FIDELITY D & D BANCORP INC - Quarter Report: 2005 September (Form 10-Q)

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

 

FOR QUARTER ENDED SEPTEMBER 30, 2005

 

 

COMMISSION FILE NUMBER: 333-90273

 

 

FIDELITY D & D BANCORP, INC.

 

 

 

PRINCIPAL OFFICE:

BLAKELY & DRINKER ST.

DUNMORE, PENNSYLVANIA 18512

 

 

TELEPHONE:

570-342-8281

 

The Company (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 Company was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

ý  YES    o  NO

 

 

The Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

 

o  YES    ý  NO

 

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

o  YES    ý  NO

 

 

 

 

FIDELITY D & D BANCORP, INC.

 

Form 10-Q September 30, 2005

 

Index

Part I. Financial information
Item 1.	Financial Statements:
	Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004
	Consolidated Statements of Income for the three and nine months ended September 30, 2005 and 2004
	Consolidated Statements of Changes in Shareholders’ Equity for the nine months ended September 30, 2005 and 2004
	Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004
	Notes to Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosure about Market Risk
Item 4.	Controls and Procedures
Part II. Other Information
Item 1.	Legal Proceedings
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.	Defaults upon Senior Securities
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits
Signatures
Exhibit index

 

 

2

 

FIDELITY D & D BANCORP, INC.

Consolidated Balance Sheets

As of September 30, 2005 and December 31, 2004

 

		September 30, 2005				December 31, 2004
		(unaudited)				(audited)
ASSETS
Cash and due from banks		$		10,855,055		$	9,013,060
Interest-bearing deposits with financial institutions		106,763				1,203,334
Total cash and cash equivalents		10,961,818				10,216,394
Available-for-sale securities		104,503,869				112,612,513
Held-to-maturity securities		2,224,161				3,056,305
Federal Home Loan Bank Stock		4,409,800				4,568,700
Loans and leases, net (allowance for loan losses of $6,034,549 in 2005 and $5,987,798 in 2004)		390,338,304				381,546,375
Loans available-for-sale (fair value $702,356 in 2005 and $582,141 in 2004)		697,456				576,378
Bank premises and equipment, net		10,671,310				11,163,292
Cash surrender value of bank-owned life insurance		7,816,244				7,613,437
Other assets		4,748,463				3,385,790
Accrued interest receivable		1,959,704				1,722,850
Foreclosed assets held for sale		103,382				213,104
Total assets		$	538,434,511			$		536,675,138
LIABILITIES
Deposits
Non-interest-bearing		$	70,331,584			$	65,357,535
Certificates of deposit of $100,000 or more		86,893,558				93,986,033
Other interest-bearing deposits		212,191,121				206,271,767
Total deposits		369,416,263				365,615,335
Accrued interest payable and other liabilities		6,067,621				3,039,809
Short-term borrowings		44,026,811				50,534,046
Long-term debt		70,536,586				71,119,188
Total liabilities		490,047,281				490,308,378
SHAREHOLDERS’ EQUITY
Preferred stock authorized 5,000,000 shares with no par value; none issued		—				—
Capital stock authorized 10,000,000 shares with no par value; issued and outstanding 1,851,024 shares in 2005 and 1,839,572 shares in 2004		10,471,172				10,072,134
Retained earnings		38,628,530				36,396,027
Accumulated other comprehensive loss		(712,472			)	(101,401			)
Total shareholders’ equity		48,387,230				46,366,760
Total liabilities and shareholders’ equity		$		538,434,511		$	536,675,138

 

 

3

 

FIDELITY D & D BANCORP, INC.

Consolidated Statements of Income

(unaudited)

 

 

