UNITED STATES

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 JUNE 30, 2005

 

COMMISSION FILE NUMBER: 333-90273

 

FIDELITY D & D BANCORP, INC.

 

STATE OF INCORPORATION:		IRS EMPLOYER IDENTIFICATION NO:
PENNSYLVANIA		23-3017653

 

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

 

The number of outstanding shares of Common Stock of Fidelity D & D Bancorp, Inc. on July 29, 2005, the latest practicable date, was 1,847,395 shares.

 

 

FIDELITY D & D BANCORP, INC.

 

Form 10-Q June 30, 2005

 

Index

 

Part I. Financial information
Item 1. Financial Statements:
	Consolidated Balance Sheets as of June 30, 2005 and December 31, 2004
	Consolidated Statements of Income for the three and six months ended June 30, 2005 and 2004
	Consolidated Statements of Changes in Shareholders’ Equity for the six months ended June 30, 2005 and 2004
	Consolidated Statements of Cash Flows for the six months ended June 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 June 30, 2005 and December 31, 2004

 

		June 30, 2005			December 31, 2004
		(unaudited)			(audited)
ASSETS
Cash and due from banks		$	10,450,074		$	9,013,060
Interest-bearing deposits with financial institutions		402,676			1,203,334
Total cash and cash equivalents		10,852,750			10,216,394
Available-for-sale securities		107,955,147			112,612,513
Held-to-maturity securities		2,703,782			3,056,305
Federal Home Loan Bank Stock		4,306,100			4,568,700
Loans and leases, net (allowance for loan losses of $5,873,378 in 2005 and $5,987,798 in 2004)		382,299,701			381,546,375
Loans available-for-sale (fair value $76,935 in 2005 and $582,141 in 2004)		76,173			576,378
Bank premises and equipment, net		10,767,091			11,163,292
Cash surrender value of bank-owned life insurance		7,742,162			7,613,437
Other assets		4,102,811			3,385,790
Accrued interest receivable		2,062,886			1,722,850
Foreclosed assets held for sale		452,034			213,104
Total assets		$	533,320,637		$	536,675,138
LIABILITIES
Deposits
Non-interest-bearing		$	69,233,001		$	65,357,535
Certificates of deposit of $100,000 or more		89,572,994			93,986,033
Other interest-bearing deposits		210,372,330			206,271,767
Total deposits		369,178,325			365,615,335
Accrued interest payable and other liabilities		3,054,050			3,039,809
Short-term borrowings		42,267,004			50,534,046
Long-term debt		70,732,233			71,119,188
Total liabilities		485,231,612			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 1,847,395 shares in 2005 and 1,839,572 shares in 2004		10,344,157			10,072,134
Retained earnings		37,740,613			36,396,027
Accumulated other comprehensive income (loss)		4,255			(101,401		)
Total shareholders’ equity		48,089,025			46,366,760
Total liabilities and shareholders’ equity		$	533,320,637		$	536,675,138

 

3

 

FIDELITY D & D BANCORP, INC.

Consolidated Statements of Income

(unaudited)

 

