SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2003 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) <TABLE> <S> <C> 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) </TABLE> 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 ___ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes X 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. <TABLE> <S> <C> Title Outstanding Common Stock ($1.00 par value) 8,013,110 Shares Outstanding November 12, 2003 </TABLE> 1
CITIZENS & NORTHERN CORPORATION Index <TABLE> <S> <C> Part I. Financial Information Item 1. Financial Statements Consolidated Balance Sheet - September 30, 2003 and December 31, 2002 Page 3 Consolidated Statement of Income - Three Months and Nine Months Ended September 30, 2003 and 2002 Page 4 Consolidated Statement of Cash Flows - Nine Months Ended September 30, 2003 and 2002 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 9 through 22 Item 3. Quantitative and Qualitative Disclosures About Market Risk Pages 22 through 24 Item 4. Controls and Procedures Page 24 Part II. Other Information Page 25 Signatures Page 26 Exhibit 31.1. Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Chief Executive Officer Page 27 Exhibit 31.2. Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Chief Financial Officer Page 28 Exhibit 32. Certifications Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Page 29 </TABLE> 2
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q ITEM 1. FINANCIAL STATEMENTS <TABLE> <CAPTION> CONSOLIDATED BALANCE SHEET SEPTEMBER 30, DECEMBER 31, (In Thousands Except Share Data) 2003 2002 (UNAUDITED) (NOTE) <S> <C> <C> ASSETS Cash and due from banks: Noninterest-bearing $ 17,224 $ 14,185 Interest-bearing 1,234 715 ----------- ----------- Total cash and cash equivalents 18,458 14,900 Available-for-sale securities 482,064 512,175 Held-to-maturity securities 565 707 Loans, net 500,005 445,356 Bank-owned life insurance 17,310 16,758 Accrued interest receivable 5,888 5,960 Bank premises and equipment, net 12,023 10,333 Foreclosed assets held for sale 78 56 Other assets 13,619 12,523 ----------- ----------- TOTAL ASSETS $ 1,050,010 $ 1,018,768 =========== =========== LIABILITIES Deposits: Noninterest-bearing $ 72,391 $ 70,824 Interest-bearing 580,337 569,480 ----------- ----------- Total deposits 652,728 640,304 Dividends payable 1,682 1,586 Short-term borrowings 45,167 43,635 Long-term borrowings 216,696 208,214 Accrued interest and other liabilities 11,631 9,192 ----------- ----------- TOTAL LIABILITIES 927,904 902,931 ----------- ----------- STOCKHOLDERS' EQUITY Common stock, par value $1.00 per share; authorized 10,000,000 shares; issued 8,226,033 in 2003 and 5,431,021 in 2002 8,226 5,431 Stock dividend distributable -- 1,639 Paid-in capital 20,081 21,153 Retained earnings 84,498 77,584 ----------- ----------- Total 112,805 105,807 Accumulated other comprehensive income 11,487 12,146 Unamortized stock compensation (79) (49) Treasury stock, at cost: 214,751 shares at September 30, 2003 (2,107) 145,415 shares at December 31, 2002 (2,067) ----------- ----------- TOTAL STOCKHOLDERS' EQUITY 122,106 115,837 ----------- ----------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 1,050,010 $ 1,018,768 =========== =========== </TABLE> The accompanying notes are an integral part of these consolidated financial statements. Note: The balance sheet at December 31, 2002 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> (In thousands, except per share data) 3 MONTHS ENDED FISCAL YEAR TO DATE (Unaudited) SEPT. 30, SEPT. 30, 9 MONTHS ENDED SEPT. 30, 2003 2002 2003 2002 (CURRENT) (PRIOR YEAR) (CURRENT) (PRIOR YEAR) <S> <C> <C> <C> <C> INTEREST INCOME Interest and fees on loans $ 8,164 $ 7,864 $ 24,049 $ 22,663 Interest on balances with depository institutions 1 5 8 18 Interest on loans to political subdivisions 206 143 572 435 Interest on federal funds sold -- 16 8 30 Income from available-for-sale and held-to-maturity securities: Taxable 3,027 4,810 10,571 14,598 Tax-exempt 1,859 1,523 5,421 4,291 Dividends 296 314 797 805 ---------- ---------- ---------- ---------- Total interest and dividend income 13,553 14,675 41,426 42,840 ---------- ---------- ---------- ---------- INTEREST EXPENSE Interest on deposits 3,470 4,383 11,201 13,008 Interest on short-term borrowings 121 221 362 735 Interest on long-term borrowings 2,064 2,071 6,424 5,993 ---------- ---------- ---------- ---------- Total interest expense 5,655 6,675 17,987 19,736 ---------- ---------- ---------- ---------- Interest margin 7,898 8,000 23,439 23,104 Provision for loan losses 250 280 850 640 ---------- ---------- ---------- ---------- Interest margin after provision for loan losses 7,648 7,720 22,589 22,464 ---------- ---------- ---------- ---------- OTHER INCOME Service charges on deposit accounts 452 453 1,307 1,260 Service charges and fees 91 61 210 194 Trust and financial management income 413 413 1,258 1,358 Insurance commissions, fees and premiums 63 108 220 448 Increase in cash surrender value of life insurance 175 213 552 648 Fees related to credit card operation 207 168 564 450 Other operating income 304 226 762 652 ---------- ---------- ---------- ---------- Total other income before realized gains on securities, net 1,705 1,642 4,873 5,010 Realized gains on securities, net 660 489 3,289 2,496 ---------- ---------- ---------- ---------- Total other income 2,365 2,131 8,162 7,506 ---------- ---------- ---------- ---------- OTHER EXPENSES Salaries and wages 2,356 2,467 7,129 7,056 Pensions and other employee benefits 777 716 2,437 1,975 Occupancy expense, net 310 229 967 815 Furniture and equipment expense 345 358 1,029 1,199 Pennsylvania shares tax 196 184 588 550 Other operating expense 1,352 1,356 4,074 4,069 ---------- ---------- ---------- ---------- Total other expenses 5,336 5,310 16,224 15,664 ---------- ---------- ---------- ---------- Income before income tax provision 4,677 4,541 14,527 14,306 Income tax provision 759 831 2,617 2,938 ---------- ---------- ---------- ---------- NET INCOME $ 3,918 $ 3,710 $ 11,910 $ 11,368 ========== ========== ========== ========== PER SHARE DATA: Net income - basic $ 0.49 $ 0.46 $ 1.49 $ 1.42 Net income - diluted $ 0.49 $ 0.46 $ 1.48 $ 1.42 ---------- ---------- ---------- ---------- Dividend per share $ 0.21 $ 0.20 $ 0.63 $ 0.5733 ---------- ---------- ---------- ---------- Number shares used in computation - basic 8,010,753 8,006,142 8,008,547 8,009,856 Number shares used in computation - diluted 8,071,173 8,031,880 8,055,627 8,030,398 </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> SEPTEMBER 30, SEPTEMBER 30, 2003 2002 CASH FLOWS FROM OPERATING ACTIVITIES: <S> <C> <C> Net income $ 11,910 $ 11,368 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 850 640 Realized gains on securities, net (3,289) (2,496) Gain on sale of foreclosed assets, net (83) (26) Depreciation expense 815 1,054 Accretion and amortization, net 1,124 (508) Increase in cash surrender value of life insurance (552) (648) Amortization of restricted stock 77 62 Increase in accrued interest receivable and other assets (79) (956) Increase in accrued interest payable and other liabilities 2,903 3,148 --------- --------- Net Cash Provided by Operating Activities 13,676 11,638 --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from maturity of held-to-maturity