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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
_______________
FORM 10-K
_______________
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ________ TO ________
COMMISSION FILE NUMBER 000-31825
HERITAGE FINANCIAL HOLDING CORPORATION
(Exact name of registrant specified in its charter)
DELAWARE 63-1259533
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
211 LEE STREET NE 35601
DECATUR, ALABAMA (Zip Code)
(Address of principal executive offices)
Registrant's telephone number, including area code: (256) 355-9500
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK - PAR VALUE $0.01 PER SHARE
(Title of Class)
Indicate by a check mark whether 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, and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ]
Indicate by a check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [ ] No [X]
State the aggregate market value of the voting and non-voting common
equity held by non-affiliates computed by reference to the price at which the
common equity was last sold, or the average bid and asked price of such common
equity, as of the last business day of the registrant's most recently completed
second fiscal quarter. Common Stock, par value $0.01 per share- $24,640,575.
Indicate the number of shares outstanding of each of the registrant's
classes of common stock as of March 24, 2003. Common Stock, par value $0.01 per
share - 10,510,791 shares
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the annual proxy statement for the annual meeting of
stockholders on May 18, 2004 incorporated by reference into Part III.
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HERITAGE FINANCIAL HOLDING CORPORATION
2003 FORM 10-K ANNUAL REPORT
Table of Contents
PART I. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS. . . . . . . . . . . . . 1
RISK FACTORS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
ITEM 1. BUSINESS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
ITEM 2. PROPERTIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
ITEM 3. LEGAL PROCEEDINGS. . . . . . . . . . . . . . . . . . . . . . . . . 12
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. . . . . . . . 12
PART II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS. . . . . . . . . . . . . . . . . . . . . . . . 12
ITEM 6. SELECTED FINANCIAL DATA. . . . . . . . . . . . . . . . . . . . . . 15
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND. . 16
RESULTS OF OPERATIONS
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. . . . 37
ITEM 8. FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . 37
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.. . . . . . . . . . . . . . . . . . . . . . . 68
ITEM 9A. CONTROLS AND PROCEDURES . . . . . . . . . . . . . . . . . . . . . 68
PART III. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
ITEM 10, 11, 12, 13 AND 14. DIRECTORS AND EXECUTIVE OFFICERS OF THE
REGISTRANT; EXECUTIVE COMPENSATION; SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS; CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS; AND
PRINCIPAL ACCOUNTANT FEES AND SERVICES.. . . . . . . . . . . . . . 69
PART IV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. 70
EXHIBIT 16 - LETTER FROM SCHAUER TAYLOR COX VICE MORGAN & FOWLER, P.C.. . . 74
EXHIBIT 21 - SUBSIDIARIES OF THE REGISTRANT . . . . . . . . . . . . . . . . 75
EXHIBIT 23.1 - CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS. . . . . 76
EXHIBIT 23.1 - CONSENT OF INDEPENDENT AUDITORS. . . . . . . . . . . . . . . 77
EXHIBIT 24 - POWER OF ATTORNEY. . . . . . . . . . . . . . . . . . . . . . . 78
EXHIBIT 31.1 CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER . . . . . . . . . 80
EXHIBIT 31.2 CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER . . . . . . . . . 81
EXHIBIT 32.1 CHIEF EXECUTIVE OFFICER CERTIFICATION UNDER 18 USC 1350. . . . 82
EXHIBIT 32.2 CHIEF FINANCIAL OFFICER CERTIFICATION UNDER 18 USC 1350. . . . 83
PART I
CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report and documents incorporated by reference herein, may
contain certain statements relating to our future results based on information
currently available. The presentations, and certain of the other disclosures in
this Annual Report, including any statements preceded by, followed by or which
include the words, "may," "could," "should," "will," "would," "believe,"
"expect," "anticipate," "estimate," "intend," "plan," "assume," or similar
expressions, constitute forward-looking statements within the meaning of Section
21E of the Securities Exchange Act of 1934, as amended. These forward looking
statements, implicitly and explicitly, include the assumptions underlying the
statements and other information with respect to our beliefs, plans, objectives,
goals, expectations, anticipations, estimates, intentions, financial condition,
results of operations, future performance and business, including our
expectations and estimates with respect to our revenues, expenses, return on
equity, return on assets, efficiency ratio, asset quality and other financial
data and capital and performance ratios.
Although we believe that the expectations reflected in our forward-looking
statements are reasonable, these statements involve risks and uncertainties
which are subject to change based on various important factors (some of which
are beyond our control). The following factors, among others, could cause our
financial performance to differ materially from our goals, plans, objectives,
intentions, expectations, and other forward-looking statements: (1) the extent
to which we are able to achieve and maintain certain capital ratios at the
Company and the Bank, as well as the effects of the inability or failure to
achieve such ratios; (2) the effects of certain operating restrictions on the
Company and the Bank, including, without limitation, the ability to declare or
pay dividends without prior regulatory approval; (3) the strength of the United
States economy in general and the strength of the regional and local economics
in which we conduct operations; (4) the effects of, and changes in, trade,
monetary and fiscal policies and laws, including interest rate policies of the
Board of Governors of the Federal Reserve System; (5) inflation, interest rate,
market and monetary fluctuations; (6) our timely development of new products and
services to a changing environment, including the features, pricing and quality
compared to the products and services of our competitors; (7) the willingness of
users to substitute competitors' products and services for our products and
services; (8) the impact of changes in financial services policies, laws and
regulations, including laws, regulations and policies concerning taxes, banking,
securities and insurance, and the application thereof by regulatory bodies; (9)
technological changes; (10) changes in consumer spending and savings habits;
(11) regulatory or judicial proceedings; and (12) the declaration of war and the
commencement of hostilities in Iraq and elsewhere. We also direct your attention
to the Risk Factors discussed immediately following this section under the
heading "Risk Factors."
If one or more of the factors affecting our forward-looking information and
statements proves incorrect, then our actual results, performance or
achievements could differ materially from those expressed in, or implied by
forward-looking information and statements contained in this Annual Report. We
do not intend to update or revise our forward-looking information and
statements, whether written or oral, to reflect any changes. All forward-looking
statements attributable to us are expressly qualified by these cautionary
statements.
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RISK FACTORS
THE COMPANY AND THE BANK ARE RESTRICTED FROM CERTAIN ACTIVITIES INCLUDING
PAYMENT OF DIVIDENDS TO STOCKHOLDERS.
During 2002, management of the Company identified significant operational
and asset quality deficiencies at the Bank. These deficiencies resulted in
material increases to the Bank's loan loss reserves, resulting in material
reductions in the capital levels of the Company and the Bank. As a result, the
Board of Directors and management of the Company and the Bank identified
specific corrective steps and actions to address capital deficiencies, improve
asset quality, and enhance operational controls and procedures. The Bank,
without the prior written approval of its regulators, may not declare or pay any
cash dividends. In addition, the Bank determined to hire and retain certain
personnel who were given specific written authority by the Board of Directors to
implement sound lending, recordkeeping and accounting practices. The Bank also
took steps to develop an educational program for board members and to create a
written review of the Bank's staffing requirements. During 2003, management's
actions to improve asset quality and enhance operational controls and procedures
resulted in the Bank's Tier 1 leverage ratio reaching 8.58% as of December 31,
2003. Additionally, both the Company and the Bank were considered "well
capitalized" as of December 31, 2003.
If the quality of the Company's assets does not continue to improve, or if
there is additional deterioration in the Bank's loan portfolio, the Company and
the Bank may be required to take additional remedial action that may further
restrict the Company's and the Bank's operations in future periods.
THE COMPANY AND THE BANK HAVE MADE SIGNIFICANT CHANGES TO THE BANK'S LOAN LOSS
RESERVES AS A RESULT OF REVIEWS OF THE BANK'S LOAN PORTFOLIO, AND THE BANK MAY
BE REQUIRED TO FURTHER INCREASE THE ALLOWANCE FOR LOAN AND LEASE LOSSES.
During the course of a targeted, limited scope review of the loan portfolio
of the Bank conducted in 2002, management identified certain assets in the
Bank's loan portfolio that management believed should be classified. Due to the
erosion in asset quality identified by the review, the Company increased the
allowance for loan losses by $2,000,000 during the quarterly period ended June
30, 2002. Additional review of the Bank's loan portfolio subsequently identified
additional asset quality problems, which resulted in the Company's increasing
the allowance for loan losses net of charge offs and recoveries by a total of
$20,916,364 for the year ending December 31, 2002.
Management of the Company and the Bank have taken corrective action to
improve asset quality and enhance operational controls and procedures.
Management, acting in concert with the Board of Directors, determined to charge
off $11,388,509 in loans during the course of 2003. As a result of management's
ongoing evaluation of the adequacy of the allowance for loan losses, a decline
in problem credits brought about by the implementation of new loan policies and
procedures and continued recoveries of loans previously charged off, management
decided to reduce the allowance for loan losses during 2003 to $14,562,283 at
December 31, 2003, compared to $26,990,594 at December 31, 2002.
Management continues to review the Bank's loan policies and procedures, as
well as the credit review process. Additional classifications of assets may
result in increases in the Bank's allowance for loan losses, and such increases
could have a material adverse effect on the Company's and the Bank's financial
condition and results of operations.
ITEM 1. BUSINESS
GENERAL
We are a Delaware-chartered bank holding company headquartered in Decatur,
Alabama. We offer a broad range of banking and related products and services in
ten locations in Northern Alabama through Heritage Bank, an Alabama banking
corporation and our principal subsidiary. We had assets of approximately $522
million, loans of approximately $386 million, deposits of approximately $416
million and stockholders' equity of approximately $30 million at December 31,
2003. Our principal executive offices are located at 211 Lee Street NE, Decatur,
Alabama 35601, and the telephone number is (256) 355-9500.
The Company's business is conducted primarily through the Bank. Although we
have no immediate plans to conduct any other business, the Company may engage
directly or indirectly in a number of activities which the
2
Federal Reserve has determined to be so closely related to banking or managing
or controlling banks as to be a proper incident thereto.
SUBSIDIARY BANK
At December 31, 2003, the Bank conducted business through nine locations in
Morgan, Madison, Marshall and Jefferson counties, Alabama. We offer a wide range
of commercial and retail banking services, including savings and time deposit
accounts, personal and commercial loans and personal and commercial checking
accounts. We seek to provide superior service to our customers and to become a
vital component of each of the communities that we serve.
