Oak Valley Bancorp - Quarter Report: 2008 September (Form 10-Q)

Table of Contents

 

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2008
OR
o	TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission file number 001-34142

 

OAK VALLEY BANCORP

(Exact name of registrant as specified in its charter)

 

 

125 N. Third Ave., Oakdale, CA  95361

(Address of principal executive offices)

 

(209) 848-2265

Issuer’s telephone number

 

Not applicable

(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o No x

 

APPLICABLE ONLY TO CORPORATE ISSUERS

 

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: 7,658,252 shares of common stock outstanding as of September 30, 2008.

 

 

 

Table of Contents

 

Oak Valley Bancorp

September 30, 2008

 

Index

 

			Page
PART I – FINANCIAL INFORMATION
Item 1.	Financial Statements
Condensed Consolidated Balance Sheets at September 30, 2008, December 31, 2007			3
Condensed Consolidated Statements of Earnings for the Three and Nine Month Periods Ended September 30, 2008 and 2007			4
Condensed Consolidated Statements of Changes of Shareholders’ Equity for the Nine-Month Period Ended September 30, 2008 and Year Ended December 31, 2007			5
Condensed Consolidated Statements of Cash Flows for the Nine-Month Periods Ended September 30, 2008 and 2007			6
Notes to Consolidated Financial Statements			7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		14
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		28
Item 4T.	Controls and Procedures		28
PART II – OTHER INFORMATION
Item 1.	Legal Proceedings		29
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		29
Item 3.	Defaults Upon Senior Securities		29
Item 4.	Submission of Matters to a Vote of Security Holders		29
Item 5.	Other Information		29
Item 6.	Exhibits		29

 

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OAK VALLEY BANCORP

CONDENSED BALANCE SHEETS

 

		September 30,			December 31,
		2008			2007
		(Unaudited)
ASSETS
Cash and due from banks		$	10,263,546		$	10,397,951
Federal funds sold		375,000			3,805,000
Cash and cash equivalents		10,638,546			14,202,951
Securities available for sale		32,899,653			33,372,624
Loans, net of allowance for loan loss of $4,649,723 in 2008 and $4,506,753 in 2007		411,032,444			382,264,026
Bank premises and equipment, net		10,244,896			10,108,620
Other real estate owned		4,364,693			—
Accrued interest and other assets		20,930,919			14,310,569
		$	490,111,151		$	454,258,790
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits		$	365,229,560		$	377,347,776
Accrued interest and other liabilities		2,730,165			3,549,624
FHLB advances		78,000,000			31,000,000
Total liabilities		445,959,725			411,897,400
Shareholders’ equity
Preferred stock, no par value; 10,000,000 shares authorized, none issued or outstanding		—			—
Common stock, no par value; 10,000,000 shares authorized and 7,658,252 shares and  7,607,780 shares issued and outstanding at  September 30, 2008 and December 31, 2007, respectively		23,019,218			22,843,171
Additional paid-in capital		1,904,073			1,748,380
Retained earnings		19,148,174			17,723,646
Accumulated other comprehensive income, net of tax		79,961			46,193
Total shareholders’ equity		44,151,426			42,361,390
		$	490,111,151		$	454,258,790

 

See accompanying notes

 

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OAK VALLEY BANCORP

CONDENSED STATEMENTS OF EARNINGS (UNAUDITED)

 

		3 MONTHS ENDED						9 MONTHS ENDED
		SEPTEMBER 30,						SEPTEMBER 30,
		2008			2007			2008			2007
Interest and fees on loans		$	7,040,391		$	7,632,002		$	20,750,394		$	22,765,409
Interest on securities available for sale		403,064			409,574			1,205,973			1,203,435
Interest on federal funds sold		4,254			54,543			13,831			140,877
Interest on deposits with banks		566			832			1,592			3,621
Total interest income		7,448,275			8,096,951			21,971,790			24,113,342
Deposits		1,700,868			2,986,791			5,568,872			8,573,026
FHLB advances		455,441			243,046			1,214,339			1,389,833
Federal funds purchased		238			8,067			7,554			36,979
Total interest expense		2,156,547			3,237,904			6,790,765			9,999,838
Net interest income		5,291,728			4,859,047			15,181,025			14,113,504
Provision for loan losses		602,000			145,000			1,187,000			435,000
Net interest income after provision for loan losses		4,689,728			4,714,047			13,994,025			13,678,504
Service charges on deposits		337,264			267,723			984,556			807,853
Earnings on cash surrender value of life insurance		99,241			43,615			249,103			102,231
Mortgage commissions		23,410			14,404			94,859			166,868
Other		174,557			170,410			561,250			463,928
Total Non-interest income		634,472			496,152			1,889,768			1,540,880
Salaries and employee benefits		2,319,467			2,121,404			7,200,869			6,274,485
Occupancy expenses		675,728			603,483			2,015,674			1,656,663
Data processing fees		193,009			169,036			562,007			385,131
Telephone expenses		74,360			64,226			218,742			188,255
Other operating expenses		1,272,645			614,323			3,125,421			1,792,342
Total Non-interest expense		4,535,209			3,572,472			13,122,713			10,296,876
Earnings before provision for income taxes		788,991			1,637,727			2,761,080			4,922,508
Provision for income taxes		239,595			668,270			883,150			1,948,270
NET EARNINGS		$	549,396		$	969,457		$	1,877,930		$	2,974,238
Net Earnings Per Share		$	0.07		$	0.13		$	0.25		$	0.41
Net Earnings Per Share - assuming dilution		$	0.07		$	0.13		$	0.24		$	0.40

