10-Q 1 l06851ae10vq.txt CITIZENS & NORTHERN 10-Q 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 three-month period ended March 31, 2004 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: 0-16084 CITIZENS & NORTHERN CORPORATION (Exact name of Registrant as specified in its charter) Pennsylvania 23-2451943 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 90-92 Main Street Wellsboro, Pa. 16901 (Address of principal executive offices) (Zip code) 570-724-3411 (Registrant's telephone number including area code) Not applicable (Former name, former address, and former fiscal year, if changed since last report) 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 an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes _X_ No___ (APPLICABLE ONLY TO CORPORATE REGISTRANTS) Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. Title Outstanding Common Stock ($1.00 par value) 8,100,267 Shares Outstanding May 5, 2004 1 CITIZENS & NORTHERN CORPORATION Index Part I. Financial Information Item 1. Financial Statements Consolidated Balance Sheet - March 31, 2004 and December 31, 2003 Page 3 Consolidated Statement of Income - Three Months Ended March 31, 2004 and 2003 Page 4 Consolidated Statement of Cash Flows - Three Months Ended March 31, 2004 and 2003 Page 5 Notes to Consolidated Financial Statements Pages 6 through 10 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Pages 10 through 24 Item 3. Quantitative and Qualitative Disclosures About Market Risk Pages 24 through 26 Item 4. Controls and Procedures Page 26 Part II. Other Information Page 27 Signatures Page 28 Exhibit 31.1. Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Chief Executive Officer Page 29 Exhibit 31.2. Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Chief Financial Officer Page 30 Exhibit 32. Certifications Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Page 31
2 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEET MARCH 31, DECEMBER 31, (In Thousands Except Share Data) 2004 2003 (UNAUDITED) (NOTE) ASSETS Cash and due from banks: Noninterest-bearing $ 13,077 $ 13,938 Interest-bearing 1,072 1,233 -------------------------------------------------------------------------------------------------------------------------------- Total cash and cash equivalents 14,149 15,171 Available-for-sale securities 526,985 483,032 Held-to-maturity securities 448 560 Loans, net 525,561 518,800 Bank-owned life insurance 17,632 17,473 Accrued interest receivable 6,167 5,632 Bank premises and equipment, net 14,397 12,482 Foreclosed assets held for sale 53 101 Other assets 15,735 13,650 -------------------------------------------------------------------------------------------------------------------------------- TOTAL ASSETS $ 1,121,127 $ 1,066,901 ================================================================================================================================ LIABILITIES Deposits: Noninterest-bearing $ 75,898 $ 75,616 Interest-bearing 575,022 582,449 -------------------------------------------------------------------------------------------------------------------------------- Total deposits 650,920 658,065 Dividends payable 1,786 1,763 Short-term borrowings 47,882 37,763 Long-term borrowings 257,184 235,190 Accrued interest and other liabilities 33,113 8,777 -------------------------------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES 990,885 941,558 -------------------------------------------------------------------------------------------------------------------------------- STOCKHOLDERS' EQUITY Common stock, par value $1.00 per share; authorized 10,000,000 shares; issued 8,307,305 in 2004 and 8,226,033 in 2003 8,307 8,226 Stock dividend distributable - 2,164 Paid-in capital 22,422 20,104 Retained earnings 86,860 84,940 -------------------------------------------------------------------------------------------------------------------------------- Total 117,589 115,434 Accumulated other comprehensive income 14,612 12,037 Unamortized stock compensation (121) (54) Treasury stock, at cost: 188,127 shares at March 31, 2004 (1,838) 211,408 shares at December 31, 2003 (2,074) -------------------------------------------------------------------------------------------------------------------------------- TOTAL STOCKHOLDERS' EQUITY 130,242 125,343 -------------------------------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 1,121,127 $ 1,066,901 ================================================================================================================================
The accompanying notes are an integral part of these consolidated financial statements. Note: The balance sheet at December 31, 2003 has been derived from the audited financial statements at that date but does not include all the information and notes required by U.S. generally accepted accounting principles for complete financial statements. 3 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q CONSOLIDATED STATEMENT OF INCOME (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
3 MONTHS ENDED MARCH 31, MARCH 31, 2004 2003 INTEREST INCOME Interest and fees on loans $ 8,235 $ 7,862 Interest on balances with depository institutions 3 2 Interest on loans to political subdivisions 214 167 Interest on federal funds sold 1 3 Income from available-for-sale and held-to-maturity securities: Taxable 3,264 3,946 Tax-exempt 1,935 1,742 Dividends 363 208 ------------------------------------------------------------------------------------------------------------------------ Total interest and dividend income 14,015 13,930 ------------------------------------------------------------------------------------------------------------------------ INTEREST EXPENSE Interest on deposits 3,343 3,916 Interest on short-term borrowings 123 142 Interest on long-term borrowings 2,237 2,185 ------------------------------------------------------------------------------------------------------------------------ Total interest expense 5,703 6,243 ------------------------------------------------------------------------------------------------------------------------ Interest margin 8,312 7,687 Provision for loan losses 350 350 ------------------------------------------------------------------------------------------------------------------------ Interest margin after provision for loan losses 7,962 7,337 ------------------------------------------------------------------------------------------------------------------------ OTHER INCOME Service charges on deposit accounts 421 409 Service charges and fees 76 69 Trust and financial management revenue 457 378 Insurance commissions, fees and premiums 109 80 Increase in cash surrender value of life insurance 159 193 Fees related to credit card operation 184 162 Other operating income 219 249 ------------------------------------------------------------------------------------------------------------------------ Total other income before realized gains on securities, net 1,625 1,540 Realized gains on securities, net 964 1,721 ------------------------------------------------------------------------------------------------------------------------ Total other income 2,589 3,261 ------------------------------------------------------------------------------------------------------------------------ OTHER EXPENSES Salaries and wages 2,671 2,448 Pensions and other employee benefits 984 864 Occupancy expense, net 377 340 Furniture and equipment expense 336 332 Pennsylvania shares tax 212 196 Other operating expense 1,648 1,352 ------------------------------------------------------------------------------------------------------------------------ Total other expenses 6,228 5,532 ------------------------------------------------------------------------------------------------------------------------ Income before income tax provision 4,323 5,066 Income tax provision 617 994 ------------------------------------------------------------------------------------------------------------------------ NET INCOME $ 3,706 $ 4,072 ======================================================================================================================== PER SHARE DATA: Net income - basic $ 0.46 $ 0.50 Net income - diluted $ 0.45 $ 0.50 ------------------------------------------------------------------------------------------------------------------------ Dividend per share $ 0.22 $ 0.21 ------------------------------------------------------------------------------------------------------------------------ Number of shares used in computation - basic 8,112,061 8,087,124 Number of shares used in computation - diluted 8,168,162 8,115,839
The accompanying notes are an integral part of these consolidated financial statements. 4 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
