FORM 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 (Mark One) /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the three-month period ended March 31, 2002 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: 0-16084 CITIZENS & NORTHERN CORPORATION (Exact name of Registrant as specified in its charter) Pennsylvania 23-2451943 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 90-92 Main Street Wellsboro, Pa. 16901 (Address of principal executive offices) (Zip code) 570-724-3411 (Registrant's telephone number including area code) Not applicable (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 APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS: Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes ____ No ____ (APPLICABLE ONLY TO CORPORATE REGISTRANTS) Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. Title Outstanding Common Stock ($1.00 par value) 5,283,312 Shares Outstanding May 10, 2002 1
<TABLE> <CAPTION> CITIZENS & NORTHERN CORPORATION Index <S> <C> Part I. Financial Information Item 1. Financial Statements Consolidated Balance Sheet - March 31, 2002 and December 31, 2001 Page 3 Consolidated Statement of Income - Three Months Ended March 31, 2002 and 2001 Page 4 Consolidated Statement of Cash Flows - Three Months Ended March 31, 2002 and 2001 Page 5 Notes to Consolidated Financial Statements Pages 6 through 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Pages 8 through 20 Item 3. Information About Market Risk Pages 20 and 21 Part II. Other Information Page 22 Signatures Page 23 </TABLE> 2
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q ITEM 1. FINANCIAL STATEMENTS <TABLE> <CAPTION> CONSOLIDATED BALANCE SHEET MARCH 31, DECEMBER 31, (In Thousands Except Share Data) 2002 2001 (UNAUDITED) (NOTE) <S> <C> <C> ASSETS Cash and due from banks: Noninterest-bearing $ 10,434 $ 14,055 Interest-bearing 2,569 1,981 - ------------------------------------------------------------------------------------------------------- Total cash and cash equivalents 13,003 16,036 Available-for-sale securities 478,851 433,969 Held-to-maturity securities 1,178 1,448 Loans, net 385,422 373,963 Bank-owned life insurance 16,129 15,905 Accrued interest receivable 5,689 4,871 Bank premises and equipment, net 10,220 9,967 Foreclosed assets held for sale 318 179 Other assets 12,115 10,661 - ------------------------------------------------------------------------------------------------------- TOTAL ASSETS $ 922,925 $ 866,999 ======================================================================================================= LIABILITIES Deposits: Noninterest-bearing $ 63,235 $ 63,858 Interest-bearing 528,738 512,416 - ------------------------------------------------------------------------------------------------------- Total deposits 591,973 576,274 Dividends payable 1,466 1,466 Short-term borrowings 37,885 58,064 Long-term borrowings 185,731 125,584 Accrued interest and other liabilities 5,634 5,424 - ------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES 822,689 766,812 - ------------------------------------------------------------------------------------------------------- STOCKHOLDERS' EQUITY Common stock, par value $1.00 per share; authorized 10,000,000 shares; issued 5,431,021 in 2002 and 5,378,212 in 2001 5,432 5,378 Stock dividend distributable - 1,369 Paid-in capital 21,133 19,758 Retained earnings 72,698 70,352 - ------------------------------------------------------------------------------------------------------- Total 99,263 96,857 Accumulated other comprehensive income 2,985 5,284 Unamortized stock compensation (112) (17) Treasury stock, at cost: 140,854 shares at March 31, 2002 (1,900) 143,412 shares at December 31, 2001 (1,937) - ------------------------------------------------------------------------------------------------------- TOTAL STOCKHOLDERS' EQUITY 100,236 100,187 - ------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 922,925 $ 866,999 ======================================================================================================= </TABLE> The accompanying notes are an integral part of these consolidated financial statements. Note: The balance sheet at December 31, 2001 has been derived from the audited financial statements at that date but does not include all the information and notes required by generally accepted accounting principles for complete financial statements. 3
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q CONSOLIDATED STATEMENT OF INCOME (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) <TABLE> <CAPTION> 3 MONTHS ENDED MARCH 31, MARCH 31, 2002 2001 <S> <C> <C> INTEREST INCOME Interest and fees on loans $ 7,257 $ 6,902 Interest on balances with depository institutions 8 19 Interest on loans to political subdivisions 150 171 Interest on federal funds sold 4 61 Income from available-for-sale and held-to-maturity securities: Taxable 4,664 4,733 Tax-exempt 1,311 944 Dividends 248 263 - ----------------------------------------------------------------------------------------------------------- Total interest and dividend income 13,642 13,093 - ----------------------------------------------------------------------------------------------------------- INTEREST EXPENSE Interest on deposits 4,257 5,693 Interest on short-term borrowings 272 1,331 Interest on long-term borrowings 1,787 468 - ----------------------------------------------------------------------------------------------------------- Total interest expense 6,316 7,492 - ----------------------------------------------------------------------------------------------------------- Interest margin 7,326 5,601 Provision for loan losses 180 150 - ----------------------------------------------------------------------------------------------------------- Interest margin after provision for loan losses 7,146 5,451 - ----------------------------------------------------------------------------------------------------------- OTHER INCOME Service charges on deposit accounts 384 296 Service charges and fees 65 68 Trust and financial management revenue 439 387 Insurance commissions, fees and premiums 215 138 Increase in cash surrender value of life insurance 224 222 Fees related to credit card operation 130 128 Other operating income 230 195 - ----------------------------------------------------------------------------------------------------------- Total other income before realized gains on securities, net 1,687 1,434 Realized gains on securities, net 1,226 455 - ----------------------------------------------------------------------------------------------------------- Total other income 2,913 1,889 - ----------------------------------------------------------------------------------------------------------- OTHER EXPENSES Salaries and wages 2,238 2,018 Pensions and other employee benefits 615 580 Occupancy expense, net 278 259 Furniture and equipment expense 447 346 Expenses related to credit card operation 71 77 Pennsylvania shares tax 183 196 Other operating expense 1,274 1,122 - ----------------------------------------------------------------------------------------------------------- Total other expenses 5,106 4,598 - ----------------------------------------------------------------------------------------------------------- Income before income tax provision 4,953 2,742 Income tax provision 1,115 477 - ----------------------------------------------------------------------------------------------------------- NET INCOME $ 3,838 $ 2,265 =========================================================================================================== PER SHARE DATA: Net income - basic $ 0.73 $ 0.43 Net income - diluted $ 0.72 $ 0.43 - ----------------------------------------------------------------------------------------------------------- Dividend per share $ 0.28 $ 0.26 - ----------------------------------------------------------------------------------------------------------- Number of shares used in computation - basic 5,291,559 5,308,562 Number of shares used in computation - diluted 5,301,360 5,308,856 </TABLE> The accompanying notes are an integral part of these consolidated financial statements. 4
