CALIFORNIA FIRST LEASING CORP - Quarter Report: 2003 December (Form 10-Q)

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The accompanying notes are an integral part
of these consolidated financial statements.

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NOTE 1- BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The financial statements should be read in conjunction with the financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended June 30, 2003. The material under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations" is written with the presumption that the readers have read or have access to the 2003 Annual Report on Form 10-K, which contains Management's Discussion and Analysis of Financial Condition and Results of Operations as of June 30, 2003 and for the year then ended.

In the opinion of management, the unaudited financial statements contain all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the balance sheet as of December 31, 2003 and the statements of earnings and cash flows for the three and six-month periods ended December 31, 2003 and 2002. The results of operations for the three and six-month periods ended December 31, 2003 are not necessarily indicative of the results of operations to be expected for the entire fiscal year ending June 30, 2004.

Certain reclassifications have been made to the fiscal 2003 financial statements to conform with the presentation of the second quarter of fiscal 2004 financial statements.

NOTE 2 - STOCK-BASED COMPENSATION

At December 31, 2003, the Company had two stock option plans, which are more fully described in Note 1 in the Company's 2003 Annual Report on form 10-K. The Company accounts for these Plans under APB Opinion No. 25, "Accounting for Stocks Issued to Employees," under which no compensation cost has been recognized. In accordance with Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"), as amended by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure," ("SFAS No. 148") the Company adopted the disclosure requirements of SFAS No. 148. Had compensation cost for these plans been determined consistent with SFAS No. 123, the Company's net income and earnings per share would have been reduced to the following proforma amounts:

Since the SFAS No. 123 method of accounting has not been applied to options granted prior to July 1, 1995, the resulting pro forma compensation cost may not be indicative of that to be expected in future periods.

NOTE 3 - RELATED PARTY TRANSACTION

Included in Demand and Money Market Deposits at December 31, 2003 is a deposit in a money market account in the amount of $1.7 million from an affiliate, as defined in Rule 12b-2 of the Securities Exchange Act of 1934, of California First National Bancorp. The terms of such account are the same terms offered on similar accounts to non-affiliated depositors.

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California First National Bancorp (the "Company") is a bank holding company. The Company has two leasing subsidiaries, Amplicon, Inc. ("Amplicon") and California First Leasing Corporation ("CFLC", collectively the "Leasing Companies") that are involved in the leasing and financing of computers, computer networks and other high technology assets. The leasing subsidiaries are also engaged in the re-marketing of leased assets at lease expiration. California First National Bank ("CalFirst Bank" or the "Bank"), another subsidiary, is an FDIC-insured national bank that gathers deposits using the telephone, the Internet and direct mail, and leases capital assets to businesses and organizations as well as provides business loans to fund the purchase of assets leased by third parties.

The Company's direct finance income includes interest income earned on the Company's investment in lease receivables and residuals. Other income primarily includes gains realized on the sale of leased property, income from sales-type and operating leases and gains realized on the sale of leases, and other fee income. Income from sales-type leases relates to the re-lease of off-lease property ("lease extensions") and new lease transactions that qualify as sales-type leases, generally where the fair value of the property subject to the lease differs from the Company's carrying cost. Income from operating leases generally involves the re-lease of off-lease property that is booked as an operating lease rather than as a sales-type lease.

The Company's operating results are subject to quarterly fluctuations resulting from a variety of factors, including the volume of new lease originations, the volume and profitability of leased property being re-marketed through re-lease or sale, variations in the mix of lease originations, the size and credit quality of the lease portfolio, interest rates and economic conditions in general. The Company has insignificant interest bearing liabilities, and therefore, reductions in interest rates in general can reduce the yield earned on the investment in lease receivables and on the investment in securities and other interest earning assets with little offsetting benefit from lower interest expense.

The Company conducts its leasing business in a manner designed to mitigate risks. However, the assumption of risk is a key source of earnings in the leasing and banking industries and the Company is subject to risks through its investment in lease receivables held in its own portfolio, lease transactions in process, and residual investments. The Company takes steps to manage risks through the implementation of strict credit management processes and on-going risk management review procedures.