 

See accompanying notes

 

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OAK VALLEY BANCORP

CONDENSED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)

 

		YEAR ENDED DECEMBER 31, 2007 AND THE NINE MONTH PERIOD ENDED SEPTEMBER 30, 2008
															Accumulated
						Additional									Other			Total
		Common Stock				Paid-in			Retained			Comprehensive			Comprehensive			Shareholders’
		Shares		Amount		Capital			Earnings			Income			Income			Equity
Balances, January 1, 2007		7,103,243		17,648,475		$	1,502,004		$	15,243,222		$			$	(204,772	)	$	34,188,929
Stock offering		456,431		5,020,739														5,020,739
Stock offering expense				(25,000	)													(25,000		)
Stock options exercised		48,106		198,957														198,957
Tax benefit of stock options exercised						116,303												116,303
Cash dividends ($0.19 per share)									(1,444,697		)							(1,444,697		)
Stock based compensation						130,073												130,073
Comprehensive income
Net changes in unrealized gain on available-for-sale securities (net of income tax of $163,169)												$	250,965		250,965			250,965
Net earnings									3,925,121			3,925,121						3,925,121
Comprehensive income												$	4,176,086
Balances, December 31, 2007		7,607,780		22,843,171		$	1,748,380		$	17,723,646					$	46,193		$	42,361,390
Stock options exercised		50,472		176,047														176,047
Tax benefit of stock options exercised						54,195												54,195
Cash dividends ($0.05 per share)									(382,943		)							(382,943		)
Stock based compensation						101,498												101,498
Cumulative effect of adopting EITF 06-04 (net of tax of $49,383)									(70,459		)							(70,459		)
Comprehensive income
Net changes in unrealized gain on available-for-sale securities (net of income tax of $21,956)												$	33,768		33,768			33,768
Net earnings									1,877,930			1,877,930						1,877,930
Comprehensive income												$	1,911,698
Balances, September 30, 2008		7,658,252		23,019,218		$	1,904,073		$	19,148,174					$	79,961		$	44,151,426

 

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OAK VALLEY BANCORP

CONDENSED STATEMENTS OF CASH FLOWS (UNAUDITED)

 

		9 MONTHS ENDED SEPTEMBER 30,
		2008			2007
CASH FLOWS FROM OPERATING ACTIVITIES:
Net earnings		$	1,877,930		$	2,974,238
Adjustments to reconcile net earnings to net cash from operating activities:
Provision for loan losses		1,187,000			435,000
Depreciation, amortization and accretion, net		835,826			739,164
Stock-based compensation expense		101,498			97,531
Excess tax benefits from stock-based payment arrangements		(54,195		)	(125,252		)
Gain on sale of premises and equipment		(2,428		)	(14,400		)
Decrease (increase) in accrued interest receivable		100,599			(62,496		)
Decrease in accrued interest payable and other liabilities		(939,301		)	(5,262,914		)
Increase in other assets		(1,899,326		)	(872,418		)
Net cash from operating activities		1,207,603			(2,091,547		)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of securities available for sale		(6,459,330		)	(12,713,175		)
Proceeds from maturities, calls, and principal paydowns of securities available for sale		6,995,919			14,580,990
Net increase in loans		(34,320,111		)	(7,737,243		)
Purchase of BOLI policies		(4,740,000		)	0
Proceeds from sales of premises and equipment		47,778			14,400
Net purchases of premises and equipment		(1,025,346		)	(5,430,134		)
Net cash from investing activities		(39,501,090		)	(11,285,162		)
CASH FLOWS FROM FINANCING ACTIVITIES:
FHLB advanced funds		205,463,000			97,784,000
FHLB payments		(158,463,000		)	(107,434,000		)
Federal funds advances		63,175,000			(144,110,000		)
Federal funds payments		(63,175,000		)	143,160,000
Dividends paid		(382,943		)	(1,444,697		)
Net increase in demand deposits and savings accounts		6,249,207			28,906,000
Net decrease in time deposits		(18,367,424		)	(21,278,141		)
Excess tax benefits from stock-based payment arrangements		54,195			125,252
Proceeds from sale of common stock and exercise of stock options		176,047			5,188,736
Net cash from financing activities		34,729,082			897,150
NET DECREASE IN CASH AND CASH EQUIVALENTS		(3,564,405		)	(12,479,559		)
CASH AND CASH EQUIVALENTS,
beginning of period		14,202,951			27,819,177
CASH AND CASH EQUIVALENTS,
end of period		$	10,638,546		$	15,339,618
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the year for:
Interest		$	7,860,601		$	10,457,367
Income taxes		$	890,000		$	1,776,000
NON-CASH INVESTING ACTIVITIES:
Real estate acquired through foreclosure		$	4,364,693		$	0
Net change in unrealized gain/loss on available-for-sale securities		$	55,724		$	88,548
NON-CASH INVESTING ACTIVITIES:
Tax benefit from stock options exercised		$	54,195		$	125,252
Cumulative effect of adopting EITF 06-04		$	119,842		$	0

