point decline in short-term interest rates prompted by several
consecutive Federal Reserve rate cuts from March through December
2008.
º •
º The provision for loan losses of $7.1 million for the third quarter of
2009, compared to $1.6 million in the third quarter of 2008 and
$10.7 million in the second quarter of 2009. The provision for loan
losses for the nine months ended September 30, 2009 was $28.3 million,
compared to $11.0 million for the same period a year ago.
º •
º Noninterest income increased 39% to $2.4 million in the third quarter
of 2009 from $1.7 million in the third quarter of 2008, and increased
12% to $5.6 million in the first nine months of 2009 from $5.0 million
in the first nine months of 2008, primarily due to a $643,000 gain on
the sale of SBA loans.
º •
º Noninterest expense increased 3% to $10.7 million in the third quarter
of 2009 from $10.4 million in the third quarter of 2008, and increased
7% to $34.2 million for the nine months ended September 30, 2009 from
$32.0 million for the nine months ended September 30, 2008. The
increase in noninterest expense is primarily due to problem loan
expenses, higher FDIC deposit insurance costs, and higher professional
fees.
º •
º The efficiency ratio was 76.89% and 85.38% in the three and nine
months ended September 30, 2009, compared to 70.56% and 72.48% in the
three and nine months ended September 30, 2008, respectively,
primarily due to compression of the net interest margin and higher
noninterest expense.
º •
º The income tax benefit for the three and nine months ended
September 30, 2009 was $1.8 million and $11.0 million, respectively,
as compared to an income tax expense of $309,000 and $39,000 for the
same periods in 2008. The negative effective income tax rates for the
three and nine months ended September 30, 2009 were due to the loss
before income taxes. The difference in the effective tax rate compared
to the combined federal and state statutory tax rate of 42% is
primarily the result of the Company's investment in life insurance
policies whose earnings are not subject to taxes, tax credits related
to investments in low income housing limited partnerships, and
interest income from tax-free loans and municipal securities.
º •
º The Federal Reserve completed the field work portion of its regularly
scheduled examination of Heritage Commerce Corp and Heritage Bank of
Commerce in September 2009.
The following are important factors in understanding our current financial condition and liquidity position:
º •
º Total assets decreased by $131.6 million, or 9%, to $1.37 billion at
September 30, 2009 from $1.50 billion at December 31, 2008.
º •
º Total loans, excluding loans held-for-sale, decreased $168.8 million,
or 13%, to $1.08 billion at September 30, 2009 compared to
$1.25 billion at September 30, 2008, and decreased $167.1 million, or
13%, compared to $1.25 billion at December 31, 2008. Land and
construction loans decreased $59.2 million from $256.6 million at
December 31, 2008 to $197.4 million at September 30, 2009.
º •
º The allowance for loan losses increased to $29.0 million, or 2.68% of
total loans, compared to $22.3 million, or 1.79% of total loans at
September 30, 2008, and $25.0 million, or 2.00% of total loans at
December 31, 2008.
º •
º Nonperforming assets increased $33.1 million to $58.2 million, or
4.26% of total assets, from $25.1 million, or 1.66% of total assets at
September 30, 2008, and increased $17.1 million from $41.1 million, or
2.74% of total assets at December 31, 2008.
º •
º Net charge-offs increased to $9.6 million in the third quarter of
2009, compared to $129,000 in the third quarter of 2008.
º •
º Deposits decreased to $1.12 billion at September 30, 2009, compared to
$1.19 billion at September 30, 2008, and $1.15 billion at December 31,
2008.
º •
º The ratio of noncore funding (which consists of time deposits $100,000
and over, CDARS deposits, brokered deposits, securities under
agreement to repurchase, notes payable and other short-term
borrowings) to total assets was 28% at September 30, 2009, compared to
32% at September 30, 2008 and December 31, 2008.
º •
º The loan to deposit ratio was 96.88% at September 30, 2009, compared
to 105.41% at September 30, 2008, and 108.20% at December 31, 2008.
º •
º Heritage Bank of Commerce is well-capitalized with a leverage ratio of
9.82%, a tier 1 risk-based capital ratio of 11.24%, and a total
risk-based capital ratio of 12.51% at September 30, 2009.
º •
º Heritage Commerce Corp is well-capitalized with a leverage ratio of
10.08%, a tier 1 risk-based capital ratio of 11.55%, and a total
risk-based capital ratio of 12.82% at September 30, 2009.
Deposits
The composition and cost of the Company's deposit base are important in analyzing the Company's net interest margin and balance sheet liquidity characteristics. Except for brokered time deposits, the Company's depositors are generally located in its primary market area. Depending on loan demand and other funding requirements, the Company also obtains deposits from wholesale sources including deposit brokers. The Company had $181.8 million in brokered deposits at September 30, 2009, compared to $185.1 million at September 30, 2008. Deposits from title insurance companies, escrow accounts and real estate exchange facilitators decreased to $32.9 million at September 30, 2009, compared to $82.5 million at September 30, 2008. The Company has a policy to monitor all deposits that may be sensitive to interest rate changes to help assure that liquidity risk does not become excessive due to concentrations.