securities 140 616 Proceeds from sales of available-for-sale securities 46,876 25,650 Proceeds from calls and maturities of available-for-sale securities 153,160 110,099 Purchase of available-for-sale securities (168,755) (183,963) Purchase of Federal Home Loan Bank of Pittsburgh stock (1,178) (125) Redemption of Federal Home Loan Bank of Pittsburgh stock 168 -- Net increase in loans (55,671) (52,428) Purchase of premises and equipment (2,505) (1,341) Proceeds from sale of foreclosed assets 233 477 --------- --------- Net Cash Used in Investing Activities (27,532) (101,015) --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Net increase in deposits 12,424 60,205 Net increase (decrease) in short-term borrowings 1,532 (19,381) Proceeds from long-term borrowings 46,000 75,153 Repayments of long-term borrowings (37,518) (20,017) Purchase of treasury stock (174) (238) Sale of treasury stock 141 60 Dividends paid (4,991) (4,452) --------- --------- Net Cash Provided by Financing Activities 17,414 91,330 --------- --------- INCREASE IN CASH AND CASH EQUIVALENTS 3,558 1,953 CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 14,900 16,036 --------- --------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 18,458 $ 17,989 ========= ========= SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Assets acquired through foreclosure of real estate loans $ 172 $ 436 Interest paid $ 14,352 $ 16,422 Income taxes paid $ 2,570 $ 3,599 </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, 2002, 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-month and nine-month periods ended September 30, 2003 might not be indicative of the results for the year ending December 31, 2003. 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 splits and 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. As shown in the table that follows, diluted earnings per share is computed using weighted average common shares outstanding, plus 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> NINE MONTHS ENDED SEPTEMBER 30, 2003 Earnings per share - basic $ 11,910,000 8,008,547 $ 1.49 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 197,322 Hypothetical share repurchase at $23.68 (150,242) ------------ --------- -------- Earnings per share - diluted $ 11,910,000 8,055,627 $ 1.48 ============ ========= ======== NINE MONTHS ENDED SEPTEMBER 30, 2002 Earnings per share - basic $ 11,368,000 8,009,856 $ 1.42 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 137,249 Hypothetical share repurchase at $19.29 (116,707) ------------ --------- -------- Earnings per share - diluted $ 11,368,000 8,030,398 $ 1.42 ============ ========= ======== </TABLE> 6
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q <TABLE> <CAPTION> WEIGHTED- AVERAGE EARNINGS NET COMMON PER INCOME SHARES SHARE <S> <C> <C> <C> QUARTER ENDED SEPTEMBER 30, 2003 Earnings per share - basic $ 3,918,000 8,010,753 $ 0.49 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 216,930 Hypothetical share repurchase at $26.01 (156,510) ----------- --------- -------- Earnings per share - diluted $ 3,918,000 8,071,173 $ 0.49 =========== ========= ======== QUARTER ENDED SEPTEMBER 30, 2002 Earnings per share - basic $ 3,710,000 8,006,142 $ 0.46 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 137,249 Hypothetical share repurchase at $20.19 (111,511) ----------- --------- -------- Earnings per share - diluted $ 3,710,000 8,031,880 $ 0.46 =========== ========= ======== </TABLE> 3. STOCK COMPENSATION PLANS As permitted by Accounting Principles Board Opinion No. 25, the Corporation uses the intrinsic value method of accounting for stock compensation plans. Utilizing the intrinsic value method, compensation cost is measured by the excess of the quoted market price of the stock as of the grant date (or other measurement date) over the amount an employee or director must pay to acquire the stock. Stock options issued under the Corporation's stock option plans have no intrinsic value, and accordingly, no compensation cost is recorded for them. The Corporation has also made awards of restricted stock. Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period. The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-based Compensation," to stock options. 7
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q (IN THOUSANDS) <TABLE> <CAPTION> 3 MONTHS ENDED FISCAL YEAR-TO-DATE SEPT. 30, 9 MONTHS ENDED SEPT. 30, 2003 2002 2003 2002 <S> <C> <C> <C> <C> Net income, as reported $ 3,918 $ 3,710 $ 11,910 $ 11,368 Deduct: Total stock option compensation expense determined under fair value method for all awards, net of tax effects (9) (11) (115) (178) --------- --------- ---------- ---------- Pro forma net income $ 3,909 $ 3,699 $ 11,795 $ 11,190 ========= ========= ========== ========== Earnings per share-basic: As reported $ 0.49 $ 0.46 $ 1.49 $ 1.42 Pro forma $ 0.49 $ 0.46 $ 1.47 $ 1.40 Earnings per share-diluted: As reported $ 0.49 $ 0.46 $ 1.48 $ 1.42 Pro forma $ 0.48 $ 0.46 $ 1.46 $ 1.39 </TABLE> 4. 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. Comprehensive income is calculated as follows: <TABLE> <CAPTION> 3 MONTHS ENDED 9 MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, (IN THOUSANDS) 2003 2002 2003 2002 <S> <C> <C> <C> <C> Net income $ 3,918 $ 3,710 $ 11,910 $ 11,368 Other comprehensive (loss)/income: Unrealized holding (losses)/gains on available-for-sale securities: (Losses)/Gains arising during the period (4,199) 6,387 2,291 14,461 Reclassification adjustment for realized gains (660) (489) (3,289) (2,496) -------- -------- -------- -------- Other comprehensive (loss)/income before income tax (4,859) 5,898 (998) 11,965 Income tax related to other comprehensive (loss)/income 1,651 (2,005) 339 (4,068) -------- -------- -------- -------- Other comprehensive (loss)/income (3,208) 3,893 (659) 7,897 -------- -------- -------- -------- Comprehensive income $ 710 $ 7,603 $ 11,251 $ 19,265 ======== ======== ======== ======== </TABLE> 5. CONTINGENCIES In the normal course of business, the Corporation may be subject to pending and threatened lawsuits in which claims for monetary damages could be asserted. In management's opinion, the Corporation's financial position and results of operations would not be materially affected by the outcome of such pending legal proceedings. 8
