Citizens Financial Services - 10-Q quarterly report FY

Indicate by checkmark whether the registrant (1) has filed all reports 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 checkmark whether the registrant is an accelerated filer (as described in Rule 12b-2 of the Exchange Act). Yes____ No __X__

Indicate by checkmark whether the registrant is a shell company (as described in Rule 12b-2 of the Exchange Act). Yes____ No __X__

The number of shares outstanding of the Registrant's Common Stock, as of November 1, 2005, 2,846,542 shares of Common Stock, par value $1.00.

Citizens Financial Services, Inc.

Form 10-Q

INDEX

Citizens Financial Service, Inc., (individually and collectively, the “Company”) is a Pennsylvania corporation organized as the holding company of its wholly owned subsidiary, First Citizens National Bank (the “Bank”), and its subsidiary, First Citizens Insurance Agency, Inc. All material inter-company balances and transactions have been eliminated in consolidation.

The accompanying consolidated financial statements have been prepared pursuant to rules and regulations of the Securities and Exchange Commission (SEC) and in compliance with accounting principles generally accepted in the United States of America. Because this report is based on an interim period, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted.

 In the opinion of Management of the registrant, the accompanying interim financial statements for the quarters ended September 30, 2005 and 2004 include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the financial condition and the results of operations for the period. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. The financial performance reported for the Company for the nine-month period ended September 30, 2005 is not necessarily indicative of the results to be expected for the full year. This information should be read in conjunction with the Company’s Annual Report to shareholders and Form 10-K for the period ended December 31, 2004.

Income tax expense is less than the amount calculated using the statutory tax rate, primarily the result of tax-exempt income earned from state and municipal securities and loans and investment in tax credits.

    

For a detailed disclosure on the Company’s pension and employee benefit plans, please refer to Note 8 of the Company’s Consolidated Financial Statements included in the 2004 Annual Report on Form 10-K.

The following sets forth the components of net periodic benefit costs of the defined benefit plans for the three months and nine months ended September 30, 2005 and 2004, respectively (dollars presented in thousands):

The Company has contributed $382,000 to its defined benefit pension plan as of September 30, 2005. No further contributions in 2005 are expected.

The Company also sponsors a defined contribution plan covering substantially all of its employees. The Company contributes three percent of applicable salaries into the plan. Through September 30, 2005, the Company contributed $145,000 into the defined contribution plan.

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (FAS No. 123R). FAS No. 123R revised FAS No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. FAS No. 123R will require compensation costs related to share-based payment transactions to be recognized in the financial statement (with limited exceptions). The amount of compensation cost will be measured based on the grant-date fair value of the equity or liability instruments issued. Compensation cost will be recognized over the period that an employee provides service in exchange for the award.

In April, the Securities and Exchange Commission adopted a new rule that amends the compliance dates for FAS No. 123R. The Statement requires that compensation cost relating to share-based payment transactions be recognized in financial statements and that this cost be measured based on the fair value of the equity or liability instruments issued. FAS No. 123R covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. The Company will adopt FAS No. 123R on January 1, 2006 and is currently evaluating the impact the adoption of the standard will have on the Company’s results of operations.

In March 2005, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 107 ("SAB No. 107"), Share-Based Payment, providing guidance on option valuation methods, the accounting for income tax effects of share-based payment arrangements upon adoption of FAS No. 123R, and the disclosures in MD&A subsequent to the adoption. The Company will provide SAB No. 107 required disclosures upon adoption of FAS No. 123R on January 1, 2006 and is currently evaluating the impact the adoption of the standard will have on the Company’s financial condition, results of operations, and cash flows.

In December 2004, FASB issued FAS No. 153, Exchanges of Nonmonetary Assets - An Amendment of APB Opinion No. 29. The guidance in APB Opinion No. 29, Accounting for Nonmonetary Transactions, is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. The guidance in that Opinion, however, included certain exceptions to that principle. FAS No. 153 amends Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The provisions of FAS No. 153 are effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. Early application is permitted and companies must apply the standard prospectively. The adoption of this standard is not expected to have a material effect on the Company’s results of operations or financial position.

In June 2005, the FASB issued FAS No. 154, Accounting Changes and Errors Corrections, a replacement of APB Opinion No. 20 and FAS No. 3. The Statement applies to all voluntary changes in accounting principle, and changes the requirements for accounting for and reporting of a change in accounting principle. FAS No. 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle unless it is impractical. APB Opinion No. 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. FAS No.154 improves the financial reporting because its requirements enhance the consistency of financial reporting between periods. The provisions of FAS No. 154 are effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.

The Company has entered into a Purchase and Assumption Agreement, dated August 22, 2005 (and subsequently amended September 13, 2005) with Fulton Savings Bank, a New York state-chartered mutual savings bank headquartered in Fulton, New York, to acquire the Hannibal Branch of Fulton Savings Bank.

