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OVLY > SEC Filings for OVLY > Form 10-Q on 13-Aug-2014All 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 2013 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 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:

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.

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 non-accrual 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.

Asset Impairment Judgments

Certain of our assets are carried in our consolidated balance sheets 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.

Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired and are carried at fair value or below. Appraisals are done periodically on impaired loans and if required an allowance is established based on the fair value of collateral less the cost related to liquidation of the collateral. In some circumstances, an impaired loan may be charged off to bring the carrying value to fair value.

Other real estate assets ("OREO") acquired through, or in lieu of, foreclosure are held-for-sale and are initially recorded at the lower of cost or fair value, less selling costs. Any write-downs to fair value at the time of transfer to OREO are charged to the allowance for loan losses, subsequent to foreclosure. Appraisals or evaluations are then done periodically and 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.

Net realizable value of the underlying collateral is the fair value of the collateral less estimated selling costs and any prior liens. Appraisals, recent comparable sales, offers and listing prices are factored in when valuing the collateral. We review and verify the qualifications and licenses of the certified general appraisers used for appraising commercial properties or certified residential appraisers for residential properties. Real estate appraisals may utilize a combination of approaches including replacement cost, sales comparison and the income approach. Comparable sales and income data are analyzed by the appraisers and adjusted to reflect differences between them and the subject property such as type, leasing status and physical condition. When the appraisals are received, Management reviews the assumptions and methodology utilized in the appraisal, as well as the overall resulting value in conjunction with independent data sources such as recent market data and industry-wide statistics. We generally use a 6% discount for selling costs which is applied to all properties, regardless of size. Appraised values may be adjusted to reflect changes in market conditions that have occurred subsequent to the appraisal date, or for revised estimates regarding the timing or cost of the property sale. These adjustments are based on qualitative judgments made by management on a case-by-case basis.

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.

Fair Value Measurements

We use fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. We base our fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Securities available for sale, derivatives, and loans held for sale, if any, are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record certain assets at fair value on a non-recurring basis, such as certain impaired loans held for investment and securities held to maturity that are other-than-temporarily impaired. These non-recurring fair value adjustments typically involve write-downs of individual assets due to application of lower-of-cost or market accounting.

We have established and documented a process for determining fair value. We maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. Whenever there is no readily available market data, management uses its best estimate and assumptions in determining fair value, but these estimates involve inherent uncertainties and the application of management's judgment. As a result, if other assumptions had been used, our recorded earnings or disclosures could have been materially different from those reflected in these financial statements.

Deferred Compensations Plans

Future compensation under the Company's executive salary continuation plan and director retirement plan is earned for services rendered through retirement. The Company accrues for the salary continuation liability based on anticipated years of service and vesting schedules provided under the plans. The Company's current benefit liability is determined based on vesting and the present value of the benefits at a corresponding discount rate. The discount rate used is an equivalent rate for investment-grade bonds with lives matching those of the service periods remaining for the salary continuation contracts, which average approximately 20 years.


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 six month periods ended June 30, 2014:

Thanks to our deep roots in the communities that we serve, our focus on customer care and our selectivity in lending, during the first six months of 2014, 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 $589.5 million and have posted net income available to common shareholders of $0.32 and $0.49 per diluted share for the three and six month periods ended June 30, 2014, respectively. While published economic data indicates that the downturn is behind us, it is not clear at what speed the economy will recover.

The Company recognized net income available to common shareholders of $2,537,000 and $3,945,000 for the three and six month periods ended June 30, 2014, respectively, as compared to $1,374,000 and $2,606,000 for the same periods in 2013. The Company recognized net income before preferred stock dividends of $3,945,000 for the six months ended June 30, 2014, as compared to $2,674,000 for the same period in 2013. The factors contributing to these results will be discussed below.

The Company recognized $68,000 in the first quarter ended March 31, 2013, associated with the accrual for preferred stock dividends for the Series B Preferred Stock that the U.S. Treasury owned under the Small Business Lending Fund ("SBLF"). The Company repurchased 6,750 shares of Series B Preferred Stock in May 2012 and the remaining 6,750 shares were repurchased in March 2013, therefore there were no shares of Series B Preferred Stock outstanding and no preferred stock dividends paid during 2014.

In the three and six month periods ended June 30, 2014, the Company recognized a $1,877,000 reversal of loan loss provisions due to a loan settlement of $2,923,000 which resulted in a net loan recovery of $1,877,000. This compares to loan loss provisions of $100,000 and $200,000, respectively, during the same periods in 2013. The decrease was mainly due to the loan recovery and management's assessment of the appropriate level for the allowance for loan losses. The Company continues to monitor the Bank's loan portfolio with the objective of avoiding defaults or write-downs. The Board of Directors and all employees continue to work hard to ensure a high level of underwriting standards. Despite these actions, the possibility of additional losses cannot be eliminated.

