LCNB CORP - Annual Report: 2006 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.   20549

FORM 10-K

(Mark One)

(  X  )

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

For the fiscal year ended December 31, 2006

 (      )

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)

Securities registered pursuant to Section 12(b) of the Exchange Act:

Name of each exchange

  Title of Each Class

   on which registered   

None

None

Securities registered pursuant to 12(g) of the Exchange Act:

COMMON STOCK, NO PAR VALUE

(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

                                [  ] Yes          [X] No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.                            

                                [  ] Yes          [X] No

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.                      [X] Yes         [  ] No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     [  ]

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          [X] Accelerated filer          [  ] Non-accelerated filer

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

.                               [  ] Yes          [ X ] No

The aggregate market value of the registrant’s outstanding voting common stock held by nonaffiliates on June 30, 2006, determined using a per share closing price on that date of $36.50 as quoted on the Nasdaq Over-the-Counter Bulletin Board, was $105,653,119.00.

As of March 1, 2007, 3,184,718 common shares were issued and outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement included in the Notice of Annual Meeting of Shareholders to be held April 10, 2007, dated March 9, 2007, are incorporated by reference into Part III.

LCNB Corp.

For the Year Ended December 31, 2006

TABLE OF CONTENTS

PART I

Item 1.  Business

FORWARD-LOOKING STATEMENTS

Certain matters disclosed herein may be deemed to be forward-looking statements that involve risks and uncertainties.  Forward looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact. Such statements are often characterized by the use of qualifying words and their derivatives such as “expects,” “anticipates,” “believes,” “estimates,” “plans,” “projects,” or other statements concerning opinions or judgments of the Company and its management about future events.   Factors that could influence the accuracy of such forward looking statements include, but are not limited to, regulatory policy changes, interest rate fluctuations, loan demand, loan delinquencies and losses, general economic conditions and other risks.  Such forward-looking statements represent management's judgment as of the current date.  Actual strategies and results in future time periods may differ materially from those currently expected.  LCNB Corp. disclaims, however, any intent or obligation to update such forward-looking statements.  LCNB Corp. intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

DESCRIPTION OF LCNB CORP.'S BUSINESS

General Description

LCNB Corp., an Ohio corporation formed in December, 1998, is a financial holding company headquartered in Lebanon, Ohio.  Through its subsidiaries, Lebanon Citizens National Bank (the “Bank") and Dakin Insurance Agency, Inc. ("Dakin"), LCNB is engaged in the commercial banking and insurance agency businesses.  LCNB Corp. and its subsidiaries are herein collectively referred to as “LCNB”.  

The predecessor of LCNB Corp., the Bank, was formed as a national banking association in 1877.  On May 19, 1999, the Bank became a wholly-owned subsidiary of LCNB.  The Bank's main office is located in Warren County, Ohio and 20 branch offices are located in Warren, Butler, Clinton, Clermont, and Hamilton Counties, Ohio.  In addition, the Bank operates 28 automated teller machines ("ATMs") in its market area.

The Bank is a full service community bank offering a wide range of commercial and personal banking services.  Deposit services include checking accounts, NOW accounts, savings accounts, Christmas and vacation savings, money market deposit accounts, Classic 50 accounts (a Senior Citizen program), individual retirement accounts, and certificates of deposit.  Deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund, which is administered by the Federal Deposit Insurance Corporation (the “FDIC”).

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Loan products offered include commercial loans, commercial and residential real estate loans, construction loans, various types of consumer loans, and Small Business Administration loans.  The Bank's residential mortgage lending activities consist primarily of loans for purchasing or refinancing personal residences, home equity lines of credit, and loans for commercial or consumer purposes secured by residential mortgages.  Consumer lending activities include automobile, boat, home improvement and personal loans.  The Bank also offers indirect financing through various automotive, boat, and lawn and garden dealers.

The Trust and Investment Management Division of the Bank performs complete trust administrative functions and offers agency and trust services, retirement savings products, and mutual fund investment products to individuals, partnerships, corporations, institutions and municipalities.

Security brokerage services are offered by the Bank through arrangements with UVEST Financial Services, Inc., a registered broker/dealer.  Licensed brokers offer a full range of investment services and products, including financial needs analysis, mutual funds, securities trading, annuities, and life insurance.

Other services offered include safe deposit boxes, night depositories, U.S. savings bonds, travelers' checks, money orders, cashier's checks, bank-by-mail, ATMs, cash and transaction services, debit cards, wire transfers, electronic funds transfer, utility bill collections, notary public service, personal computer based cash management services, 24 hour telephone banking, PC Internet banking, and other services tailored for both individuals and businesses.

The Bank is not dependent upon any one significant customer or specific industry.  Business is not seasonal to any material degree.

The address of the main office of the Bank is 2 North Broadway, Lebanon, Ohio 45036; telephone (513) 932-1414.  Its primary market area encompasses all of Butler and Warren Counties and portions of Clinton, Clermont, and Hamilton Counties.

Dakin, an Ohio corporation, has been an independent insurance agency in Lebanon, Ohio since 1876.  Its primary office is at 24 East Mulberry Street, Lebanon, Ohio 45036; telephone (513) 932-4010.  Since being acquired by LCNB on April 11, 2000, Dakin maintains additional offices in the Bank's Maineville and Mason offices.  Dakin is engaged in selling and servicing personal and commercial insurance products and annuity products and is regulated by the Ohio Department of Insurance.

Effective September 1, 2002, Dakin purchased substantially all of the insurance renewal rights and client list of an insurance agency located in Dayton, Ohio.  As part of the purchase, Dakin received all commission income received after September 1, 2002, and assignments of agency agreements that the agency had with insurers with whom Dakin did not already have an agreement.  In consideration for the assets purchased, Dakin paid to the seller certain percentages of the commissions received from the agency's customer base over a four-year period.

On May 31, 2006, Dakin purchased the existing book of business of Altemeier Oliver & Company Agency, Inc. (“AOC”), an independent insurance agency located in Blue Ash, Ohio.  The acquired assets consisted solely of a customer list intangible asset.

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Competition

The Bank faces strong competition both in making loans and attracting deposits.  The deregulation of the banking industry and the wide spread enactment of state laws that permit multi-bank holding companies as well as the availability of nationwide interstate banking has created a highly competitive environment for financial services providers. The Bank competes with other national and state banks, savings and loan associations, credit unions, finance companies, mortgage brokerage firms, realty companies with captive mortgage brokerage firms, mutual funds, insurance companies, brokerage and investment banking companies, and other financial intermediaries operating in its market and elsewhere, many of whom have substantially larger financial and managerial resources.  

The Bank seeks to minimize the competitive effect of other financial institutions through a community banking approach that emphasizes direct customer access to the Bank's president and other officers in an environment conducive to friendly, informed, and courteous personal services.  Management believes that the Bank is well positioned to compete successfully in its primary market area.  Competition among financial institutions is based upon interest rates offered on deposit accounts, interest rates charged on loans and other credit and service charges, the quality and scope of the services rendered, the convenience of the banking facilities, and, in the case of loans to commercial borrowers, relative lending limits.

Management believes the commitment of the Bank to personal service, innovation, and involvement in the communities and primary market areas it serves, as well as its commitment to quality community banking service, are factors that contribute to its competitive advantage.

Dakin competes with numerous other independent and exclusive insurance agencies (an exclusive agent sells for only one insurance company) and with insurance companies that sell direct to individuals and businesses without using agents.  Dakin competes by representing high quality insurance companies, providing personalized and responsive service to its clients, and providing convenient office locations.

