**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.20549**

 

**FORM 10-QSB**

 

**ý****  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**Forthe quarterly period ended September 30, 2003**

 

**o****  TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**Forthe Transition Periodfrom         to         **

 

**CommissionFile No. 0-25020**

 

**HERITAGE OAKS BANCORP**

(Exact name of registrant as specified incharter)

 

**STATEOF CALIFORNIA**

(State or other jurisdiction ofincorporation or organization)

 

**77-0388249**

(I.R.S. Employer IdentificationCode)

 

**54512th STREET, PASO ROBLES, CA  93446**

(Address of principal office)

 

**(805)239-5200**

(Registrant’s telephone number,including area code)

 

**Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the precedingtwelve (12) months (or for such shorter period that the registrant was requiredto file such reports), and (2) has been subject to such filing requirements forthe past ninety (90) days.**

**YES  ****ý   NO  ****o**

 

**Indicate the numberof shares outstanding of each of the issuer’s classes of common stock, as ofthe latest practicable date:**

 

**No par value Common Stock – 2,990,103shares outstanding at October 10, 2003.**

 

 

----

 

**TABLE OF CONTENTS**

 
| Part 1. Financial Information   |
|--------------------------------------|
|                                 |   |
|                                 | Item 1. Financial Statements |
|                                 |   |
|                                 | Consolidated Balance Sheets |
|                                 | Consolidated Statements of Operations (Un-audited) |
|                                 | Consolidated Statements of Cash Flows  (Un-audited) |
|                                 | Consolidated Statement of Changes in Stockholders’  Equity (Un-audited) |
|                                 | Notes to Consolidated Financial Statements  (Un-audited) |
|                                 |   |
|                                 | Item 2. Management’s Discussion and  Analysis of Financial Condition and Results of Operations |
|                                 |   |
|                                 | Item 3. Controls and Procedures |
|                                 |   |
| Part 2.  Other Information |
|                                 |   |
|                                 | Item  6. Exhibits and Reports on Form 8-K |
|                                 |   |
| Signatures                           |
|                                 |   |
| Certifications                       |
|                                 |   |
| Exhibits                             |

 

2

----

 

**PART 1. FINANCIALINFORMATION**

**Item 1. Financial Statements**

 

HERITAGE OAKS BANCORPCONSOLIDATED BALANCE SHEETS(in thousands)

 
|                                                                                                                                                                    |   | **31-Dec-02** |    | **30-Sep-03**   |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------|---------|-----------------|--------|
|                                                                                                                                                                    |   |          |    | **(Unaudited)** |   |
| ASSETS                                                                                                                                                                  |   |          |    |            |   |
| Cash and due  from banks                                                                                                                                                |   | $             | 23,514  |            | $      | 24,010 |   |
| Federal  funds sold                                                                                                                                                     |   | 37,040        |    | 25,700          |   |
|                                                                                                                                                                    |   |          |    |            |   |
| Total cash  and cash equivalents                                                                                                                                        |   | 60,554        |    | 49,710          |   |
|                                                                                                                                                                    |   |          |    |            |   |
| Interest  bearing deposits other banks                                                                                                                                  |   | 497           |    | 497             |   |
|                                                                                                                                                                    |   |          |    |            |   |
| Securities  Available for sale                                                                                                                                          |   | 65,396        |    | 39,401          |   |
| Federal Home  Loan Bank Stock, at cost                                                                                                                                  |   | 1,951         |    | 1,681           |   |
| Loans Held  For Sale                                                                                                                                                    |   | 8,166         |    | 8,578           |   |
| Loans, net                                                                                                                                                              |   | 187,311       |    | 214,844         |   |
|                                                                                                                                                                    |   |          |    |            |   |
| Property,  premises and equipment, net                                                                                                                                  |   | 4,543         |    | 6,591           |   |
| Cash  surrender value life insurance                                                                                                                                    |   | 5,416         |    | 6,440           |   |
| Deferred Tax  Assets                                                                                                                                                    |   | 1,171         |    | 1,602           |   |
| Core Deposit  Intangible                                                                                                                                                |   | 358           |    | 328             |   |
| Other assets                                                                                                                                                            |   | 1,900         |    | 2,139           |   |
|                                                                                                                                                                    |   |          |    |            |   |
| TOTAL ASSETS                                                                                                                                                            |   | $             | 337,263 |            | $      | 331,811 |   |
|                                                                                                                                                                    |   |          |    |            |   |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                                                                                              |   |          |    |            |   |
| LIABILITIES                                                                                                                                                             |   |          |    |            |   |
| Deposits:                                                                                                                                                               |   |          |    |            |   |
| Demand,  non-interest bearing                                                                                                                                           |   | $             | 106,556 |            | $      | 111,842 |   |
| Savings,  NOW, and money market deposits                                                                                                                                |   | 112,568       |    | 111,407         |   |
| Time  deposits of $100,000 or more                                                                                                                                      |   | 8,154         |    | 9,093           |   |
| Time  deposits under $100,000                                                                                                                                           |   | 36,901        |    | 37,947          |   |
| Total  deposits                                                                                                                                                         |   | 264,179       |    | 270,289         |   |
|                                                                                                                                                                    |   |          |    |            |   |
| Other  borrowed money                                                                                                                                                   |   | 38,000        |    | 28,500          |   |
| Securities  Sold under Agreement to Repurchase                                                                                                                          |   | 258           |    | 355             |   |
| Company  Obligated Preferred Securities of Subsidiary Trust Holding Floating Rate  Junior Subordinated Deferred Interest Debentures                                     |   | 8,000         |    | 8,000           |   |
| Other  liabilities                                                                                                                                                      |   | 7,013         |    | 2,286           |   |
| Total  liabilities                                                                                                                                                      |   | 317,450       |    | 309,430         |   |
|                                                                                                                                                                    |   |          |    |            |   |
| COMMITMENTS  AND CONTINGENCIES                                                                                                                                          |   | —        |    | —          |   |
|                                                                                                                                                                    |   |          |    |            |   |
| Stockholders’  equity                                                                                                                                              |   |          |    |            |   |
| Common  stock, no par value;  20,000,000 shares authorized; issued and outstanding 2,924,810 and 2,990,103  for December 31, 2002 and September 30, 2003, respectively. |   | 9,703         |    | 11,698          |   |
| Retained  earnings                                                                                                                                                      |   | 9,548         |    | 10,566          |   |
| Accumulated  other comprehensive income                                                                                                                                 |   | 562           |    | 117             |   |
| Total  stockholders’ equity                                                                                                                                        |   | 19,813        |    | 22,381          |   |
| TOTAL  LIABILITIES & STOCKHOLDERS’ EQUITY                                                                                                                      |   | $             | 337,263 |            | $      | 331,811 |   |

 

----

(1) These numbers have beenderived from the audited financial statements.

 

See notes to condensedfinancial statements

 

3

----

 

**HERITAGE OAKS BANCORP**

**CONSOLIDATED STATEMENTS OF INCOME**

**For the three months ended September 30,**

(inthousands except per share date)

 
|                                                       |   | **2002**        |   | **2003**        |   |
|------------------------------------------------------------|--------|-----------------|--------|-----------------|--------|
|                                                       |   | **(Unaudited)** |   | **(Unaudited)** |   |
| Interest  Income:                                          |   |            |   |            |   |
|                                                       |   |            |   |            |   |
| Interest and  fees on loans                                |   | $               | 3,329  |            | $      | 3,869 |   |
| Investment  securities                                     |   | 692             |   | 412             |   |
| Federal  funds sold and commercial paper                   |   | 140             |   | 73              |   |
| Time  certificates of deposit                              |   | 1               |   | 3               |   |
| Total  interest income                                     |   | 4,162           |   | 4,357           |   |
|                                                       |   |            |   |            |   |
| Interest  Expense:                                         |   |            |   |            |   |
|                                                       |   |            |   |            |   |
| Now accounts                                               |   | 53              |   | 4               |   |
| MMDA  accounts                                             |   | 188             |   | 105             |   |
| Savings  accounts                                          |   | 12              |   | 10              |   |
| Time  deposits of $100,000 or more                         |   | 43              |   | 34              |   |
| Other time  deposits                                       |   | 268             |   | 216             |   |
| Other  borrowed funds                                      |   | 498             |   | 407             |   |
| Total  interest expense                                    |   | 1,062           |   | 776             |   |
|                                                       |   |            |   |            |   |
| Net Interest  Income Before Prov. for Possible Loan Losses |   | 3,100           |   | 3,581           |   |
| Provision  for loan losses                                 |   | 150             |   | 75              |   |
| Net interest  income after provision for loan losses       |   | 2,950           |   | 3,506           |   |
|                                                       |   |            |   |            |   |
| Non-interest  Income:                                      |   |            |   |            |   |
| Service  charges on deposit accounts                       |   | 382             |   | 404             |   |
| Gain(Loss)  of Sale of Securities                          |   | (20             | )      | 2               |   |
| Other income                                               |   | 546             |   | 574             |   |
| Total  Non-interest Income                                 |   | 908             |   | 980             |   |
|                                                       |   |            |   |            |   |
| Non-interest  Expense:                                     |   |            |   |            |   |
| Salaries and  employee benefits                            |   | 1,368           |   | 1,593           |   |
| Occupancy  and equipment                                   |   | 398             |   | 408             |   |
| Other  expenses                                            |   | 989             |   | 1,012           |   |
| Total  Noninterest Expenses                                |   | 2,755           |   | 3,013           |   |
| Income  before provision for income taxes                  |   | 1,103           |   | 1,473           |   |
| Provision  for applicable income taxes                     |   | 427             |   | 557             |   |
| Net Income                                                 |   | $               | 676    |            | $      | 916 |   |
|                                                       |   |            |   |            |   |
| Earnings per  share:    (See note #4)  |   |            |   |            |   |
| Basic                                                      |   | $               | 0.23   |            | $      | 0.31 |   |
| Fully  Diluted                                             |   | $               | 0.21   |            | $      | 0.29 |   |

 

See notes to condensed financial statements

 

4

----

 

