**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

**ý****  QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the Quarterly PeriodEnded         June 30, 2004**

 

**o****  TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**Commission File No. 0-31525**

 

**COMMUNITY VALLEY BANCORP**

(Exact name of registrant as specified in itscharter)

 

| **California**                                                                        |   | **68-0479553**           |
|---------------------------------------------------------------------------------------|--------|--------------------------|
| (State or other jurisdiction of  incorporation or organization)                       |   | (IRS Employer ID Number) |
|                                                                                  |   |                     |
| **2041 Forest Avenue, Chico, California**                                             |   | **95928**                |
| (Address of principal executive offices)                                              |   | (Zip code)               |
|                                                                                  |   |                     |
| **(530) 899-2344**                                                                    |
| (Registrant’s telephone number,  including area code)                            |
|                                                                                  |
| **not applicable**                                                                    |
| (Former name, former address and former  fiscal year, if changed  since last report.) |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

Yes  ý     No  o

 

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

 

Yes  o     No  ý

 

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

 

No par value Common Stock – 3,635,956 shares outstanding atJuly 31, 2003.

 

 

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PART 1-FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

 

COMMUNITY VALLEY BANCORP

CONSOLIDATED BALANCE SHEET (Unaudited)

 
| **(In thousands except per share  data)**                                                                                                                                             |   | **June 30,  2004** |    | **December 31,  2003** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|---------|-----------------------------|--------|
| ASSETS                                                                                                                                                                                |   |                    |    |                        |   |
|                                                                                                                                                                                  |   |                    |    |                        |   |
| Cash and due from banks                                                                                                                                                               |   | $                       | 27,698  |                        | $      | 26,205 |   |
| Federal funds sold                                                                                                                                                                    |   | 43,110                  |    | 50,605                      |   |
| Interest-bearing deposits in banks                                                                                                                                                    |   | 9,013                   |    | 7,925                       |   |
| Investment securities (market value of  $4,428 at June 30, 2004 and $4,326 at December 31, 2003)                                                                            |   | 4,471                   |    | 4,325                       |   |
| Loans held for sale                                                                                                                                                                   |   | 1,445                   |    | 2,279                       |   |
| Loans, less allowance for loan losses of  $4,013 at June 30, 2004 and $3,587 at December 31, 2003                                                                           |   | 304,129                 |    | 270,231                     |   |
| Bank premises and equipment, net                                                                                                                                                      |   | 9,065                   |    | 8,554                       |   |
| Accrued interest receivable and other  assets                                                                                                                                         |   | 15,655                  |    | 16,599                      |   |
|                                                                                                                                                                                  |   | $                       | 414,586 |                        | $      | 386,723 |   |
|                                                                                                                                                                                  |   |                    |    |                        |   |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                             |   |                    |    |                        |   |
|                                                                                                                                                                                  |   |                    |    |                        |   |
| Deposits:                                                                                                                                                                             |   |                    |    |                        |   |
| Non-interest bearing                                                                                                                                                                  |   | $                       | 78,511  |                        | $      | 68,463 |   |
| Interest bearing                                                                                                                                                                      |   | 289,121                 |    | 274,048                     |   |
| Total deposits                                                                                                                                                                        |   | 367,632                 |    | 342,511                     |   |
|                                                                                                                                                                                  |   |                    |    |                        |   |
| Employee stock ownership plan note payable                                                                                                                                            |   | 759                     |    | 832                         |   |
| Subordinated debenture                                                                                                                                                                |   | 8,248                   |    | 8,248                       |   |
|                                                                                                                                                                                  |   |                    |    |                        |   |
| Accrued interest payable and other  liabilities                                                                                                                                       |   | 5,832                   |    | 5,183                       |   |
|                                                                                                                                                                                  |   |                    |    |                        |   |
| Total liabilities                                                                                                                                                                     |   | 382,471                 |    | 356,774                     |   |
|                                                                                                                                                                                  |   |                    |    |                        |   |
| Commitments and contingencies                                                                                                                                                         |   |                    |    |                        |   |
|                                                                                                                                                                                  |   |                    |    |                        |   |
| Shareholders’ equity:                                                                                                                                                            |   |                    |    |                        |   |
| Common stock – no par value; 20,000,000  shares authorized; issued and outstanding – 3,635,956 shares at June 30,  2004 and 3,621,824 shares at December 31, 2003 |   | 7,695                   |    | 7,271                       |   |
| Unearned ESOP shares (87,412 shares at  June 30, 2004 and 90,909 shares at December 31, 2003, at cost)                                                                      |   | (1,033                  | )       | (1,070                      | )      |
|                                                                                                                                                                                  |   |                    |    |                        |   |
| Retained earnings                                                                                                                                                                     |   | 25,453                  |    | 23,746                      |   |
|                                                                                                                                                                                  |   |                    |    |                        |   |
| Accumulated other comprehensive income, net  (Note 3)                                                                                                                                 |   | 0                       |    | 2                           |   |
|                                                                                                                                                                                  |   |                    |    |                        |   |
| Total shareholders’ equity                                                                                                                                                       |   | 32,115                  |    | 29,949                      |   |
|                                                                                                                                                                                  |   | $                       | 414,586 |                        | $      | 386,723 |   |

 

See Notes to Unaudited Consolidated Financial Statements

 

2

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COMMUNITY VALLEY BANCORP

CONSOLIDATED STATEMENT OF INCOME

(Unaudited)

 
|                                                             |   | **For the  periods ended June 30,** |   |
|------------------------------------------------------------------|--------|------------------------------------------|--------|
|                                                             |   | **Three  months**                        |   | **Six Months** |   |
| **(In thousands, except per share  data)**                       |   | **2004**                                 |   | **2003** |   | **2004** |   | **2003** |   |
|                                                             |   |                                     |   |   |   |   |   |   |   |
| Interest income:                                                 |   |                                     |   |   |   |   |   |   |   |
| Interest and fees on loans                                       |   | $                                        | 5,615  |   | $ | 4,871 |   | $ | 10,972 |   | $ | 9,645 |   |
| Interest on Federal funds sold                                   |   | 121                                      |   | 199 |   | 243 |   | 381 |   |
| Interest on deposits in banks                                    |   | 58                                       |   | 49 |   | 116 |   | 90 |   |
| Interest and dividends on investment  securities:                |   |                                     |   |   |   |   |   |   |   |
| Taxable                                                          |   | 33                                       |   | 26 |   | 61 |   | 62 |   |
| Exempt from Federal income taxes                                 |   | 10                                       |   | 19 |   | 20 |   | 38 |   |
| Dividends                                                        |   | 3                                        |   |   |   | 3 |   |   |   |
|                                                             |   |                                     |   |   |   |   |   |   |   |
| Total interest income                                            |   | 5,840                                    |   | 5,164 |   | 11,415 |   | 10,216 |   |
| Interest expense:                                                |   |                                     |   |   |   |   |   |   |   |
| Interest on deposits                                             |   | 849                                      |   | 1,019 |   | 1,727 |   | 2,032 |   |
| Interest on subordinated debt                                    |   | 102                                      |   | 104 |   | 203 |   | 234 |   |
| Interest on note payable                                         |   | 8                                        |   | 8 |   | 17 |   | 16 |   |
| Total interest expense                                           |   | 959                                      |   | 1,131 |   | 1,947 |   | 2,282 |   |
|                                                             |   |                                     |   |   |   |   |   |   |   |
| Net interest income                                              |   | 4,881                                    |   | 4,033 |   | 9,468 |   | 7,934 |   |
|                                                             |   |                                     |   |   |   |   |   |   |   |
| Provision for loan losses                                        |   | 190                                      |   | 120 |   | 415 |   | 270 |   |
| Net interest income after provision for  loan losses             |   | 4,691                                    |   | 3,913 |   | 9,053 |   | 7,664 |   |
|                                                             |   |                                     |   |   |   |   |   |   |   |
| Non-interest income                                              |   | 1,554                                    |   | 1,383 |   | 2,783 |   | 2,566 |   |
|                                                             |   |                                     |   |   |   |   |   |   |   |
| Non-interest expense:                                            |   |                                     |   |   |   |   |   |   |   |
| Salaries and employee benefits                                   |   | 2,101                                    |   | 1,945 |   | 4,380 |   | 3,886 |   |
| Occupancy                                                        |   | 245                                      |   | 204 |   | 484 |   | 376 |   |
| Furniture and equipment                                          |   | 311                                      |   | 233 |   | 664 |   | 473 |   |
| Other expense                                                    |   | 1,092                                    |   | 950 |   | 2,008 |   | 1,816 |   |
| Total non-interest expense                                       |   | 3,749                                    |   | 3,332 |   | 7,536 |   | 6,551 |   |
|                                                             |   |                                     |   |   |   |   |   |   |   |
| Income before income taxes                                       |   | 2,496                                    |   | 1,964 |   | 4,300 |   | 3,679 |   |
|                                                             |   |                                     |   |   |   |   |   |   |   |
| Income taxes                                                     |   | 1,031                                    |   | 848 |   | 1,747 |   | 1,526 |   |
|                                                             |   |                                     |   |   |   |   |   |   |   |
| Net income                                                       |   | $                                        | 1,465  |   | $ | 1,116 |   | $ | 2,553 |   | $ | 2,153 |   |
|                                                             |   |                                     |   |   |   |   |   |   |   |
| Basic earnings per share (Note 2)                                |   | $                                        | .41    |   | $ | .32 |   | $ | .72 |   | $ | .61 |   |
| Diluted earnings per share (Note 2)                              |   | $                                        | .39    |   | $ | .30 |   | $ | .68 |   | $ | .58 |   |
|                                                             |   |                                     |   |   |   |   |   |   |   |
| Cash dividends per share of issued and  outstanding common stock |   | $                                        | .075   |   | $ | .056 |   | $ | .15 |   | $ | .11 |   |

 

See Notes to Unaudited Consolidated Financial Statements

 

3

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COMMUNITY VALLEY BANCORP

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

(Unaudited)

