**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

(Mark One)

 [  X  ] Quarterly report pursuant to Section 13 or l5(d) of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2005

 

[    ]      Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the transition period from ________ to ________

 

Commission File Number 000-24503

 

**WASHINGTON BANKING COMPANY**

(Exact name of registrant as specified in its charter)

 
|  
**Washington**

**91-1725825**

 
 
(State or other jurisdiction of

(I.R.S. Employer

 
incorporation or organization)

Identification Number)

 

**450 SW Bayshore Drive**

**Oak Harbor, Washington         98277**

(Address of principal executive offices)   (Zip Code)

 

**(360) 679-3121**

(Registrant’s telephone number, including area code)

 

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

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes   [  X  ]       No [   ] 

 

Indicate by check mark if the registrant is an accelerated filer within the meaning of Rule 12b-2 under the Securities Exchange Act of 1934, as amended.   Yes   [   ]       No [  X  ] 

 

 

               The number of shares of the issuer’s Common Stock outstanding at August 10, 2005 was 7,323,832.

 

 

 

 

 

**Table of Contents******

 

 

**PART I-FINANCIAL INFORMATION******

Page

Item 1.

Financial Statements

 

 

Condensed Consolidated Statements of Financial Condition -

 

 

June 30, 2005 and December 31, 2004

1

 

 

 

 

Condensed Consolidated Statements of Income -

 

 

Three and Six Months Ended June 30, 2005 and 2004

2

 

 

 

 

Condensed Consolidated Statements of Shareholders’ Equity and Comprehensive Income -

 

 

Six Months Ended June 30, 2005 and 2004

3

 

 

 

 

Condensed Consolidated Statements of Cash Flows -

 

 

Six Months Ended June 30, 2005 and 2004

4

 

 

 

 

Notes to Condensed Consolidated Financial Statements

5

 

 

 

Item 2.

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

9

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

20

Item 4.

Controls and Procedures

20

 

 

 

 

**PART II-OTHER INFORMATION**

 

Item 1.

Legal Proceedings

21

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

21

Item 3.

Defaults Upon Senior Securities

21

Item 4.

Submission of Matters to a Vote of Security Holders

21

Item 5.

Other Information

21

Item 6.

Exhibits 

22

 

Signatures

23

 

 

 

 

**PART I – FINANCIAL INFORMATION**

**Item 1.**

**Financial Statements**

 

**WASHINGTON BANKING COMPANY**
**AND SUBSIDIARY**
Condensed Consolidated Statements of Financial Condition

June 30, 2005 and December 31, 2004 (unaudited)

(Dollars in thousands)

 

 

 

 ****

 

**June 30,**

 ****

**December 31,**

**Assets******

 

**2005**

 ****

**2004**

 

 

 

Cash and due from banks

$

18,644

$

16,814

Interest-bearing deposits

 

795

 

1,119

Federal funds sold

 

12,775

 

—

 

 

 

Total cash and cash equivalents

 

32,214

 

17,933

 

 

 

 

 

Investment securities available for sale

 

18,224

 

19,304

Federal Home Loan Bank stock

 

1,984

 

1,976

 

 

 

 

 

Loans held for sale

 

11,339

 

8,311

Loans receivable

 

610,698

 

579,980

Allowance for loan losses

 

(8,554)

 

(7,903)

 

 

 

Total loans, net

 

602,144

 

572,077

 

 

 

 

 

Premises and equipment, net

 

20,882

 

20,375

Bank owned life insurance

 

10,385

 

10,217

Other assets

 

8,421

 

7,531

 

 

 

Total assets

$

705,593

$

657,724

 

 

 

 

 

 

 

 

**Liabilities and Shareholders’ Equity******

 

 

 

 

Liabilities:

 

 

 

 

Deposits

 

 

 

 

Noninterest-bearing demand

$

99,780

$

77,820

NOW accounts

 

65,490

 

52,019

Money market accounts

 

173,279

 

167,238

Savings

 

55,618

 

55,742

Time deposits

 

228,849

 

210,182

 

 

 

Total deposits

 

623,016

 

563,001

 

 

 

 

 

Other borrowed funds

 

10,000

 

27,000

Junior subordinated debentures

 

15,007

 

15,007

Other liabilities

 

4,246

 

3,125

 

 

 

Total liabilities

 

652,269

 

608,133

Commitments and contingencies

 

—

 

—

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

Preferred stock, no par value. Authorized 20,000 shares:

 

 

 

 

no shares issued or outstanding

 

—

 

—

Common stock, no par value. Authorized 11,822,706 shares:

 

 

 

 

issued and outstanding 7,321,302 and 7,239,052 shares

 

 

 

 

at June 30, 2005 and December 31, 2004, respectively (1)

 

31,779

 

31,516

Retained earnings

 

21,520

 

17,928

Accumulated other comprehensive income 

 

25

 

147

 

 

 

Total shareholders’ equity

 

53,324

 

49,591

 

 

 

Total liabilities and shareholders’ equity

$

705,593

$

657,724

 

 

 

(1) Adjusted for the 4-for-3 stock split distributed May 17, 2005.

 

 

 

 

See accompanying notes to condensed consolidated financial statements.