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q PART I - FINANCIAL INFORMATION (CONTINUED) ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS 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, and are generally not historical facts, are identifiable by the use of words such as, "believe", "expect", "intend", "anticipate", "estimate", "project", and similar expressions. These forward-looking statements are subject to risks and uncertainties that are difficult to predict, may be beyond management's control and could cause results to differ materially from those currently anticipated. Factors which could have a material adverse impact 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 Federal Reserve Board and the U. S. Government, particularly related to changes in interest rates - - decline in market value of available-for-sale securities - - 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, or the application of generally accepted accounting principles. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. REFERENCES TO 2003 AND 2002 Unless otherwise noted, all references to "2003" in the following discussion of operating results are intended to mean the nine months ended September 30, 2003, and similarly, references to "2002" are intended to mean the nine months ended September 30, 2002. EARNINGS OVERVIEW Net income for 2003 was $11,910,000, or $1.49 per share - basic and $1.48 per share - diluted. This represents an increase of 4.9% in net income per share - basic and an increase of 4.2% in net income per share - diluted over 2002. Return on average assets was 1.54% in 2003, down from 1.63% in 2002. Return on average equity decreased to 13.10% in 2003 from 14.39% in 2002. The most significant income statement changes between 2003 and 2002 were as follows: - - Net realized gains on securities were $3,289,000 in 2003, compared to $2,496,000 in 2002. In both years, the gains were mainly from sales of bank stocks. These sales resulted from circumstances specific to each underlying company, and the proceeds have been reinvested in other bank stocks. Total gains from sales of bank stocks amounted to $1,972,000 in 2003 and $1,789,000 in 2002. Other security gains (net) from debt securities amounted to $1,317,000 in 2003 and $710,000 in 2002, and consisted mainly of sales and calls of municipal and U.S. Agency bonds. - - The interest margin increased by $335,000, or 1.5%, to $23,439,000 in 2003 from $23,104,000 in 2002. Average interest rates on deposits and borrowed funds have been substantially lower in 2003 than in 2002. However, the Corporation has experienced significant growth in loans, which has more than offset the effects of lower yields in 2003. Changes in the net interest margin are discussed in more detail later in Management's Discussion and Analysis under "Net Interest Margin". 9
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q - - Other (noninterest) expenses increased $560,000, or 3.6%, in 2003 compared to 2002. The increase reflects increases in payroll costs and employee benefits. As described in more detail in the "Noninterest Expense" section of Management's Discussion and Analysis, these cost increases reflect a higher number of employees, as well as increases in costs related to employee health insurance and the defined benefit pension plan. - - The income tax provision decreased to $2,617,000 in 2003 from $2,938,000 in 2002. While pre-tax income has increased, the Corporation's effective tax rate fell to 18.0% in 2003 from 20.5% in 2002. This lower effective tax rate resulted mainly from management's decision to increase the weighting of tax-exempt obligations of states and political subdivisions, as a percentage of total assets. THIRD QUARTER 2003 - ------------------ Net income for the third quarter 2003 was $3,918,000, an increase of $208,000 (5.6%) over the third quarter 2002. Net income per share was $0.49 (Basic and Diluted) for the third quarter 2003, as compared to $0.46 (Basic and Diluted) for the third quarter 2002. Net Income for the third quarter 2003 is slightly less than the $3,920,000 reported in the second quarter and $4,072,000 reported in the first quarter 2003. As you can see in Table I, the interest margin increased $44,000 in the third quarter over the second quarter, and $167,000 in the second quarter over the first quarter. However, net realized security gains were $248,000 lower in the third quarter than the second quarter, and $813,000 lower in the second quarter than in the first quarter. TABLE I - QUARTERLY FINANCIAL DATA (IN THOUSANDS) <TABLE> <CAPTION> SEPT. 30, JUNE 30, MAR. 31, DEC. 31, SEPT. 30, JUNE 30, MAR. 31, 2003 2003 2003 2002 2002 2002 2002 <S> <C> <C> <C> <C> <C> <C> <C> Interest income $13,553 $13,943 $13,930 $14,445 $14,675 $14,523 $13,642 Interest expense 5,655 6,089 6,243 6,579 6,675 6,745 6,316 ------- ------- ------- ------- ------- ------- ------- Interest margin 7,898 7,854 7,687 7,866 8,000 7,778 7,326 Provision for loan losses 250 250 350 300 280 180 180 ------- ------- ------- ------- ------- ------- ------- Interest margin after provision for loan losses 7,648 7,604 7,337 7,566 7,720 7,598 7,146 Other income 1,705 1,628 1,540 1,614 1,642 1,681 1,687 Securities gains 660 908 1,721 392 489 781 1,226 Other expenses 5,336 5,356 5,532 5,185 5,310 5,248 5,106 ------- ------- ------- ------- ------- ------- ------- Income before income tax provision 4,677 4,784 5,066 4,387 4,541 4,812 4,953 Income tax provision 759 864 994 796 831 992 1,115 ------- ------- ------- ------- ------- ------- ------- Net income $ 3,918 $ 3,920 $ 4,072 $ 3,591 $ 3,710 $ 3,820 $ 3,838 ======= ======= ======= ======= ======= ======= ======= Net income per share - basic $ 0.49 $ 0.49 $ 0.51 $ 0.45 $ 0.46 $ 0.48 $ 0.48 ======= ======= ======= ======= ======= ======= ======= Net income per share - diluted $ 0.49 $ 0.49 $ 0.51 $ 0.45 $ 0.46 $ 0.48 $ 0.48 ======= ======= ======= ======= ======= ======= ======= </TABLE> The number of shares used in calculating net income per share for each quarter presented in Table I reflects the retroactive effect of stock splits and dividends. PROSPECTS FOR THE REMAINDER OF 2003 - ----------------------------------- Management believes earnings prospects for the fourth quarter 2003 are good. Net loans are up 17.6% as of September 30, 2003 compared to September 30, 2002. The Corporation's major concentration continues to be real estate secured loans, with significant growth over the last 12 months in both residential and commercial loans outstanding. With interest rates at or near forty-year lows throughout most of 2003, interest-earning assets have been repricing faster than interest-bearing liabilities. In that interest rate environment, it is a challenge to maintain or grow the interest margin while limiting interest rate risk to a prudent level. While short-term interest rates remain at or near historically low levels, 10
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q longer-term rates (such as the 10-year U.S. Treasury bond yield) have risen during the third quarter 2003 from their position in June 2003. Higher long-term rates, along with several positive economic reports in recent weeks, could be an indicator that short-term interest rates will rise over the next year or so. Although rising short-term rates would probably not have a significant effect on fourth quarter 2003 earnings, the Corporation's results for 2004 may be affected by the expected slowdowns in prepayments on loans and mortgage-backed securities and by higher interest costs on deposits and borrowed funds. The Corporation's interest rate risk is discussed in more detail in Item 3 of Form 10-Q. The other major variable that could affect fourth quarter 2003 earnings is securities gains and losses. The Corporation's management makes decisions regarding sales of securities based on a variety of factors, with an overall goal of maximizing portfolio return over a long-term horizon. It is possible that management may sell some investment securities in the fourth quarter 2003 in an effort to address the possible further effects of rising interest rates. It is difficult to predict, with any degree of precision, the amounts of securities gains and losses that may be realized during the fourth quarter 2003. CRITICAL ACCOUNTING ESTIMATES 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 reporting periods. 