Item 1. Business
General
Washington Banking Company (the “Company”) is a registered bank holding company with two wholly-owned subsidiaries: Whidbey Island Bank (the “Bank”), the Company’s principal subsidiary and Washington Banking Capital Trust I (the “Trust”). The Company closed its wholesale lending subsidiary, Washington Funding Group, Inc. (the “Group”) effective June 30, 2004. The Group was formed in January 2003 for the purpose of expanding the Bank’s wholesale mortgage real estate lending platform. During the second quarter of 2004, the Company elected to concentrate corporate resources toward the Bank’s retail operations and closed the Group’s operations. Although the Group’s income from the sale of loans enhanced the Company’s total revenues during 2003 and 2004, the operation of those offices did not provide a satisfactory financial return in either year.
At December 31, 2005, the Company had total assets of $726.0 million, total deposits of $637.5 million and shareholders’ equity of $57.9 million. A more thorough discussion of the Company’s financial performance appears in Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations beginning on page 11 of this report.
The Bank is a Washington state-chartered bank that conducts a full-service community commercial banking business. The Bank also offers nondeposit managed investment products and services, which are not Federal Deposit Insurance Corporation (“FDIC”) insured. These programs are provided through the investment advisory companies Elliott Cove Capital Management LLC and DFC Services & DFC
Insurance Services. Another nondeposit product offered through the Bank, which is not FDIC insured, is a sweep investment option available through a brokerage account.
The Trust was formed in June 2002 for the exclusive purpose of issuing trust preferred securities to acquire junior subordinated debentures issued by the Company. Those debentures are the sole assets of the Trust and payments on the debt are the sole revenues of the Trust. The Company has fully and unconditionally guaranteed all obligations of the Trust.
The Company’s website address is www.wibank.com. Exchange Act reports are available free of charge from the Company’s website. The reports can also be obtained through the Securities and Exchange Commission’s (the “SEC”) EDGAR database at http://www.sec.gov. The contents of the Company’s Internet website are not incorporated into this report or into any other communication delivered to security holders or furnished to the SEC.
Growth Strategy
The Company’s strategy is one of value-added growth. Management believes that qualitative and sustainable growth of the Company, coupled with maintaining profitability, is currently the most appropriate path to providing good value for its shareholders. To date, the Company’s growth has been achieved organically and it attributes its reputation for focusing on customer service and satisfaction as one of the cornerstones to the Company’s success. The Company’s primary objectives are to improve profitability and operating efficiencies, increase market penetration in areas currently served, and to continue an expansion strategy in appropriate market areas.
The Company’s geographical expansion to date has primarily been concentrated along the I-5 corridor from Snohomish to Whatcom Counties; however, additional areas will be considered if they meet the Company’s criteria. Acquisition of banks or branches may also be used as a means of expansion if appropriate opportunities are presented. The primary factors considered in determining the areas of geographic expansion are the availability of knowledgeable personnel, such as managers and lending officers with experience in their fields of expertise, longstanding community presence and extensive banking relationships, customer demand and perceived market potential.
Management believes that increasing the success of current branches and expanding into appropriate market places while managing up-front costs is an excellent way to build franchise value and increase business. The Company’s strategy is to support its employees in providing a high level of personal service to its customers while expanding the loan, deposit and investment products and other services that the Company offers. Maintenance of asset quality will be emphasized by controlling nonperforming assets and adhering to prudent underwriting standards. In addition, management will maintain its focus on improving operating efficiencies and internal operating systems to further manage noninterest expense.
Growth requires expenditures of substantial sums to purchase or lease real property and equipment and to hire experienced personnel. New branch offices are often not profitable for a period of time after opening and management expects that earnings may be negatively affected in the short term.
Market Areas
The Company’s primary market area currently consists of Island, Skagit, Whatcom, Snohomish and San Juan counties in northwest Washington State. Although the Pacific Northwest is typically associated with industries such as computer technology, aerospace and coffee, the Company’s market encompasses distinct economies that are somewhat removed from the Seattle metropolitan region.
Island County’s largest population center, Oak Harbor, is dominated by a large military presence with naval operations at NAS Whidbey Island. The jobs generated by NAS Whidbey contribute significantly to the county’s economy. Other primary industries providing employment for county residents are: education; health and social services; retail trade; and manufacturing. Due to its natural beauty, the county attracts tourism and has a number of retirement communities.
The economy of Skagit County is primarily comprised of agriculture, fishing, wood products, tourism, international trade, and specialized manufacturing. With its accessible ports and refineries, Skagit County is the center of the state’s petroleum industry.
Whatcom County, which borders Canada, has an economy with a prominent manufacturing base, as well as a significant academic-research and vocational-technical base, as it is the home of Western Washington University, one of Washington’s largest four-year academic centers. The United States Customs and Border Patrol and municipal, county and state governments give Whatcom County an additional employment base.
Snohomish County is one of the fastest growing areas in the state. Industrial sectors include aerospace, biotechnology, and electronics, as well as a military naval base and large retail influences.
The economy of San Juan County is predominantly comprised of retail trade, tourism, finance and insurance, and real estate services. The county is known for its beautiful locale, which attracts many visitors, and serves as a second home to an affluent sector of the population.
Washington State’s economy has rebounded from the low employment levels experienced in 2001 - 2003, with recent employment growth being the strongest in five years. Construction employment and sales of building materials were strong as the housing market remained robust through most of 2005. Even as mortgage rates drift higher, they are still relatively low by historical standards, and Washington State population continues to rise. The large military bases located in the Company’s region continue to have a positive economic impact.
Competition
The Company operates in a highly competitive banking environment, competing for deposits, loans and other financial services with a number of larger and well-established commercial banks, savings banks, savings and loan associations, credit unions and other institutions, including nonbanking financial services companies.
Some of the Bank’s competitors are not subject to the same regulations as the Bank; they may have substantially higher lending limits, and may offer certain services that the Bank does not provide. Federal law allows mergers or other combinations, relocations of a bank’s main office and branching across state lines. Recent amendments to the federal banking laws to eliminate certain barriers between banking and commercial firms are expected to result in even greater competition in the future. Although the Company has been able to compete effectively in its market areas to date, there can be no assurance that the Company’s competitive efforts will continue to be successful.
Executive Officers of the Company
The following table sets forth certain information about the executive officers of the Company:
Michal D. Cann. Mr. Cann, 57, has been the President and Chief Executive Officer of the Company since its inception in 1996, the President and Chief Executive Officer of the Bank since 1993, and a director of the Bank since 1992. Mr. Cann has over 30 years of banking experience, previously having
served as the President of Valley Bank, Mount Vernon, Washington, and in other senior management positions in other banks and a bank holding company.
Phyllis A. Hawkins. During 2005, Ms. Hawkins, 57, was the Senior Vice President and Controller of the Company and the Bank. Prior to that appointment, she served as the Chief Financial Officer since 1996. Ms. Hawkins also served as the chairperson for the Bank’s Asset/ Liability Management Committee and the Risk Management Committee through 2004. She began working for the Bank in 1969 and has held various positions in operations, human resources and auditing. Ms. Hawkins was promoted to Senior Vice President/ Operations Administration Manager effective first quarter 2006.
Joseph W. Niemer. Mr. Niemer, 54, is the Executive Vice President and Chief Credit Officer of the Bank. Mr. Niemer has over 30 years of experience in various credit-related positions with Pacific Northwest-based banks. Most recently, he was the Senior Vice President and Chief Credit Officer for Washington Mutual Bank’s Commercial Group, where he oversaw commercial and commercial real estate credit decisions.
Richard A. Shields. Mr. Shields, 46, is the Senior Vice President and Chief Financial Officer of the Company and the Bank. Mr. Shields joined the Bank in 2004 and has over 20 years of experience in various accounting-related positions with Pacific Northwest-based banks. Most recently, he was the Vice President and Controller at a community bank that grew substantially both organically and through multiple acquisitions.
John L. Wagner. Mr. Wagner, 62, is the Executive Vice President and Chief Operating Officer of the Bank. He joined the Bank in 1999 as Senior Vice President and Regional Manager in Whatcom County. In 2002, Mr. Wagner was selected to oversee branch administration and was promoted to COO in 2004. Mr. Wagner has an extensive background in banking and international finance as well as comprehensive administrative experience as former President of Bank of Washington in Bellingham, Washington.
Employees
The Company had 296 full time equivalent employees at December 31, 2005. None of the Company’s employees are covered by a collective bargaining agreement or represented by a collective bargaining group. Management considers its relations with employees to be good.
The Company’s principal subsidiary, Whidbey Island Bank, provides services through nineteen bank branches in five counties located in northwestern Washington. In addition to the President, the Bank has an established management team of senior executives who are fully involved and responsible for the day-to-day business of the Bank.
Supervision and Regulation
The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956 (“BHC Act”) registered with and subject to examination by the Federal Reserve Board (“FRB”). The Bank is a Washington state-chartered commercial bank and is subject to examination, supervision and regulation by the Washington State Department of Financial Institutions - Division of Banks (“Division”). FDIC insures the Bank’s deposits and in that capacity also regulates the Bank.
The Company’s earnings and activities are affected by legislation, by actions of the FRB, the Division, the FDIC and other regulators, by local legislative and administrative bodies, and by decisions of courts in Washington State. These include limitations on the ability of the Bank to pay dividends to the Company, and numerous federal and state consumer protection laws imposing requirements on the making, enforcement, and collection of consumer loans, and restrictions by regulators on the sale of mutual funds and other uninsured investment products to customers.
Gramm-Leach-Bliley Financial Services Modernization Act. Congress enacted major federal financial institution reform legislation in 1999. Title I of the Gramm-Leach-Bliley Act (the “GLB Act”), which became effective March 11, 2000, allows bank holding companies to elect to become financial holding
companies. In addition to activities previously permitted bank holding companies, financial holding companies may engage in nonbanking activities that are financial in nature, such as securities, insurance and merchant banking activities, subject to certain limitations.
The activities of bank holding companies, such as the Company that are not financial holding companies, are generally limited to managing or controlling banks. A bank holding company is required to obtain the prior approval of the FRB for the acquisition of more than 5% of the outstanding shares of any class of voting securities or substantially all of the assets of any bank or bank holding company. Nonbank acquisitions by bank holding companies such as the Company are generally limited to 5% of voting shares of a company and activities previously determined by the FRB by regulation or order to be so closely related to banking as to be a proper incident to banking or managing or controlling banks.
The GLB Act also included the most extensive consumer privacy provisions ever enacted by Congress. These provisions, among other things, require full disclosure of the Company’s privacy policy to consumers and mandate offering the consumer the ability to “opt out” of having non-public personal information disclosed to third parties. Pursuant to these provisions, the federal banking regulators have adopted privacy regulations. In addition, the states are permitted to adopt more extensive privacy protections through legislation or regulation. The Company does not disclose any nonpublic personal information about its customers or former customers to anyone, except as permitted by law.
