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, 2005 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.) </TABLE> 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 ----- ----- 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 ----- ----- Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes No X ----- ----- (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> <CAPTION> Title Outstanding - ----- ----------- <S> <C> Common Stock ($1.00 par value) 8,220,791 Shares Outstanding October 28, 2005 </TABLE> 1
CITIZENS & NORTHERN CORPORATION Index <TABLE> <S> <C> Part I. Financial Information Item 1. Financial Statements Consolidated Balance Sheet - September 30, 2005 and December 31, 2004 Page 3 Consolidated Statement of Income - Three Months and Nine Months Ended September 30, 2005 and 2004 Page 4 Consolidated Statement of Cash Flows - Nine Months Ended September 30, 2005 and 2004 Pages 5 through 6 Notes to Consolidated Financial Statements Pages 7 through 12 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Pages 12 through 25 Item 3. Quantitative and Qualitative Disclosures About Market Risk Pages 26 through 28 Item 4. Controls and Procedures Page 28 Part II. Other Information Pages 29 through 30 Signatures Page 31 Exhibit 31.1. Rule 13a-14(a)/15d-14(a) Certification - Chief Executive Officer Page 32 Exhibit 31.2. Rule 13a-14(a)/15d-14(a) Certification - Chief Financial Officer Page 33 Exhibit 32. Section 1350 Certifications Page 34 </TABLE> 2
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q ITEM 1. FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEET (In Thousands Except Share Data) <TABLE> <CAPTION> SEPT. 30, DEC. 31, 2005 2004 (UNAUDITED) (NOTE) ----------- ---------- <S> <C> <C> ASSETS Cash and due from banks: Noninterest-bearing $ 19,439 $ 14,845 Interest-bearing 12,394 4,108 ---------- ---------- Total cash and cash equivalents 31,833 18,953 Available-for-sale securities 449,059 475,085 Held-to-maturity securities 424 433 Loans, net 637,646 572,826 Bank-owned life insurance 18,500 18,083 Accrued interest receivable 5,371 5,094 Bank premises and equipment, net 21,679 16,725 Foreclosed assets held for sale 153 497 Intangible asset - core deposit intangible, net 526 -- Intangible asset - goodwill 2,944 -- Other assets 15,464 15,306 ---------- ---------- TOTAL ASSETS $1,183,599 $1,123,002 ========== ========== LIABILITIES Deposits: Noninterest-bearing $ 99,033 $ 80,378 Interest-bearing 653,975 596,167 ---------- ---------- Total deposits 753,008 676,545 Dividends payable 1,891 1,864 Short-term borrowings 41,805 34,178 Long-term borrowings 246,499 270,827 Accrued interest and other liabilities 8,928 8,003 ---------- ---------- TOTAL LIABILITIES 1,052,131 991,417 ---------- ---------- STOCKHOLDERS' EQUITY Common stock, par value $1.00 per share; authorized 20,000,000 shares, issued 8,389,418 in 2005 and 8,307,305 in 2004 8,389 8,307 Stock dividend distributable -- 2,188 Paid-in capital 24,893 22,456 Retained earnings 94,697 90,484 ---------- ---------- Total 127,979 123,435 Accumulated other comprehensive income 5,510 10,535 Unamortized stock compensation (74) (46) Treasury stock, at cost: 168,927 shares at September 30, 2005 (1,947) 204,659 shares at December 31, 2004 (2,339) ---------- ---------- TOTAL STOCKHOLDERS' EQUITY 131,468 131,585 ---------- ---------- TOTAL LIABILITIES & STOCKHOLDERS' EQUITY $1,183,599 $1,123,002 ========== ========== </TABLE> The accompanying notes are an integral part of these consolidated financial statements. Note: The balance sheet at December 31, 2004 has been derived from the audited financial statements at that date but does not include all the information and notes required by U.S. 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 9 MONTHS ENDED ------------------------- ------------------------- SEPT. 30, SEPT. 30, SEPT. 30, SEPT. 30, 2005 2004 2005 2004 (CURRENT) (PRIOR YEAR) (CURRENT) (PRIOR YEAR) ---------- ------------ ---------- ------------ <S> <C> <C> <C> <C> INTEREST INCOME Interest and fees on loans $ 10,003 $ 8,620 $ 28,327 $ 25,181 Interest on balances with depository institutions 11 3 24 7 Interest on loans to political subdivisions 293 260 808 713 Interest on federal funds sold 31 4 61 8 Income from available-for-sale and held-to-maturity securities: Taxable 3,580 3,499 10,859 10,256 Tax-exempt 1,419 1,844 4,306 5,717 Dividends 234 343 787 1,049 ---------- ---------- ---------- ---------- Total interest and dividend income 15,571 14,573 45,172 42,931 ---------- ---------- ---------- ---------- INTEREST EXPENSE Interest on deposits 3,870 3,086 10,924 9,394 Interest on short-term borrowings 337 122 894 371 Interest on long-term borrowings 2,219 2,457 6,720 7,096 ---------- ---------- ---------- ---------- Total interest expense 6,426 5,665 18,538 16,861 ---------- ---------- ---------- ---------- Interest margin 9,145 8,908 26,634 26,070 Provision for loan losses 375 350 1,125 1,050 ---------- ---------- ---------- ---------- Interest margin after provision for loan losses 8,770 8,558 25,509 25,020 ---------- ---------- ---------- ---------- OTHER INCOME Service charges on deposit accounts 457 463 1,182 1,337 Service charges and fees 92 78 288 209 Trust and financial management revenue 539 453 1,589 1,483 Insurance commissions, fees and premiums 221 108 405 327 Increase in cash surrender value of life insurance 138 151 417 463 Fees related to credit card operation 264 159 712 568 Other operating income 438 215 1,148 720 ---------- ---------- ---------- ---------- Total other income before realized gains on securities, net 2,149 1,627 5,741 5,107 Realized gains on securities, net 393 459 2,388 1,744 ---------- ---------- ---------- ---------- Total other income 2,542 2,086 8,129 6,851 ---------- ---------- ---------- ---------- OTHER EXPENSES Salaries and wages 3,249 2,906 9,172 8,306 Pensions and other employee benefits 893 866 2,878 2,678 Occupancy expense, net 446 450 1,371 1,187 Furniture and equipment expense 624 437 1,922 1,161 Pennsylvania shares tax 196 212 608 635 Other operating expense 1,895 1,867 5,653 5,288 ---------- ---------- ---------- ---------- Total other expenses 7,303 6,738 21,604 19,255 ---------- ---------- ---------- ---------- Income before income tax provision 4,009 3,906 12,034 12,616 Income tax provision 722 501 2,154 1,816 ---------- ---------- ---------- ---------- NET INCOME $ 3,287 $ 3,405 $ 9,880 $ 10,800 ========== ========== ========== ========== PER SHARE DATA: Net income - basic $ 0.40 $ 0.42 $ 1.20 $ 1.32 Net income - diluted $ 0.40 $ 0.41 $ 1.19 $ 1.31 ---------- ---------- ---------- ---------- Dividend per share $ 0.23 $ 0.22 $ 0.69 $ 0.66 ---------- ---------- ---------- ---------- Number of shares used in computation - basic 8,215,365 8,182,851 8,206,438 8,186,014 Number of shares used in computation - diluted 8,283,770 8,226,968 8,270,940 8,235,179 </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> 9 MONTHS ENDED SEPT. 30, ------------------------ 2005 2004 --------- --------- <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 9,880 $ 10,800 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 1,125 1,050 Realized gains on securities, net (2,388) (1,744) Gain on sale of foreclosed assets, net (133) (34) Depreciation expense 1,687 1,077 Accretion and amortization of securities, net 223 575 Increase in cash surrender value of life insurance (417) (463) Amortization of restricted stock 69 66 Amortization of core deposit intangible 21 -- Increase in accrued interest receivable and other assets (1,566) (1,535) Increase in accrued interest payable and other liabilities 2,952 2,841 --------- --------- Net Cash Provided by Operating Activities 11,453 12,633 --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from maturity of held-to-maturity securities 7 120 Proceeds from sales of available-for-sale securities 134,919 67,809 Proceeds from calls and maturities of available-for-sale securities 45,117 72,022 Purchase of available-for-sale securities (150,012) (157,929) Purchase of Federal Home Loan Bank of Pittsburgh stock (3,883) (2,813) Redemption of Federal Home Loan Bank of Pittsburgh stock 5,390 1,779 Net increase in loans (42,671) (47,627) Purchase of premises and equipment (5,172) (4,580) Proceeds from sale of foreclosed assets 791 93 Proceeds from acquisition of Canisteo Valley Corporation, net 202 -- --------- --------- Net Cash Used in Investing Activities (15,313) (71,126) --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Net increase in deposits 38,455 14,810 Net increase in short-term borrowings 7,627 4,298 Proceeds from long-term borrowings 18,163 73,943 Repayments of long-term borrowings (42,491) (30,042) Purchase of treasury stock (59) (575) Sale of treasury stock 652 527 Tax benefit from compensation plans 60 -- Dividends paid (5,667) (5,357) --------- --------- Net Cash Provided by Financing Activities 16,740 57,604 --------- --------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 12,880 (889) CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 18,953 15,171 --------- --------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 31,833 $ 14,282 ========= ========= </TABLE> 5