Supervision and Regulation

The Sarbanes-Oxley Act of 2002 ("SOX") was signed into law by President George W. Bush on July 30, 2002.  The purpose of SOX is to strengthen accounting oversight and corporate accountability by enhancing disclosure requirements, increasing accounting and auditor regulation, creating new federal crimes, and increasing penalties for existing federal crimes.  SOX directly impacts publicly traded companies, certified public accounting firms auditing public companies, attorneys who work for public companies or have public companies as clients, brokerage firms, investment bankers, and financial analysts who work for brokerage firms or investment bankers.  Key provisions affecting LCNB include:

1.

Certification of financial reports by the chief executive officer ("CEO") and the chief financial officer ("CFO"), who are responsible for designing and monitoring internal controls to ensure that material information relating to the issuer and its consolidated subsidiaries is made known to the certifying officers by others within the company;

2.

Inclusion of an internal control report in annual reports that include management's assessment of the effectiveness of a company's internal control over financial reporting and a report by the company's independent registered public accounting firm attesting to management's assessment of internal control;

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3.

Accelerated reporting of stock trades on Form 4 by directors and executive officers;

4.

Disgorgement requirements of incentive pay or stock-based compensation profits received within twelve months of the release of financial statements if the company is later required to restate those financial statements due to material noncompliance with any financial reporting requirement that resulted from misconduct;

5.

Disclosure in a company's periodic reports stating if it has adopted a code of ethics for its CFO and principal accounting officer or controller and, if such code of ethics has been implemented,  immediate disclosure of any change in or waiver of the code of ethics;

6.

Disclosure in a company's periodic reports stating if at least one member of the audit committee is a "financial expert," as that term is defined by the Securities and Exchange Commission (the "SEC"); and

7.

Implementation of new duties and responsibilities for a company's audit committee, including independence requirements, the direct responsibility to appoint the outside auditing firm and to provide oversight of the auditing firm's work, and a requirement to establish procedures for the receipt, retention, and treatment of complaints from a company's employees regarding questionable accounting, internal control, or auditing matters.

In addition, the SEC adopted final rules on September 5, 2002, which rules were amended in December, 2005,  requiring accelerated filing of quarterly and annual reports.  Under the amended rules, “large accelerated filers” include companies with a market capitalization of $700 million or more and  “accelerated filers” include companies with a market capitalization between $75 million and $700 million.  Large accelerated filers are required to file their annual reports within 60 days of year-end and quarterly reports within 40 days. Accelerated filers are required to file their annual and quarterly reports within 75 days and 40 days, respectively.  These new accelerated filing deadlines were effective for fiscal years ending on or after December 15, 2005.  Under the new rules, LCNB is considered an accelerated filer.

LCNB Corp. and the Bank are subject to an extensive array of banking laws and regulations that are intended primarily for the protection of the customers and depositors of LCNB's subsidiaries rather than holders of LCNB's securities.  These laws and regulations govern such areas as permissible activities, loans and investments, and rates of interest that can be charged on loans and reserves.  LCNB and the Bank also are subject to general U.S. federal laws and regulations and to the laws and regulations of the State of Ohio.  Set forth below are brief descriptions of selected laws and regulations applicable to LCNB and the Bank.

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LCNB Corp., as a financial holding company, is regulated under the Bank Holding Company Act of 1956, as amended (the "Act"), and is subject to the supervision and examination of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board").  The Act requires the prior approval of the Federal Reserve Board for a bank or financial holding company to acquire or hold more than a 5% voting interest in any bank and restricts interstate banking activities.

On September 29, 1994, the Act was amended by the Interstate Banking and Branch Efficiency Act of 1994, which authorizes interstate bank acquisitions anywhere in the country, effective one year after the date of enactment, and interstate branching by acquisition and consolidation, effective June 1, 1997, in those states that have not opted out by that date.   

The Gramm-Leach-Bliley Act, which amended the Bank Holding Company Act of 1956 and other banking related laws, was signed into law on November 12, 1999.  The Gramm-Leach-Bliley Act repealed certain sections of the Glass-Steagall Act and substantially eliminated the barriers separating the banking, insurance, and securities industries.  Effective March 11, 2000, qualifying bank holding companies could elect to become financial holding companies.  Financial holding companies have expanded investment powers, including affiliating with securities and insurance firms and engaging in other activities that are "financial in nature or incidental to such financial activity" or "complementary to a financial activity."  The Gramm-Leach-Bliley Act defines "financial in nature" to include:

1.

securities underwriting, dealing, and market making;

2.

sponsoring mutual funds and investment companies;

3.

insurance underwriting and agency;

4.

merchant banking activities; and

5.

other activities that the Federal Reserve Board, in consultation with and subject to the approval of the Treasury Department, determines are financial in nature.

Financial holding companies may commence the activities listed above or acquire a company engaged in any of those activities without additional approval from the Federal Reserve.  Notice of the commencement or acquisition must be provided to the Federal Reserve within thirty days of the start of the activity.   Sixty days advance notice is required before the start of any activity that is "complementary to a financial activity."

The Financial Reform, Recovery and Enforcement Act of 1989 ("FIRREA") provides that a holding company and its controlled insured depository institutions are liable for any loss incurred by the FDIC in connection with the default of any FDIC assisted transaction involving an affiliated insured bank or savings association.

The Bank is subject to the provisions of the National Bank Act.  The Bank is subject to primary supervision, regulation and examination by the Office of the Comptroller of the Currency (the "OCC"). The Bank is also subject to the rules and regulations of the Board of Governors of the Federal Reserve System and the FDIC.  Under the Bank Holding Company Act of 1956, as amended, and under Regulations of the Federal Reserve Board pursuant thereto, a bank or financial holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit.  

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The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") substantially revised the bank regulatory and funding provisions of the Federal Deposit Insurance Act and several other federal banking statutes.  Among its many reforms, FDICIA, as amended:

1.

Required regulatory agencies to take "prompt corrective action" with financial  institutions that do not meet minimum capital requirements;

2.

Established five capital tiers:  well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized;

3.

Imposed significant restrictions on the operations of a financial institution that is not rated well-capitalized or adequately capitalized;

4.

Prohibited a depository institution from making any capital distributions, including payments of dividends or paying any management fee to its holding company, if the institution would be undercapitalized as a result;

5.

Implemented a risk-based premium system;

6.

Required an audit committee to be comprised of outside directors;

7.

Required a financial institution with more than $1 billion in total assets to issue annual, audited financial statements prepared in conformity with U.S. generally accepted accounting principles; and

8.

Required a financial institution with more than $1 billion in total assets to document, evaluate, and report on the effectiveness of the entity's internal control system and required an independent public accountant to attest to management's assertions concerning the bank's internal control system.

The members of an audit committee for banks with more than $1 billion in total assets must be independent of management.  Only a majority, rather than all, of the members of an audit committee for banks with total assets between $500 million and $1 billion must be independent.  

Financial institutions that are public companies, such as LCNB, are not relieved from their SOX internal control reporting and attestation requirements or their audit committee independence requirements by the provisions of FDICIA.

At December 31, 2006, the Bank was well capitalized based on FDICIA's guidelines.  

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The Federal Deposit Insurance Reform Act of 2005 and the Federal Deposit Insurance Reform Conforming Amendments Act of 2005 (collectively, the “Deposit Insurance Reform Acts”) were both signed into law during February, 2006.  The provisions of the Deposit Insurance Reform Acts included:

1.

Merging the Bank Insurance Fund and the Savings Association Insurance Fund into a new fund called the Deposit Insurance Fund, effective March 31, 2006;

2.

Increasing insurance coverage for retirement accounts from $100,000 to $250,000, which increase was effective April 1, 2006;

3.

Adjusting deposit insurance levels of $100,000 for non-retirement accounts and $250,000 for retirement accounts every five years based on an inflation index, with the first adjustment to be effective on January 1, 2011;

4.