 

See accompanying notes

 

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OAK VALLEY BANCORP

 NOTES TO CONDENSED FINANCIAL STATEMENTS

 

NOTE 1 – BASIS OF PRESENTATION

 

On July 3, 2008 (the “Effective Date”), a bank holding company reorganization was completed whereby Oak Valley Bancorp became the parent holding company for Oak Valley Community Bank ( the “Bank”).  On the Effective Date, each outstanding share of the Bank was converted into one share of Oak Valley Bancorp and the Bank became a wholly-owned subsidiary of the holding company. The condensed financial statements and accompanying footnotes are presented as if the reorganization occurred as of the earliest periods presented and are consistent with those of Oak Valley Community Bank, since prior to the Effective Date, Oak Valley Bancorp had no material assets, liabilities or operations.

 

The accounting principles followed by the Company and the methods of applying these principles conform with accounting principles generally accepted in the United States of America (GAAP) and with general practices within the banking industry. In preparing financial statements in conformity with GAAP, management is required to make estimates and assumptions that affect the reported amounts in the financial statements. Actual results could differ significantly from those estimates. Material estimates common to the banking industry that are particularly susceptible to significant change in the near term include, but are not limited to, the determination of the allowance for loan losses, the estimation of compensation expense related to stock options granted to employees and directors, and valuation allowances associated with deferred tax assets, the recognition of which are based on future taxable income.

 

The interim financial statements included in this report are unaudited but reflect all adjustments which, in the opinion of management, are necessary for a fair presentation of the financial position and results of operations for the interim periods presented. All such adjustments are of a normal recurring nature. The results of operations for the nine month period ended September 30, 2008  are not necessarily indicative of the results of a full year’s operations. For further information, refer to the audited financial statements and footnotes included in the Company’s annual report for the year ended December 31, 2007.

 

NOTE 2 – CURRENT ACCOUNTING PRONOUNCEMENTS

 

Change in accounting principle – During 2008 in conjunction with the Company’s filing of a Form 10 registration statement with the SEC, the Company made a change in accounting principle and adopted Staff Accounting Bulletin (SAB) No. 108. As a result, the Company recorded adjustments to its deferred tax assets and also recorded a liability related to lease agreements that include fixed rent escalation clauses.

 

In accordance with Statement of Financial Accounting Standards (SFAS) No. 154, Accounting Changes and Correction of Errors, the Company adjusted its financial statements to apply SAB No. 108 retrospectively. As a result of the change in accounting principle, the following adjustments to the financial statements were made:

 

·                  Accrued interest and other assets decreased by $144,586 at December 31, 2007.

·                  Accrued interest and other liabilities increased by $134,030 at December 31, 2007.

·                  Retained earnings decreased by $278,616 at December 31, 2007.

·                  Occupancy expense increased $42,107 for the year ended December 31, 2007.

·                  Income tax expense increased $1,270 for the year ended December 31, 2007.

 

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OAK VALLEY BANCORP

 NOTES TO CONDENSED FINANCIAL STATEMENTS

 

·                  Net income decreased $43,227 and basic and diluted earnings per share decreased $.01 per share to $.53 and $.52 per share, respectively, for the year ended December 31, 2007.

 

In September 2006, the Financial Accounting Standards Board, or FASB, issued Statement No. 157, “Fair Value Measurements” (SFAS 157). SFAS No. 157 defines the fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements and accordingly, does not require any new fair value measurements. We adopted SFAS No. 157 as of January 1, 2008 and the adoption did not have a material impact on the financial condition or results of operations of the Company.

 

In February 2007, the FASB issued SFAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115”. SFAS 159 permits an entity to choose to measure many financial instruments and certain other items at fair value. Most of the provisions of SFAS 159 are elective; however, the amendment to SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities”, applies to all entities with available for sale or trading securities. For financial instruments elected to be accounted for at fair value, an entity will report the unrealized gains and losses in earnings. We adopted SFAS No. 159 on January 1, 2008. We chose not to elect the option to measure the fair value of eligible financial assets and liabilities at fair value.