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) <TABLE> <CAPTION> 3 MONTHS ENDED MARCH 31, MARCH 31, 2002 2001 <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 3,838 $ 2,265 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 180 150 Realized gains on securities, net (1,226) (455) Gain on sale of foreclosed assets, net (8) (25) Depreciation expense 367 305 Accretion and amortization, net (101) (627) Increase in cash surrender value of life insurance (224) (222) Amortization of restricted stock 21 - Increase in accrued interest receivable and other assets (1,334) (1,010) Increase in accrued interest payable and other liabilities 1,167 2,204 - --------------------------------------------------------------------------------------------------------- Net Cash Provided by Operating Activities 2,680 2,585 - --------------------------------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from maturity of held-to-maturity securities 268 860 Purchase of held-to-maturity securities - (626) Proceeds from sales of available-for-sale securities 4,393 576 Proceeds from maturities of available-for-sale securities 26,408 36,530 Purchase of available-for-sale securities (77,838) (89,187) Purchase of restricted stock (710) - Net increase in loans (11,829) (1,651) Purchase of premises and equipment (620) (210) Proceeds from sale of foreclosed assets 59 105 - --------------------------------------------------------------------------------------------------------- Net Cash Used in Investing Activities (59,869) (53,603) - --------------------------------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES: Net increase in deposits 15,699 1,899 Net decrease in short-term borrowings (20,179) (7,306) Proceeds from long-term borrowings 60,153 60,000 Repayments of long-term borrowings (6) (5) Purchase of treasury stock (32) (130) Sale of treasury stock 13 - Dividends paid (1,492) (1,353) - --------------------------------------------------------------------------------------------------------- Net Cash Provided by Financing Activities 54,156 53,105 - --------------------------------------------------------------------------------------------------------- (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (3,033) 2,087 CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 16,036 13,824 - --------------------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 13,003 $ 15,911 ========================================================================================================= SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Assets acquired through foreclosure of real estate loans $ 191 $ 136 Interest paid $ 5,212 $ 5,437 Income taxes paid $ 520 $ 25 </TABLE> The accompanying notes are an integral part of these consolidated financial statements. 5
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF INTERIM PRESENTATION The financial information included herein, with the exception of the consolidated balance sheet dated December 31, 2001, is unaudited; however, such information reflects all adjustments (consisting solely of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods. Results reported for the three months ended March 31, 2002 might not be indicative of the results for the year ending December 31, 2002. Certain 2001 amounts have been reclassified to conform to the 2002 presentation. This document has not been reviewed or confirmed for accuracy or relevance by the Federal Deposit Insurance Corporation or any other regulatory agency. 2. PER SHARE DATA Net income per share is based on the weighted-average number of shares of common stock outstanding. The number of shares used in calculating net income and cash dividends per share reflect the retroactive effect of stock dividends for all periods presented. The following data show the amounts used in computing net income per share and the weighted average number of shares of dilutive stock options. The dilutive effect of stock options is computed as the weighted-average common shares available from the exercise of all dilutive stock options, less the number of shares that could be repurchased with the proceeds of stock option exercises based on the average share price of the Corporation's common stock during the period. <TABLE> <CAPTION> WEIGHTED- AVERAGE EARNINGS NET COMMON PER INCOME SHARES SHARE <S> <C> <C> <C> QUARTER ENDED MARCH 31, 2002 Earnings per share - basic $3,838,000 5,291,559 $ 0.73 Dilutive effect of stock options 9,801 - -------------------------------------------------------------------------------------------------------------------- Earnings per share - diluted $3,838,000 5,301,360 $ 0.72 ==================================================================================================================== QUARTER ENDED MARCH 31, 2001 Earnings per share - basic $2,265,000 5,308,562 $ 0.43 Dilutive effect of stock options 294 - -------------------------------------------------------------------------------------------------------------------- Earnings per share - diluted $2,265,000 5,308,856 $ 0.43 ==================================================================================================================== </TABLE> 3. COMPREHENSIVE INCOME Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. 6
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Comprehensive income is calculated as follows: <TABLE> <CAPTION> QUARTERS ENDED MARCH 31, (IN THOUSANDS) 2002 2001 <S> <C> <C> Net income $ 3,838 $ 2,265 Unrealized holding (losses) gains on available-for-sale securities (2,257) 7,041 Less: Reclassification adjustment for gains realized in income (1,226) (455) - ---------------------------------------------------------------------------------------------------- Other comprehensive (loss) income before income tax (3,483) 6,586 Income tax related to other comprehensive income/loss 1,184 (2,239) - ---------------------------------------------------------------------------------------------------- Other comprehensive (loss) income (2,299) 4,347 - ---------------------------------------------------------------------------------------------------- Comprehensive income $ 1,539 $ 6,612 ==================================================================================================== </TABLE> 4. DERIVATIVE FINANCIAL INSTRUMENTS In June 2001, the Corporation began to utilize derivative financial instruments related to a new certificate of deposit product called the "Index Powered Certificate of Deposit" (IPCD). IPCDs have a term of 5 years, with interest paid at maturity based on 90% of the appreciation (as defined) in the S&P 500 index. There is no guaranteed interest payable to a depositor of an IPCD - however, assuming an IPCD is held to maturity, a depositor is guaranteed the return of his or her principal, at a minimum. Statement of Financial Accounting Standards No. 133 requires the Corporation to separate the amount received from each IPCD issued into 2 components: (1) an embedded derivative, and (2) the principal amount of each deposit. Embedded derivatives are derived from the Corporation's obligation to pay each IPCD depositor a return based on appreciation in the S&P 500 index. Embedded derivatives are carried at fair value, and are included in other liabilities in the consolidated balance sheet. Changes in fair value of the embedded derivative are included in other expense in the consolidated income statement. The difference between the contractual amount of each IPCD issued, and the amount of the embedded derivative, is recorded as the initial deposit (included in interest-bearing deposits in the consolidated balance sheet). Interest expense is added to principal ratably over the term of each IPCD at an effective interest rate that will increase the principal balance to equal the contractual IPCD amount at maturity. In connection with IPCD transactions, the Corporation has entered into Equity Indexed Call Option (Swap) contracts with the Federal Home Loan Bank of Pittsburgh (FHLB-Pittsburgh). Under the terms of the Swap contracts, the Corporation must pay FHLB-Pittsburgh quarterly amounts calculated based on the contractual amount of IPCDs issued times a negotiated rate. In return, FHLB-Pittsburgh is obligated to pay the Corporation, at the time of maturity of the IPCDs, an amount equal to 90% of the appreciation (as defined) in the S&P 500 index. If the S&P 500 index does not appreciate over the term of the related IPCDs, the FHLB-Pittsburgh would make no payment to the Corporation. The effect of the Swap contracts is to limit the Corporation's cost of IPCD funds to the market rate of interest paid to FHLB-Pittsburgh. (In addition, the Corporation pays a fee of 0.75% to a consulting firm at inception of each deposit. This fee is amortized to interest expense over the term of the IPCDs.) Swap liabilities are carried at fair value, and included in other liabilities in the consolidated balance sheet. Changes in fair value of swap liabilities are included in other expense in the consolidated income statement. 7
