Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
x Quarterly Report pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934
for the Quarterly Period Ended June 30, 2010.
o Transition report pursuant to Section 13 or 15 (d) of the Exchange Act
for the Transition Period from to .
No. 0-17077
(Commission File Number)
PENNS WOODS BANCORP, INC.
(Exact name of Registrant as specified in its charter)
PENNSYLVANIA
23-2226454
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification No.)
300 Market Street, P.O. Box 967 Williamsport, Pennsylvania
17703-0967
(Address of principal executive offices)
(Zip Code)
(570) 322-1111
Registrant’s telephone number, including area code
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 o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES o NO o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o
Accelerated filer x
Non-accelerated filer o
Small reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES o NO x
On August 5, 2010 there were 3,833,849 shares of the Registrant’s common stock outstanding.
INDEX TO QUARTERLY REPORT ON FORM 10-Q
Page
Number
Part I
Financial Information
Item 1.
Financial Statements
Consolidated Balance Sheet (unaudited) as of June 30, 2010 and December 31, 2009
3
Consolidated Statement of Income (unaudited) for the Three and Six Months ended June 30, 2010 and 2009
4
Consolidated Statement of Changes in Shareholders’ Equity (unaudited) for the Six Months ended June 30, 2010 and 2009
5
Consolidated Statement of Comprehensive Income (unaudited) for the Three and Six Months ended June 30, 2010 and 2009
Consolidated Statement of Cash Flows (unaudited) for the Six Months ended June 30, 2010 and 2009
6
Notes to Consolidated Financial Statements (unaudited)
7
Item 2.
Management’s Discussion and Analysis of Financial Conditionand Results of Operations
22
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
40
Item 4.
Controls and Procedures
Part II
Other Information
Legal Proceedings
41
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
(Removed and Reserved)
Item 5.
Item 6.
Exhibits
42
Signatures
43
Exhibit Index and Exhibits
44
2
Part I. FINANCIAL INFORMATION
Item 1. Financial Statements
CONSOLIDATED BALANCE SHEET
(UNAUDITED)
June 30,
December 31,
(In Thousands, Except Share Data)
2010
2009
ASSETS:
Noninterest-bearing balances
$
12,378
13,760
Interest-bearing deposits in other financial institutions
11,963
28
Total cash and cash equivalents
24,341
13,788
Investment securities, available for sale, at fair value
225,625
208,768
Investment securities held to maturity (fair value of $83 and $108)
82
107
Loans held for sale
5,584
4,063
Loans
411,960
405,529
Less: Allowance for loan losses
5,047
4,657
Loans, net
406,913
400,872
Premises and equipment, net
7,966
7,988
Accrued interest receivable
3,673
3,523
Bank-owned life insurance
15,188
14,942
Investment in limited partnerships
4,615
4,898
Goodwill
3,032
Deferred tax asset
8,399
9,491
Other assets
4,873
4,732
TOTAL ASSETS
710,291
676,204
LIABILITIES:
Interest-bearing deposits
442,002
417,388
Noninterest-bearing deposits
87,979
79,899
Total deposits
529,981
497,287
Short-term borrowings
14,209
18,354
Long-term borrowings, Federal Home Loan Bank (FHLB)
86,778
Accrued interest payable
900
1,073
Other liabilities
7,820
5,796
TOTAL LIABILITIES
639,688
609,288
SHAREHOLDERS’ EQUITY
Common stock, par value $8.33, 10,000,000 shares authorized; 4,014,272 and 4,011,985 shares issued
33,452
33,443
Additional paid-in capital
18,032
18,008
Retained earnings
28,910
27,218
Accumulated other comprehensive loss:
Net unrealized loss on available for sale securities
(1,561
)
(3,569
Defined benefit plan
(1,920
Less: Treasury stock at cost, 180,596 and 179,028 shares
(6,310
(6,264
TOTAL SHAREHOLDERS’ EQUITY
70,603
66,916
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
See accompanying notes to the unaudited consolidated financial statements.
CONSOLIDATED STATEMENT OF INCOME
Three Months Ended
Six Months Ended
(In Thousands, Except Per Share Data)
INTEREST AND DIVIDEND INCOME:
Loans including fees
6,398
6,349
12,728
12,568
Investment securities:
Taxable
1,405
1,374
2,754
2,737
Tax-exempt
1,270
1,249
2,528
2,495
Dividend and other interest income
51
103
130
TOTAL INTEREST AND DIVIDEND INCOME
9,124
9,013
18,113
17,930
INTEREST EXPENSE:
Deposits
1,551
2,204
3,261
4,209
56
78
120
236
Long-term borrowings, FHLB
927
926
1,844
1,843
TOTAL INTEREST EXPENSE
2,534
3,208
5,225
6,288
NET INTEREST INCOME
6,590
5,805
12,888
11,642
PROVISION FOR LOAN LOSSES
400
186
700
312
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES
6,190
5,619
12,188
11,330
NON-INTEREST INCOME:
Service charges
537
541
1,047
1,066
Securities gains (losses), net
(2,086
53
(4,455
Earnings on bank-owned life insurance
128
112
299
274
Gain on sale of loans
330
512
221
Insurance commissions
273
347
701
Other
684
591
1,256
1,025
TOTAL NON-INTEREST INCOME
2,008
(392
3,704
(1,168
NON-INTEREST EXPENSE:
Salaries and employee benefits
2,615
2,595
5,352
5,077
Occupancy, net
313
318
644
657
Furniture and equipment
322
306
626
613
Pennsylvania shares tax
169
172
338
343
Amortization of investment in limited partnerships
141
283
1,430
1,353
2,733
2,557
TOTAL NON-INTEREST EXPENSE
4,990
4,885
9,976
9,530
INCOME BEFORE INCOME TAX PROVISION (BENEFIT)
342
5,916
632
INCOME TAX PROVISION (BENEFIT)
436
(490
696
(1,039
NET INCOME
2,772
832
5,220
1,671
NET INCOME PER SHARE - BASIC
0.72
0.22
1.36
0.44
NET INCOME PER SHARE - DILUTED
WEIGHTED AVERAGE SHARES OUTSTANDING - BASIC
3,834,164
3,832,520
3,834,230
3,832,135
WEIGHTED AVERAGE SHARES OUTSTANDING - DILUTED
3,834,291
3,832,596
3,834,370
3,832,173
DIVIDENDS PER SHARE
0.46
0.92
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
ACCUMULATED
COMMON
ADDITIONAL
OTHER
TOTAL
STOCK
PAID-IN
RETAINED
COMPREHENSIVE
TREASURY
SHAREHOLDERS’
SHARES
AMOUNT
CAPITAL
EARNINGS
INCOME (LOSS)
EQUITY
Balance, December 31, 2008
4,010,528
33,421
17,959
28,177
(12,266
61,027
Comprehensive income:
Net income
Other comprehensive income
2,163
Dividends declared, ($0.92 per share)
(3,526
Common shares issued for employee stock purchase plan
1,457
12
24
36
Balance, June 30, 2009
4,011,985
33,433
17,983
26,322
(10,103
61,371
Balance, December 31, 2009
4,013,142
(5,489
(3,528
1,130
9
33
Purchase of treasury stock (1,568 shares)
(46
Balance, June 30, 2010
4,014,272
(3,481
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
Three Months Ended June 30,
Six Months Ended June 30,
(In Thousands)
Net Income
Other Comprehensive income:
Change in unrealized gain (loss) on available for sale securities
3,520
3,095
(1,178
Less: Reclassification adjustment for net gains (losses) included in net income
Other comprehensive income before tax expense
2,501
5,606
3,042
3,277
Income tax expense related to other comprehensive income
850
1,906
1,034
1,114
Other comprehensive income, net of tax
1,651
3,700
Comprehensive income
4,423
4,532
7,228
3,834
CONSOLIDATED STATEMENT OF CASH FLOWS
OPERATING ACTIVITIES:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
385
364
Provision for loan losses
Accretion and amortization of investment security discounts and premiums
(1,088
(518
Securities (gains) losses, net
(53
4,455
Originations of loans held for sale
(22,939
(10,202
Proceeds of loans held for sale
21,930
9,450
(512
(221
(299
(274
Other, net
665
(1,327
Net cash provided by operating activities
4,009
3,710
INVESTING ACTIVITIES
Investment securities available for sale:
Proceeds from sales
430
4,682
Proceeds from calls and maturities
10,573
5,132
Purchases
(22,486
(9,955
Investment securities held to maturity:
26
Net increase in loans
(6,773
(11,501
Acquisition of bank premises and equipment
(363
(155
Proceeds from the sale of foreclosed assets
79
—
Purchase of bank-owned life insurance
(32
(42
Proceeds from bank-owned life insurance death benefit
Investment in limited partnership
(738
Purchases of regulatory stock
(170
Net cash used for investing activities
(18,464
(12,721
FINANCING ACTIVITIES
Net increase in interest-bearing deposits
24,614
75,159
Net increase (decrease) in noninterest-bearing deposits
8,080
(1,526
Net decrease in short-term borrowings
(4,145
(59,066
Dividends paid
Issuance of common stock
Purchase of treasury stock
Net cash provided by financing activities
25,008
11,077
NET INCREASE IN CASH AND CASH EQUIVALENTS
10,553
2,066
CASH AND CASH EQUIVALENTS, BEGINNING
16,581
CASH AND CASH EQUIVALENTS, ENDING
18,647
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Interest paid
5,398
6,385
Income taxes paid
1,600
1,175
Transfer of loans to foreclosed real estate
32
614
PENNS WOODS BANCORP, INC. AND SUBSIDIARIES
NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1. Basis of Presentation
The consolidated financial statements include the accounts of Penns Woods Bancorp, Inc. (the “Company”) and its wholly-owned subsidiaries: Woods Investment Company, Inc., Woods Real Estate Development Company, Inc., and Jersey Shore State Bank (the “Bank”) and its wholly-owned subsidiary, The M Group, Inc. D/B/A The Comprehensive Financial Group (“The M Group”). All significant inter-company balances and transactions have been eliminated in the consolidation.