**HERITAGE OAKS BANCORP**

**CONSOLIDATED STATEMENTS OF INCOME**

**For the nine months ended September 30,**

(in thousands except pershare date)

 
|                                                       |   | **2002**        |   | **2003**        |   |
|------------------------------------------------------------|--------|-----------------|--------|-----------------|--------|
|                                                       |   | **(Unaudited)** |   | **(Unaudited)** |   |
| Interest  Income:                                          |   |            |   |            |   |
|                                                       |   |            |   |            |   |
| Interest and  fees on loans                                |   | $               | 9,600  |            | $      | 11,401 |   |
| Investment  securities                                     |   | 1,552           |   | 1,493           |   |
| Federal  funds sold and commercial paper                   |   | 242             |   | 180             |   |
| Time  certificates of deposit                              |   | 3               |   | 9               |   |
| Total  interest income                                     |   | 11,397          |   | 13,083          |   |
|                                                       |   |            |   |            |   |
| Interest  Expense:                                         |   |            |   |            |   |
|                                                       |   |            |   |            |   |
| Now accounts                                               |   | 174             |   | 73              |   |
| MMDA  accounts                                             |   | 259             |   | 380             |   |
| Savings  accounts                                          |   | 35              |   | 33              |   |
| Time  deposits of $100,000 or more                         |   | 122             |   | 117             |   |
| Other time  deposits                                       |   | 862             |   | 671             |   |
| Other  borrowed funds                                      |   | 946             |   | 1,280           |   |
| Total  interest expense                                    |   | 2,398           |   | 2,554           |   |
|                                                       |   |            |   |            |   |
| Net Interest  Income Before Prov. for Possible Loan Losses |   | 8,999           |   | 10,529          |   |
| Provision  for loan losses                                 |   | 435             |   | 325             |   |
| Net interest  income after provision for loan losses       |   | 8,564           |   | 10,204          |   |
|                                                       |   |            |   |            |   |
| Non-interest  Income:                                      |   |            |   |            |   |
| Service  charges on deposit accounts                       |   | 1,024           |   | 1,206           |   |
| Investment  securities gains(loss), net                    |   | (20             | )      | 60              |   |
| Other income                                               |   | 1,484           |   | 1,543           |   |
| Total  Non-interest Income                                 |   | 2,488           |   | 2,809           |   |
|                                                       |   |            |   |            |   |
| Non-interest  Expense:                                     |   |            |   |            |   |
| Salaries and  employee benefits                            |   | 3,910           |   | 4,615           |   |
| Occupancy  and equipment                                   |   | 1,247           |   | 1,227           |   |
| Other  expenses                                            |   | 2,954           |   | 3,020           |   |
| Total  Noninterest Expenses                                |   | 8,111           |   | 8,862           |   |
| Income  before provision for income taxes                  |   | 2,941           |   | 4,151           |   |
| Provision  for applicable income taxes                     |   | 1,066           |   | 1,531           |   |
| Net Income                                                 |   | $               | 1,875  |            | $      | 2,620 |   |
|                                                       |   |            |   |            |   |
| Earnings per  share:    (See note #4)  |   |            |   |            |   |
| Basic                                                      |   | $               | 0.65   |            | $      | 0.89 |   |
| Fully  Diluted                                             |   | $               | 0.60   |            | $      | 0.83 |   |

 

See notes to condensed financial statements

 

5

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**HERITAGE OAKS BANCORP**

**CONSOLIDATED STATEMENTS OF CASHFLOWS**

**Periods ended September 30,**

**(in thousands)**

 
|                                                                                                |   | **2002**        |   | **2003**        |   |
|-----------------------------------------------------------------------------------------------------|--------|-----------------|--------|-----------------|--------|
|                                                                                                |   | **(Unaudited)** |   | **(Unaudited)** |   |
| **Cash  Flows from Operating Activities**                                                           |   |            |   |            |   |
| Net income                                                                                          |   | $               | 1,875  |            | $      | 2,620 |   |   |
| Adjustments to reconcile  net income to net cash provided by operating activities                   |   |            |   |            |   |
| Net cash provided by  operating activities                                                          |   |            |   |            |   |
| Depreciation and  amortization                                                                      |   | 484             |   | 379             |   |
| Provision for possible  loan losses                                                                 |   | 435             |   | 325             |   |
| Provision for possible  unfunded loan losses                                                        |   | 0               |   | 50              |   |
| Realized (gain)/loss on  sales of available-for-sale securities, net                                |   | 20              |   | (60             | )      |
| FHLB dividends received                                                                             |   | 0               |   | (68             | )      |
| Amortization of  premiums/discounts on investment securities, net                                   |   | 111             |   | 375             |   |
| Amortization of intangible  assets                                                                  |   | 0               |   | 30              |   |
| (Increase)/decrease in  loans held for sale                                                         |   | (2,348          | )      | (412            | )      |
| (Increase)/decrease in  deferred tax asset                                                          |   | (247            | )      | (135            | )      |
| Net increase in cash  surrender value of life insurance                                             |   | 0               |   | (195            | )      |
| (Increase)/decrease in  other assets                                                                |   | (594            | )      | (145            | )      |
| Increase/(decrease) in  other liabilities                                                           |   | 1,557           |   | (4,777          | )      |
| **NET CASH  PROVIDED BY/(USED IN) OPERATING ACTIVITIES**                                            |   | 1,293           |   | (2,013          | )      |
| **Cash  Flows From Investing Activities**                                                           |   |            |   |            |   |
| Purchase of securities  available-for-sale                                                          |   | 0               |   | (1,633          | )      |
| Purchase of mortgage  backed securities available-for-sale                                          |   | (48,492         | )      | (10,394         | )      |
| Proceeds from sales of  securities available-for-sale                                               |   | 1,390           |   | 12,365          |   |
| Proceeds from principal  reductions and maturities of securities available-for-sale                 |   | 0               |   | 757             |   |
| Proceeds from principal  reductions and maturities of mortgage backed securities available-for-sale |   | 6,493           |   | 23,845          |   |
| Proceeds from sale of FHLB  stock                                                                   |   | 0               |   | 339             |   |
| Net Change in interest  bearing deposits in other financial institutions                            |   | (1,698          | )      |            |   |
| Purchase of life insurance  policies                                                                |   | 0               |   | (830            | )      |
| Increase in loans, net                                                                              |   | (17,717         | )      | (27,858         | )      |
| Purchase of property,  premises and equipment, net                                                  |   | (1,273          | )      | (2,521          | )      |
| **NET CASH  USED IN INVESTING ACTIVITIES**                                                          |   | (61,297         | )      | (5,930          | )      |
| **Cash  Flows From Financing Activities**                                                           |   |            |   |            |   |
| Increase in deposits, net                                                                           |   | $               | 70,078 |            | $      | 6,110 |   |   |
| Net increase/(decrease) in  other borrowings                                                        |   | 38,510          |   | (9,403          | )      |
| Net decrease in notes  payable                                                                      |   | (1,895          | )      | 0               |   |
| Proceeds from sale of  Trust Preferred Securities                                                   |   | 8,000           |   | 0               |   |
| Proceeds from exercise of  stock options                                                            |   | 133             |   | 395             |   |
| Cash paid in lieu of fractional  shares                                                             |   | (7              | )      | (3              | )      |
| **NET CASH  PROVIDED/(USED) BY FINANCING ACTIVITIES**                                               |   | 114,819         |   | (2,901          | )      |
| **Net  Increase/(Decrease) in Cash and Cash Equivalents**                                           |   | 54,815          |   | (10,844         | )      |
| **Cash and  Cash Equivalents**,  Beginning of year                                                  |   | 20,398          |   | 60,554          |   |
| **Cash and  Cash Equivalents**,  End of year                                                        |   | $               | 75,213 |            | $      | 49,710 |   |   |
|                                                                                                |   |            |   |            |   |
| **Supplemental  Disclosures of Cash Flow Information**                                              |   |            |   |            |   |
| Interest paid                                                                                       |   | $               | 2,398  |            | $      | 2,554 |   |   |
| Income taxes paid                                                                                   |   | $               | 1,335  |            | $      | 1,580 |   |   |
|                                                                                                |   |            |   |            |   |
| **Supplemental  Disclosures of Non-Cash Flow Information**                                          |   |            |   |            |   |
| Change in other  comprehensive income                                                               |   | $               | 745    |            | $      | (445 | ) |
|                                                                                                     |        |                 |        |                 |        |  |  |  |  |

 

**Seenotes to condensed financial statements**

 

6

----

 

**HERITAGE OAKS BANCORP**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

**September 30, 2002 and September 30, 2003**

**(Unaudited)**

** **
|                                                                               |   | **Shares  Outstanding** |       | **Common  Stock**   |      | **Retained  Earnings** |   | **Accumulated  Other  Comprehensive  Income** |       | **Total  Stockholders’  Equity** |    |
|------------------------------------------------------------------------------------|--------|-------------------------|------------|---------------------|-----------|------------------------|--------|-----------------------------------------------|------------|---------------------------------------|---------|
|                                                                               |   |                    |       | **(in  thousands)** |      |
| **Balance January 1, 2002**                                                        |   | 1,297,880               |       | $                   | 7,535     |                   | $      | 8,496                                         |       | $                                     | (155    | ) | $ | 15,876 |   |
|                                                                               |   |                    |       |                |      |                   |   |                                          |       |                                  |    |
| Exercise of  Stock Options                                                         |   | 26,552                  |       | 134                 |      | 0                      |   |                                          |       | 134                                   |    |
|                                                                               |   |                    |       |                |      |                   |   |                                          |       |                                  |    |
| Stock  dividend - 5%                                                               |   | 64,648                  |       | 1,681               |      | (1,681                 | )      |                                          |       | 0                                     |    |
| Cash paid to  Shareholders’ in Lieu of fractional shares on 5% Stock Dividend |   |                    |       |                |      | (6                     | )      |                                          |       | (6                                    | )       |
|                                                                               |   |                    |       |                |      |                   |   |                                          |       |                                  |    |
| Stock Split  - 2 for 1                                                             |   | 1,362,528               |       |                |      |                   |   |                                          |       |                                  |    |
|                                                                               |   |                    |       |                |      |                   |   |                                          |       |                                  |    |
| Comprehensive  Income                                                              |   |                    |       |                |      |                   |   |                                          |       |                                  |    |
| Net Income                                                                         |   |                    |       |                |      | 1,875                  |   |                                          |       | 1,875                                 |    |
| Unrealized  Security Holding Gains  ‘(net of $393 tax)                        |   |                    |       |                |      |                   |   | 734                                           |       | 734                                   |    |
| Realized Security Holding Losses  ‘(net of $7 tax)                            |   |                    |       |                |      |                   |   | 11                                            |       | 11                                    |    |
|                                                                               |   |                    |       |                |      |                   |   |                                          |       |                                  |    |
| Total other  comprehensive Income                                                  |   |                    |       |                |      |                   |   |                                          |       | 2,609                                 |    |
|                                                                               |   |                    |       |                |      |                   |   |                                          |       |                                  |    |
| **Balance September 30, 2002**                                                     |   | **2,751,608**           | ** ** | **$**               | **9,350** | ** **             | **$**  | **8,684**                                     | ** ** | **$**                                 | **590** | ** ** | **$** | **18,624** | ** ** |

 
|                                                                               |   | **Shares  Outstanding** |       | **Common  Stock**   |       | **Retained  Earnings** |   | **Other  Comprehensive  Income** |       | **Total  Stockholders’  Equity** |    |
|------------------------------------------------------------------------------------|--------|-------------------------|------------|---------------------|------------|------------------------|--------|----------------------------------|------------|---------------------------------------|---------|
|                                                                               |   |                    |       | **(in  thousands)** |       |
| **Balance January 1, 2003**                                                        |   | 2,785,533               |       | $                   | 9,703      |                   | $      | 9,548                            |       | $                                     | 562     |   | $ | 19,813 |   |
|                                                                               |   |                    |       |                |       |                   |   |                             |       |                                  |    |
| Exercise of  Stock Options                                                         |   | 60,562                  |       | 329                 |       | 0                      |   |                             |       | 329                                   |    |
|                                                                               |   |                    |       |                |       |                   |   |                             |       |                                  |    |
| Stock dividend-  5%                                                                |   | 139,008                 |       | 1,599               |       | (1,599                 | )      |                             |       | 0                                     |    |
| Cash paid to  Shareholders’ in Lieu of fractional shares on 5% Stock Dividend |   |                    |       |                |       | (3                     | )      |                             |       | (3                                    | )       |
|                                                                               |   |                    |       |                |       |                   |   |                             |       |                                  |    |
| Sale of  Common Stock                                                              |   | 5,000                   |       | 67                  |       |                   |   |                             |       | 67                                    |    |
|                                                                               |   |                    |       |                |       |                   |   |                             |       |                                  |    |
| Comprehensive  Income                                                              |   |                    |       |                |       |                   |   |                             |       |                                  |    |
| Net Income                                                                         |   |                    |       |                |       | 2,620                  |   |                             |       | 2,620                                 |    |
| Unrealized  Security Holding Gains/(Losses)  ‘(net of $321 tax)               |   |                    |       |                |       |                   |   | (409                             | )          | (409                                  | )       |
| Less  reclasification adjustment for gain  (net of $24 tax)                        |   |                    |       |                |       |                   |   | (36                              | )          | (36                                   | )       |
|                                                                               |   |                    |       |                |       |                   |   |                             |       |                                  |    |
| Total other  comprehensive Income                                                  |   |                    |       |                |       |                   |   |                             |       | 2,211                                 |    |
|                                                                               |   |                    |       |                |       |                   |   |                             |       |                                  |    |
| **Balance September 30, 2003**                                                     |   | **2,990,103**           | ** ** | **$**               | **11,698** | ** **             | **$**  | **10,566**                       | ** ** | **$**                                 | **117** | ** ** | **$** | **22,381** | ** ** |

