june30200910q.htm
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 June 30, 2009
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.)


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 check mark 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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes _____ No_____

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ____                                                                                                              Accelerated filer ____

Non-accelerated filer ____                                                                                                   Smaller reporting company __X__
(Do not check if a smaller reporting company)

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

The number of outstanding shares of the Registrant’s Common Stock, as of July 27, 2009, was 2,846,001.

 
 

 


 
Citizens Financial Services, Inc.
Form 10-Q

INDEX

   
PAGE
Part I
FINANCIAL INFORMATION
 
Item 1.
Financial Statements (unaudited):
 
 
Consolidated Balance Sheet as of June 30, 2009 and
December 31, 2008
1
 
Consolidated Statement of Income for the Three Months and Six             Months Ended June 30, 2009 and 2008
2
 
Consolidated Statement of Comprehensive Income for the Three
Months and Six Months Ended June 30, 2009 and 2008
3
 
Consolidated Statement of Cash Flows for the
Six Months Ended June 30, 2009 and 2008
4
 
Notes to Consolidated Financial Statements
5-14
Item 2.
Management’s Discussion and Analysis of Financial
Condition and Results of Operations
14-32
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
32
Item 4.
Controls and Procedures
32
     
Part II
OTHER INFORMATION
 
Item 1.
Legal Proceedings
33
Item 1A.
Risk Factors
33
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
33
Item 3.
Defaults upon Senior Securities
33
Item 4.
Submission of Matters to a Vote of Security Holders
34
Item 5.
Other Information
34
Item 6.
Exhibits
35
 
Signatures
36

 
 

 


CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED BALANCE SHEET
   
(UNAUDITED)
   
     
 
June 30
December 31
(in thousands, except share and per share data)
2009
2008
ASSETS:
   
Cash and due from banks:
   
  Noninterest-bearing
 $              9,955
 $           9,692
  Interest-bearing
               31,768
            10,164
Total cash and cash equivalents
               41,723
            19,856
     
Available-for-sale securities
            181,500
          174,139
     
Loans (net of allowance for loan losses:
   
  2009, $4,622 and 2008, $4,378)
            437,450
          428,436
     
Premises and equipment
               11,847
            12,762
Accrued interest receivable
                 2,786
              2,912
Goodwill
               10,256
            10,256
Bank owned life insurance
               12,411
            12,176
Other assets
                 8,739
              8,075
     
TOTAL ASSETS
 $         706,712
 $       668,612
     
LIABILITIES:
   
Deposits:
   
  Noninterest-bearing
 $           57,669
 $         55,545
  Interest-bearing
            524,801
          491,135
Total deposits
            582,470
          546,680
Borrowed funds
               59,382
            61,204
Accrued interest payable
                 2,048
              2,233
Other liabilities
                 6,203
              5,725
TOTAL LIABILITIES
            650,103
          615,842
STOCKHOLDERS' EQUITY:
   
Common stock
   
  $1.00 par value; authorized 10,000,000 shares;
   
  issued 3,048,288 shares at June 30, 2009 and December 31, 2008, respectively
                 3,048
              3,048
Additional paid-in capital
               12,888
            12,981
Retained earnings
               44,471
            41,034
Accumulated other comprehensive income
                    548
                    26
Treasury stock, at cost:  202,287 shares at June 30, 2009
   
  and 200,918 shares at December 31, 2008
               (4,346)
             (4,319)
TOTAL STOCKHOLDERS' EQUITY
               56,609
            52,770
TOTAL LIABILITIES AND
   
   STOCKHOLDERS' EQUITY
 $         706,712
 $       668,612
     
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
Six Months Ended
 
June 30,
June 30,
(in thousands, except share and per share data)
2009
2008
2009
2008
INTEREST INCOME:
       
Interest and fees on loans
 $        7,558
 $      7,645
 $      15,035
 $    15,309
Interest-bearing deposits with banks
                 10
                 6
                 12
                 6
Investment securities:
       
    Taxable
           1,541
         1,126
           3,181
         2,249
    Nontaxable
               514
             353
               985
             689
    Dividends
                   6
               56
                 13
             141
TOTAL INTEREST INCOME
           9,629
         9,186
         19,226
       18,394
INTEREST EXPENSE:
       
Deposits
           2,863
         2,728
           5,778
         5,671
Borrowed funds
               496
             628
           1,019
         1,485
TOTAL INTEREST EXPENSE
           3,359
         3,356
           6,797
         7,156
NET INTEREST INCOME
           6,270
         5,830
         12,429
       11,238
Provision for loan losses
               150
                 -
               300
             120
NET INTEREST INCOME AFTER
       
    PROVISION FOR LOAN LOSSES
           6,120
         5,830
         12,129
       11,118
NON-INTEREST INCOME:
       
Service charges
               894
             871
           1,706
         1,647
Trust
               113
             136
               276
             303
Brokerage and insurance
                 53
               74
               153
             118
Gains on loans sold
               162
               20
               209
               42
Investment securities gains, net
               102
                 -
               118
                 -
Earnings on bank owned life insurance
               115
               86
               236
             171
Other
                 96
             131
               191
             246
TOTAL NON-INTEREST INCOME
           1,535
         1,318
           2,889
         2,527
NON-INTEREST EXPENSES:
       
Salaries and employee benefits
           2,329
         2,158
           4,625
         4,314
Occupancy
               296
             281
               617
             595
Furniture and equipment
               124
             128
               234
             261
Professional fees
               164
             148
               295
             329
FDIC insurance
               378
               39
               753
               52
Other
           1,200
         1,184
           2,339
         2,302
TOTAL NON-INTEREST EXPENSES
           4,491
         3,938
           8,863
         7,853
Income before provision for income taxes
           3,164
         3,210
           6,155
         5,792
Provision for income taxes
               692
             764
           1,337
         1,325
NET INCOME
 $        2,472
 $      2,446
 $        4,818
 $      4,467
         
Earnings Per Share
 $          0.87
 $        0.86
 $          1.69
 $        1.57
Cash Dividends Paid Per Share
 $        0.245
 $      0.235
 $        0.485
 $      0.465
         
Weighted average number of shares outstanding
   2,846,137
  2,852,867
   2,845,328
  2,853,074
         
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
Six Months Ended
 
June 30,
June 30,
(in thousands)
 
2009
 
2008
 
2009
 
2008
Net income
 
 $   2,472
 
 $    2,446
 
 $     4,818
 
 $      4,467
Other comprehensive income:
               
      Unrealized gains (losses) on available for sale securities
          401
 
     (2,535)
 
           671
 
       (1,471)
 
      Change in unrealized gain on interest rate swap
          224
 
               -
 
           238
 
                 -
 
       Less:  Reclassification adjustment for gain included in net income
        (102)
 
               -
 
         (118)
 
                 -
 
Other comprehensive income (loss) before tax
 
          523
 
     (2,535)
 
           791
 
       (1,471)
Income tax expense (benefit) related to other comprehensive income
 
          178
 
         (862)
 
           269
 
           (500)
Other comprehensive income (loss), net of tax
 
          345
 
     (1,673)
 
           522
 
           (971)
Comprehensive income
 
 $   2,817
 
 $       773
 
 $     5,340
 
 $      3,496
                 
The accompanying notes are an integral part of these unaudited consolidated financial statements.
           