Heritage Bank of Commerce is a member of the Certificate of Deposit Account Registry Service ("CDARS") program. The CDARS program allows customers with deposits in excess of FDIC insured limits to obtain coverage on time deposits through a network of banks within the CDARS program. Deposits gathered through this program are considered brokered deposits under regulatory guidelines. Deposits in the CDARS program totaled $41.4 million at September 30, 2009, and $11.7 million at December 31, 2008. There were no deposits in the CDARS program at September 30, 2008.
Liquidity
Our liquidity position refers to our ability to maintain cash flows sufficient to fund operations and to meet obligations and other commitments in a timely fashion. We believe that our liquidity position is more than sufficient to meet our operating expenses, borrowing needs and other obligations for 2009. As of September 30, 2009, we had $42.3 million in cash and cash equivalents and approximately $279.0 million in available borrowing capacity from various sources including the Federal Home Loan Bank ("FHLB"), the Federal Reserve Bank of San Francisco ("FRB"), and Federal funds facilities with several financial institutions. The Company also had $41.8 million in unpledged securities available at September 30, 2009.
Lending
Our lending business originates primarily through our branch offices located in our primary market. As a result of the weakened economy in our primary service area throughout 2008 and 2009 and loan payoffs, we have seen a contraction in our loan portfolio during the first nine months of 2009. In addition to managing growth of our loan portfolio during 2009, we have also actively managed the mix of our loan portfolio. Commercial loans account for 38% of the total loan portfolio, and commercial real estate loans (of which 51% are owner occupied) account for 38% of the portfolio. We have actively lowered our exposure to land and construction loans and our overall credit risk on these portfolios has been reduced. Land and construction loans decreased $59.2 million for the nine months ended September 30, 2009, compared to December 31, 2008, and account for 18% of our loan portfolio. We will continue to use and improve existing products to expand market share at current locations.
Net Interest Income
The management of interest income and expense is fundamental to the performance of the Company. Net interest income, the difference between interest income and interest expense, is the largest component of the Company's total revenue. Management closely monitors both total net interest income and the net interest margin (net interest income divided by average earning assets).
Because of our focus on commercial lending to closely held businesses, the Company will continue to have a high percentage of floating rate loans and other assets. Given the current volume, mix and repricing characteristics of our interest-bearing liabilities and interest-earning assets, we believe our interest rate spread is expected to increase in a rising rate environment, and decrease in a declining interest rate environment.
The Company, through its asset and liability policies and practices, seeks to maximize net interest income without exposing the Company to an excessive level of interest rate risk. Interest rate risk is managed by monitoring the pricing, maturity and repricing options of all classes of interest bearing assets and liabilities. This is discussed in more detail under Liquidity and Asset/Liability Management. In addition, we believe there are measures and initiatives we can take to improve the net interest margin, including increasing loan rates, adding floors on floating rate loans, reducing nonperforming assets, managing deposit interest rates, and reducing higher cost deposits.
From March 18, 2008 through December 16, 2008, the Board of Governors of the Federal Reserve System reduced short-term interest rates by 275 basis points. This decrease in short-term rates immediately affected the rates applicable to the majority of the Company's loans. While the decrease in interest rates also lowered the cost of interest bearing deposits, which represents the Company's primary funding source, these deposits tend to price more slowly than floating rate loans. The rapid, substantial drop in the short-term interest rates, including the prime rate, has significantly compressed the Company's net interest margin.
The net interest margin is also adversely impacted by the reversal of interest on nonaccrual loans, and the reinvestment of loan payoffs into lower yielding Treasury securities and other short-term investments.
Management of Credit Risk
We continue to proactively identify, quantify, and actively manage our problem loans. Early identification of problem loans and potential future losses will enable us to resolve credit issues with potentially less risk and ultimate losses. We maintain an allowance for loan losses in an amount that we believe is adequate to provide for losses inherent in the portfolio. While we strive to carefully manage and monitor credit quality and to identify loans that may be deteriorating, at any time there are loans included in the portfolio that may result in losses, but that have not yet been identified as potential problem loans. Through established credit practices, we attempt to identify deteriorating loans and adjust the allowance for loan losses accordingly. However, because future events are uncertain, there may be loans that deteriorate in an accelerated time frame. As a result, future additions to the allowance may be necessary. Because the loan portfolio contains a number of commercial real estate loans with relatively large balances, deterioration in the credit quality of one or more of these loans may require a significant increase to the allowance for loan losses. Future additions to the allowance may also be required based on changes in the financial condition of borrowers, such as have resulted due to the current, and potentially worsening, economic conditions or as a result of incorrect assumptions by management in determining the allowance for loan losses. Additionally, federal and state banking regulators, as an integral part of their supervisory function, periodically review our allowance for loan losses. These regulatory agencies may require us to recognize further loan loss provisions or charge-offs based upon their judgments, which may be different from ours. Any increase in the allowance for loan losses would have an adverse effect, which may be material, on our financial condition and results of operation.
