Citizens & Northern Corp - 10-Q quarterly report FY

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 þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No þ

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.

The accompanying notes are an integral part of these consolidated financial statements.

Note: The balance sheet at December 31, 2005 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.

The accompanying notes are an integral part of these consolidated financial statements.

The accompanying notes are an integral part of these consolidated financial statements.

The financial information included herein, with the exception of the consolidated balance sheet dated December 31, 2005, 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, 2006 might not be indicative of the results for the year ending December 31, 2006.

Certain merchant services revenue previously included in fees related to credit card operations has been reclassified to Other Operating Income. Merchant services revenue was $59,000 and $52,000 for the three months ended September 30, 2006 and 2005. Merchant services revenue was $139,000 and $110,000 for the nine months ended September 30, 2006 and 2005.

This document has not been reviewed or confirmed for accuracy or relevance by the Federal Deposit Insurance Corporation or any other regulatory agency.

Net income per share is based on the weighted-average number of shares of common stock outstanding. The number            of shares used in calculating net income and cash dividends per share reflect the retroactive effect of stock dividends for all periods presented. The following data show the amounts used in computing net income per share and the weighted average number of shares of dilutive stock options. 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.

Effective in the first quarter of 2006, the Financial Accounting Standards Board issued SFAS No. 123R, which replaces SFAS No. 123 and supersedes APB Opinion 25. SFAS No. 123R requires the Corporation to record stock option expense based on estimated fair value calculated using an option valuation model. The provisions of SFAS 123R must be applied to any new awards granted, and to any modifications of existing awards. Since the Corporation has neither modified, nor issued, any new options in 2006, and all options issued prior to December 31, 2005 are fully vested, the provisions of SFAS No. 123R have no impact on net income in 2006.

In previous years, the Corporation used the intrinsic value method of accounting for stock compensation plans, with compensation cost 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 had no intrinsic value; therefore, no compensation cost was recorded for them.

The Corporation has also made prior awards of restricted stock. Compensation cost related to restricted stock has been recognized based on the market price of the stock at the grant date over the vesting period.

The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value provisions of SFAS No. 123 to stock options.

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.

The components of comprehensive income, and the related tax effects, are as follows:

Amortized cost and fair value of securities at September 30, 2006 are as follows:

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, 2006.

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

The unrealized losses on debt securities are primarily the result of volatility in interest rates. Based on the credit worthiness of the issuers, management believes the Corporation’s debt securities at September 30, 2006 were not other-than-temporarily impaired.

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 at September 30, 2006 and December 31, 2005, and will not affect the Corporation’s future expenses.

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:

In September 2006, the Corporation made its annual contribution to the defined benefit pension plan of $640,000. For the nine months to date of 2006, the Corporation funded postretirement contributions totaling $39,000, with estimated annual postretirement contributions of $62,000 expected in 2006 for the full year.

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.

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:

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.

Unless otherwise noted, all references to “2006” in the following discussion of operating results are intended to mean the nine months ended September 30, 2006, and similarly, references to “2005” relate to the nine months ended September 30, 2005.

On October 12, 2006, the Corporation issued a press release with its unaudited financial results for the three-month and nine-month periods ended September 30, 2006. The net income amounts for the third quarter and year-to-date 2006, as reported in this Form 10-Q, are $15,000 higher than the amounts previously reported in the press release, due to correction of an immaterial error.

Net income in 2006 was $9,292,000, or $1.12 per share (basic and diluted). Net income per share in 2005 was $1.19 (basic) and $1.18 (diluted). Return on average assets was 1.09% in 2006, down from 1.16% in 2005. Return on average equity was 9.45% for 2006, as compared to 9.95% for the same period in 2005.

