UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

ý

 

QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

 

 

 

 

 

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005

 

 

 

OR

 

 

 

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

 

 

 

 

 

FOR THE TRANSITION PERIOD FROM                       TO                       .

 

Commission File Number  0-20800

 

STERLING FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

Washington

 

91-1572822

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification No.)

 

111 North Wall Street, Spokane, Washington 99201

(Address of principal executive offices) (Zip Code)

 

(509) 458-3711

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 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 ý  No ¨

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes ý  No ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨  No ý

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date:

 

Class

 

Outstanding as of October 31, 2005

 

 

 

Common Stock ($1.00 par value)

 

34,784,830

 

 



 

STERLING FINANCIAL CORPORATION

 

FORM 10-Q

For the Quarter Ended September 30, 2005

 

TABLE OF CONTENTS

 

PART I - Financial Information

 

 

 

 

Item 1 -

Financial Statements (Unaudited).

 

 

 

 

 

Consolidated Balance Sheets

 

 

 

 

 

Consolidated Statements of Income

 

 

 

 

 

Consolidated Statements of Cash Flows

 

 

 

 

 

Consolidated Statements of Comprehensive Income

 

 

 

 

 

Notes to Consolidated Financial Statements

 

 

 

 

Item 2 -

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

 

 

 

 

Item 3 -

Quantitative and Qualitative Disclosures About Market Risk.

 

 

 

 

Item 4 -

Controls and Procedures.

 

 

 

 

PART II - Other Information

 

 

 

 

Item 1 -

Legal Proceedings.

 

 

 

 

Item 2 -

Unregistered Sales of Equity Securities and Use of Proceeds.

 

 

 

 

Item 3 -

Defaults Upon Senior Securities.

 

 

 

 

Item 4 -

Submission of Matters to a Vote of Security Holders.

 

 

 

 

Item 5 -

Other Information.

 

 

 

 

Item 6 -

Exhibits.

 

 

 

 

Signatures

 

 



 

PART I - Financial Information

Item 1 - Financial Statements

 

STERLING FINANCIAL CORPORATION

Consolidated Balance Sheets

(Unaudited)

 

 

 

September 30,

 

December 31,

 

 

 

2005

 

2004

 

 

 

(Dollars in thousands)

 

ASSETS:

 

 

 

 

 

Cash and cash equivalents:

 

 

 

 

 

Interest bearing

 

$

500

 

$

0

 

Non-interest bearing and vault

 

119,326

 

93,187

 

Restricted

 

6,986

 

1,281

 

Investment securities and mortgage-backed securities (“MBS”):

 

 

 

 

 

Available for sale

 

1,915,287

 

2,157,136

 

Held to maturity

 

49,716

 

47,449

 

Loans receivable, net

 

4,287,684

 

4,251,877

 

Loans held for sale

 

26,091

 

14,224

 

Accrued interest receivable

 

29,925

 

27,479

 

Real estate owned and other collateralized assets, net

 

2,454

 

1,865

 

Office properties and equipment, net

 

81,007

 

78,402

 

Bank-owned life insurance (“BOLI”)

 

107,122

 

93,790

 

Goodwill

 

112,391

 

112,398

 

Other intangible assets

 

18,180

 

19,848

 

Mortgage servicing rights, net

 

5,863

 

4,078

 

Prepaid expenses and other assets, net

 

33,516

 

39,210

 

Total assets

 

$

6,796,048

 

$

6,942,224

 

 

 

 

 

 

 

LIABILITIES:

 

 

 

 

 

Deposits

 

$

4,390,757

 

$

3,863,296

 

Advances from Federal Home Loan Bank Seattle (“FHLB Seattle”)

 

1,266,874

 

1,635,933

 

Securities sold subject to repurchase agreements and funds purchased

 

461,594

 

780,012

 

Other borrowings

 

110,683

 

131,822

 

Cashiers checks issued and payable

 

3,815

 

3,213

 

Borrowers’ reserves for taxes and insurance

 

2,926

 

2,480

 

Accrued interest payable

 

15,959

 

14,842

 

Accrued expenses and other liabilities

 

43,757

 

40,782

 

Total liabilities

 

6,296,365

 

6,472,380

 

 

 

 

 

 

 

Commitments and Contingencies

 

 

 

 

 

SHAREHOLDERS’ EQUITY:

 

 

 

 

 

Preferred stock, $1 par value; 10,000,000 shares authorized; no shares issued and outstanding

 

0

 

0

 

Common stock, $1 par value; 60,000,000 shares authorized; 34,725,400 and 22,936,154 shares issued and outstanding

 

34,725

 

22,936

 

Additional paid-in capital

 

384,409

 

393,245

 

Accumulated other comprehensive loss:

 

 

 

 

 

Unrealized losses on investment securities and MBS available-for-sale, net of deferred income taxes of $15,562 and $5,467

 

(26,635

)

(9,470

)

Retained earnings

 

107,184

 

63,133

 

Total shareholders’ equity

 

499,683

 

469,844

 

Total liabilities and shareholders’ equity

 

$

6,796,048

 

$

6,942,224

 

 

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

 

1



 

STERLING FINANCIAL CORPORATION

Consolidated Statements of Income

(Unaudited)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

(Dollars in thousands, except per share data)

 

Interest income:

 

 

 

 

 

 

 

 

 

Loans

 

$

73,375

 

$

57,665

 

$

214,037

 

$

165,724

 

MBS

 

20,757

 

22,642

 

65,697

 

61,985

 

Investments and cash equivalents

 

642

 

1,319

 

2,162

 

4,548

 

Total interest income

 

94,774

 

81,626

 

281,896

 

232,257

 

 

 

 

 

 

 

 

 

 

 

Interest expense:

 

 

 

 

 

 

 

 

 

Deposits

 

23,827

 

13,696

 

63,255

 

38,233

 

Short-term borrowings

 

10,491

 

6,364

 

26,856

 

15,075

 

Long-term borrowings

 

7,368

 

11,365

 

32,065

 

34,335

 

Total interest expense

 

41,686

 

31,425

 

122,176

 

87,643

 

 

 

 

 

 

 

 

 

 

 

Net interest income

 

53,088

 

50,201

 

159,720

 

144,614

 

 

 

 

 

 

 

 

 

 

 

Provision for losses on loans

 

(3,400

)

(3,000

)

(10,550

)

(8,850

)

Net interest income after provision for losses on loans

 

49,688

 

47,201

 

149,170

 

135,764

 

 

 

 

 

 

 

 

 

 

 

Non-interest income:

 

 

 

 

 

 

 

 

 

Fees and service charges

 

9,260

 

8,116

 

24,868

 

24,836

 

Mortgage banking operations

 

2,969

 

1,477

 

14,447

 

4,440

 

Loan servicing fees

 