At December 31, 2008 and September 30, 2009, our nonperforming loans (which include nonaccrual loans) were 3.24% and 5.11% of the loan portfolio, respectively. At December 31, 2008 and September 30, 2009, our nonperforming assets (which include foreclosed real estate) were 2.74% and 4.26% of total assets, respectively. Nonperforming assets adversely affect our net income in various ways. Until economic and market conditions improve, we may expect to continue to incur losses relating to an increase in nonperforming assets. We do not record interest income on nonaccrual loans or other real estate owned, thereby adversely affecting our income, and increasing our loan administration costs. When we take collateral in foreclosures and similar proceedings, we are required to mark the related asset to the then fair market value of the collateral (less estimated costs to sell) which may ultimately result in a loss. An increase in the level of nonperforming assets increases our risk profile and may impact the capital levels our regulators believe are appropriate in light of the ensuing risk profile.
Further discussion of the management of credit risk appears under "Provision for Loan Losses" and "Allowance for Loan Losses."
Noninterest Income
While net interest income remains the largest single component of total
revenues, noninterest income is an important component. Prior to the third
quarter of 2007, a significant percentage of the Company's noninterest income
was associated with its SBA lending activity, consisting of gains on the sale of
loans sold in the secondary market and servicing income from loans sold with
servicing retained. From the third quarter of 2007 through the second quarter of
2009, the Company retained most of its SBA production. In the second quarter of
2009, $20.5 million of SBA loans were transferred to loans held-for-sale to
enhance liquidity and improve noninterest income in future periods. During the
third quarter of 2009, $14.4 million of SBA loans were sold resulting in a net
gain on sale of loans of $643,000. Other sources of noninterest income include:
loan servicing fees, service charges and fees, and company owned life insurance
income.
Noninterest Expense
Management considers the control of operating expenses to be a critical element of the Company's performance. Over the last three years the Company has undertaken several initiatives to reduce its noninterest expense and improve its efficiency. Nonetheless, noninterest expense increased in the third quarter and first nine months of 2009 compared to the same periods in 2008, due to a substantial increase in deposit insurance premiums, increased professional fees, and loan workout expense resulting from the current credit cycle. The Company's efficiency ratio was 76.89% and 85.38% in the third quarter and first nine months of 2009, respectively, compared with 70.56% and 72.48% for the same periods in 2008. The efficiency ratio increased in 2009 primarily due to compression of the Company's net interest margin and an increase in noninterest expense, as discussed above.
Capital Management
Heritage Commerce Corp and Heritage Bank of Commerce meet the regulatory definition of "well-capitalized" at September 30, 2009. As part of its asset and liability process, the Company continually assesses its capital position to take into consideration growth, expected earnings, risk profile and potential corporate activities that it may choose to pursue.
As of September 30, 2009, HBC's total risk-based capital ratio was 12.51%, compared to the 10% regulatory requirement for well-capitalized banks. Our Tier 1 risk-based capital ratio of 11.24% and our leverage ratio of 9.82% as of September 30, 2009 also significantly exceeded regulatory guidelines for well-capitalized banks. On November 21, 2008, the Company issued to the U.S. Treasury under its Capital Purchase Program 40,000 shares of Series A Preferred Stock and warrants to purchase 462,963 shares of common stock at an exercise price of $12.96 for $40 million. The terms of the U.S. Treasury TARP Capital Purchase Program could reduce investment returns to our shareholders by restricting dividends to common shareholders, diluting existing shareholders' interests, and restricting capital management practices. The Company accrued $511,000 of dividends in the third quarter of 2009 on the preferred stock issued to the U.S. Treasury under the TARP Capital Purchase Program.
In April 2009, the Company announced that the Board of Directors suspended the quarterly dividend on our common stock commencing with the second quarter of 2009, to build capital and further strengthen our balance sheet. We believe the dividend suspension will further enhance our already strong capital levels during the current economic challenges while still taking advantage of select growth opportunities. The suspension of our dividend preserved approximately $473,000 in common equity for the nine months ended September 30, 2009. We do not expect to resume paying cash dividends on our common stock for the time being, and future dividends will depend on sufficient earnings to support them and prior approval of the Federal Reserve.
In addition to the quarterly dividend payments on our preferred stock, we also service the interest payments on our outstanding trust preferred subordinated debt securities.
Recent Regulatory Examination
The Federal Reserve recently completed the field work portion of its regularly scheduled examination of the Company and Heritage Bank of Commerce in September 2009. As a result of the Company's losses in 2009, primarily due to higher provisions for loan losses because of credit quality deterioration, the . . .
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