FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
[X] QUARTERLY REPORT
PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2004
or
[ ] TRANSITION REPORT
PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _____ to _____
For Quarter Ended March 31, 2004 Commission File Number: 0-10140
CVB FINANCIAL CORP.
(Exact name of
registrant as specified in its charter)
California
(State or other jurisdiction of incorporation
or organization)
95-3629339
(I.R.S. Employer Identification No.)
701 North Haven Ave, Suite 350, Ontario, California
(Address of Principal Executive Offices)
91764
(Zip Code)
(Registrant’s
telephone number, including area code)
(909) 980-4030
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes _X_ No ___Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes _X_ No ___
Number of shares of common stock of the registrant: 48,404,418 outstanding as of May 5, 2004.
CVB FINANCIAL CORP.
2004 QUARTERLY REPORT ON FORM 10-Q
TABLE OF CONTENTS
PART I – FINANCIAL INFORMATION (UNAUDITED)
ITEM 1. FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
GENERAL
OVERVIEW
CRITICAL ACCOUNTING POLICIES
ANALYSIS OF THE RESULTS OF OPERATIONS
ANALYSIS OF FINANCIAL CONDITION
RISK MANAGEMENT
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 4. CONTROLS AND PROCEDURES
PART II — OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 5. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES
PART I - FINANCIAL INFORMATION (UNAUDITED)
Item 1. Financial Statements
CVB FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(unaudited)
Dollar amounts in thousands
March 31, December 31,
2004 2003
------------------ -------------------
ASSETS
Investment securities available-for-sale 1,902,503 1,865,782
Investment in stock of Federal Home Loan Bank (FHLB) 42,022 37,966
Loans and lease finance receivables 1,812,487 1,759,941
Allowance for credit losses (22,005) (21,282)
----------------- -----------------
Total earning assets 3,735,007 3,642,407
Cash and due from banks 118,156 112,008
Premises and equipment, net 30,035 31,069
Goodwill and other intangibles:
Amortizable 7,025 7,321
Non-amortizable 19,580 19,580
Cash value life insurance 66,012 15,800
Accrued interest receivable 16,884 15,724
Other assets 17,217 10,440
----------------- -----------------
TOTAL ASSETS $ 4,009,916 $ 3,854,349
================= =================
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Deposits:
Noninterest-bearing $ 1,153,994 $ 1,142,330
Interest-bearing 1,545,262 1,518,180
----------------- -----------------
Total deposits 2,699,256 2,660,510
Demand Note to U.S. Treasury 1,829 3,834
Short-term borrowings 354,900 405,500
Long-term borrowings 531,000 381,000
Deferred tax liabilities 9,822 5,203
Accrued interest payable 4,861 5,259
Deferred compensation 6,803 6,955
Junior subordinated debentures 82,476 82,476
Other liabilities 22,540 16,891
----------------- -----------------
TOTAL LIABILITIES 3,713,487 3,567,628
----------------- -----------------
COMMITMENTS AND CONTINGENCIES
Stockholders' Equity:
Preferred stock (authorized, 20,000,000 shares
without par; none issued or outstanding) - -
Common stock (authorized, 78,125,000 shares
without par; issued and outstanding
48,386,418 (2004) and 48,289,347 (2003)) 233,173 232,959
Retained earnings 39,596 36,482
Accumulated other comprehensive income, net of tax 23,660 17,280
----------------- -----------------
Total stockholders' equity 296,429 286,721
----------------- -----------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 4,009,916 $ 3,854,349
================= =================
See accompanying notes to the consolidated financial statements.
CVB FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
(unaudited)
Dollar amounts in thousands, except per share
For the Three Months
Ended March 31,
2004 2003
-----------------------------
Interest income:
Loans, including fees $26,250 $23,819
Investment securities:
Taxable 15,728 12,384
Tax-preferred 3,971 4,130
----------- ---------------
Total investment income 19,699 16,514
Federal funds sold 2 12
----------- ----------------
Total interest income 45,951 40,345
Interest expense:
Deposits 3,683 4,516
Borrowings 5,374 4,590
Junior subordinated debentures 1,330 -
----------- -----------------
Total interest expense 10,387 9,106
----------- ----------------
Net interest income before provision for credit losses 35,564 31,239
Provision for credit losses - -
----------- -----------------
Net interest income after
provision for credit losses 35,564 31,239
Other operating income:
Service charges on deposit accounts 3,793 3,696
Wealth Management services 1,162 1,047
Investment services 375 406
Bankcard services 425 335
Other 1,326 611
Impairment charge on investment securities (6,300) -
Gain on sale of securities, net - 794
----------- ------------------
Total other operating income 781 6,889
Other operating expenses:
Salaries and employee benefits 11,742 9,988
Occupancy 1,774 1,551
Equipment 1,856 1,492
Stationary and supplies 1,219 1,099
Professional services 1,121 682
Promotion 1,520 1,130
Data processing 354 303
Amortization of intangibles 296 111
Other 1,623 1,383
----------- -----------------
Total other operating expenses 21,505 17,739
----------- -----------------
Earnings before income taxes 14,840 20,389
Income taxes 4,768 7,685
----------- -----------------
Net earnings $10,072 $12,704
=========== ===================
Basic earnings per common share $ 0.21 $ 0.26
=========== ===================
Diluted earnings per common share $ 0.20 $ 0.26
=========== ===================
Cash dividends per common share $ 0.12 $ 0.12
=========== ===================
See accompanying notes to the consolidated financial statements.
CVB FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(Unaudited)
Accumulated
Other
Common Comprehensive
Shares Common Retained Income, Comprehensive
Outstanding Stock Earnings Net of Tax Income
-------------- ---------------- --------------- -------------------- --------------------
(amounts and shares in thousands)
Balance January 1, 2003 43,533 $ 146,449 $ 87,716 $ 25,656
Issuance of common stock 317 989
10% stock dividend 4,387 75,990 (75,990)
Repurchase of common stock (349) (615) (6,438)
Shares issued for acquisition of
Kaweah National Bank 401 7,904
Tax benefit from exercise of stock options 2,242
Cash dividends (21,638)
Comprehensive income:
Net earnings 52,832 $ 52,832
Other comprehensive income:
Unrealized (loss) on securities
available-for-sale, net (8,376) (8,376)
--------------------
Comprehensive income $ 44,456
-------------- ---------------- --------------- -------------------- ====================
Balance December 31, 2003 48,289 232,959 36,482 17,280
Issuance of common stock 157 309
Repurchase of common stock (60) (95) (1,107)
Cash dividends (5,851)
Comprehensive income:
Net earnings 10,072 $ 10,072
Other comprehensive income:
Unrealized gains on securities
available-for-sale, net of taxes $4,620 6,380 6,380
--------------------
Comprehensive income $ 16,452
-------------- ---------------- --------------- -------------------- ====================
Balance March 31, 2004 48,386 $ 233,173 $ 39,596 $ 23,660
============== ================ =============== ====================
The Company reported net unrealized gains on securities available-for-sale of $3.1 million, net of $2.2 million tax for the three
months ended March 31, 2003. Accumulated other comprehensive income as of March 31, 2003 was $22.2 million.
See accompanying notes to the consolidated financial statements.
