e10vq

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2007

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

For the transition period from to

Commission File Number 000-24503

WASHINGTON BANKING COMPANY

(Exact name of registrant as specified in its charter)


Washington		91-1725825
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification Number)

450 SW Bayshore Drive
Oak Harbor, Washington 98277
(Address of principal executive offices) (Zip Code)

(360) 679-3121
(Registrant’s telephone number, including area code)

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

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

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

Large accelerated filer [ ] Accelerated filer [X] Non-Accelerated filer [ ]

Indicate by check mark if the registrant is a shell company as defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended. Yes [ ] No [X]

The number of shares of the issuer’s Common Stock outstanding at April 30, 2007 was 9,489,103.

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

WASHINGTON BANKING COMPANY
AND SUBSIDIARIES

Condensed Consolidated Statements of Financial Condition (unaudited)

(Dollars in thousands)


			March 31,				December 31,
Assets		2007				2006

Cash and due from banks		$		21,516	$			18,984
($3,365 and $3,703, respectively, are restricted)
Interest-bearing deposits				783				761
Federal funds sold				4,640				—

Total cash, restricted cash, and cash equivalents				26,939				19,745

Investment securities available for sale				16,748				16,790

Federal Home Loan Bank stock				1,984				1,984

Loans held for sale				4,717				2,458

Loans receivable				731,895				719,580
Allowance for loan losses				(10,212)				(10,048)

Total loans, net				721,683				709,532
Premises and equipment, net				23,235				23,372
Bank owned life insurance				11,017				10,930
Other assets				9,566				9,734

Total assets	$			815,889	$			794,545


Liabilities and Shareholders’ Equity
Liabilities:
Deposits
Noninterest-bearing	$			101,222	$			96,858
Interest-bearing				315,197				303,979
Time deposits				309,954				302,930

Total deposits				726,373				703,767

FHLB overnight borrowings				—				3,075
Junior subordinated debentures				15,007				15,007
Other liabilities				5,728				6,303

Total liabilities				747,108				728,152

Commitments and contingencies				—				—

Shareholders’ equity:
Preferred stock, no par value. Authorized 20,000 shares:
no shares issued or outstanding				—				—
Common stock, no par value. Authorized 13,679,757 shares:
issued and outstanding 9,445,867 at 3/31/2007 and 9,388,600 at 12/31/2006⁽¹⁾				33,587				33,016
Retained earnings				35,217				33,422
Accumulated other comprehensive loss				(23)				(45)

Total shareholders’ equity				68,781				66,393

Total liabilities and shareholders’ equity	$			815,889	$			794,545

⁽¹⁾		Adjusted to reflect a 5-for-4 stock split distributed by the Company on September 6, 2006.

		See accompanying notes to condensed consolidated financial statements.

WASHINGTON BANKING COMPANY
AND SUBSIDIARIES

Condensed Consolidated Statements of Income (unaudited)
(Dollars and shares in thousands, except per share data)


		Three Months Ended
		March 31,
		2007			2006
Interest income:
Interest and fees on loans	$		14,495	$		12,407
Interest on taxable investment securities			121			103
Interest on tax exempt investment securities			71			80
Other			43			59

Total interest income			14,730			12,649

Interest expense:
Interest on deposits			5,323			3,095
Interest on other borrowings			34			150
Interest on junior subordinated debentures			338			309

Total interest expense			5,695			3,554

Net interest income			9,035			9,095
Provision for loan losses			550			500

Net interest income after provision for loan losses			8,485			8,595

Noninterest income:
Service charges and fees			816			817
Income from the sale of loans			155			182
SBA premium income			72			135
Other			695			749

Total noninterest income			1,738			1,883

Noninterest expense:
Salaries and benefits			4,411			4,276
Occupancy and equipment			956			858
Office supplies and printing			130			181
Data processing			141			82
Consulting and professional fees			171			119
Other			1,115			1,166

Total noninterest expense			6,924			6,682

Income before provision for income taxes			3,299			3,796
Provision for income taxes			1,032			1,244

Net income	$		2,267	$		2,552


Net income per share, basic⁽¹⁾	$		0.24	$		0.28


Net income per share, diluted⁽¹⁾	$		0.24	$		0.27


Average number of shares outstanding, basic⁽¹⁾			9,389,000			9,204,000
Average number of shares outstanding, diluted⁽¹⁾			9,558,000			9,473,000

⁽¹⁾ Adjusted to reflect a 5-for-4 stock split distributed by the Company on September 6, 2006

See accompanying notes to condensed consolidated financial statements.

WASHINGTON BANKING COMPANY
AND SUBSIDIARIES

Condensed Consolidated Statements of Shareholders’ Equity

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


													Accumulated
													other				Total
	Common stock						Retained			Deferred			comprehensive				shareholders’
	Shares			Amount			earnings			compensation			loss				equity
Balances at December 31, 2005 ⁽¹⁾		9,228	$		32,492	$		25,789	$		(386)	$		(46	)	$		57,849

Comprehensive income:
Net income		—			—			2,552			—			—				2,552
Net unrealized loss on securities available for sale, net of tax of ($18)		—			—			—			—			(35)				(35)

Total comprehensive income		—			—			—			—			—				2,517

Transition adjustment for adoption of SFAS 123(R)		—			(386)			—			386			—				—
Cash dividend, $0.05 per share⁽¹⁾		—			—			(463)			—			—				(463)
Stock based compensation expense		—			54			—			—			—				54
Issuance of common stock- stock options ⁽¹⁾		29			91			—			—			—				91
Issuance of restricted stock ⁽¹⁾		4			—			—			—			—				—

