UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 1999 or [ ] 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 0-13222 CITIZENS FINANCIAL SERVICES, INC. (Exact name of registrant as specified in its charter) PENNSYLVANIA 23-2265045 (State of other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 15 South Main Street, Mansfield, Pennsylvania 16933 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (570) 662-2121 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_____ The number of shares outstanding of the Registrant's Common Stock, as of May 5, 1999 2,773,434 shares of Common Stock, par value $1.00.
Citizens Financial Services, Inc. Form 10-Q INDEX Page Part I FINANCIAL INFORMATION (UNAUDITED) Item 1-Financial Statements Consolidated Balance Sheet as of March 31, 1999 and December 31, 1998 1 Consolidated Statement of Income for the Three Months Ended March 31, 1999 and 1998 2 Consolidated Statement of Comprehensive Income for the Three Months Ended March 31, 1999 and 1998 3 Consolidated Statement of Cash Flows for the Three Months Ended March 31, 1999 and 1998 4 Notes to Consolidated Financial Statements 5 Item 2-Management's Discussion and Analysis of Financial Condition and Results of Operations 6-16 Item 3-Quantitative and Qualitative Disclosure About Market Risk 16 Part II OTHER INFORMATION AND SIGNATURES Item 1-Legal Proceedings 17 Item 2-Changes in Securities 17 Item 3-Defaults upon Senior Securities 17 Item 4-Submission of Matters to a Vote of Security Holders 17 Item 5-Other Information 17 Item 6-Exhibits and Reports on Form 8-K 17 Signatures 18
CITIZENS FINANCIAL SERVICES, INC. CONSOLIDATED BALANCE SHEET (UNAUDITED) March 31, December 31, 1999 1998 ASSETS: Cash and due from banks: Noninterest-bearing $ 7,104,194 $ 7,175,095 Interest-bearing 54,183 129,708 Total cash and cash equivalents 7,158,377 7,304,803 Available-for-sale securities 87,896,512 93,082,429 Loans (net of allowance for loan losses 1999, $2,275,000; December 31, 1998, $2,292,000) 204,862,254 203,582,637 Foreclosed assets held for sale 1,050,636 528,630 Premises and equipment 5,922,088 5,605,686 Accrued interest receivable 2,175,262 2,188,372 Other assets 1,548,394 1,271,240 TOTAL ASSETS $310,613,523 $313,563,797 LIABILITIES: Deposits: Noninterest-bearing $ 20,683,874 $ 20,977,843 Interest-bearing 254,079,056 253,215,120 Total deposits 274,762,930 274,192,963 Borrowed funds 4,227,328 7,333,610 Accrued interest payable 1,761,277 2,362,596 Other liabilities 1,356,581 1,076,164 TOTAL LIABILITIES 282,108,116 284,965,333 STOCKHOLDERS' EQUITY: Common Stock $1.00 par value; authorized 10,000,000 shares in 1999 and 1998; issued and outstanding 2,773,434 shares in 1999 and 1998, respectively 2,773,434 2,773,434 Additional paid-in capital 7,912,967 7,912,967 Accumulated other comprehensive income 17,448,285 16,934,349 TOTAL 28,134,686 27,620,750 Net unrealized holding gains on available-for-sale securities 370,721 977,714 TOTAL STOCKHOLDERS' EQUITY 28,505,407 28,598,464 TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $310,613,523 $313,563,797 The accompanying notes are an integral part of these financial statements. 1
CITIZENS FINANCIAL SERVICES, INC. CONSOLIDATED STATEMENT OF INCOME (UNAUDITED) Three Months Ended March 31, 1999 1998 INTEREST INCOME: Interest and fees on loans $4,449,017 $4,303,018 Interest on interest-bearing deposits with banks 5,485 36,205 Interest and dividends on investments: Taxable 997,813 1,230,660 Nontaxable 224,954 67,301 Dividends 35,619 21,515 TOTAL INTEREST INCOME 5,712,888 5,658,699 INTEREST EXPENSE: Deposits 2,792,098 2,804,211 Borrowed funds 94,920 111,067 TOTAL INTEREST EXPENSE 2,887,018 2,915,278 NET INTEREST INCOME 2,825,870 2,743,421 Provision for loan losses 60,000 52,500 NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 2,765,870 2,690,921 OTHER OPERATING INCOME: Service charge 289,242 211,638 Trust 99,686 92,515 Other 133,371 53,170 Realized securities gains, net 95,482 94,797 Arbitration settlement 28,595 67,678 TOTAL OTHER OPERATING INCOME 646,376 519,798 OTHER OPERATING EXPENSES: Salaries and employee benefits 1,011,575 927,219 Occupancy 136,190 135,955 Furniture and equipment 165,945 178,695 Other professional fees 182,644 67,636 Other 732,049 711,911 TOTAL OTHER OPERATING EXPENSES 2,228,403 2,021,416 Income before provision for income taxes 1,183,843 1,189,303 Provision for income taxes 295,491 342,780 NET INCOME $ 888,352 $ 846,523 Earnings per share $0.32 $0.31 Cash dividend declared $0.135 0.125 Weighted average number of shares outstanding 2,773,434 2,773,434 The accompanying notes are an integral part of these financial statements. 2
CITIZENS FINANCIAL SERVICES, INC. CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (UNAUDITED) <TABLE> Three Months Ended March 31, 1999 1998 <S> <C> <C> Net income $ 888,352 $846,523 Other comprehensive income: Unrealized gains on securities: Gain (loss) arising during the year $ (824,204) $ 8,464 Reclassification adjustment 95,482 (919,686) (94,797) (86,333) Other comprehensive income before tax (919,686) (86,333) Income tax expense related to other comprehensive income (312,693) (29,353) Other comprehensive income, net of tax (606,993) (56,980) Comprehensive income $ 281,359 $ 789,543 </TABLE> The accompanying notes are an integral part of these financial statements. 3
