UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

Enterprise Bancorp, Inc.

 (Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (978) 459-9000

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

x Yes   o No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition for “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (Check one):

Large accelerate filer o

Accelerated filer x

Non-accelerated filer o

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

o Yes   x No

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: July 31, 2007, Common Stock - Par Value $0.01: 7,841,424 shares outstanding

ENTERPRISE BANCORP, INC.

INDEX

			Cover Page
			Index
PART I FINANCIAL INFORMATION
Item 1			Financial Statements (unaudited)
			Consolidated Balance Sheets - June 30, 2007 and December 31, 2006
			Consolidated Statements of Income -  Three and six months ended June 30, 2007 and 2006
			Consolidated Statement of Changes in Stockholders’ Equity -  Six months ended June 30, 2007
			Consolidated Statements of Cash Flows -  Six months ended June 30, 2007 and 2006
			Notes to Unaudited Consolidated Financial Statements
Item 2			Management’s Discussion and Analysis of Financial Condition  and Results of Operations
Item 3			Quantitative and Qualitative Disclosures About Market Risk
Item 4			Controls and Procedures
PART II OTHER INFORMATION
Item 1			Legal Proceedings
Item 1A			Risk Factors
Item 2			Unregistered Sales of Equity Securities and Use of Proceeds
Item 3			Defaults Upon Senior Securities
Item 4			Submission of Matters to a Vote of Security Holders
Item 5			Other Information
Item 6			Exhibits
			Signature page

 

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ENTERPRISE BANCORP, INC.

Consolidated Balance Sheets

(unaudited)

		June 30,			December 31,
(Dollars in thousands)		2007			2006
Assets
Cash and cash equivalents:
Cash and due from banks		$	44,081		$	35,583
Short-term investments		29,388			15,304
Total cash and cash equivalents		73,469			50,887
Investment securities at fair value		137,449			131,540
Loans, less allowance for loan losses of $13,117 at June 30, 2007 and $12,940 at December 31, 2006		781,528			748,173
Premises and equipment		15,707			16,015
Accrued interest receivable		5,590			5,464
Deferred income taxes, net		7,119			6,861
Bank-owned life insurance		12,483			12,212
Prepaid expenses and other assets		5,021			1,976
Core deposit intangible, net of amortization		409			475
Goodwill		5,656			5,656
Total assets		$	1,044,431		$	979,259
Liabilities and Stockholders’ Equity
Liabilities
Deposits		$	938,881		$	867,522
Borrowed funds		5,413			15,105
Junior subordinated debentures		10,825			10,825
Accrued expenses and other liabilities		4,791			6,567
Income taxes payable		100			92
Accrued interest payable		3,101			2,105
Total liabilities		963,111			902,216
Commitments and Contingencies
Stockholders’ Equity
Preferred stock, $0.01 par value per share; 1,000,000 shares authorized; no shares issued		—			—
Common stock $0.01 par value per share; 20,000,000 shares authorized; 7,839,424 and 7,722,288 shares issued and outstanding at June 30, 2007 and December 31, 2006, respectively		78			77
Additional paid-in capital		27,101			25,806
Retained earnings		54,425			51,127
Accumulated other comprehensive (loss) / income		(284		)	33
Total stockholders’ equity		81,320			77,043
Total liabilities and stockholders’ equity		$	1,044,431		$	979,259

 

See accompanying notes to the unaudited consolidated financial statements.

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ENTERPRISE BANCORP, INC.

Consolidated Statements of Income

(unaudited)

		Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in thousands, except per share data)		2007			2006			2007			2006
Interest and dividend income:
Loans		$	14,571		$	13,329		$	28,840		$	25,811
Investment securities		1,367			1,482			2,688			3,048
Total short-term investments		35			67			66			160
Total interest and dividend income		15,973			14,878			31,594			29,019
Interest expense:
Deposits		5,447			3,984			10,505			7,299
Borrowed funds		173			190			406			631
Junior subordinated debentures		295			295			589			589
Total interest expense		5,915			4,469			11,500			8,519
Net interest income		10,058			10,409			20,094			20,500
Provision for loan losses		52			244			135			517
Net interest income after provision for loan losses		10,006			10,165			19,959			19,983
Non-interest income:
Investment advisory fees		817			637			1,595			1,266
Deposit service fees		523			412			1,027			827
Bank-owned life insurance		148			41			296			82
Net gains/(losses) on sales of investment securities		425			(39		)	478			(9		)
Gains on sales of loans		59			34			99			78
Other income		543			505			1,098			1,027
Total non-interest income		2,515			1,590			4,593			3,271
Non-interest expense:
Salaries and employee benefits		5,307			5,007			10,642			10,129
Occupancy expenses		1,735			1,511			3,353			2,935
Audit, legal and other professional fees		496			303			792			625
Advertising and public relations		295			384			557			629
Supplies and postage		249			176			482			401
Investment advisory and custodial expenses		129			116			252			234
Other operating expenses		753			759			1,406			1,521
Total non-interest expense		8,964			8,256			17,484			16,474
Income before income taxes		3,557			3,499			7,068			6,780
Income tax expense		1,239			1,317			2,528			2,542
Net income		$	2,318		$	2,182		$	4,540		$	4,238
Basic earnings per share		$	0.30		$	0.29		$	0.58		$	0.56
Diluted earnings per share		$	0.29		$	0.28		$	0.58		$	0.54
Basic weighted average common shares outstanding		7,797,414			7,637,860			7,772,836			7,620,871
Diluted weighted average common shares outstanding		7,897,422			7,797,892			7,888,515			7,796,826

 

See accompanying notes to the unaudited consolidated financial statements.

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ENTERPRISE BANCORP, INC.

