LCNB CORP - Quarter Report: 2006 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, 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)

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 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 number of shares outstanding of the issuer's common stock, without par value, as of July 28, 2006 was 3,238,408 shares.

LCNB Corp.

INDEX

Page No.

Part I - Financial Information

Item 1.      Financial Statements

Consolidated Balance Sheets -

June 30, 2006, and December 31, 2005

1

Consolidated Statements of Income -

Three and Six Months Ended June 30, 2006 and 2005

2

Consolidated Statements of Comprehensive Income -

Three and Six Months Ended June 30, 2006 and 2005

3

Consolidated Statements of Stockholders' Equity -

Six Months Ended June 30, 2006 and 2005

4

Consolidated Statements of Cash Flows -

Six Months Ended June 30, 2006 and 2005

5

Notes to Consolidated Financial Statements

6-15

Report of Independent Registered Public Accounting Firm

16

Item 2.      Management's Discussion and Analysis of Financial

    Condition and Results of Operations

17-29

Item 3.      Quantitative and Qualitative Disclosures about

   Market Risks

30

Item 4.      Controls and Procedures

31

Part II - Other Information

Item 1.      Legal Proceedings

32

Item 1A.   Risk Factors

32

Item 2.      Unregistered Sales of Equity Securities and Use of Proceeds

32

Item 3.      Defaults Upon Senior Securities

33

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

33

Item 5.      Other Information

33

Item 6.      Exhibits

34

Signatures

35

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-4-

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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 unaudited interim consolidated financial statements, which have been reviewed by J.D. Cloud & Co. L.L.P., LCNB’s independent registered public accounting firm, in accordance with standards established by the Public Company Accounting Oversight Board, as indicated by their report included herein and which does not express an opinion on those statements, have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and the rules and regulations of the Securities and Exchange Commission (the “SEC”).  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, as required by Regulation S-X, Rule 10-01.

Certain prior period data presented in the financial statements have been reclassified to conform with the current year presentation.

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, 2006 are not necessarily indicative of the results to be expected for the full year ending December 31, 2006.  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 2005 Form 10-K filed with the SEC.

Note 2 - 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 will be 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.  LCNB and Dakin are in the process of finalizing the allocation of the purchase price to the acquired assets, which consist solely of intangible assets, including a customer list and covenants not to compete. LCNB anticipates the amortization period of the collective intangible assets will approximate ten years.

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 3 - 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):

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 4 -  Investment Securities

The amortized cost and estimated market value of available-for-sale investment securities at June 30, 2006 and December 31, 2005 are summarized as follows (thousands):

Information concerning securities with gross unrealized losses at June 30, 2006, aggregated by length of time that individual securities have been in a continuous loss position, is as follows (thousands):

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 4 -  Investment Securities (continued)

The decline in fair values is primarily due to increases in market interest rates.  Unrealized losses on securities at June 30, 2006 have not been recognized into income currently because management has the intent and ability to hold the securities for a period of time sufficient to allow for any anticipated recovery in fair values.  Therefore, no individual declines are deemed to be other than temporary.

Note 5 - Loans

Major classifications of loans at June 30, 2006 and December 31, 2005 are as follows (thousands):

Changes in the allowance for loan losses for the six months ended June 30, 2006 and 2005 were as follows (thousands):

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 5 - Loans (continued)

Charge-offs for the six months ended June 30, 2006 consisted of residential and commercial real estate loans, consumer loans, and checking and NOW account overdrafts.  Charge-offs for the six months ended June 30, 2005 consisted primarily of consumer loans and checking and NOW account overdrafts.  

Non-accrual, past-due, and restructured loans as of June 30, 2006 and December 31, 2005 were as follows (thousands):

Non-accrual loans at June 30, 2006 consisted of one real estate mortgage loan and one loan secured by farmland.  Non-accrual loans at December 31, 2005 consisted of two real estate mortgage loans.  Loans past-due 90 days or more and still accruing interest at June 30, 2006 consisted of one real estate mortgage loan and consumer loans.  Loans past-due 90 days or more at  December 31, 2005 consisted primarily of consumer loans.  

Restructured loans at June 30, 2006 and December 31, 2005 include a commercial loan secured by a combination of mortgages and other collateral.  The principal balance of this loan at June 30, 2006 and December 31, 2005 was $1,262,000 and $1,717,000, respectively.  The reduction in the balance as of June 30, 2006 is due to principal payments received.  Restructured loans at June 30, 2006 include two additional commercial loans to a single borrower that are secured by commercial real estate.  

Real estate acquired through foreclosure was $752,000 and $85,000 at June 30, 2006 and December 31, 2005, respectively, and is included in “other assets” in the consolidated balance sheets.  Real estate acquired at June 30, 2006 consisted of one single-family residential home.  Real estate acquired at December 31, 2005 consisted of two single-family residential homes that were sold in 2006.