Eliminating a 1.25% hard target Designated Reserve Ratio, as defined, and giving the FDIC discretion to set the Designated Reserve Ratio within a range of 1.15% to 1.50% for any given year;

5.

Eliminating certain restrictions on premium rates the FDIC charges covered institutions and establishing a risk-based premium system; and

6.

Providing for a one-time credit for institutions that paid premiums to the Bank Insurance Fund or the Savings Association Insurance Fund prior to December 31, 1996.

LCNB and the Bank are also subject to the state banking laws of Ohio.  Ohio adopted nationwide reciprocal interstate banking effective October, 1988.  However, banking laws of other states may restrict branching of banks to other counties within the state and acquisitions or mergers involving banks and bank holding companies located in other states.  Additionally, Dakin Insurance Agency, Inc. is subject to State of Ohio insurance regulations and rules and its activities are regulated by the State of Ohio Department of Insurance.

Noncompliance with laws and regulations by bank holding companies and banks can lead to monetary penalties and/or an increased level of supervision or a combination of these two items.  Management is not aware of any current significant instances of noncompliance with laws and regulations and does not anticipate any problems maintaining compliance on a prospective basis.  Recent regulatory inspections and examinations of LCNB and the Bank have not disclosed any significant instances of noncompliance.

The earnings and growth of LCNB are affected not only by general economic conditions, but also by the fiscal and monetary policies of the federal government and its agencies, particularly the Federal Reserve Board.  Its policies influence the amount of bank loans and deposits and the interest rates charged and paid thereon and thus have an effect on earnings.  The nature of future monetary policies and the effect of such policies on the future business and earnings of LCNB and the Bank cannot be predicted.

A substantial portion of LCNB's cash revenues is derived from dividends paid by the Bank.  These dividends are subject to various legal and regulatory restrictions.  Generally, dividends are limited to the aggregate of current year retained net income, as defined, plus the retained net income of the two most previous prior years.  In addition, dividend payments may not reduce capital levels below minimum regulatory guidelines.

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Employees

As of December 31, 2006, LCNB, the Bank, and Dakin employed 226 full-time equivalent employees.  LCNB is not a party to any collective bargaining agreement.  Management considers its relationship with its employees to be very good.  Employee benefit programs are considered by Management to be competitive with benefit programs provided by other financial institutions and major employers within LCNB’s market area.

Availability of Financial Information

LCNB files unaudited quarterly financial reports on Form 10-Q, annual financial reports on Form 10-K, current reports on Form 8-K, and amendments to these reports filed or furnished pursuant to Section 13(a) or 15 (d) of the Securities Exchange Act of 1934 with the SEC.  Copies of these reports are available free of charge in the shareholder information section of the Bank's web site, www.lcnb.com, as soon as reasonably practicable after they are electronically filed or furnished to the SEC, or by writing to:

Steve P. Foster

Executive Vice President, CFO

LCNB Corp.

2 N. Broadway

P.O. Box 59

Lebanon, Ohio  45036

Financial reports and other materials filed by LCNB with the SEC may also be read and copied at the SEC's Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549.  Information on the operation of the Public Reference Room may be obtained from the SEC by calling 1-800-SEC-0330.  The SEC also maintains an internet site (www.sec.gov) that contains reports, proxy and information statements, and other information regarding registrants that file reports electronically, as LCNB does.  

FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES

LCNB and its subsidiaries do not have any offices located in foreign countries and have no foreign assets, liabilities or related income and expense for the years presented.

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STATISTICAL INFORMATION

The following tables and certain tables appearing in Item 7, Management's Discussion and Analysis, present additional statistical information about LCNB Corp. and its operations and financial condition.  They should be read in conjunction with the consolidated financial statements and related notes and the discussion included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and Item 7A, Quantitative and Qualitative Disclosures about Market Risk.

Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Interest Differential

The table presenting an average balance sheet, interest income and expense, and the resultant average yield for average interest-earning assets and average interest-bearing liabilities is included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.

The table analyzing changes in interest income and expense by volume and rate is included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.

Investment Portfolio

The following table presents the carrying values of securities for the years indicated:

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Contractual maturities of debt securities at December 31, 2006, were as follows.  Actual maturities may differ from contractual maturities when issuers have the right to call or prepay obligations.

(1)

Yields on tax-exempt obligations are computed on a tax equivalent basis based upon a 34% statutory Federal income tax rate.

Excluding holdings in U.S. Treasury securities and U.S. Government Agencies, there were no investments in securities of any issuer that exceeded 10% of LCNB's consolidated shareholders' equity at December 31, 2006.

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Loan Portfolio

The following table summarizes the distribution of the loan portfolio for the years indicated:

As of December 31, 2006, there were no concentrations of loans exceeding 10% of total loans that are not already disclosed as a category of loans in the above table.

The following table summarizes the commercial and agricultural loan maturities and sensitivities to interest rate change at December 31, 2006:

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Risk Elements

Generally, a loan is placed on non-accrual status when there is an indication that the borrower's cash flows may not be sufficient to meet payments as they become due, unless the loan is well secured and in the process of collection.  Subsequent cash receipts on a non-accrual loan are recorded as a reduction of principal, and interest income is recorded once principal recovery is reasonably assured.  The current year's accrued interest on loans placed on non-accrual status is charged against earnings.  Previous years' accrued interest is charged against the allowance for loan losses.

The following table summarizes non-accrual, past-due, and restructured loans for the dates indicated:

The restructured loan at December 31, 2005 and 2004 consisted of a commercial loan whose predecessor loans were classified as loans past due 90 days or more and still accruing at December 31, 2003, at which time they had a total balance of $2,030,000.  Principal payments of $100,000 and $213,000 were made on these loans in 2005 and 2004, respectively.  Information received during the first quarter, 2004, raised uncertainties concerning the collectibility of certain collateral and management transferred the loans to the non-accrual classification, where they remained until they were re-written in October, 2004.  All related interest due on the predecessor loans was paid during October, 2004, and the loans were re-written at that time.  Such interest was recorded on a cash basis as received.  The restructured loan is secured by a combination of mortgages and other collateral.  It was not classified as restructured at December 31, 2006 because the loan was current and had a market interest rate.

Non-accrual loans at December 31, 2006 consisted of a real estate mortgage loan and a home equity line of credit made to the same borrower and one loan secured by farmland. Non-accrual loans at December 31, 2005 consisted of two real estate mortgage loans.  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; a consumer loan in the amount of $146,000; and residential real estate mortgage loans in the amount of $84,000.  Interest income that would have been recorded during 2006, 2005, and 2003 if loans on a non-accrual status at the end of those years had been current and in accordance with their original terms was approximately $48,000, $20,000 and $72,000, respectively.

Loans classified as past-due 90 days or more and still accruing interest at December 31, 2006 consisted of six consumer loans totaling $52,000 and two residential mortgage loans totaling $74,000.  Loans past-due 90 days or more and still accruing interest at December 31, 2005 consisted primarily of consumer loans.  Loans classified as past-due 90 days or more and still accruing interest at December 31, 2004 consisted of consumer loans totaling $104,000 and residential mortgage loans totaling $61,000.  Loans past-due 90 days or more and still accruing interest at December 31, 2003 included $2,030,000 of commercial loans that were re-written during 2004 and classified as restructured at December 31, 2004 (see above).  The remaining balance of loans past-due 90 days or more and still accruing interest at December 31, 2003 consisted of consumer loans totaling $136,000, residential mortgage loans totaling $146,000, and a loan with a balance of $130,000 that was secured by farmland.  Loans past-due 90 days or more and still accruing interest at December 31, 2002 included $142,000 of consumer loans and residential mortgage loans totaling $90,000.

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LCNB is not committed to lend additional funds to debtors whose loans have been modified to provide a reduction or deferral of principal or interest because of deterioration in the financial position of the borrower.