 

 

 

 

 

1

 

**WASHINGTON BANKING COMPANY**
**AND SUBSIDIARY**
Condensed Consolidated Statements of Income

Three and six months ended June 30, 2005 and 2004 (unaudited) 

(Dollars in thousands, except per share data)

 

 

 

 

 

**Three Months Ended******

 

**Six Months Ended******

 

 

**June 30,******

 

**June 30,******

 

 

**2005******

 ****

**2004******

 

**2005******

 ****

**2004******

Interest income:

 

 

 

 

Interest and fees on loans

$

10,943

$

9,091

$

21,037

$

17,864

Interest on taxable investment securities

 

80

 

79

 

168

 

187

Interest on tax exempt investment securities

 

79

 

139

 

159

 

302

Other

 

35

 

52

 

66

 

93

 

 

 

 

 

Total interest income

 

11,137

 

9,361

 

21,430

 

18,446

Interest expense:

 

 

 

 

 

 

 

 

Interest on deposits

 

2,359

 

1,881

 

4,466

 

3,649

Interest on other borrowings

 

177

 

101

 

346

 

247

Interest on junior subordinated debentures

 

260

 

184

 

497

 

364

 

 

 

 

 

Total interest expense

 

2,796

 

2,166

 

5,309

 

4,260

 

 

 

 

 

Net interest income

 

8,341

 

7,195

 

16,121

 

14,186

Provision for loan losses

 

525

 

775

 

950

 

1,600

 

 

 

 

 

Net interest income after provision for loan losses

 

7,816

 

6,420

 

15,171

 

12,586

Noninterest income:

 

 

 

 

 

 

 

 

Service charges and fees

 

771

 

771

 

1,470

 

1,517

(Loss) gain on sale of securities

 

(50)

 

144

 

(50)

 

144

Income from the sale of loans

 

212

 

400

 

384

 

678

SBA premium income

 

179

 

116

 

291

 

152

Other

 

780

 

289

 

1,448

 

606

 

 

 

 

 

Total noninterest income

 

1,892

 

1,720

 

3,543

 

3,097

Noninterest expense:

 

 

 

 

 

 

 

 

Salaries and benefits

 

3,802

 

3,421

 

7,233

 

6,906

Occupancy and equipment

 

1,096

 

991

 

2,053

 

1,962

Office supplies and printing

 

171

 

163

 

356

 

316

Data processing

 

138

 

126

 

256

 

242

Other 

 

952

 

1,205

 

2,248

 

2,185

 

 

 

 

 

Total noninterest expense

 

6,159

 

5,906

 

12,146

 

11,611

 

 

 

 

 

Income before income taxes and discontinued operations

 

 

3,549

 

2,234

 

6,568

 

4,072

Provision for income taxes

 

1,200

 

742

 

2,176

 

1,362

 

 

 

 

 

Income from continuing operations

 

2,349

 

1,492

 

4,392

 

2,710

Loss from discontinued operations, net of tax 

 

—

 

(247)

 

—

 

(370)

 

 

 

 

 

Net income

$

2,349

$

1,245

$

4,392

$

2,340

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per common share, basic (1)

 

 

 

 

 

 

 

 

Continuing operations

$

0.32

$

0.21

$

0.60

$

0.38

Discontinued operations

 

—

 

(0.03)

 

—

 

(0.05)

 

 

 

 

 

Net Income per share

$

0.32

$

0.18

$

0.60

$

0.33

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per common share, diluted (1)

 

 

 

 

 

 

 

 

Continuing operations

$

0.31

$

0.20

$

0.58

$

0.36

Discontinued operations

 

—

 

(0.03)

 

—

 

(0.05)

 

 

 

 

 

Net Income

$

0.31

$

0.17

$

0.58

$

0.31

 

 

 

 

 

Average number of shares outstanding, basic (1)

 

7,301,519

 

7,213,313

 

7,275,511

 

7,199,175

Average number of shares outstanding, diluted (1)

 

7,573,462

 

7,483,280

 

7,546,323

 

7,471,755

(1) Adjusted for the 4-for-3 stock split distributed May 17, 2005.

See accompanying notes to condensed consolidated financial statements.

 

2

 

 

 

**WASHINGTON BANKING COMPANY**
**AND SUBSIDIARY**
Condensed Consolidated Statements of Shareholders’ Equity

and Comprehensive Income

Six months ended June 30, 2005 and 2004 (unaudited)

(Dollars and shares in thousands, except per share data)

 

 

 

 

 ****

 ****

 ****

 ****

 ****

 ****

**Accumulated******

 ****

 ****

 

 ****

 ****

 ****

 ****

**other******

 ****

**Total******

 

**Common stock******

 ****

**Retained******

 ****

**comprehensive******

 ****

**shareholders’******

 

 

 

 

 

 

 

 

**Shares******

 ****

**Amount******

 ****

**earnings******

 ****

**income (loss)******

 ****

**equity******

 

 

 

 

 

**Balances at December 31, 2003******

**5,358******

**$******

**31,125******

**$******

**13,273******

**$******

**(38)******

**$******

**44,360******

Comprehensive income:

 

 

 

 

 

 

 

 

 

Net income

—

 

—

 

2,340

 

—

 

2,340

Net change in unrealized gain (loss) on 

 

 

 

 

 

 

 

 

 

securities available for sale, net of tax of $131

—

 

—

 

—

 

238

 

238

Less adjustment for gains included in net income,

 

 

 

 

 

 

 

 

 

net of income tax of ($47)

—

 

—

 

—

 

(97)

 

(97)

 

 

 

 

 

 

 

 

 

Total comprehensive income (1)

—

 

—

 

—

 

—

 

2,481

Cash dividend, $0.109 per share (2)

—

 

—

 

(735)

 

—

 

(735)

Stock option compensation

—

 

11

 

—

 

—

 

11

Stock options exercised 

52

 

155

 

—

 

—

 

155

 

 

 

 

 