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, 2006 and December 31, 2005 were $44,819,000 and $46,244,000, respectively.  Loans sold to the FHLMC during the three and six months ended June 30, 2006 totaled $902,000 and $2,125,000, respectively, and $2,068,000 and $2,796,000 during the three and six months ended June 30, 2005, respectively.

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 6 – Long-Term Debt and Other Borrowings

On March 31, 2006, a $2 million advance from the Federal Home Loan Bank, bearing an interest rate of 5.54%, matured and was paid in full by LCNB.

At June 30, 2006 and December 31, 2005, accrued interest and other liabilities included U.S. Treasury demand note borrowings of approximately $251,000 and $1,031,000, respectively.  The interest rate on these borrowings is variable and was 4.94% and 4.00% at June 30, 2006 and December 31, 2005, respectively.

Note 7 – Regulatory 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

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 7 – Regulatory Capital (continued)

Note 8 - 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, 2006 and December 31, 2005 were as follows (thousands):

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 8 – Commitments and Contingent Liabilities (continued)

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.  They include amounts not drawn on line of credit loans, commitments to make new loans, and unused overdraft protection amounts on demand and NOW accounts.  Commitments generally have fixed expiration dates or other termination clauses.  At June 30, 2006, $17,580,000 of such commitments were for fixed rate products and unused overdraft protection amounts and $72,062,000 were for adjustable rate products.  

Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party.  At June 30, 2006 and December 31, 2005, outstanding guarantees of $1,707,000 and $1,892,000, respectively, were issued to developers and contractors.  These guarantees generally are fully secured and have varying maturities.  In addition, LCNB has a participation in a letter of credit securing payment of principal and interest on a bond issue.  The participation amount at June 30, 2006 and December 31, 2005 was approximately $4.1 million.  The letter of credit will expire on July 15, 2009.  It 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.

Management believes that LCNB has sufficient liquidity to fund its commitments.

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 9 - Stock Options

Under the Ownership Incentive Plan (the "Plan") LCNB may grant 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.  As of June 30, 2006, only stock options have been granted under the Plan.  Options granted to date vest ratably over a five year period and expire ten years after the date of grant.  Stock options outstanding at June 30, 2006 were as follows (thousands):

The estimated weighted-average fair value of the options granted in 2006 was $9.01 per option.  The fair value was estimated at the date of grant using the Black-Scholes option-pricing model and the following assumptions:

Compensation expense recognized in the consolidated statements of income for all stock options granted prior to January 1, 2005 is determined using the modified prospective approach as allowed by SFAS No. 123 (revised).  Total expense related to options included in salaries and wages in the consolidated statements of income for the three and six months ended June 30, 2006 were $4,000 and $7,000, respectively and $2,000 and $4,000 for the three and six months ended June 30, 2005, respectively.

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 10 – 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, 2006 and 2005, are summarized as follows (thousands):

LCNB previously disclosed in its consolidated financial statements for the year ended December 31, 2005, that it expected to contribute $875,000 to its pension plan in 2006.  As of June 30, 2006, no contributions have been made.

Note 11 – Recent Accounting Pronouncements

Statement of Financial Accounting Standards (“SFAS”) No. 155, “Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140,” was issued in February, 2006.  It amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”.  This statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006.  LCNB has not made any transactions covered by SFAS No. 155 and is not affected by the pronouncement.

SFAS No. 156, “Accounting for Servicing of Financial Assets,” was issued in March, 2006.  It amends SFAS No. 140 and requires that a separately recognized mortgage servicing asset or liability be initially measured at fair value.  After initial recognition, an entity may choose either the amortization method or the fair value method for subsequent measurement.  Under the amortization method, the servicing asset or liability is amortized to income over the estimated life of the asset or liability.  Under the fair value method, the servicing asset or liability is measured at fair value at each financial reporting date and changes in fair value are recognized to income.  This statement is effective at the beginning of the first fiscal year beginning after September 15, 2006.  Management does not anticipate that adoption of SFAS No. 156 will have a material affect on LCNB’s income due to the limited number of loans currently being sold in the secondary market.  

Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109,” was issued in July, 2006.  It provides additional guidance for financial statement recognition of tax positions taken in tax returns.  The interpretation is effective for fiscal years beginning after December 15, 2006.  Management does not anticipate that the guidance in the interpretation will have a material affect on LCNB’s financial results.