90

 

129

 

330

 

435

 

Net gains (losses) on sales of securities

 

0

 

1,264

 

(57

)

4,571

 

Real estate owned and other collateralized assets operations

 

(23

)

196

 

188

 

(120

)

BOLI

 

1,164

 

1,089

 

3,331

 

3,342

 

Gain related to early repayment of debt

 

0

 

0

 

645

 

0

 

Other noninterest expense

 

(154

)

396

 

(402

)

(130

)

 

 

 

 

 

 

 

 

 

 

Total non-interest income

 

13,306

 

12,667

 

43,350

 

37,374

 

Non-interest expenses

 

42,599

 

36,570

 

123,848

 

111,377

 

Income before income taxes

 

20,395

 

23,298

 

68,672

 

61,761

 

Income tax provision

 

(6,505

)

(7,988

)

(22,883

)

(20,984

)

 

 

 

 

 

 

 

 

 

 

Net income

 

$

13,890

 

$

15,310

 

$

45,789

 

$

40,777

 

 

 

 

 

 

 

 

 

 

 

Earnings per share - basic

 

$

0.40

 

$

0.45

 

$

1.32

 

$

1.21

 

 

 

 

 

 

 

 

 

 

 

Earnings per share - diluted

 

$

0.40

 

$

0.44

 

$

1.31

 

$

1.18

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding - basic

 

34,660,107

 

34,015,769

 

34,581,606

 

33,811,065

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding - diluted

 

35,097,474

 

34,721,952

 

35,033,011

 

34,626,014

 

 

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

 

2



 

STERLING FINANCIAL CORPORATION

Consolidated Statements of Cash Flows

(Unaudited)

 

 

 

Nine Months Ended
September 30,

 

 

 

2005

 

2004

 

 

 

(Dollars in thousands)

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

45,789

 

$

40,777

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Provisions for losses on loans and real estate owned

 

10,550

 

8,855

 

Stock dividends on FHLB Seattle stock

 

(303

)

(3,330

)

Net gain on sales of loans, investment securities and MBS

 

(9,280

)

(6,310

)

Other gains and losses

 

(16,818

)

(118

)

Change in cash surrender value of BOLI

 

(3,332

)

(3,342

)

Depreciation and amortization

 

14,805

 

10,611

 

Change in:

 

 

 

 

 

Accrued interest receivable

 

(2,446

)

(3,403

)

Prepaid expenses and other assets

 

13,071

 

10,797

 

Cashiers checks issued and payable

 

602

 

(10,278

)

Accrued interest payable

 

1,117

 

2,028

 

Accrued expenses and other liabilities

 

(263

)

(5,997

)

Proceeds from sales of loans originated for sale

 

129,711

 

139,243

 

Loans originated for sale

 

(126,830

)

(137,505

)

Net cash provided by operating activities

 

56,373

 

42,028

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Change in restricted cash

 

(5,705

)

163

 

Loans funded and purchased

 

(2,418,560

)

(2,279,819

)

Loan principal received

 

1,889,705

 

1,718,589

 

Proceeds from sales of other loans

 

472,682

 

0

 

Purchase of investment securities

 

(13,645

)

(236,780

)

Proceeds from maturities of investment securities

 

1,405

 

226,300

 

Proceeds from sales of investment securities

 

14,844

 

97,974

 

Cash and cash equivalents acquired as part of mergers

 

0

 

44,894

 

Purchase of BOLI

 

(10,000

)

0

 

Purchase of mortgage-backed securities

 

(203,276

)

(1,240,426

)

Principal payments on mortgage-backed securities

 

292,211

 

266,150

 

Proceeds from sales of mortgage-backed securities

 

115,837

 

537,672

 

Purchase of office properties and equipment

 

(9,066

)

(8,201

)

Sales of office properties and equipment

 

249

 

0

 

Improvements and other changes to real estate owned

 

(273

)

42

 

Proceeds from sales and liquidation of real estate owned

 

2,158

 

5,076

 

Net cash provided (used) in investing activities

 

128,566

 

(868,366

)

 

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

 

3



 

 

 

Nine Months Ended
September 30,

 

 

 

2005

 

2004

 

 

 

(Dollars in thousands)

 

Cash flows from financing activities:

 

 

 

 

 

Net change in checking, regular savings and money market deposits

 

$

246,858

 

$

159,835

 

Proceeds from issuance of time deposits

 

1,674,652

 

1,565,148

 

Payments for maturing time deposits

 

(1,453,474

)

(1,426,648

)

Interest credited to deposits

 

59,425

 

35,657

 

Advances from FHLB Seattle

 

530,229

 

955,582

 

Repayment of advances from FHLB Seattle

 

(881,710

)

(748,859

)

Net change in securities sold subject to repurchase agreements and funds purchased

 

(318,418

)

318,706

 

Repayment of other borrowings

 

(19,000

)

(3,280

)

Payments for fractional shares and certain merger costs

 

(14

)

(240

)

Proceeds from exercise of stock options, net of repurchases

 

2,781

 

5,918

 

Deferred financing costs

 

(75

)

0

 

Other

 

446

 

3,722

 

Net cash provided (used) in financing activities

 

(158,300

)

865,541

 

 

 

 

 

 

 

Net change in cash and cash equivalents

 

26,639

 

39,203

 

Cash and cash equivalents, beginning of period

 

93,187

 

65,479

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

 

$

119,826

 

$

104,682

 

 

 

 

 

 

 

Supplemental disclosures:

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

Interest

 

$

121,059

 

$

83,501

 

Income taxes

 

9,560

 

16,315

 

 

 

 

 

 

 

Noncash financing and investing activities:

 

 

 

 

 

Loans converted into real estate owned and other collateralized assets

 

2,266

 

3,683

 

Common stock issued upon business combination

 

0

 

144,990

 

Common stock cash dividends accrued

 

1,738

 

0

 

Common stock dividend

 

0

 

62,468

 

Common stock split, effected as a dividend

 

11,553

 

0

 

 

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

 

4



 

STERLING FINANCIAL CORPORATION

Consolidated Statements of Comprehensive Income

(Unaudited)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

13,890

 

$

15,310

 

$

45,789

 

$

40,777

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

Change in unrealized gains (losses) on investment securities and MBS available-for-sale

 

(25,624

)

33,724

 

(27,260

)

8,879

 

Less deferred income taxes

 

9,483

 

(11,863

)

10,095

 

(3,167

)

 

 

 

 

 

 

 

 

 

 

Net other comprehensive income (loss)

 

(16,141

)

21,861

 

(17,165

)

5,712

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss)

 

$

(2,251

)

$

37,171

 

$

28,624

 

$

46,489

 

 

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

 

5



 

STERLING FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

 

1. Basis of Presentation:

 

The foregoing unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X as promulgated by the Securities and Exchange Commission.  Accordingly, these financial statements do not include all of the disclosures required by accounting principles generally accepted in the United States of America for complete financial statements.  These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2004.  In the opinion of management, the unaudited interim consolidated financial statements furnished herein include all adjustments, all of which are of a normal recurring nature, necessary for a fair statement of the results for the interim periods presented.

