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FORM 10-KSB
U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
ANNUAL REPORT UNDER SECTION 13 or 15(d) of the
SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year ended December 31, 1998
HERITAGE FINANCIAL SERVICES, INC.
(Exact Name of Registrant as Specified in Its Charter)
Tennessee 62-1484807
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
25 Jefferson Street, Clarksville, Tennessee 37040
(Address of Principal Executive Office) (Zip Code)
(615) 553-0500
(Issuer's telephone number including area code)
Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, $2.00 par value per share
Check whether the issuer: (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past
12 months (or for such shorter period that the registrant was required to
file such reports), and (2) has been subject to such filing requirements
for the past 90 days.
Yes X NO
----- -----
Check if there is no disclosure of delinquent filers pursuant to Item 405
of Regulation S-B contained in this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form
10-KSB or any amendment to this Form 10-KSB X
-----
State issuer's revenues for its most recent fiscal year:
$20,764,993
As of December 31, 1998, 579,645 shares of the registrant's Common Stock
were outstanding with an aggregate market value of $35,342,185, using the
average sale price over the last 60 days.
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Table of Contents
Item No.
Cautionary Statement Regarding Forward-Looking Information
PART I
1. Description of Business
2. Description of Property
3. Legal Proceedings
4. Submission of Matters to a Vote of Security Holders
PART II
5. Market for the Registrant's Common Equity and Related Shareholder Matters
6. Management's Discussion and Analysis of Financial Condition and Results of
Operations
7. Financial Statements
8. Changes In and Disagreements with Accountants on Accounting and Financial
Disclosure
PART III
9. Directors and Executive Officers of the Registrant
10. Executive Compensation
11. Security Ownership of Certain Beneficial Owners and Management
12. Certain Relationships and Related Transactions
PART IV
13. Exhibits and Reports on Form 8-K
Signatures
Proxy
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CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING INFORMATION
This Form 10-KSB contains or incorporates by reference certain forward-looking
statements within the meaning of Section 27A of the Securities Act and Section
21E of the Exchange Act which are intended to be covered by the safe harbors
created thereby. Those statements include, but may not be limited to, the
discussions of the Company's expectations concerning its future profitability,
its operating and growth strategies, including strategic acquisitions, both
pending and potential, and its assumptions regarding certain matters. Also, when
any of the words "believes," "expects," "anticipates," "intends," "estimates,"
"plans," or similar terms or expressions are used herein, forward-looking
statements are being made. Readers are cautioned that all forward-looking
statements involve risks and uncertainties, which could cause the future results
and shareholder values to differ materially from those expressed in the
forward-looking statements. Although the Company believes that the assumptions
underlying the forward-looking statements contained herein are reasonable, any
of the assumptions could be inaccurate and, therefore, there can be no assurance
that the forward-looking statements included or incorporated by reference herein
will prove to be accurate. In light of the significant uncertainties inherent
in the forward-looking statements included or incorporated by reference herein,
the inclusion of such information should not be regarded as a representation by
the Company or any other person that the objectives and plans of the Company
will be achieved. In addition, the Company does not intend to, and is not
obligated to, update these forward looking statements even if new information,
future events or other circumstances have made them incorrect or misleading as
of any future date
PART I
ITEM 1. DESCRIPTION OF BUSINESS
GENERAL
Heritage Financial Services, Inc. (the "Company" or "HFSI") is a registered bank
holding company which was incorporated under Tennessee law in 1992. The
Company's activities are primarily conducted through its wholly-owned
subsidiary, Heritage Bank (the "Bank") which began business in 1989 and was
acquired by the Company in 1992. The Bank is a Tennessee state bank, which was
organized in 1989 after three locally-owned banks headquartered in Montgomery
County were acquired. From the time of its opening in June 1989, until December
31, 1998, the Bank has grown to total assets exceeding $208 million.
The Bank's primary trade area is comprised of Montgomery County, Tennessee, and
the surrounding counties in Tennessee and Kentucky. The Bank considers its
primary market for loans and deposits to be individuals, small-to-medium size
businesses, and professionals within the Bank's primary trade area. A wide range
of competitive retail and commercial banking services are offered, including
checking, savings and time deposit accounts; rental of safe deposit boxes;
secured and
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unsecured loans to corporations, individuals and others; letters of
credit; leasing; and accounts receivable billing services. Traditional consumer
finance loans; property ownership; reinsurance of credit life, accidental and
health insurance; and brokerage services are also offered through subsidiaries
of the Bank. Interest on real estate, commercial and consumer loans constitutes
the largest contribution to the operating revenues of the Company.
The Bank actively solicits business in its primary market and considers the
potential growth opportunities to be favorable. However, on January 22, 1999,
the City of Clarksville sustained substantial property damage as the result of a
tornado which left much of the historic central business district in ruins. A
preliminary estimate by local authorities places the damage to real and personal
property at $72.65 million. A total of 515 properties were damaged including 320
dwellings, 150 commercial/industrial facilities and 45 government-owned
buildings. While management cannot predict the impact on the financial community
as a whole, it does not appear that any of the Bank's customers sustained
material uninsured property losses.
COMPETITION
The Bank encounters strong competition in making loans, acquiring deposits and
offering other services. Competition among financial institutions is based upon
interest rates offered on deposit accounts, interest rates charged on loans,
other credit and service charges relating to loans, the quality and scope of the
services rendered, the convenience of banking facilities and, in the case of
loans to commercial borrowers, relative lending limits. The Bank competes with
other commercial banks, savings and loan associations, credit unions, finance
companies, mutual funds, insurance companies, brokerage and investment banking
companies, and other financial intermediaries. Many of these competitors, some
of which are affiliated with large bank holding companies, have substantially
greater resources and lending limits, and may offer certain services that the
Bank does not currently provide. In addition, many of the Bank's non-bank
competitors are not subject to the same extensive federal regulations that
govern bank holding companies and federally insured banks.
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the
"IBBEA") authorized bank holding companies to acquire banks and other bank
holding companies without geographic limitations beginning September 30, 1995.
The arrival of interstate banking is expected to increase further the
competitiveness of the banking industry.
In addition, beginning on June 1, 1997, the IBBEA authorized interstate mergers
and consolidations of existing banks, provided that neither bank's home state
had opted out of interstate branching by May 31, 1997. Tennessee did not opt out
of interstate branching. Interstate branching provides that once a bank has
established branches in a state through an interstate merger, the bank may
establish and acquire additional branches at any location in the state where any
bank involved in the interstate merger could have established or acquired
branches under applicable federal or state law.
The continued deregulation of the financial services industry may have a
detrimental effect on the Company's long-term growth and profitability.
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LENDING ACTIVITIES
Heritage Bank and its consumer finance subsidiary offers a wide range of lending
services, including real estate, consumer and commercial loans, to individuals
and small businesses and other organizations that are located in or conduct a
substantial portion of their business in the Bank's primary market. Total loans,
net of unearned interest, at December 31, 1998, amounted to $167.5 million, or
88% of total earning assets. The interest rates charged on loans vary with the
degree of risk, maturity and amount of the loan and are further subject to
competitive pressures, market interest rates, availability of funds and
government regulations.
REAL ESTATE LOANS. Loans secured by real estate are the primary component of the
Bank's loan portfolio, constituting $120.4 million, or 72% of total loans, net
of unearned interest, at December 31, 1998. Real estate loans consist of
commercial - $60 million, 1-4 family residential - $44.7 million, and
construction - $12.4 million at December 31, 1998. The majority of the Bank's
real estate loans are at variable interest rates, which approximate current
market interest rates. Origination fees are normally charged for all loans
secured by real estate.
Included in real estate loans are 1-4 family residential loans originated for
sale in the secondary market. Such loans are made in accordance with
underwriting standards set by the purchaser of the loan, normally as to
loan-to-value ratio, interest rate and documentation. The Bank generally
collects from the borrower or purchaser a combination of the origination fee,
discount points and/or service release fee. During 1998, the Bank sold $44.2
million of 1-4 family residential loans to such purchasers.
CONSUMER LOANS. Consumer lending includes installment lending to individuals in
the Bank's primary market area and consists of loans to purchase automobiles,
appliances and other consumer durables, as well as, unsecured loans. Consumer
loans constituted $20.5 million, or 12% of total loans, net of unearned
interest, at December 31, 1998. This amount includes $5.2 million of sub-prime
loans originated through the Bank's consumer finance subsidiary and through the
acquisition of loans from another local finance company in the fourth quarter of
1998. Consumer loans are underwritten based on the borrower's income, current
debt level, past credit history and collateral. Consumer rates are both variable
and fixed. Terms generally range from four to five years on automobile loans and
one to five years on loans for other consumer durable goods, depending on the
nature and condition of the collateral. Periodic amortization, generally
monthly, is required.
COMMERCIAL, FINANCIAL AND AGRICULTURAL LOANS. The Bank makes loans for
commercial purposes in various lines of business. The loans are generally
secured by accounts receivable, inventory or, in the case of equipment loans,
the financed equipment. The loans are both variable and fixed, and the terms
generally do not extend beyond five years. Commercial, financial and
agricultural loans
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constituted $26.6 million, or 16% of total loans at December 31, 1998. Interest
rates are negotiable based upon the borrower's financial condition, credit
history, management stability and collateral.
LOAN APPROVAL. Certain risks are inherent in making loans. These include
prepayment risks, risks resulting from uncertainties in the future value of
collateral, risks resulting from changes in economic and industry conditions and
risks inherent in dealing with individual borrowers. The Bank attempts to
minimize loan losses through various means and uses standardized underwriting
criteria. In particular, the Bank generally relies on the cash flow of a debtor
as the source of repayment and secondarily on the value of the underlying
collateral. Additionally, the Bank attempts to utilize shorter term loans in
order to reduce the risk of a decline in the value of the collateral.
The Bank addresses repayment risk by adhering to internal credit policies and
procedures. These policies and procedures include officer and customer lending
limits, a multi-layered loan approval process for larger loans, documentation,
examination and follow-up procedures for any exceptions to credit procedures.
Any credit in excess of $500,000 must have the approval of the executive
committee of the board of directors.
LOAN REVIEW. The Bank maintains a continuous loan review system. Under this
system, each loan officer is directly responsible for monitoring the risk in his
portfolio and is required to inform the loan review officer when credit quality
deteriorates. The loan review officer assigns risk ratings to credits reviewed.
The Bank's risk rating system incorporates the basic regulatory system as set
forth in the applicable regulatory asset quality examination procedures.
The loan review officer reports directly to the executive committee of the board
of directors. The loan review officer is required to annually review 50% of the
commercial loan portfolio. The review includes all relationships in excess of
$400,000. Other review requirements are in place to provide management with
early warning systems for problem credits as well as compliance with stated
lending policies. The loan reviews and adequacy of the allowance for loan losses
is reviewed quarterly by the executive committee.
DEPOSITS
The principal source of funds for the Bank is its base of local area deposits,
consisting of demand deposits, interest checking, savings, money market and
retirement accounts, and certificates of deposit. In addition, due to the
competitive market for local deposits, the Bank supplements its deposit base
with brokered deposits and certificates obtained via a national network. Demand
deposits and interest checking provide the Bank with a source of fee income and
cross-marketing opportunities, as well as, a low-cost source of funding.
Savings, money market and certificates of deposit also provide a relatively
stable and low cost source of funding. The largest source of funds for the Bank
are certificates of deposit.
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Management sets deposit rates weekly. Management believes that the rates offered
are competitive with those offered by other institutions in the Bank's primary
market. The Bank focuses on customer service to attract and retain deposits.
MONETARY POLICIES
The operating results of the Bank and the Company are affected by credit
policies of monetary authorities, particularly the Federal Reserve Board. The
instruments of monetary policy employed by the Federal Reserve Board include
open market operations in U.S. government securities, changes in the discount
rate on bank borrowings, and changes in reserve requirements against bank
deposits.
PERSONNEL
At December 31, 1998, the Company had 103 full-time equivalent employees of
which 27 were Bank officers. None of these employees are a party to a collective
bargaining agreement. The Company considers its relations with its employees to
be good.
Employee benefit programs include group life, disability, dental and health
insurance, a 401(k) pension plan, an employee stock ownership plan (ESOP),
discretionary incentive bonuses, stock option plans, training programs and paid
vacations.
SUPERVISION AND REGULATION
The Company and the Bank are subject to state and federal banking laws and
regulations which impose specific requirements or restrictions and provide for
general regulatory oversight with respect to virtually all aspects of their
operations. These laws and regulations are generally intended to protect
depositors, not shareholders. The following summaries of statutes and
regulations affecting banks and bank holding companies do not purport to be
complete. Such summaries are qualified in their entirety by reference to the
statutes and regulations described.
BANK HOLDING COMPANY ACT OF 1956
The Company is a registered bank holding company under the Bank Holding Company
Act of 1956 (the "BHCA"). Under the BHCA, the Company is subject to periodic
examination by the Federal Reserve and is required to file periodic reports of
its operations and such additional information as the Federal Reserve may
require. The Company's activities are limited to managing or controlling banks,
furnishing services to or performing services for its subsidiaries, and engaging
in other activities that the Federal Reserve determines to be so closely related
to banking or managing or controlling banks as to be a proper incident thereto.
With certain limited exceptions, the BHCA requires every bank holding company to
obtain the prior approval of the Federal Reserve before (i) acquiring
substantially all the assets of any bank, (ii) acquiring direct or indirect
ownership or control of any voting shares of any bank if after such
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acquisition it would own or control more than 5% of the voting shares of such
bank (unless it already owns or controls the majority of such shares), or (iii)
merging or consolidating with another bank holding company.
In addition, and subject to certain exceptions, the BHCA and the Change in Bank
Control Act, together with regulations thereunder, require Federal Reserve
approval (or, depending on the circumstances, no notice of disapproval) prior to
any person or company acquiring "control" of a bank holding company, such as the
Company. Control is conclusively presumed to exist if an individual or company
acquires 25% or more of any class of voting securities of the bank holding
company. Control is rebuttably presumed to exist if a person acquires 10% or
more but less than 25% of any class of voting securities and either the Company
has registered securities under Section 12 of the Exchange Act or no other
person will own a greater percentage of that class of voting securities
immediately after the transaction. The regulations provide a procedure for
challenge of the rebuttable control presumption.
Under the BHCA, a bank holding company is generally prohibited from engaging in,
or acquiring direct or indirect control of more than 5% of the voting shares of
any company engaged in, nonbanking activities, unless the Federal Reserve Board,
by order or regulation, has found those activities to be so closely related to
banking or managing or controlling banks as to be a proper incident thereto.
Some of the activities that the Federal Reserve Board has determined by
regulation to be proper incidents to the business of a bank holding company
include marking or servicing loans and certain types of leases, engaging in
approved insurance and discount brokerage activities, performing qualifying data
processing services, acting in certain circumstances as a fiduciary or
investment or financial adviser, owning savings associations, and making
investments in qualifying corporations or projects designed to promote community
welfare.
The Federal Reserve Board has imposed certain capital requirements on bank
holding companies under the BHCA, including a minimum leverage ratio and a
minimum ratio of "qualifying" capital to risk-weighted assets. These
requirements are described below under "Capital Requirements."
In accordance with Federal Reserve Board policy, the Company is expected to act
as a source of financial strength to the Bank and to commit resources to support
the Bank in circumstances in which the Company might not otherwise do so. Under
the BHCA, the Federal Reserve Board may require a bank holding company to
terminate any activity or relinquish control of a nonbank subsidiary (other than
a nonbank subsidiary of a bank) upon the Federal Reserve Board's determination
that such activity or control constitutes a serious risk to the financial
soundness or stability of any subsidiary depository institution of the bank
holding company. Further, federal bank regulatory authorities have additional
discretion to require a bank holding company to divest itself of any bank or
nonbank subsidiary if the agency determines that divestiture may aid the
depository institution's financial condition.
The Federal Reserve Board has the power to prohibit dividends by bank holding
companies if their actions constitute unsafe or unsound practices. The Federal
Reserve Board has issued a policy
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statement on the payment of cash dividends by bank holding companies, which
expresses the Federal Reserve Board's view that a bank holding company
experiencing earnings weaknesses should not pay cash dividends that exceed its
net income or that could only be funded in ways that weaken the bank holding
company's financial health, such as by borrowing.
In approving acquisitions by bank holding companies of banks and companies
engaged in the banking-related activities described above, the Federal Reserve
considers a number of factors, including the expected benefits to the public
such as greater convenience, increased competition, or gains in efficiency, as
weighed against the risks of possible adverse effects such as undue
concentration of resources, decreased or unfair competition, conflicts of
interest, or unsound banking practices. The Federal Reserve is also empowered to
differentiate between new activities and activities commenced through the
acquisition of a going concern.
The attorney general of the United States may, within 15 days after approval by
the Federal Reserve Board of an acquisition, bring an action challenging such
acquisition under the federal antitrust laws, in which case the effectiveness of
such approval is stayed pending a final ruling by the courts. Failure of the
Attorney General to challenge an acquisition does not, however, exempt the
holding company from complying with both state and federal antitrust laws after
the acquisition is consummated or immunize the acquisition from future challenge
under the anti-monopolization provisions of the Sherman Act.
A bank holding company and its subsidiaries are also prohibited from engaging in
certain tie-in arrangements in connection with the extension of credit or
provision of any property or service. Thus, an affiliate of a bank holding
company may not extend credit, lease, sell property, or furnish any services or
fix or vary the consideration for these on the condition that (i) the customer
must obtain or provide some additional credit, property, or services from or to
its bank holding company or subsidiaries thereof or (ii) the customer may not
obtain some other credit, property, or services from a competitor, except to the
extent reasonable conditions are imposed to assure the soundness of the credit
extended. Proposals to allow some exceptions to these rules recently have been
enacted, and additional regulatory relief on this issue is pending.