SERVICES
We focus on commercial, consumer, residential mortgage and real estate
construction lending to customers in our local markets. Our retail loan products
include mortgage banking services, home equity lines of credit, consumer loans,
including automobile loans, and loans secured by certificates of deposit and
savings accounts. Our commercial loan products include working capital lines of
credit, term loans for both real estate and equipment, letters of credit and
Small Business Administration loans. We also offer a variety of deposit programs
to individuals and businesses and other organizations, including a variety of
personal checking, savings, money market and NOW accounts, as well as business
checking and saving accounts. In addition, we offer individual retirement
accounts, safe deposit and night depository facilities and additional services
such as internet banking and the sale of traveler's checks, money orders and
cashier's checks.
MARKET AREAS
The Company conducts its banking activities in Morgan, Madison, Marshall
and Jefferson counties in Alabama and in the surrounding vicinities. Within
those areas, the Company has banking offices located in the cities of Decatur,
Huntsville, Madison, Birmingham and Trussville, Alabama.
LENDING ACTIVITIES
We offer a range of lending services, including real estate, consumer and
commercial loans, primarily to individuals and businesses and other
organizations that are located in or conduct a substantial portion of their
business in our market areas. Our total loans at December 31, 2003 were $385.9
million, or 78.0% of total earning assets. The interest rates we charge on loans
vary with the risk, maturity and amount of the loan and are subject to
competitive pressures, money market rates, availability of funds and government
regulations. We do not have any foreign loans.
LOAN PORTFOLIO
Real Estate Loans - Loans secured by real estate are a significant
component of our loan portfolio, constituting $257.1 million, or 66.7% of total
loans at December 31, 2003. Our primary type of real estate loan is
single-family first mortgage loans, construction loans and acquisition and
development loans, typically structured with fixed or adjustable interest rates,
based on market conditions. Fixed rate loans usually have terms of five years or
less, with payments through the date of maturity generally based on a 15 to 30
year amortization schedule. Adjustable rate loans generally have a term of 5 to
30 years. We typically charge an origination fee on these mortgage loans.
Our nonresidential mortgage loans include commercial, industrial and land
loans. The commercial real estate loans are typically used to provide financing
for retail establishments, offices and manufacturing facilities. We generally
require nonresidential mortgage loans to have an 80% loan-to-value ratio and
usually underwrite commercial loans on the basis of the borrower's cash flow and
ability to service the debt from earnings, more than on the basis of the value
of the collateral. Terms are typically five years and may have payments through
the date of maturity based on a 15 to 30 year amortization schedule.
Construction loans usually have a term of twelve months and generally require
personal guarantees.
Commercial, Financial and Agricultural Loans - At December 31, 2003, we had
general commercial, financial and agricultural loans of $116.2 million,
comprising 30.1% of the total loan portfolio. Commercial loans consist primarily
of operating loans made to manufacturers, wholesalers and retailers of goods,
service companies
3
and other industries. We concentrate on making loans to small and medium size
companies. The primary repayment risk for commercial loans is the failure of the
borrower due to economic or financial factors. Although we typically look to a
commercial borrower's cash flow as the principal source of repayment, many
commercial loans are secured by inventory, equipment, accounts receivable and
other assets. These loans are typically made on terms up to five years at fixed
or variable rates and are secured by accounts receivable, inventory or, in the
case of equipment loans, the financed equipment. We attempt to reduce our credit
risk on commercial loans by limiting the loan to value ratio to 65% on loans
secured by accounts receivable or inventory and 75% on equipment loans.
Agricultural loans are comprised of loans to finance agricultural production,
loans to farmers and loans secured by farmland. We are able to manage the risks
inherent in these types of loans due to our small number of agricultural loans.
Consumer Loans - At December 31, 2003, loans to individuals for personal
expenditures totaled $12.5 million, comprising some 3.2% of our loan portfolio.
These consumer loans include loans to purchase automobiles, recreational
vehicles, mobile homes, appliances and boats, and the Bank continues to hold a
small amount of credit card loans. Consumer loans are underwritten based on the
borrower's income, current debt, credit history and collateral. Terms generally
range from four to five years on automobile loans and one to three years on
other consumer loans.
CREDIT PROCEDURES AND REVIEW
During 2002, we identified significant weaknesses in our loan policy,
including our loan approval process, credit analysis, loan review and other key
lending support functions. As part of our response to these issues, we have
revised the Bank's loan policy to address areas we believed to be inadequate,
and have hired additional personnel to upgrade our compliance in these areas.
Loan Approval - We attempt to minimize loan losses through various means
and use generally recognized underwriting criteria. In particular, on larger
credits, we generally rely on the cash flow of a debtor as the source of
repayment and secondarily on the value of the underlying collateral. In
addition, we attempt to utilize shorter loan terms in order to reduce the risk
of a decline in the value of such collateral. We have reduced the unsecured
lending authority of our officers and have reduced the overdraft authority of
our officers in order to address certain loan portfolio issues.
We address repayment risks by adhering to internal credit policies and
procedures that include officer and customer lending limits, a multi-layered
loan approval process for larger loans, periodic documentation examination and
follow-up procedures for any exceptions to credit policies. The point in our
loan approval process at which a loan is approved depends on the size of the
borrower's credit relationship with the Bank. We require approval by the Board
of Directors of the Bank for new advances of credit to any borrowers with loans
classified Substandard and prohibit the advance of additional credit to any
borrower with loans classified Doubtful or Loss.
Loan Review - The Bank has a loan review process designed to promote early
identification of credit quality problems. All lending officers are charged with
the responsibility of reviewing all past due loans in their respective
portfolios. Lending officers establish a watch list of loans to be reviewed by
management and the Board of Directors. Lending officers also conduct a regular
centralized internal review which tests compliance with loan policy and
documentation for all loans over $250,000 and a sampling of smaller loans.
The entire loan portfolio undergoes close scrutiny to maintain its quality
and diversity and to assure proper documentation. This policy also requires that
each loan have an agreed upon repayment schedule and gives individual lending
officers the responsibility of obtaining, and analyzing current credit
information. Maximum loan to value ratios and terms are established in the
policy for the various types of loans. The criteria outlined in the Bank's loan
policy follows guidelines provided by banking regulators. Through the Bank's
credit policy and credit review procedures, management believes that it is able
to identify areas of concern in the loan portfolio and to take corrective action
when necessary.
DEPOSITS
Core deposits are our principal source of funds, constituting approximately
80.3% of our total deposits as of December 31, 2003. Core deposits consist of
demand deposits, interest-bearing transaction accounts, savings deposits and
certificates of deposit (excluding certificates of deposit and other time
deposits over $100,000). Transaction accounts include checking, money market and
NOW accounts that provide the Bank with a source of fee income and
cross-marketing opportunities, as well as a low-cost source of funds. Time and
savings accounts also
4
provide a relatively stable and low-cost source of funding. The largest source
of funds for the Bank is certificates of deposit. Certificates of deposit in
excess of $100,000 are held primarily by customers outside of our market areas.
Deposit rates are reviewed weekly by senior management. We believe our
rates are competitive with those offered by competing institutions in our market
areas; however, we focus on customer service, not high rates, to attract and
retain deposits.
COMPETITION
The banking industry in Alabama is highly competitive, and our
profitability depends principally on our ability to compete in our market areas.
The area is dominated by a number of major banks and bank holding companies that
have substantially greater resources, and numerous offices and affiliates
operating over wide geographic areas. We encounter strong competition both in
making loans and attracting deposits. Competition among financial institutions
is based upon interest rates offered on deposit accounts, interest rates charged
on loans and other credit and service charges. Customers also consider the
quality and scope of the services rendered, the convenience of banking
facilities and, in the case of loans to commercial borrowers, relative lending
limits, and may also consider the fact that other banks offer different
services. Many of the large regional banks against which we compete have
significantly greater lending limits and may offer additional products; however,
we believe we have been able to compete effectively with other financial
institutions, regardless of their size, by emphasizing customer service and by
providing a wide array of services. In addition, most of our non-bank
competitors are not subject to the same extensive federal regulations that
govern bank holding companies and federally insured banks. See "Supervision and
Regulation." Competition may further intensify if additional financial services
companies enter markets in which we conduct business.
EMPLOYEES
As of December 31, 2003, the Company employed approximately 162 individuals
of which approximately 150 were full-time employees. The Company believes that
its relations with these employees are generally good.
SUPERVISION AND REGULATION
The Company, as a bank holding company under the Bank Holding Company Act
of 1956, as amended ("BHCA"), is subject to the supervision, examination and
reporting requirements of the Federal Reserve Board and the BHCA. The BHCA and
other federal laws subject bank holding companies to particular restrictions on
the types of activities in which they may engage and to a range of supervisory
requirements and activities, including regulatory enforcement actions for
violations of laws and regulations. The Company is required to file with the
Federal Reserve periodic reports and such other information as the Federal
Reserve may request. The Federal Reserve conducts examinations of the Company,
and also may examine its subsidiaries. The State of Alabama does not regulate
bank holding companies.
In November 1999, Congress enacted the Gramm-Leach-Bliley Act ("GLBA"),
which made substantial revisions to the statutory restrictions separating
banking activities from certain other financial activities. Under the GLBA, bank
holding companies that are "well-capitalized" and "well-managed" and whose
subsidiary banks have satisfactory or better ratings under the Community
Reinvestment Act of 1977, as amended (the "CRA"), and meet certain other
conditions can elect to become "financial holding companies." Financial holding
companies and their subsidiaries are permitted to acquire or engage in
previously impermissible activities, such as insurance underwriting, travel
agency activities, broad insurance agency activities, merchant banking, and
other activities that the Federal Reserve determines to be financial in nature
or complimentary to financial activities. In addition, under the merchant
banking authority added by the GLBA and Federal Reserve regulations, financial
holding companies are authorized to invest in companies that engage in
activities that are not financial in nature, as long as the financial holding
company makes its investment with the intention of limiting the terms of its
investment, does not manage the company on a day-to-day basis, and the investee
company does not cross-market with any of the financial holding company's
controlled depository institutions. Financial holding companies continue to be
subject to the overall oversight and supervision of the Federal Reserve. While
the Company has not elected to become a financial holding company, and may not
do so at the present time, it may elect to do so in the future.