CITIZENS FINANCIAL SERVICES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED) <TABLE> Three months Ended March 31, CASH FLOWS FROM OPERATING ACTIVITIES: 1999 1998 <S> <C> <C> Net income $ 888,352 $ 846,523 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 60,000 52,500 Provision for depreciation and amortization 190,721 189,268 Amortization and accretion of investment securities 114,800 84,121 Deferred income taxes 16,251 6,856 Realized gains on securities (95,482) (94,797) Realized gains on loans sold (9,180) (13,795) Gain of sales or disposals of premises and equipment (377) 0 Originations of loans held for sale (998,500) (886,300) Proceeds from sales of loans held for sale 1,007,680 900,095 (Gain) loss on sale of foreclosed assets held for sale (11,607) 7,625 Decrease (increase) in accrued interest receivable and other assets 5,207 (112,696) Increase in accrued interest payable and other liabilities (320,902) (117,984) Net cash provided by operating activities 846,963 861,416 CASH FLOWS FROM INVESTING ACTIVITIES: Available-for-sale securities: Proceeds from sales of securities 8,843,777 7,169,219 Proceeds from maturity and principal repayments of securities 4,536,541 1,000,000 Purchase of securities (9,133,405) (4,117,552) Held-to-maturity securities: Proceeds from maturity and principal repayments of securities 0 3,992,423 Purchase of securities 0 (3,003,586) Net increase in loans (1,900,017) (1,080,993) Capital expenditures (484,034) (137,526) Proceeds from sale of premises and equipment 50,000 35,000 Proceeds from sale of foreclosed assets held for sale 4,480 0 Net cash used by investing activities 1,917,342 3,856,985 CASH FLOWS FROM FINANCING ACTIVITIES: Net increase in deposits 569,967 1,585,439 Proceeds from long-term borrowings 249,034 61,104 Repayments of long-term borrowings (203,172) (54,101) Net (decrease) increase in short-term borrowed funds (3,152,143) 19,086 Dividends paid (374,414) (346,679) Net cash (used) provided by financing activities (2,910,730) 1,268,207 Net (decrease) increase in cash and cash equivalents (146,425) 5,986,608 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 7,304,803 6,342,359 CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 7,158,378 $12,328,967 Supplemental Disclosures of Cash Flow Information: Interest paid $ 3,488,337 $ 3,484,718 Income taxes paid $ 0 $ 0 </TABLE> The accompanying notes are an integral part of these financial statements. 4
CITIZENS FINANCIAL SERVICES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Note 1 - Basis of Presentation The consolidated financial statements include the accounts of Citizens Financial Services, Inc. and its wholly-owned subsidiary, First Citizens National Bank (the "Bank"), (collectively, the "Company"). All material inter-company balances and transactions have been eliminated in consolidation. The accompanying interim financial statements have been prepared by the Company without audit and, in the opinion of management, reflect all adjustments (which include only normal recurring adjustments) necessary to present fairly the Company's financial position as of March 31, 1999, and the results of operations for the interim periods presented. 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. Actual results could differ significantly from those estimates. For further information refer to the consolidated financial statements and footnotes thereto incorporated by reference in the Company's Annual Report on Form 10-K for the year ended December 31, 1998. In June 1998, the Financial Accounting Standards Board issued Statement No. 133, (SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This Statement establishes accounting and reporting standards for derivative instruments and for hedging activities. The Company implemented this statement effective October 1, 1998 and has reclassified all of its securities as available-for- sale. The impact of the reclassification resulted in a significant change in net unrealized holding gains on available-for-sale securities during the 4th quarter of 1998. Note 2 - Earnings per Share Earnings per share calculations give retroactive effect to stock dividends declared by the Company. The number of shares used in the earnings per share and dividends per share calculation was 2,773,434 for 1999 and 1998. Item 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 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 conditions and results of operations. Our discussion should be read in conjunction with the preceding March 31, 1999 Financial Report. The results of operations for the three months ended March 31, 1999 and 1998 are not necessarily indicative of the results to be expected for the full year. 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 the information concerning possible or assumed future results of operations of Citizens Financial Services, Inc., First Citizens National Bank, or the combined company. When we use such words as "believes", "expects", "anticipates", or similar expressions, we are making forward-looking statements. You should note that many factors, some of which are discussed elsewhere in this document and in the documents we incorporate by reference, could affect the future financial results. These factors include, but are not limited to, the following: *operating, legal and regulatory risks; *economic, political and competitive forces affecting our banking, securities, asset management and credit services; *risk that our analysis of these risks and forces could be incorrect and/or the strategies developed to address them could be unsuccessful. 5