3 MONTHS ENDED MARCH 31, MARCH 31, 2004 2003 CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 3,706 $ 4,072 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 350 350 Realized gains on securities, net (964) (1,721) Loss (gain) on sale of foreclosed assets, net 6 (28) Depreciation expense 322 295 Accretion and amortization, net 127 313 Increase in cash surrender value of life insurance (159) (194) Amortization of restricted stock 24 26 Increase in accrued interest receivable and other assets (1,270) (962) Increase in accrued interest payable and other liabilities 936 2,137 ---------------------------------------------------------------------------------------------------- Net Cash Provided by Operating Activities 3,078 4,288 ---------------------------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from maturity of held-to-maturity securities 110 112 Proceeds from sales of available-for-sale securities 11,526 26,566 Proceeds from calls and maturities of available-for-sale securities 36,802 45,219 Purchase of available-for-sale securities (65,445) (51,780) Purchase of Federal Home Loan Bank of Pittsburgh stock (2,463) (225) Redemption of Federal Home Loan Bank of Pittsburgh stock 1,090 - Net increase in loans (7,111) (15,458) Purchase of premises and equipment (2,237) (376) Proceeds from sale of foreclosed assets 42 71 ---------------------------------------------------------------------------------------------------- Net Cash (Used in) Provided by Investing Activities (27,686) 4,129 ---------------------------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES: Net (decrease) increase in deposits (7,145) 8,053 Net increase (decrease) in short-term borrowings 10,119 (21,022) Proceeds from long-term borrowings 41,767 14,800 Repayments of long-term borrowings (19,773) (1,806) Purchase of treasury stock - (174) Sale of treasury stock 407 19 Dividends paid (1,789) (1,614) ---------------------------------------------------------------------------------------------------- Net Cash Provided by (Used in) Financing Activities 23,586 (1,744) ---------------------------------------------------------------------------------------------------- (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (1,022) 6,673 CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 15,171 14,900 ---------------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 14,149 $ 21,573 ==================================================================================================== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Accrued purchase of available-for-sale securities $ 22,096 $ - Assets acquired through foreclosure of real estate loans $ - $ 39 Interest paid $ 4,274 $ 4,960 Income taxes paid $ 150 $ 960
The accompanying notes are an integral part of these consolidated financial statements. 5 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF INTERIM PRESENTATION The financial information included herein, with the exception of the consolidated balance sheet dated December 31, 2003, is unaudited; however, such information reflects all adjustments (consisting solely of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods. Results reported for the three months ended March 31, 2004 might not be indicative of the results for the year ending December 31, 2004. This document has not been reviewed or confirmed for accuracy or relevance by the Federal Deposit Insurance Corporation or any other regulatory agency. 2. PER SHARE DATA Net income per share is based on the weighted-average number of shares of common stock outstanding. The number of shares used in calculating net income and cash dividends per share reflect the retroactive effect of stock splits and dividends for all periods presented. The following data show the amounts used in computing net income per share and the weighted average number of shares of dilutive stock options. As shown in the table that follows, diluted earnings per share is computed using weighted average common shares outstanding, plus weighted-average common shares available from the exercise of all dilutive stock options, less the number of shares that could be repurchased with the proceeds of stock option exercises based on the average share price of the Corporation's common stock during the period.
WEIGHTED- AVERAGE EARNINGS NET COMMON PER INCOME SHARES SHARE QUARTER ENDED MARCH 31, 2004 Earnings per share - basic $ 3,706,000 8,112,061 $0.46 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 198,006 Hypothetical share repurchase at $26.24 (141,905) ---------------------------------------------------------------------------------------------------- Earnings per share - diluted $ 3,706,000 8,168,162 $0.45 ==================================================================================================== QUARTER ENDED MARCH 31, 2003 Earnings per share - basic $ 4,072,000 8,087,124 $0.50 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 182,635 Hypothetical share repurchase at $20.60 (153,920) ---------------------------------------------------------------------------------------------------- Earnings per share - diluted $ 4,072,000 8,115,839 $0.50 ====================================================================================================
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q 3. STOCK COMPENSATION PLANS As permitted by Accounting Principles Board Opinion No. 25, the Corporation uses the intrinsic value method of accounting for stock compensation plans. Utilizing the intrinsic value method, compensation cost is measured by the excess of the quoted market price of the stock as of the grant date (or other measurement date) over the amount an employee or director must pay to acquire the stock. Stock options issued under the Corporation's stock option plans have no intrinsic value, and accordingly, no compensation cost is recorded for them. The Corporation has also made awards of restricted stock. Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period. The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-based Compensation," to stock options. (NET INCOME IN THOUSANDS) 3 MONTHS ENDED MARCH 31, 2004 2003 Net income, as reported $3,706 $4,072 Deduct: Total stock option compensation expense determined under fair value method for all awards, net of tax effects (49) (59) -------------------------------------------------------------------------------- Pro forma net income $3,657 $4,013 ================================================================================ Earnings per share-basic As reported $0.46 $0.50 Pro forma $0.45 $0.49 Earnings per share-diluted As reported $0.45 $0.50 Pro forma $0.45 $0.49 4. COMPREHENSIVE INCOME U.S. generally accepted accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. 7 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q The components of comprehensive income, and the related tax effects, are as follows:
QUARTERS ENDED MARCH 31, (IN THOUSANDS) 2004 2003 Net income $ 3,706 $ 4,072 Unrealized holding gains on available-for-sale securities 4,865 3,171 Less: Reclassification adjustment for gains realized in income (964) (1,721) ----------------------------------------------------------------------------------------------- Other comprehensive income before income tax 3,901 1,450 Income tax related to other comprehensive income (1,326) (493) ----------------------------------------------------------------------------------------------- Other comprehensive income 2,575 957 ----------------------------------------------------------------------------------------------- Comprehensive income $ 6,281 $ 5,029 ===============================================================================================
5. SECURITIES Amortized cost and fair value of securities at March 31, 2004 are summarized as follows:
MARCH 31, 2004 GROSS GROSS UNREALIZED UNREALIZED AMORTIZED HOLDING HOLDING FAIR (IN THOUSANDS) COST GAINS LOSSES VALUE AVAILABLE-FOR-SALE SECURITIES: Obligations of the U.S. Treasury $ - $ - $ - $ - Obligations of other U.S. Government agencies 57,184 892 (332) 57,744 Obligations of states and political subdivisions 163,071 5,672 (1,202) 167,541 Other securities 55,508 2,672 (377) 57,803 Mortgage-backed securities 199,091 2,678 (285) 201,484 ------------------------------------------------------------------------------------------------------------------------------ Total debt securities 474,854 11,914 (2,196) 484,572 Marketable equity securities 29,992 12,857 (436) 42,413 ------------------------------------------------------------------------------------------------------------------------------ Total $ 504,846 $ 24,771 $ (2,632) $ 526,985 ============================================================================================================================== HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ 318 $ 38 $ - $ 356 Obligations of other U.S. Government agencies 98 19 - 117 Mortgage-backed securities 32 2 - 34 ------------------------------------------------------------------------------------------------------------------------------ Total $ 448 $ 59 $ - $ 507 ==============================================================================================================================
8 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q The following table presents gross unrealized losses and fair value of investments aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at March 31, 2004.