The interim financial statements are unaudited but, in the opinion of management, reflect all adjustments necessary for the fair presentation of results for such periods. The results of operations for any interim period are not necessarily indicative of results for the full year. These financial statements should be read in conjunction with the financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.
The accounting policies followed in the presentation of interim financial results are the same as those followed on an annual basis. These policies are presented on pages 38 through 44 of the Annual Report on Form 10-K for the year ended December 31, 2009.
In reference to the attached financial statements, all adjustments are of a normal recurring nature pursuant to Rule 10-01(b) (8) of Regulation S-X.
Note 2. Recent Accounting Pronouncements
In December 2009, the FASB issued ASU 2009-16, Accounting for Transfer of Financial Assets. ASU 2009-16 provides guidance to improve the relevance, representational faithfulness, and comparability of the information that an entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets. ASU 2009-16 is effective for annual periods beginning after November 15, 2009 and for interim periods within those fiscal years. The adoption of this guidance did not have a material impact on the Company’s financial statements.
In January 2010, the FASB issued ASU 2010-01, Equity (Topic 505): Accounting for Distributions to Shareholders with Components of Stock and Cash — a consensus of the FASB Emerging Issues Task Force. ASU 2010-01 clarifies that the stock portion of a distribution to shareholders that allows them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected in EPS prospectively and is not a stock dividend. ASU 2010-01 is effective for interim and annual periods ending on or after December 15, 2009 and should be
applied on a retrospective basis. The adoption of this guidance did not have a material impact on the Company’s financial statements.
In January 2010, the FASB issued ASU 2010-05, Compensation — Stock Compensation (Topic 718): Escrowed Share Arrangements and the Presumption of Compensation. ASU 2010-05 updates existing guidance to address the SEC staff’s views on overcoming the presumption that for certain shareholders escrowed share arrangements represent compensation. ASU 2010-05 is effective January 15, 2010. The adoption of this guidance did not have a material impact on the Company’s financial statements.
In January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. ASU 2010-06 amends Subtopic 820-10 to clarify existing disclosures, require new disclosures, and includes conforming amendments to guidance on employers’ disclosures about postretirement benefit plan assets. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. The Company has presented the necessary disclosures in Note 4 (Net Periodic Benefit Cost-Defined Benefit Plans) herein.
In February 2010, the FASB issued ASU 2010-08, Technical Corrections to Various Topics. ASU 2010-08 clarifies guidance on embedded derivatives and hedging. ASU 2010-08 is effective for interim and annual periods beginning after December 15, 2009. The adoption of this guidance did not have a material impact on the Company’s financial position or results.
In March 2010, the FASB issued ASU 2010-11, Derivatives and Hedging. ASU 2010-11 provides clarification and related additional examples to improve financial reporting by resolving potential ambiguity about the breadth of the embedded credit derivative scope exception in ASC 815-15-15-8. ASU 2010-11 is effective at the beginning of the first fiscal quarter beginning after June 15, 2010. The adoption of this guidance did not have a material impact on the Company’s financial statements.
In April 2010, the FASB issued ASU 2010-18, Receivables (Topic 310): Effect of a Loan Modification When the Loan is a Part of a Pool That is Accounted for as a Single Asset — a consensus of the FASB Emerging Issues Task Force. ASU 2010-18 clarifies the treatment for a modified loan that was acquired as part of a pool of assets. Refinancing or restructuring the loan does not make it eligible for removal from the pool, the FASB said. The amendment will be effective for loans that are part of an asset pool and are modified during financial reporting periods that end July 15, 2010 or later. The amendment is not expected to have a significant impact on the Company’s financial statements.
In July 2010, FASB issued ASU No. 2010-20, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. ASU 2010-20 is intended to provide additional information to assist financial statement users in assessing an entity’s credit risk exposures and evaluating the adequacy of its allowance for credit losses. The
8
disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. The amendments in ASU 2010-20 encourage, but do not require, comparative disclosures for earlier reporting periods that ended before initial adoption. However, an entity should provide comparative disclosures for those reporting periods ending after initial adoption. The Company is currently evaluating the impact the adoption of this guidance will have on the Company’s financial position or results of operations.
Note 3. Per Share Data
There are no convertible securities which would affect the denominator in calculating basic and dilutive earnings per share. Net income as presented on the consolidated statement of income will be used as the numerator. The following table sets forth the composition of the weighted average common shares (denominator) used in the basic and dilutive per share computation.
Weighted average common shares issued
4,013,892
4,011,548
4,013,610
4,011,163
Average treasury stock shares
(179,728
(179,028
(179,380
Weighted average common shares and common stock equivalents used to calculate basic earnings per share
Additional common stock equivalents (stock options) used to calculate diluted earnings per share
127
76
140
38
Weighted average common shares and common stock equivalents used to calculate diluted earnings per share
Options to purchase 990 shares of common stock at a strike price of $24.72 were outstanding during the six months ended June 30, 2010. The average market price of the Company’s stock was $31.46 for the six months ended June 30, 2010. Options to purchase 990 shares of common stock were outstanding during the six months ended June 30, 2009 but were not included in the computation of diluted earnings per share as they were anti-dilutive due to the strike price range being greater than the average market price for the six months ended June 30, 2009.
Note 4. Net Periodic Benefit Cost-Defined Benefit Plans
For a detailed disclosure on the Company’s pension and employee benefits plans, please refer to Note 12 of the Company’s Consolidated Financial Statements included in the Annual Report on Form 10-K for the year ended December 31, 2009.