CVB FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
For the Three Months
Ended March 31,
2004 2003
----------------- -----------------
(amounts in thousands
CASH FLOWS FROM OPERATING ACTIVITIES:
Interest received $ 46,695 $ 39,008
Service charges and other fees received 7,055 6,099
Interest paid (10,846) (10,725)
Cash paid to suppliers and employees (15,685) (18,848)
----------------- -----------------
Net cash provided by operating activities 27,219 15,534
----------------- -----------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sales of investment securities available-for-sale - 34,762
Proceeds from repayment of MBS 92,227 137,558
Proceeds from repayment of investment securities available-for-sale - 1,885
Proceeds from maturity of investment securities available-for-sale 11,920 4,725
Purchases of investment securities available-for-sale (20,869) (77,355)
Purchases of MBS (118,841) (390,637)
Purchases of FHLB stock (4,056) (13,000)
Net increase in loans (57,405) (12,979)
Proceeds from sales of premises and equipment 27 75
Purchase of premises and equipment (533) (2,462)
Purchase of Bank Owned Life Insurance (50,000) -
Other investing activities (3,000) -
----------------- -----------------
Net cash used in investing activities (150,530) (317,428)
----------------- -----------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in transaction deposits 74,077 12,637
Net increase in time deposits (35,269) (1,645)
Advances from Federal Home Loan Bank 150,000 -
Repayment of advances from Federal Home Loan Bank (41,000) -
Net (decrease) increase in short-term borrowings (11,605) 240,112
Cash dividends on common stock (5,851) (5,303)
Repurchase of common stock (1,202) -
Proceeds from exercise of stock options 309 284
----------------- -----------------
Net cash provided by financing activities 129,459 246,085
----------------- -----------------
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS 6,148 (55,809)
CASH AND CASH EQUIVALENTS, beginning of period 112,008 164,973
----------------- -----------------
CASH AND CASH EQUIVALENTS, end of period $ 118,156 $ 109,164
================= =================
See accompanying notes to the consolidated financial statements.
CVB FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(unaudited)
For the Three Months
Ended March 31,
2004 2003
--------------- ---------------
(amounts in thousands)
RECONCILIATION OF NET EARNINGS TO NET CASH PROVIDED BY
OPERATING ACTIVITIES:
Net earnings $ 10,072 $ 12,704
Adjustments to reconcile net earnings to net cash
provided by operating activities:
Impairment charge on investment securities 6,300 -
Gain on sale of investment securities - (794)
(Gain) loss on sale of premises and equipment (21) 4
Increase in cash value of life insurance (211) (60)
Net amortization of premiums on investment securities 3,542 3,146
Depreciation and amortization 1,859 1,380
Change in accrued interest receivable (1,160) (3,039)
Change in accrued interest payable (398) (1,157)
Deferred taxes 5,937 -
Change in other assets and liabilities 1,299 3,350
--------------- ---------------
Total adjustments 17,147 2,830
--------------- ---------------
NET CASH PROVIDED BY OPERATING ACTIVITIES $ 27,219 $ 15,534
=============== ===============
Supplemental Schedule of Noncash Investing and Financing Activities
Securities purchased and not settled $ - $ 40,960
See accompanying notes to the consolidated financial statements.
CVB FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO THE
CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
For the three months
ended March 31, 2004 and 2003
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying condensed consolidated unaudited financial statements and notes thereto have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission for Form 10-Q and conform to practices within the banking industry and include all of the information and disclosures required by accounting principles generally accepted in the United States of America for interim financial reporting. The results of operations for the three months ended March 31, 2004 are not necessarily indicative of the results for the full year. These financial statements should be read in conjunction with the financial statements, accounting policies and financial notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003 filed with the Securities and Exchange Commission. In the opinion of management, the accompanying condensed consolidated unaudited financial statements reflect all adjustments (consisting only of normal recurring adjustments), which are necessary for a fair representation of financial results for the interim periods presented. A summary of the significant accounting policies consistently applied in the preparation of the accompanying consolidated financial statements follows.
Principles of Consolidation —The consolidated financial statements include the accounts of CVB Financial Corp. (the “Company”) and its wholly owned subsidiaries, Citizens Business Bank (the “Bank”) and the Bank’s wholly owned subsidiary, Golden West Enterprises, Inc., Community Trust Deed Services, CVB Ventures, Inc., Chino Valley Bancorp, and ONB Bancorp after elimination of all intercompany transactions and balances.
Nature of Operations —The Company’s primary operations are related to traditional banking activities, including the acceptance of deposits and the lending and investing of money through the operations of the Bank. The Bank has one subsidiary, Golden West Enterprises, Inc., which is located in Costa Mesa, California, which provides automobile and equipment leasing, and brokers mortgage loans. The Bank also provides trust services to customers through its Wealth Management Division and Business Financial Centers (branch offices). The Bank’s customers consist primarily of small to mid-sized businesses and individuals located in the Inland Empire, San Gabriel Valley, Orange County, Fresno County, Tulare County, and Kern County areas of Southern California. The Bank operates 37 Business Financial Centers with its headquarters located in the city of Ontario.
Investment Securities —The Company classifies as held-to-maturity those debt securities that it has the positive intent and ability to hold to maturity. All other debt and equity securities are classified as available-for-sale. Securities held-to-maturity are accounted for at cost and adjusted for amortization of premiums and accretion of discounts. Securities available-for-sale are accounted for at fair value, with the net unrealized gains and losses, net of income tax effects, presented as a separate component of stockholders’ equity. At each reporting date, available-for-sale securities are assessed to determine whether there is an other-than-temporary impairment. Such impairment, if any, is required to be recognized in current earnings rather than as a separate component of stockholders’ equity. Realized gains and losses on sales of securities are recognized in earnings at the time of sale and are determined on a specific-identification basis. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. The Company’s investment in Federal Home Loan Bank (“FHLB”) stock is carried at cost.
Loans and Lease Finance Receivables —Loans and lease finance receivables are reported at the principal amount outstanding, less deferred net loan origination fees and the allowance for credit losses. Interest on loans and lease finance receivables is credited to income based on the principal amount outstanding. Interest income is not recognized on loans and lease finance receivables when collection of interest is deemed by management to be doubtful. In the ordinary course of business, the Company enters into commitments to extend credit to its customers. These commitments are not reflected in the accompanying consolidated financial statements. As of March 31, 2004, the Company had entered into commitments with certain customers amounting to $684.8 million compared to $607.7 million at December 31, 2003. Letters of credit at March 31, 2004, and December 31, 2003, were $55.8 million and $46.0 million, respectively.
The Bank receives collateral to support loans, lease finance receivables, and commitments to extend credit for which collateral is deemed necessary. The most significant categories of collateral are real estate, principally commercial and industrial income-producing properties, real estate mortgages, and assets utilized in agribusiness.
Nonrefundable fees and direct costs associated with the origination or purchase of loans are deferred and netted against outstanding loan balances. The deferred net loan fees and costs are recognized in interest income over the loan term in a manner that approximates the level-yield method.
Provision and Allowance for Credit Losses — The determination of the balance in the allowance for credit losses is based on an analysis of the loan and lease finance receivables portfolio using a systematic methodology and reflects an amount that, in management’s judgment, is adequate to provide for probable credit losses inherent in the portfolio, after giving consideration to the character of the loan portfolio, current economic conditions, past credit loss experience, and such other factors as deserve current recognition in estimating inherent credit losses. The provision for credit losses is charged to expense. For the three months ended March 31, 2004, the Company charged-off loans totaling $308,000 and had recoveries of $1,031,000.
A loan for which collection of principal and interest according to its original terms is not probable is considered to be impaired. The Company’s policy is to record a specific valuation allowance, which is included in the allowance for credit losses, or charge off that portion of an impaired loan that exceeds its fair value. Fair value is usually based on the value of underlying collateral.
