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WBCO > SEC Filings for WBCO > Form 10-K on 15-Mar-2013All Recent SEC Filings

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Form 10-K for WASHINGTON BANKING CO


15-Mar-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with Item 8- Financial Statements and Supplementary Data.

Executive Overview

Significant items for the year ended December 31, 2012 were as follows:

Net income per diluted common share was $1.09 for the year ended December 31, 2012, compared to $0.97 for the year ended December 31, 2011.

Total assets and deposits were relatively stable at $1.7 billion and $1.5 billion, respectively.

Allowance for loan losses to total non-covered loans decreased to 2.01% at year end 2012 from 2.22% a year ago.

Net charge-offs to average non-covered loans was 0.97% for 2012, compared to 1.37% for 2011.

Nonperforming non-covered assets to total assets was 1.10% at year end 2012, compared to 1.44% at year end 2011.

Continued progress in resolving acquired loans which declined by $54.1 million to $214.1 million at December 31, 2012.

The Company's net interest margin, on a tax-equivalent basis, increased to 5.54% for 2012, compared to 5.47% for 2011.

The Bank opened its 31st full-service branch in Woodinville in December 2012.

Summary of Critical Accounting Policies

Significant accounting policies are described in the consolidated financial statements in Note (1) Summary of Significant Accounting Policies. Several of these accounting policies require management to make difficult, subjective or complex judgments or estimates. Management believes that the following accounting policies could be considered critical under the SEC's definition.

Allowance for Loan Losses: The allowance for loan losses is established to absorb known and inherent losses attributable to loans outstanding. The adequacy of the allowance is monitored on a regular basis and is based on management's evaluation of numerous quantitative and qualitative factors. Quantitative factors include our historical loss experience, delinquency and charge-off trends, estimates of, and changes in, collateral values, changes in risk ratings on loans and other factors. Qualitative factors include the general economic environment in our markets and, in particular, the state of the real estate market and specific relevant industries. Other qualitative factors that are considered in our methodology include, size and complexity of individual loans in relation to the lending officer's background and experience levels, loan structure, extent and nature of waivers of existing loan policies, and pace of loan portfolio growth.

As the Company adds new products, increases the complexity of the loan portfolio, and expands its geographic coverage, the Company intends to enhance and adapt its methodology to keep pace with the size and complexity of the loan portfolio. Changes in any of the above factors could have a significant effect on the calculation of the allowance for credit losses in any given period. The Company believes that its systematic methodology continues to be appropriate given our size and level of complexity.

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Acquired Loans: In accordance with FASB ASC 310-30, acquired loans are aggregated into pools, based on individually evaluated common risk characteristics, and aggregate expected cash flows were estimated for each pool. A pool is accounted for as a single asset with a single interest rate, cumulative loss rate and cash flow expectation. The Bank aggregated all of the loans acquired in the FDIC-assisted acquisitions of City Bank and North County Bank into 18 and 14 pools, respectively. A loan will be removed from a pool of loans only if the loan is sold, foreclosed, assets are received in satisfaction of the loan, or the loan is written off, and will be removed from the pool at the carrying value. If an individual loan is removed from a pool of loans due to a payoff, the difference between its carrying amount and the cash received will be recognized in income immediately and would not affect the effective yield used to recognize the accretable difference on the remaining pool. Loans originally placed into a performing pool will not be reported individually as 30-89 days past due, non-performing (90+ days past due or nonaccrual) or accounted for as a troubled debt restructuring as the pool is the unit of accounting. Rather, these metrics related to the underlying loans within a performing pool will be considered in our ongoing assessment and estimates of future cash flows. If, at acquisition, the loans are collateral dependent and acquired primarily for the rewards of ownership of the underlying collateral, or if cash flows expected to be collected cannot be reasonably estimated, accrual of income is inappropriate. Such loans will be placed into nonperforming (nonaccrual) loan pools.

The cash flows expected to be received over the life of the pool were estimated by management with the assistance of a third party valuation specialist. These cash flows were input into an ASC 310-30 compliant accounting loan system which calculates the carrying values of the pools and underlying loans, book yields, effective interest income and impairment, if any, based on actual and projected events. Default rates, loss severity and prepayment speed assumptions will be periodically reassessed and updated within the accounting model to update the expectation of future cash flows. The excess of the cash flows expected to be collected over the pool's carrying value is considered to be the accretable yield and is recognized as interest income over the estimated life of the loan or pool using the effective yield method. The accretable yield will change due to changes in the timing and amounts of expected cash flows. For the performing loan pools, a prepayment assumption as documented by the valuation specialist is initially applied. Changes in the accretable yield will be disclosed quarterly.