Additional legislation may be enacted or regulations imposed to further regulate banking and financial services or to limit finance charges or other fees or charges earned in such activities. There can be no assurance whether any such legislation or regulation will place additional limitations on the Company’s operations or adversely affect its earnings.
There are various legal restrictions on transactions between the Company and any nonbank subsidiaries, and between the Company and the Bank. With certain exceptions, federal law also imposes limitations on, and requires collateral for, extensions of credit by insured depository institutions, such as the Bank, to their nonbank affiliates, such as the Company.
Interstate Banking and Branching. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Interstate Act”) permits nationwide interstate banking and branching under certain circumstances. Subject to certain limitations and restrictions, a bank holding company, with prior approval of the FRB, may acquire an out-of-state bank. Banks in states that do not prohibit out-of-state mergers may merge with the approval of the appropriate federal banking agency. A state bank may establish a de novo branch out of state if such branching is expressly permitted by the other state.
Federal and State Bank Regulation. Among other things, applicable federal and state statutes and regulations which govern a bank’s activities relate to minimum capital requirements, required reserves against deposits, investments, loans, legal lending limits, mergers and consolidations, borrowings, issuance of securities, payment of dividends, establishment of branches and other aspects of its operations. The Division and the FDIC also have authority to prohibit banks under their supervision from engaging in what they consider to be unsafe and unsound practices.
Specifically with regard to the payment of dividends, there are certain limitations on the ability of the Company to pay dividends to its shareholders. It is the policy of the FRB that bank holding companies should pay cash dividends on common stock only out of income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash dividends that undermines the bank holding company’s ability to serve as a source of strength to its banking subsidiaries.
Various federal and state statutory provisions also limit the amount of dividends that subsidiary banks can pay to their holding companies without regulatory approval. Additionally, depending upon the circumstances, the FDIC or the Division could take the position that paying a dividend would constitute an unsafe or unsound banking practice.
Under longstanding FRB policy, a bank holding company is expected to act as a source of financial strength for its subsidiary banks and to commit resources to support such banks. The Company could be required to commit resources to the Bank in circumstances where it might not do so, absent such policy.
The Bank is required to file periodic reports with the FDIC and the Division and is subject to periodic examinations and evaluations by those regulatory authorities. These examinations must be conducted every 12 months. The FDIC and the Division may each accept the results of an examination by the other in lieu of conducting an independent examination.
In the liquidation or other resolution of a failed insured depository institution, deposits in offices and certain claims for administrative expenses and employee compensation are afforded a priority over other general unsecured claims, including nondeposit claims, and claims of a parent company such as the Company. Such priority creditors would include the FDIC, which succeeds to the position of insured depositors.
Capital Adequacy. The Company and the Bank are subject to risk-based capital and leverage guidelines issued by federal banking agencies for banks and bank holding companies. These agencies are required by law to take specific prompt corrective actions with respect to institutions that do not meet minimum capital standards. As of December 31, 2005, the Company and the Bank exceeded the minimum capital standards.
Sarbanes-Oxley Act of 2002. The Company is also subject to the periodic reporting, information disclosure, proxy solicitation, insider trading restrictions and other requirements of the Securities Exchange Act of 1934, including provisions of the Sarbanes Oxley Act of 2002.
USA Patriot Act of 2001. Under the USA Patriot Act of 2001 (“Patriot Act”), adopted by the U.S. Congress on October 26, 2001 to combat terrorism, FDIC-insured banks and commercial banks are required to increase their due diligence efforts for correspondent accounts and private banking customers. The Patriot Act requires the Bank to engage in additional record keeping or reporting, requiring identification of owners of accounts, or of the customers of foreign banks with accounts, and restricting or prohibiting certain correspondent accounts. While management believes that the Patriot Act may affect recordkeeping and reporting expenses to some degree, it does not believe that it will have a material adverse effect on the Company’s business and operations.
Effects of Governmental Monetary Policies
Profitability in banking depends on interest rate differentials. In general, the difference between the interest earned on a bank’s loans, securities and other interest-earning assets and the interest paid on a bank’s deposits and other interest-bearing liabilities is the major source of a bank’s earnings. Thus, the earnings and growth of the Company are affected not only by general economic conditions, but also by the monetary and fiscal policies of the United States and its agencies, particularly the FRB. The FRB implements national monetary policy for such purposes as controlling inflation and recession by its open market operations in United States government securities, control of the discount rate applicable to borrowing from the FRB and the establishment of reserve requirements against certain deposits. The actions of the FRB in these areas influence growth of bank loans, investments and deposits, and also affect interest rates charged on loans and paid on deposits. The nature and impact of future changes in monetary policies and their impact on the Company are not predictable.
Item 1A.
Item 1A.
Risk Factors
Historical performance may not be indicative of future performance and, as noted elsewhere in this report, the Company has included forward-looking statements about it’s business, plans and prospects that are subject to change. Forward-looking statements are particularly located in, but not limited to, the sections Item 1 - Business and Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations. In addition to the other risks or uncertainties contained in this report, the following risks may affect operating results, financial condition and cash flows. If any of these risks occur, either alone or
in combination with other factors, the Company’s business, financial condition or operating results could be adversely affected. Moreover, readers should note this is not an exhaustive list; that some risks are unknown or not quantifiable, and other risks that are currently perceived as immaterial may ultimately prove more significant than expected. Statements about plans, predictions or expectations should not be construed to be assurances of performance or promises to take a given course of action.
Adequacy of the Allowance for Loan Losses. The Company has established a reserve for possible losses expected in connection with loans in the credit portfolio. This allowance reflects estimates of the collectibility of certain identified loans, as well as an overall risk assessment of total loans outstanding. The determination of the amount of loan loss allowance is subjective; although the method for determining the amount of the allowance uses criteria such as risk ratings and historical loss rates, these factors may not be adequate predictors of future loan performance. Accordingly, the Company cannot offer assurances that these estimates ultimately will prove correct or that the loan loss allowance will be sufficient to protect against losses that ultimately may occur. If the loan loss allowance proves to be inadequate, it may require unexpected charges to income, which would adversely impact results of operations and financial condition. Moreover, bank regulators frequently monitor banks’ loan loss allowances, and if regulators were to determine that the allowance was inadequate, they may require the Company to increase the allowance, which also would adversely impact revenues and financial condition.
Growth and Management. Financial performance and profitability will depend on the Company’s ability to manage recent growth and potential future growth. In addition, any future acquisitions and continued growth may present operating and other problems that could have an adverse effect on the Company’s business, financial condition and results of operations. Accordingly, there can be no assurance that the Company will be able to execute it’s growth strategy or maintain the level of profitability that it has achieved in the past.
Changes in Market Interest Rates. The Company’s earnings are impacted by changing interest rates. Changes in interest rates affect the demand for new loans, the credit profile of existing loans, the rates received on loans and securities, and rates paid on deposits and borrowings. The relationship between the rates received on loans and securities and the rates paid on deposits and borrowings is known as the net interest spread. Based on the Company’s current volume and mix of interest-bearing liabilities and interest-earning assets, net interest spread could be expected to increase during times when interest rates rise in a parallel shift along the yield curve and, conversely, to decline during times of similar falling interest rates. Exposure to interest rate risk is managed by monitoring the re-pricing frequency of rate-sensitive assets and rate-sensitive liabilities over any given period. Although management believes the current level of interest rate sensitivity is reasonable, significant fluctuations in interest rates could potentially have an adverse affect on the Company’s business, financial condition and results of operations.
Liquidity. Liquidity measures the ability to meet loan demand and deposit withdrawals and to service liabilities as they come due. Dramatic fluctuations in loan or deposit balances make it challenging to manage liquidity. A sharp reduction in deposits could force the Company to borrow heavily in the wholesale deposit market. In addition, rapid loan growth during periods of low liquidity could induce the Company to purchase federal funds from correspondent banks, borrow at the Federal Home Loan Bank of Seattle or Federal Reserve discount window, raise deposit interest rates and/or decline loans.
Geographic Concentration. Substantially, all of the Company’s business is derived from a five-county area in northwest Washington State. Employment opportunities within these communities have traditionally been primarily in the areas of military spending, oil and gas industries, tourism and manufacturing. Many of the markets served by the Company have quickly earned a reputation as desirable places for quality of life for families and entrepreneurs. While the Company’s expansion strategy has been built around these growing and diverse geographic markets, the Company’s business is, and will remain, sensitive to economic factors that relate to these industries and to local and regional business conditions. As a result, local or regional economic downturns, or downturns that disproportionately affect one or more of the key industries in the Company’s markets, may have a more pronounced effect upon it’s business than they might on an institution that is more broadly diverse in geographic concentration. The extent of
the future impact of these events on economic and business conditions cannot be predicted; however, prolonged or acute fluctuations could have a material and adverse impact upon the Company’s results of operation and financial condition.
Regulation. The Company is subject to government regulation that could limit or restrict it’s activities, which in turn could adversely impact operations. The financial services industry is regulated extensively. Federal and state regulation is designed primarily to protect the deposit insurance funds and consumers, as well as shareholders. These regulations can sometimes impose significant limitations on operations. Moreover, federal and state banking laws and regulations undergo frequent, significant changes. Changes in laws and regulations may affect the cost of doing business, limit permissible activities (including insurance and securities activities), or the Company’s competitive position in relation to credit unions, savings associations and other financial institutions. These changes could also reduce federal deposit insurance coverage, broaden the powers or geographic range of financial holding companies, alter the taxation of financial institutions and change the structure and jurisdiction of various regulatory agencies.
Federal monetary policy, particularly as implemented through the Federal Reserve System, can significantly affect credit availability. Other federal legislation such as the Sarbanes-Oxley Act can dramatically shift resources and costs to ensure adequate compliance.
Competition. The financial services business in the Company’s market areas is highly competitive and competition may adversely affect performance. Competition continues to increase due to changes in regulation, technological advances, and the accelerating pace of consolidation among financial services providers. The Company faces competition both in attracting deposits and in originating loans and competes for loans principally through the pricing of interest rates and loan fees, and the efficiency and quality of services. Increasing levels of competition in the banking and financial services industries may reduce our market share or cause the pricing for services to be realigned. Results may differ in future periods depending upon the nature or level of competition.
Credit Risk. A source of risk arises from the possibility that losses will be sustained if a significant number of borrowers, guarantors and related parties fail to perform in accordance with the terms of their loans. The Company has adopted underwriting and credit monitoring procedures and credit policies, including the establishment and review of the allowance for credit losses, which it believes are appropriate to minimize risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying its credit portfolio. These policies and procedures, however, may not prevent unexpected losses that could materially affect results of operations.
Item 1B.
Item 1B.