		Three Months Ended						Six Months Ended
		June 30, 2005			June 30, 2004			June 30, 2005			June 30, 2004
Interest income
Interest and fees on loans:
Taxable		$	5,738,145		$	5,461,234		$	11,402,820		$	10,873,586
Nontaxable		116,119			74,428			214,529			158,516
Leases		14,502			42,926			32,795			92,346
Interest-bearing deposits with financial institutions		6,283			1,095			8,971			2,210
Investment securities:
US Government agencies		921,085			1,073,414			1,831,242			2,292,009
States and political subdivisions (non-taxable)		128,105			116,328			240,560			251,706
Other securities		171,943			43,765			298,758			95,932
Federal funds sold		6,635			—			47,427			10,210
Total interest income		7,102,817			6,813,190			14,077,102			13,776,515
Interest expense
Certificates of deposit of $100,000 or more		697,641			710,597			1,373,664			1,601,268
Other deposits		978,115			920,201			1,858,331			1,970,850
Securities sold under repurchase agreements		141,308			101,400			338,117			204,261
Other short- and long-term borrowings and other		967,604			989,827			1,913,037			1,976,026
Total interest expense		2,784,668			2,722,025			5,483,149			5,752,405
Net interest income		4,318,149			4,091,165			8,593,953			8,024,110
Provision for loan losses		300,000			400,000			380,000			1,250,000
Net interest income after provision for loan losses		4,018,149			3,691,165			8,213,953			6,774,110
Other income:
Service charges on deposit accounts		674,210			540,291			1,272,531			1,066,220
Gain (loss) on:
Investment securities		2,643			—			2,643			9,497
Loans		3,985			70,776			(7,457		)	94,387
Leased assets		919			(61,920		)	(33,954		)	(155,186		)
Foreclosed assets held-for-sale		(8,016		)	(8,218		)	(7,611		)	(8,218		)
Write-down lease residual		—			—			(220,000		)	—
Fees, other service charges and other income		452,766			529,956			867,968			1,010,602
Total other income		1,126,507			1,070,885			1,874,120			2,017,302
Other operating expenses:
Salaries and employee benefits		1,753,198			1,703,504			3,496,119			3,448,020
Premises and equipment		737,021			718,216			1,471,476			1,437,627
Advertising		148,599			84,685			279,808			145,192
Professional fees and services		413,875			312,705			795,918			598,576
Other		559,571			719,598			1,134,855			1,184,320
Total other operating expenses		3,612,264			3,538,708			7,178,176			6,813,735
Income before provision for income taxes		1,532,392			1,223,342			2,909,897			1,977,677
Provision for income taxes		396,584			302,449			754,700			431,877
Net income		$	1,135,808		$	920,893		$	2,155,197		$	1,545,800
Per share data:
Net income - basic		$	0.62		$	0.50		$	1.17		$	0.84
Net income - diluted		$	0.62		$	0.50		$	1.17		$	0.84
Dividends		$	0.22		$	0.22		$	0.44		$	0.44

 

4

 

FIDELITY D & D BANCORP, INC.

Consolidated Statements of Changes in Shareholders’ Equity

For the Six Months Ended June 30, 2005 and 2004

 

															Accumulated other
		Capital stock					Treasury stock					Retained			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												1,545,800						1,545,800
Change in net unrealized holding gains (losses) on available-for-sale securities, net net of reclassification adjustments															(1,542,613		)	(1,542,613		)
Comprehensive income																		3,187
Reissued treasury stock through Employee Stock Purchase Plan				(8,329		)	1,635		61,370									53,041
Dividends reinvested through Dividend Reinvestment Plan		3,519		120,390			3,592		134,678									255,068
Dividends declared												(803,627		)				(803,627		)
Balance, June 30, 2004 (unaudited)		1,831,789		$	9,810,940		—		$	—		$	35,384,149		$	(1,755,521	)	$	43,439,568
Balance, December 31, 2004 (audited)		1,839,572		$	10,072,134		—		$	—		$	36,396,027		$	(101,401	)	$	46,366,760
Comprehensive income:
Net income												2,155,197						2,155,197
Change in net unrealized holding gains (losses) on available-for-sale securities, net net of reclassification adjustments															105,656			105,656
Comprehensive income																		2,260,853
Stock issued through Employee Stock Purchase Plan		1,031		31,671														31,671
Dividends reinvested through Dividend Reinvestment Plan		6,792		240,352														240,352
Dividends declared												(810,611		)				(810,611		)
Balance, June 30, 2005 (unaudited)		1,847,395		$	10,344,157		—		$	—		$	37,740,613		$	4,255		$	48,089,025

 

5

 

FIDELITY D & D BANCORP, INC.

Consolidated Statements of Cash Flows

(unaudited)

 