 

In September 2006 the Emerging Issues Task Force (“EITF”) ratified EITF issue 06-04, “Accounting for Deferred Compensation and Postretirement Benefit Aspect of Endorsement Split-Dollar Life Insurance Arrangements”.   This ruling provides that the Company should recognize a liability for future benefits based on the agreements held with employees.  The issue was effective for fiscal years beginning after December 17, 2007.  The Company adopted this pronouncement effective January 1, 2008 and has recorded an initial liability of $119,842 with an offsetting adjustment to retained earnings of $70,459 and deferred taxes of $49,383, pursuant to this accounting pronouncement.

 

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OAK VALLEY BANCORP

 NOTES TO CONDENSED FINANCIAL STATEMENTS

 

NOTE 3 – LOANS

 

Loan totals were as follows:

 

		SEPTEMBER 30,			DECEMBER 31,
		2008			2007
Loans
Commercial real estate		$	240,059,833		$	208,309,072
Commercial		40,308,203			45,496,794
Real estate construction		90,631,577			83,173,030
Agriculture		23,886,459			31,429,970
Residential real estate and consumer		21,778,213			19,400,263
Total loans		416,664,285			387,809,129
Less:
Deferred loan fees and costs, net		(982,118		)	(1,038,350		)
Allowance for loan losses		(4,649,723		)	(4,506,753		)
Net loans		$	411,032,444		$	382,264,026

 

Changes in the allowance for loan losses were as follows:

 

		SEPTEMBER 30,			DECEMBER 31,
		2008			2007
Balance, beginning of year		$	4,506,753		$	4,341,062
Provision charged to operations		1,187,000			555,000
Loans charged off		(1,032,913		)	(401,510		)
Loan recoveries		4,491			4,275
Reclassification of reserve related to off-balance-sheet commitments		(15,608		)	7,926
Balance, end of period		$	4,649,723		$	4,506,753

 

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OAK VALLEY BANCORP

 NOTES TO CONDENSED FINANCIAL STATEMENTS

 

NOTE 3 – LOANS (CONTINUED)

 

Effective July 1, 2008, the expense associated with the allowance for off-balance-sheet commitments is recorded separately as a component of other expenses.  The $15,608 reclassification from the allowance for loan losses to other liabilities is a non-recurring adjustment.

 

The total recorded investment in impaired loans at September 30, 2008, was $2,175,362 which had a loan loss reserve of $305,807.  The total recorded investment in impaired loans at December 31, 2007, was $9,087,462 which had a loan loss reserve of $461,694.  No interest income was recognized on impaired loans, while considered impaired during 2008 and 2007.  As of September 30, 2008 we had no funding commitments on impaired loans.

 

NOTE 4 – OTHER REAL ESTATE OWNED

 

As of September 30, 2008, seven loans with outstanding balances of $4,364,693 were reclassified to other real estate owned.

 

Real estate properties acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at the lower of carrying amount of the loan or fair value of the property at the date of foreclosure less selling costs.  Subsequent to foreclosure, valuations are periodically performed and any subject revisions in the estimate of fair value are reported as adjustment to the carrying value of the real estate, provided the adjusted carrying amount does not exceed the original amount at foreclosure.  Revenues and expenses from operations and changes in the valuation allowance are included in other operating expenses.

 

NOTE 5 - OTHER POST-RETIREMENT BENEFIT PLANS

 

During January 2008, the Bank has awarded certain officers a salary continuation plan (the “Plan”). Under the Plan, the participants will be provided with a fixed annual retirement benefit for twenty years after retirement. The Bank is also responsible for certain pre-retirement death benefits under the Plan. In connection with the implementation of the Plan, the Bank purchased single premium life insurance policies on the life of each of the officers covered under the Plan. The Bank is the owner and partial beneficiary of these life insurance policies. The assets of the Plan, under Internal Revenue Service regulations, are owned by the Bank and are available to satisfy the Bank’s general creditors.

 

During January 2008 the Bank awarded two of its directors a director retirement plan (“DRP”). Under the DRP, the participants will be provided with a fixed annual retirement benefit for ten years after retirement. The Bank is also responsible for certain pre-retirement death benefits under the DRP. In connection with the implementation of the DRP, the Bank purchased single premium life insurance policies on the life of each director covered under the DRP. The Bank is the owner and partial beneficiary of these life insurance policies. The assets of the DRP, under Internal Revenue Service regulations, are the property of the Bank and are available to satisfy the Bank’s general creditors.

 

Future compensation under both plans is earned for services rendered through retirement. The Bank accrues for the salary continuation liability based on anticipated years of service and vesting schedules provided under the plans. The Bank’s current benefit liability is determined based on vesting and the present value of the benefits at a corresponding discount rate. The discount rate used is an equivalent rate for investment-grade bonds with lives matching those of the service periods remaining for the salary continuation contracts, which average approximately 20 years.