(In thousands except number of shares)

 
|                                                         |   |              |   |         |   |         |   |              |   | **Accumulated**        |   |              |   |       |   |
|--------------------------------------------------------------|--------|-------------------|--------|--------------|--------|--------------|--------|-------------------|--------|------------------------|--------|-------------------|--------|------------|--------|
|                                                         |   |              |   | **Unearned** |   |         |   | **Other**         |   | **Total**              |   |              |   |
|                                                         |   | **Common  Stock** |   | **ESOP**     |   | **Retained** |   | **Comprehensive** |   | **Shareholders’** |   | **Comprehensive** |   |
|                                                         |   | **Shares**        |   | **Amount**   |   | **Shares**   |   | **Earnings**      |   | **Income**             |   | **Equity**        |   | **Income** |   |
|                                                         |   |              |   |         |   |         |   |              |   |                   |   |              |   |       |   |
| Balance, January 1, 2003                                |   | 3,580,468         |   | $            | 6,660  |         | $      | (852              | )      | $                      | 19,559 |              | $      | 14         |   | $ | 25,381 |   |   |   |
|                                                         |   |              |   |         |   |         |   |              |   |                   |   |              |   |       |   |
| Comprehensive income (Note 3):                               |   |              |   |         |   |         |   |              |   |                   |   |              |   |       |   |
| Net income                                                   |   |              |   |         |   |         |   | 5,269             |   |                   |   | 5,269             |   | $          | 5,269  |   |
| Other comprehensive loss, net of tax                         |   |              |   |         |   |         |   |              |   |                   |   |              |   |       |   |
| Unrealized loss on available-for-sale investment  securities |   |              |   |         |   |         |   |              |   | (12                    | )      | (12               | )      | (12        | )      |
|                                                         |   |              |   |         |   |         |   |              |   |                   |   |              |   | $          | 5,257  |   |
|                                                         |   |              |   |         |   |         |   |              |   |                   |   |              |   |       |   |
| Exercise of stock options and related tax benefit            |   | 41,356            |   | 462          |   |         |   |              |   |                   |   | 462               |   |       |   |
| Earned ESOP shares                                           |   |              |   | 150          |   | 102          |   |              |   |                   |   | 252               |   |       |   |
| Shares acquired or redeemed by ESOP                          |   |              |   |         |   | (321         | )      |              |   |                   |   | (321              | )      |       |   |
| Cash dividends- $.30 per share                               |   |              |   |         |   |         |   | (1,082            | )      |                   |   | (1,082            | )      |       |   |
|                                                         |   |              |   |         |   |         |   |              |   |                   |   |              |   |       |   |
| Balance, December 31, 2003                              |   | 3,621,824         |   | 7,272        |   | (1,071       | )      | 23,746            |   | 2                      |   | 29,949            |   |       |   |
|                                                         |   |              |   |         |   |         |   |              |   |                   |   |              |   |       |   |
| Comprehensive income (Note 3):                               |   |              |   |         |   |         |   |              |   |                   |   |              |   |       |   |
| Net income                                                   |   |              |   |         |   |         |   | 2,553             |   |                   |   | 2,553             |   | $          | 2,553  |   |
| Other comprehensive loss, net of tax:                        |   |              |   |         |   |         |   |              |   |                   |   |              |   |       |   |
| Unrealized loss on available-for-sale investment  securities |   |              |   |         |   |         |   |              |   | (2                     | )      | (2                | )      | (2         | )      |
|                                                         |   |              |   |         |   |         |   |              |   |                   |   |              |   |       |   |
| Total comprehensive income                                   |   |              |   |         |   |         |   |              |   |                   |   |              |   | $          | 2,551  |   |
| Retirement of common stock                                   |   | (12,000           | )      | (25          | )      |         |   | (299              | )      |                   |   | (324              | )      |       |   |
| Exercise of stock options and related tax benefit            |   | 26,132            |   | 397          |   |         |   |              |   |                   |   | 397               |   |       |   |
| Earned ESOP shares                                           |   |              |   | 51           |   | 38           |   |              |   |                   |   | 89                |   |       |   |
| Cash  dividends declared                                     |   |              |   |         |   |         |   | (547              | )      |                   |   | (547              | )      |       |   |
|                                                         |   |              |   |         |   |         |   |              |   |                   |   |              |   |       |   |
| Balance, June 30, 2004                                  |   | 3,635,956         |   | $            | 7,695  |         | $      | (1,033            | )      | $                      | 25,453 |              | $      | 0          |   | $ | 32,115 |   |   |   |

 

See Notes to Unaudited Consolidated Financial Statements

 

4

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COMMUNITY VALLEY BANCORP

CONSOLIDATED STATEMENT OF CASH FLOWS (Unaudited**)**

 
| **(In thousands)****For the six months ended June 30,**                       |   | **2004** |   | **2003** |   |
|------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|
|                                                                               |   |     |   |     |   |
| Cash flows from operating activities:                                              |   |     |   |     |   |
| Net income                                                                         |   | $        | 2,553  |     | $      | 2,153 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |   |     |   |     |   |
| Provision for loan losses                                                          |   | 415      |   | 270      |   |
| Deferred loan origination costs, net                                               |   | 23       |   | (50      | )      |
| Depreciation and amortization                                                      |   | 646      |   | 497      |   |
| Gain on disposition of Bank premises and  equipment                                |   |     |   | (1       | )      |
| Net decrease in loans held for sale                                                |   | 834      |   | 3,301    |   |
| Increase in cash surrender value of  bank-owned life insurance                     |   | (250     | )      | (1,705   | )      |
| Non-cash compensation expense associated  with the ESOP                            |   | 90       |   | 83       |   |
| Decrease in accrued interest receivable and  other assets                          |   | 1,387    |   | 367      |   |
| Increase (decrease) in accrued interest  payable and other liabilities             |   | 647      |   | (1,017   | )      |
|                                                                               |   |     |   |     |   |
| Net cash provided by operating activities                                          |   | 6,345    |   | 3,898    |   |
|                                                                               |   |     |   |     |   |
| Cash flows from investing activities:                                              |   |     |   |     |   |
|                                                                               |   |     |   |     |   |
| Increase in interest-bearing deposits in  banks                                    |   | (1,088   | )      | (2,577   | )      |
| Proceeds from called available-for-sale  investment securities                     |   | 300      |   |     |   |
| Proceeds from called held-to-maturity  investment securities                       |   | 250      |   | 2,200    |   |
| Proceeds from matured held-to-maturity  investment securities                      |   | 130      |   |     |   |
| Proceeds from principal payments of  held-to-maturity investment securities        |   | 150      |   |     |   |
| Purchase of held-to-maturity investment  securities                                |   | (1,012   | )      | (1,311   | )      |
| Purchases of bank premises and equipment                                           |   | (1,448   | )      | (748     | )      |
| Proceeds from sale of bank premises and  equipment                                 |   | 323      |   |     |   |
| Net increase in loans                                                              |   | (34,336  | )      | (12,237  | )      |
|                                                                               |   |     |   |     |   |
| Net cash used in investing activities                                              |   | (36,731  | )      | (14,641  | )      |
|                                                                               |   |     |   |     |   |
| Cash flows from financing activities:                                              |   |     |   |     |   |
|                                                                               |   |     |   |     |   |
| Net increase in demand, interest-bearing  and savings deposits                     |   | $        | 22,737 |     | $      | 27,720 |   |
| Net increase (decrease) in time deposits                                           |   | 2,384    |   | (3,312   | )      |
| Repayment of ESOP loan, net                                                        |   | (73      | )      | 10       |   |
| Payment of cash dividends                                                          |   | (544     | )      | (538     | )      |
| Cash paid for fractional shares                                                    |   | (6       | )      |     |   |
| Exercise of stock options                                                          |   | 210      |   | 151      |   |
| Purchase of unearned ESOP shares                                                   |   |     |   | (78      | )      |
| Common shares purchased                                                            |   | (324     | )      |     |   |
|                                                                               |   |     |   |     |   |
| Net cash provided by financing activities                                          |   | 24,384   |   | 30,577   |   |
|                                                                               |   |     |   |     |   |
| (Decrease) increase in cash and cash  equivalents                                  |   | (6,002   | )      | 19,834   |   |
|                                                                               |   |     |   |     |   |
| Cash and cash equivalents at beginning of  year                                    |   | 76,810   |   | 73,031   |   |
|                                                                               |   |     |   |     |   |
| Cash and cash equivalents at end of period                                         |   | $        | 70,808 |     | $      | 92,865 |   |

 

See Notes to Unaudited Consolidated Financial Statements

 

5

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**Community Valley Bancorp and Subsidiaries**

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

1.  BASIS OF PRESENTATION

 

The accompanying unaudited consolidated financial statements ofCommunity Valley Bancorp and subsidiaries (the “Company”) have been prepared inaccordance with the instructions to Form 10-Q and Article 10 of RegulationS-X.  Accordingly, certain informationand notes required by accounting principles generally accepted in the United Statesfor annual financial statements are not included herein.  In the opinion of management, alladjustments (which consist solely of normal recurring accruals) considerednecessary for a fair presentation of the results for the interim periodspresented have been included.  Theseinterim consolidated financial statements should be read in conjunction withthe financial statements and related notes contained in the Company’s 2003Annual Report to Shareholders on Form 10-K.

 

The consolidated financial statements include the accounts of theCompany and its wholly owned bank subsidiary, Butte Community Bank.  All significant inter-company balances andtransactions have been eliminated in consolidation.  The results of operations for the three and six month periodsended June 30, 2004 may not necessarily be indicative of the operatingresults for the full year 2004.

 

On February 20, 2004, the Board of Directors declared afour-for-three stock split effective March 26, 2004 for shareholders ofrecord on March 2, 2004.  All share and per share data has beenretroactively adjusted to reflect the stock split.

 

The preparation of consolidated financial statements in conformity withaccounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions.  These estimatesand assumptions affect the reported amounts of assets and liabilities at thedate of the financial statements and the reported amounts of revenues andexpenses during the reporting period.  Actual results could differ fromthese estimates.

 

2.  EARNINGS PER SHARECOMPUTATION

 

Basic earnings per share are computed by dividing net income by theweighted average common shares outstanding for the period (3,555,791 and3,548,252 shares for the three and six month periods ended June 30, 2004and 3,504,448 and 3,502,404 shares for the three and six month periods endedJune 30, 2003).  Diluted earningsper share reflect the potential dilution that could occur if outstanding stockoptions were exercised using the treasury stock method.   Diluted earnings per share is computed bydividing net income by the weighted average common shares outstanding for theperiod plus the dilutive effect of options (242,179 and 256,593 shares for thethree and six month periods ended June 30, 2004 and 195,220 and 186,395shares for the three and six month periods ended June 30, 2003).  Earnings per share are retroactivelyadjusted for stock splits and dividends for all periods presented.

 

3. COMPREHENSIVE INCOME

 

Comprehensiveincome is reported in addition to net income for all periods presented.  Comprehensive income is made up of netincome plus other comprehensive income or loss.  The Company’s only source of comprehensive income or loss, iscomprised of changes in unrealized gains or losses, net of taxes, onavailable-for-sale securities, adjusted for the effect of realized gains orlosses on available-for-sale securities, net of taxes.

 

6

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## **4.**  STOCK –BASED COMPENSATION

## ** **

The Company issues stock options under three stock-based compensationplans, the Community Valley Bancorp 1991, 1997 and 2000 Stock OptionPlans.  The Company accounts for theseplans under the recognition and measurement principles of APB Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related Interpretations.  No stock-based compensation cost isreflected in net income, as all options granted under these plans had anexercise price equal to the market value of the underlying common stock on thedate of grant.  In accordance withFinancial Accounting Standards Board (“FASB”) No. 148, *Accounting for Stock-Based Compensation – Transitionand Disclosure, an Amendment of FASB No. 123,* the following tableillustrates the effect on net income and earnings per share if the Company hadapplied the fair value recognition provisions of FASB Statement No. 123, *Accountingfor Stock-Based Compensation*, to stock-based employee compensation.

 

Pro forma adjustments to the Company’s consolidated net earnings andearnings per share are disclosed during the periods in which the options becomevested.