 

7

----

 

**Note 1.****          CONSOLIDATED FINANCIAL STATEMENTS**

 

In the opinion of Management, the un-auditedconsolidated condensed financial statements contain all (consisting of onlynormal recurring adjustments) adjustments necessary to present fairly HeritageOaks Bancorp’s (the “Company”) consolidated financial position at September 30,2003 and results of cash flows for the nine months ended September 30, 2002 and2003 and the results of operation for the three and nine months ended September30, 2002 and 2003.

 

Certain information and footnote disclosuresnormally presented in financial statements prepared in accordance withgenerally accepted accounting principles have been omitted. These interimconsolidated condensed financial statements should be read in conjunction withthe consolidated financial statements and notes thereto included in the Company’s2002 Annual Report to shareholders. The results for the three and nine monthsended September 30, 2002 and 2003 may not necessarily be indicative of theoperating results for the full year.

 

**Note 2.****          INVESTMENTSECURITIES**

 

In accordance with SFAS No. 115 “Accountingfor Certain Investments in Debt and Equity Securities”, which addresses theaccounting for investments in equity securities that have a readilydeterminable fair values and for investments in all debt securities, securitiesare classified in three categories and accounted for as follows: debit andequity securities that the Company has the positive intent and ability to holdto maturity are classified as held-to-maturity and are measured at amortizedcost; debt and equity securities bought and held principally for the purpose ofselling in the near term are classified as trading securities and are measuredat fair value, with the unrealized gains and losses included in earnings; debtand equity securities not classified as either held-to-maturity or tradingsecurities are deemed as available-for-sale and are measured at fair value,with the unrealized gains and losses, net of applicable taxes, reported in aseparate component of stockholders’ equity. Any gains and losses on sales ofinvestments are computed on a specific identification basis.

 

The amortized cost and fair values of investment securities availablefor sale at September 30, 2003 and December 31, 2002 were:

 
| **September 30, 2003****(in thousands)**                  |   | **Amortized  Cost** |       | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |       | **Fair  Value** |     |
|-----------------------------------------------------------|--------|---------------------|------------|------------------------------|--------|-------------------------------|------------|-----------------|----------|
|                                                      |   |                |       |                         |   |                          |       |            |     |
| Obligations  of U.S. government agencies and corporations |   | $                   | 541        |                         | $      | —                        |       | $               | (16      | ) | $ | 525 |   |
| Mortgage-backed  securities                               |   | 28,366              |       | 231                          |   | (62                           | )          | 28,535          |     |
| Obligations  of State and Political Subdivisions          |   | 10,289              |       | 239                          |   | (196                          | )          | 10,332          |     |
| Other  Securities                                         |   | 9                   |       | 0                            |   | 0                             |       | 9               |     |
| **TOTAL**                                                 |   | **$**               | **39,205** | ** **                   | **$**  | **470**                       | ** ** | **$**           | **(274** | **)** | **$** | **39,401** | ** ** |

** **
| **December 31,2002****(in thousands)**                    |   | **Amortized  Cost** |       | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |       | **Fair  Value** | ** ** |
|-----------------------------------------------------------|--------|---------------------|------------|------------------------------|--------|-------------------------------|------------|-----------------|------------|
|                                                      |   |                |       |                         |   |                          |       |            | ** ** |
| Obligations  of U.S. government agencies and corporations |   | $                   | 817        |                         | $      | 1                             |       | $               | (19        | ) | $ | 799 |   |
| Mortgage-backed  securities                               |   | 54,480              |       | 778                          |   | (5                            | )          | 55,253          |       |
| Obligations  of State and Political Subdivisions          |   | 9,154               |       | 247                          |   | (66                           | )          | 9,335           |       |
| Other  Securities                                         |   | 9                   |       | 0                            |   | 0                             |       | 9               |       |
| **TOTAL**                                                 |   | **$**               | **64,460** | ** **                   | **$**  | **1,026**                     | ** ** | **$**           | **(90**    | **)** | **$** | **65,396** | ** ** |

 

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**Note 3. LOANS AND ALLOWANCE FOR LOAN LOSSES**

 

Note 3: Loans and Reserve for Possible LoanLosses

 

Major classifications of loans were:

(in thousands)

 
|                                     |   | **December  31,  2002** |    | **September  30,  2003** |   |
|------------------------------------------|--------|-------------------------|---------|--------------------------|--------|
|                                     |   |                    |    |                     |   |
| Commercial,  financial, and agricultural |   | $                       | 40,373  |                     | $      | 35,882 |   |
| Real  estate-construction                |   | 30,773                  |    | 32,323                   |   |
| Real  estate-mortgage                    |   | 116,759                 |    | 148,015                  |   |
| Installment  loans to individuals        |   | 2,291                   |    | 1,980                    |   |
| All other  loans (including overdrafts)  |   | 273                     |    | 192                      |   |
|                                     |   | 190,469                 |    | 218,392                  |   |
|                                     |   |                    |    |                     |   |
| Less -  deferred loan fees, net          |   | (822                    | )       | (800                     | )      |
| Less -  reserve for possible loan losses |   | (2,336                  | )       | (2,748                   | )      |
|                                     |   |                    |    |                     |   |
| Total loans                              |   | $                       | 187,311 |                     | $      | 214,844 |   |
|                                     |   |                    |    |                     |   |
| Loans Held  For Sale                     |   | $                       | 8,166   |                     | $      | 8,578 |   |

 

Concentrationof Credit Risk

At September 30, 2003, approximately $ 180.3million of the Bank’s loan portfolio was collateralized by various forms ofreal estate. Such loans are generally made to borrowers located in San LuisObispo and Santa Barbara Counties. The Bank attempts to reduce itsconcentration of credit risk by making loans which are diversified by projecttype. While Management believes that the collateral presently securing thisportfolio is adequate, there can be no assurances that significantdeterioration in the California real estate market would not expose the Bank tosignificantly greater credit risk.

 

At September 30, 2003, the Bank wascontingently liable for letters of credit accommodations made to its customertotaling approximately $2.3 million and un-disbursed loan commitments in theapproximate amount of $87.0 million. The Bank makes commitments to extendcredit in the normal course of business to meet the financing needs of itscustomers. Commitments to extend credit are agreement to lend to a customer aslong as there is no violation of any condition established in the contract.Commitments generally have fixed expiration dates or other termination clausesand may require payment of a fee. Since many of the commitments are expected toexpire without being drawn upon, the total outstanding commitment amount doesnot necessarily represent future cash requirements. Standby letters of creditwritten are conditional commitments issued by the Bank to guarantee theperformance of a customer to a third party. The credit risk involved in issuingletters of credit is essentially the same as that involve in extending loanfacilities to customers. The Bank anticipates no losses as a result of suchtransactions.

 

Allowance forLoan Losses

An allowance for loan losses has beenestablished by management to provide for those loans that may not be repaid intheir entirety for a variety of reasons. The allowance is maintained at a levelconsidered by management to be adequate to provide for probable incurredlosses. The allowance is increased by provisions charged to earnings and isreduced by charge-offs, net of recoveries. The provision for loan losses isbased upon past loan loss experience and management’s evaluation of the loanportfolio under current economic conditions. Loans are charged to the allowancefor loan losses when, and to the extent, they are deemed by management to beun-collectible. The allowance for loan losses is composed of allocations forspecific loans and a historical portion for all other loans.

 

9

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An analysis of the changes in the reserve for possible loan losses isas follows:

 
| **(in  thousands)**                         |   | **December  31,  2002** |   | **September  30,  2003** | ** ** |
|---------------------------------------------|--------|-------------------------|--------|--------------------------|------------|
|                                        |   |                    |   |                     |       |
| Balance at  beginning of year               |   | $                       | 1,744  |                     | $          | 2,336 |   |
| Additions  charged to operating expense     |   | 545                     |   | 325                      |       |
| Loans  charged off                          |   | (82                     | )      | (145                     | )          |
| Recoveries  of loans previously charged off |   | 129                     |   | 232                      |       |
| Balance at  end of year                     |   | $                       | 2,336  |                     | $          | 2,748 |   |

 

The Bank recognized that credit losses willbe experienced and the risk of loss will vary with, among other things, generaleconomic conditions; the type of loan being made; the creditworthiness of theborrower over the term of the loan and in the case of a collateralized loan,the quality of the collateral for such loan. The allowance for loan lossrepresents the Bank’s estimate of the allowance necessary to provide forprobable incurred losses in the portfolio. In making this determination, theBank analyzes the ultimate collectibility of the loans in its portfolio byincorporating feedback provided by internal loan staff, an independent loanreview function, and information provided by examinations performed byregulatory agencies. The Bank makes monthly evaluations as to the adequacy ofthe allowance for loan losses.

 

The analysis of the allowance for loan losses is comprised of threecomponents; specific credit allocation; general portfolio allocation; andsubjectively by determined allocation. Effective January 1, 1995, the Bankadopted Statement of Financial Accounting Standards No.114, Accounting byCreditors for Impairment of a Loan (SFAS 114), as amended by SFAS No. 118,Accounting by Creditors for Impairment of a Loan - Income Recognition andDisclosures. These pronouncements provide that when it is probable that acreditor will be unable to collect all amounts due in accordance with the termsof the loan that such loan is deemed impaired. Impaired loans are accounted fordifferently in that the amount of the impairment is measured and reflected inthe records of the creditor. Theallowance for credit losses related to loans that are identified for evaluationin accordance with Statement 114 is based on discounted cash flows using theloan’s initial effect interest rate or the fair value of the collateral forcertain collateral dependent loans. The general portfolio allocation consistsof an assigned reserve percentage based on the credit rating of the loan. Thesubjective portion is determined based on loan history and the Bank’s evaluationof various factors including current economic conditions and trends in theportfolio including delinquencies and impairment, as well as changes in thecomposition of the portfolio.