		Three Months Ended							Nine Months Ended
		September 30, 2005				September 30, 2004			September 30, 2005			September 30, 2004
Interest income
Interest and fees on loans:
Taxable		$	6,012,028			$	5,386,418		$	17,414,848		$	16,260,004
Nontaxable		120,630				75,264			335,159			233,780
Leases		7,056				34,089			39,851			126,435
Interest-bearing deposits with financial institutions		3,263				1,861			12,234			4,071
Investment securities:
US Government agencies		861,777				1,064,878			2,693,019			3,356,887
States and political subdivisions (non-taxable)		156,931				114,858			397,491			366,564
Other securities		162,285				59,303			461,043			155,235
Federal funds sold		—				1,028			47,427			11,238
Total interest income		7,323,970				6,737,699			21,401,072			20,514,214
Interest expense
Certificates of deposit of $100,000 or more		722,680				700,172			2,096,344			2,301,440
Other deposits		1,023,540				903,016			2,881,871			2,873,866
Securities sold under repurchase agreements		148,677				119,240			486,794			323,501
Other short- and long-term borrowings and other		1,066,817				997,357			2,979,854			2,973,383
Total interest expense		2,961,714				2,719,785			8,444,863			8,472,190
Net interest income		4,362,256				4,017,914			12,956,209			12,042,024
Provision for loan losses		300,000				450,000			680,000			1,700,000
Net interest income after provision for loan losses		4,062,256				3,567,914			12,276,209			10,342,024
Other income:
Service charges on deposit accounts		689,435				554,394			1,961,966			1,620,614
Gain (loss) on:
Investment securities		—				—			2,643			9,497
Loans		8,468				61,065			1,011			155,452
Leased assets		22,626				(50,690		)	(11,328		)	(205,876		)
Foreclosed assets held-for-sale		41,472				4,102			33,861			(4,116		)
Write-down lease residual		—				—			(220,000		)	—
Fees, other service charges and other income		466,186				579,867			1,334,154			1,590,469
Total other income		1,228,187				1,148,738			3,102,307			3,166,040
Other operating expenses:
Salaries and employee benefits		1,755,611				1,745,107			5,251,730			5,193,127
Premises and equipment		750,266				690,847			2,221,742			2,128,474
Advertising		127,709				158,193			407,517			303,385
Professional fees and services		290,619				273,447			1,086,537			872,023
Other		666,582				790,200			1,801,437			1,974,520
Total other operating expenses		3,590,787				3,657,794			10,768,963			10,471,529
Income before provision for income taxes		1,699,656				1,058,858			4,609,553			3,036,535
Provision for income taxes		405,311				245,346			1,160,011			677,223
Net income		$		1,294,345		$	813,512		$	3,449,542		$	2,359,312
Per share data:
Net income - basic		$		0.70		$	0.45		$	1.87		$	1.29
Net income - diluted		$		0.70		$	0.45		$	1.87		$	1.29
Dividends		$		0.22		$	0.22		$	0.66		$	0.66

 

 

4

 

 

FIDELITY D & D BANCORP, INC.

Consolidated Statements of Changes in Shareholders’ Equity

For the Nine Months Ended September 30, 2005 and 2004

 

 

		Capital stock					Treasury stock					Retained			Accumulated other comprehensive
		Shares		Amount			Shares		Amount			earnings			income (loss)			Total
Balance, December 31, 2003 (audited)		1,828,270		$	9,698,879		(5,227	)	$	(196,048	)	$	34,641,976		$	(212,908	)	$	43,931,899
Comprehensive income:
Net income												2,359,312						2,359,312
Change in net unrealized holding gains (losses) on available-for-sale securities, net, net of reclassification adjustments															363,620			363,620
Comprehensive income																		2,722,932
Reissued treasury stock through Employee Stock Purchase Plan				(8,329		)	1,635		61,370									53,041
Dividends reinvested through Dividend Reinvestment Plan		7,192		243,615			3,592		134,678									378,293
Dividends declared												(1,206,621		)				(1,206,621		)
Balance, September 30, 2004 (unaudited)		1,835,462		$	9,934,165		—		$	—		$	35,794,667		$	150,712		$	45,879,544
Balance, December 31, 2004 (audited)		1,839,572		$	10,072,134		—		$	—		$	36,396,027		$	(101,401	)	$	46,366,760
Comprehensive income:
Net income												3,449,542						3,449,542
Change in net unrealized holding gains (losses) on available-for-sale securities, net, net of reclassification adjustments															(611,071		)	(611,071		)
Comprehensive income																		2,838,471
Stock issued through Employee Stock Purchase Plan		1,031		31,671														31,671
Dividends reinvested through Dividend Reinvestment Plan		10,421		367,367														367,367
Dividends declared												(1,217,039		)				(1,217,039		)
Balance, September 30, 2005 (unaudited)		1,851,024		$	10,471,172		—		$	—		$	38,628,530		$	(712,472	)	$	48,387,230

 

 

5

 

FIDELITY D & D BANCORP, INC.

Consolidated Statements of Cash Flows

(unaudited)

 