Balances at March 31, 2006		9,261	$		32,251	$		27,878	$		—	$		(81	)	$		60,048


Balances at December 31, 2006 ⁽¹⁾		9,389	$		33,016	$		33,422	$		—	$		(45	)	$		66,393
Comprehensive income:
Net income		—			—			2,267			—			—				2,267
Net unrealized gain on securities available for sale, net of tax of $12		—			—			—			—			22				22

Total comprehensive income		—			—			—			—			—				2,289

Cash dividend, $0.05 per share		—			—			(472)			—			—				(472)
Stock based compensation expense		—			142			—			—			—				142
Issuance of common stock- stock options		55			382			—			—			—				382
Issuance restricted stock		2			—			—			—			—				—
Tax benefit associated with stock awards		—			47			—			—			—				47

Balances at March 31, 2007		9,446	$		33,587	$		35,217	$		—	$		(23	)	$		68,781

⁽¹⁾ Adjusted to reflect a 5-for-4 stock split distributed by the Company on September 6, 2006

See accompanying notes to condensed consolidated financial statements.

WASHINGTON BANKING COMPANY
AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows (unaudited)

(Dollars in thousands)


		Three Months Ended
		March 31,
		2007			2006

Cash flows from operating activities:
Net income from continuing operations	$		2,267	$		2,552
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of investment premiums, net			—			3
Deferred income tax expense (benefit)			164			(122)
Depreciation and amortization			443			408
Earnings on bank owned life insurance			(87)			(88)
Provision for loan losses			550			500
Net loss on sale of premises and equipment			—			127
Net loss on sale of other real estate			—			(6)
Write-downs of other real estate			—			10
Excess tax benefits from stock based compensation			(47)			—
Amortization of stock-based compensation			142			54
Net change in assets and liabilities:
Net decrease in subsidiary investment			11			12
Net (increase) decrease in loans held for sale			(2,259)			1,404
Increase in other assets			(336)			(705)
Decrease in other liabilities			(575)			(1,071)

Cash provided by operating activities			273			3,078


Cash flows from investing activities:
Purchases of investment securities, available for sale			(928)			—
Maturities/calls/principal payments of investment and mortgage-backed securities, available for sale			1,005			8
Net increase in loans			(12,701)			(21,056)
Purchases of premises and equipment			(306)			(612)
Proceeds from the sale of other real estate owned and premises and equipment			363			65

Cash flows used by investing activities			(12,567)			(21,595)


Cash flows from financing activities:
Net increase in deposits			22,606			8,517
Net decrease in FHLB overnight borrowings			(3,075)			—
Dividends paid on common stock			(472)			(463)
Excess tax benefits from stock based compensation			47			—
Proceeds from issuance of common stock- stock options			382			91

Cash flows provided by financing activities			19,488			8,145

Net change in cash and cash equivalents			7,194			(10,372)
Cash and cash equivalents at beginning of period			19,745			42,027

Cash and cash equivalents at end of period	$		26,939	$		31,655


Supplemental information:
Loans foreclosed and transferred to other real estate owned	$		—	$		69
Cash paid for interest			5,714			3,572
Cash paid for income taxes			810			—

See accompanying notes to condensed consolidated financial statements.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three months ended March 31, 2007 and 2006 (unaudited)
(Dollars in thousands, except per share data)

(1)

Description of Business and Summary of Significant Accounting Policies

(a) Description of Business: Washington Banking Company (the “Company” or “WBCO”) is a registered bank holding company formed on April 30, 1996. At March 31, 2007, WBCO had two wholly owned subsidiaries – Whidbey Island Bank (“WIB” or the “Bank”), the Company’s principal subsidiary, and Washington Banking Capital Trust I (the “Trust”). The business of the Bank, which is focused in the northern area of Western Washington, consists primarily of attracting deposits from the general public and originating loans. The region’s economy has evolved from one that was once heavily dependent upon forestry, fishing and farming to an economy with a much more diverse blend of industries including retail trade, services, manufacturing, tourism and a large military base presence. Although the Bank has a diversified loan portfolio, a substantial portion of its borrowers’ ability to repay their loans is dependent upon the economic conditions affecting this area.

(b) Basis of Presentation: The accompanying interim condensed consolidated financial statements include the accounts of WBCO and its subsidiaries described above. The accompanying interim condensed consolidated financial statements have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles in the United States of America for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the December 31, 2006 audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC. In management’s opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007. In preparing the condensed consolidated financial statements, estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses are required. Actual results could differ from those estimates.

(c) Reclassifications: Certain amounts in prior year’s financial statements may have been reclassified to conform to the 2007 presentation. These reclassifications had no significant impact on the Company’s financial position or results of operations.

(2)

Recent Financial Accounting Pronouncements

In February 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (Including an amendment of FASB Statement No. 115). This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This Statement is effective for entities’ first fiscal year that begins after November 15, 2007. The Company did not early adopt and has not determined if it will adopt the standard at this time.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three months ended March 31, 2007 and 2006 (unaudited)
(Dollars in thousands, except per share data)

(3)

Earnings Per Share

On September 6, 2006 the Company issued a 5-for-4 stock split to shareholders of record as of August 21, 2006. All periods presented have been restated to reflect the stock split.

