UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2007

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from               to                      

Commission file number: 333-90273

FIDELITY D & D BANCORP, INC.

 

Address of principal executive offices:

BLAKELY & DRINKER ST.

DUNMORE, PENNSYLVANIA 18512

TELEPHONE:

570-342-8281

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subjected to such filing requirements for the past 90 days.

x YES    o NO

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

Large accelerated filer o     Accelerated filer o     Non-accelerated filer x

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

o YES    x NO

The number of outstanding shares of Common Stock of Fidelity D & D Bancorp, Inc. at July 31, 2007, the latest practicable date, was 2,067,620 shares.

               

FIDELITY D & D BANCORP, INC.

Form 10-Q June 30, 2007

Index

Part I. Financial Information
Item 1.	Financial Statements:
	Consolidated Balance Sheets as of June 30, 2007 and December 31, 2006
	Consolidated Statements of Income for the three and six months ended June 30, 2007 and 2006
	Consolidated Statements of Changes in Shareholders’ Equity for the six months ended June 30, 2007 and 2006
	Consolidated Statements of Cash Flows for the six months ended June 30, 2007 and 2006
	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 1A.	Risk Factors
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

PART I – Financial Information

Item 1: Financial Statements

FIDELITY D & D BANCORP, INC. AND SUBSIDIARY

 

Consolidated Balance Sheets

 

		June 30, 2007			December 31, 2006
		(unaudited)			(audited)
Assets:
Cash and due from banks		$	12,096,955		$	13,732,137
Interest-bearing deposits with financial institutions		123,578			68,711
Total cash and cash equivalents		12,220,533			13,800,848
Available-for-sale securities		106,712,776			98,841,364
Held-to-maturity securities		1,251,710			1,569,372
Federal Home Loan Bank Stock		4,151,900			3,795,100
Loans and leases, net (allowance for loan losses of $5,294,537 in 2007 and $5,444,303 in 2006)		420,153,494			417,199,048
Loans available-for-sale (fair value $208,896 in 2007; $123,156 in 2006)		204,800			122,000
Bank premises and equipment, net		13,331,402			11,324,465
Cash surrender value of bank owned life insurance		8,331,225			8,177,961
Other assets		4,587,944			4,788,105
Accrued interest receivable		2,546,684			2,502,576
Foreclosed assets held for sale		—			197,149
Total assets		$	573,492,468		$	562,317,988
Liabilities:
Deposits:
Interest-bearing		$	349,263,741		$	336,592,620
Non-interest-bearing		72,067,616			73,741,975
Total deposits		421,331,357			410,334,595
Accrued interest payable and other liabilities		4,235,491			4,179,170
Short-term borrowings		29,601,083			33,656,150
Long-term debt		66,125,522			62,536,210
Total liabilities		521,293,453			510,706,125
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, 2,067,620 shares in 2007 and 2,057,433 shares in 2006		19,056,491			18,702,537
Retained earnings		35,170,129			33,874,118
Accumulated other comprehensive loss		(2,027,605		)	(964,792		)
Total shareholders’ equity		52,199,015			51,611,863
Total liabilities and shareholders’ equity		$	573,492,468		$	562,317,988

 

See notes to consolidated financial statements

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FIDELITY D & D BANCORP, INC. AND SUBSIDIARY

 

Consolidated Statements of Income

(unaudited)

 

		Three Months Ended						Six Months Ended
		June 30, 2007			June 30, 2006			June 30, 2007			June 30, 2006
Interest income:
Loans and leases:
Taxable		$	7,141,888		$	6,879,670		$	14,316,917		$	13,378,288
Nontaxable		118,352			121,462			227,869			253,620
Interest-bearing deposits with financial institutions		1,929			2,239			4,721			4,776
Investment securities:
U.S. government agency and corporations		1,016,972			986,083			1,936,260			1,871,265
States and political subdivisions (nontaxable)		124,512			150,274			249,351			291,318
Other securities		280,523			230,802			526,422			429,212
Federal funds sold		202			638			54,654			36,126
Total interest income		8,684,378			8,371,168			17,316,194			16,264,605
Interest expense:
Deposits		3,222,678			2,750,117			6,556,701			5,147,023
Securities sold under repurchase agreements		115,576			163,426			231,033			298,875
Other short-term borrowings and other		260,939			162,229			334,012			224,191
Long-term debt		762,629			1,029,972			1,567,702			2,098,783
Total interest expense		4,361,822			4,105,744			8,689,448			7,768,872
Net interest income		4,322,556			4,265,424			8,626,746			8,495,733
Provision for loan losses		—			175,000			—			250,000
Net interest income after provision for loan losses		4,322,556			4,090,424			8,626,746			8,245,733
Other income:
Service charges on deposit accounts		761,922			635,054			1,394,239			1,266,781
Gain (loss) on sale of:
Loans		31,171			26,858			67,896			41,843
Investment securities		—			2			—			(166		)
Premises and equipment		(22,924		)	—			73,633			1,560
Leased assets		—			100			—			15,154
Foreclosed assets held for sale		127,621			216			142,749			621
Fees and other service charges		431,324			421,722			864,260			886,984
Total other income		1,329,114			1,083,952			2,542,777			2,212,777
Other expenses:
Salaries and employee benefits		2,165,352			1,974,057			4,300,329			3,980,871
Premises and equipment		784,285			823,559			1,590,110			1,624,410
Advertising		183,620			159,904			342,625			288,277
Other		954,296			990,629			1,967,532			1,977,341
Total other expenses		4,087,553			3,948,149			8,200,596			7,870,899
Income before provision for income taxes		1,564,117			1,226,227			2,968,927			2,587,611
Provision for income taxes		405,384			287,607			765,843			617,360
Net income		$	1,158,733		$	938,620		$	2,203,084		$	1,970,251
Per share data:
Net income - basic		$	0.56		$	0.45		$	1.07		$	0.96
Net income - diluted		$	0.56		$	0.45		$	1.07		$	0.96
Dividends		$	0.22		$	0.22		$	0.44		$	0.44