The supervision and regulation of bank holding companies and their
subsidiaries are intended primarily for the protection of depositors, the
deposit insurance funds of the Federal Deposit Insurance Corporation (the
"FDIC") and the banking system as a whole, not for the protection of bank
holding company stockholders or creditors. The
5
banking agencies have broad enforcement power over bank holding companies and
banks, including the power to impose substantial fines and other penalties for
violation of laws and regulations. The following description summarizes some of
the laws to which we are subject. References herein to applicable statutes and
regulations are brief summaries thereof, do not purport to be complete and are
qualified in their entirety by reference to such statutes and regulations.
The Bank is subject to regulation, supervision and examination by the
Federal Reserve, the Federal Deposit Insurance Corporation ("FDIC") and the
Alabama Banking Department. As a member of the FDIC, the Bank's deposits are
insured to the maximum extent provided by law.
Regulatory Restrictions on Dividends - The payment of dividends to the
Company by the Bank is subject to certain restrictions imposed by state and
federal banking laws, regulations and authorities. The Federal Reserve Board
requires that bank holding companies should pay cash dividends on common stock
only out of income available over the past year and only if prospective earnings
retention is consistent with the bank holding company's expected future needs
and financial condition. This policy provides that bank holding companies should
not maintain a level of cash dividends that undermines the bank holding
company's ability to serve as a source of strength for its banking subsidiaries.
The prior approval of the Federal Reserve is required if the total of all
dividends declared by the state member bank in any calendar year will exceed the
sum of such bank's net profits for the year and its retained net profits for the
preceding two calendar years, less any required transfers to surplus. Federal
law also prohibits any state member bank from paying dividends that would be
greater than such bank's undivided profits after deducting statutory bad debt
reserves in excess of such bank's allowance for loan losses. The Bank is
currently prohibited from paying a cash dividend to the Company without seeking
prior written approval from federal banking authorities.
Under Alabama law, a bank may not pay a dividend in excess of 90% of its
net earnings until the bank's surplus is equal to at least 20% of its capital.
The Bank is also required by Alabama law to obtain the prior approval of the
Superintendent of the State Banking Department of Alabama for its payment of
dividends if the total of all dividends declared by the Bank in any calendar
year will exceed the total of (1) the Bank's net earnings (as defined by
statute) for that year, plus (2) its retained net earnings for the preceding two
years, less any required transfers to surplus. No dividends may be paid from the
Bank's surplus without the prior written approval of the Superintendent. The
Bank is currently prohibited from paying dividends to the Company without the
prior approval of the Superintendent of the State Banking Department.
In addition, federal bank regulatory authorities have authority to prohibit
the payment of dividends by bank holding companies if their actions constitute
unsafe or unsound practices. The Federal Reserve Board has issued a policy
statement on the payment of cash dividends by bank holding companies, which
expresses the Federal Reserve Board's view that a bank holding company
experiencing earnings weaknesses should not pay cash dividends that exceed its
net income or that could only be funded in ways that weaken the bank holding
company's financial health, such as by borrowing. Our ability and the Bank's
ability to pay dividends in the future is currently, and could be further,
influenced by bank regulatory policies and capital guidelines.
Source of Strength - Under Federal Reserve Board policy, a bank holding
company is expected to act as a source of financial strength for its bank
subsidiary and commit resources to its support. This support may be required by
the Federal Reserve Board at times when, absent this policy, additional
investments in a troubled bank may not otherwise be warranted. A bank holding
company, in certain circumstances, could be required to guarantee the capital
plan of an undercapitalized banking subsidiary. In addition, any capital loans
by a bank holding company to any of its depository institution subsidiaries
likely will be unsecured and subordinate in right of payment to deposits and to
certain other indebtedness of the banks.
Under the Federal Deposit Insurance Act ("FDIA"), an FDIC-insured
depository institution can be held liable for any loss incurred by, or
reasonably expected to be incurred by, the FDIC in connection with (1) the
default of a common controlled FDIC-insured depository institution or (2) any
assistance provided by the FDIC to any commonly controlled FDIC-insured
depository institution "in danger of default." "Default" is defined generally as
the appointment of a conservator or receiver, and "in danger of default" is
defined generally as the existence of certain conditions indicating that a
default is likely to occur in the absence of regulatory assistance. The FDIC's
claim for damages is superior to claims of stockholders of the insured
depository institution or its holding company but is subordinate to claims of
depositors, secured creditors and holders of subordinated debt (other than
affiliates) of the commonly controlled FDIC-insured depository institution.
Common controlled FDIC-insured depository
6
institutions are liable to the FDIC for any losses incurred in connection with
the failure of a commonly controlled institution.
Safe and Sound Banking Practices - Bank holding companies are not permitted
to engage in unsafe or unsound banking practices. The Federal Reserve Board has
broad authority to prohibit activities of bank holding companies and their
non-banking subsidiaries which represent unsafe or unsound banking practices or
which constitute violations of laws or regulations, and can assess civil money
penalties for certain activities conducted on a knowing or reckless basis, if
those activities caused a substantial loss to a depository institution. The
penalties can be as high as $1,000,000 for each day the activity continues.
The Federal Reserve adopted the Federal Financial Institutions Examination
Council's ("FFIEC") updated rating system which assigns each financial
institution a confidential composite "CAMELS" rating based on an evaluation and
rating of six essential components of an institution's financial condition and
operations including capital adequacy, asset quality, management, earnings,
liquidity and sensitivity to market risk. For most institutions, the FFIEC has
indicated that market risk is rated based upon, but not limited to, an
assessment of the sensitivity of the financial institution's earnings or the
economic value of its capital to adverse changes in interest rates, foreign
exchange rates, commodity prices, or equity prices; management's ability to
identify, measure, monitor and control exposure to market risk; and the nature
and complexity of interest rate risk exposure arising from nontrading positions.
Capital Adequacy Requirements - We are required to comply with the capital
adequacy standards established by the Federal Reserve Board, and the Bank is
subject to additional requirements of the FDIC and the Alabama Banking
Department. The Federal Reserve Board has adopted two basic measures of capital
adequacy for bank holding companies: a risk-based measure and leverage measure.
All applicable capital standards must be satisfied for a bank holding company to
be in compliance.
The risk-based capital standards are designed to make regulatory
requirements more sensitive to differences in risk profiles among banks and bank
holding companies, to account for off-balance-sheet exposure, and to minimize
disincentives for holding liquid capital assets. Assets and off-balance-sheet
items are assigned to broad risk categories, each with appropriate weights. The
resulting capital ratios represent capital as a percentage of total
risk-weighted assets and off-balance-sheet items.
The minimum guidelines for the ratio ("Total Risk-Based Capital Ratio") of
total capital ("Total Capital") to risked-weighted assets (including certain
off-balance sheet items, such as standby letters of credit) is 8%. At least half
of Total Capital must be comprised of common stock, minority interests in the
equity accounts of consolidated subsidiaries, noncumulative perpetual preferred
stock, and a limited amount of cumulative perpetual preferred stock, less
goodwill and other intangible assets ("Tier 1 Capital"). The remainder may
consist of subordinated debt, other preferred stock, and a limited amount of
loan loss reserves ("Tier 2 Capital").
In addition, the Federal Reserve Board has established minimum leverage
ratio guidelines for bank holding companies and state member banks. These
guidelines provide for a minimum ratio (the "Leverage Ratio") of Tier 1 Capital
to average assets, less goodwill and certain other intangible assets, of 3% for
bank holding companies that meet certain specified criteria, including having
the highest regulatory rating. All other bank holding companies generally are
required to maintain a Leverage Ratio of at least 3%, plus an additional cushion
of 1% - 2%, if the institution has less than the highest regulatory rating. The
guidelines also provide that bank holding companies experiencing internal growth
or making acquisitions will be expected to maintain strong capital positions
substantially above the minimum supervisory levels without significant reliance
on intangible assets. Furthermore, the Federal Reserve Board has indicated that
it will consider a tangible Tier 1 Capital Leverage Ratio (deducting all
intangibles) and other indicia of capital strength in evaluating proposals for
expansion or new activities.
The Federal Deposit Insurance Corporation Improvement Act of 1991
("FDICIA"), among other things, requires the federal banking agencies to take
"prompt corrective action" regarding depository institutions that do not meet
minimum capital requirements. FDICIA establishes five capital tiers: "well
capitalized," "adequately capitalized," "undercapitalized," "significantly
undercapitalized," and "critically undercapitalized." A bank's capital tier will
depend upon how its capital levels compare to various relevant capital measures
and certain other factors, as established by regulations.
All of the federal banking agencies have adopted regulations establishing
relevant capital measures and relevant capital levels. The relevant capital
measures are the Total Capital ratio, Tier 1 capital ratio, and the leverage
7
ratio. Under the regulations, a state member bank will be (i) well capitalized
if it has a Total Capital ratio of 10% or greater, a Tier 1 capital ratio of 6%
or greater, a Tier 1 leverage ratio of 5% or greater and is not subject to any
written agreement, order, capital directive or prompt corrective action
directive by a federal bank regulatory agency to meet and maintain a specific
capital level for any capital measure, (ii) adequately capitalized if it has a
Total Capital ratio of 8% or greater, a Tier 1 capital ratio of 4% or greater,
and a leverage ratio of 4% or greater (3% in certain circumstances), (iii)
undercapitalized if it has a Total Capital ratio of less than 8%, a Tier 1
capital ratio of less than 4% (3% in certain circumstances), and a leverage
ratio of less than 4%, (iv) significantly undercapitalized if it has a Total
Capital ratio of less than 6%, a Tier 1 capital ratio of less than 3% and a
leverage ratio of less than 3% or (v) critically undercapitalized if its
tangible equity is equal to or less than 2% of average quarterly tangible
assets.
As of December 31, 2003, the consolidated capital ratios of the Company and
the Bank were as follows:
REGULATORY
MINIMUM COMPANY BANK
----------- -------- ------
Tier 1 leverage ratio 3.0-5.0% 6.31% 8.64%
Tier 1 Risk-based capital ratio 4% 8.63% 10.71%
Total Risk-based capital ratio 8% 10.28% 11.99%
As of December 31, 2003, the Company and the Bank were "well capitalized."
Acquisitions by Bank Holding Companies - The BHCA requires every bank
holding company to obtain prior approval of the Federal Reserve Board before it
(1) may acquire all or substantially all of the assets of any bank; (2) may
acquire direct or indirect ownership or control of any voting shares of any
bank, if after such acquisition it would own or control, directly or indirectly,
more than 5% of the voting shares of such bank; or (3) may merge or consolidate
with any other bank holding company. In approving bank acquisitions by bank
holding companies, the Federal Reserve Board is required to consider the
financial and managerial resources and future prospects of the bank holding
company and the banks concerned, the convenience and needs of the communities to
be served and various other factors.