The following sets forth the components of the net periodic benefit cost of the domestic non-contributory defined benefit plan for the six months ended June 30, 2010 and 2009, respectively:
Service cost
131
136
263
272
Interest cost
171
170
340
Expected return on plan assets
(160
(127
(321
(254
Amortization of transition obligation
(1
(2
Amortization of prior service cost
13
Amortization of net loss
37
84
73
Net periodic cost
185
270
368
539
The following table sets forth by level, within the fair value hierarchy detailed in Note 8 (Fair Value Measurements), the Plan’s assets at fair value as of June 30, 2010:
June 30, 2010
Level I
Level II
Level III
Total
Assets:
Cash and cash equivalents
206
Mutual funds - taxable fixed income
3,073
Mutual funds - domestic equity
3,351
Mutual funds - international equity
1,138
Total assets at fair value
7,768
Employer Contributions
The Company previously disclosed in its consolidated financial statements, included in the Annual Report on Form 10-K for the year ended December 31, 2009, that it expected to contribute a minimum of $400,000 to its defined benefit plan in 2010. As of June 30, 2010, there were contributions of $244,000 made to the plan.
Note 5. Off Balance Sheet Risk
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments are primarily comprised of commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit, interest rate, or liquidity risk in excess of the amount recognized in the consolidated balance sheet. The contract amounts of these instruments express the extent of involvement the Company has in particular classes of financial instruments.
10
The Company’s exposure to credit loss from nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The Company may require collateral or other security to support financial instruments with off-balance sheet credit risk.
Financial instruments whose contract amounts represent credit risk are as follows at June 30, 2010 and December 31, 2009:
Commitments to extend credit
83,015
80,061
Standby letters of credit
1,341
1,334
Commitments to extend credit are legally binding agreements to lend to customers. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future liquidity requirements. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company, on an extension of credit is based on management’s credit assessment of the counterparty.
Standby letters of credit represent conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These instruments are issued primarily to support bid or performance related contracts. The coverage period for these instruments is typically a one year period with an annual renewal option subject to prior approval by management. Fees earned from the issuance of these letters are recognized upon expiration of the coverage period. For secured letters of credit, the collateral is typically Bank deposit instruments or customer business assets.
Note 6. Reclassification of Comparative Amounts
Certain comparative amounts for the prior period have been reclassified to conform to current period presentations. Such reclassifications had no effect on net income or shareholders’ equity.
Note 7. Employee Stock Purchase Plan
The Company maintains the Penns Woods Bancorp, Inc. 2006 Employee Stock Purchase Plan (“Plan”). The Plan is intended to encourage employee participation in the ownership and economic progress of the Company. The Plan allows for up to 1,000,000 shares to be purchased by employees. The purchase price of the shares is 95% of market value with an employee eligible to purchase up to the lesser of 15% of base compensation or $12,000 in market value annually. During the six months ended June 30, 2010 and 2009, there were 1,130 and 1,457 shares issued under the plan, respectively.
11
Note 8. Fair Value Measurements
The following disclosures show the hierarchal disclosure framework associated with the level of pricing observations utilized in measuring assets and liabilities at fair value.
Level I:
Quoted prices are available in active markets for identical assets or liabilities as of the reported date.
Level II:
Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities include items for which quoted prices are available but traded less frequently, and items that are fair valued using other financial instruments, the parameters of which can be directly observed.
Level III:
Assets and liabilities that have little to no pricing observability as of the reported date. These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.
This hierarchy requires the use of observable market data when available.
The following table presents the assets reported on the balance sheet at their fair value on a recurring basis as of June 30, 2010 and December 31, 2009, by level within the fair value hierarchy. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.
Assets measured on a recurring basis:
Investment securities, available for sale
U.S. Government and agency securities
31,694
State and political securities
161,745
Other debt securties
19,339
Equity securities
12,847
Total assets measured on a recurring basis
212,778
December 31, 2009
Investment securities, available for sale:
39,136
144,877
12,976
11,779
196,989
The following table presents the assets reported on the Consolidated Balance Sheet at their fair value on a non-recurring basis as of June 30, 2010 and December 31, 2009, by level within the fair value hierarchy. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.
Assets Measured on a Non-recurring Basis:
Impaired Loans
7,652
Other real estate owned
616
7,510
672
Note 9. Estimated Fair Value of Financial Instruments
The Company is required to disclose estimated fair values for its financial instruments. Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Also, it is the Company’s general practice and intention to hold most of its financial instruments to maturity and not to engage in trading or sales activities. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current
economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions can significantly affect the estimates.
Estimated fair values have been determined by the Company using historical data and an estimation methodology suitable for each category of financial instruments. The Company’s fair value estimates, methods, and assumptions are set forth below for the Company’s other financial instruments.
As certain assets and liabilities, such as deferred tax assets, premises and equipment, and many other operational elements of the Company, are not considered financial instruments but have value, this estimated fair value of financial instruments would not represent the full market value of the Company.
The estimated fair values of the Company’s financial instruments are as follows at June 30, 2010 and December 31, 2009:
Carrying
Fair
Value
Financial assets:
Available for sale
Held to maturity
83
108
402,225
403,279
Financial liabilities:
435,834
408,056
91,363
89,082
14
Cash and Cash Equivalents, Loans Held for Sale, Accrued Interest Receivable, Short-term Borrowings, and Accrued Interest Payable:
The fair value is equal to the carrying value.
Investment Securities:
The fair value of investment securities available for sale and held to maturity is equal to the available quoted market price. If no quoted market price is available, fair value is estimated using the quoted market price for similar securities. Regulatory stocks’ fair value is equal to the carrying value.
Loans:
Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial real estate, residential real estate, construction real estate, and other consumer. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories.
The fair value of performing loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the Company’s historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions.
Fair value for significant nonperforming loans is based on recent external appraisals. If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and discounted rates are judgmentally determined using available market information and specific borrower information.
Bank-Owned Life Insurance:
The fair value is equal to the cash surrender value of the life insurance policies.
Deposits:
The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings, NOW, and money market accounts, is equal to the amount payable on demand as of June 30, 2010 and December 31, 2009. The fair value of certificates of deposit is based on the discounted value of contractual cash flows.
The fair value estimates above do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market, commonly referred to as the core deposit intangible.
Long Term Borrowings:
The fair value of long term borrowings is based on the discounted value of contractual cash flows.
15
Commitments to Extend Credit, Standby Letters of Credit, and Financial Guarantees Written:
There is no material difference between the notional amount and the estimated fair value of off-balance sheet items at June 30, 2010 and December 31, 2009. The contractual amounts of unfunded commitments and letters of credit are presented in Note 5.
Note 10. Federal Home Loan Bank Stock
The Bank is a member of the Federal Home Loan Bank of Pittsburgh (the “FHLB”), which is one of 12 regional Federal Home Loan Banks. Each Federal Home Loan Bank serves as a reserve or central bank for its members within its assigned region. It is funded primarily from funds deposited by member institutions and proceeds from the sale of consolidated obligations of the Federal Home Loan Bank System. It makes loans to members (i.e., advances) in accordance with policies and procedures established by the board of directors of the Federal Home Loan Bank. As a member, the Bank is required to purchase and maintain stock in the FHLB in an amount equal to the greater of 1% of its aggregate unpaid residential mortgage loans, home purchase contracts or similar obligations at the beginning of each year or 5% of its outstanding advances from the FHLB. At June 30, 2010, the Bank held $7,271,300 in stock of the FHLB, which was in compliance with this requirement.
The Company evaluated its holding of FHLB stock for impairment and deemed the stock to not be impaired due to the expected recoverability of the par value, which equals the value reflected within the Company’s financial statements. The decision was based on several items ranging from the estimated true economic losses embedded within the FHLB’s mortgage portfolio to the FHLB’s liquidity position and credit rating. The Company utilizes the impairment framework outlined in GAAP to evaluate FHLB stock for impairment.
The following factors were evaluated to determine the ultimate recoverability of the par value of the Company’s FHLB stock holding; (i) the significance of the decline in net assets of the FHLB as compared to the capital stock amount for the FHLB and the length of time this situation has persisted; (ii) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB; (iii) the impact of legislative and regulatory changes on the institutions and, accordingly, on the customer base of the FHLB; (iv) the liquidity position of the FHLB; and (v) whether a decline is temporary or whether it affects the ultimate recoverability of the FHLB stock based on (a) the materiality of the carrying amount to the member institution and (b) whether an assessment of the institution’s operational needs for the foreseeable future allow management to dispose of the stock.
