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HEOP > SEC Filings for HEOP > Form 10-Q on 5-Nov-2012All Recent SEC Filings

Show all filings for HERITAGE OAKS BANCORP



Quarterly Report

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. You can find many but not all of these statements by looking for words such as "approximates," "believes," "expects," "anticipates," "estimates," "intends," "plans," "would," "may" and other similar expressions in this Quarterly Report on Form 10-Q. The Company claims the protection of the safe harbor contained in the Private Securities Litigation Reform Act of 1995. The Company cautions investors that any forward-looking statements presented in this Quarterly Report on Form 10-Q, or those that the Company may make orally or in writing from time to time, are based on the Company's beliefs, and on assumptions made by, and information available to management at the time such statements are first made.
The actual outcome will be affected by known and unknown risks, trends, uncertainties and factors that are beyond the Company's control or ability to predict. Although the Company believes that management's assumptions are reasonable, they are not guarantees of future performance and some will inevitably prove to be incorrect. As a result, the Company's actual future results can be expected to differ from management's expectations, and those differences may be material and adverse to the Company's business, results of operations and financial condition. Accordingly, investors should use caution in relying on forward-looking statements to anticipate future results or trends.

Some of the risk and uncertainties that may cause the Company's actual results, performance or achievements to differ materially from those expressed include the following: the ongoing financial crisis in the United States, including the continuing softness in the California real estate market, and the response of federal and state government and our regulators thereto, general economic conditions in those areas in which the Company operates, competition, fluctuations in interest rates, changes in the Company's business strategy or development plans, changes in governmental regulation, changes in the credit quality of our loan portfolio, as well as economic, political and global changes arising from the war on terrorism, social unrest and other civil disturbances, the Company's ability to increase profitability, sustain growth, the Company's beliefs as to the adequacy of its existing and anticipated allowance for loan losses, beliefs and expectations about, and requirements to comply with the terms of the Memoranda of Understanding issued by regulatory authorities having oversight of the Company's and Bank's operations, and financial policies of the United States government. For further discussion of these and other factors, see "Item 1A. Risk Factors" in the Company's 2011 Annual Report on Form 10-K.

Any forward-looking statements in this report and all subsequent written and oral forward-looking statements attributable to the Company or any person acting on behalf of the Company are expressly qualified in their entirety by the cautionary statements contained or referred to in this section. The Company does not undertake any obligation to release publicly any revisions to forward-looking statements in this report to reflect events or circumstances after the date of this report.


The Company

Heritage Oaks Bancorp (the "Company") is a California corporation organized in 1994 to act as a holding company for Heritage Oaks Bank ("Bank"), a bank serving San Luis Obispo and Santa Barbara Counties. In October 2006, the Company formed Heritage Oaks Capital Trust II ("Trust II"). Trust II is a statutory business trust formed under the laws of the State of Delaware and is a wholly-owned, non-financial, non-consolidated subsidiary of the Company.

Other than holding the shares of the Bank, the Company conducts no significant activities, although it is authorized, with the prior approval of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), the Company's principal regulator, to engage in a variety of activities which are deemed closely related to the business of banking. The Company has also formed a subsidiary, CCMS Systems, Inc. which is currently inactive and has not been capitalized. The Company has no present plans to utilize CCMS Systems, Inc.

Between March 2010 and mid-April 2012, the Company operated under a Consent Order with the Federal Deposit Insurance Corporation ("FDIC") and the California Department of Financial Institutions ("DFI") and a Written Agreement with the Federal Reserve Bank of San Francisco ("FRB"). In April 2012, the Bank's Consent Order was terminated and replaced with an informal Memorandum of Understanding. Similarly in July 2012, the Company's Written Agreement was terminated and replaced with an informal memorandum of understanding.

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The regulatory environment is discussed in more detail in Note 11. Regulatory Matters, of the condensed consolidated financial statements filed with this Quarterly Report on Form 10-Q.