TENNESSEE BANKING ACT AND FEDERAL DEPOSIT INSURANCE ACT
The Bank is incorporated under the banking laws of the State of Tennessee and,
as such, is subject to the applicable provisions of those laws. The Bank is
subject to the supervision of the TDFI and to regular examination by that
department. The Bank's deposits are insured by the FDIC through the Bank
Insurance Fund ("BIF"), and they are therefore subject to the provisions of the
Federal Deposit Insurance Act and to examination by the FDIC.
The TDFI and the FDIC (the "Bank Regulatory Authorities") will regulate or
monitor virtually all areas of the Bank's operations, including security devices
and procedures, adequacy of capitalization and loss reserves, loans,
investments, borrowings, deposits, mergers, issuances of securities, payment of
dividends, interest rates payable on deposits, interest rates or fees chargeable
on loans,
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establishment of branches, corporate reorganizations, maintenance of books and
records, and adequacy of staff training to carry on safe lending and deposit
gathering practices. The federal Bank Regulatory Authorities have established
regulatory standards for all insured depository institutions and depository
institution holding companies relating, among other things, to: (i) internal
controls, information systems, and audit systems; (ii) loan documentation; (iii)
credit underwriting; (iv) interest rate risk exposure; and (v) asset quality.
The Bank Regulatory authorities also require the Bank to maintain certain
capital ratios. The Bank is required to prepare periodic reports on their
financial condition and to conduct an annual audit of their financial affairs in
compliance with minimum standards and procedures prescribed by the Bank
Regulatory Authorities. The Bank undergoes regular on-site examinations by each
Bank Regulatory Authority having jurisdiction over it.
DEPOSIT INSURANCE. The FDIC establishes rates for the payment of premiums by
federally insured banks and thrifts for deposit insurance. A separate Bank
Insurance Fund ("BIF") and Savings Association Insurance Fund ("SAIF") are
maintained for commercial banks and thrifts, respectively, with insurance
premiums from the industry used to offset losses from insurance payouts when
banks and thrifts fail. Insured depository institutions like the Bank pay for
deposit insurance under a risk-based premium system. Under the premium system, a
depositor institution pays premiums to BIF or SAIF ranging from $0.00 to $0.27
per $100 of insured deposits depending on its capital levels and risk profile,
as determined by its primary federal regulator on a semi-annual basis. The
assessment rate for the Bank is currently $0.00 per $100 of insured deposits.
Increases in deposit insurance premiums will increase the Bank's cost of funds,
and there can be no assurance that such cost can be passed on to the Bank's
customers.
TRANSACTIONS WITH AFFILIATES AND INSIDERS. The Bank is subject to the provisions
of Section 23A of the Federal Reserve Act, which place limits on the amount of
loans or extensions of credit to, or investments in, or certain other
transactions with, affiliates and on the amount of advances to third parties
collateralized by the securities or obligations of affiliates. The aggregate of
all covered transactions is limited in amount, as to any one affiliate, to 10%
of the bank's capital and surplus and to all affiliates, 20% of the bank's
capital and surplus. Furthermore, within the foregoing limitations as to amount,
each covered transaction must meet specified collateral requirements. Compliance
is also required with certain provisions designed to avoid the taking of low
quality assets.
The Bank is also subject to the provisions of Section 23B of the Federal Reserve
Act which, among other things, prohibit an institution from engaging in certain
transactions with certain affiliates unless the transactions are on terms
substantially the same, or at least as favorable to such institution or its
subsidiaries, as those prevailing at the time for comparable transaction with
nonaffiliated companies. The Bank is subject to certain restrictions on
extensions of credit to executive officers, directors, certain principal
shareholders, and their related interests. Such extensions of credit (i) must be
made on substantially the same terms, including interest rates and collateral,
as those prevailing at the time for comparable transactions with third parties
and (ii) must not involve more than the normal risk of repayment or present
other unfavorable features.
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DIVIDENDS. There are certain limitations under Tennessee law on the payment of
dividends by banks. Under Tennessee law, the directors of a state bank, after
making proper deduction for all expenditures, expenses, taxes, losses, bad
debts, and any write-offs or other deductions required by the TDFI, may credit
net profits to the bank's undivided profits account, and may quarterly,
semi-annually, or annually declare a dividend in such amount as they shall judge
expedient after deducting any net loss from the undivided profits account and
transferring to the bank's surplus account (i) the amount (if any) required to
raise the surplus ("Additional Paid-in-Capital Account") to 50% of the capital
stock and (ii) the amount required (if any), but not less than 10% of net
profits, until the paid-in-surplus account equals the capital stock account,
provided that the bank is adequately reserved against deposits and such reserves
will not be impaired by the declaration of the dividend.
A state bank, with the approval of the TDFI, may transfer funds from its surplus
account to the undivided profits (retained earnings) account or any part of its
paid-in-capital account. The payment of dividends by any bank is dependent upon
its earnings and financial condition and, in addition to the limitations
referred to above, is subject to the statutory power of certain federal and
state regulatory agencies to act to prevent what they deem unsafe or unsound
banking practices. The payment of dividends could, depending upon the financial
condition of the Bank, be deemed to constitute such an unsafe or unsound
practice. Tennessee law prohibits state banks from paying dividends other than
from undivided profits, and when the surplus account is less than the capital
stock account, imposes certain other restrictions on dividends. The FDIA
prohibits a state bank, the deposits of which are insured by the FDIC, from
paying dividends if it is in default in the payment of any assessments due the
FDIC.
INTERSTATE BANKING AND BRANCHING LEGISLATION.
Tennessee law imposes limitations on the ability of a state bank to establish
branches in Tennessee. Under current Tennessee law, any Tennessee bank or
national bank domiciled in Tennessee may establish branch offices at any
location in any county in the state. Furthermore, Tennessee and federal law
permits out-of-state acquisitions by bank holding companies, interstate merging
by banks, and de novo branching by interstate banks, subject to certain
conditions. The Riegle-Neal Interstate Banking and Branching Efficiency Act of
1994 (the "IBBEA") authorizes interstate acquisitions of banks and bank holding
companies without geographic limitation beginning one year after enactment. In
addition, since June 1, 1997, a bank may merge with a bank in another state as
long as neither of the states has opted out of interstate branching between the
date of enactment of the IBBEA and May 31, 1997. Tennessee did not opt out of
interstate branching. The IBBEA further provides that states may enact laws
permitting interstate merger transactions prior to June 1, 1997. Tennessee did
not enact such a law. A bank may establish and operate a de novo branch in a
state in which the bank does not maintain a branch if that state explicitly
permits de novo branching. Once a bank has established branches in a state
through an interstate merger transaction, the bank may establish and acquire
additional branches at any location in the state where any bank involved in the
interstate merger transaction could have established or acquired branches under
applicable federal or state law. A bank that has established a branch in a state
through de novo branching may establish and acquire additional branches in such
state in the same manner and to the same extent as
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a bank having a branch in such state as a result of an interstate merger. If a
state opts out of interstate branching within the specified time period, no bank
in any other state may establish a branch in the opting out of state, whether
through an acquisition or de novo. These powers may result in an increase in the
number of competitors in the Bank's markets. The Company believed the Bank can
compete effectively in the market despite any impact of these branching powers,
but there can be no assurance that future developments will not affect the
Bank's ability to compete effectively.
COMMUNITY REINVESTMENT ACT. The Community Reinvestment Act requires that, in
connection with examinations of financial institutions within their respective
jurisdictions, the federal Bank Regulatory Authorities evaluate the record of
the financial institutions in meeting the credit needs of their local
communities, including low and moderate income neighborhoods, consistent with
the safe and sound operation of those institutions. These factors are also
considered in evaluating mergers, acquisitions and applications to open a branch
or facility.
OTHER REGULATIONS. Interest and certain other charges collected or contracted
for by the Bank are subject to state usury laws and certain federal laws
concerning interest rates. The Bank's loan operations are also subject to
certain state and federal laws applicable to credit transactions, such as the
federal Truth-In-Lending Act, governing disclosures of credit terms to consumer
borrowers; the Home Mortgage Disclosure Act of 1975, requiring financial
institutions to provide information to enable the public and public officials to
determine whether a financial institution will be fulfilling its obligation to
help meet the housing needs of the community it serves; the Equal Credit
Opportunity Act, prohibiting discrimination on the basis of race, creed or other
prohibited factors in extending credit; the Fair Credit Reporting Act of 1978,
governing the use and provision of information to credit reporting agencies; the
Fair Debt Collection Act, governing the manner in which consumer debts may be
collected by collection agencies; and the rules and regulations of the various
federal agencies charged with the responsibility of implementing such federal
laws. The deposit operations of the Bank also are subject to both state and
federal Right to Financial Privacy Acts, which imposes a duty to maintain
confidentiality of consumer financial records and prescribes procedures for
complying with administrative subpoenas of financial records, and the Electronic
Funds Transfer Act and Regulation E issued by the Federal Reserve Board to
implement that act, which governs automatic deposits to and withdrawals from
deposit accounts and customers' rights and liabilities arising from the use of
automated teller machines and other electronic banking services.
ENFORCEMENT POWERS. Federal law makes strong civil and criminal penalties
available for use by the Federal Regulatory Agencies against depository
institutions and certain "institution-affiliated parties" (primarily including
management, employees and agents of a financial institution, independent
contractors such as attorneys and accountants and others who participate in the
conduct of the financial institution's affairs). These practices can include the
failure of an institution to timely file required reports or the filing of false
or misleading information or the submission of inaccurate reports. Civil
penalties may be as high as $1,000,000 a day for such violations. Criminal
penalties for some financial institution crimes have increased to 20 years. In
addition, regulators are provided with considerable flexibility to commence
enforcement actions against institutions and
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institution-affiliated parties. Possible enforcement actions include the
termination of deposit insurance. Furthermore, regulators have broad power to
issue cease and desist orders that may, among other things, require affirmative
action to correct any harm resulting from a violation or practice, including
restitution, reimbursement, indemnifications or guarantees against loss. A
financial institution may also be ordered to restrict its growth, dispose of
certain assets, rescind agreements or contracts, or take other actions as
determined by the ordering agency to be appropriate. The TDFI has similar
enforcement powers.
CAPITAL REQUIREMENTS
The federal regulatory agencies use capital adequacy guidelines in their
examination and regulation of banks. If the capital falls below the minimum
levels established by these guidelines, the Bank may be denied approval to
acquire or establish additional banks or non-bank businesses, or to open
facilities, or the Bank may be subject to other regulatory restrictions or
actions.
RISK-BASED CAPITAL REQUIREMENTS. All of the federal regulatory agencies have
adopted risk-based capital guidelines for banks and bank holding companies. The
risk-based capital guidelines are designed to make regulatory capital
requirements more sensitive to differences in risk profile among banks to
account for off-balance sheet exposure and to minimize disincentives for holding
liquid assets. Assets and off-balance sheet items are assigned to broad risk
categories each with appropriate weights. The resulting capital ratios represent
capital as a percentage of total risk-weighted assets and off-balance sheet
items. The ratios are minimums. The guidelines require all federally regulated
banks to maintain a minimum risk-based total capital ratio of 8%, of which at
least 4% must be Tier 1 capital (see the description of Tier 1 capital and Tier
2 capital below).
A banking organization's qualifying total capital consists of two components:
Tier 1 capital (core capital) and Tier 2 capital (supplementary capital). Tier 1
capital is an amount equal to the sum of (i) common shareholders' equity
(including adjustments for any surplus or deficit); (ii) non-cumulative
perpetual preferred stock; and (iii) the company's minority interests in the
equity accounts of consolidated subsidiaries. Intangible assets generally must
be deducted from Tier 1 capital , subject to limited exceptions for goodwill
arising from certain supervisory acquisitions. Other intangible assets may be
included in an amount up to 25% of Tier 1 capital, provided that the asset meets
each of the following criteria: (i) the asset must be able to be separated and
sold apart from the banking organization or the bulk of its assets; (ii) the
market value of the asset must be established on an annual basis through an
identifiable stream of cash flows and there must be a high degree of certainty
that the asset will hold this market value notwithstanding the future prospects
of the banking organization; and (iii) the banking organization must demonstrate
that a liquid market exists for the asset. Intangible assets in excess of 25% of
Tier 1 capital generally are deducted from a banking organization's regulatory
capital. At least 50% of the banking organization's total regulatory capital
must consist of Tier 1 capital.
Tier 2 is an amount equal to the sum of (i) the allowance for possible credit
losses in an amount up to 1.25% of risk-weighted assets; (ii) cumulative
perpetual preferred stock with an original maturity of
<PAGE> 14
20 years or more and related surplus; (iii) hybrid capital instruments
(instruments with characteristics of both debt and equity), perpetual debt and
mandatory convertible debt securities; and (iv) in an amount up to 50% of Tier 1
capital, eligible term subordinated debt and intermediate-term preferred stock
with an original maturity of five years or more, including related surplus. The
inclusion of the foregoing of Tier 2 capital are subject to certain requirements
and limitations of the banking regulators.
Investments in unconsolidated banking and finance subsidiaries, investments in
securities subsidiaries and reciprocal holdings of capital instruments must be
deducted from capital. The federal banking regulators may require other
deductions on a case-by-case basis.
Under the risk-weighted capital guidelines, balance sheets assets and certain
off-balance sheet items, such as standby letters of credit, are assigned to one
of four risk weight categories (0%, 20%, 50%, or 100%) according to the nature
of the asset and its collateral or the identity of any obligor or guarantor. For
example, cash is assigned to the 0% risk category, while loans secured by
one-to-four family residences are assigned to the 50% risk category. The
aggregate amount of such assets and off-balance sheet items in each risk
category is adjusted by the risk weight assigned to that category to determine
weighted values, which are added together to determine the total risk-weighted
assets for the banking organization. Accordingly, an asset, such as a commercial
loan, which is assigned to a 100% risk category is included in risk-weighted
assets at its nominal face value, whereas a loan secured by a single-family home
mortgage is included at only 50% of its nominal face value. The application
ratios are equal to capital, as determined, divided by risk-weighted assets, as
determined.
LEVERAGE CAPITAL REQUIREMENTS. The banking regulators have issued a final
regulation requiring certain banking organizations to maintain additional
capital of 1% to 2% above a 3% minimum Tier 1 Leverage Capital Ratio (Tier 1
capital, less intangible assets, to total assets). In order for an institution
to operate at or near the minimum Tier 1 leverage capital requirement of 3%, the
banking regulators expect that such institution would have well-diversified
risk, no undue rate risk exposure, excellent asset quality, high liquidity and
good earnings. In general, the bank would have to be considered a strong banking
organization, rated in the highest category under the bank rating system and
have no significant plans for expansion. Higher Tier 1 leverage capital ratios
of up to 5% will generally be required if all of the above characteristics are
not exhibited, or if the institution is undertaking expansion, seeking to engage
in new activities, or otherwise faces unusual or abnormal risks.
The rule provides that institutions not in compliance with the regulation are
expected to be operating in compliance with a capital plan or agreement with the
regulator. If they do not do so, they are deemed to be engaging in an unsafe and
unsound practice and may be subject to enforcement action. Failure to maintain
capital of at least 2% of assets constitutes an unsafe and unsound practice and
may be subject to enforcement action. Failure to maintain capital of at least 2%
of assets constitutes an unsafe and unsound condition justifying termination of
FDIC insurance.
<PAGE> 15
EFFECT OF GOVERNMENTAL POLICIES
The Bank's earnings will be affected by the difference between the interest
earned by the Bank on its loans and investments and the interest paid by the
Bank on its deposits or other borrowings. The yields on its assets and the rates
paid on its liabilities are sensitive to changes in prevailing market rates of
interest. Thus, the earnings and growth of the Bank will be influenced by
general economic conditions, fiscal policies of the federal government, and the
policies of regulatory agencies, particularly the Federal Reserve, which
establishes national monetary policy. The nature and impact of any future
changes in fiscal or monetary policies cannot be predicted.
Commercial banks are affected by the credit policy of various regulatory
authorities, including the Federal Reserve. An important function of the Federal
Reserve is to regulate the national supply of bank credit. Among the instruments
of monetary policy used by the Federal Reserve to implement these objections are
open market operations in U.S. Government securities, changes in reserve
requirements on bank deposits, changes in the discount rate on bank borrowings,
and limitations on interest rates that banks may pay on time deposits. The
Federal Reserve uses these means in varying combinations to influence overall
growth of bank loans, investments and deposits, and also to affect interest
rates charged on loans, received on investments or paid for deposits.
The monetary and fiscal policies of regulatory authorities, including the
Federal Reserve, also affect the banking industry. Through changes in the
reserve requirements against bank deposits, open market operations in U.S.
Government securities and changes in the discount rate on bank borrowings, the
Federal Reserve influences the cost and availability of funds obtained for
lending and investing. No prediction can be made with respect to possible future
changes in interest rates, deposit levels or loan demand or with respect to the
impact of such changes on the business and earnings of the Bank.
From time to time, various federal and state laws, rules and regulations, and
amendments to existing laws, rules and regulations, are enacted that affect
banks and bank holding companies. Future legislation and regulation could
significantly change the competitive environment for banks and bank holding
companies. The Company cannot predict the likelihood or effect of any such
legislation or regulation.
YEAR 2000 COMPLIANCE
Financial institutions are highly dependent on complex computer systems and
networks to conduct their business. Financial institutions are also adversely
affected by developments that adversely affect the businesses or operations of
their customers. For these reasons, the potential inability of computers to
recognize the Year 2000 presents a major challenge to the Company and the Bank.