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, in June 2003, the American Institute of Certified Public Accountants issued an exposure draft of a statement of position that would establish detailed implementation guidance for calculating the allowance for loan losses. The exposure draft of this statement of position calls for implementation of its provisions in 2004. Implementation of this detailed guidance, if it is approved, could result in an adjustment to the Corporation's allowance. 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 2003 and 2002. 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 $26,238,000 in 2003, an increase of $958,000, or 3.8%, over 2002. As reflected in Table IV, the increase in net interest margin was caused by the growth in volume. Increased interest income from higher volumes of earning assets exceeded increases in interest expense attributable to higher volumes of interest-bearing liabilities by $3,306,000 in 2003 compared to 2002. Table IV also shows that interest rate changes had the effect of decreasing net interest income $2,348,000 in 2003 compared to 2002. 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 11
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q liabilities) shrunk to 3.29% for the first 9 months of 2003, from 3.38% for the year ended December 31, 2002 and 3.43% for the first 9 months of 2002. INTEREST INCOME AND EARNING ASSETS As indicated in Table II, interest income decreased slightly to $44,225,000 in 2003 from $45,016,000 in 2002. Income from available-for-sale securities decreased $2,331,000, or 10.8% while interest from loans increased $1,590,000 or 6.8%. Overall, the majority of the increase in interest income resulted from higher volumes of loans, which more than offset the effect of lower interest rates. As indicated in Table III, average available-for-sale securities in 2003 amounted to $476,096,000, an increase of 3.0% over 2002. 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 in 2002. 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 2002 and the first 9 months of 2003. The average rate of return on available-for-sale securities was 5.42% for 2003, considerably lower than the 6.26% level in 2002. Table III also shows changes in the composition of the available-for-sale securities portfolio. The average balance of U.S. Government agency securities fell to 14% of the average balance of the total portfolio in 2003 from 17% in the first 9 months of 2002. The average balance of mortgage-backed securities has also fallen to 38% of the total portfolio in 2003 from 46% in the first 9 months of 2002. In 2002 and 2003, as a result of declining interest rates, substantial amounts of U.S. Government agency securities were called. This rate environment also led to increased prepayments on mortgage-backed securities. The Corporation reinvested much of the proceeds in obligations of state and political subdivisions (municipal bonds). Municipal bonds were a larger portion of the portfolio in 2003 than in 2002. The average balance of municipal bonds grew to $142,813,000, or 30% of the portfolio, in 2003 from $109,556,000, or 24% of the portfolio, in the first 9 months of 2002. 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. Other securities consist of corporate obligations, mainly "Trust Preferred Securities" issued by financial institutions. Trust Preferred Securities are long-term obligations (usually 20-40 year maturities, often callable at the issuer's option after 5-10 years), which bear interest at fixed or variable rates. The average balance of other securities increased to $55,284,000 in 2003 from $33,481,000 for the first 9 months of 2002, primarily as a result of purchases of Trust Preferred Securities. The average balance of gross loans increased 18.6% in 2003 over the first 9 months of 2002, to $475,830,000 from $401,302,000. The largest area of growth was real estate secured loans, with substantial increases in both residential and commercial mortgages. The average rate of return on loans fell to 6.99% in 2003 from 7.76% in the first 9 months of 2002, due to lower market rates. The Corporation experienced a great deal of refinancing and rate modification activity in 2002 and early 2003, which has negatively impacted loan yields, and probably will result in loan yields that are low by historical standards for the next few years. INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES Interest expense fell $1,749,000, or 8.9%, to $17,987,000 in 2003 from $19,736,000 in 2002. Overall, the impact of lower interest rates was more than the impact of higher volumes of interest-bearing liabilities in 2003 compared to 2002. In Table IV, you can see the impact of lower interest rates on the Corporation's major categories of interest-bearing deposits - principally, CDs and money market accounts. In contrast, interest expense on IRAs increased $527,000 in 2003, to $3,858,000. In late 2002, the Corporation lowered the minimum interest rate on IRAs from 5% to 3%; however, this change will not affect most accounts until the second quarter 2004. As you can calculate from Table III, total average deposits (interest-bearing and noninterest-bearing) increased to $650,396,000 in the first 9 months of 2003 from $604,677,000 in the first 9 months of 2002. This represents an increase of 7.6%. Of the increase in average deposits, the largest growth categories were money market accounts (growth in average balance of $20,136,000, or 11.9%) and IRA's ($15,854,000, or 17.7%). 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 2.90% for 2003, from 3.46% for the year ended December 31, 2002 and 3.50% for 2002. 12
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE II - ANALYSIS OF INTEREST INCOME AND EXPENSE <TABLE> <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, INCREASE/ (IN THOUSANDS) 2003 2002 (DECREASE) <S> <C> <C> <C> INTEREST INCOME Available-for-sale securities: U.S. Treasury securities $ -- $ 75 $ (75) Securities of other U.S. Government agencies and corporations 2,461 3,696 (1,235) Mortgage-backed securities 5,717 8,768 (3,051) Obligations of states and political subdivisions 7,952 6,266 1,686 Equity securities 797 805 (8) Other securities 2,366 2,014 352 ------- ------- ------- Total available-for-sale securities 19,293 21,624 (2,331) ------- ------- ------- Held-to-maturity securities: U.S. Treasury securities 13 23 (10) Securities of other U.S. Government agencies and corporations 11 16 (5) Mortgage-backed securities 3 6 (3) ------- ------- ------- Total held-to-maturity securities 27 45 (18) ------- ------- ------- Interest-bearing due from banks 8 18 (10) Federal funds sold 8 30 (22) Loans: Real estate loans 20,212 18,830 1,382 Consumer 2,177 2,186 (9) Agricultural 148 148 -- Commercial/industrial 1,463 1,440 23 Other 45 50 (5) Political subdivisions 839 636 203 Leases 5 9 (4) ------- ------- ------- Total loans 24,889 23,299 1,590 ------- ------- ------- Total Interest Income 44,225 45,016 (791) ------- ------- ------- INTEREST EXPENSE Interest checking 207 330 (123) Money market 2,113 3,008 (895) Savings 355 380 (25) Certificates of deposit 4,653 5,933 (1,280) Individual Retirement Accounts 3,858 3,331 527 Other time deposits 15 26 (11) Federal funds purchased 67 33 34 Other borrowed funds 6,719 6,695 24 ------- ------- ------- Total