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OVLY > SEC Filings for OVLY > Form 10-Q on 13-Nov-2012All Recent SEC Filings

Show all filings for OAK VALLEY BANCORP



Quarterly Report

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

The following discussion explains the significant factors affecting our operations and financial position for the periods presented. The discussion should be read in conjunction with our financial statements and the notes related thereto which appear or that are referenced to elsewhere in this report, and with the audited consolidated financial statements and accompanying notes included in our 2011 Annual Report on Form 10-K, as amended. Average balances, including balances used in calculating certain financial ratios, are generally comprised of average daily balances.

The discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions. This discussion and analysis includes executive management's ("Management") insight of the Company's financial condition and results of operations of Oak Valley Bancorp and its subsidiary. Unless otherwise stated, the "Company" refers to the consolidated entity, Oak Valley Bancorp, while the "Bank" refers to Oak Valley Community Bank

Forward-Looking Statements

Some matters discussed in this Form 10-Q may be "forward-looking statements" within the meaning of the Private Litigation Reform Act of 1995 and therefore may involve risks, uncertainties and other factors which may cause our actual results to be materially different from the results expressed or implied by our forward-looking statements. These statements generally appear with words such as "anticipate," "believe," "estimate," "may," "intend," and "expect." Although management believes that the assumptions and

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expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to be correct. Factors that could cause actual results to differ from results discussed in forward-looking statements include, but are not limited to: economic conditions (both generally and in the markets where the Company operates); competition from other providers of financial services offered by the Company; changes in government regulation and legislation; changes in interest rates; material unforeseen changes in the financial stability and liquidity of the Company's credit customers; risks associated with concentrations in real estate related loans; changes in accounting standards and interpretations; and other risks as may be detailed from time to time in the Company's filings with the Securities and Exchange Commission, all of which are difficult to predict and which may be beyond the control of the Company or the Company. The Company undertakes no obligation to revise forward-looking statements to reflect events or changes after the date of this discussion or to reflect the occurrence of unanticipated events.

Forward-looking statements speak only as of the date they are made, and the Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made, whether as a result of new information, future developments or otherwise, except as may be required by law.

Critical Accounting Estimates

Management has determined the following five accounting policies to be critical:

Asset Impairment Judgments

Certain of our assets are carried in our statements of financial condition at fair value or at the lower of cost or fair value. Valuation allowances are established when necessary to recognize impairment of such assets. We periodically perform analyses to test for impairment of various assets. In addition to our impairment analyses related to loans, another significant impairment analysis relates to other than temporary declines in the value of our securities.

Our available for sale portfolio is carried at estimated fair value, with any unrealized gains and losses, net of taxes, reported as accumulated other comprehensive income in shareholders' equity. We conduct a periodic review and evaluation of the securities portfolio to determine if the value of any security has declined below its carrying value and whether such decline is other than temporary. If such decline is deemed other than temporary, we would adjust the carrying amount of the security by writing down the security to fair market value through a charge to current period income. The market values of our securities are significantly affected by changes in interest rates.

In general, as interest rates rise, the market value of fixed-rate securities will decrease; as interest rates fall, the market value of fixed-rate securities will increase. With significant changes in interest rates, we evaluate our intent and ability to hold the security for a sufficient time to recover the recorded principal balance. Estimated fair values for securities are based on published or securities dealers' market values. Market volatility is unpredictable and may impact such values.

Allowance for Loan Losses

Accounting for allowance for loan losses involves significant judgment and assumptions by management and is based on historical data and management's view of the current economic environment. At least on a quarterly basis, our management reviews the methodology and adequacy of allowance for loan losses and reports its assessment to the Board of Directors for its review and approval.

We base our allowance for loan losses on an estimation of probable losses inherent in our loan portfolio. Our methodology for assessing loan loss allowances are intended to reduce the differences between estimated and actual losses and involves a detailed analysis of our loan portfolio in three phases:

the specific review of individual loans,

the segmenting and review of loan pools with similar characteristics and,

our judgmental estimate based on various subjective factors.