 

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OAK VALLEY BANCORP

 NOTES TO CONDENSED FINANCIAL STATEMENTS

 

During January 2008, the Bank entered into split-dollar life insurance agreements with certain officers. In connection with the implementation of the split-dollar agreements, the Bank purchased single premium life insurance policies on the life of each of the officers covered by the split-dollar life insurance agreements. The Bank is the owner of the policies and the partial beneficiary in an amount equal to the cash surrender value of the policies.

 

The combined cash surrender value of all Bank-owned life insurance policies was $9,768,990 and $4,749,230 at September 30, 2008 and December 31, 2007, respectively.

 

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OAK VALLEY BANCORP

 NOTES TO CONDENSED FINANCIAL STATEMENTS

 

NOTE 6 - FAIR VALUE MEASUREMENTS

 

SFAS No. 157, Fair Value Measurements, which the Company adopted effective January 1, 2008, defines fair value, establishes a framework for measuring fair value, establishes a three-level valuation hierarchy for disclosure of fair value measurement and enhances disclosure requirements for fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follow:

 

Level 1:  Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level 2:  Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level 3:  Inputs to the valuation methodology are unobservable and significant to the fair value measurement.

 

In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy.  In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety.  The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment , and considers factors specific to the asset or liability.

 

Assets and liabilities measured at fair value on a recurring and non-recurring basis are summarized below:

 

		Fair Value Measurements at September 30, 2008 Using
		September 30, 2008			Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Assets and liabilities measured on a recurring basis:
Available-for-sale securities		$	32,899,653		$	—		$	32,899,653		$	—
Assets and liabilities measured on a non-recurring basis:
Impaired Loans		$	1,867,372		$	—		$	—		$	1,867,372

 

The fair value of securities available for sale equals quoted market price, if available.  If quoted market prices are not available, fair value is determined using quoted market prices for similar securities.  Changes in fair market value are recorded in other comprehensive income net of tax.  SFAS No. 157

 

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OAK VALLEY BANCORP

 NOTES TO CONDENSED FINANCIAL STATEMENTS

 

applies to loans measured for impairment using the practical expedients permitted by SFAS No. 114, Accounting by Creditors for Impairment of a Loan, including impaired loans measured at an observable market price (if available), or at the fair value of the loan’s collateral (if the loan is collateral dependent). Fair value of the loan’s collateral, when the loan is dependent on collateral, is determined by appraisals or independent valuation which is then adjusted for the cost related to liquidation of the collateral. At September 30, 2008, impaired loans had a principal balance of $2,175,362, with a valuation allowance of $305,807 at September 30, 2008.  Upon being classified as impaired, charge offs were taken to reduce the balance of each loan to an estimate of the collateral fair market value less cost to dispose. This estimate was a level 3 valuation.  There was no direct impact on the income statement.  The charge-offs were recorded as a debit to the allowance for loan losses.

 

NOTE 7 – EARNINGS PER SHARE

 

The Bank computes earnings per share (“EPS”) in accordance with SFAS No. 128, Earnings per Share. SFAS No. 128 requires the presentation of basic EPS, which does not consider the effect of common stock equivalents and diluted EPS, which considers all dilutive common stock equivalents.

 

		THREE MONTHS ENDED						NINE MONTHS ENDED
In thousands (except share and per		SEPTEMBER 30,						SEPTEMBER 30,
share amounts)		2008			2007			2008			2007
BASIC EARNINGS PER SHARE
Net income		$	549,396		$	969,457		$	1,877,930		$	2,974,238
Weighted average shares outstanding		7,658,252			7,567,719			7,636,687			7,283,187
Net income per share		$	0.07		$	0.13		$	0.25		$	0.41
DILUTED EARNINGS PER SHARE
Net income		$	549,396		$	969,457		$	1,877,930		$	2,974,238
Weighted average shares outstanding		7,658,252			7,567,719			7,636,687			7,283,187
Effect of dilutive stock options		84,839			150,049			100,363			159,817
Weighted average shares of common stock and common stock equivalents		7,743,091			7,717,768			7,737,050			7,443,004
Net income per diluted share		$	0.07		$	0.13		$	0.24		$	0.40

 

During the three and nine month periods ended September 30, 2008, anti-dilutive weighted average options to purchase 260,304 and 244,728 shares of common stock, respectively, in prices ranging from $7.00 to $15.67 were outstanding .   Anti-dilutive weighted average options of 181,794 and 192,610, respectively, were outstanding during the same three and nine month periods of 2007 with prices ranging from $12.23 to $15.67.  They were not included in the computation of diluted EPS because the options’ exercise price was greater than the average market price of the common shares. These options begin to expire in 2015.