Based on its analysis of these factors, the Company determined that its holding of FHLB stock was not impaired on June 30, 2010.
16
Note 11. Investment Securities
The amortized cost and estimated fair values of investment securities at June 30, 2010 and December 31, 2009 are as follows:
Gross
Amortized
Unrealized
Cost
Gains
Losses
Available for sale (AFS)
29,335
2,359
167,860
1,623
(7,738
Other debt securities
18,868
641
Total debt securities
216,063
4,623
(7,908
11,927
1,163
(243
Total investment securities AFS
227,990
5,786
(8,151
Held to maturity (HTM)
1
77
Total investment securities HTM
37,038
2,098
153,914
733
(9,770
12,271
834
(129
203,223
3,665
(9,899
10,952
981
(154
214,175
4,646
(10,053
101
102
17
The following tables show the Company’s gross unrealized losses and fair value, aggregated by investment category and length of time, that the individual securities have been in a continuous unrealized loss position, at June 30, 2010 and December 31, 2009.
Less than Twelve Months
Twelve Months or Greater
36,129
1,593
35,452
6,145
71,581
7,738
6,537
58
1,013
7,550
42,666
36,465
6,257
79,131
7,908
1,119
167
496
1,615
243
43,785
1,818
36,961
6,333
80,746
8,151
60,005
2,336
36,267
7,434
96,272
9,770
1,191
129
37,458
7,563
97,463
9,899
159
27
918
1,077
154
60,164
2,363
38,376
7,690
98,540
10,053
18
At June 30, 2010 there were a total of 79 and 99 individual securities that were in a continuous unrealized loss position for less than twelve months and greater than twelve months, respectively.
The Company reviews its position quarterly and has determined that, at June 30, 2010, the declines outlined in the above table represent temporary declines and the Company does not intend to sell and does not believe they will be required to sell these securities before recovery of their cost basis, which may be at maturity. There were 178 positions that were temporarily impaired at June 30, 2010. The Company has concluded that the unrealized losses disclosed above are not other than temporary but are the result of interest rate changes, sector credit ratings changes, or company-specific ratings changes that are not expected to result in the non-collection of principal and interest during the period.
The amortized cost and estimated fair value of debt securities at June 30, 2010, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities since borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Available for Sale
Held to Maturity
Fair Value
Due in one year or less
1,004
1,011
25
Due after one year to five years
17,073
17,682
52
Due after five years to ten years
4,261
3,986
Due after ten years
193,725
190,099
Total gross proceeds from sales of securities available for sale were $430,000 and $4,682,000, for June 30, 2010 and 2009, respectively. The following table represents gross realized gains and losses on those transactions:
Gross realized gains:
162
Total gross realized gains
62
166
Gross realized losses:
4,584
Total gross realized losses
4,621
19
Gross realized losses for the equity securities portfolio include impairment charges of $0 and $4,584,000 for the six months ended June 30, 2010 and 2009, respectively.
Note 12. Loans
The allocation of the loan portfolio, by delinquency status, as of June 30, 2010 and December 31, 2009 is presented below:
Past Due
90 Days
Or More
30 To 89
& Still
Non-
Current
Days
Accruing
Accrual
Commercial and agricultural
54,379
100
54,502
Real estate mortgage:
Residential
170,191
1,742
332
952
173,217
Commercial
147,593
1,886
1,950
151,429
Construction
19,589
97
3,386
23,072
Installment loans to individuals
10,658
99
10,761
402,410
3,924
348
6,299
412,981
Less:
Net deferred loan fees
1,021
Allowance for loan losses
396,342
30 To 90
45,930
457
182
46,647
165,313
7,333
951
749
174,346
147,455
2,860
1,429
465
152,209
18,247
2,992
556
21,795
11,192
311
11,549
388,137
13,953
2,565
1,891
406,546
1,017
382,463
The recorded investment in loans for which impairment has been recognized amounted to $8,621,000 at June 30, 2010, compared to $8,312,000 at December 31, 2009. The valuation allowance related to impaired loans amounted to $969,000 at June 30, 2010 and $802,000 at December 31, 2009. The increase in impaired loans and valuation allowance is primarily from a few commercial relationships.
A loan is considered impaired, based on current information and events, if it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.
20
CAUTIONARY STATEMENT FOR PURPOSES OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995
This Report contains certain “forward-looking statements” including statements concerning plans, objectives, future events or performance and assumptions and other statements which are other than statements of historical fact. The Company cautions readers that the following important factors, among others, may have affected and could in the future affect the Company’s actual results and could cause the Company’s actual results for subsequent periods to differ materially from those expressed in any forward-looking statement made by or on behalf of the Company herein: (i) the effect of changes in laws and regulations, including federal and state banking laws and regulations, with which the Company must comply, and the associated costs of compliance with such laws and regulations either currently or in the future as applicable; (ii) the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies as well as by the Financial Accounting Standards Board, or of changes in the Company’s organization, compensation and benefit plans; (iii) the effect on the Company’s competitive position within its market area of the increasing consolidation within the banking and financial services industries, including the increased competition from larger regional and out-of-state banking organizations as well as non-bank providers of various financial services; (iv) the effect of changes in interest rates; and (v) the effect of changes in the business cycle and downturns in the local, regional or national economies.
You should not put undue reliance on any forward-looking statements. These statements speak only as of the date of this Quarterly Report on Form 10-Q, even if subsequently made available by the Company on its website or otherwise. The Company undertakes no obligation to update or revise these statements to reflect events or circumstances occurring after the date of this Quarterly Report on Form 10-Q.
21
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operation
EARNINGS SUMMARY
Comparison of the Three and Six Months Ended June 30, 2010 and 2009
Summary Results
Net income for the three months ended June 30, 2010 was $2,772,000 compared to $832,000 for the same period of 2009 as after-tax securities losses decreased $1,413,000 (from a loss of $1,376,000 to a gain of $37,000). Included within the change in after-tax securities losses for the three months ended June 30, 2009 was an other than temporary impairment charge relating to certain equity securities held in the investment portfolio of $2,251,000. Basic and diluted earnings per share for the three months ended June 30, 2010 were $0.72 compared to $0.22 for the three months ended June 30, 2009. Return on average assets and return on average equity were 1.58% and 15.76% for the three months ended June 30, 2010 compared to 0.51% and 5.45% for the corresponding period of 2009. Net income from core operations (“operating earnings”) increased to $2,735,000 for the three months ended June 30, 2010 compared to $2,208,000 for the same period of 2009. Operating earnings per share for the three months ended June 30, 2010 were $0.71 basic and dilutive compared to $0.58 basic and dilutive for the three months ended June 30, 2009.
The six months ended June 30, 2010 generated net income of $5,220,000 compared to $1,671,000 for the same period of 2009. Comparable results were impacted by a decrease in after-tax securities losses of $2,975,000 (from a loss of $2,940,000 for the 2009 period to a gain of $35,000 for the 2010 period). Earnings per share, basic and diluted, for the six months ended June 30, 2010 were $1.36 as compared to $0.44 for the comparable period of 2009. Return on average assets and return on average equity were 1.50% and 15.05% for the six months ended June 30, 2010 compared to 0.51% and 5.54% for the corresponding period of 2009. Operating earnings increased 12.4% to $5,185,000 for the six months ended June 30, 2010 compared to $4,611,000 for the comparable period of 2009, resulting in basic and dilutive operating earnings per share increasing 12.5% to $1.35 from $1.20 for the six month periods ended June 30, 2010 and 2009, respectively.
Management uses the non-GAAP measure of net income from core operations, or operating earnings, in its analysis of the Company’s performance. This measure, as used by the Company, adjusts net income by excluding significant gains or losses that are unusual in nature. Because certain of these items and their impact on the Company’s performance are difficult to predict, management believes the presentation of financial measures excluding the impact of such items provides useful supplemental information in evaluating the operating results of the Company’s core businesses. For purposes of this Quarterly Report on Form 10-Q, net income from core operations, or operating earnings, means net income adjusted to exclude after-tax net securities gains or losses. These disclosures should not be viewed as a substitute for net income determined in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies.