 

The allowance for loan losses is based onestimate, and ultimate losses will vary from current estimates. These estimatesare reviewed monthly, and as adjustments, either positive or negative, becomenecessary, a corresponding increase or decrease is made in the provision forloan losses. The methodology used to determine the adequacy of the allowancefor possible loan losses for the third quarter of 2003 is consistent with priorperiods.

 

The Bank’s provision for loan losses was$150,000 for the third quarter of 2002, compared to $75,000 for the same periodin 2003. During the third quarter of 2003, the bank received a loan recovery inthe approximate amount of $159,000. This recovery was for a loan charged off in2000. For the nine months ending September 30, 2002, the provision for losseswas $435,000 compared to $325,000 for the same period in 2003.

 

The allowance for loan losses as a percentageof total net loans was 1.28% as of September 30, 2003 and 1.25% as of December31, 2002. Management believes that the allowance for credit losses at September30, 2003 is prudent and warranted, based on information currently available.

 

Non-Accrualand Non-Performing Loans

Loan on non-accrual status totaled $1,345,755and $792,489 at December 31, 2002 and September 30, 2003, respectively.Typically, these loans have adequate collateral protection and/or personalguaranties to provide a

 

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source of repayment to the Bank. Most of theloans on non-accrual are related to several commercial loans that are beingaddressed by specific workout plans at this time. Interest income that wouldhave been recognized on non-accrual loans if they had performed in accordancewith the terms of the loans was approximately $134,508 and $90,034 for theperiod ended December 31, 2002 and September 30, 2003, respectively.

 

Non-performing loans include non-accrualloans and accruing loans that are 90 days or more delinquent. The Bank had noloans that were 90 days or more delinquent at December 31, 2002 and $5,045 atSeptember 30, 2003 that were still accruing interest.

 

Non-performing loans were .40% and .24% oftotal assets as of December 31, 2002 and September 30, 2003, respectively. Theallowance for loan loss to non-performing loans was 1.74x and 3.47x at December31, 2002 and September 30, 2003, respectively.

 

**Note4.****          EARNINGSPER SHARE**

 

Basic earnings per share are based on theweighted average number of shares outstanding before any dilution from commonstock equivalents. Diluted earnings per share reflects the potential dilutionthat could occur if securities or other contract to issue common stock wereexercised or converted into common stock or resulted in the issuance of commonstock that then shares in the earnings of the entity.

 

On July 19, 2002, the Company announced thatthe Board of Directors of the Company approved a two-for-one stock split. Therecord date for the stock split was August 2, 2002 and the pay date was August15, 2002. Holders of shares of common stock of Heritage Oaks Bancorp wereissued one additional share of common stock for each share of common stockowned on the record date of August 2, 2002.

 

On March 4, 2003, the Company announced thatthe Board of Directors of the Company approved a 5% stock dividend. The recorddate for the stock dividend was March 14, 2003 and the pay date was March 28,2003.

 

Share information has been retroactivelyadjusted for the two-for-one stock split in August 2002 and the 5% stockdividend in March 2003.

 

Earnings per share and total number of sharesused for calculating basic earnings per share for the three months endedSeptember 30, 2002 and 2003, were $.23 and $.31 and 2,908,525 and 2,968,667,respectively. Earnings per share and total number of shares used forcalculating diluted earnings per share for the three months ended September 30,2002 and 2003, were $.21 and $.29 and 3,148,107 and 3,158,788, respectively.

 

Earnings per share and total number of sharesused for calculating basic earnings per share for the nine months endedSeptember 30, 2002 and 2003, were $.65 and $.89 and 2,888,718 and 2,944,769,respectively. Earnings per share and total number of shares used forcalculating diluted earnings per share for the nine months ended September 30,2002 and 2003, were $.60 and $.83 and 3,150,048, and 3,145,112, respectively.

 

The following table illustrates the effect on net income and earningsper share if the Company had applied the fair value recognition provision ofSFAS 123, Accounting for Stock Based Compensation, to stock based employeecompensation:

 

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|                                                                                            |   | **Three Months Ended** |   | **Nine Months Ended**  |   |
|-------------------------------------------------------------------------------------------------|--------|------------------------|--------|------------------------|--------|
|                                                                                            |   | **September 30, 2002** |   | **September 30, 2003** |   | **September 30, 2002** |   | **September 30, 2003** |   |
|                                                                                            |   | **(In Thousands)**     |   |
| Net income:                                                                                     |   |                   |   |                   |   |   |   |   |   |
| As reported                                                                                     |   | $                      | 676    |                   | $      | 916 |   | $ | 1,875 |   | $ | 2,620 |   |
| Stock-based compensation  using the intrinsic value method                                      |   | —                 |   | —                 |   | — |   | — |   |
| Stock-based compensation  that would have been reported using the fair value method of SFAS 123 |   | (54                    | )      | (10                    | )      | (104 | ) | (67 | ) |
| Pro forma net income                                                                            |   | $                      | 622    |                   | $      | 906 |   | $ | 1,771 |   | $ | 2,553 |   |
|                                                                                            |   |                   |   |                   |   |   |   |   |   |
| Weighted Average Shares  Outstanding - Basic                                                    |   | 2,909                  |   | 2,969                  |   | 2,889 |   | 2,945 |   |
| Weighted Average Shares  Outstanding - Diluted                                                  |   | 3,148                  |   | 3,159                  |   | 3,150 |   | 3,145 |   |
|                                                                                            |   |                   |   |                   |   |   |   |   |   |
| Basic Earnings per share                                                                        |   |                   |   |                   |   |   |   |   |   |
| As reported                                                                                     |   | $                      | 0.23   |                   | $      | 0.31 |   | $ | 0.65 |   | $ | 0.89 |   |
| Pro forma                                                                                       |   | $                      | 0.21   |                   | $      | 0.31 |   | $ | 0.61 |   | $ | 0.87 |   |
|                                                                                            |   |                   |   |                   |   |   |   |   |   |
| Earnings per share -  assuming dilution                                                         |   |                   |   |                   |   |   |   |   |   |
| As reported                                                                                     |   | $                      | 0.21   |                   | $      | 0.29 |   | $ | 0.60 |   | $ | 0.83 |   |
| Pro forma                                                                                       |   | $                      | 0.20   |                   | $      | 0.29 |   | $ | 0.56 |   | $ | 0.81 |   |

 

**Note 5.****          PREMISE**

 

On July 26, 2002, the Bank purchased a parcelof land (approximately 2 acres) on the corner of Niblick and South River Roadsin Paso Robles, Ca. The purchase price was $900,000. It is the intent of theBank to build a full service branch on this parcel and to relocate the existing“Woodland” office, that is currently located at 171 Niblick Road, Paso Robles,Ca. At this time, the Bank anticipates that the building will be approximately5,000 square feet in size and will open in the first quarter of 2004.

 

On July 3, 2003, the Bank closed escrow to purchase real propertylocated at 500 13th Street, Paso Robles, Ca. This property islocated directly adjacent to the Bank’s Headquarters. The purchase price was$1.1 million. It is the Bank’s intention to either remodel and expand the existingbuilding or to build a new structure on the site to allow for the consolidationof all Administrative functions of the Bank within the new facility. The Bankanticipates that this project will be complete in the second quarter of 2005.

 

**Note 6.****          ISSUANCEOF TRUST PREFERRED SECURITIES**

 

On April 10, 2002, the Companycompleted its offering of trust preferred securities in the amount of $8.0million. The securities were issued by a special purpose business trust formedby the Company and were sold to a pooled investment vehicle sponsored bySandler O’Neill & Partners, L.P. and Salomon Smith Barney Inc. in a privatetransaction. The securities were sold pursuant to an applicable exemption fromregistration under the Securities Act of 1933, as amended (the “Act”), and havenot been registered under the Act. Sandler O’Neill assisted the Company in the placement of the trustpreferred securities. The securities may not be offered or sold in the UnitedStates absent registration or an applicable exemption from registrationrequirements.

 

The $8.0 million in trust preferred securities have a floating rate ofinterest, which is reset semi-annually, equal to 6-month LIBOR plus 3.70%.  The floating rate, however, may not exceed11.0% for the first five years.

 

As the result of the issuance of $8.0 million in trust preferredsecurities, on April 11, 2002, the Company down-streamed $5.2 million to theBank in the form of Tier I Capital. This enabled the Bank to implement aninvestment strategy of $38 million whereby the Bank borrowed $38 million fromthe Federal Home Loan Bank (FHLB) and purchased approximately $40 million ininvestment securities. The purchased investment securities serve as collateralfor the borrowing.

 

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**Note7.****          RECENT LEGISLATIVEACTIVITYSARBANES-OXLEY ACT OF 2002**

 

On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Actof 2002 (the “Act”).

 

On August 28, 2002, inaccordance with Section 302 of the Act, the Securities and Exchange Commission(the “SEC”) adopted final rules that require an issuer’s principal executiveand principal financial officer to certify the contents, including thefinancial and other information, of the issuer’s quarterly and annual reports.The rules became effective on August 29, 2002. In addition, the SEC adoptedpreviously proposed rules requiring issuers to maintain, and regularly evaluatethe effectiveness of control and procedures designed to ensure that theinformation required in reports filed under the Securities Exchange Act of 1934is recorded, processed, summarized and reported on a timely basis.

 

A separate provision of the Act (section 906) creates an independentCEO and CFO certification obligation that took effect immediately upon signingthe Act into law and impacted periodic reporting beginning with the June 30,2002 10-QSB. The certification in section 906 provides for a statement that anyperiodic report containing financial statements fully complies with Section13(a) or 15 (d) of the Exchange Act and that the information contained in theperiodic report fairly presents, in all material respects, the financialcondition and results of operation of the public company.

 

The SEC has also recently amended Exchange Act Rules 13a-15 and 15d-15that require an issuer to establish and maintain an overall system ofdisclosure controls and procedures that are adequate to meet its Exchange Actreporting obligations.

 

**Note 8.****          RecentAccounting Pronouncements**

 

In August 2002, the FASB approved, inprinciple, Statement 147 which will replace certain paragraphs in Statement 72,“Accounting for Certain Acquisitions of Banking or Thrift Institutions”. Thenew guidance was effective on September 30, 2002. The requirement in Statement72 to recognize (and amortize) an “unidentifiable intangible asst” when moreliabilities are acquired than assets, such as in a branch purchase that is abusiness combination, will no longer apply. Previously recorded core depositintangibles must continue to be amortized.

 

The Bank acquired four branch offices fromWestamerica Bank in November 2001. The premium, net of fair value for certainassets acquired, was fully accounted for as core deposit intangibles. This coredeposit intangible has and will continue to be amortized over a period of tenyears.

 

Core Deposit Intangible and Goodwill in theapproximate amount of $4.5 million will be created as the result of therecently announced merger transaction with Hacienda Bank (refer to Management’sDiscussion and Analysis, Recent Events). Once finalized, the ultimate amount ofintangible created may vary depending on the fair value assessment of assetsand liabilities acquired on the purchase date.