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REPORT OF INDEPENDENT  REGISTERED PUBLIC ACCOUNTING FIRM

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, 2006, and the related consolidated statements of income and comprehensive income for each of the three-month and six-month periods ended June 30, 2006 and 2005, and the related consolidated statements of shareholders’ equity and cash flows for each of the six-month periods ended June 30, 2006 and 2005.  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, 2005 (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 February 16, 2006, 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, 2005, is fairly stated in all material respects, in relation to the consolidated balance sheet from which it has been derived.

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

Cincinnati, Ohio

July 27, 2006

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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.  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 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 will be 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.  LCNB and Dakin are in the process of finalizing the allocation of the purchase price to the acquired assets, which consist solely of intangible assets, including a customer list and covenants not to compete. LCNB anticipates the amortization period of the collective intangible assets will approximate ten years.

Results of Operations

LCNB earned $1,609,000 or $0.49 per share for the three months ended June 30, 2006, compared to $1,692,000 or $0.51 per share for the three months ended June 30, 2005.  The return on average assets (ROAA) for the second quarter, 2006 was 1.19% and the return on average equity (ROAE) was 12.35%, compared with an ROAA of 1.26% and an ROAE of 13.01% for the second quarter of 2005.  The decrease in net income for the second quarter, 2006 is primarily attributable to a decrease in net interest income, an increase in the provision for loan losses, and an increase in non-interest expense.  These items were partially offset by an increase in non-interest income.

LCNB earned $3,218,000 or $0.99 per share during the first six months of 2006 compared to $3,098,000 or $0.93 per share for the first six months of 2005.  The ROAA and ROAE for the first six months of 2006 were 1.20% and 12.41%, respectively.  The comparable ratios for the first six months of 2005 were 1.18% and 11.92%, respectively.  The provision for loan losses for the 2006 period was less than the provision recorded during the 2005 period and non-interest income for the first six months of 2006 was greater than the amount for the comparable 2005 period.  These positive effects on net income were partially offset by a decrease in net interest income and an increase in non-interest expense.     

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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

Three Months Ended June 30, 2006 vs. 2005.

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, 2006 and 2005, average balances for interest-earning assets and interest-bearing liabilities, the income or expense related to each item, and the resulting average yields earned or rates paid.

(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, 2006 as compared to the same period in 2005.  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, 2006 totaled $4,813,000, a decrease of $70,000 from the comparable period in 2005.  Total interest expense increased $700,000, which was partially offset by an increase in total interest income of $630,000.  

The increase in total interest income was primarily due to a 49 basis point (one basis point equals 0.01%) increase in the average rate earned on earning assets and secondarily to a $1.3 million increase in average interest earning assets, from $497.1 million for the three months ended June 30, 2005 to $498.4 million for the same period in 2006.  The increase in interest earning assets was primarily from loan growth, which increased by $23.8 million on an average basis.  The increase in the average rate earned on earning assets was primarily due to general increases in market interest rates.

The increase in total interest expense was primarily due to a 71 basis point increase in the average rate paid, slightly offset by a $3.0 million decrease in average interest-bearing liabilities.  The increase in the average rate paid on interest-bearing liabilities was primarily due to general increases in market interest rates.

The net interest margin narrowed 7 basis points in the second quarter, 2006 compared to the second quarter, 2005. The tighter margin reflects highly competitive market pricing conditions for both loans and deposits and a relatively flat yield curve between short-term and long-term interest rates.  As a result, average deposit rates increased faster than average loan rates.

Six Months Ended June 30, 2006 vs. 2005.

The following table presents, for the six months ended June 30, 2006 and 2005, 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, 2006 as compared to the same period in 2005.  

Net interest income on a fully tax-equivalent basis for the first half of 2006 totaled $9,687,000, a $23,000 decrease from the first half of 2005.  Total interest expense increased $1,454,000 and was partially offset by an increase in total interest income of $1,431,000.

The increase in total interest income was due primarily to a 47 basis point increase in the average rate earned on earning assets, from 5.73% for the first half of 2005 to 6.20% for the first half of 2006, and secondarily to a $9.7 million increase in average total earning assets.  The increase in average earning assets was due to a $23.9 million increase in average loans, largely offset by a $10.1 decrease in federal funds sold and interest-bearing demand deposits and a $4.2 million decrease in investment securities.

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LCNB Corp. and Subsidiaries

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

Operations (continued)

The increase in total interest expense was due primarily to a 69 basis point increase in the average rate paid on interest-bearing liabilities.  The net interest margin narrowed 9 basis points in the first half of 2006 compared to the first half of 2005 for substantially the same reasons previously discussed.

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 six months ended June 30, 2006 consisted of residential and commercial real estate loans, consumer loans, and checking and NOW account overdrafts.  Charge-offs for the six months ended June 30, 2005 consisted primarily of consumer loans and checking and NOW account overdrafts.  