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) (CONTINUED) <TABLE> <CAPTION> 9 MONTHS ENDED SEPT. 30, ------------------------ 2005 2004 ------- ------- <S> <C> <C> SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Assets acquired through foreclosure of real estate loans $ 268 $ 510 Interest paid $16,019 $13,300 Income taxes paid $ 2,092 $ 2,438 ACQUISITION OF CANISTEO VALLEY CORPORATION: Cash and cash equivalents received $ 7,136 $ -- Cash paid for acquisition (6,934) -- ------- ------- Net cash received on acquisition $ 202 $ -- ======= ======= NONCASH ASSETS RECEIVED AND LIABILITIES ASSUMED FROM ACQUISITION OF CANISTEO VALLEY CORPORATION: Assets received: Available for sale securities $ 9,439 $ -- Loans 23,542 -- Premises and equipment 1,469 -- Foreclosed assets 46 -- Intangible asset - core deposit intangible 547 -- Intangible asset - goodwill 2,944 -- Other assets 446 -- ------- ------- Total noncash assets received $38,433 $ -- ======= ======= Liabilities assumed: Deposits $38,008 $ -- Other liabilities 627 -- ------- ------- Total noncash liabilities assumed $38,635 $ -- ======= ======= </TABLE> The accompanying notes are an integral part of these consolidated financial statements. 6
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, 2004, 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, 2005 might not be indicative of the results for the year ending December 31, 2005. 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, 2005 Earnings per share - basic $ 9,880,000 8,206,438 $1.20 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 215,283 Hypothetical share repurchase at $30.55 (150,781) ----------- --------- ----- Earnings per share - diluted $ 9,880,000 8,270,940 $1.19 =========== ========= ===== NINE MONTHS ENDED SEPTEMBER 30, 2004 Earnings per share - basic $10,800,000 8,186,014 $1.32 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 190,915 Hypothetical share repurchase at $25.38 (141,750) ----------- --------- ----- Earnings per share - diluted $10,800,000 8,235,179 $1.31 =========== ========= ===== </TABLE> 7
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, 2005 Earnings per share - basic $3,287,000 8,215,365 $0.40 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 211,805 Hypothetical share repurchase at $31.51 (143,400) ---------- --------- ----- Earnings per share - diluted $3,287,000 8,283,770 $0.40 ========== ========= ===== QUARTER ENDED SEPTEMBER 30, 2004 Earnings per share - basic $3,405,000 8,182,851 $0.42 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 184,187 Hypothetical share repurchase at $24.83 (140,070) ---------- --------- ----- Earnings per share - diluted $3,405,000 8,226,968 $0.41 ========== ========= ===== </TABLE> 3. STOCK COMPENSATION PLANS The Corporation uses the intrinsic value method of accounting for stock compensation plans, under Accounting Principles Board Opinion No. 25 (APB Opinion 25), and as permitted by Statement of Financial Accounting Standards (SFAS) No. 123. 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. 8
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value provisions of SFAS No. 123 to stock options. <TABLE> <CAPTION> 3 MONTHS ENDED 9 MONTHS ENDED SEPT. 30, SEPT. 30, --------------- ---------------- (NET INCOME IN THOUSANDS) 2005 2004 2005 2004 - ------------------------- ------ ------ ------ ------- <S> <C> <C> <C> <C> Net income, as reported $3,287 $3,405 $9,880 $10,800 Deduct: Total stock option compensation expense determined under fair value method for all awards, net of tax effects -- (5) (69) (96) ------ ------ ------ ------- Pro forma net income $3,287 $3,400 $9,811 $10,704 ====== ====== ====== ======= Earnings per share-basic As reported $ 0.40 $ 0.42 $ 1.20 $ 1.32 Pro forma $ 0.40 $ 0.42 $ 1.20 $ 1.31 Earnings per share-diluted As reported $ 0.40 $ 0.41 $ 1.19 $ 1.31 Pro forma $ 0.40 $ 0.41 $ 1.19 $ 1.30 </TABLE> In December 2004, the Financial Accounting Standards Board issued SFAS No. 123R, which replaces SFAS No. 123 and supersedes APB Opinion 25. SFAS No. 123R will require the Corporation to record stock option expense based on estimated fair value calculated using an option valuation model. As issued, SFAS No. 123R would have applied to new awards granted, and to modifications of existing awards, on or after July 1, 2005. In April 2005, however, the Securities and Exchange Commission extended the date for mandatory implementation of SFAS No. 123R, effectively requiring the Corporation to apply SFAS No. 123R in the first quarter 2006. The Corporation does not plan early implementation of the provisions of SFAS No. 123R. 4. COMPREHENSIVE INCOME U.S. generally accepted accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although unrealized gains and losses on available-for-sale securities are reported as a separate component of the equity section of the balance sheet, changes in unrealized gains and losses on available-for-sale securities, along with net income, are components of comprehensive income (loss). The components of comprehensive income, and the related tax effects, are as follows: <TABLE> <CAPTION> 3 MONTHS ENDED 9 MONTHS ENDED --------------------- --------------------- SEPT. 30, SEPT. 30, SEPT. 30, SEPT. 30, (IN THOUSANDS) 2005 2004 2005 2004 - -------------- --------- --------- --------- --------- <S> <C> <C> <C> <C> Net income $ 3,287 $ 3,405 $ 9,880 $10,800 Unrealized holding (losses) gains on available-for-sale securities (4,104) 9,760 (5,226) (988) Reclassification adjustment for gains realized in income (393) (459) (2,388) (1,744) ------- ------- ------- ------- Other comprehensive (loss) income before income tax (4,497) 9,301 (7,614) (2,732) Income tax related to other comprehensive income/loss 1,529 (3,163) 2,589 930 ------- ------- ------- ------- Other comprehensive (loss) income (2,968) 6,138 (5,025) (1,802) ------- ------- ------- ------- Comprehensive income $ 319 $ 9,543 $ 4,855 $ 8,998 ======= ======= ======= ======= </TABLE> 9
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q 5. SECURITIES Amortized cost and fair value of securities at September 30, 2005 are summarized as follows: <TABLE> <CAPTION> SEPTEMBER 30, 2005 ----------------------- GROSS GROSS UNREALIZED UNREALIZED AMORTIZED HOLDING HOLDING FAIR (IN THOUSANDS) COST GAINS LOSSES VALUE - -------------- --------- ---------- ---------- -------- <S> <C> <C> <C> <C> AVAILABLE-FOR-SALE SECURITIES: Obligations of the U.S. Treasury $ 502 $ -- $ (1) $ 501 Obligations of other U.S. Government agencies 45,999 -- (386) 45,613 Obligations of states and political subdivisions 128,277 2,820 (1,013) 130,084 Other securities 96,855 1,565 (1,136) 97,284 Mortgage-backed securities 146,324 190 (2,943) 143,571 -------- ------- ------- -------- Total debt securities 417,957 4,575 (5,479) 417,053 Marketable equity securities 22,754 9,596 (344) 32,006 -------- ------- ------- -------- Total $440,711 $14,171 $(5,823) $449,059 ======== ======= ======= ======== HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ 314 $ 13 $ -- $ 327 Obligations of other U.S. Government agencies 98 9 -- 107 Mortgage-backed securities 12 -- -- 12 -------- ------- ------- -------- Total $ 424 $ 22 $ -- $ 446 ======== ======= ======= ======== </TABLE> The following table presents gross unrealized losses and fair value of investments aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at September 30, 2005. <TABLE> <CAPTION> LESS THAN 12 MONTHS 12 MONTHS OR MORE TOTAL --------------------- -------------------- --------------------- FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED (IN THOUSANDS) VALUE LOSSES VALUE LOSSES VALUE LOSSES - -------------- -------- ---------- ------- ---------- -------- ---------- <S> <C> <C> <C> <C> <C> <C> AVAILABLE-FOR-SALE SECURITIES: Obligations of the U.S. Treasury $ 501 $ (1) $ -- $ -- $ 501 $ (1) Obligations of other U.S. Government agencies 40,140 (360) 1,474 (26) 41,614 (386) Obligations of states and political subdivisions 39,204 (660) 8,677 (353) 47,881 (1,013) Other securities 51,196 (805) 13,994 (331) 65,190 (1,136) Mortgage-backed securities 60,900 (880) 73,764 (2,063) 134,664 (2,943) -------- ------- ------- ------- -------- ------- Total debt securities 191,941 (2,706) 97,909 (2,773) 289,850 (5,479) Marketable equity securities 3,763 (108) 2,090 (236) 5,853 (344) -------- ------- ------- ------- -------- ------- Total temporarily impaired available-for-sale securities $195,704 $(2,814) $99,999 $(3,009) $295,703 $(5,823) ======== ======= ======= ======= ======== ======= HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ -- $ -- $ -- $ -- $ -- $ -- Obligations of other U.S. Government agencies -- -- -- -- -- -- Mortgage-backed securities -- -- -- -- -- -- -------- ------- ------- ------- -------- ------- Total temporarily impaired held-to-maturity securities $ -- $ -- $ -- $ -- $ -- $ -- -------- ------- ------- ------- -------- ------- </TABLE> 10