 

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities known to exist as of the date the financial statements are published, and the reported amounts of revenues and expenses during the reporting period.  Uncertainties with respect to such estimates and assumptions are inherent in the preparation of Sterling Financial Corporation’s (“Sterling’s”) consolidated financial statements; accordingly, it is possible that the actual results could differ from these estimates and assumptions, which could have a material effect on the reported amounts of Sterling’s consolidated financial position and results of operations.

 

2. Other Borrowings:

 

The components of other borrowings are as follows (in thousands):

 

 

 

September 30,

 

December 31,

 

 

 

2005

 

2004

 

 

 

 

 

 

 

Term note payable(1)

 

$

0

 

$

19,000

 

Sterling obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely junior subordinated deferrable interest debentures of Sterling(2)

 

108,701

 

108,685

 

Other(3)

 

1,982

 

4,137

 

Total

 

$

110,683

 

$

131,822

 

 


(1)           At December 31, 2004, Sterling had a $19 million variable-rate term note with U.S. Bank, N.A. (“U.S. Bank”).  On March 31, 2005, Sterling repaid $14 million of principal on this borrowing.  On April 29, 2005, Sterling repaid the remaining balance of this borrowing.

 

On May 18, 2005, Sterling entered into a $40 million seven-year variable-rate credit agreement (the “Credit Facility”) with Bank of Scotland.  Amounts loaned pursuant to the Credit Facility bear Eurodollar interest at the LIBOR rate (as defined in the Credit Facility) plus a specified margin based on Sterling’s credit ratings and compliance with the terms of the Credit Facility.  The Credit Facility is secured by a portion of the preferred stock of Sterling’s wholly owned subsidiary, Sterling Savings Bank.  The Credit Facility contains representations and warranties, and negative and affirmative covenants by Sterling, including financial covenants and restrictions on certain actions by Sterling, such as Sterling’s ability to incur debt, make investments and make acquisitions of other entities.  Sterling is obligated to commence repayment of any loan principal on the third anniversary of the date Sterling entered into the Credit Facility, and is permitted to prepay loan principal without penalty.  No amounts borrowed and repaid under the Credit Facility may be reborrowed.  As of September 30, 2005, no funds had been advanced to Sterling under the Credit Facility.  For further details, see Sterling’s Form 8-K filed May 20, 2005 at the SEC’s website, www.sec.gov.

 

6



 

(2)           Sterling raises capital from time to time through the formation and acquisition of trusts (the “Trusts”), which issue capital securities (“Trust Preferred Securities”) to investors.  These Trusts are business trusts in which Sterling owns all of the common equity.  The proceeds from the sale of the Trust Preferred Securities are used to purchase junior subordinated deferrable interest debentures (“Junior Subordinated Debentures”) issued by Sterling.  Sterling’s obligations under the Junior Subordinated Debentures and related documents, taken together, constitute a full and unconditional guarantee by Sterling of the Trusts’ obligations under the Trust Preferred Securities.  As of September 30, 2005, Sterling had seven such Trusts.  The Trusts are not consolidated and the Trust Preferred Securities and common stock are treated as debt of Sterling.  The common stock issued by the Trusts is recorded as other assets in the consolidated balance sheets, and totaled $3.3 million at September 30, 2005 and December 31, 2004.  The Trust Preferred Securities have been structured to qualify as Tier 1 capital, subject to certain limitations.  The Junior Subordinated Debentures and related Trust Preferred Securities are redeemable, under certain conditions, at Sterling’s option.  Interest is paid quarterly or semi-annually.  Details of the Trusts are as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

Contractual

 

 

 

 

 

 

 

 

 

 

 

Mandatorily

 

 

 

Rate at

 

Carrying

 

 

 

 

 

Maturity

 

 

 

Redeemable Capital

 

 

 

September 30,

 

Value (in

 

Subsidiary Issuer

 

Issue Date

 

Date

 

Call Date

 

Security

 

Rate Index

 

2005

 

thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sterling Capital

 

June 2003

 

Sept 2033

 

Sept 2008

 

Floating Rate

 

3 month LIBOR

 

 

 

 

 

Trust VI

 

 

 

 

 

 

 

Capital Securities

 

plus 3.20%

 

7.07

%

10,310

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sterling Capital

 

May 2003

 

May 2033

 

June 2008

 

Floating Rate

 

3 month LIBOR

 

 

 

 

 

Statutory Trust V

 

 

 

 

 

 

 

Capital Securities

 

plus 3.25%

 

7.21

%

20,619

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sterling Capital

 

May 2003

 

May 2033

 

May 2008

 

Floating Rate

 

3 month LIBOR

 

 

 

 

 

Trust IV

 

 

 

 

 

 

 

Preferred Securities

 

plus 3.15%

 

6.94

%

10,310

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sterling Capital

 

April 2003

 

April 2033

 

April 2008

 

Floating Rate

 

3 month LIBOR

 

 

 

 

 

Trust III

 

 

 

 

 

 

 

Capital Securities

 

plus 3.25%

 

6.94

%

14,433

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Klamath First Capital

 

April 2002

 

April 2032

 

April 2007

 

Floating Rate

 

6 month LIBOR

 

 

 

 

 

Trust II

 

 

 

 

 

 

 

Capital Securities

 

plus 3.70%

 

7.11

%

13,141

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Klamath First Capital

 

July 2001

 

July 2031

 

June 2006

 

Floating Rate

 

6 month LIBOR

 

 

 

 

 

Trust I

 

 

 

 

 

 

 

Capital Securities

 

plus 3.75%

 

7.67

%

15,145

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sterling Capital

 

July 2001

 

July 2031

 

June 2006

 

10.25% Cumulative

 

 

 

 

 

 

 

Trust II

 

 

 

 

 

 

 

Capital Securities

 

Fixed

 

10.25

%

24,743

 

 

 

 

 

 

 

 

 

 

 

 

 

7.88

%*

108,701

 

 


* weighted average rate

 

7



 

(3)           During 2002, Sterling financed the sale of certain loans to an unrelated party.  Since the underlying loans served as collateral on the loan to the purchaser, this sale was accounted for as a financing.  At September 30, 2005 and December 31, 2004, $2.0 million and $4.1 million, respectively, remained outstanding on the financing.

 

3. Earnings Per Share:

 

The following table presents the basic and diluted earnings per share computations.  All per share amounts reflect the 3 for 2 stock split that was effected on August 31, 2005.

