10-Q 1 q063.txt 10Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 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: 33-96358 KENTUCKY BANCSHARES, INC. (Exact name of registrant as specified in its charter) Kentucky 61-0993464 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) P.O. Box 157, Paris, Kentucky 40362-0157 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (859)987-1795 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. 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. Large accelerated filer _ Accelerated filer _ Non-accelerated filer X Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No X___ Number of shares of Common Stock outstanding as of November 13, 2006: 2,859,157. KENTUCKY BANCSHARES, INC. Table of Contents Part I - Financial Information Item 1. Financial Statements Consolidated Balance Sheets 3 Consolidated Statements of Income and Comprehensive Income 4 Consolidated Statements of Changes in Stockholders' Equity 6 Consolidated Statements of Cash Flows 7 Notes to Consolidated Financial Statements 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 14 Item 3. Quantitative and Qualitative Disclosures About Market Risk 20 Item 4. Controls and Procedures 22 Part II - Other Information 22 Signatures 23 Exhibits 31.1 Certifications of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 24 31.2 Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 26 32 Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 28 Item 1 - Financial Statements KENTUCKY BANCSHARES, INC. CONSOLIDATED BALANCE SHEETS (unaudited) (thousands) 9/30/2006 12/31/2005 Assets Cash and due from banks $ 12,511 $ 11,456 Federal funds sold 167 2,708 Cash and cash equivalents 12,678 14,164 Securities available for sale 142,456 160,652 Loans 439,492 370,912 Allowance for loan losses (5,142) (4,310) Net loans 434,350 366,602 Federal Home Loan Bank stock 6,372 5,398 Bank premises and equipment, net 14,482 10,702 Interest receivable 5,812 3,719 Goodwill 12,471 9,111 Other intangible assets 2,127 766 Mortgage servicing rights 748 802 Other assets 1,304 834 Total assets $ 632,800 $ 572,750 Liabilities and Stockholders' Equity Deposits Non-interest bearing $ 89,190 $ 72,193 Time deposits, $100,000 and over 65,873 61,597 Other interest bearing 299,996 297,841 Total deposits 455,059 431,631 Repurchase agreements and other borrowings 20,185 16,838 Federal Funds Purchased 15,620 - Federal Home Loan Bank advances 75,339 66,749 Subordinated debentures 7,217 7,217 Interest payable 2,889 2,714 Other liabilities 1,454 1,055 Total liabilities 577,763 526,204 Stockholders' equity Common stock 12,442 6,813 Retained earnings 43,034 40,666 Accumulated other comprehensive income (loss) (439) (933) Total stockholders' equity 55,037 46,546 Total liabilities & stockholders' equity $ 632,800 $ 572,750 See Accompanying Notes KENTUCKY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (unaudited) (thousands, except per share amounts) Nine Months Ending 9/30/2006 9/30/2005 INTEREST INCOME: Loans, including fees $ 20,911 $ 17,265 Securities available for sale 4,779 3,637 Other 99 172 Total interest income 25,789 21,074 INTEREST EXPENSE: Deposits 8,593 5,527 Other 3,359 2,695 Total interest expense 11,952 8,222 Net interest income 13,837 12,852 Loan loss provision 334 583 Net interest income after provision 13,503 12,269 NON-INTEREST INCOME: Service charges 3,767 3,377 Loan service fee income 201 197 Trust department income 455 332 Securities available for sale gains (losses), net 41 63 Gain on sale of mortgage loans 178 265 Other 758 873 Total other income 5,400 5,107 NON-INTEREST EXPENSE: Salaries and employee benefits 6,985 6,420 Occupancy expenses 1,705 1,686 Amortization 289 259 Advertising and marketing 363 330 Taxes other than payroll, property and income 439 407 Other 2,550 2,499 Total other expenses 12,331 11,601 Income before taxes 6,572 5,775 Income taxes 1,849 1,496 Net income $ 4,723 $ 4,279 Other Comprehensive Income, net of tax: Change in Unrealized Gains (Losses) on Securities 494 (803) Comprehensive Income $ 5,217 $ 3,476 Earnings per share Basic $ 1.73 $ 1.60 Diluted 1.72 1.59 See Accompanying Notes KENTUCKY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (unaudited) (thousands, except per share amounts) Three Months Ending 9/30/2006 9/30/2005 INTEREST INCOME: Loans, including fees $ 7,726 $ 5,937 Securities available for sale 1,751 1,234 Other 16 150 Total interest income 9,493 7,321 INTEREST EXPENSE: Deposits 3,274 2,191 Other 1,369 884 Total interest expense 4,643 3,075 Net interest income 4,850 4,246 Loan loss provision 94 167 Net interest income after provision 4,756 4,079 NON-INTEREST INCOME: Service charges 1,474 1,182 Loan service fee income 68 66 Trust department income 138 117 Securities available for sale gains (losses), net 64 10 Gain on sale of mortgage loans 74 78 Other 281 266 Total other income 2,099 1,719 NON-INTEREST EXPENSE: Salaries and employee benefits 2,536 2,119 Occupancy expenses 628 566 Amortization 128 88 Advertising and marketing 123 110 Taxes other than payroll, property and income 150 135 Other 939 809 Total other expenses 4,504 3,827 Income before taxes 2,351 1,971 Income taxes 637 541 Net income $ 1,714 $ 1,430 Other Comprehensive Income, net of tax: Change in Unrealized Gains (Losses) on Securities 1,976 (604) Comprehensive Income $ 3,690 $ 826 Earnings per share Basic $ 0.60 $ 0.54 Diluted 0.60 0.54 See Accompanying Notes KENTUCKY BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (unaudited) (thousands, except number of shares) Accumulated Other Total ----Common Stock---- Retained Comprehensive Stockholders' Shares Amount Earnings Income Equity Balances, December 31, 2005 2,666,897 $ 6,813 $ 40,666 $ (933) $ 46,546 Common stock issued, includes 198,836 shares issued in business combination 204,811 5,633 - 5,633 Common stock purchased (12,151) (53) (303) - (356) Noncash compensation expense attributed to stock option and employee stock purchase plan grants - 49 - - 49 Net change in unrealized gain (loss) on securities available for sale, net of tax - - - 494 494 Net income - - 4,723 - 4,723 Dividends declared - $0.75 per share - - (2,052) - (2,052) Balances, September 30, 2006 2,859,557 $ 12,442 $ 43,034 $ (439) $ 55,037