Consolidated Statement of Changes in Stockholders’ Equity

(unaudited)

Six months ended June 30, 2007

(Dollars in thousands)		Common  Stock			Additional  Paid-in  Capital			Retained Earnings			Comprehensive Income			Accumulated  Other  Comprehensive  Income (Loss)			Total  Stockholders’  Equity
Balance at December 31, 2006		$	77		$	25,806		$	51,127					$	33		$	77,043
Comprehensive income																	—
Net income								4,540			$	4,540					4,540
Other comprehensive income, net											(317		)	(317		)	(317		)
Total comprehensive income											$	4,223
Common stock dividend paid ($0.16 per share)								(1,242		)							(1,242		)
Common stock issued under dividend reinvestment plan					530												530
Stock-based compensation					398												398
Stock options exercised		1			367												368
Balance at June 30, 2007		$	78		$	27,101		$	54,425					$	(284	)	$	81,320
Disclosure of other comprehensive income (loss):
Gross unrealized holding losses on securities arising during the period											$	(97	)
Income tax benefit											91
Net unrealized holding losses, net of tax											(6		)
Reclassification adjustment for net gains included in net income:
Net realized gains on sales of securities during the period											478
Income tax expense											(167		)
Reclassification adjustment, net of tax											311
Other comprehensive loss, net of reclassification											$	(317	)

 

See the accompanying notes to the unaudited consolidated financial statements

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ENTERPRISE BANCORP, INC.

Consolidated Statements of Cash Flows

(unaudited)

		Six months ended
		June 30,			June 30,
(Dollars in thousands)		2007			2006
Cash flows from operating activities:
Net income		$	4,540		$	4,238
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		135			517
Depreciation and amortization		1,344			1,266
Amortization of intangible assets		66			66
Stock-based compensation expense		320			252
Net (gains)/losses on sales of investment securities		(478		)	9
Gains on sales of loans		(99		)	(78		)
Income on bank-owned life insurance, net		(271		)	(55		)
(Increase) decrease in:
Loans held for sale, net of gain		23			(598		)
Accrued interest receivable		(126		)	(243		)
Prepaid expenses and other assets		(829		)	77
Increase (decrease) in:
Accrued expenses and other liabilities		(1,816		)	136
Accrued interest payable		996			670
Change in income taxes		8			(63		)
Net cash provided by operating activities		3,813			6,194
Cash flows from investing activities:
Proceeds from sales of investment securities		4,608			3,220
Proceeds from maturities, calls and pay-downs of investment securities		8,360			10,462
Purchase of investment securities		(19,004		)	(4,595		)
Purchase of tax credits		(1,735		)	—
Net increase in loans		(33,680		)	(32,445		)
Additions to premises and equipment, net		(1,103		)	(2,671		)
Purchases of bank-owned life insurance		—			(9,897		)
Net cash used in investing activities		(42,554		)	(35,926		)
Cash flows from financing activities:
Net increase in deposits		71,359			115,092
Net increase (decrease) in borrowed funds		(9,692		)	(54,595		)
Cash dividends paid		(1,242		)	(1,066		)
Proceeds from issuance of common stock		530			471
Proceeds from exercise of stock options		368			227
Tax benefit from exercise of stock options		—			14
Net cash provided by financing activities		61,323			60,143
Net (decrease) / increase in cash and cash equivalents		22,582			30,411
Cash and cash equivalents at beginning of period		50,887			38,381
Cash and cash equivalents at end of period		$	73,469		$	68,792
Supplemental financial data:
Cash Paid For:
Interest		$	10,504		$	7,849
Income taxes		2,522			2,590
Supplemental schedule of non-cash investing activity:
Transfer from loans to Other Real Estate Owned		$	266		—

 

See accompanying notes to the unaudited consolidated financial statements.

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ENTERPRISE BANCORP, INC.

Notes to Unaudited Consolidated Financial Statements

(1)           Organization of Holding Company

Enterprise Bancorp, Inc. (the “company”) is a Massachusetts corporation organized at the direction of Enterprise Bank and Trust Company, (the “bank”), for the purpose of becoming the holding company for the bank.  The bank, a Massachusetts trust company, has three wholly owned subsidiaries, Enterprise Insurance Services, LLC, Enterprise Investment Services, LLC, and Enterprise Security Corporation, organized for the purposes of engaging in insurance sales activities, offering non-deposit investment products and services and investing in equity securities on its own behalf and not as a broker, respectively.

(2)           Basis of Presentation

The accompanying unaudited consolidated financial statements and these notes should be read in conjunction with the company’s December 31, 2006 audited consolidated financial statements and notes thereto contained in the company’s 2006 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 16, 2007.  Interim results are not necessarily indicative of results to be expected for the entire year.  The company has not changed its significant accounting and reporting policies from those disclosed in its 2006 annual report.

In the opinion of management, the accompanying consolidated financial statements reflect all necessary adjustments consisting of normal recurring accruals for a fair presentation.  All significant intercompany balances and transactions have been eliminated in the accompanying consolidated financial statements.

Certain fiscal 2006 information has been reclassified to conform to the 2007 presentation.

(3)                     Critical Accounting Estimates

In preparing the consolidated financial statements in conformity with U. S. generally accepted accounting principles, management is required to exercise judgment in determining many of the methodologies, assumptions and estimates to be utilized.  These estimates and assumptions affect the reported amounts of assets and liabilities as of the balance sheet date and revenues and expenses for the period.  Actual results could differ should the assumptions and estimates used change over time.

As discussed in the company’s 2006 Annual Report on Form 10-K, the two most significant areas in which management applies critical assumptions and estimates that are particularly susceptible to change relate to the determination of the allowance for loan losses and the impairment valuation of goodwill.  Refer to note 1 to the company’s consolidated financial statements included in the company’s 2006 Annual Report on Form 10-K for significant accounting policies.

(4)       Accounting for Uncertainty in Income Taxes

In July the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - An interpretation of FASB Statement No 109” (“FIN 48”). The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006.  The adoption of FIN 48 did not have a material impact on the company’s financial position or results of operation.

The company’s policy is to classify interest resulting from underpayment of income taxes as income tax expense in the first period the interest would begin accruing according to the provisions of the relevant tax law.  The company classifies penalties resulting from underpayment of income taxes as income tax expense in the period for which the company claims or expects to claim an uncertain tax position or in the period in which the company’s judgment changes regarding an uncertain tax position.