(IN THOUSANDS) LESS THAN 12 MONTHS 12 MONTHS OR MORE TOTAL FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED VALUE LOSSES VALUE LOSSES VALUE LOSSES AVAILABLE-FOR-SALE SECURITIES: Obligations of the U.S. Treasury $ - $ - $ - $ - $ - $ - Obligations of other U.S. Government agencies 9,656 (332) - - 9,656 (332) Obligations of states and political subdivisions 40,354 (1,175) 1,822 (27) 42,176 (1,202) Other securities 7,207 (302) 5,025 (75) 12,232 (377) Mortgage-backed securities 47,983 (285) - - 47,983 (285) --------------------------------------------------------------------------------------------------------------------------------- Total debt securities 105,200 (2,094) 6,847 (102) 112,047 (2,196) Marketable equity securities 5,454 (369) 876 (67) 6,330 (436) --------------------------------------------------------------------------------------------------------------------------------- Total temporarily impaired available-for-sale Securities $110,654 $ (2,463) $ 7,723 $ (169) $118,377 $ (2,632) ================================================================================================================================= HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ - $ - $ - $ - $ - $ - Obligations of other U.S. Government agencies - - - - - - Mortgage-backed securities - - - - - - --------------------------------------------------------------------------------------------------------------------------------- Total temporarily impaired held-to-maturity Securities $ - $ - $ - $ - $ - $ - =================================================================================================================================
The unrealized losses on debt securities are primarily the result of volatility in interest rates. Based on the credit worthiness of the issuers, which are almost exclusively U.S. Government agencies or state and political subdivisions, management believes the Corporation's debt securities at March 31, 2004 were not other-than-temporarily impaired. Of the total $436,000 unrealized losses on equity securities at March 31, 2004, $285,000 was from a preferred stock issued by an U.S. Government agency. Management believes this security's fair value is affected primarily by volatility in interest rates, and that there is very little credit risk associated with this security. For the remaining equity securities for which fair value was less than cost at March 31, 2004, management believes the financial condition and near-term prospects of those issuers indicate those securities were not other-than-temporarily impaired. 6. DEFINED BENEFIT PLANS The Corporation has a noncontributory defined benefit pension plan for all employees meeting certain age and length of service requirements. Benefits are based primarily on years of service and the average annual compensation during the highest five consecutive years within the final ten years of employment. Also, the Corporation sponsors a defined benefit health care plan that provides postretirement medical benefits and life insurance to employees who meet certain age and length of service requirements. This plan contains a cost-sharing feature, which causes participants to pay for all future increases in costs related to benefit coverage. Accordingly, actuarial assumptions related to health care cost trend rates do not affect the liability balance and will not affect the Corporation's future expenses. The Corporation uses a December 31 measurement date for its plans. 9 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q The components of net periodic benefit costs from these defined benefit plans are as follows: (IN THOUSANDS)
PENSION POSTRETIREMENT BENEFITS BENEFITS 3 MONTHS ENDED 3 MONTHS ENDED MARCH 31, MARCH 31, 2004 2003 2004 2003 Service cost $ 119 $ 99 $ 11 $ 8 Interest cost 155 148 16 15 Expected return on plan assets (187) (154) - - Amortization of transition (asset) obligation (6) (6) 9 9 Recognized net actuarial loss 16 22 1 - ------------------------------------------------------------------------------------------------- Net periodic benefit cost $ 97 $ 109 $ 37 $ 32 =================================================================================================
The Corporation funded its total defined benefit pension contribution for 2004 of $328,000 in April 2004. In the first quarter 2004, the Corporation funded postretirement contributions totaling $13,000. The estimated total (annual) amount of 2004 postretirement contributions is $60,000. 7. CONTINGENCIES In the normal course of business, the Corporation may be subject to pending and threatened lawsuits in which claims for monetary damages could be asserted. In management's opinion, the Corporation's financial position and results of operations would not be materially affected by the outcome of such pending legal proceedings. CITIZENS & NORTHERN CORPORATION - FORM 10 - Q PART I - FINANCIAL INFORMATION (CONTINUED) ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain statements in this section and elsewhere in Form 10-Q are forward-looking statements. Citizens & Northern Corporation and its wholly-owned subsidiaries (collectively, the Corporation) intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995. Forward-looking statements, which are not historical facts, are based on certain assumptions and describe future plans, business objectives and expectations, and are generally identifiable by the use of words such as, "believe", "expect", "intend", "anticipate", "estimate", "project", and similar expressions. These forward-looking statements are subject to risks and uncertainties that are difficult to predict, may be beyond management's control and could cause results to differ materially from those currently anticipated. Factors which could have a material adverse impact on the operations and future prospects of the Corporation include, but are not limited to, the following: - changes in monetary and fiscal policies of the Federal Reserve Board and the U. S. Government, particularly related to changes in interest rates - changes in general economic conditions - legislative or regulatory changes - downturn in demand for loan, deposit and other financial services in the Corporation's market area - increased competition from other banks and non-bank providers of financial services - technological changes and increased technology-related costs - changes in accounting principles, or the application of generally accepted accounting principles. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. 10 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q REFERENCES TO 2004 AND 2003 Unless otherwise noted, all references to "2004" in the following discussion of operating results are intended to mean the three months ended March 31, 2004, and similarly, references to "2003" are intended to mean the three months ended March 31, 2003. EARNINGS OVERVIEW Net income in 2004 was $3,706,000, or $.46 per share - basic and $.45 per share - diluted. This represents a decrease of 9.0% in net income compared to 2003. Return on average assets was 1.38% in 2004, down from 1.62% in 2003. Return on average equity decreased to 11.45% in 2004 from 13.83% in 2003. The most significant income statement changes between 2004 and 2003 were as follows: - Net realized gains on securities were $964,000 in 2004, compared to $1,721,000 in 2003. In both years, the gains were mainly from sales of bank stocks. These sales resulted from circumstances specific to each underlying company, and the proceeds have been reinvested in other bank stocks. Total gains from sales of bank stocks amounted to $926,000 in 2004 and $1,286,000 in 2003. - Other (noninterest) expenses increased $696,000, or 12.6%, in 2004 compared to 2003. The increase reflects increases in payroll costs and employee benefits, and other expenses. Increases in other expenses are described in more detail in the "Noninterest Expense" section of Management's Discussion and Analysis. - The interest margin increased $625,000, or 8.1%, to $8,312,000 in 2004 from $7,687,000 in 2003. The Corporation has experienced significant growth in loans, and has identified opportunities to borrow funds and invest the proceeds in securities at positive spreads. Also, average interest rates on deposits and borrowed funds have been lower in 2004. Changes in the net interest margin are discussed in more detail later in Management's Discussion and Analysis. - The income tax provision decreased to $617,000 in the first quarter of 2004 from $994,000 in the first quarter of 2003. The Corporation's effective tax rate fell to 14.3% in 2004 from 19.6% in 2003. This lower effective tax rate resulted mainly from lower pre-tax income and management's decision to increase the weighting of tax-exempt obligations of states and political subdivisions, as a percentage of total assets. TABLE I - QUARTERLY FINANCIAL DATA (IN THOUSANDS)