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


	Three Months Ended
	March 31,
	2007		2006
Weighted average shares-basic		9,389,000		9,204,000

Effect of dilutive securities: stock awards		169,000		269,000


Weighted average shares-diluted		9,558,000		9,473,000

At March 31, 2007 and 2006, there were options to purchase 250,417 and 413,170 shares of common stock outstanding, respectively. For the three months ended March 31, 2007, 3,533 options were antidilutive and therefore not included in the computation of diluted net income per share. There were no antidilutive options at March 31, 2006.

(4)

Stock-Based Compensation

(a) Stock Options: The Company measures the fair value of each stock option grant at the date of the grant, using the Black Scholes option pricing model. The weighted average fair value per share of options granted during the three months ended March 31, 2007 and 2006 was $5.11 and $5.79 per share, respectively. The following assumptions were used in arriving at the fair value of options granted:


	Three Months Ended
	March 31,
	2007			2006
Risk-free interest rate		4.85	%		4.32	%

Dividend yield rate		1.50	%		1.40	%

Price volatility		33.00	%		38.13	%

Expected life of stock options		5 years			7 years

The Company recognizes compensation expense for stock option awards on a straight-line basis over the requisite service period of the award. For the three months ended March 31, 2007 and 2006 the Company recognized $28 and $17, respectively, in stock based compensation expense as a component of salaries and benefits. As of March 31, 2007 there was approximately $166 of total unrecognized compensation cost related to nonvested stock awards.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three months ended March 31, 2007 and 2006 (unaudited)
(Dollars in thousands, except per share data)

The following table summarizes information on stock option activity during 2007:



				Weighted		Weighted average			Aggregate
				average exercise		remaining contractual			intrinsic
	Shares			price per share		terms (in years)			value
Outstanding at January 1, 2007		331,944	$		6.03

Granted		1,000			15.77

Exercised		(77,627)			5.16			$		817

Forfeited, expired or cancelled		(4,900)			9.64


Outstanding at March 31, 2007		250,417	$		6.31		3.96	$		2,257



Exercisable at March 31, 2007		202,630	$		5.09		3.05	$		2,069

The aggregate intrinsic value in the table above represents the total pretax intrinsic value (i.e., the difference between the Company’s closing stock price on March 31, 2007 and the exercise price, times the number of shares) that would have been received by the option holders had all the option holders exercised their options on March 31, 2007. This amount changes based upon the fair market value of the Company’s stock.

(b) Restricted Stock Awards: The Company grants restricted stock periodically for the benefit of employees. Recipients of restricted stock do not pay any cash consideration to the Company for the shares and receive all dividends with respect to such shares, whether or not the shares have vested. Restrictions are based on continuous service.

The following table summarizes information on restricted stock activity during 2007:


				Weighted average		Weighted average remaining
	Shares			grant price per share		contractual terms (in years)
Outstanding at January 1, 2007		50,123	$		12.50

Granted		2,536			15.80

Vested		(15,640)			11.37

Forfeited, expired or cancelled		(2,678)			12.59


Outstanding at March 31, 2007		34,341	$		13.26		3.70

For the three months ended March 31, 2007 and 2006 the Company recognized $44 and $37, respectively, in restricted stock compensation expense as a component of salaries and benefits. As of March 31, 2007 there was $407 of total unrecognized compensation costs related to nonvested restricted stock.

(5)

Income Taxes

The Company adopted FIN 48, Accounting for Uncertainty in Income Taxes, on January 1, 2007. FIN 48 is an interpretation of SFAS No. 109, Accounting for Income Taxes, and it seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. In addition, FIN 48 provides guidance on derecognition, classification, interest and penalties, and accounting in interim periods and requires expanded disclosure with respect to uncertainty in income taxes. As a result of the implementation of FIN 48, the Company recognized no material adjustments in the liability for unrecognized income tax benefits, all of which would affect the Company’s effective income tax rate if recognized.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three months ended March 31, 2007 and 2006 (unaudited)
(Dollars in thousands, except per share data)

Income tax expense attributable to income for the three months ended March 31, 2007 and 2006 consisted of the following:


		Three Months Ended
		March 31,
		2007			2006

Federal:
Current tax expense	$		868	$		1,366
Deferred tax expense (benefit)			164			(122)

Total	$		1,032	$		1,244

The Company’s effective tax rate varies from the federal income tax statutory rates of 35.0% in 2007 and 34.3% in 2006. A reconciliation of the differences for the three months ended March 31, 2007 and 2006 is as follows:


		Three Months Ended
		March 31,
		2007			2006

Income tax expense at federal statutory rates	$		1,155	$		1,302

Federal tax credits			(100)			—

Tax-exempt securities			(78)			(75)

Other items			55			17


Total	$		1,032	$		1,244

The effective tax rate for 2007 is impacted by Federal tax credits related to the New Markets Tax Credit program whereby a subsidiary of Whidbey Island Bank has been awarded $3,100 in future Federal tax credits which are available through 2012. Tax benefits related to these credits will be recognized for financial reporting purposes in the same periods that the credits are recognized in the Company’s income tax returns. The Company believes that it will comply with the various regulatory provisions of the New Markets Tax Credit program in 2007, and therefore has reflected the impact of the credits in its estimated annual effective tax rate for 2007.