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Amounts recorded as of March 31, 2002 and December 31. 2001, and for the first quarter 2002, related to IPCDs are as follows (in thousands): <TABLE> <CAPTION> MARCH 31, DEC. 31, 2002 2001 <S> <C> <C> Contractual amount of IPCDs (equal to notional amount of Swap contracts) $ 2,156 $ 1,410 Carrying value of IPCDs 1,780 1,154 Carrying value of embedded derivative liabilities 326 233 Carrying value of Swap contract liabilities 62 31 </TABLE> 3 MONTHS ENDED MARCH 31, 2002 Interest expense $ 16 Other expense 4 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q PART I - FINANCIAL INFORMATION (CONTINUED) ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND OF OPERATIONS MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain statements in this section and elsewhere in Form 10-Q are forward-looking statements. Citizens & Northern Corporation and its wholly-owned subsidiaries (collectively, the Corporation) intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995. Forward-looking statements, which are based on certain assumptions and describe future plans, business objectives and expectations, are generally identifiable by the use of words such as, "believe", "expect", "intend", "anticipate", "estimate", "project", and similar expressions. The Corporation's ability to predict results or the actual effect of future plans or occurrences is inherently uncertain. Factors which could have a material adverse effect on the operations and future prospects of the Corporation include, but are not limited to, the following: - - changes in monetary and fiscal policies of the U.S. Treasury and the Federal Reserve Board, particularly related to changes in interest rates - - changes in general economic conditions - - legislative or regulatory changes - - downturn in demand for loan, deposit and other financial services in the Corporation's market area - - increased competition from other banks and non-bank providers of financial services - - technological changes and increased technology-related costs - - changes in accounting principles. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. 8
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q EARNINGS OVERVIEW Net income for the first quarter 2002 was $3,838,000, or $0.73 per share - basic and $0.72 per share - diluted. This represents an increase of 67.4% in net income per share - diluted over the first quarter 2001. Return on average assets, excluding unrealized gains and losses on securities, increased 44.6%, to 1.75% in the first quarter 2002 compared to 1.21% in the first quarter 2001. Including the effects of unrealized gains and losses on securities, return on average assets increased to 1.74% in the first quarter 2002 from 1.21% in the first quarter 2001. Return on average equity, excluding unrealized gains and losses on securities, rose 58.4%, to 16.06% in the first quarter 2002 from 10.14% in the first quarter 2001. Including unrealized gains and losses on securities, return on average equity increased 49.6%, to 15.09% in the first quarter 2002 from 10.09% in the first quarter 2001. The most significant income statement changes between the first quarter 2002 and the first quarter 2001 were as follows: - - The interest margin increased significantly ($1,725,000, or 30.8%), to $7,326,000 in the first quarter 2002 from $5,601,000 in the first quarter 2001. The Corporation's net interest margin (excess of interest and dividend income over interest expense) widened dramatically over the last three quarters of 2001 and the first quarter 2002 compared to the previous several quarters. This resulted primarily from reductions in interest rates on deposits and borrowed funds. Also, the Corporation has experienced significant growth in deposits and loans, and has identified opportunities to borrow funds and invest the proceeds in securities at positive spreads. Changes in the net interest margin are discussed in more detail later in Management's Discussion and Analysis. - - Net realized gains on securities were $1,226,000 in the first quarter 2002, compared to $455,000 in the first quarter 2001. In the first quarter 2002, the Corporation sold its holdings of 2 bank stocks for realized gains totaling $1,109,000 (pre-tax). These sales resulted from circumstances specific to each underlying company, and the proceeds have been reinvested in other bank stocks. - - Other (noninterest) expenses increased $508,000, or 11.0%, in the first quarter 2002 compared to the first quarter 2001. The increase reflects increases in payroll costs, depreciation and maintenance agreements associated with computer hardware and software. These types of costs have increased as a result of the need to add personnel and supplement existing systems to keep up with expansion of services and growth in lending activity over the last few years. - - The income tax provision increased to $1,115,000 in the first quarter 2002 from $477,000 in the first quarter 2001, because pre-tax income is higher. 9
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE I - QUARTERLY FINANCIAL DATA (IN THOUSANDS) <TABLE> <CAPTION> MAR. 31, DEC. 31, SEPT. 30, JUNE 30, MAR. 31, 2002 2001 2001 2001 2001 <S> <C> <C> <C> <C> <C> Interest income $ 13,642 $ 13,776 $ 13,962 $ 13,830 $ 13,093 Interest expense 6,316 6,549 7,037 7,278 7,492 - -------------------------------------------------------------------------------------------------------------------------- Interest margin 7,326 7,227 6,925 6,552 5,601 Provision for loan losses 180 150 150 150 150 - -------------------------------------------------------------------------------------------------------------------------- Interest margin after provision for loan losses 7,146 7,077 6,775 6,402 5,451 Other income 1,687 1,570 1,600 1,516 1,434 Securities gains 1,226 203 520 742 455 Other expenses 5,106 4,918 4,575 4,580 4,598 - -------------------------------------------------------------------------------------------------------------------------- Income before income tax provision 4,953 3,932 4,320 4,080 2,742 Income tax provision 1,115 740 914 891 477 - -------------------------------------------------------------------------------------------------------------------------- Net income $ 3,838 $ 3,192 $ 3,406 $ 3,189 $ 2,265 ========================================================================================================================== Net income per share - basic $ 0.73 $ 0.60 $ 0.64 $ 0.60 $ 0.43 ========================================================================================================================== Net income per share - diluted $ 0.72 $ 0.60 $ 0.64 $ 0.60 $ 0.43 ========================================================================================================================== </TABLE> The number of shares used in calculating net income per share for each quarter of 2001 reflects the retroactive effect of a 1% stock dividend declared in December 2001 and issued in January 2002. PROSPECTS FOR THE REMAINDER OF 2002 Overall, prospects for the remainder of 2002 are very good. Despite a national recession, loan demand has been outstanding over the last year (net loans are up 18.8% as of March 31, 2002 compared to one year earlier) and continues to be strong. The Corporation's major concentration continues to be real estate secured loans, with significant new loans generated recently, and "in the pipeline," related to both residential and commercial activity. Deposits and customer repurchase agreements have also grown substantially (up 11.3% as of March 31, 2002 compared to one year earlier), and there continues to be significant customer demand in recent months. The largest category of deposit growth in recent months has been certificates of deposit, in part because investors have moved funds out of the U.S. stock market. Also, the Corporation has developed some new, innovative CD products over the last year. In June 2001, the Corporation began to offer Index Powered CDs, which are described in more detail in Note 4 to the consolidated financial statements. Effective in May 2002, the Corporation began to offer "Roll-up" CDs. Roll-up CDs allow the investor to increase the interest rate, to the Corporation's current CD rate for the same term, once during the term of a 3-year, 4-year or 5-year term, subject to limitations. This roll-up feature permits the investor an opportunity to receive a higher rate of return, if rates increase, without risk of reduction in rate over the term of the CD. Management believes the Corporation is positioned to do well over the rest of 2002; however, it may be difficult to achieve net income in the remaining quarters as high as in the first quarter. From an interest rate risk perspective, the Corporation is liability sensitive. That means the Corporation's interest expense associated with interest-bearing liabilities (deposits and borrowed funds) changes more quickly and dramatically than does its income from interest earning assets (primarily securities and loans). As short-term market interest rates fell throughout 2001, the Corporation realized lower interest expense in its financial statements. This pattern continued into the first quarter 2002. However, as can be seen in Table I, the rate of growth in the interest margin has slowed over the last four quarters. The interest margin increased $951,000 in the second quarter 2001 over the prior quarter, then increased $373,000 in the third quarter 2001, $302,000 in the fourth quarter 2001, and $99,000 in the first quarter 2002. Currently, yields on securities and loans are at relatively low historic levels, and if short-term rates rise later this year, the Corporation's interest margin will probably shrink. Most economic forecasts anticipate an increase in short-term interest rates to occur later this year; however, the timing, magnitude and abruptness of the expected change is uncertain. Another major variable that may affect 2002 earnings is securities gains and losses. As described earlier, net realized securities gains were unusually high in the first quarter 2002. At this time, it is impossible to predict, with any degree of precision, the amounts of securities gains and losses that may be realized over the remainder of 2002. 10