Readers should carefully review the risk factors described in other documents our Company files from time to time with the Securities and Exchange Commission, including the quarterly reports on Form 10-K to be filed by our Company and any current reports on Form 8-K filed by our Company. 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. We maintain our central office in Mansfield, Pennsylvania. Presently we operate banking facilities in Mansfield, Blossburg, Ulysses, Genesee, Wellsboro, Troy, Sayre, Canton, Gillett and the Wellsboro Weis Market store. Additionally, we have automatic teller machines (ATMs) located in Soldiers and Sailors Memorial Hospital in Wellsboro, Mansfield Wal-Mart and at Mansfield University. Our Company's lending and deposit products and investment services are offered primarily within the vicinity of the service area. Our Company faces strong competition in the communities it serves from other commercial banks, savings banks, and savings and loan associations, some of which are substantially larger institutions than our subsidiary. In addition, personal and corporate trust services are offered by insurance companies, investment counseling firms, and other business firms and individuals. We also compete with credit unions, issuers of money market funds, securities brokerage firms, consumer finance companies, mortgage brokers and insurance companies. 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 Company offers the following trust and investment services: *Investment management accounts that assume managerial duties for investment accounts. *Custody services for safekeeping and preservation of assets. *Mutual funds that provide an asset allocation program. *Personal trust services that include stand-by, living and testamentary trusts. *Estate planning and administration to provide financial planning. *Retirement plan services for individuals and businesses. FINANCIAL CONDITION INVESTMENTS The investment portfolio, including available-for-sale, decreased by $5.2 million or 5.6% in 1999 as compared to a decrease of $4.3 million in 1998. Proceeds from maturing investments were applied to borrowings and new loans. LOANS Historically, loans have been originated by our Company to customers in North Central Pennsylvania and the Southern Tier of New York. Loans have been originated primarily through direct loans to our existing customer base, with new customers generated by referrals from real estate brokers, building contractors, attorneys, accountants and existing customers. We also do a limited amount of indirect loans through new and used car dealers in the primary lending area. As shown in the following tables, the change in loans grew by $14 million compared to the 1998 period, the result of continued demand and attractive interest rates. In addition, $1 million in conforming mortgage loans were originated and sold on the secondary market through the Federal Home Loan Mortgage Corporation, providing over $9,000 of income in origination fees and premiums on loans sold. Residential mortgage lending is a principal business activity and one our Company expects to continue by providing a full complement of competitively priced conforming, nonconforming and home equity mortgages. 6
Commercial lending activity is primarily focused on small businesses and our Company's commercial lending officers have been successful in attracting new business loans. We expect loans to state and political subdivisions will continue to increase in 1999 as the result of bond refinancing activity in a lower interest rate environment. <TABLE> March 31, 1999 1998 1997 Amount Percent Amount Percent Amount Percent <S> <C> <C> <C> <C> <C> <C> Real estate: Residential $133,413 64.3 $122,877 63.6 $112,470 61.7 Commercial 27,481 13.3 27,075 14.0 28,174 15.5 Agricultural 8,817 4.3 8,111 4.2 5,848 3.2 Loans to individuals for household, family and other purchases 14,544 7.0 13,924 7.2 14,835 8.1 Commercial and other loans 12,008 5.8 10,545 5.5 11,103 6.1 State and political subdivision loans 10,925 5.3 10,621 5.5 9,879 5.4 Total loans 207,188 100.0 193,153 100.0 182,309 100.0 Unearned income 51 82 154 Net loans $207,137 $193,071 $182,155 </TABLE> 1999/1998 1998/1997 Change Change $ % $ % Real estate: Residential 10,536 8.6 10,407 9.3 Commercial 406 1.5 (1,099) (3.9) Agricultural 706 8.7 2,263 38.7 Loans to individuals for household, family and other purchases 620 4.5 (911) (6.1) Commercial and other loans 1,463 13.9 (558) (5.0) State and political subdivision loans 304 2.9 742 7.5 Total loans 14,035 7.3 10,844 5.9 7