The BHCA further provides that the Federal Reserve Board may not approve
any transaction that would result in a monopoly or would be in furtherance of
any combination or conspiracy to monopolize or attempt to monopolize the
business of banking in any section of the United States, or the effect of which
may be substantially to lessen competition or to tend to create a monopoly in
any section of the country, or that in any other manner would be in restraint of
trade, unless the anti-competitive effects of the proposed transaction are
clearly outweighed by the public interest in meeting the convenience and needs
of the communities to be served. The Federal Reserve Board is required to
consider the financial and managerial resources and future prospects of the bank
holding companies and banks concerned, including capital adequacy, and the
convenience of the community to be served including the parties' performance
under the Community Reinvestment Act.
Control Acquisitions - The Change in Bank Control Act prohibits a person or
group of persons from acquiring "control" of a bank holding company unless the
Federal Reserve Board has been notified and has not objected to the transaction.
Under a rebuttable presumption established by the Federal Reserve Board, the
acquisition of 10% or more of a class of voting stock of a bank holding company
with a class of securities registered under Section 12 of the Exchange Act,
would, under the circumstances set forth in the presumption, constitute
acquisition of control of that bank holding company.
In addition, under the BHCA, any company is required to obtain the prior
approval of the Federal Reserve Board before acquiring 25% (and bank holding
companies are required to obtain prior approval from the Federal Reserve Board
before acquiring 5%) or more of the outstanding common stock of a bank holding
company, or otherwise obtain control or a "controlling influence" over the bank
holding company.
Branching - The BHCA, as amended by the interstate banking provisions of
the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the
"Interstate Banking Act") repealed prior statutory restrictions on interstate
banking, such that a bank holding company may acquire a bank located in any
other state, and any bank holding company located outside Alabama may lawfully
acquire any Alabama-based bank regardless of state law to
8
the contrary, in either case subject to certain deposit-percentage, aging
requirements and other restrictions. In addition, the Interstate Banking Act
generally provided that after June 1, 1997, national state-chartered banks may
branch interstate through acquisition of banks in other states. The State of
Alabama has laws relating specifically to acquisition of banks, bank holding
companies and other types of financial institutions in each state, by financial
institutions that are based in, and not based in, those states. Alabama law has
set five years as the minimum age of banks which may be acquired.
Restrictions on Transactions With Affiliates and Insiders - The Company is
a legal entity separate and distinct from the Bank. Transactions between the
Bank and its affiliates, including the Company, are subject to Sections 23A and
23B of the Federal Reserve Act. Section 23A defines "covered transactions,"
which include extensions of credit, and limits a bank's covered transactions
with any affiliate to 10% of such bank's capital and surplus. All covered and
exempt transactions between a bank and its affiliates must be on terms and
conditions consistent with safe and sound banking practices, and banks and their
subsidiaries are prohibited from purchasing low-quality assets from the bank's
affiliates. Finally, Section 23A requires that all of a bank's extensions of
credit to an affiliate be appropriately secured by acceptable collateral,
generally United States government or agency securities. Section 23B of the
Federal Reserve Act generally requires that certain transactions between a bank
and its respective affiliates be on terms substantially the same, or at least as
favorable to such bank, as those prevailing at the time for comparable
transactions with or involving other nonaffiliated persons.
The restrictions on loans to directors, executive officers, principal
stockholders and their related interests (collectively referred to herein as
"insiders") contained in the Federal Reserve Act and Regulation O apply to all
insured institutions and their subsidiaries and bank holding companies. These
restrictions include limits on loans to one borrower and conditions that must be
met before such a loan can be made. There is also an aggregate limitation on all
loans to insiders and their related interests. These loans cannot exceed the
institution's total unimpaired capital and surplus, and the FDIC may determine
that a lesser amount is appropriate. Insiders are subject to enforcement actions
for knowingly accepting loans in violation of applicable restrictions. State
banking laws also have similar provisions.
FDIC Insurance Assessments - Each financial institution is assigned to one
of three capital groups - well capitalized, adequately capitalized or
undercapitalized - and further assigned to one of three subgroups within a
capital group, on the basis of supervisory evaluations by the institution's
primary federal and, if applicable, state regulators and other information
relevant to the institution's financial condition and the risk posed to the
applicable insurance fund. The actual assessment rate applicable to a particular
bank will, therefore, depend in part upon the risk assessment classification so
assigned to the bank by the FDIC.
Under the FDIA, insurance of deposits may be terminated by the FDIC upon a
finding that the institution has engaged in unsafe and unsound practices, is in
an unsafe or unsound condition to continue operations, or has violated any
applicable law, regulation, rule, order, or condition imposed by the FDIC.
Community Reinvestment Act - The Company and the Bank are subject to the
Community Reinvestment Act ("CRA"). The CRA and the regulations issued
thereunder are intended to encourage banks to help meet the credit needs of
their service area, including low and moderate income neighborhoods, consistent
with the safe and sound operations of the banks. The CRA does not establish
specific lending requirements or programs for financial institutions, nor does
it limit an institution's discretion to develop the types of products and
services that it believes are best suited to its particular community,
consistent with the CRA. The CRA requires a bank's primary federal regulator, in
connection with its examination of the institution, to assess the institution's
record of assessing and meeting the credit needs of the community served by that
institution, including low- and moderate-income neighborhoods. These regulatory
assessments are utilized by the Federal Reserve when considering applications to
establish branches, merger applications and applications to acquire the assets
and assume the liabilities of another bank. The Financial Institutions Reform,
Recovery and Enforcement Act of 1989 ("FIRREA") requires federal banking
agencies to make public a rating of a bank's performance under the CRA. In the
case of a bank holding company, the CRA performance record of the banks involved
in the transaction are reviewed by federal banking agencies in connection with
the filing of an application to acquire ownership or control of shares or assets
of a bank or thrift or to merge with any other bank holding company. An
unsatisfactory record can substantially delay or block the transaction. The Bank
has received a satisfactory CRA rating from federal banking agencies.
Current CRA Regulations rate banks based on their actual performance in
meeting community credit needs. CRA performance is evaluated by the Federal
Reserve, the Bank's primary federal regulator, using a lending test, or
investment test, and a service test. The Federal Reserve also will consider: (i)
demographic data about the
9
community; (ii) the bank's capacity and constraints; (iii) the bank's product
offerings and business strategy; and (iv) data on the prior performance of the
bank and similarly situated lenders. As a result of the GLBA, CRA agreements
with private parties must be disclosed and annual CRA reports must be made to a
bank's primary federal regulator. A bank holding company will not be permitted
to become a financial holding company and no new activities authorized under
GLBA may be commenced by a holding company or by a bank financial subsidiary if
any of its bank subsidiaries received less than a "satisfactory" CRA rating in
its latest CRA examination.
USA Patriot Act - On October 26, 2001, President Bush signed into law the
Uniting and Strengthening America by Providing Appropriate Tools Required to
Intercept and Obstruct Terrorism Act of 2001 (the "USA Patriot Act"), which is
designed to deny terrorists and others the ability to obtain access to the
United States financial system. Title III of the USA Patriot Act is the
International Money Laundering Abatement and Anti-Terrorist Financing Act of
2001. Among its provisions, the USA Patriot Act mandates or will require
financial institutions to implement additional policies and procedures,
including additional due diligence and record keeping with respect to any or all
of the following matters, among others: money laundering; suspicious activities
and currency transaction reporting; and currency crimes. The U.S. Department of
the Treasury in consultation with the Federal Reserve Board and other federal
financial institution regulators has promulgated rules and regulations
implementing the USA Patriot Act which (i) prohibits U.S. correspondent accounts
with foreign banks that have no physical presence in any jurisdiction; (ii)
require financial institutions to maintain certain records for correspondent
accounts of foreign banks; (iii) require financial institutions to produce
certain records relating to anti-money laundering compliance upon request of the
appropriate federal banking agency; (iv) require due diligence with respect to
private banking and correspondent banking accounts; (v) facilitate information
sharing between the government, federal law enforcement and financial
institutions; (vi) require financial institutions to have in place an anti-money
laundering program; and (vii) require financial institutions to have in place a
Customer Identification Program, including risk-based procedures to verify the
identity of each customer. The Company has implemented and will continue to
implement the provisions of the USA Patriot Act as such provisions become
effective. The Company currently maintains and will continue to maintain
policies and procedures to comply with the USA Patriot Act requirements. At this
time, the Company does not expect that the USA Patriot Act will have a
significant impact on the financial position of the Company.
Consumer Laws and Regulations - In addition to the laws and regulations
discussed herein, the Bank is also subject to certain consumer laws and
regulations that are designed to protect consumers in transactions with banks.
While the list set forth herein is not exhaustive, these laws and regulations
include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds
Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity
Act and the Fair Housing Act, among others. These laws and regulations mandate
certain disclosure requirements and regulate the manner in which financial
institutions must deal with customers when taking deposits, making loans to or
engaging in other types of transactions with such customers.
LEGISLATIVE AND REGULATORY CHANGES
Various bills are routinely introduced in the United States Congress and
the Alabama legislature with respect to the regulation of financial
institutions. Certain of these proposals, if adopted, could significantly change
the regulation of banks and the financial services industry. We cannot predict
whether any of these proposals will be adopted or, if adopted, how these
proposals would affect us.
EFFECT ON ECONOMIC ENVIRONMENT
The policies of regulatory authorities, especially the monetary policy of
the Federal Reserve Board, have a significant effect on the operating results of
bank holding companies and their subsidiaries. Among the means available to the
Federal Reserve Board to affect the money supply are open market operations in
U.S. Government securities, changes in the discount rate on member bank
borrowings and changes in reserve requirements against member bank deposits.
These means are used in varying combinations to influence overall growth and
distribution of bank loans, investments and deposits, and their use may affect
interest rates charged on loans or paid for deposits.
Federal Reserve Board monetary policies have materially affected the
operating results of commercial banks in the past and are expected to continue
to do so in the future. The nature of future monetary policies and the effect of
such policies on our business and earnings cannot be predicted.