Interest Expense 17,987 19,736 (1,749) ------- ------- ------- Net Interest Income $26,238 $25,280 $ 958 ======= ======= ======= </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 IIL - ANALYSIS OF AVERAGE DAILY BALANCES AND RATES (DOLLARS IN THOUSANDS) <TABLE> <CAPTION> 9 MONTHS YEAR 9 MONTHS ENDED RATE OF ENDED RATE OF ENDED RATE OF 9/30/2003 RETURN/ 12/31/2002 RETURN/ 9/30/2002 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 $ - 0.00% $ 1,241 6.04% $ 1,659 6.04% Securities of other U.S. Government agencies and corporations 68,743 4.79% 75,646 6.25% 77,348 6.39% Mortgage-backed securities 181,935 4.20% 209,539 5.30% 213,752 5.48% Obligations of states and political subdivisions 142,813 7.44% 113,540 7.61% 109,556 7.65% Equity securities 27,321 3.90% 21,858 5.25% 21,307 5.05% Other securities 55,284 5.72% 43,826 6.79% 38,481 7.00% ---------- ---- --------- ---- --------- ---- Total available-for-sale securities 476,096 5.42% 465,650 6.16% 462,103 6.26% ---------- ---- --------- ---- --------- ---- Held-to-maturity securities: U.S. Treasury securities 320 5.43% 511 5.28% 566 5.43% Securities of other U.S. Government agencies and corporations 226 6.51% 331 6.04% 342 6.25% Mortgage-backed securities 71 5.65% 131 6.87% 142 5.65% ---------- ---- --------- ---- --------- ---- Total held-to-maturity securities 617 5.85% 973 5.76% 1,050 5.73% ---------- ---- --------- ---- --------- ---- Interest-bearing due from banks 1,463 0.73% 1,444 1.18% 1,513 1.59% Federal funds sold 890 1.20% 2,698 1.56% 2,455 1.63% Loans: Real estate loans 390,911 6.91% 338,133 7.53% 329,870 7.63% Consumer 32,090 9.07% 29,720 10.01% 29,286 9.98% Agricultural 2,859 6.92% 2,556 7.79% 2,520 7.85% Commercial/industrial 32,720 5.98% 28,182 6.86% 27,765 6.93% Other 904 6.66% 1,028 6.71% 982 6.81% Political subdivisions 16,265 6.90% 10,929 7.85% 10,751 7.91% Leases 81 8.25% 122 9.02% 128 9.40% ---------- ---- --------- ---- --------- ---- Total loans 475,830 6.99% 410,670 7.67% 401,302 7.76% ---------- ---- --------- ---- --------- ---- Total Earning Assets 954,896 6.19% 881,435 6.84% 868,423 6.93% Cash 13,345 13,318 13,531 Unrealized gain/loss on securities 20,666 12,462 10,703 Allowance for loan losses (5,877) (5,453) (5,386) Bank premises and equipment 10,696 10,246 10,218 Other assets 35,912 30,993 31,591 ---------- ---- --------- ---- --------- Total Assets $1,029,638 $ 943,001 $ 929,080 ========== ==== ========= ==== ========= INTEREST-BEARING LIABILITIES Interest checking $ 37,675 0.73% $ 37,984 1.12% $ 37,934 1.16% Money market 189,751 1.49% 171,767 2.31% 169,615 2.37% Savings 54,523 0.87% 49,779 1.01% 49,735 1.02% Certificates of deposit 192,405 3.23% 195,099 3.97% 193,322 4.10% Individual Retirement Accounts 105,198 4.90% 90,856 4.96% 89,344 4.98% Other time deposits 1,941 1.03% 1,814 1.98% 2,112 1.65% Federal funds purchased 6,778 1.32% 2,347 1.87% 2,255 1.96% Other borrowed funds 239,758 3.75% 211,092 4.29% 208,785 4.29% ---------- ---- --------- ---- --------- ---- Total Interest-bearing Liabilities 828,029 2.90% 760,738 3.46% 753,102 3.50% Demand deposits 68,903 66,093 62,615 Other liabilities 11,506 8,575 8,055 ---------- ---- --------- ---- --------- ---- Total Liabilities 908,438 835,406 823,772 ---------- ---- --------- ---- --------- ---- Stockholders' equity, excluding other comprehensive income/loss 107,561 99,361 98,239 Other comprehensive income/loss 13,639 8,234 7,069 ---------- ---- --------- ---- --------- ---- Total Stockholders' Equity 121,200 107,595 105,308 ---------- ---- --------- ---- --------- ---- Total Liabilities and Stockholders' Equity $1,029,638 $ 943,001 $ 929,080 ========== ==== ========= ==== ========= ==== Interest Rate Spread 3.29% 3.38% 3.43% Net Interest Income/Earning Assets 3.67% 3.85% 3.91% </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) 9 MONTHS ENDED 9/30/03 VS. 9/30/02 CHANGE IN CHANGE IN TOTAL VOLUME RATE CHANGE <S> <C> <C> <C> EARNING ASSETS Available-for-sale securities: U.S. Treasury securities $ (38) $ (37) $ (75) Securities of other U.S. Government agencies and corporations (379) (856) (1,235) Mortgage-backed securities (1,186) (1,865) (3,051) Obligations of states and political subdivisions 1,856 (170) 1,686 Equity securities 198 (206) (8) Other securities 766 (414) 352 ------- ------- ------- Total available-for-sale securities 1,217 (3,548) (2,331) ------- ------- ------- Held-to-maturity securities: U.S. Treasury securities (10) -- (10) Securities of other U.S. Government agencies and corporations (6) 1 (5) Mortgage-backed securities (3) -- (3) ------- ------- ------- Total held-to-maturity securities (19) 1 (18) ------- ------- ------- Interest-bearing due from banks (1) (9) (10) Federal funds sold (15) (7) (22) Loans: Real estate loans 3,267 (1,885) 1,382 Consumer 199 (208) (9) Agricultural 19 (19) -- Commercial/industrial 237 (214) 23 Other (4) (1) (5) Political subdivisions 292 (89) 203 Leases (3) (1) (4) ------- ------- ------- Total loans 4,007 (2,417) 1,590 ------- ------- ------- Total Interest Income 5,189 (5,980) (791) ------- ------- ------- INTEREST-BEARING LIABILITIES Interest checking (2) (121) (123) Money market 325 (1,220) (895) Savings 35 (60) (25) Certificates of deposit (28) (1,252) (1,280) Individual Retirement Accounts 582 (55) 527 Other time deposits (2) (9) (11) Federal funds purchased 48 (14) 34 Other borrowed funds 925 (901) 24 ------- ------- ------- Total Interest Expense 1,883 (3,632) (1,749) ------- ------- ------- Net Interest Income $ 3,306 $(2,348) $ 958 ======= ======= ======= </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) 9 MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, 2003 2002 <S> <C> <C> Service charges on deposit accounts $1,307 $1,260 Service charges and fees 210 194 Trust and financial management revenue 1,258 1,358 Insurance commissions, fees and premiums 220 448 Increase in cash surrender value of life insurance 552 648 Fees related to credit card operation 564 450 Other operating income 762 652 ------ ------ Total other operating income, before realized gains on securities, net 4,873 5,010 Realized gains on securities, net 3,289 2,496 ------ ------ Total Other Income $8,162 $7,506 ====== ====== </TABLE> Total noninterest income increased $656,000, or 8.7%, in 2003 compared to 2002. The most significant change - the increase in net realized security gains - is discussed in the "Earnings Overview" section of Management's Discussion and Analysis. Other items of significance are as follows: - - Trust and financial management revenue decreased $100,000, or 7.4%, for 2003 versus 2002. Trust and financial management revenue is affected significantly by the market value of assets under management. Throughout approximately the first 5 months of 2003, depressed equity market values reduced the market value of assets under management. However, in the second quarter and during the third quarter 2003, equity market prices rallied and as of September 30, 2003, the value of trust assets under management increased to $307,623,000, or 13.8% higher than September 30, 2002. - - Insurance commissions and fees dropped $228,000, or 50.9%, for 2003 compared to 2002. The decrease in insurance-related revenues had 2 components: (1) a decrease in revenues of $173,000 from Bucktail Life Insurance Company ("Bucktail"), a subsidiary of the Corporation that