Deposits changed by $16.4 million or 6.3% during the 1999/1998 period. Deposit growth increased primarily because of competitive pricing of our money market deposit accounts and certificates of deposit. <TABLE> March 31, 1999 1998 1997 Amount Percent Amount Percent Amount Percent <S> <C> <C> <C> <C> <C> <C> Noninterest-bearing deposits $20,684 7.5 $18,827 7.3 $18,829 7.5 NOW accounts 35,217 12.8 32,659 12.6 30,548 12.3 Savings deposits 27,759 10.1 26,561 10.3 27,471 11.1 Money market deposit accounts 38,826 14.1 34,884 13.5 26,175 10.6 Certificates of deposit 152,277 55.5 145,437 56.3 145,225 58.5 Total deposits $274,763 100.0 $258,368 100.0 $248,243 100.0 </TABLE> 1999/1998 1998/1997 Change Change $ % $ % Noninterest-bearing deposits 1,857 9.5 204 1.1 NOW accounts 2,558 7.8 2,111 6.9 Savings deposits 1,198 4.5 (910) (3.3) Money market deposit accounts 3,942 11.3 8,709 33.3 Certificates of deposit 6,840 4.7 212 0.1 Total deposits 16,395 6.3 10,126 4.1 Borrowed funds decreased $3.1 million during the first three months of 1999 compared with almost no change during the 1998 period. The large decrease in 1999 resulted from repayments of short-term borrowing to the Federal Home Loan Bank as a result of strong deposit growth. The Company's daily cash requirements or short-term investments are met by using the financial instruments available through the Federal Home Loan Bank. CAPITAL The Company has computed its risk-based capital ratios as follows (dollars in thousands): <TABLE> March 31, December 31, 1999 1998 Amount Ratio Amount Ratio <S> <C> <C> <C> <C> Total capital (to risk-weighted assets) Company $29,772 14.99% $29,296 14.99% For capital adequacy purposes 15,887 8.00% 15,632 8.00% To be well capitalized 19,859 10.00% 19,540 10.00% Tier I capital (to risk-weighted assets) Company $27,434 13.81% $26,893 13.96% For capital adequacy purposes 7,943 4.00% 7,816 4.00% To be well capitalized 11,915 6.00% 11,724 6.00% Tier I capital (to average assets) Company $27,434 8.82% $26,893 8.66% For capital adequacy purposes 12,439 4.00% 12,423 4.00% To be well capitalized 15,548 5.00% 15,529 5.00% </TABLE> See the discussion of liquidity below for details regarding future expansion plans and the impact on capital. 8
RESULTS OF OPERATIONS Net income for the three month period ending March 31, 1999 was $888,000 an increase of $42,000 or 4.9% over the $847,000 for the 1998 related period. Earnings per share was $.32 during the first three months of 1999 compared with $.31 during the comparable 1998 period. Net interest income, the most significant component of earnings, is the amount by which interest generated from earning assets exceeds interest expense on liabilities. Net interest income for the current three month period, after provision for loan losses, was $2,766,000, an increase of $75,000 or 2.8% compared with an increase of $67,000 or 2.6% during the same period in 1998. 9
<TABLE> Analysis of Average Balances and Interest Rates (1) March 31 March 31 March 31 1999 1998 1997 Average Average Average Average Average Average Balance Interest Rate Balance Interest Rate Balance Interest Rate <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> ASSETS $ $ % $ $ % $ $ % Short-term investments: Interest-bearing deposits at banks 408 5 4.97% 2,635 36 5.54% 525 7 5.41% Total short-term investments 408 5 4.97% 2,635 36 5.54% 525 7 5.41% Investment securities: Taxable 70,457 1,034 5.87% 76,236 1,252 6.57% 84,017 1,331 6.34% Tax-exempt (3) 19,724 341 6.92% 6,061 102 6.73% 606 19 12.54% Total investment securities 90,181 1,376 6.10% 82,297 1,354 6.58% 84,623 1,350 6.38% Loans: Residential mortgage loans 132,552 2,807 8.59% 122,809 2,711 8.95% 114,496 2,584 9.15% Commercial and farm loans 37,325 840 9.13% 35,186 835 9.62% 35,124 852 9.84% Loans to state and political subdivisions 10,053 211 8.51% 10,622 221 8.44% 9,963 179 7.29% Other loans 26,680 663 10.08% 24,455 611 10.13% 23,249 589 10.27% Loans, net of discount (2)(3)(4) 206,610 4,521 8.87% 193,072 4,378 9.20% 182,832 4,204 9.33% Total interest-earning assets 297,199 5,902 8.05% 278,004 5,768 8.41% 267,980 5,561 8.42% Cash and due from banks 7,016 6,142 6,355 Bank premises and equipment 5,757 5,760 4,570 Other assets 1,696 4,472 2,848 Total non-interest bearing assets 14,469 16,374 13,773 Total assets 311,668 294,378 281,753 LIABILITIES AND STOCKHOLDERS' EQUITY Interest-bearing liabilities: NOW accounts 34,988 155 1.80% 32,151 180 2.27% 31,184 184 2.39% Savings accounts 26,787 124 1.88% 26,457 144 2.21% 27,491 150 2.21% Money market accounts 39,253 418 4.32% 35,577 425 4.84% 26,219 285 4.41% Sub-total 101,028 697 2.80% 94,185 749 3.23% 84,894 619 2.96% Certificates of deposit 151,347 2,095 5.61% 144,680 2,055 5.76% 140,897 2,023 5.82% Other borrowed funds 7,371 95 5.23% 7,198 111 6.25% 11,130 168 6.12% Total interest-bearing liabilities 259,746 2,887 4.51% 246,063 2,915 4.80% 236,921 2,810 4.81% Demand deposits 20,333 19,060 17,976 Other liabilities 3,091 3,109 3,398 Total non-interest-bearing liabilities 23,424 22,169 21,374 Stockholders' equity 28,498 26,146 23,458 Total liabilities and stockholders' Equity 311,668 294,378 281,753 Net interest income 3,015 2,853 2,751 Net interest spread (5) 3.55% 3.61% 3.61% Net interest income as a percentage of average interest-earning assets 4.11% 4.16% 4.16% Ratio of interest-earning assets to interest-bearing liabilities 1.14 1.13 1.13 </TABLE> (1) Averages are based on daily averages. (2) Includes loan origination and commitment fees. (3) Tax exempt interest revenue is shown on a tax equivalent basis for proper comparison using a statutory federal income tax rate of 34%. (4) Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets. (5) Interest rate spread represents the difference between the average rate earned on interest-earning assets and the average rate paid on interest- bearing liabilities. 10