Critical Accounting Policies and Estimates

The preparation of the Company's financial statements requires management to make certain critical accounting estimates that impact the stated amount of assets and liabilities at a financial statement date and the reported amount of income and expenses during a reporting period. These accounting estimates are based on management's judgment and are considered to be critical because of their significance to the financial statements and the possibility that future events may differ from current judgments, or that the use of different assumptions could result in materially different estimates. The critical accounting policies and estimates have not changed from and should be read in conjunction with the Company's Annual Report filed on Form 10-K for the year ended June 30, 2003.

The Company's estimates are reviewed continuously to ensure reasonableness. However, the amounts the Company may ultimately realize could differ from such estimated amounts.

CONSOLIDATED STATEMENT OF EARNINGS ANALYSIS

          Summary -- For the second quarter ended December 31, 2003, net earnings of $2.5 million decreased $426,000, or 14.7%, compared to $2.9 million for the second quarter ended December 31, 2002. Diluted earnings per share decreased 15.4% to $0.22 per share for the second quarter of fiscal 2004 compared to $0.26 per share for the second quarter of the prior year. The results of the second quarter of fiscal 2004 reflect higher income from end-of-term transactions offset by an increase in selling, general and administrative ("SG&A") expenses and lower finance and interest income. The volume of new lease transactions booked during the second quarter of fiscal 2004 was $32.9 million, a 3.5% increase from the same quarter of the prior year.

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          For the six months ended December 31, 2003, net earnings of $4.8 million decreased $1.2 million, or 19.9%, compared to the six months ended December 31, 2002. Diluted earnings per share decreased 17.3% to $0.43 for the first six months of fiscal 2004 compared to $0.52 for the same period of the prior year. The results of the first six months of fiscal 2004 reflect lower interest and finance income and higher S,G&A expenses, while income from end-of-term transactions remained flat. The volume of new lease transactions booked during the six months ended December 31, 2003 was $55.6 million, a 9.7% decrease from the same period of the prior year, as fewer lease transactions were completed during the first quarter of fiscal 2004.

          Net Direct Finance and Interest Income -- Net direct finance and interest income is the difference between interest earned on the investment in capital leases, securities and other interest earning investments and interest paid on deposits or other borrowings. Net direct finance and interest income is affected by changes in the volume and mix of interest earning assets, the movement of interest rates, and funding and pricing strategies.

          Net direct finance and interest income was $4.7 million for the quarter ended December 31, 2003, a $506,000, or 9.8%, decrease compared to the same quarter of the prior year. Direct finance income of $4.7 million decreased by $270,000 as a result of lower yields earned on a higher average investment in capital leases held in the Company's own portfolio. Interest income on investments declined by $183,000 due primarily to a decline in interest rates but also due to a decrease in average balances of cash and cash equivalents during the period. Interest expense on deposits was $115,000 for the second quarter of fiscal 2004 compared to $62,000 for the same quarter of the prior year, primarily reflecting an increase in average deposit balances.

          For the six months ended December 31, 2003, net direct finance and interest income was $9.3 million, a $674,000, or 6.7%, decrease compared to the same period of the prior year. Direct finance income of $9.3 million decreased by $218,000 as a result of lower yields on a higher average investment in capital leases held in our own portfolio. Interest income on investments declined by $406,000 due to the combined impact of lower yields on lower investment balances during the period. Interest expense on deposits was $180,000 for the first six months of fiscal 2003 compared to $130,000 for the same period of the prior year, reflecting an increase in average deposit balances.

          The following table presents the components of the increases (decreases) in net direct finance and interest income by volume and rate:

         Discounted lease rentals and non-recourse debt offset each other, and do not contribute to the Company's net interest and finance income.

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          The following tables present the Company's average balance sheets, direct finance income and interest earned or interest paid, the related yields and rates on major categories of the Company's interest-earning assets and interest-bearing liabilities. Yields/rates are presented on an annualized basis.