 

 

 

Three Months Ended September 30,

 

 

 

2005

 

2004

 

 

 

Net
Income

 

Weighted
Avg. Shares

 

Per Share
Amount

 

Net
Income

 

Weighted
Avg. Shares

 

Per Share
Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic computations

 

$

13,890,000

 

34,660,107

 

$

0.40

 

$

15,310,000

 

34,015,769

 

$

0.45

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Common stock options

 

0

 

401,355

 

0.00

 

0

 

706,183

 

(0.01

)

Contingently issuable shares

 

0

 

36,012

 

0.00

 

0

 

0

 

0.00

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted computations

 

$

13,890,000

 

35,097,474

 

$

0.40

 

$

15,310,000

 

34,721,952

 

$

0.44

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Antidilutive options not included in diluted earnings per share

 

 

 

456,000

 

 

 

 

 

0

 

 

 

 

 

 

Nine Months Ended September 30,

 

 

 

2005

 

2004

 

 

 

Net
Income

 

Weighted
Avg. Shares

 

Per Share
Amount

 

Net
Income

 

Weighted
Avg. Shares

 

Per Share
Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic computations

 

$

45,789,000

 

34,581,606

 

$

1.32

 

$

40,777,000

 

33,811,065

 

$

1.21

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Common stock options

 

0

 

415,393

 

(0.01

)

0

 

814,949

 

(0.03

)

Contingently issuable shares

 

0

 

36,012

 

0.00

 

0

 

0

 

0.00

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted computations

 

$

45,789,000

 

35,033,011

 

$

1.31

 

$

40,777,000

 

34,626,014

 

$

1.18

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Antidilutive options not included in diluted earnings per share

 

 

 

456,000

 

 

 

 

 

0

 

 

 

 

8



 

4. Non-Interest Expenses:

 

The following table details the components of Sterling’s total non-interest expenses:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Employee compensation and benefits

 

$

23,274

 

$

19,286

 

$

67,625

 

$

57,610

 

Occupancy and equipment

 

6,578

 

5,901

 

19,241

 

17,048

 

Depreciation

 

2,227

 

1,856

 

6,348

 

5,379

 

Amortization of core deposit intangibles

 

556

 

556

 

1,667

 

1,667

 

Advertising

 

2,251

 

1,985

 

6,668

 

5,692

 

Data processing

 

3,179

 

2,688

 

9,391

 

7,587

 

Insurance

 

304

 

299

 

934

 

866

 

Legal and accounting

 

486

 

762

 

2,274

 

2,360

 

Travel and entertainment

 

1,081

 

941

 

3,263

 

2,877

 

Goodwill litigation costs

 

0

 

146

 

189

 

286

 

Merger and acquisition costs

 

0

 

0

 

0

 

4,835

 

Other

 

2,663

 

2,150

 

6,248

 

5,170

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

42,599

 

$

36,570

 

$

123,848

 

$

111,377

 

 

5. Segment Information:

 

For purposes of measuring and reporting the financial results, Sterling is divided into the following five business segments:

 

                  The Community Banking segment consists of the operations conducted by Sterling’s subsidiary, Sterling Savings Bank.

 

                  The Residential Mortgage Banking segment originates and sells servicing-retained and servicing-released residential loans through loan production offices in Washington, Oregon, Idaho, Montana and Utah primarily through Sterling Savings Bank’s subsidiary Action Mortgage Company (“Action Mortgage”).

 

                  The Commercial Mortgage Banking segment originates, sells and services commercial real estate loans and participation interests in commercial real estate loans through offices in Washington, Oregon, Arizona and California primarily through Sterling Savings Bank’s subsidiary INTERVEST-Mortgage Investment Company.

 

                  The Retail Brokerage segment markets fixed income and equity products, mutual funds, fixed and variable annuities, insurance and other financial products within the Sterling Savings Bank financial service center network through sales representatives of Sterling Savings Bank’s subsidiary Harbor Financial Services, Inc.

 

                  The Other and Eliminations segment represents the parent company expenses and intercompany eliminations of revenue and expenses.

 

9



 

The following table presents certain financial information regarding Sterling’s segments and provides a reconciliation to Sterling’s consolidated totals for the periods presented:

 

 

 

As of and for the Three Months Ended September 30, 2005

 

 

 

Community
Banking

 

Residential
Mortgage
Banking

 

Commercial
Mortgage
Banking

 

Retail
Brokerage

 

Other and
Eliminations

 

Total

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

89,576

 

$

3,189

 

$

1,150

 

$

0

 

$

859

 

$

94,774

 

Interest expense

 

(39,718

)

0

 

0

 

0

 

(1,968

)

(41,686

)

Net interest income (expense)

 

49,858

 

3,189

 

1,150

 

0

 

(1,109

)

53,088

 

Provision for loan losses

 

(3,400

)

0

 

0

 

0

 

0

 

(3,400

)

Noninterest income

 

11,092

 

2,865

 

1,720

 

964

 

(3,335

)

13,306

 

Noninterest expense

 

(34,344

)

(4,927

)

(1,998

)

(1,041

)

(289

)

(42,599

)

Income before income taxes

 

$

23,206

 

$

1,127

 

$

872

 

$

(77

)

$

(4,733

)

$

20,395

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

6,862,568

 

$

21,166

 

$

20,200

 

$

748

 

$

(108,634

)

$

6,796,048

 

 

 

 

As of and for the Three Months Ended September 30, 2004

 

 

 

Community
Banking

 

Residential
Mortgage
Banking

 

Commercial
Mortgage
Banking

 

Retail
Brokerage

 

Other and
Eliminations

 

Total

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

77,669

 

$

2,217

 

$

1,512

 

$

0

 

$

228

 

$

81,626

 

Interest expense

 

(29,350

)

0

 

0

 

0

 

(2,075

)

(31,425

)

Net interest income (expense)

 

48,319

 

2,217

 

1,512

 

0

 

(1,847

)

50,201

 

Provision for loan losses

 

(3,000

)

0

 

0

 

0

 

0

 

(3,000

)

Noninterest income

 

12,347

 

2,458

 

653

 

984

 

(3,775

)

12,667

 

Noninterest expense

 

(31,863

)

(3,642

)

(990

)

(754

)

679

 

(36,570

)

Income before income taxes

 

$

25,803

 

$

1,033

 

$

1,175

 

$

230

 

$

(4,943

)

$

23,298

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

6,779,710

 

$

19,814

 

$

17,052

 

$

1,787

 

$

(84,917

)

$

6,733,446

 

 

10



 

 

 

As of and for the Nine Months Ended September 30, 2005

 

 

 

Community
Banking

 

Residential
Mortgage
Banking

 

Commercial
Mortgage
Banking

 

Retail
Brokerage

 