The company did not have any unrecognized tax benefits accrued as income tax liabilities or receivables or as deferred tax items at June 30, 2007 or December 31, 2006.  The Company is subject to federal and state income tax examinations for tax years beginning after December 31, 2002.

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(5)           Stock-Based Compensation

The company has not significantly changed the general terms and conditions related to stock compensation from those disclosed in the company’s 2006 Annual Report on Form 10-K.

Total stock-based compensation expense, which includes stock option awards and restricted stock awards to officers and other employees, and director stock compensation in lieu of cash fees to directors, was $136 thousand and $134 thousand for the three months ended June 30, 2007 and 2006, respectively and $320 thousand and $252 thousand for the six months ended June 30, 2007 and 2006, respectively.

The company recognized stock-based compensation expense related to stock option awards of $75 thousand and $206 thousand for the three and six months ended June 30, 2007, compared to $70 thousand and $139 thousand for the same periods in 2006.  Stock-based compensation expense recognized in association with a restricted stock award amounted to $13 and $25 thousand for the three month and six month periods ended June 30, 2007 and 2006.  Stock-based compensation expense related to Directors’ election to receive shares of common stock in lieu of cash fees for attendance at Board and Board Committee meetings amounted to $48 thousand and $89 thousand for the three and six months ended June 30, 2007, compared to $51 thousand and $88 thousand for the same periods in 2006.   In January 2007, 10,575 shares of common stock were issued to directors in lieu of cash fees related to 2006 annual directors’ stock-based compensation expense of $167 thousand.

There were 3,500 and 127,600 stock option awards granted to employees during the three and six months periods ended June 30, 2007, respectively. No options were granted during the same periods ended June 30, 2006.   The options become exercisable at the rate of 25% per year and expire seven years from the date of grant.  In addition, the options provide for full vesting upon attainment of age 62 while remaining employed with the bank, or upon a change in control of the company.

The per share weighted average fair value of stock options granted in 2007 was determined to be $3.69.  The weighted average fair value of the options was determined to be 22% of the market value of the stock at the date of grant.  The assumptions used in the valuation model for determining weighted average fair value of the 2007 stock option grants for the risk-free interest rate, expected volatility, dividend yield and expected life in years were 4.43%, 21%, 2.03% and 5.5 years, respectively.

Refer to note 9 “Stock Based Compensation Plans” in the company’s 2006 Annual Report on Form 10-K for a description of the assumptions used in the valuation model.

(6)                     Supplemental Retirement Plan

The following table illustrates the net periodic benefit cost for the supplemental executive retirement plan for the three months and six months ended June 30, 2007 and June 30, 2006:

		Three months ended June 30,						Six months ended June 30,
(Dollars in thousands)		2007			2006			2007			2006
Service Cost		$	138		$	135		$	276		$	269
Interest Cost		32			22			64			44
Net periodic benefit cost		$	170		$	157		$	340		$	313

 

The company anticipates accruing an additional $339 thousand to the plan during the remainder of 2007.

(7)       Earnings Per Share

Basic earnings per share are calculated by dividing net income by the weighted average number of common shares outstanding during the period.  Diluted earnings per share reflects the effect on weighted average shares outstanding of the number of additional shares outstanding if dilutive stock options were converted into common stock using the treasury stock method.

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The table below presents the increase in average shares outstanding, using the treasury stock method, for the diluted earnings per share calculation for the three and six months ended June 30th and the effect of those shares on earnings:

		Three months ended June 30,					Six months ended June 30,
		2007			2006		2007			2006
Basic weighted average common shares outstanding		7,797,414			7,637,860		7,772,836			7,620,871
Dilutive shares		100,008			160,032		115,679			175,955
Diluted weighted average common shares outstanding		7,897,422			7,797,892		7,888,515			7,796,826
Basic earnings per share		$	0.30		0.29		$	0.58		0.56
Effect of dilutive shares		(0.01		)	(0.01	)	—			(0.02	)
Diluted earnings per share		$	0.29		0.28		$	0.58		0.54

 

At June 30, 2007, there were additional options outstanding to purchase up to 142,425 shares which were excluded from the calculation of diluted earnings per share due to the exercise price of these options exceeding the average market price of the company’s common stock.  These options, which were not dilutive at that date, may potentially dilute earnings per share in the future.

(8)       Guarantees and Commitments

Standby letters of credit are conditional commitments issued by the company to guarantee the performance by a customer to a third party.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  If the letter of credit is drawn upon the company creates a loan for the customer with the same criteria associated with similar loans.  The fair value of these commitments was estimated to be the fees charged to enter into similar agreements.  The estimated fair value of these commitments carried on the balance sheet was $35 thousand and $72 thousand at June 30, 2007 and 2006, respectively. These amounts are amortized to income over the life of the letters of credit, typically one year.

Fixed and adjustable rate residential mortgage loans are generally originated using underwriting standards and standard documentation allowing their sale in the secondary market. Depending on the current interest rate environment, management projections of future interest rates and the overall asset-liability management strategy of the company, management may elect to sell or hold residential loan production for the company’s portfolio. The company generally does not pool mortgage loans for sale, but instead sells the loans on an individual basis. The company may retain or sell the servicing when selling the loans. Interest rate lock commitments related to the origination of mortgage loans that will be sold are considered derivative instruments.  The company estimates the fair value of these derivatives using the difference between the guaranteed interest rate in the commitment and the current market interest rate. To reduce the net interest rate exposure arising from its loan sale activity, the company enters into the commitment to sell these loans at essentially the same time that the interest rate lock commitment is quoted on the origination of the loan.   The commitments to sell loans are also considered derivative instruments, with estimated fair values based on changes in current market rates.   At June 30, 2007, the estimated fair value of the company’s derivative instruments was considered to be immaterial.

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Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s discussion and analysis should be read in conjunction with the company’s consolidated financial statements and notes thereto contained in this report and the company’s 2006 Annual Report on Form 10-K.