reinsures credit and mortgage life and accident and health insurance, and (2) a decrease in revenues of $55,000 from the insurance division of C & N Financial Services Corporation ("C&NFSC"). The decrease in Bucktail revenues is mainly attributed to timing items which are not expected to be indicative of a long-term decline. The chief reason for the decline in Bucktail revenues is the implementation of credit insurance changes to comply with the Home Owners Equity Protection Act (HOEPA) that became effective October 1, 2002. Under HOEPA, it is necessary to provide insurance protection on an outstanding daily balance method, rather than on a single premium basis. C&NFSC, a subsidiary of Citizens & Northern Bank, began its insurance agency operations in 2000, with limited activity to date. C&NFSC insurance revenues amounted to $85,000 in 2003 and $140,000 in 2002. Management continues to explore opportunities to expand insurance related revenues. - - The increase in cash surrender value of life insurance fell $96,000 to $552,000 in 2003 from $648,000 in 2002. The Corporation's policy return is determined, in part, by the amount of earnings generated from a pooled separate investment trust held by the life insurance company. In 2003, earnings on that pooled separate trust fund have been lower than in 2002, which is reflective of lower market yields on debt securities. - - Credit card fee income has increased mainly due to the formation of a "Reward Card Program" which pays users a rebate for using their credit card. This program was started in April of 2003 and has had the desired effect of raising card usage. This, along with an increased rate on interchange fees, has raised overall credit card fees 25.3% in 2003. - - Other operating income has increased 16.9% due mainly to an increase of $38,000 in gains from the sales of other real estate and from the receipt of a grant of $33,000 for staff training. 16
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE VI- COMPARISON OF NONINTEREST EXPENSE <TABLE> (IN THOUSANDS) 9 MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, 2003 2002 <S> <C> <C> Salaries and wages $ 7,129 $ 7,056 Pensions and other employee benefits 2,437 1,975 Occupancy expense, net 967 815 Furniture and equipment expense 1,029 1,199 Pennsylvania shares tax 588 550 Other operating expense 4,074 4,069 ------- ------- Total Other Expense $16,224 $15,664 ======= ======= </TABLE> Salaries and wages increased $73,000, or 1.0%, for 2003 compared to 2002. The increase is mainly the result of annual merit raises, generally ranging from 2%-5%, and an increase in number of employees. Included in salaries and wages expense is an estimate of incentive bonuses. The incentive bonus plan provides for compensation to be paid to certain key officers, with the payment amounts based on a combination of personal and corporate performance. The estimate of such expense for 2003 decreased $349,000 from the accrual recorded for 2002. Excluding incentive bonus expense, salaries and wages increased 6.3% in 2003 over 2002. Pensions and other employee benefits increased $462,000, or 23.4%, in 2003 over 2002. A portion of this increase is directly related to the increase in salaries and wages. Also, pension expense from the Corporation's defined benefit pension plan increased $190,000 in 2003 over 2002. Although the defined benefit pension plan remains adequately funded, a decline in the market value of plan assets, along with an increased number of covered employees, contributed to the increase in expense in 2003. Group health insurance expense increased $80,000 in 2003, mainly due to increases in rates. Occupancy expense increased $152,000, or 18.7%, in 2003 over 2002. The greatest portion of the increase in occupancy expense is attributable to increased costs of $43,000 for building maintenance and repairs. Depreciation expense also rose $33,000 from last year's level, insurance premiums increased over $25,000 and total energy costs increased nearly $24,000. Furniture and equipment expense decreased $170,000, or 14.2%, in 2003 compared to 2002. The largest decrease within this category was in depreciation expense, which decreased $188,000 or 25.9%. There were several substantial capital expenditures, which became fully depreciated in 2002, reducing the expense for the first 9 months of 2003. 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. Table VII provides a summary of investment securities held at September 30, 2003 and December 31, 2002. As reflected in Table VII, the carrying value (fair value) of available-for-sale securities fell to $482,064,000 at September 30, 2003 from $512,175,000 at December 31, 2002. Much of the reduction was caused by rapid principal payments on mortgage-backed securities, due to declining interest rates. The allowance for loan losses and stockholders' equity are discussed in separate sections of Management's Discussion and Analysis. 17
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE VII - INVESTMENT SECURITIES (In Thousands) <TABLE> <CAPTION> SEPTEMBER 30, 2003 DECEMBER 31, 2002 AMORTIZED FAIR AMORTIZED FAIR COST VALUE COST VALUE <S> <C> <C> <C> <C> AVAILABLE-FOR-SALE SECURITIES: Obligations of other U.S. Government agencies $ 63,331 $ 63,399 $ 71,657 $ 72,348 Obligations of states and political subdivisions 156,399 158,189 127,690 130,879 Other securities 47,784 49,833 62,296 63,592 Mortgage-backed securities 166,559 168,529 207,244 212,276 -------- -------- -------- -------- Total debt securities 434,073 439,950 468,887 479,095 Marketable equity securities 30,584 42,114 24,886 33,080 -------- -------- -------- -------- Total $464,657 $482,064 $493,773 $512,175 ======== ======== ======== ======== HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ 320 $ 356 $ 321 $ 359 Obligations of other U.S. Government agencies 197 218 297 322 Mortgage-backed securities 48 50 89 93 -------- -------- -------- -------- Total $ 565 $ 624 $ 707 $ 774 ======== ======== ======== ======== </TABLE> CASH FLOWS The consolidated statement of cash flows depicts the Corporation's sources and uses of cash. In 2003, net cash provided by operating activities totaled $13,676,000, up from $11,638,000 in 2002. Other major sources or uses of cash are changes in available-for-sale securities, loans, deposits and borrowings. In 2003, a significant source of cash was from available-for-sale securities, for which sales, calls and maturities exceeded purchases by $31,281,000. Also in 2003, deposits increased $12,424,000 and short-term and long-term borrowings increased (net) $10,014,000. These sources of cash helped fund loan growth, as the net increase in loans, as presented in the consolidated statement of cash flows, was $55,671,000. In 2002, the net increases in deposits of $60,205,000 and short-term and long-term borrowings of $35,755,000 helped fund growth in available-for-sale securities (excess of purchases over proceeds from sales, calls or maturities) of $48,214,000 and loans of $52,428,000. 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 and historical loss experience, as modified for identified trends and concerns, 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, modified for risk adjustment factors identified by management for each 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 management's knowledge of specific losses within the portfolio may be incomplete. The allowance for loan losses was $5,898,000 at September 30, 2003, an increase of $109,000 from the balance at December 31, 2002. As you can see in Table VIII, net charge-offs totaled $741,000 in the first nine months of 2003, which is relatively high compared to the amounts of net charge-offs in each of the prior 5 years. Net charge-offs for 2003 included $212,000 in the third quarter, $83,000 in the second quarter and $446,000 in the first quarter. Most of the 18