At December 31, 2006, there were no material additional loans not already disclosed as non-accrual, restructured, accruing past due 90 days or more, or impaired where known information about possible credit problems of the borrowers causes management to have serious doubts as to the ability of such borrowers to comply with present loan repayment terms.

Summary of Loan Loss Experience

The table summarizing the activity related to the allowance for loan losses is included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.

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The following table presents the allocation of the allowance for loan loss:

This allocation is made for analytical purposes.  The total allowance is available to absorb losses from any category of the portfolio.  The decrease in the commercial, secured by real estate category at December 31, 2006 is due to improvements in credit quality, primarily reflecting the reclassification of the loan that was included in the restructured category at December 31, 2005 and 2004.  The increase in the allocation to the commercial, secured by real estate category at December 31, 2005 reflects growth in the portfolio and an increase in the dollar volume of loans assigned to the higher-risk classifications of substandard or doubtful.  The increase in the allocation to the residential real estate category at December 31, 2005 reflects an increase in non-accrual loans and foreclosures at LCNB, an increase in residential second mortgage and home equity loans with high (90% or more) loan-to-value ratios, and an increase in bankruptcies and foreclosures in the Southwestern Ohio economy in general.  The decrease in the allocation to the consumer loan category at December 31, 2005 reflects decreased delinquencies.  The decrease in the allocation to the commercial and industrial category at December 31, 2004 reflects decreased delinquencies.  There is not an allocation to the credit card category for 2006, 2005, or 2004 because this portfolio was sold during the first quarter, 2004.  Allocations to the consumer and credit card categories were less at December 31, 2003 as compared to December 31, 2002 because of general economic improvements in late 2003.

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Deposits

The statistical information regarding average amounts and average rates paid for the deposit categories is included in the "Distribution of Assets, Liabilities and Shareholders' Equity" table included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.

The following table presents the contractual maturity of time deposits of $100,000 or more at December 31, 2006:

Return on Equity and Assets

The statistical information regarding the return on assets, return on equity, dividend payout ratio, and equity to assets ratio is presented in Item 6, Selected Financial Data.

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Item 1A.  Risk Factors

There are risks inherent in LCNB’s operations, many beyond management’s control, which may adversely affect its financial condition and results from operations and should be considered in evaluating the company. Credit, market, operational, liquidity, interest rate and other risks are described elsewhere in this report. Other risk factors may include the items described below.

LCNB’s earnings are significantly affected by market interest rates.

Fluctuations in interest rates may negatively impact LCNB’s profitability.  A primary source of income from operations is net interest income, which is equal to the difference between interest income earned on loans and investment securities and the interest paid for deposits and other borrowings. These rates are highly sensitive to many factors beyond LCNB’s control, including general economic conditions and the monetary and fiscal policies of the United States Federal government.  

The Open Market Committee of the Board of Governors of the Federal Reserve System regulates the supply of money and credit in the United States, primarily by setting the intended federal funds rate.   The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.  The intended federal funds rate significantly influences the interest rates LCNB earns on loans and investments and the rate paid for deposits and other borrowings.  

From January 2001 to mid 2003, the Open Market Committee cut the intended federal funds rate thirteen times, and short-term interest rates reached their lowest levels in 45 years.  During 2004, 2005, and 2006, the Open Market Committee increased the federal funds rate seventeen times.  As a consequence, LCNB’s net interest margin (net interest income divided by average interest-earning assets, generally loans and investments) has decreased during this period, as the rates paid for deposits and borrowings increased more rapidly than the rates earned on loans and securities could be adjusted.  

The slope of the yield curve (that is, the relationship between short and long-term interest rates) also affects LCNB’s net interest income and net interest margin.  As discussed above, rates rose in general during 2005 and 2006, but short-term rates rose significantly more than long-term rates.  Consequently, short-term term rates at year-end 2005 were not significantly below long-term rates and short-term rates at year-end 2006 were generally above long-term rates, placing further pressure on LCNB’s net interest margin.  The following graph compares Constant Maturity Treasury rates, as released by the U.S. Department of the Treasury, for various maturities as of year-end 2006, 2005, and 2004.  

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--

LCNB expects the current level of interest rates and the current slope of the yield curve will cause further downward pressure on its net interest margin.

Increases in general interest rates could have a negative impact on LCNB’s results of operations by reducing the ability of borrowers to repay their current loan obligations.  Some residential real estate mortgage loans, most home equity line of credit loans, and approximately 59% of LCNB’s commercial loans have adjustable rates.  Borrower inability to make scheduled loan payments due to a higher loan cost could result in increased loan defaults, foreclosures, and write-offs and may necessitate additions to the allowance for loan losses.  In addition, increases in the general level of interest rates may decrease the demand for new consumer and commercial loans, thus limiting LCNB’s growth and profitability.  A general increase in interest rates may also result in deposit disintermediation, which is the flow of deposits away from banks and other depository institutions into direct investments that have the potential for higher rates of return, such as stocks, bonds, and mutual funds.   If this occurs, LCNB may have to rely more heavily on borrowings as a source of funds in the future, which could negatively impact its net interest margin.

Banking competition in Southwestern Ohio is intense.

LCNB faces strong competition for deposits, loans, trust accounts, and other services from other banks, savings banks, credit unions, mortgage brokers, and other financial institutions.  Many of LCNB’s competitors include major financial institutions that have been in business for many years and have established customer bases, numerous branches, and substantially higher regulatory lending limits.  Dominant competitors in the Southwestern Ohio area include U.S. Bank, National City Corporation, Fifth Third Bank, Chase, KeyBank, and First Financial Bank.  In addition, credit unions are growing larger due to more flexible membership requirement regulations and are offering more financial services than they legally could in the past.

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LCNB also competes with numerous real estate brokerage firms, some owned by realty companies, for residential real estate mortgage loans.  Incentives offered by captive finance companies owned by the major automobile companies, primarily General Motors Acceptance Corporation (GMAC), Chrysler Financial, and Ford Motor Credit Company (FMCC),  have limited the banking industry’s opportunities for growth in the new automobile loan market.  The banking industry now competes with brokerage firms and mutual fund companies for funds that would have historically been held as bank deposits.  Technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems.  Many of LCNB’s competitors have fewer regulatory constraints and may have lower cost structures.  

If LCNB is unable to attract and retain loan, deposit, and trust customers, its growth and profitability levels may be negatively impacted.

Economic conditions in Southwestern Ohio could adversely affect LCNB’s financial condition and results of operations.

LCNB has 21 offices located in Warren, Butler, Clinton and Hamilton Counties in Southwestern Ohio.  As a result of this geographic concentration, LCNB’s results are heavily influenced by economic conditions in this area. A deterioration in economic conditions or a natural or manmade disaster in Southwestern Ohio or Ohio in general could have a material adverse impact on the ability of borrowers to make scheduled loan payments, the fair value of underlying loan collateral, the ability of depositors to maintain or add to deposit balances, the demand for trust and brokerage services, and the demand for other products and services offered by LCNB.

The allowance for loan losses may be inadequate.

The provision for loan losses is determined by management based upon its evaluation of the amount needed to maintain the allowance for loan losses at a level considered appropriate in relation to the estimated risk of losses inherent in the portfolio.  In addition to historic charge-off percentages, factors taken into consideration to determine the adequacy of the allowance for loan losses include the nature, volume, and consistency of the loan portfolio, overall portfolio quality, a review of specific problem loans, the fair value of any underlying collateral, and current economic conditions that may affect borrowers’ ability to make payments.  Increases in the allowance result in an expense for the period.   By its nature, the evaluation is imprecise and requires significant judgment.  Actual results may vary significantly from management’s assumptions.  If, as a result of general economic conditions or a decrease in asset quality, management determines that additional increases in the allowance for loan losses are necessary, LCNB will incur additional expenses.