		Nine Months Ended
		September 30, 2005			September 30, 2004
Cash flows from operating activities:
Net income		$	3,449,542		$	2,359,312
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation		880,897			911,171
Amortization of securities (net of accretion)		180,449			441,223
Provision for loan losses		680,000			1,700,000
Deferred income tax		(184,956		)	(594,889		)
Write-down of foreclosed assets held-for-sale		50,451			121,789
Write-down lease residual		220,000			—
Increase in cash surrender value of life insurance		(202,807		)	(240,365		)
Gain on sale of investment securities		(2,643		)	(9,497		)
Gain on sale of loans		(1,011		)	(155,452		)
(Gain) loss on sale of foreclosed assets held-for-sale		(33,861		)	4,116
Loss on sale of leased assets		11,328			205,876
Loss on disposal of equipment		589			3,661
Amortization of loan servicing rights		71,871			71,078
Change in:
Accured interest receivable		(236,854		)	(265,828		)
Other assets		(861,362		)	80,950
Accrued interest payable and other liabilities		221,490			(146,708		)
Net cash provided by operating activities		4,243,123			4,486,437
Cash flows from investing activities:
Held-to-maturity securities:
Proceeds from maturities, calls and paydowns		827,760			1,445,868
Available-for-sale securities:
Proceeds from sales		19,282,027			3,850,562
Proceeds from maturities, calls and paydowns		11,934,551			19,920,791
Purchases		(24,207,222		)	(11,080,552		)
Net decrease FHLB stock		158,900			11,300
Proceeds from sale of loans available-for-sale		1,561,456			15,491,238
Net increase in loans and leases		(9,770,169		)	(8,648,029		)
Proceeds from sale of leased assets		766,598			753,007
Acquisition of bank premises and equipment		(389,504		)	(187,993		)
Proceeds from sale of foreclosed assets held-for-sale		444,814			411,514
Net cash provided by investing activities		609,211			21,967,706
Cash flows from financing activities:
Net increase in noninterest-bearing deposits		4,974,049			1,222,968
Net decrease in certificates of deposit of $100,000 or more		(7,092,475		)	(13,648,229		)
Net increase (decrease) in other interest-bearing deposits		5,919,354			(13,587,583		)
Net decrease in short-term borrowings		(6,507,235		)	(10,267,020		)
Net (decrease) increase in long-term borrowings		(582,602		)	4,434,483
Dividends paid, net of dividend reinvestment		(849,672		)	(828,328		)
Proceeds from employee stock purchase plan		31,671			53,041
Net cash used in financing activities		(4,106,910		)	(32,620,668		)
Net increase (decrease) in cash and cash equivalents		745,424			(6,166,525		)
Cash and cash equivalents, beginning		10,216,394			19,231,601
Cash and cash equivalents, ending		$	10,961,818		$	13,065,076

 

 

6

 

FIDELITY D & D BANCORP, INC.

 

Notes to Consolidated Financial Statements

(unaudited)

 

1. Nature of operations and critical accounting policies

 

Principles of consolidation

 

The accompanying unaudited consolidated financial statements of Fidelity D & D Bancorp, Inc., and its wholly owned subsidiary, The Fidelity Deposit and Discount Bank (the Bank or collectively, the Company) have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and with the instructions to this Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnote disclosures required by GAAP for complete financial statements.  In the opinion of Management, all normal recurring adjustments necessary for a fair presentation of the financial condition and results of operations for the periods have been included.  All significant inter-company balances and transactions have been eliminated in consolidation.  Prior period amounts have been reclassified, when necessary, to conform to the current period’s presentation.

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported periods.  Actual results could differ from those estimates.  For additional information and disclosures required under GAAP, please refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

 

Nature of operations

 

The Bank is a commercial bank chartered in the Commonwealth of Pennsylvania and a wholly owned subsidiary of the Company.  Having commenced operations in 1903, the Bank provides a full range of traditional banking services, trust services and alternative financial products from its main office located in Dunmore and other branches throughout Lackawanna and Luzerne counties.

 

Management is responsible for the fairness, integrity and objectivity of the unaudited financial statements included in this report.  Management prepared the unaudited financial statements in accordance with GAAP.  In meeting its responsibility for the financial statements, Management depends on the Company’s accounting systems and related internal controls.  These systems and controls are designed to provide reasonable, but not absolute, assurance that the financial records accurately reflect the transactions of the Company, the Company’s assets are safeguarded and that financial statements present fairly the financial condition and results of operations of the Company.

 

In the opinion of Management, the consolidated balance sheets as of September 30, 2005 and December 31, 2004 and the related consolidated statements of income for each of the three and nine month periods ended September 30, 2005 and September 30, 2004 and changes in shareholders’ equity and cash flows for each of the nine months ended September 30, 2005 and September 30, 2004 present fairly the financial condition and results of operations of the Company.  All material adjustments required for a fair presentation have been made.  These adjustments are of a normal recurring nature.  There have been no material changes in accounting principles, practices or in the method of application and there have been no retroactive adjustments during these periods.  The results of operations for interim periods are not necessarily indicative of the results of operations for the entire year.

 

This Quarterly Report on Form 10-Q should be read in conjunction with the Company’s audited financial statements for the year ended December 31, 2004 and the notes included therein, included within the Company’s Annual Report filed on Form 10-K.

 

Critical accounting policies

 

The presentation of financial statements in conformity with GAAP requires Management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates.

 

7

 

A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses (the allowance).  Management believes that the allowance, as of September 30, 2005, is adequate and reasonable.  Given the 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 the future.  In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance.  Such agencies may require the Company to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.