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q The unrealized losses on debt securities are primarily the result of volatility in interest rates. Based on the credit worthiness of the issuers, which are almost exclusively U.S. Government agencies or state and political subdivisions, management believes the Corporation's debt securities at September 30, 2005 were not other-than-temporarily impaired. 6. DEFINED BENEFIT PLANS The Corporation has a noncontributory defined benefit pension plan for all employees meeting certain age and length of service requirements. Benefits are based primarily on years of service and the average annual compensation during the highest five consecutive years. In addition, the Corporation sponsors a defined benefit health care plan that provides postretirement medical benefits and life insurance to employees who meet certain age and length of service requirements. This plan contains a cost-sharing feature, which causes participants to pay for all future increases in costs related to benefit coverage. Accordingly, actuarial assumptions related to health care cost trend rates do not affect the liability balance and will not affect the Corporation's future expenses. Recently, the Corporation has determined that prescription drug benefits provided under the postretirement plan are actuarially equivalent to benefits that will be available under the Medicare Prescription Drug, Improvement and Modernization Act ("Medicare Part D"). Management has not yet determined the effects of future reimbursements to the Plan on the liability balance. Accordingly, the financial statement amounts and disclosures related to the postretirement benefits plan do not reflect the effects of changes that may result from Medicare Part D. The Corporation uses a December 31 measurement date for its plans. The components of net periodic benefit costs from these defined benefit plans are as follows: <TABLE> <CAPTION> PENSION POSTRETIREMENT 9 MONTHS ENDED 9 MONTHS ENDED SEPT. 30, SEPT. 30, -------------- -------------- (IN THOUSANDS) 2005 2004 2005 2004 - -------------- ----- ----- ---- ---- <S> <C> <C> <C> <C> Service cost $ 356 $ 357 $ 35 $ 33 Interest cost 464 465 50 48 Expected return on plan assets (595) (561) -- -- Amortization of transition (asset) obligation (17) (18) 27 27 Recognized net actuarial loss 29 48 2 3 ----- ----- ---- ---- Net periodic benefit cost $ 237 $ 291 $114 $111 ===== ===== ==== ==== </TABLE> <TABLE> <CAPTION> PENSION POSTRETIREMENT 3 MONTHS ENDED 3 MONTHS ENDED SEPT. 30, SEPT. 30, -------------- -------------- (IN THOUSANDS) 2005 2004 2005 2004 - -------------- ----- ----- ---- ---- <S> <C> <C> <C> <C> Service cost $ 118 $ 119 $11 $11 Interest cost 155 155 17 16 Expected return on plan assets (198) (187) -- -- Amortization of transition (asset) obligation (5) (6) 9 9 Recognized net actuarial loss 10 16 1 1 ----- ----- ---- ---- Net periodic benefit cost $ 80 $ 97 $38 $37 ===== ===== ==== ==== </TABLE> Management intends to include employees of First State Bank in coverage under the defined benefit pension and postretirement plans, effective September 1, 2005 (see Note 8 for more information concerning the acquisition). Currently, management has not determined the effect, if any, on 2005 funding requirements or financial statement amounts that may result from providing coverage to the First State Bank employees; however, the impact is not expected to be significant in relation to the Corporation's total obligations. Excluding possible adjustment for the addition of First State Bank employees, the Corporation funded its total expected defined benefit pension contribution for 2005 of $178,000 in April 2005. In the first nine months of 2005, the Corporation funded postretirement contributions totaling $39,000. The estimated total (annual) amount of 2005 postretirement contributions is $52,000. 11
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q 7. 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. ACQUISITION Effective at 11:59 p.m. on August 31, 2005, Citizens & Northern Corporation acquired 100% of Canisteo Valley Corporation in an all-cash merger transaction. Accordingly, the results of operations for Canisteo Valley Corporation have been included in the accompanying consolidated financial statements from that date forward. Canisteo Valley Corporation is the parent company of First State Bank, a New York State chartered commercial bank with offices in Canisteo and South Hornell, NY. The acquisition of Canisteo Valley Corporation and First State Bank permits expansion of Citizens & Northern Corporation's banking operations into communities located in the southern tier of New York State, in close proximity to many of the northern Pennsylvania branch locations, and provides First State Bank with the administrative and credit management resources of a larger organization. The Corporation is still in the process of obtaining final valuations on loans, intangible assets, premises and equipment, deposits and other liabilities; accordingly, allocation of the purchase price is subject to modification in the future. Information regarding the purchase price and estimated fair values of assets acquired and liabilities assumed as of the acquisition date is provided as supplemental information in the consolidated statement of cash flows. The pro forma effect of Canisteo Valley Corporation's (including First State Bank's) revenues and operating results on the Corporation's financial statements for all periods presented in this Form 10-Q would not be significant. 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 Citizens & Northern Corporation ("Corporation") is a holding company whose principal activity is community banking. The Corporation's principal office is located in Wellsboro, Pennsylvania. The largest subsidiary is Citizens & Northern Bank ("C&N Bank"), which had total assets of $1,107,963,000 at September 30, 2005. In the third quarter 2005, the Corporation completed the acquisition of Canisteo Valley Corporation and its subsidiary, First State Bank, a New York State chartered commercial bank with offices in Canisteo and South Hornell, NY. The acquisition of Canisteo Valley Corporation and First State Bank permits expansion of Citizens & Northern Corporation's banking operations into communities located in the southern tier of New York State, in close proximity to many of the northern Pennsylvania branch locations, and provides First State Bank with the administrative and credit management resources of a larger organization. The Corporation's other wholly-owned subsidiaries are Citizens & Northern Investment Corporation, Bucktail Life Insurance Company ("Bucktail") and Canisteo Valley Corporation. Citizens & Northern Investment Corporation was formed in 1999 to engage in investment activities. Bucktail reinsures credit and mortgage life and accident and health insurance on behalf of C&N Bank. FORWARD-LOOKING STATEMENTS Certain statements in this section and elsewhere in this quarterly report on 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 not historical facts, are based on certain assumptions and describe future plans, business objectives and expectations, and are generally identifiable by the use of words such as, "should", "likely", "expect", "plan", "anticipate", "target", "forecast", and "goal". 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 expressed or implied by such forward-looking statements. 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: 12
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q - - changes in monetary and fiscal policies of the Federal Reserve Board and the U. S. Government, 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, 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 2005 AND 2004 Unless otherwise noted, all references to "2005" in the following discussion of operating results are intended to mean the nine months ended September 30, 2005, and similarly, references to "2004" are intended to mean the nine months ended September 30, 2004. EARNINGS OVERVIEW Net income in 2005 was $9,880,000, or $1.20 per share (basic) and $1.19 per share (diluted). This represents a decrease of 8.5% from 2004. Return on average assets was 1.16% in 2005, as compared to 1.30% in 2004. Return on average equity was 9.95% in 2005, as compared to 11.28% in 2004. The most significant income statement changes between 2005 and 2004 were as follows: - The interest margin of $26,634,000 in 2005 was $564,000, or 2.2%, higher than in 2004. Average (gross) loans outstanding increased 11.8% as compared to one year earlier, to $607,981,000 in 2005. The increase in loan volume has been the major reason for the slight growth in the interest margin in 2005 over 2004. As described in the Net Interest Margin section of Management's Discussion and Analysis, on a fully taxable equivalent basis, the interest margin is slightly lower in 2005 than in 2004. - Net realized gains from securities amounted to $2,388,000 in 2005, up $644,000 from 2004. The Corporation's volume of investment security sales was high by historical standards during the first nine months of 2005, as management identified several bank stocks that were deemed fully valued and also sold selected debt securities in an effort to manage its interest rate risk position. - Other (noninterest) income increased $634,000 (12.4%) in 2005 as compared to 2004. This category includes several sources of revenue. The sources of revenue with the largest increases in 2005 included the following: fees related to credit card operations of $144,000; dividends from Federal Home Loan Bank of Pittsburgh stock of $122,000; and Trust and Financial Management revenues of $106,000. Other changes in noninterest income are discussed in more detail later in Management's Discussion and Analysis. - Other (noninterest) expense increased $2,349,000 (12.2%) in 2005 as compared to 2004. Total salaries and benefit expenses increased $1,066,000, or 9.7% in 2005 over 2004, primarily due to new hires to accommodate expansion into new branches (Williamsport and South Williamsport in 2004, Jersey Shore in August 2005, and Canisteo and South Hornell, NY, in September 2005), and from the addition of new employees for support functions, such as Risk Management, Finance and Training. Furniture and equipment expense increased $761,000, or 65.6%, mainly due to depreciation and maintenance costs associated with the new core banking software system, which was implemented in the fourth quarter 2004. - The income tax provision increased to $2,154,000 in 2005 from $1,816,000 in 2004. The Corporation's effective tax rate rose to 17.9% in 2005 from 14.4% in 2004. This higher effective tax rate resulted mainly from management's decision to decrease the weighting of tax-exempt obligations of states and political subdivisions, as a percentage of total assets, to avoid or reduce what would have otherwise been a substantial alternative minimum tax liability. 13