The most significant income statement changes between 2006 and 2005 were as follows:

Net income in the third quarter 2006 was $3,273,000, or $14,000 (0.4%) lower than third quarter 2005 net income, and $74,000 (2.3%) higher than the second quarter 2006. The net interest margin totaled $8,319,000 in the third quarter 2006, down 9.0% from the third quarter 2005, mainly because of the impact of rising short-term interest rates on C&N’s cost of funds. Net securities gains for the third quarter 2006 amounted to $1,602,000, or $1,209,000 more than the corresponding amount in the third quarter 2005. The income tax provision in the third quarter 2006 was $1,016,000, or 23.8% of pre-tax income, up from $722,000 or 18.0% of pre-tax income for the third quarter 2005. The higher tax rate in 2006 resulted from management’s decision to reduce the percentage of assets held in tax-exempt securities, in an effort to avoid or minimize payment of alternative minimum tax.

The number of shares used in calculating net income per share for each quarter presented in Table I reflects the retroactive effect of stock dividends.

The yield curve has been flat or slightly inverted (meaning there is little or no difference between short-term and long-term interest rates, or that short-term rates are higher than long-term rates) throughout much of 2005 and all of 2006 to date. In this type of interest rate environment, there is little opportunity for the Corporation to earn a positive spread between earnings on available-for-sale securities and interest costs associated with borrowings, and therefore, this type of yield

curve is not favorable for the net interest margin. Unless the shape of the yield curve changes significantly, management expects to utilize cash flows from operations, and may sell some available-for-sale securities, to pay off borrowings as they mature in the fourth quarter 2006, effectively reducing total assets and liabilities. Management hopes to use earnings from
growth in loans, funded by deposits, to offset the anticipated reduction in net interest income associated with the lack of opportunity for a positive spread between earnings on securities and the interest costs on borrowings.

On November 30, 2005, the Corporation sold substantially its entire credit card portfolio, and recognized a gain of $1.9 million. As part of the sale, the Corporation continued to provide servicing of these credit cards through May 18, 2006. The Corporation recorded a $280,000 liability for the estimated direct costs of providing servicing, net of servicing fees to be received from the buyer. Also in 2005, the Corporation recorded an accrual of $175,000 for estimated losses associated with credit card receivables sold with recourse. The $1.9 million gain recorded in 2005 was net of the servicing and recourse liabilities. Through September 30, 2006, direct servicing costs, net of fees received, have totaled $60,000, with a remaining liability balance for servicing of $220,000. Losses charged against the recourse liability through September 30, 2006, have totaled $58,000, with a remaining liability balance of $117,000. The liabilities for servicing and recourse losses are included in accrued interest and other liabilities in the consolidated balance sheet. Management expects to pay for additional expenditures related to servicing the credit card portfolio, and for losses on receivables sold with recourse, over the remainder of 2006, with the total amount of the expenditures to be determined by mid-December 2006 (the Corporation’s recourse obligation expires as of November 30, 2006). Management expects to record the difference between the total amount of the additional servicing expenditures and recourse losses, and the related liability balances, as a gain or loss in the fourth quarter 2006.

Another major variable that affects the Corporation’s earnings is securities gains and losses, particularly from bank stocks and other equity securities. 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 2006.

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 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).

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 2006 and 2005. In each of these tables, the amounts of interest income earned on tax-exempt securities and loans have been adjusted to a fully taxable-equivalent basis.

Accordingly, the net interest margin amounts reflected in these tables exceed the amounts presented in the consolidated financial statements. The discussion that follows is based on amounts in the Tables.

The net interest margin, on a tax-equivalent basis, of $27,198,000 in 2006 decreased $1,820,000, or 6.3% from 2005. The volume/rate analysis in Table IV shows that the net interest margin fell $2,995,000 in 2006 as a result of interest rate changes. The reduction in net interest income from higher rates reflects the Corporation’s “liability sensitive” position, that is, deposits and borrowings reprice more quickly, on average, than the earning assets base of loans and available-for-sale securities. Table IV also shows that volume increases had the effect of increasing net interest income $1,175,000 in 2006 compared to 2005, as an increased volume of loans generated higher interest income of $2,454,000,and lower long-term borrowings decreased interest expense $1,792,000, while lower available-for-sale securities decreased interest income $2,318,000. 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) tightened to 2.93% in 2006, compared to 3.22% for the year ended December 31, 2005 and 3.29% for the first nine months of 2005.