		Six Months Ended
		June 30, 2005			June 30, 2004
Cash flows from operating activities:
Net income		$	2,155,197		$	1,545,800
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		562,985			615,541
Amortization of securities (net of accretion)		144,482			315,524
Provision for loan losses		380,000			1,250,000
Deferred income tax		(85,283		)	(128,406		)
Write-down of foreclosed assets held-for-sale		36,293			73,701
Write-down lease residual		220,000			—
Increase in cash surrender value of life insurance		(128,725		)	(161,665		)
Gain on sale of investment securities		(2,643		)	(9,497		)
Gain on sale of loans		(7,457		)	(94,387		)
Loss on sale of foreclosed assets held-for-sale		7,611			8,218
Loss on sale of leased assets		33,954			155,186
(Gain) loss on disposal of equipment		(589		)	3,736
Amortization of loan servicing rights		51,717			56,319
Change in:
Accured interest receivable		(340,036		)	(64,807		)
Other assets		(656,222		)	(273,465		)
Accrued interest payable and other liabilities		15,051			(21,429		)
Net cash provided by operating activities		2,386,335			3,270,369
Cash flows from investing activities:
Held-to-maturity securities:
Proceeds from maturities, calls and paydowns		349,441			1,243,638
Available-for-sale securities:
Proceeds from sales		19,282,027			3,850,562
Proceeds from maturities, calls and paydowns		7,170,330			16,278,082
Purchases		(21,773,663		)	(6,035,552		)
Net decrease FHLB stock		262,600			11,300
Proceeds from sale of loans available-for-sale		807,434			11,331,731
Net increase in loans and leases		(2,564,544		)	(3,342,844		)
Proceeds from sale of leased assets		407,660			502,924
Acquisition of bank premises and equipment		(166,195		)	(146,924		)
Proceeds from sale of foreclosed assets held-for-sale		104,526			341,862
Net cash provided by investing activities		3,879,616			24,034,779
Cash flows from financing activities:
Net increase in noninterest-bearing deposits		3,875,466			1,569,165
Net decrease in certificates of deposit of $100,000 or more		(4,413,039		)	(10,409,620		)
Net increase (decrease) in other interest-bearing deposits		4,100,563			(15,298,171		)
Net decrease in short-term borrowings		(8,267,042		)	(9,566,629		)
Net decrease in long-term borrowings		(386,955		)	(375,607		)
Dividends paid, net of dividend reinvestment		(570,259		)	(548,559		)
Proceeds from employee stock purchase plan		31,671			53,041
Net cash used in financing activities		(5,629,595		)	(34,576,380		)
Net increase (decrease) in cash and cash equivalents		636,356			(7,271,232		)
Cash and cash equivalents, beginning		10,216,394			19,231,601
Cash and cash equivalents, ending		$	10,852,750		$	11,960,369

 

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 June 30, 2005 and December 31, 2004 and the related consolidated statements of income for each of the three and six month periods ended June 30, 2005 and June 30, 2004 and changes in shareholders’ equity and cash flows for each of the six months ended June 30, 2005 and June 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 June 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.

 

Another material estimate is the calculation of fair values of the Company’s investment securities. 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 available-for-sale (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 June 30, 2005 and December 31, 2004, the Company’s portfolio of loans AFS was comprised of 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 six months ended June 30, 2005 and 2004:

 

		Income numerator			Weighted-average common shares denominator		EPS
June 30, 2005
Basic EPS		$	2,155,197		1,843,048		$	1.17
Dilutive effect of potential common stock:
Stock options:
Exercise of options outstanding					7,700
Hypothetical share repurchase at $35.60					(7,203	)
Diluted EPS		$	2,155,197		1,843,545		$	1.17
June 30, 2004
Basic EPS		$	1,545,800		1,826,886		$	0.84
Dilutive effect of potential common stock:
Stock options:
Exercise of options outstanding					5,100
Hypothetical share repurchase at $35.00					(4,517	)
Diluted EPS		$	1,545,800		1,827,469		$	0.84

 

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 six months of 2005, the Company did not grant stock options under any of its stock plans.

 

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 June 30, 2005 compared to December 31, 2004 and the results of operations for the three and six month periods ended June 30, 2005 compared to the respective periods ended June 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

 

9

 

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 or terrorism.

 

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 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

 

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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 properties.

 

COMPARISON OF FINANCIAL CONDITION AT
JUNE 30, 2005 AND DECEMBER 31, 2004

 

Overview

 

Consolidated assets decreased $3,355,000 or 0.6%, during the six months ended June 30, 2005 to $533,321,000. The decrease resulted from a decrease in total borrowings of $8,654,000, partially offset by increases in deposits of $3,563,000 and shareholders’ equity of $1,722,000. Since December 31, 2004, total investments decreased $5,010,000, total loans increased $253,000 and cash and cash equivalents increased $636,000. All other assets increased $766,000. The increase in shareholders’ equity was attributable to earnings net of dividends paid of $1,345,000, an increase in common stock of $272,000 and a $106,000 net unrealized holding gain on AFS securities recorded in other comprehensive income (loss).

