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HBKS > SEC Filings for HBKS > Form 10-K on 29-Mar-2013All Recent SEC Filings

Show all filings for HERITAGE BANKSHARES INC /VA | Request a Trial to NEW EDGAR Online Pro

Form 10-K for HERITAGE BANKSHARES INC /VA


29-Mar-2013

Annual Report


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

Management's discussion and analysis is intended to assist readers in the understanding and evaluation of our financial condition and results of operations. The discussion and analysis should be read in conjunction with the audited consolidated financial statements and accompanying notes included in this annual report on Form 10-K and the supplemental financial data appearing throughout this discussion and analysis.

Overview

The Company, through the Bank, engages in a general community and commercial banking business, targeting the banking needs of small to medium sized businesses in its primary service area, which includes Chesapeake, Norfolk and Virginia Beach, Virginia. The principal business of the Bank is to attract deposits and to lend or invest those deposits on profitable terms. These deposits are in varied forms of both demand and time accounts including checking accounts, interest checking, money market accounts, savings accounts and certificates of deposit.

The Company actively extends commercial credit and is involved in the construction and real estate lending market. Loans consist of varying terms and may be secured or unsecured. Loans to individuals are limited to owners or senior managers of existing or prospective business clients and are for personal, household and family purposes. Loans to businesses are made for purposes such as working capital, financing of facilities, and equipment purchases.

Critical Accounting Policies

The preparation of our consolidated financial statements and accompanying notes are governed by accounting principles generally accepted in the United States of America. The preparation of these consolidated


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financial statements requires management to use judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. While we believe our judgments, estimates and assumptions are reasonable under the circumstances, actual results may differ materially under different conditions or using different assumptions.

We believe our critical accounting policies are those that are particularly sensitive in terms of judgments and the extent to which estimates are used, and include (a) the valuation of the allowance for loan losses and the impairment of loans, (b) the impairment of financial investments and other accounts, (c) the deferral of loan fees and direct loan origination costs, and (d) accounting for income taxes.

The Financial Accounting Standards Board ("FASB") Accounting Standards Codification (the "Codification" or "ASC"). In June 2009, the FASB issued an accounting standard which established the Codification to become the single source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities, with the exception of guidance issued by the U.S. Securities and Exchange Commission and its staff. All guidance contained in the Codification carries an equal level of authority. The Codification is not intended to change GAAP, but rather is expected to simplify accounting research by reorganizing current GAAP into approximately 90 accounting topics. We adopted this accounting standard in preparing our consolidated financial statements for the period ended December 31, 2009. The adoption of this accounting standard, which was subsequently codified into ASC Topic 105, "Generally Accepted Accounting Principles," had no impact on retained earnings and will have no impact on our statements of income and condition.

Allowance for Loan Losses; Impairment of Loans. The allowance for loan losses is maintained at a level which, in management's judgment, is adequate to absorb estimated credit losses on existing loans. If judgments and assumptions were to differ significantly from those used by management to estimate the allowance, the allowance for loan losses and the provision for loan losses on our income statement could be impacted materially. In addition, the allowance for loan losses is subject to review by various regulators who conduct examinations of the allowance for loan losses and may require adjustments to the allowance based upon the regulators' assessment regarding our adequacy and the methodology used. (For further discussion of the Company's allowance for loan losses, see "Lending Activities - Allowance for Loan Losses" located below in this Management's Discussion and Analysis of Financial Condition and Results of Operations.)

A loan is considered impaired when it is probable that we will be unable to collect all interest and principal payments due according to the contractual terms of the loan agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, or the fair value of the collateral if the loan is collateral dependent. A valuation allowance is maintained to the extent that the measure of the impaired loan is less than the recorded investment.

Impairment of Financial Investments and Other Accounts. Impairment of investment securities, other equity investments and other asset accounts results in a write-down that must be included in net income when fair value of the asset declines below cost and is other-than-temporary. The fair values of these investments and other assets are subject to change, as they are influenced by market conditions and management decisions.

