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WBCO > SEC Filings for WBCO > Form 10-Q on 8-Aug-2013All Recent SEC Filings

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Form 10-Q for WASHINGTON BANKING CO


8-Aug-2013

Quarterly Report


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

Note Regarding Forward-Looking Statements: This Quarterly Report on Form 10-Q includes 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. These forward-looking statements describe Washington Banking Company's (the "Company") management's expectations regarding future events and developments such as future operating results, growth in loans and deposits, the FDIC indemnification asset and covered loans, credit quality and adequacy of the allowance for loan losses, and continued success of the Company's business plan. Readers should not place undue reliance on forward-looking statements, which reflect management's views only as of the date hereof. The words "will," "believe," "expect," "should," "anticipate" and words of similar meaning are intended in part to help identify forward-looking statements. Future events are difficult to predict, and the expectations described below are necessarily subject to risk and uncertainty that may cause actual results to differ materially. In addition to discussions about risks and uncertainties set forth from time to time in the Company's filings with the Securities and Exchange Commission (the "SEC"), factors that may cause actual results to differ materially from those contemplated in such forward-looking statements include, among others: (1) local and national economic conditions;
(2) changes in interest rates and their impact on net interest margin; (3) competition among financial institutions; (4) legislation or regulatory requirements; and (5) the ability to realize efficiencies expected from investment in personnel and infrastructure. However, the reader should be aware that these factors are not an exhaustive list, and it should not be assumed that these are the only factors that may cause actual results to differ from expectations. In addition, the reader should note that the Company does not intend to update any of the forward-looking statements or the uncertainties that may adversely impact those statements.

The following discussion and analysis should be read in conjunction with the financial statements and notes thereto presented elsewhere in this report.

Overview

Washington Banking Company (referred to in this report as the "Company") is a registered bank holding company with two wholly-owned subsidiaries: Whidbey Island Bank (the "Bank"), the Company's principal subsidiary and Washington Banking Master Trust (the "Trust"). Headquartered in Oak Harbor, the Company's market area is primarily northwestern Washington. The market area encompasses distinct economies and none are particularly dependent upon a single industrial or occupational source. The economies within the market areas have evolved from being heavily dependent upon forestry, fishing and farming to a more diverse blend of industries including retail trade, services, manufacturing, tourism and a large military presence.

The Company's strategy is one of value-added growth. Management believes that qualitative and sustainable growth of the Company, coupled with maintaining profitability, is currently the most appropriate path to providing good value for its shareholders. Prior to 2010, the Company's growth had been achieved organically. On April 16, 2010 and September 24, 2010, the Bank acquired certain assets and assumed certain liabilities of City Bank and North County Bank, respectively, from the Federal Deposit Insurance Corporation ("FDIC") in FDIC-assisted transactions.

The Company attributes its reputation for focusing on customer service and satisfaction as one of the cornerstones to the Company's success. The Company's primary objectives are to improve profitability and operating efficiencies, increase market penetration in areas currently served and to continue an expansion strategy in appropriate market areas.

The Company's geographical expansion to date has primarily been concentrated along the I-5 corridor from King to Whatcom Counties; however, additional areas will be considered if they meet the Company's criteria. Acquisition of banks or branches may also be used as a means of expansion if appropriate opportunities are presented. The primary factors considered in determining the areas of geographic expansion are the availability of knowledgeable personnel, such as managers and lending officers with experience in their fields of expertise, longstanding community presence and extensive banking relationships, customer demand and perceived market potential.

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Executive Overview

Significant items for the second quarter of 2013 were as follows:

Net income available to common shareholders per diluted share was $0.19 and $0.48 for the three and six months ended June 30, 2013, compared to $0.18 and $0.49 for the three and six months ended June 30, 2012, respectively.

The Company recorded a $10.9 million impairment charge related to the credit deterioration in the covered loan portfolio. Related to the impairment charge, the Company also recorded an $8.7 million write up of the indemnification asset and a $626 thousand reversal of a portion of the FDIC clawback liability.

Net interest margin, on a tax equivalent basis, was 4.68% and 4.76% for the three and six months ended June 30, 2013, respectively, compared to 5.67% and 5.74% for the same periods a year ago.