10
STATISTICAL DISCLOSURE
Statistical and other information regarding the following items are set forth in
"Item 7 - Management's Discussion and Analysis of Financial Condition and
Results of Operations" in the pages indicated below.
Page(s)
Loan Portfolio 19
Selected Loan Maturity and Interest Rate Sensitivity . . . . . . . . . . . . 19
Securities Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Securities Portfolio Maturity Schedule . . . . . . . . . . . . . . . . . . . 20
Maturities of Large Time Deposits . . . . . . . . . . . . . . . . . . . . . 21
Return on Equity and Assets . . . . . . . . . . . . . . . . . . . . . . . . 22
Capital Adequacy Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Interest Rate Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . 25
Average Balances, Interest Income/Expense and Yields/Rates . . . . . . . . . 28
Rate/Volume Variance Analysis . . . . . . . . . . . . . . . . . . . . . . . 29
Summary of Loan Loss Experience . . . . . . . . . . . . . . . . . . . . . . 31
Allocation of Loan Loss Reserve . . . . . . . . . . . . . . . . . . . . . . 32
Nonperforming Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Noninterest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Noninterest Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Interest Rate Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
11
ITEM 2. PROPERTIES
Our headquarters are located at 211 Lee Street NE, Decatur, Morgan County,
Alabama. We operate eight banking offices throughout Northern Alabama, one
mortgage origination office and two operations centers. We own two and lease
nine of these offices. Rental expense on the leased properties totaled
approximately $753,119 in 2003.
ITEM 3. LEGAL PROCEEDINGS
The Bank received demand letters from two former directors, officers and
employees of the Bank. The Bank terminated such officers in November 2002 for
cause, as such term is defined by their respective employment contracts. One
officer has claimed monetary compensation, stock options and attorneys' fees,
while the second officer has claimed monetary compensation, as well as stock
options and payment of country club dues for two years following the date of his
termination. The Bank maintains that it terminated each of these officers for
"cause" and that it is under no obligation to pay them any additional
compensation. On March 14, 2003, one of these officers filed a lawsuit against
the Bank in the Circuit Court for Morgan County, Alabama, alleging breach of
contract and demanding certain payments and benefits allegedly due under his
employment agreement. The Bank subsequently received notice that a suit had been
filed by a second former officer and director in the Circuit Court of Jefferson
County, Alabama, alleging similar causes of action against the Bank. The Bank
successfully removed each of these cases to the United States District Court for
the Northern District of Alabama. On March 9, 2004, the Bank reached agreement
on the settlement of the claims of one of the former officers. The Bank intends
to vigorously defend the remaining action brought against the Bank, and does not
believe that the final outcome will have a material impact on the Bank or the
Company.
While we may from time-to-time be a party to various legal proceedings
arising from the ordinary course of business, we believe that there are
currently no other proceedings threatened or pending against us at this time
that will, individually or in the aggregate, materially or adversely affect our
business, financial condition or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of stockholders of the Company during
the fourth quarter of the fiscal year covered by this report.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company is not listed on any exchange and there is no organized trading
market for the shares of its common stock. When shares are traded, they are
traded in privately negotiated transactions. Therefore, no reliable information
is available as to trades of the Company's common stock, or as to the prices at
which such common stock has traded.
Management has reviewed the limited information available to the Company as
to the ranges at which shares of the Company's common stock has been sold. The
following table sets forth, on a per share basis for the periods indicated, the
high and low sale prices of the Company's common stock based solely on such
limited available information.
Fiscal 2003 Fiscal 2002
-------------- ---------------
High Low High Low
------- ----- ------- ------
First Quarter $ 8.00 $7.00 $ 12.50 $ 8.00
Second Quarter $ 6.00 $3.50 $ 12.00 $10.00
Third Quarter $ 4.50 $4.00 $ 10.50 $ 9.50
Fourth Quarter $ 8.00 $4.00 $ 9.50 $ 9.50
As of December 31, 2003 the Company had approximately 1,156 stockholders of
record.
12
Holders of our common stock are entitled to receive dividends when, as and
if declared by our board of directors. We have never paid dividends on our
common stock. We conduct our principal business through our subsidiaries,
primarily the Bank. We derive cash available to pay dividends primarily, if not
entirely, from dividends paid by our subsidiaries. There are certain
restrictions that limit the Bank's ability to pay dividends to us and on our
ability to pay dividends. In addition, the Bank is currently prohibited from
paying dividends to the Company without the prior approval of the Superintendent
of the State Banking Department. Our ability to pay dividends to our
stockholders will depend on our earnings and financial condition, liquidity and
capital requirements, the general economic and regulatory climate, our ability
to service any equity or debt obligations senior to our common stock and other
factors deemed relevant by our board of directors. We currently intend to retain
any future earnings to fund the development and growth of our business.
Therefore, we do not at the present time anticipate paying any cash dividends on
our common stock in the foreseeable future.
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
The following table provides information as of December 31, 2003 regarding
compensation plans (including individual compensation arrangements) under which
common stock of the Company is authorized for issuance.
EQUITY COMPENSATION PLAN INFORMATION
Number of securities
remaining available for
Number of Securities to be Weighted-average exercise future issuance under
issued upon exercise of price of outstanding equity compensation plans
outstanding options, options, warrants and (excluding securities
warrants and rights rights reflected in column (a))
Plan Category (a) (b) (c)
- ----------------------------------------------------------------------------------------------------------
Equity Compensation
Plans Approved by 1,876,000 3.36 --
Security Holders
Equity Compensation
Plans not Approved by -- -- --
Security Holders
Total 1,876,000 3.36
See Note 13 to the Consolidated Financial Statements for information regarding
the material features of the above plans. Each of the above plans provides that
the number of shares with respect to which options may be granted, and the
number of shares of Company common stock subject to an outstanding option, shall
be proportionately adjusted in the event of a subdivision or consolidation of
shares or the payment of a stock dividend on Company common stock, and the
purchase price per share of outstanding options shall be proportionately
revised.
13
MANAGEMENT'S STATEMENT ON
RESPONSIBILITY FOR FINANCIAL REPORTING
HERITAGE FINANCIAL HOLDING CORPORATION
The management of Heritage Financial Holding Corporation is responsible for
the content and integrity of the consolidated financial statements and all other
financial information included in this annual report. Management believes that
the financial statements have been prepared in conformity with generally
accepted accounting principles applied on a consistent basis to reflect, in all
material respects, the substance of events and transactions that should be
included, and that the other financial information in the annual report is
consistent with those financial statements. The financial statements necessarily
include amounts that are based on management's best estimates and judgments.
Management maintains and depends upon Heritage Financial Holding
Corporation's accounting systems and related systems of internal controls. The
internal control systems are designed to ensure that transactions are properly
authorized and recorded in the Company's financial record and to safeguard the
Company's assets from material loss or misuse. The Company maintains an internal
audit staff which monitors compliance with the Company's systems of internal
controls and reports to management and to the audit committee of the board of
directors.
The audit committee of the board of directors, composed solely of outside
directors, has responsibility for recommending to the board of directors the
appointment of the independent auditors for Heritage Financial Holding
Corporation. The committee meets periodically with the internal auditors and the
independent auditors to review the scope and findings of their respective
audits. The internal auditors, independent auditors and management each have
full and free access to meet privately as well as together with the committee to
discuss internal controls, accounting, auditing, or other financial reporting
matters.
The consolidated financial statements of Heritage Financial Holding
Corporation have been audited by Porter, Keadle, Moore, LLP, independent
auditors, who were engaged to express an opinion as to the fairness of
presentation of such financial statements.
/s/ William M. Foshee /s/ Larry R. Mathews
- ------------------------------ -------------------------------------
William M. Foshee Larry R. Mathews
Chief Financial Officer President and Chief Executive Officer
14
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected financial data and ratios for the
Company and should be read in conjunction with our consolidated financial
statements including the related notes and "Management's Discussion and Analysis
of Financial Condition and Results of Operations." See "Item 8. Heritage
Financial Holding Corporation and Subsidiaries Financial Statements."
Years ended December 31,
-----------------------------------------------------
2003 2002 2001 2000 1999
--------- --------- --------- --------- ---------
(Dollars in thousands except per share data)
EARNINGS SUMMARY:
Interest income $ 30,343 $ 40,465 $ 42,966 $ 35,660 $ 17,248
Interest expense 15,389 21,742 28,594 22,018 9,874
Net interest income 14,954 18,723 14,371 13,642 7,374
Provision for loan losses (1,646) 29,469 3,602 3,389 1,808
Net interest income (loss) after
provision for loan losses 16,600 (10,746) 10,769 10,253 5,566
Noninterest income 4,987 3,825 2,844 1,039 642
Noninterest expense 19,795 15,380 10,023 8,113 4,952
Income (loss) before income taxes 1,793 (22,300) 3,590 3,179 1,256
Income taxes (benefit) 664 (7,887) 1,224 991 395
Net income (loss) 1,129 (14,413) 2,366 2,188 861
PER COMMON SHARE DATA:
(Retroactively adjusted for effects of stock splits)
Net income (loss) - basic $ 0.11 (1.65) $ 0.28 $ 0.26 $ 0.12
Net income (loss) - diluted $ 0.11 (1.65) 0.23 0.22 0.11
Cash dividends declared per common share $ 0.00 0.00 0.00 0.00 0.00
SELECTED AVERAGE BALANCES:
Total assets $537,065 $617,255 $559,921 $401,615 $213,101
Total loans 455,672 544,079 489,897 333,340 172,418
Securities 51,564 39,961 26,662 23,183 19,405
Earning assets 523,986 605,723 546,517 389,795 204,643
Deposits 461,371 544,598 496,283 348,819 180,072
Stockholders' equity 28,213 35,296 34,178 29,910 19,062
Shares outstanding (thousands) (split adjusted) 10,048 8,717 8,485 8,317 7,226
SELECTED PERIOD-END BALANCES:
Total assets $522,426 $592,942 $568,291 $471,458 $297,952
Total loans 385,887 523,850 505,381 422,135 244,620
Securities 101,935 36,762 25,894 26,846 19,969
Earnings assets 494,565 587,734 550,865 458,478 287,307
Deposits 415,615 525,631 504,310 421,244 249,032
Stockholders' equity 30,106 23,703 36,124 33,499 21,920
Shares outstanding (thousands) (split adjusted) 10,511 8,821 8,515 8,476 7,581
SELECTED RATIOS:
Return on average equity 4.00% (4.08)% 6.92% 7.32% 4.52%
Return on average assets 0.21% (2.34)% 0.42% 0.54% 0.40%
Net interest margin (taxable equivalent) 2.86% 3.11% 2.65% 3.52% 3.63%
Allowance for loan losses to loans 3.77% 5.15% 1.20% 1.20% 1.24%
Net charge-offs to average loans 2.37% 1.57% 0.53% 0.41% 0.10%
Average equity to average assets 5.25% 5.72% 6.10% 7.45% 8.95%
15
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
The following is a narrative discussion and analysis of significant changes
in our results of operations and financial condition. The principal purpose of
this review is to provide the reader of the attached financial statements and
accompanying footnotes with a detailed analysis of our financial results. Among
other things, this discussion provides commentary on our critical accounting
policies, strategy, operating philosophies, the components of net interest
margin and balance sheet strength as measured by the quality of assets, the
composition of the loan portfolio and capital adequacy.