MAR. 31, DEC. 31, SEPT. 30, JUNE 30, MAR. 31, 2004 2003 2003 2003 2003 Interest income $14,015 $13,797 $13,553 $13,943 $13,930 Interest expense 5,703 5,550 5,655 6,089 6,243 ----------------------------------------------------------------------------------------------------------------- Interest margin 8,312 8,247 7,898 7,854 7,687 Provision for loan losses 350 250 250 250 350 ----------------------------------------------------------------------------------------------------------------- Interest margin after provision for loan losses 7,962 7,997 7,648 7,604 7,337 Other income 1,625 1,722 1,705 1,628 1,540 Securities gains 964 1,510 660 908 1,721 Other expenses 6,228 5,890 5,336 5,356 5,532 ----------------------------------------------------------------------------------------------------------------- Income before income tax provision 4,323 5,339 4,677 4,784 5,066 Income tax provision 617 992 759 864 994 ----------------------------------------------------------------------------------------------------------------- Net income $ 3,706 $ 4,347 $ 3,918 $ 3,920 $ 4,072 ================================================================================================================= Net income per share - basic $ 0.46 $ 0.54 $ 0.48 $ 0.48 $ 0.50 ================================================================================================================= Net income per share - diluted $ 0.45 $ 0.53 $ 0.48 $ 0.48 $ 0.50 =================================================================================================================
The number of shares used in calculating net income per share for each quarter presented in Table I reflects the retroactive effect of stock splits and dividends. 11 PROSPECTS FOR THE REMAINDER OF 2004 Overall, management expects financial results for the remainder of 2004 to be relatively comparable to 2003. Loan growth is expected to continue, although perhaps not at the +15% pace enjoyed for the last three years. As you can see in Table I, the interest margin has grown slightly in each of the last 5 quarters, to $8,312,000 in the first quarter of 2004 from $7,687,000 in the 1st quarter 2003. Recently, interest rates have risen quite rapidly. As of April 27, 2004, for example, closing yields on U.S. Treasury Bonds with terms of 2, 3, 5, and 10 years had all risen 50 basis points or more from their levels one month earlier. Management anticipates continued rising rates over much of 2004, including increases in short-term rates in the last half of the year. The impact of rising rates would likely be a slight "squeeze" on the net interest margin, as (on average) deposits and borrowings would be expected to reprice slightly faster than loans and debt securities. The Corporation's interest rate risk is discussed in more detail in Item 3 of Form 10-Q. The other major variable that could affect 2004 earnings is securities gains and losses. The Corporation's management makes decisions regarding the sales of securities based on a variety of factors, with an overall goal of maximizing portfolio return over a long-term horizon. Therefore, it is difficult to predict, with any degree of precision, the amounts of securities gains and losses that may be realized over the remainder of 2004. Total capital purchases for 2004 are estimated to range from $5 million to $8 million. Included in this amount are estimated costs related to two significant projects that are currently in progress: (1) renovation of the facility on Market Street in Williamsport, and (2) implementation of a new core banking computer system. Trust and Financial Management, Commercial Lending and a few other personnel moved into the Williamsport facility in February 2004, and the branch is expected to open before the end of the second quarter 2004. Total capitalized costs incurred related to the Williamsport renovation through March 31, 2004 amounted to $2,238,000 with estimated additional cost to be incurred on the project of $300,000. In March 2004, management selected a new core processing system from Open Solutions, Inc., and made a substantial initial payment of almost $1.5 million. Management expects the core system to be completed by year-end 2004 at a total capitalized cost of approximately $2.5 million. Although the amount of capital spending expected for 2004 is high by the Corporation's normal historical standards, it is not expected to have a material, adverse impact on the Corporation's financial position or results of operations in 2004. CRITICAL ACCOUNTING POLICIES The presentation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates. A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses. Management believes that the allowance for loan losses is adequate and reasonable. The Corporation's methodology for determining the allowance for loan losses is described in a separate section later in Management's Discussion and Analysis. Given the very subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions, and could, therefore, calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination. Another material estimate is the calculation of fair values of the Corporation's debt securities. The Corporation receives estimated fair values of debt securities from an independent valuation service, or from brokers. In developing these fair values, the valuation service and the brokers use estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments. Based on experience, management is aware that estimated fair values of debt securities tend to vary among brokers and other valuation services. Accordingly, when selling debt securities, management typically obtains price quotes from more than one source. The large majority of the Corporation's securities are classified as available-for-sale. Accordingly, these securities are carried at fair value on the consolidated balance sheet, with unrealized gains and losses excluded from earnings and reported separately through accumulated other comprehensive income (included in stockholders' equity). 