In recognition of the potential effect of the Year 2000 problem, the Federal
Reserve Board and Bank Regulatory Authorities have issued numerous directives to
bank holding companies and financial institutions requiring comprehensive
investigation and remediation of possible Year 2000 problems. These directives
address the computer systems used by the banks and those used by customers and
<PAGE> 16
vendors. Management believes that the Company and the Bank are currently in
compliance with each applicable directive issued by the Bank Regulatory
Authorities, and the Company does not believe that the costs it will incur to
ensure the Year 2000 compliance of its computer systems will be significant.
ITEM 2. DESCRIPTION OF PROPERTY
The Bank's new main banking office was substantially completed and occupied
during the fourth quarter of 1998. This facility also serves as the principal
office of the Company. The new 40,000 square foot facility is located at 25
Jefferson Street in the central business district of Clarksville. Total building
costs for the new main office project will approximate $9 million. The temporary
facility utilized prior to completion of the new main banking office was razed
in the fourth quarter of 1998.
The Bank and its subsidiaries currently operate five full service banking
offices, three consumer finance offices, and a full service investment brokerage
office. The Bank owns all of the banking offices at which it conducts business
except the Hilldale branch located on Madison Street in Clarksville. The three
consumer finance offices and the investment brokerage office are leased.
Automated teller machines (ATMs) are located at each of the full service banking
offices. In addition, ATM machines are located in thirteen convenience markets
in Montgomery and surrounding counties.
Note 7 to the Company's consolidated financial statements contains additional
information relating to lease commitments and amounts invested in premises and
equipment.
ITEM 3. LEGAL PROCEEDINGS
The Company, in the normal course of business, is subject to various pending and
threatened litigation. Based upon consultation with legal counsel, management
does not anticipate that the ultimate liability, if any, resulting from such
litigation will have a material effect on the Company's financial condition and
results of operations.
There are no material legal proceedings to which any director, any nominee for
election as a director, principal officer of the Bank or Company, or any
associate of the foregoing, or any owner of record or beneficial owner of more
than 5% of any class of voting securities of the Company is a party adverse to
the Company, or the Bank, or has a material adverse impact to the Company or the
Bank.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the last quarter
of the period covered by this report.
<PAGE> 17
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The common stock of Heritage Financial Services, Inc. is not traded through an
organized exchange nor is there a known active trading market. The following
table indicates the quarterly range of high and low sale prices and the
dividends declared during each calendar quarter of 1998 and 1997. The prices
indicated represent known transactions and may not necessarily represent all
trading transactions for the periods.
<TABLE>
<CAPTION>
Year Ended December 31, 1998 Year Ended December 31, 1997
---------------------------- ----------------------------
Dividend Dividend
High Low Declared High Low Declared
---- --- -------- ---- --- --------
<S> <C> <C> <C> <C> <C> <C>
First Quarter 75.00 75.00 - 42.00 32.00 -
Second Quarter 95.00 65.00 - 49.00 44.00 -
Third Quarter 100.00 85.00 - 49.00 44.00 -
Fourth Quarter 95.00 82.00 1.35 75.00 62.00 1.20
</TABLE>
As of December 31, 1998, there were 924 shareholders of record of Heritage
Financial Services, Inc.
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
GENERAL
The purpose of this discussion and analysis is to provide readers with
information relevant to understanding and assessing the financial condition and
results of operations of Heritage Financial Services, Inc. (Heritage Financial
or Company). Heritage Financial's business activity is currently limited to
holding the stock of its wholly-owned subsidiary, Heritage Bank (Bank).
Accordingly, the discussion that follows relates primarily to the financial
condition and results of operation of Heritage Bank and its subsidiaries. This
discussion should be read in conjunction with the consolidated financial
statements and accompanying notes.
PROSPECTIVE INFORMATION. Certain of the information included in this discussion
and analysis includes forward-looking statements. Many factors affect the
Company's financial position and profitability, including fluctuations in local,
national and global economies (e.g., inflation or deflation, employment levels,
availability of resources, production and sales levels, foreign competition,
etc.), the volatility of interest rates, political events, regulatory actions,
changes in technology, competition from other providers of financial services,
and the continued growth of the market in which the Company operates. Because
these factors are unpredictable and beyond the Company's control, actual results
may vary materially from those anticipated.
<PAGE> 18
NATURE OF BUSINESS. Heritage Bank is a locally-owned, independent bank with its
primary market in Montgomery County, Tennessee and the surrounding counties of
Tennessee and Kentucky. The Bank provides general commercial banking services
(including mortgage banking, accounts receivable financing and commercial
leasing) through five banking offices. Heritage Bank also has four non-bank
affiliates which provide financial services incidental to the Bank's operations,
including brokerage services, property ownership, consumer finance loan
origination, and reinsurance of credit life, accident and health insurance
contracts.
RESULTS OF OPERATIONS. The Company's consolidated results of operations are
dependent primarily on net interest income, which is the difference between the
interest income earned on interest-earning assets, such as loans and securities,
and the interest expense incurred on interest-bearing liabilities, such as
deposits and other borrowings. The Company also generates noninterest income,
including service charges on deposit accounts and fees from mortgage banking
activities, insurance sales and brokerage services. The Company's noninterest
expenses consist primarily of employee compensation and benefits and other
general and administrative expenses.
SUBSEQUENT EVENT. On January 22, 1999, the City of Clarksville sustained
substantial property damage as the result of a tornado which left much of the
historic central business district in ruins. A preliminary estimate by local
authorities places the damage to real and personal property at $72.65 million.
The estimated loss amount does not include the cost of business interruption,
the public/private cost of debris removal from right of ways, or the value of
vehicles or trees lost or damaged during the storm. A total of 515 properties
were damaged including 320 dwellings, 150 commercial/industrial facilities and
45 government-owned buildings. Of those properties, 306 received minor damage,
82 moderate damage, 22 major damage and 105 were completely destroyed. While
management cannot predict the impact of the tornado on the community as a whole,
it does not appear that any of the Bank's customers sustained material uninsured
property losses.
FINANCIAL CONDITION
OVERVIEW. The Bank experienced steady loan growth during 1998, which was
primarily funded by certificates of deposit. At December 31, 1998, the Company
reported total assets of $208.2 million compared with $166.1 million at the end
of 1997. Average total assets were $186.6 million in 1998 compared with $148.2
million in 1997.
EARNING ASSETS. Average earning assets of the Company for 1998 increased 25%, or
$34.2 million, to $173.1 million from $138.9 million for 1997. This compares to
growth of average earning assets of 23% and 18% for 1997 and 1996, respectively.
The Company's ratio of average earning assets to average total assets declined
to 92.8% for 1998, compared to 93.7% and 94.3% for 1997 and 1996, respectively.
The 1998 decline is due to the $4.2 million increase in average nonearning
assets, primarily resulting from costs associated with the construction of the
new main office facility. Approximately $1.0 million in additional construction
costs will be required during 1999.
Economic growth in the local market has enabled the Bank to achieve continued
loan growth (the primary earning asset). Average loans for 1998 increased 26%,
or $31.6 million, to $151.9 million,
<PAGE> 19
while average loan growth for 1997 and 1996 was 29% each year. The changing mix
of earning assets was favorable during the last three years as average loans
were an increasing percentage of average earning assets. Average loans for 1998
were 88% of average earning assets, compared to 87% and 83% during 1997 and
1996, respectively. Strong loan demand and fewer purchases of investment
securities have led to the improved earning asset composition.
Commercial real estate loans continued as the single largest loan category,
representing 33% and 27% of average loans for 1998 and 1997, respectively.
Average commercial real estate loans grew $17.6 million (54%) in 1998 and $9.7
million (42%) in 1997. The growth in commercial real estate loans reflects the
continued light industrial and retail growth in the Bank's lending area. Average
real estate construction loans amounted to 9% and 14% of average loans for 1998
and 1997, respectively. Average real estate construction loans decreased $2.6
million (16%) in 1998 following a 22% increase in 1997, primarily because of
slower residential housing sales and fewer speculative housing starts.
The consumer loan portfolio primarily consists of installment loans to finance
the purchase of automobiles and household goods, and for other consumer
purposes, requiring periodic payments of principal and interest. Average
consumer loans represented 11% of average loans for both 1998 and 1997. Average
consumer loans increased $3.8 million (28%) in 1998 and $1.8 million (15%) in
1997. Continued growth of the Bank's consumer finance subsidiary (which was
formed in June, 1997) plus the acquisition of certain assets of a locally-owned
finance company substantially accounted for the increase in consumer loans
during 1998.
Portfolio residential loans (1-4 family, excluding mortgage loans held for sale)
amounted to 29% of average loans for both 1998 and 1997. Average portfolio
residential loans increased 25% in 1998 and 28% in 1997. The 1998 increase was
primarily attributable to a $6.1 million increase in commercial purpose loans
secured by 1-4 family mortgages, while the 1997 increase was a combination of
increases in 1-4 family consumer mortgages ($3.1 million) and commercial purpose
loans secured by 1-4 family mortgages ($4.6 million).
The Bank maintains a securities portfolio of principally debt securities held
for sale as a source of income and liquidity, to balance interest rate risk with
other categories of the balance sheet, and to supply securities to pledge as
required collateral for certain deposits. The level of average securities to
average earnings assets declined during 1997 and 1998 as a portion of the
proceeds from the sale, call and maturity of securities and the principal
collected on mortgage-backed securities was used to fund loan growth. The
average balance of securities increased $2.4 million in 1998 compared to
decreases of $0.5 million and $3.4 million in 1997 and 1996, respectively.
Average securities for 1998 were 12% of average total earning assets, as
compared to 13% and 17% during 1997 and 1996, respectively. Net securities gains
totaling $25,000 for 1998 resulted primarily from calls of securities prompted
by declines in market interest rates.
At December 31, 1998, the securities portfolio consisted of: U.S. agency
obligations - 22%, mortgage- and asset-backed securities - 47%, tax-exempt
securities - 27%, and equity securities
<PAGE> 20
(primarily FHLB stock) - 4%. U.S. agency obligations include $1 million of
structured notes (as currently defined by regulatory agencies). Mortgage-backed
securities consist of collateralized mortgage obligations ("CMOs") and pass
through mortgage-backed securities that are U.S. agency backed or backed by U.S.
agency-pooled collateral. Asset-backed securities are AAA rated securities
collateralized by student loans which are 98% insured by either government or
private insurance. Tax-exempt securities are principally general obligation
bonds rated "investment grade" by Moody's or Standard & Poor's.
FUNDING SOURCES. The Bank's primary funding source is its base of local area
deposits which consist of noninterest-bearing demand, interest checking,
savings, money market and retirement accounts, and certificates of deposit. The
Bank had total deposits of $176.6 million as of December 31, 1998, compared to
$134.4 million as of December 31, 1997. Average 1998 deposits increased 23%, or
$29.5 million to $155.6 million from $126.1 million in 1997. Average deposit
growth for 1997 and 1996 was $20.4 million (19%) and $14.3 million (16%),
respectively.
Certificates of deposit (generally the Bank's highest rate-paying deposit)
accounted for most of the deposit growth in 1998 and 1997. To fund loan growth,
management offered attractive rates for certificates of deposit. Average 1998
certificates of deposits increased 31%, or $21.3 million to $90.0 million from
$68.7 million in 1997. Average certificates of deposit growth for 1997 and 1996
was $15.1 million (28%) and $10.6 million (25%), respectively. Local deposits
accounted for 83% and 93% of average interest-bearing liabilities in 1998 and
1997, respectively.
Due to the competitive local market for deposits, the Bank supplements its
deposit base with alternative funding sources including Federal funds purchased,
borrowings from the Federal Home Loan Bank (FHLB), brokered certificates of
deposit, and certificates of deposit obtained via a national network. The
average balance of these alternative funding sources amounted to $24.8 million
and $8.2 million in 1998 and 1997, respectively. Alternative funding sources
totaled 17% of average interest-bearing liabilities in 1998 and 7% in 1997.
Management expects an increasing need to rely on alternative funding sources to
fund future loan growth. Additional use of FHLB borrowings and Federal funds
purchased, as well as brokered and nonlocal certificates of deposits may be
necessary to meet the challenge of obtaining acceptable funding sources without
incurring an undesirable amount of interest rate risk.
NONPERFORMING ASSETS, PAST DUE LOANS, POTENTIAL PROBLEM ASSETS, AND THE
ALLOWANCE FOR LOAN LOSSES. Nonperforming assets consist of (1) nonaccrual loans
where the recognition of interest income was discontinued, (2) loans which have
been restructured to provide for a reduction or deferral of interest or
principal because the borrower's financial condition deteriorated, (3) loans
past due ninety days or more that are still accruing interest, and (4)
foreclosed and repossessed assets. Nonperforming assets were 1.91% ($3.1
million) and 0.63% ($0.9 million) of portfolio loans (excludes mortgage loans
held for sale) and foreclosed and repossessed assets at December 31, 1998 and
1997, respectively.
<PAGE> 21
Potential problem assets represent those assets where information about possible
credit problems of borrowers has caused management to have serious doubts about
the borrower's ability to comply with present repayment terms. This definition
is believed to be substantially consistent with the standards established by
banking regulatory agencies for loans classified substandard and doubtful.
Potential problem assets, which are not included in nonperforming assets, were
2.05% ($3.4 million) of portfolio loans for 1998, compared to 2.09% ($2.8
million) for 1997. The 1998 increase in potential problem assets is principally
related to three commercial loans secured by real estate and/or chattel to
borrowers in the Bank's primary lending area totaling $1.2 million. At December
31, 1998, potential problem assets included the following commercial and
consumer loans: (1) secured by real estate - $1.5 million, (2) secured by real
estate and chattel (principally inventory, equipment and receivables) - $1.6
million, (3) secured by vehicles and/or chattel - $0.2 million, and (4)
unsecured loans - $0.1 million.
Management's policy is to maintain the allowance for loan losses at a level
sufficient to absorb estimated losses inherent in the loan portfolio. During
1998, management increased the Company's allowance due to continued loan growth
and higher trending delinquencies, nonperforming assets, and net charge-offs.
The consolidated allowance for loan losses was 1.64% of outstanding portfolio
loans at December 31, 1998 (Bank - 1.54%; finance company - 4.96%), as compared
to 1.42% at December 31, 1997 (Bank - 1.41%; finance company - 2.49%). The
year-end 1998 ratio of the allowance for loan losses to nonperforming assets was
86%, as compared to 224% for 1997. The allowance for loan losses as a percent of
nonperforming assets plus potential problem loans was 42% and 52% as of December
31, 1998 and 1997, respectively.
CAPITAL. Management believes that a strong capital position is vital to
continued profitability and to promote depositor and investor confidence.
Stockholders' equity was $15.8 million or 7.59% of total assets at December 31,
1998, and $13.3 million or 7.98% of total assets at December 31, 1997. Net
income is the primary source of new capital for the Company. In addition, net
proceeds from stock transactions, including shares issued through director and
employee plans, contributed $408,000 and $271,000 of capital in 1998 and 1997,
respectively. Unrealized gain or loss on securities held for sale, net of
applicable income taxes, are recorded directly to stockholders' equity. To
record the fair value of securities held for sale, stockholders' equity was
increased by $60,000 and $97,000 during 1998 and 1997, respectively.
Heritage Financial's continuing record of strong earnings performance allowed
the board of directors to raise the annual dividend 13% to $1.35 per share in
1998 from the 1997 level of $1.20 per share. The board develops and reviews the
capital goals of Heritage Financial and the Bank. The Company's dividend policy
is designed to retain sufficient amounts for healthy financial ratios,
considering future planned asset growth and other prudent financial management
principles.
Heritage Bank and the banking industry are subject to various regulatory capital
requirements administered by the federal banking agencies. Failure to meet
minimum capital requirements can initiate certain mandatory actions by
regulators that, if undertaken, could have a direct material effect on the
Bank's financial statements. Capital adequacy in the banking industry is
evaluated primarily
<PAGE> 22
by the use of ratios which measure capital against assets and certain
off-balance-sheet items. Certain ratios weight these assets based on risk
characteristics according to regulatory accounting practices. At December 31,
1998, the Bank's capital exceeded the regulatory minimums and met the regulatory
definition of "well-capitalized". The Bank's capital ratios and the regulatory
guidelines are presented in Note 14 to the consolidated financial statements.
INTEREST RATE SENSITIVITY AND LIQUIDITY MANAGEMENT
Managing net interest income is a critical element in optimizing the earnings of
a banking organization. Movements in interest and the corresponding effects on
the net interest income may significantly affect profitability. With the goal of
consistent earnings growth with minimal interest rate risk, the Bank's
asset/liability management (ALCO) committee oversees this process by
establishing guidelines to manage the sensitivity and repricing of the Bank's
assets and liabilities.
The impact of interest rate changes can be mitigated by maintaining a balance
between interest rate-sensitive assets and liabilities within given time frames.
The difference between assets and liabilities within a given repricing period is
expressed as a ratio and as a dollar amount known as the "gap," both of which
are used as a measure of interest rate risk. A ratio of 100% suggests a balanced
position between rate-sensitive assets and liabilities within a given repricing
period. While the measurement process and related assessment of risk are
somewhat imprecise, the Bank believes its asset/liability management program
allows adequate reaction time for trends in the market place as they occur,
thereby minimizing the potential negative effect of its gap position against the
event of interest rate changes.
The Bank also uses net interest income simulation modeling to better quantify
the impact of potential interest rate fluctuations on net interest income. With
this understanding, management can best determine possible balance sheet
changes, pricing strategies, and appropriate levels of capital and liquidity
which allow the Bank to generate strong net interest income while controlling
and monitoring interest rate risk.