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q CRITICAL ACCOUNTING POLICIES The presentation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates. A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses. Management believes that the allowance for loan losses is adequate and reasonable. The Corporation's methodology for determining the allowance for loan losses is described in a separate section later in Management's Discussion and Analysis. Given the very subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions, and could, therefore calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination. Further, a task force of the American Institute of Certified Public Accountants is working on detailed implementation guidance for calculating the allowance for loan losses. Implementation of that detailed implementation guidance could result in an adjustment to the allowance; however, based on the latest targeted effective date, that guidance would not affect the Corporation until 2004. Another material estimate is the calculation of fair values of the Corporation's debt securities. The Corporation receives estimated fair values of debt securities from an independent valuation service, or from brokers. In developing these fair values, the valuation service and the brokers use estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments. Based on experience, management is aware that estimated fair values of debt securities tend to vary among brokers and other valuation services. Accordingly, when selling debt securities, management typically obtains price quotes from more than one source. The large majority of the Corporation's securities are classified as available-for-sale. Accordingly, these securities are carried at fair value on the consolidated balance sheet, with unrealized gains and losses excluded from earnings and reported separately through accumulated other comprehensive income (included in stockholders' equity). NET INTEREST MARGIN The Corporation's primary source of operating income is represented by the net interest margin. The net interest margin is equal to the difference between the amounts of interest income and interest expense. Tables II, III and IV include information regarding the Corporation's net interest margin for the first quarter 2002 and 2001. In each of these tables, the amounts of interest income earned on tax-exempt securities and loans have been adjusted to a fully taxable-equivalent basis. Accordingly, the net interest margin amounts reflected in these tables exceed the amounts presented in the consolidated financial statements. The discussion that follows is based on amounts in the Tables. The net interest margin, on a tax-equivalent basis, was $7,998,000 in the first quarter 2002, an increase of $1,922,000, or 31.6%, over the first quarter 2001. Table IV shows that interest rate changes had the effect of increasing net interest income $1,156,000 in the first quarter 2002 over the same period in 2001. As presented in Table III, the "Interest Rate Spread" (excess of average rate of return on interest-bearing assets over average cost of funds on interest-bearing liabilities) widened to 3.46% for the first quarter 2002, from 3.17% for the year ended December 31, 2001 and 2.78% for the first quarter 2001. Growth in volume also contributed to the higher net interest margin in the first quarter 2002. Table IV shows that increased interest income from higher volumes of earning assets exceeded increases in interest expense attributable to higher volumes of interest-bearing liabilities by $766,000. 11
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q INTEREST INCOME AND EARNING ASSETS Interest income increased 5.5% to $14,314,000 in the first quarter 2002 from $13,568,000 in the first quarter 2001. Income from available-for-sale securities increased $492,000, or 7.8%, and interest from loans increased $328,000 or 4.6%. Overall, the increase in interest income resulted from higher volumes of securities and loans, which more than offset the effect of lower interest rates. As indicated in Table III, average available-for-sale securities in the first quarter 2002 amounted to $438,651,000, an increase of 20.4% over the first quarter 2001. In total, available-for-sale securities grew because management was able to identify opportunities to borrow funds and invest the proceeds in securities at a positive spread. These opportunities were available because of the "steep yield curve" (longer-term interest rates much higher than shorter-term rates) that existed throughout most of the last 9 months of 2001 and the first quarter 2002. The average rate of return on available-for-sale securities was 6.29% for the first quarter 2002, considerably lower than the 7.03% level in the first quarter 2001. Table III also shows that the composition of the available-for-sale securities portfolio has changed significantly. The average balance of U.S. Government agency securities fell to 18% of the average balance of the total portfolio in the first quarter 2002 from 37% in the first quarter 2001. In contrast, the average balance of mortgage-backed securities increased to 47% of the total portfolio in the first quarter 2002 from 31% in the first quarter 2001. In the third and fourth quarters of 2001, as a result of declining interest rates, substantial amounts of U.S. Government agency securities were called. The Corporation reinvested much of the proceeds in mortgage-backed securities. Also, much of the leveraged security purchases described above consisted of mortgage-backed securities. The portfolio's increased weighting in mortgage-backed securities is designed to provide increased cash flow, in the form of monthly principal and interest payments. This increased level of cash inflows will be available to be reinvested at higher rates when interest rates rise. Obligations of state and political subdivisions (municipal bonds) also were a larger portion of the portfolio in the first quarter 2002 than in 2001. The average balance of municipal bonds grew to $98,853,000, or 23% of the portfolio, in the first quarter 2002 from $69,005,000, or 19% of the portfolio, in the first quarter 2001. On a taxable equivalent basis, municipal bonds are the highest yielding category of available-for-sale security. The Corporation determines the levels of its municipal bond holdings based on income tax planning and other considerations. The average balance of gross loans increased 15.8% in the first quarter 2002 over the first quarter 2001, to $380,925,000 from $328,838,000. The largest area of growth was real estate secured loans, with substantial increases in both residential and commercial mortgages. Among the factors that helped create the growth in loans was the opening of the Muncy, PA office in October 2000. The Corporation also increased its lending staff in Bradford and Tioga (PA) Counties during the second half of 2001. The average rate of return on loans fell to 7.96% in the first quarter 2002 from 8.82% in the first quarter 2001, due to lower market rates. The Corporation experienced a great deal of refinancing and rate modification activity in 2001, which has impacted loan yields in the first quarter 2002, and probably will continue to impact returns for the next few years. INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES Interest expense fell $1,176,000, or 15.7%, to $6,316,000 in the first quarter 2002 from $7,492,000 in the first quarter 2001. Overall, the impact of lower interest rates more than offset higher volumes of interest-bearing liabilities in the first quarter 2002 compared to the first quarter 2001. In Table IV, you can see the impact of lower interest rates on the Corporation's major categories of interest-bearing deposits - principally, money market accounts, CDs and savings accounts. Table IV also shows that interest expense from other borrowed funds increased in the first quarter 2002 by $282,000 over the first quarter 2001. This increase was attributable to higher average balances, related to borrowings used to purchase available-for-sale securities, as discussed earlier. As you can calculate from Table III, total average deposits (interest-bearing and noninterest-bearing) increased $52,622,000, or 10.0%, for the first quarter 2002 over the first quarter 2001. Of the increase in average deposits, nearly half ($25,625,000) consisted of growth in CDs. Table III also reflects the downward trend in interest rates incurred on liabilities, as the overall cost of funds on interest-bearing liabilities fell to 3.59% for the first quarter 2002, from 4.40% for the year ended December 31, 2001 and 5.07% for the first quarter 2001. 12