At March 31, 2004, impaired loans totaled $0.7 million. These loans were supported by collateral with a fair market value, net of prior liens, of $1.6 million.
Premises and Equipment — Premises and equipment are stated at cost, less accumulated depreciation, which is provided for in amounts sufficient to relate the cost of depreciable assets to operations over their estimated service lives using the straight-line method. Properties under capital lease and leasehold improvements are amortized over the shorter of their economic lives or the initial terms of the leases.
Other Real Estate Owned —Other real estate owned represents real estate acquired through foreclosure in satisfaction of commercial and real estate loans and is stated at fair value, minus estimated costs to sell (fair value at time of foreclosure). Loan balances in excess of fair value of the real estate acquired at the date of acquisition are charged against the allowance for credit losses. Any subsequent operating expenses or income, reduction in estimated values, and gains or losses on disposition of such properties are charged to current operations.
Business Combinations and Intangible Assets –The Company has engaged in the acquisition of financial institutions and the assumption of deposits and purchase of assets from other financial institutions in its market area. The Company has paid premiums on certain transactions, and such premiums are recorded as intangible assets, in the form of goodwill or other intangible assets. In accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 142, goodwill is not being amortized whereas identifiable intangible assets with finite lives are amortized over their useful lives. On an annual basis, the Company tests goodwill and intangible assets for impairment.
Additionally, as required by SFAS No. 142, the Company completed its annual impairment test as of June 30, 2003 and did not record any impairment of goodwill. At March 31, 2004 goodwill was $19.6 million (net of amortization of $5.4 million recorded prior to the adoption of SFAS No. 142). As of March 31, 2004, intangible assets that continue to be subject to amortization include core deposits of $7.0 million (net of $4.2 million of accumulated amortization). Amortization expense for such intangible assets was $296,000 for the three months ended March 31, 2004. Estimated amortization expense, for the remainder of 2004 is expected to be $889,000. Estimated amortization expense, for the succeeding five fiscal years is $1.16 million for year one and $1.15 million for the years two to five. The weighted average remaining life of intangible assets is approximately 5.0 years.
Income Taxes —Deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end, based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income.
Earnings per Common Share —Basic earnings per share are computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding during each period. The computation of diluted earnings per common share considers the number of shares issuable upon the assumed exercise of outstanding common stock options. Share and per share amounts have been retroactively restated to give effect to all stock splits and dividends. The actual number of shares outstanding at March 31, 2004 was 48,386,418. The table below presents the reconciliation of earnings per share for the periods indicated.
Earnings Per Share Reconciliation
(Dollars and shares in thousands, except per share amounts)
For the Three Months
Ended March 31,
2004 2003
----------------------------------------------- ------------------------------------------------
Weighted Weighted
Income Average Shares Per Share Income Average Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------------------------------------------- ------------------------------------------------
BASIC EPS
Income available to
common stockholders $ 10,072 48,368 $0.21 $ 12,704 47,993 $0.26
EFFECT OF DILUTIVE
SECURITIES
Incremental shares
from assumed exercise
of outstanding options 833 (0.01) 1,009 0.00
--------------------------------------------- ---------------------------------------------
DILUTED EPS
Income available to
common stockholders $ 10,072 49,201 $0.20 $ 12,704 49,002 $0.26
=============================================== ================================================
Stock-Based Compensation —At March 31, 2004, the Company has two stock-based employee compensation plans, which are described more fully in Note 14 in the Company’s Annual Report on Form 10-K. The Company applies the intrinsic value method as described in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its plans. Accordingly, compensation cost is not recognized when the exercise price of an employee stock option equals or exceeds the fair market value of the stock on the date the option is granted. The following table presents the pro forma effects on net income and related earnings per share if compensation costs related to the stock option plans were measured using the fair value method as prescribed under SFAS No. 123, “Accounting for Stock-Based Compensation”:
For the Three Months
Ended March 31,
2004 2003
------------- -------------
(Dollars in thousands)
Net income, as reported $ 10,072 $ 12,704
Deduct: Total stock-based employee compensation 154 171
expense determined under fair value based method for all
awards, net of related tax effects
----------- -----------
Pro forma net income $ 9,918 $ 12,533
=========== ===========
Earnings per share:
Basic - as reported $ 0.21 $ 0.26
Basic - pro forma $ 0.21 $ 0.26
Diluted - as reported $ 0.20 $ 0.26
Diluted - pro forma $ 0.20 $ 0.26
The Black-Scholes option-pricing model requires the use of subjective assumptions, which can materially affect fair value estimates. Therefore, this model does not necessarily provide a reliable single measure of the fair value of the Company’s stock options. The fair value of each stock option granted in 2004 was estimated on the date of the grant using the following weighted-average assumptions as of March 31, 2004: (1) expected dividend yield of 2.3%; (2) risk-free interest rate of 2.8%; (3) expected volatility of 37.6%; and (4) expected lives of options of 6.4 years. The assumptions as of March 31, 2003 are as follow: (1) expected dividend yield of 2.7%; (2) risk-free interest rate of 2.8%; (3) expected volatility of 36.7%; and (4) expected lives of options of 7.1 years. There were 266,000 and 8,850 options granted during the first three months in 2004 and 2003, respectively.
Statement of Cash Flows —Cash and cash equivalents as reported in the statements of cash flows include cash and due from banks and fed funds sold.
Trust Services —The Company maintains funds in trust for customers. The amount of these funds and the related liability have not been recorded in the accompanying consolidated balance sheets because they are not assets or liabilities of the Bank or Company, with the exception of any funds held on deposit with the Bank. Trust fees are recorded on an accrual basis.
Use of Estimates in the Preparation of Financial Statements — The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Recent Accounting Pronouncements — FASB issued FIN No. 46R, “Consolidation of Variable Interest Entities,” an interpretation of Accounting Research Bulletin No. 51. FIN No. 46R requires that variable interest entities be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or is entitled to receive a majority of the entity’s residual returns or both. FIN No. 46R also requires disclosures about variable interest entities that companies are not required to consolidate but in which a company has a significant variable interest. The adoption of this statement did not have a material effect on the Company’s results of operations, financial position or cash flows.
In April 2003, FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” which clarifies and amends financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”. In general, SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of this statement did not have a material effect on the Company’s results of operations, financial position or cash flows.
In May 2003, FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” which establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity that have been presented either entirely as equity or between the liabilities section and the equity section of the statement of financial position. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for public companies at the beginning of the first interim period beginning after June 15, 2003. The adoption of this statement did not have a material effect on the Company’s results of operations, financial position or cash flows.
In December 2003, the Accounting Standards Executive Committee of the AICPA issued Statement of Position No. 03-3 (“SOP 03-3”), “Accounting for Certain Loans or Debt Securities Acquired in a Transfer”. SOP 03-3 addresses the accounting for differences between the contractual cash flows and the cash flows expected to be collected from purchased loans or debt securities if those differences are attributable, in part, to credit quality. SOP 03-3 requires purchased loans and debt securities to be recorded initially at fair value based on the present value of the cash flows expected to be collected with no carryover of any valuation allowance previously recognized by the seller. Interest income should be recognized based on the effective yield from the cash flows expected to be collected. To the extent that the purchased loans or debt securities experience subsequent deterioration in credit quality, a valuation allowance would be established for any additional cash flows that are not expected to be received. However, if more cash flows subsequently are expected to be received than originally estimated, the effective yield would be adjusted on a prospective basis. SOP 03-3 will be effective for loans and debt securities acquired after December 31, 2004. Although the Company anticipates that the implementation of SOP 03-3 will require loan system and operational changes to track credit related losses on loans purchased starting in 2005, it is not expected to have a significant effect on the Company’s results of operations, financial position and cash flows.