Other and
Eliminations

 

Total

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

267,494

 

$

8,297

 

$

5,247

 

$

0

 

$

858

 

$

281,896

 

Interest expense

 

(116,345

)

0

 

0

 

0

 

(5,831

)

(122,176

)

Net interest income (expense)

 

151,149

 

8,297

 

5,247

 

0

 

(4,973

)

159,720

 

Provision for loan losses

 

(10,550

)

0

 

0

 

0

 

0

 

(10,550

)

Noninterest income

 

39,015

 

7,446

 

4,409

 

2,635

 

(10,155

)

43,350

 

Noninterest expense

 

(102,451

)

(13,311

)

(5,124

)

(2,665

)

(297

)

(123,848

)

Income before income taxes

 

$

77,163

 

$

2,432

 

$

4,532

 

$

(30

)

$

(15,425

)

$

68,672

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

6,862,568

 

$

21,166

 

$

20,200

 

$

748

 

$

(108,634

)

$

6,796,048

 

 

 

 

As of and for the Nine Months Ended September 30, 2004

 

 

 

Community
Banking

 

Residential
Mortgage
Banking

 

Commercial
Mortgage
Banking

 

Retail
Brokerage

 

Other and
Eliminations

 

Total

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

220,152

 

$

6,499

 

$

4,925

 

$

1

 

$

680

 

$

232,257

 

Interest expense

 

(81,577

)

0

 

0

 

0

 

(6,066

)

(87,643

)

Net interest income (expense)

 

138,575

 

6,499

 

4,925

 

1

 

(5,386

)

144,614

 

Provision for loan losses

 

(8,850

)

0

 

0

 

0

 

0

 

(8,850

)

Noninterest income

 

36,091

 

6,305

 

1,867

 

2,843

 

(9,732

)

37,374

 

Noninterest expense

 

(96,115

)

(10,275

)

(3,147

)

(2,225

)

385

 

(111,377

)

Income before income taxes

 

$

69,701

 

$

2,529

 

$

3,645

 

$

619

 

$

(14,733

)

$

61,761

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

6,779,710

 

$

19,814

 

$

17,052

 

$

1,787

 

$

(84,917

)

$

6,733,446

 

 

11



 

6. Stock Options:

 

As permitted by Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”), Sterling elected to retain the compensation measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and related interpretations, for stock options.  Under APB No. 25, compensation cost is recognized at the measurement date in the amount, if any, that the quoted market price of Sterling’s common stock exceeds the option exercise price.  Sterling grants its common stock options to employees with exercise prices equal to the market price of Sterling’s common stock on the measurement date.  Thus, no compensation cost is recognized.

 

Sterling has chosen not to record compensation expense using fair value measurement provisions in the statement of income.  See New Accounting Policies for guidance on the effect of the FASB’s revision of SFAS No. 123.  Had compensation cost for Sterling’s plans been determined based on the fair value at the grant dates for awards under the plans, Sterling’s reported net income and earnings per share would have been changed to the pro forma amounts indicated below:

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

(Dollars in thousands, except per share amounts)

 

 

 

 

 

 

 

 

 

 

 

Reported net income

 

$

13,890

 

$

15,310

 

$

45,789

 

$

40,777

 

Add back: Stock-based employee compensation expense, net of related tax effects

 

0

 

0

 

0

 

0

 

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects

 

(92

)

(1,009

)

(146

)

(3,027

)

Pro forma

 

$

13,798

 

$

14,301

 

$

45,643

 

$

37,750

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share:

 

 

 

 

 

 

 

 

 

Reported earnings per share

 

$

0.40

 

$

0.45

 

$

1.32

 

$

1.21

 

Stock-based employee compensation, fair value

 

0.00

 

(0.03

)

0.00

 

(0.09

)

Pro forma earnings per share

 

$

0.40

 

$

0.42

 

$

1.32

 

$

1.12

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per share:

 

 

 

 

 

 

 

 

 

Reported earnings per share

 

$

0.40

 

$

0.44

 

$

1.31

 

$

1.18

 

Stock-based employee compensation, fair value

 

(0.01

)

(0.03

)

(0.01

)

(0.09

)

Pro forma earnings per share

 

$

0.39

 

$

0.41

 

$

1.30

 

$

1.09

 

 

12



 

A significant portion of the options granted in 2004 vested in 2004.  The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model based upon the following weighted average assumptions:

 

 

 

Nine Months Ended
September 30,

 

 

 

2005(1)

 

2004

 

 

 

 

 

 

 

Expected volatility

 

N/A

 

85% - 132%

 

Expected lives (in years)

 

N/A

 

4 - 10

 

Risk free interest rates

 

N/A

 

2.86% - 6.52%

 

Expected forfeiture rate

 

N/A

 

0%

 

Annual dividend yield

 

N/A

 

0%

 

 


(1)           In 2005, no stock options have been issued.

 

7. New Accounting Policies:

 

In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment,” which established accounting standards for transactions involving the issuance of equity instruments to employees for services rendered.  This statement is a revision of SFAS No. 123, and supersedes APB No. 25.  This statement requires the estimation and recognition of the grant date fair value of stock options issued to employees.  This statement is effective for Sterling as of January 1, 2006.  Management is currently evaluating the effect of this new standard.

 

In September 2004, the FASB agreed to issue additional guidance on the application of Emerging Issues Task Force (“EITF”) Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments.”  The FASB also deferred the measurement and recognition guidance contained in EITF Issue 03-1.  In June 2005, the FASB revised EITF Issue 03-1 by deleting the requirement for investors to demonstrate the ability and intent to hold securities until recovery of impairment.  Sterling will continue to apply relevant other-than-temporary guidance to its investment securities and MBS portfolio, as applicable.

 

In December 2003, the American Institute of Certified Public Accountants issued Statement of Position No. 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer” (“SOP No. 03-3”).  SOP No. 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans acquired in a transfer if those differences are attributable, at least in part, to credit quality.  SOP No. 03-3 is effective for loans acquired in fiscal years beginning after December 15, 2004.  The implementation of SOP No. 03-3 did not have a material effect on Sterling’s consolidated financial statements.

 

8. Derivatives and Hedging:

 

Sterling, through its subsidiary Action Mortgage, enters into interest rate lock commitments (“rate locks”) to prospective residential mortgage borrowers.  Action Mortgage hedges interest rate risk (“IRR”) by entering into non-binding (“best-efforts”) forward sales agreements with third parties.  In addition, to improve and protect the profit margin on loans sold into the secondary market, Action Mortgage hedges IRR by entering into binding (“mandatory”) forward sales agreements on MBS with third parties.