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q THIRD QUARTER 2005 Net Income in the third quarter 2005 was $3,287,000, which was 3.5% lower than third quarter 2004 Net Income of $3,405,000. As you can see in Table I below, Net Income for the third quarter 2005 was very flat in comparison to results for each of the first two quarters. The interest margin increased $392,000 in the third quarter 2005, as compared to the previous quarter, due to a higher average loans outstanding and other factors, while net realized gains on securities fell to $393,000 in the third quarter from $929,000 in the second quarter. TABLE I - QUARTERLY FINANCIAL DATA (IN THOUSANDS) <TABLE> <CAPTION> SEPT. 30, JUNE 30, MAR. 31, DEC. 31, SEPT. 30, JUNE 30, MAR. 31, (IN THOUSANDS) 2005 2005 2005 2004 2004 2004 2004 --------- -------- -------- -------- --------- -------- -------- <S> <C> <C> <C> <C> <C> <C> <C> Interest income $15,571 $14,908 $14,693 $14,991 $14,573 $14,343 $14,015 Interest expense 6,426 6,155 5,957 5,745 5,665 5,493 5,703 ------- ------- ------- ------- ------- ------- ------- Interest margin 9,145 8,753 8,736 9,246 8,908 8,850 8,312 Provision for loan losses 375 375 375 350 350 350 350 ------- ------- ------- ------- ------- ------- ------- Interest margin after provision for loan losses 8,770 8,378 8,361 8,896 8,558 8,500 7,962 Other income 2,149 1,889 1,703 1,815 1,627 1,855 1,625 Securities gains 393 929 1,066 1,133 459 321 964 Other expenses 7,303 7,173 7,128 6,746 6,738 6,289 6,228 ------- ------- ------- ------- ------- ------- ------- Income before income tax provision 4,009 4,023 4,002 5,098 3,906 4,387 4,323 Income tax provision 722 725 707 1,035 501 698 617 ------- ------- ------- ------- ------- ------- ------- Net income $ 3,287 $ 3,298 $ 3,295 $ 4,063 $ 3,405 $ 3,689 $ 3,706 ======= ======= ======= ======= ======= ======= ======= Net income per share - basic $ 0.40 $ 0.40 $ 0.40 $ 0.50 $ 0.42 $ 0.45 $ 0.45 ======= ======= ======= ======= ======= ======= ======= Net income per share - diluted $ 0.40 $ 0.40 $ 0.40 $ 0.49 $ 0.41 $ 0.45 $ 0.45 ======= ======= ======= ======= ======= ======= ======= </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 2005 An update on the Corporation's expansion projects is as follows: - Expansion in Lycoming County, PA, continues. The Jersey Shore office opened in August 2005, and construction has begun on a branch facility in Old Lycoming Township, PA. We hope to open the Old Lycoming Township office in the first quarter 2006. - As reported earlier in Management's Discussion and Analysis, we closed on the acquisition of Canisteo Valley Corporation, the parent company of First State Bank of Canisteo, NY, in the third quarter 2005. This transaction added two more banking locations, and increased assets by approximately $38.6 million. - Construction has begun on a new administrative building in Wellsboro, within 2 blocks of the main office. We expect to move into this facility in the first quarter 2006. 14
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Management expects the investments in new markets to provide future, continuing opportunities for earnings growth. However, consistent with results for the first nine months of 2005, noninterest expense for the year 2005 is expected to be up significantly from the year 2004, mainly due to payroll and other start-up costs related to the new branches, as well as costs from a full year of depreciation and maintenance from the core computer system that was placed in service in October 2004. Further, short-term interest rates have been rising faster than long-term rates, causing a negative effect on the Corporation's net interest margin. Thus far in 2005, loan demand has been good, and higher loan volumes have allowed the Corporation to maintain its interest margin at a level approximately equal with that of 2004. Management is concerned that recent events, including substantial increases in prices of petroleum-based products in 2005, possibly exacerbated by the hurricanes in the U.S. Gulf Coast area, could lead to a higher level of inflation than experienced in recent years. The possibility of higher inflation could lead the Federal Reserve to continue to increase its Federal Funds target rate, which could harm the Corporation's operating results in two ways - by increasing the cost of funds, and by dampening the economy (and therefore, demand for loans). The Corporation's exposure to interest rate risk is discussed in more detail in Item 3. Another major variable that affects the Corporation's earnings is securities gains and losses. Management's decisions regarding sales of securities are based on a variety of factors, with the overall goal of maximizing portfolio return over a long-term horizon. It is difficult to predict, with much precision, the amount of net securities gains and losses that will be realized in the fourth quarter 2005. CRITICAL ACCOUNTING POLICIES The presentation of financial statements in conformity with U.S. 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. Another material estimate is the calculation of fair values of the Corporation's investments in 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 2005 and 2004. 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. 15
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q The net interest margin, on a tax-equivalent basis, was $29,018,000 in 2005, down $113,000, or 0.4%, from 2004. As reflected in Table IV, interest rate changes had the effect of decreasing net interest income $954,000 in 2005 as compared to 2004, as rising short-term interest rates caused increases in the Corporation's interest expense on money market deposits, certificates of deposits and short-term borrowings. Table IV also shows that increased interest income from higher volumes of earning assets (primarily loans) exceeded increases in interest expense attributable to higher volumes of interest-bearing liabilities by $841,000 in 2005 compared to 2004. 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) was 3.29% for the first nine months of 2005, compared to 3.43% for the year ended December 31, 2004 and 3.44% for the first nine months of 2004. INTEREST INCOME AND EARNING ASSETS Interest income increased 3.4%, to $47,556,000 in 2005 from $45,992,000 in 2004. Interest and fees from loans increased $3,280,000, or 12.5%, while income from available-for-sale securities decreased $1,785,000, or 9.0%. Overall, the majority of the increase in interest income resulted from higher volumes of loans, which more than offset the effect of the lower average volume of available-for-sale securities. As indicated in Table III, average available-for-sale securities in the first nine months of 2005 amounted to $445,162,000, a decrease of 8.1% from the first nine months of 2004. Proceeds from sales and maturities of securities have been used, in part, to help fund the substantial growth in loans. Also, because short-term interest rates have been rising faster than long-term rates, there have been few opportunities to purchase mortgage-backed securities or other bonds at spreads sufficient to justify the applicable interest rate risk. The average rate of return on available-for-sale securities was 5.39% for first nine months of 2005, slightly lower than the 5.44% level in the nine months of 2004, and the 5.41% rate of return for the year ended December 31, 2004. Tax-exempt securities (municipal bonds) were a smaller portion of the Corporation's earning assets in 2005 than in 2004. The average balance of municipal bonds shrunk to $121,618,000 in 2005 from $158,842,000 in the first nine months of 2004. Management decided to reduce the Corporation's investment in municipal bonds during the fourth quarter 2004, in order to reduce the alternative minimum tax liability incurred in 2004, and reduce or eliminate the potential for an alternative minimum tax liability that would otherwise have been expected for 2005. The average balance of gross loans increased 11.8% in the first nine months of 2005 over the first nine months of 2004, to $607,981,000 from $543,700,000. The largest growth was in commercial loans, due in part to new personnel and relationships in Williamsport and throughout Lycoming County, as well as from growth in staffing and an increased emphasis on commercial lending throughout the Corporation's market area over the last few years. The average rate of return on loans was 6.49% in the first nine months of 2005, as compared to 6.44% in the first nine months of 2004. The aggregate average interest rate on the commercial loan portfolio has increased steadily over the second and third quarters of 2005, as variable rates in the market (mainly Prime, 1-month LIBOR and 3-month LIBOR) have increased. INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES Interest expense rose $1,677,000, or 9.9%, to $18,538,000 in 2005 from $16,861,000 in 2004. Table III reflects the current trend in interest rates incurred on liabilities, as the overall cost of funds on interest-bearing liabilities rose to 2.72% for the first nine months of 2005, from 2.52% for the first nine months of 2004. In Table III, you can see the impact of rising short-term interest rates on some of the Corporation's largest sources of funds: (1) money market accounts, which increased to an average rate of 1.98% in 2005 from 1.22% in the first nine months of 2004, (2) certificates of deposit, which increased to an average rate of 3.20% from 2.82%, and (3) short-term borrowings, which rose to an average rate of 2.55% from 1.29%. Helping to offset some of the impact of rising short-term market rates were IRAs, for which the average rate fell to 3.40% from 3.93%, and long-term borrowings, for which the average rate fell to 3.46% from 3.56%. In the first quarter 2004, the average rate paid on the majority of the Corporation's IRAs was 5%, which was the "floor" on 18-month passbook IRAs that existed prior to October 1, 2003. Effective April 1, 2004, the floor on those IRAs fell to 3%, and the Corporation's passbook IRA rate has ranged from 3.25% to 3.50% thereafter. The decrease in average rate incurred on long-term borrowings resulted from repayment of borrowings originated in earlier interest rate cycles at higher rates. 16