Reclassification — Certain amounts in the prior periods’ financial statements and related footnote disclosures have been reclassified to conform to the current presentation.
Shareholder Rights Plan — In 2000, the Company adopted a shareholder rights plan designed to maximize long-term value and to protect shareholders from improper takeover tactics and takeover bids which are not fair to all shareholders. In accordance with the plan, preferred share purchase rights were distributed as a dividend at the rate of one right to purchase one one-thousandth of a share of the Company’s Series A Participating Preferred Stock at an initial exercise price of $50.00 (subject to adjustment as described in the terms of the plan) upon the occurrence of certain triggering events. For additional information concerning this plan, see Note 11 to Consolidated Financial Statements. “Commitments and Contingencies” contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.
Other Contingencies — In the ordinary course of business, the Company becomes involved in litigation. Based upon the Company’s internal records and discussions with legal counsel, the Company records reserves for estimates of the probable outcome of all cases brought against them.
On January 27, 2004, employees of the Bank discovered that a break-in had occurred at one of its Business Financial Centers. During this break-in, some of the customers’ safe deposit boxes were compromised. The amount of the recompense to be made to the customers has not been determined. The Bank is working with its customers and insurance company to make restitution.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
GENERAL
Management’s discussion and analysis is written to provide greater insight into the results of operations and the financial condition of CVB Financial Corp. and its subsidiaries. Throughout this discussion, “Company” refers to CVB Financial Corp. and its subsidiaries as a consolidated entity. “CVB” refers to CVB Financial Corp. as the unconsolidated parent company and “Bank” refers to Citizens Business Bank and its wholly owned subsidiary, Golden West Enterprises, Inc. For a more complete understanding of the Company and its operations, reference should be made to the financial statements included in this report and in the Company’s 2003 Annual Report on Form 10-K. Certain statements in this Report on Form 10-Q constitute “forward-looking statements” under the Private Securities Litigation Reform Act of 1995 which involve risks and uncertainties. Our actual results may differ significantly from the results discussed in such forward-looking statements. Factors that might cause such a difference include, but are not limited to, economic conditions, competition in the geographic and business areas in which we conduct operations, natural disasters, fluctuations in interest rates, credit quality, and government regulations. For additional information concerning these factors, see the periodic filings the Company makes with the Securities and Exchange Commission, and in particular “Item 1. Business — Factors That May Affect Results” contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. Additionally, our financial results and operations may be affected by competition which has manifested itself with increased pricing pressures for loans and deposits, thus compressing our net interest margin. Because of the pressure on the net interest margin, other operating income has become a more important element in the total revenue of the Company.
OVERVIEW
We are a bank holding company with one bank subsidiary, Citizens Business Bank. We have two active subsidiaries, Community Trust Deed Services, which is owned by CVB Financial Corp. and Golden West Enterprises, Inc, which is owned by Citizens Business Bank. We are based in Ontario, California in the Inland Empire. Our geographical market area goes from Fresno (the middle of the Central Valley) in the north to Laguna Beach (in Orange County) in the south. Our mission is to offer the finest financial products and services to professionals and businesses in our market area.
Our main source of income is from the interest earned on our loans and investments and our major area of expense is the interest paid on deposits and borrowings. As such our income is subject to interest rates and their impact on our income statement. We are also subject to competition from other financial institutions, which may affect our pricing of products and services, and the fees and interest rates we can charge on them. See the Risk Management section of this Item 2.
Economic conditions in our Southern California service area impact our business. The economy of this area has not had the decline that other areas of the state and country have witnessed during the past few years. However, we are still subject to any changes in the economy in this area. One of the mainstays in our market place has been construction. Southern California is not building enough houses to meet the demand. Although we do not provide mortgages on single-family residences, we still benefit from construction growth since we provide construction loans to builders. This is one area of our balance sheet that has grown over last year.
Our growth in loans and investments compared with the first quarter of 2003 has allowed our interest income to grow even though there was a decline in the interest rate environment. The Bank has always had an excellent base of interest free deposits due primarily to the fact that we specialize in businesses and professionals as customers. This has allowed us to have a low cost of deposits, currently 0.56% for the first quarter of 2004.
We enhanced the Bank’s capital position in the last quarter of 2003 with the issuance by the Company of $82.5 million in junior subordinated debentures. The cash received from these junior subordinated debentures was contributed as capital to the Bank. The Bank used the proceeds to purchase investment securities to enhance earnings.
During the current quarter, we wrote down the carrying value of two issues of Federal Home Loan Mortgage Association preferred stock. These securities pay dividends based on LIBOR and perform like a bond. However, based on generally accepted accounting principles, these securities must be evaluated as an equity security not a bond. Since there was a loss of value that was deemed other-than-temporary, we charged $6.3 million against current earnings in the first three months of 2004 to adjust the basis of these issues. We still have $40.8 million of unrealized gains in our investment portfolio.
CRITICAL ACCOUNTING POLICIES
Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. We believe that our most critical accounting policies upon which our financial condition depends, and which involve the most complex or subjective decisions or assessment are as follows:
Allowance for Credit Losses: Arriving at an appropriate level of allowance for credit losses involves a high degree of judgment. The Company’s allowance for credit losses provides for probable losses based upon evaluations of known and inherent risks in the loan portfolio. The determination of the balance in the allowance for credit losses is based on an analysis of the loan and lease finance receivables portfolio using a systematic methodology and reflects an amount that, in management’s judgment, is adequate to provide for probable credit losses inherent in the portfolio, after giving consideration to the character of the loan portfolio, current economic conditions, past credit loss experience, and such other factors as deserve current recognition in estimating inherent credit losses. The provision for credit losses is charged to expense. For a full discussion of our methodology of assessing the adequacy of the allowance for credit losses, see the “Risk Management” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Investment Portfolio: The investment portfolio is an integral part of the Company’s financial performance. We invest primarily in fixed income securities. Accounting estimates are used in the presentation of the investment portfolio and these estimates do impact the presentation of the Company’s financial condition and results of operations. Many of the securities included in the investment portfolio are purchased at a premium or discount. The premiums or discounts are amortized or accreted over the life of the security. For mortgage-related securities (i.e., securities that are collateralized and payments received from underlying mortgages), the amortization or accretion is based on estimated average lives of the securities. The lives of these securities can fluctuate based on the amount of prepayments received on the underlying collateral of the securities. The amount of prepayments varies from time to time based on the interest rate environment (i.e., lower interest rates increase the likelihood of refinances) and the rate of turnover of the mortgages (i.e., how often the underlying properties are sold and mortgages paid-off). We use estimates for the average lives of these mortgage-related securities based on information received from third parties whose business it is to compile mortgage related data and develop a consensus of that data. We adjust the rate of amortization or accretion regularly to reflect changes in the estimated average lives of these securities.
Income Taxes: We account for income taxes by deferring income taxes based on estimated future tax effects of differences between the tax and book basis of assets and liabilities considering the provisions of enacted tax laws. These differences result in deferred tax assets and liabilities, which are included in the Company’s balance sheets. We must also assess the likelihood that any deferred tax assets will be recovered from future taxable income and establish a valuation allowance for those assets determined to not likely be recoverable. Management judgment is required in determining the amount and timing of recognition of the resulting deferred tax assets and liabilities, including projections of future taxable income. Although we have determined a valuation allowance is not required for all deferred tax assets, there is no guarantee that these assets are recognizable.