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(1) Direct finance income and interest expense on discounted lease rentals and non-recourse debt of $23,421,000 and $54,864,000 at December 31, 2003 and 2002, respectively, offset each other and do not contribute to the Company's net direct finance and interest income.

(2) Average balance is based on month-end balances, and includes non-accrual leases, and is presented net of unearned income.

          Provision for Lease Losses -- The Company's provision for lease losses in the second quarter and six months ended December 31, 2003 was $45,000 and $123,000, respectively, compared to $38,000 and $218,000, respectively, for the same periods of the prior fiscal year. The provision for both periods reflects a stable portfolio.

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          Other Income -- Other income is a significant source of income for the Company, accounting for 48% of the Company's gross profit during the quarter ended December 31, 2003 and 43% during the second quarter of the prior year. Total other income for the quarter ended December 31, 2003 increased by $365,000, or 9.4%, to $4.2 million, compared to $3.9 million for the same quarter of the prior fiscal year. The increase in other income is primarily due to a $382,000, or 16%, increase in gain on sale of leases and leased property to $2.8 million for the second quarter of fiscal 2004 from $2.4 million for the same period of the prior year. This reflected an increase in income from a slightly higher volume of leased property sales. Operating and sales type income of $1.3 million during the second quarter of fiscal 2004 remained flat compared to the same quarter of fiscal 2003.

          For the six months ended December 31, 2003, other income accounted for 46% of the Company's gross profit compared to 45% for the comparable period of the prior fiscal year. Total other income for the first six months of both years was $8.0 million. Other income during the first six months of fiscal 2004 includes an increase in gain on sale of leases and leased property of $510,000 to $5.2 million from $4.6 million for the same period of the prior year. This primarily reflected a higher volume of leased property sales. Offsetting this increase is a decrease in operating and sales type income of $651,000 to $2.4 million during the first six months of fiscal 2004, compared to $3.1 million for the same period of fiscal 2003. This decrease was due to a lower volume of lease extensions. Other miscellaneous income increased $80,000 to $365,000 for the six months ended December 31, 2003 compared to the same period of the prior year.

           Selling, General, and Administrative Expenses -- S,G&A expenses increased by $545,000, or 13%, to $4.8 million during the second quarter of fiscal 2004 compared to $4.3 million during the second quarter of fiscal 2003. For the first six months, S,G&A expenses increased $1.29 million, or 16%, to $9.4 million from $8.2 million reported for the first six months of the prior fiscal year. The increase in S,G&A for both periods is due to higher costs related to an expansion of the sales organization that increased the average headcount by approximately 20% during the first half of fiscal 2004 compared to the comparable period of the prior year.

          Taxes -- Taxes were accrued at a tax rate of 38.5% for the six months ended December 31, 2003 and 2002, representing the estimated annual tax rate for the years ending June 30, 2004 and 2003, respectively.

FINANCIAL CONDITION ANALYSIS

Lease Portfolio Analysis

          The Company's risk assets are comprised almost exclusively of leases for capital assets to businesses and other commercial or non-profit organizations. All leases are secured by the underlying property being leased. A portion of lease originations are discounted to banks or finance companies on a non-recourse basis at fixed interest rates. Leases that are not assigned to financial institutions are held in internal portfolios. Over the past few years, the Company has funded a significantly greater percentage of new lease transactions internally. During the six months ended December 31, 2003, approximately 92% of the total dollar amount of new leases booked by the Company were held in its own portfolio, compared to 90% during the first six months of fiscal 2003. During the six months ended December 31, 2003, the Company's net investment in capital leases remained relatively flat at $146.3 million compared to $146.4 million at June 30, 2003. The portfolio at December 31, 2003 included an increase of $1.2 million in the net investment in lease receivables, which was offset by a $1.3 million reduction in the investment in estimated residual values.