The first phase of our methodology involves the specific review of individual loans to identify and measure impairment. We evaluate each loan by use of a risk rating system, except for homogeneous loans, such as automobile loans and home mortgages. Specific risk rated loans are deemed impaired if all amounts, including principal and interest, will likely not be collected in accordance with the contractual terms of the related loan agreement. Impairment for commercial and real estate loans is measured either based on the present value of the loan's expected future cash flows or, if collection on the loan is collateral dependent, the estimated fair value of the collateral, less selling and holding costs.

The second phase involves the segmenting of the remainder of the risk rated loan portfolio into groups or pools of loans, together with loans with similar characteristics, for evaluation. We determine the calculated loss ratio to each loan pool based on its historical net losses and benchmark it against the levels of other peer banks.

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In the third phase, we consider relevant internal and external factors that may affect the collectability of loan portfolio and each group of loan pool. The factors considered are, but are not limited to:

concentration of credits,

nature and volume of the loan portfolio,

delinquency trends,

non-accrual loan trend,

problem loan trend,

loss and recovery trend,

quality of loan review,

lending and management staff,

lending policies and procedures,

economic and business conditions, and

other external factors including regulatory review.

Our management estimates the probable effect of such conditions based on our judgment, experience and known or anticipated trends. Such estimation may be reflected as an additional allowance to each group of loans, if necessary. Management reviews these conditions with our senior credit officers. To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management's estimate of the effect of such condition may be reflected as a specific allowance applicable to such credit or portfolio segment. Where any of these conditions is not evidenced by a specific, identifiable problem credit or portfolio segment as of the evaluation date, management's evaluation of the inherent loss related to such condition is reflected in the unallocated allowance.

Central to our credit risk management and our assessment of appropriate loss allowance is our loan risk rating system. Under this system, the originating credit officer assigns borrowers an initial risk rating based on a thorough analysis of each borrower's financial capacity in conjunction with industry and economic trends. Approvals are made based upon the amount of inherent credit risk specific to the transaction and are reviewed for appropriateness by senior line and credit administration personnel. Credits are monitored by line and credit administration personnel for deterioration in a borrower's financial condition which may impact the ability of the borrower to perform under the contract. Although management has allocated a portion of the allowance to specific loans, specific loan pools, and off-balance sheet credit exposures (which are reported separately as part of other liabilities), the adequacy of the allowance is considered in its entirety.

Non-Accrual Loan Policy

Interest on loans is credited to income as earned and is accrued only if deemed collectible. Accrual of interest is discontinued when a loan is over 90 days delinquent or if management believes that collection is highly uncertain. Generally, payments received on nonaccrual loans are recorded as principal reductions. Interest income is recognized after all principal has been repaid or an improvement in the condition of the loan has occurred that would warrant resumption of interest accruals. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due.

Stock-Based Compensation

The Company recognizes in the statement of income the grant-date fair value of stock options and other equity-based forms of compensation issued to employees over the employees' requisite service period (generally the vesting period). The Company uses the straight-line recognition of expenses for awards with graded vesting. The Company utilizes a binomial pricing model for all grants. Expected volatility is based on the historical volatility of the price of the Company's stock for the period equal to the contractual stock option term. The Company uses historical data to estimate option exercise and stock option forfeiture rates within the valuation model. The expected term of options granted for the binomial model is derived from applying a historical suboptimal exercise factor to the contractual term of the grant. For binomial pricing, the risk-free rate for periods is equal to the U.S. Treasury yield at the time of grant and commensurate with the contractual term of the grant.

Other Real Estate Owned

Other real estate owned, which represents real estate acquired through foreclosure, or deed in lieu of foreclosure in satisfaction of commercial and real estate loans, is carried at the lower of cost or estimated fair value less the estimated selling costs of the real estate.