 

Other material estimates include the determinations of fair values of the Company’s investment securities and loans classified as available-for-sale (AFS).  The Company receives estimated fair values of investment securities from an independent valuation service.  In developing these fair values, the valuation service uses 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 investment securities tend to vary among valuation services.  Accordingly, when selling investment securities, Management typically obtains price quotes from more than one source.  The majority of the Company’s investment securities are classified as AFS.  AFS securities are carried at fair market value on the consolidated balance sheet, with unrealized gains and losses, net of income tax, reported as a separate component of shareholders’ equity in accumulated other comprehensive income (loss).

 

The fair market value of residential mortgage loans, classified as AFS, is obtained from the Federal National Mortgage Association (FNMA). The fair value of Small Business Administration (SBA) loans, classified as AFS, is obtained from an outside pricing source. To determine the fair market value of student loans, classified as AFS, the Bank uses the pricing obtained from the most recent student loans sold from its AFS portfolio. The market to which the Bank sells mortgage and other loans is restricted and price quotes from other sources are typically not obtained. As of September 30, 2005, the Company’s portfolio of loans AFS was comprised of residential mortgage loans and student loans. At December 31, 2004, the portfolio was comprised of only student loans.

 

2. Earnings per share

 

Basic earnings per share (EPS) is computed using the weighted-average number of shares of common stock outstanding. Diluted EPS is computed in the same manner as basic EPS but reflects the potential dilution of common stock equivalents. Dilution would occur if Company-issued “in-the-money” stock options were exercised and converted into common stock. Stock options are in-the-money if the market value of the underlying stock is greater than the option’s exercise or strike price. The Company uses the treasury stock method to determine the dilutive effect of its unexercised stock options. Under this method, the proceeds received from shares issued in a hypothetical exercise of stock options are assumed to be used to purchase treasury stock.

 

The following data illustrates the amounts used in computing EPS and the effects on income and the weighted-average number of shares of potentially dilutive common stock for the nine months ended September 30, 2005 and 2004:

 

8

 

 

 

3. Stock plans

 

The Company uses the intrinsic value method of accounting for stock-based compensation plans, under Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25), and as permitted by Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation (SFAS No. 123).  Under the intrinsic value method, compensation cost is measured by the excess of the quoted market price of the stock, as of the grant date (or other measurement date) over the stock’s exercise price.  Since all options issued under the Company’s stock-based compensation plans had an exercise price equal to the quoted market value of the underlying common stock on the date of grant, the stock is deemed to have no intrinsic value.  Accordingly, no compensation cost is recorded.

 

The alternative fair value method of accounting for stock-based compensation provided under SFAS No. 123 requires the use of option valuation models, such as the Black-Scholes option pricing model.  The Black-Scholes option pricing model was not developed for use in valuing stock options granted under employer stock option plans.  Rather, the Black-Scholes option pricing model was developed for use in estimating the fair market value of short-term options traded in organized exchanges.  Options traded in organized exchanges have no vesting restrictions and are fully transferable.  In addition, option valuation models require the input of highly subjective assumptions including the expected or implied volatility of the options underlying stock.  Since the options granted under the Company’s stock option plans have characteristics significantly different from those of marketable options and because changes in the subjective input assumptions can materially impact the estimated fair market value, in Management’s opinion, the existing valuation models do not necessarily provide a reliable single measure of the fair market value of its employee stock options at the time of grant.

 

In December 2004, the Financial Accounting Standards Board issued SFAS 123(R) which replaces SFAS 123, and supersedes APB No. 25.  SFAS 123(R) requires that the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements.  SFAS 123(R) applies to all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share options, or other equity instruments (except for those held by an ESOP) or by incurring liabilities (1) in amounts based (even in part) on the price of the entity’s shares or other equity instruments, or (2) that require (or may require) settlement by the issuance of an entity’s shares or other equity instruments.  Public entities such as the Company are not required to apply SFAS 123(R) until the beginning of the first interim reporting period or fiscal year beginning after December 31, 2005.  The Company does not plan early implementation of the provisions of SFAS 123(R).

 

In 2004 and for the first nine months of 2005, the Company did not grant stock options under any of its stock plans.

 

 

9

 

Item 2:                                        Management’s Discussion and Analysis of Results of Operations and Financial Condition

 

The following is Management’s discussion and analysis of the significant changes in the consolidated financial condition of the Company as of September 30, 2005 compared to December 31, 2004 and the results of operations for the three and nine month periods ended September 30, 2005 compared to the respective periods ended September 30, 2004.  Current performance may not be indicative of future results. This discussion should be read in conjunction with the Company’s 2004 Annual Report filed on Form 10-K.

 

Forward looking statements

 

This Quarterly Report on Form 10-Q contains a number of forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act.  These statements may be identified by the use of the words “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “outlook,” “plan,” “potential,” “predict,” “project,” “should,” “will,” “would” and similar terms and phrases, including references to assumptions.  Forward looking statements include risks and uncertainties.