LCNB’s loan portfolio includes a substantial amount of commercial and industrial loans and commercial real estate loans, which may have more risks than residential or consumer loans.

LCNB’s commercial and industrial and commercial real estate loans comprise a substantial portion of its total loan portfolio. These loans generally carry larger loan balances and involve a greater degree of financial and credit risk than home equity, residential mortgage, or consumer loans. The increased financial and credit risk associated with these types of loans is a result of several factors, including the concentration of principal in a limited number of loans, the size of loan balances, the effects of general economic conditions on income-producing properties, and the increased difficulty of evaluating and monitoring these types of loans.

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The repayment of loans secured by commercial real estate is often dependent upon the successful operation, development, or sale of the related real estate or commercial business and may, therefore, be subject to adverse conditions in the real estate market or economy. If the cash flow from the project is reduced, the borrower’s ability to repay the loan may be impaired. In such cases, LCNB may take one or more actions to protect its financial interest in the loan.  Such actions may include foreclosure on the real estate securing the loan, taking possession of other collateral that may have been pledged as security for the loan, or modifying the terms of the loan.  If foreclosed on, commercial real estate is often unique and may not be as salable as a residential home.

LCNB is subject to environmental liability risk associated with lending activities.

A significant portion of the Bank’s loan portfolio is secured by real property. During the ordinary course of business, the Bank may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Bank may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Bank to incur substantial expenses and may materially reduce the affected property’s value or limit the Bank’s ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase the Bank’s exposure to environmental liability. Although the Bank has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the LCNB’s financial condition and results of operations.

The banking industry is highly regulated.

Commercial banks are highly regulated.  LCNB Corp. is subject to regulation, supervision, and examination by the Federal Reserve Board and the Bank is subject to regulation, supervision, and examination by the Office of the Comptroller of the Currency (the “OCC”).   LCNB Corp. and the Bank are also subject to regulation and examination by the FDIC, as the deposit insurer.  Federal and state laws and regulations govern numerous matters including, but not limited to, changes in the ownership or control of banks, maintenance of adequate capital, permissible business operations, maintenance of deposit insurance, protection of customer financial privacy, the level of reserves held against deposits, restrictions on dividend payments, the making of loans, and the acceptance of deposits.  See the previous section titled “Supervision and Regulation” for more information on this subject.

Federal regulators may initiate various enforcement actions against a financial institution that violates laws or regulations or that operates in an unsafe or unsound manner.  These enforcement actions may include, but are not limited to, the assessment of civil money penalties, the issuance of cease-and-desist or removal orders, and the imposition of written agreements.

Proposals to change the laws governing financial institutions are periodically introduced in Congress and proposals to change regulations are periodically considered by the regulatory bodies.  Such future legislation and/or changes in regulations could increase or decrease the cost of doing business, limit or expand permissible activities, or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions.  The likelihood of any major changes in the future and their effects are impossible to determine.

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LCNB’s controls and procedures may fail or be circumvented.

Management regularly reviews and updates LCNB’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of LCNB’s controls and procedures or failure to comply with regulations related to its controls and procedures could have a material adverse effect on LCNB’s business, results of operations, and financial condition.

LCNB’s information systems may experience an interruption or breach in security.

LCNB relies heavily on communications and information systems to conduct its business. Any failure, interruption, or breach in security of these systems could result in failures or disruptions in LCNB’s customer relationship management, general ledger, deposit, loan, and other systems. While LCNB has policies and procedures designed to prevent or limit the effect of the failure, interruption, or security breach of its information systems, there can be no assurance that any such occurrences will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions, or security breaches of LCNB’s information systems could damage LCNB’s reputation, result in a loss of customer business, subject LCNB to additional regulatory scrutiny, or expose LCNB to civil litigation and possible financial liability, any of which could have a material adverse effect on its financial condition and results of operations.

Risk factors related to LCNB’s trust business.

Competition for trust business is intense.  Competitors include other commercial bank and trust companies, brokerage firms, investment advisory firms, mutual fund companies, accountants, and attorneys.

LCNB’s trust business is directly affected by conditions in the debt and equity securities markets.  The debt and equity securities markets are affected by, among other factors, domestic and foreign economic conditions and the monetary and fiscal policies of the United States Federal government, all of which are beyond LCNB’s control.  Changes in economic conditions may directly affect the economic performance of the trust accounts in which clients’ assets are invested.  A decline in the fair value of the trust accounts caused by a decline in general economic conditions directly affects LCNB’s trust fee income because such fees are primarily based on the fair value of the trust accounts.  In addition, a sustained decrease in the performance of the trust accounts or a lack of sustained growth may encourage clients to seek alternative investment options.

In addition, the management of trust accounts is subject to the risk of mistaken distributions, negligent investment choices, and miscellaneous other incorrect decisions.  Such mistakes may give rise to surcharge actions by beneficiaries, with damages substantially in excess of the fees earned from management of the accounts.

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Risk factors related to Dakin Insurance Agency, Inc.

Competition within the insurance agency business is also intense.  Dakin competes with numerous other independent and exclusive insurance agencies (an exclusive agent sells for only one insurance company) and with insurance companies that sell direct to individuals and businesses without using agents.  

Premium growth within the insurance industry tends to exhibit a cyclical nature.  Premium growth might average double digits during the first part of the cycle and then be negative during the later part of the cycle.  Such cycles appear to be heavily influenced by general economic conditions, but can also be affected by natural disasters, stock market returns, and the reinsurance market.  Deterioration in economic conditions may also have a material adverse impact on the ability of insurance customers to make scheduled premium payments.

Commissions paid independent agents by insurance carriers have been trending downward.  Agents therefore need to continually write new business to prevent earnings decreases.

Item 1B. Unresolved Staff Comments

Not applicable

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Item 2.  Properties

The Bank conducts its business from the following offices:

(1)

Excess space in this office is leased to third parties.

(2)

A Dakin office is located in this office.

(3)

The Bank owns the Oxford office building and leases the land.

In addition to the above offices, the Bank is constructing a new office at 2705 Far Hills Avenue, Oakwood, Ohio  45419.  The Bank owns the office building and leases the land.

Dakin owns its main office at 20 & 24 East Mulberry Street, Lebanon, Ohio  45036.  Excess space in this office is leased to third parties.  Dakin's two other offices are located in the Bank's branch offices.

Item 3.  Legal Proceedings

Except for routine litigation incident to their businesses, LCNB is not a party to any material pending legal proceedings and none of their property is the subject of any such proceedings.

Item 4.  Submission of Matters to a Vote of Security Holders

None

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PART II

Item 5.  Market for Registrant's Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities.

LCNB had approximately 581 registered holders of its common stock as of December 31, 2006.  The number of shareholders includes banks and brokers who act as nominees, each of whom may represent more than one shareholder.  The common stock is currently traded on the Nasdaq Over-The-Counter Bulletin Board service under the symbol "LCNB".  Several market-makers facilitate the trading of the shares of common stock.  Trade prices for shares of LCNB Common Stock, reported through registered securities dealers, are set forth below.  Trades have occurred during the periods indicated without the knowledge of LCNB.  The trade prices shown below are interdealer without retail markups, markdowns or commissions.  

The following table presents cash dividends per share declared and paid in the periods shown.  

It is expected that LCNB will continue to pay dividends on a similar schedule, to the extent permitted by business and other factors beyond management's control. LCNB depends on dividends from its subsidiaries for the majority of its liquid assets, including the cash needed to pay dividends to its shareholders. National banking law limits the amount of dividends the Bank may pay to the sum of retained net income, as defined, for the current year plus retained net income for the previous two years. Prior approval from the OCC, the Bank’s primary regulator, would be necessary for the Bank to pay dividends in excess of this amount. In addition, dividend payments may not reduce capital levels below minimum regulatory guidelines. Management believes the Bank will be able to pay anticipated dividends to LCNB without needing to request approval.

