CALIFORNIA FIRST LEASING CORP - Annual Report: 2004 (Form 10-K)

       The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended, and is registered with, regulated and examined by the Board of Governors of the Federal Reserve System (the "FRB"). In addition to the regulation of the Company, the Bank is subject to extensive regulation and periodic examination, principally by the Office of the Comptroller of the Currency ("OCC"). The Bank's deposits are insured up to $100,000 by the Federal Deposit Insurance Corporation ("FDIC") and the Bank is a member bank within the San Francisco Federal Reserve district.

       The Bank Holding Company Act, the Federal Reserve Act, and the Federal Deposit Insurance Act subject the Company and the Bank to a number of laws and regulations. The primary concern of banking regulation is "Safety and Soundness" with an emphasis on asset quality and capital adequacy. These laws and regulations also encompasses a broad range of other regulatory concerns including insider transactions, the adequacy of the reserve for lease losses, inter-company transactions, regulatory reporting, adequacy of systems of internal controls and limitations on permissible activities. The federal banking agencies possess broad powers to take corrective action as deemed appropriate for an insured depository institution and its holding company. The FRB routinely examines the Company, which exam includes the Leasing Companies. The OCC, which has primary supervisory authority over the Bank, regularly examines banks in such areas as reserves, loans, investments, management practices, and other aspects of operations. These examinations are designed for the protection of the Bank's depositors rather than the Company's shareholders. The Bank must furnish annual and quarterly reports to the OCC, which has the authority under the Financial Institutions Supervisory Act to prevent a national bank from engaging in an unsafe or unsound practice in conducting its business. Many of these laws and regulations have undergone significant change in recent years. Future changes to these laws and regulations, and other new financial services laws and regulations are likely, and cannot be predicted with certainty.

       Under FRB policy, the Company is expected to serve as a source of financial and managerial strength to the Bank and, under appropriate circumstances, to commit resources to support the Bank. Certain loans by the Company to the Bank would be subordinate in right of payment to deposits in, and certain other indebtedness of, the Bank.

       Among the regulations that affect the Company and the Bank are provisions of Section 23A of the Federal Reserve Act. Section 23A places limits on the amount of loans or extensions of credit the Bank may make to affiliates and the amount of assets purchased from affiliates, except for transactions exempted by the FRB. The aggregate of all of the above transactions is limited in amount, as to any one affiliate, to 10% of a bank's capital and surplus and, as to all affiliates combined, to 20% of a bank's capital and surplus. The Bank and the Company must also comply with certain provisions designed to avoid the Bank buying low-quality assets. The Company and the Bank are also subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibits an institution from engaging in transactions with affiliates unless the transactions are on terms substantially the same, or at least as favorable to the institution as those prevailing at the time for comparable transactions with nonaffiliated companies. All services provided by the Company or its subsidiaries to the Bank are in accordance with this provision.

       In December 2002, the FRB approved Regulation W ("Reg. W"), which implements, interprets and applies statutory provision in sections 23A and 23B, and became effective April 1, 2003. Under Reg. W, a bank does not have to comply with the quantitative limits of Section 23A when making a loan or extension of credit to an affiliate if 1) the extension of credit was originated by the affiliate; 2) the bank makes an independent evaluation of the creditworthiness of the borrower and commits to purchase the extension of credit before the affiliate makes or commits to make the extension of credit; 3) the bank does not make a blanket advance commitment to purchase loans from the affiliate and 4) the dollar amount of all purchases over any 12 month period by the bank from an affiliate does not represent more than 50% of that affiliate's credit extensions during such period. The Company believes the Bank's purchase of lease receivables from the Leasing Companies conform to the requirements of Reg. W. In addition, the Company has agreed with the FRB that the Bank's purchase of leases from the Leasing Companies will not exceed 50% of the Bank's lease portfolio.

       At the time that Reg. W was published in December 2002, the FRB proposed for public comment an amendment to Reg. W that would limit the amount of extensions of credit that a bank could purchase from an affiliate to 100% of the bank's capital and surplus. If Reg. W is amended in accordance with this proposal, the ability of the Bank to purchase lease receivables from the Leasing Companies would be impacted. The final structure of Reg. W cannot be determined at this time, and there are no assurances that future regulations or interpretations from the FRB will not limit further or prohibit the Bank's purchases of leases from the Leasing Companies.

