Citizens Financial Services, Inc. First Quarter 2006 Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q



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

For the quarterly period ended March 31, 2006

Or

[ ] 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 0-13222

CITIZENS FINANCIAL SERVICES, INC.
(Exact name of registrant as specified in its charter)

                         PENNSYLVANIA                                                 23-2265045
                         (State or other jurisdiction of incorporation or organization)              (I.R.S. Employer Identification No.)


First Citizens National Bank
15 South Main Street
Mansfield, Pennsylvania 16933
(Address of principal executive offices)(Zip Code)

Registrant's telephone number, including area code: (570) 662-2121

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

Indicate by check mark whether the registrant is 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 File ____ Accelerated Filer ____ Non-accelerated Filer __X__


Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes____ No __X__

The number of shares outstanding of the Registrant's Common Stock, as of May 1, 2006, 2,820,098 shares of Common Stock, par value $1.00.




 
Citizens Financial Services, Inc.
Form 10-Q

INDEX
 
   
PAGE
Part I 
FINANCIAL INFORMATION
 
Item 1.
Financial Statements (unaudited):
 
 
Consolidated Balance Sheet as of March 31, 2006 and
December 31, 2005
1
 
Consolidated Statement of Income for the
Three Months Ended March 31, 2006 and 2005
2
 
Consolidated Statement of Comprehensive Income for the
Three Months Ended March 31, 2006 and 2005
3
 
Consolidated Statement of Cash Flows for the
Three Months Ended March 31, 2006 and 2005
4
 
Notes to Consolidated Financial Statements
5-6
Item 2.
Management’s Discussion and Analysis of Financial
Condition and Results of Operations
7-20
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
21
Item 4.
Controls and Procedures
21
     
Part II 
OTHER INFORMATION
 
Item 1.
Legal Proceedings
22
Item 1A.
Risk Factors
22
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
22
Item 3.
Defaults upon Senior Securities
22
Item 4.
Submission of Matters to a Vote of Security Holders
23
Item 5.
Other Information
23
Item 6.
Exhibits
24-25
 
Signatures
26



CITIZENS FINANCIAL SERVICES, INC.
 
 
 
 
 
CONSOLIDATED BALANCE SHEET
 
 
 
 
 
(UNAUDITED)
 
 
 
 
 
 
 
 
 
 
 
 
 
March 31
 
December 31
 
(in thousands except share data)
 
2006
 
2005
 
ASSETS:
 
 
 
 
 
Cash and due from banks:
 
 
 
 
 
Noninterest-bearing
 
$
9,781
 
$
8,498
 
Interest-bearing
   
21
   
111
 
Total cash and cash equivalents
   
9,802
   
8,609
 
 
         
Available-for-sale securities
   
105,220
   
102,602
 
 
         
Loans (net of allowance for loan losses of $3,709 and $3,664)
   
385,116
   
379,139
 
 
         
Premises and equipment
   
12,195
   
12,305
 
Accrued interest receivable
   
2,316
   
2,164
 
Goodwill
   
8,605
   
8,605
 
Core deposit intangible
   
539
   
684
 
Bank owned life insurance
   
7,815
   
7,743
 
Other assets
   
8,595
   
7,390
 
 
         
TOTAL ASSETS
 
$
540,203
 
$
529,241
 
 
         
LIABILITIES:
         
Deposits:
         
Noninterest-bearing
 
$
52,360
 
$
50,600
 
Interest-bearing
   
375,087
   
379,199
 
Total deposits
   
427,447
   
429,799
 
Borrowed funds
   
67,042
   
52,674
 
Accrued interest payable
   
1,657
   
1,862
 
Commitment to purchase investment securities
   
-
   
752
 
Other liabilities
   
2,786
   
2,593
 
TOTAL LIABILITIES
   
498,932
   
487,680
 
STOCKHOLDERS' EQUITY:
         
Common Stock
         
$1.00 par value; authorized 10,000,000 shares;
         
issued 2,965,257 shares in 2006 and 2005, respectively
   
2,965
   
2,965
 
Additional paid-in capital
   
11,359
   
11,359
 
Retained earnings
   
31,930
   
31,251
 
TOTAL
   
46,254
   
45,575
 
Accumulated other comprehensive loss
   
(1,942
)
 
(1,540
)
Less: Treasury Stock, at cost 144,088 shares for
         
2006 and 118,715 for 2005, respectively
   
(3,041
)
 
(2,474
)
TOTAL STOCKHOLDERS' EQUITY
   
41,271
   
41,561
 
TOTAL LIABILITIES AND
         
STOCKHOLDERS' EQUITY
 
$
540,203
 
$
529,241
 
 
         
The accompanying notes are an integral part of these unaudited consolidated financial statements.
   
 
1

 

CITIZENS FINANCIAL SERVICES, INC.
 
 
 
 
 
CONSOLIDATED STATEMENT OF INCOME
 
 
 
 
 
(UNAUDITED)
 
 
 
 
 
 
 
Three Months Ended
 
 
 
March 31,
 
(in thousands, except per share data)
 
2006
 
2005
 
INTEREST INCOME:
         
Interest and fees on loans
 
$
6,519
 
$
5,919
 
Investment securities:
         
Taxable
   
819
   
792
 
Nontaxable
   
226
   
117
 
Dividends
   
67
   
51
 
TOTAL INTEREST INCOME
   
7,631
   
6,879
 
INTEREST EXPENSE:
         
Deposits
   
2,601
   
2,168
 
Borrowed funds
   
663
   
378
 
TOTAL INTEREST EXPENSE
   
3,264
   
2,546
 
NET INTEREST INCOME
   
4,367
   
4,333
 
Provision for loan losses
   
60
   
-
 
NET INTEREST INCOME AFTER
         
PROVISION FOR LOAN LOSSES
   
4,307
   
4,333
 
NON-INTEREST INCOME:
         
Service charges
   
706
   
673
 
Trust
   
129
   
121
 
Brokerage
   
58
   
38
 
Insurance
   
36
   
83
 
Investment securities losses, net
   
(6
)
 