 

Forward-looking statements are based on various assumptions and analyses made by us in light of Management’s experience and its perception of historical trends, current conditions and expected future developments, as well as other factors it believes are appropriate under the circumstances.  These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors (many of which are beyond our control) that could cause actual results to differ materially from future results expressed or implied by such forward-looking statements.  These factors include, without limitation, the following:

 

•                  the timing and occurrence or non-occurrence of events may be subject to circumstances beyond our control;

 

•                  there may be increases in competitive pressure among financial institutions or from non-financial institutions;

 

•                  changes in the interest rate environment may reduce interest margins;

 

•                  changes in deposit flows, loan demand or real estate values may adversely affect our business;

 

•                  changes in accounting principles, policies or guidelines may cause our financial condition to be perceived differently;

 

•                  general economic conditions, either nationally or locally in some or all areas in which we do business, or conditions in the securities markets or the banking industry may be less favorable than we currently anticipate;

 

•                  legislative or regulatory changes may adversely affect our business;

 

•                  technological changes may be more rapid, difficult or expensive than we anticipate;

 

•                  success or consummation of new business initiatives may be more difficult or expensive than we anticipate; or

 

•                  acts of war, terrorism or natural disaster.

 

Management cautions readers not to place undue reliance on forward-looking statements, which reflect analyses only as of the date of this document.  We have no obligation to update any forward-looking statements to reflect events or circumstances after the date of this document.  Readers should review the risk factors described in other documents that we file or furnish, from time to time, with the Securities and Exchange Commission, including Annual Reports to Shareholders, Annual Reports filed on Form 10-K and other current reports filed or furnished on Form 8-K.

 

General

 

The Company’s results of operations depend primarily on its net interest income.  Net interest income is the difference between interest income and interest expense.  Interest income is generated from yields on interest-earning assets which consist principally of loans and investment securities.  Interest expense is incurred from rates paid on interest-bearing

 

 

10

 

liabilities which consist of deposits and borrowings.  Net interest income is determined by the Company’s interest rate spread (i.e., the difference between the yields earned on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities.  The interest rate spread is influenced by the overall interest rate environment, the composition and characteristics of interest-earning assets and interest-bearing liabilities and by the competition in our marketplace.  The interest rate spread and the changes in the interest rate spread, from period-to-period, is also influenced by differences in the maturity and re-pricing characteristics of assets compared to the maturity and re-pricing characteristics of the liabilities that fund them.

 

The Company’s profitability is also affected by the level of its non-interest income and expenses, provision for loan losses and provision for income taxes.  Non-interest income consists of service charges on the Bank’s loan and deposit products, trust and asset management service fees, net gains or losses from sales of leases, securities and loans AFS and increases in the cash surrender value of the bank-owned life insurance.  Non-interest expense consists of compensation and related employee benefit expenses, occupancy, equipment, data processing, advertising, marketing, professional fees, insurance and other operating overhead.

 

The Company’s profitability is significantly affected by general economic and competitive conditions, changes in market interest rates, government policies and actions of regulatory authorities.  The Company’s loan portfolio is comprised principally of commercial and commercial real estate loans.  The properties underlying the Company’s mortgages are concentrated in northeastern Pennsylvania.  Credit risk, which represents the possibility of the Company not recovering amounts due from its borrowers, is significantly related to local economic conditions in the areas the properties are located as well as the Company’s loan underwriting standards.  Economic conditions affect the market value of the underlying collateral as well as the levels of occupancy of multi-family dwellings and levels of adequate cash flow and revenue generation from other income-producing commercial properties.

 

 

COMPARISON OF FINANCIAL CONDITION AT

SEPTEMBER 30, 2005 AND DECEMBER 31, 2004

 

Overview

 

Consolidated assets increased $1,759,000 or 0.3%, during the nine months ended September 30, 2005 to $538,435,000.  The increase resulted from increases in total deposits of $3,801,000, accrued expenses and other liabilities of $3,028,000 and total stockholders’ equity of $2,020,000.   These items were partially offset by a decrease in total borrowings of $7,090,000.  Since December 31, 2004, the carrying value of total loans increased $8,913,000 and cash and cash equivalents increased $745,000.  The carrying value of the Bank’s investment portfolio declined $8,940,000.  The increase in shareholders’ equity was attributable to earnings net of dividends declared of $2,233,000, an increase in common stock of $399,000, partially offset by a $611,000 net unrealized holding loss on AFS securities recorded in other comprehensive income (loss).