 
3

 

CITIZENS FINANCIAL SERVICES, INC.
   
CONSOLIDATED STATEMENT OF CASH FLOWS
   
(UNAUDITED)
Six Months Ended
 
June 30,
(in thousands)
2009
2008
CASH FLOWS FROM OPERATING ACTIVITIES:
   
  Net income
 $        4,818
 $         4,467
  Adjustments to reconcile net income to net
   
   cash provided by operating activities:
   
    Provision for loan losses
               300
                120
    Depreciation and amortization
               305
                324
    Amortization and accretion of investment securities
               100
                  14
    Deferred income taxes
                 15
                  18
    Investment securities gains, net
             (118)
                    -
    Realized gains on loans sold
             (209)
                (42)
    Earnings on bank owned life insurance
             (236)
              (171)
    Originations of loans held for sale
       (10,597)
           (3,522)
    Proceeds from sales of loans held for sale
         10,806
            3,564
    Loss on sale of foreclosed assets held for sale
                 49
                    -
    Decrease (increase) in accrued interest receivable
               126
                (41)
    Decrease in accrued interest payable
             (185)
              (248)
    Other, net
               404
                  91
      Net cash provided by operating activities
            5,578
            4,574
     
CASH FLOWS FROM INVESTING ACTIVITIES:
   
  Available-for-sale securities:
   
    Proceeds from sales of available-for-sale-securities
            6,778
-
    Proceeds from maturity and principal repayments of securities
         27,988
            7,965
    Purchase of securities
       (41,557)
         (13,321)
  Proceeds from redemption of regulatory stock
                    -
            4,331
  Purchase of regulatory stock
             (586)
           (3,027)
  Net increase in loans
         (9,582)
           (5,247)
  Purchase of premises and equipment
             (855)
                (98)
  Proceeds from sale of premises and equipment
            1,405
                    -
  Proceeds from sale of foreclosed assets held for sale
               231
                    -
      Net cash used in investing activities
       (16,178)
           (9,397)
     
CASH FLOWS FROM FINANCING ACTIVITIES:
   
  Net increase in deposits
         35,790
          29,100
  Proceeds from long-term borrowings
         10,040
          14,107
  Repayments of long-term borrowings
       (12,050)
         (10,793)
  Net increase (decrease) in short-term borrowed funds
               189
         (23,594)
  Purchase of treasury stock
             (192)
              (182)
  Stock awards
                 71
                  42
  Dividends paid
         (1,381)
           (1,314)
      Net cash  provided by financing activities
         32,467
            7,366
     
          Net increase in cash and cash equivalents
         21,867
            2,543
     
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
         19,856
          10,389
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 $      41,723
 $       12,932
     
Supplemental Disclosures of Cash Flow Information:
   
    Interest paid
 $        6,982
 $         7,157
     
    Income taxes paid
 $        1,350
 $         1,190
     
    Loans transferred to foreclosed property
 $            374
 $             273
     
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 Services, Inc., (individually and collectively with its direct and indirect subsidiaries, the “Company”) is a Pennsylvania corporation organized as the holding company of its wholly owned subsidiary, First Citizens National Bank (the “Bank”), and the Bank’s subsidiary, First Citizens Insurance Agency, Inc. (“First Citizens Insurance”).

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.  Certain of the prior year amounts have been reclassified to conform with the current year presentation.  Such reclassifications had no effect on net income or stockholders’ equity.  All material inter-company balances and transactions have been eliminated in consolidation.

In the opinion of management of the Company, the accompanying interim financial statements for the quarters ended June 30, 2009 and 2008 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 six-month period ended June 30, 2009 is not necessarily indicative of the results to be expected for the full year.  Certain of the prior year amounts have been reclassified to conform with the current year presentation. Such reclassifications had no effect on net income or stockholders’ equity.  This information should be read in conjunction with the Company’s Annual Report to shareholders on Form 10-K for the year ended December 31, 2008.

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
Six months ended
 
June 30,
June 30,
 
2009
2008
2009
2008
         
Net income applicable to common stock
$2,472,000
$2,446,000
$4,818,000
$4,467,000
Weighted average common shares outstanding
2,846,137
2,852,867
2,845,328
2,853,074
         
Earnings per share
$0.87
$0.86
$1.69
$1.57


Note 3 - Income Tax Expense

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

5



Note 4 – Investments

The amortized cost and estimated fair value of investment securities at June 30, 2009 and December 31, 2008 were as follows (in thousands):

   
Gross
Gross
Estimated
 
Amortized
Unrealized
Unrealized
Fair
June 30, 2009
Cost
Gains
Losses
Value
Available-for-sale securities:
       
  U.S. Agency securities
 $      43,837
 $         1,076
 $             (90)
 $       44,823
  Obligations of state and
       
    political subdivisions
         51,364
               453
              (616)
          51,201
  Corporate obligations
           5,967
                    -
              (242)
            5,725
  Mortgage-backed securities
         76,629
            2,753
                    -
          79,382
  Equity securities
              371
                    5
                (7)
               369
Total available-for-sale securities
 $    178,168
 $         4,287
 $           (955)
 $     181,500
         
         
         
   
Gross
Gross
Estimated
 
Amortized
Unrealized
Unrealized
Fair
December 31, 2008
Cost
Gains
Losses
Value
Available-for-sale securities:
       
  U.S. Agency securities
 $      27,628
 $         1,314
 $                 -
 $       28,942
  Obligations of state and
       
    political subdivisions
         44,188
               424
              (480)
          44,132
  Corporate obligations
           5,964
                    -
              (668)
            5,296
  Mortgage-backed securities
         93,037
            2,437
                (67)
          95,407
  Equity securities
              545
                 20
              (203)
               362
Total available-for-sale securities
 $    171,362
 $         4,195
 $        (1,418)
 $     174,139

 
The following table shows the Company’s gross unrealized losses and estimated fair value of the Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time, that the individual securities have been in a continuous unrealized loss position, at June 30, 2009 and December 31, 2008 (in thousands). As of June 30, 2009 and December 31, 2008, the Company owned 51 and 47 securities whose estimated fair value was less than their cost basis, respectively.

June 30, 2009
Less than Twelve Months
Twelve Months or Greater
Total
   
Estimated
Gross
Estimated
Gross
Estimated
Gross
   
Fair
Unrealized
Fair
Unrealized
Fair
Unrealized
   
Value
Losses
Value
Losses
Value
Losses
U.S. Agency securities
 $        15,758
 $               90
 $                  -
 $                  -
 $        15,758
 $               90
Obligations of states and
           
     political subdivisions
           14,294
                363
             6,920
                253
           21,214
                616
Corporate obligations
                     -
                     -
             5,725
                242
             5,725
                242
Mortgage-backed securities
                     -
                     -
                     -
                     -
                     -
                     -
 
Total debt securities
           30,052
                453
           12,645
                495
           42,697
                948
Equity securities
                197
                    2
                  83
                    5
                280
                    7
               
    Total securities
 $        30,249
 $             455
 $        12,728
 $             500
 $        42,977
 $             955
               
               
               