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q charge-off amounts for the first quarter 2003 were from loans that had been identified as impaired in 2002, and for which an appropriate allowance had been provided in 2002. Table IX presents a summary of the allocated allowance by loan type, as well as the unallocated portion of the allowance. The allowance for impaired loans was $1,526,000 at September 30, 2003, as compared to $1,362,000 at June 30, 2003 and $1,877,000 at December 31, 2002. The allowance for impaired loans is adjusted based on management's assessment of individual loans. Table IX also shows that the unallocated portion of the allowance was $1,998,000 at September 30, 2003, down from the unallocated allowance balance of $2,219,000 at June 30, 2003, but still higher than the unallocated allowance of $1,759,000 at December 31, 2002. Management has maintained a higher unallocated allowance throughout most of 2003, as compared to the end of 2002, because of concerns related to the high level of charge-offs in 2003. The provision for loan losses increased to $850,000 in the nine months ended September 30, 2003 from $640,000 in 2002. 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. In 2003, the higher provision for loan losses resulted, in part, from the increase in the unallocated portion of the allowance. 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 (IN THOUSANDS) <TABLE> <CAPTION> 9 MONTHS 9 MONTHS ENDED ENDED SEPT. 30, SEPT. 30, YEARS ENDED DECEMBER 31, 2003 2002 2002 2001 2000 1999 1998 <S> <C> <C> <C> <C> <C> <C> <C> Balance, beginning of year $5,789 $5,265 $5,265 $5,291 $5,131 $4,820 $4,913 ------ ------ ------ ------ ------ ------ ------ Charge-offs: Real estate loans 162 102 123 144 272 81 257 Installment loans 299 100 116 138 77 138 144 Credit cards and related plans 137 156 190 200 214 192 264 Commercial and other loans 303 123 123 231 53 219 301 ------ ------ ------ ------ ------ ------ ------ Total charge-offs 901 481 552 713 616 630 966 ------ ------ ------ ------ ------ ------ ------ Recoveries: Real estate loans 69 17 30 6 26 81 12 Installment loans 46 26 30 27 23 60 43 Credit cards and related plans 14 14 18 20 28 30 40 Commercial and other loans 31 14 58 34 23 10 15 ------ ------ ------ ------ ------ ------ ------ Total recoveries 160 71 136 87 100 181 110 ------ ------ ------ ------ ------ ------ ------ Net charge-offs 741 410 416 626 516 449 856 Provision for loan losses 850 640 940 600 676 760 763 ------ ------ ------ ------ ------ ------ ------ Balance, end of period $5,898 $5,495 $5,789 $5,265 $5,291 $5,131 $4,820 ====== ====== ====== ====== ====== ====== ====== </TABLE> 19
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE IX - ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES BY TYPE (IN THOUSANDS) <TABLE> <CAPTION> AS OF AS OF SEPT. 30, JUNE 30, AS OF DECEMBER 31: 2003 2003 2002 2001 2000 1999 1998 <S> <C> <C> <C> <C> <C> <C> <C> Commercial $1,495 $1,434 $1,315 $1,837 $1,612 $2,081 $ 650 Consumer mortgage 512 488 460 674 952 834 97 Impaired loans 1,526 1,362 1,877 83 273 609 290 Consumer 367 357 378 494 471 437 702 All other commitments -- -- -- -- -- 150 202 Unallocated 1,998 2,219 1,759 2,187 1,983 1,020 2,879 ------ ------ ------ ------ ------ ------ ------ Total Allowance $5,898 $5,860 $5,789 $5,265 $5,291 $5,131 $4,820 ====== ====== ====== ====== ====== ====== ====== </TABLE> TABLE X - SUMMARY OF LOANS BY TYPE (IN THOUSANDS) <TABLE> <CAPTION> AS OF SEPT. 30, AS OF DECEMBER 31, 2003 2002 2001 2000 1999 1998 <S> <C> <C> <C> <C> <C> <C> Real estate - construction $ 1,159 $ 103 $ 1,814 $ 452 $ 649 $ 1,004 Real estate - mortgage 414,592 370,453 306,264 263,325 247,604 230,815 Consumer 32,824 31,532 29,284 28,141 29,140 30,924 Agricultural 3,167 3,024 2,344 1,983 1,899 1,930 Commercial 34,722 30,874 24,696 20,776 18,050 17,630 Other 1,290 2,001 1,195 948 1,025 1,062 Political subdivisions 18,076 13,062 13,479 12,462 12,332 7,449 Lease receivables 73 96 152 218 222 218 --------- -------- --------- --------- --------- --------- Total 505,903 451,145 379,228 328,305 310,921 291,032 Less: unearned discount -- -- -- -- (29) (29) --------- -------- --------- --------- --------- --------- 505,903 451,145 379,228 328,305 310,892 291,003 Less: allowance for loan losses (5,898) (5,789) (5,265) (5,291) (5,131) (4,820) --------- -------- --------- --------- --------- --------- Loans, net $ 500,005 $ 445,356 $ 373,963 $ 323,014 $ 305,761 $ 286,183 ========= ========= ========= ========= ========= ========= </TABLE> DERIVATIVE FINANCIAL INSTRUMENTS The Corporation utilizes derivative financial instruments related to a 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. 20
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q 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. Amounts recorded as of September 30, 2003 and December 31, 2002, and for 2003 and 2002, related to IPCDs are as follows (in thousands): <TABLE> <CAPTION> SEPT. 30, DEC. 31, 2003 2002 <S> <C> <C> Contractual amount of IPCDs (equal to notional amount of Swap contracts) $ 3,408 $ 3,028 Carrying value of IPCDs 2,977 2,572 Carrying value of embedded derivative liabilities 214 156 Carrying value of Swap contract liabilities 222 309 </TABLE> <TABLE> <CAPTION> 9 MONTHS ENDED 9 MONTHS ENDED SEPT. 30, SEPT. 30, 2003 2002 <S> <C> <C> Interest expense $ 89 $ 61 Other expense 8 1 </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 various investment securities. At September 30, 2003, the Corporation had unused borrowing availability with correspondent banks and the Federal Home Loan Bank of Pittsburgh totaling approximately $174,095,000. Additionally, the Corporation uses repurchase agreements placed with brokers to borrow funds secured by investment assets, and uses "RepoSweep" arrangements to borrow funds from commercial banking customers on an overnight basis. On a longer-term basis, one of the tools used to measure liquidity is the loan to deposit ratio. As of September 30, 2003, this ratio was 74%, which (by banking industry standards) is a relatively low ratio (which indicates a relatively high level of liquidity). This low loan to deposit ratio permits the Corporation to utilize "excess" funds to purchase investment securities. If required to raise cash in an emergency situation, the Corporation could sell non-pledged investment securities to meet its obligations. Management believes the combination of its strong capital position (discussed in the next section), ample available borrowing facilities and low loan to deposit ratio have placed the Corporation in a position of minimal short-term and long-term liquidity risk. 21