-
 
Earnings on bank owned life insurance
   
72
   
74
 
Other
   
137
   
121
 
TOTAL NON-INTEREST INCOME
   
1,132
   
1,110
 
NON-INTEREST EXPENSES:
         
Salaries and employee benefits
   
2,036
   
1,921
 
Occupancy
   
308
   
303
 
Furniture and equipment
   
152
   
175
 
Professional fees
   
140
   
145
 
Amortization
   
144
   
144
 
Other
   
1,111
   
1,143
 
TOTAL NON-INTEREST EXPENSES
   
3,891
   
3,831
 
Income before provision for income taxes
   
1,548
   
1,612
 
Provision for income taxes
   
272
   
345
 
NET INCOME
 
$
1,276
 
$
1,267
 
 
         
Earnings Per Share
 
$
0.45
 
$
0.44
 
Cash Dividend Declared
 
$
0.21
 
$
0.20
 
 
         
Weighted average number of shares outstanding
   
2,840,325
   
2,867,995
 
 
         
The accompanying notes are an integral part of these unaudited consolidated financial statements.

2



CITIZENS FINANCIAL SERVICES, INC.
 
 
 
 
 
 
 
 
 
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
 
 
 
 
 
 
 
 
 
(UNAUDITED)
 
 
 
 
 
 
 
 
 
 
 
Three Months Ended
 
 
 
March 31
 
(in thousands)
 
 
 
2006
 
 
 
2005
 
Net income
     
$
1,276
     
$
1,267
 
Other comprehensive loss:
                 
Unrealized losses on available for sale securities
   
(614
)
     
(1,664
)
   
Less: Reclassification adjustment for losses included in net income
   
6
                
-
        
Other comprehensive loss before tax
       
(608
)
     
(1,664
)
Income tax benefit related to other comprehensive loss
       
(207
)
     
(566
)
Other comprehensive loss, net of tax
   
            
   
(401
)
 
  
   
(1,098
)
Comprehensive income
   
  
 
$
875
   
  
 
$
169
 
 
                 
The accompanying notes are an integral part of these unaudited consolidated financial statements.
           
 
3


CITIZENS FINANCIAL SERVICES, INC.
 
 
 
 
 
CONSOLIDATED STATEMENT OF CASH FLOWS
 
 
 
 
 
(UNAUDITED)
 
Three Months Ended
 
 
 
March 31,
 
(in thousands)
 
2006
 
2005
 
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
 
 
Net income
 
$
1,276
 
$
1,267
 
Adjustments to reconcile net income to net
         
cash provided by operating activities:
         
Provision for loan losses
   
60
   
-
 
Depreciation and amortization
   
382
   
370
 
Amortization and accretion of investment securities
   
138
   
188
 
Deferred income taxes
   
(82
)
 
5
 
Investment securities losses, net
   
6
   
-
 
Earnings on bank owned life insurance
   
(72
)
 
(74
)
Originations of loans held for sale
   
(589
)
 
(637
)
Proceeds from sales of loans held for sale
   
595
   
647
 
Gain on sale of foreclosed assets held for sale
   
(13
)
 
(9
)
Increase in accrued interest receivable
   
(152
)
 
(300
)
Decrease in accrued interest payable
   
(205
)
 
(238
)
Other, net
   
(90
)
 
115
 
Net cash provided by operating activities
   
1,254
   
1,334
 
 
         
CASH FLOWS FROM INVESTING ACTIVITIES:
         
Available-for-sale securities:
         
Proceeds from sales of available-for-sale securities
   
3,793
   
-
 
Proceeds from maturity and principal repayments of securities
   
3,878
   
4,024
 
Purchase of securities
   
(11,792
)
 
(4,739
)
Proceeds from redemption of Regulatory Stock
   
683
   
715
 
Purchase of Regulatory Stock
   
(1,269
)
 
(729
)
Net increase in loans
   
(6,174
)
 
(9,136
)
Purchase of premises and equipment
   
(81
)
 
(80
)
Proceeds from sale of premises and equipment
   
-
   
200
 
Proceeds from sale of foreclosed assets held for sale
   
50
   
108
 
Net cash used in investing activities
   
(10,912
)
 
(9,637
)
 
         
CASH FLOWS FROM FINANCING ACTIVITIES:
         
Net decrease in deposits
   
(2,352
)
 
(5,850
)
Proceeds from long-term borrowings
   
288
   
8,021
 
Repayments of long-term borrowings
   
(71
)
 
-
 
Net increase in short-term borrowed funds
   
14,151
   
5,371
 
Purchase of Treasury Stock
   
(567
)
 
-
 
Dividends paid
   
(598
)
 
(568
)
Net cash provided by financing activities
   
10,851
   
6,974
 
 
         
Net increase (decrease) in cash and cash equivalents
   
1,193
   
(1,329
)
 
         
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
   
8,609
   
9,339
 
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 
$
9,802
 
$
8,010
 
 
         
Supplemental Disclosures of Cash Flow Information:
         
Interest paid
 
$
3,459
 
$
2,776
 
 
         
Income taxes paid
 
$
150
 
$
-
 
 
         
The accompanying notes are an integral part of these unaudited consolidated financial statements.
   
 
4


CITIZENS FINANCIAL SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


Note 1 - Basis of Presentation

Citizens Financial Service, Inc., (individually and collectively, the “Company”) is a Pennsylvania corporation organized as the holding company of its wholly owned subsidiary, First Citizens National Bank (the “Bank”), and its subsidiary, First Citizens Insurance Agency, Inc. All material inter-company balances and transactions have been eliminated in consolidation.

The accompanying consolidated financial statements have been prepared pursuant to rules and regulations of the Securities and Exchange Commission (SEC) and in conformity with U.S. generally accepted accounting principles. Because this report is based on an interim period, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted.