Goodwill and Intangible Assets: We have acquired entire banks and branches of banks. Those acquisitions accounted for under the purchase method of accounting have given rise to goodwill and intangible assets. We record the assets acquired and liabilities assumed at their fair value. These fair values are arrived at by use of internal and external valuation techniques. The purchase price is allocated to the assets and liabilities, resulting in identifiable intangibles. Any excess purchase price after this allocation results in goodwill. Both goodwill and intangible assets are tested on an annual basis for impairment.
ANALYSIS OF THE RESULTS OF OPERATIONS
Earnings
We reported net earnings of $10.1 million for the three months ended March 31, 2004. This represented a decrease of $2.6 million or 20.72%, over net earnings of $12.7 million, for the three months ended March 31, 2003. Basic earnings per share for the three-month period decreased to $.21 per share for 2004, compared to $0.26 per share for 2003. Diluted earnings per share decreased to $.20 per share for the first three months of 2004, compared to $0.26 per share for the same three-month period last year. The annualized return on average assets was 1.03% for the first three months of 2004 compared to a return on average assets of 1.67% for the three months ended March 31, 2003. The annualized return on average equity was 13.79% for the three months ended March 31, 2004, compared to a return of 19.25% for the three months ended March 31, 2003.
During the three months ended March 31, 2004, the Company recorded a charge of $6.3 million for the other-than-temporary impairment on two issues of preferred stock issued by the Federal Home Loan Mortgage Corporation (Freddie Mac). Although theses securities are technically equity securities, experts in the investment industry recognize that this type of security performs like a bond or a debt security. They are priced and analyzed like a bond for investment purposes. In spite of having these bond characteristics, we were required to write the securities down $6.3 million as a result of an other-than-temporary decline in market value due to the interest rate environment. These securities are equity securities with no stated maturity dates. A maturity date would provide a date certain when the security would be redeemed at par or face value.
During the three months ended March 31, 2004, the Company had no net gains or losses on sales of securities. During the three months ended March 31, 2003, the Company had net gains on sales of securities of $0.8 million. The net gains on sale of investments were taken to reposition some of the securities in the Bank’s portfolios, which would not perform well under the then current or anticipated yield environments.
Net earnings, excluding the impact of the other-than-temporary impairment write-down on investment securities, totaled $14.3 million for the three month ended March 31, 2004. This represented an increase of $2.1 million, or 17.52%, compared to net earnings, excluding the net gains on sales of investment securities, of $12.2 million for the first three months of 2003.
The following table reconciles the differences in net earnings with and without the other-than-temporary impairment write-down and net gains on sales of investment securities in conformity with accounting principles generally accepted in the United States of America:
Net Earnings Reconciliation
For the Three Months
Ended March 31,
( amounts in thousands )
2004 2003
--------------------------------------------------------------------------------------
Before Income Income Net Earnings Before Income Income Net
Taxes Taxes Taxes Taxes Earnings
--------------------------------------------------------------------------------------
Net Earnings excluding other-than-temporary $ 21,140 $ 6,792 $ 14,348 $ 19,595 $ 7,386 $ 12,209
impairment write-down and net gains on sale of
securities
Other-than-temporary impairment
write-down
(6,300) (2,024) (4,276)
Net gains on sale of securities
794 299 495
------------------------------------------- -----------------------------------------
Net Earnings as reported $ 14,840 $ 4,768 $ 10,072 $ 20,389 $ 7,685 $ 12,704
=========================================== =========================================
We have presented net earnings without the other-than-temporary impairment write-down on investment securities and realized net gains on sales of investment securities to show shareholders the earnings from operations unaffected by the impact of these items. We believe this presentation allows the reader to more easily assess the results of the Company’s operations and business.
Net Interest Income
The principal component of the Company’s earnings is net interest income, which is the difference between the interest and fees earned on loans and investments (earning assets) and the interest paid on deposits and borrowed funds (interest-bearing liabilities). When net interest income is expressed as a percentage of average earning assets, the result is the net interest margin. The net interest spread is the yield on average earning assets minus the cost of average interest-bearing liabilities. Our net interest income, interest spread, and net interest margin are sensitive to general business and economic conditions. These conditions include short-term and long-term interest rates, inflation, monetary supply, and the strength of the economy, in general, and the local economies in which we conduct business. Our ability to manage the net interest income during changing interest rate environments will have a significant impact on our overall performance. We manage net interest income through affecting changes in the mix of earning assets as well as the mix of interest-bearing liabilities, changes in the level of interest-bearing liabilities in proportion to earning assets, and in the growth of earning assets.
The Company’s net interest income (before provision for credit losses) totaled $35.6 million for the three months ended March 31, 2004. This represented an increase of $4.3 million, or 13.84%, over net interest income of $31.2 million for the same period in 2003. The increase in net interest income of $4.3 million resulted from a $5.6 million increase in interest income, offset by a $1.3 million increase in interest expense. The $5.6 million increase in interest income resulted from the $790.8 million increase in average earning assets, which offset the decline in the average yield on earning assets to 5.15% for the first three months of 2004 from 5.81% for the same period in 2003. The $1.3 million increase in interest expense resulted from a $621.0 million increase in average interest-bearing liabilities, offset by a decline in the average rate paid on interest-bearing liabilities to 1.66% for the first three months of 2004 from 1.97% for the same period in 2003.
Interest income totaled $46.0 million for the first three months of 2004. This represented an increase of $5.6 million, or 13.89%, compared to total interest income of $40.3 million for the same period last year. The increase in interest income was primarily the result of the increase in average earnings assets from $2.90 billion in the first three months of 2003 to $3.69 billion in the same period in 2004. This represents a 27.23% increase for the first three months of 2004 over the same period last year. This was partially offset by a decline in the average yield on earning assets, which decreased by 66 basis points.
Interest expense totaled $10.4 million for the first three months of 2004. This represented an increase of $1.3 million, or 14.08%, over total interest expense of $9.1 million for the same period last year. The increase in interest expense was primarily the result of an increase in average interest-bearing liabilities even though the cost of these liabilities decreased by 31 basis points.
Table 1 shows the average balances of assets, liabilities, and stockholders’ equity and the related interest income, expense, and rates for the three-month periods ended March 31, 2004, and 2003. Yields for tax-preferenced investments are shown on a taxable equivalent basis using a 35% tax rate.