Interest income increased 4.9%, to $49,875,000 in 2006 from $47,556,000 in 2005. Interest and fees from loans increased $3,800,000, or 12.9%, while income from available-for-sale securities decreased $1,695,000, or 9.4%.

As indicated in Table III, average available-for-sale securities in the first nine months of 2006 amounted to $391,742,000, a decrease of 12.0% from the first nine months of 2005. Proceeds from sales and maturities of securities have been used, in part, to help fund the continued growth in loans. Also, since 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 of 5.55% for the first nine months of 2006 was higher than the 5.39% level in the first nine months of 2005, and the 5.35% rate for the year ended December 31, 2005. The higher average yield on available-for-sale securities is attributed, in part, to the sale of certain lower yielding securities in the fourth quarter 2005. Such lower yielding securities were acquired in 2003 and 2004, when market yields were lower than current conditions. In addition, increased holdings of adjustable rate trust preferred securities in 2005 and 2006 have contributed to the increased yield since the yield on these securities generally rises consistent with short-term rates.

The average balance of gross loans increased 8.1% to $657,447,000 for the first nine months of 2006 from $607,981,000 in the first nine months of 2005. Since the Corporation acquired First State Bank on September 1, 2005, First State Bank’s loans are included in the calculation of average loans throughout the nine months ended September 30, 2006, but are included for only one month of 2005. Excluding loans acquired from First State Bank, average loans increased 4.9%. The average rate of return on loans was 6.77% in the first nine months of 2006, as compared to 6.49% in first nine months of 2005, and 6.53% for the year 2005.

Interest expense rose $4,139,000, or 22.3%, to $22,677,000 in 2006 from $18,538,000 in 2005. Table III reflects the current trend in interest rates incurred on liabilities, as the overall cost of funds on interest-bearing liabilities rose to 3.38% for the first nine months of 2006, from 2.81% for the year ended December 31, 2005, and 2.72% for the first nine months of 2005.

From Table III, you can calculate that total average deposits (interest-bearing and noninterest-bearing) increased to $752,575,000 in the first nine months of 2006, or a 9.5% increase, from $687,363,000 in the first nine months of 2005. The most significant increases in average deposits by categories were $29,974,000 for interest checking accounts (74.4%), $22,440,000 for certificates of deposit (11.7%), and $17,541,000 (20.8%) for demand deposit accounts. Average money market account balances decreased $10,230,000, or 5.4%, in the first nine months of 2006 as compared to the same period in 2005, as some depositors’ have moved balances to higher-rate certificates of deposit or withdrawn funds to invest in equities. Most of the increase in interest checking balances is attributable to one local governmental customer, for which the Corporation became the primary depository institution in September 2005. In addition, the

acquisition of First State Bank contributed significantly to the increase in average deposits in 2006 compared to 2005. Excluding First State Bank, average total deposits increased 4.9% in 2006 compared to 2005.

The combined average total short-term and long-term borrowed funds decreased $60,527,000 to $246,069,000 in the first nine months of 2006 from $306,596,000 in the first nine months of 2005. Throughout most of 2005 and 2006, the yield curve has been flat or inverted, limiting opportunities for the Corporation to earn a positive spread over interest costs associated with maintaining borrowed funds. Accordingly, the Corporation has been paying off borrowings as they mature, or rolling them over at terms of less than one year. The pace of such changes or trends is reflected in the Corporation’s consolidated balance sheet, as total short-term borrowings increased to $63,479,000 at September 30, 2006 from $34,734,000 at December 31, 2005, while total long-term borrowings decreased to $168,470,000 at September 30, 2006 from $232,205,000 at December 31, 2005.

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%.