Unresolved Staff Comments
The Company had no unresolved staff comments from the Securities and Exchange Commission.
Item 2.
Item 2. Properties
The executive offices of the Company are located at 450 Southwest Bayshore Drive in Oak Harbor, WA in a building that is owned by the Company on leased land. The building also houses the Bank’s Oak Harbor branch. At December 31, 2005, the Bank conducted business at 19 locations, twelve of which are owned by the Bank, including the main office in Coupeville, WA, and seven are leased under various agreements. The Company owns two additional facilities for administrative purposes and owns a parcel of land in Bellingham, WA for the construction of a new branch site.
The Company entered into an earnest money agreement for property in the Smokey Point/Arlington, WA area with plans to relocate the Smokey Point branch, which is currently leased. Management anticipates the closing of the sale and the branch construction to begin during the third quarter of 2006.
Item 3.
Item 3. Legal Proceedings
The Company and its subsidiaries are, from time to time, defendants in, and are threatened with, various legal proceedings arising from regular business activities. Management believes that its liability for
damages, if any, arising from such claims or contingencies will not have a material adverse effect on the Company’s results of operations, financial conditions or cash flows.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of securities holders of the Company during the quarter ended December 31, 2005.
PART II
Item 5.
Item 5.
Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The Company’s common stock is traded on the Nasdaq National Market System under the symbol “WBCO.”
The Company is aware that blocks of its stock are held in street name by brokerage firms. As a result, the number of shareholders of record does not include the actual number of beneficial owners of the Company’s stock. As of March 7, 2006, the Company’s common stock was held of record by approximately 342 shareholders, a number which does not include beneficial owners who hold shares in “street name.”
The following are the high and low adjusted closing prices for the Company’s stock as reported by the Nasdaq National Market System and the quarterly cash dividends paid by the Company to its shareholders on a per share basis during 2005 and 2004, as adjusted for stock dividends and splits:
The Company’s dividend policy requires the Board of Directors to review the Company’s financial performance, capital adequacy, cash resources, regulatory restrictions, economic conditions and other factors, and if such review is favorable, the Board may declare and pay dividends. For 1997 and prior years, cash dividends were paid on an annual basis. After completion of the initial public offering in 1998, the Company has paid cash dividends on a quarterly basis. On October 24, 2002, the Company distributed a 10% stock dividend, and on February 26, 2004, the Company distributed a 15% stock dividend. In addition, the Company declared a 4-for-3 stock split to shareholders of record as of May 2, 2005, which was distributed on May 17, 2005. The ability of the Company to pay dividends will depend on the profitability of the Bank, the need to retain or increase capital, and the dividend restrictions imposed upon the Bank by applicable banking law. Although the Company anticipates payment of a regular quarterly cash dividend, future dividends are subject to these limitations and to the discretion of the Board of Directors, and could be reduced or eliminated.
Sales of Unregistered Securities
The Company had no sales of unregistered securities during the fourth quarter of 2005.
Purchases of Equity Securities
The Company had no purchases of its equity securities during the fourth quarter of 2005.
Item 6.
Item 6. Selected Financial Data
Consolidated Five-Year Statements of Operations and Selected Financial Data
The following table sets forth selected audited consolidated financial information and certain financial ratios for the Company. This information is derived in part from the audited consolidated financial statements and notes thereto of the Company set forth in Item 8 - Financial Statements and Supplementary Data and should be read in conjunction with the Company’s financial statements and the management discussion set forth in Item 7
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with Item 8 - Financial Statements and Supplementary Data.
Executive Overview
2005 was a record setting year for the Company. For the year ended December 31, 2005, the Company reported record net income of $9.5 million and recorded fully diluted earnings per share of $1.26. At year end, the Company reported total assets of $726 million, total loans of $630 million, and total deposits of $637 million. Other significant achievements and events in 2005 included:
•
Operating efficiency ratio improved by 3% to 60.37%.
•
Net interest margin expanded by 0.21% to 5.36%.
•
Nonperforming assets as a percent of total assets decreased to 0.30%.
•
Liquidation of all other real estate owned, a $1.22 million decrease.
•
Continued organic growth; 9% for loans and 13% for total deposits.
•
Solid expansion of noninterest-bearing deposits to $105 million or 17% of total deposits.
•
Return on average assets improved to 1.37% from 0.98%.
•
Improvement in the return on average equity to 17.87% from 13.37%.
•
A 4-for-3 stock split in May 2005.
The Company also dealt with some challenges in the past year including:
•
Continued decline in revenues from the sale of mortgage loans from a record high of $2.1 million in 2003 to $773,000 in 2005.
•
Implemented the compliance requirements of the Sarbanes Oxley Act, Section 404.
Summary of Critical Accounting Policies
The SEC defines “critical accounting policies” as those that require application of management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in future periods. The Company’s significant accounting policies are described in Item 8 - Financial Statements and Supplementary Data, Note 1 - Summary of Significant Accounting Policies.
Results of Operations Overview
For the year ended December 31, 2005, net income was $9.5 million or $1.26 per diluted share, an increase of 52% on a per diluted share basis from 2004. Income from continuing operations, which excludes the after tax operating loss from the closure of Washington Funding Group in 2004, increased 43% in diluted earnings per share compared with 2004. The improvement of diluted earnings per share is attributed to improved net interest income and other noninterest income. Additionally, the Company has actively managed noninterest expenses and as a result improved the operating efficiency ratio to 60.37% in 2005, from 63.55% in 2004.
Net Interest Income: In 2005, net interest income on a tax equivalent basis increased 15% from $29.9 million in 2004 to $34.5 million at year end. The increase in net interest income was primarily due to an increase in average earning assets of $61.6 million in 2005 and to a lesser extent, an increase in the interest spread. Loans, the largest component of earning assets, increased an average of $61.7 million, compared with 2004. The yield on earning assets increased to 7.16% in 2005, 0.49% higher than 2004. The increase was due to repricing of variable rate loans, as well as higher rates on new loan originations in 2005 compared with 2004. Average interest-bearing liabilities increased $42.5 million in 2005 compared with 2004. The cost of interest-bearing liabilities increased 0.36% to 2.14% in 2005 compared with 2004. The increase was primarily the result of an increase in the cost of time deposits and to a lesser extent interest-bearing demand and money market accounts. The cost of interest-bearing deposits generally increased during 2005 as a result of increases in short term interest rates. As a result of the above changes, the interest rate spread widened 0.13% to 5.02% in 2005 and the net interest margin widened 0.21% to 5.36%. The net interest margin widened by more than the spread due to an increase of $15.4 million in average noninterest-bearing sources of funds.
Net interest income increased $2.4 million in 2004 compared with 2003 due to increases in average earning assets offset by a decrease in the interest margin. Average earning assets increased $54.0 million while the interest rate margin decreased 0.07%. The increase in average earning assets was driven by an increase in average loans while the decrease in the margin was due primarily to declining yields on earning assets.
The following table details the changes in net interest income over the last three years:
(1)
Of this amount, loan fees accounted for $1,365, $1,081, and $976, for the years ended December 31, 2005, 2004 and 2003, respectively. Loan totals include both current and nonaccrual loans.
(2)
Interest income on non-taxable assets is presented on a fully tax-equivalent basis using a federal statutory rate of 34.3%, 34% and 34%, for the years ended December 31, 2005, 2004 and 2003, respectively. These adjustments were $259, $316, and $341, for the years ended December 31, 2005, 2004 and 2003, respectively.
The following table details the effects of the interest changes over the last two years:
(1)
Interest income on non-taxable investments is presented on a fully tax-equivalent basis using the federal statutory rate of 34.3%, 34% and 34%, for the years ended December 31, 2005, 2004 and 2003, respectively.
(2)
The changes attributable to the combined effect of volume and interest rates have been allocated proportionately.
(3)
Interest income previously accrued on nonaccrual loans is reversed in the period the loan is placed on nonaccrual status.
Provision for Loan Losses: The provision for loan losses is highly dependent on the Company’s ability to manage asset quality and control the level of net charge-offs through prudent underwriting standards. The provision for loan losses decreased 36% to $2.3 million in 2005 from $3.5 million in 2004. The $1.2 million decrease in the provision from 2004 to 2005 was due to lower net charge-offs and overall improved credit quality of the loan portfolio. Net charge-offs for 2005 were $1.3 million versus $1.7 million in 2004. The provision for loan losses increased $300,000 from $3.2 million in 2003 to $3.5 million in 2004. Due to improvements in asset quality, collection of recoveries, changes in the loan portfolio mix, and overall loan growth, loan loss expenses were successfully controlled in 2005. During this same time, the Company added to the allowance for loan losses. The allowance, as a percent of total loans, grew from 1.36% in 2004 to 1.40% in 2005. For further discussion of the Company’s asset quality see the Credit Risks and Asset Quality section found in Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Noninterest Income: Noninterest income remains a key focus of the Company. Since 2003, the Company has focused on diversifying the noninterest income mix. In 2003, 72% of noninterest income consisted of income from sale of loans and service charges, while in 2004, 63% of noninterest income was derived from these products. In 2005, 54% of noninterest income came from income from sale of loans and service charges. The diversification of the noninterest income mix resulted primarily from the introduction of nondeposit investment products. In 2005, these products provided an additional $652,000 of noninterest income compared with 2004.
In 2005, noninterest income increased 9% to $7.3 million as compared to $6.7 million in 2004 and $5.9 million in 2003. This change is primarily attributed to a combination of income from the Company’s Bank Owned Life Insurance (“BOLI”) product, increases in Small Business Administration (“SBA”) premiums, ATM income and sales of nondeposit investment products, with an offsetting decrease in income from the sale of real estate loans. The Company’s BOLI product was purchased in July 2004. In 2005, the Bank realized a full year of income from this product, which represented an additional $124,000 of noninterest income. The increase in 2004 noninterest income from 2003 was primarily attributed to an increase in service charges and BOLI income.
Income from the sale of loans has continued to impact the Company. In 2005, increased competition and staff turnover contributed to the decline in income from sales of loans. In 2004, income from sales of loans decreased by $934,000 due to record high refinancing and home sales in 2003.
Noninterest Expense: The Company continues to focus on controlling noninterest expenses. As a result of consolidating back office operations and improving operating efficiencies, the Company continued to successfully manage noninterest expense during 2005. Due to this focused effort, noninterest expense grew by only $2.0 million or 8% in 2005. The Company’s efficiency ratio improved 3% from 63.55% in 2004 to 60.37% at year end. As detailed in the table below, the majority of the increase was attributed to salaries and benefits and other expenses:
The increase in salaries and benefits expense in 2005 was a result of:
•
Employee benefits paid by the Company increased $296,000 or 15% as compared to the prior year. This increase was due primarily to increased costs of health insurance. Additionally, the Company issued restricted stock awards in March of 2005 with related costs of approximately $97,000. See Item 8 - Financial Statements and Supplementary Data, Note 12 - Stock Incentive Plans.