Deferral of Loan Fees and Direct Loan Origination Costs. Generally accepted accounting policies relating to accounts receivable require that loan fees and direct loan origination costs be deferred and recognized as an adjustment to the loan's yield. While the amount of fees to be deferred is generally apparent in the origination of a loan, we utilize estimates to determine the amount of deferred direct origination costs, especially payroll costs, that are attributable to the loan origination process. Management's estimates of the amount of costs associated with successful loan origination activities are reviewed and updated annually.

Accounting for Income Taxes. The determination of the Company's effective tax rate requires judgment. In the ordinary course of business, there are transactions and calculations for which the ultimate tax outcomes are uncertain. In addition, our tax returns are subject to audit by various tax authorities. Although we believe our estimates are reasonable, there can be no assurance that the final tax outcome will not be materially different than that which is reflected in the income tax provision and accrual.


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Selected Financial Ratios

The information presented below is derived in part from our audited consolidated
financial statements and notes thereto, which appear elsewhere in this annual
report on Form 10-K (see Item 8, "Financial Statements and Supplementary Data,"
below). This information should be read in conjunction with our consolidated
financial statements.



                                               For the Years Ended December 31,
                                              2012              2011          2010
    Return on average assets (1)                 0.74 %            0.83 %       0.74 %
    Return on average equity (2)                 7.96 %            8.46 %       5.60 %
    Average equity to average assets (3)        11.76 %           12.63 %      13.29 %
    Dividend payout ratio (4)                   62.50 %           30.77 %      36.92 %

(1) Net income after tax, before preferred stock dividends and accretion of discount, divided by average total assets.

(2) Net income after tax, before preferred stock dividends and accretion of discount, divided by average common equity.

(3) Average equity divided by average total assets.

(4) Represents common dividends declared per share divided by basic net income per share.

Financial Condition of the Company

Total Assets. The Company's total assets increased by $42.0 million, or 14.2%, from $294.6 million at December 31, 2011 to $336.6 million at December 31, 2012. The increase in assets resulted primarily from a $36.2 million increase in our aggregate cash, securities available for sale, interest-bearing deposits in other banks and federal funds sold, together with a $7.8 million increase in loans held for investment, net.

Investments. Securities available for sale decreased by $24.1 million, from $45.3 million at December 31, 2011 to $21.2 million at December 31, 2012. Overnight funds increased by $24.6 million and certificates of deposit, interest-bearing deposits in other banks (excluding overnight funds), and federal funds sold increased by a total of $35.3 million, with a resulting aggregate increase in such investment balances from $8.7 million at December 31, 2011 to $68.6 million at December 31, 2012.

Loans. Loans held for investment, net, were $221.0 million at December 31, 2012, an increase of $7.8 million from our loan balance of $213.2 million at December 31, 2011.

Asset Quality. Nonperforming assets were $699,000, or 0.21% of total assets, at December 31, 2012, compared to $1,719,000 in nonperforming assets, or 0.58% of total assets, at December 31, 2011. Accruing loans past due 90 days or more consisted of one residential 1-4 loan and other real estate owned consisted of a bank branch site that we no longer plan to utilize.

Deposits. Total deposits at December 31, 2012 were $295.2 million compared to $250.0 million at December 31, 2011, an increase of $45.2 million, or 18.1%. Core deposits, which are comprised of noninterest-bearing, money market, NOW and savings deposits, increased by $65.9 million, or 32.0%, from $205.6 million at December 31, 2011 to $271.5 million at December 31, 2012. Noninterest-bearing deposits increased by $18.7 million to $111.5 million at December 31, 2012 and, as a percentage of total deposits, noninterest-bearing deposits increased from 37.1% at December 31, 2011 to 37.8% at December 31, 2012.