Reconciliation of GAAP and non-GAAP Income
(Dollars in Thousands, Except Per Share Data)
GAAP net income
Less: securities gains (losses), net of tax
(1,376
35
(2,940
Non-GAAP operating earnings
2,735
2,208
5,185
4,611
Return on average assets (ROA)
1.58
%
0.51
1.50
0.02
-0.83
0.01
-0.90
Non-GAAP operating ROA
1.56
1.34
1.49
1.41
Return on average equity (ROE)
15.76
5.45
15.05
5.54
0.21
-9.01
0.10
-9.76
Non-GAAP operating ROE
15.55
14.46
14.95
15.30
Basic earnings per share (EPS)
(0.36
(0.76
Non-GAAP basic operating EPS
0.71
0.58
1.35
1.20
Dilutive EPS
Non-GAAP dilutive operating EPS
Interest and Dividend Income
Interest and dividend income for the three months ended June 30, 2010 increased $111,000 to $9,124,000 compared to $9,013,000 for the same period of 2009. The increase in interest income was led by an increase in loan interest resulting from growth in the average gross loan portfolio of $23,480,000. The growth offset a decline in the average taxable equivalent yield of 31 basis points (“bp”) caused by the low interest rate environment that has existed over the past year. The increase in investment portfolio income was the result of portfolio growth that offset a decline of 30 bp in yield.
During the six months ended June 30, 2010, interest and dividend income was $18,113,000, an increase of $183,000 over the same period in 2009. Interest income on the loan portfolio
23
increased as the growth in the portfolio countered a 28 bp decline in average yield. The investment portfolio interest income remained steady as the increase in portfolio size was offset by a decline in yield and a reduction in dividends received. The reduced level of dividend income is the result of a decreased level of equity investment and general decline in dividends paid by the holdings in our portfolio.
Interest and dividend income composition for the three and six months ended June 30, 2010 and 2009 was as follows:
For The Three Months Ended
June 30, 2009
Change
Amount
% Total
70.1
70.4
49
0.8
15.4
15.2
31
2.3
13.9
1.7
0.6
0.5
24.4
Total interest and dividend income
100.0
111
1.2
For The Six Months Ended
70.3
160
1.3
15.3
0.7
(27
(20.8
183
1.0
Interest Expense
Interest expense for the three months ended June 30, 2010 decreased $674,000 to $2,534,000 compared to $3,208,000 for the same period of 2009. The substantial decrease associated with deposits is primarily the result of a reduction of 76 bp in rate paid and a shift from higher cost time deposits to core deposits. Factors that led to the rate decreases include, but are not limited to, Federal Open Market Committee (“FOMC”) interest rate actions and campaigns conducted by the Company during the past two years to attract short-term CDs resulting in an increased repricing frequency. In addition, the Marcellus Shale natural gas exploration in north central Pennsylvania is creating opportunities to create new and build upon existing deposit relationships. Short-term borrowings interest expense decreased as the average balance of such borrowings decreased with current short-term borrowings consisting solely of customer repurchase agreements. Long-term borrowing interest expense remained stable, as there have been no changes to the composition of long-term borrowings.
Interest expense for the six months ended June 30, 2010 decreased 16.9% from the same period of 2009. The reasons noted for the decline in interest expense for the three month period comparison also apply to the six month period.
Interest expense composition for the three and six months ended June 30, 2010 and 2009 was as follows:
61.2
68.7
(653
(29.6
)%
2.2
2.4
(22
(28.2
36.6
28.9
0.1
Total interest expense
(674
(21.0
62.4
66.9
(948
(22.5
3.8
(116
(49.2
35.3
29.3
(1,063
(16.9
Net Interest Margin
The net interest margin (“NIM”) for the three months ended June 30, 2010 was 4.56% compared to 4.36% for the corresponding period of 2009. The increase in the NIM was driven by a 63 bp decline in the rate paid on interest bearing liabilities that more than compensated for a 40 bp decline in the yield on interest earning assets. The decrease in earning asset yield is due to the impact on the loan and investment portfolios of the current low rate environment. The decrease in the cost of interest bearing liabilities to 1.87% from 2.50% was driven by a reduction in the rate paid on time deposits of 75 bp. The reduction in the rate paid on time deposits was the result of a shortening of the time deposit portfolio that has resulted in an increasing repricing frequency during this period of decreasing rates. The duration of the time deposit portfolio has been lengthening due to the apparent bottoming or near bottoming of deposit rates.
The NIM for the six months ended June 30, 2010 was 4.52% compared to 4.42% for the same period of 2009. The impact of the items mentioned in the three month discussion also applies to the six month period. A 77 bp decline in the rate paid on time deposits served as the foundation for a 71 bp decline in rate paid on deposits, while the FOMC and general market actions affected the yield on earning assets and cost of borrowings.
The following is a schedule of average balances and associated yields for the three and six months ended June 30, 2010 and 2009:
AVERAGE BALANCES AND INTEREST RATES
Average Balance
Interest
Average Rate
Tax-exempt loans
18,750
6.67
16,934
271
6.42
All other loans
398,988
6,192
6.22
377,324
6,170
6.56
Total loans
417,738
6,504
6.24
394,258
6,441
6.55
Taxable securities
112,538
1,454
5.17
101,984
1,415
5.55
Tax-exempt securities
108,011
1,924
7.13
103,848
1,892
7.29
Total securities
220,549
3,378
6.13
205,832
3,307
6.43
8,938
0.09
1,371
0.00
Total interest-earning assets
647,225
9,884
6.12
601,461
9,748
6.52
54,681
55,793
Total assets
701,906
657,254
Liabilities and shareholders’ equity:
Savings
65,483
45
0.28
61,383
81
0.53
Super Now deposits
64,931
92
0.57
56,645
0.93
Money market deposits
101,361
291
1.15
64,374
367
2.29
Time deposits
209,344
1,123
2.15
224,918
1,625
2.90
Total interest-bearing deposits
441,119
407,320
2.17
12,306
1.82
18,035
1.73
4.23
4.22
Total borrowings
99,084
983
3.92
104,813
3.79
Total interest-bearing liabilities
540,203
1.87
512,133
2.50
Demand deposits
83,205
73,930
8,150
10,113
Shareholders’ equity
70,348
61,078
Total liabilities and shareholders’ equity
Interest rate spread
4.25
4.02
Net interest income/margin
7,350
4.56
6,540
4.36
1. Information on this table has been calculated using average daily balance sheets to obtain average balances.
2. Nonaccrual loans have been included with loans for the purpose of analyzing net interest earnings.
3. Income and rates on a fully taxable equivalent basis include an adjustment for the difference between annual income from tax-exempt obligations and the taxable equivalent of such income at the standard 34% tax rate.
18,018
604
6.76
16,420
538
6.61
397,018
12,329
6.26
375,687
12,213
415,036
12,933
6.28
392,107
12,751
109,607
2,854
5.21
101,937
2,867
5.63
107,515
3,830
7.12
102,757
3,780
7.36
217,122
6,684
6.16
204,694
6,647
6.49
Interest bearing deposits
8,257
0.07
640,415
19,620
597,501
19,398
6.53
54,988
55,459
695,403
652,960
63,891
0.31
60,517
63,994
201
0.63
55,276
260
0.95
94,313
579
1.24
52,888
580
2.21
214,749
2,384
2.24
215,069
3,210
3.01
436,947
383,750
13,518
1.79
39,641
1.19
100,296
1,964
3.90
126,419
2,079
3.27
537,243
1.95
510,169
2.48
80,636
72,633
8,142
9,870
69,382
60,288
4.21
4.05
14,395
4.52
13,110
4.42
The following table presents the adjustment to convert net interest income to net interest income on a fully taxable equivalent basis for the three and six months ended June 30, 2010 and 2009.