12 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q NET INTEREST MARGIN The Corporation's primary source of operating income is represented by the net interest margin. The net interest margin is equal to the difference between the amounts of interest income and interest expense. Tables II, III and IV include information regarding the Corporation's net interest margin for 2004 and 2003. In each of these tables, the amounts of interest income earned on tax-exempt securities and loans have been adjusted to a fully taxable-equivalent basis. Accordingly, the net interest margin amounts reflected in these tables exceed the amounts presented in the consolidated financial statements. The discussion that follows is based on amounts in the Tables. The net interest margin, on a tax-equivalent basis, was $9,321,000 in 2004, an increase of $746,000, or 8.7%, over 2003. As reflected in Table IV, the increase in net interest margin was caused by the growth in volume. Increased interest income from higher volumes of earning assets exceeded increases in interest expense attributable to higher volumes of interest-bearing liabilities by $837,000 in the first quarter 2004 compared to the first quarter 2003. Table IV also shows that interest rate changes had the effect of decreasing net interest income $91,000 in 2004 as compared to 2003. As presented in Table III, the "Interest Rate Spread" (excess of average rate of return on interest-bearing assets over average cost of funds on interest-bearing liabilities) was 3.39% for the first quarter 2004, compared to 3.31% for the year ended December 31, 2003 and 3.30% for the first quarter 2003. INTEREST INCOME AND EARNING ASSETS Interest income increased 1.3% to $15,024,000 in 2004 from $14,818,000 in 2003. Income from available-for-sale securities decreased $233,000, or 3.5%, while interest from loans increased $443,000 or 5.5%. Overall, the majority of the increase in interest income resulted from higher volumes of loans, which more than offset the effect of lower interest rates. As indicated in Table III, average available-for-sale securities in the first quarter 2004 amounted to $467,945,000, a decrease of 2.0% from the first quarter 2003. The average rate of return on available-for-sale securities was 5.56% for first quarter 2004, lower than the 5.69% level in the first quarter 2003, but higher than the rate of return for the year ended December 31, 2003 of 5.43%. Table III also shows changes in the composition of the available-for-sale securities portfolio. The average balance of mortgage-backed securities dropped to $171,334,000 in the first quarter 2004 from $194,678,000 in the first quarter 2003. The rapidly falling interest rate environment during most of the second and third quarters of 2003 led to very high amounts of prepayments on mortgage-backed securities. Municipal bonds were a larger portion of the portfolio in the first quarter 2004 than in the first quarter 2003. The average balance of municipal bonds grew to $160,624,000, or 34% of the portfolio, in the first quarter 2004 from $133,468,000, or 28% of the portfolio, in the first 3 months of 2003. On a taxable equivalent basis, municipal bonds are the highest yielding category of available-for-sale security. The Corporation determines the levels of its municipal bond holdings based on income tax planning and other considerations. Other securities consist of corporate obligations, mainly "Trust Preferred Securities" issued by financial institutions, and Collateralized Mortgage Obligations (CMOs). Trust Preferred Securities are long-term obligations (usually 20-40 year maturities, often callable at the issuer's option after 5-10 years) which bear interest at fixed or variable rates. The average balance of other securities decreased to $47,265,000 in the first quarter 2004 from $60,702,000 for the first 3 months of 2003, primarily as a result of principal payments received on CMOs. The average balance of gross loans increased 15.4% in the first quarter 2004 over the first 3 months of 2003, to $529,155,000 from $458,392,000. The largest area of growth was real estate secured loans, with substantial increases in both residential and commercial mortgages. The average rate of return on loans fell to 6.50% in the first quarter 2004 from 7.17% in the first 3 months of 2003, due to lower market rates. 13 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES Interest expense fell $540,000, or 8.6%, to $5,703,000 in 2004 from $6,243,000 in 2003. Overall, the impact to interest expense of lower interest rates was more than twice the impact of higher volumes of interest-bearing liabilities. In Table IV, you can see the impact of lower interest rates on the Corporation's major categories of interest-bearing deposits - principally, CDs and money market accounts. In contrast, interest expense on Individual Retirement Accounts (IRAs) increased $126,000. The Corporation's 18-month "Passbook" IRA rate (which pays interest at a variable rate, re-set at the beginning of each calendar quarter) changed from 5% to 3.5% on the majority of IRA s, effective for the second quarter 2004. The change in IRA rate will reduce interest expense approximately $350,000 in the second quarter 2004 as compared to the first quarter 2004. As you can calculate from Table III, total average deposits (interest-bearing and noninterest-bearing) increased to $652,398,000 in the first three months of 2004 from $640,500,000 in the first three months of 2003. This represents an increase of 1.9%. Of the increase in average deposits, the largest growth categories were demand deposits of $9,116,000, or 13.9% and IRA's of $12,732,000, or 12.5%. Average Certificates of Deposit fell 7.0% to $182,735,000 in 2004 from $196,532,000 in 2003. Overall, deposit growth has been very low in recent months. Management believes the return to positive U.S. stock market performance in 2003 has motivated some customers to move funds out of the Bank to mutual funds and other equity securities. Also, deposits from a few of the Corporation's Municipal and not-for-profit customers have fallen over the last several months due to the customers' use of the funds for building projects. Table III reflects the downward trend in interest rates incurred on liabilities, as the overall cost of funds on interest-bearing liabilities fell to 2.66% for the first quarter 2004, from 2.84% for the year ended December 31, 2003 and 3.10% for the first quarter 2003. Average total short-term and long-term borrowed funds increased $42,985,000 to $285,127,000 in the first quarter 2004 from $242,142,000 in the first quarter 2003. The Corporation has utilized borrowings to fund security purchases and to help fund loan growth during this period of low deposit growth. 14 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE II - ANALYSIS OF INTEREST INCOME AND EXPENSE
THREE MONTHS ENDED MARCH 31, INCREASE/ (IN THOUSANDS) 2004 2003 (DECREASE) INTEREST INCOME Available-for-sale securities: U.S. Treasury securities $ - $ - $ - Securities of other U.S. Government agencies and corporations 675 796 (121) Mortgage-backed securities 1,863 2,272 (409) Obligations of states and political subdivisions 2,844 2,553 291 Equity securities 363 208 155 Other securities 719 868 (149) ----------------------------------------------------------------------------------------------------------- Total available-for-sale securities 6,464 6,697 (233) ----------------------------------------------------------------------------------------------------------- Held-to-maturity securities: U.S. Treasury securities 4 4 - Securities of other U.S. Government agencies and corporations 2 5 (3) Mortgage-backed securities 1 1 - ----------------------------------------------------------------------------------------------------------- Total held-to-maturity securities 7 10 (3) ----------------------------------------------------------------------------------------------------------- Interest-bearing due from banks 3 2 1 Federal funds sold 1 3 (2) Loans: Real estate loans 7,053 6,555 498 Consumer 614 737 (123) Agricultural 47 49 (2) Commercial/industrial 511 502 9 Other 9 17 (8) Political subdivisions 314 244 70 Leases 1 2 (1) ----------------------------------------------------------------------------------------------------------- Total loans 8,549 8,106 443 ----------------------------------------------------------------------------------------------------------- Total Interest Income 15,024 14,818 206 ----------------------------------------------------------------------------------------------------------- INTEREST EXPENSE Interest checking 57 75 (18) Money market 575 799 (224) Savings 68 127 (59) Certificates of deposit 1,270 1,668 (398) Individual Retirement Accounts 1,371 1,245 126 Other time deposits 2 2 - Federal funds purchased 29 15 14 Other borrowed funds 2,331 2,312 19 ----------------------------------------------------------------------------------------------------------- Total Interest Expense 5,703 6,243 (540) ----------------------------------------------------------------------------------------------------------- Net Interest Income $ 9,321 $ 8,575 $ 746 ===========================================================================================================