The following table reflects the Bank's interest rate sensitivity position both
individually within specified time periods and cumulatively over various time
horizons. In the table, assets and liabilities are placed in categories based on
their actual or expected repricing date. As indicated in the table, a
significant percentage of the Bank's assets and liabilities reprice within three
months. In a period of generally falling interest rates, this gap position will
normally result in a decrease in net interest income. Whereas, in a period of
generally rising interest rates, this gap position will normally result in an
increase in net interest income. The Federal Reserve Board acted to reduce
short-term rates in late 1998, resulting in a negative impact on net interest
income in the fourth quarter. Additional declines in interest rates could have a
similar effect in 1999.
<PAGE> 23
INTEREST RATE SENSITIVITY
<TABLE>
<CAPTION>
(dollars in thousands) TIME TO REPRICING OR MATURITY FROM DECEMBER 31, 1998
4 MONTHS OVER 1
3 MONTHS THROUGH THROUGH OVER 3
OR LESS 1 YEAR 3 YEARS YEARS TOTAL
-------- ------- ------- ------ --------
<S> <C> <C> <C> <C> <C>
Interest-earning assets:
Loans $86,739 $ 44,343 $28,248 $ 2,264 $161,594
Mortgage loans held for sale 3,222 - - - $ 3,222
Securities 4,840 3,357 6,059 7,609 $ 21,865
- ------------------------------------------------------------------------------------------------------------------------
Total interest-earning assets $94,801 $ 47,700 $34,307 $ 9,873 $186,681
- ------------------------------------------------------------------------------------------------------------------------
Interest-bearing liabilities:
Transaction and savings $ 8,089 $ 29,795 $ 9,713 $ 4,417 $ 52,014
Certificates of deposit 25,175 51,682 14,156 9,428 $100,441
Borrowed funds 12,332 16 32 1,027 $ 13,407
- ------------------------------------------------------------------------------------------------------------------------
Total interest-bearing liabilities $45,596 $ 81,493 $23,901 $14,872 $165,862
- ------------------------------------------------------------------------------------------------------------------------
Interest sensitivity gap $49,205 $(33,793) $10,406 $(4,999) $ 20,819
Cumulative interest sensitivity gap $49,205 $ 15,412 $25,818 $20,819
Cumulative net interest-earning
assets as a percentage of
interest-bearing liabilities (1) 208% 112% 117% 113%
</TABLE>
(1) If all transaction and savings accounts had been included in the 3 months or
less category above, the cumulative net interest-earning assets as a percentage
of interest-bearing liabilities would have been 106%, 101%, 114% and 113%,
respectively, for the 3 months or less, 4 months through 1 year, over 1 through
3 years, and over 3 years categories.
The ALCO committee also monitors the Company's liquidity position. The objective
of liquidity management is to ensure the ability to meet cash flow needs of
customers, such as new loan demand and deposit withdrawals, while at the same
time maximizing lending and investment opportunities. Failure to properly manage
liquidity requirements can result in the need to satisfy customer withdrawals
and other obligations with expensive funding sources. Too much liquidity on the
balance sheet can also be undesirable as earnings will suffer due to
underutilized resources. The Bank maintains adequate liquidity with sufficient
levels of liquid assets, deposit growth, and available alternative funding
sources.
The worldwide concern about Year 2000 computer programming issues could have an
adverse effect on the Bank's liquidity position if deposit customers lose
confidence in the banking system and withdraw their funds. While every effort is
being made to prepare for these issues, management is currently unable to
predict the reaction of customers and the impact, if any, on the Bank's
liquidity
<PAGE> 24
position and needs during 1999. However, steps are being taken to increase the
amount of funds available to the Bank in the event additional liquidity is
needed.
At December 31, 1998, the Bank had available approximately $7.0 million in FHLB
advances and $14.3 million in Federal funds lines of credit with other financial
institutions. The Bank also has access to nonlocal funds through certificate of
deposit brokers and via a national certificate of deposit network. In addition,
management believes Heritage Financial, which had no debt at December 31, 1998,
could secure short-term or long-term lines of credit with other financial
institutions to meet liquidity needs. Arrangements are also being made to allow
the Bank to borrow from the Federal Reserve Bank's discount window if needed.
RESULTS OF OPERATIONS
COMPARISON OF YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996. Heritage Financial's
net income rose $550,000 to reach $2,852,000 in 1998, a 24% increase over 1997.
Net income for 1997 increased 9% from the $2,105,000 earned in 1996 while 1996
net income increased 25% . Basic net income per share was $5.00 in 1998,
compared with $4.15 in 1997 and $3.93 in 1996. Diluted net income per share was
$4.98 for 1998, compared with $4.11 in 1997 and $3.84 in 1996. Return on average
stockholders' equity increased to 19.35% in 1998 from 18.65% in 1997 and 20.27%
in 1996. Return on average total assets declined for the year ended December 31,
1998 to 1.53% from 1.55% in 1997 and 1.76% in 1996.
NET INTEREST INCOME. For purposes of this discussion, net interest income has
been adjusted to a fully taxable equivalent basis for certain tax-exempt loans
and investments included in earning assets. Net interest income, the Bank's
largest single source of earnings, represents the difference between interest
(including fees) earned on loans, securities and other earning assets and the
interest paid on deposits and other borrowings obtained to fund them. The net
interest margin is net interest income, on a tax equivalent basis, expressed as
a percentage of average earning assets. The margin is influenced by a number of
factors, such as the volume and mix of earning assets and funding sources, the
interest rate environment, and the level of earning assets funded by
interest-free funding sources (primarily noninterest-bearing demand deposits and
equity capital).
On a fully taxable-equivalent (TE) basis, net interest income for 1998 grew 23%,
or $1.8 million over 1997. Average earning assets increased 25% or $34.2 million
between years, while average interest-bearing liabilities rose 28% or $33.2
million. The Company's net interest margin was 5.49% and 5.59% for 1998 and
1997, respectively.
The yield on average earning assets decreased 9 basis points to 9.77% in 1998.
The mix of earning assets changed as the average balance of higher-yielding
loans rose $31.6 million (26%) and comprised 88% of average earning assets, up
from 87% in 1997. Overall loan yields declined 9 basis points to 10.26%,
primarily due to the decline in market interest rates and increasing competitive
pressures in the Bank's local market. The average balance of securities
increased 13% or $2.4 million, while the yield on securities declined 38 basis
points to 6.29%, as lower-yielding securities replaced those sold, called or
maturing.
<PAGE> 25
All of the Company's interest-bearing deposit categories rose during 1998 as
average interest-bearing deposits grew $27.6 million or 25%. While all
categories increased, certificates of deposits led with a $21.3 million, or 31%,
increase in average balances. Other borrowed funds also played a significant
role in the funding of asset growth by increasing $5.6 million or 69%. The cost
of all average interest-bearing liability categories decreased 13 basis points
to 4.92%, primarily the result of an overall decline in market interest rates
and capitalized interest on the new main office building.
During 1997, net interest income rose 23%, or $1.5 million and totaled $7.8
million. Average earning assets grew 23% in 1997, a $26.2 million increase.
Interest-bearing liabilities rose $24.9 million or 27%. Net interest margin was
5.59% for both 1997 and 1996. The yield on average earning assets increased 16
basis points to 9.86%. The mix of earning assets shifted favorably as average
loans grew $26.7 million or 29%, while average securities decreased $0.5 million
or 2%.
Average interest-bearing liabilities grew $24.9 million or 27% during 1997,
while the cost of average interest-bearing liabilities increased 4 basis points
to 5.05%. Certificates of deposits led the increase by rising 28% or $15.1
million. The increase in the cost of interest-bearing liabilities was primarily
due to the change in the mix to higher rate paying certificates of deposit and,
to a lesser extent, an increase in rates.
Nonrecurring capitalized interest costs associated with the construction of the
Bank's new main office facility increased net interest income and reduced the
cost of average interest-bearing liabilities for 1998 and 1997 by $246,000
($157,000 after-tax) and $67,000 ($43,000 after-tax), respectively. Had
capitalized interest been included in interest expense, the cost of average
interest-bearing liabilities would have been 5.09% rather than 4.92%, and the TE
net interest margin would have been 5.35% instead of 5.49%. Capitalized interest
increased basic net income per share by $0.276 and diluted net income per share
by $0.275 during 1998 ($0.077 and $0.077, respectively, in 1997).
The following table sets forth certain information relating to the Company's
average consolidated balance sheets and consolidated statements of income for
the years ended December 31, 1998, 1997 and 1996.
<PAGE> 26
AVERAGE BALANCE SHEETS AND ANALYSIS OF NET INTEREST INCOME
<TABLE>
<CAPTION>
(dollars in thousands) 1998 1997 1996
--------------------------- --------------------------- --------------------------
AVERAGE AVERAGE AVERAGE
AVERAGE YIELD/ AVERAGE YIELD/ AVERAGE YIELD/
ASSETS BALANCE INTEREST COST BALANCE INTEREST COST BALANCE INTEREST COST
--------------------------- --------------------------- --------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Earning Assets
Net loans (1) $151,938 $15,590 10.26% $120,343 $12,453 10.35% $ 93,599 $ 9,746 10.41%
Taxable securities 16,139 986 6.11% 15,224 995 6.53% 15,524 930 5.99%
Tax exempt securities 4,750 328 6.91% 3,308 241 7.29% 3,478 246 7.07%
Federal funds sold 274 15 5.47% - - 0.00% 51 3 4.98%
- -----------------------------------------------------------------------------------------------------------------------------------
Total earning assets 173,101 16,919 9.77% 138,876 13,689 9.86% 112,651 10,925 9.70%
Nonearning assets 13,459 9,280 6,787
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $186,560 $148,156 $119,438
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing Liabilities
Interest checking $ 11,132 $ 209 1.88% $ 9,757 $ 202 2.07% $ 8,523 $ 178 2.09%
Money market accounts 26,481 1,069 4.04% 21,911 921 4.21% 19,656 848 4.31%
Savings accounts 5,427 117 2.16% 5,188 128 2.47% 4,976 122 2.46%
Retirement accounts 3,599 183 5.08% 3,479 187 5.38% 3,227 178 5.51%
Certificates of deposit 78,991 4,454 5.64% 68,728 4,029 5.86% 53,626 3,175 5.92%
Brokered CDs 3,585 212 5.91% - - - - - -
National CDs 7,429 424 5.71% - - - - - -
Other borrowings 13,815 742 5.37% 8,194 454 5.54% 2,359 129 5.45%
- -----------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing liabilities(2) 150,459 7,410 4.92% 117,257 5,922 5.05% 92,367 4,629 5.01%
Noninterest-bearing liabilities 21,357 18,558 16,684
- -----------------------------------------------------------------------------------------------------------------------------------
Total liabilities 171,816 135,815 109,051
Stockholders' equity 14,744 12,341 10,386
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY $186,560 $148,156 $119,438
Net interest income/net interest spread (2) $ 9,509 4.85% $ 7,767 4.81% $ 6,295 4.69%
Net earning assets/net interest margin (2) $ 22,642 5.49% $ 21,619 5.59% $ 20,284 5.59%
</TABLE>
(1) Net loans include mortgage loans held for sale.
(2) In 1998 and 1997, the Company capitalized $246,000 and $67,000,
respectively, of interest expense related to the carrying cost
construction in progress.
<PAGE> 27
The following table presents the extent to which changes in interest rates and
changes in the volume of earning assets and interest-bearing liabilities have
affected the Company's interest income and expense during the years indicated.
RATE/VOLUME ANALYSIS
<TABLE>
<CAPTION>
(dollars in thousands)
1998 VS. 1997 1997 VS. 1996 1996 VS. 1995
ASSETS INCREASE (DECREASE) DUE TO INCREASE (DECREASE) DUE TO INCREASE (DECREASE) DUE TO
--------------------------- ---------------------------- -----------------------------
VOLUME RATE TOTAL VOLUME RATE TOTAL VOLUME RATE TOTAL
--------------------------- ---------------------------- -----------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Interest income on:
Loans $3,269 $(132) $3,137 $2,784 $(77) $2,707 $2,164 $ 85 $2,249
Taxable securities 60 (69) (9) (18) 83 65 (185) (14) (199)
Tax exempt securities 105 (18) 87 (12) 7 (5) (28) (3) (31)
Federal funds sold 15 - 15 (3) - (3) (6) (1) (7)
- ----------------------------------------------------------------------------------------------------------------------------------
Total interest income $3,449 $(219) $3,230 $2,751 $ 13 $2,764 $1,945 $ 67 $2,012
- ----------------------------------------------------------------------------------------------------------------------------------
Interest expense on:
Interest checking 29 (22) 7 26 (1) 25 2 (12) (10)
Money market accounts 192 (44) 148 97 (24) 73 53 32 85
Savings accounts 6 (17) (11) 5 1 6 6 1 7
Retirement accounts 6 (10) (4) 14 (5) 9 (4) (12) (16)
Certificates of deposit 602 (177) 425 894 (40) 854 595 170 765
Brokered CDs 212 - 212 - - - - - -
National CDs 424 - 424 - - - - - -
Other borrowings 311 (23) 288 318 7 325 67 (10) 57
- ----------------------------------------------------------------------------------------------------------------------------------
Total interest expense $1,782 $(294) $1,488 $1,354 $(62) $1,292 $ 719 $ 169 $ 888
- ----------------------------------------------------------------------------------------------------------------------------------
Net Interest Income $1,667 $ 75 $1,742 $1,397 $ 75 $1,472 $1,226 $(102) $1,124
</TABLE>
Changes attributable to both rate and volume have been allocated to rate.
PROVISION FOR LOAN LOSSES. The provision for loan losses is the charge to
operating income that management determines to be necessary to maintain the
allowance for loan losses at an adequate level, and reflects management's
estimate of the risk of loss inherent in the loan portfolio. The provision for
loan losses was $1,325,000, $675,700 and $485,000 in 1998, 1997 and 1996,
respectively. The provision has increased to cover the growth of the loan
portfolio and increases in net chargeoffs, nonperforming assets, and potential
problem assets.
Net chargeoffs to average portfolio loans outstanding (excludes mortgage loans
held for sale) was 0.41% ($624,000), 0.26% ($311,000) and 0.23% ($208,000) for
1998, 1997 and 1996, respectively. The coverage ratio of net income plus
provision for loan losses to net chargeoffs was 6.69 in 1998, 9.56 in 1997, and
12.44 in 1996. The year-end allowance for loan losses divided by net chargeoffs
yielded a coverage ratio of 4.33, 6.14, and 7.42 for 1998, 1997, and 1996,
respectively. During 1999, management plans to adequately provide for both net
chargeoffs and for identifiable future losses associated with planned increases
in the Bank's commercial, mortgage and consumer portfolios.
NONINTEREST INCOME. Besides the attention to net interest income, the Company
focuses on its ability to generate additional noninterest income from both core
business and newer initiatives, such
<PAGE> 28
as brokerage services and insurance. Excluding securities gains, noninterest
income contributed 29%, 31% and 34% in 1998, 1997 and 1996, respectively, of
total tax equivalent revenues (net interest income plus noninterest income).
Total noninterest income (excluding securities gains in all periods) increased
13%, 6% and 30% in 1998, 1997 and 1996, respectively. Noninterest income
(excluding securities gains) as a percentage of average total assets was 2.10%,
2.35% and 2.75% for 1998, 1997 and 1996, respectively.
Services charges on deposit accounts (the largest component of noninterest
income) increased $4,000 (0.3%), $80,000 (6%) and $52,000 (4%) in 1998, 1997 and
1996, respectively. The Bank contracted with a local convenience store chain in
the second quarter of 1997 to place automated teller machines (ATMs) inside its
stores. That affiliation has resulted in significantly increased ATM transaction
fees, particularly from noncustomers. ATM transaction fee income increased
$114,000 (67%) in 1998, $92,000 (119%) in 1997, and $7,000 (11%) in 1996. Fewer
commercial customers participated in the Bank's accounts receivable financing
program during 1998. Income from accounts receivable financing declined $131,000
(34%) in 1998 following a $17,000 (5%) increase in 1997 and a $106,000 (40%)
increase in 1996.
Lower interest rates created greater demand for mortgage refinancing during
1998. Income from mortgage banking activities increased $142,000 (20%) in 1998
following a decrease of $159,000 (19%) in 1997 and an increase of $365,000 (74%)
in 1996. During the fourth quarter of 1998, a $108,000 ($69,000 after-tax)
nonrecurring charge to noninterest income was recorded to write down the value
of the Bank's originated mortgage servicing rights. The write-down was due to
anticipated prepayments on mortgage loans serviced by the Bank following the
decline in mortgage interest rates during 1998. The decline in the value of
mortgage servicing rights decreased basic net income per share by $0.121 and
diluted net income per share by $0.120 in 1998. Management expects the demand
for refinancing to subside during 1999, resulting in less income from mortgage
activities.
Noninsured investment products (e.g., debt and equity securities, mutual funds,
annuities, etc.) continue to grow in popularity with the Bank's customers. The
brokerage subsidiary's first three years of operations under the broker/dealer
relationship with Raymond James & Associates (formerly Robert Thomas Securities)
resulted in increased brokerage fees of $22,000 (6%), $92,000 (34%) and $191,000
(132%) in 1998, 1997 and 1996, respectively. The nominal increase during 1998 is
believed to be the result of increased competition, both locally and from
national discount brokerage firms.