On April 17, 2001, LCNB's Board of Directors authorized three separate stock repurchase programs, two phases of which continue.  The shares purchased will be held for future corporate purposes.

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Under the "Market Repurchase Program" LCNB was originally authorized to purchase up to 100,000 shares of its stock through market transactions with a selected stockbroker.  On November 14, 2005, the Board of Directors extended the Market Repurchase Program by increasing the shares authorized for repurchase to 200,000 total shares.  Through December 31, 2006, 145,222 shares had been purchased under this program.  No shares were purchased under the Market Repurchase Program during the three months ended December 31, 2006.

The "Private Sale Repurchase Program" is available to shareholders who wish to sell large blocks of stock at one time.  Because LCNB's stock is not widely traded, a shareholder releasing large blocks may not be able to readily sell all shares through normal procedures.  Purchases of blocks will be considered on a case-by-case basis and will be made at prevailing market prices.  There is no limit to the number of shares that may be purchased under this program.  A total of 215,934 shares have been purchased under this program since its inception through December 31, 2006.  The following table shows information relating to private sale repurchases during the three months ended December 31, 2006:

LCNB established an Ownership Incentive Plan during 2002 that allows for the issuance of up to 100,000 shares of stock-based awards to eligible employees, as determined by the Board of Directors.  The awards may be in the form of stock options, share awards, and/or appreciation rights.  Only stock options had been awarded at December 31, 2006.  The following table shows information relating to stock options outstanding at December 31, 2006:

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The graph below provides an indicator of cumulative total shareholder returns for LCNB as compared with the Nasdaq Composite and the SNL Midwest OTC-BB and Pink Sheet Banks.  This graph covers the period from December 31, 2001 through December 31, 2006.  The cumulative total shareholder returns included in the graph reflect the returns for the shares of common stock of LCNB.  The information provided in the graph assumes that $100 was invested on December 31, 2001 in LCNB common stock, the Nasdaq Composite, and the SNL Midwest OTC-BB and Pink Sheet Banks and that all dividends were reinvested.

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Item 6.  Selected Financial Data

The following represents selected consolidated financial data of LCNB for the years ended December 31, 2002 through 2006 and are derived from LCNB's consolidated financial statements.  This data should be read in conjunction with the consolidated financial statements and the notes thereto included in Item 8 of this Form 10-K and Management's Discussion and Analysis of Financial Condition and Results of Operations and Quantitative and Qualitative Disclosures about Market Risk included in Items 7 and 7A, respectively, of this Form 10-K, and are qualified in their entirety thereby and by other detailed information elsewhere in this Form 10-K.

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(1)

All per share data have been adjusted to reflect a 100% stock dividend accounted for as a stock split in 2004.

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Item 7.  Management's Discussion and Analysis of Financial Condition and Results of Operations

Introduction

The following is management's discussion and analysis of the consolidated financial condition and consolidated results of operations of LCNB.  It is intended to amplify certain financial information regarding LCNB and should be read in conjunction with the Consolidated Financial Statements and related Notes and the Financial Highlights contained in the 2006 Annual Report to Shareholders.

Forward-Looking Statements

Certain matters disclosed herein may be deemed to be forward-looking statements that involve risks and uncertainties.  Forward looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact. Such statements are often characterized by the use of qualifying words and their derivatives such as “expects,” “anticipates,” “believes,” “estimates,” “plans,” “projects,” or other statements concerning opinions or judgments of the Company and its management about future events.   Factors that could influence the accuracy of such forward looking statements include, but are not limited to, regulatory policy changes, interest rate fluctuations, loan demand, loan delinquencies and losses, general economic conditions and other risks.  Such forward-looking statements represent management's judgment as of the current date.  Actual strategies and results in future time periods may differ materially from those currently expected.  LCNB disclaims, however, any intent or obligation to update such forward-looking statements.  LCNB intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

Acquisition

On May 31, 2006, Dakin purchased the existing book of business of Altemeier Oliver & Company Agency, Inc. (“AOC”), an independent insurance agency located in Blue Ash, Ohio.  The acquisition of AOC was accounted for using the purchase accounting method and the results of operations of AOC have been included in the consolidated financial statements of LCNB since the acquisition date.  The acquired assets consisted solely of a customer list intangible asset.  This intangible asset will be amortized on a straight-line basis over a ten year period.

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Overview

LCNB earned $6,514,000 in 2006, compared to $6,705,000 in 2005 and $6,596,000 in 2004.  Basic and diluted earnings per share for 2006, 2005, and 2004 were $2.01, $2.03, and $1.97, respectively.  Performance ratios for 2006, 2005, and 2004 included:

Net interest income for 2006, 2005, and 2004 was $18,315,000, $18,570,000, and $18,280,000, respectively.  Net interest income decreased during 2006 primarily due to a decrease in the taxable equivalent net interest margin from 3.99% for 2005 to 3.84% for 2006, partially offset by an increase in average interest earning assets.  Net interest income increased during 2005 as compared to 2004 primarily due to loan growth, partially offset by a decrease in the interest rate margin from 4.02% for 2004 to 3.99% for 2005.  

Total non-interest income grew from $7,659,000 for 2004 to $7,956,000 for 2005 and $8,345,000 for 2006.  Primary drivers of this upward trend were trust income, primarily from growth in trust and brokerage assets managed, increases in service charges and fees, and increases in insurance agency income.

Total non-interest expense also increased.  Total non-interest expense for 2004 was $16,404,000, compared to $17,243,000 in 2005 and $17,838,000 in 2006.  Normal salary and wage increases and increased employee benefit costs comprised a significant portion of this increase.  

Net Interest Income

The amount of net interest income earned by LCNB is influenced by the dollar amount ("volume") and mix of interest earning assets and interest bearing liabilities and the rates earned or paid on each.  The following table presents, for the years indicated, the distribution of average assets, liabilities and shareholders' equity, as well as the total dollar amounts of interest income from average interest earning assets and the resultant yields on a fully taxable equivalent basis, and the dollar amounts of interest expense and average interest-bearing liabilities and the resultant rates paid.

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(1)

Includes non-accrual loans if any.  Income from tax-exempt loans is included in interest income on a taxable 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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The following table presents the changes in 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 years indicated.  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.

(1)

Non-accrual loans, if any, are included in average loan balances.

(2)

Change in interest income from non-taxable loans and investment securities is computed based on interest income determined on a taxable equivalent yield basis.  Interest income has been divided by a factor comprised of the complement of the incremental tax rate of 34%.

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2006 vs. 2005.  Tax equivalent interest income increased $2,875,000 due to a 44  basis point (a basis point equals 0.01%) increase in the average rate earned on interest-earning assets and to a $10.8 million increase in total average interest-earning assets.  The increase in average rates earned was primarily due to general increases in market rates.  The increase in average interest-earning assets occurred primarily in the loan portfolio, which grew $28.4 million on an average basis.  The loan growth was partially offset by a $14.3 million decrease in average taxable and nontaxable investment securities and a $3.5 million decrease in average federal funds sold and interest-bearing demand deposits.

Interest expense increased $3,201,000 primarily due to a 73 basis point increase in the average rate paid on interest-bearing liabilities and secondarily to a $9.5 million increase in average interest-bearing liabilities.  The increase in average rates paid is primarily due to general increases in market rates.   IRA and time certificates grew $10.2 million on an average basis and average NOW and money fund deposits grew $19.1 million.  These increases were partially offset by a $18.8 million decrease in average savings deposits.