TABLE 1 - Distribution of Average Assets, Liabilities, and Stockholders' Equity; Interest Rates and Interest Differentials
As of March 31, 2004 As of March 31, 2003
----------------------------------------- ----------------------------------------------
Average Average Interest
ASSETS Balance Interest Rate Balance Interest Rate Change
----------------- -------------- ------- ------------ ---------- -------- ----------
(amounts in thousands)
Investment Securities
Taxable (1) $ 1,528,446 $ 15,238 4.02% $ 1,093,161 $ 12,080 4.47% 3,158
Tax preferenced (2) 359,288 3,971 5.85% 352,133 4,130 6.20% (159)
Federal Funds Sold & Reverse repo 879 2 0.92% 889 12 5.40% (10)
Investment in FHLB stock 39,590 490 4.95% 23,872 304 5.09% 186
Loans (3) (4) 1,766,715 26,250 5.98% 1,434,083 23,819 6.74% 2,431
----------------- -------------- ------- ------------ ---------- -------- ----------
Total Earning Assets 3,694,918 45,951 5.15% 2,904,138 40,345 5.81% 5,606
Total Non Earning Assets 230,954 172,837
----------------- ------------
Total Assets $ 3,925,872 $ 3,076,975
================= ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Demand Deposits $ 1,102,699 $ 893,495
Savings Deposits (5) 1,001,387 $ 1,757 0.71% 828,155 $ 2,589 1.27% (832)
Time Deposits 535,828 1,926 1.45% 566,228 1,927 1.38% (1)
----------------- -------------- ------- ------------ ---------- -------- ----------
Total Deposits 2,639,914 3,683 0.56% 2,287,878 4,516 0.80% (833)
----------------- -------------- ------- ------------ ---------- -------- ----------
Other Borrowings 948,650 6,704 2.80% 470,519 4,590 3.90% 2,114
----------------- -------------- ------- ------------ ---------- -------- ----------
Interest Bearing Liabilities 2,485,865 10,387 1.66% 1,864,902 9,106 1.97% 1,281
----------------- -------------- ------- ------------ ---------- -------- ----------
Total deposits and borrowings 3,588,564 2,758,397 4,325
Other Liabilities 43,600 51,030
Stockholders' Equity 293,708 267,548
----------------- ------------
Total Liabilities and Stockholders'
Equity $ 3,925,872 $3,076,975
================= ============
Net interest income $ 35,564 $31,239
============== ==========
Net interest spread - tax equivalent 3.49% 3.84%
Net interest margin 3.99% 4.50%
Net interest margin - tax equivalent 4.02% 4.54%
Net interest margin excluding loan fees 3.79% 4.29%
Net interest margin excluding loan fees - tax equivalent 3.82% 4.34%
- ----------------------------------------------------------------------
(1) Includes short-term interest bearing deposits with other institutions
(2) Non tax equivalent rate for 2004 was 4.42% and 2003 was 4.69%.
(3) Loan fees are included in total interest income as follows, (000)s omitted: 2004, $1,848 and 2003, $1,470.
(4) Non performing loans are included in net loans as follows, (000)s omitted: 2004, $719 and 2003, $1,109.
(5) Includes interest bearing demand and money market accounts
As stated above, the net interest margin measures net interest income as a percentage of average earning assets. The net interest margin is an indication of how effectively the Company generates its source of funds and employs its earning assets. The Company’s taxable equivalent (TE) net interest margin was 4.02% for the first three months of 2004, compared to 4.54% for the same period last year. The decrease in the net interest margin over the same period last year is the result of a number of factors. The most significant was the decreasing interest rate environment, which impacted interest earned and interest paid as a percent of earning assets. This was partially offset by changes in the mix of assets and liabilities as follows:
It is difficult to attribute the above changes to any one factor. However, the declining interest rate environment is a significant factor. Interest rates are at their lowest in 45 years. In addition, the banking and financial services businesses in the Company’s market areas are highly competitive. This competition has an influence on the strategies the Company employs.
The net interest spread is the difference between the yield on average earning assets less the cost of average interest-bearing liabilities. The net interest spread is an indication of our ability to manage interest rates received on loans and investments and paid on deposits and borrowings in a competitive and changing interest rate environment. Our net interest spread (TE) was 3.49% for the first three months of 2004 and 3.84% for the same period last year. The decrease in the net interest spread for the three months ended March 31, 2004 resulted from a 66 basis point decrease in the yield on earning assets offset by a 31 basis point decrease in the cost of interest-bearing liabilities, thus generating a 35 basis point decrease in the net interest spread over the same period last year.
The yield (TE) on earning assets decreased to 5.15% for the first three months of 2004, from 5.81% for the same period last year, and reflects a decreasing interest rate environment and a change in the mix of earning assets. Average loans as a percent of earning assets decreased to 47.81% in the first three months of 2004 from 49.38% for the same period in 2003. Average investments as a percent of earning assets increased to 52.19% in the first three months of 2004 from 50.62% for the same period in 2003. Average federal funds sold as a percent of earning assets decreased to 0.02% in the first three months of 2004 from 0.03% for the same period in 2003. Investments and federal funds sold typically have a lower yield than loans. The yield on loans for the first three months of 2004 decreased to 5.98% as compared to 6.74% for the same period in 2003 as a result of the decreasing interest rate environment and competition for quality loans. The yield (TE) on investments for the first three months of 2004 decreased to 4.37% compared to 4.89% for the same period in 2003 as a result of the decreasing interest rate environment. The decrease in the yield on earning assets for the first three months of 2004 was the result of lower yields on both loans and investments as a result of the lower interest rate environment.
The cost of average interest-bearing liabilities decreased to 1.66% for the first three months of 2004 as compared to 1.97% for the same period in 2003, reflecting a decreasing interest rate environment and a change in the mix of interest-bearing liabilities. Average borrowings as a percent of average interest-bearing liabilities increased to 38.16% during the first three months of 2004 as compared to 25.23% for the same period in 2003. Borrowings typically have a higher cost than interest-bearing deposits. The cost of interest-bearing deposits for the first three months of 2004 decreased to 0.56% as compared to 0.80% for the same period in 2003, reflecting the decreasing interest rate environment offset by competition for interest-bearing deposits. The cost of borrowings for the first three months of 2004 decreased to 2.80% as compared to 3.90% for the same period in 2003, also reflecting the decreasing interest rate environment. The FDIC has approved the payment of interest on certain demand deposit accounts. This could have a negative impact on our net interest margin, net interest spread, and net earnings, should this be implemented fully. Currently, we pay interest on NOW and Money Market Accounts.
Table 2 summarizes the changes in interest income and interest expense based on changes in average asset and liability balances (volume) and changes in average rates (rate). For each category of interest-earning assets and interest-bearing liabilities, information is provided with respect to changes attributable to (1) changes in volume (change in volume multiplied by initial rate), (2) changes in rate (change in rate multiplied by initial volume) and (3) changes in rate/volume (change in rate multiplied by change in volume).
TABLE 2 - Rate and Volume Analysis for Changes in Interest Income, Interest
Expense and Net Interest Income
2004 Compared to 2003
Increase (Decrease) Due to
-----------------------------------------------------
Rate/
Volume Rate Volume Total
----------- ------------ ----------- -----------
( amounts in thousands )
Interest Income:
Taxable investment securities $ 4,865 $ (1,216) $ (491) $ 3,158
Tax-advantaged securities 84 (230) (13) (159)
Fed funds sold & interest-bearing
deposits with other institutions - (10) - (10)
Investment in FHLB stock 200 (8) (6) 186
Loans 5,589 (2,680) (478) 2,431
----------- ------------ ----------- -----------
Total interest on earning assets 10,738 (4,144) (988) 5,606
----------- ------------ ----------- -----------
-
Interest Expense:
Savings deposits 549 (1,140) (241) (832)
Time deposits (105) 97 7 (1)
Other borrowings 4,714 (1,294) (1,306) 2,114
----------- ------------ ----------- -----------
Total interest on interest-bearing liabilities 5,158 (2,337) (1,540) 1,281
----------- ------------ ----------- -----------
Net Interest Income $ 5,580 $ (1,807) $ 552 $ 4,325
=========== ============ =========== ===========
Interest and Fees on Loans
Our major source of revenue and primary component of interest income is interest and fees on loans. Interest and fees on loans totaled $26.2 million for the first three months of 2004. This represented an increase of $2.4 million, or 10.20%, over interest and fees on loans of $23.8 million for the same period in 2003. The increase in interest and fees on loans for the first three months of 2004 reflects increases in the average balance of loans offset by a lower interest rate environment. The yield on loans decreased to 5.98% for the first three months of 2004, compared to 6.74% for the same period in 2003. Deferred loan origination fees, net of costs, totaled $7.9 million at March 31, 2004. This represented an increase of $3.8 million, or 89.96%, from deferred loan origination fees, net of costs, of $4.1 million at March 31, 2003. The increase was primarily contributed by Golden West Enterprises auto and equipment leases.