 

(In thousands, except per share data)

 
|                                                                                                                                           |   | **Three  Months Ended** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|
|                                                                                                                                           |   | **June 30, 2004**  |   | **June 30, 2003** |   |
|                                                                                                                                           |   |                    |   |   |   |
| Net income as reported                                                                                                                         |   | $                       | 1,465  |   | $ | 1,116 |   |
|                                                                                                                                           |   |                    |   |   |   |   |   |
| Deduct:  Total stock-based compensation expense  determined under the fair value based method for all awards, net of related  tax effects |   | (71                     | )      | (64 | ) |
|                                                                                                                                           |   |                    |   |   |   |
| Pro forma net income                                                                                                                           |   | $                       | 1,394  |   | $ | 1,052 |   |
|                                                                                                                                           |   |                    |   |   |   |
| Basic earnings per share -  as reported                                                                                                        |   | $                       | 0.41   |   | $ | 0.32 |   |
|                                                                                                                                           |   |                    |   |   |   |
| Basic earnings per share -  pro forma                                                                                                          |   | $                       | 0.39   |   | $ | 0.30 |   |
|                                                                                                                                           |   |                    |   |   |   |
| Diluted earnings per share -  as reported                                                                                                      |   | $                       | 0.39   |   | $ | 0.30 |   |
|                                                                                                                                           |   |                    |   |   |   |
| Diluted earnings per share -  pro forma                                                                                                        |   | $                       | 0.37   |   | $ | 0.28 |   |

 

7

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|                                                                                                                                           |   | **Six Months  Ended**  |   |
|------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|--------|
|                                                                                                                                           |   | **June 30, 2004** |   | **June 30, 2003** |   |
|                                                                                                                                           |   |                   |   |   |   |
| Net earnings as reported                                                                                                                       |   | $                      | 2,553  |   | $ | 2,153 |   |
|                                                                                                                                           |   |                   |   |   |   |   |   |
| Deduct:  Total stock-based compensation expense  determined under the fair value based method for all awards, net of related  tax effects |   | (143                   | )      | (129 | ) |
|                                                                                                                                           |   |                   |   |   |   |
| Pro forma net income                                                                                                                           |   | $                      | 2,410  |   | $ | 2,024 |   |
|                                                                                                                                           |   |                   |   |   |   |
| Basic earnings per share -  as reported                                                                                                        |   | $                      | 0.72   |   | $ | 0.61 |   |
|                                                                                                                                           |   |                   |   |   |   |
| Basic earnings per share -  pro forma                                                                                                          |   | $                      | 0.68   |   | $ | 0.58 |   |
|                                                                                                                                           |   |                   |   |   |   |
| Diluted earnings per share -  as reported                                                                                                      |   | $                      | 0.68   |   | $ | 0.58 |   |
|                                                                                                                                           |   |                   |   |   |   |
| Diluted earnings per share -  pro forma                                                                                                        |   | $                      | 0.63   |   | $ | 0.56 |   |

 

8

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**Item 2. MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OFCOMMUNITY VALLEY BANCORP**

 

The following is Community Valley Bancorp’s (the “Company”)management’s discussion and analysis of the significant changes in balancesheet accounts for June 30, 2004 and December 31, 2003 and income andexpense accounts for the three and six month periods ended June 30, 2004and 2003. The discussion is designed to provide a better understanding ofsignificant trends related to the Company’s financial condition, results ofoperations, liquidity, capital resources and interest rate sensitivity.

 

In addition to the historical information contained herein, this reporton Form 10-Q contains certain forward-looking statements.  The reader of this report should understandthat all such forward-looking statements are subject to various uncertaintiesand risks that could affect their outcome.  The Company’s actual results could differ materially from thosesuggested by such forward-looking statements. Factorsthat could cause or contribute to such differences include, but are not limitedto, variances in the actual versus projected growth in assets, return onassets, loan losses, expenses, rates charged on loans and earned on securitiesinvestments, rates paid on deposits, competition effects, fee and othernoninterest income earned, general economic conditions, nationally, regionallyand in the operating market areas of the Company and its subsidiaries, changesin the regulatory environment, changes in business conditions and inflation,changes in securities markets, data processing problems, a decline inreal estate values in the Company’s market area,  the effects of terrorism,including the events of September 11, 2001 and thereafter, and the conductof the war on terrorism by the United States and its allies, as well as other factors. Thisentire report should be read putting such forward-looking statements incontext.

 

## **GeneralDevelopment of Business**

 

The Company is a bank holding company registered under the Bank HoldingCompany Act of 1956, as amended. The Company was incorporated under the laws ofthe State of California in 2002.  As abank holding company, the Company is authorized to engage in the activitiespermitted under the Bank Holding Company Act of 1956, as amended, andregulations thereunder.** **Itsprincipal office is located at 2041 Forest Avenue, Chico, California 95928 andits telephone number is (530) 899-2344.

 

The Company owns 100% of the issued and outstanding common shares ofButte Community Bank.  Butte CommunityBank was incorporated and commenced business in Paradise and Oroville,California in 1990.  Butte CommunityBank operates ten full service offices within its primary service areas ofButte, Sutter, Yuba and Tehama Counties. The Bank also maintains Loan Production Offices in Citrus Heights andRedding. Butte Community Bank’s primary business is serving the commercialbanking needs of small to mid-sized businesses and consumers within thosecounties.  Butte Community Bank acceptschecking and savings deposits, offers money market deposit accounts and certificatesof deposit, makes secured and unsecured commercial, secured real estate, andother installment and term loans and offers other customary banking services.

 

**Critical AccountingPolicies**

 

*General*

 

The Company’s significant accounting principles are described in Note 2of the consolidated financial statements and are essential to understandingManagement’s Discussion and Analysis of Results of Operations and FinancialCondition. Community Valley Bancorp’s consolidated financial statements areprepared in accordance with accounting principles generally accepted in theUnited States of America (GAAP). The financial information contained within ourstatements is, to a significant extent, financial information that is based onmeasures of the financial effects of transactions and events that have alreadyoccurred. Some of the Company’s accounting principles require significantjudgement to estimate values of assets or liabilities. In addition, certainaccounting principles require significant judgment in applying the complexaccounting principles to transactions to determine the most appropriatetreatment. The following is a summary of the more judgmental and complexaccounting estimates and principles.

 

9

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*Allowance for Loan Losses (ALL)*

 

The allowance for loan losses is management’s best estimate of theprobable losses that may be sustained in our loan portfolio. The allowance isbased on two basic principles of accounting:  (1) SFAS No.5 whichrequires that losses be accrued when they are probable of occurring andestimable and (2) SFAS No. 114, which requires that losses be accrued onimpaired loans based on the differences between the value of collateral,present value of future cash flows or values that are observable in thesecondary market and the loan balance. The Company performs periodic andsystematic detailed evaluations of its lending portfolio to identify andestimate the inherent risks and assess the overall collectibility. Theseevaluations include general conditions such as the portfolio composition, sizeand maturities of various segmented portions of the portfolio such as secured,unsecured, construction, and Small Business Administration (“SBA”).

 

Additional factors include concentrations of borrowers, industries,geographical sectors, loan product, loan classes and collateral types, volumeand trends of loan delinquencies and non-accrual, criticized and classifiedassets and trends in the aggregate in significant credits identified as watchlist items. There are several components to the determination of the adequacyof the ALL. Each of these components is determined based upon estimates thatcan and do change when the actual events occur. The Company estimates the SFASNo. 5 portion of the ALL based on the segmentation of its portfolio. Forthose segments that require an ALL, the Company estimates loan losses on amonthly basis based upon its ongoing loan review process and analysis of loanperformance. The Company follows a systematic and consistently applied approachto select the most appropriate loss measurement methods and support itsconclusions and rationale with written documentation. One method of estimatingloan losses for groups of loans is through the application of loss rates to thegroups’ aggregate loan balances. Such rates typically reflect historical lossexperience for each group of loans, adjusted for relevant economic factors overa defined period of time. The Company evaluates and modifies its lossestimation model as needed to ensure that the resulting loss estimate isconsistent with GAAP.

 

For individually impaired loans, SFAS No. 114 provides guidance onthe acceptable methods to measure impairment. Specifically, SFAS No. 114states that when a loan is impaired, the Company should measure impairmentbased on the present value of expected future principal and interest cash flowsdiscounted at the loan’s effective interest rate, except that as a practicalexpedient, a creditor may measure impairment based on a loan’s observablemarket price or the fair value of collateral, if the loan is collateraldependent. When developing the estimate of future cash flows for a loan, theCompany considers all available information reflecting past events and currentconditions, including the effect of existing environmental factors.

 

*Loan Sales and Servicing*

 

The Company originates government guaranteed loans and mortgage loansthat may be sold in the secondary market.  The amounts of gains recordedon sales of loans and the initial recording of servicing assets and interestonly (I/O) strips is based on the estimated fair values of the respectivecomponents.  In recording the initial value of the servicing assets andthe fiar value of the I/O strips receivable, the Company uses estimates whichare made based on management’s expectations of future prepayment and discountrates.  Servicing assets are amortized over the estimated life of therelated loan.  I/O strips are not significant at December 31,2003.  These prepayment and discount rates were based on current marketconditions and historical performance of the various pools of servicedloans.  If actual prepayments with respect to sold loans occur morequickly than projected the carrying value of the servicing assets may have tobe adjusted through a charge to earnings.

 

*Stock-Based Compensation*

 

The Company uses the intrinsic value based method for measuringcompensation cost related to stock options. Under the intrinsic value basedmethod, compensation cost is the excess, if any, of the quoted market price ofthe stock at grant date over the amount an employee must pay to acquire thestock. This cost is amortized on a straight-line basis over the vesting periodof the options granted. The Company applies Accounting Principles Board Opinion(“APB”) No. 25 *Accounting for Stock Issuedto Employees*and related interpretations in accounting for stockoptions.  No compensation cost has been recorded in the accompanyingfinancial statements because all options have been granted at an exercise priceof no less than the fair market value at date of grant.

 

10

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*Revenue recognition*

 

The Company’s primary source of revenue is interest income, which isthe difference between the interest income it receives on interest-earningassets and the interest expense it pays on interest-bearing liabilities, and(ii) fee income, which includes fees earned on deposit services, incomefrom SBA lending, electronic-based cash management services, mortgage brokeragefee income and merchant credit card processing services. Interest income isrecorded on an accrual basis. Note 1 to the Consolidated Financial Statementsoffers an explanation of the process for determining when the accrual ofinterest income is discontinued on an impaired loan.

 

*Income Taxes*

 

The Company accounts for income taxes under the asset and liabilitymethod. Under the asset and liability method, deferred tax assets andliabilities are recognized for the future tax consequences attributable todifferences between the financial statement carrying amounts of existing assetsand liabilities and their respective tax bases. Deferred tax assets andliabilities are measured using currently enacted tax rates applied to suchtaxable income in the years in which those temporary differences are expected tobe recovered or settled. The effect on deferred tax assets and liabilities of achange in tax rates is recognized in income in the period that includes theenactment date. If future income should prove non-existent or less than theamount of deferred tax assets within the tax years to which they may beapplied, the asset may not be realized and our net income will be reduced.

 

**Overview**

 

The Company recorded net income of $1,465,000 for the quarter endedJune 30, 2004, which was a 31% increase from the $1,116,000 reported forthe same period of 2003.  Dilutedearnings per share for the second quarter of 2004 were $0.39, compared to the$0.30 recorded in the second quarter of 2003. The annualized return on average equity (ROAE) and the return on averageassets (ROA) for the second quarter of 2004 were 18.45% and 1.43%,respectively, as compared to 16.62% and 1.25%, respectively, for the sameperiod in 2003.