December 31, 2008
Less than Twelve Months
Twelve Months or Greater
Total
   
Estimated
Gross
Estimated
Gross
Estimated
Gross
   
Fair
Unrealized
Fair
Unrealized
Fair
Unrealized
   
Value
Losses
Value
Losses
Value
Losses
U.S. Agency securities
 $                  -
 $                  -
 $                  -
 $                  -
 $                  -
 $                  -
Obligations of states and
           
     political subdivisions
           16,910
                463
             1,348
                  17
           18,258
                480
Corporate obligations
             1,874
                135
             3,421
                533
             5,295
                668
Mortgage-backed securities
             9,413
                  67
                     -
                     -
             9,413
                  67
 
Total debt securities
           28,197
                665
             4,769
                550
           32,966
             1,215
Equity securities
                231
                203
                   -
                   -
                231
                203
               
    Total securities
 $        28,428
 $             868
 $          4,769
 $             550
 $        33,197
 $          1,418
 

 
6


The Company’s investment securities portfolio contains unrealized losses on U.S. Agency securities issued or backed by the full faith and credit of the United States government or are generally viewed as having the implied guarantee of the U.S. government.  For fixed maturity investments with unrealized losses due to interest rates where the Company does not intend to sell these investments and it is not more likely than not that the Company will be required to sell the investment before recovery of their amortized cost basis, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired.  For equity securities where the fair value has been significantly below cost for one year, the Company’s policy is to recognize an impairment loss unless sufficient evidence is available that the decline is not other than temporary and a recovery period can be predicted.  The Company has concluded that any impairment of its investment securities portfolio outlined in the above table is not other than temporary and are not credit related.  Rather, it is the result of interest rate changes, sector credit rating changes, or company-specific rating changes that are not expected to result in the non-collection of principal and interest during the period.

Proceeds from sales of securities available-for-sale for the six months ended June 30, 2009 and 2008 were $6,778,000 and $0, respectively.  For the three months ended June 30, 2009 and 2008, proceeds from sales of securities available-for-sale were $4,600,000 and $0, respectively.  The gross gains and losses were as follows (in thousands):

 
Three Months Ended
Six Months Ended
 
 June 30,
 June 30,
 
2009
2008
2009
2008
Gross gains
 $           157
 $                 -
 $            209
 $                 -
Gross losses
                55
                    -
                 91
                    -
Net gains
 $           102
 $                 -
 $            118
 $                 -

        Investment securities with an approximate carrying value of $105,298,000 and $106,669,000 at June 30, 2009 and December 31, 2008, respectively, were pledged to secure public funds and certain other deposits as provided by law.
 
        Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.   The amortized cost and estimated fair value of debt securities at June 30, 2009, by contractual maturity, are shown below (in thousands):


7


 

 
Amortized
 
Estimated
 
Cost
 
Fair Value
Available-for-sale securities:
     
  Due in one year or less
 $        2,490
 
 $         2,541
  Due after one year through five years
         20,343
 
          20,783
  Due after five years through ten years
         30,604
 
          31,163
  Due after ten years
       124,360
 
        126,644
Total
 $    177,797
 
 $     181,131


Note 5 - 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 2008 Annual Report on Form 10-K.

Noncontributory Defined Benefit Pension Plan

The Bank sponsors a noncontributory defined benefit pension plan (“Pension Plan”) covering substantially all employees and officers.  The Bank’s funding policy is to make annual contributions, if needed, based upon the funding formula developed by the plan’s actuary.

The Pension Plan was amended, effective January 1, 2008, to cease eligibility for employees with a hire date of January 1, 2008 or later.  In lieu of the Pension Plan, employees with a hire date of January 1, 2008 or later are eligible to receive, after meeting certain length of service requirements, an annual discretionary 401(k) plan contribution from the Bank equal to a percentage of an employee’s base compensation.  The contribution amount, if any, is placed in a separate account within the 401(k) plan and is subject to a vesting requirement.

The Pension Plan was also amended, effective January 1, 2008, for employees who are still eligible to participate.  The amended Pension Plan requires benefits to be paid to eligible employees based primarily upon age and compensation rates during employment.  Upon retirement or other termination of employment, employees can elect either an annuity benefit or a lump sum distribution of vested benefits in the Pension Plan.

The following sets forth the components of net periodic benefit costs of the Pension Plan for the three and six months ended June 30, 2009 and 2008, respectively (in thousands):

 
Three Months Ended
 
Six Months Ended
 
 June 30,
 
 June 30,
 
2009
2008
 
2009
2008
           
Service cost
 $                 35
 $             174
 
 $             150
 $             276
Interest cost
                    49
                249
 
                193
                348
Expected return on plan assets
                    (11)
                (316)
 
                 (189)
                 (429)
Net amortization and deferral
                    56
                    (2)
 
                   62
                  15
           
Net periodic benefit cost
 $              130
 $           105
 
 $             217
 $             210
           


 The Company expects to contribute $500,000 to the Pension Plan in 2009.  As of June 30, 2009, the Company has contributed $77,891.

8



Defined Contribution Plan

The Company sponsors a voluntary 401(k) savings plan (“401(k) Plan”) which eligible employees can elect to contribute up to the maximum amount allowable not to exceed the limits of IRS Code Sections 401(k).  The 401(k) Plan was amended, effective January 1, 2008. Under the amended 401(k) Plan, the Company’s contributions are no longer required, but are dependent upon the contributions of the eligible employees.  The Company’s contributions vest immediately.  Contributions by the Company totaled $105,000 and $103,000 for the six months ended June 30, 2009 and 2008, respectively.

Directors’ Deferred Compensation Plan

The Company’s directors may elect to defer all or portions of their fees until their retirement or termination from service.  Amounts deferred under the plan earn interest based upon the highest current rate offered to certificate of deposit customers.  Amounts deferred under the plan are not guaranteed and represent a general liability of the Company.  Amounts included in interest expense on the deferred amounts totaled $18,000 and $19,000 for the six months ended June 30, 2009 and 2008, respectively.

Restricted Stock Plan

Effective April 18, 2006, shareholders of the Company approved the 2006 Restricted Stock Plan (the “Plan”).  Employees and non-employee corporate directors are eligible to receive awards of restricted stock based upon performance related requirements.  Awards granted under the Plan are in the form of the Company’s common stock and are subject to certain vesting requirements including continuous employment or service with the Company.  100,000 shares of the Company’s common stock have been authorized under the Plan, which terminates April 18, 2016.  The Plan assists the Company in attracting, retaining and motivating employees to make substantial contributions to the success of the Company and to increase the emphasis on the use of equity as a key component of compensation.

For the six months ended June 30, 2009 and 2008, 7,526 and 4,993 shares of restricted stock were awarded and 2,517 and 937 shares were vested, respectively.  Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period. Compensation expense related to restricted stock was $45,000 and $22,000 for the six months ended June 30, 2009 and 2008, respectively.

Note 6 – Fair Value Measurements
 
Effective January 1, 2008, the Company adopted SFAS No. 157, which, among other things, requires enhanced disclosures about assets and liabilities carried at fair value. SFAS No. 157 establishes a hierarchal disclosure framework associated with the level of pricing observability utilized in measuring assets and liabilities at fair value. The three broad levels defined by SFAS No. 157 hierarchy are as follows:

 
Level I:
Quoted prices are available in active markets for identical assets or liabilities as of the reported date.
 