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The fair value of the property is based upon a current appraisal. The difference between the fair value of the real estate collateral and the loan balance at the time of transfer is recorded as a loan charge off if fair value is lower. Subsequent to foreclosure, management periodically performs valuations and the OREO property is carried at the lower of carrying value or fair value, less costs to sell. The determination of a property's estimated fair value incorporates (1) revenues projected to be realized from disposal of the property, (2) construction and renovation costs, (3) marketing and transaction costs, and (4) holding costs (e.g., property taxes, insurance and homeowners' association dues). Any subsequent declines in the fair value of the OREO property after the date of transfer are recorded through a write-down of the asset. Any subsequent operating expenses or income, reduction in estimated fair values, and gains or losses on disposition of such properties are charged or credited to current operations.


Oak Valley Community Bank commenced operations in May 1991. We are an insured bank under the Federal Deposit Insurance Act and are a member of the Federal Reserve. Since its formation, the Bank has provided basic banking services to individuals and business enterprises in Oakdale, California and the surrounding areas. The focus of the Bank is to offer a range of commercial banking services designed for both individuals and small to medium-sized businesses in the two main areas of service of the Company: the Central Valley and the Eastern Sierras.

The Bank offers a complement of business checking and savings accounts for its business customers. The Bank also offers commercial and real estate loans, as well as lines of credit. Real estate loans are generally of a short-term nature for both residential and commercial purposes. Longer-term real estate loans are generally made with adjustable interest rates and contain normal provisions for acceleration. In addition, the Bank offers traditional residential mortgages through a third party.

The Bank also offers other services for both individuals and businesses including online banking, remote deposit capture, merchant services, night depository, extended hours, traveler's checks, wire transfer of funds, note collection, and automated teller machines in a national network. The Bank does not currently offer international banking or trust services although the Bank may make such services available to the Bank's customers through financial institutions with which the Bank has correspondent banking relationships. The Bank does not offer stock transfer services nor does it directly issue credit cards.

Effective July 3, 2008, Oak Valley Community Bank became a subsidiary of Oak Valley Bancorp, a newly established bank holding company. Oak Valley Bancorp operates Oak Valley Community Bank as a community bank in the general commercial banking business, with our primary market encompassing the California Central Valley around Oakdale and Modesto, and the Eastern Sierras. As such, unless otherwise noted, all references are about Oak Valley Bancorp (the "Company").

Overview of Results of Operations and Financial Condition

The purpose of this summary is to provide an overview of the items management focuses on when evaluating the condition of the Company and its success in implementing its business and shareholder value strategies. The Company's business strategy is to operate the Bank as a well-capitalized, profitable and independent community oriented bank. The Company's shareholder value strategy has three major themes: (1) enhancing shareholder value; (2) making its retail banking franchise more valuable; and (3) efficiently utilizing its capital.

Management believes the following were important factors in the Company's performance during the three and nine month periods ended September 30, 2012:

Thanks to our deep roots in the communities that we serve, our focus on customer care and our selectivity in lending, during the first nine months of 2012, our performance has been better than most institutions of our size that compete in our market. Despite the stagnant economy affecting our primary market areas, we have been able to increase our core deposits to $540.8 million and have posted net income available to common shareholders of $0.18 and $0.51 per diluted share for the three and nine month periods ended September 30, 2012, respectively. While recently published economic data indicate that the current downturn may be easing, it is not clear when or at what speed the recession will end. To the extent that the recession continues, it will affect the market areas that we serve and our results accordingly.

The Company recognized net income available to common shareholders of $1,394,000 and $3,924,000 for the three and nine month periods ended September 30, 2012, respectively, as compared to $1,177,000 and $3,371,000 for the same periods in 2011. The Company recognized net income before preferred stock dividends and accretion of $1,479,000 and $4,292,000 for the three and nine months ended September 30, 2012, respectively, as compared to $1,749,000 and $4,364,000 for the same periods in 2011. The factors contributing to these results will be discussed below.