 

Net income for the six months ended June 30, 2004 was $2,553,000(up 18.6%) compared to the $2,153,000 recorded in the first six months of2003.   The primary reason for theincrease in net income was the growth in earning assets the companyexperienced.

 

Total assets of the Company increased by $28,700,000 or (7.2%) fromDecember 31, 2003 to $414,500,000 at June 30, 2004.  Net loans totaled $304,100,000, up$33,900,000 (12.5%) from the ending balances on December 31, 2003.  Deposit balances at June 30, 2004 totaled$367,600,000, up $25,100,000 (7.3%) from December 31, 2003.

 

Table One below provides a summary of the components of net income forthe periods indicated:

 

11

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**Table One:  Components of Net Income**

 
|                                                             |   | **Three  months ended  June 30,** |   | **Six months  ended  June 30,** |   |
|------------------------------------------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
| **(In thousands, except  percentages)**                          |   | **2004**                               |   | **2003**                             |   | **2004** |   | **2003** |   |
|                                                             |   |                                   |   |                                 |   |   |   |   |   |
| Net interest income                                              |   | $                                      | 4,881  |                                 | $      | 4,033 |   | $ | 9,468 |   | $ | 7,934 |   |
| Provision for loan losses                                        |   | (190                                   | )      | (120                                 | )      | (415 | ) | (270 | ) |
| Non-interest income                                              |   | 1,554                                  |   | 1,383                                |   | 2,783 |   | 2,566 |   |
| Non-interest expense                                             |   | (3,749                                 | )      | (3,332                               | )      | (7,536 | ) | (6,551 | ) |
| Provision for income taxes                                       |   | (1,031                                 | )      | (848                                 | )      | (1,747 | ) | (1,526 | ) |
|                                                             |   |                                   |   |                                 |   |   |   |   |   |
| Net income                                                       |   | $                                      | 1,465  |                                 | $      | 1,116 |   | $ | 2,553 |   | $ | 2,153 |   |
|                                                             |   |                                   |   |                                 |   |   |   |   |   |
| Average total assets (In millions)                               |   | $                                      | 413.0  |                                 | $      | 360.8 |   | $ | 401.6 |   | $ | 346.3 |   |
| Net income (annualized) as a percentage of  average total assets |   | 1.42                                   | %      | 1.24                                 | %      | 1.27 | % | 1.24 | % |

 

**Results of Operations**

 

## **Net InterestIncome and Net Interest Margin**

 

Net interest income represents the excess of interest and fees earnedon interest earning assets (loans, securities, federal funds sold andinvestments in time deposits) over the interest paid on deposits and borrowedfunds.  Net interest margin is netinterest income expressed as a percentage of average earning assets.

 

The Company’s net interest margin was 5.42% for the three month and sixmonth periods ending June 30, 2004. Net interest income increased $848,000 (21%) for the second quarter of2004 compared to the same period in 2003. Net interest income increased $1,534,000 (19.3%) for the six monthsended June 30, 2004 over the same period in 2003.   The primary reason for this increase wasthe loan growth and the resulting interest income and fees associated with thatgrowth together with the decrease in the interest rates paid on deposits.

 

Interest expense was $172,000 (15.2%) lower in the second quarter of2004 versus the prior year period. The average balances of interest bearingliabilities were $33,264,000 (12.6%) higher in the second quarter of 2004versus the same quarter in 2003. Even though the interest bearing balancesincreased, rates paid on these liabilities decreased 42 basis points on aquarter over quarter basis.     Interestexpense was $335,000 (14.6%) lower in the six month period ended June 30,2004 versus the prior year period.  Theaverage balances of interest bearing liabilities were $34,342,000 (13.4%)higher in the six-month period ended June 30, 2004 versus the same periodin 2003.  Rates paid on interest bearingliabilities decreased 45 basis points on a year over year basis.  The reason for this decrease was the abilityof management to channel the growth of the deposits away from higher interestrate certificates of deposit to lower rate demand deposits and to lower theaverage cost of certificates of deposit as higher cost deposits were re-pricedin a lower rate environment.

 

Table Two, Analysis of Net Interest Margin on Earning Assets, and TableThree, Analysis of Volume and Rate Changes on Net Interest Income and Expenses,are provided to enable the reader to understand the components and past trendsof the Company’s interest income and expense. Table Two provides an analysis of net interest margin on earning assetssetting forth average assets, liabilities and shareholders’ equity; interestincome earned and interest expense paid and average rates earned and paid; andthe net interest margin on earning assets.

 

12

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**Table Two:  Analysis of Net Interest Margin on EarningAssets**

 

Three Months Ended June 30,

 
|                                            |   | **2004**         |    | **2003**     |   |
|-------------------------------------------------|--------|------------------|---------|--------------|--------|
| **(In thousands, except  percentages)**         |   | **Avg  Balance** |    | **Interest** |   | **Avg  Yield (4)** |   | **Avg  Balance** |   | **Interest** |   | **Avg  Yield (4)** |   |
|                                            |   |             |    |         |   |   |   |   |   |   |   |   |   |
| **Assets:**                                     |   |             |    |         |   |   |   |   |   |   |   |   |   |
| Earning assets                                  |   |             |    |         |   |   |   |   |   |   |   |   |   |
| Loans (1)                                       |   | $                | 298,616 |         | $      | 5,615 |   | 7.56 | % | $ | 246,939 |   | $ | 4,871 |   | 7.91 | % |
| Taxable investment securities                   |   | 3,897            |    | 36           |   | 3.41 | % | 1,812 |   | 26 |   | 5.76 | % |
| Tax-exempt investment securities (2)            |   | 705              |    | 10           |   | 5.71 | % | 975 |   | 19 |   | 7.82 | % |
| Federal funds sold                              |   | 49,979           |    | 121          |   | 0.97 | % | 67,480 |   | 199 |   | 1.18 | % |
| Interest bearing deposits in banks              |   | 8,863            |    | 58           |   | 2.63 | % | 5,884 |   | 49 |   | 3.34 | % |
| Total earning assets                            |   | 362,060          |    | 5,840        |   | 6.49 | % | 323,090 |   | 5,164 |   | 6.41 | % |
| Cash & due from banks                       |   | 26,486           |    |         |   |   |   | 14,681 |   |   |   |   |   |
| Other assets                                    |   | 24,489           |    |         |   |   |   | 23,112 |   |   |   |   |   |
|                                            |   | $                | 413,036 |         |   |   |   |   | $ | 360,884 |   |   |   |   |   |
|                                            |   |             |    |         |   |   |   |   |   |   |   |   |   |
| **Liabilities & Shareholders’ Equity** |   |             |    |         |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                   |   |             |    |         |   |   |   |   |   |   |   |   |   |
| NOW & MMDA                                  |   | $                | 174,829 |         | 263    |   | 0.61 | % | $ | 145,708 |   | 370 |   | 1.03 | % |
| Savings                                         |   | 27,993           |    | 34           |   | 0.49 | % | 21,678 |   | 26 |   | .49 | % |
| Time deposits                                   |   | 85,638           |    | 552          |   | 2.59 | % | 87,836 |   | 623 |   | 2.88 | % |
| Other borrowings                                |   | 8,782            |    | 110          |   | 5.04 | % | 8,756 |   | 112 |   | 5.19 | % |
| Total interest bearing liabilities              |   | 297,242          |    | 959          |   | 1.30 | % | 263,978 |   | 1,131 |   | 1.72 | % |
| Demand deposits                                 |   | 77,678           |    |         |   |   |   | 61,715 |   |   |   |   |   |
| Other liabilities                               |   | 6,174            |    |         |   |   |   | 8,265 |   |   |   |   |   |
| Total liabilities                               |   | 381,094          |    |         |   |   |   | 333,958 |   |   |   |   |   |
| Shareholders’ equity                       |   | 31,942           |    |         |   |   |   | 26,926 |   |   |   |   |   |
|                                            |   | $                | 413,036 |         |   |   |   |   | $ | 360,884 |   |   |   |   |   |
| Net interest income & margin (3)            |   |             |    | $            | 4,881  |   | 5.42 | % |   |   | $ | 4,033 |   | 5.00 | % |

 

----

(1)          Loan interest includes loan fees of $499,000and $437,000 during the three months ended June 30, 2004 and June 30,2003 respectively.

(2)          Does not include taxable-equivalentadjustments that primarily relate to income on certain securities that areexempt from federal income taxes.

(3)          Net interest margin is computed by dividingnet interest income by total average earning assets.

(4)          Average yield is calculated based on actualdays in quarter (91 for June 30, 2004 and June 30, 2003) andannualized to actual days in year (366 for 2004 and 365 for 2003).

 

13

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Six Months Ended June 30,

 
|                                            |   | **2004**         |    | **2003**     |   |
|-------------------------------------------------|--------|------------------|---------|--------------|--------|
| **(In thousands, except  percentages)**         |   | **Avg  Balance** |    | **Interest** |   | **Avg  Yield (4)** |   | **Avg  Balance** |   | **Interest** |   | **Avg  Yield (4)** |   |
|                                            |   |             |    |         |   |   |   |   |   |   |   |   |   |
| **Assets:**                                     |   |             |    |         |   |   |   |   |   |   |   |   |   |
| Earning assets                                  |   |             |    |         |   |   |   |   |   |   |   |   |   |
| Loans (1)                                       |   | $                | 288,741 |         | $      | 10,972 |   | 7.64 | % | $ | 243,065 |   | $ | 9,645 |   | 8.00 | % |
| Taxable investment securities                   |   | 3,619            |    | 61           |   | 3.39 | % | 2,041 |   | 62 |   | 6.03 | % |
| Tax-exempt investment securities (2)            |   | 725              |    | 20           |   | 5.55 | % | 1,027 |   | 38 |   | 7.46 | % |
| Federal funds sold                              |   | 49,783           |    | 243          |   | 0.98 | % | 63,689 |   | 381 |   | 1.21 | % |
| Interest bearing deposits in banks              |   | 8,555            |    | 116          |   | 2.73 | % | 5,284 |   | 90 |   | 3.43 | % |
| Total earning assets                            |   | 351,423          |    | 11,415       |   | 6.51 | % | 315,106 |   | 10,216 |   | 6.54 | % |
| Cash & due from banks                       |   | 25,979           |    |         |   |   |   | 14,297 |   |   |   |   |   |
| Other assets                                    |   | 24,211           |    |         |   |   |   | 22,169 |   |   |   |   |   |
|                                            |   | $                | 401,613 |         |   |   |   |   | $ | 351,572 |   |   |   |   |   |
|                                            |   |             |    |         |   |   |   |   |   |   |   |   |   |
| **Liabilities & Shareholders’ Equity** |   |             |    |         |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                   |   |             |    |         |   |   |   |   |   |   |   |   |   |
| NOW & MMDA                                  |   | $                | 170,603 |         | 564    |   | .66 | % | $ | 141,325 |   | 728 |   | 1.04 | % |
| Savings                                         |   | 26,942           |    | 68           |   | .51 | % | 21,108 |   | 63 |   | .60 | % |
| Time deposits                                   |   | 85,175           |    | 1,095        |   | 2.59 | % | 86,177 |   | 1,241 |   | 2.91 | % |
| Other borrowings                                |   | 9,037            |    | 220          |   | 4.90 | % | 8,745 |   | 250 |   | 5.76 | % |
| Total interest bearing liabilities              |   | 291,757          |    | 1,947        |   | 1.34 | % | 257,355 |   | 2,282 |   | 1.79 | % |
| Demand deposits                                 |   | 73,406           |    |         |   |   |   | 62,163 |   |   |   |   |   |
| Other liabilities                               |   | 5,074            |    |         |   |   |   | 5,561 |   |   |   |   |   |
| Total liabilities                               |   | 370,237          |    |         |   |   |   | 325,079 |   |   |   |   |   |
| Shareholders’ equity                       |   | 31,376           |    |         |   |   |   | 26,493 |   |   |   |   |   |
|                                            |   | $                | 401,613 |         |   |   |   |   | $ | 351,572 |   |   |   |   |   |
| Net interest income & margin (3)            |   |             |    | 9,468        |   | 5.42 | % |   |   | 7,934 |   | 5.08 | % |
|                                                 |        |                  |         |              |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)          Loan interest includes loan fees of$1,031,000 and $917,000 during the six months ended June 30, 2004 andJune 30, 2003, respectively.

