CALIFORNIA FIRST LEASING CORP - Quarter Report: 2004 December (Form 10-Q)

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

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

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

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 and stockholders' equity as of December 31, 2004 and the statements of earnings and cash flows for the three and six-month periods ended December 31, 2004 and 2003. The results of operations for the three and six-month periods ended December 31, 2004 are not necessarily indicative of the results of operations to be expected for the entire fiscal year ending June 30, 2005.

Certain reclassifications have been made to the fiscal 2004 financial statements to conform with the presentation of the second quarter of fiscal 2005 financial statements.

On December 16, 2004, the Financial Accounting Standards Board ("FASB"), issued FASB Statement No. 123R (revised 2004), "Share-based Payment" ("SFAS 123R"). This Statement requires entities to expense the estimated fair value of employee stock options and similar awards and provides certain changes to the method for valuing stock-based compensation, among other changes. SFAS 123R will be effective for interim periods and fiscal years beginning after June 15, 2005. The Company will adopt SFAS 123R using a modified prospective application under which SFAS 123R will apply to new awards and to awards that are outstanding on the effective date and are subsequently modified or cancelled. Compensation expense for outstanding awards for which the requisite service has not been rendered as of the effective date will be recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under SFAS 123. At December 31, 2004, unamortized compensation expense determined in accordance with SFAS 123R that we expect to record during the first quarter of fiscal 2006 is approximately $47,000 before income taxes. The Company may incur additional expense during the first quarter of fiscal 2006 related to new awards, if any, granted during the last six months of fiscal 2005 that cannot yet be quantified. We are in the process of determining how the new method of valuing stock-based compensation as prescribed in SFAS 123R will be applied to valuing stock-based awards granted after the effective date and the impact the recognition of compensation expense related to such awards will have on our financial statements.

On December 15, 2004, the Company paid a special dividend of $2.00 per outstanding common share, which totaled $22.2 million, to stockholders of record on December 1, 2004. In connection with the distribution, stock options under the Company's two stock option plans held by employees and directors of the Company that were not exercised prior to the distribution date were re-priced to preserve the economic benefit of the stock options at such time. The re-pricing was implemented in accordance with the provisions for an equity restructuring under FASB Interpretation No. 44 ("FIN 44"), "Accounting for Certain Transactions Involving Stock Compensation -- an Interpretation of APB Opinion No. 25." Accordingly, no compensation expense resulted from the re-pricing of the options. However, because FIN 44 limited the re-pricing adjustments, an additional 136,618 options were granted in order to preserve the economic benefit of the stock options. The exercise price of the re-priced options range from $5.20 to $15.27.

The following table summarizes the stock option activity for the periods indicated:

The Company has two leasing subsidiaries, California First Leasing Corporation ("CalFirst Leasing") and Amplicon, Inc. ("Amplicon"), collectively the "Leasing Companies". The Company has a bank subsidiary, California First National Bank ("CalFirst Bank" or the "Bank"), which is an FDIC-insured national bank. Below is a summary of each segment's financial results for the quarter and six months ended December 31, 2004 and 2003:

     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's principal market risk exposure is interest rate risk, which is the exposure due to differences in the repricing characteristics of interest-earning assets and interest-bearing liabilities. The Company's balance sheet structure is primarily short-term in nature, with a greater portion of assets that reprice or mature within one year. As a result, the Company's current exposure to interest rate risk largely results from declines in interest rates and the impact on net direct finance and interest income.

     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.

     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, 2004.

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

Overview of Results and Trends

     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 the first six months of fiscal 2005 primarily reflect the impact of a smaller portfolio of assets reaching the end of term, which resulted in an 18% decline in other income compared to the first six months of fiscal 2004. This decrease was not completely offset by higher net direct finance and interest income after provision for lease losses resulting from higher yields earned on cash investments and improved portfolio performance which allowed for the Company to make no provision for lease losses during the first six months.

      The Company has continued efforts to increase the investment in capital leases. New lease bookings during the first six months were up 41% to $79.2 million, and contributed to a 9% increase in the net investment in capital leases. This increase should contribute to growth in direct finance income in coming quarters. During the second quarter of fiscal 2005, lease originations were 22.5% above the level of the second quarter of the prior year, but for the six months, originations were up only 6%. The backlog of approved transactions at December 31, 2004 remained flat compared to June 30, 2004, but was about 4% above the level of a year ago. Property acquired for transactions in process was up 34% from the level at June 30, 2004 to $42 million, despite the increased bookings. These indicators should point toward a higher level of lease bookings for the full fiscal year and growth in the investment in capital leases.