 

In April 2003, the FASB issued SFAS No. 149,“Amendment of Statement 133 on Derivative Instruments and HedgingActivities.”  SFAS No. 149 amends andclarifies accounting for derivative instruments, including certain derivativeinstruments embedded in other contracts and loan commitments that relate to theorigination of mortgage loans held for sale, and for hedging activities underSFAS No. 133.  SFAS No. 149 is generallyeffective for contracts entered into or modified after June 30, 2003.  The adoption of SFAS No. 149 did not have amaterial impact on the financial condition or operating results of the Company.

 

In May 2003, the FASB issued SFAS No. 150, “Accounting for CertainFinancial Instruments with Characteristics of both Liabilities andEquity.”  SFAS No. 150 establishesstandards for how an issuer classifies and measures certain financialinstruments with characteristics of both liabilities and equity.  It requires that an issuer classify afinancial instrument that is within its scope as a liability (or an asset insome circumstances.)  Many of thoseinstruments were previously classified as equity.  SFAS No. 150 is generally effective for financial instrumentsentered into or modified after May 31, 2003, and otherwise is

 

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effective at the beginning of the first interim period beginning afterJune 15, 2003.  The adoption of SFAS No.150 did not have a material impact on the financial condition or operatingresults of the Company.

 

**Note 9.****          Reclassifications**

 

Certain amounts in the 2002 financial statements have been reclassifiedto conform to the 2003 presentation.

 

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**Certain statementscontained in this Quarterly Report on Form 10-QSB (“Quarterly Report”),including, without limitation, statements containing the words “believes”,“anticipates”, “intends”, “expects”, and words of similar impact, constitute“forward-looking statements” within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities and Exchange Act of1934. Such forward-looking statements involve known and unknown risks,uncertainties and other factors that may cause the actual results, performanceor achievements of the Company to be materially different from any futureresults, performance or achievements expressed or implied by such forward-lookingstatements. Such factors include, among others, the following: general economicand business conditions in those areas in which the Company operates,demographic changes, competition, fluctuations in interest rates, changes inbusiness strategy or development plans, changes in governmental regulation,credit quality, the availability of capital to fund the expansion of theCompany’s business, economic, political and global changes arising from theterrorist attacks of September 11, 2001 and their aftermath and other factorsreferenced in the Company’s filings with the SEC. (Refer to the Company’sDecember 31, 2002 10-KSB, ITEM 1. Description of Business.) The Companydisclaims any obligation to update any such factors or to publicly announce theresults of any revisions to any of the forward-looking statements containedherein to reflect future events or developments.**

 

**ITEM2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OF OPERATIONS**

 

HeritageOaks Bancorp (the “Company”) commenced operations on November 15, 1994 with theacquisition of Heritage Oaks Bank (the “Bank”).  Each shareholder of the Bank received one share of stock in theCompany in exchange for each share of Heritage Oaks Bank stock owned.  The Bank became a wholly owned subsidiary ofthe Company.  The Bank is the onlyactive financial subsidiary owned by the Company. In April 2002, the Companyformed Heritage Oaks Capital Trust I (the “Trust”). The Trust is a statutorybusiness trust formed under the laws of the State Of Delaware and iswholly-owned by the Company.

 

**RECENT EVENTS**

 

Acquisition

OnJune 11, 2003, Heritage Oaks Bancorp (the “Company”), a California corporation,and Hacienda Bank (the “Seller”), a California Banking corporation, enteredinto an Agreement to Merge and Plan of Reorganization (“Agreement”). Subject tothe terms and conditions of the Agreement and the Agreement of Merger, at theEffective time, Seller will become a wholly owned subsidiary of the Company inaccordance with the procedures specified in the California Financial Code (CFC)and the California General Corporation Law (CGCL) by merging with a whollyowned subsidiary of the Company, Heritage Oaks Merger Corp. Seller will be theSurviving Bank in the Merger.

 

The Agreement provides thatshareholders of Hacienda Bank will have the election of receiving Heritage OaksBancorp common stock, cash or a combination in return for their shares ofHacienda Bank stock, provided that cash must constitute not less than 25% normore than 35% of the total consideration issued in the merger. Hacienda Bankshareholders who elect stock will receive 0.5208 in Heritage Oaks Bancorpstock. Hacienda Bank shareholders who elect cash will receive $6.50 cash pershare which is subject to possible upward adjustment up to $6.75 per sharebased on changes in the price of Heritage Oaks Bancorp stock preceding theeffective date of the transaction. The transaction is valued at approximately$9.7 million.  It represents approximately1.71 times Hacienda Bank book value at December 31, 2002 and 22.8 times 2002earnings.  The merger is structured tobe tax-free and is intended to be accounted for as a purchase.  Heritage Oaks Bancorp expects thetransaction to close in the fourth quarter 2003 and is expected to be accretiveto earnings in 2004.

 

TheMerger requires the affirmative approval of the holder of the outstandingshares of the Company and the Seller.

 

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The name of the Surviving Bankshall be “Hacienda Bank.”  Upon theconsummation of the Merger, the separate corporate existence of HOMC shallcease:  All assets, rights, franchises,titles and interests of Seller and HOMC in and to every type of property (real,personal and mixed, including all the right, title and interest to HOMC’snames, trade names, service marks and the like) and choses in action shall betransferred to and vested in Seller by virtue of the Merger without any deed orother transfer, and Seller, without order or action on the part of any court orotherwise, shall hold and enjoy all rights of property, franchises andinterests in the same manner and to the same extent that such rights,franchises and interests were held by Seller and HOMC at the effective time ofthe Merger.  At the Effective Time,Seller shall be liable for all liabilities of Seller and HOMC, and all debts,liabilities, obligations and contracts of Seller and HOMC, whether matured orun-matured, accrued, absolute, contingent or otherwise, and whether or notreflected or reserved against on balance sheets, books of accounts or recordsof Seller and Bank, shall be those of Seller; and all rights of creditors orother obligees and all liens on property of Seller and HOMC shall be preservedunimpaired.

 

Hacienda Bank, Heritage OaksBank and Heritage Oaks Bancorp are all well-capitalized as of September 30,2003 and it is the intent to remain well-capitalized on the effective date ofthe transaction.

 

The acquisition was finalized on the close of business October 31,2003. Hacienda Bank shareholders elected , after application of applicable proration provisions, to receive 75% of the consideration in stock and 25% incash. The Company will issue approximately 602,485 shares to the formerHacienda Bank shareholders and approximately $2.6 million in cash.

 

The September 30, 2003 financial results for the Company do not includeHacienda Bank’s financial results.

 

On July 15, 2003, the Company received a commitment letter from PacificCoast Bankers Bank for a revolving line of credit in the amount of $3.5million. The Company will pledge 339,332 shares or 51% of its stock in HeritageOaks Bank as collateral. The funds were used in the acquisition of HaciendaBank for payment to shareholders who elect cash and/or Tier I capital in theform of Surplus to its financial subsidiaries.

 

**CRITICAL ACCOUNTINGPOLICIES**

 

The Company’s significantaccounting policies are set forth in note 1 of the consolidated financialstatements as of December 31, 2002 which was filed on Form 10-KSB. Of thesesignificant accounting policies, the Company considers its policy regarding theallowance for loan losses to be its most critical accounting policy, because itrequires management’s most subjective and complex judgments.  In addition, changes in economic conditionscan have a significant impact on the allowance for loan losses and thereforethe provision for loan losses and results of operations. The Company hasdeveloped appropriate policies and procedures for assessing the adequacy of theallowance for loan losses, recognizing that this process requires a number ofassumptions and estimates with respect to its loan portfolio. The Company’sassessments may be impacted in future periods by changes in economicconditions, the impact of regulatory examinations, and the discovery ofinformation with respect to borrowers, which is not known to management at thetime of the issuance of the consolidated financial statements. Refer to “Note3. Allowances for Loan Losses” found elsewhere in this document for a detailedexplanation of the Company’s assessment.

 

**FINANCIAL CONDITION**

 

As of September 30, 2003, total consolidatedassets of Heritage Oaks Bancorp were $331.8 million compared to $337.3 millionat December 31, 2002. This represents a decrease of 1.66%. The components ofthis decrease are discussed below.

 

Cash and DueFrom Banks

Total cash and due from banks at September 30, 2003 was $24.0 millioncompared to $23.5 million at

 

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December 31, 2002. This line item will vary depending on cash lettersfrom the previous night and actual cash on hand in the branches. The balance inthe Fed account had a closing balance of $8.9 million to meet the target forReserve Requirements.

 

Loans

Total net loans at September30, 2003 were $214.8 million compared to $187.3 million at December 31, 2002.This represents an increase of 14.7%.

 

For the nine months endingSeptember 30, 2003, commercial, financial and agriculture loans decreased by$4.5 million or 11.1%.  The decrease canbe attributed in part to the payoff of a $1 million equipment loan throughrefinance by another lender, the payoff of a $600 thousand line of credit bysale of collateral, the payoff of a $500 thousand equipment loan (refinance)and the payoff of several agricultural loans. Borrowers have also been hesitant to use credit lines due to economicuncertainties and the risks associated with business expansions.

 

Real estate-construction loans increased by$1.6 million or 5.0%.  The increase canbe attributed to several large construction loans booked in late 2002 and early2003 now underway with funds drawn. Additionally, numerous single family construction loans have been madeand are funding as building progresses. These loans are spread throughout our market area with the majority inthe North County and the North Coast communities. Approximately 72% of theconstruction loans are commercial properties with 22% being 1-4 familyresidential and the balance is a condo project. Commercial construction loansare typically drawn for a 12 month period. When construction is complete, the loans are typically termed out over25 years with 10 or 15 year maturities. Interest rates are tied to the prime rate and range from fully variableto fixed rates for 2-3 year periods. Rates are dictated by the borrower/projectstrength and by competitive pressures.

 

Real estate-mortgage loans increased by $31.2million or 26.8%. Many new commercial real estate loans have been madeincluding a $1.6 million mini-storage loan, a $3.3million office/retailbuilding loan, a $3.2 million motel loan, a $1.9 million industrial propertyloan and 2 motels for $2.8 million to one borrower.  In addition, construction was finished on 2 hotels, one for $4million and one for $2.4 million, and the loans were converted to amortizingmortgages.  These loans combined withseveral smaller loans contributed to the increase in real estate-mortgageloans. These loans are typically amortized over 25 years with 10 or 15 yearmaturities.  Interest rates are tied toprime rate and range from fully variable to adjusting every 2-3 years.  A few have been fixed for 5 year periods.

 

Loans held for sale increased to $8.6 millionat September 30, 2003 from $8.2 million at December 31, 2002. Typically, loansheld for sale are sold within 30 days of funding.

 

Securities

The Company manages its securities portfolioto provide a source of both liquidity and earnings. The Bank has anasset/liability committee that develops current investment policies based uponits operating needs and market circumstance. The Bank’s investment policy isformally reviewed and approved annually by its board of directors. Theasset/liability committee of the Bank is responsible for reporting andmonitoring compliance with the investment policy. Reports are provided to theBank’s board of directors on a regular basis.

 

Securities available-for-sale are carried atfair value, with related unrealized net gains or losses, net of deferred incometaxes, recorded as an adjustment to equity capital. As of September 30, 2003,net unrealized gains decreased $445 thousand from an unrealized gain of $562thousand at December 31, 2002 to an unrealized gain of $117 thousand.