(2)          Does not include taxable-equivalentadjustments that primarily relate to income on certain securities that isexempt from federal income taxes.

(3)          Net interest margin is computed by dividingnet interest income by total average earning assets.

(4)          Average yield is calculated based on actualdays in period (182 for June 30, 2004 and 181 days for June 30, 2003)and annualized to actual days in year (366 for 2004 and 365 for 2003).

 

14

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Table Three sets forth a summary of the changes in interest income andinterest expense from changes in average asset and liability balances (volume)and changes in average interest rates. On a quarter over quarter basis for the period ending June 30, 2004net interest income has increased $848,000 over the same time period in2003.  Interest income from earningassets has increased by $676,000. Changes in the volume of earning assets,primarily loans, have resulted in an increase in interest income of $1,014,000while interest income from changes in rates has decreased by $338,000.  Interest expense for the second quarter of2004 was $172,000 less than the same time period in 2003.  Changes in the volume of interest bearingliabilities, primarily the increase in balances of demand deposits, hasresulted in a net increase of interest expense of $67,000.  Decreases in average rates paid, primarilyon certificates of deposit and demand deposits have resulted in an interestexpense reduction of $239,000.   On ayear-to-date basis through June 30, 2004, net interest income hasincreased $1,535,000 over the same time period in 2003.  Interest income from earning assets hasincreased by $1,200,000.  Changes in thevolume of earning assets, primarily loans, have resulted in an increase ininterest income of $1,826,000 while interest income from changes in rates hasdecreased by $626,000.  Interest expensefor the six month period was $335,000 less than the same time period in 2003.  Changes in the volume of interest bearingliabilities, primarily the increase in balances of demand deposits, haveresulted in a net increase of interest expense of $163,000.  Decreases in average rates paid, primarilyon certificates of deposit and demand deposits have resulted in an interestexpense reduction of $498,000.

 

**Table Three: Analysis of Volume and Rate Changes on Net Interest Income and Expenses(Unaudited)**

 

(In thousands) Three Months Ended June 30, 2004 over 2003

Increase (decrease) due to change in:

 
|                                 |   | **Volume** |   | **Rate (3)** |   | **Net Change** |   |
|--------------------------------------|--------|------------|--------|--------------|--------|----------------|--------|
| Interest-earning assets:             |   |       |   |         |   |           |   |
| Net loans (1)                        |   | $          | 1,017  |         | $      | (273           | )      | $ | 744 |   |
| Taxable investment securities        |   | 30         |   | (20          | )      | 10             |   |
| Tax exempt investment securities (2) |   | (5         | )      | (4           | )      | (9             | )      |
| Federal funds sold                   |   | (51        | )      | (27          | )      | (78            | )      |
| Investment in time deposits          |   | 25         |   | (16          | )      | 9              |   |
| Total                                |   | 1,014      |   | (338         | )      | 676            |   |
|                                 |   |       |   |         |   |           |   |
| Interest-bearing liabilities:        |   |       |   |         |   |           |   |
| Demand deposits                      |   | 75         |   | (182         | )      | (107           | )      |
| Savings deposits                     |   | 8          |   | 8            |   |           |   |
| Time deposits                        |   | (16        | )      | (55          | )      | (71            | )      |
| Other borrowings                     |   | 0          |   | (2           | )      | (2             | )      |
| Total                                |   | 67         |   | (239         | )      | (172           | )      |
| Interest differential                |   | $          | 947    |         | $      | (99            | )      | $ | 848 |   |

 

----

(1)          The average balance of non-accruing loans isimmaterial as a percentage of total loans and, as such, has been included innet loans.

(2)          Does not include taxable-equivalentadjustments that primarily relate to income on certain securities that isexempt from federal income taxes.

(3)          The rate/volume variance has been included inthe rate variance.

 

15

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**Table Three: Analysis of Volume and Rate Changes on Net Interest Income and Expenses(Unaudited)**

 

(In thousands) Six Months Ended June 30, 2004 over 2003

Increase (decrease) due to change in:

 
|                                 |   | **Volume** |   | **Rate (3)** |   | **Net Change** |   |
|--------------------------------------|--------|------------|--------|--------------|--------|----------------|--------|
| Interest-earning assets:             |   |       |   |         |   |           |   |
| Net loans (1)                        |   | $          | 1,817  |         | $      | (490           | )      | $ | 1,327 |   |
| Taxable investment securities        |   | 47         |   | (44          | )      | 3              |   |
| Tax exempt investment securities (2) |   | (11        | )      | (7           | )      | (18            | )      |
| Federal funds sold                   |   | (83        | )      | (55          | )      | (138           | )      |
| Investment in time deposits          |   | 56         |   | (30          | )      | 26             |   |
| Total                                |   | 1,826      |   | (626         | )      | 1,200          |   |
|                                 |   |       |   |         |   |           |   |
| Interest-bearing liabilities:        |   |       |   |         |   |           |   |
| Demand deposits                      |   | 151        |   | (315         | )      | (164           | )      |
| Savings deposits                     |   | 17         |   | (12          | )      | 5              |   |
| Time deposits                        |   | (14        | )      | (133         | )      | (147           | )      |
| Other borrowings                     |   | 9          |   | (38          | )      | (29            | )      |
| Total                                |   | 163        |   | (498         | )      | (335           | )      |
| Interest differential                |   | $          | 1,663  |         | $      | (128           | )      | $ | 1,535 |   |

 

----

(1)          The average balance of non-accruing loans isimmaterial as a percentage of total loans and, as such, has been included innet loans.

(2)          Does not include taxable-equivalentadjustments that primarily relate to income on certain securities that isexempt from federal income taxes.

(3)          The rate/volume variance has been included inthe rate variance.

 

16

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## **Non-interestIncome**

 

Table Four below provides a summary of the components of noninterestincome for the periods indicated (dollars in thousands) (percent of assetsannualized):

 

**TableFour:  Components of Noninterest Income(Unaudited)**

 

Three Months Ended June 30,     

 
|                                |   | **2004** |   | **% of Avg.  Assets** |   | **2003** |   | **% of Avg.  Assets** |   |
|-------------------------------------|--------|----------|--------|-----------------------|--------|----------|--------|-----------------------|--------|
|                                |   |     |   |                  |   |     |   |                  |   |
| Service charges on deposit accounts |   | $        | 511    |                  | .49    |     | $      | 264                   |   | .28 |   |
| Loan servicing fees                 |   | 94       |   | .09                   |   | 374      |   | .40                   |   |
| Fees - alternative investment sales |   | 93       |   | .09                   |   | 61       |   | .08                   |   |
| Merchant fee income                 |   | 78       |   | .08                   |   | 45       |   | .04                   |   |
| Gain on the sale of loans           |   | 543      |   | .52                   |   | 472      |   | .52                   |   |
| Other                               |   | 235      |   | .23                   |   | 167      |   | .20                   |   |
|                                |   |     |   |                  |   |     |   |                  |   |
| Total non-interest income           |   | $        | 1,554  |                  | 1.50   |     | $      | 1,383                 |   | 1.52 |   |

 

Six Months Ended June 30,     

 
|                                |   | **2004** |   | **% of Avg.  Assets** |   | **2003** |   | **% of Avg.  Assets** |   |
|-------------------------------------|--------|----------|--------|-----------------------|--------|----------|--------|-----------------------|--------|
|                                |   |     |   |                  |   |     |   |                  |   |
| Service charges on deposit accounts |   | $        | 964    |                  | .48    |     | $      | 522                   |   | .30 |   |
| Loan servicing fees                 |   | 186      |   | .09                   |   | 713      |   | .41                   |   |
| Fees - alternative investment sales |   | 230      |   | .11                   |   | 81       |   | .05                   |   |
| Merchant fee income                 |   | 162      |   | .08                   |   | 151      |   | .09                   |   |
| Gain on the sale of loans           |   | 788      |   | .39                   |   | 766      |   | .44                   |   |
| Other                               |   | 453      |   | .23                   |   | 333      |   | .19                   |   |
|                                |   |     |   |                  |   |     |   |                  |   |
| Total non-interest income           |   | $        | 2,783  |                  | 1.38   |     | $      | 2,566                 |   | 1.48 |   |

 

## **Non-interest income was up $171,000(12.4%) to $1,554,000 for the three months ended June 30, 2004 as comparedto $1,383,000 for the three months ended June 30, 2003.    Increases in non-interest income wererealized in fees from service charges (up 93.6%), fees from alternativeinvestment sales (up 52.5%), merchant processing fees (up 73.3%), sale of loans(up 15%) and other (up 40.7%).**

## ** **

## **Loan servicing income declined as aresult of fewer loans being sold on the secondary market through FNMA (FannieMae) as many customers of the Company had already taken advantage of the lowlevels in mortgage financing rates during 2003.**

## ** **

## **The increase in service chargeincome was the result of additional deposit accounts opened during the secondquarter and fees resulting from the overdraft privilege deposit product.  The Investment Department, which sellsthird-party mutual funds and annuities, experienced an increase in fees due toan increase in sales during the second quarter.**

 

For the six months ended June 30, 2004, non-interest income was up$217,000 (8.5%) to

 

17

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$2,783,000 as compared to the $2,566,000 total for the six months endedJune 30, 2003.   All of thecomponents of non-interest income showed gains with the exception of loanservicing fees which was down $527,000 or (283%) for the same reason statedabove for the three month period. Increases were realized in service charges on deposit accounts (up 84.7%),alternative investment sales (up 184%), merchant fee income (up 7.3%), gain onsale of loans (up 2.9%), and other (up 36%).

 

**Non-interest Expense**

 

Non-interest expense increased $418,000(12.5%) to $3,749,000 in the second quarter of 2004 versus $3,331,000 in thesecond quarter of 2003.  On a quarterover quarter basis, full time equivalent employees increased by 8.  Salary and employee benefits increased$156,000 (8%) resulting from normal cost of living raises, commissions paid toButte Community Bank’s Real Estate Loan agents and staffing additions madeduring the year as the Company continues to grow and implement the newtechnology acquired during the year. Benefit costs and employer taxes increased commensurate with thesalaries.    On a quarter over quarterbasis, occupancy expenses were higher by $41,000 (20.1%).  This increase in costs is associated withthe opening of the Red Bluff office and the Marysville office, and is relatedto building depreciation, utilities, janitorial services and propertytaxes.   Fixed asset expense was $311,000in the second quarter of 2004 compared to $233,000 in the same period of 2003,representing a 33.5% increase.   Otherexpenses increased $142,000 (14.9%) in the second quarter of 2004 versus thesecond quarter of 2003.