Level II:
Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities include items for which quoted prices are available but traded less frequently, and items that are fair valued using other financial instruments, the parameters of which can be directly observed.
   
Level III:
Assets and liabilities that have little to no pricing observability as of the reported date. These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.
 
 
 
 
9

 
The following tables present the assets reported on the consolidated statements of financial condition at their fair value as of June 30, 2009 and December 31, 2009 by level within the fair value hierarchy. As required by SFAS No. 157, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.
 

(In thousands)
 
June 30, 2009
   
Level 1
 
Level II
 
Level III
   
Total
Assets:
                 
Securities available for sale
 
 $  369
 
 $181,131
 
 $   -
   
 $181,500
                   
 Fair value measurements on non-recurring basis:
                 
Impaired Loans
 
 $    -
 
 $  1,600
 
 $   -
   
 $  1,600
                   
   Trust Preferred Interest Rate Swap
 
 $    -
 
 $   (106)
 
 $   -
   
 $   (106)
                   
                   
(In thousands)
 
December 31, 2008
   
Level 1
 
Level II
 
Level III
   
Total
Assets:
                 
Securities available for sale
 
 $  362
 
 $173,777
 
 $   -
   
 $174,139
                   
 Fair value measurements on non-recurring basis:
                 
Impaired Loans
 
 $    -
 
 $    830
 
 $   -
   
 $    830
                   
   Trust Preferred Interest Rate Swap
 
 $    -
 
 $   (330)
 
 $   -
   
 $   (330)



The estimated fair values of the Company’s financial instruments are as follows (in thousands):


 
June 30
 
December 31
 
2009
 
2008
 
Carrying
Estimated
 
Carrying
Estimated
 
Amount
Fair Value
 
Amount
Fair Value
Financial assets:
         
Cash and cash equivalents
 $ 41,723
 $ 41,723
 
 $  19,856
 $ 19,856
Available-for-sale securities
  181,500
  181,500
 
   174,139
  174,139
Net loans
  437,450
  452,332
 
   428,436
  445,571
Bank owned life insurance
   12,411
   12,411
 
    12,176
   12,176
Regulatory stock
    3,956
    3,956
 
     3,371
    3,371
Accrued interest receivable
    2,786
    2,786
 
     2,912
    2,912
           
           
Financial liabilities:
         
Deposits
 $582,470
 $589,127
 
 $ 546,680
 $555,089
Borrowed funds
   59,382
   56,261
 
    61,204
   60,823
Accrued interest payable
    2,048
    2,048
 
     2,233
    2,233
 

 
10

 
Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument.  These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument.  Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions can significantly affect the estimates.

Estimated fair values have been determined by the Company using historical data, as generally provided in the Company’s regulatory reports, and an estimation methodology suitable for each category of financial instruments. The Company’s fair value estimates, methods and assumptions are set forth below for the Company’s other financial instruments.

Cash and Cash Equivalents:

The carrying amounts for cash and due from banks approximate fair value because they mature within one year and do not present unanticipated credit concerns.

Accrued Interest Receivable and Payable:

The carrying amounts for accrued interest receivable and payable approximate fair value because they are generally received or paid in 90 days or less and do not present unanticipated credit concerns.

Available-For-Sale Securities:

The fair values of available-for-sale securities are based on quoted market prices as of the balance sheet date.  For certain instruments, fair value is estimated by obtaining quotes from independent dealers.

Loans:

Fair values are estimated for portfolios of loans with similar financial characteristics.  The fair value of performing loans has been estimated by discounting expected future cash flows. The discount rate used in these calculations is derived from the Treasury yield curve adjusted for credit quality, operating expense and prepayment option price, and is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the Company’s historical experience with repayments for each loan classification, modified as required by an estimate of the effect of current economic and lending conditions.
Fair value for significant nonperforming loans is based on recent external appraisals. If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and discount rates are judgmentally determined using available market information and specific borrower information.

Bank Owned Life Insurance:

The carrying value of bank owned life insurance approximates fair value based on applicable redemption provisions.

Regulatory Stock:

The carrying value of regulatory stock approximates fair value based on applicable redemption provisions.

Deposits:

The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings and NOW accounts, and money market accounts, is equal to the amount payable on demand. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.  The deposits’ fair value estimates do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market, commonly referred to as the core deposit intangible.

11

 
Borrowed Funds:

Rates available to the Company for borrowed funds with similar terms and remaining maturities are used to estimate the fair value of borrowed funds.


Note 7 – Recent Accounting Pronouncements
 
       In April 2009, the FASB issued FSP No. FAS 141(R)-1, Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies.  This FSP requires companies acquiring contingent assets or assuming contingent liabilities in business combination to either (a) if the assets’ or liabilities’ fair value can be determined, recognize them at fair value, at the acquisition date, or (b) if the assets’ or liabilities’ fair value cannot be determined, but (i) it is probable that an asset existed or that a liability had been incurred at the acquisition date and (ii) the amount of the asset or liability can be reasonably estimated, recognize them at their estimated amount, at the acquisition date.   If the fair value of these contingencies cannot be determined and they are not probable or cannot be reasonably estimated, then companies should not recognize these contingencies as of the acquisition date and instead should account for them in subsequent periods by following other applicable GAAP.  This FSP also eliminates the FAS 141R requirement of disclosing in the footnotes to the financial statements the range of expected outcomes for a recognized contingency.  This FSP shall be effective for assets or liabilities arising from contingencies in business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008.  The Company adopted the provisions of this, as required, and the adoption did not have a material impact on the Company’s results of operations.

In April 2009, the FASB issued FSP No. FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.  This FSP relates to determining fair values when there is no active market or where the price inputs being used represent distressed sales.  It reaffirms the need to use judgment to ascertain if a formerly active market has become inactive and in determining fair values when markets have become inactive. FSP No. FAS 157-4 is effective for interim and annual periods ending after June 15, 2009, but entities may early adopt this FSP for the interim and annual periods ending after March 15, 2009. The Company adopted the provisions of FSP No. FAS 157-4, as required, and the adoption did not have a material impact on the Company’s results of operations.

In April 2009, the FASB issued FSP No. FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments, which relates to fair value disclosures for any financial instruments that are not currently reflected on the balance sheet of companies at fair value.  Prior to issuing this FSP, fair values for these assets and liabilities were only disclosed once a year. The FSP now requires these disclosures on a quarterly basis, providing qualitative and quantitative information about fair value estimates for all those financial instruments not measured on the balance sheet at fair value.  FSP No. FAS 107-1 and APB 28-1 is effective for interim and annual periods ending after June 15, 2009, but entities may adopt this FSP earlier for the interim and annual periods ending after March 15, 2009.  The Company adopted the provisions of FSP No. FAS 107-1 and APB 28-1, as required, and the adoption did not have a material impact on the Company’s results of operations.

In April 2009, the FASB issued FSP No. FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments, which provides additional guidance designed to create greater clarity and consistency in accounting for and presenting impairment losses on securities.  FSP No. FAS 115-2 and FAS 124-2 is effective for interim and annual periods ending after June 15, 2009, but entities may adopt this FSP earlier for the interim and annual periods ending after March 15, 2009.  The Company adopted the provisions of FSP No. FAS 115-2 and FAS 124-2, as required, and the adoption did not have a material impact on the Company’s results of operations.