Special Note Regarding Forward-Looking Statements

This report contains certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, including statements concerning plans, objectives, future events or performance and assumptions and other statements that are other than statements of historical fact.  Forward-looking statements may be identified by reference to a future period or periods or by use of forward-looking terminology such as “anticipates”, “believes”, “expects”, “intends”, “may”, “plans”, “pursue”, “views” and similar terms or expressions. Various statements contained in Item 2 — “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 3 — “Quantitative and Qualitative Disclosures About Market Risk,” including, but not limited to, statements related to management’s views on the banking environment and the economy, competition and market expansion opportunities, the interest rate environment, credit risk and the level of future non-performing assets and charge-offs, potential asset and deposit growth, future non-interest expenditures and non-interest income growth, and borrowing capacity are forward-looking statements.  The company wishes to caution readers that such forward-looking statements reflect numerous assumptions and involve a number of risks and uncertainties that may adversely affect the company’s future results. The following important factors, among others, could cause the company’s results for subsequent periods to differ materially from those expressed in any forward-looking statement made herein: (i) changes in interest rates could negatively impact net interest income;  (ii) changes in the business cycle and downturns in the local, regional or national economies, including deterioration in the local real estate market, could negatively impact credit and/or asset quality and result in credit losses and increases in the company’s reserve for loan losses; (iii) changes in consumer spending could negatively impact the company’s credit quality and financial results; (iv) increasing competition from larger regional and out-of-state banking organizations as well as non-bank providers of various financial services could adversely affect the company’s competitive position within its market area and reduce demand for the company’s products and services; (v) deterioration of securities markets could adversely affect the value or credit quality of the company’s assets and the availability of funding sources necessary to meet the company’s liquidity needs; (vi) changes in technology could adversely impact the company’s operations and increase technology-related expenditures;  (vii) increases in employee compensation and benefit expenses could adversely affect the company’s financial results;  (viii) changes in laws and regulations that apply to the company’s business and operations could increase the company’s regulatory compliance costs and adversely affect the company’s business environment, operations and financial results; and (ix) changes in accounting standards, policies and practices, as may be adopted or established by the regulatory agencies, the Financial Accounting Standards Board (the “FASB”)or the Public Company Accounting Oversight Board could negatively impact the company’s financial results.  Therefore, the company cautions readers not to place undue reliance on any such forward-looking information and statements.

Overview

Composition of Earnings

The current flat interest rate environment continues to negatively impact margins and challenge earnings growth for the banking industry. At Enterprise Bancorp, Inc., this environment has contributed to slower loan and negative low cost deposit growth and continued pressure on the company’s net interest margin from rising funding costs.

The company reported net income growth of 6% for the three months ended June 30, 2007 compared to the same quarter in the prior year.  Net income for the current quarter ended June 30, 2007 amounted to $2.318 million compared to $2.182 million for the same period in 2006. Diluted earnings per share were $0.29 for the quarter compared to $0.28 for the same period in 2006, an increase of 4%.

Net income for the six months ended June 30, 2007 amounted to $4.540 million compared to $4.238 million for the same period in 2006, an increase of 7%. Diluted earnings per share were $0.58 for the six months ended June 30, 2007 compared to $0.54 for the same period in 2006, an increase of 7%.

Net income growth resulted primarily from an increase in non-interest income and a decrease in the provision for loan losses, partially offset by an increase in non-interest expense and a decrease in net interest income.

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·      Quarter-to-date

The company’s earnings are largely dependent on its net interest income, which is the difference between interest income on loans and investments and interest expense on deposits and borrowings. Net interest income for the quarter ended June 30, 2007 amounted to $10.1 million, representing a $351 thousand, or 3%, decrease from the same period in 2006.

Net interest margin, the difference between interest earned on assets less the cost of funding (primarily deposits) divided by average interest earning assets, was 4.51% for the quarter ended June 30, 2007 compared to 4.59% and 4.83% for the quarters ended March 31, 2007 and June 30, 2006, respectively.  The decrease in net interest margin resulted from both the flat yield curve and a highly-competitive marketplace.

Non-interest income was $2.5 million for the quarter ended June 30, 2007, an increase of $925 thousand, or 58%, over the same period in 2006.  The growth resulted primarily from an increase of $464 thousand in gains on sales of securities, and from increases of $180 thousand in investment advisory fees, $107 thousand in bank-owned life insurance income and $111 thousand in deposit-service fees.

Non-interest expense amounted to $9.0 million for the quarter ended June 30, 2007 compared to $8.3 million for the same period in 2006, an increase of 9%.  The increases were predominantly in occupancy and compensation-related costs which supports the company’s growth.

The provision for loan losses, which is impacted by asset quality and loan growth, amounted to $52 thousand for the quarter ended June 30, 2007 compared to $244 thousand in the first quarter of 2006.  The reduced provision reflects continued favorable asset quality.  The allowance for loan losses to total loans ratio was 1.65% at June 30, 2007 compared to 1.70% at December 31, 2006.  The company’s management of credit risk is reviewed in more detail under the heading “Asset Quality and the Allowance for Loan Losses” contained in the Financial Condition section of this Item 2.

·      Year-to-date

Net interest income for the six months ended June 30, 2007 amounted to $20.1 million, a $406 thousand, or 2%, decrease from the same period in 2006.  Net interest margin was 4.55% for the six months ended June 30, 2007 compared to 4.81% for the same period ended June 30, 2006.

Non-interest income was $4.6 million for the six months ended June 30, 2007, an increase of $1.3 million, or 40%, over the same period in 2006.  The growth resulted primarily from an increase of $487 thousand in gains on sales of securities, which occurred mainly in the second quarter, and from increases of $329 thousand in investment advisory fees, $214 thousand in bank-owned life insurance income and $200 thousand in deposit-service fees.

Non-interest expense amounted to $17.5 million for the six months ended June 30, 2007 compared to $16.5 million for the same period in 2006, an increase of 6%.  The increase was mainly in occupancy and compensation-related costs which supports the company’s growth.

The provision for loan losses for the six months ended June 30, 2007 amounted to $135 compared to $517 thousand for the same period in 2006, a decrease of $382 thousand.  As noted above, the reduced provision reflects continued favorable asset quality during the period.