 

Non-interest expense for the six month periodended June 30, 2004 was $7,536,000 versus $6,551,000 for the same periodin 2003.  Salaries and benefitsincreased by $494,000 (12.7%) due to cost of living raises added benefit costsand employer taxes associated with the staffing additions made during the yearas the Company continues to grow and implement the new technology acquiredduring the year.  On a year over yearbasis, full time equivalent employees increased by 16 to 189.   Premises expense was up $108,000 (28.7%)from the first six months of 2003 to the first six months of 2004.  Fixed asset expense was up 191,000(40.4%).  This increase relates totechnology upgrades made to our core banking systems and the furniture fixturesand equipment needed to open the two offices mentioned above. As with thequarter-to-quarter comparison, much of the increase in premise expense is alsorelated to the opening of the new Red Bluff and Marysville offices.   Other expenses increased by $388,000 (24%).

 

## **Provision for LoanLosses**

## ** **

The Company provided $190,000 for loan losses for the second quarter of2004 as compared to $120,000 for the second quarter of 2003.  Net loan recoveries for the three monthsended June 30, 2004 was $1,000 as compared to $3,000 in net recoveries forthe three months ended June 30, 2003.  For the first six months of 2004, the Company made provisions for loanlosses of $415,000.   This compares tothe provision for loan losses of $270,000 for the first six months of 2003.

 

**Provision for IncomeTaxes**

 

The effective tax rate for the second quarter and first six months of2004 was 41.3% and 40.6%, versus 43.2% and 41.4%, for the same period in 2003.

 

**Balance SheetAnalysis**

 

The Company’s total assets were $414,586,000 at June 30, 2003 ascompared to $386,723,000 at December 31, 2003, representing an increase of7.2%.  The average balance of totalassets for the six months ended June 30, 2004 was $401,613,000, whichrepresents an increase of $50,041,000 (14.2%) over the $351,572,000 during thesix-month period ended June 30, 2003.

 

18

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## **Loans**

## ** **

The Company concentrates its lending activities in the followingprincipal areas: 1) commercial; 2) real estate; 3) residential real estate andreal estate construction (both commercial and residential); 4) agriculture; and5) consumer loans.  Commercial andresidential real estate loans are generally secured by improved property, withoriginal maturities of 3-10 years.  AtJune 30, 2004, these principal areas accounted for approximately 20%, 43%,20%, 9% and 8%, respectively, of the Company’s loan portfolio.    The mix at December 31, 2003 was 20%,42%, 23%, 8% and 8%.  Continuing strongeconomic activity in the Company’s market area, new borrowers developed throughthe Company’s marketing efforts and credit extensions expanded to existingborrowers, offset by normal loan pay-downs and payoffs, resulted in netincreases in loan balances for commercial loans These changes are consistentwith the Company’s history of increased real estate construction activityduring the summer months.  Continuingstrong economic activity in the Company’s market area, new borrowers developedthrough the Company’s marketing efforts and credit extensions expanded toexisting borrowers, offset by normal loan pay-downs and payoffs, resulted innet increases in loan balances for commercial loans ($7,411,000 or 13.7%),residential real estate ($17,873,000 or 15.6%) agricultural loans ($7,640,000or 36.7%),and consumer ($1,430,000 or 6.5%) and a decrease in real estate construction($7,000 or .01%).  Table Five belowsummarizes the composition of the loan portfolio as of June 30, 2004 andDecember 31, 2003.

 

**Table Five: LoanPortfolio Composition (Unaudited)**

 
| **(In thousands)**        |   | **June 30,  2004** |    | **December 31,  2003** |   |
|---------------------------|--------|-------------------------|---------|-----------------------------|--------|
| Commercial                |   | $                       | 61,487  |                        | $      | 54,076 |   |
| Real estate:              |   |                    |    |                        |   |
| Mortgage                  |   | 132,785                 |    | 114,912                     |   |
| Construction              |   | 63,189                  |    | 63,196                      |   |
|                      |   |                    |    |                        |   |
| Agriculture               |   | 28,460                  |    | 20,820                      |   |
| Consumer                  |   | 23,277                  |    | 21,847                      |   |
| Total loans               |   | 309,198                 |    | 274,851                     |   |
| Allowance for loan losses |   | (4,013                  | )       | (3,587                      | )      |
| Deferred loan fees, net   |   | (1,056                  | )       | (1,033                      | )      |
| Total net loans           |   | $                       | 304,129 |                        | $      | 270,231 |   |

 

The majority of the Company’s loans aredirect loans made to individuals and local businesses.  The Company relies substantially on localpromotional activity and personal contacts by bank officers, directors andemployees to compete with other financial institutions.  The Company makes loans to borrowers whoseapplications include a sound purpose and a viable primary repayment source,generally supported by a secondary source of repayment.

 

Commercial loans consist of credit lines foroperating needs, loans for equipment purchases, working capital, and variousother business loan products.  Consumerloans include a range of traditional consumer loan products such as personallines of credit and loans to finance purchases of autos, boats, recreationalvehicles, mobile homes and various other consumer items.  Real estate construction loans are generallycomposed of commitments to customers within the Company’s service area forconstruction of both commercial properties and custom and semi-customsingle-family residences.  Real estatemortgage loans consist primarily of loans secured by first trust deeds oncommercial and residential properties typically with maturities from 3 to 10years and original loan to value ratios generally from 65% to 80%.  Agriculture loans consist primarily of croploans to farmers of peaches, prunes, walnuts, and almonds.  In general, except in the case of loans withSBA or FMHA guarantees, the Company does not make long-term mortgage loans;however, Butte Community Bank has a residential lending division to assistcustomers in securing most forms of longer term single-family mortgagefinancing.

 

19

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## **Risk Elements**

## ** **

The Company assesses and manages credit riskon an ongoing basis through a total credit culture that emphasizes excellentcredit quality, extensive internal monitoring and established formal lendingpolicies.  Additionally, the Company contractswith an outside loan review consultant to periodically review the existing loanportfolio.  Management believes itsability to identify and assess risk and return characteristics of the Company’sloan portfolio is critical for profitability and growth.  Management strives to continue its emphasison credit quality in the loan approval process, active credit administrationand regular monitoring.  With this inmind, management has designed and implemented a comprehensive loan review andgrading system that functions to continually assess the credit risk inherent inthe loan portfolio.

 

Ultimately, underlying trends in economic andbusiness cycles may influence credit quality. The Company’s business is concentrated in the Butte and Sutter CountyArea. The economy of these two counties is diversified with professionalservices, manufacturing, agriculture and real estate investment andconstruction.

 

Special emphasis is placed within thecommunities in which the Company has offices (Chico, Paradise, Magalia,Oroville, Yuba City, Red Bluff, and Marysville).  The Company also maintains loan production offices in the citiesof Citrus Heights and Redding. Single-family residential construction is the primary lending productfrom the Roseville location serving the greater Sacramento area.  The primary focus of the loan productionoffice in Redding is commercial loans with an emphasis on SBA and othergovernment loan programs.

 

The Company has significant extensions ofcredit and commitments to extend credit that are secured by real estate.  The ultimate repayment of these loans isgenerally dependent on personal or business cash flows or the sale orrefinancing of the real estate.  TheCompany monitors the effects of current and expected market conditions and otherfactors on the collectability of real estate loans.  The more significant factors management considers involve thefollowing:  lease, absorption and salerates; real estate values and rates of return; operating expenses; inflation;and sufficiency of collateral independent of the real estate including, inlimited instances, personal guarantees.

 

In extending credit and commitments toborrowers, the Company generally requires collateral and/or guarantees assecurity.  The repayment of such loansis expected to come from cash flow or from proceeds from the sale of selectedassets of the borrowers.  The Company’srequirement for collateral and/or guarantees is determined on a case-by-casebasis in connection with management’s evaluation of the creditworthiness of theborrower.  Collateral held varies butmay include accounts receivable, inventory, property, plant and equipment,income-producing properties, residences and other real property.  The Company secures its collateral byperfecting its security interest in business assets, obtaining deeds of trust,or outright possession among other means.

 

## **In management’s judgment, aconcentration exists in real estate loans, which represented approximately63.4% of the Company’s loan portfolio at June 30, 2004, which reflects animprovement from the 64.8% concentration level at December 31, 2003.  Management believes the concentration tohave no more than the normal risk of collectability; however, a substantialdecline in the economy in general, or a decline in real estate values in theCompany’s primary market areas in particular, could have an adverse impact onthe collectability of these loans and require an increase in the provision forloan losses which could adversely affect the Company’s future prospects, resultsof operations, profitability and stock price. Management believes that its lending policies and underwriting standardswill tend to minimize losses in an economic downturn; however, there is noassurance that losses will not occur under such circumstances.  The Company’s loan policies and underwritingstandards include, but are not limited to, the following: (1) maintaining athorough understanding of the Company’s service area and originating asignificant majority of its loans within that area, (2) maintaining a thoroughunderstanding of borrowers’ knowledge, capacity, and market position in theirfield of expertise, (3) basing real estate loan approvals not only on marketdemand for the project, but also on the borrowers’ capacity to support the projectfinancially in the event it does not perform to expectations (whether sale orincome performance), and (4) maintaining conforming and prudent loan to valueand loan to cost ratios based on independent outside appraisals and ongoinginspection and analysis by the Company’s lending officers.**

 

20

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## **Nonaccrual, PastDue and Restructured Loans**

## ** **

Management generally places loans on nonaccrual status when they become90 days past due, unless the loan is well secured and in the process ofcollection.  Loans are charged off when,in the opinion of management, collection appears unlikely.

 

Table Six below sets forth nonaccrual loans as of June 30, 2004and December 31, 2003.  There wereno loans past due 90 days or more and still accruing interest at June 30,2004 or December 31, 2003.

 

**Table Six: Non-Performing Loans (Unaudited)**

 
| **(In thousands)**         |   | **June 30,  2004** |   | **December 31,  2003** |   |
|----------------------------|--------|-------------------------|--------|-----------------------------|--------|
| Nonaccrual:                |   |                    |   |                        |   |
| Commercial                 |   | 47                      |   | 46                          |   |
| Real estate                |   | 71                      |   |                        |   |
| Consumer and other         |   | 7                       |   | 8                           |   |
| Total non-performing loans |   | $                       | 125    |                        | $      | 54 |   |
|                            |        |                         |        |                             |        |  |  |

 

At June 30, 2004, non-performing loans and leases were .04% oftotal loans and leases.  The recordedinvestments in loans that were considered to be impaired totaled $125,000 atJune 30, 2004 and $54,000 at December 31, 2003.  One of the four impaired loans shown forJune 30, 2004 had a U.S. Government guarantee for 80% of the loan balancewhich was $22,830.  The remainingbalance of this loan is $5,707 and will be charged off.   The other three loans have a very lowpotential for loss.  There were no loanconcentrations in excess of 10% of total loans not otherwise disclosed as acategory of loans as of June 30, 2004 or December 31, 2003.  Management is not aware of any potentialproblem loans, which were accruing and current at June 30, 2004, whereserious doubt exists as to the ability of the borrower to comply with thepresent repayment terms.