 

13



 

The risks inherent in such mandatory forward sales agreements include the risk that, if for any reason Action Mortgage does not close and sell the loans in question, it is nonetheless obligated to deliver MBS to the counterparty on the agreed terms.  Action Mortgage could incur significant costs in acquiring replacement loans or MBS and such costs could have a material adverse impact on mortgage banking operations in future periods, especially in rising interest rate environments.

 

Rate locks and forward sales agreements on held-for-sale loans are considered to be derivatives. Sterling has recorded the estimated fair values of these rate locks and forward sales agreements on its balance sheet in either other assets or other liabilities. Changes in the fair values of these derivative instruments are recorded in income from mortgage banking operations in the income statement as the changes occur.  The estimated fair value of rate locks and forward sales commitments were greater than the contracted amounts at September 30, 2005, which resulted in assets of $94,000 and $98,000, respectively.  At December 31, 2004, rate locks and forward sales commitments were assets of $76,000 and $12,000, respectively.

 

9. Charter Conversion:

 

On July 8, 2005, Sterling announced that it had received regulatory approval from the Washington State Department of Financial Institutions to convert Sterling Savings Bank, its wholly-owned subsidiary, from a state-chartered savings and loan association to a state-chartered commercial bank.  Sterling also announced that the approval from the Federal Reserve Board to convert Sterling from a savings and loan holding company to a bank holding company had been received.  The charter conversion was effective as of July 8, 2005.

 

10. Stock Split and Cash Dividend:

 

On July 26, 2005, Sterling announced a 3 for 2 stock split, which was effected on August 31, 2005 to shareholders of record as of August 17, 2005.  This split was effected in the form of a 50% stock dividend and resulted in 11,553,249 shares of common stock being issued.  All per share amounts reflect this split.  Sterling also announced a quarterly cash dividend of $0.05 per share of common stock, which resulted in $1.7 million being paid on October 14, 2005 to shareholders of record as of September 30, 2005.

 

11. Subsequent Event:

 

On October 25, 2005, Sterling announced a quarterly cash dividend of $0.055 per share of common stock, payable on January 13, 2006 to shareholders of record as of December 30, 2005.

 

14



 

Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operation

 

STERLING FINANCIAL CORPORATION

Comparison of the Three and Nine Months Ended September 30, 2005 and 2004

 

This report contains forward-looking statements.  For a discussion about such statements, including the risks and uncertainties inherent therein, see “Forward-Looking Statements.”  Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes presented elsewhere in this report and in Sterling’s 2004 annual report on Form 10-K.

 

General

 

Sterling Financial Corporation (“Sterling”) is a bank holding company, the significant operating subsidiary of which is Sterling Savings Bank.  The principal operating subsidiaries of Sterling Savings Bank are Action Mortgage Company (“Action Mortgage”), INTERVEST-Mortgage Investment Company (“INTERVEST”) and Harbor Financial Services, Inc. (“Harbor Financial”).  Sterling Savings Bank commenced operations in 1983 as a Washington State-chartered federally insured stock savings and loan association headquartered in Spokane, Washington.  On July 8, 2005, Sterling Savings Bank converted to a commercial bank.

 

Sterling provides personalized, quality financial services to its customers as exemplified by its “Hometown Helpful” philosophy and “Perfect Fit” banking products.  Sterling believes that this dedication to personalized service has enabled it to grow both its retail deposit base and its lending portfolio in the Pacific Northwest region.  With $6.80 billion in total assets at September 30, 2005, Sterling originates loans and attracts Federal Deposit Insurance Corporation (“FDIC”) insured deposits from the general public through 138 financial service centers located in Washington, Oregon, Idaho and Montana.  Sterling also originates loans through Action Mortgage residential loan production offices in the four-state area, as well as Utah, and through INTERVEST commercial real estate lending offices in Washington, Oregon, Arizona and California.  Sterling also markets fixed income and equity products, mutual funds, fixed and variable annuities and many other financial products through Harbor Financial service representatives located throughout Sterling’s financial service center network.

 

Sterling continues to implement its strategy to become the leading community bank in the Pacific Northwest by increasing its commercial real estate, business banking, consumer and construction lending while also increasing its retail deposits, particularly transaction accounts.  Commercial real estate, business banking, consumer and construction loans generally produce higher yields than residential loans.  Management believes that a community bank mix of assets and liabilities will enhance its net interest income (“NII”) (the difference between the interest earned on loans and investments and the interest paid on deposits and borrowings) and will increase other fee income, although there can be no assurance in this regard.  Such loans, however, generally involve a higher degree of risk than financing residential real estate.  Sterling’s revenues are derived primarily from interest earned on loans and mortgage-backed securities (“MBS”), fees and service charges, and mortgage banking operations (“MBO”).  The operations of Sterling, and banking institutions generally, are influenced significantly by general economic conditions and by policies of its primary regulatory authorities, the Board of Governors of the Federal Reserve System (“FRB”), the FDIC and the Washington State Department of Financial Institutions (“Washington Supervisor”).

 

15



 

Executive Summary and Highlights

 

Sterling’s earnings of $13.9 million, or $0.40 per diluted share, for the third quarter of 2005 represented a 9% decrease over earnings of $15.3 million, or $0.44 per diluted share, for the prior year’s comparable quarter.  For the nine months ended September 30, 2005, Sterling recorded earnings of $45.8 million, or $1.31 per diluted share, a 12% increase over earnings of $40.8 million or $1.18 per diluted share for the prior year’s comparable nine month period.  The decrease in net income for the third quarter of 2005 from the third quarter of 2004 mainly reflected a greater proportional increase in non-interest expense relative to NII and non-interest income.  The increase in net income for the nine months ended September 30, 2005 over the nine months ended September 30, 2004 reflected an increase in NII and non-interest income.

 

NII of $53.1 million for the third quarter of 2005 and $159.7 million for the nine months ended September 30, 2005 represented a 6% and 10% increase over the respective 2004 amounts, primarily due to increased average loan volumes.  Sterling’s net interest margin for the three and nine months ended September 30, 2005 increased by 2 and decreased by 8 basis points, respectively, from the comparable 2004 periods.  The increase in net interest margin for the quarter ended September 30, 2005 over the quarter ended September 30, 2004 was attributed to a higher average loan volume.  The decrease for the nine months ended September 30, 2005 from the nine months ended September 30, 2004 was primarily due to a greater proportional increase in the cost of funds versus the yield on loans, and a decrease in income resulting from the Federal Home Loan Bank Seattle’s suspension of its dividends.

 

Mortgage banking operations income increased to $14.4 million for the nine months ended September 30, 2005, up from $4.4 million for the same period in 2004.  Sterling sold $643.3 million in residential permanent and commercial real estate loans during the nine months ended September 30, 2005, compared to $137.5 million during the nine months ended September 30, 2004.