The excess of the contractual balances due over the cash flows expected to be collected is considered to be the nonaccretable difference. The nonaccretable difference represents the estimate of the credit losses expected to occur and was considered in determining the fair value of the loans as of the acquisition date. Subsequent to the acquisition date, any increases in expected cash flows over those expected at purchase date in excess of fair value are adjusted through the accretable difference on a prospective basis. Any subsequent decreases in expected cash flows over those expected at purchase date are recognized by recording an impairment. Any disposals of loans, including sales of loans, payments in full or foreclosures, result in the removal of the loan from the pool at its carrying amount.

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FDIC Indemnification Asset: The Company has elected to account for amounts receivable under the loss share agreement as an indemnification asset in accordance with FASB ASC 805, Business Combinations. The FDIC indemnification asset is initially recorded at fair value, based on the discounted value of expected future cash flows under the loss share agreement. The difference between the present value and the undiscounted cash flows the Company expects to collect from the FDIC will be accreted into noninterest income over the life of the FDIC indemnification asset.

The FDIC indemnification asset is reviewed periodically and adjusted for any changes in expected cash flows based on recent performance and expectations for future performance of the covered portfolio. These adjustments are measured on the same basis as the related covered loans and covered other real estate owned. Any increases in cash flow of the covered assets over those expected will reduce the FDIC indemnification asset and any decreases in cash flow of the covered assets under those expected will increase the FDIC indemnification asset. Increases and decreases to the FDIC indemnification asset are recorded as adjustments to noninterest income.

Fair Value: FASB ASC 820, Fair Value Measurements and Disclosures, establishes a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no pricing observability and a higher degree of judgment utilized in measuring fair value. Pricing observability is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction.

Results of Operations Overview

For the year ended December 31, 2012, net income available to common shareholders was $16.8 million, or $1.09 per diluted common share, compared to $14.9 million, or $0.97 per diluted common share, for the year ended December 31, 2011, and $23.9 million, or $1.55 per diluted common share, for the year ended December 31, 2010.

Net income available to common shareholders for the year ended December 31, 2010, included a $19.9 million pre-tax bargain purchase gain related to the September 24, 2010 FDIC-assisted acquisition of North County Bank.

In addition to results presented in accordance with generally accepted accounting principles in the United States of America ("GAAP"), this filing presents certain non-GAAP financial measures. Management believes that certain non-GAAP financial measures provide investors with information useful in understanding the Company's financial performance; however, readers of this report are urged to review these non-GAAP measures in conjunction with the GAAP results, as reported.

Operating earnings are not a measure of performance calculated in accordance with GAAP. However, management believes that operating earnings are an important indication of the ability to generate earnings through the Company's fundamental banking business. Since operating earnings exclude the effects of certain items that are unusual and/or difficult to predict, management believes that operating earnings provide useful supplemental information to both management and investors in evaluating the Company's financial results.

Operating earnings should not be considered in isolation or as a substitute for net income, cash flows from operating activities or other income or cash flow statement data calculated in accordance with GAAP. Moreover, the manner in which the Company calculates operating earnings may differ from that of other companies reporting measures with similar names.

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The following table provides the reconciliation of the Company's GAAP earnings to operating earnings (non-GAAP) for the periods presented:

(dollars in thousands)                                        For the Year Ended
                                                                 December 31,
                                                       2012          2011          2010
GAAP earnings available to common shareholders       $  16,844     $  14,868     $  23,911
Provision for income tax                                 7,856         7,111        11,797
GAAP earnings available to common shareholders
before provision for income tax                         24,700        21,979        35,708
Adjustments to GAAP earnings available to common
shareholders
Bargain purchase gain on acquisition                         -             -       (19,925 )
Merger related expenses                                      -           324         2,113
Accelerated accretion of remaining preferred stock
discount                                                     -         1,046             -
Operating earnings before tax                           24,700        23,349        17,896
Provision for income tax                                 7,856         7,224         5,563
Net operating earnings                               $  16,844     $  16,125     $  12,333

Diluted GAAP earnings per common share               $    1.09     $    0.97     $    1.55
Diluted operating earnings per common share          $    1.09     $    1.05     $    0.80

Tangible common equity, tangible assets and tangible book value per common share are not measures that are calculated in accordance with GAAP. However, management uses these non-GAAP measures in their analysis of the Company's performance. Management believes that these non-GAAP measures are an important indication of the Company's ability to grow both organically and through business combinations, and with respect to tangible common equity, the Company's ability to pay dividends and to engage in various capital management strategies.