Sources and Uses of Funds

The company’s primary sources of funds are deposits, brokered certificates of deposit, borrowings from the Federal Home Loan Bank of Boston (the “FHLB”), repurchase agreements, current earnings and proceeds from the sales, maturities and paydowns on loans and investment securities.  The company uses funds to originate loans, purchase investment securities, conduct operations, expand the branch network, and pay dividends to shareholders.

Total assets amounted to $1.044 billion at June 30, 2007, an increase of 7% since December 31, 2006. The company’s core asset strategy is to grow loans, primarily commercial loans.  Total loans increased 4% since December 31, 2006 and amounted to $794.6 million, or 76% of total assets. Commercial loans amounted to $675.7 million, or 85% of total loans.

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The investment portfolio is the other key component of the company’s earning assets and is primarily used to invest excess funds, provide liquidity and to manage the company’s asset-liability position. Total investments amounted to $137.4 million at June 30, 2007, or 13% of total assets, and have increased $5.9 million since December 31, 2006.

Management’s primary strategy for funding assets growth is through low cost deposits (primarily checking accounts). Asset growth in excess of low cost deposits is typically funded through higher cost deposits (certificates of deposit and money market / savings products), brokered deposits, repurchase agreements, FHLB borrowings, and investment portfolio cash flow.  Over the past eighteen months the company has increased its use of brokered term deposits (“brokered CDs”) and internally generated certificates of deposit as an alternative funding source, as the rate environment has continued to impact the company’s ability to generate growth in lower costing deposits.  Lower costing deposits declined by $7.6 million, or 2%, since December 31, 2006 and by $9.2 million, or 2%, since December 31, 2005.

At June 30, 2007, total deposits, which included brokered CDs, amounted to $938.9 million, representing 8% growth over December 31, 2006. Total deposits, excluding brokered CDs, amounted to $818.8 million at June 30, 2007, representing a 2% increase since December 31, 2006.  At June 30, 2007, the company had $120.1 million in brokered CDs and $2.3 million in FHLB borrowings compared to $64.9 million in brokered CDs and $10.3 million in FHLB borrowings at December 31, 2006.

Opportunities and Risks

Management remains committed to a long-term strategy of geographic market expansion and commercial banking growth.  The company’s primary market is the Merrimack Valley and North Central regions of Massachusetts and the South Central region of New Hampshire. Management recognizes that substantial competition exists in the marketplace and views this as a key business risk.  Market competition includes the expanded commercial lending capabilities of credit unions, the shift to commercial lending by traditional savings banks, the presence of large regional and national commercial banks, as well as the products offered by non-bank financial services competitors.

 Management believes the company’s business model, strong service culture, skilled management team and brand name create opportunities for the company to be the leading provider of banking and investment management services in its growing market area. Management continually strives to differentiate the company from competitors by providing highly competitive commercial banking, investment, and insurance products delivered through prompt and personal service based on management’s familiarity and understanding of the banking and other financial service needs of its customers, which include businesses, professionals, and consumers.

Despite these competitive challenges, the company has been successful in growing its commercial banking services. Management believes this growth is the result of ongoing business development efforts and continued market expansion within existing and into new markets. The company has fourteen branch locations; its fifteenth branch facility is currently under construction in the city of Methuen, Massachusetts and is anticipated to open in early 2008. The company continues to look for market and branch opportunities that will increase long-term franchise value and shareholder returns. Such expansion typically increases the company’s operating expenses, primarily in salary and benefits, marketing, and occupancy, before the growth benefits are fully realized in those markets.

In addition to growth and competition, the company’s significant challenges continue to be the effective management of interest rate, credit and operational risk.

The re-pricing frequency of interest earning assets and liabilities are not identical, and therefore subject the company to the risk of adverse changes in interest rates. This is often referred to as “interest rate risk” and is reviewed in more detail in Item 3, “Quantitative and Qualitative Disclosures About Market Risk.”

Credit risk management is reviewed below in this Item 2 under the heading “Asset Quality and the Allowance for Loan Losses.”

Operational risk management is also a key component of the company’s risk management process, particularly as it relates to technology administration, information security, and business continuity.

Management utilizes a combination of third party security assessments, key technologies and ongoing internal evaluations in order to continually monitor and safeguard information on its operating systems and that of third party service providers.  The company contracts with outside parties to perform a broad scope of both internal and external security assessments on a regular basis. These third parties test the company’s security controls and network configuration, and assess internal practices

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and other key items.  In addition, the company contracts with an outside service provider to monitor usage patterns and identify unusual activity on bank issued debit/ATM cards.  The company also utilizes firewall technology and an intrusion detection system to protect against unauthorized access and commercial software that continuously scans for computer viruses on the company’s information systems.

The company maintains an Information Security and Technology Practices policy applicable to all employees.  The policy outlines the employee’s responsibilities and key components of the company’s Information Security and Technology Practices Program, which include the following: identification and assessment of risk; institution of policies and procedures to manage and control the risk; risk assessment of outsourced service providers; development of strategic security contingency plans; training of all officers and employees; and reporting to the Board of Directors.  Significant technology issues, related changes in risk and results of third party security assessments are reported to the Board’s Banking Technology and Audit Committees.  The Board, through these committees, reviews the status of the Information Security and Technology Practices Program and makes adjustments to the policy as deemed necessary.

The company has a Business Continuity Plan that consists of the information and procedures required to enable rapid recovery from an occurrence that would disable the company for an extended period.  The plan establishes responsibility for assessing a disruption of business, contains alternative strategies for the continuance of critical business functions, assigns responsibility for restoring services, and sets priorities by which critical services will be restored.

Financial Condition

Total assets increased $65.2 million, or 7%, over December 31, 2006, to $1.044 billion at June 30, 2007.  The increase was primarily attributable to increases in total loans and short-term investments.

Short-term investments

As of June 30, 2007, short-term investments amounted to $29.4 million compared to $15.3 million at December 31, 2006. Short-term investments represented 3% of total assets at June 30, 2007, compared to 2% at December 31, 2006.  Short-term investments carried as cash equivalents consisted of overnight federal funds sold and money market mutual funds.