A reinsurance subsidiary was formed in 1996 to generate underwriting profits by
providing life and disability insurance to borrowers of the Bank. Life and
disability insurance premiums increased $77,000 (71%) in 1998 and $101,000 in
1997, largely due to increased sales volume by the Bank's finance company
subsidiary. Income from unconsolidated subsidiary includes a $148,000 ($95,000
after-tax) gain realized during the second quarter of 1998 by Heritage
Investment Corporation from the sale of a speculative industrial building which
was constructed as a community development project. Profits from the project
will be reinvested to promote community development (i.e., affordable housing,
community services and economic development, including community
<PAGE> 29
stabilization and revitalization). The gain from the sale of the industrial
building increased both basic net income per share and diluted net income per
share by $0.166 in 1998.
NONINTEREST EXPENSE. Noninterest expense is significant to the Company's
financial performance. Management is continually challenged to control operating
costs and improve efficiencies while still providing higher levels of customer
service. Noninterest expense increased $684,000 (10%), $1,088,000 (19%), and
$1,181,000 (26%) in 1998, 1997 and 1996, respectively. The ratio of noninterest
expense to average total assets was 4.05%, 4.64% and 4.84% for 1998, 1997 and
1996, respectively.
Salaries and employee benefits, the largest component of noninterest expense,
increased 16% in 1998 and 1997, compared to 37% in 1996. The ratio of personnel
expense as a percentage of average total assets was 2.24% in 1998 compared to
2.44% and 2.62%, respectively, for 1997 and 1996. The Bank's continued growth
and diversification contributed to the increases in all three years. The
commercial lending staff was increased during both 1998 and 1997. The consumer
lending staff grew when the Bank's consumer finance subsidiary was formed in
1997 and expanded again in 1998 in connection with the acquisition of certain
assets of another local consumer finance company. During 1996, the brokerage
service staff was expanded and the Hilltop branch, which opened in late 1995,
reported its first full year of operation. Management expects 1999 expenses to
rise as the Bank grows its commercial, mortgage and consumer lending portfolios.
Salaries and employee benefits include commissions paid in the brokerage service
and mortgage banking operations. As revenues increase or decrease in these
business lines, the commissions change accordingly. In addition, contributions
to the employee and director incentive bonus and ESOP pension plans are
contingent upon the Company attaining certain net income goals which are
predetermined annually. Contributions to these plans increase or decrease in
relationship to the extent to which the goals are achieved or surpassed.
Furniture and equipment expense increased 10% or $75,000 in 1998, compared to
72% and 12% in 1997 and 1996, respectively. The 1998 increase included system
enhancements necessitated by Year 2000 issues and additional expansion of the
Bank's ATM network, while the 1997 increase included costs related to the
Company's ongoing effort to provide the infrastructure necessary to efficiently
accommodate future growth. During 1997, equipment lease expense increased
$252,000 as leasing arrangements were used to upgrade the Bank's technology and
communications equipment, as well as to expand its ATM network. Occupancy
expense increased $44,000 (8%) in 1998, $61,000 (12%) in 1997, and $80,000 (20%)
in 1996. The increases in 1998 and 1997 included costs associated with the
formation and expansion of the Bank's consumer finance subsidiary, while the
1996 increase was primarily the result of adding the new Hilltop branch.
Occupancy expense and, to a lesser extent, furniture and equipment expense are
expected to increase in 1999 due to costs associated with the Bank's new main
office facility, which was substantially completed and occupied during the
fourth quarter of 1998. In addition, during 1999 the Bank expects to incur
additional expenses relating to Year 2000 issues (approximately $125,000 in 1998
<PAGE> 30
and 1999, combined). Other noninterest expense includes expenses related to the
Bank's reinsurance subsidiary, which began operations in 1996, totaling $62,000
in 1998, $30,000 in 1997 and $3,000 in 1996.
Each of the remaining noninterest expense categories experienced nominal
increases or decreases in 1998, while all categories increased in 1997 and 1996.
These increases are the result of the Bank's continued growth and costs related
to generating noninterest income, as well as moving and other expenses
associated with the Bank's new main office facility.
The Company monitors its expense ratio and utilizes the efficiency ratio as a
measure of its success in increasing revenues, while controlling costs. The
expense ratio (noninterest expense minus noninterest income, excluding
securities gains and losses, divided by average total assets) was 1.94% in 1998,
2.29% in 1997 and 2.09% in 1996. The efficiency ratio, which is calculated
excluding the same items, divides noninterest expense by net interest income
(TE) plus noninterest income. The efficiency ratio was 56.22%, 61.41%, and
60.31% for 1998, 1997, and 1996, respectively. Cost containment in 1999 is a
priority of management.
PROVISION FOR INCOME TAXES. The Company records a provision for income taxes
currently payable and for taxes payable in the future because of differences in
the timing of recognition of certain items for financial statement and income
tax purposes. The major differences between the effective tax rate applied to
the Company's financial statement income and the federal statutory rate is
caused by state income taxes, net of federal tax benefit, and interest on
tax-exempt securities and loans. The Company's effective tax rate was 36% in
1998 and 1997, and 37% in 1996. See Note 9 to the consolidated financial
statements for additional details of the Company's income tax provision.
<PAGE> 31
ADDITIONAL GUIDE 3 STATISTICAL DISCLOSURES REQUIRED BY BANK HOLDING COMPANIES
INVESTMENT PORTFOLIO. The following table presents the carrying value by
maturity distribution of the investment portfolio along with weighted average
yields thereon as of December 31, 1998.
<TABLE>
<CAPTION>
(dollars in thousands)
Within 1-5 5-10 Beyond
Investment Category 1 Year Years Years 10 Years Total
------------------- ------ ------- ------- -------- -----
<S> <C> <C> <C> <C> <C>
U.S. agencies $ - $ 3,201 $ 1,518 $ - $ 4,719
Tax-exempt securities 166 1,992 996 2,742 5,896
----- ------ ------- ------ -------
Total $ 166 $ 5,193 $ 2,514 $2,742 $10,615
===== ======= ======= ====== =======
Weighted average yield (tax
equivalent basis) 8.53% 6.14% 6.97% 6.44% 6.45%
===== ======= ======= ====== =======
Mortgage-backed, asset-backed and equity securities $11,251
=======
Weighted average yield on mortgage-backed, asset-backed and equity securities 6.20%
=======
</TABLE>
LOAN PORTFOLIO. The following table presents as of December 31, 1998, 1997,
1996, 1995 and 1994, a summary of loans outstanding by category. The Company has
no foreign loans.
<TABLE>
<CAPTION>
(dollars in thousands)
As of December 31,
------------------
Type of Loan 1998 1997 1996 1995 1994
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Real estate:
1-4 family residential $ 44,743 $ 39,221 $ 28,474 $ 24,648 $ 21,477
Construction 12,442 16,760 16,729 9,164 6,490
Commercial 60,072 41,305 26,082 20,663 15,226
Commercial, financial and
agricultural 27,004 22,835 20,140 15,926 10,262
Consumer 22,043 14,937 12,387 10,213 9,938
--------- --------- --------- -------- --------
166,304 135,058 103,812 80,614 63,393
Less unearned interest (2,007) (208) (36) (44) (64)
--------- --------- --------- -------- --------
Total loans $ 164,296 $ 134,850 $ 103,776 $ 80,570 $ 63,329
--------- --------- --------- -------- --------
</TABLE>
The following is a presentation of portfolio loans (excludes mortgage loans held
for sale) by contractual maturity as of December 31, 1998.
<PAGE> 32
<TABLE>
<CAPTION>
(dollars in thousands)
Type of Loan Over 1
- ------------ 1 year through Over
Real Estate: or less 5 years 5 years Total
------- ------- ------- -----
<S> <C> <C> <C> <C>
1-4 family residential $11,902 $ 6,350 $26,491 $ 44,743
Construction 11,502 578 363 12,442
Commercial 13,974 12,269 33,766 60,008
Commercial, financial
and agricultural 16,313 5,412 2,841 24,566
Leases 59 1,983 -- 2,043
Consumer 8,191 11,164 1,139 20,495
------- ------- ------- --------
Total $61,941 $37,755 $64,600 $164,296
======= ======= ======= ========
</TABLE>
At December 31, 1998, portfolio loans due after one year with predetermined
interest rates totaled $35,494,000, and portfolio loans due after one year with
floating or adjustable interest rates totaled $51,226,000.
The following table presents information regarding nonperforming assets and
accruing loans which are contractually past due 90 days or more as to principal
or interest payments. Nonperforming assets consist of (a) nonaccrual loans, (b)
restructured loans, and (c) foreclosed and repossessed assets.
<TABLE>
<CAPTION>
(dollars in thousands) December 31,
------------
Nonperforming Assets: 1998 1997 1996 1995 1994
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Nonaccrual loans $ 803 $ 95 $ 173 $120 $ 70
Restructured loans 99 82 86 93 --
Accruing loans which are contractually
past due 90 days or more as to
principal and interest payments 1,941 451 935 16 273
Foreclosed and repossessed assets 297 225 74 247 5
------ ---- ------ ---- ----
Total nonperforming assets $3,140 $853 $1,268 $476 $348
------ ---- ------ ---- ----
</TABLE>
A loan is considered impaired when it is probable that the Company will be
unable to collect the scheduled payments of principal and interest due under the
contractual terms of the loan agreement. Impaired loans are measured at the
present value of expected cash flows discounted at the loan's effective interest
rate, at the loan's observable market price, or at the fair value of the
collateral if the loan is collateral dependent.
<PAGE> 33
The Company considers all loans on nonaccrual to be impaired. Interest accruals
on loans are discontinued when, in the opinion of management, it is not
reasonable to expect that such interest will be collected, or generally, when
collection of principal or interest becomes 90 days or more past due. Management
may make exceptions to this policy when the estimated net realizable value of
the collateral is sufficient to recover the principal and interest balance. When
interest accrual is discontinued, all unpaid accrued interest is reversed.
Interest income is subsequently recognized only to the extent cash payments are
received.
Interest income that would have been earned on nonaccrual loans if the loans had
been current in accordance with their original terms and had been outstanding
throughout the period amounted to $23,000, $27,000 and $13,000 in 1998, 1997 and
1996, respectively. Interest income recognized on nonaccrual loans amounted to
$40,000, $4,000 and $5,000 in 1998, 1997 and 1996, respectively.
Potential problem loans, which are not included in nonperforming assets, were
$3,368,000, $2,814,000 and $447,000 at December 31, 1998, 1997 and 1996,
respectively. Potential problem assets represent those assets where information
about possible credit problems of borrowers has caused management to have
serious doubts about the borrower's ability to comply with present repayment
terms. This definition is believed to be substantially consistent with the
standards established by banking regulatory agencies for loans classified
substandard and doubtful.
As of December 31, 1998, the Bank had no concentrations of ten percent or more
of total loans in any single industry nor any geographical area outside the
immediate market area of the Bank.
Although the Company's loan portfolio is concentrated in Montgomery County,
Tennessee and the surrounding counties in Tennessee and Kentucky, management
does not believe this geographic concentration presents an abnormally high risk.
SUMMARY OF LOAN LOSS EXPERIENCE. The activity in the Bank's allowance for loan
losses is presented in the following table for the years ended December 31, 1998
and 1997.
<PAGE> 34
<TABLE>
<CAPTION>
(dollars in thousands)
Years Ended December 31,
------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Balance at beginning of period $1,908 $1,544 $1,267 $1,023 $ 795
------ ------ ------ ------ ------
Charge-offs:
Real estate:
1-4 family residential 8 -- -- -- --
Construction -- -- -- -- --
Commercial -- -- -- -- 11
Commercial, financial and agricultural 240 129 93 19 11
Consumer 417 212 151 131 73
------ ------ ------ ------ ------
665 341 244 150 95
------ ------ ------ ------ ------
Recoveries:
Real estate:
1-4 family residential -- -- -- -- --
Construction -- -- -- -- --
Commercial -- -- -- -- --
Commercial, financial and agricultural 9 8 29 1 11
Consumer 32 21 7 19 5
------
41 29 36 20 16
------ ------ ------ ------ ------
Net charge-offs 624 312 208 130 79
------ ------ ------ ------ ------
Additions charged to operations 1,325 676 485 374 307
Addition due to loans purchased 93 -- -- -- --
------ ------ ------ ------ ------
Balance at end of period $2,702 $1,908 $1,544 $1,267 $1,023
====== ====== ====== ====== ======
Ratio of net charge-offs to average portfolio
loans outstanding during the period
(excludes mortgage loans held for sale) 0.41% 0.26% 0.23% 0.18% 0.13%
</TABLE>
<PAGE> 35
At December 31, 1998 and 1997, the allowance for loan losses was allocated as
follows:
<TABLE>
<CAPTION>
(dollars in thousands)
December 31, 1998 December 31, 1997
------------------------- ------------------------
% of loans in % of loans in
each category each category
Amount to total loans Amount to total loans
------ -------------- ------ --------------
<S> <C> <C> <C> <C>
Real estate:
1-4 residential $ 220 27.2% $ 238 22.5%
Construction 182 7.6% 170 12.4%
Commercial 911 36.5% 425 30.5%
Commercial, financial and agricultural 440 16.2% 317 17.1%
Consumer 626 12.5% 303 17.5%
Unallocated 323 N/A 455 N/A
------ ------ ------ ------
Total $2,702 100.0% $1,908 100.0%
====== ====== ====== ======
</TABLE>
DEPOSITS. The following table presents the amount outstanding of time
certificates of deposit of $100,000 or more and respective maturities for the
years ended December 31, 1998 and 1997.
<TABLE>
<CAPTION>
(dollars in thousands)
December 31, December 31,
1998 1997
---- ----
<S> <C> <C>
three months or less $ 5,345 $ 3,178
three to six months 1,833 2,482
six to twelve months 4,734 3,379
over twelve months 3,360 2,632
-------- --------
Total $ 15,272 $ 11,671
========= ========
</TABLE>
<PAGE> 36
RETURN ON EQUITY AND ASSETS. Return on average assets (ROA), return on average
stockholders' equity (ROE), average equity to average assets ratio, and dividend
payout ratio for the periods indicated are as follows:
<TABLE>
<CAPTION>
Years Ended December 31,
1998 1997
---- ----
<S> <C> <C>
Return on average assets 1.53% 1.55%
Return on average equity 19.35% 18.65%
Average equity to average assets ratio 7.90% 8.33%
Dividend payout ratio 27.28% 29.54%
</TABLE>
SHORT-TERM BORROWINGS. The Company did not have any category of short-term
borrowings for which the average balance outstanding during the reported periods
was 30 percent or more of stockholders' equity at the end of the reported
periods.
<PAGE> 37
INDEPENDENT AUDITORS' REPORT
The Board of Directors
Heritage Financial Services, Inc.
We have audited the consolidated balance sheets of Heritage Financial Services,
Inc. and Subsidiary as of December 31, 1998 and 1997, and the related
consolidated statements of operations, changes in stockholders' equity, and cash
flows for each of the three years in the period ended December 31, 1998. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. 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.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Heritage Financial
Services, Inc. and Subsidiary as of December 31, 1998 and 1997, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1998, in conformity with generally
accepted accounting principles.