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q As you can calculate from Table III, total average deposits (interest-bearing and noninterest-bearing) increased to $687,363,000 in the first nine months of 2005 from $665,713,000 in the first nine months of 2004, an increase of 3.3%. Average total short-term and long-term borrowed funds amounted to $306,596,000 in the first nine months of 2005, up slightly from $304,561,000 in the first nine months of 2004. In 2004, the Corporation utilized borrowings to fund security purchases and to help fund loan growth. In 2005, this trend has changed, as management has begun to use proceeds from the securities portfolio to help fund loan growth, and has either rolled over maturing long-term borrowings into short-term borrowing instruments at lower rates, or "shrunk the balance sheet" by paying off long-term borrowings as they mature, without replacement. This change in trend is reflected in the consolidated balance sheet, as total short-term borrowings increased to $41,805,000 at September 30, 2005 from $34,178,000 at December 31, 2004, and total long-term borrowings decreased to $246,499,000 at September 30, 2005 from $270,827,000 at December 31, 2004. TABLE II - ANALYSIS OF INTEREST INCOME AND EXPENSE <TABLE> <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, ----------------- INCREASE/ (IN THOUSANDS) 2005 2004 (DECREASE) - -------------- ------- ------- ---------- <S> <C> <C> <C> INTEREST INCOME Available-for-sale securities: Taxable $11,627 $11,286 $ 341 Tax-exempt 6,315 8,441 (2,126) ------- ------- ------- Total available-for-sale securities 17,942 19,727 (1,785) ------- ------- ------- Held-to-maturity securities, Taxable 19 20 (1) Interest-bearing due from banks 24 7 17 Federal funds sold 61 8 53 Loans: Taxable 28,327 25,180 3,147 Tax-exempt 1,183 1,050 133 ------- ------- ------- Total loans 29,510 26,230 3,280 ------- ------- ------- Total Interest Income 47,556 45,992 1,564 ------- ------- ------- INTEREST EXPENSE Interest checking 218 173 45 Money market 2,812 1,748 1,064 Savings 218 211 7 Certificates of deposit 4,576 3,839 737 Individual Retirement Accounts 3,095 3,418 (323) Other time deposits 5 5 -- Short-term borrowings 894 371 523 Long-term borrowings 6,720 7,096 (376) ------- ------- ------- Total Interest Expense 18,538 16,861 1,677 ------- ------- ------- Net Interest Income $29,018 $29,131 $ (113) ======= ======= ======= </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%. 17
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE III - 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 9/30/2005 RETURN/ 12/31/2004 RETURN/ 9/30/2004 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: Taxable $ 323,544 4.80% $ 331,447 4.65% $ 325,458 4.63% Tax-exempt 121,618 6.94% 151,049 7.09% 158,842 7.10% ---------- ---- ---------- ---------- ---- Total available-for-sale securities 445,162 5.39% 482,496 5.41% 484,300 5.44% ---------- ---- ---------- ---------- ---- Held-to-maturity securities, Taxable 429 5.92% 460 5.87% 466 5.73% Interest-bearing due from banks 1,355 2.37% 1,449 0.76% 1,249 0.75% Federal funds sold 2,698 3.02% 778 1.29% 894 1.20% Loans: Taxable 582,967 6.50% 530,045 6.46% 522,479 6.44% Tax-exempt 25,014 6.32% 21,307 6.58% 21,221 6.61% ---------- ---- ---------- ---------- ---- Total loans 607,981 6.49% 551,352 6.47% 543,700 6.44% ---------- ---- ---------- ---------- ---- Total Earning Assets 1,057,625 6.01% 1,036,535 5.96% 1,030,609 5.96% Cash 9,077 14,273 14,722 Unrealized gain/loss on securities 12,823 16,182 16,454 Allowance for loan losses (7,100) (6,523) (6,466) Bank premises and equipment 18,214 14,953 14,428 Other assets 45,793 38,621 38,006 ---------- ---------- ---------- Total Assets $1,136,432 $1,114,041 $1,107,753 ========== ========== ========== INTEREST-BEARING LIABILITIES Interest checking $ 40,301 0.72% $ 39,188 0.59% $ 39,594 0.58% Money market 190,231 1.98% 192,450 1.31% 191,363 1.22% Savings 58,431 0.50% 57,439 0.49% 56,685 0.50% Certificates of deposit 191,352 3.20% 180,332 2.85% 182,151 2.82% Individual Retirement Accounts 121,606 3.40% 116,622 3.75% 116,315 3.93% Other time deposits 1,295 0.52% 1,275 0.39% 1,453 0.46% Short-term borrowing 46,930 2.55% 39,458 1.37% 38,538 1.29% Long-term borrowing 259,666 3.46% 268,211 3.55% 266,023 3.56% ---------- ---- ---------- ---------- ---- Total Interest-bearing Liabilities 909,812 2.72% 894,975 2.53% 892,122 2.52% Demand deposits 84,147 82,001 78,152 Other liabilities 10,117 8,691 9,792 ---------- ---------- ---------- Total Liabilities 1,004,076 985,667 980,066 ---------- ---------- ---------- Stockholders' equity, excluding other comprehensive income/loss 124,090 117,695 116,828 Other comprehensive income/loss 8,266 10,679 10,859 ---------- ---------- ---------- Total Stockholders' Equity 132,356 128,374 127,687 ---------- ---------- ---------- Total Liabilities and Stockholders' Equity $1,136,432 $1,114,041 $1,107,753 ========== ========== ========== Interest Rate Spread 3.29% 3.43% 3.44% Net Interest Income/Earning Assets 3.67% 3.78% 3.78% </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. 18
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE IV - ANALYSIS OF VOLUME AND RATE CHANGES (IN THOUSANDS) <TABLE> <CAPTION> YTD ENDED 9/30/05 VS. 9/30/04 -------------------------------- CHANGE IN CHANGE IN TOTAL VOLUME RATE CHANGE --------- --------- -------- <S> <C> <C> <C> EARNING ASSETS Available-for-sale securities: Taxable $ (68) $ 409 $ 341 Tax-exempt (1,944) (182) (2,126) ------- ------ ------- Total available-for-sale securities (2,012) 227 (1,785) ------- ------ ------- Held-to-maturity securities, Taxable (2) 1 (1) Interest-bearing due from banks 1 16 17 Federal funds sold 30 23 53 Loans: Taxable 2,916 231 3,147 Tax-exempt 180 (47) 133 ------- ------ ------- Total loans 3,096 184 3,280 ------- ------ ------- Total Interest Income 1,113 451 1,564 ------- ------ ------- INTEREST-BEARING LIABILITIES Interest checking 3 42 45 Money market (10) 1,074 1,064 Savings 6 1 7 Certificates of deposit 200 537 737 Individual Retirement Accounts 149 (472) (323) Other time deposits (1) 1 -- Short-term borrowings 95 428 523 Long-term borrowings (170) (206) (376) ------- ------ ------- Total Interest Expense 272 1,405 1,677 ------- ------ ------- Net Interest Income $ 841 $ (954) $ (113) ======= ====== ======= </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. 19
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE V - COMPARISON OF NONINTEREST INCOME (IN THOUSANDS) <TABLE> <CAPTION> 9 MONTHS ENDED --------------------- SEPT. 30, SEPT. 30, 2005 2004 --------- --------- <S> <C> <C> Service charges on deposit accounts $1,182 $1,337 Service charges and fees 288 209 Trust and financial management revenue 1,589 1,483 Insurance commissions, fees and premiums 405 327 Increase in cash surrender value of life insurance 417 463 Fees related to credit card operation 712 568 Other operating income 1,148 720 ------ ------ Total other operating income, before realized gains on securities, net 5,741 5,107 Realized gains on securities, net 2,388 1,744 ------ ------ Total Other Income $8,129 $6,851 ====== ====== </TABLE> Total noninterest income increased $1,278,000, or 18.7%, in 2005 compared to 2004, including an increase in net realized gains on securities of $644,000. Securities gains are discussed in the Earnings Overview section of Management's Discussion and Analysis. Other items of significance are as follows: - - Service charges on deposit accounts fell $155,000, or 11.6%, in 2005 as compared to 2004. Changes in deposit account processing resulting from the new core banking system resulted in overdraft and other charges not being assessed for some transactions that would have generated charges with the former system. Management has been working with the core system vendor, and during the third quarter 2005 was able to reestablish virtually all of the remaining, significant overdraft and service charge routines. Those changes, along with fee increases in overdraft and other services, helped restore service charge revenue in the third quarter 2005 to a level almost as high as in 2004 (as reflected in the consolidated income statement, service charges on deposit accounts totaled $457,000 in the third quarter 2005, in comparison to $463,000 in the third quarter 2004). - - Other service charges and fees increased $79,000, or 37.8%, in 2005 over 2004, primarily from higher volumes of transactions, including letters of credit, ATM surcharges and other transactions. - - Trust and financial management revenue increased $106,000, or 7.1%, in 2005 over 2004. Much of the trust fees are determined based on the amount of assets under management, which have increased 13.0% as of September 30, 2005 as compared to one year earlier, to $404,899,000. - - Insurance commissions, fees and premiums increased $78,000, or 23.9%, in 2005 over 2004. In the third quarter 2005, Bucktail recorded a "catch-up" adjustment to recognize revenue of approximately $100,000 for insurance premiums associated with policies issued related to collateral mortgage transactions. Overall, Bucktail's operations are not a significant component of the Corporation's operations. - - The increase in cash surrender value of insurance fell $46,000, or 9.9%, in 2005 as compared to 2004. 