In September 2012, the Company announced that the Bank has entered into a definitive agreement with Coast National Bank to purchase its Morro Bay, California branch facilities, related fixed assets and a major portion of the deposit base maintained at the branch. The acquisition is expected to be completed in the fourth quarter of 2012, subject to various customary conditions to closing, most notably regulatory approval by the bank regulatory agencies with authority over each of the banks. The Bank will pay market value for the building and the fixed assets, and a blended deposit premium of 2.2% for the deposits, which includes approximately 35.5% non-interest bearing demand deposits. No loans will be transferred. The Bank expects to receive approximately $30 million of cash in connection with the acquisition, which it will invest in new loans and investment securities.

Executive Summary of Operating Results

Net income for the three and nine months ended September 30, 2012, when compared to the same periods ended a year earlier, improved by $4.3 million and $6.3 million, respectively. These improvements were largely driven by the reversal of the valuation allowance related to our deferred tax assets and improvements in the levels of non-interest income and non-interest expense, which improvements were partially offset by higher loan loss provisions and a modest reduction in net interest income.

The reversal of the valuation allowance related to our deferred tax assets was the result of our ongoing evaluation of the recoverability of our deferred tax assets during the three and nine months ended September 30, 2012. As part of this evaluation, it was determined that $4.1 million and $5.6 million, respectively, of the previously established valuation allowance for deferred tax assets were now more likely than not recognizable as future tax benefits. The reversal of the deferred tax asset valuation allowance over the first nine months of 2012 reflects the impact of improved earnings and loan portfolio credit quality over the past eight quarters, which management believes provided adequate positive evidence as to the full recoverability of these deferred tax assets. See Note 6. Income Taxes, of the notes to the condensed consolidated financial statements filed with this Quarterly Report on Form 10-Q for a more detailed discussion of the accounting for the Company's deferred tax asset valuation allowance.

Non-interest income increased by $0.4 million and $2.5 million during the three and nine months ended September 30, 2012, respectively, as compared to the corresponding periods in 2011. The increases in the three and nine month non-interest income were largely due to improvements in the amount of gains on the sale of mortgage loans and improvements in the gain/(loss) on sale of OREO. In addition, the nine month period benefitted from an increase in the amount of gains on sale of available for sale securities. Non-interest expense declined by $0.3 million and $1.4 million in the three and nine months ended September 30, 2012, respectively, as compared to the corresponding periods in 2011, largely due to declines in the level of OREO valuation allowances and OREO related expenses, reductions in the level of regulatory assessment costs and occupancy costs. For the nine months ended September 30, 2012, these reductions in non-interest expense were substantially offset by increases in the provision for potential mortgage repurchases. See "Non-Interest Income" and "Non-Interest Expense" under Results of Operations, below, for additional information on improvements in these two components of earnings.

Loan loss provision expense was $1.3 million and $7.7 million for the three and nine months ended September 30, 2012, respectively, which represents an increase of $0.2 million and $2.3 million from that reported in the corresponding periods in 2011. As more fully discussed in the Provision for Loan Loss section of Results of Operations, below, the higher provisioning requirements in 2012 were largely due to provisioning in conjunction with charge-offs from updated specific reserve calculations. While we continue to see a general stabilization in the credit quality of the portfolio, we remain subject to loan specific credit events such as those which occurred in the first nine months of 2012, the effects of which can be and have been material. See "Provision for Loan Losses" under Results of Operations, below, for additional information related to the provision for loan losses.

Management believes that the operating results for the first nine months of 2012 continue to reflect positive trends in financial performance including growth in the loan portfolio and deposits, improvements in our operating efficiency and improvements in asset quality, despite the elevated level of charge-offs related to the updating of specific reserves recorded, primarily in the first two quarters of 2012. These trends are not only a result of what appears to be continued signs of stabilization in the local economy first seen in 2011, but also management's focus on controlling costs, and from improvements in asset quality realized through a combination of sales of classified assets and improvement in credit quality in the loan portfolio in general throughout 2011 and continuing during the first nine months of 2012.