January 15, 1999
<PAGE> 38
ITEM 7. FINANCIAL STATEMENTS
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
Consolidated Balance Sheets
December 31, 1998 and 1997
<TABLE>
<CAPTION>
Assets 1998 1997
<S> <C> <C>
Cash and due from banks $ 7,611,438 $ 4,531,237
Securities, available-for-sale, at fair value 21,865,281 19,153,082
Mortgage loans held for sale 3,222,057 631,486
Loans 164,296,266 134,850,045
Allowance for loan losses (2,702,194) (1,908,420)
Net loans 161,594,072 132,941,625
Premises and equipment 10,354,558 5,461,051
Accrued interest receivable 1,889,196 1,584,622
Deferred income taxes 575,800 590,213
Foreclosed and repossessed assets 296,783 225,132
Other assets 802,254 964,434
Total assets $ 208,211,439 $ 166,082,882
Liabilities and Stockholders' Equity
Deposits:
Noninterest-bearing $ 24,163,261 $ 18,821,225
Interest-bearing 152,455,100 115,559,087
Total deposits 176,618,361 134,380,312
Federal funds purchased and other short-term borrowings 3,675,000 8,150,000
Long-term borrowings 9,732,277 8,785,688
Accrued interest payable 742,048 555,956
Other liabilities 1,648,852 958,275
Total liabilities 192,416,538 152,830,231
Stockholders' equity:
Preferred stock, no par value. Authorized
1,000,000 shares; no shares issued
or outstanding - -
Common stock, $2.00 par value. Authorized
1,000,000 shares; issued 579,645 shares
in 1998 and 568,574 shares in 1997 1,159,290 1,137,148
Additional paid-in capital 5,464,157 5,078,586
Retained earnings 9,054,518 6,980,416
Accumulated other comprehensive income, net 116,936 56,501
Total stockholders' equity 15,794,901 13,252,651
Total liabilities and stockholders' equity $ 208,211,439 $ 166,082,882
</TABLE>
See accompanying notes to consolidated financial statements.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
Consolidated Statements of Operations
Years Ended December 31, 1998, 1997 and 1996
<TABLE>
<CAPTION>
1998 1997 1996
<S> <C> <C> <C>
Interest income:
Loans, including fees $ 15,583,411 12,453,155 9,741,973
Investment securities:
Taxable 986,347 994,678 930,172
Tax-exempt 229,080 168,158 171,462
Federal funds sold 14,459 - 2,534
Total interest income 16,813,297 13,615,991 10,846,141
Interest expense:
Deposits 6,668,238 5,468,212 4,500,893
Other 742,277 453,887 128,590
Total interest expense 7,410,515 5,922,099 4,629,483
Net interest income 9,402,782 7,693,892 6,216,658
Provision for loan losses 1,325,000 675,700 485,000
Net interest income after provision
for loan losses 8,077,782 7,018,192 5,731,658
Noninterest income:
Service charges on deposit accounts 1,388,951 1,385,435 1,305,585
Service charges on ATM transactions 283,338 169,582 77,592
Mortgage banking activities 837,920 696,312 854,934
Accounts receivable financing 257,306 388,238 371,239
Net securities gains (losses) 24,828 (2,376) 83,126
Brokerage fees 387,410 365,321 273,029
Life and disability insurance premiums 185,266 108,595 7,953
Income from unconsolidated subsidiary 147,580 - -
Other 439,097 364,360 398,947
</TABLE>
<PAGE> 39
<TABLE>
<S> <C> <C> <C>
Total noninterest income 3,951,696 3,475,467 3,372,405
Noninterest expenses:
Salaries and employee benefits 4,186,044 3,617,344 3,129,271
Occupancy 592,094 548,209 487,334
Furniture and equipment 791,191 716,445 417,587
Data processing 425,371 469,602 412,363
Advertising and public relations 299,989 301,479 280,536
Communications 261,028 230,199 217,073
Supplies 243,166 285,693 235,703
Other 754,158 699,753 600,511
Total noninterest expenses 7,553,041 6,868,724 5,780,378
Income before income taxes 4,476,437 3,624,935 3,323,685
Income taxes 1,624,075 1,322,991 1,218,685
Net income $ 2,852,362 2,301,944 2,105,000
Earnings per common share:
Basic $ 5.00 4.15 3.93
Diluted 4.98 4.11 3.84
Average common shares outstanding:
Basic 570,581 554,204 535,407
Diluted 573,049 560,162 547,900
</TABLE>
See accompanying notes to consolidated financial statements.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
Consolidated Statements of Changes in Stockholders' Equity
Year Ended December 31, 1998, 1997 and 1996
<TABLE>
<CAPTION>
ACCUMULATED
ADDITIONAL OTHER
COMMON PAID-IN RETAINED COMPREHENSIVE TOTAL
STOCK CAPITAL EARNINGS INCOME EQUITY
- ---------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
BALANCE AT DECEMBER 31, 1995 $ 1,059,244 4,494,993 3,800,907 (8,157) 9,346,987
Dividends declared, $1.00 per share -- -- (547,385) -- (547,385)
Issuance of common stock 3,584 50,176 -- -- 53,760
Exercise of stock options 25,694 108,776 -- -- 134,470
Purchase and retirement of common stock (2,990) (37,993) -- -- (40,983)
Shares issued under employee benefit plan 17,202 226,530 -- -- 243,732
Comprehensive income:
Net income -- -- 2,105,000 -- 2,105,000
Change in unrealized loss on
securities available-for-sale -- -- -- 19,121 19,121
Less reclassification adjustment, net of
deferred income tax benefit of $32,000 -- -- -- (51,500) (51,500)
Total comprehensive income 2,072,621
- ---------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1996 1,102,734 4,842,482 5,358,522 (40,536) 11,263,202
Dividends declared, $1.20 per share -- -- (680,050) -- (680,050)
Issuance of common stock 3,744 56,156 -- -- 59,900
Exercise of stock options 29,006 136,024 -- -- 165,030
Purchase and retirement of common stock (3,962) (93,627) -- -- (97,589)
Shares issued under employee benefit plan 5,626 137,551 -- -- 143,177
Comprehensive income:
Net income -- -- 2,301,944 -- 2,301,944
Change in unrealized gain (loss) on
securities available-for-sale -- -- -- 95,537 95,537
Less reclassification adjustment, net of
deferred income taxes of $1,000 -- -- -- 1,500 1,500
Total comprehensive income 2,398,981
- ---------------------------------------------------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 1997 1,137,148 5,078,586 6,980,416 56,501 13,252,651
Dividends declared, $1.35 per share -- -- (778,260) -- (778,260)
Issuance of common stock 2,696 71,433 -- -- 74,129
Exercise of stock options 13,300 69,200 -- -- 82,500
Purchase and retirement of common stock (154) (7,062) -- -- (7,216)
Shares issued under employee benefit plan 6,300 252,000 -- -- 258,300
Comprehensive income:
Net income -- -- 2,852,362 -- 2,852,362
Change in unrealized gain on
securities available-for-sale -- -- -- 75,435 75,435
Less reclassification adjustment, net of
deferred income tax benefit of $10,000 -- -- -- (15,000) (15,000)
Total comprehensive income 2,912,797
- ---------------------------------------------------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 1998 $ 1,159,290 5,464,157 9,054,518 116,936 15,794,901
===========================================================================================================================
</TABLE>
See accompanying notes to consolidated financial statements.
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
Consolidated Statements of Cash Flows
Years Ended December 31, 1998, 1997 and 1996
<TABLE>
<CAPTION>
Increase (decrease) in cash and due from banks 1998 1997 1996
<S> <C> <C> <C>
Cash flows from operating activities:
Net income $ 2,852,362 2,301,944 2,105,000
Adjustments to reconcile net income to net
cash provided by operating activities:
Deferred income tax benefit (20,000) (73,000) (117,000)
Depreciation and amortization 349,294 359,288 356,122
Net securities (gains) losses (24,828) 2,376 (83,126)
Provision for loan losses 1,325,000 675,700 485,000
Net accretion of securities (75,908) (95,396) (106,613)
Mortgage loans originated for sale (46,832,004) (37,526,362) (40,324,099)
Proceeds from sale of mortgage loans 44,241,433 39,228,356 39,686,899
Increase in accrued interest receivable (304,574) (291,615) (350,381)
Increase in accrued interest payable 186,092 113,084 24,202
Increase in other liabilities 690,577 227,783 215,871
Other, net (203,554) (143,940) (227,479)
Net cash provided by operating activities 2,183,890 4,778,218 1,664,396
Cash flows from investing activities:
Proceeds from sales of securities available-for-sale 84,212 927,040 3,428,727
Maturities and redemptions of securities
available-for-sale 8,554,251 2,476,502 2,128,530
Purchases of securities available-for-sale (11,095,312) (3,115,758) (2,762,675)
Advances to limited liability company - - (2,662)
Net increase in other loans (29,977,446) (31,384,020) (23,415,947)
Purchases of premises and equipment, net (5,008,485) (3,310,883) (463,995)
Net cash used by investing activities (37,442,780) (34,407,119) (21,088,022)
Cash flows from financing activities:
Increase in deposits 42,238,049 19,068,704 15,253,430
Increase (decrease) in federal funds purchased
and other short-term borrowings (4,475,000) 3,300,000 3,450,000
Repayment of long-term borrowings (2,053,411) (43,221) (37,633)
Proceeds from long-term borrowings 3,000,000 8,645,750 -
Proceeds from issuance of common stock 156,629 224,930 188,230
Shares issued under employee benefit plan 258,300 143,177 243,732
Purchase and retirement of common stock (7,216) (97,590) (40,983)
Cash dividends paid (778,260) (680,050) (547,385)
Net cash provided by financing activities 38,339,091 30,561,700 18,509,391
Net increase (decrease) in cash and
due from banks 3,080,201 932,799 (914,235)
Cash and due from banks at beginning of year 4,531,237 3,598,438 4,512,673
Cash and due from banks at end of year $ 7,611,438 4,531,237 3,598,438
Supplemental disclosures of cash flow information:
Cash paid during year for interest $ 7,224,423 5,809,015 4,629,483
Cash paid during year for income taxes 1,660,746 1,436,788 1,416,594
Non-cash investing activities:
Capitalized interest 246,342 67,083 3,097
Stock dividend $ 60,200 51,500 26,600
</TABLE>
See accompanying notes to consolidated financial statements.
<PAGE> 40
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
GENERAL
Heritage Financial Services, Inc., through its subsidiary, Heritage
Bank, provides a variety of banking and investment services to
individuals and businesses through its banking offices in Clarksville
and Montgomery County, Tennessee. Its primary deposit products are
demand and savings deposits and certificates of deposit, and its
primary lending products are commercial, real estate mortgage and
installment loans. The Bank provides investment services through
Heritage Investment Center, Inc., insurance services through Central
Life Insurance Company, and consumer loans through Advance Credit
Company Inc., all of which are wholly-owned subsidiaries of the Bank
(see Note 15). The accounting principles followed and the methods of
applying those principles conform with generally accepted accounting
principles and to general practices in the banking industry. The
significant policies are summarized as follows:
PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements include the accounts
of Heritage Financial Services, Inc. (the Company), a one-bank holding
company, and its wholly-owned subsidiary, Heritage Bank (the Bank) and
its subsidiaries. Material intercompany accounts and transactions have
been eliminated in consolidation.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make 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 revenues
and expenses during the reporting periods. Actual results could differ
from those estimates.
CASH AND CASH EQUIVALENTS
For the purpose of presentation in the statements of cash flows, cash
and cash equivalents are defined as those amounts included in the
balance sheet caption "cash and due from banks".
INVESTMENT SECURITIES
Securities are classified into three categories: held-to-maturity
(HTM), available-for-sale (AFS), and trading. Securities classified as
held-to-maturity, which are those the Company has the positive intent
and ability to hold to maturity, are reported at amortized cost.
Debt securities not classified as held-to-maturity are classified as
available-for-sale. Securities available-for-sale are carried at fair
value with unrealized gains and losses reported in other comprehensive
income. Realized gains (losses) on securities available-for-sale are
included in other income (expense) and, when applicable, are reported
as a reclassification adjustment, net of tax, in other comprehensive
income.
<PAGE> 41
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
INVESTMENT SECURITIES, CONTINUED
Realized gains and losses are reported in earnings based on the
adjusted cost of the specific security sold. The Company currently has
no held-to-maturity or trading securities.
LOANS
Loans which management has the intent and ability to hold for the
foreseeable future are reported at their outstanding principal balance.
Interest on commercial and real estate loans is computed daily based on
the principal amount outstanding. Interest on installment loans is
recognized using both the interest method and a method which
approximates the interest method. Loan origination fees in excess of
related direct costs are deferred and recognized as an adjustment of
yield using the interest method.
A loan is considered impaired when it is probable that the Company will
be unable to collect the scheduled payments of principal and interest
due under the contractual terms of the loan agreement. Impaired loans
are measured at the present value of expected future cash flows
discounted at the loan's effective interest rate, at the loan's
observable market price, or at the fair value of the collateral if the
loan is collateral dependent. If the measure of the impaired loan is
less than the recorded investment in the loan, a creditor shall
recognize an impairment by creating or adjusting a valuation allowance
with a corresponding charge or credit to the provision for loan losses.
The Company considers all loans on non-accrual status to be impaired.
Interest accruals on loans are discontinued when, in the opinion of
management, it is not reasonable to expect that such interest will be
collected, or generally, when collection of principal or interest
becomes 90 days or more past due. Management may make exceptions to
this policy when the estimated net realizable value of the collateral
is sufficient to recover the principal and interest balance. When
interest accrual is discontinued, all unpaid accrued interest is
reversed. Interest income is subsequently recognized only to the extent
cash payments are received.
MORTGAGE LOANS HELD FOR SALE
Certain mortgage loans held for sale to permanent investors are stated
at lower of cost or market in the aggregate with respect to the entire
portfolio. At December 31, 1998, cost approximates the market value of
such loans.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is established by charges to operations
based on management's evaluation of the assets, economic conditions and
other factors considered necessary to maintain the allowance at an
adequate level. In evaluating the adequacy of the allowance, management
makes certain estimates and assumptions which are susceptible to change
in the near term.
<PAGE> 42
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
ALLOWANCE FOR LOAN LOSSES, CONTINUED
While management uses available information to recognize losses on
loans, future additions to the allowance may be necessary based on
changes in economic conditions. Uncollectible loans are charged to the
allowance account in the period such determination is made. Recoveries
on loans previously charged off are credited to the allowance account
in the period received.
Allowances for impaired loans are generally determined based on
collateral values or the present value of estimated cash flows.
PREMISES AND EQUIPMENT
Premises and equipment are stated at cost, less accumulated
depreciation and amortization. The provision for depreciation is
computed principally on the straight-line method over the estimated
useful lives of the assets.
FORECLOSED AND REPOSSESSED ASSETS
Real estate acquired through foreclosure is recorded at the lower of
the outstanding loan amount or fair value, determined by appraisal,
less estimated costs to sell, at the date of foreclosure. Other
repossessed assets are recorded at the lower of the loan amount or fair
value, determined by recognized industry standards at the date the
properties are repossessed. Further declines in value, as well as
losses resulting from disposition are charged to operations.
PER SHARE AMOUNTS
Earnings per share (EPS) is calculated in accordance with Statement of
Financial Accounting Standards (SFAS) No. 128. The statement requires
the dual presentation of basic and diluted EPS on the income statement.
Basic EPS excludes dilution, and is computed by dividing income
available to common stockholders by the weighted-average number of
common shares outstanding for the period. Diluted EPS reflects the
potential dilution that could occur if securities or contracts to issue
common stock were exercised or converted into common stock that then
shared in the earnings of the entity.
MORTGAGE SERVICING RIGHTS
Separate assets are recognized for the rights to service mortgage loans
for others regardless of how those servicing rights are acquired.
Mortgage servicing rights are determined based on the present value of
the difference between the yield on loans sold less a normal servicing
fee and the yield paid to the investor over the estimated lives of the
loans. The mortgage servicing rights are amortized on a method which
approximates a level yield over the estimated lives of serviced loans
considering assumed prepayment patterns.
<PAGE> 43
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
The carrying values of the mortgage servicing rights are evaluated for
impairment based on their fair values categorized by coupon rate. Fair
values of servicing rights are determined by estimating the present
value of future net servicing income considering the average interest
rate and the average remaining lives of the related mortgage loans
being serviced.
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
STOCK-BASED COMPENSATION
Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting
for Stock-Based Compensation", defines a fair value-based method of
measuring employee stock options or similar equity instruments. Under
this method, compensation cost is measured at the option grant date
based on the value of the award and is recognized over the service
period, which is usually the vesting period. In lieu of recording the
value of such options, the Company has elected to continue to measure
compensation cost using APB Opinion 25 and to provide pro forma
disclosures quantifying the difference between compensation cost
included in reported net income and the related cost measured by such
fair value-based method.
TRANSFER AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF
LIABILITIES
Effective January 1, 1997, the Company adopted SFAS No. 125,
"Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities". The statement, which supercedes SFAS
No. 122, provides accounting and reporting standards for transfers and
servicing of financial assets and extinguishments of liabilities on
application of a financial-components approach that focuses on control.
It distinguishes transfers of financial assets that are sales from
transfers of assets that are secured borrowings. The adoption of SFAS
125 did not have a material effect on the Company's financial position
or results of operations.
INCOME TAXES
The Company files a consolidated tax return with its subsidiary. Income
taxes are allocated to members of the consolidated group on a separate
return basis. Income taxes have been provided using the liability
method as prescribed by Statement of Financial Accounting Standards No.
109, "Accounting for Income Taxes".
COMPREHENSIVE INCOME
On January 1, 1998, the Company adopted Statement of Financial
Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income".
SFAS No. 130 establishes standards for reporting comprehensive income.
Comprehensive income includes net income and other comprehensive income
which is defined as non-owner related transactions in equity.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair
value of each class of financial instruments for which it is
practicable to estimate that value.
<PAGE> 44
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
Cash and Due From Banks - The carrying amount is a reasonable estimate
of fair value.
Securities - The fair value is based on quoted market prices, if
available. For securities where quoted market prices are not available,
fair value is estimated based on market prices of similar securities.
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
FAIR VALUE OF FINANCIAL INSTRUMENTS
Mortgage Loans Held for Sale - These instruments are awaiting funding
(generally 30 days or less) from permanent investors. The carrying
amount is a reasonable estimate of fair value.
Loans - The fair value of loans is estimated by discounting the future
cash flows using the current rates at which similar loans would be made
to borrowers with similar credit ratings and for the same remaining
maturities.
Deposits - The fair value of demand deposits, savings accounts, and
money market deposits is the amount payable on demand as of the
reporting date. The fair value of fixed-maturity certificates of
deposit is estimated using the rates currently offered for deposits of
similar remaining maturities.
Federal Funds Purchased and Short-Term Borrowings - These instruments
generally have an original term to maturity of 30 days or less and,
therefore, their carrying amount is a reasonable estimate of fair
value.
Long-Term Borrowings - The fair value of long-term borrowings is
estimated using rates currently offered for obligations with similar
remaining maturities and rate structures.
Commitments to Extend Credit and Standby Letters of Credit - Generally,
commitments to extend credit and standby letters of credit have
original terms, at their issuance, of one year or less; therefore, the
fair value of these instruments does not materially differ from their
stated value.
RECENT ACCOUNTING PRONOUNCEMENTS
SFAS No. 133 "Accounting for Derivative Instruments and Hedging
Activities" establishes accounting and reporting standards for
derivative instruments and hedging activities. It requires that an
entity recognize all derivatives as either assets or liabilities in the
balance sheets and measure those instruments at fair value. This
statement is effective for all fiscal quarters of fiscal years
beginning after June 15, 1999. The adoption of the provisions of this
statement is not expected to have a material impact on the Company's
financial statements.
RECLASSIFICATIONS
Certain amounts have been reclassified in the previous years' financial
statements to conform
<PAGE> 45
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
with the current year's classifications.
(2) RESTRICTED CASH BALANCES
The Company's subsidiary bank is required to maintain reserves, in the
form of cash and due from banks against its deposit liabilities.
Aggregate reserves of $868,000 were required to be maintained to
satisfy federal regulatory requirements at December 31, 1998.