The components of deferred income tax included in other assets in the accompanying consolidated financial statements at March 31, 2007 and December 31, 2006 are as follows:


		March 31,			December 31,
		2007			2006

Deferred tax assets:
Loan loss allowances	$		3,574	$		3,517
Deferred compensation			306			404
Other			30			20
Market value adjustment of investment securities available for sale			14			25

Total deferred tax assets			3,924			3,966


Deferred tax liabilities:
Deferred loan fees			1,639			1,552
Premises and equipment			394			433
Investment in partnership			175			140
FHLB stock			152			152
Prepaid expenses			116			111
Other			68			23

Total deferred tax liabilities			2,544			2,411

Deferred tax assets, net	$		1,380	$		1,555

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three months ended March 31, 2007 and 2006 (unaudited)
(Dollars in thousands, except per share data)

There was no valuation allowance for deferred tax assets as of March 31, 2007 or December 31, 2006. The Company has determined that it is not required to establish a valuation allowance for the deferred tax assets as management believes it is more likely than not that the deferred tax assets will be realized in the normal course of business.

(6)

Subsequent Events

On April 2, 2007, Washington Banking Master Trust (the “Master Trust”), a wholly-owned subsidiary of the Company, was created for the exclusive purpose of issuing trust preferred securities. The Master Trust issued $10,300 of trust preferred securities with a thirty year maturity and are callable by the Company after five years. The securities require quarterly interest payments by the Master Trust. The interest rate is reset quarterly at the three-month LIBOR rate plus 1.56%.

On April 3, 2007, the Company announced the adoption of a stock repurchase plan. The plan authorizes the Company to repurchase up to 472,134 shares of common stock.

On April 26, 2007, the Company announced that its Board of Directors declared a cash dividend of $0.06 per share to shareholders of record as of May 8, 2007, payable on May 23, 2007.

(7)

Commitments and Guarantees

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. Except for certain long-term guarantees, most guarantees expire in one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounted to one hundred percent of the commitment amount at March 31, 2007. The Company routinely charges a fee for these credit facilities. Such fees are amortized into income over the life of the agreement, and unamortized amounts were not significant as of March 31, 2007. As of March 31, 2007 the commitments under these agreements were $1,764.

At March 31, 2007, the Company was the guarantor of trust preferred securities. The Company has issued junior subordinated debentures to a wholly owned special purpose trust, which has issued trust preferred securities. The sole assets of the special purpose trust are the junior subordinated debentures issued by the Company. Washington Banking Company has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements. The maximum amount of future payments the Company will be required to make under these agreements is the principal and interest of the trust preferred securities, the principal of which totaled $15,007 at March 31, 2007.

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

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

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

Overview

Washington Banking Company (referred to in this report as the “Company”) is a registered bank holding company with two wholly-owned subsidiaries: Whidbey Island Bank (the “Bank”), the Company’s principal subsidiary and Washington Banking Capital Trust I (the “Trust”). Headquartered in Oak Harbor, the Company’s market area is primarily northwestern Washington. The market area encompasses distinct economies, and none are particularly dependent upon a single industrial or occupational source. The economies within the market areas have evolved from being heavily dependent upon forestry, fishing and farming to a more diverse blend of industries including retail trade, services, manufacturing, tourism and a large military presence.

The Company’s strategy is one of value-added growth. Management believes that qualitative and sustainable growth of the Company, coupled with maintaining profitability, is currently the most appropriate path to providing good value for its shareholders. To date, the Company’s growth has been achieved organically and it attributes its reputation for focusing on customer service and satisfaction as one of the cornerstones to the Company’s success. The Company’s primary objectives are to improve profitability and operating efficiencies, increase market penetration in areas currently served, and to continue an expansion strategy in appropriate market areas.

Summary of Critical Accounting Policies

Significant accounting policies are described in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2006 as filed in Form 10-K. Not all of these accounting policies require management to make difficult, subjective or complex judgments or estimates. Management believes that the following accounting policies could be considered critical under the SEC’s definition.

Allowance for Loan Losses: There have been no material changes in the accounting policy relating to allowance for loan losses as compared to that contained in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2006 as filed in Form 10-K.

Stock-based Compensation: There have been no material changes in the accounting policy relating to stock-based compensation as compared to that contained in Note (1) of the Notes to Consolidated Financial Statements for the year ended December 31, 2006 as filed in Form 10-K.

Results of Operations Overview

The Company’s net income decreased to $2.3 million or $0.24 per diluted share, in the first quarter of 2007, compared with $2.6 million or $0.27 per diluted share in the first quarter of 2006. Return on average equity decreased to 13.69% in the first quarter of 2007, compared with 17.68% in the corresponding quarter of 2006. Return on average assets decreased to 1.15% in the first quarter of 2007, compared with 1.45% in first quarter of 2006.