 

See Notes to Consolidated Financial Statements

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FIDELITY D & D BANCORP, INC. AND SUBSIDIARY

 

Consolidated Statements of Changes in Shareholders’ Equity

For the six months ended June 30, 2007 and 2006

 

										Accumulated
										other
		Capital stock					Retained			comprehensive
		Shares		Amount			earnings			income (loss)			Total
Balance, December 31, 2005 (audited)		1,854,217		$	10,594,901		$	39,363,461		$	(1,112,333	)	$	48,846,029
Cumulative effect of change in accounting principle, net of tax							(343,717		)				(343,717		)
Total comprehensive income:
Net income							1,970,251						1,970,251
Change in net unrealized holding losses on available-for-sale securities, net of reclassification adjustment and tax effects										(1,235,511		)	(1,235,511		)
Comprehensive income													734,740
Issuance of common stock through Employee Stock Purchase Plan		1,571		48,151									48,151
Dividends reinvested through Dividend Reinvestment Plan		7,638		283,819									283,819
Stock-based compensation expense				28,744									28,744
Cash dividends declared							(898,916		)				(898,916		)
Stock dividend declared		185,394		7,462,100			(7,469,548		)				(7,448		)
Balance, June 30, 2006 (unaudited)		2,048,820		$	18,417,715		$	32,621,531		$	(2,347,844	)	$	48,691,402
Balance, December 31, 2006 (audited)		2,057,433		$	18,702,537		$	33,874,118		$	(964,792	)	$	51,611,863
Total comprehensive income:
Net income							2,203,084						2,203,084
Change in net unrealized holding losses on available-for-sale securities, net of reclassification adjustment and tax effects										(1,034,092		)	(1,034,092		)
Change in cash flow hedge intrinsic value										(28,721		)	(28,721		)
Comprehensive income													1,140,271
Issuance of common stock through Employee Stock Purchase Plan		2,266		67,820									67,820
Dividends reinvested through Dividend Reinvestment Plan		7,921		279,176									279,176
Stock-based compensation expense				6,958									6,958
Cash dividends declared							(907,073		)				(907,073		)
Balance, June 30, 2007 (unaudited)		2,067,620		$	19,056,491		$	35,170,129		$	(2,027,605	)	$	52,199,015

 

See Notes to Consolidated Financial Statements

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FIDELITY DEPOSIT & DISCOUNT BANCORP, INC. AND SUBSIDIARY

 

Consolidated Statements of Cash Flows

(unaudited)

 