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 2005, earnings from that pooled separate trust fund were lower than in 2004, which is reflective of lower market yields on debt securities. - - Fees related to the Corporation's credit card operation increased $144,000, or 25.4%, in 2005 over 2004, primarily because of higher volumes and rates on merchant processing and interchange transactions. - - Other operating income increased $428,000, or 59.4%, in 2005 over 2004. Within this line item, the largest changes in 2005 were increases in the following categories: dividends from Federal Home Loan Bank of Pittsburgh stock of $122,000; gains from sales of foreclosed assets (other real estate) of $79,000; debit card fees of $76,000; broker dealer revenues of $75,000; and training grant revenue of $65,000. 20
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE VI- COMPARISON OF NONINTEREST EXPENSE (IN THOUSANDS) <TABLE> <CAPTION> 9 MONTHS ENDED --------------------- SEPT. 30, SEPT. 30, 2005 2004 --------- --------- <S> <C> <C> Salaries and wages $ 9,172 $ 8,306 Pensions and other employee benefits 2,878 2,678 Occupancy expense, net 1,371 1,187 Furniture and equipment expense 1,922 1,161 Pennsylvania shares tax 608 635 Other operating expense 5,653 5,288 ------- ------- Total Other Expense $21,604 $19,255 ======= ======= </TABLE> Salaries and wages increased $866,000, or 10.4%, in 2005 over 2004. The increase in salaries expense is primarily a reflection of a greater number of employees, resulting from expansion into new branches and the addition of new employees for support functions. The number of full-time equivalent employees was 338 as of September 30, 2005, up 7.0% from one year earlier. Occupancy expense increased $184,000, or 15.5%, in 2005 over 2004, primarily as a result of higher depreciation and maintenance costs associated with new facilities. Furniture and equipment expense increased $761,000, or 65.5%, in 2005 over 2004. Depreciation expense within this category increased $528,000, to $1,185,000 in 2005 from $657,000 in 2004, including approximately $450,000 of depreciation in 2005 from the new core banking software system. Similarly, maintenance and repair expense within this category increased $216,000, to $619,000 in 2005 from $403,000 in 2004, primarily because of maintenance costs associated with the new core banking software system of approximately $270,000 in 2005. Other operating expense increased $365,000, or 6.9%, in 2005 over 2004. Most of the line items within this category increased in 2005, in part due to expansion into more locations and the resulting higher volume of transactions and costs. The most significant increases within this category were expenses associated with maintaining and preparing other real estate properties for sale, which increased $192,000 in 2005 to $242,000, and attorney fees, which increased $160,000 in 2005 to $188,000, mainly because of collection activities on a large commercial credit. Helping to reduce the overall increase in this category was a decrease in professional fees of $477,000, to $139,000 in 2005. In 2004, the Corporation incurred a significant amount of professional fees expense associated with the core banking system conversion. 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. Also included in the Net Interest Margin section is a discussion of a change in trend regarding available-for-sale securities, short-term and long-term borrowings. As noted earlier in Management's Discussion and Analysis, the acquisition of Canisteo Valley Corporation increased total assets and total liabilities by approximately $38.6 million each as of the August 31, 2005 purchase date. This acquisition did not have a material impact on the Corporation's liquidity or capital position. The allowance for loan losses and stockholders' equity are discussed in separate sections of Management's Discussion and Analysis. As discussed in the "Prospects for the Remainder of 2005" section of Management's Discussion and Analysis, the Corporation completed construction of a new branch in Jersey Shore in 2005, and is in the process of building a new administrative building in Wellsboro and a branch in Old Lycoming Township. In addition to the building projects, the Corporation will need to purchase furniture, equipment and computer-related items on an ongoing basis for its existing and new operations. In total, management expects 2005 capital purchases to range between $6.5 and $7.5 million. As discussed in the Earnings Overview section of Management's Discussion and Analysis, management expects the initial depreciation and start-up costs associated with the new locations to have a negative impact on 2005 earnings; however, in light of the Corporation's strong capital position, the overall impact of 2005 capital purchases is not expected to be materially adverse to the Corporation's financial condition. 21
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q PROVISION AND ALLOWANCE FOR LOAN LOSSES 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. For C&N Bank's portfolio, 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 qualitative risk adjustment factors identified by management for each type of loan. The charge-off ratio and qualitative factors are then applied to the current outstanding loan balance for each type of loan (net of other loans that are individually evaluated). For First State Bank's portfolio, the process is identical to that described for C&N Bank, except that the ratio of net charge-offs to average balances is determined over a three-year period. The allowance for loan losses was $7,643,000 at September 30, 2005, an increase of $856,000 from the balance at December 31, 2004. The allowance for loan losses recorded as part of the Canisteo Valley Corporation (First State Bank) acquisition amounted to $377,000. Although there were loans included on the First State Bank watch list as of the acquisition date that management is monitoring, substantially all of these loans are commercial loans with low balances, or consumer or residential mortgage loans that can be collectively evaluated for impairment. Accordingly, there were no acquired loans that have been classified individually as impaired. Net charge-offs amounted to $646,000 in the first nine months of 2005, while the provision for loan losses was $1,125,000. In the first nine months of 2004, net charge-offs totaled $577,000, and the provision was $1,050,000. 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 the second quarter 2005, management changed its process for determining and disclosing the components of the allowance for loan losses. A management committee evaluated several qualitative factors, including economic conditions, lending policies, changes in the portfolio, risk profile of the portfolio, competition and regulatory requirements, and other factors. This analysis was performed separately for 4 categories of lending activity: commercial, mortgage, consumer and credit card. The management committee met again in the third quarter and updated its analysis. Based on the results of these evaluations, allocations were made to the components of the allowance shown in Table VIII. In periods prior to June 30, 2005, the portion of the allowance determined by management's subjective assessment of economic conditions and other factors was reflected completely in the unallocated component of the allowance. Primarily as a result of this change in process, Table VIII shows the amounts allocated to the allowance for commercial, consumer mortgage and consumer loans at September 30, 2005 and June 30, 2005 have increased in comparison to the corresponding amounts at December 31, 2004, while the unallocated portion of the allowance decreased to $0 at September 30, 2005 and $328,000 at June 30, 2005 from $2,578,000 at December 31, 2004. As indicated in Table IX, total impaired loans amounted to $8,010,000 at September 30, 2005, as compared to $8,258,000 at June 30, 2005, $8,261,000 at December 31, 2004 and $4,621,000 at December 31, 2003. In total, the valuation allowance related to impaired loans amounted to $1,938,000 at September 30, 2005, up from $1,614,000 at June 30, 2005 and $1,378,000 at December 31, 2004. Table IX also shows that the amount of loans classified as nonaccrual amounted to $7,458,000 at September 30, 2005, as compared to $7,910,000 at June 30, 2005, $7,796,000 at December 31, 2004 and $1,145,000 at December 31, 2003. The growth in 2004 in past due and nonaccrual loans resulted mainly from certain large commercial loan relationships, including one commercial