**Balances at June 30, 2004******

**5,410******

**$******

**31,291******

**$******

**14,878******

**$******

**103******

**$******

**46,272******

 

 

 

 

 

 ****

 

 

 

 

 

 

 

 

 

**Balances at December 31, 2004******

**5,429******

**$******

**31,516******

**$******

**17,928******

**$******

**147******

**$******

**49,591******

Comprehensive income:

 

 

 

 

 

 

 

 

 

Net income

—

 

—

 

4,392

 

—

 

4,392

Net change in unrealized gain (loss) on 

 

 

 

 

 

 

 

 

 

securities available for sale, net of tax of ($90)

—

 

—

 

—

 

(155)

 

(155)

Plus adjustment for losses included in net income,

 

 

 

 

 

 

 

 

 

net of income tax of $17

—

 

—

 

—

 

33

 

33

 

 

 

 

 

 

 

 

 

Total comprehensive income (1)

 

 

 

 

 

 

 

 

4,270

Tax benefit associated with stock options

—

 

30

 

—

 

—

 

30

Cash dividend, $0.109 per share (2)

—

 

—

 

(800)

 

—

 

(800)

Stock option compensation

—

 

12

 

—

 

—

 

12

Four-for-three stock split

1,810

 

—

 

—

 

—

 

—

Stock options exercised (2)

47

 

188

 

—

 

—

 

188

Restricted Stock (2)

35

 

483

 

—

 

—

 

483

Unearned Restricted Stock (2)

—

 

(450)

 

—

 

—

 

(450)

 

 

 

 

 

**Balances at June 30, 2005******

**7,321******

**$******

**31,779******

**$******

**21,520******

**$******

**25******

**$******

**53,324******

 

 

 

 

 

 ****

 ****

 ****

 ****

 ****

 ****

 ****

 ****

 ****

 ****

(1) Comprehensive income for the three months ended June 30, 2005 and 2004 was $2,361 and $1,289, respectively.

(2) Adjusted for the 4-for-3 stock split distributed May 17, 2005.

See accompanying notes to condensed consolidated financial statements.

 

 

3

 

**WASHINGTON BANKING COMPANY**
**AND SUBSIDIARY**
Condensed Consolidated Statements of Cash Flows

Six months ended June 30, 2005 and 2004 (unaudited)

(Dollars in thousands)

 

 

 

 

 

**Six Months Ended June 30,******

 

 

**2005******

 ****

**2004******

 

 

 

Cash flows from operating activities:

 

 

 

 

Net income from continuing operations

 

$

4,392

$

2,710

Adjustments to reconcile net income to net cash 

 

 

 

 

Provided by operating activities:

 

 

 

 

Federal Home Loan Bank stock dividends

 

(8)

 

(45)

Amortization of investment premiums, net

 

14

 

17

Net decrease (increase) in subsidiary investment

 

39

 

(313)

Earnings on bank owned life insurance

 

(168)

 

(10)

Provision for loan losses

 

950

 

1,600

Net increase in loans held for sale

 

(3,028)

 

(7,608)

Net loss (gain) on sale of securities

 

50

 

(144)

Depreciation and amortization of premises and equipment

 

806

 

892

Net (gain) loss on sale of premises and equipment

 

(101)

 

161

Net (gain) loss on sale of other real estate 

 

(7)

 

31

Write-downs of other real estate

 

85

 

—

Tax benefit associated with stock options

 

(30)

 

—

Amortization of restricted stock

 

33

 

—

(Increase) decrease in other assets

 

(612)

 

420

Increase (decrease) in other liabilities

 

597

 

(693)

 

 

 

Cash flows from continuing operating activities

 

3,012

 

(2,982)

Loss from discontinued operations

 

 

—

 

(370)

 

 

 

Cash flows from operating activities

 

3,012

 

(3,352)

 

 

 

Cash flows from investing activities:

 

 

 

 

Maturities/calls/principal payments of investment and

 

 

 

 

 

mortgage-backed securities available for sale

 

366

 

4,985

Sale of investment securities, available for sale

 

455

 

5,799

Maturities/calls of investment securities held to maturity

 

—

 

475

Purchase of bank-owned life insurance

 

—

 

(10,000)

Net increase in loans

 

(31,077)

 

(41,225)

Purchases of premises and equipment

 

(1,661)

 

(1,811)

Proceeds from the sale of other real estate owned, premises and equipment

 

783

 

141

 

 

 

Cash flows from investing activities

 

(31,134)

 

(41,636)

 

 

 

Cash flows from financing activities:

 

 

 

 

Net increase in deposits

 

60,015

 

56,515

Net decrease in FHLB overnight borrowings

 

(22,000)

 

(1,000)

Gross payments on other borrowed funds

 

(5,000)

 

(5,000)

New borrowings on other borrowed funds

 

10,000

 

—

Dividends paid on common stock

 

(800)

 

(735)

Proceeds from stock options exercised

 

188

 

155

 

 

 

Cash flows from financing activities

 

42,403

 

49,935

 

 

 

Net change in cash and cash equivalents

 

14,281

 

4,947

Cash and cash equivalents at beginning of period

 

17,933

 

20,605

 

 

 

Cash and cash equivalents at end of period

$

32,214

$

25,552

 

 

 

Supplemental information:

 

 

 

 

Loans foreclosed and transferred to other real estate owned 

$

53

$

18

Cash paid for interest

 

5,183

 

4,204

Cash paid for income taxes

 

2,380

 

1,499

Transfer of investments from HTM to AFS

 

—

 

14,267

Deconsolidation of trust preferred securities

 

—

 

15,000

See accompanying notes to condensed consolidated financial statements.