 

As the result of the issuance of $8.0 million in trust preferredsecurities, in April 2002, the Company down-streamed $5.2 million to the Bankin the form of Tier I Capital. This enabled the Bank to implement an investmentstrategy whereby the Bank borrowed $38 million from the Federal Home Loan Bank(FHLB) and purchased approximately $40 million in investment securities. Thepurchased investment securities

 

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serve as collateral for $19 million of the remaining borrowing. TheBank made this decision knowing that it would improve the return on averageequity by increasing the net interest income in absolute terms even though itwould reduce the return on average assets and the net interest margin as apercentage. Prior to investing, the Bank performed extensive due diligence inassessing the interest rate and market value risk of this strategy includingthe performance in various interest rate scenarios of up and down 100, 200 and300 basis points. Management believes that the 300 basis points variances wouldnot have a material effect on the overall interest rate and market value risksto the Company.

 

Securities available-for-sale decreased to$39.4 million at September 30, 2003 from $65.4 million at December 31, 2002.This represents a decrease of $26.0 million or 39.8%. When executing the investmentstrategy in April 2002, all of the securities purchased were either MortgagedBacked Securities (MBS) or Collateralized Mortgage Obligations (CMO).Securities backed by mortgage collateral have experienced acceleratedpre-payments due to the low interest rate environment. As cash flows come tothe Bank in the form of accelerated pre-payments, they are being usedpredominantly to fund loan demand.

 

At September 30, 2003, available-for-sale securities in the portfolioincluded obligations of state and political subdivisions, obligations of USgovernment agencies and corporations and mortgaged backed securities issued byvarious agencies.

 

All fixed and adjustable rate mortgage pools contain a certain amountof risk related to the uncertainty of prepayments of the underlying mortgages.Interest rate changes have a direct impact upon prepayment rates. The Bank usescomputer simulation models to test the average life, duration, marketvolatility and yield volatility of adjustable rate mortgage pools under variousinterest rate assumptions to monitor volatility. Stress tests are performedquarterly.

 

Federal FundsSold

Federal funds sold were $25.7 million atSeptember 30, 2003 compared to $37.0 million at December 31, 2002. The primaryreason for retaining these large over night investments is due to the volatilenature of certain deposit relationships that are related to the current robustmortgage business. These relationships are discussed in more detail under“Deposits and Borrowed Funds”.

 

Deposits and BorrowedFunds

Total deposits were $270.3 million atSeptember 30, 2003 compared to $264.2 million at December 31, 2002. Thisrepresents an increase of $6.1 million or 2.3%.

 

At September 30, 2003, approximately $48.6 million of demand depositswere held by three, long time customers of the Bank all of whom transact inmortgage related business’. These same customers had balances of $59.6 millionin demand deposits at December 31, 2002. The decrease of $11 million for thesecustomers is directly related to the upward movement of long-term rates duringmost of the third quarter of 2003. It has been well documented that the realestate re-finance market slowed measurably during this time. These volatileaccount relationships are included in the volatile liability dependency reportthat the Bank produces on a monthly basis. Management and the Board ofDirectors of the Bank are keenly aware that when the mortgage market conditionschange, these relationships are impacted. This is the primary reason for thelarge balances maintained in over night investing in Federal Funds Sold.  Even with this $11 million decrease, demanddeposits increased overall by $5.3 million. This growth is attributed to theBank’s presence in its primary market area and continued marketing efforts.

 

Savings, NOW and money market deposits were $111.4 million at September30, 2003 compared to $112.6 million at December 31, 2002. This represents adecrease of $1.2 million or 1.0%. NOW accounts increased approximately $600thousand and savings $1.5 million for the first nine months of 2003. Moneymarket accounts decreased $3.3 million during the same period. This decrease iswithin the non-personal category of money market deposits.

 

Time deposits of  >$100,000and <$100,000 increased by approximately $900 thousand and $1.0 million,

 

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respectively.

 

Core deposits, (time deposits less than$100,000, demand, and savings) gathered in the local communities served by theBank continue to be the Bank’s primary source of funds for loans andinvestments.  Core deposits of $261.2million represented 96.6% of total deposits at September 30, 2003. The Companydoes not purchase funds through deposit brokers.

 

The Bank has established borrowing lines with the FederalHome Loan Bank (FHLB) of approximately $11.5 million and $24 million secured byloans and securities, respectively. At September 30, 2003, the Bank hadborrowings of $28.5 million against those lines. The $28.5 million borrowingconsists of $9.5 million maturing in April 2004 and $19 million maturing inApril 2005. On February 22, 2003, the Bank repaid $9.5 million to the FHLB thatmatured on April 24, 2003. The cost of the pre-payment penalty plus lostopportunity income in the form of Fed Funds Sold resulted in less than $500 ofcost to the Bank.

 

The Bank utilizes securities sold under repurchaseagreements as a source of funds.  TheBank had $355 thousand in securities sold under repurchase agreements atSeptember 30, 2003 compared to $258 thousand at December 31, 2002.

 

CapitalResources

 

On March 4, 2003, the Companyannounced that the Board of Directors of the Company approved a 5% stockdividend. The record date for the stock dividend was March 14, 2003 and the paydate was March 28, 2003. A press release was issued on March 4, 2003.

 

On July 19, 2002, the Board of Directors of theCompany declared a two for one (2 for 1) stock split.  The record date for the stock split was August 2, 2002 and thepay date was August 15, 2002.  Holdersof shares of common stock of Heritage Oaks Bancorp were issued one additionalshare of common stock for each share of common owned on the record date ofAugust 2, 2002. A Press Release was issued on July 19, 2002.

 

In April 2002, the Company completed its offering of trust preferredsecurities in the amount of $8.0 million. The securities were issued by aspecial purpose business trust formed by the Company and were sold to a pooledinvestment vehicle sponsored by Sandler O’Neill & Partners, L.P. andSalomon Smith Barney Inc. in a private transaction. The securities were soldpursuant to an applicable exemption from registration under the Securities Actof 1933, as amended (the “Act”), and have not been registered under theAct.  Sandler O’Neill assisted theCompany in the placement of the trust preferred securities. The securities maynot be offered or sold in the United States absent registration or anapplicable exemption from registration requirements.

 

The $8.0 million in trust preferred securities have a floating rate ofinterest, which is reset semi-annually, equal to 6-month LIBOR plus 3.70%.  The floating rate, however, may not exceed11.0% for the first five years.

 

The Company is reflecting the trust preferred securities as financingdebt on its consolidated balance sheet.

 

If the Company elects to defer interest payments pursuant to terms ofthe agreement, then the Company may not (i) declare or pay any dividends ordistributions on, or redeem, purchase, acquire or make a liquidation paymentwith respect to any of the Company’s capital stock, or (ii) make any payment ofprincipal of or premium, if any, or interest on or repay, repurchase or redeemany debt securities of the Company that rank pari passu with or junior ininterest to the Debt Securities, **otherthan,**among other items**,**adividend in the form of stock, warrants, options or other rights in the samestock as that on which the dividend is being paid or ranks pari passu with orjunior to such stock. The prohibition on payment of dividends and payments onpari passu or junior debt also applies in the case of an event of default under

 

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the agreements.

 

The Company used the proceeds from the sale of thesecurities for general corporate purposes, including the repayment ofoutstanding indebtedness of $1.8 million on April 11, 2002 and capitalcontributions to the Bank for future growth.

 

The Company issued a press release announcing the saleon April 10, 2002.

 

The Company’s total stockholders equity was $22.4 million at September30, 2003 compared to $19.8 million at December 31, 2002. The increase incapital was from net income of $2.6 million, $.4 million from stock optionsexercised and common stock issued, $.4 million net change in other comprehensiveincome related to unrealized security holding gain, net of tax.

 

On July 15, 2003, the Company received a commitment letter from PacificCoast Bankers Bank for a revolving line of credit in the amount of $3.5million. The Company will pledge approximately 339,332 shares or 51% of itsstock in Heritage Oaks Bank as collateral. The funds will be used (i) in theacquisition of Hacienda Bank for payment to shareholders who elect cash and/or(ii) to infuse Tier I capital in the form of Surplus to its banking subsidiaries.

 

Capital ratios for commercial banks in the United States are generallycalculated using several different formulas. These calculations are referred to as the “Leverage Ratio” and two “riskbased” calculations known as: “Tier One Risk Based Capital Ratio” and the“Total Risk Based Capital Ratio.”  These standards were developed through joint efforts of bankingauthorities from 12 different countries around the world.  The standards essentially take into accountthe fact that different types of assets have different levels of riskassociated with them.  Further, theytake into account the off-balance sheet exposures of banks when assessingcapital adequacy.

 

The Leverage Ratio calculation simply divides common stockholdersequity (reduced by any Goodwill a bank may have) by the total average assets ofthe bank.  In the Tier One Risk BasedCapital Ratio, the numerator is the same as the leverage ratio, but thedenominator is the total “risk-weighted assets” of the bank.  Risk weighted assets are determined bysegregating all the assets and off balance sheet exposures into different riskcategories and weighing them by a percentage ranging from 0% (lowest risk) to100% (highest risk).  The Total RiskBased Capital Ratio again uses “risk-weighted assets” in the denominator, butexpands the numerator to include other capital items besides equity such as alimited amount of the loan loss reserve, long-term capital debt, preferredstock and other instruments.

 

Summarizedbelow are the Bank’s and Company’s capital ratios at September 30, 2003:

** **
|                               |   | **Regulatory  Standard** |   | **Heritage  Oaks  Bank** |   | **Heritage  Oaks  Bancorp** |   |
|------------------------------------|--------|--------------------------|--------|--------------------------|--------|-----------------------------|--------|
| **Adequately  Capitalized**        |   | **Well  Capitalized**    |
| Leverage Ratio                     |   | 4.00                     | %      | 5.00                     | %      | 8.21                        | %      | 8.58 | % |
|                               |   |                     |   |                     |   |                        |   |   |   |
| Tier One Risk Based  Captial Ratio |   | 4.00                     | %      | 6.00                     | %      | 10.60                       | %      | 11.09 | % |
|                               |   |                     |   |                     |   |                        |   |   |   |
| Total Risk Based Captial  Ratio    |   | 8.00                     | %      | 10.00                    | %      | 11.69                       | %      | 12.56 | % |

 

For the Company, approximately $7.0 million and $1.0 million of thetrust preferred securities are accounted for as Tier I and Tier II Capital, respectively,for purposes of calculating Regulatory Capital.

 

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**RESULTS OF OPERATIONSFOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2001 AND 2002**

 

The Company reported net income for the ninemonths ended September 30, 2003 of $2.6 million compared to $1.9 millionfor the same period in 2002. Per share earnings on a diluted basis for the ninemonths ending September 30, 2003 and September 30, 2002 were $.83 and $.60,respectively. Basic per share earnings for the nine months ending September 30,2003 and September 30, 2002 were $.89 and $.65, respectively.

 

Return on Average Assets (ROA) and Return onAverage Equity (ROE) was 1.07% and 16.38%, respectively, based on annualizingthe first nine months of earnings for September 30, 2003. This compares toReturn on Average Assets (ROA) and Return on Average Equity (ROE) of .96% and14.70%, respectively, based on annualizing the first nine months of earningsfor September 30, 2002.