Subject to regulatory approval, the Company intends to purchase certain assets and assume certain liabilities of the Hannibal branch. Immediately following the branch transaction, and again subject to regulatory approval, the Company intends to close and relocate the Hannibal branch to Wellsville, New York. The Company anticipates that the proposed transaction will be consummated during the fourth quarter of 2005. It is expected that the total acquisition costs of approximately $200,000 will be recognized in the fourth quarter.

Forward-looking statements may prove inaccurate. We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of Citizens Financial Services, Inc., First Citizens National Bank, First Citizens Insurance Agency, Inc. or the combined company. When we use such words as "believes," "expects,” "anticipates," or similar expressions, we are making forward-looking statements. For a variety of reasons, actual results could differ materially from those contained in or implied by forward-looking statements. The Company would like to caution readers that the following important factors, among others, may have affected and could in the future affect the Company’s actual results and could cause the Company’s actual results for subsequent periods to differ materially from those expressed in any forward looking statement:

The following is management's discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in its accompanying consolidated financial statements for Citizens Financial Service, Inc., a bank holding company and its subsidiary (the Company). Our Company's consolidated financial condition and results of operations consist almost entirely of our wholly owned subsidiary’s (First Citizens National Bank) financial condition and results of operations. Management’s discussion and analysis should be read in conjunction with the preceding September 30, 2005 financial information. The results of operations for the three and nine months ended September 30, 2005 and 2004 are not necessarily indicative of the results you may expect for the full year.

Our Company currently engages in the general business of banking throughout our service area of Potter, Tioga and Bradford counties in North Central Pennsylvania and Allegany, Steuben, Chemung and Tioga counties in Southern New York. Our lending and deposit products and investment services are offered primarily within the vicinity of our service area.

The market area that First Citizens National Bank operates is rural in nature. The customer makeup consists of small businesses and individuals. The state of the economy in the region is mixed with unemployment rates generally running above the state and national averages at this time.

We face strong competition in the communities we serve from other commercial banks, savings banks, savings and loan associations and credit unions, some of which are substantially larger institutions than our subsidiary. In addition, insurance companies, investment-counseling firms, and other business firms and individuals offer personal and corporate trust services. We also compete with credit unions, issuers of money market funds, securities brokerage firms, consumer finance companies and mortgage brokers. These entities are strong competitors for virtually all types of financial services.

In recent years, the financial services industry has experienced tremendous change to competitive barriers between bank and non-bank institutions. We not only must compete with traditional financial institutions, but also with other business corporations that have begun to deliver competing financial services. Competition for banking services is based on price, nature of product, quality of service, and in the case of certain activities, convenience of location.

Our Trust and Investment Department services range from professional estate settlement services through management of complex trust accounts to investment management and custody of securities. Our Trust and Investment Department manages retirement accounts for many area companies and individuals. We also manage many individual IRAs, both rollover and contributory.

The Investment Department offers full service brokerage services in selected locations throughout the Bank’s market area and appointments can be made in any First Citizens National Bank branch.

The Bank offers life and health insurance, as well as annuities through our insurance subsidiary, First Citizens Insurance Agency, Inc.

Total assets (shown in the Consolidated Balance Sheet) have increased 2.0% since year-end 2004 to $509.6 million. Total loans increased 4.4% to $375.5 million and investment securities decreased 5.5% to $90.5 million since year-end 2004. Total deposits increased 2.8% to $430.7 million since year-end 2004. Explanations of variances will be described within the following appropriate sections.

Cash and cash equivalents totaled $8,408,000 at September 30, 2005 compared to $9,339,000 on December 31, 2004. Noninterest-bearing cash decreased $1,294,000 since year-end 2004, while interest-bearing cash increased $363,000 during that same period. We believe the liquidity needs of the Company are satisfied by the current balance of cash and cash equivalents, the availability of traditional funding sources, and the portion of the investment and loan portfolios that mature within one year. These sources of funds will enable the Company to meet cash obligations and off-balance sheet commitments as they come due.

The total investment portfolio is held as available for sale. Investments available for sale are accounted for at fair value with unrealized gains and losses, net of deferred taxes, reported as a component of stockholders’ equity. The amortized cost and estimated fair value of investment securities at September 30, 2005 and December 31, 2004 were as follows (in thousands):

Our investment portfolio decreased by $5,235,000 or 5.5% from December 31, 2004 to September 30, 2005. So far in 2005, we have purchased approximately $9.6 million of municipal bonds. Given current interest rates, we have focused on purchasing higher coupon, longer-term municipals in an effort to extend the portfolio. Offsetting these purchases is approximately $13.1 million of principal repayments from our mortgage backed securities portfolio, which we continue to receive approximately $1.5 million per month. These principal repayments have been used to fund investment purchases and loan growth.