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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, 2006 consisted of one real estate mortgage loan and one loan secured by farmland.  Non-accrual loans at December 31, 2005 consisted of two real estate mortgage loans.  Loans past-due 90 days or more and still accruing interest at June 30, 2006 consisted of one real estate mortgage loan and consumer loans.  Loans past-due 90 days or more at  December 31, 2005 consisted primarily of consumer loans.  

Restructured loans at June 30, 2006 and December 31, 2005 include a commercial loan secured by a combination of mortgages and other collateral.  The principal balance of this loan at June 30, 2006 and December 31, 2005 was $1,262,000 and $1,717,000, respectively.  The reduction in the balance as of June 30, 2006 is due to principal payments received.  Restructured loans at June 30, 2006 include two additional commercial loans to a single borrower that are secured by commercial real estate.  

Non -Interest Income

Three Months Ended June 30, 2006 vs. 2005.

Non-interest income of $2,178,000 for the second quarter of 2006 was $142,000, or 7.0%, greater than for the same period in 2005 primarily due to a $29,000 increase in trust income, a $57,000 increase in insurance agency income, and a $70,000 increase in service charges and fees.  Trust income increased primarily due to an increase in brokerage fees, resulting from new business.  Insurance agency income increased primarily due to new business.  Service charges and fees increased primarily due to an increase in check card income and an increase in the number of non-sufficient fund charges.  Check card income grew because a greater number of cards were outstanding and because of the increasing popularity of check cards as a retail payment method.   

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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, 2006 vs. 2005.

Non-interest income of $4,139,000 for the first half of 2006 was $378,000, or 10.1%, greater than for the same period in 2005 primarily due to a $198,000 increase in trust income, a $128,000 increase in insurance agency income, and a $64,000 increase in service charges and fees.  The increase in trust income was primarily due to an increase in brokerage income resulting from new business and from trust fee modifications.  Insurance agency income increased due to an increase in contingency income recognized during the first quarter and due to new business.  Service charges and fees increased primarily due to an increase in check card income.   

Non-Interest Expense

Three Months Ended June 30, 2006 vs. 2005.

Total non-interest expense increased $136,000, or 3.2%, during the second quarter, 2006 compared to the second quarter, 2005, primarily due to increases in salaries and wages.  Salaries and wages increased $111,000, or 5.9%, primarily due to additional employees and routine salary and wage increases.

Six Months Ended June 30, 2006 vs. 2005.

Total non-interest expense increased $333,000, or 3.9%, during the first half, 2006 compared to the first half of 2005 primarily due to a $197,000 increase in salaries and wages and a $112,000 increase in ATM expense, which is included in other non-interest expense.  Salaries and wages increased for substantially the same reasons discussed above.  The increase in ATM expense is primarily due to fee adjustments from the vendor related to prior periods that were recognized during the first quarter, 2006.

Income Taxes

LCNB’s effective tax rates for the six months ended June 30, 2006 and 2005 were 25.2% and 24.8%, respectively.  The difference between the statutory rate of 34.0% and the effective tax rate is primarily due to tax-exempt interest income from municipal securities and tax-exempt earnings from bank owned life insurance.

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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

Federal funds sold and interest bearing demand deposits totaled $12.4 million at June 30, 2006, or $10.5 more than at December 31, 2005.  The increase reflects management’s decision to build cash and cash equivalents to fund increased loan demand and to service higher levels of public fund deposits.  

Securities available for sale had a market value of $112.0 million at June 30, 2006, approximately $21.5 million less than at December 31, 2005.  Increases in unrealized losses during the first half of 2006 comprise only $0.6 million of the decline.  The balance of the decrease primarily reflects management’s decision to invest most of the funds received from investment maturities and calls in federal funds sold and interest bearing demand deposits, thus building cash and cash equivalents, and in new loans.

Gross loans, before the allowance for loan losses, at June 30, 2006 were $373.5 million, approximately $13.7 million greater than at December 31, 2005.  Commercial loans secured by real estate comprised $11.7 million of the increase and consumer loans comprised another $2.9 million of the increase.  

Interest-bearing deposits at June 30, 2006 totaled $411.4 million, approximately $12.0 million greater than at December 31, 2005.  NOW accounts increased $29.1 million, partially offset by declines in money market deposit accounts, regular savings, and time deposits.  The increase in the NOW account classification was primarily due to a $26.1 million increase in public fund NOW account deposits.  Public fund deposits represent deposits by local and state governmental entities, and balances maintained are highly volatile.

Long-term debt at June 30, 2006 was $40,000, which was a $2.0 million decrease from the balance at December 31, 2005.  The decrease is due to the maturation and payment in full of a $2.0 Federal Home Loan Bank note on March 31, 2006.

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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 sheets. The analysis uses quarterly averages to give a better indication of balance sheet trends.