(3) INVESTMENT SECURITIES
The following table reflects the amortized cost and fair values of
investment securities held at December 31, 1998 and 1997.
<TABLE>
<CAPTION>
1998
- ----------------------------------------------------------------------------------------------------------------
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
AVAILABLE-FOR-SALE COST GAINS LOSSES VALUE
- ---------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
U.S. AGENCIES $ 4,685,871 50,986 18,250 4,718,607
MORTGAGE-BACKED U.S.
AGENCIES 9,748,597 54,587 25,377 9,777,807
ASSET-BACKED U.S.
AGENCIES 565,716 8,784 - 574,500
TAX-EXEMPT SECURITIES 5,783,985 132,395 20,413 5,895,967
EQUITY SECURITIES 898,400 - - 898,400
- ---------------------------------------------------------------------------------------------------------------
$ 21,682,569 246,752 64,040 21,865,281
===============================================================================================================
1997
- ---------------------------------------------------------------------------------------------------------------
U.S. agencies $ 10,420,563 62,584 65,110 10,418,037
Mortgage-backed
U.S. agencies 3,876,781 50,078 46,497 3,880,362
Tax-exempt securities 3,929,241 87,253 11 4,016,483
Equity securities 838,200 - - 838,200
- ---------------------------------------------------------------------------------------------------------------
$ 19,064,785 199,915 111,618 19,153,082
===============================================================================================================
</TABLE>
The amortized cost and fair value of debt securities at December 31, 1998 by
contractual maturity are shown below. Expected maturities will differ from
contractual maturities because borrowers may have the right to call or prepay
obligations.
<PAGE> 46
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
<TABLE>
<CAPTION>
AMORTIZED FAIR
COST VALUE
----------------------------------
<S> <C> <C>
Available-for-sale:
Due in one year or less $ 165,000 166,058
Due after one through five years 5,125,964 5,192,662
Due after five through ten years 2,460,253 2,513,595
Due after ten years 2,718,577 2,742,259
Mortgage and asset-backed securities 10,314,313 10,352,307
----------------------------------
$ 20,784,107 20,966,881
==================================
</TABLE>
Securities carried at $8,689,000 and $6,052,000 at December 31, 1998
and 1997, respectively, were pledged to secure public deposits and for
other purposes as required or permitted by law.
(3) INVESTMENT SECURITIES, CONTINUED
For the years ended December 31, 1998, 1997 and 1996, the Company had
gross realized gains from sales of securities available-for-sale of
$26,546, $7,790, and $85,988, respectively, and gross realized losses
of $1,718, $10,165, and $2,862, respectively.
(4) LOANS
A summary of loans outstanding by category follows:
<TABLE>
<CAPTION>
1998 1997
- ---------------------------------------------------------------------------------------------------------
<S> <C> <C>
Real estate:
1 to 4 family residential properties 44,742,818 39,220,945
Construction 12,442,125 16,759,666
Commercial 60,071,717 41,305,233
Commercial, financial and agricultural 27,003,981 22,835,030
Consumer 22,043,029 14,936,983
- ---------------------------------------------------------------------------------------------------------
166,303,670 135,057,857
Less unearned interest (2,007,404) (207,812)
- ---------------------------------------------------------------------------------------------------------
Total loans 164,296,266 134,850,045
=========================================================================================================
</TABLE>
At December 31, 1998 and 1997, the Bank had loans amounting to $803,191
and $95,270, respectively that were specifically classified as impaired
(non-accrual status). The allowance for loan losses related to impaired
loans amounted to approximately $141,000 and $30,000 at December 31,
1998 and 1997, respectively. The average balance of these loans
amounted to approximately $447,000, $186,000, and $107,000 for the
years ended December 31, 1998, 1997 and 1996, respectively. If the
impaired loans had been current throughout their terms, gross interest
income for the year ended December 31, 1998, would have increased
$23,235.
Certain parties (principally directors and officers of the Bank,
including their affiliates, families,
<PAGE> 47
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
and companies in which they hold ten percent or more ownership) were
customers of, and had loans and other transactions with the Bank in the
ordinary course of business. The outstanding balances of such loans
totaled $4,071,867 and $3,675,182 as of December 31, 1998 and 1997,
respectively. During 1998, $3,068,785 of new loans were made and
repayments amounted to $2,672,100. These loan transactions were made on
substantially the same terms as those prevailing at the time for
comparable loans to other persons. They did not involve more than the
normal risk of collectibility or present other unfavorable features.
(5) COMMITMENTS AND CONTINGENT LIABILITIES
The Bank is a party to financial instruments with off-balance sheet
risk in the normal course of business to meet the financing needs of
its customers. These financial instruments include commitments to
extend credit, standby letters of credit and mortgage loans sold with
recourse. Those instruments involve, to varying degrees, elements of
credit risk in excess of the amount recognized in the balance sheet.
The contract or notional amounts of those instruments reflect the
extent of involvement the Bank has in those particular financial
instruments.
The Bank's exposure to credit loss in the event of nonperformance by
the other party to the financial instrument for commitments to extend
credit, standby letters of credit, and mortgage loans sold with
recourse is represented by the contractual notional amount of those
instruments. The Bank uses the same credit policies in making
commitments and conditional obligations as it does for on-balance sheet
instruments.
<TABLE>
<CAPTION>
CONTRACT OR
NOTIONAL AMOUNT
----------------
<S> <C>
Financial instruments whose contract amounts represent credit risk:
Commitments to extend credit $16,779,000
Standby letters of credit 1,277,000
</TABLE>
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 Bank evaluates each customer's creditworthiness on a
case-by-case basis. The amount of collateral obtained if deemed
necessary by the Bank upon extension of credit is based on management's
credit evaluation. Collateral held varies but may include accounts
receivable, inventory, property,
<PAGE> 48
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
plant and equipment, 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. All letters of credit are due within one year or less of
the original commitment date. The credit risk involved in issuing
letters of credit is essentially the same as that involved in extending
loan facilities to customers.
In connection with its mortgage banking activities, the Bank may be
required to repurchase certain loans sold if they become delinquent
within a specified period, generally no longer than 120 days. The
number of loans the Bank has been required to repurchase since
inception of the mortgage banking department has not been material.
(5) COMMITMENTS AND CONTINGENT LIABILITIES, CONTINUED
The Bank primarily serves customers located in Montgomery County,
Tennessee and surrounding areas. As such, the Bank's loans,
commitments, and stand-by letters of credit have been granted to
customers in that area. The area's largest employer is the United
States Army base at Fort Campbell which employs approximately 23,400
military personnel and 4,300 civilians. Concentration of credit by type
of loan is presented in Note 4.
In the normal course of business, the Bank is involved in various legal
proceedings. Management has concluded, based upon advice of counsel,
that the result of these proceedings will not have a material effect on
the Bank's financial condition or results of operations.
(6) ALLOWANCE FOR LOAN LOSSES
Changes in the allowance for loan losses are as follows:
<TABLE>
<CAPTION>
1998 1997 1996
- --------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
BALANCE AT BEGINNING OF YEAR $ 1,908,420 1,544,123 1,267,252
Provision charged to operating
expenses 1,325,000 675,700 485,000
Addition due to loans purchased 92,846 - -
Loan losses:
Loans charged off (665,270) (341,023) (244,581)
Recoveries on loans previously
charged off 41,198 29,620 36,452
- --------------------------------------------------------------------------------------------------------------
BALANCE AT END OF YEAR $ 2,702,194 1,908,420 1,544,123
==============================================================================================================
</TABLE>
<PAGE> 49
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(7) PREMISES AND EQUIPMENT AND LEASE COMMITMENTS
Annual provisions for depreciation and amortization totaled $341,586,
$340,173, and $339,916 for 1998, 1997 and 1996, respectively. The
following is a summary of bank premises and equipment as of December
31, 1998 and 1997:
<TABLE>
<CAPTION>
1998 1997
- ------------------------------------------------------------------------------------------------------
<S> <C> <C>
Land $ 934,809 934,809
Land improvements 883,487 156,332
Buildings 7,693,834 835,213
Furniture and equipment 2,160,470 1,676,983
Leasehold improvements 242,001 259,870
Construction in progress - 3,410,278
- ------------------------------------------------------------------------------------------------------
11,914,601 7,273,485
Less allowance for depreciation and amortization 1,560,043 1,812,434
- ------------------------------------------------------------------------------------------------------
$ 10,354,558 5,461,051
======================================================================================================
</TABLE>
(7) PREMISES AND EQUIPMENT AND LEASE COMMITMENTS, CONTINUED
In November 1998, the Bank began operating from its new main office
building. Additional expenditures to complete the building project are
expected to be approximately $1,000,000.
Capitalized interest associated with the construction of the new main
office building amounted to $246,342, $67,083 and $3,097 in 1998, 1997
and 1996, respectively.
Rent expense for 1998, 1997 and 1996 was $543,225, $523,458, and
$246,994, respectively. Future minimum rental payments required under
operating leases that have initial or remaining non-cancelable lease
terms in excess of one year as of December 31, 1998 are as follows:
<TABLE>
<CAPTION>
Year Ending
December 31, Amount
-------------- ------
<S> <C>
1999 $ 449,331
2000 327,527
2001 227,643
2002 59,581
2003 3,070
Later years 4,730
</TABLE>
<PAGE> 50
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(8) DEPOSITS
A summary of deposits at December 31, 1998 and 1997 follows:
<TABLE>
<CAPTION>
1998 1997
- --------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Noninterest-bearing demand $ 24,163,261 18,821,225
Interest checking 11,934,625 10,485,366
Money market accounts 30,816,424 22,353,707
Savings 5,767,909 5,195,774
Retirement accounts 3,494,844 3,546,987
Certificates of deposit of $100,000 or more 15,272,242 11,670,621
Other time 85,169,056 62,306,632
- --------------------------------------------------------------------------------------------------------------
$ 176,618,361 134,380,312
==============================================================================================================
</TABLE>
Interest expense on deposits of $100,000 or more amounted to $822,407, $540,637,
and $382,048 in 1998, 1997 and 1996, respectively.
(9) INCOME TAXES
The provision for income taxes consists of the following:
<TABLE>
<CAPTION>
1998 1997 1996
- --------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
CURRENT: Federal $1,366,208 1,174,841 1,118,052
State 277,867 221,150 217,633
- --------------------------------------------------------------------------------------------------------------
Total current 1,644,075 1,395,991 1,335,685
- --------------------------------------------------------------------------------------------------------------
DEFERRED: Federal (16,500) (61,500) (98,500)
State (3,500) (11,500) (18,500)
- --------------------------------------------------------------------------------------------------------------
Total deferred (20,000) (73,000) (117,000)
- --------------------------------------------------------------------------------------------------------------
Total provision for income
taxes $1,624,075 1,322,991 1,218,685
==============================================================================================================
</TABLE>
The sources of deferred income taxes (benefits) and the tax effect of each
follows:
<TABLE>
<CAPTION>
1998 1997 1996
- --------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Provision for loan losses $ (257,000) (119,000) (98,500)
Depreciation 197,000 (8,500) (24,500)
Mortgage servicing rights 38,000 53,000 13,000
Other, net 2,000 1,500 (7,000)
- --------------------------------------------------------------------------------------------------------------
$ (20,000) (73,000) (117,000)
==============================================================================================================
</TABLE>
The tax effects of each type of temporary difference that gives rise to net
deferred tax assets are as follows:
<TABLE>
<CAPTION>
1998 1997
- -------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Allowance for loan losses $ 881,260 624,260
Property and equipment (127,000) 70,000
Mortgage servicing rights (104,000) (66,000)
Other, net (8,260) (6,260)
Unrealized losses on securities (66,200) (31,787)
- -------------------------------------------------------------------------------------------------------------
$ 575,800 590,213
=============================================================================================================
</TABLE>
<PAGE> 51
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(9) INCOME TAXES, CONTINUED
A reconciliation of the provision for income taxes with the amount of
income taxes computed at the federal statutory rate (34%) follows:
<TABLE>
<CAPTION>
1998 1997 1996
- -------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Tax expense at statutory rate $ 1,521,989 1,224,057 1,130,053
Increase (decrease) in taxes
resulting from:
Tax exempt interest (82,885) (57,153) (60,983)
Disallowed interest expense 15,532 9,703 8,895
State income taxes, net of
federal tax benefit 181,082 138,369 131,428
Other, net (11,643) 8,015 9,292
- --------------------------------------------------------------------------------------------------------------
$ 1,624,075 1,322,991 1,218,685
==============================================================================================================
</TABLE>
(10) LONG-TERM BORROWINGS
The Bank obtains various short-term and long-term advances from the
Federal Home Loan Bank of Cincinnati (FHLB) under Blanket agreements
for Advances and Security Agreements (Agreements). The Agreements
entitle the Bank to borrow funds from the FHLB to fund mortgage loan
programs and satisfy other funding needs. At December 31, 1998, the
Bank
<PAGE> 52
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
had lines of credit from the FHLB totaling $7.0 million, all of which
was undrawn and available. Of the long-term advances at December 31,
1998, $1,087,000 were at fixed rates ranging from 4.90% to 6.35%, and
$8,646,000 were at a rate which floats with LIBOR (London Interbank
Offered Rate) with a weighted-average rate of 5.39%. FHLB advances are
collateralized by the Bank's FHLB stock amounting to $878,400 and
certain single-family first mortgage loans in the approximate amount of
$14.6 million. The long-term advances provide for scheduled monthly
payments but may be prepaid at the option of the Bank with the payment
of a premium. The floating rate advances may generally be prepaid at
any monthly anniversary date at the current outstanding principal
balance.
Maturities of the FHLB advances are as follows:
<TABLE>
<S> <C>
1999 $ 17,545
2000 13,356
2001 2,022,878
2002 14,580
2003 15,494
Later years 7,648,424
------------------
$ 9,732,277
==================
</TABLE>
(11) MORTGAGE SERVICING RIGHTS
The outstanding balance of loans serviced for others was $29,016,000,
$13,234,000 and $3,054,000 at December 31, 1998, 1997 and 1996,
respectively. Mortgage servicing rights of $272,500, $155,800, and
$33,100 were capitalized in 1998, 1997 and 1996, respectively.
Amortization and write-down of those rights amounted to $173,600,
$14,400, and $1,000 for the years ended 1998, 1997 and 1996,
respectively.
(12) STOCK COMPENSATION PLANS
The Company has two long-term incentive stock option plans for key
employees. The stock option plans provide for these key employees to
purchase shares of the Company's $2.00 par value common stock at the
fair market value at the date of the grant. The options granted under
the plans become exercisable over a period not to exceed ten years. The
1989 Stock Option Plan provides for the granting of options to purchase
up to 150,000 shares and all of the options under this plan have been
granted. The 1998 Stock Option Plan also provides for the granting of
options to purchase up to 150,000 shares and 19,619 options under this
plan have been granted.
In 1998, the shareholders of the Company approved the adoption of the
Outside Directors' Stock Option Plan. This stock option plan provides
for non-employee directors to purchase shares of the Company's $2.00
par value common stock at the fair market value at the date
<PAGE> 53
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
of the grant. The options granted under the plan become exercisable
over a period not to exceed ten years. The plan provides for the
granting of options to purchase up to 40,000 shares. Each non-employee
director is to be automatically granted 500 shares annually for the
years 1998 through 2002. Such options vest at the rate of 20% annually,
and 5,000 shares under this plan have been granted.
As discussed in Note 1, the Company will continue to apply APB Option
25 and related interpretations on accounting for its plans.
Accordingly, no compensation cost has been recognized for the plans.
Had compensation cost for the Company's plans been determined based on
the fair value at the grant date for awards under those plans
consistent with the method of FASB Statement No. 123, the Company's net
income would have been reduced by $87,000 ($.15 per share), $15,000
($.03 per share), and $14,000 ($.03 per share) for 1998, 1997 and 1996,
respectively.
The fair value of the options granted is estimated as of the date
granted using the Black-Scholes option pricing model with the following
weighted-average assumptions used for grants: dividend yield of 4.0
percent, risk-free interest rate of 6.0 percent, and expected lives of
five years in 1998, 1997 and 1996, and expected volatility of 21
percent in 1998, 33 percent in 1997, and 19 percent in 1996.
A summary of the status of the Company's stock option plans for the
three years ended December 31, 1998 and changes during those years is
presented below.
(12) STOCK COMPENSATION PLANS, CONTINUED
<TABLE>
<CAPTION>
Weighted-
Average
Total Option Exercisable Exercise
Shares Shares Price
- --------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Options outstanding at December 31, 1995 40,850 31,350 11.47
Options which became exercisable - 1,500 14.00
Granted 10,050 - 25.00
Exercised (12,847) (12,847) 10.47
- --------------------------------------------------------------------------------------------------------------
Options outstanding at December 31, 1996 38,053 20,003 11.47
Options which became exercisable - 2,000 16.75
Granted 11,069 - 36.61
Exercised (14,503) (14,503) 11.38
- --------------------------------------------------------------------------------------------------------------
Options outstanding at December 31, 1997 34,619 7,500 23.84
Options which became exercisable - 2,000 16.75
Granted 58,500 - 55.23
Option forfeited (250) - 55.00
Exercised (6,650) (6,650) 12.41
- --------------------------------------------------------------------------------------------------------------
Options outstanding at December 31, 1998 86,219 2,850 45.93
==============================================================================================================
</TABLE>
<PAGE> 54
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
The weighted-average fair value of options, calculated using the
Black-Scholes option pricing model, granted during 1998, 1997 and 1996
was $10.33, $9.77 and $9.43, respectively.