As described in the table above, the yield on earning assets, on a tax-equivalent basis, was 8.05% and 8.41% during the first three months of 1999 and 1998, respectively (a decline of 36 basis points). The cost of funds was 4.51% and 4.80% during the same three month period (a decrease of 29 basis points). In comparing the average interest cost of 1999 versus 1998, NOW accounts decreased 47 basis points, savings accounts decreased 33 basis points, and money market accounts decreased by 52 basis points (the result of an increase in higher balance accounts). The interest rate on certificates of deposit decreased by 15 basis points. As described above, the we have experienced a narrowing interest margin percentage during the three months of 1999. The current flat yield curve has limited our opportunity to increase margin with new business as the existing investments and loans mature or repay. We continue to review various pricing and investment strategies to enhance deposit growth while maintaining or expanding the current interest margin. Analysis of Changes in Net Interest Income of a Tax Equivalent Basis (in thousands) <TABLE> 1999 vs. 1998 1998 vs.1997 Change in Change in Total Change in Change in Total Volume Rate Change Volume Rate Change <S> <C> <C> <C> <C> <C> <C> Interest Income: Short-term investments: Interest-bearing deposits at banks $ (30) $ (1) $ (31) $ 29 $ 0 $ 29 Total short-term investments (30) (1) (31) 29 0 29 Investment securities: Taxable (94) (124) (218) (129) 50 (79) Tax-exempt 227 12 239 87 (4) 83 Total investment securities 133 (112) 21 (42) 46 4 Loans: Residential mortgage loans 216 (119) 97 182 (55) 127 Commercial and farm loans 51 (46) 5 1 (18) (17) Loans to state and political subdivisions (12) 2 (10) 12 30 42 Other loans 55 (3) 52 30 (8) 22 Loans, net of Discount 310 (166) 144 225 (51) 174 Total Interest Income 413 (279) 134 212 (5) 207 Interest Expense: Interest-bearing deposits: NOW accounts 16 (41) (25) 33 (37) (4) Savings accounts 2 (22) (20) (6) 0 (6) Money Market accounts 44 (51) (7) 98 42 140 Certificates of deposit 94 (54) 40 51 (19) 32 Total interest-bearing deposits 156 (168) (12) 176 (14) 162 Other borrowed funds 3 (19) (16) (60) 3 (57) Total interest expense 159 (187) (28) 116 (11) 105 Net interest income $ 254 $ (92) $ 162 $ 96 $ 6 $ 102 </TABLE> (1) The portion of the total change attributable to both volume and rate changes during the year has been allocated to volume and rate components based upon the absolute dollar amount of the change in each component prior to allocation. The above table details the change in net interest income and shows an increase of $413,000 resulting from volume changes in investments and loans. The volume of interest expense increased the cost of interest-bearing deposits and borrowings by $159,000. The positive gain from volume of $254,000 when combined with decrease of income due to rate of $92,000 resulted in a net increase of $162,000 compared to a net increase of $102,000 for the same period in 1998. 11
The provision for loan losses increased to $60,000 in 1999 up from $52,500 in 1998. This provision was appropriate given management's quarterly review of the allowance for loan losses that is based on the following information: migration analysis of delinquent and non accrual loans, estimated future losses on loans, recent review of large problem credits, local and national economic conditions, historical loss experience, OCC qualitative adjustments, purchase of loans through acquisitions and peer comparisons. OTHER INCOME March 31, OTHER INCOME: 1999 1998 1997 Service charges $289 $212 $195 Trust 100 92 94 Other 133 53 57 Arbitration settlement 29 68 884 Realized securities gains, net 95 95 0 TOTAL OTHER OPERATING INCOME $646 $520 $1,230 1999/1998 1998/1997 Change Change $ % $ % Service charges 77 36.3 17 8.7 Trust 8 8.7 (2) (2.1) Other 80 150.9 (4) (7.0) Arbitration settlement (39) (57.4) (816) (92.3) Realized securities gains, net 0 0 95 TOTAL 126 24.2 (710) (57.7) Total other operating income increased $126,000 compared with the same period in 1998 primarily as a result of the increase in other income during 1999. Service charge income increased as a result of additional checking account, ATM and MasterMoney Card charges. We continue to evaluate means of increasing other operating income to off-set the loss of net interest income described above. One approach, recently, is to apply service charges on business accounts by charging fees on transaction activity (reduced by earnings credit based on customers' balances) to more equitably recover costs. We expect to continue this analysis for our other products. OTHER EXPENSES March 31, OTHER OPERATING EXPENSES: 1999 1998 1997 Salaries and employee benefits $1,011 $927 $1,104 Occupancy 136 136 138 Furniture and equipment 166 179 150 Professional fees 183 67 41 Other 732 712 607 TOTAL OTHER OPERATING EXPENSES $2,228 $2,021 $2,040 1999/1998 1998/1997 Change Change $ % $ % Salaries and employee benefits 84 9.1 (177) (16.0) Occupancy 0 0 (2) (1.4) Furniture and equipment (13) (7.3) 29 19.3 Professional fees 116 173.1 26 63.4 Other 20 2.8 105 17.3 TOTAL 207 10.2 (19) (0.9) Total other operating expense was $2,228,000 in 1999 reflecting an increase of $207,000 over the 1998 period. 12