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE II - ANALYSIS OF INTEREST INCOME AND EXPENSE (IN THOUSANDS) <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, INCREASE/ 2002 2001 (DECREASE) <S> <C> <C> <C> INTEREST INCOME Available-for-sale securities: U.S. Treasury securities $ 37 $ 37 $ - Securities of other U.S. Government agencies and corporations 1,270 2,339 (1,069) Mortgage-backed securities 2,747 1,902 845 Obligations of states and political subdivisions 1,914 1,344 570 Equity securities 248 263 (15) Other securities 589 428 161 - -------------------------------------------------------------------------------------------------------------------- Total available-for-sale securities 6,805 6,313 492 - -------------------------------------------------------------------------------------------------------------------- Held-to-maturity securities: U.S. Treasury securities 11 11 - Securities of other U.S. Government agencies and corporations 7 11 (4) Mortgage-backed securities 3 5 (2) - -------------------------------------------------------------------------------------------------------------------- Total held-to-maturity securities 21 27 (6) - -------------------------------------------------------------------------------------------------------------------- Interest-bearing due from banks 7 19 (12) Federal funds sold 5 61 (56) Loans: Real estate loans 5,995 5,600 395 Consumer 736 778 (42) Agricultural 47 46 1 Commercial/industrial 462 456 6 Other 14 17 (3) Political subdivisions 219 246 (27) Leases 3 5 (2) - -------------------------------------------------------------------------------------------------------------------- Total loans 7,476 7,148 328 - -------------------------------------------------------------------------------------------------------------------- Total Interest Income 14,314 13,568 746 - -------------------------------------------------------------------------------------------------------------------- INTEREST EXPENSE Interest checking 106 204 (98) Money market 958 1,787 (829) Savings 130 275 (145) Certificates of deposit 1,998 2,333 (335) Individual Retirement Accounts 1,057 1,082 (25) Other time deposits 8 12 (4) Overnight borrowings 14 36 (22) Other borrowed funds 2,045 1,763 282 - -------------------------------------------------------------------------------------------------------------------- Total Interest Expense 6,316 7,492 (1,176) - -------------------------------------------------------------------------------------------------------------------- Net Interest Income $ 7,998 $ 6,076 $ 1,922 ==================================================================================================================== </TABLE> Note: Interest income from tax-exempt securities and loans has been adjusted to a fully tax-equivalent basis, using the Corporation's marginal federal income tax rate of 34%. 13
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE III - ANALYSIS OF AVERAGE DAILY BALANCES AND RATES <TABLE> <CAPTION> 3 MONTHS YEAR 3 MONTHS (DOLLARS IN THOUSANDS) ENDED RATE OF ENDED RATE OF ENDED RATE OF 3/31/2002 RETURN/ 12/31/2001 RETURN/ 3/31/2001 RETURN/ AVERAGE COST OF AVERAGE COST OF AVERAGE COST OF BALANCE FUNDS BALANCE FUNDS BALANCE FUNDS <S> <C> <C> <C> <C> <C> <C> EARNING ASSETS Available-for-sale securities, at amortized cost: U.S. Treasury securities $ 2,502 6.00% $ 2,506 6.03% $ 2,508 5.98% Securities of other U.S. Government agencies and corporations 78,239 6.58% 113,186 6.82% 136,018 6.97% Mortgage-backed securities 205,440 5.42% 150,838 6.29% 113,031 6.82% Obligations of states and political subdivisions 98,853 7.85% 78,741 7.89% 69,005 7.90% Equity securities 20,182 4.98% 21,062 5.18% 21,855 4.88% Other securities 33,435 7.14% 29,577 7.59% 22,030 7.88% - ------------------------------------------------------------------------------------------------------------------------------------ Total available-for-sale securities 438,651 6.29% 395,910 6.80% 364,447 7.03% - ------------------------------------------------------------------------------------------------------------------------------------ Held-to-maturity securities: U.S. Treasury securities 730 6.11% 742 5.39% 740 6.03% Securities of other U.S. Government agencies and corporations 434 6.54% 680 6.32% 746 5.98% Mortgage-backed securities 163 7.46% 205 7.80% 234 8.67% - ------------------------------------------------------------------------------------------------------------------------------------ Total held-to-maturity securities 1,327 6.42% 1,627 6.08% 1,720 6.37% - ------------------------------------------------------------------------------------------------------------------------------------ Interest-bearing due from banks 1,901 1.49% 2,659 3.08% 1,653 4.66% Federal funds sold 1,069 1.90% 5,064 3.63% 4,358 5.68% Loans: Real estate loans 311,233 7.81% 279,828 8.37% 264,129 8.60% Consumer 28,974 10.30% 28,062 10.89% 28,100 11.23% Agricultural 2,356 8.09% 2,070 9.18% 1,934 9.65% Commercial/industrial 26,188 7.15% 22,212 8.24% 20,996 8.81% Other 864 6.57% 892 7.62% 848 8.13% Political subdivisions 11,169 7.95% 13,108 7.96% 12,624 7.90% Leases 141 8.63% 181 9.39% 207 9.80% - ------------------------------------------------------------------------------------------------------------------------------------ Total loans 380,925 7.96% 346,353 8.56% 328,838 8.82% - ------------------------------------------------------------------------------------------------------------------------------------ Total Earning Assets 823,873 7.05% 751,613 7.57% 701,016 7.85% Cash 12,769 11,871 10,458 Unrealized gain/loss on securities 9,290 6,639 570 Allowance for loan losses (5,326) (5,370) (5,366) Bank premises and equipment 10,162 9,602 9,328 Other assets 31,082 30,874 32,087 - ------------------------------------------------------------------------------------------------------------------------------------ Total Assets $ 881,850 $ 805,229 $ 748,093 ==================================================================================================================================== INTEREST-BEARING LIABILITIES Interest checking $ 37,112 1.16% $ 37,192 1.75% $ 35,574 2.33% Money market 163,196 2.38% 153,738 3.49% 156,171 4.64% Savings 49,064 1.07% 46,750 2.16% 44,982 2.48% Certificates of deposit 184,397 4.39% 169,275 5.48% 158,772 5.96% Individual Retirement Accounts 86,061 4.98% 79,482 5.12% 79,279 5.54% Other time deposits 1,534 2.12% 1,916 1.83% 2,023 2.41% Overnight borrowings 2,746 2.07% 4,012 4.01% 2,369 6.16% Other borrowed funds 188,669 4.40% 151,615 5.13% 120,454 5.94% - ------------------------------------------------------------------------------------------------------------------------------------ Total Interest-bearing Liabilities 3.59% 4.40% 599,624 5.07% 712,779 643,980 Demand deposits 59,926 56,226 51,867 Other liabilities 7,399 9,002 6,848 - ------------------------------------------------------------------------------------------------------------------------------------ Total Liabilities 780,104 709,208 658,339 - ------------------------------------------------------------------------------------------------------------------------------------ Stockholders' equity, excluding other comprehensive income/loss 95,617 91,703 89,378 Other comprehensive income/loss 6,129 4,318 376 - ------------------------------------------------------------------------------------------------------------------------------------ Total Stockholders' Equity 101,746 96,021 89,754 - ------------------------------------------------------------------------------------------------------------------------------------ Total Liabilities and Stockholders' Equity $ 881,850 $ 805,229 $ 748,093 ==================================================================================================================================== Interest Rate Spread 3.46% 3.17% 2.78% Net Interest Income/Earning Assets 3.94% 3.80% 3.52% </TABLE> (1) Rates of return on tax-exempt securities and loans are presented on a fully taxable-equivalent basis. (2) Nonaccrual loans have been included with loans for the purpose of analyzing net interest earnings. 14