For the Three Months Ended
For the Six Months Ended
Total interest income
Net interest income
Tax equivalent adjustment
760
735
1,507
1,468
Net interest income (fully taxable equivalent)
The following table sets forth the respective impact that both volume and rate changes have had on net interest income on a fully taxable equivalent basis for the three and six month periods ended June 30, 2010 and 2009:
2010 vs 2009
Increase (Decrease)
Due to
Volume
Rate
Net
Interest income:
Loans, tax-exempt
30
39
66
1,360
(1,338
999
(883
116
Taxable investment securities
491
(452
773
(786
(13
Tax-exempt investment securities
238
(206
(193
50
2,121
(1,985
2,057
(1,835
222
Interest expense:
Savings deposits
34
(70
(36
(78
(62
(140
(39
65
(124
(59
744
(820
(76
493
(494
(106
(396
(502
(5
(821
(826
(48
(200
725
(1,399
369
(1,432
Change in net interest income
1,396
(586
810
1,688
(403
1,285
Provision for Loan Losses
The provision for loan losses is based upon management’s quarterly review of the loan portfolio. The purpose of the review is to assess loan quality, identify impaired loans, analyze delinquencies, ascertain loan growth, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets served. An external independent loan review is also performed annually for the Bank. Management remains committed to an aggressive program of problem loan identification and resolution.
The allowance for loan losses is determined by applying loss factors to outstanding loans by type, excluding loans for which a specific allowance has been determined. Loss factors are based on management’s consideration of the nature of the portfolio segments, changes in mix and volume of the loan portfolio, and historical loan loss experience. In addition, management considers industry standards and trends with respect to non-performing loans and its knowledge and experience with specific lending segments.
Although management believes it uses the best information available to make such determinations and that the allowance for loan losses is adequate at June 30, 2010, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making the initial determinations. A downturn in the local economy, increased unemployment, and delays in receiving financial information from borrowers could result in increased levels of nonperforming assets, charge-offs, loan loss provisions, and reductions in income. Additionally, as an integral part of the examination process, bank regulatory agencies periodically review the Bank’s loan loss allowance. The banking agencies could require the recognition of additions to the loan loss allowance based on their judgment of information available to them at the time of their examination.
While determining the appropriate allowance level, management has attributed the allowance for loan losses to various portfolio segments; however, the allowance is available for the entire portfolio as needed.
The allowance for loan losses increased from $4,657,000 at December 31, 2009 to $5,047,000 at June 30, 2010. At June 30, 2010 and December 31, 2009, the allowance for loan losses to total loans was 1.23% and 1.15%, respectively.
The provision for loan losses totaled $400,000 and $700,000 for the three and six months ended June 30, 2010, compared to $186,000 and $312,000 for the same periods in 2009. The amount of the increase in the provision was the result of several factors, including but not limited to, an increase in gross loans of $19,886,000 since June 30, 2009, a ratio of annualized net charge-offs to average loans of 0.15% for the six months ended June 30, 2010, a ratio of nonperforming loans to total loans of 1.61% at June 30, 2010, and a ratio of the allowance for loan losses to nonperforming loans of 75.94% at June 30, 2010. Nonperforming loans increased to $6,646,000 at June 30, 2010 from $4,456,000 at December 31, 2009 due to a commercial real estate loan being changed to nonaccrual status. Internal loan review and analysis and the continued uncertainty surrounding the economy, coupled with the ratios noted previously, dictated an increase in the provision for loan losses. The increase did not equate to the change in charge-offs and nonperforming loans due to the economic situation and the collateral status of the nonperforming loans and overall loan portfolio in general, which limits the loan specific allocation of the allowance for loan losses.
Following is a table showing the changes in the allowance for loan losses for the six months ended June 30, 2010 and 2009:
29
Balance at beginning of period
4,356
Charge-offs:
Real estate
192
Commercial and industrial
261
64
70
90
Total charge-offs
384
346
Recoveries:
47
Total recoveries
74
55
Net charge-offs
310
Additions charged to operations
Balance at end of period
4,377
Ratio of net annualized charge-offs during the period to average loans outstanding during the period
0.15
Following is a table showing the changes in total nonperforming loans as of:
Total Nonperforming Loans
Nonaccrual
6,646
March 31, 2010
3,703
3,863
4,456
September 30, 2009
1,448
4,396
5,844
2,089
578
2,667
Loans not included above which are troubled debt restructurings, totaled $744,000, $426,000, and $0 at June 30, 2010, December 31, 2009, and June 30, 2009, respectively.
Non-interest Income
Total non-interest income for the three months ended June 30, 2010 compared to the same period in 2009 increased $2,400,000 to $2,008,000 due to a $2,142,000 decrease in net securities losses. Excluding net securities gains and losses, non-interest income for the second quarter of 2010 would have increased $258,000 compared to the 2009 period. Deposit service charges decreased minimally as overdraft fee income decreased slightly, in addition to customers migrating to no service charge checking accounts that were introduced in previous periods as part of customer acquisition and retention programs. Gain on sale of loans provided the primary increase in non-interest income. The significant increase was primarily the result of increased volume attributed to the home buyer tax credit.
Insurance commissions for the three months ended June 30, 2010 decreased due to a softening market and shift in product mix. Management of The M Group continues to pursue new and
build upon current relationships. The sales call program continues to expand to other financial institutions, which results in additional revenue for The M Group if another sales outlet is added. However, the addition of another sales outlet for The M Group can take up to a year or more to be completed.
Total non-interest income for the six months ended June 30, 2010 compared to the same period in 2009 increased $4,872,000. Excluding net securities gains, non-interest income would have increased $364,000 compared to the 2009 period. The increase in non-interest income for the six month period is the result of the same items noted in the three month discussion.
Non-interest income composition for the three and six months ended June 30, 2010 and 2009 was as follows:
Deposit service charges
26.7
(138.0
(4
(0.7
2.8
532.1
2,142
102.7
Bank owned life insurance
6.4
(28.6
14.3
16.4
(26.3
227
220.4
13.6
(88.5
(74
(21.3
34.1
(150.7
93
15.7
Total non-interest income
2,400
(612.2
28.3
(91.3
(19
(1.8
1.4
381.5
4,508
101.2
8.1
(23.5
9.1
13.8
(18.9
131.7
14.5
(60.0
(164
(23.4
33.9
(87.8
231
22.5
4,872
(417.1
Non-interest Expense
Total non-interest expense increased $105,000 for the three months ended June 30, 2010 compared to the same period of 2009. The increase in salaries and employee benefits was attributable to several items including standard cost of living wage adjustments for employees, increased pension expense, and other benefit costs. Other expenses increased primarily due to normal anticipated inflationary adjustments to ongoing business operating costs.
Total non-interest expense increased $446,000 for the six months ended June 30, 2010 compared to the same period of 2009. The increase in non-interest expense for the six month period is the result of the same items noted in the three month discussion.
Non-interest expense composition for the six months ended June 30, 2010 and 2009 was as follows:
52.4
53.1
6.3
6.5
(1.6
5.2
3.4
3.5
(3
(1.7
2.9
28.6
27.7
5.7
Total non-interest expense
105
2.1
53.6
53.3
275
5.4
6.9
(2.0
3.6
(1.5
3.0
27.4
26.8
176
446
4.7
Provision for Income Taxes
Income taxes increased $926,000 and $1,735,000 for the three and six months ended June 30, 2010 compared to the same period of 2009. The primary cause of the changes in tax expense is the impact of net securities losses in the three and six month periods of 2009. Excluding the impact of the net securities gains and losses, the effective tax rate for the three and six months ended June 30, 2010 was 13.23% and 11.36% compared to 9.02% and 9.36% for the same period of 2009. The Company currently is in a deferred tax asset position due to the low income housing tax credits earned both currently and previously. Management has reviewed the deferred tax asset and has determined that the asset will be utilized within the appropriate carry forward period and therefore does not require a valuation allowance.
ASSET/LIABILITY MANAGEMENT
Cash and Cash Equivalents
Cash and cash equivalents increased $10,553,000 from $13,788,000 at December 31, 2009 to $24,341,000 at June 30, 2010 primarily as a result of the following activities during the six months ended June 30, 2010:
Loans Held for Sale
Activity regarding loans held for sale resulted in loan originations exceeding sale proceeds, less $512,000 in realized gains, by $1,521,000 for the six months ended June 30, 2010.