 

 

 

 

 

4

 

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

Six months ended June 30, 2005 and 2004 (unaudited)

(Dollars in thousands, except per share data)

 

 

 

**(1)**

**Description of Business and Summary of Significant Accounting Policies**

 
(a)

Description of Business

 
Washington Banking Company (the “Company” or “WBCO”) is a registered bank holding company formed on April 30, 1996. At June 30, 2005, WBCO had two wholly-owned subsidiaries – Whidbey Island Bank (“WIB” or the “Bank”), the Company’s principal subsidiary, and Washington Banking Capital Trust I (the “Trust”). The business of the Bank, which is focused in the northern area of Western Washington, consists primarily of attracting deposits from the general public and originating loans. The region’s economy has evolved from one that was once heavily dependent upon forestry, fishing and farming to an economy with a much more diverse blend of industries including retail trade, services, manufacturing, tourism and a large military base presence. Although the Bank has a diversified loan portfolio, a substantial portion of itsborrowers’ ability to repay their loans is dependent upon the economic conditions affecting this area.

 

The Trust was formed in June 2002 for the exclusive purpose of issuing trust preferred securities and common securities and using the $15,000 in proceeds from the issuance to acquire junior subordinated debentures issued by WBCO. The Company deconsolidated the Trust in 2004, pursuant to Financial Accounting Standards Board (“FASB”) Financial Interpretation No. 46R (“FIN 46R”).

 

Washington Funding Group, Inc., a wholesale mortgage real estate lending company (“WFG”), was a former subsidiary of the Company formed in January 2003. The primary purpose of WFG was to provide a loan-funding source for brokers of mortgage loans. The loans were originated and sold in the name of the Bank. The Company closed WFG’s operations effective June 30, 2004.

(b)

Basis of Presentation

The accompanying interim condensed consolidated financial statements include the accounts of WBCO and its subsidiaries described above. The accompanying interim condensed consolidated financial statements have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the December 31, 2004 audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC on March 25, 2005. In management’s opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation havebeen included. Operating results for the six months ended June 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. In preparing the consolidated financial statements, estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses are required. Actual results could differ from those estimates.

(c)

Segments

Pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 131, *Disclosure about Segments of an Enterprise and Related Information,* the Company has evaluated the requirements of this standard and identified two reportable segments: WIB and the discontinued operations of WFG, both wholly-owned subsidiaries of Washington Banking Company. Due to the discontinuation of WFG in the second quarter of 2004, the Company currently has only one segment, WIB, and is not required to disclose segment reporting by this standard.

(d)

Reclassifications

Certain amounts in prior year’s financial statements may have been reclassified to conform to the 2005 presentation. These reclassifications had no significant impact on the Company’s financial position or results of operations.

 

5

 

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

Six months ended June 30, 2005 and 2004 (unaudited)

(Dollars in thousands, except per share data)

 

 

 

**(2)**

**Recent Financial Accounting Pronouncements**

In December 2004, FASB issued SFAS No. 123R, *Shared Based Payment,*which is a revision of SFAS No. 123, *Accounting for Stock-Based Compensation.* Statement No. 123R supersedes Accounting Principles Board Opinion No. 25 (“APB 25”), *Accounting for Stock Issued to Employees*, and amends SFAS No. 95, *Statement of Cash Flows*. 

 

As permitted by SFAS No. 123, the Company currently accounts for share-based payments to employees using APB 25 intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. The adoption of SFAS No. 123R’s fair value method will have an impact on the Company’s result of operations, although it will have no impact on the overall financial position. The impact of adoption of SFAS No. 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted SFAS No. 123R in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123. Also, SFAS No. 123R requires the benefit of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required undercurrent literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. 

 

The SEC recently announced the adoption of a new rule that amends the compliance dates for SFAS No. 123R for public companies. Under the Statement as issued by the FASB, fair-value accounting would have been mandatory for the first interim or annual reporting period beginning after June 15, 2005, for public companies that were not small business issuers; all other companies, including all nonpublic companies, were to begin using the new rules for reporting periods after December 15, 2005. The SEC’s new rule allows public companies to implement SFAS No. 123R at the beginning of the next fiscal year, instead of the next reporting period, after June 15 or December 15, 2005, as applicable. The SEC’s new rule does not change the accounting required by SFAS No. 123R, only the compliance deadlines have been altered. With the recent extension, the Company expects to adopt SFAS No. 123R onJanuary 1, 2006.

**(3)**

**Earnings Per Share**

The following table reconciles the denominator of the basic and diluted earnings per share computation: 

 

 

 

**Three Months Ended June 30,******

 

**Six Months Ended June 30,******

 

 

**2005******

 ****

**2004******

 

**2005******

 ****

**2004******

 

 

 

 

 

Weighted average shares-basic

 

7,301,519

 

7,213,313

 

7,275,511

 

7,199,175

Effect of dilutive securities: stock options 

 

271,943

 

269,967

 

270,812

 

272,580

 

 

 

 

 

Weighted average shares-diluted

 

7,573,462

 

7,483,280

 

7,546,323

 

7,471,755

 

 

 

 

 

Adjusted for the 4-for-3 stock split distributed on May 17, 2005.

 

The Company declared a 4-for-3 stock split to shareholders of record on May 2, 2005 and payable on May 17, 2005. On February 26, 2004, the Company issued a 15% stock dividend to shareholders of record as of February 10, 2004. All periods presented have been restated to reflect the stock split and dividends. At June 30, 2005 and 2004, there were options to purchase 412,632 and 485,499 shares of common stock outstanding, respectively. For the six months ended June 30, 2005 and 2004 no options were antidilutive and therefore all were included in the computation of diluted net income per share. 

