LCNB CORP - Quarter Report: 2006 March (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 March 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)

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 May 4, 2006 was 3,259,008 shares.

LCNB Corp.

INDEX

Page No.

Part I - Financial Information

Item 1.

Financial Statements

Consolidated Balance Sheets -

March 31, 2006, and December 31, 2005

1

Consolidated Statements of Income -

Three Months Ended March 31, 2006 and 2005

2

Consolidated Statements of Comprehensive Income -

Three Months Ended March 31, 2006 and 2005

3

Consolidated Statements of Stockholders' Equity -

Three Months Ended March 31, 2006 and 2005

4

Consolidated Statements of Cash Flows -

Three Months Ended March 31, 2006 and 2005

5

Notes to Consolidated Financial Statements

6-14

Report of Independent Registered Public Accounting Firm

15

Item 2.

Management's Discussion and Analysis of Financial

  Condition and Results of Operations

16-24

Item 3.

Quantitative and Qualitative Disclosures about

  Market Risk

25

Item 4.

Controls and Procedures

26

Part II - Other Information

Item 1.

Legal Proceedings

27

Item 1A.

Risk Factors

27

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

27

Item 3.

Defaults Upon Senior Securities

28

Item 4.

Submission of Matters to a Vote of Security Holders

28

Item 5.

Other Information

28

Item 6.

Exhibits

28

Signatures

29

PART I – FINANCIAL INFORMATION

Item 1.  Financial Statements

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 accompanying (a) consolidated balance sheet as of December 31, 2005, which has been derived from financial statements audited by J.D. Cloud & Co. L.L.P., LCNB’s registered independent public accounting firm (“J.D. Cloud”), and (b) the unaudited interim consolidated financial statements, which have been reviewed by J.D. Cloud 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 months ended March 31, 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.

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 2 - Earnings Per Share

Basic earnings per share is calculated by dividing net income by the weighted average number of common shares outstanding during the period.  Diluted earnings per share is adjusted for the dilutive effects of stock options.  The diluted average number of common shares outstanding has been increased for the assumed exercise of stock options with proceeds used to purchase treasury shares at the average market price for the period.  The computations were as follows for the three months ended March 31, 2006 and 2005 (thousands, except share and per share data):

Note 3 -  Investment Securities

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

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 3 – Investment Securities (continued)

Information concerning securities with gross unrealized losses at March 31, 2006 and December 31, 2005, aggregated by length of time that individual securities have been in a continuous loss position, is as follows (thousands):

The decline in fair values is primarily due to increases in market interest rates.  Unrealized losses on securities at March 31, 2006 have not been recognized in 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.

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 4 - Loans

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

Changes in the allowance for loan losses for the three months ended March 31, 2006 and 2005 were as follows (thousands):

Charge-offs for the three months ended March 31, 2006 and 2005 consisted of consumer loans and checking and NOW account overdrafts.  

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 4 – Loans (continued)

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

Non-accrual loans at March 31, 2006 consisted of two real estate mortgage loans and one home equity line of credit loan.  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 March 31, 2006 and December 31, 2005 consisted primarily of consumer loans.  The restructured loan at both dates is a commercial loan secured by a combination of mortgages and other collateral.  The smaller balance on March 31, 2006 is due to principal payments received.  

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 March 31, 2006 and December 31, 2005 were $45,766,000 and $46,244,000, respectively.  Loans sold to the FHLMC during the three months ended March 31, 2006 and 2005 totaled $1,223,000 and $728,000, respectively.  

Note 5 – 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 March 31, 2006 and December 31, 2005, accrued interest and other liabilities include U.S. Treasury demand note borrowings of approximately $198,000 and $1,031,000, respectively.  The interest rate on these borrowings is variable and was 4.68% and 4.00% at March 31, 2006 and December 31, 2005, respectively.