12

 
In May 2009, the FASB issued FAS No. 165, Subsequent Events, which requires companies to evaluate events and transactions that occur after the balance sheet date but before the date the financial statements are issued, or available to be issued in the case of non-public entities.  FAS No. 165 requires entities to recognize in the financial statements the effect of all events or transactions that provide additional evidence of conditions that existed at the balance sheet date, including the estimates inherent in the financial preparation process.  Entities shall not recognize the impact of events or transactions that provide evidence about conditions that did not exist at the balance sheet date but arose after that date.  FAS No. 165 also requires entities to disclose the date through which subsequent events have been evaluated.  FAS No. 165 was effective for interim and annual reporting periods ending after June 15, 2009.  The Company adopted the provisions of FAS No. 165, as required, and adoption did not have a material impact on Company’s results of operations or financial position.

In June 2009, the FASB issued FAS No. 166, Accounting for Transfers of Financial Assets. FAS 166 removes the concept of a qualifying special-purpose entity (QSPE) from FAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, and removes the exception from applying FIN 46(R). This statement also clarifies the requirements for isolation and limitations on portions of financial assets that are eligible for sale accounting. This statement is effective for fiscal years beginning after November 15, 2009. As such, the Company plans to adopt FAS No. 166 effective January 1, 2010. The adoption of this standard is not expected to have a material effect on the Company’s results of operations or financial position.
 
In June 2009, the FASB issued FAS No. 167, Amendments to FASB Interpretation No. 46(R). FAS 167, which amends FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities, (FIN 46(R)), prescribes a qualitative model for identifying whether a company has a controlling financial interest in a variable interest entity (VIE) and eliminates the quantitative model prescribed by FIN 46(R). The new model identifies two primary characteristics of a controlling financial interest: (1) provides a company with the power to direct significant activities of the VIE, and (2) obligates a company to absorb losses of and/or provides rights to receive benefits from the VIE. FAS No. 167 requires a company to reassess on an ongoing basis whether it holds a controlling financial interest in a VIE. A company that holds a controlling financial interest is deemed to be the primary beneficiary of the VIE and is required to consolidate the VIE. This statement is effective for fiscal years beginning after November 15, 2009. The adoption of this standard is not expected to have a material effect on the Company’s results of operations or financial position.
 
In June 2009, the FASB issued FAS No. 168, The ‘FASB Accounting Standards Codification’ and the Hierarchy of Generally Accepted Accounting Principles. FAS No. 168 establishes the FASB Accounting Standards Codification (Codification), which was officially launched on July 1, 2009, and became the primary source of authoritative U.S. GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under the authority of Federal securities laws are also sources of authoritative GAAP for SEC registrants. The subsequent issuances of new standards will be in the form of Accounting Standards Updates that will be included in the Codification. FAS No. 168 is effective for financial statements issued for interim and annual periods ending after September 15, 2009. As such, the Company plans to adopt FAS No.168 in connection with its third quarter 2009 reporting. As the Codification is neither expected nor intended to change GAAP, the adoption of FAS No.168 will not have a material impact on its results of operations or financial position.


Note 8 – Branch Acquisition

  On November 21, 2008, the Company acquired the Mansfield branch of the Elmira Savings Bank located in Mansfield, Pennsylvania.  The acquisition included retail deposits of $16,889,000 and loans of $267,000.  Land, building and certain other fixed assets were acquired with an appropriate fair market value of $296,000.  The Company also recorded goodwill of $1,651,000 and $67,000 of core deposit intangible.  Upon completion of the acquisition, the Bank had approximately 40% of the deposit market share in Tioga County.  


13


Note 9 - Subsequent Events

The Company assessed events occurring subsequent to June 30, 2009 through August 10, 2009 for potential recognition and disclosure in the consolidated financial statements. No events have occurred that would require adjustment to or disclosure in the consolidated financial statements which were issued on August 10, 2009.


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

Cautionary Statement
 
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 words such 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 to implement strategic initiatives designed to increase revenues or manage expenses, or we may not be able 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 also experience greater losses than expected due to the ever increasing volume of information theft and fraudulent scams impacting our customers and the banking industry.
·  
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.
 
        Additional factors that may affect our results are discussed in the Company’s Annual Report on Form 10-K under “Item 1.A/ Risk Factors.”  Except as required by applicable law and regulation, we assume no obligation to update or revise any forward-looking statements after the date on which they are made.


14



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 the Company.  Our Company's consolidated financial condition and results of operations consist almost entirely of the Bank’s financial condition and results of operations. Management’s discussion and analysis should be read in conjunction with the preceding financial statements presented under Part I.  The results of operations for the three months and six months ended June 30, 2009 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 17 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 November 2008, we completed the acquisition of another Mansfield location from The Elmira Savings Bank, FSB (see Footnote 7 to the Consolidated Financial Statements).  In New York, we have a branch office in Wellsville, Allegany County.


Risk Management

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.

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.

Competition

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 the Bank. 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.  The financial services industry continues to experience tremendous change to competitive barriers between bank and non-bank institutions. We must compete not only with traditional financial institutions, but also 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 primarily based on price, nature of product, quality of service, and convenience of location.

15

 
Trust and Investment Services

Our Investment and Trust Services Department offers professional trust administration, investment management services, estate planning and administration, and custody of securities.  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.  Revenues and fees of the Trust Department are reflected in the Company’s financial statements.  As of June 30, 2009 and December 31, 2008, the Trust Department had $77.1 and $74.3 million of assets under management, respectively.  The $2.8 million increase is primarily attributable to a recovery in market values of trust assets since the end of the year.

Our Investment Representatives offer full service brokerage services and financial planning throughout the Bank’s market area.  Products such as mutual funds, annuities, health and life insurance are made available through our insurance subsidiary, First Citizens Insurance.  Fee income from the sale of these products is reflected in the Company’s financial statements as a component of non-interest income in the Consolidated Statement of Income.


Results of Operations

Overview of the Income Statement
 
       The Company had net income of $4,818,000 for the first six months of 2009 compared with earnings of $4,467,000 for last year’s comparable period, an increase of $351,000 or 7.9%. Earnings per share for the first six months of 2009 were $1.69, compared to $1.57 last year, representing a 7.6% increase.  Annualized return on assets and return on equity for the six months of 2009 were 1.42% and 17.79%, respectively, compared with 1.50% and 17.80% for last year’s comparable period.

Net income for the three month’s ended June 30, 2009 was $2,472,000 compared to $2,446,000 in the comparable 2008 period, an increase of $26,000. Earnings per share for the three months ended June 30, 2009 and 2008 were $0.87 and $0.86 per share, respectively.  Annualized return on assets and return on equity for the quarter ended June 30, 2009 was 1.43% and 17.99%, respectively, compared with 1.64% and 19.24% for the same 2008 period.

Net Interest Income

Net interest income, the most significant component of the Company’s 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 six months of 2009 was $12,429,000, an increase of $1,191,000, or 10.6%, compared to the same period in 2008.  For the first six months of 2009, the provision for loan losses totaled $300,000, an increase of $180,000 over 2008.  Consequently, net interest income after the provision for loan losses was $12,129,000 compared to $11,118,000 during the first six months of 2008.