 

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Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion explains the significant factors affecting our operations and financial position for the periods presented. The discussion should be read in conjunction with our financial statements and the notes related thereto which appear elsewhere in this report.

 

Forward-Looking Statements

 

Some matters discussed in this Form 10-Q may be “forward-looking statements” within the meaning of the Private Litigation Reform Act of 1995 and therefore may involve risks, uncertainties and other factors which may cause our actual results to be materially different from the results expressed or implied by our forward-looking statements.  These statements generally appear with words such as “anticipate,” “believe,” “estimate,” “may,” “intend,” and “expect.”  Although management believes that the assumptions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to be correct.  Factors that could cause actual results to differ from results discussed in forward-looking statements include, but are not limited to: economic conditions (both generally and in the markets where the Bank operates); competition from other providers of financial services offered by the Bank; government regulation and legislation; changes in interest rates; material unforeseen changes in the financial stability and liquidity of the Bank’s credit customers; and other risks as may be detailed from time to time in the Company’s filings with the Securities and Exchange Commission, all of which are difficult to predict and which may be beyond the control of the Company or the Bank.  The Company undertakes no obligation to revise forward-looking statements to reflect events or changes after the date of this discussion or to reflect the occurrence of unanticipated events.

 

Critical Accounting Estimates

 

 The discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that effect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions.

 

Allowance for Loan Losses

 

Accounting for allowance for loan losses involves significant judgment and assumptions by management and is based on historical data and management’s view of the current economic environment. At least on a quarterly basis, our management reviews the methodology and adequacy of allowance for loan losses and reports its assessment to the Board of Directors for its review and approval.

 

We base our allowance for loan losses on an estimation of probable losses inherent in our loan portfolio. Our methodology for assessing loan loss allowances are intended to reduce the differences between estimated and actual losses and involves a detailed analysis of our loan portfolio in three phases:

 

· the specific review of individual loans,

 

· the segmenting and review of loan pools with similar characteristics in accordance with SFAS No. 5, “Accounting for Contingencies,” and

 

· our judgmental estimate based on various subjective factors:

 

The first phase of our methodology involves the specific review of individual loans to identify and measure impairment. We evaluate each loan by use of a risk rating system, except for homogeneous loans, such as automobile loans and home mortgages. Specific risk rated loans are deemed impaired if all amounts, including principal and interest, will likely not be collected in accordance with the contractual terms of the related loan agreement. Impairment for commercial and real estate loans is measured either based on the present value of the loan’s expected future cash flows or, if collection on the loan is collateral dependent, the estimated fair value of the collateral, less selling and holding costs.

 

The second phase involves the segmenting of the remainder of the risk rated loan portfolio into groups or pools of loans, together with loans with similar characteristics, for evaluation in accordance with SFAS No. 5. We determine the calculated loss ratio to each loan pool based on its historical net losses and benchmark it against the levels of other peer banks.

 

In the third phase, we consider relevant internal and external factors that may affect the collectibility of loan portfolio and each group of loan pool. The factors considered are, but are not limited to:

 

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· concentration of credits,

 

· nature and volume of the loan portfolio,

 

· delinquency trends,

 

· non-accrual loan trend,

 

· problem loan trend,

 

· loss and recovery trend,

 

· quality of loan review,

 

· lending and management staff,

 

· lending policies and procedures,

 

· economic and business conditions, and

 

· other external factors.

 

Our management estimates the probable effect of such conditions based on our judgment, experience and known or anticipated trends. Such estimation may be reflected as an additional allowance to each group of loans, if necessary. Management reviews these conditions with our senior credit officers. To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s estimate of the effect of such condition may be reflected as a specific allowance applicable to such credit or portfolio segment. Where any of these conditions is not evidenced by a specific, identifiable problem credit or portfolio segment as of the evaluation date, management’s evaluation of the inherent loss related to such condition is reflected in the unallocated allowance

 

Central to our credit risk management and our assessment of appropriate loss allowance is our loan risk rating system. Under this system, the originating credit officer assigns borrowers an initial risk rating based on a thorough analysis of each borrower’s financial capacity in conjunction with industry and economic trends. Approvals are made based upon the amount of inherent credit risk specific to the transaction and are reviewed for appropriateness by senior line and credit administration personnel. Credits are monitored by line and credit administration personnel for deterioration in a borrower’s financial condition which may impact the ability of the borrower to perform under the contract. Although management has allocated a portion of the allowance to specific loans, specific loan pools, and off-balance sheet credit exposures (which are reported separately as part of other liabilities), the adequacy of the allowance is considered in its entirety.

 

Non-Accrual Loan Policy

 

Interest on loans is credited to income as earned and is accrued only if deemed collectible. Accrual of interest is discontinued when a loan is over 90 days delinquent or if management believes that collection is highly uncertain. Generally, payments received on nonaccrual loans are recorded as principal reductions. Interest income is recognized after all principal has been repaid or an improvement in the condition of the loan has occurred that would warrant resumption of interest accruals.