 

Net income for the three months endingSeptember 30, 2003 was $916 thousand, compared to $676 thousand for the sameperiod in 2002. Per share earnings on a diluted basis for the three monthsending September 30, 2003 and September 30, 2002 were $.29 and $.21,respectively. Basic per share earnings for the three months ending September30, 2003 and September 30, 2002 were $.31 and $.23, respectively.

 

Increased year-to-date earnings are theresult of the Bank’s efforts to maintain a favorable net interest margin duringthe very challenging interest rate environment experienced this year. Inaddition to this, the efficiency ratio for the Company improved to 66.4% from70.6% for the nine months ending September 30, 2003 and 2002, respectively.

 

The following discussion highlights changes incertain items in the consolidated statements of income.

 

# **NetInterest Income**

Net interest income, the primary component ofthe net earnings of a financial institution, refers to the difference betweenthe interest paid on deposits and borrowings, and the interest earned on loansand investments.  The net interestmargin is the amount of net****interestincome expressed as a percentage of average earning assets.  Factors considered in the analysis of netinterest income are the composition and volume of earning assets andinterest-bearing liabilities, the amount of non-interest bearing liabilitiesand non-accrual loans, and changes in market interest rates.

 

Net interest income for the nine monthsending September 30, 2003 was $10.5 million compared to $9 million for the sameperiod in 2002. This represents an improvement of $1.5 million or 17.0%. As apercentage of average earning assets, the net interest margin for the firstnine months of 2003 decreased to 4.81% from 5.17% for the same period one yearearlier. This decrease in net interest margin is the direct result of the 50basis point decrease in prime rate in November 2002 and an additional decreaseof 25 basis points on June 25, 2003. If the volume of earning assets continuesto increase at present growth rates, the Company anticipates that the amount ofnet interest income will rise even if the net interest margin narrows .

 

For the first nine months of 2003, theaverage yield on interest earning assets decreased 56 basis points from thesame period in 2002 while the average rate on interest bearing liabilitiesdecreased by 22 basis points from the same period in 2002. The increase in netinterest income for the nine months ending September 30, 2003 compared to thesame period in 2002 is due to the volume increase of $59.3 million in averageinterest earning assets at an average rate of 6.00% while interest bearingliabilities increased by $30.1 million at an average rate of 1.82%.

 

Net interest income for the three monthsending September 30, 2003 was $3.6 million compared to $3.1 million for thesame period in 2002. This represents an increase of $500 thousand or 15.6%.Interest income was $4.4 million and $4.2 million for the three months endingSeptember 30, 2003 and 2002,

 

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respectively. Increased interest income wasprimarily the result of higher outstanding loan average balances. Interestexpense for this three month period was $776 thousand at September 30, 2003compared to $1.1 million at September 30, 2002. Interest expense decreased dueto the early payoff of $9.5 million borrowing with the FHLB. This borrowingmatured on April 25, 2003 but was repaid in February 2003.

 

The following table sets forth the averagebalance sheet information, interest income and expense, average yields andrates and net interest income and margin for the nine months ended September30, 2003 and 2002.

 

**AVERAGE BALANCE SHEET INFORMATION FOR SEPTEMBER 30,(dollars in thousands)**

 
|                                                                                                                                |   | **2002**             |    | **2003**                     |   |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------|---------|------------------------------|--------|
|                                                                                                                                |   | **Average  Balance** |    | **Average Yield  Rate Paid** |   | **Amount  Interest** |   | **Average  Balance** |   | **Average  Yield  Rate Paid** |   | **Amount  Interest** |   |
| Interest Earning Assets:                                                                                                            |   |                 |    |                         |   |   |   |   |   |   |   |   | ** ** |
| Time deposits with other  banks                                                                                                     |   | $                    | 135     |                         | 2.97   | % | $ | 3 |   | $ | 595 |   | 2.02 | % | $ | 9 |   |
| Investment securities  taxable                                                                                                      |   | 39,100               |    | 4.61                         | %      | 1,349 |   | 44,118 |   | 3.53 | % | 1,165 |   |
| Investment securities  non-taxable                                                                                                  |   | 5,839                |    | 4.79                         | %      | 209 |   | 10,035 |   | 4.52 | % | 339 |   |
| Federal funds sold                                                                                                                  |   | 19,270               |    | 1.64                         | %      | 236 |   | 21,413 |   | 1.06 | % | 169 |   |
| Loans (1) (2)                                                                                                                       |   | 167,886              |    | 7.65                         | %      | 9,600 |   | 215,368 |   | 7.08 | % | 11,401 |   |
|                                                                                                                                |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| Total interest earning  assets                                                                                                      |   | 232,230              |    | 6.56                         | %      | 11,397 |   | 291,529 |   | 6.00 | % | 13,083 |   |
|                                                                                                                                |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| Allowance for possible  loan losses                                                                                                 |   | (2,016               | )       |                         |   |   |   | (2,530 | ) |   |   |   |   |
| Non-earning assets:                                                                                                                 |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                                                                                                             |   | 17,986               |    |                         |   |   |   | 21,057 |   |   |   |   |   |
| Property, premises and  equipment                                                                                                   |   | 3,772                |    |                         |   |   |   | 5,086 |   |   |   |   |   |
| Other assets                                                                                                                        |   | 9,207                |    |                         |   |   |   | 10,210 |   |   |   |   |   |
|                                                                                                                                |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| TOTAL ASSETS                                                                                                                        |   | 261,179              |    |                         |   |   |   | 325,352 |   |   |   |   |   |
|                                                                                                                                |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| Interest -bearing  liabilities:                                                                                                     |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| Savings/NOW/money market                                                                                                            |   | 84,770               |    | 0.74                         | %      | 469 |   | 110,340 |   | 0.59 | % | 486 |   |
| Time deposits                                                                                                                       |   | 46,751               |    | 2.81                         | %      | 983 |   | 46,140 |   | 2.28 | % | 788 |   |
| Other borrowings                                                                                                                    |   | 25,878               |    | 4.89                         | %      | 946 |   | 31,062 |   | 5.51 | % | 1,280 |   |
|                                                                                                                                |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| Total interest-bearing  liabilities                                                                                                 |   | 157,399              |    | 2.04                         | %      | 2,398 |   | 187,542 |   | 1.82 | % | 2,554 |   |
|                                                                                                                                |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| Non-interest bearing  liabilities:                                                                                                  |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| Demand deposits                                                                                                                     |   | 79,794               |    |                         |   |   |   | 105,335 |   |   |   |   |   |
| Other liabilities                                                                                                                   |   | 1,642                |    |                         |   |   |   | 3,152 |   |   |   |   |   |
|                                                                                                                                |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| Total liabilities                                                                                                                   |   | 238,835              |    |                         |   |   |   | 296,029 |   |   |   |   |   |
|                                                                                                                                |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| Securities Sold under  Agreement to Repurchase                                                                                      |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| Company Obligated  Preferred Securities of Subsidiary Trust Holding Floating Rate Junior  Subordinated Deferred Interest Debentures |   | 5,333                |    |                         |   |   |   | 8,000 |   |   |   |   |   |
|                                                                                                                                |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| Stockholders’ equity                                                                                                           |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| Common stock                                                                                                                        |   | 8,917                |    |                         |   |   |   | 11,083 |   |   |   |   |   |
| Retained earnings                                                                                                                   |   | 7,989                |    |                         |   |   |   | 9,770 |   |   |   |   |   |
| Valuation Allowance  Investments                                                                                                    |   | 105                  |    |                         |   |   |   | 470 |   |   |   |   |   |
|                                                                                                                                |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| Total stockholders’ equity                                                                                                     |   | 17,011               |    |                         |   |   |   | 21,323 |   |   |   |   |   |
|                                                                                                                                |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                    |   | $                    | 261,179 |                         |   |   |   |   | $ | 325,352 |   |   |   |   |   |
|                                                                                                                                |   |                 |    |                         |   |   |   |   |   |   |   |   |   |
| Net Interest Income                                                                                                                 |   |                 |    |                         |   | $ | 8,999 |   |   |   |   |   | $ | 10,529 |   |
| Net Interest Margin (3)                                                                                                             |   |                 |    | 5.17                         | %      |   |   |   |   | 4.81 | % |   |   |

 

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**(1)****        ****Nonaccrual loans have been included in total loans.**

**(2)****        ****Loan fees of $457,773, $529,104 and $532,065 for2001, 2002and 2003, respectively, have been included in the interest income computation.** 

**(3)****        ****Net interest income has been calculated by dividing the netinterest income by total earning assets.**

 

The hypothetical impacts of sudden interest rate movements applied tothe Bank’s asset and liability

 

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balances are modeled monthly. The results of this movement indicate howmuch of the Bank’s net interest income is “at risk” from various sudden ratechanges. Although interest rates normally would not change in this suddenmanner, this exercise is valuable in identifying risk exposures. The resultsfor the Bank’s September 30, 2003 balances indicate that the Bank’s netinterest income at risk over a one year time horizon from a 1% and 2% ratemovement are within the Bank’s policy guidelines for such sudden changes.

 
|                          |   | **Rates Down  2%** |   | **Rates Down  1%** |   | **Rates Up  1%** |   | **Rates Up  2%** |   |
|-------------------------------|--------|--------------------|--------|--------------------|--------|------------------|--------|------------------|--------|
| Change in Net Interest Income |   | (7.50              | )%     | (4.08              | )%     | 5.65             | %      | 12.51            | %      |

 

It is important to note that the above tableis a summary of several forecasts and actual results may vary. The forecastsare based on estimates and assumptions of management that may turn out to bedifferent and may change over time. Factors effecting these estimates andassumptions include, but are not limited to 1) competitor behavior, 2) economicconditions both locally and nationally, 3) actions taken by the Federal ReserveBoard, 4) customer behavior and 5) management’s responses.  Changes that vary significantly from theassumptions and estimates may have significant effects on the Bank’s netinterest income. Therefore, the results of this analysis should not be reliedupon as indicative of actual future results.

 

Non-interest Income

Non-interest income forthe nine months ending September 30, 2003 was $2.8 millioncompared to $2.5 million for the same period in 2002. That represents anincrease of $300 thousand or 12.9%. Non-interest income for the three monthsending September 30, 2003 was $981 thousand compared to $908 thousand for thesame period in 2002. That represents an increase of $73 thousand or 8.0%.Non-interest income consists of bankcard merchant fees, mortgage originationfees, gains or losses on sale of securities and other fees and service chargeson deposit accounts.

 

Income from service charges on deposit accounts income was $1.2 millionfor the nine months ending September 30, 2003 compared to $1.0 millionfor the same period in 2002. Income from service charges on deposit accountsincome was $404 thousand for the three months ending September 30, 2003compared to $382 thousand for the same period in 2002. The increase for bothperiods reported is the result of 1) a revised service charge schedule thatbecame effective in August 2002 and 2) overall deposit growth.