Like most community banks, we derive most of our income from interest we
receive on our loans and investments. Our primary source of funds for making
these loans and investments is our deposits, on which we pay interest.
Consequently, one of the key measures of our success is our amount of net
interest income, or the difference between the income on our interest earning
assets, such as loans and investments, and the expense on our interest-bearing
liabilities such as deposits. Another key measure is the spread between the
yield we earn on these interest-earning assets and the rate we pay on our
interest-bearing liabilities.
We have included a number of tables in the following discussion which we
believe assist our description of our results of operations and financial
condition. However, our financial statements present a complete picture of such
results of operations and financial condition, and you should read this
discussion in conjunction with the consolidated financial statements and
selected financial data included elsewhere in this Annual Report.
Our principal subsidiary is Heritage Bank (the "Bank"), a financial
institution organized and existing under the laws of Alabama and headquartered
in Decatur, Alabama. The Bank operates ten offices throughout Northern Alabama.
The Company also has another wholly owned subsidiary, Heritage Financial
Statutory Trust I ("Heritage Trust"), a Connecticut statutory trust. Heritage
Trust is a consolidated special purpose entity formed solely to issue cumulative
trust preferred securities.
The Company was established in the year 2000 in order to facilitate a
reorganization and merger of the Company and the Bank into a bank holding
company structure. The reorganization was effective on August 31, 2000.
RESTRICTIONS ON OPERATIONS
As previously reported, a targeted, limited scope review of the Bank's loan
portfolio identified certain assets of the Bank that management and regulatory
authorities believed should be classified. In connection with such review, the
Company and the Bank took steps to charge off or establish additional loan loss
reserves for specified assets and to adjust the Bank's levels of loan loss
provisions.
Management has taken certain corrective actions to address concerns about
the Bank's asset quality. The Bank may not declare or pay cash dividends without
seeking the prior approval of the regulatory authorities. During 2002 and 2003,
the Company and the Bank hired certain management personnel who were given
specific written authority by the Board of Directors to implement sound lending,
recordkeeping and accounting practices. Management also developed an educational
program for the Board of Directors and completed a written review of staffing
requirements for the Bank.
Management's focus on addressing asset quality, loan and audit issues has
resulted in a substantial decrease in loan loss reserves during 2003 and in
increase in the Bank's Tier I leverage ratio to 8.58% as of December 31, 2003.
Management continues to be vigilant in its review of the Bank's loan portfolio,
as an increase in classified loans and other loan-related issues could trigger
additional restrictions on the Bank's operations.
CRITICAL ACCOUNTING POLICIES
The accounting and financial reporting policies of the Company conform to
accounting principles generally accepted in the United States of America and to
general practices within the banking industry. Following is a description of the
accounting policies applied by the Company which are deemed "critical." In
determining which accounting policies are "critical" in nature, the Company has
identified the policies that require significant judgment
16
or involve complex estimates. The application of these policies has a
significant impact on the Company's financial statements. Financial results
could differ significantly if different judgments or estimates are applied.
Allowance for Loan Losses
The allowance for loan losses is established through provisions for loan
losses charged to operations. Loans are charged against the allowance for loan
losses when management believes that the collection of principal is unlikely.
Subsequent recoveries, if any, are credited to the allowance. Management's
evaluation of the adequacy of the allowance for loan losses is based on a formal
analysis which assesses the risk within the loan portfolio. This analysis
includes consideration of historical performance, current economic conditions,
level of nonperforming loans, loan concentrations, and review of certain
individual loans. Actual losses for these loans can vary significantly from this
estimate. Management continually reviews the methodology and assumptions used to
calculate the allowance for appropriateness given the most recent losses
realized and other factors that influence the estimation process. Management
believes that the allowance for loan losses is adequate. While management uses
available information to recognize losses on loans, future additions to the
allowance for loan losses may be necessary based on changes in economic
conditions and the results of management's ongoing review of the loan portfolio.
In addition, various regulatory agencies, as an integral part of their
examination process, periodically review the bank's allowances for loan losses.
Such agencies may require the bank to recognize additions to the allowance for
loan losses based on their judgments.
EXECUTIVE SUMMARY
The Bank is a $535 million financial institution with community banking
offices, operations and team members located principally in Morgan, Madison,
Marshall and Jefferson County, Alabama. We gather substantially all of our
deposits in these market areas. We use these deposits, as well as other
financing sources, to fund our loan and investment portfolios. We earn interest
income on our loans and investments. In addition, we generate noninterest income
from a number of sources including deposit and loan services, mortgage
originations, and investment securities. Our principal noninterest expenses
include employee compensation and benefits, occupancy and equipment related
costs, data processing and other administrative expenses. Our financial results
are affected by our credit quality, the economic environment, including interest
rates, consumer and business confidence and spending, as well as the competitive
conditions within our industry.
EARNINGS OVERVIEW
The Company recorded net income of $1,129,000 for the year ended 2003, a
107.8% increase over the same period in 2002. The Company experienced a net loss
of ($14,413,000) in 2002, a 709.2% decrease from 2001. The Company also recorded
earnings per share (basic and diluted) for the year ended 2003 of $0.11, a 106.7
% increase over the loss of ($1.65) for 2002, which was a 689.3% decrease from
basic earnings per share for the year ended 2001 of $0.28.
The increase in the Company's net income in 2003 is primarily attributable
to the $31,115,000 decrease in the provision for loan losses. The Company
experienced a 20% decrease in net interest income due to decreases in average
loans of 16.3%, decreases in average earning assets of 13.5% and decreases in
average total assets of 13.0%.
Interest expense decreased by $6,353,000, or 29.2% in 2003. This decrease
is due both to a decrease in interest rates payable on deposits and a decrease
in average total deposits of $83,227,000 in 2003.
Noninterest income increased $1,162,000, or 30.4% for the year ended
December 31, 2003. The increase is due primarily to a large increase in mortgage
banking income and service fees. While mortgage origination growth helped fuel
the Company's return to profitability, rising mortgage interest rates in the
last half of 2003 caused mortgage originations to decrease. Mortgage origination
income may not return to the high level experienced in 2003 during 2004.
Noninterest expense increased by $4,415,000, or 28.7%, in 2003 versus 2002.
Increases in noninterest expense were primarily fueled by an increase in
occupancy and equipment expense, an increase in data processing expense and an
increase in advertising expense. The Company attributed these expense increases
to growth of the Company's infrastructure and its requirements for additional
technology to monitor its loan portfolio.
17
HIGHLIGHTS
During 2003, we worked diligently to resolve issues with the credit quality
of our loan portfolio, revise our lending and loan review policies and address
any substandard loans remaining on our books. As a result, we have significantly
reduced our nonperforming assets, from $29,782,000 at December 31, 2002 to
$17,594,000 at December 31, 2003. We have also worked to return our regulatory
capital ratios to levels in excess of regulatory requirements and, as a result,
the Company and the Bank were considered "well capitalized" at December 31,
2003.
CHALLENGES
While we made great strides during 2003, we faced, and will continue to
face, challenges to our continued growth. We will work to increase net interest
income following the $3.8 million decrease, or 20%, we experienced during 2003.
Additionally, while the increase in noninterest income of $1,162,000 was
helpful, we will continue to search for alternative income sources as we believe
mortgage banking revenues may decrease or remain at 2003 levels during the
coming year. We also experienced a decrease of $110 million in deposits during
2003, although much of this decrease was in brokered and out of area deposits.
We will continue to strive toward a greater share of the deposit market in our
areas.
EARNING ASSETS
Our total assets were $522,426,000 at December 31, 2003, a decrease of
$70,516,000, or 11.9% from December 31, 2002. The decrease primarily resulted
from a decrease in gross loans of $137,963,000. Total assets were $592,942,000
at December 31, 2002, an increase of $24,651,000, or 4.3% from $568,291,000 as
of December 31, 2001. The increase in total assets in 2002 primarily related to
an increase in securities available for sale of $10,868,000 and other assets,
primarily deferred tax assets, of $9,169,000. The increase in total assets was
funded primarily by an increase in deposits.
Our average earning assets were $523,986,000 in 2003, representing a
decrease of $81,737,000 or 13.5% from 2002. The decrease in average earning
assets was mainly due to the decease in average loans outstanding of
$88,407,000. This decrease in average loans was due to an effort by management
to increase the quality of our loan portfolio.
Management considers many criteria in managing assets, including
creditworthiness, diversification and structural characteristics, maturity and
interest rate sensitivity. The following table sets forth the Bank's
interest-earning assets by category at December 31, in each of the last three
years.
Years Ended December 31,
-------------------------------
2003 2002 2001
---------- -------- ---------
(In thousands)
Interest-bearing deposits with banks $ 116 $ 98 $ 326
Securities 101,935 36,762 25,894
Federal funds sold 632 14,681 6,716
Mortgage loans held-for-sale 5,996 12,343 12,548
Loans:
Real estate 257,210 371,714 344,749
Commercial and other 128,676 152,136 160,632
---------- -------- ---------
Total loans 385,886 523,850 505,381
---------- -------- ---------
Interest-earning assets $ 494,565 $587,734 $ 550,865
========== ======== =========
LOAN PORTFOLIO
Loans are the largest category of interest-earning assets, accounting for
87.0% of average interest earning assets at December 31, 2003. Loans typically
provide higher yields than other types of interest-earning assets. Loans involve
inherent risk and liquidity risks which management attempts to control and
mitigate. Our average loans, net of unearned income, totaled $455.7 million at
December 31, 2003, a decrease of $88,407,000, or 16.3% from the December 31,
2002 average loans of $544.1 million. This decrease resulted from lower loan
volume as a result of credit policies and procedures initiated in the first
quarter of 2003 in response to the Bank's previous asset quality
18
issues. Due to these same credit quality issues, net charge-offs of $10.8
million and foreclosures of $13.2 million in 2003 also affected the balances.