 

A comparison of selected balance sheet information as of September 30, 2005 and December 31, 2004 follows:

 

Investment securities

 

The Bank’s investment policy is designed to complement its lending activities, generate a favorable return without incurring undue interest rate and credit risk, manage interest rate sensitivity, provide monthly cash flow and manage liquidity at acceptable levels.  In establishing investment strategies, the Bank considers its business and growth or restructuring plans, the economic environment, the interest rate sensitivity position, the types of securities held, permissible purchases, credit quality, maturity and re-pricing terms, call or average-life intervals and investment concentrations.  The policy prescribes permissible investment categories that meet the policy standards and Management is responsible for structuring and executing the specific investment purchases within these policy parameters.  Management buys and sells investment securities from time-to-time depending on market conditions, business trends, liquidity needs, capital levels and structuring strategies.  Investment security purchases provide a way to quickly invest excess liquidity in order to generate additional earnings.  The Bank generally earns a positive interest spread by assuming interest rate risk and using deposits and/or borrowings to purchase securities with longer maturities.

 

At the time of purchase, the Bank classifies investment securities into one of three categories: trading, AFS or held-to- maturity (HTM).  To date, Management has not purchased any securities for trading purposes.  Management classifies most securities as AFS even though it has no immediate intent to sell them.  The AFS designation affords Management the flexibility to sell securities and adjust or restructure the balance sheet in response to capital levels, liquidity needs, structuring strategies and/or changes in market conditions.  Securities AFS are carried at net fair market value in the

 

 

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consolidated balance sheet with an adjustment to shareholders’ equity, net of tax, which is presented under the caption “Accumulated other comprehensive income (loss).”  Securities designated as HTM are carried at amortized cost.

 

During the second quarter, the Bank restructured approximately $19.5 million of investment securities holdings to enhance current earnings while simultaneously addressing the interest rate risk in the portfolio from the continued flattening of the treasury yield curve.  The restructuring included the sale and purchase of securities that re-allocated the diversification away from heavily weighted mortgage-backed securities.  At September 30, 2005, approximately 45.4% of the carrying value of the investment portfolios was comprised of mortgage-backed securities that amortize and provide monthly cash flow, compared to 55.7% at December 31, 2004.  Also at September 30, 2005, agency and municipal bonds comprised 30.3% and 14.4%, respectively, of the investment portfolios.  The carrying value of investment securities totaled $106,728,000 or 19.8% of total assets as of September 30, 2005 compared to $115,669,000 or 21.6% as of December 31, 2004.  At September 30, 2005, the portfolio is comprised of HTM and AFS securities with carrying values of $2,224,000 and $104,504,000, respectively.

 

At September 30, 2005, the AFS debt securities were recorded with a net unrealized loss in the amount of $1,246,000.  The increase in the unrealized loss is due to the relative increase in the interest rate environment which has an inverse relationship with the market values of debt securities.  Also at September 30, 2005, AFS equity securities were recorded in the amount of $445,000 including an unrealized gain in the amount of $166,000.

 

The amortized cost and fair value of investment securities HTM and AFS at September 30, 2005 consisted of the following (dollars in thousands):

 

 

 

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The amortized cost and fair value of investments HTM and AFS by contractual maturity at September 30, 2005 are as follows (dollars in thousands):

 

		Amortized			Market
		cost			value
Held-to-maturity securities:
Mortgage-backed securities		$	2,224		$	2,289
Available-for-sale securities:
Debt securities:
One year or less		120			120
One through five years		7,310			7,139
Five through ten years		24,127			23,798
Over ten years		26,806			26,760
Total debt securities		58,363			57,817
Mortgage-backed securities		46,942			46,242
Equity securities		279			445
Total available-for-sale		105,584			104,504
Total securities		$	107,808		$	106,793

 

Expected maturities will differ from contractual maturities because issuers and borrowers may have the right to call or repay obligations with or without call or prepayment penalty. Federal agency and municipal securities are included based on their original stated maturity. Mortgage-backed securities, which are based on weighted-average lives and subject to monthly principal pay-downs, are listed in total. Equity securities, which have no stated maturity, are carried at the lower of cost or fair market value.

 

Loans available - for- sale (AFS)

 

Generally, upon origination, certain residential mortgages, the guaranteed portions of SBA loans and student loans may be classified as AFS.  In the event of market interest rate increases, fixed-rate loans and loans not immediately scheduled to re-price would no longer produce yields consistent with the current market.  In a declining interest rate environment, the Bank would be exposed to prepayment risk and, as rates on adjustable rate loans decrease, interest income would be negatively affected.  To better manage prepayment and interest rate risk, loans that meet these conditions may be classified as AFS.  Consideration is also given to the Company’s current liquidity position and expected future liquidity needs.  Loans AFS are carried at the lower of cost or estimated fair value.  If the fair market values of these loans fall below their amortized cost, the loan is written down by the difference with a corresponding charge to current earnings.  Subsequent appreciation, if any, is credited to current earnings but only to the extent of previous write-downs.