       In connection with its approval of the Company's purchase of the stock of the Bank, the FRB and the OCC required the Company and the Bank to make certain commitments with respect to the operation of the Bank. These commitments included: (i) the Bank and the Company entering into a binding written agreement setting forth the Company's obligations to provide capital maintenance and liquidity support to the Bank, if and when necessary; (ii) the Bank's Board of Directors executing a binding written agreement with the OCC setting forth certain actions that the Bank would take if the Bank did not achieve certain operating results; (iii) during the first three years of operation, or until the Bank has reported four consecutive quarters of minimum acceptable profitability, the Bank must obtain prior approval from the OCC before implementing any significant deviation or change from its original operating plan; (iv) the Company must comply with Reg. W; and (v) the Bank's purchases of leases from affiliates will represent no more than 50% of the Bank's lease portfolio. Fiscal 2004 was the third year of the Bank's operations, and during such time, the Bank did not report four consecutive quarters of minimum acceptable profitability, which the OCC defined as net income in excess of $100,000 in each quarter. At the request of the OCC, the Bank has submitted a forecast for fiscal 2005 to the OCC that shows that the Bank expects to achieve four consecutive quarters of minimum profitability during fiscal 2005.

       Bank holding companies are subject to risk-based capital guidelines adopted by the FRB. The Company currently is required to maintain (i) Tier 1 capital equal to at least six percent of its risk-weighted assets and (ii) total capital (the sum of Tier 1 and Tier 2 capital) equal to ten percent of risk-weighted assets. The FRB also requires the Company to maintain a minimum Tier 1 "leverage ratio" (measuring Tier 1 capital as a percentage of adjusted total assets) of at least five percent. At June 30, 2004 and 2003, the Company exceeded all these requirements.

       The Bank is also subject to risk-based and leverage capital requirements mandated by the OCC. In general, banks are required to maintain a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%. In addition to the risk-based guidelines, banks are generally required to maintain a minimum ratio of Tier 1 capital to adjusted total assets, referred to as the leverage ratio, of 4%. As a condition of the approval to commence banking operations, for the first three years of the Bank's existence, the Bank is required to maintain a Tier 1 capital to adjusted total assets ratio, or leverage ratio, of not less than 8%. At June 30, 2004 and 2003, the Bank had capital in excess of all minimum risk-based and leverage capital requirements.

       Under the Community Reinvestment Act ("CRA"), the Bank has a continuing and affirmative obligation, consistent with safe and sound operation, to help meet the credit needs of their entire communities, including low- and moderate-income neighborhoods. CalFirst Bank is designated as a wholesale institution for CRA purposes. To evaluate the CRA performance of banks with this designation, regulatory agencies use the community development test. This includes an assessment of the level and nature of the Bank's community development lending, investments and services. The CRA requires the OCC, in connection with its examination of the Bank, to assess and assign one of four ratings to the Bank's record of meeting the credit needs of its community. The CRA also requires that the Bank publicly disclose their CRA ratings. During fiscal 2004, CalFirst Bank was subjected to its first CRA examination and received a "satisfactory" rating on the CRA performance evaluation.

       The principal source of cash flow to the Company, including cash flow to pay dividends on its common shares, is dividends from its subsidiaries and fees for services rendered to its subsidiaries. Various statutory and regulatory provisions limit the amount of dividends or fees that may be paid to the Company by the Bank. The Company does not depend on the Bank for such amounts, and believes the Leasing Companies have sufficient cash flow and assets to meet the Company's requirements.

       On November 12, 1999, the Gramm-Leach-Bliley Act ("Gramm-Leach") became law. Gramm-Leach significantly changed the regulatory structure and oversight of the financial services industry. Most importantly for the Company and the Bank, Gramm-Leach established new requirements for financial institutions to provide new privacy protections to consumers. In June of 2000, the Federal banking agencies jointly adopted a final regulation providing for the implementation of these protections. It requires a financial institution to provide notice to customers about its privacy policies and practices, describes under what conditions a financial institution may disclose nonpublic personal information about consumers to non-affiliated third parties, and provides an "opt-out" method for consumers to prevent the financial institution from disclosing that information to non-affiliated third parties. Financial institutions were required to be in compliance with the final regulation by July 1, 2001, and the Bank and the Company believe that they were in compliance at such date, and continue to be in compliance.