The Company recognized $84,000 and $368,000 in the third quarter and nine month period ended September 30, 2012, respectively, associated with the accrual for preferred stock dividends for the Series B Preferred Stock that the U.S. Treasury owns under the Small Business Lending Fund ("SBLF"). The Company repurchased 6,750 Series B Preferred Stock in May 2012 and thus had 6,750 shares outstanding at September 30, 2012. So long as such preferred stock remains outstanding under SBLF, it will pay quarterly cumulative dividends at a variable rate between 1% and 5% per year for the first 2.5 years depending on growth of our small business loan portfolio. If there is no loan growth after 2.5 years, the dividend rate could increase to 7% and if the preferred stock remains outstanding after 4.5 years, the rate increases to 9%, regardless of loan growth. In comparison, the three and nine month periods of 2011 reflected $169,000 and $506,000, respectively, for preferred

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stock dividends but also included preferred stock accretion of $403,000 and $487,000 as the original series A preferred stock were issued under the TARP program at a discount. The Company converted out of the TARP program and into the Small Business Lending Funding ("SBLF") program in August 2011, which resulted in preferred stock discount accretion of $389,000 in the third quarter of 2011, the full remaining balance of the discount.

The Company has taken significant steps to reduce the risk of loan losses. In the three and nine month periods ended September 30, 2012, the provision for loan loss was $300,000 and $900,000, respectively, which was flat for the third quarter and decreased by $300,000 year-to-date, compared to the same periods in 2011. The decrease was mainly due to management's assessment of the appropriate level for the allowance for loan losses and a decrease in the level of non-accrual loans. The Company continues to monitor the Bank's loan portfolio with the objective of avoiding defaults or write-downs. Despite these actions, the possibility of additional losses cannot be eliminated, but the Board of Directors and all employees continue to work hard to make the best of these continuing challenging conditions.

Net interest income decreased $85,000 or 1.3% and $115,000 or 0.6% for the three and nine month periods ended September 30, 2012, respectively, compared to the same periods in 2011. The decrease was primarily due to loan and investment security yield reduction.

Non-interest income increased by $27,000 or 3.5% and $179,000 or 8.5% for the three and nine months ended September 30, 2012, as compared to the same periods in 2011. The increase was primarily due to gains in mortgage commissions as well as an operating recovery of $120,000 posted in the first quarter of 2012 as described below.

Non-interest expense increased by $319,000 or 7.6% and $601,000 or 4.6% for the three and nine month periods ended September 30, 2012, respectively, as compared to the same periods in 2011. The primary reason for the increase was an increase in salaries and benefits and occupancy associated with new branch openings in mid-2011, which was offset in part by the reduction in the write downs of OREO property values as described below.

Total assets increased $15.6 million or 2.6% from December 31, 2011. Total net loans decreased by $6.8 million or 1.7% and investment securities increased by $16.6 million or 18.5% from December 31, 2011 to September 30, 2012, while deposits increased by $17.1 million or 3.2% for the same period.

Income Summary

For the three and nine month periods ended September 30, 2012, the Company recorded net income available to common shareholders of $1,394,000 and $3,924,000, respectively, representing increases of $217,000 and $553,000, as compared to the same periods in 2011. Return on average assets (annualized) was 0.97% and 0.96% for the three and nine months ended September 30, 2012, respectively, as compared with 1.21% and 1.03% for the same periods in 2011. Annualized return on average common equity was 9.02% and 8.78% for the three and nine months ended September 30, 2012, respectively, as compared to 8.44% and 8.43% for the same periods of 2011.