 

At September 30, 2005, loans AFS amounted to $697,000 with a corresponding fair value of $703,000, compared to $576,000 and $582,000, respectively at December 31, 2004.  For the nine months ended September 30, 2005, residential and student loans with principal balances of $878,000 and $682,000, respectively were sold into the secondary market with combined net gains of approximately $16,000 being recognized.  At September 30, 2005 the balance of loans AFS consisted of $413,000 of residential mortgages and $285,000 of student loans.  At December 31, 2004, the entire balance of loans AFS consisted of student loans.

 

Loans and leases

 

The Bank originates commercial and commercial real estate loans, residential, consumer, home equity and construction loans.  The relative volume of originations is dependent upon customer demand, current interest rates and the perception and duration of future interest rate levels.  The Bank focuses its efforts, whenever possible, on the expansion of variable-rate portfolios of residential and consumer loans as well as commercial loans, along with fixed-rate residential real estate loans.  The broad spectrum of products provides diversification which helps manage, to an extent, interest

 

 

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rate risk and credit concentration risk.  Credit risk is further managed through underwriting policies and procedures and loan monitoring practices.  Interest rate risk is managed using various asset/liability modeling techniques and analyses.  The interest rates on most commercial loans are adjustable with reset intervals of five years or less.  Whenever practical, the Bank originates variable-rate loans.

 

The majority of our loan portfolio is collateralized, at least in part, by real estate in the greater Lackawanna and Luzerne counties of Pennsylvania.  Commercial lending activities generally involve a greater degree of credit risk than residential lending because they typically have larger balances and are more affected by adverse conditions in the economy.  Because payments on loans secured by commercial and commercial real estate often depend upon the successful operation and management of the properties and the businesses which operate from within them, repayment of such loans may be affected by factors outside the borrower’s control.  Such factors may include adverse conditions in the real estate market, the economy, the industry or changes in government regulations.  As such, commercial loans require more ongoing evaluation and monitoring which occurs with the Bank’s credit administration and outsourced loan review functions.

 

During the first quarter of 2005, the Bank established a reserve for estimated impairment from the future sales of its leased vehicles which was netted against the gross amount of direct finance leasing.  The estimated impairment was based on the historical sales performance of terminated leases which are typically sold below their residual value.  The balance of the Bank’s leased vehicles should mature or payoff during the remainder of 2005.  As of September 30, 2005, the Company expects the current balance of the reserve to be adequate to absorb the remaining anticipated losses.  Currently, the Company does not anticipate re-entering the direct finance lease business when the current agreements expire in 2005.

 

Loans, net of unearned income of $396,373,000 at September 30, 2005 increased $8,839,000 from $387,534,000 at December 31, 2004.  The increase was from successful implementation and marketing strategies for residential mortgages and consumer home equity installment lending partially offset by a decline in commercial loans and run-off of receivables from the Bank’s auto leasing business.  The decrease in commercial lending was primarily from a sold loan participation during the first quarter of 2005 and the maturity of an automobile dealer’s floor plan note that was not renewed. 

 

The following table sets forth the composition of the loan portfolio at September 30, 2005 and December 31, 2004:

 

		September 30, 2005			December 31, 2004
Commercial and commercial real estate		$	212,046,121		$		221,968,137
Residential real estate		99,800,950			91,294,401
Consumer and home equity		71,625,825			61,487,608
Real estate construction		12,043,129			10,620,472
Direct financing leases		858,189			2,211,978
Gross loans		396,374,214			387,582,596
Less:
Unearned discount		1,361			48,423
Allowance for loan losses		6,034,549			5,987,798
Net loans		390,338,304			381,546,375
Loans available-for-sale		697,456			576,378
Total loans		$	391,035,760		$	382,122,753

 

Allowance for loan losses

 

Management continually evaluates the credit quality of the Bank’s loan portfolio and, on a quarterly basis, performs a formal review of the adequacy of the allowance for loan losses (the allowance).  The allowance reflects management’s best estimate of the amount of credit losses in the loan portfolio.  Management’s judgment is based on the evaluation of individual loans, past experience, the assessment of current economic conditions and other relevant factors including the amounts and timing of cash flows expected to be received on impaired loans.  Those estimates may be susceptible to significant change.  The provision for loan losses represents the amount necessary to maintain an appropriate allowance. Loan losses are charged directly against the allowance when loans are deemed to be uncollectible.  Recoveries on previously charged-off loans are added to the allowance when received.