Non-covered loans, net of allowance for loan losses, totaled $836.3 million at June 30, 2013, compared to $836.0 million at December 31, 2012.

Nonperforming non-covered assets to total assets improved to 0.96% at June 30, 2013, compared to 1.10% at December 31, 2012.

Total risk-based capital for the Company was 19.86% at June 30, 2013, compared to 19.39% at December 31, 2012. The FDIC requires a minimum total risk-based capital ratio of 10% to be considered "well-capitalized."

Tangible book value per common share totaled $11.04 at June 30, 2013, compared to $11.41 at December 31, 2012.

Authorized a stock repurchase program allowing for the buyback of up to 775,000 shares (approximately 5%) of current outstanding common stock.

Summary of Critical Accounting Policies

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and the accompanying notes. Changes in these estimates and assumptions are considered reasonably possible and may have a material impact on the consolidated financial statements and thus actual results could differ from the amounts reported and disclosed herein. Significant accounting policies are described in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2012, as filed with the SEC on Form 10-K. Not all 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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Covered Loans: Covered 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 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 a provision for loan losses. 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.

FDIC Indemnification Asset: The Company has elected to account for amounts receivable under the loss share agreement as an indemnification asset. 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.

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Results of Operations Overview

For the three months ended June 30, 2013, net income available to common shareholders totaled $2.9 million, or $0.19 per diluted common share, compared to net income available to common shareholders of $2.8 million, or $0.18 per diluted common share, for the same period a year ago. Net income available to common shareholders for the period was primarily attributable to continued improvement in asset quality and strong mortgage banking income.

For the six months ended June 30, 2013, net income available to common shareholders totaled $7.5 million, or $0.48 per diluted common share, compared to net income available to common shareholders of $7.6 million, or $0.49 per diluted common share, for the six months ended June 30, 2012.

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.

Fully tax-equivalent net interest income and fully tax-equivalent net interest margin are non-GAAP performance measurements that management believes provide investors with a more accurate picture of the Company's operational performance and are consistent with industry practice. The calculation for both measurements involves grossing up interest income on tax-exempt loans and investments by an amount that makes it comparable to taxable income.

Neither fully tax-equivalent net interest income nor fully tax-equivalent net interest margin should be considered in isolation nor as a substitute for net interest income or net interest margin or any other measure calculated in accordance with GAAP. Moreover, the manner in which the Company calculates fully tax-equivalent net interest income and fully tax-equivalent net interest margin may differ from that of other companies reporting measures with similar names.

The following table provides the reconciliation of the Company's net interest income (GAAP) to a fully tax-equivalent net interest income (non-GAAP) and net interest margin (GAAP) to a fully tax-equivalent net interest margin (non-GAAP) for the periods presented:

(dollars in thousands)                      Three Months Ended               Six Months Ended
                                                 June 30,                        June 30,
                                           2013            2012            2013            2012
GAAP net interest income               $    17,357     $    20,889     $    35,539     $    42,191
Tax-equivalent adjustment                      216             277             422             542
Tax-equivalent net interest income     $    17,573     $    21,166     $    35,961     $    42,733
Average interest earning assets        $ 1,507,438     $ 1,501,373     $ 1,523,229     $ 1,497,348
Net interest margin                           4.62 %          5.60 %          4.70 %          5.67 %
Tax-equivalent net interest margin            4.68 %          5.67 %          4.76 %          5.74 %

Tangible common equity, tangible assets and tangible book value per common share are measures that are not 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:

(dollars in thousands)                      June 30, 2013      December 31, 2012
Total shareholders' equity                 $      177,250     $         182,624
Adjustments to shareholders' equity
Goodwill and other intangible assets, net          (5,809 )              (6,027 )
Tangible common equity                     $      171,441     $         176,597
Total assets                               $    1,617,493     $       1,687,677
Adjustments to total assets
Goodwill and other intangible assets, net          (5,809 )              (6,027 )
Total tangible assets                      $    1,611,684     $       1,681,650
Common shares outstanding at end of period     15,527,037            15,483,598
Tangible common equity ratio                        10.64 %               10.50 %
Tangible book value per common share       $        11.04     $           11.41

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);