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE IV - ANALYSIS OF VOLUME AND RATE CHANGES <TABLE> <CAPTION> (IN THOUSANDS) QUARTERS ENDED 3/31/02 VS. 01 CHANGE IN CHANGE IN TOTAL VOLUME RATE CHANGE <S> <C> <C> <C> EARNING ASSETS Available-for-sale securities: U.S. Treasury securities $ - $ - $ - Securities of other U.S. Government agencies And corporations (945) (124) (1,069) Mortgage-backed securities 1,300 (455) 845 Obligations of states and political subdivisions 578 (8) 570 Equity securities (21) 6 (15) Other securities 204 (43) 161 - -------------------------------------------------------------------------------------------------------------------- Total available-for-sale securities 1,116 (624) 492 - -------------------------------------------------------------------------------------------------------------------- Held-to-maturity securities: U.S. Treasury securities - - - Securities of other U.S. Government agencies and corporations (5) 1 (4) Mortgage-backed securities (1) (1) (2) - -------------------------------------------------------------------------------------------------------------------- Total held-to-maturity securities (6) - (6) - -------------------------------------------------------------------------------------------------------------------- Interest-bearing due from banks 3 (15) (12) Federal funds sold (30) (26) (56) Loans: Real estate loans 938 (543) 395 Consumer 23 (65) (42) Agricultural 9 (8) 1 Commercial/industrial 101 (95) 6 Other - (3) (3) Political subdivisions (29) 2 (27) Leases (1) (1) (2) - -------------------------------------------------------------------------------------------------------------------- Total loans 1,041 (713) 328 - -------------------------------------------------------------------------------------------------------------------- Total Interest Income 2,124 (1,378) 746 - -------------------------------------------------------------------------------------------------------------------- INTEREST-BEARING LIABILITIES Interest checking 9 (107) (98) Money market 77 (906) (829) Savings 23 (168) (145) Certificates of deposit 339 (674) (335) Individual Retirement Accounts 88 (113) (25) Other time deposits (3) (1) (4) Overnight borrowings 5 (27) (22) Other borrowed funds 820 (538) 282 - -------------------------------------------------------------------------------------------------------------------- Total Interest Expense 1,358 (2,534) (1,176) - -------------------------------------------------------------------------------------------------------------------- Net Interest Income $ 766 $ 1,156 $ 1,922 ==================================================================================================================== </TABLE> (1) Changes in income on tax-exempt securities and loans is presented on a fully taxable-equivalent basis, using the Corporation's marginal federal income tax rate of 34%. (2) The change in interest due to both volume and rates has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amount of the change in each. 15
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE V - COMPARISON OF NONINTEREST INCOME <TABLE> <CAPTION> (IN THOUSANDS) 3 MONTHS ENDED MARCH 31, MARCH 31, 2002 2001 <S> <C> <C> Service charges on deposit accounts $ 384 $ 296 Service charges and fees 65 68 Trust and financial management revenue 439 387 Insurance commissions, fees and premiums 215 138 Increase in cash surrender value of life insurance 224 222 Fees related to credit card operation 130 128 Other operating income 230 195 - -------------------------------------------------------------------------------------------------- Total other operating income, before realized gains on securities, net 1,687 1,434 Realized gains on securities, net 1,226 455 - -------------------------------------------------------------------------------------------------- Total Other Income $ 2,913 $ 1,889 ================================================================================================== </TABLE> Total noninterest income increased $1,024,000, or 54.2%, in the first quarter 2002 compared to the first quarter 2001. The most significant change - the increase in security gains - is discussed in the "Earnings Overview" section of Management's Discussion and Analysis. Other items of significance are as follows: - - Service charges on deposit accounts increased $88,000, or 29.7%. This increase resulted from increased numbers of accounts and higher average balances, as well as fee increases implemented in the second half of 2001 on certain types of services. - - Trust and financial management revenue increased $52,000, or 13.4%. This increase resulted from fee increases implemented in the latter part of 2001, and from receipt of certain fees for services provided prior to 2002. Trust revenue is recorded on a cash basis, which does not vary materially from the accrual basis. - - Insurance revenue increased $77,000, or 55.8%. Revenue from the insurance agency division of C&N Financial Services Corporation increased to $79,000 in the first quarter 2002 from $40,000 in the first quarter 2001. Also, revenue from accident and health, mortgage group life, and individual life insurance, sold to lending customers through Bucktail Life Insurance Company, increased to $136,000 in the first quarter 2002 from $98,000 in the first quarter 2001. TABLE VI- COMPARISON OF NONINTEREST EXPENSE (IN THOUSANDS) 3 MONTHS ENDED MARCH 31, MARCH 31, 2002 2001 Salaries and wages $ 2,238 $ 2,018 Pensions and other employee benefits 615 580 Occupancy expense, net 278 259 Furniture and equipment expense 447 346 Pennsylvania shares tax 183 196 Expenses related to credit card operation 71 77 Other operating expense 1,274 1,122 - ------------------------------------------------------------------------------- Total Other Expense $ 5,106 $ 4,598 =============================================================================== Salaries and wages increased $220,000, or 10.9%, in the first quarter 2002 compared to the first quarter 2001. The increase is the result of annual merit raises ranging from 2%-5%, an increase in the number of employees and an increase in incentive bonus expense. Increases in staff during the last 3 quarters of 2001 and first quarter 2002 included the addition of new positions in branch and commercial lending, branch administration, compliance and marketing. The number of full-time equivalent employees has increased 7.1%, to 256 as of March 31, 2002 compared to 239 as of March 31, 2001. The incentive bonus plan provides for compensation to be paid to certain key officers early in the following year, with the payment amounts based on a combination of personal and corporate performance in the current year. The estimate of such expense for the first quarter 2002 increased $42,000 over the accrual recorded in the first quarter 2001. 16
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Pensions and other employee benefits increased $35,000, or 6.0%, in the first quarter 2002 over the first quarter 2001. This increase is directly related to the increase in salaries and wages. Furniture and equipment expense increased $101,000, or 29.2%, in the first quarter 2002 compared to the first quarter 2001. The largest increase within this category was in depreciation expense, which increased $56,000. There were several substantial capital expenditures over the last 3 quarters of 2001 and first quarter 2002 that produced higher depreciation expense in the first quarter 2002. The most significant items were new proof of deposit software, a new phone system and ongoing purchases of PCs and software required to maintain and upgrade the computer network. Repairs and maintenance expense increased $36,000, primarily from maintenance contracts associated with computer hardware and software. Other expense increased $152,000, or 13.5%, in the first quarter 2002 over the first quarter 2001. This category includes many different types of expenses. Some of the overall increase in this category was caused by increases in number of transactions processed and number of employees. The most significant individual change within this category was an increase of $76,000 in expenses from Bucktail Life Insurance Company, which resulted mainly from a larger amount of life insurance claims incurred. FINANCIAL CONDITION Significant changes in the average balances of the Corporation's earning assets and interest-bearing liabilities are described in the "Net Interest Margin" section of Management's Discussion and Analysis. There are no significant changes in the Corporation's consolidated balance sheet as of March 31, 2002 compared to December 31, 2001, other than the items addressed in that discussion. Table VII provides a summary of investment securities held at March 31, 2002 and December 31, 2001. The allowance for loan losses and stockholders' equity are discussed in separate sections of Management's Discussion and Analysis. TABLE VII - INVESTMENT SECURITIES <TABLE> <CAPTION> (In Thousands) MARCH 31, 2002 DECEMBER 31, 2001 AMORTIZED FAIR AMORTIZED FAIR COST VALUE COST VALUE AVAILABLE-FOR-SALE SECURITIES: <S> <C> <C> <C> <C> Obligations of the U.S. Treasury $ 2,501 $ 2,528 $ 2,503 $ 2,557 Obligations of other U.S. Government agencies 81,402 79,411 75,295 75,172 Obligations of states and political subdivisions 105,311 104,145 95,835 95,261 Other securities 32,376 32,547 34,315 34,532 Mortgage-backed securities 231,800 231,302 198,269 198,975 - ------------------------------------------------------------------------------------------------------- Total debt securities 453,390 449,933 406,217 406,497 Marketable equity securities 20,937 28,918 19,745 27,472 - ------------------------------------------------------------------------------------------------------- Total $474,327 $478,851 $425,962 $433,969 ======================================================================================================= HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ 724 $ 730 $ 726 $ 735 Obligations of other U.S. Government agencies 297 305 547 561 Mortgage-backed securities 157 163 175 181 - ------------------------------------------------------------------------------------------------------- Total $ 1,178 $ 1,198 $ 1,448 $ 1,477 ======================================================================================================= </TABLE> 17