Average loans increased $54,182,000 or 11.1% from year-end 2001 to 2002. The
increase in loans was a result of strong loan demand, primarily due to the
increase in refinancing. Loan growth for 2002 was funded primarily through
deposits. The most significant loan increase came from real estate mortgage
loans, which increased approximately $36,832,000 or 13.4% over the 2001 year-end
amount.
The Loan Portfolio table presents the classifications of loans by major
category at December 31, 2003, and for each of the preceding four years.
December 31,
------------------------------------------------------------------------------------------------------------
2003 2002 2001 2000 1999
-------------------- -------------------- -------------------- -------------------- --------------------
Percent Percent Percent Percent Percent
Amount of Total Amount of Total Amount of Total Amount of Total Amount of Total
--------- --------- --------- --------- --------- --------- --------- --------- --------- ---------
(Dollars in Thousands)
Commercial,
financial and
agricultural $116,202 30.11% $132,237 25.24% $138,344 26.71% $105,393 24.97% $ 66,144 27.04%
Real estate -
construction 26,583 6.89 60,206 11.49 70,073 13.53 90,603 21.46 49,432 20.21
Real estate-mortgage 230,626 59.77 311,508 59.47 274,676 55.46 205,422 48.66 112,643 46.05
Consumer 12,475 3.23 19,899 3.80 22,288 4.30 20,717 4.91 16,410 6.70
--------- --------- --------- --------- --------- --------- --------- --------- --------- ---------
385,886 100.0% 523,850 100.0% 505,381 100.0% 422,135 100.0% 244,629 100.0%
========= ========= ========= ========= =========
Allowance for loan
losses (14,562) (26,991) (6,074) (5,065) (3,036)
Unearned income - - - - (9)
--------- --------- --------- --------- ---------
Net loans $371,324 $496,859 $499,307 $417,070 $241,584
========= ========= ========= ========= =========
The following table sets forth maturities of selected categories of the
loan portfolio and the related sensitivity to interest rate changes.
SELECTED LOAN MATURITY AND INTEREST RATE SENSITIVITY
Rate Structure for Loans
Maturity Maturing Over One Year
--------------------------------------- -----------------------------
Over One
One Year Over Predetermined Floating or
Year or Through Five Interest Adjustable
Less Five Years Years Total Rate Rate
-------- ----------- ------ -------- -------------- -------------
(Amounts in thousands)
Commercial, financial
and agricultural $ 59,440 $ 51,583 $5,179 $116,202 $ 29,432 $ 27,330
Real estate - construction 24,867 1,520 196 26,583 883 833
-------- ----------- ------ -------- -------------- -------------
Total $ 84,307 $ 53,103 $5,375 $142,785 $ 30,315 $ 28,163
======== =========== ====== ======== ============== =============
SECURITIES PORTFOLIO
Our portfolio of securities classified as available for sale increased by
$63,912,000 or 182.0% from the year 2002 to 2003. The increase in the portfolio
in 2003 was the result of market opportunities that allowed us to make purchases
with an acceptable interest rate spread. The securities portfolio increased by
$10,868,000 or 42.0% from the year 2001 to 2002. The balance in the securities
portfolio increased as a result of deposit growth in 2002.
We maintain an investment strategy of seeking portfolio yields within
acceptable risk levels, as well as providing liquidity. The Bank maintains one
classification of securities: "Available-for-Sale." The classification of
securities as Available-for-Sale is consistent with our investment philosophy of
maintaining flexibility to manage the portfolio. The Available-for-Sale
securities are carried at fair market value and represent all of our securities
at year-end 2003 and 2002. At year-end 2003 and 2002, unrealized gains in the
Available-for-Sale portfolio amounted to $342,000 and $95,000, respectively.
At year-end 2003 and 2002, obligations of the United States Government or
its agencies and obligations of states and political subdivisions represented
approximately 32.2% and 63.1%, respectively, of our securities portfolio.
19
The following table presents the carrying amounts of our securities
portfolio at December 31, in each of the last three years.
December 31,
-------------------------
2003 2002 2001
------- ------- -------
(In thousands)
AVAILABLE-FOR-SALE
U.S. government and agencies . . . . . . . . . . . $30,593 $ - $15,697
Mortgage-backed securities . . . . . . . . . . . . 61,640 23,208 617
Asset-backed securities . . . . . . . . . . . . . . - - 4,474
State and municipal . . . . . . . . . . . . . . . . 1,336 1,330 2,590
Corporate debt . . . . . . . . . . . . . . . . . . 5,469 10,588 1,190
------- ------- -------
Total . . . . . . . . . . . . . . . . . . . . . . $99,038 $35,126 $24,568
======= ======= =======
The maturities and weighted average yields of the investments in the 2003
portfolio of securities are presented below. Amounts are presented at amortized
cost.
SECURITY PORTFOLIO MATURITY SCHEDULE
Maturing
-----------------------------------------------------------------------------
Within After One But After Five But After
One Year Within Five Years Within Ten Years Ten Years
-------------- --------------------- --------------------- ---------------
Amount Yield Amount Yield Amount Yield Amount Yield
------- ----- --------- ---------- --------- ---------- ------- ------
(Amounts in thousands)
SECURITIES AVAILABLE-FOR-SALE
U. S. Government and agencies $ - - $ 7,100 2.05% $ 23,388 2.50% - -%
Mortgage-backed securities . . - - 368 4.52% 9,522 4.12% 51,553 4.35%
State and municipal (1) . . . - - - - 185 3.65% 1,109 5.53%
Corporate debt . . . . . . . . - - - - - - 5,470 8.63%
------- ----- --------- ---------- --------- ---------- ------- ------
$ - - $ 7,468 2.17% $ 33,095 2.97% $58,132 4.71%
======= ========= ========= =======
(1) The weighted average yields are calculated on the basis of the cost and
effective yield weighted for the scheduled maturity of each security. The
weighted average yields on tax-exempt obligations have been computed on a
fully taxable equivalent basis using a tax rate of 34%.
We did not hold any securities of which the aggregate value on December 31,
2003, 2002 and 2001 exceeded ten percent of stockholders' equity at that date.
(Securities which are payable from and secured by the same source of revenue or
taxing authority are considered to be securities of a single issuer. Securities
of the U.S. Government and U.S. Government agencies and corporations are not
included.)
DEPOSITS AND BORROWED FUNDS
Our average deposits decreased by $83,226,000 or 15.3% from 2002 to 2003.
The decrease primarily resulted from a decrease of $88.7 million in certificate
of deposits as we decreased our reliance on brokered and out of market funds.
Brokered funds decreased by $19.9 million in 2003 and out of market funds
decreased by $35.3 million in 2003. Our average deposits rose $48,315,000 or
9.7% from the year 2001 to 2002. The largest area of growth in 2002 was in
interest bearing demand accounts, which increased $7,417,000 or 13.8%. From 2001
to 2002, other time deposits of more than $100,000 increased $4,990,000 or 3.5%.
Savings deposits increased $3,582,000 or 7.4%, and time deposits of less than
$100,000 increased $4,616,000 or 1.9%. From year-end 2001 to year-end 2002,
total non-interest bearing deposits increased $716,000 or 3.4%. Deposit growth
has been generated primarily outside of our local markets.
20
The following table sets forth our deposit structure at December 31, of
each of the last three years.
December 31,
----------------------------
2003 2002 2001
-------- -------- --------
(In thousands)
Noninterest-bearing deposits:
Individuals, partnerships and corporations . . . . . . $ 22,992 $ 21,961 $ 21,296
U.S. Government and states and political subdivisions 624 -- --
Certified and official checks . . . . . . . . . . . . 4,526 -- --
-------- -------- --------
Total noninterest-bearing deposits . . . . . . . . . 28,142 21,961 21,296
-------- -------- --------
Interest-bearing deposits:
Interest-bearing demand accounts . . . . . . . . . . . 77,141 61,244 53,776
Saving accounts . . . . . . . . . . . . . . . . . . . 48,558 51,769 48,187
Certificates of deposit, less than $100,000 . . . . . 167,404 244,448 239,831
Certificates of deposit, more than $100,000 . . . . . 94,370 146,209 141,220
-------- -------- --------
Total interest-bearing deposits . . . . . . . . . . 387,473 503,670 483,014
-------- -------- --------
Total deposits . . . . . . . . . . . . . . . . . . . $415,615 $525,631 504,310
======== ======== ========
The following table presents a breakdown by category of the average amount
of deposits and the average rate paid on deposits for the periods indicated:
Years Ended December 31,
---------------------------------------------------
2003 2002 2001
--------------- --------------- -----------------
Amount Rate Amount Rate Amount Rate
-------- ----- -------- ----- -------- -------
(Dollars in thousands)
Noninterest-bearing deposits . . $ 25,897 -% $ 21,832 -% $ 16,975 -%
Interest-bearing demand deposits 63,161 1.22 50,622 1.61 39,299 3.10
Savings deposits . . . . . . . . 54,125 1.16 64,773 1.92 43,079 3.17
Time deposits . . . . . . . . . . 318,188 3.64 407,370 4.33 396,930 6.09
-------- ----- -------- ----- -------- -------
Total deposits . . . . . . . . $461,371 2.98% $544,597 3.62% $496,283 5.39%
======== ======== ========
At December 31, 2003, time deposits greater than $100,000 aggregated
approximately $94,370,000. Maturities of time certificates of deposit and other
time deposits of $100,000 or more outstanding at December 31, 2003, are
summarized as follows (in thousands):
MATURITIES OF LARGE TIME DEPOSITS
(In thousands)
Three months or less . . . . . . . . . . . . . . . . . . . . $ 8,556
Over three through six months . . . . . . . . . . . . . . . . 12,169
Over six through twelve months . . . . . . . . . . . . . . . 36,269
Over twelve months . . . . . . . . . . . . . . . . . . . . . 37,376
-------
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . $94,370
=======
Borrowed funds of $74,308,000 as of December 31, 2003, consist of long-term
Federal Home Loan Bank advances, an advance from a pooled trust preferred
private placement for subordinated debentures, a short-term borrowing from a
commercial bank and federal funds purchased. We have $12,500,000 in lines to
purchase Federal Funds, on an unsecured basis, from commercial banks. At
December 31, 2003, we had $406,000 advanced against these lines. At December 31,
2002 and 2001, we had no funds advanced against these lines. We are also
approved to borrow up to $88,733,000 under various short-term and long-term
programs offered by the Federal Home Loan Bank of Atlanta. These borrowings are
secured under a blanket lien agreement on certain qualifying mortgage
instruments in loan and investment security portfolios. The unused portion of
these available funds amounted to $32,311,000, $42,223,000, and $46,000,000 at
year-end 2003, 2002 and 2001, respectively.