The net interest margin, on a tax equivalent basis, decreased from 3.99% for 2005 to 3.84% for 2006.  Even though the average rate earned on interest-earning assets increased 44 basis points, this increase was offset by the 73 basis point increase in the average rate paid on interest-bearing liabilities.  Short-term market rates increased more than long-term market rates during 2006.  Consequently, short-term rates at year-end 2006 were generally above long-term rates, placing further pressure on LCNB’s net interest margin.  The following graph compares Constant Maturity Treasury rates, as released by the U.S. Department of the Treasury, for various maturities as of year-end 2006, 2005, and 2004.  

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2005 vs. 2004.  Tax equivalent interest income increased $2,024,000 primarily due to a $12.1 million increase in total average interest-earning assets and secondarily to a 28 basis point increase in the average rate earned on such assets.  The growth in average interest-earning assets occurred primarily in the loan portfolio, which increased $19.6 million on an average basis.  The loan growth was partially offset by a $4.4 million decrease in average federal funds sold and interest-bearing demand deposits and a $3.2 million decrease in average taxable and nontaxable investment securities.  The increase in average rates earned was primarily due to a general increase in market rates.

Interest expense increased $1,664,000 primarily due to a 33 basis point increase in the average rate paid on interest-bearing liabilities and secondarily to an $18.2 million increase in average interest-bearing liabilities.  The increase in the average rate paid is primarily due to a general increase in market rates.  IRA and time certificates grew $18.3 million on an average basis and average NOW and money fund deposits grew $11.5 million.  These increases were partially offset by a $10.5 million decrease in average savings deposits.

The net interest margin, on a tax equivalent basis, decreased slightly, from 4.02% during 2004 to 3.99% during 2005.  Even though the average rate earned on interest-earning assets increased 28 basis points, this increase was offset by a 33 basis point increase in the average rate paid on interest-bearing liabilities.  Short-term rates increased significantly during 2005, while longer-term rates remained substantially stable.  Consequently, short-term rates at year-end 2005 were not significantly below long-term rates

Provisions and Allowance for Loan Losses

The provision for loan losses is determined by management based upon it's evaluation of the amount needed to maintain the allowance for loan losses at a level considered appropriate in relation to the estimated risk of losses inherent in the portfolio.  In addition to historic charge-off percentages, factors taken into consideration to determine the adequacy of the allowance for loan losses include the nature, volume, and consistency of the loan portfolio, overall portfolio quality, a review of specific problem loans, and current economic conditions that may affect borrowers’ ability to pay.  The following table presents the total loan loss provision and the other changes in the allowance for loan losses for the years 2002 through 2006.

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The commercial and industrial loan charge-off of $126,000 during 2004 is due to one company that had filed bankruptcy.  Consumer loan charge-offs included $41,000 during 2004 and $25,000 during 2003 that were due to a yacht that was subsequently repossessed and sold in 2004.  The balance of increased consumer loan charge-offs during 2004 and 2003 are due to a greater number of troubled loans.

Charge-offs and recoveries classified as “Other” during 2005 and 2006 represent charge-offs and recoveries on checking and NOW account overdrafts.  LCNB charges off such overdrafts when considered uncollectible, but no later than 60 days from the date first overdrawn.  Prior to 2005, overdrafts considered uncollectible were netted against service charges and fees in non-interest income.  

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Non-Interest Income

2006 vs. 2005.  Total non-interest income for 2006 was $389,000 or 4.9% more than for 2005.  The increase is primarily due to a $262,000 increase in trust income, a $231,000 increase in insurance agency income, and an $85,000 or 2.1% increase in service charges and fees.  The increase in trust income was due to trust fee modifications and new business.  Insurance agency income increased due to new business and the policies obtained from purchasing AOC’s book of business.  Service charges and fees increased primarily due to an increase in check card income, which grew because of the increasing popularity of check cards as a retail payment method.  Offsetting these increases was a $111,000 decrease in other operating income, which is primarily attributable to a non-recurring $85,000 gain recognized on the sale of an unused branch building during 2005.

2005 vs. 2004.  Total non-interest income for 2005 was $297,000 or 3.9% more than for 2004.  Non-interest income for 2004 included a $306,000 gain from sales of investment securities and a $403,000 gain from the sale of LCNB’s credit card portfolio.  Sales of investment securities during 2005 produced a slight loss of $8,000.  Excluding the above mentioned gains and losses, non-interest income for 2005 was $1,014,000 greater than for 2004.  The increase was primarily the result of increases in income from bank owned life insurance, brokerage income, insurance agency income, and service charges on deposit accounts.

Income from bank owned life insurance during 2005 totaled $487,000, compared to $29,000 for 2004.  The insurance was purchased in December, 2004, so 2005 is the first full year of income for this item.  

Trust income increased $126,000 or 8.2% primarily due to growth in brokerage accounts managed.  LCNB offers brokerage investment products through a partnership with UVEST Financial Services, Inc., a registered broker/dealer.  Total brokerage accounts managed increased 45.8% during 2005, from $24.8 million at December 31, 2004 to $36.2 million at December 31, 2005.

Service charges and fees increased $182,000 or 4.7% primarily due to an increase in check card income and the absence of checking and NOW account overdraft charge-offs netted against service charges and fees on deposit accounts prior to 2005.  Beginning in 2005, checking and NOW account overdrafts are charged against the allowance for loan losses.  

Insurance agency income increased $92,000 or 6.8% primarily due to a $60,000 increase in contingency commissions received.  Contingency commissions are profit-sharing arrangements on property and casualty policies between the originating agency and the carrier and are generally based on underwriting results and written premiums.  As such, the amount received each year can vary significantly depending on loss experience.  

Other operating income for 2005 was $110,000 or 84.6% greater than for 2004.  Approximately $85,000 of the increase was due to the gain recognized from the sale of an unused branch building mentioned above.   

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Non-Interest Expense

2006 vs. 2005.  Total non-interest expense increased $595,000 or 3.5% during 2006 compared with 2005.  Contributing to the increase were a $365,000 or 4.9% increase in salaries and wages, a $160,000 or 8.7% increase in pension and other employee benefits, a $91,000 or 7.1% increase in occupancy expense, and an $85,000 increase in ATM expense.   

Salaries and wages increased due to additional employees and routine salary and wage increases.  Pension and other employee benefits increased primarily due to increased pension expenses, increased health insurance costs, and increased FICA matching requirements.  The increase in occupancy expense is largely due to rent expense for the land at the new Oakwood office currently under construction.  The increase in ATM expense is primarily due to certain one-time fee adjustments that were recognized during the first quarter, 2006.  

2005 vs. 2004.  Total non-interest expense increased $839,000 or 5.1% during 2005 compared with 2004.  Much of the increase was in wages and salaries, which were approximately $540,000 or 7.8% greater in 2005 than in 2004.  The increase was primarily due to routine salary and wage increases and to additional staffing required by the respective openings of the Fairfield office during the fourth quarter, 2004 and the Lebanon High School Warrior office during the first quarter, 2005.

Occupancy expense, net increased $101,000 or 8.6%.  Increased expenditures for utilities, additional rent expense primarily for the Fairfield office, and additional depreciation expense for buildings and premises contributed to this increase.  The additional depreciation expense was primarily caused by the new Loveland office at 500 Loveland-Madeira Road, which opened during the second quarter, 2005 and replaced an office located at 615 West Loveland Avenue.

Contributing to the $147,000 or 4.8% increase in other non-interest expense were increased write-offs on bad and fraudulent checks, increased ATM maintenance costs, and increased professional expenses.  Partially offsetting these increases was a $125,000 decrease in credit card expenses due to the sale of the portfolio during 2004.