In the opinion of Management of the registrant, the accompanying interim financial statements for the quarters ended March 31, 2006 and 2005 include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the financial condition and the results of operations for the period. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. The financial performance reported for the Company for the three-month period ended March 31, 2006 is not necessarily indicative of the results to be expected for the full year. This information should be read in conjunction with the Company’s Annual Report to shareholders and Form 10-K for the period ended December 31, 2005.

Note 2 - Earnings per Share

The following table sets forth the computation of earnings per share. Earnings per share calculations give retroactive effect to stock dividends declared by the Company. The Company has no dilutive securities.
 
 
Three months ended
 
March 31,
 
2006
2005
 
 
 
Net income applicable to common stock
$1,276,000
$1,267,000
Weighted average common shares outstanding
2,840,325
2,867,995
     
Earnings per share
$0.45
$0.44
 
Note 3 - Income Tax Expense

Income tax expense is less than the amount calculated using the statutory tax rate, primarily the result of tax-exempt income earned from state and municipal securities and loans and investments in tax credits.

Note 4 - Employee Benefit Plans

For a detailed disclosure on the Company's pension and employee benefits plans, please refer to Note 10 of the Company's Consolidated Financial Statements included in the 2005 Annual Report on Form 10-K.

5

 
Defined Benefit Plan

The following sets forth the components of net periodic benefit costs of the noncontributory defined benefit plan for the three months ended March 31, 2006 and 2005, respectively (dollars presented in thousands):

 
Pension Benefits
       
 
2006
 
2005
Service cost
$ 91
 
$ 68
Interest cost
82
 
60
Expected return on plan assets
(95)
 
(68)
Net amortization and deferral
15
 
6
       
Net periodic benefit cost
$ 93
 
$ 66
 
The Company previously disclosed in its financial statements for the year ended December 31, 2005, that it expected to contribute $340,000 to its noncontributory defined benefit pension plan in 2006. As of March 31, 2006, no contributions have been made.

Defined Contribution Plan

The Company also sponsors a defined contribution, 401(k) plan covering substantially all of its employees. The Company contributes three percent of applicable salaries into the plan. Contributions totaled $49,900 and $51,000 for the three months ended March 31, 2006 and 2005, respectively.


Note 5 - Recent Accounting Pronouncements

In February 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting (“FAS”) No. 155, Accounting for Certain Hybrid Instruments, as an amendment of FASB Statements No. 133 and 140. FAS No. 155 allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis. 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. The adoption of this standard is not expected to have a material effect on the Company’s results of operations or financial position.

In March 2006, the FASB issued FAS No. 156, Accounting for Servicing of Financial Assets. This Statement, which is an amendment to FAS No. 140, will simplify the accounting for servicing assets and liabilities, such as those common with mortgage securitization activities. Specifically, FAS No. 156 addresses the recognition and measurement of separately recognized servicing assets and liabilities and provides an approach to simplify efforts to obtain hedge-like (offset) accounting. FAS No. 156 also clarifies when an obligation to service financial assets should be separately recognized as a servicing asset or a servicing liability, requires that a separately recognized servicing asset or servicing liability be initially measured at fair value, if practicable, and permits an entity with a separately recognized servicing asset or servicing liability to choose either of the amortization or fair value methods for subsequent measurement. The provisions of FAS No. 156 are effective as of the beginning of the first fiscal year that begins after September 15, 2006. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s results of operations.
 
6

 
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Cautionary Statement
 
Forward-looking statements may prove inaccurate. We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of Citizens Financial Services, Inc., First Citizens National Bank, First Citizens Insurance Agency, Inc. or the combined company. When we use such words as "believes," "expects,” "anticipates," or similar expressions, we are making forward-looking statements. For a variety of reasons, actual results could differ materially from those contained in or implied by forward-looking statements. The Company would like to caution readers that the following important factors, among others, may have affected and could in the future affect the Company’s actual results and could cause the Company’s actual results for subsequent periods to differ materially from those expressed in any forward looking statement:
 
·  
Interest rates could change more rapidly or more significantly than we expect.
·  
The economy could change significantly in an unexpected way, which would cause the demand for new loans and the ability of borrowers to repay outstanding loans to change in ways that our models do not anticipate.
·  
The stock and bond markets could suffer a significant disruption, which may have a negative effect on our financial condition and that of our borrowers, and on our ability to raise money by issuing new securities.
·  
It could take us longer than we anticipate implementing strategic initiatives designed to increase revenues or manage expenses, or we may be unable to implement those initiatives at all.
·  
Acquisitions and dispositions of assets could affect us in ways that management has not anticipated.
·  
We may become subject to new legal obligations or the resolution of litigation may have a negative effect on our financial condition.
·  
We may become subject to new and unanticipated accounting, tax, or regulatory practices, regulations or requirements, including the costs of compliance with such changes.
·  
We could experience greater loan delinquencies than anticipated, adversely affecting our earnings and financial condition.
·  
We could lose the services of some or all of our key personnel, which would negatively impact our business because of their business development skills, financial expertise, lending experience, technical expertise and market area knowledge.

Introduction

The following is management's discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in its accompanying consolidated financial statements for Citizens Financial Service, Inc., a bank holding company and its subsidiary (the Company). Our Company's consolidated financial condition and results of operations consist almost entirely of our wholly owned subsidiary’s (First Citizens National Bank) financial conditions and results of operations. Management’s discussion and analysis should be read in conjunction with the preceding March 31, 2006 financial information. The results of operations for the three months ended March 31, 2006 and 2005 are not necessarily indicative of the results you may expect for the full year.

Our Company currently engages in the general business of banking throughout our service area of Potter, Tioga and Bradford counties in North Central Pennsylvania and Allegany, Steuben, Chemung and Tioga counties in Southern New York. We maintain our central office in Mansfield, Pennsylvania. Presently we operate 16 banking facilities. In Pennsylvania, these offices are located in Mansfield, Blossburg, Ulysses, Genesee, Wellsboro, Troy, Sayre, Canton, Gillett, Millerton, LeRaysville, Towanda, the Wellsboro Weis Market store, and the Mansfield Wal-Mart Super Center. In New York, we have a temporary banking office in Wellsville. A permanent banking facility is anticipated to be completed in late 2006. This marks the Company’s first office location in New York.