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Although we experienced a temporary set-back in overall asset quality due to the impact of the credit issues addressed in the first two quarters of 2012, we have seen some stabilization and improvement in classified and non-accrual loans in the third quarter of 2012. Further in October 2012, one of the largest loans that moved to non-accrual status in the first half of 2012 was paid-off and will result in a $1.1 million recovery being recorded to the allowance for loan losses in the fourth quarter. This pay-off will also result in a $3.9 million reduction in non-accrual and classified loans in the fourth quarter. That said, management believes that the improvements in asset quality, since asset quality issues peaked at December 31, 2010, are a meaningful indicator of overall positive trends for the Company as evidenced by:

the decrease in classified assets from $87.9 million at December 31, 2010 to $58.5 million at September 30, 2012;
the decline in special mention risk graded loan balances from $55.0 million at December 31, 2010 to $30.1 million at September 30, 2012; and
the decline in OREO balances outstanding from $6.7 million at December 31, 2010 to $0.6 million at September 30, 2012.

While the Company is cautiously optimistic about the current positive trends in credit quality that we experienced in 2011 and thus far in 2012, it is unclear as to how uncertainties in the U.S. and global economy, such as continued high levels of unemployment, could impact the local economy.

Local Economy

The economy in the Company's primary market area (San Luis Obispo and Santa Barbara Counties) is based primarily on agriculture, tourism, light industry, oil and retail trade. Additionally, the local economy in San Luis Obispo County and to a lesser degree Santa Barbara County is dependent on the level of employment generated by state and local government agencies. Services supporting these industries have also developed in the areas of medical, financial and educational services. The population of San Luis Obispo County, the City of Santa Maria (in Northern Santa Barbara County), and the City of Santa Barbara totaled approximately 270,000, 100,000, and 89,000, respectively, according to the 2011 estimated economic data provided by the U.S. Census Bureau based on the 2010 Census. The moderate climate allows a year round growing season in the local economy's agricultural sector. The leading agricultural industry in the Company's primary market area is the production of wine grapes and the related production of premium quality wines. Vineyards in production have grown significantly over the past several years throughout the Company's service area. In addition, cattle ranching represents a major part of the agriculture industry in the Company's primary market area. Furthermore, access to numerous recreational activities and destinations including lakes, mountains and beaches provide a relatively stable tourism industry from many areas including the Los Angeles/Orange County basin, the San Francisco Bay area and the San Joaquin Valley.

The general business climate in 2008 through 2010 proved to be challenging not only on the national level, but within the state of California, and more specifically in the Company's primary market area. As the real estate market and general economic conditions waned throughout those years, the ability of borrowers to satisfy their obligations to the financial sector languished. Although the Company's primary market area has historically witnessed a more stable level of economic activity, the weakened state of the real estate market in conjunction with a decline in economic activity in the Company's primary market area negatively impacted the credit quality of the loan portfolio. The labor market information published by the California Employment Development Department in September 2012 shows the unemployment rate within California to be approximately 10.6%, showing continued improvement from its recent high. Within the Company's primary market area, the labor market information also shows the unemployment rate within San Luis Obispo and Santa Barbara counties continuing to improve in 2011 and into 2012, as these areas reported unemployment levels of approximately 8% in September 2012.

Management remains cautiously optimistic that early signs show that the Company's primary market area is beginning to stabilize as compared to the significant downward trends experienced during 2008 through 2010. The signs of stabilization are not only reflected in the improving unemployment rates mentioned above, but also include a general improvement in the financial information being provided by our customers as part of their regular loan reviews. Additionally, several local economists have recently reported that the improvements in unemployment, the tourism industry, housing and household income are all indicators of stabilization in our primary market area. However, there can be no assurances that the impact of growing concerns about the global economy may not have trickle down effects on the local economy in which the Company operates. Should global economic conditions worsen, it could negatively impact, among other things, the financial condition of borrowers to whom the Company has extended credit.