Note: Interest income from tax-exempt securities and loans has been adjusted to a fully tax-equivalent basis, using the Corporation's marginal federal income tax rate of 34%. 15 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE III - ANALYSIS OF AVERAGE DAILY BALANCES AND RATES
(DOLLARS IN THOUSANDS) 3 MONTHS YEAR 3 MONTHS ENDED RATE OF ENDED RATE OF ENDED RATE OF 3/31/2004 RETURN/ 12/31/2003 RETURN/ 3/31/2003 RETURN/ AVERAGE COST OF AVERAGE COST OF AVERAGE COST OF BALANCE FUNDS% BALANCE FUNDS% BALANCE FUNDS% EARNING ASSETS Available-for-sale securities, at amortized cost: U.S. Treasury securities $ - 0.00% $ - 0.00% $ - 0.00% Securities of other U.S. Government agencies and corporations 58,733 4.62% 67,218 4.72% 63,936 5.05% Mortgage-backed securities 171,334 4.37% 176,800 4.20% 194,678 4.73% Obligations of states and political subdivisions 160,624 7.12% 146,371 7.36% 133,468 7.76% Equity securities 29,989 4.87% 28,084 4.16% 24,937 3.38% Other securities 47,265 6.12% 52,980 5.76% 60,702 5.80% ---------------------------------------------------------------------------------------------------------------------------------- Total available-for-sale securities 467,945 5.56% 471,453 5.43% 477,721 5.69% ---------------------------------------------------------------------------------------------------------------------------------- Held-to-maturity securities: U.S. Treasury securities 318 5.06% 320 5.31% 321 5.05% Securities of other U.S. Government agencies and corporations 148 5.44% 220 5.00% 272 7.46% Mortgage-backed securities 38 10.58% 64 4.69% 82 4.95% ---------------------------------------------------------------------------------------------------------------------------------- Total held-to-maturity securities 504 5.59% 604 5.13% 675 6.01% ---------------------------------------------------------------------------------------------------------------------------------- Interest-bearing due from banks 965 1.25% 1,669 0.60% 1,849 0.44% Federal funds sold 357 1.13% 680 1.18% 982 1.24% Loans: Real estate loans 438,034 6.48% 399,353 6.79% 375,802 7.07% Consumer 33,436 7.39% 32,386 8.75% 32,471 9.20% Agricultural 2,933 6.45% 2,924 6.81% 2,782 7.14% Commercial/industrial 35,405 5.80% 32,909 6.15% 32,030 6.36% Other 608 5.95% 851 6.58% 1,056 6.53% Political subdivisions 18,674 6.76% 16,649 6.87% 14,159 6.99% Leases 65 6.19% 78 6.41% 92 8.82% ---------------------------------------------------------------------------------------------------------------------------------- Total loans 529,155 6.50% 485,150 6.88% 458,392 7.17% ---------------------------------------------------------------------------------------------------------------------------------- Total Earning Assets 998,926 6.05% 959,556 6.15% 939,619 6.40% Cash 13,268 13,583 12,398 Unrealized gain/loss on securities 21,693 20,296 19,271 Allowance for loan losses (6,166) (5,908) (5,864) Bank premises and equipment 12,805 11,090 10,444 Other assets 36,835 36,103 31,541 ----------------------------------------------------------------------------------------------------------------------- Total Assets $1,077,361 $1,034,720 $1,007,409 ======================================================================================================================= INTEREST-BEARING LIABILITIES Interest checking $37,934 0.60% $37,647 0.71% $35,707 0.85% Money market 186,375 1.24% 190,161 1.43% 187,697 1.73% Savings 54,997 0.50% 54,789 0.78% 51,633 1.00% Certificates of deposit 182,735 2.80% 190,019 3.14% 196,532 3.44% Individual Retirement Accounts 114,686 4.81% 106,216 4.88% 101,954 4.95% Other time deposits 1,057 0.76% 1,666 1.02% 1,479 0.55% Federal funds purchased 9,614 1.21% 7,033 1.29% 4,229 1.44% Other borrowed funds 275,513 3.40% 242,358 3.67% 237,913 3.94% ---------------------------------------------------------------------------------------------------------------------------------- Total Interest-bearing Liabilities 862,911 2.66% 829,889 2.84% 817,144 3.10% Demand deposits 74,614 70,528 65,498 Other liabilities 10,396 12,032 6,965 ---------------------------------------------------------------------------------------------------------------------------------- Total Liabilities 947,921 912,449 889,607 ---------------------------------------------------------------------------------------------------------------------------------- Stockholders' equity, excluding other comprehensive income/loss 115,123 108,876 105,055 Other comprehensive income/loss 14,317 13,395 12,747 ---------------------------------------------------------------------------------------------------------------------------------- Total Stockholders' Equity 129,440 122,271 117,802 ---------------------------------------------------------------------------------------------------------------------------------- Total Liabilities and Stockholders' Equity $1,077,361 $1,034,720 $1,007,409 ================================================================================================================================== Interest Rate Spread 3.39% 3.31% 3.30% Net Interest Income/Earning Assets 3.75% 3.70% 3.70%
(1) Rates of return on tax-exempt securities and loans are presented on a fully taxable-equivalent basis. (2) Nonaccrual loans have been included with loans for the purpose of analyzing net interest earnings. 16 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE IV - ANALYSIS OF VOLUME AND RATE CHANGES
(IN THOUSANDS) YTD ENDED 3/31/04 VS. 3/31/03 CHANGE IN CHANGE IN TOTAL VOLUME RATE CHANGE EARNING ASSETS Available-for-sale securities: U.S. Treasury securities $ -- $ -- $ -- Securities of other U.S. Government agencies and corporations (59) (62) (121) Mortgage-backed securities (251) (158) (409) Obligations of states and political subdivisions 508 (217) 291 Equity securities 49 106 155 Other securities (196) 47 (149) ---------------------------------------------------------------------------------------------- Total available-for-sale securities 51 (284) (233) ---------------------------------------------------------------------------------------------- Held-to-maturity securities: U.S. Treasury securities -- -- -- Securities of other U.S. Government agencies and corporations (2) (1) (3) Mortgage-backed securities (1) 1 -- ---------------------------------------------------------------------------------------------- Total held-to-maturity securities (3) -- (3) ---------------------------------------------------------------------------------------------- Interest-bearing due from banks (1) 2 1 Federal funds sold (2) -- (2) Loans: Real estate loans 1,070 (572) 498 Consumer 22 (145) (123) Agricultural 3 (5) (2) Commercial/industrial 53 (44) 9 Other (6) (2) (8) Political subdivisions 78 (8) 70 Leases (1) -- (1) ---------------------------------------------------------------------------------------------- Total loans 1,219 (776) 443 ---------------------------------------------------------------------------------------------- Total Interest Income 1,264 (1,058) 206 ---------------------------------------------------------------------------------------------- INTEREST-BEARING LIABILITIES Interest checking 5 (23) (18) Money market (6) (218) (224) Savings 8 (67) (59) Certificates of deposit (108) (290) (398) Individual Retirement Accounts 162 (36) 126 Other time deposits (1) 1 -- Federal funds purchased 16 (2) 14 Other borrowed funds 351 (332) 19 ---------------------------------------------------------------------------------------------- Total Interest Expense 427 (967) (540) ---------------------------------------------------------------------------------------------- Net Interest Income $ 837 $ (91) $ 746 ==============================================================================================
(1) Changes in income on tax-exempt securities and loans is presented on a fully taxable-equivalent basis, using the Corporation's marginal federal income tax rate of 34%. (2) The change in interest due to both volume and rates has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amount of the change in each. 17 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE V - COMPARISON OF NONINTEREST INCOME