•
Salaries increased by $692,000 or 5% compared to the prior year. The increase was attributable to general wage increases and commissions paid on sales of nondeposit investment products. The Company’s number of full time equivalent employees remained relatively flat with 296 and 289 at December 31, 2005 and 2004, respectively.
•
Bonuses for 2005 increased by $473,000. The increase in bonus expense was consistent with the performance of the Company and the performance goals set by senior management for 2005.
The increase in other noninterest expenses in 2005 was related to the following areas:
•
During 2005, the Company implemented the regulations of Section 404 of the Sarbanes Oxley Act of 2002. As a result, the Company incurred additional consulting and auditing fees of approximately $212,000.
•
The Company took write downs on the recorded values of several foreclosed properties totaling $253,000 in 2005 versus write downs of $54,000 in 2004. These properties were subsequently sold in 2005. For further details concerning foreclosed properties, see the Credit Risks and Asset Quality section found in Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations.
•
Washington State business and occupation tax (“B&O”) paid in 2005 increased $177,000 compared with the previous year. This increase was consistent with the Company’s increase in gross income for 2005.
Noninterest expense increases in 2003 and 2004 were in the areas of compensation and benefits, and general costs associated to support the Company’s ongoing efforts to grow the organization.
Income Tax: The Company’s consolidated effective tax rate, as a percentage of pre-tax income from continuing operations, increased 1.03%, to 32.34%, in 2005 versus an effective tax rate of 31.31% for 2004 and 2003. The effective tax rate is lower than the statutory rate due to nontaxable income generated from
investments in BOLI, tax-exempt municipal bonds and loans. Additional information on income taxes is provided in Item 8 - Financial Statements and Supplementary Data, Note 9 - Income Taxes.
Financial Condition Overview
In 2005, the Company focused on growing its loan portfolio and deposit funding base. Total loans at December 31, 2005 were $630 million, with loan growth of $50 million, or 9% for the year. Total deposits at year end 2005 were $637 million, with deposit growth totaling $74 million or 13% for the year. Approximately $28 million of the total deposit growth, or 38%, was attributed to noninterest-bearing deposits. Shareholders’ equity increased $8.3 million to $58 million, with a book value of $7.84 per share at 2005 year end.
Investment Securities: The composition of the Company’s investment portfolio reflects management’s investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of investment income. The investment securities portfolio mitigates interest rate inherent in the loan portfolio, while providing a vehicle for the investment of available funds and a source of liquidity.
During 2005, the Company’s investment portfolio was relatively unchanged from the prior year. In 2005, securities maturing or sold were reinvested in equivalent securities. In 2004, total investment securities decreased $10.9 million compared to the previous year. The decrease was a result of the sale and maturity of investment securities that were not replaced due to the low rate environment coupled with an anticipated increase in loan demand and purchase of a BOLI product. The Company’s investment portfolio mix, based upon amortized cost, is outlined in the table below:
Investment Portfolio as of:
(1)
No investment in aggregate, to a single issuer, exceeds 10% of shareholders’ equity.
The average life of the Company’s investment portfolio in 2005 increased to 3.2 years from 2.9 years in 2004. The following table further details the Company’s investment portfolio, based upon market value at December 31, 2005. Additional information about the investment portfolio is provided in Item 8 - Financial Statements and Supplementary Data, Note 3 - Investment Securities.
Loans: Interest and fees earned on the Company’s loan portfolio is the primary source of revenue. Total loans represented 87% of total assets or $630 million at December 31, 2005. This represented a $50 million, or 9% , increase for the year. In 2005, the commercial real estate segment was the primary source of growth, adding an additional $45 million in loans. The Company attempts to balance the diversity of its portfolio, believing that this provides a good means of minimizing risk due to loss and interest rate sensitivity. Active portfolio management has resulted in solid loan growth and a diversified portfolio that is not heavily concentrated in any one industry or in any one community. The following table further details the loan portfolio:
The Company’s loan portfolio composition is comprised of the following loan types:
•
Commercial Loans: Commercial loans include both secured and unsecured loans for working capital and expansion. Short-term working capital loans generally are secured by accounts receivable, inventory and/or equipment, while longer-term commercial loans are usually secured by equipment.
•
Real Estate Mortgage Loans: Real estate loans consist of two types: one-to-four family residential and commercial properties.
+
One-to-Four Family Residential Loans: One-to-four family residential loans are secured principally by 1st deeds of trust on residential properties principally located within the Company’s market area.
+
Commercial Real Estate Loans: Commercial real estate loans are secured principally by manufacturing facilities, apartment buildings and commercial buildings for office, storage and warehouse space. Loans secured by commercial real estate may involve a greater degree of risk than one-to-four family residential loans. Payments on such loans are often dependent on successful business management operations.
•
Real Estate Construction Loans: Real estate construction loans consist of three types: 1) commercial real estate, 2) one-to-four family residential construction, and 3) speculative construction.
+
Commercial Real Estate: Commercial real estate construction loans are primarily for owner-occupied properties.
+
One-to-Four Family Residential: One-to-four family residential construction loans are for the construction of custom homes, where the homebuyer is the borrower.
+
Speculative Construction: Speculative construction provides financing to builders for the construction of pre-sold homes and speculative residential construction. With few exceptions, the Company limits the number of unsold homes being built by each builder. The Company lends to qualified builders who are building in markets that management believes it understands and in which it is comfortable with the economic conditions.
•
Consumer Loans: The Company’s consumer loan portfolio consists of automobile loans, boat and recreational vehicle financing, home equity and home improvement loans, and miscellaneous secured and unsecured personal loans.
+
Direct Consumer Loans: Direct consumer loans consist of automobile loans, boat and recreational vehicle financing, home equity and home improvement loans, and miscellaneous secured and unsecured personal loans originated directly by the Bank’s loan officers.
+
Indirect Consumer Loans: The Company makes loans for new and used automobile and recreational vehicles that are originated indirectly by selected dealers located in the Company’s market areas. The Company has limited its indirect loan purchases primarily to dealerships that are established and well known in their market areas and to applicants that are not classified as sub-prime.
The Company makes certain loans which are guaranteed by the SBA. The SBA, an independent agency of the federal government, provides loan guarantees to qualifying small and medium sized businesses for up to 85% of the principal loan amount. The Company currently sells the guaranteed portion of each loan to investors in the secondary market. The guaranteed portion of an SBA loan is generally sold at a premium. The Company retains the unguaranteed portion of the loan. The retained portion of the SBA loan is classified within the portfolio by loan type.
Specific types of loans within the Company’s portfolio are more sensitive to interest rate changes. Commercial and real estate construction loan interest rates are primarily based upon current market rates
plus a basis point spread charged by the Company. To better understand the Company’s risk associated with these loans, the following table sets forth the maturities by loan type:
Maturity and Sensitivity of Loans to Changes in Interest Rates
Credit Risks and Asset Quality
Credit Risks: The extension of credit, in the form of loans or other credit substitutes, to individuals and businesses is a major portion of the Company’s principal business activity. Company policies and applicable laws and regulations require risk analysis as well as ongoing portfolio and credit management.
The Company manages its credit risk through lending limit constraints, credit review, approval policies and extensive, ongoing internal monitoring. Through this monitoring process, nonperforming loans are identified. Nonperforming assets consist of nonaccrual loans, restructured loans, past due loans and other real estate owned. Additional information on nonperforming assets is provided in Item 8 - Financial Statements and Supplementary Data, Note 1 - Significant Accounting Policies. Nonperforming assets are assessed for potential loss exposure on an individual or homogeneous group basis. Further details on the loss analysis are provided below in the Allowance for Loan Losses section.
The following table summarizes the Company’s nonperforming assets for the past five years:
Allowance for Loan Losses: The allowance for loan losses is maintained at a level considered adequate by management to provide for loan losses inherent in the portfolio. The Company assesses the allowance on a quarterly basis. The Company’s methodology for making such assessments and determining the adequacy of the allowance includes the following key elements:
•
Specific allowances for identified problem loans and portfolio segments.
•
A formula allowance based upon the historical loss experience of the loan portfolio, mix of the portfolio by loan type and the loan grade quality.
•
A general unallocated allowance consistent with SFAS No. 5, “Accounting for Contingencies.”
The evaluation of each element and the overall allowance is based on a continuing assessment of nonperforming assets, recent and historical loss experience, and other factors, including regulatory guidance and economic factors. The allocation of the allowance is based on an evaluation of nonperforming assets, historical ratios of loan losses and other factors that may affect future loan losses in specific categories of loans.
The following table shows the allocation of the allowance for loan losses, by loan type, for the past five years:
(1)
Represents the total of all outstanding loans in each category as a percent of total loans outstanding.
While the Company believes that it uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected if circumstances differ substantially from the assumptions used in making the final determination. Based on the assessment of loan quality, the Company believes that the current allowance for loan losses is appropriate under the current circumstances and economic conditions.
Asset Quality: The Company’s asset quality has improved over the past two years. Additionally, increased recoveries of prior charge-offs have helped decrease net charge-offs to average loans by 0.34% since 2003. The following table sets forth historical information regarding the Company’s net charge-offs and average loans for the past five years:
The following table sets forth historical information regarding changes in the Company’s allowance for loan losses:
Deposits and Borrowings
Deposits: In 2005, the Company made a concerted effort to expand its core deposit base, through competitive pricing and delivery of quality service. The Company’s efforts were successful with a 13% increase in total deposits over year end 2004. The Company was particularly successful in attracting an additional $38 million in noninterest-bearing deposits to end 2005 at $105 million, a 35% increase over 2004. As outlined in the following table, the Company increased average deposit balances during 2005 while controlling the cost of those deposits.
Certificates of Deposit (“CDs”) were approximately 38% of the total deposit base as of December 31, 2005. Approximately 48% of total CDs outstanding had balances of $100,000 or more at December 31, 2005. The following table sets forth the amounts and maturities of these CDs:
Additional information regarding deposits is provided in Item 8 - Financial Statements and Supplementary Data, Note 6 - Deposits.
Borrowings: Total borrowings outstanding decreased 41% from $42 million in 2004 to $25 million in 2005. The change in borrowings is attributable to the repayment of $22.0 million in Federal Home Loan Bank (the “FHLB”) overnight borrowings, and the net change of $5.0 million in short term borrowings from the FHLB. The Company’s sources of funds consist of borrowings from correspondent banks, the FHLB and junior subordinated debentures.