		Six Months Ended
		June 30, 2007			June 30, 2006
Cash flows from operating activities:
Net income		$	2,203,084		$	1,970,251
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, amortization and accretion		586,199			669,504
Provision for loan losses		—			250,000
Deferred income tax (benefit) expense		(67,626		)	32,967
Stock-based compensation expense		6,958			28,744
Loss from investment in limited partnership		40,200			45,000
Proceeds from sale of loans available-for-sale		7,285,804			4,905,215
Originations of loans available-for-sale		(7,300,708		)	(4,630,167		)
Increase in cash surrender value of life insurance		(153,264		)	(141,133		)
Net gain on sale of loans		(67,896		)	(41,843		)
Net loss on sale of investment securities		—			166
Net gain on sale of foreclosed assets held-for-sale		(142,749		)	(621		)
Net gain on disposal of premises and equipment		(73,633		)	(1,560		)
Change in:
Accrued interest receivable		(44,108		)	(631,911		)
Other assets		(72,481		)	(235,411		)
Accrued interest payable and other liabilities		57,131			15,860
Net cash provided by operating activities		2,256,911			2,235,061
Cash flows from investing activities:
Held-to-maturity securities:
Proceeds from maturities, calls and principal pay-downs		317,077			210,027
Available-for-sale securities:
Proceeds from sales		—			1,537,337
Proceeds from maturities, calls and principal pay-downs		7,476,006			3,247,531
Purchases		(16,764,629		)	(22,776,490		)
Net (increase) decrease in FHLB stock		(356,800		)	69,800
Net increase in loans and leases		(3,199,446		)	(14,906,819		)
Proceeds from sale of premises and equipment		247,008			1,560
Acquisition of bank premises and equipment		(2,111,460		)	(419,654		)
Proceeds from sale of foreclosed assets held-for-sale		584,088			39,711
Net cash used in investing activities		(13,808,156		)	(32,996,997		)
Cash flows from financing activities:
Net increase in deposits		10,996,762			43,356,715
Net (decrease) increase in short-term borrowings		(4,055,067		)	2,886,109
Repayments of long-term debt		(16,410,688		)	(15,379,437		)
Proceeds from long-term debt advances		20,000,000			—
Proceeds from employee stock purchase plan		67,820			48,151
Dividends paid, net of dividends reinvested		(627,897		)	(615,097		)
Cash payments in lieu of fractional shares on stock dividend		—			(7,448		)
Net cash provided by financing activities		9,970,930			30,288,993
Net decrease in cash and cash equivalents		(1,580,315		)	(472,943		)
Cash and cash equivalents, beginning		13,800,848			12,594,540
Cash and cash equivalents, ending		$	12,220,533		$	12,121,597

 

See notes to consolidated financial statements

6

FIDELITY D & D BANCORP, INC.

Notes to Consolidated Financial Statements

(unaudited)

1.      Nature of operations and critical accounting policies

Nature of operations

The Fidelity Deposit and Discount Bank (the Bank) is a commercial bank chartered in the Commonwealth of Pennsylvania and a wholly-owned subsidiary of Fidelity D & D Bancorp, Inc. (the Company or collectively, the Company).  Having commenced operations in 1903, the Bank is committed to provide superior customer service, while offering a full range of banking products and financial and trust services, to both our consumer and commercial customers from our main office located in Dunmore and other branches throughout Lackawanna and Luzerne counties.

Principles of consolidation

The accompanying unaudited consolidated financial statements of the Company and the Bank 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 are 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, refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

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 the 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, 2007 and December 31, 2006 and the related consolidated statements of income for the three- and six-month periods ended June 30, 2007 and 2006 and changes in shareholders’ equity and cash flows for the six months ended June 30, 2007 and 2006 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.

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, 2006, 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.

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, 2007, 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.

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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 may obtain price quotes from more than one source.  Available-for-sale (AFS) securities are carried at fair value on the consolidated balance sheet, with unrealized gains and losses, net of income tax, reported separately within shareholders’ equity through accumulated other comprehensive income (loss).

The fair value of residential mortgage loans, classified as AFS, is obtained from the Federal National Mortgage Association or the Pennsylvania Housing Finance Authority.  To determine the fair value of student loans, classified as AFS, the Bank uses the pricing obtained from the most recent student loans sold from its AFS portfolio.  From time-to-time, the Bank may originate Small Business Administration (SBA) loans AFS.  The fair value of SBA loans, classified as AFS, is obtained from an outside pricing source.  The market to which the Bank sells mortgage and other loans is restricted and price quotes from other sources are not typically obtained.  As of June 30, 2007, the AFS loan portfolio consisted of residential mortgages.

2.      Earnings per share

Basic earnings per share (EPS) is computed by dividing income available to common shareholders by the weighted-average number of common stock outstanding for the period.  Diluted EPS is computed in the same manner as basic EPS but reflects the potential dilution that could occur if stock options to issue additional common stock were exercised, which would then result in additional stock outstanding to share in or dilute the earnings of the Company.  The Company maintains two share-based compensation plans that may generate additional potential dilutive common shares. Generally, dilution would occur if Company-issued stock options were exercised and converted into common stock.

In the computation of diluted EPS, the Company uses the treasury stock method to determine the dilutive effect of its granted but unexercised stock options.  Under this method, the assumed proceeds received from shares issued, in a hypothetical stock option exercise, are assumed to be used to purchase treasury stock.  Pursuant to the guidance of Statement of Financial Accounting Standard (SFAS) No. 128, Earnings Per Share, proceeds include: proceeds from the exercise of outstanding stock options; compensation cost for future service that the Company has not yet recognized; and any “windfall” tax benefits that would be credited directly to shareholders’ equity when the grant generates a tax deduction (or a reduction in proceeds if there is a charge to equity).  For a further discussion on the Company’s stock option plans, see Note 3, below.