Income Taxes

LCNB's effective tax rates for the years ended December 31, 2006, 2005, and 2004 were 24.9%, 25.0%, and 27.1%, respectively.  The difference between the statutory rate of 34.0% and the effective tax rate is primarily due to tax-exempt interest income and secondarily, for the 2006 and 2005 periods, tax-exempt earnings from bank owned life insurance.

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Assets

Net loans grew $30.7 million or 8.6% during 2006.  Most of the loan growth occurred in the commercial loans secured by real estate category, which grew $17.0 million, and in the residential real estate category, which grew $12.2 million.  At December 31, 2006, residential real estate loans comprised approximately 44.6% of LCNB’s total loan portfolio and commercial loans, both secured by real estate and not secured by real estate, comprised 45.4% of the portfolio.  The remaining 10.0% of the portfolio is mostly various types of consumer loans, including auto, boat, and unsecured loans.  

The increase in the loan portfolio was financed by a $22.4 million decrease in investment securities and a $14.3 million increase in short-term borrowings.   The decline in investment securities reflects management’s decision to invest part of the funds received from maturities and calls into loan growth.

Deposits

Total deposits decreased $2.9 million during 2006.  Regular savings deposits decreased $14.3 million and IRA and time certificates decreased $1.1 million, while NOW and money fund deposits increased $12.3 million.  Much of the growth in NOW and money fund deposits can be attributed to LCNB’s Premier Checking product, which grew $8.5 million during the year.  Premier Checking is a tiered product paying higher rates of interest at each tier level.  During 2006 LCNB added additional tiers, making the product more attractive.  

Liquidity

Liquidity is the ability to have funds available at all times to meet the commitments of LCNB.  These commitments may include paying dividends to shareholders, funding new loans for borrowers, funding withdrawals by depositors, paying general and administrative expenses, and funding capital expenditures.  Sources of liquidity include growth in deposits, principal payments received on loans, proceeds from the sale of loans, the sale or maturation of investment securities, cash generated by operating activities, and the ability to borrow funds.  Management closely monitors the level of liquid assets available to meet ongoing funding requirements. It is management's intent to maintain adequate liquidity so that sufficient funds are readily available at a reasonable cost.  LCNB experienced no liquidity or operational problems during the past year as a result of current liquidity levels.

Deposits are the primary source of funds used to support earning assets.  During 2006 total deposits decreased slightly by $2.9 million and, consequently, were not a source of funds for loan growth.  Management decided not to reinvest approximately $14.4 million of investment securities that either matured or were called, but used the funds to support loan growth.  In addition, a $14.3 million increase in short-term borrowings was also used to support loan growth.  

The liquidity of LCNB is enhanced by the fact that 80.4% of total deposits at December 31, 2006, were "core" deposits. Core deposits, for this purpose, are defined as total deposits less public funds and certificates of deposit greater than $100,000.  

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Liquid assets include cash, federal funds sold and securities available for sale.  Except for investments in the stock of the Federal Reserve Bank and FHLB, all of LCNB's investment portfolio is classified as "available for sale" and can be readily sold to meet liquidity needs.  At December 31, 2006, LCNB's liquid assets amounted to $126.6 million or 23.1% of total assets, down from $148.8 million or 27.6% of total assets at December 31, 2005.  The primary reason for the decrease was the reduction in investment securities mentioned above.

An additional source of funding is borrowings from the Federal Home Loan Bank ("FHLB").  No FHLB borrowings were outstanding at December 31, 2006 and the total available borrowing capacity at that date was approximately $82 million.

Short-term borrowings may include federal funds borrowed, short-term advances from the FHLB, and advances from a line of credit with another financial institution.  At December 31, 2006, LCNB could borrow up to $26.8 million through a Cash Management Advance program with the FHLB of Cincinnati and up to $10 million through the line of credit with another financial institution.  Nothing was outstanding under either program at December 31, 2006.  Any advance received under the FHLB’s Cash Management Advance program would apply against the total available borrowing capacity in effect at that time.  The maximum amount of the line of credit with another financial institution was increased to $20 million during January, 2007.    

Commitments to extend credit at December 31, 2006, totaled $83.2 million and standby letters of credit totaled $5.7 million and are more fully described in Note 11 to LCNB's Financial Statements.  Since many commitments to extend credit may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

Capital expenditures may include the construction or acquisition of new office buildings, improvements to LCNB's twenty-one offices, purchases of furniture and equipment, and additions or improvements to LCNB’s information technology system.  Material commitments for capital expenditures outstanding as of December 31, 2006 totaled approximately $1.2 million.

The following table provides information concerning LCNB's contractual obligations at December 31, 2006:

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The following table provides information concerning LCNB's commitments at December 31, 2006:

Capital Resources

LCNB and Lebanon Citizens National Bank (the “Bank”) are required by banking regulators to meet certain minimum levels of capital adequacy. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on LCNB's and the Bank's financial statements.  These minimum levels 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 the Bank'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 4.00% and the ratio of Total capital (Tier 1 capital plus Tier 2 capital) to risk-weighted assets must be at least 8.00%. 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 3.00%.  A table summarizing the regulatory capital of LCNB and the Bank at December 31, 2006 and 2005, is included in Note 14, "Regulatory Matters", of the 2006 Annual Report to Shareholders.

The FDIC, the insurer of deposits in financial institutions, has adopted a risk-based insurance premium system based in part on an institution's capital adequacy. Under this system, a depository institution is required to pay successively higher premiums depending on its capital levels and its supervisory rating by its primary regulator. It is management's intention to maintain sufficient capital to permit the Bank to maintain a "well capitalized" designation (the FDIC's highest rating).

On April 17, 2001, LCNB's Board of Directors authorized three separate stock repurchase programs, two phases of which continue.  The shares purchased will be held for future corporate purposes.

Under the "Market Repurchase Program" LCNB was originally authorized to purchase up to 100,000 shares of its stock through market transactions with a selected stockbroker.  On November 14, 2005, the Board of Directors extended the Market Repurchase Program by increasing the shares authorized for repurchase to 200,000 total shares.  Through December 31, 2006, 145,222 shares had been purchased under this program.

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The "Private Sale Repurchase Program" is available to shareholders who wish to sell large blocks of stock at one time.  Because LCNB's stock is not widely traded, a shareholder releasing large blocks may not be able to readily sell all shares through normal procedures.  Purchases of blocks will be considered on a case-by-case basis and will be made at prevailing market prices.  A total of 215,934 shares had been purchased under this program at December 31, 2006.

LCNB established an Ownership Incentive 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.  No awards were granted during 2005 or 2002.  Stock options for 3,967, 4,054 and 5,528 shares were granted to key executive officers of LCNB during the first quarters of 2006, 2004, and 2003, respectively.

The exercise price for stock options granted shall not be less than the fair market value of the stock on the date of grant.  Options vest ratably over a five-year period and the maximum term for each grant will be specified by the Board of Directors, but cannot be greater than ten years from the date of grant.  In the event of an optionee's death, incapacity, or retirement, all outstanding options held by that optionee shall immediately vest and be exercisable.

Critical Accounting Policies

Allowance for Loan Losses.  The allowance for loan losses is established through a provision for loan losses charged to expense.  Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely.  The allowance is an amount that management believes will be adequate to absorb inherent losses in the loan portfolio, based on evaluations of the collectibility of loans and prior loan loss experience.  The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrowers' ability to pay.  

The allowance consists of specific, general, and unallocated components.  The specific component relates to loans that are classified as either doubtful, substandard, or special mention.  For such loans an allowance is established when the discounted cash flows or collateral value is lower than the carrying value of that loan.  The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors.  An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses.  The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

Based on its evaluations, management believes that the allowance for loan losses will be adequate to absorb estimated losses inherent in the current loan portfolio.