Gross loans increased $6,431,000 since December 31, 2009 due primarily to an increase of non-real estate and construction loans, which was partially offset by a decrease in residential and commercial real estate loans.
The allocation of the loan portfolio, by category, as of June 30, 2010 and December 31, 2009 is presented below:
Commercial, financial and agricultural
13.2
11.5
7,855
16.8
42.0
43.1
(1,129
(0.6
36.8
37.5
(780
(0.5
5.6
1,277
5.9
2.6
(788
(6.8
Less: Net deferred loan fees
(0.2
(0.3
0.4
Gross loans
6,431
1.6
Investments
The estimated fair value of the investment securities portfolio at June 30, 2010 has increased $16,832,000 since December 31, 2009. The change is primarily due to purchases of state and political securities and short-term corporate securities as the level of net unrealized losses remained constant. The unrealized losses within the debt securities portfolio are the result of market activity, not credit issues/ratings, as approximately 90% of the debt securities portfolio is currently rated A or higher by either S&P or Moody’s.
The Company considers various factors, which include examples from applicable accounting guidance, when analyzing the available for sale portfolio for possible other than temporary impairment. The Company primarily considers the following factors in its analysis: length of time and severity of the market value being less than carrying value, reduction of dividend paid (equities), continued payment of dividend/interest, credit rating, and financial condition of an issuer, intent and ability to hold until anticipated recovery (which may be maturity), and general outlook for the economy, specific industry, and entity in question.
The bond portion of the portfolio review is conducted with emphases on several factors. Continued payment of principal and interest is given primary importance with credit rating and financial condition of the issuer following as the next most important. Credit ratings were reviewed with the ratings of the bonds being satisfactory. Those that were not currently rated were discussed with a third party and/or underwent an internal financial review. The Company also monitors whether each of the investments incurred a decline in market value from carrying value of at least 20% for twelve consecutive months or a similar decline of at least 50% for six consecutive months. Each bond is reviewed to determine whether it is a general obligation bond, which is backed by the credit and taxing power of the issuing jurisdiction, or revenue bond, which is only payable from specified revenues. Based on the review undertaken by the
Company, the Company determined that the decline in value of the various bond holdings were deemed to be temporary and were the result of the general market downturns and interest rate/yield curve changes, not credit issues. The fact that almost all of such bonds are general obligation bonds further solidified the Company’s determination that the decline in the value of these bond holdings is temporary.
The fair value of the equity portfolio continues to fluctuate as the economic turbulence continues to impact financial sector stock pricing. The stock market improvement over the first six months of 2010 has led to an increase in net unrealized gains of $182,000 to $1,163,000 at June 30, 2010. In addition, the amortized cost of the equity securities portfolio has increased $975,000 as the Company has begun to build the portfolio balance, while continuing to diversify geographic risk.
The equity portion of the portfolio, which is invested entirely in financial institutions, is reviewed for possible other than temporary impairment in a similar manner to the bond portfolio with greater emphasis placed on the length of time the market value has been less than the carrying value and financial sector outlook. The Company also reviews dividend payment activities and, in the case of financial institutions, whether or not such issuer was participating in the TARP Capital Purchase Program. The starting point for the equity analysis is the length and severity of a market price decline. The Company monitors two primary measures: 20% decline for twelve consecutive months and 50% decline for six consecutive months in market value from carrying value.
The distribution of credit ratings by amortized cost and estimated fair values for the debt security portfolio at June 30, 2010 follows:
A- to AAA
B- to BBB+
C to CCC+
Not Rated
152,431
147,993
5,823
5,129
9,606
8,623
18,022
18,561
800
46
Total debt securities AFS
199,788
198,248
6,623
5,862
9,652
8,668
Total debt securities HTM
Financing Activities
Total deposits increased 6.6% or $32,694,000 from December 31, 2009 to June 30, 2010. The growth was led by a substantial increase in money market deposits of 35.7% from December 31, 2009 to June 30, 2010. The increase in core deposits (deposits less time deposits) has provided relationship driven funding for the loan and investment portfolios, while also reducing the utilization of FHLB borrowings. The increase in deposits is the result of a deposit gathering program coupled with customers coming back to their hometown bank in the wake of the economic turbulence. Electronic delivery channels, such as remote deposit capture and mobile banking, are being emphasized as efforts to capitalize on the economic stimulus being provided by the Marcellus Shale natural gas exploration.
Deposit balances and their changes for the periods being discussed follow:
16.6
16.1
10.1
NOW accounts
65,802
12.4
64,361
12.9
1,441
101,301
19.1
74,634
15.0
26,667
35.7
66,789
12.6
60,827
12.2
5,962
9.8
208,110
39.3
217,566
43.8
(9,456
(4.3
32,694
6.6
Borrowed Funds
Total borrowed funds decreased 3.9% or $4,145,000 to $100,987,000 at June 30, 2010 compared to $105,132,000 at December 31, 2009. The decrease in borrowed funds is primarily the result of growth in deposits as part of the previously discussed deposit gathering campaigns that were utilized to provide loan portfolio funding and to reduce the level of total borrowings. FHLB
repurchase agreements were utilized as their structure allowed for a reduction in interest expense, while providing the ability to reduce the borrowings at our discretion as deposit levels increased.
Short-term borrowings:
FHLB repurchase agreements
5,155
4.9
(5,155
(100.0
Securities sold under agreement to repurchase
14.1
13,199
1,010
7.7
Total short-term borrowings
17.5
(22.6
85.9
82.5
Total borrowed funds
100,987
105,132
(3.9
Capital
The adequacy of the Company’s capital is reviewed on an ongoing basis with reference to the size, composition, and quality of the Company’s resources and regulatory guidelines. Management seeks to maintain a level of capital sufficient to support existing assets and anticipated asset growth, maintain favorable access to capital markets, and preserve high quality credit ratings.
Bank holding companies are required to comply with the Federal Reserve Board’s risk-based capital guidelines. The risk-based capital rules are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies and to minimize disincentives for holding liquid assets. Specifically, each is required to maintain certain minimum dollar amounts and ratios of total risk-based, tier I risk-based, and tier I leverage capital. In addition to the capital requirements, the Federal Deposit Insurance Corporation Improvements Act (FDICIA) established five capital categories ranging from “well capitalized” to “critically undercapitalized.” To be classified as “well capitalized”, total risk-based, tier I risked-based, and tier I leverage capital ratios must be at least 10%, 6%, and 5%, respectively.
Capital ratios as of June 30, 2010 and December 31, 2009 were as follows:
Ratio
Total Capital (to Risk-weighted Assets)
Actual
69,907
67,738
For Capital Adequacy Purposes
36,828
8.0
35,094
To Be Well Capitalized
46,036
10.0
43,867
Tier I Capital (to Risk-weighted Assets)
64,446
14.0
62,709
18,414
4.0
17,547
27,621
6.0
26,320
Tier I Capital (to Average Assets)
9.3
27,785
26,914
34,732
5.0
33,642
Liquidity; Interest Rate Sensitivity and Market Risk
The asset/liability committee addresses the liquidity needs of the Company to ensure that sufficient funds are available to meet credit demands and deposit withdrawals as well as to the placement of available funds in the investment portfolio. In assessing liquidity requirements, equal consideration is given to the current position as well as the future outlook.
The following liquidity measures are monitored for compliance and were within the limits cited at June 30, 2010:
1. Net Loans to Total Assets, 85% maximum
2. Net Loans to Total Deposits, 100% maximum
3. Cumulative 90 day Maturity GAP %, +/- 20% maximum
4. Cumulative 1 Year Maturity GAP %, +/- 25% maximum
Fundamental objectives of the Company’s asset/liability management process are to maintain adequate liquidity while minimizing interest rate risk. The maintenance of adequate liquidity provides the Company with the ability to meet its financial obligations to depositors, loan customers, and shareholders. Additionally, it provides funds for normal operating expenditures and business opportunities as they arise. The objective of interest rate sensitivity management is to increase net interest income by managing interest sensitive assets and liabilities in such a way that they can be repriced in response to changes in market interest rates.