(IN THOUSANDS) 3 MONTHS ENDED MARCH 31, MARCH 31, 2004 2003 Service charges on deposit accounts $ 421 $ 409 Service charges and fees 76 69 Trust and financial management revenue 457 378 Insurance commissions, fees and premiums 109 80 Increase in cash surrender value of life insurance 159 193 Fees related to credit card operation 184 162 Other operating income 219 249 -------------------------------------------------------------------------- Total other operating income, before realized gains on securities, net 1,625 1,540 Realized gains on securities, net 964 1,721 -------------------------------------------------------------------------- Total Other Income $2,589 $3,261 ==========================================================================
Total noninterest income decreased $672,000, or 20.6%, in 2004 compared to 2003. The most significant change - the decrease in net realized security gains - is discussed in the "Earnings Overview" section of Management's Discussion and Analysis. Other items of significance are as follows: - Trust and financial management revenue increased $79,000, or 20.9%, for 2004 versus 2003. Trust and financial management revenue is affected significantly by the market value of assets under management. As of March 31, 2004, the value of trust assets under management amounted to $353,762,000, an increase of $75,214,000 or 27.0% from $278,548,000 as of March 31, 2003. - Insurance commissions and fees rose $29,000, or 36.3%, for 2004 compared to 2003. The increase in insurance-related revenues had 2 components: (1) an increase in the revenues of $20,000 from Bucktail Life Insurance Company ("Bucktail"), a subsidiary of the Corporation that reinsures credit and mortgage life and accident and health insurance, and (2) an increase in revenues of $9,000 from the insurance division of C & N Financial Services Corporation ("C&NFSC"). C&NFSC, a subsidiary or Citizens & Northern Bank, began its insurance agency operations in 2002, with limited activity to date. C&NFSC insurance revenues amounted to $39,000 in 2004 and $30,000 in 2003. Management continues to explore opportunities to expand insurance related revenues. - Credit card fee income has increased mainly due to the formation of a "Reward Card Program" which pays users a rebate for using their credit card. This program was started in April 2003 and has had the desired effect of raising card usage. This, along with an increased rate on interchange fees, has raised overall credit card fees 13.6%. - The increase in cash surrender value of life insurance fell $34,000 to $159,000 in 2004 from $193,000 for 2003. The Corporation's policy return is determined, in part, by the earnings generated from a pooled separate investment trust held by the life insurance company. In 2004, the earnings on that pooled separate trust fund have been lower than in 2003, which is reflective of lower market yields on debt securities. 18 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE VI- COMPARISON OF NONINTEREST EXPENSE (IN THOUSANDS)
3 MONTHS ENDED MARCH 31, MARCH 31, 2004 2003 Salaries and wages $ 2,671 $ 2,448 Pensions and other employee benefits 984 864 Occupancy expense, net 377 340 Furniture and equipment expense 336 332 Pennsylvania shares tax 212 196 Other operating expense 1,648 1,352 --------------------------------------------------------------------------------------------------- Total Other Expense $ 6,228 $ 5,532 ===================================================================================================
Salaries and wages increased $223,000, or 9.1%, for 2004 compared to 2003. The increase is the result of annual merit raises generally ranging from 2%-5% and an increase in the number of employees. The number of full-time equivalent employees increased 10.6% to 293 as of March 31, 2004 from 265 as of March 31, 2003. Pensions and other employee benefits increased $120,000, or 13.9%, in 2004 over 2003. The largest expense increases within this category were increases of $32,000 in Savings & Retirement (401(k)) expense, $27,000 in health insurance expense and $18,000 in unemployment compensation expense. In addition to the impact of more employees and a higher salary base, health care and unemployment rates were higher in 2004 than in 2003. Occupancy Expense rose $37,000, or 10.9%, in 2004 compared to 2003. The majority of this increase is directly related to the general overall increase in utility rates, coupled with the addition of the Williamsport facility. Light, fuel and water rose $24,000, or 33.7%, in 2004 over 2003. Other Operating Expense increased $296,000 or 21.9% in 2004 compared to 2003. Overall, the increase in Other Operating Expense resulted from higher volumes of loans and other transactions, start-up of the Williamsport facility and other activities that have resulted in more expenses incidental to personnel and technology. The largest increases in expenses within this category were as follows: - Expenses related to Bucktail, $45,000 - Telephone services, $42,000 - Office supplies, $31,000 - Postage, $21,000 - PC software, $17,000 - Employee tuition and education, $16,000. FINANCIAL CONDITION Significant changes in the average balances of the Corporation's earning assets and interest-bearing liabilities are described in the "Net Interest Margin" section of Management's Discussion and Analysis. The allowance for loan losses and stockholders' equity are discussed in separate sections of Management's Discussion and Analysis. The following are significant changes in the Corporation's consolidated balance sheet as of March 31, 2004 compared to December 31, 2003, other than the items addressed in those discussions: - As reflected in the consolidated balance sheet, the carrying value of available-for-sale securities rose to $526,985,000 at March 31, 2004 from $483,032,000 at December 31, 2003. Much of the increase is in mortgage-backed securities. Management has identified investment opportunities and entered into long-term repurchase agreements to fund them. - Also reflected in the consolidated balance sheet, accrued interest and other liabilities rose to $33,113,000 at March 31, 2004 from $8,777,000 at December 31, 2003, an increase of $24,336,000. A major portion of this increase, $22,096,000, is attributable to an accrued purchase of mortgage-backed securities, which settled early in the second quarter. 19 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q PROVISION AND ALLOWANCE FOR LOAN LOSSES The allowance for loan losses includes two components, allocated and unallocated. The allocated component of the allowance for loan losses reflects probable losses resulting from the analysis of individual loans and historical loss experience, as modified for identified trends and concerns, for each loan category. The historical loan loss experience element is determined based on the ratio of net charge-offs to average loan balances over a five-year period, for each significant type of loan, modified for risk adjustment factors identified by management for each type of loan. The charge-off ratio, as modified, is then applied to the current outstanding loan balance for each type of loan (net of other loans that are individually evaluated). The unallocated portion of the allowance is determined based on management's assessment of general economic conditions as well as specific economic factors in the market area. This determination inherently involves a higher degree of uncertainty and considers current risk factors that may not have yet manifested themselves in the Bank's historical loss factors used to determine the allocated component of the allowance, and it recognizes that management's knowledge of specific losses within the portfolio may be incomplete. The allowance for loan losses was $6,370,000 at March 31, 2004, an increase of $273,000 