Risk identification and management are essential elements for the successful management of the Company. In the normal course of business, the Company is subject to various types of risk, including interest rate, credit, liquidity and regulatory risk.
 
7


Interest rate risk is the sensitivity of net interest income and the market value of financial instruments to the direction and frequency of changes in interest rates. Interest rate risk results from various re-pricing frequencies and the maturity structure of the financial instruments owned by the Company. The Company uses its asset/liability and funds management policy to control and manage interest rate risk.

Credit risk represents the possibility that a customer may not perform in accordance with contractual terms. Credit risk results from loans with customers and the purchasing of securities. The Company’s primary credit risk is in the loan portfolio. The Company manages credit risk by adhering to an established credit policy and through a disciplined evaluation of the adequacy of the allowance for loan losses. Also, the investment policy limits the amount of credit risk that may be taken in the investment portfolio.

Liquidity risk represents the inability to generate or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and obligations to depositors. The Company has established guidelines within its asset/liability and funds management policy to manage liquidity risk. These guidelines include, among other things, contingent funding alternatives.

Regulatory risk represents the possibility that a change in law, regulations or regulatory policy may have a material effect on the business of the Company and its subsidiary. We can not predict what legislation might be enacted or what regulations might be adopted, or if adopted, the effect thereof on our operations.

Readers should carefully review the risk factors described in other documents our Company files from time to time with the Securities and Exchange Commission, including the Annual Report for the year ended December 31, 2005, filed by our Company and any current reports on Form 8-K filed by us.

We face strong competition in the communities that we serve from other commercial banks, savings banks, and savings and loan associations, some of which are substantially larger institutions than our subsidiary. In addition, insurance companies, investment-counseling firms, and other business firms and individuals offer personal and corporate trust services. We also compete with credit unions, issuers of money market funds, securities brokerage firms, consumer finance companies, mortgage brokers and insurance companies. These entities are strong competitors for virtually all types of financial services.

In recent years, the financial services industry has experienced tremendous change to competitive barriers between bank and non-bank institutions. We must compete with traditional financial institutions, other business corporations that have begun to deliver competing financial services, and banking services that are easily accessible through the internet. Competition for banking services is based on price, nature of product, quality of service, and in the case of certain activities, convenience of location.

Trust and Investment Services

Our Investment and Trust Services Department is committed to helping our customers meet their financial goals. The Trust Department offers professional trust administration, investment management services, estate planning and administration, and custody of securities. We also help the members of our communities prepare for retirement by providing retirement plans for local employers and by managing individual IRA accounts. Assets held by the Company in a fiduciary or agency capacity for its customers are not included in the consolidated financial statements since such items are not assets of the Company. As of March 31, 2006 and December 31, 2005, the Trust Department had $78.5 million and $75.2 million of assets under management, respectively.

Our Investment Representatives offer full service brokerage services throughout the Bank’s market area, and appointments can be made at any First Citizens National Bank branch. The Investment Representatives provide financial planning and help our customers achieve their financial goals with their choice of mutual funds, annuities, health and life insurance. These products are made available through our insurance subsidiary, First Citizens Insurance Agency, Inc.

Results of Operations

Overview of the Income Statement

The Company had net income of $1,276,000 for the first three months of 2006 compared with earnings of $1,267,000 for last year’s comparable period, an increase of $9,000. Earnings per share for the first three months of 2006 were $0.45, compared to $.44 last year. Annualized return on assets and return on equity for the three months of 2006 was .96% and 11.84%, respectively, compared with 1.01% and 12.41% for last year’s comparable period. Details of the reasons for this change are discussed on the following pages.
 
8


Net Interest Income

Net interest income, the most significant component of earnings, is the amount by which interest income generated from interest-earning assets exceeds interest expense on interest-bearing liabilities.

Net interest income, for the first quarter of 2006, after provision for loan losses, was $4,307,000, a decrease of $26,000, compared to the same period in 2005. For the first three months of 2006, the provision for losses totaled $60,000. For the first three months of 2005, the provision was $0.

The following table sets forth the average balances of, and the interest earned or incurred on, each principal category of assets, liabilities and stockholders’ equity, the related rates, net interest income and rate “spread” created: 
 
9


 
           
Analysis of Average Balances and Interest Rates (1)
         
                                       
   
March 31, 2006
 
March 31, 2005
 
March 31, 2004
 
   
Average
     
Average
 
Average
     
Average
 
Average
     
Average
 
   
Balance (1)
 
Interest
 
Rate
 
Balance (1)
 
Interest
 
Rate
 
Balance (1)
 
Interest
 
Rate
 
(dollars in thousands)
 
$ 
 
$
 
% 
 
 $
 
$
 
% 
 
$ 
 
$
 
 %
 
ASSETS
                                     
Short-term investments:
                                     
Interest-bearing deposits at banks
   
8
   
-
   
4.36
   
10
   
-
   
2.43
   
2,577
   
5
   
0.79
 
Total short-term investments
   
8
   
-
   
4.36
   
10
   
-
   
2.43
   
2,577
   
5
   
0.79
 
Investment securities:
                                                       
Taxable
   
84,313
   
898
   
4.26
   
89,605
   
854
   
3.81
   
95,711
   
973
   
4.07
 
Tax-exempt (3)
   
23,117
   
342
   
5.92
   
11,223
   
177
   
6.31
   
7,637
   
128
   
6.70
 
Total investment securities
   
107,430
   
1,240
   
4.62
   
100,828
   
1,031
   
4.09
   
103,348
   
1,101
   
4.26
 
Loans:
                                                       