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 6 – 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 - 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 include 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 March 31, 2006 and December 31, 2005 were as follows (thousands):

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  They include amounts not drawn in 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 March 31, 2006, $13,490,000 of such commitments was for fixed rate products and unused overdraft protection amounts and $56,509,000 was for adjustable rate products.  

Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party.  At March 31, 2006 and December 31, 2005, outstanding guarantees of $1,698,000 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 March 31, 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 lending and capital expenditure 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 8 - 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 March 31, 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 March 31, 2006 were as follows (thousands):

The estimated weighted-average fair value of the options granted in 2006 was $9.24 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 months ended March 31, 2006 and 2005 were $3,000 and $2,000, respectively.

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LCNB Corp. and Subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(Continued)

Note 9 – 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 months ended March 31, 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 March 31, 2006, no contributions have been made.

Note 10 – 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.  LCNB will be required to account for all new servicing assets or liabilities acquired on or after January 1, 2007 in accordance with SFAS No. 156.  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.  

- 14 -

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 March 31, 2006, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the three-month periods ended March 31, 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

May 3, 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.

Results of Operations

Earnings for the first quarter of 2006 were $1,609,000 or $0.49 basic and diluted earnings per share, compared to $1,406,000 or $0.42 basic and diluted earnings per share for the first quarter of 2005.  Return on average assets for the quarters ended March 31, 2006 and 2005 were 1.21% and 1.09%, respectively.  Return on average equity for the first quarter, 2006 was 12.46%, compared to 10.83% for the first quarter, 2005.

The increase in net income during the first quarter, 2006 was significantly influenced by:

·

a $210,000 decrease in the provision for loan losses;

·

a $169,000 increase in trust and brokerage income, partly from new business and partly from fee modifications; and

·

a $69,000 increase in contingency commissions recognized by Dakin Insurance Agency.

Contingency commissions are profit-sharing arrangements on property and casualty policies between the originating agency and the underwriter and are generally based on underwriting results and written premium.  As such, the amount received each year can vary significantly depending on loss experience.  

Net Interest Income

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 March 31, 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 rate 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.

- 17 -

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 tax-equivalent 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 March 31, 2006 as compared to the comparable 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.

Net interest income on a fully tax-equivalent basis for the three months ended March 31, 2006 totaled $4,874,000, a slight increase of $47,000 from the comparable period in 2005.  Total interest income increased $801,000 and was largely offset by an increase in total interest expense of $754,000.  

The increase in total interest income was due to a 44 basis point (a basis point equals 0.01%) increase in the average rate earned on earning assets, from 5.75% for the first quarter of 2005 to 6.19% for the first quarter of 2006, and to an $18.1 million increase in average interest earning assets, from $480.0 million for the three months ended March 31, 2005 to $498.1 million for the same period in 2006.  The increase in average interest earning assets was due to a $24.0 million increase in average loans, partially offset by a decrease of $8.2 million in federal funds sold and interest-bearing demand deposits.  Most of the loan growth was in the commercial real estate loan portfolio.

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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 primarily due to a 68 basis point increase in the average rate paid and secondarily to a $14.7 million increase in average interest-bearing liabilities.  Most of the increase in average interest-bearing liabilities was in the deposit category, which increased $12.4 million, while average short-term borrowings increased $2.3 million.  Most of the increase in average interest-bearing deposits was in certificate of deposit, IRA, and NOW accounts, partially offset by decreases in regular savings and money fund investment accounts.

The net interest margin narrowed 11 basis points in the first quarter, 2006 compared to the first quarter, 2005. The tighter margin reflects highly competitive market pricing conditions for both loans and deposits, resulting in average deposit rates increasing faster than average loan rates.  

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 allowance for loan losses at March 31, 2006 is $100,000 less than at March 31, 2005 due primarily to an improvement in the credit quality of one significant loan during the quarter.  The total loan loss provision or reduction in the allowance for loan losses and other changes are shown below.  