The following table summarizes information about the stock options
outstanding under the Company's plans at December 31, 1998:
<TABLE>
<CAPTION>
Exercise Number Average Number
Price Outstanding Remaining Life Exercisable
<S> <C> <C> <C>
10 1,650 0.5 years 1,650
12 3,000 1.5 years 1,000
18 3,000 5.3 years -
25 9,250 4.4 years 200
32 8,069 3.0 years -
49 3,000 8.7 years -
55 57,750 9.3 years -
82 500 9.8 years -
</TABLE>
The effect of these options after applying the "treasury stock" method
was to increase average common shares outstanding by 2,468 in 1998,
5,958 in 1997, and 12,493 in 1996.
(13) EMPLOYEE BENEFITS
During 1992 the Company established a noncontributory Employee Stock
Ownership Plan("ESOP"), which covers substantially all employees.
Employer contributions to the ESOP are determined annually by the board
of directors and amounted to $181,250 in 1998, $143,750 in 1997, and
$131,250 in 1996.
The Company does not provide postretirement or postemployment benefits
other than those mentioned above.
<PAGE> 55
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(14) STOCKHOLDERS' EQUITY
The Company's charter authorizes 1,000,000 shares of preferred stock,
no par value. Shares of the preferred stock may be issued from time to
time in one or more series, each such series to be so designated as to
distinguish the shares thereof from the shares of all other series and
classes. The board of directors has the authority to divide any or all
classes of preferred stock and to fix and determine the relative rights
and preferences of the shares of any series so established. The board
currently has no intent to issue such preferred stock.
Funds for cash distributions to shareholders and normal operating
expenses of the Company are derived primarily from dividends from the
subsidiary bank. The Company and its subsidiary bank are subject to
federal and state statutes and regulations that impose restrictions on
the amount of dividends that can be declared without prior regulatory
approval. At December 31, 1998, approximately $2,000,000 of retained
earnings was available for dividend declaration without prior
regulatory approval.
Under capital adequacy guidelines and the regulatory framework for
prompt corrective action, the Company and its subsidiary bank are
required to meet specific capital adequacy guidelines that involve
quantitative measures of a bank's assets, liabilities, and certain
off-balance sheet items as calculated under regulatory accounting
practices. Failure to meet minimum capital requirements can initiate
certain mandatory and possible additional discretionary actions by
regulators that, if undertaken, could have a material effect on the
Company's financial condition. The capital amounts and classifications
are also subject to qualitative judgments by the regulators about
components, risk weightings, and other factors. The risk-based
guidelines are based on the assignment of risk weights to assets and
off-balance sheet items depending on the level of credit risk
associated with them.
In addition to minimum capital requirements, under the regulatory
framework for prompt corrective action, regulatory agencies have
specified certain ratios an institution must maintain to be considered
"undercapitalized", "adequately capitalized", and "well capitalized".
As of December 31, 1998 the most recent notification from the bank's
regulatory authority categorized the Company and the Bank as "well
capitalized". There are no conditions or events since that notification
that management believes have changed the bank's category.
<PAGE> 56
The Company and the Bank's capital amounts and ratios at December 31,
1998 were as follows:
(14) STOCKHOLDERS' EQUITY, CONTINUED
<TABLE>
<CAPTION>
TO BE WELL CAPITALIZED
REQUIRED UNDER PROMPT CORRECTIVE
MINIMUM ACTION PROVISIONS ACTUAL
------------------------------ ------------------------------ ---------------------------------
HERITAGE HERITAGE HERITAGE
FINANCIAL FINANCIAL FINANCIAL
HERITAGE SERVICES HERITAGE SERVICES HERITAGE SERVICES
BANK INC. BANK INC. BANK INC.
------------------------------- ------------------------------ ---------------------------------
<S> <C> <C> <C> <C> <C> <C>
DECEMBER 31, 1998
- -----------------
AMOUNT:
TIER I TO AVERAGE
ASSETS $ 8,132,000 8,133,000 10,165,000 10,166,000 15,202,000 15,623,000
TIER I TO RISK-
BASED ASSETS 6,265,000 6,265,000 9,397,000 9,398,000 15,202,000 15,623,000
TOTAL CAPITAL TO
RISK-BASED ASSETS 12,567,000 12,530,000 15,661,000 15,663,000 17,184,000 17,606,000
RATIOS:
TIER I TO AVERAGE
ASSETS 4.00% 4.00% 5.00% 5.00% 7.48% 7.68%
TIER I TO RISK-
BASED ASSETS 4.00% 4.00% 6.00% 6.00% 9.71% 9.97%
TOTAL CAPITAL TO
RISK-BASED ASSETS 8.00% 8.00% 10.00% 10.00% 10.97% 11.24%
DECEMBER 31, 1997
- -----------------
AMOUNT:
Tier I to average
assets 6,618,000 6,426,000 8,273,000 8,033,000 12,210,000 12,651,000
Tier I to risk-
based assets 5,397,000 5,397,000 6,746,000 8,095,000 12,210,000 12,651,000
Total capital to risk-
based assets 10,794,000 10,794,000 13,492,000 13,492,000 13,899,000 14,340,000
RATIOS:
Tier I to average
assets 4.00% 4.00% 5.00% 5.00% 7.38% 7.87%
Tier I to risk-
based assets 4.00% 4.00% 6.00% 6.00% 9.05% 9.38%
Total capital to risk-
based assets 8.00% 8.00% 10.00% 10.00% 10.30% 10.63%
</TABLE>
<PAGE> 57
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(15) BANK SUBSIDIARIES
Heritage Investment Corporation (the Corporation) is a wholly-owned
subsidiary of the Bank. The Corporation entered into an arrangement to
build a speculative industrial building in the Clarksville/Montgomery
County Industrial Park. The Corporation invested $490,000, or 40.5% of
the total project cost. In 1998, the industrial building was sold and a
gain of $147,580 was realized from the sale. Currently, the Corporation
is inactive.
Heritage Investment Center (the Center) was incorporated June 28, 1995,
as a wholly-owned subsidiary of Heritage Bank. On July 24, 1995, the
Center purchased the assets of an investment brokerage business.
Goodwill in the amount of $78,735 related to the purchase is being
amortized over five years. The Center is engaged in investment
brokerage activities under the broker/dealer relationship of Raymond
James Financial Services.
Central Life Insurance Company (Central) was incorporated December,
1996 as a wholly-owned subsidiary of Heritage Bank. Central has entered
into a reinsurance arrangement and receives underwriting profits by
providing life and disability insurance to borrowers of Heritage Bank.
Management services are provided to Central through a third party.
Advance Credit Company, Inc. (Advance Credit) began operations in June,
1997 as a wholly-owned subsidiary of the Bank. Advance Credit is
located in Clarksville, Tennessee and originates traditional consumer
finance loans.
(16) FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair values of the Company's financial instruments are as
follows:
<TABLE>
<CAPTION>
DECEMBER 31, 1998 December 31, 1997
------------------------------------------------------------------------------
CARRYING FAIR Carrying Fair
AMOUNT VALUE Amount Value
------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Financial assets:
Cash and cash
equivalents $ 7,611,438 7,611,438 4,531,237 4,531,237
Securities 21,865,281 21,865,281 19,153,082 19,153,082
Mortgage loans held for
sale 3,222,057 3,222,057 631,486 631,486
Loans receivable 164,296,266 164,668,266 134,850,045 135,216,000
Financial liabilities:
Deposits 176,618,361 174,258,361 134,380,312 134,264,000
Short-term borrowings 3,675,000 3,675,000 8,150,000 8,150,000
Long-term borrowings 9,732,227 9,728,227 8,785,688 8,785,000
</TABLE>
<PAGE> 58
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(16) FAIR VALUE OF FINANCIAL INSTRUMENTS, CONTINUED
<TABLE>
<CAPTION>
DECEMBER 31, 1998 December 31, 1997
------------------------------------------------------------------------------
Off-balance sheet NOTIONAL FAIR Notional Fair
instruments: AMOUNT VALUE Amount Value
------------------ ----------------- ------------------- -------------------
<S> <C> <C>
Loan commitments $ 16,779,000 - 16,054,000 -
Letters of credit 1,277,000 - 662,000 -
</TABLE>
(17) PARENT COMPANY FINANCIAL INFORMATION
Following are condensed balance sheets of Heritage Financial Services,
Inc. (parent company only) as of December 31, 1998 and 1997, and the
related condensed statements of operations and cash flows for the three
years ended December 31, 1998.
CONDENSED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31, 1998 1997
- -------------------------------------------------------------------------------------------------------------
ASSETS:
<S> <C> <C>
Cash $ 400,130 415,626
Securities available-for-sale 20,000 20,000
Investment in subsidiary bank, at equity 15,374,870 12,812,124
Other assets 5,901 5,901
- -------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $ 15,800,901 13,253,651
- -------------------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY:
Other liabilities 6,000 1,000
Stockholders' equity:
Common stock, $2.00 par value 1,159,278 1,137,147
Additional paid-in capital 5,464,169 5,078,587
Retained earnings 9,054,518 6,980,416
Unrealized gains (losses) on AFS securities, net 116,936 56,501
- -------------------------------------------------------------------------------------------------------------
Total stockholders' equity 15,794,901 13,252,651
- -------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 15,800,901 13,253,651
=============================================================================================================
</TABLE>
<PAGE> 59
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(17) PARENT COMPANY FINANCIAL INFORMATION, CONTINUED
CONDENSED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31, 1998 1997 1996
- ---------------------------------------------------------------------------------------------------------
INCOME:
<S> <C> <C> <C>
Dividends from subsidiary $ 650,000 500,000 400,000
Other income 50 - 12,381
- ---------------------------------------------------------------------------------------------------------
TOTAL INCOME 650,050 500,000 412,381
- ---------------------------------------------------------------------------------------------------------
EXPENSES:
Other expenses - 5,771 5,771
- ---------------------------------------------------------------------------------------------------------
NET INCOME BEFORE INCOME TAXES AND
EQUITY IN UNDISTRIBUTED INCOME OF
SUBSIDIARY 650,050 494,229 408,419
INCOME TAX EXPENSE (BENEFIT) - (2,000) 4,000
- ---------------------------------------------------------------------------------------------------------
NET INCOME BEFORE EQUITY IN
UNDISTRIBUTED EARNINGS OF SUBSIDIARY 650,050 496,229 404,419
EQUITY IN UNDISTRIBUTED EARNINGS OF
SUBSIDIARY 2,202,312 1,805,715 1,700,581
- ---------------------------------------------------------------------------------------------------------
NET INCOME $ 2,852,362 2,301,944 2,105,000
=========================================================================================================
</TABLE>
CONDENSED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31, 1998 1997 1996
- --------------------------------------------------- ------------------- ----------------- ------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
<S> <C> <C> <C>
Net income $ 2,852,362 2,301,944 2,105,000
Adjustments to reconcile net income to
net cash provided by operating
activities:
Equity in undistributed earnings of
subsidiary (2,202,312) (1,805,715) (1,700,581)
Other, net 5,000 3,771 41,986
- --------------------------------------------------- ------------------- ----------------- ------------------
NET CASH PROVIDED BY OPERATING
ACTIVITIES 655,050 500,000 446,405
- --------------------------------------------------- ------------------- ----------------- ------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of securities available-for-sale - (20,000) -
- --------------------------------------------------- ------------------- ----------------- ------------------
NET CASH USED BY INVESTING ACTIVITIES $ - (20,000) -
- --------------------------------------------------- ------------------- ----------------- ------------------
</TABLE>
<PAGE> 60
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(17) PARENT COMPANY FINANCIAL INFORMATION, CONTINUED
CONDENSED STATEMENTS OF CASH FLOWS, continued
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31, 1998 1997 1996
- --------------------------------------------------- ------------------- ----------------- ------------------
<S> <C> <C> <C>
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common
stock $ 156,629 224,930 188,230
Shares issued under employee benefit
plan 258,300 143,177 243,732
Purchase and retirement of common
stock (7,215) (97,590) (40,983)
Capital contributed to subsidiary (300,000) - -
Cash dividends paid (778,260) (680,050) (547,385)
- --------------------------------------------------- ------------------- ----------------- ------------------
NET CASH USED BY FINANCING ACTIVITIES (670,546) (409,533) (156,406)
- --------------------------------------------------- ------------------- ----------------- ------------------
NET INCREASE (DECREASE) IN CASH (15,496) 70,467 289,999
CASH AT BEGINNING OF YEAR 415,626 345,159 55,160
- --------------------------------------------------- ------------------- ----------------- ------------------
CASH AT END OF YEAR $ 400,130 415,626 345,159
- --------------------------------------------------- ------------------- ----------------- ------------------
</TABLE>
HERITAGE FINANCIAL SERVICES, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(18) YEAR 2000 ISSUES
The approach of the year 2000 presents problems to computer users such
as the Company. Many computer systems in use today, particularly older
computers and computer programs, may not be able to properly interpret
dates after December 31, 1999 because they use only two digits to
indicate the year in a date. For example, the year 2000 could be
interpreted as the year 1900 by such systems. As a result, the systems
could produce inaccurate data, or not function at all.
In anticipation of this potential problem, the Company has developed a
comprehensive plan to ensure that all of its systems are able to
properly deal with the year 2000. The Company is currently testing the
ability of each system to properly perform, and is implementing
corrective measures when deficiencies are found. At this point, the
Company anticipates no difficulty in achieving full year 2000
capability and does not expect the costs of achieving full capability
to be material.
As a financial institution, the Company is also exposed to potential
risk if borrowers and depositors suffer year 2000 related difficulties
and are unable to repay their loans or maintain their deposit balances.
The Company has performed an assessment of the year 2000 readiness of
significant borrowers and depositors. At this time, the Company is
unable to determine what impact, if any, the year 2000 will have on
either the loan payment performance of borrowers or the balances of key
depositors. Thus far, however, none of the Company's borrowers or
depositors have reported the expectation of material adverse impacts as
a result of the year 2000.
<PAGE> 61
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
There have been no disagreements with the Company's independent auditors on any
matters of accounting principles or practices or financial statement disclosure.
PART III
ITEM 9. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information with respect to the directors and executive officers is incorporated
herein by reference to the proxy statement relating to the annual meeting of
shareholders to be held April 20, 1999.
ITEM 10. EXECUTIVE COMPENSATION
Information with respect to executive compensation is incorporated herein by
reference to the proxy statement relating to the annual meeting of shareholders
to be held April 20, 1999.
<PAGE> 62
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information with respect to the security ownership of certain beneficial owners
and management is incorporated herein by reference to the proxy statement
relating to the annual meeting of shareholders to be held April 20, 1999.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information with respect to certain relationships and related transactions is
incorporated herein by reference to the proxy statement relating to the annual
meeting of shareholders to be held April 20, 1999.
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
(1) Articles of Incorporation and Bylaws*
(27) Financial Data Schedule (for SEC use only)
* Incorporated herein by reference to the Preeffective Amendment No. 2
to the Form S-4 Registration Statement of Heritage Financial Service,
Inc. filed with the Securities and Exchange Commission on
January 23, 1992.
(b) No Reports on Form 8-K were filed during the 1998 calendar year.
<PAGE> 63
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
Heritage Financial Services, Inc.
- ---------------------------------
(Registrant)
By Earl O. Bradley, III
--------------------
Earl O. Bradley, III
President and Chief Executive Officer
Date March 16, 1999
--------------
By Jack L. Graham
--------------
Jack L. Graham
Chief Financial Officer
Date March 16, 1999
--------------
In accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.
By David R. Farris By James W. Russell
--------------- ----------------
Director Director
Date March 16, 1999 Date March 16, 1999
-------------- --------------
By W. Lawson Mabry By George R. Fleming, Sr.
--------------- ----------------------
Director Director
Date March 16, 1999 Date March 16, 1999
-------------- --------------
<TABLE> <S> <C>
<ARTICLE> 9
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 7,611
<INT-BEARING-DEPOSITS> 0
<FED-FUNDS-SOLD> 0
<TRADING-ASSETS> 0
<INVESTMENTS-HELD-FOR-SALE> 21,865
<INVESTMENTS-CARRYING> 0
<INVESTMENTS-MARKET> 0
<LOANS> 167,518
<ALLOWANCE> 2,702
<TOTAL-ASSETS> 208,211
<DEPOSITS> 176,618
<SHORT-TERM> 3,675
<LIABILITIES-OTHER> 2,391
<LONG-TERM> 9,732
0
0
<COMMON> 6,623
<OTHER-SE> 9,172
<TOTAL-LIABILITIES-AND-EQUITY> 208,211
<INTEREST-LOAN> 15,583
<INTEREST-INVEST> 1,216
<INTEREST-OTHER> 14
<INTEREST-TOTAL> 16,813
<INTEREST-DEPOSIT> 6,668
<INTEREST-EXPENSE> 742
<INTEREST-INCOME-NET> 9,403
<LOAN-LOSSES> 1,325
<SECURITIES-GAINS> 25
<EXPENSE-OTHER> 7,553
<INCOME-PRETAX> 4,476
<INCOME-PRE-EXTRAORDINARY> 4,476
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 2,852
<EPS-PRIMARY> 5.00
<EPS-DILUTED> 4.98
<YIELD-ACTUAL> 9.71
<LOANS-NON> 803
<LOANS-PAST> 1,941
<LOANS-TROUBLED> 99
<LOANS-PROBLEM> 3,368
<ALLOWANCE-OPEN> 1,908
<CHARGE-OFFS> 665
<RECOVERIES> 41
<ALLOWANCE-CLOSE> 2,702
<ALLOWANCE-DOMESTIC> 2,379
<ALLOWANCE-FOREIGN> 0
<ALLOWANCE-UNALLOCATED> 323
</TABLE>