Residential mortgage loans
   
203,365
   
3,481
   
6.94
   
197,447
   
3,321
   
6.82
   
187,097
   
3,301
   
7.16
 
Commercial & farm loans
   
125,974
   
2,325
   
7.49
   
115,222
   
1,950
   
6.86
   
81,063
   
1,384
   
6.92
 
Loans to state & political subdivisions
   
43,318
   
640
   
5.99
   
37,965
   
564
   
6.02
   
37,015
   
570
   
6.25
 
Other loans
   
12,932
   
280
   
8.78
   
12,367
   
270
   
8.85
   
12,634
   
284
   
9.12
 
Loans, net of discount (2)(3)(4)
   
385,589
   
6,726
   
7.07
   
363,001
   
6,105
   
6.82
   
317,809
   
5,539
   
7.07
 
Total interest-earning assets
   
493,027
   
7,966
   
6.55
   
463,839
   
7,136
   
6.24
   
423,734
   
6,645
   
6.36
 
Cash and due from banks
   
8,606
               
8,372
               
8,135
             
Bank premises and equipment
   
12,276
               
11,769
               
10,592
             
Other assets
   
18,532
   
  
   
  
   
18,789
   
  
   
  
   
18,617
   
  
   
  
 
Total non-interest earning assets
   
39,414
               
38,930
               
37,344
             
Total assets
   
532,441
   
  
   
  
   
502,769
   
  
   
  
   
461,078
   
  
   
  
 
LIABILITIES AND STOCKHOLDERS' EQUITY
                                               
Interest-bearing liabilities:
                                                       
NOW accounts
   
80,617
   
319
   
1.60
   
68,324
   
114
   
0.68
   
58,341
   
48
   
0.33
 
Savings accounts
   
38,899
   
29
   
0.30
   
40,327
   
28
   
0.28
   
37,449
   
26
   
0.28
 
Money market accounts
   
45,358
   
309
   
2.76
   
43,880
   
157
   
1.45
   
44,273
   
103
   
0.94
 
Certificates of deposit
   
212,394
   
1,944
   
3.71
   
214,609
   
1,869
   
3.53
   
202,764
   
1,787
   
3.57
 
Total interest-bearing deposits
   
377,268
   
2,601
   
2.80
   
367,140
   
2,168
   
2.39
   
342,827
   
1,964
   
2.32
 
Other borrowed funds
   
57,313
   
663
   
4.69
   
46,137
   
378
   
3.32
   
32,805
   
213
   
2.63
 
Total interest-bearing liabilities
   
434,581
   
3,264
   
3.05
   
413,277
   
2,546
   
2.50
   
375,632
   
2,177
   
2.35
 
Demand deposits
   
48,203
               
44,128
               
43,169
             
Other liabilities
   
6,529
               
4,513
               
4,287
             
Total non-interest-bearing liabilities
   
54,732
           
48,641
           
47,456
         
Stockholders' equity
   
43,128
               
40,851
               
37,990
             
Total liabilities & stockholders' equity
   
532,441
   
  
   
  
   
502,769
   
  
   
  
   
461,078
   
  
   
  
 
Net interest income
   
  
   
4,702
   
  
   
    
   
4,590
   
  
   
  
   
4,468
   
  
 
Net interest spread (5)
               
3.50
%
             
3.74
%
             
4.01
%
Net interest income as a percentage
                                                       
of average interest-earning assets
               
3.87
%
             
4.01
%
             
4.28
%
Ratio of interest-earning assets
                                                       
to interest-bearing liabilities
               
1.13
               
1.12
               
1.13
 
                                                         
(1) Averages are based on daily averages.
                                                       
(2) Includes loan origination and commitment fees.
                                               
(3) Tax exempt interest revenue is shown on a tax equivalent basis for proper comparison using
                       
a statutory federal income tax rate of 34%.
                                   
(4) Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets.
     
(5) Interest rate spread represents the difference between the average rate earned on interest-earning assets
                 
and the average rate paid on interest-bearing liabilities.
                                         
 
10

 
Tax exempt revenue is shown on a tax-equivalent basis for proper comparison using a statutory, federal income tax rate of 34%. For purposes of the comparison, as well as the discussion that follows, this presentation facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Company’s 34% Federal statutory rate. The following table represents the adjustment to convert net interest income to net interest on a fully taxable equivalent basis for the periods ending March 31, 2006 and 2005:
 
   
For the Three Months
 
   
Ended March 31,
 
   
(dollars in thousands)
 
   
2006
 
2005
 
           
Total interest income
 
$
7,631
 
$
6,879
 
Total interest expense
   
3,264
   
2,546
 
               
Net interest income
   
4,367
   
4,333
 
Tax equivalent adjustment
   
335
   
257
 
               
Net interest income (fully taxable equivalent)
 
$
4,702
 
$
4,590
 

  The following table shows the tax-equivalent effect of changes in volume and rate on interest income and expense.

   
2006 vs. 2005 (1)
 
2005 vs. 2004 (1)
 
   
Change in
 
Change
 
Total
 
Change in
 
Change
 
Total
 
 (in thousands)
 
Volume
 
in Rate
 
Change
 
Volume
 
in Rate
 
Change
 
Interest Income:
                         
Short-term investments:
                         
Interest-bearing deposits at banks
 
$
-
 
$
-
 
$
-
 
$
(8
)
$
3
 
$
(5
)
Investment securities:
                                     
Taxable
   
(52
)
 
96
   
44
   
136
   
(255
)
 
(119
)
Tax-exempt
   
177
   
(12
)
 
165
   
57
   
(8
)
 
49
 
Total investments
   
125
   
84
   
209
   
193
   
(263
)
 
(70
)
Loans:
                                     
Residential mortgage loans
   
104
   
56
   
160
   
178
   
(158
)
 
20
 
Commercial & farm loans
   
736
   
(361
)
 
375
   
578
   
(12
)
 
566
 
Loans to state & political subdivisions
   
79
   
(3
)
 
76
   
15
   
(21
)
 
(6
)
Other loans
   
12
   
(2
)
 
10
   
(7
)
 
(7
)
 