The following table illustrates the data used in computing basic EPS and a reconciliation to derive at the components of diluted EPS for the periods indicated:

Six months ended June 30,		2007			2006
Basic EPS:
Net income available to common shareholders		$	2,203,084		$	1,970,251
Weighted-average common shares outstanding		2,062,416			2,043,865
Basic EPS		$	1.07		$	0.96
Diluted EPS:
Net income available to common shareholders		$	2,203,084		$	1,970,251
Weighted-average common shares outstanding		2,062,416			2,043,865
Dilutive potential common shares		1,080			2,024
Weighted-average common shares and dilutive potential shares		2,063,496			2,045,889
Diluted EPS		$	1.07		$	0.96

 

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3.      Stock plans

The Company uses the fair value method of accounting for stock-based compensation provided under SFAS 123R, Share Based Payment.  SFAS 123R requires that the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements.  SFAS 123R 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.

The Company has two stock-based compensation plans (the stock option plans).  The stock option plans were shareholder-approved and permit the grant of share-based compensation awards to its directors, key officers and certain other employees.  The Company believes that these stock option plans better align the interest of its directors, key officers and employees with the interest of its shareholders.  The Company further believes that the granting of share-based awards, under the provisions of the stock option plans, is necessary to retain the knowledge base, continuity and expertise of its directors, key officers and certain employees.

The Company established the 2000 Independent Directors Stock Option Plan and has reserved 55,000 shares of its un-issued capital stock for issuance under the plan.  Under the 2000 Independent Directors Stock Option Plan, each outside director is awarded stock options to purchase 500 shares of the Company’s common stock on the first business day of January, each year, at the fair market value on date of grant.  No stock options were awarded during the first six months of 2007 or for the year ended December 31, 2006, due to the directors’ voluntary election to forego the award.  At June 30, 2007 there were 14,850 unexercised stock options outstanding under this plan.

The Company has also established the 2000 Stock Incentive Plan and has reserved 55,000 shares of its un-issued capital stock for issuance under the plan.  Under the 2000 Stock Incentive Plan, key officers and certain other employees are eligible to be awarded qualified stock options to purchase the Company’s common stock at the fair market value on the date of grant.  No stock options were awarded during the first six months of 2007.  During the first six months of 2006, 2,200 stock options were issued under this plan at a grant-date fair value of $6.21 per share.  The options vest over a six month period and for the six months ended June 30, 2006 approximately $14,000 of stock-based compensation expense was recorded and is included as a component of salaries and employee benefits in the consolidated statements of income.  As of June 30, 2007, there were 5,830 unexercised stock options outstanding under this plan.

In addition to the two stock option plans above, the Company has established the 2002 Employee Stock Purchase Plan (the ESPP) and has reserved 110,000 shares of its un-issued capital stock for issuance under the plan.  The plan was designed to promote broad-based employee ownership of the Company’s stock.  Under the 2002 ESPP, employees may have automatic payroll deductions to purchase the Company’s capital stock at a discounted price based on the fair market value of the Company’s capital stock on either the commencement date or termination date.  At June 30, 2007, 8,317 shares have been issued under the ESPP.  The ESPP is considered a compensatory plan and, as such, is required to comply with the provisions of SFAS 123R.  The Company recognizes compensation expense on its ESPP Plan on the date the shares are purchased.  For the six months ended June 30, 2007 and 2006, compensation expense related to the ESPP approximated $7,000 and $15,000, respectively, and is included as a component of salaries and employee benefits in the consolidated statements of income.

4.      Derivative instruments

As part of the Company’s overall interest rate risk management strategy, the Company has adopted a policy whereby the Company may periodically use derivative instruments to minimize significant fluctuations in earnings caused by interest rate volatility.  This interest rate risk management strategy entails the use of interest rate floors, caps and swaps.  During the fourth quarter of 2006, the Company entered into a three-year interest rate floor derivative agreement on $20,000,000 notional value of its prime-based loan portfolio.  The transaction required the payment of a premium by the Company to the seller for the right to receive payments in the event national prime drops below a pre-determined level (strike rate), essentially converting floating rate loans to fixed rate loans when prime drops below the contractual strike rate.  When purchased, the Company recorded an asset representing the fair value of the hedge at the time of purchase.  The Company has designated this agreement as a cash flow hedge pursuant to SFAS No. 133.  Accordingly, the change in the fair value of the instrument related to the hedge’s intrinsic value, or approximately -$29,000, is recorded as a component of other comprehensive income (OCI) in the consolidated statement of changes in shareholders’ equity and the portion of the change in fair value related to the time value expiration, or approximately $74,000, is recorded in the consolidated statements of income as a reduction of interest income for the six months ended June 30, 2007.  No gain or loss has been recognized in earnings due to hedge ineffectiveness as of June 30, 2007.  As of June 30, 2007, the Company does not expect to reclassify any amount from OCI to earnings over the next twelve months and no hedge has been discontinued.  Also, as of June 30, 2007, the fair value of the derivative contract approximated $122,000 and is a component of other assets in the consolidated balance sheet.

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5.      Recent accounting pronouncements

In July 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 (FIN 48).  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement 109, Accounting for Income Taxes.  FIN 48 is effective for the year ending December 31, 2007.

The Company adopted FIN 48 during the first quarter of 2007 and has evaluated its material tax positions as of June 30, 2007.  The adoption of FIN 48 does not have an immediate effect on its consolidated financial statements.  Under the “more-likely-than-not” threshold guidelines, the Company believes no significant uncertain tax positions exist, either individually or in the aggregate, that would give rise to the non-recognition of an existing tax benefit.  In periods subsequent to June 30, 2007, determinations of potentially adverse material tax positions will be evaluated to determine whether an uncertain tax position may have previously existed or has been originated.  In the event an adverse tax position is determined to exist, penalty and interest will be accrued, in accordance with the Internal Revenue Service guidelines, and recorded as a component of other expenses in the Company’s consolidated statements of income.

As of June 30, 2007, there were no unrecognized tax benefits that, if recognized, would significantly affect the Company’s effective tax rate.  Also, as of June 30, 2007, there were no penalties and interest recognized in the consolidated statements of income as a result of the adoption of FIN 48, nor does the Company foresee a change in its material tax positions that would give rise to the non-recognition of an existing tax benefit during the forthcoming twelve months.

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

The following is management’s discussion and analysis of the significant changes in the consolidated financial condition of the Company as of June 30, 2007 compared to December 31, 2006 and the results of operations for the three and six months ended June 30, 2007 and 2006.  Current performance may not be indicative of future results.  This discussion should be read in conjunction with the Company’s 2006 Annual Report filed on Form 10-K.

Forward-looking statements

This Interim 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 management 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;

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·                  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;

·                  acts of war or 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 principal revenues are derived from interest, dividends and fees earned on its interest-earning assets, which are comprised of loans, securities and other short-term investments.  The Company’s principal expenses consist of interest paid on its interest-bearing liabilities, which are comprised of deposits, short- and long-term borrowings and operating and general expenses.  The Company’s profitability depends 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 dependent upon the 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 significantly impacted by: changes in interest rates and market yield curves and their related impact on cash flows; the composition and characteristics of interest-earning assets and interest-bearing liabilities; differences in the maturity and re-pricing characteristics of assets compared to the maturity and re-pricing characteristics of the liabilities that fund them and by the competition in our marketplace.

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 mostly of service charges on the Bank’s loan and deposit products, trust and asset management service fees, increases in the cash surrender value of the bank owned life insurance (BOLI), net gains or losses from sales of loans and securities AFS and from the sales of other real estate (ORE) properties.  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 underwriting standards.  Economic conditions affect the market value of the underlying collateral as well as the levels of adequate cash flow and revenue generation from income-producing commercial and multi-family properties.

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COMPARISON OF RESULTS OF OPERATIONS

THREE AND SIX MONTHS ENDED JUNE 30, 2007 AND JUNE 30, 2006

Overview

Net income for the second quarter of 2007 was $1,159,000, or a 23% increase compared to $939,000 recorded in the same quarter in 2006.  Diluted earnings per share were $0.56 and $0.45 for each of the respective periods.  For the six months ended June 30, 2007, net income was $2,203,000, or $1.07 per share compared to $1,970,000, or $0.96 per share for the six months ended June 30, 2006.  The increase in net income for both the quarter and six months ended June 30, 2007, compared to the prior year periods, was the result of increases in net interest income, non-interest income and a decrease in the provision for loan losses, partially offset by increases in non-interest expense and the provision for income taxes.

The increases in net income was the primary cause of the improvement in return on average assets (ROA) and return on average shareholders’ equity (ROE) to 0.82% and 8.79%, respectively, for the three months ended June 30, 2007 compared to 0.66% and 7.66%, respectively, for the same period in 2006.  For the six months ended June 30, 2007, ROA and ROE were 0.78% and 8.46% compared to 0.70% and 8.08% for the first half of 2006.

Net interest income and interest sensitive assets / liabilities

Net interest income increased $57,000 to $4,322,000 for the second quarter of 2007, from $4,265,000 recorded in the same period of 2006.  The increase was partially due to the restoration of some large commercial loans from non-performing to performing status during the second half of 2006.  During the second quarter of 2007, the yield on the commercial loan portfolio increased 29 basis points compared to the second quarter of 2006.  In addition, all other categories of earning assets were either originated or re-priced at higher rates in the second quarter of 2007 compared to the second quarter of 2006.  Compared to the second quarter of 2006, the yield on interest-earning assets increased 32 basis points during the second 2007 quarter.  As a result, total interest income increased $313,000, or 4%, during the three months ended June 30, 2007, compared to the three months ended June 30, 2006.  Partially offsetting the effect interest rates had on interest-earning assets was an increase in interest expense of $256,000, or 6%, caused mostly by increases in rates paid on interest-bearing deposits.  The blended rate paid on all interest-bearing deposits increased 48 basis points in the current year quarter compared to the comparative quarter of 2006.  The increase in rates paid was due to deposit-gathering strategies and competitive pressure in conjunction with the prolonged inverted-shaped interest rate yield curve.  The average balance of total interest-bearing deposits increased $6,800,000 during the second quarter of 2007 compared to the same quarter of 2006 and is also $4,200,000 higher on average than the average for the full year 2006.  The Bank will continue its quest to raise deposit levels and reduce its dependency on borrowings.  Interest expense on borrowings and repurchase agreements declined $216,000 in the second quarter of 2007, compared to the second quarter of 2006, due mostly to an $18,500,000 decline in the average balances.

During the second quarter of 2007, the Bank’s tax-equivalent margin and spread were 3.34% and 2.63%, respectively, compared to 3.26% and 2.64% during the second quarter of 2006.  The decline in spread was from interest costs outpacing the yields earned on assets.  The eight basis point improvement in margin is from higher net interest income on a lower level of interest-earning assets in the second quarter of 2007 compared to the second quarter of 2006.

Similar to the second quarter comparisons, the Bank’s tax-equivalent margin and spread for the six months ended June 30, 2007 were 3.35% and 2.65%, respectively, compared to 3.30% and 2.70% during the same period for 2006.  The decline in spread was from interest costs outpacing the yields earned on assets.  The cost of interest-bearing deposits increased 67 basis points during the first half of 2007 compared to the first half of 2006.  However, success in deposit gathering strategies has resulted in a $15,700,000 increase in average balances of interest-bearing deposits and enabled the Bank to reduce its position on high-cost borrowings by $22,600,000 on average.  As a result, interest expense increased $921,000, or 12%, for the six months ended June 30, 2007 compared to the six months ended June 30, 2006.  Offsetting the increase in interest expense was an increase in interest income of $1,052,000, or 6%, for the comparable periods.  The migration of the large commercial loans to performing status as well as higher earning rates in the other loan categories and the investment portfolio helped increase the yield on interest-earning assets by 42 basis points during the first half of 2007 compared to the same 2006 period.  The five basis point improvement in the tax-equivalent margin is from higher net interest income which increased $131,000, or 2%, compared to the first half of 2006, on a similar level of interest-earning assets during the first half of 2007.

The interest rate environment has improved slightly during the past several months, but continues to remain challenging.  The yield curve which has recently become positively sloped still remains relatively flat, thereby limiting profitable growth opportunities.  The more positively-shaped yield curve and our successful deposit gathering strategies, debt reduction, and improved credit quality of the Bank’s earning assets will help position the Bank to optimize net interest income during this challenging rate environment and should be further enhanced when the shape of the yield curve returns to a steeper, more positive, normal slope.

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The following tables set forth, a comparison of average balance sheet amounts and their corresponding fully tax-equivalent (FTE) interest income and expense and annualized tax-equivalent yield and cost for the periods indicated (dollars in thousands):

		Three months ended						Six months ended						Year ended
		June 30,						June 30,						December 31,
		2007			2006			2007			2006			2006
Average interest-earning assets:
Loans and leases		$	420,551		$	420,394		$	422,952		$	417,403		$	418,390
Investments		114,561			122,582			109,569			118,340			115,319
Federal funds sold		15			56			2,085			1,720			2,479
Interest-bearing deposits		190			203			201			241			240
Total		$	535,317		$	543,235		$	534,807		$	537,704		$	536,428
Average interest-bearing liabilities:
Other interest-bearing deposits		$	196,513		$	184,461		$	198,328		$	178,658		$	185,786
Certificates of deposit		147,909			153,192			151,305			155,319			154,474
Borrowed funds		76,868			89,684			72,158			88,421			79,627
Repurchase agreements		18,336			24,042			18,106			24,414			23,391
Total		$	439,626		$	451,379		$	439,897		$	446,812		$	443,278
Interest income (FTE):
Loans and leases		$	7,321		$	7,064		$	14,662		$	13,763		$	28,357
Investments		1,494			1,454			2,856			2,760			5,612
Federal funds sold		1			1			55			36			123
Interest-bearing deposits		2			2			5			5			9
Total		$	8,818		$	8,521		$	17,578		$	16,564		$	34,101
Interest expense:
Other interest-bearing deposits		$	1,554		$	1,324		$	3,184		$	2,374		$	5,467
Certificates of deposit		1,667			1,426			3,372			2,773			6,026
Borrowed funds		1,024			1,193			1,902			2,323			4,244
Repurchase agreements		116			163			231			299			624
Total		$	4,361		$	4,106		$	8,689		$	7,769		$	16,361
Net interest income (FTE)		$	4,457		$	4,415		$	8,889		$	8,795		$	17,740

 

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		Three months ended				Six months ended				Year ended
		June 30,				June 30,				December 31,
		2007		2006		2007		2006		2006
Yield on average interest-earning assets
Loans and leases		6.98	%	6.74	%	6.99	%	6.65	%	6.78	%
Investments		5.23	%	4.76	%	5.26	%	4.70	%	4.87	%
Federal funds sold		5.28	%	4.56	%	5.29	%	4.23	%	4.97	%
Interest-bearing deposits		4.07	%	4.42	%	4.75	%	3.99	%	3.82	%
Total		6.61	%	6.29	%	6.63	%	6.21	%	6.36	%
Rates on average interest-bearing liabilities
Other interest-bearing deposits		3.17	%	2.88	%	3.24	%	2.68	%	2.94	%
Certificates of deposit		4.52	%	3.73	%	4.49	%	3.60	%	3.90	%
Borrowed funds		5.34	%	5.33	%	5.31	%	5.30	%	5.33	%
Repurchase agreements		2.53	%	2.73	%	2.57	%	2.47	%	2.67	%
Total		3.98	%	3.65	%	3.98	%	3.51	%	3.69	%
Net interest spread		2.63	%	2.64	%	2.65	%	2.70	%	2.67	%
Net interest margin		3.34	%	3.26	%	3.35	%	3.30	%	3.31	%

 

In the tables above, interest income was adjusted to a tax-equivalent basis to recognize the income from the various tax-exempt assets as if the interest was fully taxable.  This treatment allows a uniform comparison among the yields on interest-earning assets.  The calculations were computed on a fully tax-equivalent basis using the corporate federal tax rate of 34%.  Net interest spread represents the difference between the yield on interest-earning assets and the rate on interest-bearing liabilities.  Net interest margin represents the ratio of net interest income to total average interest-earning assets.

Provision for loan losses

The provision for loan losses represents the necessary amount to charge against current earnings, the purpose of which is to increase the allowance for loan losses to a level that represents management’s best estimate of known and inherent losses in the Bank’s loan and lease portfolio.  Loans and leases determined to be uncollectible are charged off against the allowance for loan losses.

The required amount of the provision for loan losses, based upon the adequate level of the allowance for loan losses, is subject to ongoing analysis of the loan portfolio.  The Bank’s Special Asset Committee meets periodically to review problem loans and leases.  The committee is comprised of Bank management, including the chief risk officer, loan workout officers and collection personnel.  The committee reports quarterly to the Credit Administration Committee of the Board of Directors.

Management continuously reviews the risks inherent in the loan and lease portfolio.  Specific factors used to evaluate the adequacy of the loan loss provision during the formal process include:

·                  Specific loans that could have loss potential

·                  Levels of and trends in delinquencies and non-accrual loans

·                  Levels of and trends in charge-offs and recoveries

·                  Trends in volume and terms of loans

·                  Changes in risk selection and underwriting standards

·                  Changes in lending policies, procedures and practices

·                  Experience, ability and depth of lending management

·                  National and local economic trends and conditions

·                  Changes in credit concentrations

No provision for loan losses has been recorded during 2007.  The Bank’s non-performing loans, which consists of loans past due 90 days or more plus non-accruing loans, increased $1,060,000, or 31%, to $4,498,000 since December 31, 2006.  However, non-performing loans declined year-to-year by $3,252,000, or 42%, from $7,750,000 at June 30, 2006.  The non-accrual component of non-performing loans showed a $3,109,000 decline while the 90 day delinquencies showed a $143,000 decline in the same period.  The decrease from June 30, 2006 was mainly attributable to the collection and pay-offs of

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non-performing loans.  The increase from December 31, 2006 was due mainly to commercial loan relationships that had migrated to delinquent status and were placed on non-accrual.  Because there is sufficient collateral that secured these loans, there have been fewer charge-offs, mild loan growth and the allowance for loan losses is deemed to be adequate to absorb the potential for future losses on existing problem loans, no provision for loan losses was required during the first half of 2007.  This compares with $175,000 and $250,000 recorded during the quarter and six months ended June 30, 2006.  After taking into account charge-offs and recoveries, the allowance was $5,295,000 at June 30, 2007 compared to $5,738,000 at June 30, 2006.

Other income

Total other (non-interest) income improved $245,000, or 23%, for the three months ended June 30, 2007 compared to the three months ended June 30, 2006.  The Bank recognized net gains of $127,000 from sales of foreclosed properties and experienced growth in deposit fees revenue of $127,000.  The gain from the sale of foreclosed properties was the result of excess collateral value compared to the net book value of sold foreclosed property.  The increase in deposit fees was caused by growth in debit card interchange and overdraft charges.

For the six months ended June 30, 2007 other income increased $330,000, or 15%, compared to the six months ended June 30, 2006.  Contributing to the increase were growth in deposit fees, gains from sales of foreclosed properties and a first quarter 2007 gain from the sale of an owned commercial facility previously leased to a non-related third party.

Other operating expenses

For the second quarter ended June 30, 2007, other (non-interest) expenses increased $139,000, or 4%, compared to the same 2006 quarter.  Salaries and related employee benefits increased $191,000, or 10%, due to annual merit pay increases, more full-time equivalent employees and interim recognition of performance-based incentives.  The $39,000 decline in premises and equipment was due to less equipment related maintenance costs required in 2007 compared to 2006.  Advertising expense increased $24,000 during the quarter ended June 30, 2007 compared to the quarter ended June 30, 2006, with the grand opening and relocation project of one branch office.  The $36,000 decline in the other component of other operating expenses was caused mostly by reductions in professional fees and the Bank’s FDIC assessment.

For the six months ended June 30, 2007, other expenses increased $330,000, or 4%, compared to the six months ended June 30, 2006.  Salary and related employee benefits increased $319,000, or 8%, due to pay increases and performance-based incentives.  Advertising increased $54,000, or 19%, during the period caused principally by the aforementioned activities associated with the branch relocation project and a winter deposit-gathering campaign earlier this year.

Income tax provision

Compared to 2006, income before provision for income taxes for the second quarter and first six months of 2007 increased $338,000 and $381,000, respectively.  The effective federal income tax rate was 25.9% and 25.8% for the three and six months ended June 30, 2007, compared to 23.5% and 23.9% for each of the respective 2006 periods.  The effective tax rate increase is attributable to higher pre-tax earnings and a decrease in tax-free interest income from municipal securities and tax-free loans, partially offset by an increase in the tax-free earnings from the BOLI, collectively representing a smaller portion of pre-tax earnings.

COMPARISON OF FINANCIAL CONDITION AT

JUNE 30, 2007 AND DECEMBER 31, 2006

Overview

Consolidated assets increased $11,174,000, or 2%, during the six months ended June 30, 2007.  The net asset increase in total assets was due to increases in total deposits of $11,000,000 and shareholders’ equity of $587,000 partially offset by a net reduction in borrowings of $466,000.

Investment securities

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 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

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

At June 30, 2007, the carrying value of investment securities totaled $107,965,000, or 19% of total assets compared to $100,411,000, or 18% of total assets at December 31, 2006.  Also as of June 30, 2007, approximately 46% of the carrying value of the investment portfolio was comprised of mortgage-backed securities that amortize and provide monthly cash flow.  Agency, corporate and municipal bonds comprised 30%, 12% and 11%, respectively, of the investment portfolio at June 30, 2007.

As illustrated in the following table of amortized cost and fair market value of investment securities, the portfolio is comprised of HTM and AFS securities with carrying values of $1,252,000 and $106,713,000, respectively.  At June 30, 2007, the AFS debt securities were recorded with a net unrealized loss in the amount of $3,231,000 and equity securities were recorded with an unrealized gain of $201,000 (dollars in thousands):

		Amortized			Gross unrealized			Gross unrealized			Fair
		cost			gains			losses			value
Held-to-maturity securities:
Mortgage-backed securities		$	1,252		$	14		$	1		$	1,265
Available-for-sale securities:
U.S. government agencies and corporations		$	33,162		$	—		$	1,057		$	32,105
Obligations of states and political subdivisions		12,286			1			200			12,087
Corporate bonds		13,209			42			28			13,223
Mortgage-backed securities		50,807			—			1,989			48,818
Total debt securities		109,464			43			3,274			106,233
Equity securities		279			201			—			480
Total available-for-sale		$	109,743		$	244		$	3,274		$	106,713

 

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