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)                               Three Months Ended June 30,
                                          2013                                         2012
                                         Interest                                     Interest
                          Average        earned/        Average        Average        earned/        Average
                          balance          paid       yield/rate       balance          paid       yield/rate
Assets
Non-covered loans
(1)(2)                 $   856,046     $   10,989          5.15 %   $   825,779     $   11,746          5.72 %
Covered loans              189,099          5,972         12.67 %       248,079          9,382         15.21 %
Interest-bearing
deposits                    62,533             39          0.25 %        99,484             68          0.27 %
Investments:
Taxable                    325,926          1,344          1.65 %       285,784          1,387          1.95 %
Non-taxable (2)             73,834            598          3.25 %        42,247            420          4.00 %
Interest-earning
assets                   1,507,438         18,942          5.04 %     1,501,373         23,003          6.16 %
Noninterest-earning
assets                     134,248                                      170,452
Total assets           $ 1,641,686                                  $ 1,671,825
Liabilities and
shareholders' equity
Deposits:
NOW accounts and MMA   $   636,172     $      255          0.16 %   $   602,616     $      336          0.22 %
Savings                    117,230             14          0.05 %       102,106             26          0.10 %
Time deposits              414,531            979          0.95 %       512,760          1,342          1.05 %
Total interest-bearing
deposits                 1,167,933          1,248          0.43 %     1,217,482          1,704          0.56 %
Federal funds
purchased                        -              -             - %           244              -             - %
Junior subordinated
debentures                  25,774            121          1.88 %        25,774            133          2.08 %
Total interest-bearing
liabilities              1,193,707          1,369          0.46 %     1,243,500          1,837          0.60 %
Noninterest-bearing
deposits                   248,941                                      242,784

Other liabilities           14,996                                       10,976
Total liabilities        1,457,644                                    1,497,260
Total shareholders'
equity                     184,042                                      174,565
Total liabilities and
shareholders' equity   $ 1,641,686                                  $ 1,671,825
Net interest
income/spread                          $   17,573          4.58 %                   $   21,166          5.56 %
Credit for
interest-bearing funds                                     0.10 %                                       0.11 %
Net interest margin
(2)                                                        4.68 %                                       5.67 %

(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 $216 thousand and $277 thousand for the three months ended June 30, 2013 and 2012, respectively. Taxable-equivalent is a non-GAAP performance measurement that management believes provides investors with a more accurate picture of the net interest margin and efficiency ratio for comparative purposes.

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(dollars in thousands)                                Six Months Ended June 30,
                                          2013                                         2012
                                         Interest                                     Interest
                          Average        earned/        Average        Average        earned/        Average
                          balance          paid       yield/rate       balance          paid       yield/rate
Assets
Non-covered loans
(1)(2)                 $   856,147     $   22,154          5.22 %   $   826,153     $   23,632          5.75 %
Covered loans              197,937         12,685         12.92 %       255,329         19,250         15.16 %
Federal funds sold               -              -             - %             -              -             - %
Interest-bearing
deposits                    78,192             98          0.25 %        91,593            119          0.26 %
Investments:
Taxable                    319,762          2,657          1.68 %       284,015          2,743          1.94 %
Non-taxable (2)             71,191          1,164          3.30 %        40,258            807          4.03 %
Interest-earning
assets                   1,523,229         38,758          5.13 %     1,497,348         46,551          6.25 %
Noninterest-earning
assets                     133,932                                      171,363
Total assets           $ 1,657,161                                  $ 1,668,711
Liabilities and
shareholders' equity
Deposits:
NOW accounts and MMA   $   636,974     $      512          0.16 %   $   603,047     $      731          0.24 %
Savings                    116,235             28          0.05 %       101,511             52          0.10 %
Time deposits              428,491          2,018          0.95 %       522,521          2,766          1.06 %
Total interest-bearing
deposits                 1,181,700          2,558          0.44 %     1,227,079          3,549          0.58 %
Federal funds
purchased                        -              -             - %           122              -             - %
Junior subordinated
debentures                  25,774            239          1.87 %        25,774            269          2.10 %
Total interest-bearing
liabilities              1,207,474          2,797          0.47 %     1,252,975          3,818          0.61 %
Noninterest-bearing
deposits                   250,622                                      232,702
Other liabilities           15,707                                        9,764
Total liabilities        1,473,803                                    1,495,441
. . .
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