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          The Company often makes payments to purchase leased property prior to the commencement of the lease. The disbursements for these lease transactions in process are generally made to facilitate the lessees' property implementation schedule. The lessee is contractually obligated by the lease to make rental payments directly to the Company during the period that the transaction is in process, and the lessee is generally obligated to reimburse the Company for all disbursements under certain circumstances. At December 31, 2003, the Company's investment in property acquired for transactions in process was $31.5 million, which related to approved lease commitments of approximately $108 million. This compared to $20.3 million invested in property acquired for transactions in process at June 30, 2003, which related to approximately $81 million of approved lease commitments. The increase was primarily due to the larger volume of lease transactions in process during the first half of fiscal 2004.

          The Company monitors the performance of all leases held in its own portfolio, transactions in process and lease transactions assigned to lenders, if the Company retains a residual investment in the leased property subject to the lease. An ongoing review of all leases 10 or more days delinquent is conducted. Lessees who are delinquent with the Company or an assignee are coded in the Company's accounting and tracking systems in order to provide management visibility, periodic reporting, and appropriate reserves. The accrual of interest income on leases will generally be discontinued when the lease becomes 90 days or more past due on its lease payments with the Company, unless the Company believes the investment is otherwise recoverable. Leases may be placed on non-accrual earlier if the Company has significant doubt about the ability of the lessee to meet its lease obligations, as evidenced by consistent delinquency, deterioration in the lessee's financial condition or other relevant factors.

The following table summarizes the Company's non-performing capital leases:

          In addition to the non-performing capital leases identified above, there was $1.1 million of investment in capital leases at December 31, 2003 for which management has concerns regarding the ability of the lessees to continue to meet existing lease obligations, compared with $2.8 million at June 30, 2003. This amount consists of leases classified as substandard or doubtful, or with lessees that currently are experiencing financial difficulties or that management believes may experience financial difficulties in the future.

Allowance for Lease Losses

          The allowance for lease losses provides coverage for probable and estimatable losses in the Company's lease portfolios. The allowance recorded is based on a quarterly review of all leases outstanding and transactions in process. Lease receivables or residuals are charged off when they are deemed completely uncollectible. The determination of the appropriate amount of any provision is based on management's judgment at that time and takes into consideration all known relevant internal and external factors that may affect the lease portfolio.

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          The allowance for lease losses increased to $4.3 million (2.9% of net investment in capital leases) at December 31, 2003 from $4.2 million (2.8% of net investment in capital leases) at June 30, 2003. This allowance consisted of $2.1 million allocated to specific accounts and $2.2 million that was unallocated. The change in the allowance at December 31, 2003 primarily relates to a decrease in specific reserves as the Company's exposure to certain credits has decreased. The Company considers the allowance for doubtful accounts of $4.3 million at December 31, 2003 adequate to cover losses specifically identified as well as inherent in the lease portfolios. However, no assurance can be given that the Company will not, in any particular period, sustain lease losses that are sizeable in relation to the amount reserved, or that subsequent evaluations of the lease portfolio, in light of factors then prevailing, including economic conditions and the on-going credit review process will not require significant increases in the allowance for loan and lease losses. Among other factors, an economic slowdown may have an adverse impact on the adequacy of the allowance for lease losses by increasing credit risk and the risk of potential loss even further. As the Company has retained a significantly greater percentage of leases in its own portfolio, this creates increased exposure to delinquencies, repossessions, foreclosures and losses than the Company has historically experienced.

Liquidity and Capital Resources

          The Company funds its operating activities through internally generated funds, non-recourse debt and bank deposits. The Leasing Companies' capital expenditures for leased property purchases are occasionally financed by assigning certain base lease term payments to banks or other financial institutions, including CalFirst Bank. The assigned lease payments are discounted at fixed rates such that the lease payments are sufficient to fully amortize the aggregate outstanding debt. At December 31, 2003, the Company had outstanding non-recourse debt aggregating $23.4 million relating to property under capital leases. In the past, the Company has been able to obtain adequate non-recourse funding commitments, and the Company believes it will be able to do so in the future.