Average total deposits increased by $28.1 million, or 11.5%, from $244.3 million for the twelve-month period ended December 31, 2011 to $272.4 million for the twelve-month period ended December 31, 2012. Average core deposits increased by $46.1 million, or 23.6%, over the comparable twelve-month periods. Average noninterest-bearing deposits increased by $11.8 million, from $88.4 million in the twelve-month period ending December 31, 2011 to $100.2 million in the twelve-month period ending December 31, 2012. As a percentage of average total deposits, average noninterest-bearing deposits increased slightly from 36.2% at December 31, 2011 to 36.8% at December 31, 2012.

Borrowed Funds. Borrowed funds decreased by $3.2 million, from $6.3 million at December 31, 2011 to $3.1 million at December 31, 2012.

Capital. Stockholders' equity increased by $237,000, from $36,437,000 at December 31, 2011 to $36,674,000 at December 31, 2012, primarily due to an increase in earnings, partially offset by a $333,000 decrease in accumulated other comprehensive income related to the reduction of our securities available for sale portfolio and an $819,000 special dividend declared in the fourth quarter of 2012.


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Net Interest Income

Like most financial institutions, the primary component of our earnings is net interest income. Net interest income is the difference between interest income, primarily from loan and investment securities portfolios, and interest expense, primarily on customer deposits and other Company borrowings. Changes in net interest income result from changes in volume, spread and margin. For purposes of determining such changes in net interest income, (a) volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, (b) spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and (c) margin refers to net interest income divided by average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as levels of noninterest-bearing liabilities. During the years ended December 31, 2012 and 2011, our average interest-earning assets were $291.3 million and $269.1 million, respectively. During these same years, our net interest margins, on a tax-equivalent basis, were 3.58% and 4.12%, respectively.


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Average Balances and Average Rates Earned and Paid. The following table sets forth for the Company, for the periods indicated, information with regard to average balances of assets and liabilities, as well as the total dollar amounts on a tax-equivalent basis of interest income from interest-earning assets and interest expense on interest-bearing liabilities, resultant yields or costs, net interest income, net interest spread, net interest margin and ratio of average interest-earning assets to average interest-bearing liabilities. In preparing the table, nonaccrual loans are included in the average loan balance.

                                                     YEAR ENDED                                YEAR ENDED                                YEAR ENDED
                                                 DECEMBER 31, 2012                         DECEMBER 31, 2011                         DECEMBER 31, 2010
                                         Average                                   Average                                   Average
                                         Balance                     Yield/        Balance                     Yield/        Balance                     Yield/
                                           (1)         Interest       Cost           (1)         Interest       Cost           (1)         Interest       Cost
                                                                                         (dollars in thousands)
Interest-earning assets (2)
Loans (2) (3)                           $ 214,956      $  10,388        4.82 %    $ 214,962      $  11,423        5.31 %    $ 193,394      $  10,218        5.28 %
Investment securities taxable              35,682            824        2.31 %       26,561            799        3.01 %       41,996          1,404        3.34 %
FHLB and Federal Reserve Stock              1,238             48        3.86 %        1,972             48        2.44 %        2,232             40        1.79 %
Federal funds sold                             73             -         0.02 %          136             -         0.08 %          651              1        0.12 %
Other interest income                      39,358            183        0.46 %       25,489             93        0.36 %       24,365            132        0.54 %

Total interest-earning assets             291,307         11,443        3.92 %      269,120         12,363        4.59 %      262,638         11,795        4.49 %

Noninterest-earning assets
Other real estate owned                     1,472                                       522                                       102
Other assets                               22,326                                    17,263                                    17,656

Total assets                            $ 315,105                                 $ 286,905                                 $ 280,396


Interest-bearing liabilities
Money market, NOW accounts              $ 137,501      $     693        0.50 %    $ 103,907      $     579        0.56 %    $  98,962      $     586        0.59 %
Savings deposits                            4,230              6        0.15 %        3,488              6        0.18 %        2,957              6        0.20 %
Certificates of deposit                    30,515            244        0.80 %       48,517            634        1.31 %       49,072            806        1.64 %