(14
)
Total loans, net of discount
   
931
   
(310
)
 
621
   
764
   
(198
)
 
566
 
Total Interest Income
   
1,056
   
(226
)
 
830
   
949
   
(458
)
 
491
 
Interest Expense:
                                     
Interest-bearing deposits:
                                     
NOW accounts
   
16
   
189
   
205
   
7
   
59
   
66
 
Savings accounts
   
(1
)
 
2
   
1
   
2
   
-
   
2
 
Money Market accounts
   
5
   
147
   
152
   
(1
)
 
55
   
54
 
Certificates of deposit
   
(19
)
 
94
   
75
   
103
   
(21
)
 
82
 
Total interest-bearing deposits
   
1
   
432
   
433
   
111
   
93
   
204
 
Other borrowed funds
   
38
   
247
   
285
   
150
   
15
   
165
 
Total interest expense
   
39
   
679
   
718
   
261
   
108
   
369
 
Net interest income
 
$
1,017
 
$
(905
)
$
112
 
$
688
 
$
(566
)
$
122
 
                                       
(1) The portion of the total change attributable to both volume and rate changes during the year has been allocated
to volume and rate components based upon the absolute dollar amount of the change in each component prior to allocation.
 
As can be seen from the preceding tables, we continue to experience a compression of our net interest margin. Due to the flattening of the yield curve, the net interest spread has decreased from 3.74% for the first three months of 2005 to 3.50% for the first three months of 2006. While short-term interest rates have increased nearly 375 basis points since June 2004, long-term rates have remained relatively stable. As such, our cost of funds (interest paid on deposits and borrowings) has increased while the rates earned on interest bearing assets have not increased accordingly and have in fact remained relatively flat. As the yield curve becomes steeper, away from a flatter yield curve, we would anticipate our interest margin to improve. We continue to review various pricing and investment strategies to enhance deposit growth while maintaining or improving the current interest margin.
 
11

 
Tax equivalent net interest income rose from $4,468,000 in 2004 to $4,590,000 in 2005, and increased to $4,702,000, in 2006. In the period ending March 31, 2006, net interest income increased $112,000 on a tax equivalent basis over the same period in 2005. The increased volume of interest-earning assets of $29.2 million generated an increase in interest income of $1,056,000 while the increased volume of interest-bearing liabilities of $21.3 million produced an additional $39,000 of interest expense. Combined, this resulted in an increase due to volume of $1,017,000 in net interest income.
 
Comparing the first quarter of 2006 with 2005, the yield on interest-earning assets increased 31 basis points from 6.24% to 6.55% and the average interest rate on interest-bearing liabilities increased 55 basis points, from 2.50% to 3.05%. As such, the net change in rate resulted in a negative $905,000 of net interest income primarily due to the flattened yield curve referred to above.

Provision For Loan Losses

      For the three-month period ending March 31, 2006, we provided $60,000 to the provision as a result of our quarterly review of the allowance for loan losses. Management's quarterly review of the allowance for loan losses is based on the following information: migration analysis of delinquent and non-accrual loans, estimated future losses on loans, recent review of large problem credits, local and national economic conditions, historical loss experience, OCC qualitative adjustments and peer comparisons.

Non-interest Income
 
Non-interest income as detailed below increased $22,000 or 2.0%, for the first three months of 2006 when compared to the same period in 2005. Service charge income increased by $33,000 as it continues to be the primary source of non-interest income. For the first three months, account service charges totaled $706,000 compared to $673,000 last year. Most of this is attributable to the increase in NSF fees of $17,000 and an increase of $19,000 of fee income derived from customers’ usage of their debit cards. Brokerage income is up $20,000 from last year and insurance revenue is down $47,000 from 2005 due to a couple large annuity transactions early in 2005 that were not duplicated this year.

The following table shows the breakdown of non-interest income for the three months ended March 31, 2006 and 2005:

   
Three months ended
         
   
March 31,
 
Change
 
(dollars in thousands)
 
2006
 
2005
 
Amount
 
% 
 
Service charges
 
$
706
 
$
673
 
$
33
   
4.9
 
Trust
   
129
   
121
   
8
   
6.6
 
Brokerage
   
58
   
38
   
20
   
52.6
 
Insurance
   
36
   
83
   
(47
)
 
(56.6
)
Investment securities losses, net
   
(6
)
 
-
   
(6
)
 
-
 
Earnings on bank owned life insurance
   
72
   
74
   
(2
)
 
(2.7
)
Other
   
137
   
121
   
16
   
13.2
 
Total
 
$
1,132
 
$
1,110
 
$
22
   
2.0
 
 
We continue to evaluate means of increasing non-interest income. Our approach is to apply service charges on business transaction accounts by charging fees on transaction activity, reduced by earnings credit based on customers' balances, to more equitably recover costs. Additionally, we are focused on the continued growth of our Trust and brokerage areas as a means to service all of our customers financial needs and increase non-interest income.
 
12


Non-interest Expense

Total non-interest expense, as detailed below, increased $60,000 or 1.6%, for the first three months of 2006, compared to the same period in 2005. The increase in salaries and employee benefits of $115,000 is due mainly to merit increases and higher costs for health insurance and pension expense. Furniture and equipment costs are down due to decreased depreciation expense from assets becoming fully depreciated.