FHLB Borrowings: The Company relies upon advances from the FHLB to supplement funding needs. The FHLB provides credit for member financial institutions in the form of overnight borrowings, short term and long term advances. As a member, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances on the pledge of certain of its mortgage loans and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met. At December 31, 2005 the Company had an outstanding $10.0 million short-term advance, with a remaining unused line of credit of $95.1 million. Additional information regarding FHLB borrowings is provided in Item 8 - Financial Statements and Supplementary Data, Note 7 - FHLB Advances and Stock.
Junior Subordinated Debentures: The Company had approximately $15 million of junior subordinated debentures outstanding as of 2005 year end. The entire amount of debentures outstanding have interest rates which adjust on a quarterly basis based on the London Interbank Overnight Rate (“LIBOR”) plus 3.65%. Increases in short term interest rates during 2005 resulted in increased interest expense for the debentures. The debentures have a 30-year maturity, but are callable at the Company’s option without penalty after June 27, 2007. As of December 31, 2005, the entire amount of debentures outstanding qualified as Tier 1 capital for regulatory capital purposes. Additional information regarding junior subordinated debentures is provided in Item 8 - Financial Statements and Supplementary Data, Note 8 - Trust Preferred Securities and Junior Subordinated Debentures.
Capital
Shareholders’ Equity: Shareholders’ equity increased $8.3 million from $49.6 million in 2004 to $57.8 million at 2005 year end, with an ending book value of $7.84 per share. The increase in shareholders’ equity was due to the retention of approximately $7.9 million, or 83%, of net income for the year and the exercise of stock options, and related tax benefit, of $470,000. The Company paid approximately $1.6 million in cash dividends during 2005. The following table represents the cash dividends declared and dividend payout ratio for the past three years:
Cash dividends are approved by the Board of Directors in connection with its review of the Company’s capital plan. The cash dividend is subject to regulatory limitation as described in Item 1 - Business, Supervision and Regulation Section. There is no assurance that future cash dividends will be declared or increased. In 2005, the Company declared a 4-for-3 stock split to shareholders of record on May 2, 2005 and distributed on May 17, 2005. Additionally, restricted stock awards valued at $483,000, with vesting periods ranging from three to five years, were granted in 2005. For further information on shareholders’ equity see Item 8 - Financial Statements and Supplementary Data, Consolidated Statements of Shareholders’ Equity.
Regulatory Capital Requirements: The Company (on a consolidated basis) and the Bank are subject to minimum capital requirements, under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. The Federal Reserve and FDIC regulations set forth the qualifications necessary for bank holding companies and banks to be classified as “well capitalized,” primarily for assignment of insurance premium rates. Failure to qualify as “well capitalized” can: (a) negatively impact a bank’s ability to expand and to engage in certain activities, (b) cause an increase in insurance premium rates, and (c) impact a bank holding company’s ability to utilize certain expedited filing procedures, among other things. The Company’s and Bank’s current capital ratios are located in Item 8 - Financial Statements and Supplementary Data, Note 13 - Regulatory Capital Matters.
Liquidity and Cash Flow
Whidbey Island Bank: The principal objective of the Bank’s liquidity management program is to maintain the ability to meet day-to-day cash flow requirements of its customers who either wish to withdraw funds or to draw upon credit facilities to meet their cash needs. The Bank monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. In addition to liquidity from core deposits and the repayment and maturities of loans, the Bank can utilize established federal funds, lines of credit with correspondent banks, sale of investment securities or borrowings from the FHLB.
Washington Banking Company: The Company is a separate legal entity from the Bank and must provide for its own liquidity. Substantially all of the Company’s revenues are obtained from dividends declared and paid by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to the Company. However, management believes that such restrictions will not have an adverse impact on the ability of the Company to meets its ongoing cash obligations, which consist principally of debt service on the $15 million of outstanding junior subordinated debentures, which totaled approximately $1.1 million in 2005. Further information on the Company’s cashflows can be found in Item 8 - Financial Statements and Supplementary Data, Note 15 - Washington Banking Company Information.
Consolidated Cashflows: The consolidated cashflows of the Company and its subsidiary the Bank are disclosed in the Consolidated Statement of Cash Flows found in Item 8 - Financial Statements and Supplementary Data. Net cash provided by operating activities was $20.2 million during 2005. The principal source of cash provided by operating activities was net income from continuing operations. Investing activities used $52.4 million in 2005. The net use of cash was principally $51.7 million in loan growth. Financing activities provided $56.2 million, primarily through net deposit growth, but offset by dividend payments to shareholders of $1.6 million.
Capital Resources
Off-Balance Sheet Commitments: Standby letters of credit, commercial letters of credit, and financial guarantees written, are conditional commitments issued by the Company to guarantee the performance of a customer to a third party or payment by a customer to a third party. Those guarantees are primarily issued in international trade or to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Except for certain long-term guarantees, the majority of guarantees expire in one year. The credit risk involved in issuing letters of credit is essentially
the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounts to one hundred percent of the commitment amount at December 31, 2005. The Company routinely charges a fee for these credit facilities. The Company has not been required to perform on any financial guarantees. The following table summarizes the Company’s commitments to extend credit:
Commitments to Extend Credit
Contractual Commitments: The Company is party to many contractual financial obligations, including repayment of borrowings and operating lease payments. The following table summarizes the contractual obligations of the Company as of December 31, 2005:
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures about Market Risk
Asset/ Liability Management
The purpose of asset/ liability management is to provide stable net interest income by protecting the Company’s earnings from undue interest rate risk that arises from volatile interest rates and changes in the balance sheet mix, and by managing the risk/ return relationships between liquidity, interest rate risk, market risk, and capital adequacy. The Company maintains an asset/ liability management policy that provides guidelines for controlling exposure to interest rate risk by utilizing the following ratios and trend analyses: liquidity, equity, volatile liability dependence, portfolio maturities, maturing assets and maturing liabilities. The Company’s policy is to control the exposure of its earnings to changing interest rates by generally endeavoring to maintain a position within a narrow range around an “earnings neutral position,” which is defined as the mix of assets and liabilities that generate a net interest margin that is least affected by interest rate changes.
Market Risk
Interest Rate Risk: The Company is exposed to interest rate risk. Interest rate risk is the risk that financial performance will decline over time due to changes in prevailing interest rates and resulting yields on interest-earning assets and costs of interest-bearing liabilities. Generally, there are three sources of interest rate risk as described below:
Re-pricing Risk: Generally, re-pricing risk is the risk of adverse consequences from a change in interest rates that arises because of differences in the timing of when those interest rate changes affect an institution’s assets and liabilities.
Basis Risk: Basis risk is the risk of adverse consequences resulting from unequal changes in the spread between two or more rates for different instruments with the same maturity.
Option Risk: In banking, option risks are known as borrower options to prepay loans and depositor options to make deposits, withdrawals, and early redemptions. Option risk arises whenever bank products give customers the right, but not the obligation, to alter the quantity of the timing of cash flows.
A number of measures are used to monitor and manage interest rate risk, including income simulations and interest sensitivity (gap) analyses. An income simulation model is the primary tool used to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates. Key assumptions in the model include prepayment speeds on fixed rate assets, cash flows and maturities of other investment securities, and loan and deposit volumes and pricing. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management strategies, among other factors.
Interest Rate Sensitivity: The analysis of an institution’s interest rate gap (the difference between the repricing of interest-earning assets and interest-bearing liabilities during a given period of time) is another standard tool for the measurement of the exposure to interest rate risk. The Company believes that because interest rate gap analysis does not address all factors that can affect earnings performance, it should be used in conjunction with other methods of evaluating interest rate risk.
The following table sets forth the estimated maturity or repricing, and the resulting interest rate gap of the Company’s interest-earning assets and interest-bearing liabilities at December 31, 2005. The interest rate gaps reported in the table arise when assets are funded with liabilities having different repricing intervals. The amounts shown in the following table could be significantly affected by external factors such as changes in prepayment assumptions, early withdrawals of deposits and competition:
Impact of Inflation and Changing Prices
The primary impact of inflation on the Company’s operations is increased operating costs. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on a financial institution’s performance than the effects of general levels of inflation. Although interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services, increases in inflation generally have resulted in increased interest rates.
Item 8.
Item 8.
Financial Statements and Supplementary Data
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The Company’s management, including its Chief Executive Officer and its Chief Financial Officer, together with its consolidated subsidiary, is responsible for establishing, maintaining and assessing adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934). The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting purposes in accordance with accounting principals generally accepted in the United States of America.
The Company’s internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principals generally accepted in the United States of America, and that receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Company; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the Company’s financial statements.
Management recognizes that there are inherent limitations in the effectiveness of any system of internal control, and accordingly, even effective internal control can provide only reasonable assurance with respect to financial statement preparation and fair presentation. Further, because of changes in conditions, the effectiveness of internal control may vary over time.
The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in the Internal Control-Integrated Framework. Based on this assessment, management believes that, as of December 31, 2005, the Company’s internal control over financial reporting was effective based on those criteria.
The Company’s independent registered public accounting firm has audited management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, as stated in their report on page 28, which expresses unqualified opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
Washington Banking Company
We have audited the accompanying consolidated statement of financial condition of Washington Banking Company and subsidiaries (Company) as of December 31, 2005 and 2004, and the related consolidated statements of income, shareholders’ equity, comprehensive income and cash flows for each of the three years in the period ended December 31, 2005. We also have audited management’s assessment included in the accompanying Management’s Report on Internal Control over Financial Reporting that the Company maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management’s assessment, and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audits.
We conducted our audits in accordance with auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinion.
The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and Directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM-(CONTINUED)
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Washington Banking Company and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and cash flows for each of the three years ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, management’s assessment that Washington Banking Company maintained effective internal control over financial reporting as of December 31, 2005 is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Furthermore, in our opinion, Washington Banking Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
Bellingham, Washington
WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Consolidated Statements of Financial Condition
December 31, 2005 and 2004
(Dollars in thousands, except per share data)
See accompanying notes to consolidated financial statements.
WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Consolidated Statements of Income
Years Ended December 31, 2005, 2004 and 2003
(Dollars in thousands, except per share data)
See accompanying notes to consolidated financial statements.
WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Consolidated Statements of Shareholders’ Equity
Years Ended December 31, 2005, 2004 and 2003
(Dollars and shares in thousands, except per share data)
(1)
Adjusted to reflect a 4-for-3 stock split distributed by the Company May 17, 2005.
See accompanying notes to consolidated financial statements.
WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
Years Ended December 31, 2005, 2004 and 2003
(Dollars in thousands)
See accompanying notes to consolidated financial statements.
WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Years Ended December 31, 2005, 2004 and 2003
(Dollars in thousands)
See accompanying notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(1)
Description of Business and Summary of Significant Accounting Policies
(a)
Description of Business
Washington Banking Company (the “Company”) is a registered bank holding company formed on April 30, 1996. At December 31, 2005, the Company had two wholly-owned subsidiaries - Whidbey Island Bank (the “Bank”), the Company’s principal subsidiary, and Washington Banking Capital Trust I (the “Trust”). The business of the Bank, which is focused in the northern area of Western Washington, consists primarily of attracting deposits from the general public and originating loans. During the past decade, the region experienced strong population growth and economic diversification. The region’s economy has evolved from one that was once heavily dependent upon forestry, fishing and farming to an economy with a much more diverse blend of industries including retail trade, services, manufacturing, tourism and a large military base presence. Although the Bank has a diversified loan portfolio, a substantial portion of its borrowers’ ability to repay their loans is dependent upon the economic conditions affecting this area.
The Trust, the second subsidiary of the Company, was formed in June 2002 for the exclusive purpose of issuing trust preferred securities and common securities and using the $15,000 in proceeds from the issuance to acquire junior subordinated debentures issued by the Company. In 2003, the Trust subsidiary was consolidated. In 2004, pursuant to Financial Accounting Standards Board (“FASB”) Financial Interpretation No. 46R (“FIN 46R”), the Company deconsolidated the Trust. See Note 8 - Trust Preferred Securities and Junior Subordinated Debentures.
Washington Funding Group (“the Group”), a wholesale mortgage real estate lending company, was a Washington State corporation formed in January 2003. The primary purpose of this subsidiary was to provide a loan-funding source for brokers of mortgage loans. The loans were originated and sold in the name of the Bank. During the second quarter of 2004, the Company decided to concentrate corporate resources toward the Bank’s retail operations and close the Group’s operations effective June 30, 2004. Although the wholesale business enhanced the Company’s noninterest income during 2003 and 2004, the operation of those offices did not provide a satisfactory financial return. The cash flow from the Group’s operations in 2003 and 2004 came entirely from operating activities.
(b)
Basis of Presentation
The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries as described above. The consolidated financial statements of the Company have been prepared in conformity with accounting principles generally accepted in the United States of America. All significant intercompany balances and transactions have been eliminated in consolidation. In preparing the consolidated financial statements, in conformity with generally accepted accounting principles, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expense during the reported periods. Actual results could differ from these estimates. Management considers the estimates used in developing the allowance for loan losses to be particularly sensitive estimates that may be subject to revision in the near term.
(c)
Segments
Pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 131, Disclosure about Segments of an Enterprise and Related Information, the Company has evaluated the requirements of this standard and had identified two reportable segments: Whidbey Island Bank and the discontinued operations of Washington Funding Group, Inc., both wholly-owned subsidiaries of Washington Banking Company. Due
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
to the discontinuation of the Group in the second quarter of 2004, the Company currently has only one segment, Whidbey Island Bank, and is not required to disclose segment reporting by this standard.
(d)
Recent Financial Accounting Pronouncements
In May 2005, FASB issued SFAS No. 154, Accounting Changes and Error Corrections, which replaces APB Opinion No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS No. 154 changed the requirements for the accounting for and reporting of a change in accounting principle and applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed.
APB Opinion No. 20 required most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. The issuance of SFAS No. 154 now requires restating prior periods’ financial statements to reflect any changes in accounting principle, unless the Company is not able to determine either the period-specific effects or the cumulative effect of the change. The adoption of SFAS No. 154 did not have a material impact on the Company’s result of operations and overall financial position.
In December 2004, FASB issued SFAS No. 123R, Shared Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. Statement No. 123R supersedes APB No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows.
As permitted by SFAS No. 123, the Company currently accounts for share-based payments to employees using APB 25 intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. The adoption of SFAS No. 123R’s fair value method will have an impact on the Company’s result of operations, although it will have no impact on the overall financial position. The impact of adoption of SFAS No. 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted SFAS No. 123R in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123. Also, SFAS No. 123R requires the benefit of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption.
The SEC recently announced the adoption of a new rule that amends the compliance dates for SFAS No. 123R for public companies. Under the Statement as issued by the FASB, fair-value accounting would have been mandatory for the first interim or annual reporting period beginning after June 15, 2005, for public companies that were not small business issuers; all other companies, including all nonpublic companies, were to begin using the new rules for reporting periods after December 15, 2005. The SEC’s new rule allows public companies to implement SFAS No. 123R at the beginning of the next fiscal year, instead of the next reporting period, after June 15 or December 15, 2005, as applicable. The SEC’s new rule does not change the accounting required by SFAS No. 123R, only the compliance deadlines have been altered. With the recent extension, the Company will adopt SFAS No. 123R on January 1, 2006. The Company has evaluated SFAS No. 123R and believes the adoption of the standard will not have a material impact on the financial statements.
(e)
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash on hand and due from banks, interest-earning deposits and federal funds sold, all of which have original maturities of three months or less.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
(f)
Federal Home Loan Bank Stock
The Bank’s investment in FHLB stock is carried at par value, which approximates its fair value. As a member of the FHLB system, the Bank is required to maintain a minimum level of investment in FHLB stock based on specific percentages of the Bank’s outstanding mortgages, total assets or FHLB advances. At December 31, 2005, the Bank’s minimum required investment was approximately $1,203. Amounts in excess of the required minimum for FHLB membership may be redeemed at par at FHLB’s discretion, which is subject to their capital plan, bank policies, and regulatory requirements, which may be amended or revised periodically.
(g)
Investment Securities
Investment securities available for sale include securities that management intends to use as part of its overall asset/liability management strategy and that may be sold in response to changes in interest rates and resultant prepayment risk and other related factors. Securities available for sale are carried at market value, and unrealized gains and losses (net of related tax effects) are excluded from net income but are included as a separate component of comprehensive income. Upon realization, such gains and losses will be included in net income using the specific identification method.
Investment securities held to maturity are comprised of debt securities for which the Company has positive intent and ability to hold to maturity and are carried at cost, adjusted for amortization of premiums and accretion of discounts using the interest method over the estimated lives of the securities.
Management determines the appropriate classification of investment securities at the purchase date in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities.
(h)
Loans Held for Sale
Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Net unrealized losses are recognized through a valuation allowance by charges to income. When a loan is sold, the gain is recognized in the consolidated statement of income as the proceeds less the book value of the loan including unamortized fees and capitalized direct costs.
(i)
Loans Receivable, Net
Loans receivable, net, are stated at the unpaid principal balance, net of: premiums, unearned discounts, net deferred loan origination fees, and the allowance for loan losses.
Interest on loans is calculated using the simple interest method based on the daily balance of the principal amount outstanding and is credited to income as earned.
Loans are placed on nonaccrual status when collection of principal or interest is considered doubtful (generally, loans 90 days or more past due).
A loan is considered impaired when, based upon currently known information, it is deemed probable that the Company will be unable to collect all amounts due as scheduled according to the original terms of the agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical expedient, based on the loan’s observable market price or the fair value of collateral, if the loan is collateral dependent.
Interest income previously accrued on nonaccrual loans, but not yet received, is reversed in the period the loan is placed on nonaccrual status. Payments received are generally applied to principal. However, based on management’s assessment of the ultimate collectibility of an impaired or nonaccrual loan, interest income may be recognized on a cash basis. Nonaccrual loans are returned to an accrual status when
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
management determines the circumstances have improved to the extent that there has been a sustained period of repayment performance and both principal and interest are deemed collectible.
Loan fees and certain direct loan origination costs are deferred and the net fee or cost is recognized in interest income using the interest method over the estimated life of the individual loans, adjusted for actual prepayments.
(j)
Allowance for Loan Losses
The allowance for loan losses is based upon the Company’s estimates. The Company determines the adequacy of the allowance for loan losses based on evaluations of the loan portfolio, recent loss experience and other factors, including economic and market conditions. The Company determines the amount of the allowance for loan losses required for certain sectors based on relative risk characteristics of the loan portfolio. Actual losses may vary from current estimates. These estimates are reviewed periodically and as adjustments become necessary, are reported in earnings in the periods in which they become known. The allowance for loan losses is increased by expensing to the provisions for loan losses. Losses are charged to the allowance and recoveries are credited to the allowance.
(k)
Premises and Equipment
Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets. The estimated useful lives used to compute depreciation and amortization include buildings and building improvements, 15 to 40 years; land improvements, 15 to 25 years; furniture, fixtures and equipment, 3 to 7 years; and leasehold improvements, lesser of useful life or life of the lease.
(l)
Bank Owned Life Insurance
During the second quarter of 2004, the Bank made a $10,000 investment in bank owned life insurance (“BOLI”). These policies insure the lives of officers of the Bank, and name the Bank as beneficiary. Noninterest income is generated tax-free (subject to certain limitations) from the increase in the policies’ underlying investments made by the insurance company. The Bank is capitalizing on the ability to partially offset costs associated with employee compensation and benefit programs with the BOLI.
(m)
Other Real Estate Owned
Other real estate owned includes properties acquired through foreclosure. These properties are recorded at the lower of cost or estimated fair value. Losses arising from the acquisition of property, in full or partial satisfaction of loans, are charged to the allowance for loan losses.
Subsequent to the transfer to other real estate owned, these assets continue to be recorded at the lower of cost or fair value (less estimated cost to sell), based on periodic evaluations. Generally, legal and professional fees associated with foreclosures are expensed as incurred. However, in no event are recorded costs allowed to exceed fair value. Subsequent gains, losses or expenses recognized on the sale of these properties are included in noninterest income or expense.
(n)
Federal Income Taxes
The Company files a consolidated federal income tax return. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the periods in which
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rate is recognized in income in the period that includes the enactment date.
(o)
Stock-Based Compensation
The Company recognizes the financial effects of stock-based employee compensation based on the intrinsic value method of accounting prescribed by APB 25, Accounting for Stock Issued to Employees and FASB Interpretation No. 44 (“FIN 44”), Accounting for Certain Transactions Involving Stock Compensation. Generally, stock options are issued at a price equal to the fair value of the Company’s stock as of the grant date. Under APB 25, options issued in this manner do not result in the recognition of employee compensation in the Company’s financial statements.
The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation:
(1)
Adjusted to reflect a 4-for-3 stock split distributed by the Company May 17, 2005.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
The remaining unrecognized compensation for fair value stock options was approximately $63 as of December 31, 2005.
The pro forma information recognizes, as compensation, the value of stock options granted using an option valuation model known as the Black Scholes model. Pro forma earnings per share amounts also reflect an adjustment for an assumed purchase of treasury stock from proceeds deemed obtained from the issuance of stock options. There were no options issued in 2004 or 2005. The following are the weighted averages of the assumptions used to estimate the fair value of the options:
Management believes that the assumptions used in the option-pricing model are highly subjective and represent only one estimate of possible value, as there is no active market for the options granted. The fair value of the options granted will be allocated to pro forma earnings over the vesting period of the options.
(p)
Reclassifications
Certain amounts in previous years may have been reclassified to conform to the 2005 financial statement presentation.