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q 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 September 30, 2003: TABLE X - CAPITAL RATIOS <TABLE> <CAPTION> 9/30/2003 CITIZENS & REGULATORY STANDARDS: NORTHERN CORPORATION WELL MINIMUM (ACTUAL) CAPITALIZED STANDARD - -------------------------------------------------------------------------------- <S> <C> <C> <C> Total capital to risk-weighted assets 20.55% 10% 8% Tier 1 capital to risk-weighted assets 18.68% 6% 4% Tier 1 capital to average total assets 10.74% 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. INFLATION Over the last several years, direct inflationary pressures on the Corporation's payroll-related and other noninterest costs have been modest. In fact, some economists have warned of the risk of deflationary pressures. 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 or deflationary pressure, in managing interest rate and other financial risks. 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 a significant 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 expenses. The model measures and projects potential changes in net interest income, and calculates the discounted present value of anticipated cash flows of financial instruments, assuming an immediate increase or decrease in interest rates. Management ordinarily runs a variety of scenarios within a range of plus or minus 50-300 basis points of current rates. 22
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q 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 baseline one-year scenario. The policy limit for market value variance is minus 30% from the baseline one-year scenario. As Table XII shows, as of September 30, 2003, the Bank's net interest income calculations show a decrease of 1.4% in the +200 basis point scenario and a decrease of 4.2% in the -200 basis point scenario. Both of these levels are well within the policy threshold. However, if interest rates were to immediately increase 200 basis points, the Bank's calculations based on the model show that the market value of portfolio equity would decrease 38.2%, which exceeds the policy threshold and is indicative of a long-term sensitivity to rising rates. In the fourth quarter 2003, management will evaluate whether to restructure the securities portfolio or make other changes to asset or liability holdings in an effort to reduce exposure to decline in market value in a rising interest rate environment. 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. TABLE XII - THE EFFECT OF HYPOTHETICAL CHANGES IN INTEREST RATES <TABLE> <CAPTION> PERIOD ENDING SEPTEMBER 30, 2004 (IN THOUSANDS) SEPTEMBER 30, 2003 DATA CURRENT PLUS 200 MINUS 200 INTEREST BASIS BASIS RATES POINTS POINTS SCENARIO AMOUNT % CHANGE AMOUNT % CHANGE <S> <C> <C> <C> <C> <C> Interest income $ 53,215 $ 57,589 $ 47,767 Interest expense 20,716 25,556 16,619 - ------------------------------------------------------------------------------- --------------- Net Interest Income $ 32,499 $ 32,033 -1.4% $ 31,148 -4.2% ==================================================================================================================== Market Value of Portfolio Equity at Sept. 30, 2003 $111,598 $ 68,949 -38.2% $ 141,401 26.7% ==================================================================================================================== PERIOD ENDING DECEMBER 31, 2003 (IN THOUSANDS) DECEMBER 31, 2002 DATA CURRENT PLUS 200 MINUS 200 INTEREST BASIS BASIS RATES POINTS POINTS SCENARIO AMOUNT % CHANGE AMOUNT % CHANGE Interest income $ 54,989 $ 59,608 $ 49,607 Interest expense 24,132 29,320 19,083 - ------------------------------------------------------------------------------ --------------- Net Interest Income $ 30,857 $ 30,288 -1.8% $ 30,524 -1.1% ==================================================================================================================== Market Value of Portfolio Equity at Dec. 31, 2002 $108,144 $ 71,117 -34.2% $ 130,764 20.9% ==================================================================================================================== </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, 23
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q 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 September 30, 2003 and December 31, 2002 are presented in Table XIII. <TABLE> <CAPTION> TABLE XIII - EQUITY SECURITIES (IN THOUSANDS) HYPOTHETICAL HYPOTHETICAL 10% 20% DECLINE IN DECLINE IN FAIR MARKET MARKET AT SEPTEMBER 30, 2003 COST VALUE VALUE VALUE <S> <C> <C> <C> <C> Banks and bank holding companies $ 16,975 $ 28,805 $ (2,881) $ (5,761) Other equity securities 13,609 13,308 (1,331) (2,662) - ----------------------------------------------------------------------------------------------------- Total $ 30,584 $ 42,113 $ (4,212) $ (8,423) ===================================================================================================== HYPOTHETICAL HYPOTHETICAL 10% 20% DECLINE IN DECLINE IN FAIR MARKET MARKET AT DECEMBER 31, 2002 COST VALUE VALUE VALUE Banks and bank holding companies $ 16,336 $ 24,511 $ (2,451) $ (4,902) Other equity securities 8,550 8,569 (857) (1,714) - ----------------------------------------------------------------------------------------------------- Total $ 24,886 $ 33,080 $ (3,308) $ (6,616) ===================================================================================================== </TABLE> PART I - FINANCIAL INFORMATION (CONTINUED) ITEM 4. CONTROLS AND PROCEDURES The Corporation's Chief Executive Officer and Chief Financial Officer carried out an evaluation of the design and effectiveness of the Corporation's disclosure controls and procedures pursuant to Rule 13a-15(e) and Rule 15d-15(e) of the Securities Exchange Act of 1934 as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Corporation's disclosure controls and procedures are effective to ensure that information required to be disclosed in reports the Corporation files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. There were no significant changes in the Corporation's internal control over financial reporting that occurred during the period covered by this report that has materially affected, or that is reasonably likely to materially affect, our internal control over financial reporting. 24
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q PART II - OTHER INFORMATION Item 1. Legal Proceedings The Corporation and the Bank are involved in various legal proceedings incidental to their business. Management believes the aggregate liability, if any, resulting from such pending and threatened legal proceedings will not have a material, adverse effect on the Corporation's financial condition or results of operations. 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: Page ---- Exhibit 31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Chief Executive Officer 27 Exhibit 31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Chief Financial Officer 28 Exhibit 32 Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 29 b. A Current Report on Form 8-K under Item 12, dated July 10, 2003, was furnished to report the Corporation's consolidated earnings results for the second quarter 2003. 25
CITIZENS & 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 November 13, 2003 By: Craig G. Litchfield /s/ - ----------------- ----------------------- Date Chairman, President and Chief Executive Officer November 13, 2003 By: Mark A. Hughes /s/ - ----------------- ------------------ Date Treasurer and Chief Financial Officer 26