Salaries and benefit's expense increased by $84,000 for the current period reflecting normal merit increases. Other professional fees increased $116,000 reflect management's efforts to implement strategic growth initiatives. In addition, Y2K expense was $7,000 for the three months ending March 31, 1999. Provision for Income Taxes The provision for income taxes before extraordinary item was $295,000 during 1999 compared with $343,000 during the 1998 related period. LIQUIDITY As detailed in the Consolidated Statement of Cash Flows, a slightly negative net cash was provided from operating, investing and financing activities during the 1999 period. The major components have been discussed previously in the financial condition section relating to investments, loans and deposits. Liquidity is a measure of our Company's ability to efficiently meet normal cash flow requirements of both borrowers and depositors. To maintain proper liquidity, we use funds management policies along with our investment policies to assure we can meet our financial obligations to depositors, credit customers and stockholders. Liquidity is needed to meet depositors' withdrawal demands, extend credit to meet borrowers' needs, provide funds for normal operating expenses and cash dividends, and fund other capital expenditures. Our Company's historical activity in this area can be seen in the Consolidated Statement of Cash Flows from investing and financing activities. Cash generated by operating activities, investing activities and financing activities influences liquidity management. The most important source of funds is the deposits that are primarily core deposits (deposits from customers with other relationships). Short-term debt from the Federal Home Loan Bank supplements our Company's availability of funds. Our Company's use of funds is shown in the investing activity section of the Consolidated Statement of Cash Flows, where the net increase in loans is detailed. Other significant uses of funds are capital expenditures, purchase of loans and acquisition premiums. Surplus funds are then invested in investment securities. Capital expenditures were $484,000 in 1999, $347,000 more than 1998, primarily the result of the acquisition of property that is now our operations center described below. These purchases will allow greater operating efficiency and provide our customers with a higher quality product. On February 8, 1999, we acquired a property near the Mansfield Wal-Mart consisting of a large office building on 2 acres, to be used as an administration and/or operations facility. We expect the costs of acquisition and remodeling to be approximately $1 million. This building will allow us to discontinue rentals of two other properties. Our calculations show this move should result in a net saving. Our Company continues to plan for an approximate $2 million renovation of the Mansfield community office. This effort has been in various stages of planning for more than eight years. We expect renovation to take place in late 1999 or early 2000. We believe our Company has sufficient resources to complete these projects from our normal operations and that they will have a long-term positive effect on revenues, efficiency and the capacity for future growth. Management believes that it has sufficient resources to complete these projects from its normal operations. It is anticipated that these changes will have a long-term positive effect on revenues, efficiency and the capacity for future growth. 13
Liquidity is achieved primarily from temporary or short-term investments in the Federal Home Loan Bank of Pittsburgh, PA ("FHLB"), and investments that mature less than one year. The Company also has a maximum borrowing capacity at the FHLB of approximately $97.5 million as an additional source of liquidity. There are no short-term borrowings from the FHLB as of September 30,1998. Apart from those matters described above, management does not currently believe that there are any current trends, events or uncertainties that would have a material impact on capital. CREDIT QUALITY RISK The following table identifies amounts of loan losses and non-performing loans. Past due loans are those that were contractually past due 90 days or more as to interest or principal payments. March 31, December 31, 1999 1998 1997 1996 1995 Non-performing loans: Non-accruing loans $ 494 $1,495 $1,169 $ 844 $ 762 Impaired loans 577 382 382 414 697 Accrual loans - 90 days or more past due 17 15 170 723 689 Total non-performing loans 1,088 1,892 1,721 1,981 2,148 Foreclosed assets held for sale 1,051 529 238 164 208 Total non-performing assets $2,139 $2,421 $1,959 $2,145 $2,356 Non-performing loans as a percent of loans net of unearned income 0.53% 0.92% 0.90% 1.09% 1.33% Non-performing assets as a percent of loans net of unearned income 1.03% 1.18% 1.02% 1.18% 1.46% Allowance for possible loan loasses: March 31, December 31, 1999 1998 1997 1996 1995 Balance at beginning of period $2,292 $2,138 $1,995 $1,833 $1,721 Charge-offs (110) (112) (83) (64) (69) Recoveries 33 48 16 21 18 Provision for loan losses 60 218 210 205 163 Balance at end of period $2,275 $2,292 $2,138 $1,995 $1,833 Allowance for losses as a percent of total loans 1.10% 1.11% 1.11% 1.09% 1.13% The provision for loan losses increased to $60,000 in the current three month period. The Company does not accrue interest income on impaired loans. Subsequent cash payments received are applied to the outstanding principal balance or recorded as interest income, depending upon management's assessment of its ultimate ability to collect principal and interest. 14