(2)
Restrictions on Cash Balance
The Company is required to maintain an average reserve balance with the Federal Reserve Bank or maintain such reserve balance in the form of cash. The amount of the required reserve balance on December 31, 2005 and 2004 was $3,313 and $2,686, respectively, and was met by holding cash with the Federal Reserve Bank.
(3)
Investment Securities
The amortized costs and market values of investment securities at December 31, 2005 and 2004 are as summarized:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
(Continued)
Certain investment securities shown in the preceding table currently have fair values less than amortized cost and therefore contain unrealized losses. As of December 31, 2005 and 2004, the Company had 12 investment securities for both periods that were in an unrealized loss position. The Company has evaluated these securities and has determined that the decline in value is temporary and is related to the change in market interest rates since purchase. The decline in value is not related to any company or industry specific event.
In 2005, the Company sold $504 available for sale securities, which had an amortized cost of $454. The gross realized loss was ($50).
In 2004, the Company transferred all of the municipal securities from held to maturity to available for sale as a result of management’s review of the Company’s liquidity needs, the asset/liability position, the scheduled maturities and the rate environment trends. The amortized cost of the transferred securities was $14,267 with a fair market value of $14,679 and a related net unrealized gain of $412. The Company sold $5,799 of available for sale securities, which had an amortized cost of $5,661. The gross realized gain was $195 and the gross realized loss was ($51).
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
The amortized cost and market value of investment securities by contractual maturity at December 31, 2005 are as follows:
At December 31, 2005 and 2004, investment securities with recorded values of $5,910 and $9,262, respectively, were pledged to secure public deposits and for other purposes as required or permitted by law.
(4)
Loans and Allowance for Loan Losses
The loan portfolio composition, based upon the purpose and primary source of repayment of the loans, was as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
The following is an analysis of the changes in the allowance for loan losses:
The Company had impaired loans which consisted of nonaccrual and accrual loans. As of December 31, 2005, the Company had no commitments to extend additional credit on these impaired loans. Impaired loans and their related reserve for loan losses were as follows:
The average balance on impaired loans was as follows:
The following table details the interest income which would have been recognized if the loans had accrued interest, in accordance with their original terms, and the interest actually recognized.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
(5) Premises and Equipment
Premises and equipment consisted of the following:
(6) Deposits
Deposits are summarized as follows:
Certificates of deposit mature as follows:
(7) FHLB Advances and Stock
The Bank is required to maintain an investment in the stock of FHLB. The requirement is based on the following components:
•
3.5% of the average daily balance of advances outstanding during the most recent quarter; plus
•
the greater of $500 or 0.75% of mortgage loans and pass-through securities; or
•
5.0% of the outstanding balance of loans sold to the FHLB minus the membership requirement.
During 2005, the FHLB suspended payment of dividends. The Company evaluated this suspension and has determined that the suspension of dividends is temporary and that the stock is not considered impaired as of December 31, 2005.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
A credit line has been established by FHLB for Whidbey Island Bank. At December 31, 2005, the line of credit available to the Bank was $95,100. The Bank may borrow from the FHLB in amounts up to 15% of its total assets. Advances on the line are collateralized by securities pledged and held in safekeeping by the FHLB, as well as supported by eligible real estate loans. As of December 31, 2005, collateral consisted entirely of eligible real estate loans in the amount of $140,759.
The Bank’s FHLB advances mature as follows:
The Bank had no overnight borrowings outstanding as of December 31, 2005. At December 31, 2004 the Bank had $22,000 of overnight borrowings outstanding.
(8) Trust Preferred Securities and Junior Subordinated Debentures
Washington Banking Capital Trust I, a statutory business trust, is a wholly-owned subsidiary of the Company created for the exclusive purposes of issuing and selling capital securities and utilizing sale proceeds to acquire junior subordinated debt issued by the Company. On June 27, 2002, the Trust issued $15,000 of trust preferred securities with a 30-year maturity, callable after the fifth year by Washington Banking Company. The rate adjusts quarterly based on Three-Month LIBOR plus 3.65%. On December 31, 2005 the rate was 7.80%. These securities, within certain limitations, are considered Tier I capital for the purposes of regulatory capital requirements.
The junior subordinated debentures are the sole assets of the Trust, and payments under the junior subordinated debentures are the sole revenues of the Trust. All of the common securities of the Trust are owned by the Company. Washington Banking Company has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements.
Pursuant to FIN 46R, the Company deconsolidated the trust beginning first quarter of 2004 and began to report the junior subordinated debentures within the liabilities section of the statement of financial condition. Prior to deconsolidation, the Trust and the related trust preferred securities were included within borrowings as a separate line item in the Company’s statement of financial condition.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
(9) Income Taxes
Income tax expense (benefit) consisted of the following:
The following table presents major components of the net deferred federal income tax asset resulting from differences between financial reporting and tax basis:
Reconciliation between the statutory federal income tax rate and the effective tax rate is as follows:
There was no valuation allowance for deferred tax assets as of December 31, 2005 or 2004. The Company has determined that it is not required to establish a valuation allowance for the deferred tax assets as
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
management believes it is more likely than not that the deferred tax asset of $3,418 and $3,004 at December 31, 2005 and 2004, respectively, will be realized in the normal course of business.
(10)
Earnings Per Share
The following illustrates the reconciliation of the numerators and denominators of the basic and diluted earnings per share (“EPS”) computations:
On May 17, 2005, the Board of Directors issued a 4-for-3 stock split to shareholders of record as of May 2, 2005. On February 26, 2004, the Board of Directors issued a 15% stock dividend to shareholders of record as of February 10, 2004. All periods presented have been restated to reflect the stock split and dividend.
(11) Employee Benefit Plans
(a) 401(k) and Profit Sharing Plan:
During 1993, the Board of Directors approved a defined contribution plan (“the Plan”). The Plan covers substantially all full-time employees and many part-time employees once they meet the age and length of service requirements. The Plan allows for a voluntary salary reduction, under which eligible employees are permitted to defer a portion of their salaries, with the Company contributing a percentage of the employee’s contribution to the employee’s account. Employees are fully vested in their elected and employer matching contributions at all times. At the discretion of the Board of Directors, an annual profit sharing contribution may be made to eligible employees. Profit sharing contributions vest over a six-year period.
The Company’s contributions for the years ended December 31, 2005, 2004 and 2003 under the employee matching feature of the plan were $215, $196 and $176, respectively. This represents a match of the participating employees’ salary deferral of 50% of the first 5% of the compensation deferred. There were no contributions under the profit sharing portion of the plan for the years presented.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
(b) Deferred Compensation Plan:
In December 2000, the Bank approved the adoption of an Executive Deferred Compensation Plan (“Comp Plan”) to take effect January 2001, under which select participants may elect to defer receipt of a portion of eligible compensation. The following is a summary of the principal provisions of the Compensation Plan:
Purpose: The purpose of the Comp Plan is to (1) provide a deferred compensation arrangement for a select group of management or highly compensated employees within the meaning of Sections 201(2) and 301(a)(3) of ERISA and directors of the Bank, and (2) attract and retain the best available personnel for positions of responsibility with the Bank and its subsidiaries. The Comp Plan is intended to be an unfunded deferred compensation agreement. Participation in the Comp Plan is voluntary.
Source of Benefits: Benefits under the Comp Plan are payable solely by the Bank. To enable the Bank to meet its financial commitment under the Comp Plan, assets may be set aside in a corporate-owned vehicle. These assets are available to all general creditors of the Bank in the event of the Bank’s insolvency. Participants of the Comp Plan are unsecured general creditors of the Bank with respect to the Comp Plan benefits. Deferrals under the Comp Plan may reduce compensation used to calculate benefits under the Bank’s 401(k) Plan.
(c) Bank Owned Life Insurance:
During the second quarter of 2004, the Bank made a $10,000 investment in BOLI. These policies insure the lives of officers of the Bank, and name the Bank as beneficiary. Noninterest income is generated tax-free (subject to certain limitation) from the increase in the policies’ underlying investments made by the insurance company.
(12) Stock Incentive Plans
The Company adopted the 2005 Stock Incentive Plan (“2005 Plan”) following stockholder’s approval at the 2005 Annual Meeting of Stockholders. The Company had 336,493 options outstanding under prior plans as of December 31, 2005. Subsequent to the adoption of the 2005 Plan, no additional grants may be issued under the prior plan.
The 2005 Plan provides grants of up to 666,666 shares, which includes any remaining shares subject to stock awards under the prior plan for future awards, or which have been forfeited, cancelled or expire. Grants from the 2005 Plan may take any of the following forms: incentive stock options, nonqualified stock options, restricted stock, restricted unit, performance shares, performance units, stock appreciation rights or dividend equivalent rights. As of December 31, 2005, the Company had 665,666 shares available for grant.
(a) Stock Options:
Under the terms of the 2005 Plan, the exercise price of each incentive stock option must be greater than or equal to the market price of the Company’s stock on the date of the grant. The plan further provides that no stock option granted to a single grantee may exceed $100 in aggregate fair market value in a single calendar year. Stock options vest over a period of no greater than five years from the date of grant. Additionally, the right to exercise the option terminates ten years from the date of grant.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
The following table summarizes the stock option activity of qualified shares:
Financial data pertaining to outstanding stock option activity of qualified shares:
The following table summarizes stock option activity of the nonqualified shares:
Financial data pertaining to outstanding nonqualified stock options:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
Pro forma information regarding net income and earnings per share, as required by SFAS No. 123, Accounting for Stock-Based Compensation, is included in Note 1(o) of Notes to Consolidated Financial Statements.
(b) Restricted Stock Awards:
During 2005, the Company issued 34,959 (net of forfeited) shares of restricted stock, with an average grant price of $13.65. Restricted stock awards vest over a period of three to five years from date of grant.
(13)
Regulatory Capital Matters
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about risk components, asset risk weighting and other factors.
Risk-based capital guidelines issued by the FDIC establish a risk-adjusted ratio relating capital to different categories of assets and off-balance sheet exposures for banks. The Bank’s Tier 1 capital is comprised primarily of common equity and trust preferred securities, and excludes the equity impact of adjusting available-for-sale securities to fair value. Total capital also includes a portion of the allowance for loan losses, as defined according to regulatory guidelines.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital to risk-weighted assets (as defined in the regulations), and of Tier 1 capital to average assets (as defined in the regulations). As of December 31, 2005, the Bank met the minimum capital requirements to which it is subject and is considered to be “well-capitalized.”
The following tables describe the Company’s and Bank’s regulatory capital and threshold requirements for the 2005 and 2004 periods, respectively:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
In addition, under Washington State banking regulations, the Bank is limited as to the ability to declare or pay dividends to the Company up to the amount of the Bank’s retained earnings then on hand.