Investments

At June 30, 2007, the investment portfolio’s fair market value was $137.5 million, representing an increase of $5.9 million since December 31, 2006.  The fair market value of the investment portfolio represented 13% of total assets at both June 30, 2007 and December 31, 2006.

During the six months ended June 30, 2007,  the company sold $4.6 million in equity investments based on management’s decision to take advantage of certain investment opportunities and to reallocate funds within the equity portfolio, in addition, during this period, the company received $8.4 million in principal paydowns, calls and maturities.  These proceeds were used to purchase $19.0 million in securities, primarily within the equity and municipal securities portfolios.

The net unrealized loss on the portfolio at June 30, 2007 was $738 thousand compared to a net unrealized loss of $163 thousand at December 31, 2006.  The net unrealized gain or loss in the company’s fixed income portfolio fluctuates as interest rates rise and fall.  Due to the fixed rate nature of this portfolio, as rates fall the value of the portfolio rises, and as rates rise, the value of the portfolio declines.  The unrealized gains or loss on fixed income investments will also decline as the securities approach maturity.  The net unrealized gain or loss on equity securities will change based on changes in the market value of the individual securities and mutual funds in the portfolio.  Unrealized gains or losses will only be recognized in the statements of income if the securities are sold. However, if an unrealized loss on a fixed income or equity security is deemed to be other-than-temporary, the company marks the investment down to its carrying value through a charge to earnings.

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The following table summarizes the fair market value of investments at the dates indicated:

(Dollars in thousands)		June 30, 2007			December 31, 2006			June 30, 2006
Federal agency obligations(1)		$	10,365		$	10,405		$	14,986
Collateralized mortgage obligations and other mortgage backed securities (CMO/MBS)		59,992			61,431			66,831
Municipal securities		55,945			48,762			55,180
Available-for-sale fixed income securities		$	126,302		$	120,598		$	136,997
Equity securities		9,538			8,481			6,243
Federal Home Loan Bank stock(2)		1,609			1,428			1,267
Certificates of deposit		—			1,033			1,000
Total investments		$	137,449		$	131,540		$	145,507

 

(1)            Federal agency obligations include securities issued by government-sponsored enterprises such as Fannie Mae, Freddie Mac, and the FHLB.  These securities do not represent obligations of the U.S. government and are not backed by the full faith and credit of the United States Treasury.

(2)            The bank is required to purchase FHLB stock in association with outstanding advances from the FHLB; this stock is classified as a restricted investment and carried at cost.

From time to time the company may pledge investments from the portfolio as collateral for various municipal deposit accounts, repurchase agreements and treasury, tax and loan deposits.  The fair value of securities pledged as collateral was $25.2 million and $27.1 million at June 30, 2007 and December 31, 2006 respectively.  Securities designated as qualified collateral for FHLB borrowing capacity amounted to $46.7 million and $46.2 million at June 30, 2007 and December 31, 2006 respectively.

Loans

The company specializes in lending to business entities, non-profit organizations, professionals and individuals. The company’s primary lending focus is on the development of high quality commercial relationships achieved through active business development efforts, strong community involvement and focused marketing strategies.  Loans made by the company to businesses include commercial mortgage loans, construction loans, secured and unsecured commercial loans and lines of credit, and standby letters of credit.  The company also originates equipment lease financing for businesses.  Loans made to individuals include residential mortgage loans, home equity loans, residential construction loans, secured and unsecured personal loans and lines of credit and mortgage loans on investment and vacation properties.

Total loans were $794.6 million at June 30, 2007, an increase of $33.5 million, or 4%, compared to December 31, 2006.  Total loans represented 76% of total assets at both June 30, 2007 and December 31, 2006.

The following table sets forth the loan balances by certain loan categories at the dates indicated and the percentage of each category to gross loans.

		June 30, 2007					December 31, 2006					June 30, 2006
(Dollars in thousands)		Amount			Percent		Amount			Percent		Amount			Percent
Commercial real estate		$	381,203		48.0	%	$	368,621		48.3	%	$	341,368		46.5	%
Commercial and industrial		175,971			22.1	%	164,865			21.6	%	164,061			22.4	%
Commercial construction		118,482			14.9	%	114,078			15.0	%	120,692			16.4	%
Total Commercial loans		$	675,656		85.0	%	$	647,564		84.9	%	$	626,121		85.3	%
Residential mortgages		67,026			8.4	%	61,854			8.1	%	55,248			7.5	%
Residential construction		4,847			0.5	%	3,981			0.5	%	4,264			0.6	%
Home equity		43,093			5.4	%	44,038			5.8	%	43,673			6.0	%
Consumer		4,653			0.6	%	4,307			0.6	%	3,815			0.5	%
Loans held for sale		625			0.1	%	549			0.1	%	943			0.1	%
Gross loans		$	795,900		100	%	$	762,293		100.0	%	$	734,064		100.0	%
Deferred fees, net		(1,255		)			(1,180		)			(1,298		)
Total loans		794,645					761,113					732,766
Allowance for loan losses		(13,117		)			(12,940		)			(12,486		)
Net loans		$	781,528				$	748,173				$	720,280

 

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Commercial real estate loans were $381.2 million at June 30, 2007, compared to $368.6 million at December 31, 2006, an increase of $12.6 million, or 3%.  Commercial real estate loans are typically secured by apartment buildings, office or mixed-use facilities, strip shopping malls or other commercial property.

Commercial and industrial loans totaled $176.0 million at June 30, 2007, compared to $164.9 million at December 31, 2006, an increase of $11.1 million, or 7%.  Commercial loans include seasonal revolving lines of credit, working capital loans, equipment financing (including equipment leases), term loans, revolving lines of credit and loans under various U.S. Small Business Administration programs.  These commercial credits may be unsecured loans or lines to financially strong borrowers, secured in whole or in part by real estate unrelated to the principal purpose of the loan or secured by inventories, equipment or receivables, and are generally guaranteed by the principals of the borrower.

Commercial construction loans amounted to $118.5 million at June 30, 2007, compared to $114.1 million at December 31, 2006.  Commercial construction loans include the development of residential housing and condominium projects, the development of commercial and industrial use property and loans for the purchase and improvement of raw land.