Net Interest Income: One of the Company’s key sources of earnings is net interest income. To make it easier to compare results among several periods and the yields on various types of earning assets (some of which are taxable and others which are not), net interest income is presented in this discussion on a “taxable-equivalent basis” (i.e., as if it were all taxable at the same rate). There are several factors that affect net interest income including:

§		The volume, pricing, mix and maturity of interest-earning assets and interest-bearing liabilities;

§		The volume of free funds (consisting of noninterest-bearing deposits and other liabilities and shareholders’ equity);

§		The volume of noninterest-earning assets;

§		Market interest rate fluctuations; and

§		Asset quality

The following tables set forth various components of the balance sheet that affect interest income and expense, and their respective yields or rates:


		Average Balance Sheet and Analysis of Net Interest Income and Yields/Rates
		Three Months Ended									Three Months Ended
		March 31, 2007									March 31, 2006
		Average			Interest		Average				Average			Interest		Average
(Dollars in thousands)		balance			earned/paid		yield				balance			earned/paid		yield
Assets

Loans ^{(1) (2)}	$		723,735	$		14,628		8.20	%	$		639,742	$		12,433		7.88	%
Federal funds sold			1,771			22		5.04	%			3,457			39		4.58	%
Interest-earning cash			770			10		5.27	%			867			11		5.15	%
Investments:
Taxable			12,393			133		4.35	%			13,696			112		3.32	%
Non-taxable ⁽²⁾			6,798			104		6.22	%			7,589			124		6.63	%

Interest-earning assets			745,467			14,897		8.10	%			665,351			12,719		7.75	%
Noninterest-earning assets			51,717									46,702

Total assets	$		797,184							$		712,053


Liabilities and Shareholders’ Equity
Deposits:
Interest demand and money market	$		252,937	$		1,583		2.54	%	$		216,038	$		814		1.53	%
Savings			49,176			91		0.75	%			57,690			112		0.79	%
Time deposits			308,592			3,649		4.80	%			247,336			2,169		3.56	%

Interest-bearing deposits			610,705			5,323		3.53	%			521,064			3,095		2.41	%
Federal funds purchased			2,291			34		5.84	%			4,519			54		4.85	%
Junior subordinated debentures			15,007			338		9.13	%			15,007			309		8.35	%
Other borrowed funds			¾			¾		0.00	%			10,046			96		3.88	%

Interest-bearing liabilities			628,003			5,695		3.68	%			550,636			3,554		2.62	%
Noninterest-bearing deposits			96,097									98,780
Other noninterest-bearing liabilities			5,920									4,094

Total liabilities			730,020									653,510
Shareholders’ equity			67,164									58,543

Total liabilities and shareholders’ equity	$		797,184							$		712,053


Net interest income				$		9,202							$		9,165


Net interest spread								4.42	%								5.13	%

Net interest margin								5.01	%								5.59	%


⁽¹⁾	Average balance includes nonaccrual loans.

⁽²⁾	Interest income on non-taxable investments and loans is presented on a taxable-equivalent basis using the federal statutory rate of 35.0% and 34.3% in 2007 and 2006, respectively. These adjustments were $167 and $70 for the three months ended March 31, 2007 and 2006, respectively. Taxable-equivalent is a Non GAAP performance measurement that management believes provides investors with a more accurate picture of the net interest margin and efficiency ratio for comparative purposes.

Taxable-equivalent net interest income was flat at $9.2 million in the first quarter of 2007 and 2006. Though taxable-equivalent net interest income was flat, there were significant changes in the mix of interest-earning assets and interest-bearing liabilities and their related rates. Average interest-earning assets increased due to strong loan growth. The yields on interest-earning assets increased 35 basis points in the first quarter of 2007 to 8.10%, from 7.75% in the same period in 2006. Pricing pressure caused the average cost of interest-bearing liabilities to increase 106 basis points from the corresponding quarter in 2006, which was exacerbated by the change in the deposit mix towards higher cost time deposit and money market products. These changes caused the net interest margin to decrease 58 basis points in the first quarter of 2007 to 5.01% from 5.59% in the same period last year.

The following table shows how changes in yields or rates and average balances affected net interest income for the first quarters of 2007 and 2006:


		Three Months Ended
		March 31
		2007 vs. 2006
		Increase (decrease) due to⁽²⁾:
		Volume			Rate			Total
Assets:

Loans ^{(1) (3)}	$		1,632	$		563	$		2,195
Federal funds sold			(19)			2			(17)
Interest-bearing cash			(1)			¾			(1)
Investments ⁽¹⁾			(24)			25			1


Total interest earning assets			1,589			590			2,178


Liabilities:

Deposits:
Interest demand and money market			139			630			769
Savings			(17)			(4)			(21)
Time deposits			537			943			1,480
Interest on other borrowed funds			(27)			6			(21)
Junior subordinated debentures			¾			29			29
Other interest-bearing liabilities			(95)			¾			(95)


Total interest-bearing liabilities			538			1,603			2,141


Total increase (decrease) in net interest income	$		1,050	$		(1,013)	$		37


⁽¹⁾		Interest on loans and investments is presented on a fully tax-equivalent basis.

⁽²⁾		The changes attributable to the combined effect of volume and interest rates have been allocated proportionately.

⁽³⁾		Interest income previously accrued on nonaccrual loans is reversed in the period the loan is placed on nonaccrual status.

Noninterest Income: Noninterest income in the first quarter of 2007 decreased 8% to $1.7 million compared to $1.9 million in the corresponding quarter of 2006. Changes in noninterest income were primarily due to a $63,000 decline in SBA premiums and a $27,000 decline in income from the sale of loans as compared to the corresponding quarter in 2006. Additionally, annuity income, a component of other noninterest income, decreased $92,000 in the first quarter of 2007, compared to the first quarter of 2006. These decreases were offset by an increase in electronic banking fees, a component of other noninterest income, of $63,000.