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In this instance, the Company may suffer credit losses and be required to make further, and possibly significant, provisions to the allowance for loan losses, which would have a direct and adverse impact on our earnings and profitability.

Critical Accounting Policies

Our accounting policies are integral to understanding the Company's financial condition and results of operations. Accounting policies that management considers to be significant, including newly issued standards to be adopted in future periods, are disclosed in Note 1. Summary of Significant Accounting Policies, of the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2011.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("U.S. GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates.

Estimates that are particularly susceptible to significant change because they require management to make material estimates and assumptions related to the determination of the allowance for loan losses, the valuation of real estate acquired through foreclosure, the carrying value of the Company's deferred tax assets and estimates used in the determination of the fair value of certain financial instruments.

Allowance for Loan Losses and Valuation of Foreclosed Real Estate

In connection with the determination of the specific credit component of the allowance for loan losses for non-performing loans in the loan portolio and the value of foreclosed real estate, management obtains independent appraisals for significant properties. While management uses available information to recognize losses on non-performing loans and foreclosed real estate, future additions to the allowance may be necessary based on changes in local economic conditions.

The general portfolio allocation of the allowance is determined by pooling performing loans by collateral type and purpose. These loans are then further segmented by an internal loan grading system that classifies loans as: pass, special mention, substandard and doubtful. Estimated loss rates are then applied to each segment according to loan grade to determine the amount of the general portfolio allocation. Estimated loss rates are determined through an analysis of historical loss rates for each segment of the loan portfolio, based on the Company's prior experience with such loans. In addition qualitatively determined adjustments are made to the historical loss history to give effect to certain internal and external factors that may have either a positive or negative impact on the overall credit quality of the loan portfolio.

Because of all of the variables that go into the determination of both the specific and general allocation components of the allowance for loan losses, as well as the valuation of foreclosed real estate, it is reasonably possible that the allowance for loan losses and foreclosed real estate values may change in future periods. See also Note 4. Allowance for Loan Losses, of the condensed consolidated financial statements filed with this Quarterly Report on Form 10-Q.

Realizability of Deferred Tax Assets

The Company uses an estimate of its future earnings in determining if it is more likely than not that the carrying value of its deferred tax assets will be realized over the period they are expected to reverse. If based on all available evidence, the Company believes that a portion or all of its deferred tax assets will not be realized, a valuation allowance must be established. During 2010, the Company established a valuation allowance against a portion of its deferred tax assets. Based on management's ongoing assessment of the realizability of its deferred tax assets, it reduced the level of the valuation allowance in 2011. In 2012, the Company determined that it was more likely than not that the entire deferred tax asset balance would be fully realized and therefore reversed the remaining valuation allowance over the first nine months of 2012. See also Note 6. Income Taxes, of the condensed consolidated financial statements filed with this Quarterly Report on Form 10-Q.

Fair Value of Financial Instruments

The degree of judgment utilized by management in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available actively quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of observable pricing and a lesser degree of judgment utilized in measuring fair value.

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Conversely, financial instruments rarely traded or not quoted will generally have little or no observable pricing and a higher degree of judgment is utilized in measuring the fair value of such instruments. Observable pricing is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and the characteristics specific to the transaction. See also Note 9. Fair Value of Assets and Liabilities, of the condensed consolidated financial statements filed with this Quarterly Report on Form 10-Q.

Where You Can Find More Information

Under Sections 13 and 15(d) of the Securities Exchange Act of 1934, as amended, periodic and current reports must be filed with the SEC. The Company electronically files the following reports with the SEC: Annual Report on Form 10-K; Quarterly Report on Form 10-Q; Current Report on Form 8-K; and a Proxy Statement on Form DEF 14A. The Company may file additional forms from time to time. The SEC maintains an internet site,, from which all forms filed electronically may be accessed. Additionally, all forms filed with the SEC and additional shareholder information is available free of charge on the Company's website:

The Company posts these reports and other filings to its website as soon as reasonably practicable after filing them with the SEC. None of the information on or hyperlinked from the Company's website is incorporated into this Quarterly Report on Form 10-Q.