Net interest income increased $151,000 or 2.5% and $406,000 or 3.4% for the three and six month periods ended June 30, 2014, respectively, compared to the same periods in 2013. The increase was primarily due to growth of our loan and investment security portfolios.

Non-interest income increased by $109,000 or 13.3% and $134,000 or 8.4% for the three and six months ended June 30, 2014, respectively, as compared to the same periods in 2013. The increase was primarily realized in service charge income due to an increase in the number of deposit accounts and increase investment service fee income.

Non-interest expense increased by $255,000 or 5.4% and $497,000 or 5.3% for the three and six month periods ended June 30, 2014, respectively, as compared to the same periods in 2013. The increase was mainly due to an increase in staffing necessary to support the loan and deposit growth and preparation for expansion into the Tracy market.

Total assets increased $6.5 million or 1.0% from December 31, 2013. Total net loans increased by $16.5 million or 4.0% and investment securities increased by $6.7 million or 5.7% from December 31, 2013 to June 30, 2014, while deposits increased by $0.3 million or 0.1% for the same period.

Income Summary

For the three and six month periods ended June 30, 2014, the Company recorded net income available to common shareholders of $2,537,000 and $3,945,000, respectively, representing increases of $1,163,000 and $1,339,000, as compared to the same periods in 2013. Return on average assets (annualized) was 1.50% and 1.17% for the three and six months ended June 30, 2014, respectively, as compared with 0.86% and 0.84% for the same periods in 2013. Annualized return on average common equity was 14.53% and 11.65% for the three and six months ended June 30, 2014, respectively, as compared to 8.48% and 8.16% for the same periods of 2013.

Net income before provisions for income taxes and preferred stock dividends increased $1,982,000 and $2,120,000 for the three and six month periods ended June 30, 2014, respectively, from the comparable 2013 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              Increase
(In thousands)                                          (Decrease)            (Decrease)
                                                       Three Months
                                                           Ended           Six Months Ended
                                                       June 30, 2014         June 30, 2014
Change from 2013 to 2014 in:
Net interest income                                  $             151     $             406
Provision for loan losses                                        1,977                 2,077
Non-interest income                                                109                   134
Non-interest expense                                              (255 )                (497 )
Change in income before income taxes                 $           1,982     $           2,120

These variances will be explained in the discussion below.

Net Interest Income

Net interest income is the largest source of the Company's operating income. For the three and six month periods ended June 30, 2014, net interest income was $6.2 million and $12.3 million, respectively, which represented increases of $151,000 or 2.5% and $406,000 or 3.4% from the comparable periods in 2013.

The net interest margin (net interest income as a percentage of average interest earning assets) was 4.07% and 4.06% for the three and six months period ended June 30, 2014, respectively, which declined compared to 4.18% and 4.11% for the same periods in 2013. 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 2014, 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 cost of funds on interest-bearing liabilities did recognize a moderate decrease of 6 basis points and 7 basis points for the three and six months ended June 30, 2014, compared to 2013 due to further rate reductions and a shift from high cost CDs into demand deposit and savings accounts. In addition, average non-interest-bearing demand deposit balances increased by $16.9 million and $16.3 million, respectively, for the three and six month periods ended June 30, 2014, as compared to the same periods of 2013.

Earning asset yield decreased by 14 basis points and 11 basis points for the three and six month periods ended June 30, 2014, respectively, compared to the same periods of 2013. The yield on loans decreased by 31 basis points and 35 basis points for the second quarter and six month period of 2014, respectively, as compared to 2013, in spite of the significant portion of our loans that are at their contractual rate floors. This decrease in loan yield was primarily a result of competitive pressure on the pricing of new loan fundings. The drop in loan yield was offset by deploying a portion of the low yielding cash equivalent balances into loan and investment balances which recognized increases of $30.6 million and $11.3 million, respectively, in the six month period of 2014 as compared to 2013.

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 six month periods ended June 30, 2014 and 2013:

Net Interest Analysis

                               Three Months Ended June 30, 2014                   Three Months Ended June 30, 2013
(in thousands)                               Interest                                           Interest
                           Average           Income /       Avg Rate/         Average           Income /       Avg Rate/
                           Balance           Expense          Yield           Balance           Expense          Yield
Earning assets:
Gross loans (1) (2)     $     418,696       $    5,527            5.29 %   $     391,381       $    5,461            5.60 %
Investment securities
(2)                           121,728              935            3.08 %         115,476              872            3.03 %
Federal funds sold             17,516               10            0.23 %           8,499                5            0.24 %
deposits                       68,310               51            0.30 %          77,972               54            0.28 %
assets                        626,250            6,523            4.18 %         593,328            6,392            4.32 %
. . .
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