The Bank, like other financial institutions, must have sufficient funds available to meet its liquidity needs for deposit withdrawals, loan commitments and originations, and expenses. In order to control cash flow, the Bank estimates future cash flows from deposits, loan payments, and investment security payments. The primary sources of funds are deposits, principal and interest payments on loans and investment securities, FHLB borrowings, and brokered deposits. Management believes the Bank has adequate resources to meet its normal funding requirements.
Management monitors the Company’s liquidity on both a long and short-term basis, thereby providing management necessary information to react to current balance sheet trends. Cash flow needs are assessed and sources of funds are determined. Funding strategies consider both customer needs and economical cost. Both short and long-term funding needs are addressed by maturities and sales of available for sale investment securities, loan repayments and maturities, and liquidating money market investments such as federal funds sold. The use of these resources, in conjunction with access to credit provides core funding to satisfy depositor, borrower, and creditor needs.
Management monitors and determines the desirable level of liquidity. Consideration is given to loan demand, investment opportunities, deposit pricing and growth potential, as well as the current cost of borrowing funds. The Company has a current borrowing capacity at the FHLB of $216,627,000. In addition to this credit arrangement, the Company has additional lines of credit with correspondent banks of $13,934,000. Management believes it has sufficient liquidity to satisfy estimated short-term and long-term funding needs. FHLB borrowings totaled $86,778,000 as of June 30, 2010.
Interest rate sensitivity, which is closely related to liquidity management, is a function of the repricing characteristics of the Company’s portfolio of assets and liabilities. Asset/liability management strives to match maturities and rates between loan and investment security assets with the deposit liabilities and borrowings that fund them. Successful asset/liability management results in a balance sheet structure which can cope effectively with market rate fluctuations. The matching process is affected by segmenting both assets and liabilities into future time periods (usually 12 months, or less) based upon when repricing can be effected. Repriceable assets are subtracted from repriceable liabilities, for a specific time period to determine the “gap”, or difference. Once known, the gap is managed based on predictions about future market interest rates. Intentional mismatching, or gapping, can enhance net interest income if market rates move as predicted. However, if market rates behave in a manner contrary to predictions, net interest income will suffer. Gaps, therefore, contain an element of risk and must be prudently managed. In addition to gap management, the Company has an asset/liability management policy which incorporates a market value at risk calculation which is used to determine the effects of interest rate movements on shareholders’ equity and a simulation analysis to monitor the effects of interest rate changes on the Company’s balance sheet.
The Company currently maintains a GAP position of being liability sensitive. The Company has strategically taken this position as it has decreased the duration of the time deposit portfolio, while continuing to maintain a primarily fixed rate earning asset portfolio with a duration greater than the liabilities utilized to fund earning assets. Lengthening of the liability portfolio coupled
with the addition of limited short-term assets is being undertaken. These actions are expected to reduce, but not eliminate, the liability sensitive structure of the balance sheet.
A market value at risk calculation is utilized to monitor the effects of interest rate changes on the Company’s balance sheet and more specifically shareholders’ equity. The Company does not manage the balance sheet structure in order to maintain compliance with this calculation. The calculation serves as a guideline with greater emphases placed on interest rate sensitivity. Changes to calculation results from period to period are reviewed as changes in results could be a signal of future events. As of the most recent analysis, the results of the market value at risk calculation were outside of established guidelines due to the strategic direction being taken.
Interest Rate Sensitivity
In this analysis the Company examines the result of a 100 and 200 basis point change in market interest rates and the effect on net interest income. It is assumed that the change is instantaneous and that all rates move in a parallel manner. Assumptions are also made concerning prepayment speeds on mortgage loans and mortgage securities.
The following is a rate shock forecast for the twelve month period ended June 30, 2011 assuming a static balance sheet as of June 30, 2010.
Parallel Rate Shock in Basis Points
-200
-100
Static
+100
+200
23,295
24,567
25,092
25,294
25,657
Change from static
(1,797
(525
202
565
Percent change from static
-7.16
-2.09
0.81
2.25
The model utilized to create the report presented above makes various estimates at each level of interest rate change regarding cash flow from principal repayment on loans and mortgage-backed securities and or call activity on investment securities. Actual results could differ significantly from these estimates which would result in significant differences in the calculated projected change. In addition, the limits stated above do not necessarily represent the level of change under which management would undertake specific measures to realign its portfolio in order to reduce the projected level of change. Generally, management believes the Company is well positioned to respond expeditiously when the market interest rate outlook changes.
Inflation
The asset and liability structure of a financial institution is primarily monetary in nature. Therefore, interest rates rather than inflation have a more significant impact on the Company’s performance. Interest rates are not always affected in the same direction or magnitude as prices of other goods and services, but are reflective of fiscal policy initiatives or economic factors which are not measured by a price index.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market risk for the Company is comprised primarily of interest rate risk exposure and liquidity risk. Interest rate risk and liquidity risk management is performed at the Bank level as well as the Company level. The Company’s interest rate sensitivity is monitored by management through selected interest rate risk measures produced by an independent third party. There have been no substantial changes in the Company’s gap analyses or simulation analyses compared to the information provided in the Annual Report on Form 10-K for the period ended December 31, 2009. Additional information and details are provided in the “Liquidity and Interest Rate Sensitivity” section of “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Generally, management believes the Company is well positioned to respond in a timely manner when the market interest rate outlook changes.
Item 4. Controls and Procedures
An analysis was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2010. There were no changes in the Company’s internal control over financial reporting that occurred during the quarter ended June 30, 2010, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Part II. OTHER INFORMATION
Item 1. Legal Proceedings
None.
Item 1A. Risk Factors
There are no material changes to the risk factors set forth in Part I, Item 1A, “Risk Factors,” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. Please refer to that section for disclosures regarding the risks and uncertainties related to the Company’s business.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Average
Total Number of
Maximum Number (or
Number of
Price Paid
Shares (or Units)
Approximate Dollar Value)
Shares (or
per Share
Purchased as Part of
of Shares (or Units) that
Units)
(or Units)
Publicly Announced
May Yet Be Purchased
Period
Purchased
Plans or Programs
Under the Plans or Programs
Month #1 (April 1 - April 30, 2010)
78,344
Month #2 (May 1 - May 31, 2010)
1,568
29.27
76,776
Month #3 (June 1 - June 30, 2010)
On April 27, 2010, the Board of Directors extended the previously approved authorization to repurchase up to 197,000 shares, or approximately 5%, of the outstanding shares of the Company for an additional year to April 30, 2011. To date, there have been 120,224 shares repurchased under this plan.
Item 3. Defaults Upon Senior Securities
None
Item 4. (Removed and Reserved)
Item 5. Other Information
Item 6. Exhibits
(3) (i)
Articles of Incorporation of the Registrant, as presently in effect (incorporated by reference to Exhibit 3(i) of the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2005).
(3) (ii)
Bylaws of the Registrant’s as presently in effect (incorporated by reference to Exhibit 3(ii) of the Registrant’s Current Report on Form 8-K filed June 17, 2005).
(31) (i)
Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief Executive Officer.
(31) (ii)
Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief Financial Officer.
(32) (i)
Section 1350 Certification of Chief Executive Officer.
(32) (ii)
Section 1350 Certification of Chief Financial Officer.
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.
(Registrant)
Date: August 9, 2010
/s/ Ronald A. Walko
Ronald A. Walko, President and Chief Executive Officer
(Principal Executive Officer)
/s/ Brian L. Knepp
Brian L. Knepp, Chief Financial Officer
(Principal Financial Officer and Principal Accounting Officer)
EXHIBIT INDEX
Exhibit 31(i)
Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief Executive Officer
Exhibit 31(ii)
Rule 13a-14(a)/Rule 15d-14(a) Certification of Chief Financial Officer
Exhibit 32(i)
Section 1350 Certification of Chief Executive Officer
Exhibit 32(ii)
Section 1350 Certification of Chief Financial Officer