 

 

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Management applies two primary components during the loan review process to determine the adequacy of allowance levels.  The two components consist of a specific loan loss allocation, for loans that are deemed impaired, and a general loan loss allocation for those loans where a specific loss has not been allocated.  The methodology to analyze the adequacy of the allowance is as follows:

 

•                  Identification of specific problem loans by loan category;

•                  Calculation of specific allowances required based on collateral and other persuasive evidence;

•                  Identification of loans collateralized by cash and cash equivalents;

•                  Determination of remaining homogenous pools by loan category and eliminating loans collateralized by cash and cash equivalents and eliminating loans with specific loss allocations;

•                  Application of historical loss percentages (three-year average) to pools to determine the allowance allocation; and

•                  Application of qualitative factor adjustment percentages to historical losses for trends or changes in the loan portfolio.

 

Allocation of the allowance for different categories of loans is based on the methodology as explained above.  A key element of the methodology to determine the allowance is the Company’s credit risk evaluation process, which includes credit risk-grading of individual commercial loans.  Commercial loans are assigned credit risk grades based on the Company’s assessment of conditions that affect the borrower’s ability to meet its contractual obligations under the loan agreement.  That process includes reviewing borrowers’ current financial information, historical payment experience, credit documentation, public information and other information specific to each individual borrower.  The changes in the allocations from period to period are based upon reviews of the loan and lease portfolios.

 

Net charge-offs for the nine months ended September 30, 2005 were $633,000, compared to $588,000, for the same period in 2004.  Net charge-offs of commercial loans were $588,000 for the nine months ended September 30, 2005 compared to $176,000 in the first nine months of 2004.  Real estate mortgage net charge-offs declined to $11,000 for the first nine months of 2005 compared to $220,000 in the first nine months of 2004.  Consumer loan net charge-offs were $34,000 for the first nine months of 2005 compared to $146,000 for the same 2004 period.  There were no lease financing charge-offs or recoveries during the current period.  Some deterioration in the credit quality of various non-performing commercial loans caused an increase of commercial loan charge-offs during the nine months ended September 30, 2005 compared to the same 2004 period. Improvement in the credit quality and collection effort helped to reduce the real estate and consumer charge-offs.  In addition, recoveries for the 2005 period include $115,000 from the sale of previously charged-off loans.

 

Management believes that the current balance in the allowance for loans losses of $6,035,000 is sufficient to withstand the identified potential credit quality issues that may arise and are inherent to the portfolio.  Management is unaware of any potential problem loans that have not been reviewed.  Potential problem loans are those where there is known information that leads Management to believe repayment of principal and/or interest is in jeopardy and the loans are neither on non-accrual status nor past due 90 days or more.  However, there could be instances which become identified during the year that may require additional charge-offs and/or increases to the allowance.  The ratio of allowance for loan losses to total loans was 1.52% at September 30, 2005 compared 1.54% at December 31, 2004 and 1.59% September 30, 2004.

 

 

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The following tables set forth the activity in the allowance for loan losses and certain key ratios for the period indicated:

 

		As of and for the				As of and for the				As of and for the
		nine months ended				year ended				nine months ended
		September 30, 2005				December 31, 2004				September 30, 2004
Balance at beginning of period		$	5,987,798			$	4,996,966			$	4,996,966
Provision charged to operations		680,000				2,150,000				1,700,000
Charge-offs:
Commercial		940,911				775,252				380,900
Real estate		20,875				266,324				229,087
Consumer		183,659				480,462				298,253
Lease financing		—				84,902				69,210
Total		1,145,445				1,606,940				977,450
Recoveries:
Commercial		352,413				226,082				205,183
Real estate		9,698				20,039				9,000
Consumer		150,085				178,727				152,543
Lease financing		—				22,924				22,724
Total		512,196				447,772				389,450
Net charge-offs		633,249				1,159,168				588,000
Balance at end of period		$	6,034,549			$	5,987,798			$	6,108,966
Total loans, end of period		$	397,070,309			$	388,110,551			$	383,185,529

 

		As of and for the				As of and for the				As of and for the
		nine months ended				year ended				nine months ended
		September 30, 2005				December 31, 2004				September 30, 2004
Net charge-offs to:
Loans, end of period		0.16		%		0.30		%		0.15		%
Allowance for loan losses		10.49		%		19.36		%		9.63		%
Provision for loan losses		93.12		%		53.91		%		34.59		%
Allowance for loan losses to:
Total loans		1.52		%		1.54		%		1.59		%
Non-accrual loans		64.47		%		60.46		%		62.14		%
Non-performing loans		60.26		%		57.24		%		59.39		%
Net charge-offs		9.53		x		5.17		x		10.39		x
Loans 30-89 days past due and still accruing		$	2,396,798			$	4,316,453			$	3,791,855
Loans 90 days past due and accruing		$	654,084			$	557,492			$	455,872
Non-accrual loans		$	9,360,643			$	9,904,276			$	9,831,170
Allowance for loan losses to loans 90 days or more past due and accruing		9.23		x		10.75		x		13.40		x

 

 

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