          During the first six months of fiscal 2004, CalFirst Bank has more actively sought to raise deposits to fund its investment in capital leases. Deposits totaled $20.8 million at December 31, 2003, compared to $7.6 million at June 30, 2003. The following table presents average balances and average rates paid on deposits for the six months ended December 31, 2003 and 2002:

          In April 2001, the Board of Directors authorized management, at its discretion, to repurchase up to 1,000,000 shares of common stock. During the six months ended December 31, 2003 the Company did not purchase any shares. As of January 31, 2004, 612,956 shares remain available under this authorization.

          At December 31, 2003, the Company's cash and cash equivalents were $66.3 million. The need for cash used for operating activities will increase as the Company's business expands. The Company believes that existing cash balances, cash flow from operations, cash flows from its financing activities, and assignments (on a non-recourse basis) of lease payments will be sufficient to meet its foreseeable financing needs.

          Stockholders' equity at December 31, 2003 was $200.0 million, or 73% of total assets, compared to $197.3 million, or 71% of total assets, at June 30, 2003. At December 31, 2003, the Company and the Bank exceed their regulatory capital requirements and are considered "well-capitalized" under guidelines established by the FRB and the OCC.

          Inflation has not had a significant impact upon the operations of the Company.

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FORWARD LOOKING STATEMENTS

          This Form 10-Q contains forward-looking statements. Statements that are not historical or current facts, including statements about beliefs and expectations, are forward-looking statements. Forward-looking statements involve inherent risks and uncertainties, and certain factors could cause actual results to differ materially from those anticipated. Factors that might affect forward-looking statements include, among other things:

• General economic or industry conditions could be less favorable than expected, resulting in a reduced demand for capital assets, deterioration in credit quality, deterioration in the recoverability of our investment in leased property and lease residual values, and a change in the allowance for lease losses;
• Changes in the domestic interest rate environment could reduce net interest income and negatively affect certain lessees, which could increase lease losses;
• Over the past few years, the Company's subsidiaries have retained an increasing number of lease transactions in their own portfolios which has increased the Company's exposure to credit risk;
• A material percentage of the Company's net investment in capital leases is with colleges and universities located throughout the United States, and the Company could be vulnerable to economic and other factors that negatively affect these lessees as a group;
• CalFirst Bank may not attract or retain sufficient deposits at attractive interest rates to fund its lease portfolio, and therefore could require additional investment by the Company, produce lower lease growth and continuing losses;
• Security breaches, systems failures, computer viruses or other similar events could damage CalFirst Bank's reputation, or Internet banks in general, and inhibit the ability to raise deposits;
• The conditions of the securities markets could change, adversely affecting certain lessees and the value or credit quality of the Company's assets, or the availability and terms of non-recourse financing obtained to complete certain lease transactions;
• The Company's Common Stock trades on the NASDAQ National Market System, but the volume of trading has been limited and the low volume of trading limits the liquidity of the Common Stock;
• Changes in the extensive laws, regulations and policies governing financial services companies could alter the Company's business environment or affect operations;
• Catastrophic events could impair the Company's business operations or systems, or that of its lessees, resulting in losses; and
• All the above factors could impact the Company's ability to remain in compliance with commitments made to federal bank regulators in connection with the formation of CalFirst Bank.

          The result of these and other factors could cause a difference from expectations of the risk characteristics of the lease portfolio, the level of defaults and a change in the provision for lease losses. Forward-looking statements speak only as of the date made. The Company undertakes no obligations to update any forward-looking statements to reflect events or circumstances arising after the date on which they are made.

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ITEM 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures.

          As of the end of the period covered by this report, the Company's management, including its principal executive officer and its principal financial officer, evaluated the effectiveness of the Company's disclosure controls and procedures, as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based on that evaluation, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective as of December 31, 2003 to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. There were no changes made during the most recent fiscal quarter to the Company's internal controls over financial reporting that materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.

PART II - OTHER INFORMATION

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

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