 

## **Allowance for LoanLosses Activity**

## ** **

We employ a systematic methodology for determining the allowance forloan losses that includes a monthly review process and monthly adjustment ofthe allowance.  Our process includes a periodic review of individual loansthat have been specifically identified as problem loans or have characteristicswhich could lead to impairment, as well as detailed reviews of other loans(either individually or in pools).  While this methodology utilizeshistorical and other objective information, the establishment of the allowancefor loan losses and the classification of loans are, to some extent, based onmanagement’s judgment and experience.

 

Our methodology incorporates a variety of risk considerations, bothquantitative and qualitative, in establishing an allowance for loan losses thatmanagement believes is appropriate at each reporting date.  Quantitativefactors include our historical loss experience, delinquency and charge-offtrends, collateral values, changes in non-performing loans, and otherfactors.  Quantitative factors also incorporate known information aboutindividual loans, including borrowers’ sensitivity to interest rate movementsand borrowers’ sensitivity to quantifiable external factors including commodityprices as well as acts of nature (freezes, earthquakes, fires, etc.) that occurin a particular period.

 

Qualitative factors include the general economic environment in ourmarkets and, in particular, the state of the agriculture industry and other keyindustries in the Northern Sacramento Valley.  The way a particular loanmight be structured, the extent and nature of waivers of existing loanpolicies, loan concentrations and the rate of portfolio growth are otherqualitative factors that are considered.

 

21

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Our methodology is, and has been, consistently followed.  However,as we add new products, increase in complexity, and expand our geographiccoverage, we expect to enhance our methodology to keep pace with the size andcomplexity of the loan portfolio.  On an ongoing basis we engage outsidefirms to independently assess our methodology, and to perform independentcredit reviews of our loan portfolio.  The FDIC and the CaliforniaDepartment of Financial Institutions review the allowance for loan losses as anintegral part of the examination processes.  Management believes that ourcurrent methodology is appropriate given our size and level ofcomplexity.  Further, management believes that the allowance for loanlosses is adequate as of June 30, 2004 to cover known and inherent risksin the loan portfolio.  However, fluctuations in credit quality, orchanges in economic conditions or other factors could cause management toincrease or decrease the allowance for loan losses as necessary.

 

The Loan Committee of the Bank reviews the adequacy of the allowancefor loan losses at least quarterly to include consideration of the relativerisks in the portfolio and current economic conditions.  The allowance is adjusted based on thatreview if, in the judgment of the loan committee and management, changes arewarranted.  The allowance for loanlosses totaled $4,013,000 or 1.30% of total loans at June 30, 2004 and$3,587,000 or 1.31% at December 31, 2003. Net recoveries to average loans for the second quarter were zero andyear to date through June 30, 2004 are.004%.

 

Table Seven below summarizes, for the periods indicated, the activityin the allowance for loan losses

 

22

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**Table Seven:Allowance for Loan Losses (Unaudited)**

 
|                                                                      |   | **Three  Months  Ended  June 30,** |    | **Six Months  Ended  June 30,** |   |
|---------------------------------------------------------------------------|--------|-----------------------------------------|---------|--------------------------------------|--------|
| **(In thousands, except for  percentages)**                               |   | **2004**                                |    | **2003**                             |   | **2004** |   | **2003** |   |
|                                                                      |   |                                    |    |                                 |   |   |   |   |   |
| Average loans outstanding                                                 |   | $                                       | 298,616 |                                 | $      | 246,939 |   | $ | 288,741 |   | $ | 243,065 |   |
|                                                                      |   |                                    |    |                                 |   |   |   |   |   |
| Allowance for possible loan losses at  beginning of period                |   | $                                       | 3,822   |                                 | $      | 3,154 |   | $ | 3,587 |   | $ | 3,007 |   |
|                                                                      |   |                                    |    |                                 |   |   |   |   |   |
| Loans charged off:                                                        |   |                                    |    |                                 |   |   |   |   |   |
| Commercial                                                                |   |                                    |    |                                 |   |   |   |   |   |
| Real estate                                                               |   |                                    |    |                                 |   |   |   |   |   |
| Consumer                                                                  |   |                                    |    | (1                                   | )      | (7 | ) | (4 | ) |
| Total                                                                     |   |                                    |    | (1                                   | )      | (7 | ) | (4 | ) |
| Recoveries of loans previously charged off:                               |   |                                    |    |                                 |   |   |   |   |   |
| Commercial                                                                |   |                                    |    |                                 |   | 14 |   |   |   |
| Real estate                                                               |   |                                    |    |                                 |   |   |   |   |   |
| Consumer                                                                  |   | 1                                       |    | 4                                    |   | 3 |   | 4 |   |
| Total                                                                     |   | 1                                       |    | 4                                    |   | 17 |   | 4 |   |
| Net loan recoveries                                                       |   | 1                                       |    | 3                                    |   | 10 |   |   |   |
|                                                                      |   |                                    |    |                                 |   |   |   |   |   |
| Additions to allowance charged to operating  expenses                     |   | 190                                     |    | 120                                  |   | 415 |   | 270 |   |
| Allowance for loan losses at end of period                                |   | $                                       | 4,013   |                                 | $      | 3,277 |   | 4,013 |   | 3,277 |   |
| Ratio of net charge-offs to average loans  outstanding                    |   | .00                                     | %       | .00                                  | %      | .00 | % | .00 | % |
| Provision for possible loan losses to  average loans outstanding          |   | .06                                     | %       | .05                                  | %      | .14 | % | .11 | % |
| Allowance for loan losses to loans net of  deferred fees at end of period |   | 1.30                                    | %       | 1.34                                 | %      | 1.30 | % | 1.34 | % |

 

It is the policy of management to maintainthe allowance for loan losses at a level adequate for known and inherent risksin the portfolio.  Based on informationcurrently available to analyze inherent credit risk, including economicfactors, overall credit quality, historical delinquencies and a history ofactual charge-offs, management believes that the provision for loan losses andthe allowance are prudent and adequate. The Company generally makes monthly allocations to the allowance forloan losses.  The budgeted allocation isbased on estimates of loss risk and loan growth.  Adjustments may be made based on differences from estimated loangrowth, the types of loans constituting this growth, changes in risk ratingswithin the portfolio, and general economic conditions.  However, no prediction of the ultimate levelof loans charged off in future years can be made with any certainty.

 

**Other Real Estate**

 

At June 30, 2004 and December 31, 2003, the Company did nothave any other real estate (“ORE”) properties.

 

23

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## **Deposits**

## ** **

At June 30, 2004, total deposits were $367,632,000 representing anincrease of $25,121,000 (7.3%) over the December 31, 2003 balance of$342,511,000.

 

## **Capital Resources**

## ** **

The current and projected capital position of the Company and theimpact of capital plans and long-term strategies are reviewed regularly bymanagement. The Company’s capital position represents the level of capitalavailable to support continued operations and expansion.

 

The Board of Directors of the Company authorized the payment of a cashdividend of $.056 per share on January 23, 2003, April 24, 2003,July 25, 2003, October 24, 2003, and $.075 per share onJanuary 23, 2004, March 23, 2004, and June 15, 2004.  The payment of dividends in the future issubject to the discretion of the Board of Directors of the Company and willdepend on earnings, the financial condition of the Company and other relevantfactors.  The per share amounts havebeen retroactively restated for the Company’s 4 for 3 stock split approved bythe Board of Directors on February 17, 2004.

 

The Company and its subsidiary Bank are subject to certain regulationsissued by the Board of Governors of the Federal Reserve System and the FDICwhich require maintenance of certain levels of capital.  At June 30, 2004, shareholders’ equitywas $32,115,000, representing an increase of $2,166,000 (7.2%) from $29,949,000at December 31, 2003.  The Bank’sratio of total risk-based capital to risk adjusted assets was 11.3% atJune 30, 2004 compared to 12.1% at December 31, 2003.  Tier 1 risk-based capital to risk-adjustedassets was 10.1% at June 30, 2004 and 10.9% at December 31, 2003.

 

Table Eight below lists the Company and the Bank capital ratios atJune 30, 2004 and December 31, 2003, as well as the minimum ratiosrequired under regulatory definitions of capital adequacy.

 

**Table Eight: Capital Ratios (Unaudited)**

 
| **Capital to Risk-Adjusted Assets** |   | **At  June 30, 2004** |   | **At December 31,  2003** |   | **Minimum  Regulatory Requirement** |   |
|-------------------------------------|--------|----------------------------|--------|--------------------------------|--------|-------------------------------------|--------|
| **Company**                         |   |                       |   |                           |   |                                |   |
|                                |   |                       |   |                           |   |                                |   |
| Leverage ratio                      |   | 9.8                        | %      | 9.9                            | %      | 4.0                                 | %      |
|                                |   |                       |   |                           |   |                                |   |
| Tier 1 Risk-Based Capital           |   | 10.4                       | %      | 12.2                           | %      | 4.0                                 | %      |
|                                |   |                       |   |                           |   |                                |   |
| Total Risk-Based Capital            |   | 12.6                       | %      | 13.4                           | %      | 8.0                                 | %      |
|                                |   |                       |   |                           |   |                                |   |
| **Bank**                            |   |                       |   |                           |   |                                |   |
|                                |   |                       |   |                           |   |                                |   |
| Leverage ratio                      |   | 9.0                        | %      | 8.8                            | %      | 4.0                                 | %      |
|                                |   |                       |   |                           |   |                                |   |
| Tier 1 Risk-Based Capital           |   | 10.1                       | %      | 10.9                           | %      | 4.0                                 | %      |
|                                |   |                       |   |                           |   |                                |   |
| Total Risk-Based Capital            |   | 11.3                       | %      | 12.1                           | %      | 8.0                                 | %      |

 

Capital ratios are reviewed on a regular basis to ensure that capitalexceeds the prescribed regulatory minimums and is adequate to meet futureneeds.  All ratios are in excess of theregulatory definition of “Minimum” at June 30, 2004 and December 31,2003.  The Bank was considered“well-capitalized” by regulatory standards, at June 30, 2004 andDecember 31, 2003.

 

24

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**Item 3. Quantitative and Qualitative Disclosures about Market Risk**

 

**Market RiskManagement**

 

*Overview*. Market risk is the risk of loss from adverse changes in market pricesand rates.  The Company’s market riskarises primarily from interest rate risk inherent in its loan, investment anddeposit portfolios.  The goal formanaging the assets and liabilities of the Company is to maximize shareholdervalue and earnings while maintaining a high quality balance sheet withoutexposing the Company to undue interest rate risk.

 

The Board of Directors has overallresponsibility for the interest rate risk management policies.  The Bank has an Asset and LiabilityManagement Committee (ALCO) that establishes and monitors guidelines to controlthe sensitivity of earnings to changes in interest rates.