Noninterest Expense: Noninterest expense in the first quarter of 2007 increased 4% to $6.9 million compared to $6.7 million for the first quarter of 2006. Salaries and benefits for the first quarter of 2007 increased $135,000 due to a one-time insurance charge of $53,000, $19,000 of additional stock-based compensation offset by reduced deferred salary expense related to lower loan origination volumes. Occupancy and equipment for the first quarter of 2007 increased $98,000 due to the addition of a new branch in the fourth quarter of 2006. Consulting and professional fees increased $52,000 in the first quarter of 2007 due to increased audit fees.

Income Taxes: The Company’s consolidated effective tax rates for the first quarters of 2007 and 2006 were 31.3% and 32.8%, respectively. The effective tax rates are below the federal statutory rate of 35% principally due to nontaxable income generated from investments in bank owned life insurance, tax-exempt municipal bonds and loans. Additionally, the Company’s first quarter 2007 tax rate reflects a benefit from the New Market Tax Credit Program whereby a subsidiary of Whidbey Island Bank has been awarded approximately $3.1 million in future federal tax credits. The tax benefits related to these credits will be recognized in the same periods that the credits are recognized on the Company’s income tax returns.

Financial Condition Overview

Total assets were $815.9 million at March 31, 2007, an increase of $21.3 million from December 31, 2006. During the first three months of 2007 the Company continued to focus on growing the loan and deposit portfolios. Loans at March 31, 2007 grew 2% to $731.9 million compared to December 31, 2006. Deposits at March 31, 2007 were $726.4 million, an increase of 3% from December 31, 2006.

Loans: Total loans outstanding as of March 31, 2007 were $731.9 million, an increase of $12.3 million from December 31, 2006. The total loan portfolio at March 31, 2007 represented 90% of total assets as compared to 91% of total assets at December 31, 2006.

Active portfolio management has resulted in a diversified portfolio that is not heavily concentrated in any one industry or community. The following table further details the major components of the loan portfolio:


		Loan Portfolio Composition as of:
		March 31, 2007						December 31, 2006						Change
(Dollars in thousands)		Balance		% of total				Balance		% of total				2007 vs. 2006
Commercial	$		88,781		12.2	%	$		82,990		11.6	%	$		5,791

Real estate mortgages:
One-to-four family residential			54,045		7.4	%			54,509		7.6	%			(464)
Commercial			250,399		34.3	%			249,109		34.7	%			1,290

Total real estate mortgages			304,444		41.7	%			303,618		42.3	%			826
Real estate construction:
One-to-four family residential			96,627		13.2	%			96,107		13.3	%			520
Multi-family and commercial			47,849		6.6	%			46,329		6.5	%			1520

Total real estate construction			144,476		19.8	%			142,436		19.8	%			2,040
Consumer:
Indirect			109,466		15.0	%			104,794		14.6	%			4,672
Direct			82,510		11.3	%			83,741		11.7	%			(1,231)

Total consumer			191,976		26.3	%			188,535		26.3	%			3,441

Subtotal			729,677		100.0	%			717,579		100.0	%			12,098

Deferred loan fees, net			2,218						2,001						217

Total loans, net	$		731,895				$		719,580				$		12,315

Allowance for Loan Losses: The allowance for loan losses at March 31, 2007 was $10.2 million or 1.40% of total loans and 282.95% of total non-performing loans. This compares with an allowance of $10.1 million or 1.40% of total loans and 276.19% of total non-performing loans at December 31, 2006.

The allowance for loan losses is maintained at a level considered adequate by management to provide for loan losses inherent in the portfolio. The Company assesses the allowance on a quarterly basis. The evaluation of the allowance is based on a continuing assessment of nonperforming assets, recent and historical loss experience, and other factors, including regulatory guidance and economic factors. While the Company believes that it uses the best information available to determine the allowance for loan losses unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected if circumstances differ substantially from the assumptions used in making the final determination. The Company anticipates that normal growth of the loan portfolio will require continued increases in the allowance for loan losses. The following table details the activity of the allowance for loan losses:


		Three Months Ended
		March 31,
(Dollars in thousands)		2007			2006
Balance at beginning of period	$		10,048	$		8,810

Charge-offs:
Commercial			(370)			(163)
Real estate			¾			(60)
Consumer:
Direct			(88)			(101)
Indirect			(135)			(231)

Total charge-offs			(593)			(555)

Recoveries:
Commercial			48			191
Real estate			71			¾
Consumer:
Direct			34			53
Indirect			54			131

Total recoveries			207			375

Net charge-offs			(386)			(180)
Provision for loan losses			550			500

Balance at end of period	$		10,212	$		9,130


Indirect net charge-offs to average indirect loans ⁽¹⁾			0.31%			0.43%
Other net charge-offs to average other loans ⁽¹⁾			0.20%			0.06%
Net charge-offs to average loans ⁽¹⁾			0.21%			0.11%

⁽¹⁾Excludes loans held for sale.

The changes in the allocation of the allowance for loan losses in the first three months of 2007 were due primarily to changes in the loan portfolio and its mix, changes in the risk grading of loans and charge-off and recovery activity.

During the first quarter of 2007, the Company recorded a $550,000 provision for loan losses compared to $500,000 for the first quarter in 2006. Net charge-offs for first quarter of 2007 were $386,000, a $206,000 increase over the first quarter of 2006. This increase is the result of an unusually high level of recoveries in the first quarter of 2006.