 

Stock-Based Compensation

 

Effective January 1, 2006, the Bank adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share Based Payments, a revision to the previously issued guidance on accounting for stock options and other forms of equity-based compensation. SFAS No. 123R requires companies to recognize in the income statement the grant-date fair value of stock options and other equity-based forms of compensation issued to employees over the employees’ requisite service period (generally the vesting period).  The Bank has adopted SFAS No. 123R using the modified prospective method which means that the unvested portion of previously granted awards and any awards that are granted or modified after the date of adoption will be measured and accounted for under the provisions of SFAS No. 123R. Accordingly, financial statement amounts for prior periods have not been restated to reflect the fair value method of recognizing compensation cost relating to stock options. The Bank will continue to use straight-line recognition of expenses for awards with graded vesting.  The Bank utilizes a binomial pricing model for all grants. Expected volatility is based on the historical volatility of the price of the Bank’s stock. The Bank uses historical data to estimate option exercise and stock option forfeiture rates within the valuation model. The expected term of options granted for the binomial model is derived from applying a historical suboptimal exercise factor to the contractual term of the grant. For binomial pricing, the risk-free rate for periods is equal to the U.S. Treasury yield at the time of grant and commensurate with the contractual term of the grant.

 

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Other Real Estate Owned

 

Other real estate owned, which represents real estate acquired through foreclosure, or deed in lieu of foreclosure in satisfaction of commercial and real estate loans, is carried at the lower of cost or estimated fair value less the estimated selling costs of the real estate. The fair value of the property is based upon a current appraisal. The difference between the fair value of the real estate collateral and the loan balance at the time of transfer is recorded as a loan charge off if fair value is lower. Subsequent to foreclosure, management periodically performs valuations and the OREO property is carried at the lower of carrying value or fair value, less costs to sell. The  determination of a property’s estimated fair value incorporates (1) revenues projected to be realized from disposal of the property, (2) construction and renovation costs, (3) marketing and transaction costs, and (4) holding costs (e.g., property taxes, insurance and homeowners’ association dues). Any subsequent declines in the fair value of the OREO property after the date of transfer are recorded through a write-down of the asset. Any subsequent operating expenses or income, reduction in estimated fair values, and gains or losses on disposition of such properties are charged or credited to current operations.

 

Introduction

 

Effective July 3, 2008, Oak Valley Community Bank became a subsidiary of Oak Valley Bancorp, a newly established bank holding company. Oak Valley Bancorp operates Oak Valley Community Bank as a community bank in the general commercial banking business, with our primary market encompassing the California Central Valley around Oakdale and Modesto, and the Eastern Sierras. As such, unless otherwise noted, all references are about Oak Valley Community Bank.

 

Overview of Results of Operations and Financial Condition

 

·                     The Company recognized net income of $549,396 and $1,877,930 for the three and nine month periods ended September 30, 2008 as compared with $969,457 and $2,974,238 for the same periods in 2007, respectively.  The factors resulting in this decrease will be discussed below.

 

·                     Net interest income increased $432,681 or 8.9% and $1,067,521 or 7.6% for the three and nine month periods ended September 30, 2008, respectively, compared to the same periods in 2007.  These increases were primarily due to increases in the net interest margin of 9 and 17 basis points and increases in average earning assets of $27.8 million and $13.4 million for the three and nine month periods ended September 30, 2008, respectively.  The net interest margin increase is attributable primarily to liabilities repricing faster than assets in the current declining rate environment and a reduction of high cost certificates of deposit which were replaced by core deposits and FHLB advances with a lower interest rate.

 

·                     The provision for loan losses in the three and nine month periods ended September 30, 2008 increased by $457,000 and $752,000, respectively, compared to the same periods in 2007, due to loan growth, an increase in the level of non-accrual loans and management’s assessment of the appropriate level for the allowance for loan losses.

 

·                     For the three and nine month periods ended September 30, 2008, non-interest income increased by $138,320 or 27.9% and $348,888 or 22.6%, respectively, from the same period in 2007, primarily due to increased service charges on deposits and earnings on cash surrender value of life insurance policies as described below.

 

·                     Non-interest expense increased by $962,737 or 26.9% and $2,825,837 or 27.4%, for the three and nine month periods ended September 30, 2008, respectively, as compared to the same periods in 2007, principally due to increased costs for salaries and benefits and OREO year-to-date expenses of $936,370 due to overhead and market value write downs.

 

·                     Total assets increased $35.9 million or 7.9% from December 31, 2007.  Total net loans increased by $28.8 million, or 7.5% from December 31, 2007 to September 30, 2008, while deposits decreased by $12.1 million or 3.2%.