loan relationship with total outstanding loan balances of approximately $3.4 million at September 30, 2005, $3.6 million at June 30, 2005 and $3.7 million as of December 31, 2004. In 2004, management moved most of the loans outstanding related to this large relationship to nonaccrual status. Also, in 2005, a large ($600,000) residential mortgage loan to the principal owner of this relationship was moved to nonaccrual. As of September 30, 2005, the Corporation increased the valuation allowance to $657,000 from $570,000 at June 30, 2005 and $173,000 at December 31, 2004. There is another commercial loan relationship with total outstanding balances of approximately $1.6 million that has been classified as impaired and nonaccrual throughout most of 2004 and all of 2005 to date, and for which the valuation allowance was increased to $400,000 as of September 30, 2005 from an estimated amount of $200,000 as of June 30, 2005 and December 31, 2004. Management believes it has been conservative in its decisions concerning identification of impaired loans, estimates of loss and nonaccrual status. However, the actual losses realized from these relationships could vary materially from the allowances calculated as of September 30, 2005. Management continues to closely monitor these commercial loan relationships, and will adjust its estimates of loss and decisions concerning nonaccrual status, if appropriate. Tables VII, VIII, IX and X present an analysis of the allowance for loan losses, the allocation of the allowance, information concerning impaired and past due loans and a five-year summary of loans by type. 22
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE VII- ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES (IN THOUSANDS) <TABLE> <CAPTION> 9 MONTHS 9 MONTHS ENDED ENDED YEARS ENDED DECEMBER 31, SEPT. 30, SEPT. 30, ------------------------------------------ 2005 2004 2004 2003 2002 2001 2000 --------- --------- ------ ------ ------ ------ ------ <S> <C> <C> <C> <C> <C> <C> <C> Balance, beginning of year $6,787 $6,097 $6,097 $5,789 $5,265 $5,291 $5,131 ------ ------ ------ ------ ------ ------ ------ Charge-offs: Real estate loans 225 337 375 168 123 144 272 Installment loans 138 156 217 326 116 138 77 Credit cards and related plans 177 132 178 171 190 200 214 Commercial and other loans 202 11 16 303 123 231 53 ------ ------ ------ ------ ------ ------ ------ Total charge-offs 742 636 786 968 552 713 616 ------ ------ ------ ------ ------ ------ ------ Recoveries: Real estate loans 13 3 3 75 30 6 26 Installment loans 48 23 32 52 30 27 23 Credit cards and related plans 21 18 23 17 18 20 28 Commercial and other loans 14 15 18 32 58 34 23 ------ ------ ------ ------ ------ ------ ------ Total recoveries 96 59 76 176 136 87 100 ------ ------ ------ ------ ------ ------ ------ Net charge-offs 646 577 710 792 416 626 516 Allowance for loan losses recorded in acquisition 377 -- -- -- -- -- -- Provision for loan losses 1,125 1,050 1,400 1,100 940 600 676 ------ ------ ------ ------ ------ ------ ------ Balance, end of period $7,643 $6,570 $6,787 $6,097 $5,789 $5,265 $5,291 ====== ====== ====== ====== ====== ====== ====== </TABLE> TABLE VIII - ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES BY TYPE (IN THOUSANDS) <TABLE> <CAPTION> AS OF AS OF AS OF DECEMBER 31, SEPT. 30, JUNE 30, ------------------------------------------ 2005 2005 2004 2003 2002 2001 2000 --------- -------- ------ ------ ------ ------ ------ <S> <C> <C> <C> <C> <C> <C> <C> Commercial $2,376 $2,212 $1,909 $1,578 $1,315 $1,837 $1,612 Consumer mortgage 2,653 2,304 513 456 460 674 952 Impaired loans 1,938 1,614 1,378 1,542 1,877 73 273 Consumer 676 579 409 404 378 494 471 Unallocated -- 328 2,578 2,117 1,759 2,187 1,983 ------ ------ ------ ------ ------ ------ ------ Total Allowance $7,643 $7,037 $6,787 $6,097 $5,789 $5,265 $5,291 ====== ====== ====== ====== ====== ====== ====== </TABLE> TABLE IX - PAST DUE AND IMPAIRED LOANS (IN THOUSANDS) <TABLE> <CAPTION> SEPT. 30, JUNE 30, DEC. 31, DEC. 31, DEC. 31, 2005 2005 2004 2003 2002 --------- -------- -------- -------- -------- <S> <C> <C> <C> <C> <C> Impaired loans without a valuation allowance $1,024 $1,295 $3,552 $ 114 $ 675 Impaired loans with a valuation allowance 6,986 6,963 4,709 4,507 3,039 ------ ------ ------ ------ ------ Total impaired loans $8,010 $8,258 $8,261 $4,621 $3,714 ====== ====== ====== ====== ====== Valuation allowance related to impaired loans $1,938 $1,614 $1,378 $1,542 $1,877 Total nonaccrual loans $7,458 $7,910 $7,796 $1,145 $1,252 Total loans past due 90 days or more and still accruing $1,316 $1,658 $1,307 $2,546 $2,318 </TABLE> 23
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE X - SUMMARY OF LOANS BY TYPE (IN THOUSANDS) <TABLE> <CAPTION> AS OF DECEMBER 31, SEPT. 30, JUNE 30, ---------------------------------------------------- 2005 2005 2004 2003 2002 2001 2000 --------- -------- -------- -------- -------- -------- -------- <S> <C> <C> <C> <C> <C> <C> <C> Real estate - construction $ 5,863 $ 4,125 $ 4,178 $ 2,856 $ 103 $ 1,814 $ 452 Real estate - residential mortgage 357,695 346,507 347,705 330,807 292,136 245,997 207,100 Real estate - commercial mortgage 141,046 136,634 128,073 100,240 78,317 60,267 56,225 Consumer 37,150 33,064 31,702 33,977 31,532 29,284 28,141 Agricultural 2,658 2,507 2,872 2,948 3,024 2,344 1,983 Commercial 73,299 63,672 43,566 34,967 30,874 24,696 20,776 Other 1,923 1,923 1,804 1,183 2,001 1,195 948 Political subdivisions 25,655 23,119 19,713 17,854 13,062 13,479 12,462 Lease receivables -- -- -- 65 96 152 218 -------- -------- -------- -------- -------- -------- -------- Total 645,289 611,551 579,613 524,897 451,145 379,228 328,305 Less: allowance for loan losses (7,643) (7,037) (6,787) (6,097) (5,789) (5,265) (5,291) -------- -------- -------- -------- -------- -------- -------- Loans, net $637,646 $604,514 $572,826 $518,800 $445,356 $373,963 $323,014 ======== ======== ======== ======== ======== ======== ======== </TABLE> DERIVATIVE FINANCIAL INSTRUMENTS The Corporation has utilized 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. In 2004, the Corporation stopped originating new IPCDs, but continues to maintain and account for IPCDs and the related derivative contracts entered into between 2001 and 2004. 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 paid 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, 2005 and December 31, 2004, and for the first nine months of 2005 and 2004, related to IPCDs are as follows (in thousands): 24
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q <TABLE> <CAPTION> SEPT. 30, SEPT. 30, 2005 2004 --------- --------- <S> <C> <C> Contractual amount of IPCDs (equal to notional amount of Swap contracts) $3,959 $4,045 Carrying value of IPCDs 3,703 3,695 Carrying value of embedded derivative liabilities 490 297 Carrying value of Swap contract liabilities (255) 42 </TABLE> <TABLE> <CAPTION> 9 MOS. 9 MOS. ENDED ENDED SEPT. 30, SEPT. 30, 2005 2004 --------- --------- <S> <C> <C> Interest expense $117 $105 Other expense (4) 5 </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 FHLB - Pittsburgh, secured by mortgage loans and various investment securities. At September 30, 2005, the Corporation had unused borrowing availability with correspondent banks and the FHLB - Pittsburgh totaling approximately $139,783,000. 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. Further, if required to raise cash in an emergency situation, the Corporation could sell non-pledged investment securities to meet its obligations. At September 30, 2005, the carrying value of non-pledged securities was $210,114,000. Management believes the combination of its strong capital position (discussed in the next section), ample available borrowing facilities and substantial non-pledged securities portfolio have placed the Corporation in a position of minimal short-term and long-term liquidity risk. STOCKHOLDERS' EQUITY AND CAPITAL ADEQUACY The Corporation, as well as C&N Bank and First State Bank, are subject to various regulatory capital requirements administered by the federal banking agencies. For many years, the Corporation and C&N Bank have maintained strong capital positions. The following table presents consolidated capital ratios at September 30, 2005: <TABLE> <S> <C> Total capital to risk-weighted assets 17.52% Tier 1 capital to risk-weighted assets 15.98% Tier 1 capital to average total assets 10.71% </TABLE> Management expects the Corporation, as well as C&N Bank and First State 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 (as discussed in the "Financial Position" section of Management's Discussion and Analysis) during the next 12 months are not expected to have a detrimental effect on capital ratios. INFLATION The Corporation is significantly affected by the Federal Reserve Board's efforts to control inflation through changes in interest rates. As alluded to in the "Earnings Overview" section of Management's Discussion and Analysis, inflation has been on the rise in 2005, led by substantial increases in prices of petroleum-based products, with the potential for further price increases to come as a result of hurricanes in the U.S. Gulf Coast area. High inflation data could lead the Federal Reserve to continue to increase its Federal Funds target rate, which could harm the Corporation's operating results by increasing the cost of funds, and by dampening the economy (and therefore, demand for loans). Although management cannot predict future changes in the rates of inflation, management monitors the impact of economic trends, including indicators of inflationary pressure, in managing interest rate and other financial risks. 25