 

Sterling’s loan originations for the quarter ended September 30, 2005 were $955.5 million, compared with $748.7 million in the third quarter of 2004, a 28% increase.  The majority of the growth occurred in construction and commercial lending.  Sterling’s loan originations for the nine months ended September 30, 2005 were $2.69 billion, compared with $2.12 billion for same period in 2004, an increase of 26%.

 

Highlights for the third quarter of 2005 were as follows:

 

                  Loan production for the quarter was $955.5 million, up 28 percent year-over-year.

 

                  Construction loan originations increased 47 percent over the prior year, to $443.5 million for the quarter ended September 30, 2005.

 

                  Deposits increased to $4.39 billion, up $613.8 million, or 16 percent, over the same period in the prior year.

 

                  Sterling’s three-for-two stock split was payable on August 31, 2005 and distributed in the form of a 50 percent stock dividend.

 

                  Sterling’s board of directors approved a quarterly cash dividend of $0.05 per common share, payable to shareholders of record as of September 30, 2005, and paid on October 14, 2005.

 

16



 

Company Growth

 

Sterling intends to continue to pursue an aggressive growth strategy to become the leading community bank in the Pacific Northwest.  This strategy may include acquiring other financial businesses or branches thereof, or other substantial assets or deposit liabilities.  Sterling may not be successful in identifying further acquisition candidates, integrating acquisitions or preventing such acquisitions from having an adverse effect on Sterling.  There is significant competition for acquisitions in Sterling’s market area, and Sterling may not be able to acquire other businesses on attractive terms.  Furthermore, the success of Sterling’s growth strategy will depend on increasing and maintaining sufficient levels of regulatory capital, obtaining necessary regulatory approvals, generating appropriate growth and the existence of favorable economic and market conditions.  There can be no assurance that Sterling will be successful in implementing its growth strategy.

 

Critical Accounting Policies

 

The accounting and reporting policies of Sterling conform to accounting principles generally accepted in the United States of America (“GAAP”) and to general practices within the banking industry. The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.  Sterling’s management has identified the accounting policies described below as those that, due to the judgments, estimates and assumptions inherent in those policies are critical to an understanding of Sterling’s Consolidated Financial Statements and Management’s Discussion and Analysis.

 

Income RecognitionSterling recognizes interest income by methods that conform to general accounting practices within the banking industry. In the event management believes collection of all or a portion of contractual interest on a loan has become doubtful, which generally occurs after the loan is 90 days past due, Sterling discontinues the accrual of interest and any previously accrued interest recognized in income deemed uncollectible is reversed.  Interest received on nonperforming loans is included in income only if principal recovery is reasonably assured. A nonperforming loan is restored to accrual status when it is brought current, has performed in accordance with contractual terms for a reasonable period of time, and the collectibility of the total contractual principal and interest is no longer in doubt.

 

Allowance For Loan Losses.  In general, determining the amount of the allowance for loan losses requires significant judgment and the use of estimates by management. Sterling maintains an allowance for loan losses to absorb probable losses in the loan portfolio based on a quarterly analysis of the portfolio and expected future losses. This analysis is designed to determine an appropriate level and allocation of the allowance for losses among loan types by considering factors affecting loan losses, including specific losses, levels and trends in impaired and nonperforming loans, historical loan loss experience, current national and local economic conditions, volume, growth and composition of the portfolio, regulatory guidance and other relevant factors. Management monitors the loan portfolio to evaluate the adequacy of the allowance.  The allowance can increase or decrease each quarter based upon the results of management’s analysis.

 

The amount of the allowance for the various loan types represents management’s estimate of expected losses from existing loans based upon specific allocations for individual lending relationships and historical loss experience for each category of homogeneous loans.  The allowance for loan losses related to impaired loans is based on discounted cash flows using the loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. This evaluation requires management to make estimates of the amounts and timing of future cash flows on impaired loans, which consist primarily of non-accrual and restructured loans.

 

17



 

Individual loan reviews are based upon specific quantitative and qualitative criteria, including the size of the loan, loan quality ratings, value of collateral, repayment ability of borrowers, and historical experience factors.  The historical experience factors utilized and allowances for homogeneous loans (such as residential mortgage loans, personal loans, etc.) are collectively evaluated based upon historical loss experience, trends in losses and delinquencies, growth of loans in particular markets, and known changes in economic conditions in each particular lending market.

 

While management uses available information to provide for loan losses, the ultimate collectibility of a substantial portion of the loan portfolio and the need for future additions to the allowance will be based on changes in economic conditions and other relevant factors.  A slowdown in economic activity could adversely affect cash flows for both commercial and individual borrowers, as a result of which Sterling could experience increases in nonperforming assets, delinquencies and losses on loans.  There can be no assurance that the allowance for loan losses will be adequate to cover all losses, but management believes the allowance for loan losses was adequate at September 30, 2005.

 

Investment Securities and MBSAssets in the investment securities and MBS portfolios are initially recorded at cost, which includes any premiums and discounts.  Sterling amortizes premiums and discounts as an adjustment to interest income using the level interest yield method over the estimated life of the security.  The cost of investment securities sold, and any resulting gain or loss, is based on the specific identification method.

 

The loans underlying Sterling’s MBS are subject to the prepayment of principal.  The rate at which prepayments are expected to occur in future periods impacts the amount of premium to be amortized in the current period.  If prepayments in a future period are higher or lower than expected, then Sterling will need to amortize a larger or smaller amount of the premium to interest income in that future period.

 

Management determines the appropriate classification of investment securities at the time of purchase.  Held-to-maturity securities are those securities that Sterling has the positive intent and ability to hold to maturity and are recorded at amortized cost.  Available-for-sale securities are those securities that would be available to be sold in the future in response to Sterling’s liquidity needs, changes in market interest rates, and asset-liability management strategies, among others.  Available-for-sale securities are reported at fair value, with unrealized holding gains and losses reported in shareholders’ equity as a separate component of other comprehensive income, net of applicable deferred income taxes.

 

Management evaluates investment securities for other-than-temporary declines in fair value on a quarterly basis.  If the fair value of investment securities falls below their amortized cost and the decline is deemed to be other-than-temporary, the securities will be written down to current market value, resulting in a loss recorded in the income statement.  There were no investment securities that management identified to be other-than-temporarily impaired during the three months ended September 30, 2005, because the decline in fair value was attributable to changes in interest rates and not credit quality, and because Sterling has the ability and intent to hold these investments until a recovery in market price occurs, or until maturity.  Realized losses could occur in future periods due to a change in management’s intent to hold the investments to maturity, a change in management’s assessment of credit risk, or a change in regulatory or accounting requirements.