**(4)**

**Junior Subordinated Debentures**

The Trust issued $15,000 of trust preferred securities on June 27, 2002 with a 30-year maturity, callable after the fifth year by Washington Banking Company. The rate adjusts quarterly based on Three-Month LIBOR plus 3.65%. On June 30, 2005 the rate was 6.79%. These securities, within certain limitations, are considered Tier I capital for the purposes of regulatory capital requirements. 

 

6

 

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

Six months ended June 30, 2005 and 2004 (unaudited)

(Dollars in thousands, except per share data)

 

 

The junior subordinated debentures are the sole assets of the Trust, and payments under the junior subordinated debentures are the sole revenues of the Trust. All of the common securities of the Trust are owned by WBCO. Washington Banking Company has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements. 

Pursuant to FIN 46R, the Company deconsolidated the Trust beginning first quarter of 2004 and began to report the junior subordinated debentures within the liabilities section of the statement of financial condition. Prior to deconsolidation, the Trust and the related trust preferred securities were included within borrowings as a separate line item in WBCO’s statement of financial condition.

**(5)**

**Stock-Based Compensation**

The Company currently recognizes the financial effects of stock-based employee compensation based on the intrinsic value method of accounting prescribed by APB 25, *Accounting for Stock Issued to Employees* and FASB Interpretation No. 44 (“FIN 44”), *Accounting for Certain Transactions Involving Stock Compensation.*  Generally, stock options are issued at a price equal to the fair value of the Company’s stock as of the grant date. Under APB 25, options issued in this manner do not result in the recognition of employee compensation in the Company’s financial statements. 

 

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value provisions of FASB Statement No. 123, *Accounting for Stock-Based Compensation,* to stock-based employee compensation:

 

 

 

**Three Months Ended****June 30**

 

**Six Months Ended****June 30******

 

 

**2005**

 ****

**2004******

 

**2005**

 ****

**2004******

 

 

 

 

 

Net income, as reported

$

2,349

$

1,245

$

4,392

$

2,340

Stock compensation recognized, net of tax

 

4

 

4

 

8

 

8

Additional compensation for

 

 

 

 

 

 

 

 

fair value of stock options, net of tax

 

(14)

 

(15)

 

(29)

 

(30)

 

 

 

 

 

Pro forma net income

$

2,339

$

1,234

$

4,371

$

2,318

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**Basic earnings per share:**

 

 

 

 

 

 

 

 

As reported

 

 

 

 

 

 

 

 

Income from continuing operations

$

0.32

$

0.21

$

0.60

$

0.38

Loss from discontinued operations

 

—

 

(0.03)

 

—

 

(0.05)

 

 

 

 

 

Net Income

$

0.32

$

0.18

$

0.60

$

0.33

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Pro forma

 

 

 

 

 

 

 

 

Income from continuing operations

$

0.32

$

0.20

$

0.60

$

0.37

Loss from discontinued operations

 

—

 

(0.03)

 

—

 

(0.05)

 

 

 

 

 

Net Income

$

0.32

$

0.17

$

0.60

$

0.32

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**Diluted earnings per share:**

 

 

 

 

 

 

 

 

As reported

 

 

 

 

 

 

 

 

Income from continuing operations

$

0.31

$

0.20

$

0.58

$

0.36

Loss from discontinued operations

 

—

 

(0.03)

 

—

 

(0.05)

 

 

 

 

 

Net Income

$

0.31

$

0.17

$

0.58

$

0.31

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Pro forma

 

 

 

 

 

 

 

 

Income from continuing operations

$

0.31

$

0.20

$

0.58

$

0.36

Loss from discontinued operations

 

—

 

(0.03)

 

—

 

(0.05)

 

 

 

 

 

Net Income

$

0.31

$

0.17

$

0.58

$

0.31

 

 

 

 

 

Adjusted for the 4-for-3 stock split distributed May 17, 2005.

 

 

7

 

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

Six months ended June 30, 2005 and 2004 (unaudited)

(Dollars in thousands, except per share data)

 

 

 

**(6)**

**Subsequent Event**

On July 28, 2005, the Board of Directors declared a cash dividend of $0.055 per share to shareholders of record as of August 12, 2005, which is payable on August 29, 2005.

**(7)**

**Commitments**

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. Except for certain long-term guarantees, most guarantees expire in one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounts to one hundred percent of the commitment amount at June 30, 2005. The Company routinely charges a fee for these credit facilities. Such fees are amortized into income over the life of the agreement, and unamortized amounts are not significant as of June 30, 2005. 

 

As of June 30, 2005 the commitments under these agreements were as follows:

 

Standby letters of credit and financial guarantees

$1,607

 

At June 30, 2005, the Company is the guarantor of trust preferred securities. The Company has issued subordinated debentures to a wholly-owned special purpose trust, which has issued trust preferred securities. The sole assets of the special purpose trust are the subordinated debentures issued by the Company. WBCO has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements. The maximum amount of future payments the Company will be required to make under these agreements is the principal and interest of the trust preferred securities, the principal of which totaled $15,000 at June 30, 2005.

**(8)**

**Investment Securities**

Investment securities available for sale include securities that management intends to use as part of its overall asset/liability management strategy and that may be sold in response to changes in interest rates and resultant prepayment risk and other related factors. Securities available for sale are carried at market value, and unrealized gains and losses (net of related tax effects) are excluded from net income but are included as a separate component of comprehensive income. Upon realization, such gains and losses will be included in net income using the specific identification method. 