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q PROVISION AND ALLOWANCE FOR LOAN LOSSES The allowance for loan losses includes two components, allocated and unallocated. The allocated component of the allowance for loan losses reflects probable losses resulting from the analysis of individual loans, specific allowances for loans in certain industries and historical loss experience for each loan category. The historical loan loss experience element is determined based on the ratio of net charge-offs to average loan balances over a five-year period, for each significant type of loan. The charge-off ratio is then applied to the current outstanding loan balance for each type of loan (net of other loans that are individually evaluated). The unallocated portion of the allowance is determined based on management's assessment of general economic conditions as well as specific economic factors in the market area. This determination inherently involves a higher degree of uncertainty and considers current risk factors that may not have yet manifested themselves in the Bank's historical loss factors used to determine the allocated component of the allowance, and it recognizes that knowledge of the portfolio credit risk may be incomplete. As noted in Table IX, the unallocated portion of the allowance for loan losses was $2,222,000 at March 31, 2002, which is relatively consistent with the unallocated allowance of $2,187,000 at December 31, 2001. These unallocated allowance balances reflect management's concern related to possible adverse changes in the local economy, including concerns related to several local plant lay-offs. In recent months, there has been some deterioration in loan delinquency data. Total 90 day or more past due loans, plus nonaccrual loans, increased 12.0% to $3,492,000 at March 31, 2002 from $3,117,000 at December 31, 2001. As reflected in Table IX, there was little change in the total allocated portion of the allowance at March 31, 2002 ($3,115,000) as compared to December 31, 2001 ($3,078,000). The provision for loan losses increased to $180,000 in the first quarter 2002 from $150,000 in the first quarter 2001. The amount of the provision in each period is determined based on the amount required to maintain an appropriate allowance in light of the factors described above. Tables VIII, IX and X present an analysis of the allowance for loan losses, the allocation of the allowance and a five-year summary of loans by type. TABLE VIII- ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES <TABLE> <CAPTION> (IN THOUSANDS) QUARTER ENDED MARCH 31, YEARS ENDED DECEMBER 31, 2002 2001 2000 1999 1998 1997 <S> <C> <C> <C> <C> <C> <C> Balance, beginning of year $ 5,265 $ 5,291 $ 5,131 $ 4,820 $ 4,913 $ 4,776 - -------------------------------------------------------------------------------------------------------------------- Charge-offs: Real estate loans 13 144 272 81 257 246 Installment loans 42 138 77 138 144 230 Credit cards and related plans 63 200 214 192 264 305 Commercial and other loans - 231 53 219 301 3 - -------------------------------------------------------------------------------------------------------------------- Total charge-offs 118 713 616 630 966 784 - -------------------------------------------------------------------------------------------------------------------- Recoveries: Real estate loans - 6 26 81 12 21 Installment loans 7 27 23 60 43 64 Credit cards and related plans 2 20 28 30 40 30 Commercial and other loans 1 34 23 10 15 9 - -------------------------------------------------------------------------------------------------------------------- Total recoveries 10 87 100 181 110 124 - -------------------------------------------------------------------------------------------------------------------- Net charge-offs 108 626 516 449 856 660 Provision for loan losses 180 600 676 760 763 797 - -------------------------------------------------------------------------------------------------------------------- Balance, end of year $ 5,337 $ 5,265 $ 5,291 $ 5,131 $ 4,820 $ 4,913 ==================================================================================================================== </TABLE> 18
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE IX - ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES BY TYPE (IN THOUSANDS) <TABLE> <CAPTION> AT MARCH 31, AT DECEMBER 31: 2002 2001 2000 1999 1998 1997 <S> <C> <C> <C> <C> <C> <C> Commercial $ 1,632 $ 1,837 $ 1,612 $ 2,081 $ 650 $ 625 Consumer mortgage 844 674 952 834 97 350 Impaired loans 204 73 273 609 290 274 Consumer 435 494 471 437 702 375 All other commitments - - - 150 202 343 Unallocated 2,222 2,187 1,983 1,020 2,879 2,946 - ------------------------------------------------------------------------------------------------------------------- Total Allowance $ 5,337 $ 5,265 $ 5,291 $ 5,131 $ 4,820 $ 4,913 =================================================================================================================== </TABLE> TABLE X - LOANS BY TYPE (IN THOUSANDS) <TABLE> <CAPTION> MAR. 31, DEC. 31, DEC. 31, DEC. 31, DEC. 31, DEC. 31, 2002 2001 2000 1999 1998 1997 <S> <C> <C> <C> <C> <C> <C> Real estate - construction $ 1,850 $ 1,814 $ 452 $ 649 $ 1,004 $ 406 Real estate - mortgage 316,412 306,264 263,325 247,604 230,815 219,952 Consumer 28,881 29,284 28,141 29,140 30,924 33,094 Agricultural 2,424 2,344 1,983 1,899 1,930 2,424 Commercial 28,575 24,696 20,776 18,050 17,630 17,176 Other 1,914 1,195 948 1,025 1,062 6,260 Political subdivisions 10,568 13,479 12,462 12,332 7,449 5,895 Lease receivables 135 152 218 222 218 256 - ----------------------------------------------------------------------------------------------------------------- Total 390,759 379,228 328,305 310,921 291,032 285,463 Less: unearned discount - - - (29) (29) (37) - ----------------------------------------------------------------------------------------------------------------- 390,759 379,228 328,305 310,892 291,003 285,426 Less: allowance for loan losses (5,337) (5,265) (5,291) (5,131) (4,820) (4,913) - ----------------------------------------------------------------------------------------------------------------- Loans, net $385,422 $373,963 $323,014 $305,761 $286,183 $280,513 ================================================================================================================= </TABLE> LIQUIDITY Liquidity is the ability to quickly raise cash at a reasonable cost. An adequate liquidity position permits the Corporation to pay creditors, compensate for unforeseen deposit fluctuations and fund unexpected loan demand. The Corporation maintains overnight borrowing facilities with several correspondent banks that provide a source of day-to-day liquidity. Also, the Corporation maintains borrowing facilities with the Federal Home Loan Bank of Pittsburgh, secured by mortgage loans and mortgage-backed securities. At March 31, 2002, the Corporation had unused borrowing availability with correspondent banks and the Federal Home Loan Bank of Pittsburgh totaling approximately $228,207,000. Additionally, the Corporation uses repurchase agreements placed with brokers to borrow short-term funds secured by investment assets, and uses "RepoSweep" arrangements to borrow funds from commercial banking customers on an overnight basis. STOCKHOLDERS' EQUITY AND CAPITAL ADEQUACY The Corporation and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. For many years, the Corporation and the Bank have maintained strong capital positions. The following table presents consolidated capital ratios at March 31, 2002: TABLE XI - CAPITAL RATIOS <TABLE> <CAPTION> CITIZENS & NORTHERN REGULATORY STANDARDS CORPORATION WELL MINIMUM (ACTUAL) CAPITALIZED STANDARD - ------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> Total capital to risk-weighted assets 22.61% 10% 8% Tier 1 capital to risk-weighted assets 20.71% 6% 4% Tier 1 capital to average total assets 11.03% 5% 4% </TABLE> Management expects the Corporation and the Bank to maintain capital levels that exceed the regulatory standards for well-capitalized institutions for the next 12 months and for the foreseeable future. Planned capital expenditures during the next 12 months are not expected to have a detrimental effect on capital ratios or results of operations. 19