 

A comparison of selected balance sheet information as of June 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 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 at the mid- to long-term range. The restructuring included the sale and purchase of securities that re-allocated the diversification away from heavily weighted mortgage-backed securities. At June 30, 2005, approximately 47.2% of the investment portfolio was comprised of mortgage-backed securities that amortize and provide monthly cash flow, compared to 55.7% at December 31, 2004. Also at June 30, 2005, agency and municipal bonds comprised 29.5% and 13.8%, respectively, of the investment portfolio. The carrying value of investment securities totaled $110,659,000 or 20.7% of total assets as of June 30, 2005 compared to $115,669,000 or 21.6% as of December 31, 2004. Currently, the portfolio is comprised of HTM and AFS securities with carrying values of $2,704,000 and $107,955,000, respectively.

 

At June 30, 2005, the AFS debt securities were recorded with a net unrealized loss in the amount of $173,000. Also at June 30, 2005, AFS equity securities were recorded in the amount of $458,000 including an unrealized gain in the amount of $179,000.

 

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

 

		Amortized cost			Gross unrealized gains			Gross unrealized losses			Fair value
Held-to-maturity securities:
Mortgage-backed securities		$	2,704		$	90		$	—		$	2,794
Available-for-sale securities:
U.S. government agencies and corporations		$	33,014		$	1		$	374		$	32,641
Obligations of states and municipal subdivisions		14,997			278			7			15,268
Corporate bonds		10,027			41			5			10,063
Mortgage-backed securities		49,632			189			296			49,525
Sub total		107,670			509			682			107,497
Equity securities		279			179			—			458
Total available-for-sale		$	107,949		$	688		$	682		$	107,955
Total securities		$	110,653		$	778		$	682		$	110,749

 

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

 

 

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

 

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based upon 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 June 30, 2005, loans AFS amounted to $76,000 which approximated fair market value, compared to $576,000 at December 31, 2004. For the six months ended June 30, 2005, student loans with principal balances of $799,000 were sold into the secondary market with gains of approximately $8,000 being recognized. At June 30, 2005 and 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 levels. The Bank continues to focus its efforts on the expansion of variable-rate portfolios of residential and consumer loans as well as commercial loans and fixed-rate residential loans. The broad spectrum of products provides diversification which helps manage, to an extent, interest 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 is 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 2005 and periodic adjustments will be made to this reserve, during this timeframe. The amount of periodic adjustments will depend upon actual sales proceeds from the leased vehicles. 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 $388,173,000 at June 30, 2005 increased $639,000 from $387,534,000 at December 31, 2004. The increase was from successful implementation and marketing strategies for residential mortgages and consumer home equity 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 from the sold participation of a loan during the first quarter of 2005 and the maturity of an automobile dealer’s floor plan note that was not renewed.

 

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

 

		June 30, 2005			December 31, 2004
Commercial and commercial real estate		$	207,983,995		$	221,968,137
Residential real estate		95,672,565			91,294,401
Consumer and home equity		70,790,958			61,487,608
Real estate construction		12,475,700			10,620,472
Direct financing leases		1,260,796			2,211,978
Gross loans		388,184,014			387,582,596
Less:
Unearned discount		10,935			48,423
Allowance for loan losses		5,873,378			5,987,798
Net loans		$	382,299,701		$	381,546,375
Loans available-for-sale		$	76,173		$	576,378
Total loans		$	382,375,874		$	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.

 

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 by credit administration;

•                  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 six months ended June 30, 2005 were $494,000, compared to $371,000, for the same period in 2004. Net charge-offs of commercial loans were $426,000 for the six months ended June 30, 2005 compared to $148,000 in the first six months of 2004. Real estate mortgage net charge-offs declined to $21,000 for the first six

 

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months of 2005 compared to $115,000 in the first six months of 2004. Consumer loan net charge-offs were $47,000 for the first half of 2005 compared to $83,000 for the same 2004 period. There were no lease financing charge-offs during the first half of 2005. The deterioration in the credit quality of a single commercial loan was the primary cause for increased commercial loan charge-offs during the six months ended June 30, 2005 compared to the same 2004 period.