For the three months ended June 30, 2009, net interest income was $6,270,000 compared to $5,830,000, an increase of $440,000, or 7.5% over the comparable period in 2008.  The provision for loan losses this quarter was $150,000 compared to $0 last year.  As such, net interest income after the provision for loan losses was $6,120,000 for the quarter ended compared to $5,830,000 in 2008.


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 for the three months and six months ended June 30, 2009 and 2008:

16


 
Analysis of Average Balances and Interest Rates (1)
 
Six Months Ended
 
June 30, 2009
June 30, 2008
 
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
(dollars in thousands)
$
$
%
$
$
%
ASSETS
           
Short-term investments:
           
   Interest-bearing deposits at banks
       18,336
               12
0.12
              708
                  7
1.92
Total short-term investments
       18,336
               12
0.12
              708
                  7
1.92
Investment securities:
           
  Taxable
     129,173
         3,195
4.95
        93,889
          2,409
5.13
  Tax-exempt (3)
       46,574
         1,493
6.41
        33,867
          1,043
6.16
  Total investment securities
     175,747
         4,688
5.33
      127,756
          3,452
5.40
Loans:
           
  Residential mortgage loans
     205,237
         7,464
7.33
      212,620
          7,859
7.43
  Commercial & farm loans
     174,692
         6,092
7.03
      154,987
          5,900
7.66
  Loans to state & political subdivisions
       46,422
         1,438
6.25
        46,886
          1,471
6.31
  Other loans
       11,277
             501
8.96
        12,205
              554
9.13
  Loans, net of discount (2)(3)(4)
     437,628
       15,495
7.14
      426,698
        15,784
7.44
Total interest-earning assets
     631,711
       20,195
6.44
      555,162
        19,243
6.97
Cash and due from banks
         9,684
   
          9,148
   
Bank premises and equipment
       11,770
   
        12,437
   
Other assets
       27,476
   
        18,961
   
Total non-interest earning assets
       48,930
   
        40,546
   
Total assets
     680,641
   
      595,708
   
LIABILITIES AND STOCKHOLDERS' EQUITY
         
Interest-bearing liabilities:
           
  NOW accounts
     119,847
             497
            0.84
      102,051
              710
            1.40
  Savings accounts
       45,508
               73
            0.32
        39,764
                73
            0.37
  Money market accounts
       41,268
             185
            0.90
        46,177
              495
            2.16
  Certificates of deposit
     297,391
         5,023
            3.41
      224,300
          4,393
            3.94
Total interest-bearing deposits
     504,014
         5,778
            2.31
      412,292
          5,671
            2.77
Other borrowed funds
       57,777
         1,019
            3.56
        75,149
          1,485
            3.97
Total interest-bearing liabilities
     561,791
         6,797
            2.44
      487,441
          7,156
            2.95
Demand deposits
       55,793
   
        52,005
   
Other liabilities
         8,895
   
          6,066
   
Total non-interest-bearing liabilities
       64,688
   
        58,071
   
Stockholders' equity
       54,162
   
        50,196
   
Total liabilities & stockholders' equity
     680,641
   
      595,708
   
Net interest income
 
       13,398
   
        12,087
 
Net interest spread (5)
   
4.00%
   
4.02%
Net interest income as a percentage
           
  of average interest-earning assets
   
4.27%
   
4.38%
Ratio of interest-earning assets
           
  to interest-bearing liabilities
   
            1.13
   
            1.14
             
(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.
       
 
17


 
 
Analysis of Average Balances and Interest Rates (1)
 
 Three Months Ended
 
June 30, 2009
June 30, 2008
 
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
(dollars in thousands)
$
$
%
$
$
%
ASSETS
           
Short-term investments:
           
   Interest-bearing deposits at banks
          28,062
                 10
0.14
                       1,415
                              7
4.45
Total short-term investments
          28,062
                 10
0.14
                       1,415
                              7
4.45
Investment securities:
           
  Taxable
        128,082
            1,547
4.83
                   93,504
                       1,192
4.95
  Tax-exempt (3)
          48,346
               779
6.45
                   34,586
                         533
5.99
  Total investment securities
        176,428
            2,326
5.27
                 128,090
                      1,725
5.16
Loans:
           
  Residential mortgage loans
        203,680
            3,717
7.32
                  211,695
                       3,911
7.43
  Commercial & farm loans
        178,297
              3,111
7.00
                 155,642
                     2,950
8.02
  Loans to state & political subdivisions
          45,613
               704
6.19
                   48,693
                          761
6.07
  Other loans
           11,276
               250
8.89
                     11,923
                         269
9.41
  Loans, net of discount (2)(3)(4)
        438,866
            7,782
7.11
                427,953
                      7,891
7.55
Total interest-earning assets
        643,356
            10,118
6.30
                557,458
                     9,623
6.99
Cash and due from banks
           10,516
   
                      9,410
   
Bank premises and equipment
           11,770
   
                    12,377
   
Other assets
          27,652
   
                    19,228
   
Total non-interest earning assets
          49,938
   
                     41,015
   
Total assets
        693,294
   
                598,473
   
LIABILITIES AND STOCKHOLDERS' EQUITY
         
Interest-bearing liabilities:
           
  NOW accounts
        124,630
               249
              0.80
                 105,628
                          316
                        2.24
  Savings accounts
            46,111
                 37
              0.32
                   40,630
                           37
                        0.36
  Money market accounts
           41,901
                 85
              0.81
                    45,816
                         203
                        3.62
  Certificates of deposit
        301,066
            2,492
              3.32
                227,549
                      2,172
                         4.14
Total interest-bearing deposits
        513,708
            2,863
              2.23
                 419,623
                     2,728
                        3.25
Other borrowed funds
          57,861
               496
              3.44
                   67,502
                         628
                        5.40
Total interest-bearing liabilities
        571,569
            3,359
              2.36
                 487,125
                     3,356
                        3.56
Demand deposits
          57,553
   
                   54,443
   
Other liabilities
            9,224
   
                     6,038
   
Total non-interest-bearing liabilities
          66,777
   
                    60,481
   
Stockholders' equity
          54,948
   
                   50,867
   
Total liabilities & stockholders' equity
        693,294
   
                598,473
   
Net interest income
 
            6,759
   
                     6,267
 
Net interest spread (5)
   
3.94%
   
4.17%
Net interest income as a percentage
           
  of average interest-earning assets
   
4.21%
   
4.52%
Ratio of interest-earning assets
           
  to interest-bearing liabilities
   
               1.13
   
                          1.14
             
(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
   
 

18

 
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 income on a fully taxable equivalent basis for the periods ending June 30, 2009 and 2008:
 

 
For the Three Months
 
For the Six Months
(dollars in thousands)
Ended June 30
 
Ended June 30
 
2009
2008
 
2009
2008
Interest and dividend income from investment securities
         
   and interest bearing deposits at banks (non-tax adjusted)
 $             2,071
 $              1,541
 
 $        4,191
 $          3,085
Tax equivalent adjustment
                   265
                    191
 
               509
                374
Interest and dividend income from investment securities
         
   and interest bearing deposits at banks (tax equivalent basis)
 $             2,336
 $              1,732
 
 $        4,700
 $          3,459
           
           
           