See Accompanying Notes KENTUCKY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (thousands) Nine Months Ending 9/30/2006 9/30/2005 Cash Flows From Operating Activities Net Income $ 4,723 $ 4,279 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 709 707 Amortization 289 259 Amortization of premium on debt (56) (74) Securities amortization (accretion), net 33 266 Noncash compensation expense 49 - Provision for loan losses 334 583 Securities (gains) losses, net (41) (64) Originations of loans held for sale (11,624) (14,612) Proceeds from sale of loans 11,802 14,838 Federal Home Loan Bank stock dividends (246) (184) Losses (gains) on sale of fixed assets - (71) Gain on sale of mortgage loans (178) (265) Changes in: Interest receivable (2,093) (619) Other assets 1,364 264 Interest payable 175 48 Other liabilities 724 134 Net cash from operating activities 5,964 5,489 Cash Flows From Investing Activities Purchases of securities available for sale (3,215) (23,520) Proceeds from sales of securities available for sale 17,486 1,323 Proceeds from principal payments, maturities and calls of securities available for sale 36,542 13,676 Cash paid in bank acquisition (6,411) - Net change in loans (17,157) (1,478) Purchases of bank premises and equipment (1,448) (643) Proceeds from the sale of bank premises and equipment - 582 Net cash from investing activities 25,797 (10,060) Cash Flows From Financing Activities: Net change in deposits (48,851) 26,857 Net change in securities sold under agreements to repurchase, federal funds purchased and other borrowings 15,097 (9,682) Advances from Federal Home Loan Bank 80,000 15,000 Payments on Federal Home Loan Bank advances (78,118) (7,675) Proceeds from note payable 8,000 - Payment on note payable (7,000) - Proceeds from issuance of common stock 33 19 Purchase of common stock (356) (436) Dividends paid (2,052) (1,849) Net cash from financing activities (33,247) 22,234 Net change in cash and cash equivalents (1,486) 17,663 Cash and cash equivalents at beginning of period 14,164 15,455 Cash and cash equivalents at end of period $ 12,678 $ 33,118 See Accompanying Notes KENTUCKY BANCSHARES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates used in the preparation of the financial statements are based on various factors including the current interest rate environment and the general strength of the local economy. Changes in the overall interest rate environment can significantly affect the Company's net interest income and the value of its recorded assets and liabilities. Actual results could differ from those estimates used in the preparation of the financial statements. The financial information presented as of any date other than December 31 has been prepared from the Company's books and records without audit. The accompanying consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Certain financial information that is normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America, but is not required for interim reporting purposes, has been condensed or omitted. In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of such financial statements, have been included. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2005. New Accounting Pronouncements - In December 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004), "Share-Based Payment", that requires the cost resulting from stock options be measured at fair value and recognized in earnings. This Statement replaces SFAS No. 123, "Accounting for Stock-Based Compensation" and supersedes Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," which permitted the recognition of compensation expense using the intrinsic value method. The Company adopted SFAS No. 123(R) on January 1, 2006, and recognizes stock option expense based on fair value at date of grant. All new awards and awards that are modified, repurchased, or cancelled after the date of adoption are accounted for under the provisions of SFAS No. 123(R). As a result of adopting SFAS No. 123(R), the Company's income before income taxes for the three and nine months ended September 30, 2006 includes stock option compensation cost of $16 thousand and $49 thousand, respectively. Prior periods have not been revised. See Note 6, Stock Compensation, for additional information. In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments", an amendment of SFAS No. 133 and SFAS No. 140. This statement permits fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. It establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. In addition, SFAS 155 clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133. It also clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives. SFAS 155 amends Statement 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. 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 Company is evaluating the impact, if any, of the adoption of this Statement on the Company's result of operations and financial condition. In June 2006, FASB Interpretation No. 48 ("FIN 48"), Accounting for Uncertainty in Income Taxes - an interpretation of FAS 109 was issued. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity's financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. Earlier application is encouraged if an entity has not yet issued financial statements, including interim financial statements, in the period FIN 48 is adopted. The Company is currently evaluating the impact, if any, the adoption of FIN 48 will have on its consolidated financial position, results of operations or cash flows. In September 2006, the United States Securities and Exchange Commission's ("SEC") Office of the Chief Accountant and Divisions of Corporation Finance and Investment Management released Staff Accounting Bulletin ("SAB") 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements". SAB 108 was issued in order to eliminate the diversity of practice surrounding how public companies quantify financial statement misstatements. SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. SAB 108 identifies two approaches that have been widely used by public companies for quantifying the effects of financial statement misstatements: the "rollover" and "iron curtain" approaches. With the rollover approach, companies quantify the impact of misstatements based on the amount of the error originating in the current year income statement, thus ignoring the carryover effect of prior year misstatements. This approach can lead to the accumulation of misstatements on the balance sheet. The iron curtain approach focuses on the effect of correcting the period-end balance sheet, regardless of the misstatement's year of origination. The Company currently uses the rollover method for quantifying identified financial statement misstatements. In SAB 108 the SEC staff establishes a dual approach that requires quantification of financial statement errors based on the effects of the error on each of the Company's financial statements and the related financial statement disclosures. The dual approach requires quantification of misstatements under both the rollover and iron curtain methods. Companies adopting the dual approach are permitted to record a one-time cumulative effect adjustment to the carrying values of assets and liabilities with an offsetting adjustment recorded to retained earnings as of the beginning of the fiscal year of adoption to correct errors existing in prior years that previously had been considered immaterial based on appropriate use of their previous approach. The Company is in the process of evaluating the impact, if any, of the adoption of this SAB on the Company's results of operations and financial condition. In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)." SFAS No. 158 requires an employer to recognize the funded status of defined benefit postretirement plans as an asset or a liability on its balance sheet. The funded status is measured as the difference between plan assets at fair value and the benefit obligation. The Company has an unfunded postretirement benefit plan that is subject to the provisions of SFAS No. 158. For this plan, the funded status is represented by the accumulated postretirement benefit obligation. SFAS No. 158 also requires the Company to measure the funded status of its plan's assets and obligations that determine its funded status as of the balance sheet date and to recognize those changes in the year in which the changes occur as a component of other comprehensive income, net of taxes. SFAS No. 158 has no impact on how postretirement benefits are accounted for and reported in the income statement. The Company is evaluating the impact, if any, of the adoption of this Statement on the Company's result of operations and financial condition. 2. BUSINESS COMBINATION On July 7, 2006, the Company acquired 100% of the outstanding shares of Peoples Bancorp of Sandy Hook, Inc. (Peoples), parent of Peoples Bank of Sandy Hook. Operating results of Peoples are included in the consolidated financial statements since the date of acquisition. The purchase price of $14 million was 40 percent stock and 60 percent cash. The purchase price resulted in approximately $3,360,000 in goodwill, and $1,477,000 in core deposit intangible. The core deposit intangible asset will be amortized over 10 years, using an accelerated method. Goodwill will not be amortized but instead evaluated periodically for impairment. Management is still in the process of evaluating the purchase accounting entries, and additional adjustments may be made. Peoples was a $91 million asset bank holding company, and on the merger date, had loans of $51 million and deposits of $72 million. 3. INVESTMENT SECURITIES INVESTMENT SECURITIES Period-end securities are as follows: (in thousands) Amortized Unrealized Unrealized Fair Cost Gains Losses Value Available for Sale September 30, 2006 U.S. government agencies 53,634 200 (699) 53,135 States and political subdivisions 45,128 990 (232) 45,886 Mortgage-backed 43,836 - (1,377) 42,459 Equity securities 525 451 - 976 Total 143,123 1,641 (2,308) 142,456 December 31, 2005 U.S. Treasury $ 3,006 $ - $ (32) $ 2,974 U.S. government agencies 67,845 14 (826) 67,033 States and political subdivisions 37,045 756 (338) 37,463 Mortgage-backed 53,645 4 (1,309) 52,340 Equity securities 524 318 - 842 Total 162,065 1,092 (2,505) 160,652 4. LOANS Loans at period-end are as follows: (in thousands) 9/30/2006 12/31/2005 Commercial $ 29,009 $ 27,302 Real estate construction 33,037 29,822 Real estate mortgage 285,544 245,138 Agricultural 75,315 59,328 Consumer 16,587 9,322 Total 439,492 370,912 5. Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options. The factors used in the earnings per share computation follow: Nine Months Ended September 30 2006 2005 (in thousands, except per share data) Basic Earnings Per Share Net Income $4,723 $4,279 Weighted average common shares outstanding 2,730 2,680 Basic earnings per share $ 1.73 $ 1.60 Diluted Earnings Per Share Net Income $4,723 $4,279 Weighted average common shares outstanding 2,730 2,680 Add dilutive effects of assumed exercise of stock options 11 15 Weighted average common and dilutive potential common shares outstanding 2,741 2,695 Diluted earnings per share $ 1.72 $ 1.59 Three Months Ended September 30 2006 2005 (in thousands, except per share data) Basic Earnings Per Share Net Income $1,714 $1,430 Weighted average common shares outstanding 2,854 2,682 Basic earnings per share $ 0.60 $ 0.54 Diluted Earnings Per Share Net Income $1,714 $1,430 Weighted average common shares outstanding 2,854 2,682 Add dilutive effects of assumed exercise of stock options 11 15 Weighted average common and dilutive potential common shares outstanding 2,865 2,697 Diluted earnings per share $ 0.60 $ 0.54 Stock options for 32,400 shares of common stock for the nine and three months ended September 30, 2006, and for 31,100 shares of common stock for the nine months ended September 30, 2005 and for 27,600 shares of common stock for the three months ended September 30, 2005 were excluded from diluted earnings per share because their impact was antidilutive. 6. Stock Compensation The Company grants certain officers and key employees stock option awards, which vest and become fully exercisable at the end of five years. The Company also grants certain directors stock option awards, which vest and become fully exercisable immediately. The exercise price of each option, which has a ten year life, was equal to the market price of the Company's stock on the date of grant. The Company also provides to certain officers and key employees restricted stock grants, which fully vest at the end of five years. The Company records employee expense ratably over the five year period, based on the market price of the common stock on the date of grant. Total shares issuable under the restricted stock grant plan are 50,000 shares. In January 2006, 3,875 shares were granted under the plan. In December 2004, the Financial Accounting Standards Board issued a revised version of Statement of Financial Accounting Standards No. 123. It requires that the fair value of stock options and other share-based compensation be measured as of the date the grant is awarded and expensed over the period of employee service, typically the vesting period. Compensation cost will also be recorded for previously awarded options to the extent that they vest after the effective date. The following table summarizes stock option activity: Nine Months Ended September 30, 2006 Option Weighted Average Shares Exercise Price Outstanding, beginning of year 77,064 $ 25.32 Granted 1,300 29.50 Exercised (2,100) 16.19 Outstanding, end of period 76,264 25.64 Options exercisable at period end 50,242 23.23 The aggregate intrinsic value of the stock options exercised totaling 2,100 shares was $27,788 and the total intrinsic value of the stock options outstanding of 76,264 shares is $361,776. The following details stock options outstanding: September 30, 2006 December 31, 2005 Stock options vested and currently exercisable: Number 50,242 42,116 Weighted average exercise price $ 23.23 $ 21.38 Aggregate intrinsic value $ 341,994 $ 358,646 Weighted average remaining contractual life 50.1 months 47.7 months The intrinsic value for stock options is calculated based on the exercise price of the underlying awards and the market price of our common stock as of the reporting date. The Company recorded $49 thousand in stock compensation expense during the nine months ended September 30, 2006 to salaries and employee benefits. The after tax effect on net income for the nine months ended September 30, 2006 was $49 thousand, resulting in a one percent decline in earnings per share on both the basic and diluted basis. Prior to 2006, employee compensation expense under stock options was reported using the intrinsic value method. No stock-based compensation cost was reflected in net income, as all options granted had an exercise price equal to or greater than the market price of the underlying common stock at date of grant. Effective January 1, 2006, the Company adopted the fair value recognition provision of FASB Statement No. 123(R), Accounting for Stock-Based Compensation, and recognizes stock option expense based on fair value at date of grant. The following table illustrates for 2005 the effect on net income and earnings per share if expense was measured using the fair value recognition provisions of FAS 123. 2005 (In thousands, except per share amounts) Net income as reported $ 4,279 Less: Stock-based compensation expense determined under fair value based method (41) Pro forma net income $ 4,238 Basic earnings per share as reported $ 1.60 Pro forma basic earnings per share 1.58 Diluted earnings per share as reported 1.59 Pro forma diluted earnings per share 1.57 The weighted-average assumptions for options granted during the year and the resulting estimated weighted average fair values per share used in computing 2006 recognized compensation expense and 2005 for pro forma disclosures are as follows. 2006 2005 Weighted-average fair value of options granted during the year $3.14 $4.82 Risk-free interest rate 4.60% 3.98% Expected option life 8 years 8 years Expected stock price volatility 7.99% 15.11% Expected dividend yield 3.39% 3.03% The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes based stock option valuation model. This model requires the input of subjective assumptions that will usually have a significant impact on the fair value estimate. Expected volatilities are based on historical volatility of the Company's stock, and other factors. Expected dividends are based on dividend trends and the market price of the Company's stock price at grant. The Company uses historical data to estimate option exercises and employee terminations within the valuation model. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve at the time of grant. 7. Dividends per share paid for the quarter ended September 30, 2006 were $0.25 compared to $0.23 for September 30, 2005. This is the same rate of dividend paid for the first and second quarters of the respective years. 8. Components of Net Periodic Benefit Cost Nine months ended September 30 (in thousands) Pension Benefits 2006 2005 Service cost $ 354 $ 324 Interest cost 273 260 Expected return on plan assets (298) (282) (Gain) loss amortization 31 30 Net Periodic Benefit Cost $ 360 $ 332 Three months ended September 30 (in thousands) Pension Benefits 2006 2005 Service cost $ 118 $ 108 Interest cost 91 87 Expected return on plan assets (99) (94) (Gain) loss amortization 10 10 Net Periodic Benefit Cost $ 120 $ 111 Employer Contributions The Company previously disclosed in its financial statements for the year ended December 31, 2005 that it expected to contribute $204 thousand as its 2006 annual contribution to the Pension Plan. No contributions to the Pension Plan were made during the nine months ended September 30, 2006, and the Company anticipates making its annual contribution in the fourth quarter of 2006. Item 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements This discussion contains forward-looking statements under the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties. Words such as "believes," "anticipates," "expects," "intends," "plans," "targeted," and similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements. Although the Company believes that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and therefore, there can be no assurance that the forward-looking statements included herein will prove to be accurate. Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to: economic conditions (the Company and its bank operate in areas affected by various markets, including the tobacco market); competition for the Company's customers from other providers of financial and mortgage services; government legislation and regulation (which changes from time to time and over which the Company has no control); changes in interest rates (both generally and more specifically mortgage interest rates); material unforeseen changes in the liquidity, results of operations, or financial condition of the Company's customers; and other risks detailed in the Company's filings with the Securities and Exchange Commission, all of which are difficult to predict and many of which are beyond the control of the Company. The Company undertakes no obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Summary Kentucky Bancshares, Inc. recorded net income of $4.7 million, or $1.73 basic and $1.72 diluted earnings per share for the nine months ended September 30, 2006 compared to $4.3 million, or $1.60 basic and $1.59 diluted earnings for the nine month period ended September 30, 2005. The first nine months net income reflects an increase of 10.4% compared to the same time period in 2005. The earnings for the three months ended September 30, 2006 were $1.7 million, or $0.60 basic and $0.60 diluted earnings per share for the three months ended September 30, 2006 compared to $1.4 million, or $0.54 basic earnings per share and $0.54 diluted earnings per share for the three month period ending September 30, 2005. This three months period net income reflects an increase of 19.9% compared to the same time period in 2005. Return on average assets was 1.08% for the nine months ended September 30, 2006 and 1.08% for the nine month period ended September 30, 2005. Return on average equity was 12.9% for the nine month period ended September 30, 2006 and 12.5% for the same period in 2005. Return on average assets was 1.09% for the three months ended September 30, 2006 and 1.05% for the three month period ended September 30, 2005. Return on average equity was 13.0% for the three month period ended September 30, 2006 and 12.3% for the same period in 2005. Loans increased $68.6 million from $370.9 million on December 31, 2005 to $439.5 million on September 30, 2006. Increases in real estate construction, real estate mortgage, agricultural and consumer loans were offset by a decrease in commercial loans. Management attributes the growth in loans primarily to the bank merger with Peoples ($51 million in loans at acquisition) and the $11.7 million in lump-sum tobacco buyouts completed in January 2006. Total deposits increased from $431.6 million on December 31, 2005 to $455.1 million on September 30, 2006, an increase of $23.5 million, primarily the result of the bank merger with Peoples ($72 million at acquisition), offset by a decline in public fund deposits, reported in other interest bearing deposits. Net Interest Income Net interest income was $13.8 million for the nine months ended September 30, 2006 compared to $12.9 million for the nine months ended September 30, 2005, an increase of 7.7%. The interest spread was 3.27% for the first nine months of 2006 compared to 3.38% for the same period in 2005, a decrease of 11 basis points. Net interest income was $4.8 million for the three months ended September 30, 2006 compared to $4.2 million for the three months ended September 30, 2005, an increase of 14.2%. The interest spread was 3.22% for the three month period ended September 30, 2006 compared to 3.20% for the same period in 2005, an increase of 2 basis points. Generally, the increasing interest rate environment and the increased cost related to public fund deposits have contributed to declining net interest margins for the nine months in 2006 compared to 2005. For the first nine months, the yield on assets increased from 5.67% in 2005 to 6.27% in 2006. The cost of