Selected Financial Data

The table below provides selected financial data that highlights the Company's
quarterly performance results:

                                                                                                 For the quarters ended,
(dollar amounts in thousands except per share data)    09/30/12      06/30/12      03/31/12      12/31/11      09/30/11      06/30/11      03/31/11       12/31/10

Return on average assets, annualized                        2.46%         0.75%         0.65%         1.66%         0.85%         0.40%         0.22%          0.21%

Return on average equity, annualized                       18.60%         5.66%         4.82%        12.87%         6.67%         3.10%         1.73%          1.67%

Return on average common equity, annualized                21.40%         5.55%         4.49%        14.98%         6.83%         2.37%         0.65%          0.10%

Average equity to average assets                           13.22%        13.25%        13.51%        12.93%        12.80%        12.86%        12.51%         12.29%

Average common equity to average assets                    10.85%        10.83%        11.00%        10.43%        10.30%        10.29%        10.00%          9.94%

Net interest margin                                         4.36%         4.41%         4.72%         4.67%         4.67%         4.80%         4.73%          4.58%

Efficiency ratio*                                          65.47%        69.75%        65.70%        66.17%        66.52%        68.78%        70.56%         73.84%

Average loans to average deposits                          80.76%        81.80%        84.13%        82.29%        81.64%        85.76%        86.41%         85.42%

Net income                                            $     6,428   $     1,897   $     1,585   $     4,130   $     2,119   $       954   $       522   $        517

Net income available to common shareholders           $     6,071   $     1,522   $     1,204   $     3,879   $     1,746   $       584   $       157   $         26

Earnings per common share:
Basic                                                 $      0.24   $      0.06   $      0.05   $      0.16   $      0.07   $      0.02   $      0.01   $        -
Diluted                                               $      0.23   $      0.06   $      0.05   $      0.15   $      0.07   $      0.02   $      0.01   $        -
Weighted average outstanding shares:
Basic                                                  25,089,325    25,076,226    25,057,664    25,054,204    25,054,027    25,050,584    25,035,012     25,004,697
Diluted                                                26,430,717    26,399,117    26,290,370    26,261,179    26,254,045    26,252,066    26,251,608     26,247,491

* The efficiency ratio is defined as total non interest expense as a percent of the combined net interest income plus non interest income, exclusive of gains and losses on securities sales, other than temporary impairment losses, gains and losses on sale of OREO and other OREO related costs and gains and losses on sale of fixed assets.

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Results of Operations

Net Interest Income and Margin

Net interest income, the primary component of the net earnings of a financial institution, refers to the difference between the interest earned on loans and investments and the interest paid on deposits and borrowings. The net interest margin is the amount of net interest income expressed as a percentage of average earning assets. Factors considered in the analysis of net interest income are the composition and volume of interest-earning assets and interest-bearing liabilities, the amount of non-interest bearing liabilities and non-accrual loans, and changes in market interest rates. For the three months ended September 30, 2012 and 2011, the net interest margin was 4.36% and 4.67%, respectively. For the nine months ended September 30, 2012 and 2011, the net interest margin was 4.49% and 4.73%, respectively.

For the three and nine months ended September 30, 2012 as compared to the corresponding periods in 2011, increased competition, coupled with the impact of a fragile economic and low interest rate environment, has had an adverse impact on yields on new and renewing loans. In addition, the low interest rate environment has had a two-fold impact on securities' yields as new investments are typically providing lower yields and existing investments in mortgage backed securities are seeing increased levels of refinancing of the underlying mortgages, which is resulting in acceleration of the amortization of premiums paid on these securities. All of these factors have combined to reduce the yield on earning assets for the three and nine months ended September 30, 2012 by 44 basis points and 39 basis points, respectively. The mix of average earning assets for the nine months ended September 30, 2012 has also contributed to the . . .

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