Management monitors the earnings performance and the effectiveness of the liquidity of the investment portfolio on a regular basis. Through active balance sheet management and analysis of the securities portfolio, the Company maintains sufficient liquidity to satisfy depositor requirements and various credit needs of its customers.

The Company’s lending is focused in the north central Pennsylvania market and the southern tier of New York. The composition of our loan portfolio consists principally of retail lending, which includes single-family residential mortgages and other consumer lending, and commercial lending primarily to locally owned small businesses. New loans are generated primarily from direct loans to our existing customer base, with new customers generated by referrals from real estate brokers, building contractors, attorneys, accountants and existing customers.

The Company has elected to purchase bank owned life insurance to offset future employee benefit costs. As of September 30, 2005 the cash surrender value of this life insurance is $7,669,000, an increase of $220,000 since year end. The use of life insurance policies provides the bank with an asset that will generate earnings to partially offset the current costs of benefits, and eventually (at the death of the insured’s) provide partial recovery of cash outflows associated with the benefits.

Traditional deposits continue to be the most significant source of funds for the Company. As shown in the following tables (dollars in thousands), deposits increased $11,608,000 or 2.8%, since December 31, 2004. As of September 30, 2005, non-interest-bearing deposits increased $5,380,000. The Company continues to emphasize service and convenience as a low cost deposit gathering strategy. Money market deposits increased by $11,215,000, primarily due to a new deposit from a local, non-profit state and political organization. NOW and savings accounts decreased by $904,000 and $361,000, respectively. Certificates of Deposit decreased by $3,722,000 since December 31, 2004.

We anticipate that we will be able to grow our deposit base with our proposed Wellsville, New York location, subject to regulatory approval (see Note 6 to the Consolidated Financial Statements), as we expand our operations directly into Allegany County, New York.

We evaluate stockholders’ equity in relation to total assets and the risk associated with those assets. The greater the capital resources, the more likely a corporation is able to meet its cash obligations and absorb unforeseen losses. For these reasons, capital adequacy has been, and will continue to be, of paramount importance.

Total Stockholders’ Equity was $41,442,000, at September 30, 2005 compared to $40,789,000, at December 31, 2004, an increase of $653,000 or 1.6%. Excluding accumulated other comprehensive income, stockholder’s equity increased $1,697,000, or 4.2%. In the first nine months, the Company had net income of $3,898,000 and declared dividends of $1,738,000 a dividend payout ratio of 44.6% of net income.

All of the Company’s investment securities are classified as available-for-sale making this portion of the Company’s balance sheet more sensitive to the changing market value of investments. Accumulated other comprehensive income decreased $1,044,000 compared to December 31, 2004 primarily as a result of interest rate movements and current year portfolio activity.

On June 17, 2005, the Company privately purchased 21,453 shares of stock from an individual shareholder. This had the effect of increasing treasury stock $463,000 during the year.

The Company has also complied with standards of well capitalized mandated by the banking regulators. The Company’s primary regulators have established “risk-based” capital requirements designed to measure capital adequacy. Risk-based capital ratios reflect the relative risks associated with various assets entities hold in their portfolios. A weight category of 0% (lowest risk assets), 20%, 50%, or 100% (highest risk assets), is assigned to each asset on the balance sheet. The Company’s computed risk-based capital ratios are as follows (dollars in thousands):

Some financial instruments, such as loan commitments, credit lines, and letters of credit, are issued to meet customer financing needs. The contractual amount of financial instruments with off-balance sheet risk was as follows at September 30, 2005:

The Company had net income of $1,318,000 and $3,898,000 for the third quarter and first nine months of 2005, respectively. Earnings per share, for the respective periods were $0.46 and $1.36. Net income was $1,423,000 and $4,383,000 for the third quarter and first nine months of 2004, which equates to earnings per share of $0.50 and $1.53, respectively. The annualized return on average assets and the return on average equity, for the first nine months of 2005, were 1.03% and 12.53%, respectively. Details outlining the results of operations are discussed on the following pages.

Net interest income, the most significant component of earnings, is the amount by which interest generated from earning assets exceeds interest expense on interest-bearing liabilities.

Net interest income, after provision for loan losses, totaled $4,437,000 in the third quarter, a decrease of $39,000 or .9%, compared to the third quarter of 2004 and totaled $13,168,000 for the first nine months of 2005, an increase of $254,000 or 2.0% over the prior year. The Bank experienced an increase in earning assets in the past twelve months of 6.0%, due to our continued efforts to grow our existing offices.

The following table represents the adjustment to convert net interest income to net interest on a fully taxable equivalent basis for the nine months ending September 30, 2005 and 2004:

The following table shows the effect of changes in volume and rate on interest income and expense. Tax-exempt interest revenue is shown on a tax-equivalent basis for proper comparison using a statutory federal income tax rate of 34%: