LCNB CORP - Quarter Report: 2004 June (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.   20549

FORM 10-Q

(Mark One)

(  X  )

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2004

 (      )

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  000-26121

LCNB Corp.

(Exact name of registrant as specified in its charter)

Ohio

 31-1626393

(State or other jurisdiction of

(I.R.S. Employer

incorporation or organization)

Identification Number)

2 North Broadway, Lebanon, Ohio   45036

(Address of principal executive offices, including Zip Code)

(513) 932-1414

(Registrant's telephone number, including area code)

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

Yes   X  No   

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes   X  No   

The number of shares outstanding of the issuer's common stock, without par value, as of July 23, 2004 was 3,346,306 shares.

LCNB Corp.

INDEX

Page No.

Part I - Financial Information

Item 1.  Financial Statements

Consolidated Balance Sheets -

June 30, 2004, and December 31, 2003

1

Consolidated Statements of Income -

Three and Six Months Ended June 30, 2004 and 2003

2

Consolidated Statements of Comprehensive Income -

Three and Six Months Ended June 30, 2004 and 2003

3

Consolidated Statements of Stockholders' Equity -

Six Months Ended June 30, 2004 and 2003

4

Consolidated Statements of Cash Flows -

Six Months Ended June 30, 2004 and 2003

5

Notes to Consolidated Financial Statements

6-11

Independent Accountants' Review Report

12

Item 2.  Management's Discussion and Analysis of Financial

Condition and Results of Operations

13-26

Item 3.  Quantitative and Qualitative Disclosures about

Market Risks

27

Item 4  Controls and Procedures

27

Part II - Other Information

Item 1  Legal Proceedings

28

Item 2  Changes in Securities and Use of Proceeds

28-29

Item 3  Defaults by the Company on its Senior Securities

29

Item 4  Submission of Matters to a Vote of Security Holders

29

Item 5  Other Information

29

Item 6  Exhibits and Reports on Form 8-K

30

Signatures

31

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Note 1 - Basis of Presentation

Substantially all of the assets, liabilities and operations of LCNB Corp.("LCNB") are attributable to its wholly owned subsidiaries, Lebanon Citizens National Bank ("Lebanon Citizens") and Dakin Insurance Agency, Inc. ("Dakin").  The accompanying unaudited consolidated financial statements include the accounts of LCNB, Lebanon Citizens, and Dakin.

The statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and the instructions to Form 10-Q.  Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements.  In the opinion of management, the unaudited consolidated financial statements include all adjustments (consisting of normal, recurring accruals) considered necessary for a fair presentation of financial position, results of operations and cash flows for the interim periods.

The preparation of financial statements in conformity with U.S. generally accepted accounting principles 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 reporting period.  Actual results could differ from those estimates.

Results of operations for the three and six months ended June 30, 2004 are not necessarily indicative of the results to be expected for the full year ending December 31, 2004.  These unaudited consolidated financial statements should be read in conjunction with the consolidated financial statements, accounting policies and financial notes thereto included in LCNB's 2003 Form 10-K filed with the Securities and Exchange Commission.

The Board of Directors of LCNB at the regular meeting of April 13, 2004 declared a stock dividend of one share for each share owned to shareholders of record on April 20, 2004.  The stock dividend was paid on April 30, 2004 and was accounted for as a stock split.  All share and per share information for all periods presented have been retroactively restated to reflect the stock dividend.

The financial information presented on pages one through ten of this Form 10-Q has been subject to a review by J.D. Cloud & Co., L.L.P., LCNB's independent certified public accountants, as described in their report contained herein.

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 2 - Earnings Per Share

Basic earnings per share is calculated by dividing net income by the weighted average number of common shares outstanding during the period.  Diluted earnings per share is adjusted for the dilutive effects of stock options.  The diluted average number of common shares outstanding has been increased for the assumed exercise of stock options with proceeds used to purchase treasury shares at the average market price for the period.  The computations were as follows for the three and six months ended June 30 (thousands, except share and per share data):

Note 3 -  Investment Securities

Available for sale investment securities, recorded at estimated market value, consist of the following (thousands):

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 4 - Loans

Major classifications of loans at June 30, 2004 and December 31, 2003 are as follows (thousands):

Mortgage loans sold to and serviced for the Federal Home Loan Mortgage Corporation ("FHLMC") are not included in the accompanying balance sheets.  The unpaid principal balances of those loans at June 30, 2004 and December 31, 2003 were $49,888,000 and $54,802,000, respectively.  Loans sold to the FHLMC during the three and six months ended June 30, 2004 totaled $1,086,000 and $1,665,000, respectively, and $12,390,000 and $22,115,000 during the three and six months ended June 30, 2003, respectively.

Mortgage servicing rights on originated mortgage loans that have been sold are capitalized by allocating the total cost of the loans between mortgage servicing rights and the loans based on their relative fair values.  Approximately $12,000 and $18,000 were capitalized during the three and six months ended June 30, 2004, respectively, and $124,000 and $220,000 were capitalized during the three and six months ended June 30, 2003, respectively.  Capitalized mortgage servicing rights are being amortized to loan servicing income in proportion to and over the period of estimated servicing income.

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 4 - Loans (continued)

Charge-offs for the six months ended June 30, 2004 included a $107,000 partial charge-off for a commercial loan.  The balance of charge-offs for that period was primarily for consumer loans.  Charge-offs for the six months ended June 30, 2003 consisted of consumer and credit card loans.  There were no charge-offs on residential real estate or commercial loans for the 2003 period.

Non-accrual, past-due, and restructured loans as of June 30, 2004 and December 31, 2003 were as follows (thousands):

Non-accrual loans at June 30, 2004 included $1,817,000 of related commercial loans that were classified as loans past due 90 days or more and still accruing at December 31, 2003, at which time they had a balance of $2,030,000.  The $213,000 difference in the loan balances at June 30, 2004 and December 31, 2003 is due to principal payments received during the second quarter.  These loans are secured by a combination of mortgages and other collateral.  Information received during the first quarter, 2004 raised uncertainties concerning the collectibility of certain collateral and management transferred the loans to the nonaccrual classification and is continuing to classify the loans as non-accrual.

Non-accrual loans at December 31, 2003 included a commercial loan in the amount of $564,000, which was paid in full during the second quarter, 2004.

Note 5 – Other Borrowings

At June 30, 2004 and December 31, 2003, accrued interest and other liabilities included U.S. Treasury demand note borrowings of approximately $875,000 and $633,000, respectively.

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 6 - Commitments and Contingent Liabilities

LCNB is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments included commitments to extend credit.  They involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets.  Exposure to credit loss in the event of nonperformance by the other parties to financial instruments for commitments to extend credit is represented by the contract amount of those instruments.

LCNB uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.  Financial instruments whose contract amounts represent off-balance-sheet credit risk at June 30, 2004 and December 31, 2003 were as follows (thousands):

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses.  Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party.  At June 30, 2004 and December 31, 2003, outstanding guarantees of $1,995,000 and $1,880,000, respectively, were issued to developers and contractors.  These guarantees generally expire within one year and are fully secured.  In addition, LCNB has an approximate $4.9 million participation at June 30, 2004 and December 31, 2003 in a letter of credit securing payment of principal and interest on a bond issue.  This letter of credit will expire July 15, 2006, and is secured by an assignment of rents and the underlying real property.

LCNB evaluates each customer's credit worthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary, is based on management's credit evaluation of the borrower.  Collateral held varies, but may include accounts receivable; inventory; property, plant and equipment; residential realty; and income-producing commercial properties.

At June 30, 2004, LCNB is committed under various contracts to expend approximately $140,000 to complete certain building renovation projects.

LCNB and its subsidiaries are parties to various claims and proceedings arising in the normal course of business.  Management, after consultation with legal counsel, believes that the liabilities, if any, arising from such proceedings and claims will not be material to the consolidated financial position or results of operations.  

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 7 - Stock Options

LCNB established an Ownership Incentive Plan (the "Plan") during 2002 that allows for stock-based awards to eligible employees.  The awards may be in the form of stock options, share awards, and/or appreciation rights.  The Plan provides for the issuance of up to 100,000 shares.  Stock options for 4,054 shares with an exercise price of $35.315 were granted to key executive officers of LCNB during the first quarter, 2004.  At June 30, 2004, 9,582 stock options with a weighted average exercise price of $30.05 were outstanding.  The options expire in 2013 and 2014.  No options have been exercised as of June 30, 2004.

LCNB accounts for the Plan under the recognition and measurement principles of Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations.  No stock-based employee compensation cost is reflected in net income, as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant.  The pro-forma effect on net income and earnings per share if LCNB had applied the fair value recognition provisions of Statement of Financial Accounting Standards ("SFAS") No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation was not material.  Because 2003 was the first year stock options were outstanding, the pro-forma affect for 2003 and 2004 may not be indicative of the pro-forma affect on future quarters and years.

Note 8 – Employee Benefits

LCNB has a noncontributory defined benefit retirement plan that covers all regular full-time employees.  The components of net periodic pension cost for the three and six months ended June 30, 2004 and 2003, are summarized as follows (thousands):

LCNB previously disclosed in its consolidated financial statements for the year ended December 31, 2003, that it expected to contribute $650,000 to its pension plan in 2004.  As of June 30, 2004, no contributions have been made.

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INDEPENDENT  ACCOUNTANTS'  REVIEW  REPORT

To the Board of Directors and Shareholders

LCNB Corp. and subsidiaries

Lebanon, Ohio

We have reviewed the accompanying consolidated balance sheet of LCNB Corp. and subsidiaries as of June 30, 2004, and the related consolidated statements of income and comprehensive income for each of the three-month and six-month periods ended June 30, 2004 and 2003, and the related consolidated statements of cash flows and shareholders' equity for each of the six-month periods ended June 30, 2004 and 2003.  These financial statements are the responsibility of the Company's management.

We conducted our review in accordance with the standards of The Public Company Accounting Oversight Board (United States).  A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters.  It is substantially less in scope than an audit conducted in accordance with the standards of The Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole.  Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to the accompanying consolidated interim financial statements for them to be in conformity with U.S. generally accepted accounting principles.

We previously audited, in accordance with the standards of The Public Company Accounting Oversight Board (United States), the consolidated balance sheet of LCNB Corp. and subsidiaries as of December 31, 2003 (presented herein), and the related consolidated statements of income, shareholders' equity, and cash flows for the year then ended (not presented herein), and in our report dated January 16, 2004, we expressed an unqualified opinion on those consolidated financial statements.  In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2003, is fairly stated in all material respects.

/s/ J.D. Cloud & Co. L.L.P.                                      

Cincinnati, Ohio

July 15, 2004

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations

Forward Looking Statements

Certain matters disclosed herein may be deemed to be forward-looking statements that involve risks and uncertainties, including regulatory policy changes, interest rate fluctuations, loan demand, loan delinquencies and losses, and other risks.  Actual strategies and results in future time periods may differ materially from those currently expected.  Such forward-looking statements represent management's judgment as of the current date.  The Company disclaims, however, any intent or obligation to update such forward-looking statements.

Results of Operations

LCNB earned $1,556,000, or $0.46 per share, for the three months ended June 30, 2004 compared to $1,698,000, or $0.49 per share, for the three months ended June 30, 2003.  The return on average assets (ROAA) was 1.24% and the return on average equity (ROAE) was 11.89% for the second quarter of 2004, compared with an ROAA of 1.32% and an ROAE of 12.69% for the second quarter of 2003.

LCNB earned $3,218,000, or $0.96 per share, during the first six months of 2004 compared to $3,304,000, or $0.96 per share, for the first six months of 2003.  The ROAA and ROAE for the first six months of 2004 were 1.28% and 12.25%, respectively.  The comparable ratios for the first six months of 2003 were 1.30% and 12.53%, respectively.  

LCNB's earnings for the first half of 2004 included $530,000, or $350,000 on an after-tax basis, in gains from first quarter sales of investment securities totaling $11.4 million and credit card receivables totaling approximately $2.6 million.  The proceeds from the sale of investment securities were primarily used to purchase securities with a slightly longer maturity and higher average interest rates than the ones sold.  LCNB management decided to exit the credit card market and sell its receivables to MBNA America because of the high administrative costs of servicing a small credit card portfolio.  LCNB will continue to offer credit card products under a marketing agreement with MBNA.

The decrease in net income for both the three and six month periods are primarily attributed to reductions in net interest income and gains from sales of mortgage loans, along with an increase in the provision for loan losses.  Partially offsetting these influences were increases in trust income and income from service charges and fees.

Net Interest Income

Three Months Ended June 30, 2004 vs. 2003.

LCNB's primary source of earnings is net interest income, which is the difference between earnings from loans and other investments and interest paid on deposits and other liabilities.  The following table presents, for the three months ended June 30, 2004 and 2003, average balances for interest-earning assets and interest-bearing liabilities, the income or expense related to each item, and the resultant average yields earned or rates paid.

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

(1)

Includes nonaccrual loans if any.  Income from tax-exempt loans is included in interest income on a tax-equivalent basis, using an incremental rate of 34%.

(2)

Income from tax-exempt securities is included in interest income on a taxable-equivalent basis.  Interest income has been divided by a factor comprised of the complement of the incremental tax rate of 34%.

(3)

The net interest spread is the difference between the average rate on total interest-earning assets and interest-bearing liabilities.

(4)

The net interest margin is the taxable-equivalent net interest income divided by average interest-earning assets.

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

The following table presents the changes in taxable-equivalent basis interest income and expense for each major category of interest-earning assets and interest-bearing liabilities and the amount of change attributable to volume and rate changes for the three months ended June 30, 2004 as compared to the comparable period in 2003.  Changes not solely attributable to rate or volume have been allocated to volume and rate changes in proportion to the relationship of absolute dollar amounts of the changes in each.

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

Net interest income on a fully tax-equivalent basis for the three months ended June 30,  2004 totaled $4,780,000, a decrease of $82,000 from the comparable period in 2003.  Total interest income decreased $663,000 and was largely offset by a decrease in total interest expense of $581,000.  The decreases in both interest income and expense were primarily a result of decreases in the average rate earned on loans and investments and the average rate paid for deposits and borrowings.  

The decrease in total interest income was primarily due to a 41 basis point (a basis point equals 0.01%) reduction in the average rate earned on earning assets, from 5.93% for the second quarter of 2003 to 5.52% for the second quarter of 2004.  A secondary factor was an $11.9 million decrease in average interest earning assets, from $486.2 million for the three months ended June 30, 2003 to $474.3 million for the same period in 2004.  Most of the decrease was in federal funds sold and investment securities.

The decrease in total interest expense was primarily due to a 49 basis point decrease in the average rate paid and secondarily due to a $19.9 million decrease in average interest-bearing liabilities.  Average interest-bearing deposits decreased $17.8 million, while average long-term debt decreased $2.1 million.  The deposit decrease was primarily in money fund investment and certificate of deposit accounts.  The decrease in long-term debt was due to the maturation of a $2.0 million Federal Home Loan Bank advance in December, 2003.

Six Months Ended June 30, 2004 vs. 2003.

The following table presents, for the six months ended June 30, 2004 and 2003, average balances for interest-earning assets and interest-bearing liabilities, the income or expense related to each item, and the resultant average yields earned or rates paid.

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

(1)

Includes nonaccrual loans if any.  Income from tax-exempt loans is included in interest income on a tax-equivalent basis, using an incremental rate of 34%.

(2)

Income from tax-exempt securities is included in interest income on a taxable-equivalent basis.  Interest income has been divided by a factor comprised of the complement of the incremental tax rate of 34%.

(3)

The net interest spread is the difference between the average rate on total interest-earning assets and interest-bearing liabilities.

(4)

The net interest margin is the taxable-equivalent net interest income divided by average interest-earning assets.

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

The following table presents the changes in taxable-equivalent basis interest income and expense for each major category of interest-earning assets and interest-bearing liabilities and the amount of change attributable to volume and rate changes for the six months ended June 30, 2004 as compared to the comparable period in 2003.  

Net interest income on a fully tax-equivalent basis for the first half of 2004 totaled $9,532,000, a decrease of $403,000 from the first half of 2003.  Total interest income decreased $1,446,000 and was partially offset by a decrease in total interest expense of $1,043,000.

The decrease in total interest income was primarily due to a 55 basis point decrease in the average rate earned on earning assets, from 6.11% for the first half of 2003 to 5.56% for the first half of 2004.  A secondary factor was a $5.9 million decrease in average total earning assets.  

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

The decrease in total interest expense was primarily due to a 47 basis point decrease in the average rate paid, and secondarily to a $14.1 million decrease in average interest-bearing liabilities.  Average interest-bearing deposits decreased $11.9 million and average long-term debt decreased $2.1 million.  As discussed in the previous section, the deposit decrease was primarily in money fund investment and certificate of deposit accounts and the decrease in long-term debt was due to the maturation of a $2.0 million Federal Home Loan Bank advance in December, 2003.

Provision and Allowance For Loan Losses

The total provision for loan losses is determined based upon management's evaluation as to the amount needed to maintain the allowance for credit losses at a level considered appropriate in relation to the risk of losses inherent in the portfolio.  The total loan loss provision and the other changes in the allowance for loan losses are shown below.  

Charge-offs for the first half of 2004 included a $107,000 partial charge-off on a commercial loan, $238,000 in consumer loan charge-offs, and $10,000 in credit card charge-offs.  Charge-offs for the first half of 2003 included $234,000 in consumer loan charge-offs and $14,000 in credit card charge-offs.

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

The following table sets forth information regarding the past due, non-accrual and renegotiated loans of the Bank at the dates indicated:

Non-accrual loans at June 30, 2004 included $1,817,000 of related commercial loans that were classified as loans past due 90 days or more and still accruing at December 31, 2003, at which time they had a balance of $2,030,000.  The $213,000 difference in the loan balances at June 30, 2004 and December 31, 2003 is due to principal payments received during the second quarter.  These loans are secured by a combination of mortgages and other collateral.  Information received during the first quarter, 2004 raised uncertainties concerning the collectibility of certain collateral and management transferred the loans to the nonaccrual classification and is continuing to classify the loans as non-accrual.

Non-accrual loans at December 31, 2003 included a commercial loan in the amount of $564,000, which was paid in full during the second quarter, 2004.

Non -Interest Income

Three Months Ended June 30, 2004 vs. 2003.

Total non-interest income for the second quarter of 2004 was $136,000 or 8.3% greater than for the second quarter of 2003 primarily due to increased service charges and fees and increased trust income, partially offset by decreased gains from loan sales from reduced activity in the real estate mortgage loan secondary market.  Service charges and fees increased $269,000 or 38.3% primarily due to an increase in the number of non-sufficient fund charges.  Trust income was $116,000 or 49.6% greater primarily due to growth in total trust assets, from $125.9 million at June 30, 2003 to $175.9 million at June 30, 2004.  This growth was primarily from new business.

Gains from sales of mortgage loans decreased $254,000 or 92.4% due to a decrease in the volume of loans sold during the second quarter, 2004 as compared to the second quarter, 2003.  The volume of residential mortgage loan refinancing has declined with the recent increase in market rates and LCNB is also adding a greater percentage of new loans generated to its loan portfolio rather than selling them in the secondary market.  See Note 4 to the consolidated financial statements for a comparison of loans sold during the three and six months ended June 30, 2004 and 2003.

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

Six Months Ended June 30, 2004 vs. 2003.

Total non-interest income for the first six months of 2004, excluding the investment security and credit card gains, was $269,000 or 8.5% more than for the comparable period in 2003 primarily due to a $531,000 or 39.7% increase in service charges and fees and a $226,000 or 46.2% increase in trust income, partially offset by a $460,000 or 91.6% decrease in gains from sales of mortgage loans.  Service charges and fees and trust income increased and gains from sales of mortgage loans decreased for substantially the same reasons mentioned above.

Non-Interest Expense

Three Months Ended June 30, 2004 vs. 2003.

Total non-interest expense increased $122,000 or 3.1% during the second quarter, 2004 compared with the second quarter, 2003 primarily due to increases in salaries and wages, pension and other employee benefits and occupancy expenses.  Salaries and wages increased $28,000 or 1.6% primarily due to routine salary and wage increases.  Pension and other employee benefits increased $18,000 or 4.4% primarily due to increased expenses for social security and medicare matching and increased pension expense.  Occupancy expense increased $33,000 or 12.3% primarily due to increased maintenance and repair expenses.

Six Months Ended June 30, 2004 vs. 2003.

Total non-interest expense increased $467,000 or 6.0% during the first half, 2004 compared with the first half of  2003 primarily due to a $96,000 or 2.8% increase in salaries and wages, a $66,000 or 7.4% increase in pension and other employee benefits, a $48,000 or 8.7% increase in occupancy expense, and a $153,000 or 9.6% increase in other non-interest expenses.  The increases in salaries and wages and pension and other employee benefits were for substantially the same reasons described in the second quarter comparison above.  Approximately $23,000 of the increase in occupancy expense was due to increased maintenance and repair expenses, and the rest was due to smaller increases in several different occupancy classifications.  Items contributing to the increase in other non-interest expenses included maintenance contracts on computer software, postage, telephone expense, and outside services.

Income Taxes

LCNB’s effective tax rates for the six months ended June 30, 2004 and 2003 were 26.9% and 26.7%, respectively.  The difference between the statutory rate of 34.0% and the effective tax rate is primarily due to tax-exempt interest income.   

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

Financial Condition

Loans at June 30, 2004 were approximately $10.5 million greater than at December 31, 2003.  The growth can be attributed to residential real estate loan portfolio, which was $13.4 million greater at June 30, 2004 than at December 31, 2003.  The portfolio grew because, with the recent increase in market rates for residential real estate loans, LCNB is adding a greater percentage of new loans generated to its loan portfolio rather than selling them in the secondary market.  

Interest-bearing deposits at June 30, 2004 were approximately $22.2 million less than at December 31, 2003.  Approximately $15.5 million of this decrease was due to a new trust account that was obtained near year end, 2003.  The funds were temporarily deposited in a liquid, interest-bearing account at Lebanon Citizens until the trust department could invest them in other instruments during early 2004.

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

The following table highlights the changes in the balance sheet. The analysis uses quarterly averages to give a better indication of balance sheet trends.  

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

Average total interest-earning assets decreased approximately $2.7 million or 0.6% during the second quarter, 2004 compared to the first quarter, 2004.  The decline was in investment securities, which decreased $5.1 million or 3.5% on an average basis, and in federal funds sold, which decreased $1.0 million or 6.9% on an average basis.  Average loans partially offset these decreases with an increase of $3.4 million or 1.1%.  Average balances in the residential real estate and commercial loan portfolios grew during the second quarter, while consumer loans declined.  

Average total interest-bearing liabilities for the second quarter, 2004, were $5.8 million or 1.5% less than for the first quarter, 2004.  The decrease was primarily in interest-bearing deposits, which decreased $6.0 million on an average basis.  Certificate of deposit accounts decreased $7.5 million on an average basis, while IRA accounts increased $0.5 million and highly liquid savings and NOW account products increased a net $1.0 million.  Management believes the growth in the liquid products reflects investor preference for short-term, highly liquid investments during the current economic cycle.  This means much of the savings deposit growth of the last several years could be quickly withdrawn when interest rates increase.  Management is attempting to lock in a portion of these funds by offering special rates on selected certificate of deposit products.

Capital

Lebanon Citizens and LCNB are required by regulators to meet certain minimum levels of capital adequacy. These are expressed in the form of certain ratios. Capital is separated into Tier 1 capital (essentially shareholders' equity less goodwill and other intangibles) and Tier 2 capital (essentially the allowance for loan losses limited to 1.25% of risk-weighted assets). The first two ratios, which are based on the degree of credit risk in LCNB's assets, provide for weighting assets based on assigned risk factors and include off-balance sheet items such as loan commitments and stand-by letters of credit. The ratio of Tier 1 capital to risk-weighted assets must be at least 4.0% and the ratio of Total capital (Tier 1 capital plus Tier 2 capital) to risk-weighted assets must be at least 8.0%.  The capital leverage ratio supplements the risk-based capital guidelines. Banks are required to maintain a minimum ratio of Tier 1 capital to adjusted quarterly average total assets of 3.0%. For various regulatory purposes, financial institutions are classified into categories based upon capital adequacy.  The highest "well-capitalized" category requires capital ratios of at least 10% for total risk-based, 6% for Tier 1 risk-based, and 5% for leverage.  As of the most recent notification from their regulators, Lebanon Citizens and LCNB were categorized as "well-capitalized" under the regulatory framework for prompt corrective action.  Management believes that no conditions or events have occurred since the last notification that would change the Lebanon Citizens' or LCNB's category.  A summary of the regulatory capital and capital ratios of LCNB follows:

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)