Neither tangible common equity, tangible assets nor tangible book value per common share should be considered in isolation or as a substitute for common shareholders' equity or book value per common share or any other measure calculated in accordance with GAAP. Moreover, the manner in which the Company calculates tangible common equity, tangible assets and tangible book value per share may differ from that of other companies reporting measures with similar names.

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The following table provides the reconciliation of the Company's shareholders' equity (GAAP) to tangible common equity (non-GAAP) and total assets (GAAP) to tangible assets (non-GAAP) for the periods presented:

                                                               December 31,      December 31,
(dolars in thousands)                                              2012              2011
Total shareholders' equity                                     $     182,624     $     170,820
Adjustments to shareholders' equity
Goodwill and other intangible assets, net                             (6,027 )          (6,539 )
Tangible common equity                                         $     176,597     $     164,281

Total assets                                                   $   1,687,677     $   1,670,682
Adjustments to total assets
Goodwill and other intangible assets, net                             (6,027 )          (6,539 )
Tangible assets                                                $   1,681,650     $   1,664,143

Common shares outstanding at end of period                        15,483,598        15,398,197
Tangible common equity ratio                                           10.50 %            9.87 %
Tangible book value per common share                           $       11.41     $       10.67

Net Interest Income: One of the Company's key sources of earnings is net interest income. To make it easier to compare results among several periods and the yields on various types of earning assets (some of which are taxable and others which are not), net interest income is presented in this discussion on a "taxable-equivalent basis" (i.e., as if it were all taxable at the same rate). There are several factors that affect net interest income including:

The volume, pricing, mix and maturity of interest-earning assets and interest-bearing liabilities;

The volume of free funds (consisting of noninterest-bearing deposits and other liabilities and shareholders' equity); and,

The volume of noninterest-earning assets, market interest rate fluctuations, and asset quality.

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The following tables set forth various components of the balance sheet that affect interest income and expense and their respective yields or rates:

(dollars in
thousands)                                                                                            Years Ended December 31,
                                                   2012                                                               2011                                                         2010
                                                   Interest             Average                                       Interest             Average                                 Interest       Average
                            Average                earned/               yield/                Average                earned/               yield/                Average          earned/         yield/
                            balance                  paid                 rate                 balance                  paid                 rate                 balance            paid           rate
Assets
Non-covered loans
(1)(2)                   $      831,179           $   47,061                 5.66 %         $      831,997           $   50,313                 6.05 %         $      834,668     $   53,963           6.47 %
Covered loans                   242,552               36,418                15.01 %                307,836               34,819                11.31 %                226,852         19,173           8.45 %
Federal funds sold                    8                    -                    -                      519                    1                 0.20 %                  5,669              7           0.11 %
Interest-bearing
deposits                         98,169                  251                 0.26 %                101,683                  258                 0.25 %                107,664            291           0.27 %
Investments
Taxable                         291,836                5,333                 1.83 %                205,426                3,967                 1.93 %                134,100          2,348           1.75 %
Non-taxable (2)                  46,727                1,791                 3.83 %                 28,373                1,370                 4.83 %                 18,918          1,085           5.74 %
Interest-earning
assets                        1,510,471               90,854                 6.02 %              1,475,834               90,728                 6.15 %              1,327,871         76,867           5.79 %
Noninterest-earning
assets                          161,432                                                            205,420                                                            155,213
Total assets             $    1,671,903                                                     $    1,681,254                                                     $    1,483,084

Liabilities and shareholders' equity
Deposits:
NOW accounts and
MMA                      $      611,477           $    1,352                 0.22 %         $      581,189           $    2,394                 0.41 %         $      439,302     $    2,611           0.59 %
Savings                         105,085                  105                 0.10 %                 96,892                  199                 0.21 %                 74,922            189           0.25 %
Time deposits                   497,812                5,124                 1.03 %                606,771                6,899                 1.14 %                599,673          8,291           1.38 %
Total
interest-bearing
deposits                      1,214,374                6,581                 0.54 %              1,284,852                9,492                 0.74 %              1,113,897         11,091           1.00 %
Federal funds
purchased                            61                    -                    -                        3                    -                    -                      279              -           0.04 %
Junior subordinated
debentures                       25,774                  532                 2.06 %                 25,774                  489                 1.90 %                 25,774            496           1.92 %
Other
interest-bearing
liabilities                           -                    -                    -                        -                    -                    -                    6,521            243           3.73 %
Total
interest-bearing
liabilities                   1,240,209                7,113                 0.57 %              1,310,629                9,981                 0.76 %              1,146,471         11,830           1.03 %