The table below details the Company’s allocation of the allowance for loan losses by loan type and remaining unallocated allowances:


		Allocation of the Allowance for Loan Losses as of:
		March 31, 2007							December 31, 2006							March 31, 2006
				% of		% of					% of		% of					% of		% of
(Dollars in thousands)		Amount		Allowance⁽²⁾		Loans ⁽¹⁾			Amount		Allowance⁽²⁾		Loans ⁽¹⁾			Amount		Allowance⁽²⁾		Loans ⁽¹⁾

Balance applicable to:
Commercial	$		813		8.0%		12.2%	$		782		7.8%		11.6%	$		769		8.4%		12.4%
Real estate mortgage			3,220		31.5%		41.7%			3,303		32.9%		42.3%			3,005		32.9%		42.1%
Real estate construction			1,761		17.2%		19.8%			1,781		17.7%		19.8%			1,473		16.1%		18.5%
Consumer			2,578		25.2%		26.3%			2,593		25.8%		26.3%			2,407		26.4%		27.0%
Unallocated			1,840		18.1%		N/A			1,589		15.8%		N/A			1,476		16.2%		N/A

Total	$		10,212		100.0%		100.0%	$		10,048		100.0%		100.0%	$		9,130		100.0%		100.0%


⁽¹⁾		Represents the total of all outstanding loans in each category as a percent of total loans outstanding.

⁽²⁾		Represents the total allowance allocated to each loan category as a percent of total allowance for loan losses.

Nonperforming Assets: The table below shows the composition of the Company’s nonperforming assets:


		Nonperforming Assets as of:
		March 31,			December 31,
(Dollars in thousands)		2007			2006
Nonaccrual loans	$		3,609	$		3,638
Restructured loans			¾			¾

Total nonperforming loans			3,609			3,638
Other real estate owned			¾			363

Total nonperforming assets	$		3,609	$		4,001

Total impaired loans	$		3,609	$		4,001
Accruing loans past due ³ 90 days			¾			30
Potential problem loans			¾			¾
Allowance for loan losses	$		10,212	$		10,048

Nonperforming loans to loans			0.49%			0.51%
Allowance for loan losses to nonperforming loans			282.95%			276.19%
Allowance for loan losses to nonperforming assets			282.95%			251.13%
Nonperforming assets to total assets			0.44%			0.50%

Deposits: In the first three months of 2007, the Company made a concerted effort to attract deposits through competitive pricing and delivery of quality service. Total deposits in the first three months of 2007 increased $22.6 million to $726.4 million at quarter end. Money market accounts were the largest portion of the deposit growth, an $8.1 million increase for the period. Additionally, noninterest-bearing demand deposits increased $4.4 million for the period.

The following table further details the major components of the deposit portfolio:


		Deposit Composition as of:
		March 31, 2007					December 31, 2006					Change
(Dollars in thousands)		Balance		% of total			Balance		% of total			2007 vs. 2006
Noninterest-bearing demand	$		101,222		13.9%	$		96,858		13.8%	$		4,364
NOW accounts			155,997		21.5%			152,087		21.6%			3,910
Money market			109,918		15.1%			101,856		14.5%			8,062
Savings			49,282		6.8%			50,036		7.1%			(754	)
Time deposits			309,954		42.7%			302,930		43.0%			7,024

Total deposits	$		726,373		100.0%	$		703,767		100.0%	$		22,606

Junior Subordinated Debentures: On April 2, 2007, a newly created wholly-owned subsidiary of the Company issued $10.3 million of trust preferred securities. The debentures, within certain limitations, are considered Tier 1 capital for regulatory capital requirements.

Capital

Shareholders’ Equity: Total shareholders’ equity increased 4% to $68.8 million at March 31, 2007 from $66.4 million at December 31, 2006. This was principally due to the retention of $1.8 million, or approximately 80% of net income for the first three months of 2007 and proceeds from the exercise of stock awards of $382,000. The Company paid approximately $472,000 of cash dividends during the first quarter of 2007.

On May 2, 2007, the Company repurchased 85,000 shares on the open market at a price of $16.00 per share. Total cost of the transaction was $1.37 million.

Regulatory Capital Requirements: Banking regulations require bank holding companies and banks to maintain a minimum leverage ratio of core capital to adjusted average total assets of at least 4%. In addition, banking regulators have adopted risk-based capital guidelines, under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Tier I capital generally consists of common shareholders’ equity (which does not include unrealized gains and losses on securities), less goodwill and certain identifiable intangible assets, while Tier II capital includes the allowance for loan losses and subordinated debt, both subject to certain limitations.

The FDIC established the qualifications necessary to be classified as a “well-capitalized” bank, primarily for assignment of FDIC insurance premium rates. As the following table indicates, the Company and Bank qualified as “well-capitalized” at March 31, 2007 and December 31, 2006:


	Regulatory Requirements						Actual Ratios
	Adequately-			Well-			March 31,			December 31,
	capitalized			capitalized			2007			2006
Total risk-based capital ratio
Company (consolidated)		8	%		N/A			11.61	%		11.52	%
Whidbey Island Bank		8	%		10	%		11.34	%		11.19	%
Tier 1 risk-based capital ratio
Company (consolidated)		4	%		N/A			10.35	%		10.27	%
Whidbey Island Bank		4	%		6	%		10.09	%		9.94	%
Leverage ratio
Company (consolidated)		4	%		N/A			10.50	%		10.24	%
Whidbey Island Bank		4	%		5	%		10.23	%		9.92	%

There can be no assurance that additional capital will not be required in the near future due to greater-than-expected growth, unforeseen expenses or revenue shortfalls, or otherwise.