 

During the second quarter of 2004, the Company transferred all of the municipal securities from held to maturity to available for sale as a result of management’s review of the Company’s liquidity needs, the asset/liability position, the scheduled maturities and the rate environment trends. This transfer caused a related net unrealized gain of $412. In addition, the Company sold $5,799 of available for sale securities to help reposition the Company’s liability sensitive position against the anticipation of a rising rate environment. For liquidity purposes, the Company’s future security purchases will primarily be designated as available for sale. The investment portfolio consists of government agency securities, pass-through securities, as well as corporate and municipal securities. No investment exceeds 10% of the shareholders’ equity. 

 

 

8

 

 

 

**Item 2.**

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

 

**Note Regarding Forward-Looking Statements**: This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These forward-looking statements describe Washington Banking Company’s (the “Company”) management’s expectations regarding future events and developments such as future operating results, growth in loans and deposits, continued success of the Company’s business plan and the strength of the local economy. The words “will,” “believe,” “expect,” “should,” “anticipate” and words of similar construction are intended in part tohelp identify forward-looking statements. Future events are difficult to predict, and the expectations described below are necessarily subject to risk and uncertainty that may cause actual results to differ materially and adversely. In addition to discussions about risks and uncertainties set forth from time to time in the Company’s filings with the Securities and Exchange Commission (the “SEC”), factors that may cause actual results to differ materially from those contemplated in such forward-looking statements include, among others, the following possibilities: (1) local and national general and economic conditions, including the possible impact of international conflict or further terrorist events, are less favorable than expected or have a more direct and pronounced effect than expected on the Company and adversely affect the Company’s ability to continue its internal growth at historical rates and maintain the quality of its earning assets; (2) changes ininterest rates reduce interest margins more than expected or negatively affect liquidity; (3) projected business increases following strategic expansion or the opening or acquisition of new branches are lower than expected; (4) there are greater than expected costs or difficulties related to the integration of acquisitions; (5) there is increased competitive pressure among financial institutions; (6) legislation or regulatory requirements or changes that adversely affect the banking and financial services sector; and (7) the Company is unable to realize the efficiencies it expects to derive from its investment in personnel and infrastructure. However, the reader should be aware that these factors are not an exhaustive list, and the reader should not assume that these are the only factors that may cause actual results to differ from expectations. In addition, it should be noted that the Company does not intend to update any of the forward-looking statements or the uncertainties thatmay adversely impact those statements.

 

The following discussion and analysis should be read in conjunction with the financial statements and notes thereto presented elsewhere in this report.

 

***Overview***

 

Washington Banking Company (the “Company” or “WBCO”) is a registered bank holding company with two wholly-owned subsidiaries: Whidbey Island Bank (the “Bank” or “WIB”) and Washington Banking Capital Trust I (the “Trust”). A third subsidiary, Washington Funding Group, Inc. (“WFG”) was dissolved effective June 30, 2004. 

 

Headquartered in Oak Harbor, the Company’s market area is primarily northwestern Washington.  The market area encompasses distinct economies, and none are particularly dependent upon a single industrial or occupational source. The economies within the market areas have evolved from being heavily dependent upon forestry, fishing and farming to a more diverse blend of industries including retail trade, services, manufacturing, tourism and a large military presence. 

 

The Company’s strategy is one of value-added growth. Management believes that qualitative and sustainable growth of the Company, coupled with maintaining profitability, is currently the most appropriate path to enhancing value for its shareholders. To date, the Company’s growth has been achieved organically and it attributes its reputation for focusing on customer service and satisfaction as one of the cornerstones to the Company’s success. Acquisition of banks or branches may also be used as a means of expansion if appropriate opportunities are presented. Management recognizes that growth requires expenditures of substantial sums to purchase or lease real property and equipment and to hire experienced personnel, and that earnings may be negatively affected. The Company’s primary long-term objectives are to improve profitability and operating efficiencies, to increasemarket penetration in areas currently served and to continue an expansion strategy in appropriate market areas.

 

 

9

 

 

 

***Financial Highlights***

The Company’s focus on improving credit quality and increasing its core deposits contributed to record net income in the three and six months ended June 30, 2005. Revenues, on a fully tax-equivalent basis, grew to $10.3 million in the second quarter of 2005 from $9.0 million in the second quarter of 2004, a 14.3% increase, while net income grew 88.7% to $2.3 million in the quarter ended June 30, 2005, compared to $1.2 million for the like period one year ago. During the first six months of 2005, revenues, on a fully tax-equivalent basis, increased 13.2% to $19.8 million compared to $17.5 million for the first six months of 2004.  For the same periods, net income was $4.4 million compared to  $2.3 million, respectively. The increase in net income was primarily the result of (1) improved credit quality in the Bank’s loan portfolio leading to a reduction in the provision for loanlosses and (2) increases in noninterest income primarily related to SBA premiums, ATM income and the introduction of alternative income sources.  In addition, the Company improved its net interest margin by generating more noninterest bearing and low-interest bearing deposits in relation to the entire deposit portfolio despite rising trends in the interest rate market during the six months ended June 30, 2005. 

 

Earnings per diluted share increased 82.4% to $0.31, compared to $0.17 per diluted share in the second quarter of 2004. During the first six months of 2005, earnings per diluted share increased 87.1% to $0.58, compared to $0.31 per diluted share for the like period of 2004. Results for the three and six months ended June 30, 2004 were negatively impacted by ($0.03) and ($0.05), respectively, per diluted share from the operating loss associated with the discontinued subsidiary, WFG. Excluding this discontinued operation; earnings per diluted share grew 55.0% to $0.31 versus $0.20 in the second quarter of 2004, and 61.1% to $0.58 versus $0.36 for the six months ended June 30, 2004. All per share data has been adjusted to reflect the 4-for-3 stock split distributed May 17, 2005. 