Net income before provisions for income taxes and preferred stock dividends and accretion was down $377,000 and $237,000 for the third quarter and nine months ended September 30, 2012, respectively, from the comparable 2011 periods. The income statement components of these variances are as follows:

Pre-Tax Income Variance Summary:

                                        Effect on Pre-Tax      Effect on Pre-Tax
                                              Income                 Income
                                       Increase (Decrease)    Increase (Decrease)
                                        Three Months Ended     Nine Months Ended
(In thousands)                          September 30, 2012     September 30, 2012
Change from 2011 to 2012 in:
Net interest income                    $                (85 ) $               (115 )
Provision for loan losses                                 0                    300
Non-interest income                                      27                    179
Non-interest expense                                   (319 )                 (601 )
Change in income before income taxes   $               (377 ) $               (237 )

These variances will be explained in the discussion below.

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Net Interest Income

Net interest income is the largest source of the Company's operating income. For the three and nine month periods ended September 30, 2012, net interest income was $6.25 million and $18.73 million, respectively, which represented decreases of $85,000 or 1.3% and $115,000 or 0.2% from the comparable periods in 2012.

The net interest margin (net interest income as a percentage of average interest earning assets) was 4.57% and 4.66% for the three and nine month periods ended September 30, 2012, respectively, a decrease of 28 and 22 basis points, as compared to the same periods in 2011. The decrease in the net interest margin in the first nine months of 2012 was primarily attributable to a change in the mix of earning assets with a higher portion in investment securities and interest earning deposits in bank balances, which had balance increases of $26.7 million and $6.6 million, respectively, compared to the first nine months of 2011. These balances had yields of 3.85% and 0.25%, respectively, in the first nine months of 2012, which was significantly less than the yield on gross loans and thus driving down the overall yield on earning assets.

The current low market interest rate environment has had a positive impact on net interest income in previous years because the Company's balance sheet is liability sensitive which typically results in our average cost of funds decreasing faster than the average yield on interest earning assets in a declining rate environment. In 2012, we have not recognized this benefit to the same degree, as deposit interest rates are at historic lows and have essentially reached a threshold in which they cannot reasonably be further reduced. However, the total cost of funds did recognize a moderate decrease of 12 and 14 basis points for the three and nine months ended September 30, 2012, respectively, compared to 2011 due to further rate reductions and a shift from high cost CDs and FHLB borrowed funds into demand deposit and money market accounts. In addition, average non-interest-bearing demand deposit balances increased by $29.5 million and $25.2 million for the three and nine month periods ended September 30, 2012, respectively, as compared to the same periods of 2011. Compared to cost of funds, the decrease in earning asset yield was more significant at 38 and 34 basis points for the three and nine month periods ended September 30, 2012, respectively, compared to the same periods of 2011. The investment securities portfolio recognized the most significant decrease of 57 and 74 basis points for the third quarter and nine month period of 2012, respectively, as compared to 2011, mainly because of the Company deploying cash into investment security purchases, which have historically low yields. The yield on loans has remained more stable, with a reduction of 25 and 26 basis points for the third quarter and nine month period of 2012, respectively, as compared to 2011, partly as a result of the significant portion of our loans that are at their contractual rate floors.

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The following tables shows the relative impact of changes in average balances of interest earning assets and interest bearing liabilities, and interest rates earned and paid by the Company on those assets and liabilities for the three and nine month periods ended September 30, 2012 and 2011:

Net Interest Analysis

                                         Three Months Ended September 30, 2012            Three Months Ended September 30, 2011
                                                           Interest         Avg                             Interest         Avg
                                         Average           Income /        Rate/          Average           Income /        Rate/
(Dollars in thousands)                   Balance           Expense         Yield          Balance           Expense         Yield
Earning assets:
Gross loans (1) (2)                  $        389,868    $      5,636      5.74%      $        390,329    $      5,889      5.99%
Investment securities (2)                     102,847             967      3.73%                81,806             886      4.30%
Federal funds sold                             11,174               7      0.25%                 6,978               4      0.23%
Interest-earning deposits                      48,105              28      0.23%                45,655              28      0.24%
Total interest-earning assets                 551,994           6,638      4.77%               524,768           6,807      5.15%
Total noninterest earning assets               54,078                                           50,172
. . .
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