At June 30, 2007, the company had commercial loan balances participated out to various banks amounting to $6.5 million, compared to $8.2 million at December 31, 2006.  These balances participated out to other institutions are not carried as assets on the company’s financial statements.  Loans originated by other banks in which the company is the participating institution are carried in the loan portfolio at the company’s pro rata share of ownership and amounted to $16.0 million and $18.3 million at June 30, 2007 and December 31, 2006, respectively.  The company performs an independent credit analysis of each commitment prior to participation in any loan.

Loans designated as qualified collateral for FHLB borrowing capacity amounted to $156.5 million and $42.5 million at June 30, 2007 and December 31, 2006, respectively.  In January 2007, the company increased its FHLB borrowing capacity by pledging additional commercial real estate, home equity and multi-family loans as collateral to the FHLB.

Asset Quality and the Allowance for Loan Losses

The company’s credit risk management function focuses on a wide variety of factors, including, among others, current and expected economic conditions and trends, the real estate market, the financial condition of borrowers, the ability of borrowers to adapt to changing conditions or circumstances affecting their business and the continuity of borrowers’ management teams.

Management regularly monitors these factors, as well as levels of non-accrual loans, levels of charge-offs and recoveries, growth and composition of the loan portfolio, expansion in geographic market areas, comparison to industry peers and known and inherent risks in the portfolio, through ongoing credit reviews by the credit department, an external loan review service, reviews by members of senior management and the Loan Committee of the Board of Directors and the full Board of Directors.

The allowance for loan losses is an estimate of credit risk inherent in the loan portfolio.  The allowance for loan losses is established through a provision for loan losses, a direct charge to earnings.  Loan losses are charged against the allowance when management believes that the collectability of the loan principal is unlikely.  Recoveries on loans previously charged off are credited to the allowance.  The company maintains the allowance at a level that it deems adequate to absorb all reasonably anticipated losses from specifically known and other credit risks associated with the portfolio.

In making its assessment on the adequacy of the allowance, management considers several quantitative and qualitative factors that could have an effect on the credit quality of the portfolio, some of which are outlined above.  There were no significant changes in credit quality, the company’s underwriting, or the allowance assessment methodology used to estimate loan loss exposure as reported in the company’s Annual Report on Form 10-K for the year ended December 31, 2006.

The allowance for loan losses to total loans ratio was 1.65% at June 30, 2007 compared to 1.70% at December 31, 2006.  Based on the foregoing, as well as management’s judgment as to the risks inherent in the loan portfolio, the company’s allowance for loan losses was deemed adequate to absorb reasonably anticipated losses from specifically known and other credit risks associated with the portfolio as of June 30, 2007.

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The following table sets forth information regarding non-performing assets and past due loans at the dates indicated:

(Dollars in thousands)		June 30, 2007			December 31, 2006			June 30, 2006
Non-accrual loans		$	3,056		$	1,785		$	1,999
Accruing loans > 90 days past due		1			7			—
Total non-performing loans		3,057			1,792			1,999
Other real estate owned		266			—			—
Total non-performing assets		$	3,323		$	1,792		$	1,999
Total Loans		$	794,645		$	761,113		$	732,766
Allowance for loan losses		$	13,117		$	12,940		$	12,486
Allowance for loan losses: Total loans		1.65		%	1.70		%	1.70		%
Allowance for loan losses: Non-performing loans		429.08		%	722.10		%	624.61		%
Non-performing loans: Total loans		0.38		%	0.24		%	0.27		%
Non-performing assets: Total assets		0.32		%	0.18		%	0.20		%
Loans 30-89 days past due: Total loans		0.54		%	0.75		%	0.40		%

 

Total non-performing assets were $3.3 million, or 0.32% of total assets, at June 30, 2007 compared to $1.8 million and $2.0 million at December 31, 2006 and June 30, 2006, respectively, representing 0.18% and 0.20% of total assets at those respective dates.  The December 31, 2006 ratio represents a historically low level in the non-performing assets to total assets ratio.  The increase since December was mainly due to four relationships added to non-accrual status during the period amounting to approximately $1.7 million, partially offset by principal paydowns.  Overall, non-performing assets are still considered to be at low levels at June 30, 2007.

The ratio of non-performing loans to total loans increased to 0.38% as of June 30, 2007, compared to 0.24% and 0.27% at December 31, 2006 and June 30, 2006, respectively.  The increase since December was mainly due to the four relationships referred to above amounting to 0.21% of total loans at June 30, 2007.  Management does not consider the increase since December to be indicative of deterioration in the credit quality of the general loan portfolio.

Loans for which management considers it probable that not all contractual principal and interest will be collected in accordance with the original loan terms are designated as impaired loans.  The majority of impaired loans are included within the non-accrual balances; however, not every loan in non-accrual status has been designated as impaired.  Impaired loans exclude large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment, loans that are measured at fair value and leases as defined in SFAS No. 114.  Total impaired loans were $2.9 million at June 30, 2007 compared to $1.8 million and $2.0 million at December 31, 2006 and June 30, 2006, respectively.

The ratio of delinquent loans 30-89 days past due, but still accruing, as a percentage of total loans decreased to 0.54% at June 30, 2007, from 0.75% at December 31, 2006 and increased from 0.40% at June 30, 2006.  The ratio of delinquent loans to total loans will fluctuate due to the timing of customer payments.  The largest concentration of these loans is generally less than 40 days past due, as was the case at June 30, 2007 at which time approximately 90% of delinquent loans were included in the 30 – 40 day past due category.

Management closely monitors the credit quality of individual delinquent and non-performing relationships, industry concentrations, the local and regional real estate market and current economic conditions.  The level of delinquent and non-performing assets is largely a function of economic conditions and the overall banking environment.  Despite prudent loan underwriting, adverse changes within the company’s market area or deterioration in the local, regional or national economic conditions could negatively impact the company’s level of non-performing assets in the future.