Interest and dividend income from investment securities
         
   and interest bearing deposits at banks (non-tax adjusted)
 $             7,558
 $              7,645
 
 $      15,035
 $        15,309
Tax equivalent adjustment
                   224
                    246
 
               460
                475
Interest and fees on loans (tax equivalent basis)
 $             7,782
 $              7,891
 
 $      15,495
 $        15,784
           
           
           
Total interest income
 $             9,629
 $              9,186
 
 $      19,226
 $        18,394
Total interest expense
                3,359
                 3,356
 
            6,797
             7,156
Net interest income
                6,270
                 5,830
 
         12,429
           11,238
Total tax equivalent adjustment
                   489
                    437
 
               969
                849
Net interest income (tax equivalent basis)
 $             6,759
 $              6,267
 
 $      13,398
 $        12,087


19


 

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

Analysis of Changes in Net Interest Income on a Tax-Equivalent Basis (1)
             
 
 Three months ended June 30, 2009 vs. 2008 (1)
 Six months ended June 30, 2009 vs. 2008 (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
 $                15
 $               (12)
 $                  3
 $                 5
 $                 -
 $                 5
Investment securities:
           
  Taxable
                 421
                  (66)
                 355
                869
                (83)
                786
  Tax-exempt
                 223
                   23
                 246
                406
                  44
                450
Total investments
                 644
                  (43)
                 601
            1,275
                (39)
            1,236
Loans:
           
  Residential mortgage loans
                (134)
                  (60)
                (194)
              (291)
              (104)
              (395)
  Commercial & farm loans
                 416
                (255)
                 161
                562
              (370)
                192
  Loans to state & political subdivisions
                  (45)
                  (12)
                  (57)
                (19)
                (14)
                (33)
  Other loans
                  (13)
                    (6)
                  (19)
                (43)
                (10)
                (53)
Total loans, net of discount
                 224
                (333)
                (109)
                209
              (498)
              (289)
Total Interest Income
                 883
                (388)
                 495
            1,489
              (537)
                952
Interest Expense:
           
Interest-bearing deposits:
           
  NOW accounts
                   51
                (118)
                  (67)
                159
              (372)
              (213)
  Savings accounts
                     5
                    (5)
                      -
                    -
                    -
 -
  Money Market accounts
                  (19)
                  (99)
                (118)
                (49)
              (261)
              (310)
  Certificates of deposit
                 643
                (323)
                 320
            1,086
              (456)
                630
Total interest-bearing deposits
                 680
                (545)
                 135
            1,196
           (1,089)
                107
Other borrowed funds
                  (71)
                  (61)
                (132)
              (321)
              (145)
              (466)
Total interest expense
                 609
                (606)
                     3
                875
           (1,234)
              (359)
Net interest income
 $              274
 $              218
 $              492
 $             614
 $             697
 $         1,311
             
(1) The portion of the total change attributable to both volume and rate changes, which can not be separated, has been
      allocated proportionally to the change due to volume and the change due to rate prior to allocation.
   
 
 
Tax equivalent net interest income rose from $12,087,000 in 2008 to $13,398,000 in 2009, an increase of $1,311,000 for the six months ended June 30, 2009.  The tax equivalent net interest margin decreased from 4.38% for the first six months of 2008 to 4.27% in 2009.
 
Total interest income increased $952,000.  This increase is primarily a result of a $1,489,000 increase due to volume as the average balance of interest earning assets increased by $77.5 million.  There was a decrease of $537,000 due to change in rate, as the yield on interest earning assets decreased 53 basis points from 6.97% to 6.44%.  Investment income for the six months ended June 30, 2009 increased $1,236,000 over the same period last year.  Total investment securities increased by $48.0 million since last year due to investment opportunities and investing excess cash.  Taxable securities increased by $35.3 million while tax-exempt securities increased by $12.7 million, which had the effect of increasing interest income by $869,000 and $406,000, respectively, due to volume.  The purchase of tax-exempt securities, along with municipal loans, allows us to manage our effective tax rate as well as the overall yield on our interest earning assets.
 
Total loan interest income decreased $289,000 for the six months ended June 30, 2009 compared to the same period last year.  Interest income on residential mortgage loans decreased $395,000 of which $291,000 was due to volume and $104,000 was due to a decrease in rate.  The current economic recession, higher unemployment rates and other negative economic factors have resulted in lower loan demand for non-conforming residential mortgages and home equity loans.  The average balance of commercial and farm loans increased $19.7 million from a year ago primarily due to our emphasis to grow this segment of the loan portfolio.  This had a positive impact of $562,000 on total interest income due to volume.  Offsetting this, a decrease of 63 basis points earned on commercial and farm loans had the effect of decreasing interest income by $370,000.
 
20

 
Total interest expense decreased $359,000 for the six months ended June 30, 2009 compared with last year.  This decrease is primarily due to a change in rate accounting for a $1,234,000 decrease in our interest expense.  The average interest rate on interest-bearing liabilities decreased 51 basis points, from 2.95% to 2.44%.  The actions of the Federal Reserve and current economic downturn had the effect of decreasing our short-term borrowing costs as well as rates on deposit products, including shorter-term certificates of deposit and rate sensitive NOW and money market accounts.   Offsetting this, the average balance of interest-bearing liabilities increased $74.4 million resulting in an increase in interest expense of $876,000 (see also “Financial Condition – Deposits”).  The average balance of certificates of deposit increased $73.1 million causing an increase in interest expense of $1,086,000.  Offsetting the increase in average balance was a decrease in the rate on certificates of deposit from 3.94% to 3.41% resulting in a decrease of $456,000.  The average balance of NOW accounts also increased $17.8 million accounting for an increase of $159,000 in interest expense. The change in rate, 140 basis points to 84 basis points, contributed to an offset in interest expense of $372,000 resulting in an overall decrease of $213,000.  The average balance of borrowed funds decreased by $17.4 million, resulting in a decrease in interest expense of $466,000, mainly due to volume.
 
Tax equivalent net interest income for the three months ended June 30, 2009 was $6,759,000 which compares to $6,267,000 for the same period last year.  This represents an increase of $492,000 or 7.9%.  Total tax equivalent interest income was $10,118,000 compared with $9,623,000 for the comparable period last year, an increase of $495,000.  Of this amount, $883,000 was due to an increase in volume and $388,000 was due to a decrease in rate.  Total investment income increased by $601,000 compared to last year.  This was predominantly due to a change in volume of $48.3 million in investment securities.  Total interest expense slightly increased $3,000 for the three months ended June 30, 2009 compared with last year. Of this increase, $609,000 is attributable to an increase in volume mostly due to a $73.5 million increase in certificates of deposit.  In addition, $606,000 of the increase is attributable to a decrease in rate as the average rate on interest-bearing liabilities which decreased 120 basis points from 3.56% to 2.36%.
 
Provision For Loan Losses
 
       For the six-month period ending June 30, 2009, we recorded a provision of $300,000.  The provision was increased by $180,000 over the same time period in 2008 as a result of management's quarterly review of the allowance for loan losses.  This review is based on the following information: migration analysis of delinquent and non-accrual loans, impaired loans, estimated future losses on loans, recent review of large problem credits, local and national economic conditions, historical loss experience, actual and expected loan growth and peer comparisons (see also “Financial Condition – Allowance for Loan Losses”).