Total interest-bearing deposits           172,246            943        0.55 %      155,912          1,219        0.78 %      150,991          1,398        0.93 %


Other borrowings                            3,449             29        0.82 %        4,304             44        1.02 %       10,982            144        1.30 %

Total interest-bearing liabilities        175,695            972        0.56 %      160,216          1,263        0.79 %      161,973          1,542        0.96 %


Noninterest-bearing liabilities
Demand deposits                           100,148                                    88,371                                    79,237
Other liabilities                           2,217                                     2,092                                     1,930

Total liabilities                         278,060                                   250,679                                   243,140


Stockholders' equity                       37,045                                    36,226                                    37,256

Total liabilities and Stockholders'
equity                                  $ 315,105                                 $ 286,905                                 $ 280,396


Net interest income and interest
spread                                                 $  10,471        3.36 %                   $  11,100        3.80 %                   $  10,253        3.53 %


Net interest margin                                                     3.58 %                                    4.12 %                                    3.90 %


Ratio of average interest-earning
assets to average interest-bearing

liabilities 165.80 % 167.97 % 162.15 %

(1) The calculations are based on daily average balances.

(2) Yields are stated on a taxable-equivalent basis assuming tax rates in effect for the periods presented.

(3) For the purposes of these computations, nonaccrual loans are included in average loan balances.

Rate/Volume Analysis

The following table analyzes the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The table distinguishes between (i) changes attributable to volume (changes in volume multiplied by the prior period's rate), (ii) changes attributable to


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rate (changes in rate multiplied by the prior period's volume), and (iii) net change (the sum of the previous columns). The change attributable to both rate and volume (changes in rate multiplied by changes in volume) has been allocated equally to both the changes attributable to volume and the changes attributable to rate.

                                                       YEAR ENDED                               YEAR ENDED
                                               December 31, 2012 vs. 2011               December 31, 2011 vs. 2010
                                                Increase(Decrease) Due to                Increase(Decrease) Due to
                                           Volume         Rate         Total         Volume          Rate        Total
                                                                          (in thousands)
Interest income
Loans                                      $    -       $ (1,035 )    $ (1,035 )    $   1,146       $   59      $ 1,205
Investment securities taxable                  237          (212 )          25           (477 )       (128 )       (605 )
FHLB & FRB stock                               (22 )          22            -              (5 )         13            8
Federal funds sold                              -             -             -              (1 )         -            (1 )
Other interest income                           59            31            90              6          (45 )        (39 )

Total interest income                          274        (1,194 )        (920 )          669         (101 )        568


Interest expense
Deposits
Money Market/NOW accounts                      179           (65 )         114             26          (33 )         (7 )
Savings deposits                                 1            (1 )          -               1           (1 )         -
Certificates of deposit                       (190 )        (200 )        (390 )           (9 )       (163 )       (172 )
Borrowings                                      (7 )          (8 )         (15 )          (74 )        (26 )       (100 )

Total interest expense                         (17 )        (274 )        (291 )          (56 )       (223 )       (279 )

Net interest income
Increase(decrease)                         $   291      $   (920 )    $   (629 )    $     725       $  122      $   847

Comparison of Operating Results for the Twelve Months Ended December 31, 2012 and 2011

Overview. The Company's pretax income was $3,249,000 for the year ended December 31, 2012, compared to pretax income of $3,502,000 for the year ended December 31, 2011, a decrease of $253,000. This decrease resulted primarily from a $694,000 decrease in net interest income partially offset by a $317,000 increase in noninterest income and a $174,000 decrease in noninterest expense between the two years. The Company's effective tax rate for 2012 was 28.3% compared to an effective tax rate of 32.4% for 2011.