Charge-offs for the three months ended March 31, 2006 and 2005 consisted 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 non-accrual, past due, and restructured loans of LCNB at the dates indicated:

Non-accrual loans at March 31, 2006 consisted of two real estate mortgage loans and one home equity line of credit loan.  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 March 31, 2006 and December 31, 2005 consisted primarily of consumer loans.  The restructured loan at both dates is a commercial loan secured by a combination of mortgages and other collateral.  The smaller balance on March 31, 2006 is due to principal payments received.  

Non -Interest Income

Non-interest income for 2006 was $236,000 or 13.7% greater than for the same period in 2005 primarily due to the increases in trust, brokerage, and contingency commissions previously mentioned.  

Non-Interest Expense

Non-interest expense for the first quarter, 2006 was $197,000 or 4.5% greater than for the first quarter, 2005, primarily due to increases in salaries and wages, employee benefits, and ATM expenses.  Salaries and wages increased $86,000 due to normal wage increases and additional staffing.  Employee benefits increased $33,000 due to increases in health insurance and FICA matching costs.  Approximately $103,000 of the $131,000 increase in other non-interest expense is due to increased ATM expenses, primarily due to fee adjustments related to prior periods.

Income Taxes

LCNB’s effective tax rates for the three months ended March 31, 2006 and 2005 were 24.7% and 24.6%, 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 income 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)

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

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LCNB Corp. and Subsidiaries

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

Operations (continued)

Average loans increased approximately $8.7 million or 2.5% during the first quarter, 2006 compared to the fourth quarter, 2005.  The increase was primarily due to growth in the commercial real estate loan category and secondarily to growth in the consumer and residential real estate loan categories.  This growth was partially offset be a decrease in average home equity line of credit loans outstanding.

Average investment securities decreased approximately $5.2 million when comparing the average balance for the first quarter, 2006 with the average balance for the fourth quarter, 2005.  This reflects the maturation of $10.3 million and sale of $8.2 million of investment securities during the first quarter, 2006.  Purchases of new investment securities during the first quarter totaled $5.4 million.  The funds freed by the difference between maturities and sales and new purchases were used to support growth in the loan portfolio.

Average interest-bearing deposits increased $3.6 million when comparing the first quarter, 2006 with the fourth quarter, 2005.  Average certificate of deposit accounts equal to $100,000 or more increased $6.9 million and average NOW and Premier Checking accounts increased a combined $3.1 million.  These increases were partially offset with a $4.1 million decrease in average regular savings, a $1.6 million decrease in average money fund investment accounts, and a $1.1 million decrease in average certificate of deposit accounts less than $100,000.

Total interest-bearing deposits at March 31, 2006 were $407.1 million, a $7.7 million increase from the $399.4 million balance at December 31, 2005.  NOW accounts increased $18.3 million and IRA certificate of deposit accounts increased $0.7 million.  These increases were offset by declines in the remaining interest-bearing deposit classifications.  The increase in the NOW account classification was due to a $21.0 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 March 31, 2006 was $57,000, 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)

Liquidity

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 Lebanon Citizens 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 Office of the Comptroller of the Currency, Lebanon Citizens’ primary regulator, is necessary for Lebanon Citizens to pay dividends in excess of this amount.  In addition, dividend payments may not reduce capital levels below minimum regulatory guidelines.  Management believes Lebanon Citizens will be able to pay anticipated dividends to LCNB without needing to request approval.

Liquidity is the ability to have funds available at all times to meet the commitments of LCNB.  Asset liquidity is provided by cash and assets which are readily marketable or pledgeable or which will mature in the near future. Liquid assets include cash, federal funds sold, interest-bearing demand deposits, and securities available for sale.  At March 31, 2006, LCNB’s liquid assets amounted to $141.9 million or 26.3% of total assets, a slight decrease from $148.8 million or 27.6% at December 31, 2005.