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The following tables summarize the activity in the allowance for loan losses for the periods indicated:

		Six months ended June 30,
(Dollars in thousands)		2007			2006
Balance at beginning of year		$	12,940		$	12,050
Charged off		(108		)	(141		)
Recovered		150			60
Net loans recovered/(charged off)		42			(81		)
Provision charged to operations		135			517
Balance at June 30		$	13,117		$	12,486
Annualized net loans recovered/(charged off): Average loans outstanding		0.01		%	(0.02		)%

 

Net loans recovered during the six months ended June 30, 2007 were $42 thousand compared to net charge offs of $81 thousand during the same period ended June 30, 2006.  The provision reflects management’s estimate of loan loss reserves necessary to support the level of credit risk inherent in the portfolio during the period.  The provision for loan losses, which is impacted by asset quality and loan growth, amounted to $135 thousand and $517 thousand for the quarters ended June 30, 2007 and 2006 respectively.  The reduced provision reflects net recoveries, the level of loan growth and the continued favorable asset quality during the period.

Deposits

Total deposits amounted to $938.9 million at June 30, 2007 compared to $867.5 million at December 31, 2006.  The increase of $71.4 million, or 8%, primarily resulted from an increase in brokered CDs of $55.1 million.

The highly-competitive marketplace and the flat rate environment contributed to a net decline in lower costing deposit products.  In order to sustain loan growth, the company has continued to strategically utilize both internally generated CDs and brokered CDs as an alternative to funding through higher costing FHLB advances and other borrowing sources.

The following table sets forth the deposit balances by certain categories at the dates indicated and the percentage of each category to total deposits.

		June 30, 2007					December 31, 2006					June 30, 2006
(Dollars in thousands)		Amount			Percent		Amount			Percent		Amount			Percent
Demand		$	170,403		18.1	%	$	169,910		19.6	%	$	170,148		19.1	%
Interest bearing checking		173,395			18.5	%	179,533			20.7	%	184,487			20.7	%
Total checking		343,798			36.6	%	349,443			40.3	%	354,635			39.8	%
Retail savings/money markets		141,418			15.1	%	141,202			16.3	%	144,538			16.2	%
Commercial savings/money markets		135,531			14.4	%	125,584			14.5	%	135,150			15.2	%
Total savings/money markets		276,949			29.5	%	266,786			30.8	%	279,688			31.4	%
Certificates of deposit		198,040			21.1	%	186,349			21.4	%	177,633			20.0	%
Total non-brokered deposits		818,787			87.2	%	802,578			92.5	%	811,956			91.2	%
Brokered certificates of deposit		120,094			12.8	%	64,944			7.5	%	78,523			8.8	%
Total deposits		$	938,881		100	%	$	867,522		100.0	%	$	890,479		100.0	%

 

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Borrowed Funds

Borrowed funds, consisting of securities sold under agreements to repurchase (“repurchase agreements”) and FHLB borrowings, amounted to $5.4 million at June 30, 2007 compared to $15.1 million at December 31, 2006.  Total repurchase agreements declined by $1.8 million since December 31, 2006 and were $3.1 million at June 30, 2007.  Total FHLB borrowings declined by $7.9 million since December 31, 2006 and amounted to $2.3 million at June 30, 2007.

At June 30, 2007, the bank had the capacity to borrow additional funds from the FHLB of up to $132.8 million.  Management believes that the company has adequate liquidity to meet its commitments.

Liquidity

Liquidity is the ability to meet cash needs arising from, among other things, fluctuations in loans, investments, deposits and borrowings.  Liquidity management is the coordination of activities so that cash needs are anticipated and met readily and efficiently. Liquidity policies are set and monitored by the company’s Asset-Liability Committee of the Board of Directors. The company’s liquidity is maintained by projecting cash needs, balancing maturing assets with maturing liabilities, monitoring various liquidity ratios, monitoring deposit flows, maintaining liquidity within the investment portfolio and maintaining borrowing capacity in the brokered CD market and at the FHLB.

The company’s asset-liability management objectives are to maintain liquidity, provide and enhance access to a diverse and stable source of funds, provide competitively priced and attractive products to customers, conduct funding at a low cost relative to current market conditions and engage in sound balance sheet management strategies.

The company funds earning assets with deposits, brokered CDs, repurchase agreements, FHLB borrowings, commercial lines of credit, junior subordinated debentures and earnings.

Capital Resources

As of June 30, 2007, both the company and the bank qualify as “well capitalized” under applicable regulations of the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) and the Federal Deposit Insurance Corporation.  To be categorized as well capitalized, the company and the bank must maintain minimum total, Tier 1 and, in the case of the bank, leverage capital ratios as set forth in the table below.

The company’s actual capital amounts and ratios are presented as of June 30, 2007 in the table below. The bank’s capital amounts and ratios do not differ materially from the amounts and ratios presented for the company.

		Actual					Minimum Capital for Capital Adequacy Purposes					Minimum Capital To Be Well Capitalized
(Dollars in thousands)		Amount			Ratio		Amount			Ratio		Amount			Ratio
Total Capital (to risk weighted assets)		$	96,675		11.28	%	$	68,560		8.00	%	$	85,700		10.00	%
Tier 1 Capital (to risk weighted assets)		85,445			9.97	%	34,280			4.00	%	51,420			6.00	%
Tier 1 Capital (to average assets)		85,445			8.81	%	38,800			4.00	%	48,500		*	5.00	%*

 

* This requirement does not apply to the company and is reflected in the table merely for informational purposes with respect to the bank.  For the bank to qualify as “well capitalized”, it must also maintain a leverage capital ratio (Tier 1 capital to average assets) of at least 5%.

The company maintains a dividend reinvestment plan (the “DRP”).  The DRP enables stockholders, at their discretion, to elect to reinvest dividends paid on their shares of the company’s common stock by purchasing additional shares of common stock from the company at a purchase price equal to fair market value.   Shareholders utilized the DRP to invest $263 thousand of the $623 thousand cash dividend paid through June 30, 2007, into 16,461 shares of the company’s common stock.

On July 17, 2007, the company announced a quarterly dividend of $0.08 to be paid on September 4, 2007 to shareholders of record as of August 14, 2007.  The quarterly dividend represents a 14% increase over the 2006 dividend rate.

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