      Summary -- For the second quarter ended December 31, 2004, net earnings of $2.1 million decreased $395,000, or 16.0%, compared to $2.5 million for the second quarter ended December 31, 2003. Diluted earnings per share decreased 18.2% to $0.18 per share for the second quarter of fiscal 2005 compared to $0.22 per share for the second quarter of the prior year. The results of the second quarter of fiscal 2005 reflect higher net direct finance and interest income, lower income from end-of-term transactions and an increase in selling, general and administrative ("S,G&A") expenses. The volume of new lease transactions booked during the second quarter of fiscal 2005 was $49.5 million, a 47.9% increase from the same quarter of the prior year.

     For the six months ended December 31, 2004, net earnings of $3.7 million decreased $1.1 million, or 22.9%, compared to the six months ended December 31, 2003. Diluted earnings per share decreased 25.6% to $0.32 for the first six months of fiscal 2005 compared to $0.43 for the same period of the prior year. The results of the first six months of fiscal 2005 reflects slightly higher net direct finance and interest income, lower income from end-of-term transactions and higher S,G&A expenses. The volume of new lease transactions booked during the six months ended December 31, 2004 was $79.2 million, a 41.2% increase from the same period of the prior year.

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

     Net direct finance and interest income was $4.9 million for the quarter ended December 31, 2004, a $244,000, or 5.2%, increase compared to the same quarter of the prior year. Direct finance income of $4.9 million increased by $233,000 as a result of the 8% increase in the average investment in capital leases held in the Company's own portfolio, which offset the lower average yields earned. Interest income on investments increased by $118,000 due primarily to an increase in interest rates. Interest expense on deposits was $222,000 for the second quarter of fiscal 2005 compared to $115,000 for the same quarter of the prior year, primarily reflecting an increase in average deposit balances together with an increase in rates.

     For the six months ended December 31, 2004, net direct finance and interest income remained relatively flat at $9.3 million, compared to the same period of the prior year. Direct finance income of $9.1 million decreased by $175,000 as a result of lower yields on a 6% increase in the average investment in capital leases held in our own portfolio. Interest income on investments increased by $298,000 due to the higher yields on lower investment balances during the period. Interest expense on deposits was $387,000 for the first six months of fiscal 2005 compared to $180,000 for the same period of the prior year, reflecting an increase in average deposit balances and a very slight increase in rates.

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

    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.

     The Company monitors the performance of all leases held in its own portfolio, transactions in process, as well as lease transactions assigned to lenders, if the Company retains a residual investment in the leased property subject to those leases. An ongoing review of all leases ten 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 be discontinued when the lessee becomes ninety 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 $2.0 million of investment in capital leases at December 31, 2004 for which management has concerns regarding the ability of the lessees to continue to meet existing lease obligations, compared with $1.5 million at June 30, 2004. 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.

     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.

     The Company's investment securities are classified as held-to-maturity. The amortized cost, fair value, and carrying value of investment securities at December 31, 2004 were as follows:

     The Company funds its operating activities through internally generated funds, bank deposits and non-recourse debt. At December 31, 2004 and June 30, 2004, the Company's cash and cash equivalents were $34.8 million and $64.9 million, respectively. Stockholders' equity at December 31, 2004 was $184.6 million, or 70% of total assets, compared to $203.8 million, or 74% of total assets, at June 30, 2004. The decrease in both cash and stockholders' equity reflects the payment of a special dividend on December 15, 2004, which aggregated to $22.2 million. At December 31, 2004, the Company and the Bank exceed their regulatory capital requirements and are considered "well-capitalized" under guidelines established by the FRB and OCC.

     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, 2004 the Company did not repurchase any shares. As of January 31, 2005, 612,956 shares remain available under this authorization.

     The need for cash for operating activities will increase as the Company expands. The Company believes that existing cash balances, cash flow from operations, cash flows from its financing and investing activities, and assignments (on a non-recourse basis) of lease payments will be sufficient to meet its foreseeable financing needs.

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

                    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 and produce lower lease growth;

• 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;

• 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.

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, 2004 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.

ITEM 6. EXHIBITS

There were three reports on Form 8-K filed during the three months ended December 31, 2004. The report filed on October 26, 2004 related to the release of the Company's earnings for the quarter ended September 30, 2004. The report filed on November 19, 2004 related to the announcement of the special dividend payable on December 15, 2004. The report filed on November 23, 2004 related to the approval of an amendment to the Amended and Restated Stock Option Plan of California First National Bancorp and to The 1995 Equity Participation Plan of California First National Bancorp.

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.