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q PART I - FINANCIAL INFORMATION (CONTINUED) 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. C&N 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 C&N Bank are included in management's monthly simulation model calculations. Since C&N Bank makes up more than 90% of the Corporation's total assets and liabilities, and because C&N Bank is the source of the most volatile interest rate risk, presently management does not consider it necessary to run the model for the remaining entities within the consolidated group. (Management intends to add First State Bank's data to the model, beginning sometime in 2006.) 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. C&N 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. C&N Bank's policy provides limits at +/- 100, 200 and 300 basis points from current rates for fluctuations in net interest income from the baseline (flat rates) one-year scenario. The policy also limits acceptable market value variances from the baseline values based on current rates. The most sensitive scenario presented in Table XI presented below is the "+300 basis points" scenario. As the table shows, as of September 30, 2005, if interest rates were to immediately rise 300 basis points, the Bank's calculations based on the model show that although the change in net interest income is within the policy threshold, the market value of portfolio equity would decrease 51.9%, which exceeds the policy limit of 45%. Similarly, at December 31, 2004, the change in net interest income was within the policy threshold, but the market value of portfolio equity decrease of 49.2% exceeded the policy threshold. Management will continue to evaluate whether to make any changes to asset or liability holdings in an effort to reduce exposure to decline in market value or net interest income 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. 26
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE XI - THE EFFECT OF HYPOTHETICAL CHANGES IN INTEREST RATES SEPTEMBER 30, 2005 DATA (IN THOUSANDS) <TABLE> <CAPTION> 12 MOS. ENDING SEPTEMBER 30, 2006 ---------------------------------------------------------- INTEREST INTEREST NET INTEREST NII NII BASIS POINT CHANGE IN RATES INCOME EXPENSE INCOME (NII) % CHANGE RISK LIMIT - --------------------------- -------- -------- ------------ -------- ---------- <S> <C> <C> <C> <C> <C> +300 66,261 38,907 27,354 -18.5% 20.0% +200 64,443 34,913 29,530 -12.0% 15.0% +100 62,541 30,919 31,622 -5.7% 10.0% 0 60,471 26,925 33,546 0.0% 0.0% - -100 57,361 22,994 34,367 2.4% 10.0% - -200 54,053 19,948 34,105 1.7% 15.0% - -300 50,830 17,119 33,711 0.5% 20.0% </TABLE> <TABLE> <CAPTION> MARKET VALUE OF PORTFOLIO EQUITY AT SEPTEMBER 30, 2005 -------------------------------- PRESENT PRESENT PRESENT VALUE VALUE VALUE BASIS POINT CHANGE IN RATES EQUITY % CHANGE RISK LIMIT - --------------------------- ------- -------- ---------- <S> <C> <C> <C> +300 63,519 -51.9% 45.0% +200 85,968 -34.9% 35.0% +100 109,405 -17.2% 25.0% 0 132,078 0.0% 0.0% - -100 144,536 9.4% 25.0% - -200 150,378 13.9% 35.0% - -300 158,273 19.8% 45.0% </TABLE> DECEMBER 31, 2004 DATA (IN THOUSANDS) <TABLE> <CAPTION> 12 MOS. ENDING DEC. 31, 2005 ---------------------------------------------------------- INTEREST INTEREST NET INTEREST NII NII BASIS POINT CHANGE IN RATES INCOME EXPENSE INCOME (NII) % CHANGE RISK LIMIT - --------------------------- -------- -------- ------------ -------- ---------- <S> <C> <C> <C> <C> <C> +300 62,724 34,583 28,141 -16.8% 20.0% +200 61,066 30,840 30,226 -10.7% 15.0% +100 59,327 27,098 32,229 -4.7% 10.0% 0 57,343 23,510 33,833 0.0% 0.0% - -100 54,581 20,676 33,905 0.2% 10.0% - -200 51,800 17,924 33,876 0.1% 15.0% - -300 49,090 16,850 32,240 -4.7% 20.0% </TABLE> <TABLE> <CAPTION> MARKET VALUE OF PORTFOLIO EQUITY AT DECEMBER 31, 2004 -------------------------------- PRESENT PRESENT PRESENT VALUE VALUE VALUE BASIS POINT CHANGE IN RATES EQUITY % CHANGE RISK LIMIT - --------------------------- ------- -------- ---------- <S> <C> <C> <C> +300 71,244 -49.2% 45.0% +200 94,088 -32.9% 35.0% +100 117,491 -16.2% 25.0% 0 140,168 0.0% 0.0% - -100 153,026 9.2% 25.0% - -200 162,400 15.9% 35.0% - -300 171,463 22.3% 45.0% </TABLE> 27
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q 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. Included in "Other Equity Securities" in the table that follows are preferred stocks issued by U.S. Government agencies with a fair value of $1,996,000 at September 30, 2005 and $6,130,000 at December 31, 2004. 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 September 30, 2005 and December 31, 2004 are presented in Table XII. TABLE XII - EQUITY SECURITIES (IN THOUSANDS) <TABLE> <CAPTION> HYPOTHETICAL HYPOTHETICAL 10% 20% DECLINE IN DECLINE IN FAIR MARKET MARKET AT SEPTEMBER 30, 2005 COST VALUE VALUE VALUE - --------------------- -------- ------- ------------ ------------ <S> <C> <C> <C> <C> Banks and bank holding companies $18,744 $27,682 $(2,768) $(5,536) Other equity securities 4,010 4,324 (432) (865) ------- ------- ------- ------- Total $22,754 $32,006 $(3,200) $(6,401) ======= ======= ======= ======= </TABLE> <TABLE> <CAPTION> HYPOTHETICAL HYPOTHETICAL 10% 20% DECLINE IN DECLINE IN FAIR MARKET MARKET AT DECEMBER 31, 2004 COST VALUE VALUE VALUE - -------------------- -------- ------- ------------ ------------ <S> <C> <C> <C> <C> Banks and bank holding companies $17,426 $29,880 $(2,988) $(5,976) Other equity securities 8,962 8,383 (838) (1,677) ------- ------- ------- ------- Total $26,388 $38,263 $(3,826) $(7,653) ======= ======= ======= ======= </TABLE> PART I - FINANCIAL INFORMATION (CONTINUED) ITEM 4. CONTROLS AND PROCEDURES The Corporation's management, under the supervision of and with the participation of the Corporation's Chief Executive Officer and Chief Financial Officer, has carried out an evaluation of the design and effectiveness of the Corporation's disclosure controls and procedures as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Securities Exchange Act of 1934 as of the end of period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Corporation's disclosure controls and procedures are effective to ensure that all material 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 have materially affected, or that are reasonably likely to affect, our internal control over financial reporting. 28
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q PART II - OTHER INFORMATION Item 1. Legal Proceedings The Corporation, C&N Bank and First State 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. Unregistered Sales of Equity Securities and Use of Proceeds c. Issuer Purchases of Equity Securities The following table sets forth purchases by the Corporation (on the open market) of its equity securities during the third quarter 2005: <TABLE> <CAPTION> TOTAL MAXIMUM NUMBER OF DOLLAR VALUE SHARES (IN THOUSANDS) PURCHASED OF SHARES AS PART OF THAT MAY YET TOTAL AVERAGE PUBLICLY BE PURCHASED NUMBER OF PRICE ANNOUNCED UNDER THE SHARES PAID PER PLANS OR PLANS OR PERIOD PURCHASED SHARE PROGRAMS PROGRAMS - -------------------- --------- -------------- -------------- -------------- <S> <C> <C> <C> <C> July 1-31, 2005 - Not applicable Not applicable Not applicable August 1-31, 2005 - Not applicable Not applicable Not applicable September 1-30, 2005 2,000 $29.60 2,000 $2,941 ----- -------------- -------------- -------------- Total 2,000 $29.60 2,000 $2,941 ===== ============== ============== ============== </TABLE> NOTE: On August 19, 2005, the Corporation announced a plan to repurchase shares of its outstanding common stock up to a total of $3 million over a time period ending August 31, 2006. The Corporation's Board of Directors authorized repurchases from time to time at the prevailing market prices in open market or in privately negotiated transactions as, in management's sole opinion, market conditions warrant and based on stock availability, price and the Company's financial performance. The Corporation announced that it is anticipated such purchases will be made during the next twelve months, although no assurance may be given when such purchases will be made or the total number of shares that will be purchased. Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None 29
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Item 6. Exhibits <TABLE> <S> <C> 3. (i) Articles of Incorporation Incorporated by reference to the exhibits filed with the Corporation's registration statement on Form S-4 on March 27, 1987. 3. (ii) By-laws Incorporated by reference to Exhibit 3.1 of the Corporation's Form 8-K filed August 25, 2004 11. Statement re: computation of per share earnings Information concerning the computation of earnings per share is provided in Note 2 to the Consolidated Financial Statements, which is included in Part I, Item 1 of Form 10-Q 31. Rule 13a-14(a)/15d-14(a) certifications: 31.1 Certification of Chief Executive Officer Filed herewith 31.2 Certification of Chief Financial Officer Filed herewith 32. Section 1350 certifications Filed herewith </TABLE> 30
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 November 7, 2005 By: /s/ Craig G. Litchfield Date ------------------------------------ Chairman, President and Chief Executive Officer November 7, 2005 By: /s/ Mark A. Hughes Date ------------------------------------ Treasurer and Chief Financial Officer 31