Liquidity and Cash Flows

Liquidity: The principal objective of the liquidity management program is to maintain the Bank’s ability to meet the day to day cash flow requirements of its customers who either wish to withdraw funds or draw upon credit facilities to meet their needs.

Management monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. The Company’s sources of funds are customer deposits, loan repayments, current earnings, cash and demand balances due from other banks, federal funds, short-term investments, investment securities available for sale and trust preferred securities. The Company’s strategy includes maintaining a “well-capitalized” status for regulatory purposes, while maintaining a favorable liquidity position and proper asset/liability mix. With this strategy in mind, management anticipates that the Bank will rely primarily upon customer deposits and investments to provide liquidity in 2007. These funds will be used for loan originations and deposit withdrawals, to satisfy other financial commitments and to support continuing operations. Additional funds are available through established FHLB and correspondent bank lines of credit, which the Bank may use to supplement funding sources.

Consolidated Cash Flows: As disclosed in the Condensed Consolidated Statements of Cash Flows, net cash provided by operating activities was $273,000 for the first three months of 2007. Approximately $2.3 million was used to fund loans held for sale. Net cash of $12.6 million was used in investing activities for the period, primarily for the funding of net loan growth. Net cash provided by financing activities was $19.5 million for the first three months of 2007. Increase in deposits provided approximately $22.6 million of additional cash during the period.

Capital Resources:

Off-Balance Sheet Items: The Company is a party to financial instruments with off-balance sheet risk. Among the off-balance sheet items entered into in the ordinary course of business are commitments to extend credit and the issuance of letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized on the balance sheet. Certain commitments are collateralized. As of March 31, 2007 and December 31, 2006, the Company’s commitments under letters of credit and financial guarantees amounted to $1.8 million and $2.0 million, respectively. Since many of the commitments are expected to expire without being drawn upon, these total commitment amounts do not necessarily represent future cash requirements.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

At March 31, 2007, based on the measures used to monitor and manage interest rate risk, there had not been a material change in the Company’s interest rate risk since December 31, 2006. Should rates increase, the Company may, or may not be positively impacted due to its current slightly asset sensitive position. For additional information, refer to the Company’s Form 10-K for year ended December 31, 2006 filed with the SEC.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this report, management evaluated the effectiveness of the design and operation of its disclosure controls and procedures. The principal executive and financial officers supervised and participated in this evaluation. Based on this evaluation, the chief executive and financial officer each concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information required to be included in the periodic reports to the SEC. The design of any system of controls is based in part upon various assumptions about the likelihood of future events, and there can be no assurance that any of the Company’s plans, products, services or procedures will succeed in achieving their intended goals under future conditions. Management found no facts that would require the Company to take any corrective actions with regard to significant deficiencies or material weaknesses.

Changes in Internal Control over Disclosure and Reporting

There was no change in the Company’s internal control over financial reporting that occurred during the quarterly period ended March 31, 2007 that has materially affected, or is reasonably likely to materially affect, the internal control over financial reporting.

PART II – OTHER INFORMATION

Item 1. Legal Proceedings

The Company may be involved in legal proceedings in the regular course of business. At this time, management does not believe that there is pending litigation resulting in an unfavorable outcome of which would result in a material adverse change to the Company’s financial condition, results of operations or cash flows.

Item 1A. Risk Factors

For information regarding risk factors, please refer to Part I, Item 1A in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006. There have been no material changes in the Company’s risk factors from those disclosed in the 2006 Annual Report on Form 10-K.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

(a) – (c) None

Item 3. Defaults Upon Senior Securities

None

Item 4. Submission of Matters to a Vote of Security Holders

None

Item 5. Other Information

	(a)		Not applicable

	(b)		There have been no material changes in the procedures for shareholders to nominate directors to the Company’s board.

Item 6. Exhibits

Exhibits

	31.1		Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(a) and Section 302 of the Sarbanes Oxley Act of 2002
	31.2		Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(a) and Section 302 of the Sarbanes Oxley Act of 2002
	32.1		Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes Oxley Act of 2002, 18 U.S.C. Section 1350
	32.2		Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes Oxley Act of 2002, 18 U.S.C. Section 1350

Date: May 8, 2007

/s/ Michal D. Cann

Michal D. Cann

President and

Chief Executive Officer


	PART I – FINANCIAL INFORMATION	Page

Item 1.	Financial Statements

	Condensed Consolidated Statements of Financial Condition - March 31, 2007 and December 31, 2006	1

	Condensed Consolidated Statements of Income - Three Months Ended March 31, 2007 and 2006	2

	Condensed Consolidated Statements of Shareholders’ Equity and Comprehensive Income - Three Months Ended March 31, 2007 and 2006	3

	Condensed Consolidated Statements of Cash Flows - Three Months Ended March 31, 2007 and 2006	4

	Notes to Condensed Consolidated Financial Statements	5

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	10

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	18

Item 4.	Controls and Procedures	18

	PART II – OTHER INFORMATION

Item 1.	Legal Proceedings	19

Item 1A.	Risk Factors	19

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	19

Item 3.	Defaults Upon Senior Securities	19

Item 4.	Submission of Matters to a Vote of Security Holders	19

Item 5.	Other Information	19

Item 6.	Exhibits	19


	Signatures	20
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2