Liquidity is also provided by access to core funding sources, primarily core depositors in the bank’s market area.  Approximately 77.3% of total deposits at March 31, 2006 were core deposits.  Core deposits, for this purpose, are defined as total deposits less public funds and certificates of deposit equal to or greater than $100,000.  Secondary sources of liquidity include LCNB’s ability to sell loan participations, borrow funds from the Federal Home Loan Bank, purchase federal funds, or use a line of credit established with another bank.

Management closely monitors the level of liquid assets available to meet ongoing funding needs.  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 as a result of the current liquidity levels.

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LCNB Corp. and Subsidiaries

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

Operations (continued)

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”.  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.  LCNB will be required to account for all new servicing assets or liabilities acquired on or after January 1, 2007 in accordance with SFAS No. 156.  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.  

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LCNB Corp. and Subsidiaries

Item 3.  Quantitative and Qualitative Disclosures about Market Risks

The Bank's Asset and Liability Management Committee ("ALCO") primarily uses a combination of Interest Rate Sensitivity Analysis (“IRSA”) and Economic Value of Equity (“EVE”) analysis for measuring and managing interest rate risk.  IRSA is used to estimate the effect on net interest income during a one-year period of instantaneous and sustained movements in interest rates, also called interest rate shocks, of 100, 200, and 300 basis points.  The base projection uses a current interest rate scenario.  As shown below, the March 31, 2006 IRSA indicates that an increase in interest rates would have a positive effect on net interest income (“NII”), and a decrease in rates would have a negative effect on net interest income. The changes in net interest income for the up and down 100, 200, and 300 basis point rate assumptions are within LCNB’s acceptable ranges.  

IRSA shows the effect on net interest income during a one-year period only.  A more long-range model is the EVE analysis, which shows the estimated present value of future cash inflows from interest-earning assets less the present value of future cash outflows for interest-bearing liabilities for the same rate shocks.  The EVE analysis at March 31, 2006 is shown below.  It shows a negative effect on the economic value of equity for increases in interest rates and a slight positive effect for decreases in rates. The changes in the economic value of equity for these rate assumptions are within LCNB’s acceptable ranges.

The IRSA and EVE simulations discussed above are not projections of future income or equity and should not be relied on as being indicative of future operating results.  Assumptions used, including the nature and timing of interest rate levels, yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, and reinvestment or replacement of asset and liability cash flows, are inherently uncertain and, as a result, the models cannot precisely measure future net interest income or equity.  Furthermore, the models do not reflect actions that borrowers, depositors, and management may take in response to changing economic conditions and interest rate levels.  

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LCNB Corp. and Subsidiaries

Item 4.  Controls and Procedures

a)  Disclosure controls and procedures.  The Chief Executive Officer and the Chief Financial Officer have carried out an evaluation of the effectiveness of LCNB's disclosure controls and procedures that ensure that information relating to LCNB required to be disclosed by LCNB in the reports that it files or submits under the Securities and Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms.  Based upon this evaluation, these officers have concluded, that as of March 31, 2006, LCNB's disclosure controls and procedures were effective.

b)  Changes in internal control over financial reporting.  During the period covered by this report, there were no changes in LCNB's internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, LCNB's internal control over financial reporting.

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LCNB Corp. and Subsidiaries

PART II -- OTHER INFORMATION

Item 1. Legal Proceedings - Not Applicable

Item 1A.  Risk Factors – No material changes

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

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 March 31, 2006, 113,622 shares had been purchased under this program.  The following table shows information relating to the repurchase of shares under the Market Repurchase Program during the three months ended March 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 178,344 shares have been purchased since the inception of this program.  No shares were purchased during the first quarter, 2006.

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PART II.  OTHER INFORMATION

LCNB Corp. and Subsidiaries

Item 3. Defaults Upon Senior Securities - Not Applicable

Item 4. Submission of Matters to a Vote of Security Holders  - Not Applicable

Item 5. Other Information - Not Applicable

Item 6. Exhibits