       On October 26, 2001, the USA Patriot Act became law. The USA Patriot Act requires financial institutions, including the Bank, to help prevent, detect and prosecute international money laundering and the financing of terrorism. With its existing systems and controls required as an Internet bank, the Bank believes it complies with the USA Patriot Act. The Secretary of the Treasury has proposed additional regulations to implement the USA Patriot Act. Although the Company cannot predict when and in what form these regulations will be adopted, the Company believes that the cost of compliance with the USA Patriot Act is not likely to be material to it.

       The laws, regulations and policies affecting financial services businesses are continually under review by Congress and state legislatures and federal and state regulatory agencies. From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial intermediaries. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial intermediaries are frequently made in Congress, in the California legislature and before various bank regulatory agencies and other professional agencies. Changes in the laws, regulations or policies that impact the Company cannot necessarily be predicted, and they may have a material effect on the business and earnings of the Company.

       The Company and its subsidiaries, as of June 30, 2004, had 197 employees, including 130 sales managers and account executives and 23 professionals engaged in finance and credit. None of the Company's employees are represented by a labor union. The Company believes that its relations with its employees are satisfactory.

Available Information

       Our Internet address is www.calfirstbancorp.com. There we make available by link to the SEC our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports, as soon as reasonably practical after we electronically file such material with, or furnish it to, the SEC. Our SEC reports can be accessed through the Investor Information section of our Web site. Our Corporate Governance Guidelines and our Code of Ethics for Senior Financial Management are available for viewing and printing under the Corporate Governance section of our Internet site. The information found on our Web site is not part of this or any other report we file with or furnish to the SEC and is not incorporated by reference herein.

       At June 30, 2004, the Company and its subsidiaries occupied approximately 43,000 square feet of office space in Irvine, California leased from an unaffiliated party. The lease provides for monthly rental payments that average $75,060 from July 2004 through August 2009.

       The Company is sometimes named as a defendant in litigation relating to its business operations. Management does not expect the outcome of any existing suit to have a material adverse effect on the Company's financial condition or results of operations.

       None.

       The common stock of California First National Bancorp trades on the NASDAQ National Market System under the symbol CFNB. The following high and low closing sale prices for the periods shown reflect inter-dealer prices without retail markup, markdown or commissions and may not necessarily reflect actual transactions.

       The Board of Directors of the Company has adopted a policy of paying regular quarterly cash dividends, subject to an ongoing review of the Company's profitability, liquidity and future operating cash requirements. In August 2003, following changes in tax laws and based on the strength on the Company's financial position, the Board of Directors approved an increase in the quarterly dividend on the Company's common stock to $.10 a share from $.04 a share. For the fiscal year ended June 30, 2004, the Company declared cash dividends totaling $.40 per common share. For each of the fiscal years ended June 30, 2003 and 2002, the Company declared cash dividends totaling $.16 per common share.

       In April 2001, the Board of Directors authorized management, at its discretion, to repurchase up to 1,000,000 shares of common stock. Since this authorization has no termination date, the Board of Directors reviews the authorization to repurchase of common from time to time. During the year ended June 30, 2004, the Company did not repurchase any common stock. During the year ended June 30, 2003, the Company repurchased 268,900 shares at an aggregate cost of $3.3 million. As of September 17, 2004, 612,956 shares remain available under this authorization.

Equity Compensation Plan Information

      The Company's results include the operations of Amplicon, CalFirst Leasing, and CalFirst Bank. 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 and annual 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 very little 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 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.

       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 following is a description of the most critical accounting policies management applies, all of which require the use of accounting estimates and management's judgment, based on the relevant information available at the end of each period. 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 following is a description of the most critical accounting policies management applies, all of which require the use of accounting estimates and management's judgment, based on the relevant information available at the end of each period.