 

18



 

Goodwill and Other Intangible AssetsGoodwill arising from business combinations represents the value attributable to unidentifiable intangible elements in the business acquired.  Sterling’s goodwill relates to value inherent in the banking business and the value is dependent upon Sterling’s ability to provide quality, cost effective services in a competitive market place.  As such, goodwill value is supported ultimately by revenue that is generated by the volume of business transacted.  A decline in earnings as a result of a lack of growth or the inability to deliver cost effective services over sustained periods can lead to impairment of goodwill that could adversely impact earnings in future periods.

 

Sterling’s management performed the annual test of its goodwill and other intangible assets as of June 30, 2005, and concluded that the recorded values were not impaired.  There are many assumptions and estimates underlying the determination of impairment.  Another estimate using different but still reasonable assumptions could produce a significantly different result.  Additionally, future events could cause management to conclude that Sterling’s goodwill is impaired, which would result in Sterling recording an impairment loss. Any resulting impairment loss could have a material adverse impact on Sterling’s financial condition and results of operations.  Other intangible assets consisting of core-deposit intangibles with definite lives are amortized over the estimated life of the acquired depositor relationships (generally eight to ten years).

 

Real Estate Owned and Other Collateralized Assets.  Property and other assets acquired through foreclosure of defaulted mortgage or other collateralized loans are carried at the lower of cost or fair value, less estimated costs to sell.  Development and improvement costs relating to such property are capitalized to the extent they are deemed to be recoverable.

 

An allowance for losses on real estate and other assets owned is designed to include amounts for estimated losses as a result of impairment in value of the property after repossession.  Sterling reviews its real estate owned and other collateralized assets for impairment in value whenever events or circumstances indicate that the carrying value of the property or other assets may not be recoverable.  In performing the review, if expected future undiscounted cash flow from the use of the property or other assets, or the fair value, less selling costs, from the disposition of the property or other assets is less than its carrying value, an impairment loss is recognized.

 

Income Taxes.  Sterling estimates income taxes payable based on the amount it expects to owe various taxing authorities.  Accrued income taxes represent the net estimated amount due to, or to be received from, taxing authorities.  In estimating accrued income taxes, Sterling assesses the relative merits and risks of the appropriate tax treatment of transactions, taking into account the applicable statutory, judicial and regulatory guidance in the context of Sterling’s tax position.  Sterling also considers recent audits and examinations, as well as its historical experience in making such estimates.  Although Sterling uses available information to record income taxes, underlying estimates and assumptions can change over time as a result of unanticipated events or circumstances.

 

Sterling uses an estimate of future earnings to support its position that the benefit of its net deferred taxes will be realized.  If future pre-tax income should prove nonexistent or less than the amount of temporary differences giving rise to the net deferred tax assets within the tax years to which they may be applied, the assets will not be realized and Sterling’s net income will be reduced.

 

Results of Operations

 

Overview.  Sterling recorded net income of $13.9 million, or $0.40 per diluted share, for the three months ended September 30, 2005, compared with net income of $15.3 million, or $0.44 per diluted share, for the three months ended September 30, 2004.  Net income for the nine months ended September 30, 2005 was $45.8 million, or $1.31 per diluted share compared with net income of $40.8 million, or $1.18 per diluted share for the nine months ended September 30, 2004.  The decrease in net income for the third quarter of 2005 from the third quarter of 2004 mainly reflected a greater proportional increase in non-interest expense relative to NII and non-interest income.  The increase in net income for the nine months ended September 30, 2005 over the nine months ended September 30, 2004 reflected an increase in NII and non-interest income.

 

19



 

The annualized return on average assets (“ROA”) was 0.81% and 0.94% for the three months ended September 30, 2005 and 2004, respectively, and 0.88% and 0.87% for the nine months ended September 30, 2005 and 2004, respectively.  The annualized return on average equity (“ROE”) was 10.8% and 14.6% for the three months ended September 30, 2005 and 2004, respectively, and 12.5% and 13.0% for the nine months ended September 30, 2005 and 2004, respectively.  The change in ROA and ROE compared to the 2004 periods was primarily due to increases in NII and mortgage banking operations income, substantially offset by increased non-interest expense.

 

Net Interest Income.  The most significant component of earnings for a financial institution typically is NII, which is the difference between interest income, primarily from loan, MBS and investment securities portfolios, and interest expense, primarily on deposits and borrowings.  During the three months ended September 30, 2005 and 2004, NII was $53.1 million and $50.2 million, respectively, an increase of 6%.  During the nine months ended September 30, 2005 and 2004, NII was $159.7 million and $144.6 million, respectively, an increase of 10%.  The increase in NII during the 2005 periods compared to the 2004 periods was mainly due to increases in average loan volumes.

 

Changes in Sterling’s NII are a function of changes in both rates and volumes of interest-earning assets and interest-bearing liabilities.  Volume refers to the dollar level of interest-earning assets and interest-bearing liabilities.  Net interest spread refers to the difference between the yield on interest-earning assets and the rate paid on interest-bearing liabilities.  Net interest margin refers to NII divided by total average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities.

 

The following table presents the composition of the change in NII for the periods presented.  For each category of interest-earning assets and interest-bearing liabilities, the following table provides information on changes attributable to:

 

                  changes in volume – changes in volume multiplied by comparative period rate;

                  changes in rate – changes in rate multiplied by comparative period volume; and

                  changes in rate/volume – changes in rate multiplied by changes in volume.

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 

2005 vs. 2004

 

2005 vs. 2004

 

 

 

Increase (Decrease) Due to:

 

Increase (Decrease) Due to:

 

 

 

Volume

 

Rate

 

Rate/
Volume

 

Total

 

Volume

 

Rate

 

Rate/
Volume

 

Total

 

 

 

(Dollars in thousands)

 

Rate/volume analysis:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans

 

$

6,248

 

$

8,396

 

$

1,066

 

$

15,710

 

$

30,680

 

$

15,005

 

$

2,628

 

$

48,313

 

MBS

 

(1,454

)

(527

)

96

 

(1,885

)

3,321

 

426

 

(35

)

3,712

 

Investments and cash equivalents

 

3

 

(682

)

2

 

(677

)

(686

)

(1,997

)

297

 

(2,386

)

Total interest income

 

4,797

 

7,187

 

1,164

 

13,148

 

33,315

 

13,434

 

2,890

 

49,639

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest expense:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Deposits

 

2,120

 

6,908

 

1,103

 

10,131

 

6,144

 

16,292

 

2,586

 

25,022

 

Advances from FHLB Seattle

 

(835

)

682

 

(18

)

(171

)

1,434

 

1,628

 

40

 

3,102

 

All other borrowings

 

(1,720

)

2,753

 

(732

)

301

 

1,356

 

4,674

 

379

 

6,409

 

Total interest expense

 

(435

)

10,343

 

353

 

10,261

 

8,934

 

22,594

 

3,005

 

34,533

 

Net changes in NII

 

$

5,232

 

$

(3,156

)

$

811

 

$