 

Income Summary

 

For the three and nine month periods ended September 30, 2008, the Company recorded net income of $549,396 and $1,877,930, a decrease of $420,061 and $1,096,308, respectively, as compared to the $969,457 and $2,974,238 in net income for the same periods in 2007.  Return on average assets (annualized) was 0.45% and 0.54% for the third quarter and nine month period of 2008, respectively, as compared with 0.87% and 0.90% for the same periods of 2007.  Annualized return on average equity was 4.91% and 5.72% for the third quarter and nine month period of 2008, respectively, as compared with 9.34% and 10.56% for the same periods of 2007.

 

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Earnings before provisions for income taxes for the third quarter and nine month period of 2008 were down $848,736 and $2,161,428, respectively from the comparable 2007 periods.  The income statement components of these variances are as follows:

 

Pre-Tax Income Variance Summary

(In thousands)

 

		Effect on Pre-Tax Income			Effect on Pre-Tax Income
		Increase (Decrease)			Increase (Decrease)
		Three Months			Nine Months
Change from 2007 to 2008 in:
Net interest income		$	433		$	1,068
Provision for loan losses		(457		)	(752		)
Non-interest income		138			349
Non-interest expense		(963		)	(2,826		)
Change in income before income taxes		$	(849	)	$	(2,161	)

 

These variances will be explained in the discussion below.

 

Net Interest Income

 

Net interest income is the largest source of the Bank’s operating income.  For the three and nine month period ended September 30, 2008, net interest income was $5.29 million and $15.18 million, respectively, an increase of $432,681 or 8.9% and $1,067,521 or 7.6% from the comparable periods in 2007.

 

The net interest margin (net interest income as a percentage of average interest earning assets) was 4.76% and 4.71%, respectively, for the three and nine month periods ended September 30, 2008, an increase of 9 and 17 basis points as compared to the same periods in 2007.  The increase in the net interest margin in 2008 was principally attributable to the change in the deposit mix from high cost certificates of deposit to lower cost core deposit accounts which caused the rate on interest-bearing liabilities to decrease faster than the rate on earning assets.

 

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The following tables shows the relative impact of changes in average balances of interest earning assets and interest bearing liabilities, and interest rates earned and paid by the Company and the Bank on those assets and liabilities for the three and nine month periods ended September 30, 2008 and 2007:

 

Net Interest Analysis

(Dollars in thousands)

 

		Three Months Ended September 30, 2008								Three Months Ended September 30, 2007
		Average Balance			Interest Inc / Exp			Avg Rate/ Yield		Average Balance			Interest Inc / Exp			Avg Rate/ Yield
Assets:
Earning assets:
Gross loans (1) (2)		$	408,476		$	7,047		6.84	%	$	376,253		$	7,632		8.05	%
Investment securities (2)		33,475			416			4.93	%	34,666			433			4.96	%
Federal funds sold		877			4			1.93	%	4,268			55			5.07	%
Interest-earning deposits		242			1			0.93	%	77			1			4.28	%
Total interest-earning assets		443,070			7,468			6.69	%	415,264			8,121			7.76	%
Total noninterest earning assets		39,090								28,340
Total Assets		482,160								443,604
Liabilities and Shareholders’ Equity:
Interest-bearing liabilities:
Money market deposits		153,260			927			2.40	%	132,707			1,281			3.83	%
NOW deposits		54,711			102			0.74	%	53,262			150			1.12	%
Savings deposits		15,225			47			1.23	%	17,587			150			3.38	%
Time certificates of deposit $100,000 or more		33,177			280			3.34	%	65,214			813			4.94	%
Other time deposits		43,696			346			3.14	%	49,482			593			4.76	%
Other borrowings		73,900			455			2.45	%	19,215			251			5.18	%
Total interest-bearing liabilities		373,969			2,157			2.29	%	337,466			3,238			3.81	%
Noninterest-bearing liabilities:
Noninterest-bearing deposits		60,846								61,446
Other liabilities		2,999								3,498
Total noninterest-bearing liabilities		63,845								64,944
Shareholders’ equity		44,346								41,194
Total liabilities and shareholders’ equity		$	482,160							$	443,604
Net interest income					$	5,311							$	4,883
Net interest spread (3)								4.40	%							3.95	%
Net interest margin (4)								4.76	%							4.67	%

 

(1)  Loan fees have been included in the calculation of interest income. Loan fees were approximately $278,000 and $381,000 for the three months ended September 30, 2008 and 2007, respectively.  Loans are net of the allowance for loan losses, deferred fees, unearned income, and related direct costs.

 

(2) Yields on municipal securities and loans have been adjusted to their fully-taxable equivalents, based on a federal marginal tax rate of 34.0%.

 

(3) Represents the average rate earned on interest-earning assets less the average rate paid on interest-bearing liabilities.

 

(4) Represents net interest income as a percentage of average interest-earning assets.

 

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