       Residual Values -- For capital leases that qualify as direct financing leases, the aggregate lease payments receivable and estimated residual value, if any, are recorded on the balance sheet, net of unearned income and allowances, as net investment in capital leases. Of the volume of capital leases booked during the fiscal years ended June 30, 2004, 2003 and 2002, approximately 47%, 47% and 53%, respectively, were structured as "true leases," where the Company owns the leased asset at the end of the term and therefore, the Company recorded a residual value. The residual value is an estimate for accounting purposes of the fair value of the leased property at lease termination and is determined at the inception of the lease based on the property leased and the terms and conditions of the underlying lease contract. The realizability of any estimated residual value depends on future collateral values, contractual options available to the lessee, the credit of the lessee, market conditions and other subjective and qualitative factors. The estimated residual values established at lease inception are periodically reviewed to determine if values are realizable and any identified losses are recognized at such time.

       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. 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, including levels of non-performing leases, lessees' financial condition, leased property values as well as general economic conditions and credit quality indicators. The Company's allowance includes an estimate of reserves needed to cover specifically identified lease losses and certain unidentified but inherent risks in the portfolio.

       Income Taxes -- Deferred tax assets and liabilities result from temporary differences between the time income or expense items are recognized for financial statement purposes and for tax reporting. Such amounts are calculated using the enacted tax rates and laws that are expected to be in effect when the differences are expected to reverse. The determination of current and deferred income taxes is based on complex analyses of many factors including interpretation of Federal and state income tax laws, the difference between tax and financial reporting basis of assets and liabilities (temporary differences), estimates of amounts due or owed such as the timing of reversals of temporary differences and current financial accounting standards. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax liabilities.

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

       The following discussion is provided in addition to the required analysis of earnings in order to discuss trends in our business. We believe this analysis provides additional meaningful information on a comparative basis.

       The results for fiscal 2004 reflect primarily the negative impact of lower yields on earning assets, which was not offset by a sufficient increase in volume. The decrease in part relates to the lower interest rate environment that has prevailed for the last two years, and the run off of higher yielding leases booked during prior periods. The early termination of certain leases also decreased direct finance income. In addition to the lower interest rate environment, increased competition in certain markets reduced the spreads earned on certain capital leases, when compared to yields obtained in fiscal 2003 and before. As a higher percentage of the Company's investment in capital leases relates to lessees with higher credit ratings, the Company generally will not earn as high yields. Offsetting this reduction in direct finance income, the Company incurred significantly lower credit losses over the past year, which has allowed for a significantly lower provision for lease losses. The provision for lease losses decreased to $164,000 in fiscal 2004, compared to $554,000 in fiscal 2003 and $5.4 million in the year end June 30, 2002. The decline in provision relates in part to reserves established in 2002 for problem credits which were more favorably resolved than expected, but also is believed to relate to improved credit quality

       A second factor that has impacted the Company's results over the past few years is the lower volume of leases reaching the end of term, and on which the Company recognizes income from the re-lease or sale of property subject to such leases. The investment in lease residuals realized declined from $13.2 million in the year ended June 30, 2002 to $6.2 million in fiscal 2003 and $6.5 million in fiscal 2004.

       The Company's objective over the past three years has been to increase its investment in capital leases. Significant investments have been made in the development of the lease origination organizations of the Bank and CalFirst Leasing. Total sales, general and administrative expenses ("SG&A") increased by 30%, or $4.5 million, between fiscal 2002 and fiscal 2004. Given the nature of the Company's leasing activities, we believe such investment in the organization precedes the resulting growth in revenues by twelve to twenty-four months. While the volume of new leases booked during the fiscal 2004 did not increase significantly, the volume of lease proposals obtained and approved ("Originations") during fiscal 2004 was up about 42% when compared to the comparable period of the prior year.

        Summary -- For fiscal year ended June 30, 2004, net earnings decreased 9% to $9.8 million, compared to $10.7 million for fiscal 2003. Diluted earnings per share decreased 8% to $0.88 for fiscal year ended June 30, 2004, compared to $0.96 per share for fiscal 2003. The volume of new lease transactions booked during the year ended June 30, 2004 was approximately $126 million, compared to $118 million in fiscal 2003. Of the new leases booked during fiscal 2004, approximately 94% were retained in the Company's own portfolios, compared to 92% in the prior year. The net investment in capital leases increased 5% from $146.4 million at June 30, 2003 to $153.9 million at June 30, 2004. An increase in income from end of term transactions and the benefit from a reduction in the provision for lease losses were offset by a decrease in direct finance income, lower interest rates earned on a continued high level of liquid investments and higher expense levels.