 

Management believes that the current balance in the allowance for loans losses of $5,873,000 is sufficient to withstand the identified potential credit quality issues that may arise and are inherent to the portfolio. Currently, 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 currently 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 1.51% at June 30, 2005 compared 1.54% at both December 31, 2004 and June 30, 2004.

 

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 six months ended June 30, 2005			As of and for the year ended December 31, 2004			As of and for the six months ended June 30, 2004
Balance at beginning of period		$	5,987,798		$	4,996,966		$	4,996,966
Provision charged to operations		380,000			2,150,000			1,250,000
Charge-offs:
Commercial		728,516			775,252			319,370
Real estate		20,875			266,324			122,943
Consumer		108,302			480,462			201,025
Lease financing		—			84,902			44,519
Total		857,693			1,606,940			687,857
Recoveries:
Commercial		302,204			226,082			171,184
Real estate		60			20,039			8,010
Consumer		61,009			178,727			118,051
Lease financing		—			22,924			19,824
Total		363,273			447,772			317,069
Net charge-offs		494,420			1,159,168			370,788
Balance at end of period		$	5,873,378		$	5,987,798		$	5,876,178
Total loans, end of period		$	388,249,252		$	388,110,551		$	382,767,632

 

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		As of and for the six months ended June 30, 2005			As of and for the year ended December 31, 2004			As of and for the six months ended June 30, 2004
Net charge-offs to:
Loans, end of period		0.13		%	0.30		%	0.10		%
Allowance for loan losses		8.42		%	19.36		%	6.31		%
Provision for loan losses		130.11		%	53.91		%	29.66		%
Allowance for loan losses to:
Total loans		1.51		%	1.54		%	1.54		%
Non-accrual loans		57.82		%	60.46		%	56.93		%
Non-performing loans		54.91		%	57.24		%	54.28		%
Net charge-offs		11.88		x	5.17		x	15.85		x
Loans 30-89 days past due and still accruing		$	2,681,224		$	4,316,453		$	3,964,766
Loans 90 days past due and accruing		$	537,588		$	557,492		$	502,686
Non-accrual loans		$	10,158,361		$	9,904,276		$	10,322,405
Allowance for loan losses to loans 90 days or more past due and accruing		10.93		x	10.75		x	11.69		x

 

Non-performing assets

 

The Bank defines non-performing assets as accruing loans past due 90 days or more, non-accrual loans, restructured loans, other real estate owned and repossessed assets. As of June 30, 2005, non-performing assets represented 2.09% of total assets compared to 1.99% at December 31, 2004 and 2.04% at June 30, 2004.

 

The non-accrual loan balance increased $254,000 during the first six months of 2005, but was down by $164,000 compared to June 30, 2004. The balance of non-accrual loans fluctuates upward and downward depending mostly on delinquency status, pay downs, charge offs, a history of satisfactory repayments during the period a loan is classified as non-accrual and acquisition through foreclosure. During 2005, $3,381,000 of loans classified as non-accrual, including capitalized expenditures, were added to non-accrual, partially offset by payoffs or pay downs of $1,528,000, charge offs of $767,000, transfers to the Bank’s portfolio of other real estate owned (OREO) of $246,000 and $586,000 of loans that have returned to performing status.

 

Non-performing loans which includes non-accrual loans and accruing loans past due 90 days or more increased $234,000 to $10,696,000 since December 31, 2004. The ratio of non-performing loans to end of period net loans increased six basis points, during the six month period ended June 30, 2005. For the same period in 2004, the ratio of non-performing loans to net loans was 2.87%, compared to 2.80% at June 30, 2005, or a decrease of seven basis points.

 

Foreclosed assets held for sale includes OREO and repossessed assets. OREO represents eight properties that have been foreclosed upon and transferred from loans. Five of the properties are currently under contracts for sale and the remaining three are available for sale. Repossessed assets represent indirect auto loans, the payments of which have become delinquent and the vehicles repossessed.

 

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