The following tables reflect the breakdown of non-interest expense and professional fees as of March 31, 2006 and 2005:

   
Three months ended
         
   
March 31,
 
Change
 
(dollars in thousands)
 
2006
 
2005
 
Amount
 
% 
 
Salaries and employee benefits
 
$
2,036
 
$
1,921
 
$
115
   
6.0
 
Occupancy
   
308
   
303
   
5
   
1.7
 
Furniture and equipment
   
152
   
175
   
(23
)
 
(13.1
)
Professional fees
   
140
   
145
   
(5
)
 
(3.4
)
Amortization
   
144
   
144
   
-
   
-
 
Other
   
1,111
   
1,143
   
(32
)
 
(2.8
)
Total
 
$
3,891
 
$
3,831
 
$
60
   
1.6
 
 
                 
 
                 
 
 
Three months ended 
           
 
 
March 31, 
Change
(dollars in thousands)
   
2006
 
 
2005
   
Amount
 
 
% 
 
Other professional fees
 
$
88
 
$
87
 
$
1
   
1.1
 
Legal fees
   
18
   
17
   
1
   
5.9
 
Examinations and audits
   
34
   
41
   
(7
)
 
(17.1
)
Total
 
$
140
 
$
145
 
$
(5
)
 
(3.4
)

  Provision For Income Taxes

The provision for income taxes was $272,000 for the three-month period ended March 31, 2006 compared to $345,000 for the same period in 2005. The decrease was primarily a result of our increase in tax-exempt municipal securities and municipal loans. We currently hold $22.9 million of municipal securities where as we held only approximately $12.0 million this time last year.

We have entered into two limited partnership agreements to establish low-income housing projects in our market area. As a result of these agreements for tax purposes, we have recognized $502,000 out of a total $911,000 of tax credits from one project and $163,608 out of a total $385,000 on the second project, which was completed in November 2001. A total of approximately $1,290,000 of tax credits is anticipated over a ten-year period. In 2005, we entered into a third limited liability partnership for a low-income housing project for senior citizens in our Sayre market area. We expect to recognize approximately $574,000 of tax credits over a ten year period beginning sometime in 2006.

Financial Condition

Total assets (shown in the Consolidated Balance Sheet) of $540.2 million have increased 2.1% since year-end 2005’s balance of $529.2 million. Net loans increased 1.6% to $385.1 million and investment securities increased 2.6% to $105.2 million since year-end 2005. Total deposits decreased $2.4 million or .55% to $427.4 million since year-end 2005. Borrowed funds have increased $14.4 million to $67.0 million compared with $52.7 million at year-end. Explanations of variances will be described within the following appropriate sections.

13

 
Cash and Cash Equivalents

Cash and cash equivalents totaled $9,802,000 at March 31, 2006 compared to $8,609,000 on December 31, 2005. Noninterest-bearing cash increased $1,283,000 since year-end 2005, while interest-bearing cash decreased $90,000 during that same period. We believe the liquidity needs of the Company, are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources, and the portion of the investment and loan portfolios that mature within one year. These sources of funds will enable the Company to meet cash obligations and off-balance sheet commitments as they come due.

Investments

As shown in the table below, our investment portfolio increased by $2,618,000 or 2.6% from December 31, 2005 to March 31, 2006. During the first quarter of 2006 we purchased approximately $4.9 million of U.S. agency bonds, $4.9 million of mortgage-backed securities, and $1.2 million of tax-exempt municipal securities. Offsetting this, we continued to receive principal repayments in the amount of $2.6 million from our mortgaged backed securities portfolio as well as maturities in the amount of $1.2 million from our agency and municipal portfolios. We have also sold approximately $3.8 million of the portfolio in an effort to maximize our total return. The overall market value of our investment portfolio has also decreased approximately $.6 million due to increases in interest rates and the direct affect on our investment portfolio. Our investment portfolio is currently yielding 4.62% compared to 4.09% a year ago.
 
Estimated Fair Market Value of Investment Portfolio
 
 
 
March 31,
 
December 31,
 
 
 
2006
 
2005
 
(dollars in thousands)
 
Amount
 
% 
 
Amount
 
% 
 
Available-for-sale:
                 
U. S. Agency securities
 
$
15,565
   
14.8
 
$
12,754
   
12.5
 
Obligations of state & political
                         
subdivisions
   
22,907
   
21.8
   
22,612
   
22.0
 
Corporate obligations
   
8,077
   
7.7
   
8,627
   
8.4
 
Mortgage-backed securities
   
55,739
   
53.0
   
55,852
   
54.4
 
Other equity securities
   
2,932
   
2.7
   
2,757
   
2.7
 
Total
 
$
105,220
   
100.0
 
$
102,602
   
100.0
 
 
                         
 
March 31, 2006/ 
           
 
 
December 31, 2005  
           
 
Change 
           
(dollars in thousands)
   
Amount
 
 
% 
             
Available-for-sale:
                         
U. S. Agency securities
 
$
2,811
   
22.0
             
Obligations of state & political
                         
subdivisions
   
295
   
1.3
             
Corporate obligations
   
(550
)
 
(6.4
)
           
Mortgage-backed securities
   
(113
)
 
(0.2
)
           
Other equity securities
   
175
   
6.3
             
Total
 
$
2,618
   
2.6
             
 
Management continues to monitor the earnings performance and the effectiveness of the liquidity of the investment portfolio on a regular basis. Through active balance sheet management and analysis of the securities portfolio, the Company maintains sufficient liquidity to satisfy depositor requirements and various credit needs of its customers.

Loans

The Company’s lending is focused in the north central Pennsylvania market and the southern tier of New York. The composition of our loan portfolio consists principally of retail lending, which includes single-family residential mortgages and other consumer lending, and commercial lending primarily to locally owned small businesses. New loans are generated primarily from direct loans to our existing customer base, with new customers generated by referrals from real estate brokers, building contractors, attorneys, accountants and existing customers.
 
14


As shown in the tables below (dollars in thousands), total loans increased approximately $6.0 million or 1.6% during the first quarter of 2006. Residential, commercial, and agricultural real estate loans increased $1.9 million, $2.6 million and $1.3 million, respectively. Municipal loans also increased by $.7 million. Offsetting these were decreases in construction real estate loans of $1.0 million.