For the three months ending June 30, 2009, we recorded a provision of $150,000 compared to $0 in 2008.

Non-interest Income

Non-interest income for the six months ended June 30, 2009 totaled $2,889,000, an increase of $362,000 when compared to the same period in 2008.  Service charge income increased by $59,000 and continues to be the Company’s primary source of non-interest income.  For the first six months of 2009, account service charges totaled $1,706,000 compared to $1,647,000 last year.  Approximately $22,000 of the increase is attributable to customers’ usage of their debit cards, $15,000 is due to an increase in fees charged to customers for non-sufficient funds, and an additional $15,000 is due to an increase in statement service charges.

Brokerage and insurance income increased $35,000 as we continue to increase the principal amounts invested through us by our customers.  We continue to grow and develop this segment of business with our customers.  Gains on loans sold also increased $167,000 compared to last year as a result of the amount of refinancing due to favorable rates in the secondary markets during the economic downturn.  Earnings on bank owned life insurance (BOLI) increased from $171,000 in 2008 to $236,000 for the six months ended June 30, 2009.  In the fourth quarter of 2008, we invested an additional $3.4 million based upon an analysis of new employees and updated future employee benefit costs, resulting in additional BOLI income.  Trust income is down slightly by $27,000 through six months compared to 2008 due to the economy’s downturn and the affect it has had on the values of trust assets under management.

21

 
During the first half of 2009, investment securities gains amounted to $118,000 compared to $0 last year.  We sold an agency bond at a gain of $32,000 that was likely to be called later this year.  We also elected to sell several higher coupon mortgage-backed securities that were prepaying very quickly realizing a total of $157,000 in gains.  This was offset with a $16,000 loss on the sale of bank equity shares as well as an other than temporary impairment charge of $54,000 on our Freddie Mac preferred stock.

For reasons previously mentioned above, service charges increased by $23,000 for the three months ended June 30, 2009 compared to the same period in 2008.  Gains on loans sold increased by $142,000 compared to last year’s three months ended data due to significantly higher refinancing activity in the secondary market.  Investment securities gains amounted to $102,000 for the quarter compared to $0 last year.  Earnings on bank owned life insurance also showed an increase of $29,000 for the quarter ended June 30, 2009 compared to 2008 due to the increase in the BOLI investment.  Brokerage and insurance decreased $21,000 for the comparable period mainly due to some larger annuity transactions done in 2008.  Trust income, as mentioned above, declined by $23,000 comparing the last three months to the comparable 2008 period.

The following table shows the breakdown of non-interest income for the three and six months ended June 30, 2009 and 2008:
 
 
Three months ended June 30,
Change
 
2009
2008
Amount
%
Service charges
 $                   894
 $                  871
 $                  23
                 2.6
Trust
                      113
                     136
                    (23)
             (16.9)
Brokerage and insurance
                        53
                       74
                    (21)
             (28.4)
Gains on loans sold
                      162
                       20
                   142
             710.0
Investment securities gains, net
                      102
                         -
                   102
                    -
Earnings on bank owned life insurance
                      115
                       86
                     29
               33.7
Other
                        96
                     131
                    (35)
             (26.7)
Total
 $               1,535
 $              1,318
 $                217
               16.5
         
 
         
         
 
Six months ended June 30,
Change
 
2009
2008
Amount
%
Service charges
 $               1,706
 $              1,647
 $                  59
                 3.6
Trust
                      276
                     303
                    (27)
               (8.9)
Brokerage and insurance
                      153
                     118
                     35
               29.7
Gains on loans sold
                      209
                       42
                   167
             397.6
Investment securities gains, net
                      118
                         -
                   118
                    -
Earnings on bank owned life insurance
                      236
                     171
                     65
               38.0
Other
                      191
                     246
                    (55)
             (22.4)
Total
 $               2,889
 $              2,527
 $                362
               14.3

22


Non-interest Expense

Non-interest expenses increased $1,010,000 or 12.9%, through June 30, 2009 compared to the same period in 2008.  The increase in salaries and employee benefits of $311,000 is due mainly to annual merit increases, increased employee insurance premiums, and the implementation of a Supplemental Executive Retirement Plan (SERP) late in 2008.

FDIC Insurance increased by $701,000 for the six months ended June 30, 2009 primarily due to an increase in our FDIC deposit insurance assessments.  Through the first six months of this year, we have expensed $753,000 for FDIC assessments compared to only $52,000 last year.  In 2008 we recognized approximately $209,000 in credits as a result of the Federal Deposit Insurance Reform Act of 2005.  Credits related to this legislation were fully utilized by the end of 2008.  Due to the recent strain on the FDIC deposit insurance fund, the FDIC has increased their rates and will be charging a five basis point special assessment based on assets as of June 30, 2009. The payment will be made at the end of the third quarter and is expected to be approximately $330,000.  It is possible, due to the reserve balance in the fund and the many failing banks across the nation, that we could be charged another special assessment during the latter half of the year.

Professional fees decreased $34,000 due to non-recurring costs in 2008 surrounding branch expansion activities.  The $27,000 decrease in furniture and equipment is due to assets becoming fully depreciated.

For the three months ended, June 30, 2009, salaries and employee benefits increased by $171,000 due to merit increases, higher employee insurance premiums, and increased SERP benefits.  As mentioned above, FDIC insurance also increased by $339,000 compared to the same period last year.

The following tables reflect the breakdown of non-interest expense and professional fees for the three and six months ended June 30, 2009 and 2008:

 
Six months ended June 30,
Change
 
2009
2008
Amount
%
Salaries and employee benefits
 $               4,625
 $              4,314
 $                 311
                   7.2
Occupancy
                      617
                     595
                      22
                   3.7
Furniture and equipment
                      234
                     261
                    (27)
               (10.3)
Professional fees
                      295
                     329
                    (34)
               (10.3)
FDIC Insurance
                      753
                       52
                    701
           1,348.1
Other
                   2,339
                 2,302
                      37
                   1.6
Total
 $               8,863
 $              7,853
 $             1,010
                 12.9
         
 
Six months ended June 30,
Change
 
2009
2008
Amount
%
Other professional fees
 $                   145
 $                  178
 $                 (33)
               (18.5)
Legal fees
                        38
                       47
                      (9)
               (19.1)
Examinations and audits
                      112
                     104
                        8
                   7.7
Total
 $                   295
 $                  329
 $                 (34)
               (10.3)


23

 


 
Three months ended June 30,
Change
 
2009
2008
Amount
%
Salaries and employee benefits
 $               2,329
 $              2,158
 $                 171
                   7.9
Occupancy
                      296
                     281
                      15
                   5.3
Furniture and equipment
                      124
                     128
                      (4)
                 (3.1)
Professional fees
                      164
                     148
                      16
                 10.8
FDIC Insurance
                      378
                       39
                    339
               869.2
Other
                   1,200
                 1,184
                      16
                   1.4
Total
 $               4,491
 $              3,938
 $                 553
                 14.0


 
Three months ended June 30,
Change
 
2009
2008
Amount
%
Other professional fees
 $                     73
 $                    79
 $                   (6)
                 (7.6)
Legal fees
                        30
                       20
                      10
                 50.0
Examinations and audits
                        61