YEAR 2000 COMPUTER PROBLEM Bank's State of Readiness We are aware of the possibility of exposure by banks to a computer problem known as the "Year 2000 Problem" or the "Millennium Bug" (the inability of some computer programs to distinguish between the year 1900 and the year 2000). If not corrected, some computer applications could fail or create erroneous results by or at the Year 2000. This could cause entire system failures, miscalculations, and disruptions of normal business operations including, among other things, a temporary inability to process transactions, send statements, or engage in similar day to day business activities. The extent of the potential impact of the Year 2000 Problem is not yet known, and if not timely corrected, it could affect the global economy. We have assessed the extent of vulnerability of our Company's computer systems to the problem. Our Company's conversion, in August 1997, to Jack Henry and Associates (JHA) for core banking application software and the purchase of a new IBM AS/400 hardware system on which to run the core processing software, has greatly minimized our exposure to these problems. The JHA Silverlake System software was certified by the Information Technology Association of America (ITAA) on March 16, 1998 while the IBM AS\400 received the first ever Year 2000 certification by that organization. Most internal testing and validation for these primary mission critical systems was successfully completed in November 1998. The testing process of other critical systems will be completed in May 1999. Risk Assessment of Year 2000 We believe that, with modifications to existing software and conversions to new software, the Year 2000 problem will not pose a significant operational problem for us. However, because most computer systems are, by their very nature, interdependent, it is possible that non-compliant third party computers could impact our Company's computer systems. Additionally, we have taken steps to communicate with the third parties, such as wire transfer systems, telephone systems, electric companies and other utility companies with which we do businesses to coordinate Year 2000 compliance but could be adversely affected if they or the unrelated third parties are unsuccessful. We have assessed the impact the Year 2000 may have on our large loan (credit risk) and deposit customers and have determined that there is little risk to our bank. Cost of Year 2000 As described above, our primary systems are Year 2000 compliant, therefore, little programming costs will be incurred. Most of the costs incurred in addressing this problem are related to planning and internal testing and validation which are expected to be expensed as incurred. The financial impact to our Company of Year 2000 compliance was $39,000 in 1998. On the 1st quarter of 1999, our Y2K expense was $7,000 and future expenditures are not anticipated to be material to our Company's financial position or results of operations for the remainder of 1999. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from these plans. Contingency Plans We, in conjunction with our Year 2000 and Disaster Recovery consultants, are in the process of modifying our disaster recover plans to include the response to a Year 2000 problem in a most likely worst case scenario. Our Company's preliminary contingency plans involve the use of manual labor to compensate for the temporary loss of certain automated computer systems or third party vendors. Customer Awareness We have educated our employees and informed customers of our Year 2000 efforts and the actions they can take to minimize the impact on their financial activities. We have held seminars, mailed brochures, and have reported our status in our annual and quarterly reports to our shareholders. 15
GENERAL The majority of assets and liabilities of a financial institution are monetary in nature and, therefore, differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation does have an important impact on the growth of total assets and on noninterest expenses, which tend to rise during periods of general inflation. The level of inflation over the last few years has been declining. Various congressional bills have been passed and other proposals have been made for significant changes to the banking system, including provisions for: limitation on deposit insurance coverage; changing the timing and method financial institutions use to pay for deposit insurance; expanding the power of banks by removing restrictions on bank underwriting activities; tightening the regulation of bank derivatives' activities; allowing commercial enterprises to own banks; and permitting bank holding companies or our Company to own or control affiliates that engage in securities, mutual funds and insurance activities. Aside from those matters described above, we do not believe that there are any trends, events or uncertainties which would have a