(14)
Fair Value of Financial Instruments
Because broadly traded markets do not exist for most of the Company’s financial instruments, the fair value calculations attempt to incorporate the effect of current market conditions at a specific time. Fair valuations are management’s estimates of values. These calculations are subjective in nature, involve uncertainties and matters of significant judgment and do not include tax ramifications, therefore, the results cannot be determined with precision, substantiated by comparison to independent markets and may not be realized in an actual sale or immediate settlement of the instruments. There may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, which could significantly affect the results. For all of these reasons, the aggregation of the fair value calculations presented herein do not represent, and should not be construed to represent, the underlying value of the Company.
When possible, quoted market prices are used to determine fair value. In cases where a quoted market price is not available, the fair value of financial instruments is estimated using the present value of future cash flows or other valuation methods.
(a) Cash and Cash Equivalents:
The carrying value of cash and cash equivalent instruments approximates fair value.
(b) Interest-earning Deposits:
The carrying values of interest-earning deposits maturing within ninety days approximate their fair values. Fair values of other interest-earning deposits are estimated using discounted cash flow analyses based on current rates for similar types of deposits.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
(c) Federal Funds Sold:
The carrying value of federal funds sold approximates fair value.
(d) Securities:
The fair value of all investment securities, excluding FHLB stock, is based upon quoted market prices. FHLB stock is not publicly traded, however, it may be redeemed on a dollar-for-dollar basis for any amount the Bank is not required to hold. The fair value is therefore equal to the carrying value.
(e) Loans:
The loan portfolio is composed of commercial, consumer, real estate construction and real estate loans. The carrying value of variable rate loans approximates their fair value. The fair value of fixed rate loans is estimated by discounting the estimated future cash flows of loans, sorted by type and security, by the weighted average rate of such loans and rising rates currently offered by the Bank for similar loans.
(f) Deposits:
For deposits with no contractual maturity such as checking accounts, money market accounts and savings accounts, fair values approximate book values. The fair value of certificates of deposit are based on discounted cash flows using the difference between the actual deposit rate and an alternative cost of funds rate, currently offered by the Bank for similar types of deposits.
(g) Trust Preferred Securities/ Junior Subordinated Debentures:
The fair value of trust preferred securities is estimated at their recorded value due to the cost of the instrument re-pricing on a quarterly basis.
(h) Other Borrowed Funds:
Other borrowed funds consist of FHLB advances. The carrying amount of FHLB advances is estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates of similar types of borrowing arrangements.
(i) Off-Balance Sheet Items:
Commitments to extend credit represent the principal category of off-balance sheet financial instruments (see Note 16). The fair value of these commitments is not material since they are for relatively short periods of time and are subject to customary credit terms, which would not include terms that would expose the Company to significant gains or losses.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
The table below presents the carrying value amount of the Company’s financial instruments and their corresponding fair values:
(15) Washington Banking Company Information
The summarized condensed financial statements for Washington Banking Company (parent company only) are presented in the following table:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
(16) Commitments
(a)
Leasing Arrangements:
The Company is obligated under a number of noncancelable operating leases for land and buildings. The majority of these leases have renewal options. In addition, some of the leases contain escalation clauses tied to the consumer price index with caps.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
The Company’s future minimum rental payments required under land, buildings and equipment operating leases that have initial or remaining noncancelable lease terms of one year or more are as follows:
Rent expense applicable to operating leases for the years ended December 31, 2005, 2004 and 2003 was $345, $336 and $357, respectively.
(b) Commitments to Extend Credit:
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral held varies, but may include: property, plant and equipment; accounts receivable; inventory; and income-producing commercial properties.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Except for certain long-term guarantees, the majority of guarantees expire in one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounts to one hundred percent of the commitment amount at December 31, 2005.
The Bank has not been required to perform on any financial guarantees and did not incur any losses on its commitments in 2005 and 2004.
Commitments to extend credit were as follows:
(17)
Mortgage Loan Commitments and Loans Held for Sale
The Company was exposed to market risk on outstanding mortgage loan commitments and unsold residential mortgage loans held-for-sale during the first six months of 2004. As part of its risk management processes, the Company executed a program to limit portions of this risk through the use of derivative financial instruments, principally forward sales of mortgage-backed securities, and mandatory delivery contracts. The Company held open forward contracts to deliver Fannie Mae and Ginnie Mae mortgage-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
backed securities at a future date which, in conjunction with uncommitted mortgage loans held-for-sale, eliminated a portion of the market risk for a specified price. Pursuant to the requirements of SFAS No. 133, the estimated value of these derivative contracts were recognized in the accompanying financial statements at their estimated fair value. The Company did not use hedge accounting for this program because the estimated benefits from applying hedge accounting were not significant. Since the discontinuation of the Group in the second quarter of 2004, the Company has not used derivative financial instruments as a hedge against market risk on outstanding mortgage loan commitments nor unsold residential mortgage loans held-for-sale.
The following table summarizes the Company’s open positions and related gains and losses at December 31, 2003:
(18)
Related Party Transactions
As of December 31, 2005 and 2004, the Bank had loans to persons serving as directors and executive officers, and to entities related to such individuals aggregating $6,141 and $7,213, respectively. All loans were made on essentially the same terms and conditions as comparable transactions with other persons, and do not involve more than the normal risk of collectibility. During the year ended December 31, 2005, total principal additions were $11,902 and total principal payments were $12,716.
Deposits from related parties held by the Bank at December 31, 2005 and 2004 totaled $5,635 and $5,086, respectively.
(19)
Contingencies
The Company and its subsidiaries are from time to time defendants in and are threatened with various legal proceedings arising from regular business activities. Management believes the ultimate liability, if any, arising from such claims or contingencies will not have a material adverse effect on the Company’s results of operations or financial condition.
(20)
Subsequent Events
On January 26, 2006, the Board of Directors declared a cash dividend of $0.0625 per share to shareholders of record as of February 13, 2006, payable on February 28, 2006.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
(21)
Selected Quarterly Financial Data (Unaudited)
Results of operations on a quarterly basis were as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
(1)
Per share information adjusted to reflect a 4-for-3 stock split distributed by the Company May 17, 2005.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
Item 9A.
Item 9A.
Controls and Procedures
As of the end of the fiscal period covered by this report, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures. The principal executive and financial officers supervised and participated in this evaluation. Based on this evaluation, the principal executive and financial officers each concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information required to be included in the periodic reports to the SEC. The design of any system of controls is based in part upon various assumptions about the likelihood of future events, and there can be no assurance that any of the Company’s plans, products, services or procedures will succeed in achieving their intended goals under future conditions. In addition, there have been no significant changes in the internal controls or in other factors known to management that could significantly affect the internal controls subsequent to the most recent evaluation. Management found no facts that would require the Company to take any corrective actions with regard to significant deficiencies or material weaknesses.
Management’s Report on Internal Control Over Financial Reporting
See “Management’s Report on Internal Control Over Financial Reporting” set forth on page 29 in Item 8 - Financial Statements and Supplementary Data, immediately preceding the financial statement audit report of Moss Adams LLP.
Item 9B.
Item 9B. Other Information
None
PART III
Item 10.
Item 10.
Directors and Executive Officers of the Registrant
Information concerning directors of the Company is incorporated herein by reference to the section entitled “Election of Directors” beginning at page 4 of the Company’s definitive Proxy Statement dated March 24, 2006 (the “Proxy Statement”) for the annual meeting of shareholders to be held April 27, 2006.
The required information with respect to the executive officers of the Company is included under the caption “Executive Officers of the Company” in Part I of this report. Part I of this report is incorporated herein by reference.
The required information with respect to compliance with Section 16(a) of the Exchange Act is incorporated herein by reference to the section entitled “Beneficial Ownership and Section 16(a) Reporting Compliance,” beginning at page 17 of the Proxy Statement.
Item 11.
Item 11.
Executive Compensation
For information concerning executive compensation see “Executive Compensation” beginning at page 10 of the Proxy Statement, which is incorporated herein by reference. The Report of the Compensation Committee on Executive Compensation which is contained in the Proxy Statement is not incorporated by this reference.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
For information concerning security ownership of certain beneficial owners and management see “Security Ownership of Certain Beneficial Owners and Management” beginning at page 3 of the Proxy Statement, which is incorporated herein by reference.
Item 13.
Item 13.
Certain Relationships and Related Transactions
For information concerning certain relationships and related transactions, see “Interest of Management in Certain Transactions” beginning at page 18 of the Proxy Statement, which is incorporated herein by reference.
Item 14.
Item 14.
Principal Accounting Fees and Services
For information concerning principal accounting fees and services, see “Relationship with Independent Public Accountants” beginning at page 18 of the Proxy Statement, which is incorporated herein by reference.
PART IV
Item 15.
Item 15.
Exhibits, Financial Statement Schedules
(a) (1) Financial Statements: The financial statements and related documents listed in the index set forth in Item 8 of this report are filed as part of this report.
(2) Financial Statement Schedules: All other schedules to the consolidated financial statements are omitted because they are no applicable or not material or because the information is included in the consolidated financial statements or related notes in Item 8 of this report.
(3) Exhibits: The exhibits filed as part of this report and exhibits incorporated herein by reference to other documents are listed in the Index of Exhibits to this annual report on page 65.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 13th of March, 2006.
WASHINGTON BANKING COMPANY
(Registrant)
By
/s/ Michal D. Cann
Michal D. Cann
President and
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities indicated, on the 13th of March, 2006.
Principal Executive Officer:
By
/s/ Michal D. Cann
Michal D. Cann
President and
Chief Executive Officer
Principal Financial and
Accounting Officer:
By
/s/ Richard A. Shields
Richard A. Shields
Senior Vice President and
Chief Financial Officer
Michal D. Cann, pursuant to a power of attorney which is being filed with this Annual Report on Form 10-K, has signed this report on March 13, 2006, as attorney-in-fact for the following directors who constitute a majority of the board of directors.
Jerry C. Chambers
Jay T. Lien
Robert B. Olson
Anthony B. Pickering
Edward J. Wallgren
By /s/ Michal D. Cann
Michal D. Cann
Attorney-in-fact
March 13, 2006
INDEX TO EXHIBITS
(1)
Incorporated by reference to the Form SB-2 (Registration No. 333-49925) previously filed by the Company, declared effective on June 22, 1998.
(2)
Incorporated by reference to the definitive proxy statement dated August 19, 1998 for the Annual Meeting of Shareholders held September 24, 1998.
(3)
Incorporated by reference to the Form 8-K dated April 30, 1999, previously filed by the Company.
(4)
Incorporated by reference to Forms 8-K dated May 12, 2005 and September 30, 2005, previously filed by the Company.
(5)
Incorporated by reference to Form S-8 dated November 10, 2005, previously filed by the Company.
(6)
Incorporated by reference to Form 8-K dated July 14, 2005, previously filed by the Company.