 

Bankcard merchant fees were $73 thousand for the nine months endingSeptember 30, 2003 compared to $103 thousand for the same period in 2002.Bankcard merchant fees were $30 thousand for the three months endingSeptember 30, 2003 compared to $40 thousand for the same period in 2002. Whenthe Bank sold the merchant portfolio in September 1999, the compensationprovisions called for payment of certain basis points on the gross sales. InSeptember 2002, pursuant to the agreement, the basis points paid to the Bankwere reduced. This will continue until August 2004 at which time thecompensation will be renegotiated. Management does not believe that this changein revenue stream will have a material impact on the Company

 

Mortgage origination fees were $709 thousand for the nine months endingSeptember 30, 2003 compared to $496 thousand for the same period in 2002.Mortgage origination fees were $280 thousand for the three months endingSeptember 30, 2003 compared to $222 thousand for the same period in 2002. Theimpact of the very robust re-finance market has had a favorable impact to thisrevenue stream.

 

Income from the sale of securities was $60 thousand for the ninemonths ending September 30, 2003 compared to a loss on sale of securitiesof $20 thousand for the same period in 2002.Income from the sale of securitieswas $3 thousand for the three months ending September 30, 2003 comparedto a loss on sale of securities of $20 thousand for the same period in 2002. During the first quarter of 2003, the Bank soldtwo MBS securities with principal outstanding balances of approximately $7.4million and one

 

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Collateralized Mortgage Obligation (CMO) inthe amount of approximately $5 million. These securities were replaced with twoCMO securities in the total amount of approximately $11 million. These transactionscreated a gain on sale of securities of $57 thousand and were executed as theresult of an analysis on interest rate sensitivity to better position theinvestment portfolio for future interest rate movements of either up or down.The small gain for the three months ending September 30, 2003 was the result ofseveral municipal securities being called in July 2003.

 

Other Expense

Non-interestexpense was $8.9 million for the nine months endedSeptember 30, 2003 compared to $8.1 million for the same period in 2002. Thisrepresents an increase of $.8 million or 9.3%.

 

Salaries and employee benefits expense were$4.6 million and $3.9 million for the nine months ended September 30,2003 and 2002, respectively. This represents an increase of $.7 million or 18.0%.Salaries and employee benefits expense were $1.6 million and $1.4 million forthe three months ended September 30, 2003 and 2002, respectively. Thisrepresents an increase of $.2 million or 16.4%.  As the result of the Company’s growth, salaries have increasedwith the addition of, but not limited to, a Compliance Officer, TrainingOfficer, two Credit Analysts and additional support staff for the growth inloan and deposit related activity. Only 7.7% of the increase for the first ninemonths of 2003 is directly related to salaries, while the remainder of thevariance is associated with increases in workers compensation insurance, grouphealth costs and other employee related expense. Full time equivalent employeeswere 127 at September 30, 2003 compared to 92 at September 30, 2002.

 

Occupancy and equipment costs were $1.2million for the nine months ending September 30, 2003 compared to $1.2for the same period in 2002. Occupancy and equipment costs were $.4 million forthe three months ending September 30, 2003 compared to $.4 million forthe same period in 2002.

 

Expense associated with all othernon-interest expense categories was $3.0 million and $3.0 million for the ninemonths ended September 30, 2003 and 2002, respectively. Expense associatedwith all other non-interest expense categories was $1.0 million and $1.0million for the three months ended September 30, 2003 and 2002,respectively.

 

Taxes

The effective tax rate for the nine monthsending September 30, 2003 was 36.9% compared to 36.2% for the same period in2002. The effective tax rate for the three months ending September 30,2003 was 37.8% compared to 38.7% for the same period in 2002.

 

# **LocalEconomy**

The economy in the Company’s service area is basedprimarily on agriculture, tourism, light industry, oil and retail trade.Services supporting these industries have also developed in the areas ofmedical, financial and educational. The population in the two county areascomprising the Company’s service area, according to the U.S. Bureau of theCensus, was estimated at July 2001 to be approximately 655,600. San Luis ObispoCounty represents about 38% of this total with Santa Barbara County accountingfor the remaining approximately 62%. The moderate climate allows a year roundgrowing season for numerous vegetable and fruits. Vineyards and cattle ranchesalso contribute largely to the local economy. Vineyards in production havegrown significantly over the past several years throughout the Company’sservice area. Access to numerous recreational activities, including lakes,mountains and beaches, provide a relatively stable tourist industry from manyareas including the Los Angeles/Orange County basin, the San Francisco Bay areaand the San Joaquin Valley. Principally due to the diversity of the variousindustries in the Company’s service area, the area, while not immune fromeconomic fluctuations, does tend to enjoy a more stable level of economicactivity from many other areas of California.

 

The Central Coast’s leadingindustry is the production of wine grapes and production of premium qualitywines. Over the past two years, production of new vineyard land has led to anover capacity of wine grapes.  Excessproduction of wine grapes has led to a decrease in prices of grapes sold and insome cases, the inability of farmers to sell grapes at any price.  Wineries on the other hand are purchasing

 

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grapes at existing contractprices and in some cases, below contract prices. Wineries are becoming selectin the quality of grapes purchases, asking farmers to thin crops to produce ahigher quality fruit.

 

TheBank recognized in 2000 that there would be over capacity in the production ofwine grapes in our market area. As a result, efforts were made to move asignificant portion of the vineyard development loan portfolio out of the Bankand into the government sponsored Farmer Mac program. Because of these actionson the part of the Bank, it is the opinion of Management that there would notbe any negative impact from the current state of the wine grape industry.

 

Liquidity

The objective of liquidity management is to ensure the continuousavailability of funds to meet the demands of depositors, investors andborrowers.  Asset liquidity is primarilyderived from loan payments and the maturity of other earning assets.  Liquidity from liabilities is obtainedprimarily from the receipt of new deposits. The Bank’s Asset Liability Committee (ALCO) is responsible for managingthe on-and off-balance sheet commitments to meet the needs of customers whileachieving the Bank’s financial objectives. ALCO meets regularly to assess theprojected funding requirements by reviewing historical funding patterns,current and forecasted economic conditions, and individual customer fundingneeds.  Deposits generated from Bankcustomers serve as the primary source of liquidity.  The Bank has credit arrangements with correspondent banks thatserve as a secondary liquidity source in the amount of $5 million. During thefirst nine months of 2003, the average funds borrowed from correspondent bankswas $14,652.

 

As of July 1999, the Bank became a member of the Federal Home Loan Bankof San Francisco. Certain securities and loans are pledged as collateral. Theaverage funds borrowed through these facilities during the first nine months of2003 was $30.8 million.

 

The Bank manages its liquidity by maintaining a majority of itsinvestment portfolio in federal funds sold and other liquid investments.  At September 30, 2003 and 2002, the ratio ofliquid assets to deposits and other liabilities was 25.8% and 24.1%,respectively. The ratio of net loans to deposits, another key liquidity ratio,was 79.5% and 67.9% at September 30, 2003 and 2002, respectively.

 

Inflation

The assets and liabilities of a financial institution are primarilymonetary in nature.  As such theyrepresent obligations to pay or receive fixed and determinable amounts of moneythat are not affected by future changes in prices.  Generally, the impact of inflation on a financial institution isreflected by fluctuations in interest rates, the ability of customers to repaydebt and upward pressure on operating expenses.  During the two-year period ended December 31, 2002 and throughthe first nine months of 2003 the fluctuation in interest rates creatingnarrowing net interest margins has been significant to the Bank’s financialposition and results of operations. However, inflation has not been a factor inthe customer’s ability to repay debt or in upward pressure on operation expenses.

 

#### **Item 3. Controls and Procedures**

 

Evaluation ofdisclosure controls and procedures

As of the end of the period covered by this report, the Company carriedout an evaluation, under the supervision and with the participation of itsmanagement, including the Company’s Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Basedupon that evaluation, the Chief Executive Officer and Chief Financial Officerconcluded that the Company’s disclosure controls and procedures are effectiveto provide reasonable assurances that information required to be disclosed inthe reports the Company files or submits under the Securities Exchange Act of1934 is recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms.

 

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There was no change in the Company’s internal controls over financial reportingduring the quarter ended September 30, 2003 that has materially affected, or isreasonably likely to materially affect, the Company’s internal controls overfinancial reporting.

 

In designing and evaluating disclosure controls and procedures, the Company’smanagement recognized that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable, not absolute, assurances ofachieving the desired control objectives and management necessarily wasrequired to apply its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures.

 

#### **PART 2.  OTHER INFORMATION**

 

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

 

(a)                                  Exhibits:

 

**Exhibit 31.1**                               Certificationof Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of2002

 

**Exhibit31.2**                               Certificationof Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of2002

 

**Exhibit32.1**                               Certificationof Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of2002

 

**Exhibit 32.2**                               Certificationof Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of2002

 

**Exhibit10.37****                       **EmploymentAgreement with David Duarte, President and Chief Operating Officer of HaciendaBank, dated September 5, 2003 and filed with the SEC in the September 30, 200310-QSB.

 

**Exhibit 10.38****                       **Promissory Note executed on October 3, 2003for $3.5 million with Pacific Coast Bankers Bank, filed with the SEC in theSeptember 30, 2003 10-QSB.

 

(b)                                Reports on Form 8-K:

 

The Company filed the announcement of second quarter 2003 earnings onForm 8-K, Item 9 with the SEC on July 9, 2003.

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

HERITAGE OAKS BANCORP

 

DATE: October 31, 2003

 

 
|   | /s/ Lawrence P. Ward                              |   |
|--------|---------------------------------------------------|--------|
|   | Lawrence P. Ward                                  |
|   | President  Chief Executive Officer                |
|   |
|   |
|   | /s/ Margaret A. Torres                            |   |
|   | Margaret A. Torres                                |
|   | Chief Financial Officer  Executive Vice President |
|        |                                                   |        |  |

 

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# **WHERE YOU CAN FIND MORE INFORMATION**

 

Under the Securities Exchange Act of 1934 Sections 13 and 15(d),periodic and current reports must be filed with the SEC. The Companyelectronically files the following reports with the SEC: Form 10-K (AnnualReport), Form 10-Q (Quarterly Report), Form 8-K (Report of Unscheduled MaterialEvents), and Form DEF 14A (Proxy Statement). The Company may file additionalforms. The SEC maintains an Internet site, www.sec.gov, in which all formsfiled electronically may be accessed. Additionally, all forms filed with theSEC and additional shareholder information is available free of charge on theCompany’s website: www.heritageoaksbank.com

 

The Company posts these reports to its website as soon as reasonablypracticable after filing them with the SEC. None of the information on or hyperlinked from the Company’s website isincorporated into this Quarterly Report on Form 10-QSB.

 
| Exhibit 31.1   |   | Certification of Chief Executive Officer pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002                                                                                 |
|----------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Exhibit 31.2   |   | Certification of Chief Financial Officer pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002                                                                                 |
| Exhibit 32.1   |   | Certification of Chief Executive Officer pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002                                                                                 |
| Exhibit 32.2   |   | Certification of Chief Financial Officer pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002                                                                                 |
| Exhibit  10.37 |   | Employment  Agreement with David Duarte, President and Chief Operating Officer of  Hacienda Bank, dated September 5, 2003 and filed with the SEC in the  September 30, 2003 10-QSB. |
| Exhibit 10.38  |   | Promissory Note executed on  October 3, 2003 for $3.5 million with Pacific Coast Bankers Bank, filed with  the SEC in the September 30, 2003 10-QSB.                                |

 

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