Noninterest-bearing
deposits                        243,522                                                            202,297                                                            158,399
Other liabilities                12,035                                                              6,263                                                             11,158
Total liabilities             1,495,766                                                          1,519,189                                                          1,316,028
Total shareholders'
equity                          176,137                                                            162,065                                                            167,056
Total liabilities
and
shareholders'
equity                   $    1,671,903                                                     $    1,681,254                                                     $    1,483,084
Net interest
income/spread                                     $   83,741                 5.45 %                                  $   80,747                 5.39 %                            $   65,037           4.76 %
Credit for
interest-bearing
funds                                                                        0.09 %                                                             0.08 %                                                 0.14 %
Net interest margin
(2)                                                                          5.54 %                                                             5.47 %                                                 4.90 %

(1) Average balance includes nonaccrual loans.
(2) Interest income on non-taxable investments and loans is presented on a taxable-equivalent basis using the federal statutory rate of 35%. These adjustments totaled $1.1 million, $1.0 million and $918 thousand for the years ended December 31, 2012, 2011 and 2010, respectively. Taxable-equivalent is a non-GAAP performance measurement that managment believes provides investors with a more accurate picture of the net interest margin and efficiency ratio for comparative purposes.

Net interest income on a taxable-equivalent basis totaled $83.7 million for the year ended December 31, 2012, compared to $80.7 million for the same period in 2011. The $3.0 million year-over-year increase was primarily attributable to decreases in the average balance and the average rate paid on interest-bearing deposits. For the period, average interest-bearing deposits decreased $70.5 million and the average rate decreased 20 basis points. For the period, interest earned on interest-earning assets remaining relatively flat. Net interest margin (net interest income as a percentage of average interest-earning assets) on a taxable-equilavent basis was 5.54% for 2012, an increase of 7 basis points as compared to 2011.

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Net interest income on a taxable-equivalent basis increased $15.7 million for the year ended December 31, 2011 compared to the same period in 2010. The increase was primarily attributable to increases in the average balance and average yield earned on covered loans. For the period, average covered loans increased $81.0 million and the average yield increased 286 basis points. Also contributing to the increase was the $164 thousand decrease in average interest-bearing liabilities and the 27 basis point decrease in the average rate paid on those liabilities. Net interest margin on a taxable-equilavent basis was 5.47% for 2011, an increase of 57 basis points as compared to 2010.

Due to the current low interest rate environment, together with the projected principal reduction in higher yielding covered loans, management expects net interest income and net interest margin will decline in future periods.

The following table details the effects of changes in rates and volume on interest income and expense for the periods indicated:

(dollars in
thousands)                             2012 compared to 2011                                      2011 compared to 2010
                        Increase (decrease) in interest income and expense      Increase (decrease) in interest income and expense due to
                                      due to changes in (2):                                         changes in (2):
                          Volume               Rate                Total           Volume                  Rate                  Total
Assets
Non-covered loans
(1)(3)                  $       (48 )       $    (3,204 )       $    (3,252 )   $       (172 )         $     (3,478 )         $     (3,650 )
Covered loans                (2,940 )             4,539               1,599            8,033                  7,613                 15,646
Federal funds sold               (1 )                 -                  (1 )            (90 )                   84                     (6 )
Interest-bearing
deposits                         (9 )                 2                  (7 )            (15 )                  (18 )                  (33 )
Investments (1)
Taxable                       1,566                (200 )             1,366            1,356                    263                  1,619
Non-taxable                     618                (197 )               421              417                   (132 )                  285
Interest-earning
assets                  $      (814 )       $       940         $       126     $      9,529           $      4,332           $     13,861

Liabilities
Deposits:
NOW accounts and
money market            $       119         $    (1,161 )       $    (1,042 )   $        711           $       (928 )         $       (217 )
Savings                          16                (110 )               (94 )             49                    (39 )                   10
Time deposits                (1,162 )              (613 )            (1,775 )             98                 (1,490 )               (1,392 )
Total
interest-bearing
deposits                     (1,027 )            (1,884 )            (2,911 )            858                 (2,457 )               (1,599 )
Junior subordinated
debentures                        -                  43                  43                -                     (7 )                   (7 )
Other
interest-bearing
liabilities                       -                   -                   -             (122 )                 (121 )                 (243 )
Total
interest-bearing
liabilities             $    (1,027 )       $    (1,841 )       $    (2,868 )   $        736           $     (2,585 )         $     (1,849 )

(1) Interest income on non-taxable investments and loans are presented on a fully tax-equivalent basis using the federal statutory rate of 35.0% for the years ended December 31, 2012, 2011 and 2010.

(2) The changes attributable to the combined effect of volume and interest rates have been allocated proportionately.
(3) Interest income previously accrued on nonaccrual loans is reversed in the period the loan is placed on nonaccrual status.

. . .

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