 

*Asset/Liability Management*.  Activities involved in asset/liabilitymanagement include, but are not limited to, lending, accepting and placingdeposits, investing in securities, using trust preferred securities andborrowings.  Interest rate risk is theprimary market risk associated with asset/liability management.  Sensitivity of earnings to interest ratechanges arises when yields on assets change in a different time period or in adifferent amount from that of interest costs on liabilities.  To mitigate interest rate risk, thestructure of the balance sheet is managed with the goal that movements ofinterest rates on assets and liabilities are correlated and contributes toearnings even in periods of volatile interest rates.  The asset/liability management policy sets limits on theacceptable amount of variance in net interest margin and market value of equityunder changing interest environments. The Company uses simulation models to forecast earnings, net interestmargin and market value of equity.

 

Simulation of earnings is the primary toolused to measure the sensitivity of earnings to interest rate changes.  Using computer-modeling techniques, theCompany is able to estimate the potential impact of changing interest rates onearnings.  A balance sheet forecast isprepared monthly using inputs of actual loans, securities and interest bearingliability (i.e. deposits/borrowings) positions as the beginning base.  The forecast balance sheet is processedagainst seven interest rate scenarios. These scenarios include a 100, 200 and 300 basis point rising rateforecast, a flat rate forecast and a 100, 200 and 300 basis point falling rateforecast which take place within a one year time frame.  The net interest income is measured duringthe year assuming a gradual change in rates over the twelve-month horizon.  The Company’s net interest income, asforecast below, was modeled utilizing a forecast balance sheet projected frombalances as of the date indicated.

 

Table Nine below summarizes the effect on netinterest income (NII) of a ±200 basis point change in interest rates asmeasured against a constant rate (no change) scenario.  The results shown in Table nine for the twoperiods, fall within the parameters of the Bank’s policy for interest raterisk.

 

**TableNine:  Interest Rate Risk Simulation ofNet Interest as of June 30, 2004 and December 31, 2003 (Unaudited)**

 
| **(In thousands)**                      |   | **$ Change  in NII  from Current  12 Month Horizon  June 30, 2004** |   | **$ Change  in NII  from Current  12 Month Horizon  December 31, 2003** |   |
|-----------------------------------------|--------|--------------------------------------------------------------------------|--------|------------------------------------------------------------------------------|--------|
| Variation from a constant rate scenario |   |                                                                     |   |                                                                         |   |
| +200bp                                  |   | $                                                                        | 487    |                                                                         | $      | 286 |   |
| - 200bp                                 |   | $                                                                        | 461    |                                                                         | $      | 714 |   |

 

## **The simulations of earnings do notincorporate any management actions which might moderate the negativeconsequences of interest rate deviations. Therefore, they do not reflect likely actual results, but serve asestimates of interest rate risk.  Inthis simulation, the exposure to net interest income has increased due to alarger volume of assets maturing than liabilities and re-pricing at lowerrates.**

 

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## **Inflation**

## ** **

The impact of inflation on a financial institution differssignificantly from that exerted on manufacturing, or other commercial concerns,primarily because its assets and liabilities are largely monetary.  In general, inflation primarily affects theCompany and it subsidiaries through its effect on market rates of interest,which affects the Company’s ability to attract loan customers.  Inflation affects the growth of total assetsby increasing the level of loan demand, and potentially adversely affectscapital adequacy because loan growth in inflationary periods can increase atrates higher than the rate that capital grows through retention of earnings,which may be generated in the future. In addition to its effects on interest rates, inflation increasesoverall operating expenses.  Inflationhas not had a material effect upon the results of operations of the Company andits subsidiaries during the periods ended June 30, 2004, and 2003.

 

**Liquidity**

 

Liquidity management refers to the Company’s ability to provide fundson an ongoing basis to meet fluctuations in deposit levels as well as thecredit needs and requirements of its clients. Both assets and liabilities contribute to the Company’s liquidityposition.  Federal funds lines,short-term investments and securities, and loan repayments contribute toliquidity, along with deposit increases, while loan funding and depositwithdrawals decrease liquidity.  TheCompany assesses the likelihood of projected funding requirements by reviewinghistorical funding patterns, current and forecasted economic conditions andindividual client funding needs. Commitments to fund loans at June 30, 2004 and December 31,2003 were approximately $156,872,000 and $141,308,000, respectively.  Such loans relate primarily to revolvinglines of credit and other commercial loans, and to real estate constructionloans.

 

The Company’s sources of liquidity consist ofcash and due from correspondent banks, overnight funds sold to correspondentbanks, unpledged marketable investments and loans held for sale.  On June 30, 2004, consolidated liquid assetstotaled $74.9 million or 18.1% of total assets compared to $80.1 million or20.7% of total assets on December 31, 2003.  In addition to liquid assets, the Company maintains short-termlines of credit in the amount of $6,000,000 with correspondent banks.  There were no borrowings outstanding underthese arrangements at June 30, 2004.   The Bank also has informal agreements with various other banks to sellparticipations in loans, if necessary. The Company serves primarily a business and professional customer baseand, as such, its deposit base is susceptible to economic fluctuations.  Accordingly, management strives to maintaina balanced position of liquid assets to volatile and cyclical deposits.

 

Liquidity is also affected by portfolio maturities and the effect ofinterest rate fluctuations on the marketability of both assets andliabilities.  The Company can sell anyof its unpledged securities held in the available-for-sale category to meetliquidity needs.

 

## **Off-Balance SheetItems**

## ** **

The Company has certain ongoing commitments under operating leases.  These commitments do not significantlyimpact operating results. As of June 30, 2004 and December 31, 2003,commitments to extend credit and letters of credit were the only financialinstruments with off-balance sheet risk. The Company has not entered into any contracts for financial derivativeinstruments such as futures, swaps, options or similar instruments.  Loan commitments and letters of credit were$156,872,000 and $141,308,000 at June 30, 2004 and December 31, 2003,respectively.  As a percentage of netloans, these off-balance sheet items represent 49.7% and 52.3%, respectively.

 

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**Other Matters**

 

Effects of Terrorism The terrorist actions on September 11, 2001and thereafter have had significant adverse effects upon the United Stateseconomy.  Whether the terroristactivities in the future and the actions of the United States and its allies incombating terrorism on a worldwide basis will adversely impact the Company andthe extent of such impact is uncertain. However, such events have had and may continue to have an adverse effecton the economy in the Company’s market areas. Such continued economic deterioration could adversely affect theCompany’s future results of operations by, among other matters, reducing thedemand for loans and other products and services offered by the Company,increasing nonperforming loans and the amounts reserved for loan losses, andcausing a decline in the Company’s stock price.

 

**Item 4. Controls and Procedures**

 

(a)Disclosure Controls and Procedures: An evaluation of the Company’s disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-15(e) and15d-15(e)) was carried out under the supervision and with the participation ofthe Company’s Chief Executive Officer, Chief Financial Officer and othermembers of the Company’s senior management as of the end of the Company’sfiscal quarter ended March 31, 2004. The Company’s Chief Executive Officerand Chief Financial Officer concluded that the Company’s disclosure controlsand procedures as currently in effect are effective in ensuring that theinformation required to be disclosed by the Company in the reports it files orsubmits under the Exchange Act is (i) accumulated and communicated to the Company’smanagement (including the Chief Executive Officer and Chief Financial Officer)to allow timely decisions regarding required disclosure, and (ii) recorded,processed, summarized and reported within the time periods specified in theCommission’s rules and forms.

 

(b)Internal Control Over Financial Reporting: An evaluation of any changes in theCompany’s internal control over financial reporting (as defined in Exchange ActRules 13a-15(f) and 15d-15(f)), that occurred during the Company’s fiscalquarter ended June 30, 2004, was carried out under the supervision andwith the participation of the Company’s Chief Executive Officer, ChiefFinancial Officer and other members of the Company’s senior management. TheCompany’s Chief Executive Officer and Chief Financial Officer concluded that nochange identified in connection with such evaluation has materially affected,or is reasonably likely to materially affect, the Company’s internal controlover financial reporting.

 

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## **PART II – OTHER INFORMATION**

 

Item 1.  Legal Proceedings.

 

None.

 

Item 2.  Changes in Securitiesand Use of Proceeds.

 

The Board of Directors approved a plan at their June 2003 meetingto repurchase up to $3,000,000 of the outstanding common stock of theCompany.  The plan states that stockrepurchases may be made from time to time on the open market or throughprivately negotiated transactions.  Thetiming of purchases and the exact number of shares to be purchased depends onmarket conditions.  The share repurchaseplan does not include specific price targets or timetables and may be suspendedat any time.

 

**ISSUERPURCHASES OF EQUITY SECURITIES**

 
| **Period**                                        |   | **(a) Total  Number of  Shares purchased** |   | **(b)  Average Price  Paid per Share** |   | **(c) Total  Number of Shares  Purchased as Part of Publicly  Announced Plan** |   | **(d)  Maximum Dollar Value of  Shares that May Yet Be  Purchased Under the Plan** |   |
|---------------------------------------------------|--------|--------------------------------------------|--------|---------------------------------------------|--------|--------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------|--------|
|                                              |   |                                       |   |                                        |   |                                                                           |   |                                                                                    |   |
| Month #3 June 1, 2004 to June 30,  2004 |   | 12,000                                     |   | $                                           | 26.92  |                                                                           | 12,000 |                                                                                    | $      | 2,676,093 |   |
|                                                   |        |                                            |        |                                             |        |                                                                                |        |                                                                                         |        |  |  |

 

Item 3.  Defaults Upon SeniorSecurities.

 

None.

 

Item 4.  Submission of Mattersto a Vote of Security Holders.

 

At the Annual Meeting of Shareholders held on May 29, 2004, one mattercame before the meeting for vote: Election of Directors to serve until the 2004 Annual Meeting or untiltheir successors are elected.  Sharesvoted by proxy totaled 2,468,861 with no votes withholding authority.

 

Item 5.  Other Information.

 

None

 

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Item 6.  Exhibits

 

(a)  Exhibits

 

Exhibit

 
| **Number** |   | **Document  Description**                                                             |
|------------|--------|---------------------------------------------------------------------------------------|
|       |   |                                                                                  |
| (31.1)     |   | Certification of CEO pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|       |   |                                                                                  |
| (31.2)     |   | Certification of CFO pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|       |   |                                                                                  |
| (32.1)     |   | Certification of CEO pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
|       |   |                                                                                  |
| (32.2)     |   | Certification of CFO pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

(b)  Reports on Form 8-K

 

On April 14, 2004 the Company filed aReport on Form 8-k announcing first quarter earnings for 2004.

 

On June 18, 2004 the Company filed aReport on form 8-k announcing a seven and one half cent per share Cash Dividendfor shareholders of record on June 30, 2004 payable July 23, 2004.

 

 

**SIGNATURES**

 

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

 
|   | COMMUNITY VALLEY BANCORP           |
|--------|------------------------------------|
|   |                               |
|   | August 10, 2004               |   | By: | /s/ *Keith C. Robbins* |   |
|   |                               |
|   | Keith C. Robbins                   |
|   |                               |
|   | President, Chief Executive Officer |
|   |                               |
|   |                               |
|   | August 10, 2004               |   | By*:* | */s/ John F. Coger* |   |
|   |                               |
|   | John F. Coger                      |
|   |                               |
|   | Executive Vice President, CFO      |
|        |                                    |  |  |  |  |  |  |

 

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