We are cautiously optimistic that loan demand will increase for the remainder of the year. Typically, loan growth in the first quarter is less than what we normally experience throughout the year. Residential mortgage lending continues to be a principal business activity and one our Company expects to continue by providing a full complement of competitively priced conforming, nonconforming and home equity mortgages. The Company is continuing its focus on commercial lending as a means to increase loan growth as well as deposits from farmers and small businesses throughout our market area. Lenders have worked diligently on improving organic loan growth while deepening relationships with the goal to better serve customers within our market. We continue to emphasize branch office personnel training and the focus on flexibility and fast “turn around time” that will aid in growing our loan portfolio. Finally, the Company has a strong team of dedicated, experienced professionals that enable us to meet the needs of commercial and agricultural customers within our service area.


   
March 31,
 
December 31,
 
   
2006
 
2005
 
(dollars in thousands) 
 
Amount
 
% 
 
Amount
 
% 
 
Real estate:
                 
Residential
 
$
197,496
   
50.8
 
$
195,628
   
51.1
 
Commercial
   
84,772
   
21.8
   
82,128
   
21.5
 
Agricultural
   
14,274
   
3.7
   
12,991
   
3.4
 
Construction
   
6,259
   
1.6
   
7,245
   
1.9
 
Loans to individuals
                         
for household, family and other purchases
   
13,006
   
3.3
   
13,017
   
3.4
 
Commercial and other loans
   
29,763
   
7.7
   
29,260
   
7.6
 
State & political subdivision loans
   
43,255
   
11.1
   
42,534
   
11.1
 
Total loans
   
388,825
   
100.0
   
382,803
   
100.0
 
Less allowance for loan losses
   
3,709
         
3,664
       
Net loans
 
$
385,116
   
  
 
$
379,139
   
  
 
 
                 
 
March 31, 2006/ 
       
 
 
December 31, 2005  
       
 
Change 
       
(dollars in thousands) 
   
Amount
 
 
% 
         
Real estate:
                     
Residential
 
$
1,868
   
1.0
         
Commercial
   
2,644
   
3.2
         
Agricultural
   
1,283
   
9.9
         
Construction
   
(986
)
 
(13.6
)
       
Loans to individuals
                     
for household, family and other purchases
   
(11
)
 
(0.1
)
       
Commercial and other loans
   
503
   
1.7
         
State & political subdivision loans
   
721
   
1.7
         
Total loans
 
$
6,022
   
1.6
         
 
Allowance For Loan Losses

As shown in the table below, the Allowance for Loan Losses as a percentage of loans decreased from .96% at December 31, 2005 to .95% at March 31, 2006. The dollar amount of the reserve increased $45,000 since year-end 2005. The increase is a result of a $20,000 monthly provision for the first three months less net charge-offs. Gross charge-offs for the first three months of 2006 were $26,000, while recoveries were $11,000.

15

 

   
March 31,
 
December 31,
 
(dollars in thousands)
 
2006
 
2005
 
2004
 
2003
 
2002
 
Balance, at beginning of period
 
$
3,664
 
$
3,919
 
$
3,620
 
$
3,621
 
$
3,250
 
Provision charged to income
   
60
   
60
   
-
   
435
   
435
 
Increase related to acquisition
   
-
   
-
   
290
   
-
   
-
 
Recoveries on loans previously
                               
charged against the allowance
   
11
   
57
   
324
   
116
   
115
 
     
3,735
   
4,036
   
4,234
   
4,172
   
3,800
 
Loans charged against the allowance
   
(26
)
 
(372
)
 
(315
)
 
(552
)
 
(179
)
Balance, at end of year
 
$
3,709
 
$
3,664
 
$
3,919
 
$
3,620
 
$
3,621
 
                                 
Allowance for loan losses as a percent
                               
of total loans
   
0.95
%
 
0.96
%
 
1.09
%
 
1.14
%
 
1.21
%
 
                     
Allowance for loan losses as a percent
                     
of non-performing loans
   
159.73
%
 
163.94
%
 
176.53
%
 
134.62
%
 
119.94
%
 
The adequacy of the allowance for loan losses is subject to a formal analysis by management of the Company. Management deems the allowance to be adequate to absorb inherent losses probable in the portfolio, as of March 31, 2006. The Company has disclosed in its annual report on Form 10-K for the year ended December 31, 2005 the process and methodology supporting the loan loss provision.

Bank Owned Life Insurance

The Company has elected to purchase bank owned life insurance to offset future employee benefit costs. As of March 31, 2006 the cash surrender value of this life insurance is $7,815,000, an increase of $72,000 since year end. The use of life insurance policies provides the bank with an asset that will generate earnings to partially offset the current costs of benefits, and eventually (at the death of the insureds) provide partial recovery of cash outflows associated with the benefits.

Deposits

Traditional deposits continue to be the most significant source of funds for the Company. As shown in the following tables (dollars in thousands), deposits decreased $2,352,000 or .5%, since December 31, 2005. As of March 31, 2006, non-interest-bearing deposits increased by $1,760,000, savings accounts increased $2,265,000 and NOW accounts increased by $8,419,000. Most of the increase in NOW accounts is due to one large local governmental agency moving their account from a money market account to a NOW account during the quarter. Accordingly, money market deposit accounts decreased $9,509,000. Certificates of deposit declined by $5,287,000, mostly due to several local school district withdrawals totaling $6.2 million. These deposits were temporary in nature and the withdrawal was expected upon maturity.
 
16

 

 
 
March 31,
 
December 31,
 
 
 
2006
 
2005
 
(dollars in thousands)
 
Amount
 
% 
 
Amount
 
% 
 
Non-interest-bearing deposits
 
$
52,360
   
12.2
 
$
50,600
   
11.8
 
NOW accounts
   
81,967
   
19.2
   
73,548
   
17.1
 
Savings deposits
   
40,568
   
9.5
   
38,303
   
8.9
 
Money market deposit accounts
   
43,123
   
10.1
   
52,632
   
12.2
 
Certificates of deposit
   
209,429
   
49.0
   
214,716
   
50.0
 
Total
 
$
427,447
   
100.0
 
$
429,799
   
100.0
 
 
                         
 
 
March 31, 2006/ 
           
 
 
December 31, 2005  
           
 
 
Change 
           
(dollars in thousands)
   
Amount
 
 
%