Net Interest Income. The Company's net interest income before provision for loan losses decreased by $694,000, comparing the years 2012 and 2011. Our average loan portfolio remained unchanged at $215.0 million for the respective twelve-month periods ending December 31, 2012 and 2011. Our average investment in overnight funds increased by $13.7 million and our average investment in securities available for sale and other interest-earning assets (excluding loans and overnight funds) increased by $8.5 million, for a net increase in average interest-earning assets of $22.2 million comparing the two twelve-month periods. Average interest-bearing liabilities increased by $15.5 million from $160.2 million in 2011 to $175.7 million in 2012, resulting primarily from a $16.3 million increase in average interest-bearing deposits. The average yield on our interest-earning assets was adversely impacted by lower yields on loans and an increase in the average balance of investment securities and other interest-earning assets, which was only partially offset by a decrease in the average cost of interest-bearing liabilities. As a result, our interest rate spread decreased by 44 basis points from 3.80% in 2011 to 3.36% in 2012, and our net interest margin decreased by 54 basis points from 4.12% in 2011 to 3.58% in 2012.

Provision for Loan Losses. Provision for loan losses was $35,000 for 2012 compared to a $15,000 reduction in provision for loan losses for 2011.

Noninterest Income. Total noninterest income increased by $317,000, from $868,000 in 2011 to $1,185,000 in 2012. The primary factors contributing to this increase were a $197,000 increase in gains on the sale of investment securities and a $184,000 increase in income from bank-owned life insurance in 2012.


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Noninterest Expense. Total noninterest expense decreased by $174,000, from $8,324,000 in 2011 to $8,150,000 in 2012, primarily attributable to decreased compensation expense of $232,000.

Income Taxes. The Company's income tax expense for 2012 was $921,000, reflecting an effective tax rate of 28.3%, compared to income tax expense of $1,134,000 and an effective tax rate of 32.4% for 2011. This reduction in effective tax rate was primarily attributable to an increase in tax-exempt interest income and other non-taxable income.

Net Income Available to Common Stockholders. After the impact of dividends on our preferred stock, net income available to common shareholders was $2,191,000 for 2012, or earnings per diluted common share of $0.94, compared to net income available to common stockholders of $1,787,000 for 2011, or earnings per diluted common share of $0.77, an increase of $404,000, or $0.17 per diluted common share. This increase in earnings available to common stockholders is primarily attributable to qualified loan growth which resulted in a 1.75% average dividend rate on our SBLF preferred stock in 2012, compared to accelerated accretion of the discount on outstanding TARP preferred stock and the associated average dividend rate of 7.07% in 2011.

The following tables set forth, for the periods indicated, components of noninterest income and noninterest expense:

                                                               Years Ended December 31,
                                                               2012                 2011
                                                                    (in thousands)
Noninterest income
Service charges on deposit accounts                        $        252         $        334
Gain on sale of investment securities                               284                   87
Income from bank-owned life insurance                               203                   19
Late charges and other fees on loans                                 98                  129
Other                                                               348                  299

Total noninterest income                                   $      1,185         $        868


                                                               Years Ended December 31,
                                                               2012                 2011
                                                                    (in thousands)
Noninterest expense
Compensation                                               $      4,151         $      4,383
Data processing                                                     630                  580
Occupancy                                                           887                  838
Furniture and equipment                                             579                  583
Taxes and licenses                                                  318                  338
Professional fees                                                   332                  366
FDIC assessment                                                     155                  170
Loss on sale or impairment of other real estate owned                70                   54
Other miscellaneous                                               1,028                1,012

Total noninterest expense                                  $      8,150         $      8,324

Lending Activities

Loans held for investment, net of allowance for loan losses and unearned fees and costs, at December 31, 2012 were $221.0 million compared with $213.2 million at December 31, 2011, an increase of $7.8 million. As a percentage of average earning assets, average loans were 73.8% for the year ended 2012 and 79.9% for the year ended 2011.

General. We engage in a wide range of lending activities, which include the origination, primarily in our market area, of (1) commercial business loans,
(2) commercial real estate loans, (3) construction loans, (4) land acquisition and development loans, and (5) home equity, consumer and residential mortgage loans.


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Commencing in early 2005, we have taken a number of steps, such as the . . .

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