liabilities increased from 2.28% in 2005 to 3.00% in 2006. Year to date average loans are up $35.3 million, or 9.7% from September 30, 2005 to September 30, 2006. Loan interest income has increased $3.6 million for the first nine months of 2006 compared to the first nine months of 2005. Year to date average deposits increased from September 30, 2005 to September 30, 2006, up $36.8 million, or 9.4%. Deposit interest expense has increased $3.1 million for the first nine months of 2006 compared to the same period in 2005. Following the 2004 enactment of federal legislation to end the federal tobacco program and to compensate quota owners and producers, the Company offered tobacco quota owners and producers upfront, lump-sum payment buyouts ranging from 75% to 80% of the future stream of federal buyout payments during 2005. The Company made $11.7 million in lump-sum payments in January 2006 under successor in interest contracts. Similar types of buyouts are expected to continue over the next few years, but on a smaller scale. Starting in January 2006, these buyouts have generated additional net interest income. Non-Interest Income Non-interest income increased $293 thousand for the nine months ended September 30, 2006 compared to the same period in 2005 to $5.4 million. Increases in service charges of $390 thousand and trust department income (the collection of certain estate fees) of $123 thousand are offset by decreases in net gains (losses) on securities of $22 thousand, and gains on sale of mortgage loans of $87 thousand. The $380 thousand increase in non-interest income for the three months ended September 30, 2006 compared to the same time period in 2005 is mainly attributable to the increase in service charges. Gain on sale of mortgage loans decreased $87 thousand during the first nine months of 2006 compared to the same period in 2005. The decrease was $4 thousand for the three month period September 30, 2006 compared to the same time period in 2005. The volume of mortgage loan originations and sales is generally inverse to rate changes. The increasing rate environment has caused the originations of mortgage loans to be lower and the related gain on sale of mortgage loans to be lower in 2006 than in 2005. Non-Interest Expense Total non-interest expenses increased $730 thousand for the nine month period ended September 30, 2006 compared to the same period in 2005. For the three month period ended September 30, 2006, total non-interest expense increased $677 thousand. For the comparable nine month periods, salaries and benefits increased $565 thousand, an increase of 8.9%. Salaries represented $333 thousand and employee benefits represented $218 thousand of the increase in salaries and employee benefits expense during these comparable periods. Salaries and benefits increased $417 thousand for the three month period ended September 30, 2006 compared to the same period in 2005. These increases are mainly a result of the Peoples merger that was closed on July 7, 2006. Occupancy expenses increased $19 thousand to $1.7 million for the first nine months of 2006 compared to the same period in 2005. Occupancy expenses increased $62 thousand for the three month period ended September 30, 2006 compared to the same period in 2005. These minor increases are primarily a result of the Peoples merger mentioned earlier. Other expenses increased $51 thousand for the nine months ended September 30, 2006 compared to the same time period in 2005, and $130 thousand for the three months ended September 30, 2006 compared to the same time period in 2005. Amortization, advertising and marketing, and taxes other than payroll, property and income also increased over this time period. This is mainly a result of the Peoples merger mentioned earlier. Income Taxes The tax equivalent rate for the nine months ended September 30, 2006 was 28% compared to 26% in 2005. The tax equivalent rate for the three months ended September 30, 2006 was 27% compared to 27% in 2005. These rates are less than the statutory rate as a result of the tax-free securities and loans held by the Company. Recognizing the remainder of the net operating loss carryforward from the 2003 Cynthiana acquisition contributed to the lower rate in 2005. Stock Repurchase Program On October 25, 2000, the Company announced that its Board of Directors approved a stock repurchase program. The Company is authorized to purchase up to 100,000 shares of its outstanding common stock. On November 11, 2002, the Board of Directors approved and authorized the Company's repurchase of an additional 100,000 shares. In August 2004, the Board of Directors approved and the Company repurchased 122,302 shares from a third-party shareholder. These shares were outside of the previously mentioned stock repurchase programs. Shares will be purchased from time to time in the open market depending on market prices and other considerations. Through September 30, 2006, 117,460 shares have been purchased. The most recent share repurchase occurred on October 3, 2006. The repurchase program has had a positive effect on earnings per share calculations. Liquidity and Funding Liquidity risk is the possibility that the Company may not be able to meet its cash requirements. Management of liquidity risk includes maintenance of adequate cash and sources of cash to fund operations and meeting the needs of borrowers, depositors and creditors. Excess liquidity has a negative impact on earnings as a result of the lower yields on short-term assets. Cash and cash equivalents were $12.7 million as of September 30, 2006 compared to $14.2 million at December 31, 2005. In addition to cash and cash equivalents, the securities portfolio provides an important source of liquidity. Total securities