 

The Company’s profitability ratios have shown substantial improvement from a year ago, mainly due to creating and improving customer relationships and improving internal operating functions. Return on average equity (“ROE”) improved to 18.24% and return on average assets (“ROA”) grew to 1.37% in the second quarter of 2005. In the second quarter last year, ROE was 11.01% and ROA was 0.80%, due in part to the operating loss of WFG. During the first six months of 2005, ROE improved to 17.44% and ROA grew to 1.32% compared to 10.46% and 0.77%, respectively, for the like period in 2004. 

 

10

 

 

 

***Consolidated Average Balance Sheet and Analysis of Net Interest Income and Expense***

 

The following table sets forth the Company’s consolidated average balance sheet and analysis of net interest income and expense for the three months ended June 30, 2005 and 2004:

 

 

 

**Three Months Ended June 30, 2005******

 

**Three Months Ended June 30, 2004******

**(Dollars in thousands)**

 

**Average**

**balance******

 

**Interest**

**earned/paid**

 ****

**Average**

**yield******

 

**Average**

**balance******

 

**Interest**

**earned/paid**

 ****

**Average**

**yield******

 

 

 

 

 

 

 

**Assets**

 

 

 

 

 

 

 

 

 

 

 

 

Loans (1)(2)

$

609,066

$

10,966

 

7.22%

$

545,394

$

9,113

 

6.72%

Federal funds sold

 

3,082

 

22

 

2.86%

 

9,029

 

22

 

0.98%

Interest-bearing cash

 

802

 

5

 

2.50%

 

667

 

1

 

0.60%

Investments:

 

 

 

 

 

 

 

 

 

 

 

 

Taxable

 

14,047

 

88

 

2.51%

 

13,799

 

108

 

3.15%

Non-taxable (2)

 

6,890

 

118

 

6.87%

 

12,501

 

206

 

6.63%

 

 

 

 

 

 

 

Interest-earning assets

 

633,887

 

11,199

 

7.09%

 

581,390

 

9,450

 

6.54%

Noninterest-earning assets

 

52,211

 

 

 

 

 

42,225

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

$

686,098

 

 

 

 

$

623,615

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**Liabilities and**

**Shareholders’ Equity**

 

 

 

 

 

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

 

 

 

 

 

Interest demand and

 

 

 

 

 

 

 

 

 

 

 

 

money market

$

226,599

$

595

 

1.05%

$

210,606

$

393

 

0.75%

Savings

 

55,748

 

110

 

0.79%

 

45,075

 

88

 

0.79%

CDs

 

219,225

 

1,654

 

3.03%

 

212,380

 

1,400

 

2.65%

 

 

 

 

 

 

 

Interest-bearing deposits

 

501,572

 

2,359

 

1.89%

 

468,061

 

1,881

 

1.62%

Federal funds purchased

 

8,734

 

69

 

3.17%

 

1,571

 

4

 

1.02%

Junior subordinated debentures

 

15,007

 

260

 

6.95%

 

15,007

 

184

 

4.93%

Other borrowed funds

 

11,096

 

108

 

3.90%

 

8,958

 

97

 

4.36%

 

 

 

 

 

 

 

Interest-bearing liabilities

 

536,409

 

2,796

 

2.09%

 

493,597

 

2,166

 

1.76%

Noninterest-bearing deposits

 

94,129

 

 

 

 

 

81,561

 

 

 

 

Other noninterest-bearing liabilities

 

3,894

 

 

 

 

 

2,976

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total liabilities

 

634,432

 

 

 

 

 

578,134

 

 

 

 

Shareholders’ equity

 

51,666

 

 

 

 

 

45,481

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total liabilities and

 

 

 

 

 

 

 

 

 

 

 

 

shareholders’ equity

$

686,098

 

 

 

 

$

623,615

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest income 

 

 

$

8,403

 

 

 

 

$

7,284

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest spread 

 

 

 

 

 

5.00%

 

 

 

 

 

4.78%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest margin 

 

 

 

 

 

5.32%

 

 

 

 

 

5.04%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(1)   Average balance includes nonaccrual loans; Interest earned includes loan fees of  $366 and $213 for the three months ended June 30, 2005 and 2004, respectively.

( 2)Interest income on non-taxable investments and loans is presented on a fully tax-equivalent basis using the federal statutory rate of 35% and 34% for the three months ended June 30, 2005 and 2004, respectively. These adjustments were $62 and $89 for the three monthsended June 30, 2005 and 2004, respectively. Fully tax-equivalent is a non-GAAP performance measurement that management believes provides investors with a more accurate picture of the net interest margin and efficiency ratio for comparative purposes. The calculation involves grossing up interest income on tax-exempt loans and investments by an amount that makes it comparable to taxableincome.