In general, we stop accruing interest on a loan after its principal or interest becomes 90 days or more past due. When a loan is placed on nonaccrual, all interest previously accrued but not collected is charged against earnings. There was no interest income that was accrued and not reversed on non-performing loans at March 31, 2004 and 2003.
Fees collected on loans are an integral part of the loan pricing decision. Loan fees and the direct costs associated with the origination of loans are deferred and deducted from the loan balance. Deferred net loan fees are recognized in interest income over the term of the loan in a manner that approximates the level-yield method. We recognized loan fee income of $1.8 million for the first three months of 2004, as compared to $1.5 million for the same period in 2003, an increase of $378,000, or 25.73%.
Interest on Investments
The second most important component of interest income is interest on investments, which totaled $19.7 million for the first three months of 2004. This represented an increase of $3.2 million, or 19.29%, over interest on investments of $16.5 million for the same period in 2003. The increase in interest on investments for the first three months of 2004 over the same period last year reflected increases in the average balance of investments offset by a lower interest rate environment. The interest rate environment and the investment strategies we employ directly affect the yield on the investment portfolio. We continually adjust our investment strategies in response to the changing interest rate environments in order to maximize the rate of total return consistent within prudent risk parameters, and to minimize the overall interest rate risk of the Company. The weighted-average yield (TE) on investments decreased to 4.37% for the first three months of 2004, compared to 4.89% for the same period in 2003 as a result of the decreasing interest rate environment, and increased prepayments on mortgage-back securities which caused increased cash flows to be invested at lower yields. These were offset by the increase in the average investment portfolio.
Provision for Credit Losses
The Company maintains an allowance for inherent credit losses that is increased by a provision for credit losses charged against operating results. We did not make a provision for credit losses during the first three months of 2004 or 2003 and we believe the allowance is appropriate. No assurance can be given that economic conditions which adversely affect the Company’s service areas or other circumstances will not be reflected in increased provisions or credit losses in the future. The nature of this process requires considerable judgment. See “Risk Management — Credit Risk” herein.
Other Operating Income
Other operating income has become an increasingly important source of revenue for the Company. Other operating income for the Company includes income derived from special services offered by the Bank, such as wealth management and trust services, merchant card, investment services, international banking, and other business services. Also included in other operating income are service charges and fees, primarily from deposit accounts; gains (net of losses) from the sale of investment securities, other real estate owned, and fixed assets; the gross revenue from Community Trust Deed Services and other revenues not included as interest on earning assets.
Other operating income, including other-than-temporary impairment write-down and gains on the sales of investment securities, totaled $0.8 million for the first three months of 2004. This represents a decrease of $6.1 million, or 88.66%, from other operating income, including gains on the sales of investment securities, of $6.9 million for the same period in 2003. The decrease was the result of a $6.3 million other-than-temporary impairment write-down of two issues of preferred stock issued by Freddie Mac. Other operating income, without the other-than-temporary impairment write-down and gains on the sales of investment securities, totaled $7.1 million, an increase of $1.0 million or 16.18%, as compared to the same period of 2003.
Other operating income as a percent of net revenues (net interest income before loan loss provision plus other operating income) was 2.15% for the first three months of 2004, as compared to 18.07% for the same period in 2003. Excluding the other-than-temporary impairment write-down and gains on sales of investment securities, other operating income as a percent of net revenues was 16.60% for the first three months of 2004, as compared to 16.33% for the same period in 2003.
The following table reconciles the differences in other operating income and the percentage of net revenues with and without the other-than-temporary impairment write-down and gains on sales of investment securities in conformity with accounting principles generally accepted in the United States of America:
Other Operating Income Reconciliation
For the Three Months
Ended March 31,
( amounts in thousands )
2004 2003
------------------------------------------- -----------------------------------------
Without
other-than- Other-than-
temporary temporary Net gains
impairment impairment Reported Without on Reported
write-down write-down earnings gains securities earnings
------------------------------------------- -----------------------------------------
Other Operating Income $ 7,081 $ (6,300) $ 781 $ 6,095 $ 794 $ 6,889
-------------- -------------- ------------- ------------- ------------ -------------
Net Revenues $ 42,645 $ (6,300) $ 36,345 $ 37,334 $ 794 $ 38,128
-------------- -------------- ------------- ------------- ------------ -------------
Percent of Other Operating
Income to Net Revenues 16.60% 0.00% 2.15% 16.33% 100.00% 18.07%
There were no gains on sales of securities in 2004. We have presented other operating income without the other-than-temporary impairment write-down and net gains on sales of investment securities to show shareholders the earnings from operations unaffected by the impact of these items. We believe this presentation allows the reader to determine our profitability before the impact of these items. We believe the reader will be able to more easily assess the results of the Company’s operations and business.
Service charges on deposit accounts totaled $3.8 million in the first three months of 2004. This represented an increase of $97,000, or 2.64% over service charges on deposit accounts of $3.7 million for the same period in 2003. Service charges for demand deposits (checking) accounts for business customers are generally charged based on an analysis of their activity and include an earnings allowance based on their average balances. Contributing to the increase in service charges on deposit accounts in the first three months of 2004 was the lower interest rate environment that resulted in a lower account earnings allowance, which offsets service charges and the implementation of a revised service charge schedule. Service charges on deposit accounts represented 485.36% of other operating income in the first three months of 2004, as compared to 53.64% in the same period in 2003.
The Wealth Management Division provides a variety of services, which include wealth management services (both full management services and custodial services), estate planning, retirement planning, private and corporate trustee services, and probate services. Many of the fees generated by the Wealth Management Division are based on the value of assets managed. Asset values for the most part have declined with the decline in stock market values. Despite the decline in stock market values in recent years the Wealth Management Division generated fees of $1.2 million in the first three months of 2004. Fees generated by the Wealth Management Division in the first three months of 2004 increased $116,000, or 11.06% over fees generated by the Wealth Management Division of $1.0 million in the same period in 2003. Fees generated by the Wealth Management Division represented 144.94% of other operating income in the first three months of 2004, as compared to 15.19% for the same period in 2003.
Investment Services, which provides mutual funds, certificates of deposit, and other non-insured investment products, generated fees totaling $375,000 in the first three months of 2004. This represented a decrease of $31,000, or 7.61%, over fees generated of $406,000 for the same period in 2003. Fees generated by Investment Services represented 47.98% of other operating income in the first three months of 2004, as compared to 5.89% for the same period in 2003.
Bankcard, which provides merchant bankcard services (credit card processing, merchant terminals, and customer support), generated fees totaling $425,000 in the first three months of 2004. This represented an increase of $90,000, or 27.02%, over fees generated of $335,000 for the same period in 2003. Fees generated by Bankcard represented 54.43% of other operating income in the first three months of 2004, as compared to 4.86% for the same period in 2003. The increase in Bankcard fees can primarily be attributed to an increase in the number of customers using merchant bankcard services.
Other fees and income, which includes wire fees, other business services, international banking fees, check sales, ATM fees, miscellaneous income, etc., was $1.3 million in the first three months of 2004. This represented an increase of $715,000, or 116.51%, over other fees and income generated of $611,000 for the same period in 2003. Total revenue from Community Trust Deed Services was approximately $15,000 in the first three months of 2004 and $18,000 for the same period in 2003. Other fees and income represented 169.64% of other operating income in the first three months of 2004, as compared to 4.82% for the same period in 2003.
Other Operating Expenses
Other operating expenses for the Company include expenses for salaries and benefits, occupancy, equipment, stationary and supplies, professional services, promotion, data processing, amortization of intangibles, and other expenses, including prepayment penalties. Other operating expenses totaled $21.5 million for the first three months of 2004. This represents an increase of $3.8 million, or 21.23% from other operating expenses of $17.7 million for the same period in 2003.
For the most part, other operating expenses reflect the direct expenses and related administrative expenses associated with staffing, maintaining, promoting, and operating branch facilities. Our ability to control other operating expenses in relation to asset growth can be measured in terms of other operating expenses as a percentage of average assets. Operating expenses measured as a percentage of average assets decreased to 2.20% for the first three months of 2004, compared to a ratio of 2.34% for the same period in 2003. The decrease in percentage was primarily due to the increase in total average assets for the three months ended March 31, 2004 as compared to the same period in 2003.
Our ability to control other operating expenses in relation to the level of net revenue (net interest income plus other operating income) is measured by the efficiency ratio and indicates the percentage of net revenue that is used to cover expenses. For the first three months of 2004, the efficiency ratio was 59.17%, compared to a ratio of 46.52% for the same period in 2003. The increase was primarily due to the impact of the $6.3 million other-than-temporary impairment write-down in the first three months of 2004. Without the impairment charge on investment securities and net gains on sales of investment securities, the efficiency ratio would have been 50.43% in 2004 as compared to 47.51% in 2003. The increase in the ratio is mainly due to additional expenses as a result of the Kaweah National Bank acquisition and increases in salaries and employee benefits expenses from increased staffing levels.
The following table reconciles the differences in operating efficiency ratio with and without the other-than-temporary impairment write-down and net gains on sales of investment securities:
Operating Efficiency Ratio Reconciliation
For the Three Months
Ended March 31,
(amounts in thousands)
2004 2003
------------------------------------- --------------------------------------
Other Operating Other Operating
Operating Net Efficiency Operating Net Efficiency
Expense Revenues Ratio Expense Revenues Ratio
------------------------------------- --------------------------------------
Without other-than-temporary impairment $21,505 $ 42,645 50.43% $17,739 $ 37,334 47.51%
write-down and net gains on sale of
securities
Other-than-temporary impairment
write-down
(6,300)
Net gains on sale of securities
794
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Reported Amount $21,505 $ 36,345 59.17% $17,739 $ 38,128 46.53%
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We have presented the operating efficiency ratio without the other-than-temporary impairment write-down and net gains on sales of investment securities to show shareholders the earnings from operations unaffected by the impact of these items. We believe this presentation allows the reader to determine our profitability before the impact of items that may not be considered as normal operating items. We believe that the reader will be able to more easily assess the results of the Company’s operations and business.
Salaries and related expenses comprise the greatest portion of other operating expenses. Salaries and related expenses totaled $11.7 million for the first three months of 2004. This represented an increase of $1.8 million, or 17.56%, over salaries and related expenses of $10.0 million for the same period in 2003. The increases for 2004 primarily resulted from increased staffing levels and annual salary adjustments. At March 31, 2004, we employed 649 full time equivalent employees, compared to 599 full time equivalent employees at March 31, 2003. Salaries and related expenses as a percent of average assets decreased to 1.20% for the first three months of 2004, compared to 1.32% for the same period in 2003.
Occupancy and equipment expenses represent the cost of operating and maintaining branch and administrative facilities, including the purchase and maintenance of furniture, fixtures, office equipment and data processing equipment. Occupancy expense totaled $1.8 million for the first three months of 2004. This represented an increase of $223,000, or 14.36%, over occupancy expense of $1.6 million for the same period in 2003. The increase in occupancy expense is primarily due to the on-going remodeling and upkeep of our facilities. Equipment expense totaled $1.9 million for the first three months of 2004. This represented an increase of $364,000, or 24.35%, over the $1.5 million expense for the same period in 2003. The increase in equipment expense primarily reflects the upgrade to image processing equipment and the on going upgrade of other computer equipment.
Stationary and supplies expense totaled $1.2 million for the first three months of 2004. This represented an increase of $120,000, or 10.88%, over the expense of $1.1 million for the same period in 2003. Professional services totaled $1.1 million for the first three months of 2004. This represented an increase of $440,000 or 64.50%, over an expense of $682,000 for the same period in 2003. Promotion expense totaled $1.5 million for the first three months of 2004. This represented an increase of $390,000, or 34.51%, from an expense of $1.1 million for the same period in 2003. Data processing expense totaled $354,000 for the first three months of 2004. This represented an increase of $51,000, or 16.56%, from an expense of $303,000 for the same period in 2003.
The amortization expense of intangibles totaled $296,000 for the first three months of 2004 and $111,000 for the same period in 2003. This represents an increase of $185,000, or 165.93%. The increase is mainly due to additional amortization of core deposit premium as a result of the acquisition of Kaweah National Bank in September 2003.
Other operating expense totaled $1.6 million for the first three months of 2004. This represented an increase of $240,000, or 17.35%, from an expense of $1.4 million for the same period in 2003.
Most of the increases in Other Operating Expenses is due to the increase in the number of Business Financial Centers, primarily due to the acquisition of Kaweah National Bank.
Income Taxes
The Company’s effective tax rate for the first three months of 2004 was 32.13%, compared to 37.69% for the same period in 2003. The decrease was primarily due to proportionally higher amounts of tax preferenced municipal income as a percentage of total income and a reduction in reserves for prior period state taxes. The effective tax rates are below the nominal combined Federal and State tax rates as a result of tax preferenced income from certain investments for each period. The majority of tax preferenced income is derived from municipal securities.
ANALYSIS OF FINANCIAL CONDITION
The Company reported total assets of $4.01 billion at March 31, 2004. This represented an increase of $155.6 million, or 4.04%, over total assets of $3.85 billion at December 31, 2003. Earning assets totaled $3.74 billion at March 31, 2004, increasing $92.6 million, or 2.54%, over earning assets of $3.64 billion at December 31, 2003. Total liabilities were $3.71 billion at March 31, 2004, up $145.9 million, or 4.09%, over total liabilities of $3.57 billion at December 31, 2003. Total equity increased $9.7 million, or 3.41%, to $296.4 million at March 31, 2004, compared with total equity of $286.7 million at December 31, 2003.
Investment Securities
The Company reported total investment securities of $1.94 billion at March 31, 2004. This represented an increase of $40.8 million, or 2.14%, over total investment securities of $1.90 billion at December 31, 2003. Investment securities comprise 52.06% of the Company’s total earning assets at March 31, 2004.
In accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities”, securities held as “available-for-sale” are reported at current market value for financial reporting purposes. The market value, less the amortized cost of investment securities, net of income taxes, is adjusted directly to stockholders’ equity. At March 31, 2004, securities held as available-for-sale had a fair market value of $1.90 billion, representing 97.84% of total investment securities, with an amortized cost of $1.86 billion. At March 31, 2004, the net unrealized holding gains on securities avail