21
CAPITAL RESOURCES
Stockholders' equity increased $6,402,000 or 27.0% to $30,106,000 as of
December 31, 2003 compared to 2002. The increase in stockholders' equity was
attributable to the net income for the year of $1,129,000, $2,300,000 in
proceeds from a private placement in March 2003 and $2,801,000 in proceeds from
the exercise of stock options. Stockholders' equity decreased $12,421,000 or
34.4% to $23,703,000 as of December 31, 2002 compared to 2001. This decease was
primarily attributable to a net loss of $14,413,000 in 2002. Stockholders'
equity increased $2,625,000 or 7.8% to $36,124,000 as of December 31, 2001. This
increase was attributable to net income and the issuance of stock through exempt
offerings, employee stock purchase plan purchases and the exercise of stock
options.
On February 22, 2001, Heritage Financial Statutory Trust I ("Heritage
Trust"), a Connecticut statutory trust established by the Company, received
$10,000,000 in proceeds in exchange for $10,000,000 principal amount of Heritage
Trust's 10.20% cumulative trust preferred securities (the "preferred
securities") in a pooled trust preferred private placement. The proceeds of that
transaction were then used by Heritage Trust to purchase an equal amount of our
10.20% subordinated debentures (the "subordinated debentures").
Under the terms of the indenture, we may elect to defer payments of
interest for up to ten semiannual payment periods. For the duration of such
deferral period, we are restricted from paying dividends to shareholders or
paying debt that is junior to the debentures.
We have fully and unconditionally guaranteed all obligations of Heritage
Trust on a subordinated basis with respect to the preferred securities. We
account for the Heritage Trust preferred securities as a minority interest.
Subject to certain limitations, the preferred securities qualify as Tier 1
capital and are presented in the Consolidated Statements of Financial Condition
as "Guaranteed preferred beneficial interests in the Company's subordinated
debentures." The sole asset of Heritage Trust is the subordinated debentures
issued by us. Both the preferred securities of Heritage Trust and our
subordinated debentures each have 30-year lives. However, both the Company and
Heritage Trust have a call option of ten years, subject to regulatory approval,
or earlier, depending upon certain changes in tax or investment company laws, or
regulatory capital requirements.
A strong capital position, which is vital to our continued profitability,
also promotes depositor and investor confidence and provides a solid foundation
for the future growth of the organization. The objective of management is to
maintain a level of capitalization that is sufficient to take advantage of
profitable growth opportunities while meeting regulatory requirements. This is
achieved by improving profitability through effectively allocating resources to
more profitable businesses, improving asset quality, strengthening service
quality, and streamlining costs. The primary measures used by management to
monitor the results of these efforts are the ratios of return on average assets,
return on average common equity and average equity to average assets.
The table below summarizes these and other key ratios for us for each of
the last three years.
RETURN ON EQUITY AND ASSETS
2003 2002 2001
----- ------- -----
Return on average assets . . . . . . . . . . . . . 0.21% (2.34)% 0.42%
Return on average common equity . . . . . . . . . . 4.00 (4.08) 6.92
Dividend payout ratio . . . . . . . . . . . . . . . 0.00 0.00 0.00
Average common shareholders' equity to average
assets ratio . . . . . . . . . . . . . . . . . . 5.25 5.72 6.10
In addition, banks and bank holding companies are required to maintain
capital to support, on a risk-adjusted basis, certain off-balance sheet
activities such as loan commitments. The Federal Reserve Board has adopted
capital guidelines governing the activities of bank holding companies. These
guidelines require the maintenance of an amount of capital based on
risk-adjusted assets so that categories of assets with potentially higher credit
risk will require more capital than assets with lower risk.
The capital guidelines classify capital into two tiers, referred to as Tier
1 and Tier 2. Under risk-based capital requirements, Total Capital consists of
Tier 1 capital which is generally common stockholders' equity less
22
goodwill and Tier 2 capital which is primarily a portion of the allowance for
loan losses and certain qualifying debt instruments. In determining risk-based
capital requirements, assets are assigned risk-weights of 0% to 100%, depending
primarily on the regulatory assigned levels of credit risk associated with such
assets. Off-balance sheet items are considered in the calculation of
risk-adjusted assets through conversion factors established by the regulators.
The framework for calculating risk-based capital requires banks and bank holding
companies to meet the regulatory minimums of 4% Tier 1 and 8% total risk-based
capital. In 1990 regulators added a leverage computation to the capital
requirements, comparing Tier 1 capital to total average assets less goodwill.
The table below illustrates our regulatory capital ratios under federal
guidelines at December 31, 2003, 2002 and 2001:
CAPITAL ADEQUACY RATIOS
Years ended December 31,
Statutory ----------------------------------
Minimum 2003 2002 2001
---------- ----------- --------- ----------
(Amounts in thousands)
Tier 1 Capital $ 35,113 30,749 $ 46,180
Tier 2 Capital 6,732 8,687 6,074
----------- --------- ----------
Total Qualifying Capital $ 41,845 39,436 $ 52,254
=========== ========= ==========
Risk Adjusted Total Assets (including
off-balance-sheet exposures) $ 407,053 $505,129 $ 488,824
=========== ========= ==========
Adjusted quarterly average assets $ 556,466 $650,604 $ 587,901
=========== ========= ==========
Tier 1 Capital Ratio 4.00% 8.63% 6.09% 9.45%
Total Capital Ratio 8.00% 10.28% 7.81% 10.69%
Leverage Ratio 4.00% 6.31% 4.94% 7.86%
On December 31, 2003, the Company and the Bank each exceeded the regulatory
minimums and together qualified as a well capitalized institution under the
regulations. On December 31, 2002, the Bank qualified as an adequately
capitalized institution under the regulations. We have worked aggressively to
improve regulatory capital ratios which previously had deteriorated due to
issues with the Bank's credit quality.
LIQUIDITY MANAGEMENT
We focus on maintaining and managing adequate liquidity. Liquidity refers
to the ability of the Company to meet its cash flow requirements in the normal
course of business, including loan commitments, deposit withdrawals, liability
maturities and ensuring that the Company is in a position to take advantage of
investment opportunities in a timely and cost-efficient manner. Management of
liquidity also includes management of funding sources and their utilization
based on current, future and contingency needs. Additionally, management strives
to maximize our earnings by investing our excess funds in securities.
Historically, we have maintained a high loan-to-deposit ratio. Retail
deposit growth is a primary focus of our funding and liquidity strategy. To meet
our short-term liquidity needs, we maintain core deposits and have borrowing
capacity through the FHLB and federal funds lines. Long-term liquidity needs are
met primarily through these sources, time deposits, the repayment of loans,
sales of loans and the maturity or sale of investment securities, including
short-term investments. We have entered into certain contractual obligations and
commercial commitments that arise in the normal course of business and involve
elements of credit risk, interest rate risk and liquidity risk.
The liability portion of the balance sheet provides liquidity through
various interest-bearing and noninterest-bearing deposit accounts. We also
utilize a variety of funding sources to meet the needs of funding loan growth,
securities acquisitions and deposit fluctuations. Fed Funds lines and our line
of credit are sources of short-term borrowings, and we also utilize Fed Funds
lines and our credit facilities with the Federal Home Loan Bank for long-term
borrowings. At December 31, 2003 we had $12,094,000 of federal funds available
and credit of approximately $88,733,000 from The Federal Home Loan Bank of which
approximately $32,311,000 was available
23
and unused. At December 31, 2002, we had $13,500,000 of federal funds available,
$850,000 available under the short-term borrowing and a line of credit of
approximately $65,223,000 from The Federal Home Loan Bank of which approximately
$42,223,000 was available and unused.
The primary source of funds available to the Company is payment of
dividends from the Bank. Banking laws and other regulations limit the amount of
dividends a bank subsidiary may pay without prior regulatory approval. Our Bank
may not pay any dividends to the Company without the prior approval of the
regulatory authorities.
The Company has no off-balance sheet arrangements that are expected to
materially affect liquidity. The Company believes that the level of liquidity is
sufficient to meet current and future liquidity requirements.
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
The following table illustrates the Company's contractual obligations as of
December 31, 2003
Payments Due By Period
----------------------
(amounts in thousands)
Less than After
Contractual obligations Total 1 year 1-3 Years 3-5 Years 5 Years
- --------------------------- -------- ---------- ---------- ---------- --------
Note payable $ 7,480 $ 7,480 $ - $ - $ -
Trust preferred securities 10,000 - - - 10,000
Operating lease obligations 6,423 859 1,740 1,393 2,431
FHLB advances 56,422 11,422 12,000 7,000 26,000
Time deposits 261,730 175,069 68,572 18,089 -
-------- ---------- ---------- ---------- --------
Total $342,055 $ 194,830 $ 82,312 $ 26,482 $ 38,431
======== ========== ========== ========== ========
INTEREST RATE SENSITIVITY MANAGEMENT
Interest rate sensitivity is a function of the repricing characteristics of
our portfolio of assets and liabilities. These repricing characteristics are the
time frames within which the interest-bearing assets and liabilities are subject
to change in interest rates either at replacement or maturity during the life of
the instruments. Sensitivity is measured as the difference between the volume of
assets and liabilities in our current portfolio that is subject to repricing in
future time periods. The differences are known as interest sensitivity gaps and
are usually calculated separately for segments of time ranging from zero to
thirty days, thirty-one to ninety days, ninety-one days to one year, one to five
years, over five years and on a cumulative basis.
24
The following table shows interest sensitivity gaps for different intervals
as of December 31, 2003.
INTEREST RATE SENSITIVITY ANALYSIS
(Amounts in thousands)
--------------------
0-30 31-90 91-365 1-5 Over 5
Days Days Days Years Years Total
-------- --------- ---------- --------- ------- --------