 

11

 

 

 

The following table sets forth the Company’s consolidated average balance sheet and analysis of net interest income and expense for the six months ended June 30, 2005 and 2004:

 

 

 

 

 

**Six Months Ended June 30, 2005******

 

**Six Months Ended June 30, 2004******

**(Dollars in thousands)**

 

**Average**

**balance******

 

**Interest**

**earned/paid**

 ****

**Average**

**yield******

 

**Average**

**balance******

 

**Interest**

**earned/paid**

 ****

**Average**

**yield******

 

 

 

 

 

 

 

**Assets**

 

 

 

 

 

 

 

 

 

 

 

 

Loans (1)(2)

$

597,573

$

21,078

 

7.11%

$

530,563

$

17,909

 

6.79%

Federal funds sold

 

2,385

 

32

 

2.71%

 

7,016

 

33

 

0.95%

Interest-bearing cash

 

925

 

12

 

2.62%

 

676

 

3

 

0.89%

Investments:

 

 

 

 

 

 

 

 

 

 

 

 

Taxable

 

14,224

 

191

 

2.71%

 

15,551

 

245

 

3.17%

Non-taxable (2)

 

6,987

 

239

 

6.90%

 

13,542

 

448

 

6.65%

 

 

 

 

 

 

 

Interest-earning assets

 

622,094

 

21,552

 

6.99%

 

567,348

 

18,638

 

6.61%

Noninterest-earning assets

 

50,852

 

 

 

 

 

40,424

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

$

672,946

 

 

 

 

$

607,772

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**Liabilities and**

**Shareholders’ Equity**

 

 

 

 

 

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

 

 

 

 

 

Interest demand and

 

 

 

 

 

 

 

 

 

 

 

 

money market

$

221,990

$

1,087

 

0.99%

$

200,736

$

753

 

0.75%

Savings

 

56,014

 

220

 

0.79%

 

44,278

 

172

 

0.78%

CDs

 

214,872

 

3,159

 

2.96%

 

205,518

 

2,723

 

2.66%

 

 

 

 

 

 

 

Interest-bearing deposits

 

492,876

 

4,466

 

1.83%

 

450,532

 

3,648

 

1.63%

Federal funds purchased

 

11,576

 

159

 

2.77%

 

3,530

 

20

 

1.14%

Junior subordinated debentures

 

15,007

 

497

 

6.68%

 

15,007

 

364

 

4.88%

Other borrowed funds

 

9,648

 

187

 

3.91%

 

10,775

 

228

 

4.26%

 

 

 

 

 

 

 

Interest-bearing liabilities

 

529,107

 

5,309

 

2.02%

 

479,844

 

4,260

 

1.79%

Noninterest-bearing deposits

 

89,561

 

 

 

 

 

80,144

 

 

 

 

Other noninterest-bearing liabilities

 

3,494

 

 

 

 

 

2,799

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total liabilities

 

622,162

 

 

 

 

 

562,787

 

 

 

 

Shareholders’ equity

 

50,784

 

 

 

 

 

44,985

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total liabilities and

 

 

 

 

 

 

 

 

 

 

 

 

shareholders’ equity

$

672,946

 

 

 

 

$

607,772

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest income 

 

 

$

16,243

 

 

 

 

$

14,378

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest spread 

 

 

 

 

 

4.97%

 

 

 

 

 

4.82%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest margin 

 

 

 

 

 

5.27%

 

 

 

 

 

5.10%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(1)   Average balance includes nonaccrual loans; Interest earned includes loan fees of  $657 and $440 for the six months ended June 30, 2005 and 2004, respectively.

(2)   Interest income on non-taxable investments and loans is presented on a fully tax-equivalent basis using the federal statutory rate of 35% and 34% for the six months ended June 30, 2005 and 2004, respectively. These adjustments were $122 and $192 for the six months ended June 30, 2005 and 2004, respectively. Fully tax-equivalent is a non-GAAP performance measurement that management believes provides investors with a more accurate picture of the net interest margin and efficiency ratio for comparative purposes. The calculation involves grossing up interest income on tax-exempt loans and investments by an amount that makes it comparable to taxable income.

 

 

 

 

12

 

 

 

 

The following table sets forth the amounts of the changes in consolidated net interest income attributable to changes in volume and to changes in interest rates, presented on a 91/365 and 181/365-day basis. Changes attributable to the combined effect of volume and interest rates have been allocated proportionately:

 

 

 

**Three Months Ended June 30**

 

**Six Months Ended June 30**

 

 

**2005 vs. 2004**

 

**2005 vs. 2004**

 

 

**Increase (decrease) due to:**

 

**Increase (decrease) due to:**

 

 

 

 

 

**Volume**

 

**Rate**

 

**Total**

 

**Volume**

 

**Rate**

 

**Total**

 

 

 

 

 

 

 

**Assets**

 

 

 

 

 

 

 

 

 

 

 

 

Loans (1)

$

1,113

$

740

$

1,853

$

2,337

$

832

$

3,169

Federal funds sold

 

—

 

—

 

—

 

1

 

(2)

 

(1)

Interest-bearing cash

 

—

 

4

 

4

 

1

 

8

 

9

Investments (1)

 

(58)

 

(50)

 

(108)

 

(170)

 

(93)

 

(263)

 

 

 

 

 

 

 

**Total interest earning assets**

$

891

$

858

$

1,749

$

1,861

$

1,053

$

2,914

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**Liabilities**

 

 

 

 

 

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

 

 

 

 

 

Interest demand and money market

$

32

$

170

$

202

$ 

86

$ 

248

$ 

334

Savings

 

21

 

1

 

22

 

46

 

2

 

48

Time deposits

 

46

 

208

 

254

 

128

 

308

 

436

Interest on other borrowed funds

 

44

 

21

 

65

 

86

 

53

 

139

Junior subordinated debentures

 

—

 

76

 

76

 

—

 

133

 

133

Other interest-bearing liabilities

 

19

 

(8)

 

11

 

(23)

 

(18)

 

(41)

 

 

 

 

 

 

 

****

$

199

$

431

$

630

$

462

$

587

$

1,049

 

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