material adverse impact on future operating results, liquidity or capital resources. We are not aware of any current recommendations by the regulatory authorities (except as described herein) which, if they were to be implemented, would have such an effect, although the general cost of compliance with numerous and multiple federal and state laws and regulations does have, and in the future may have, a negative impact on our Company's results of operations. Item 3- Quantitative and Qualitative Disclosure About Market Risk In the normal course of conducting business activities, the Company is exposed to market risk, principally interest rate risk, through the operations of its banking subsidiary. Interest rate risk arises from market driven fluctuations in interest rates that affect cash flows, income, expense and values of financial instruments. Interest rate risk is managed by management and a committee of the board of directors. No material changes in market risk strategy occurred during the current period. A detailed discussion of market risk is provided in the SEC Form 10-K for the period ended December 31, 1998. 16
PART II - OTHER INFORMATION AND SIGNATURES Item 1 - Legal Proceedings Management is not aware of any litigation that would have a material adverse effect on the consolidated financial position of the Company. Any pending proceedings are ordinary, routine litigation incidental to the business of the Company and its subsidiary. In addition, no material proceedings are pending or are known to be threatened or contemplated against the Company and its subsidiary by government authorities. Item 2 - Changes in Securities - Nothing to report. Item 3 - Defaults Upon Senior Securities - Nothing to report. Item 4 - Submission of Matters to a Vote of Security Holders Results of the voting at the Annual Meeting of Shareholders held on April 20, 1999 at 12:00 p.m. at the Tioga County Fairgrounds Youth Building, Whitneyville, Pennsylvania, 16901 1. Election of Class 1 Directors whose term will expire in 2002 For Withhold Authority Carol J. Tama 2,307,847 35,402 R. Lowell Coolidge 2,307,847 35,402 Richard E. Wilber 2,307,843 35,406 John M. Thomas, M.D. 2,307,606 35,643 Larry J. Croft 2,308,111 35,138 Continuing Directors: Mark L. Dalton Class 2 Term Expires 2001 John E. Novak Class 2 Term Expires 2001 Rudolph J. van der Hiel Class 2 Term Expires 2001 Bruce L. Adams Class 3 Term Expires 2000 William D. Van Etten Class 3 Term Expires 2000 Item 5 - Other Information - Nothing to report. Item 6 -Exhibits and reports on Form 8-K. Exhibits. (3)(i) - Articles of Incorporation of the Corporation, as amended. (Incorporated by Reference to Exhibit (3)(i) to the Annual Report of Form 10-K for the fiscal year ended December 31, 1998, as filed with the Commission on March 17, 1999.) (3)(ii)- By-laws of the Corporation, as amended. (Incorporated by Reference to Exhibit (3)(ii) to the Annual Report of Form 10-K for the fiscal year ended December 31, 1995, as filed with the Commission on March 26, 1996.) (4) - Instruments Defining the Rights of Stockholders. (Incorporated by reference to the Registrant's Registration Statement No.2-89103 on Form S-14, as filed with the Commission on February 17, 1984.) (10) - Material Contracts. Employment Agreement between our Company and Richard E. Wilber. (Incorporated by Reference to Exhibit (10)to the Annual Report of Form 10-K for the fiscal year ended December 31, 1998, as filed with the Commission on March 17, 1998.) (11) - Computation of Earnings Per Share included on page 5 of this Form 10-Q. (27) - Financial Data Schedules, which are submitted electronically to the Securities and Exchange Commission for information only and not filed. (b) Reports on Form 8-K None. 17
Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the undersigned Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized. Citizens Financial Services, Inc. (Registrant) May 13, 1999 /s/ Richard E. Wilber By: Richard E. Wilber President and Chief Financial Officer (Principal Executive Officer) May 13, 1999 /s/ Thomas C. Lyman By: Thomas C. Lyman Treasurer (Principal Financial & Accounting Officer 18
EXHIBITS INDEX (3)(i) - Articles of Incorporation of the Corporation, as amended. (Incorporated by Reference to Exhibit (3)(i) to the Annual Report of Form 10-K for the fiscal year ended December 31, 1998, as filed with the Commission on March 17, 1999.) (3)(ii)- By-laws of the Corporation, as amended. (Incorporated by Reference to Exhibit (3)(ii) to the Annual Report of Form 10-K for the fiscal year ended December 31, 1995, as filed with the Commission on March 26, 1996.) (4) - Instruments Defining the Rights of Stockholders. (Incorporated by reference to the Registrant's Registration Statement No.2-89103 on Form S-14, as filed with the Commission on February 17, 1984.) (10) - Material Contracts. Employment Agreement between our Company and Richard E. Wilber. (Incorporated by Reference to Exhibit (10)to the Annual Report of Form 10-K for the fiscal year ended December 31, 1998, as filed with the Commission on March 17, 1998.) (11) - Computation of Earnings Per Share included on page 5 of this Form 10-Q. (27) - Financial Data Schedule, which are submitted electronically to the Securities and Exchange Commission for information only and not filed. 19