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q INFLATION Over the last several years, direct inflationary pressures on the Corporation's payroll-related and other noninterest costs have been modest. However, the Corporation is significantly affected by the Federal Reserve Board's efforts to control inflation through changes in interest rates. Management monitors the impact of economic trends, including any indicators of inflationary pressure, in managing interest rate and other financial risks. CITIZENS & NORTHERN CORPORATION - FORM 10 - Q PART I - FINANCIAL INFORMATION (CONTINUED) ITEM 3. INTEREST RATE RISK AND MARKET RISK ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK MARKET RISK The Corporation's two major categories of market risk, interest rate and equity securities risk, are discussed in the following sections. INTEREST RATE RISK Business risk arising from changes in interest rates is an inherent factor in operating a bank. The Corporation's assets are predominantly long-term, fixed rate loans and debt securities. Funding for these assets comes principally from short-term deposits and borrowed funds. Accordingly, there is an inherent risk of lower future earnings or decline in fair value of the Corporation's financial instruments when interest rates change. The Bank uses a simulation model to calculate the potential effects of interest rate fluctuations on net interest income and the market value of portfolio equity. Only assets and liabilities of the Bank are included in management's monthly simulation model calculations. Since the Bank makes up more than 90% of the Corporation's total assets and liabilities, and because the Bank is the source of the most volatile interest rate risk, management does not consider it necessary to run the model for the remaining entities within the consolidated group. For purposes of these calculations, the market value of portfolio equity includes the fair values of financial instruments, such as securities, loans, deposits and borrowed funds, and the book values of nonfinancial assets and liabilities, such as premises and equipment and accrued interest. The model measures and projects potential changes in net interest income, and calculates the discounted present value of anticipated cash flows of financial instruments, under the "base most likely" and "what if" scenarios. Typically, management runs these calculations using the base most likely scenario, and assuming increases and decreases of 100 basis points (1%), 200 basis points and 300 basis points from the base most likely scenario. The Bank's Board of Directors has established policy guidelines for acceptable levels of interest rate risk, based on an immediate increase or decrease in interest rates of 200 basis points. The policy limit for fluctuation in net interest income is minus 20% from the base most likely one-year scenario. The policy limit for market value variance is minus 30% from the base most likely one-year scenario. As Table XII shows, as of March 31, 2002, the Bank's interest rate risk calculations were within the policy thresholds. The most sensitive scenario presented is the "+200 basis points" scenario. If interest rates were to immediately increase 200 basis points, the Bank's calculations based on the model show that net interest income would decrease 13.39% over the next 12 months, and the market value of portfolio equity would decrease 26.14%. The table that follows was prepared using the simulation model described above. The model makes estimates, at each level of interest rate change, regarding cash flows from principal repayments on loans and mortgage-backed securities and call activity on other investment securities. Actual results could vary significantly from these estimates, which could result in significant differences in the calculations of projected changes in net interest margin and market value of portfolio equity. Also, the model does not make estimates related to changes in the composition of the deposit portfolio that could occur due to rate competition and the table does not necessarily reflect changes that management would make to realign the portfolio as a result of changes in interest rates. 20
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE XII - THE EFFECT OF HYPOTHETICAL CHANGES IN INTEREST RATES <TABLE> <CAPTION> Period Ending March 31, 2003 (In Thousands) March 31, 2002 Data PLUS 200 MINUS 200 MOST LIKELY BASIS BASIS FORECAST POINTS POINTS AMOUNT AMOUNT % CHANGE AMOUNT % CHANGE Interest income: <S> <C> <C> <C> <C> <C> Securities $26,784 $29,020 8.35 $ 24,488 (8.57) Interest-bearing due from banks and federal funds sold 76 134 76.32 9 (88.16) Loans 31,796 33,477 5.29 28,976 (8.87) - --------------------------------------------------------------------------------------------------------------------- Total interest income 58,656 62,631 6.78 53,473 (8.84) - --------------------------------------------------------------------------------------------------------------------- Interest expense: Interest on deposits 18,137 25,505 40.62 10,813 (40.38) Interest on borrowed funds 9,084 9,901 8.99 8,317 (8.44) - --------------------------------------------------------------------------------------------------------------------- Total interest expense 27,221 35,406 30.07 19,130 (29.72) - --------------------------------------------------------------------------------------------------------------------- Net Interest Income $31,435 $27,225 (13.39) $ 34,343 9.25 ===================================================================================================================== Market Value of Portfolio Equity at March 31, 2002 $90,526 $66,863 (26.14) $104,454 15.39 ===================================================================================================================== </TABLE> EQUITY SECURITIES RISK The Corporation's equity securities portfolio consists primarily of investments in stock of banks and bank holding companies located mainly in Pennsylvania. The Corporation also owns some other stocks and mutual funds. Investments in bank stocks are subject to the risk factors that affect the banking industry in general, including competition from nonbank entities, credit risk, interest rate risk and other factors, which could result in a decline in market prices. Also, losses could occur in individual stocks held by the Corporation because of specific circumstances related to each bank. Further, because of the concentration of bank and bank holding companies located in Pennsylvania, these investments could decline in market value if there is a downturn in the state's economy. Equity securities held as of March 31, 2002 and December 31, 2001 are presented in Table XII. TABLE XIII - EQUITY SECURITIES <TABLE> <CAPTION> (IN THOUSANDS) HYPOTHETICAL HYPOTHETICAL 10% 20% DECLINE IN DECLINE IN FAIR MARKET MARKET AT MARCH 31, 2002 COST VALUE VALUE VALUE - ---------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Banks and bank holding companies $ 19,397 $ 27,309 $ (2,731) $ (5,462) Other equity securities 1,540 1,609 (161) (322) - ---------------------------------------------------------------------------------------------------- Total $ 20,937 $ 28,918 $ (2,892) $ (5,784) ==================================================================================================== </TABLE> <TABLE> <CAPTION> HYPOTHETICAL HYPOTHETICAL 10% 20% DECLINE IN DECLINE IN FAIR MARKET MARKET AT DECEMBER 31, 2001 COST VALUE VALUE VALUE - ---------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Banks and bank holding companies $ 18,922 $ 26,636 $ (2,664) $ (5,327) Other equity securities 823 836 (84) (167) - ---------------------------------------------------------------------------------------------------- Total $ 19,745 $ 27,472 $ (2,748) $ (5,494) ==================================================================================================== </TABLE> 21
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q PART II - OTHER INFORMATION Item 1. Legal Proceedings Neither the Corporation nor any of its subsidiaries is a party to any material pending legal proceedings. Item 2. Not Applicable Item 3. Not Applicable Item 4. Not Applicable Item 5. Other Information a. None Item 6. Exhibits and Reports on Form 8 - K a. Exhibits have been omitted either because not applicable or because the required information is included elsewhere in Form 10-Q. b. On January 10, 2002, a Current Report on Form 8-K was filed to report the Corporation's consolidated earnings results for the year ended December 31, 2001. 22
CITIZENS AND NORTHERN CORPORATION - FORM 10 - Q Signature Page SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CITIZENS & NORTHERN CORPORATION May 13, 2002 By: Craig G. Litchfield /S/ - ------------ ----------------------- Date Chairman, President and Chief Executive Officer May 13, 2002 By: Mark A. Hughes /S/ - ------------ ------------------ Date Treasurer and Principal Accounting Officer 23