available for sale totaled $142.5 million at September 30, 2006. The available for sale securities are available to meet liquidity needs on a continuing basis. The Company expects the customers' deposits to be adequate to meet its funding demands. Generally, the Company relies upon net cash inflows from financing activities, supplemented by net cash inflows from operating activities, to provide cash used in its investing activities. As is typical of many financial institutions, significant financing activities include deposit gathering, and the use of short-term borrowings, such as federal funds purchased and securities sold under repurchase agreements along with long-term debt. The Company's primary investing activities include purchasing investment securities and loan originations. Management is aware of the challenge of funding sustained loan growth. Therefore, in addition to deposits, other sources of funds, such as Federal Home Loan Bank (FHLB) advances, may be used. The Company relies on FHLB advances for both liquidity, and asset/liability management purposes (primarily to fund long-term fixed rate residential mortgage loans). As of September 30, 2006, we have sufficient collateral to borrow an additional $36 million from the FHLB. In addition, as of September 30, 2006, over $48 million is available in overnight borrowing through various correspondent banks. In light of this, management believes there is sufficient liquidity to meet all reasonable borrower, depositor and creditor needs in the present economic environment. Non-Performing Assets As of September 30, 2006, the Company's non-performing loans totaled $2.0 million or 0.45% of loans compared to $1.0 million or 0.26% of loans at December 31, 2005. (See table below) The increase in non-accrual loans is comprised primarily of a number of various real estate loans. Real estate loans composed 89% of the non-performing loans as of September 30, 2006 and 79% as of December 31, 2005. Forgone interest income on the non-accrual loans for both 2006 and 2005 is immaterial. Nonperforming Assets 9/30/06 12/31/05 (in thousands) Non-accrual Loans $ 1,912 $ 774 Accruing Loans which are Contractually past due 90 days or more 44 206 Total Nonperforming and Restructured 1,956 980 Other Real Estate 533 141 Total Nonperforming and Restructured Loans and Other Real Estate $ 2,489 $ 1,121 Nonperforming and Restructured Loans as a Percentage of Loans 0.45% 0.26% Nonperforming and Restructured Loans and Other Real Estate as a Percentage of Total Assets 0.39% 0.20% Provision for Loan Losses The loan loss provision for the first nine months was $334 thousand for 2006 and $583 thousand for 2005. The loan loss provision for the three months ended September 30, 2006 was $94 thousand and $167 thousand for the same time period in 2005. The overall relative levels of nonperforming loans has allowed management to decrease the 2006 provision in order to maintain an allowance for loan losses that is representative of the risk of loss based on the quality of loans currently in the portfolio. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio (including overdrafts), information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Net charge-offs for the nine month period ended September 30, 2006 were $278 thousand compared to $236 thousand for the same period in 2005. Net charge-offs for the three month period ended September 30, 2006 were $136 thousand compared to $91 thousand for the same period in 2005. Future levels of charge-offs will be determined by the particular facts and circumstances surrounding individual loans. Management believes the current loan loss allowance is sufficient to meet probable incurred loan losses. Loan Losses Nine Months Ended September 30 (in thousands) 2006 2005 Balance at Beginning of Period $ 4,310 $ 4,163 Amounts Charged-off: Commercial 15 77 Real Estate Construction 28 - Real Estate Mortgage 135 96 Agricultural 3 - Consumer 682 180 Total Charged-off Loans 863 353 Recoveries on Amounts Previously Charged-off: Commercial 2 3 Real Estate Construction - - Real Estate Mortgage 2 7 Agricultural 21 1 Consumer 560 106 Total Recoveries 585 117 Net Charge-offs 278 236 Provision for Loan Losses 334 583 Peoples Bank Reserve Acquired 776 - Balance at End of Period 5,142 4,510 Loans Average 397,492 362,029 At September 30 439,492 359,524 As a Percentage of Average Loans: Net Charge-offs 0.07% 0.07% Provision for Loan Losses 0.08% 0.16% Allowance as a Percentage of Period-end Loans 1.17% 1.25% Allowance as a Multiple of Net Charge-offs 9.2 14.3 Allowance as a Percentage of Non-performing and Restructured Loans 263% 343% Loan Losses Quarter Ended September 30 (in thousands) 2006 2005 Balance at Beginning of Period $ 4,408 $ 4,431 Amounts Charged-off: Commercial - 15 Real Estate Construction 28 - Real Estate Mortgage 81 23 Agricultural - - Consumer 158 97 Total Charged-off Loans 267 135 Recoveries on Amounts Previously Charged-off: Commercial 1 1 Real Estate Construction - - Real Estate Mortgage 2 5 Agricultural - 1 Consumer 128 40 Total Recoveries 131 47 Net Charge-offs 136 88 Provision for Loan Losses 94 167 Peoples Bank Reserve Acquired 776 - Balance at End of Period 5,142 4,510 Loans Average 432,132 363,999 At September 30 439,492 359,524 As a Percentage of Average Loans: Net Charge-offs 0.03% 0.02% Provision for Loan Losses 0.02% 0.05% Allowance as a Multiple of Net Charge-offs 9.5 12.8 Item 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Asset/Liability management control is designed to ensure safety and soundness, maintain liquidity and regulatory capital standards, and achieve acceptable net interest income. Management considers interest rate risk to be the most significant market risk. The Company's exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximize income. Management realizes certain risks are inherent and that the goal is to identify and minimize the risks. The primary tool used by management is an interest rate shock simulation model. The Bank has no market risk sensitive instruments held for trading purposes. The following table depicts the change in net interest income resulting from 100 and 300 basis point changes in rates on the Company's interest earning assets and interest bearing liabilities. The projections are based on balance sheet growth assumptions and repricing opportunities for new, maturing and adjustable rate amounts. As of September 30, 2006 the projected percentage changes are within the Board approved limits. This period's volatility is lower when compared to the same period a year ago. The projected net interest income report summarizing the Company's interest rate sensitivity as of September 30, 2006 is as follows: (dollars in thousands) PROJECTED NET INTEREST INCOME Level Change in basis points: - 300 - 100 Rates + 100 + 300 Year One (10/06 - 9/07) Interest Income $36,547 $37,424 $38,769 $40,157 $41,140 Interest Expense 17,710 18,394 19,344 20,420 21,107 Net Interest Income 18,837 19,030 19,425 19,737 20,033 PROJECTED DOLLAR INCREASE (DECREASE) FROM "LEVEL RATES" Year One (10/06 - 9/07) Interest Income $(2,222) $(1,345) N/A $ 1,388 $ 2,371 Interest Expense (1,634) (950) N/A 1,076 1,763 Net Interest Income (588) (395) N/A 312 608 PROJECTED PERCENTAGE INCREASE (DECREASE) FROM "LEVEL RATES" Year One (10/06 - 9/07) Interest Income -5.7% -3.5% N/A 3.6% 6.1% Interest Expense -8.4% -4.9% N/A 5.6% 9.1% Net Interest Income -3.0% -2.0% N/A 1.6% 3.1% Board approved limit >-18.0% >-6.0% N/A >-4.0% >-10.0% The projected net interest income report summarizing the Company's interest rate sensitivity as of September 30, 2005 is as follows: (dollars in thousands) PROJECTED NET INTEREST INCOME Level Change in basis points: - 300 - 100 Rates + 100 + 300 Year One (10/05 - 9/06) Interest Income $ 25,295 $ 29,367 $ 31,404 $ 33,378 $ 37,171 Interest Expense 10,610 12,597 13,754 14,910 17,224 Net Interest Income 14,685 16,770 17,650 18,468 19,947 PROJECTED DOLLAR INCREASE (DECREASE) FROM "LEVEL RATES" Year One (10/05 - 9/06) Interest Income $ (6,109) $ (2,037) N/A $ 1,974 $ 5,767 Interest Expense (3,144) (1,157) N/A 1,156 3,470 Net Interest Income (2,965) (880) N/A 818 2,297 PROJECTED PERCENTAGE INCREASE (DECREASE) FROM "LEVEL RATES" Year One (10/05 - 9/06) Interest Income -19.5% -6.5% N/A 6.3% 18.4% Interest Expense -22.9% -8.4% N/A 8.4% 25.2% Net Interest Income -16.8% -5.0% N/A 4.6% 13.0% Board approved limit >-18.0% >-6.0% N/A >-4.0% >-10.0% These projected changes in net interest income as of September 30, 2006 are less when compared to the projected changes in net interest income as of September 30, 2005. Projections from September 30, 2006, year one reflected a decline in net interest income of 2.0% with a 100 basis point decline compared to the 5.0% decline in 2005. The 300 basis point increase in rates reflected a 3.1% increase in net interest income in 2006 compared to 13.0% in 2005. Item 4 - CONTROLS AND PROCEDURES As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) or Rule 15d-15(e) under the Exchange Act). Based on the foregoing, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in the reports the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required. The Company also conducted an evaluation of internal control over financial reporting to determine whether any changes occurred during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. Based on this evaluation, there has been no such change during the quarter covered by this report. Part II - Other Information Item 1. Legal Proceedings The Company is not a party to any material legal proceedings. Item 1A. Risk Factors There have been no material changes in risk factors, as previously disclosed in the December 31, 2005 Form 10-K. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds ISSUER PURCHASES OF EQUITY SECURITIES Period (a) Total (b) (c) Total Number (d) Maximum Number Number of Average of Shares (or Units) (or Approximate Dollar Shares (or Price Paid Purchased as Part Value) of Shares (or Units) Per Share of Publicly Units) that May Yet Be Purchased (or Unit) Announced Plans Purchased Under the Or Programs Plans of Programs 7/1/06 - 7/31/06 1,670 $28.31 1,670 93,021 shares 8/1/06 - 8/31/06 4,241 28.98 4,241 88,780 shares 9/1/06 - 9/30/06 6,240 29.74 6,240 82,540 shares Total 12,151 12,151 82,540 shares On October 25, 2000, the Company announced that its Board of Directors approved a stock repurchase program. The Company is authorized to purchase up to 100,000 shares of its outstanding common stock. On November 11, 2002, the Board of Directors approved and authorized the Company's repurchase of an additional 100,000 shares. In August 2004, the Board of Directors approved and the Company repurchased 122,302 shares from a third-party shareholder at a price of $28 per share. These shares were outside of the previously mentioned stock repurchase programs. Shares will be purchased from time to time in the open market depending on market prices and other considerations. Through September 30, 2006, 117,460 shares have been purchased. Item 3. Defaults upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits 31.1 Certifications of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32 Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. KENTUCKY BANCSHARES, INC. Date _____11/14/06________ __/s/Louis Prichard______________ Louis Prichard, President and C.E.O. Date _____11/14/06________ __/s/Gregory J. Dawson___________ Gregory J. Dawson, Chief Financial Officer 2 3 23 Lexlibrary/197885.1