from the balance at December 31, 2003. As you can see in Table VII, net charge-offs were relatively low by historical standards during the first quarter 2004, totaling $77,000. The provision for loan losses was $350,000 in the first quarters of 2004 and 2003. The amount of the provision in each period is determined based on the amount required to maintain an appropriate allowance in light of the factors described above. Table VIII presents a summary of the allocated allowance by loan type, as well as the unallocated portion of the allowance. The allowance for impaired loans increased $125,000, to $1,667,000 at March 31, 2004 from $1,542,000 at December 31, 2003. Table VIII also shows an increase in the unallocated portion of the allowance of $121,000, to $2,238,000 at March 31, 2004 from $2,117,000 at December 31, 2003. Table IX presents information concerning past due and impaired loans. Total impaired loans increased substantially, to $8,722,000 as of March 31, 2004 from $4,621,000 at December 31, 2003. Table IX also shows that total loans past due more than 90 days and still accruing interest increased to $5,591,000 at March 31, 2004 from $2,546,000 at December 31, 2003. These increases resulted mainly from one commercial loan relationship, with total outstanding loan balances of approximately $3.8 million as of March 31, 2004. Currently, management estimates that payment in full will be received on these loans, including principal and all interest that has been accrued. Accordingly, the Corporation's allowance calculations reflect no estimated loss as of March 31, 2004, and the relationship has not been moved into nonaccrual status. Management continues to closely monitor this situation, and will adjust its estimates of loss and decision concerning nonaccrual status, if appropriate. Tables VII, VII, IX and X present an analysis of the allowance for loan losses, the allocation of the allowance, information concerning impaired and past due loans and a five-year summary of loans by type. 20 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE VII- ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
(IN THOUSANDS) QUARTER QUARTER YEARS ENDED DECEMBER 31, ENDED ENDED MARCH 31, MARCH 31, 2004 2003 2003 2002 2001 2000 1999 Balance, beginning of year $ 6,097 $ 5,789 $ 5,789 $ 5,265 $ 5,291 $ 5,131 $ 4,820 ------------------------------------------------------------------------------------------------------------------------ Charge-offs: Real estate loans 20 57 168 123 144 272 81 Installment loans 27 187 326 116 138 77 138 Credit cards and related plans 50 48 171 190 200 214 192 Commercial and other loans - 183 303 123 231 53 219 ------------------------------------------------------------------------------------------------------------------------ Total charge-offs 97 475 968 552 713 616 630 ------------------------------------------------------------------------------------------------------------------------ Recoveries: Real estate loans 2 15 75 30 6 26 81 Installment loans 7 4 52 30 27 23 60 Credit cards and related plans 7 7 17 18 20 28 30 Commercial and other loans 4 3 32 58 34 23 10 ------------------------------------------------------------------------------------------------------------------------ Total recoveries 20 29 176 136 87 100 181 ------------------------------------------------------------------------------------------------------------------------ Net charge-offs 77 446 792 416 626 516 449 Provision for loan losses 350 350 1,100 940 600 676 760 ------------------------------------------------------------------------------------------------------------------------ Balance, end of year $ 6,370 $ 5,693 $ 6,097 $ 5,789 $ 5,265 $ 5,291 $ 5,131 ========================================================================================================================
TABLE VIII - ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES BY TYPE (IN THOUSANDS)
AS OF MARCH 31, AS OF DECEMBER 31, 2004 2003 2002 2001 2000 1999 Commercial $ 1,606 $ 1,578 $ 1,315 $ 852 $ 441 $ 2,081 Consumer mortgage 460 456 460 188 187 834 Impaired loans 1,667 1,542 1,877 1,736 2,393 609 Consumer 399 404 378 302 287 437 All other commitments - - - - - 150 Unallocated 2,238 2,117 1,759 2,187 1,983 1,020 -------------------------------------------------------------------------------------------------------------- Total Allowance $ 6,370 $ 6,097 $ 5,789 $ 5,265 $ 5,291 $ 5,131 ==============================================================================================================
TABLE IX - PAST DUE AND IMPAIRED LOANS (IN THOUSANDS) MARCH 31, DEC. 31, 2004 2003 Impaired loans without a valuation allowance $ 3,861 $ 114 Impaired loans with a valuation allowance 4,861 4,507 ------------------------------------------------------------------------------------- Total impaired loans $ 8,722 $ 4,621 ===================================================================================== Valuation allowance related to impaired loans $ 1,667 $ 1,542 Total nonaccrual loans $ 1,359 $ 1,145 Total loans past due 90 days or more and still accruing $ 5,591 $ 2,546
21 TABLE X - SUMMARY OF LOANS BY TYPE (IN THOUSANDS)
AS OF MARCH 31, AS OF DECEMBER 31, 2004 2003 2002 2001 2000 1999 Real estate - construction $ 4,061 $ 2,856 $ 103 $ 1,814 $ 452 $ 649 Real estate - mortgage 437,494 431,047 370,453 306,264 263,325 247,604 Consumer 33,647 33,977 31,532 29,284 28,141 29,140 Agricultural 2,832 2,948 3,024 2,344 1,983 1,899 Commercial 34,145 34,967 30,874 24,696 20,776 18,050 Other 1,914 1,183 2,001 1,195 948 1,025 Political subdivisions 17,773 17,854 13,062 13,479 12,462 12,332 Lease receivables 65 65 96 152 218 222 ------------------------------------------------------------------------------------------------------------------- Total 531,931 524,897 451,145 379,228 328,305 310,921 Less: unearned discount -- -- -- -- -- (29) ------------------------------------------------------------------------------------------------------------------- 531,931 524,897 451,145 379,228 328,305 310,892 Less: allowance for loan Losses (6,370) (6,097) (5,789) (5,265) (5,291) (5,131) ------------------------------------------------------------------------------------------------------------------- Loans, net $ 525,561 $ 518,800 $ 445,356 $ 373,963 $ 323,014 $ 305,761 ===================================================================================================================
DERIVATIVE FINANCIAL INSTRUMENTS The Corporation utilizes derivative financial instruments related to a certificate of deposit product called the "Index Powered Certificate of Deposit" (IPCD). IPCDs have a term of 5 years, with interest paid at maturity based on 90% of the appreciation (as defined) in the S&P 500 index. There is no guaranteed interest payable to a depositor of an IPCD - however, assuming an IPCD is held to maturity, a depositor is guaranteed the return of his or her principal, at a minimum. Statement of Financial Accounting Standards No. 133 requires the Corporation to separate the amount received from each IPCD issued into 2 components: (1) an embedded derivative, and (2) the principal amount of each deposit. Embedded derivatives are derived from the Corporation's obligation to pay each IPCD depositor a return based on appreciation in the S&P 500 index. Embedded derivatives are carried at fair value, and are included in other liabilities in the consolidated balance sheet. Changes in fair value of the embedded derivative are included in other expense in the consolidated income statement. The difference between the contractual amount of each IPCD issued, and the amount of the embedded derivative, is recorded as the initial deposit (included in interest-bearing deposits in the consolidated balance sheet). Interest expense is added to principal ratably over the term of each IPCD at an effective interest rate that will increase the principal balance to equal the contractual IPCD amount at maturity. In connection with IPCD transactions, the Corporation has entered into Equity Indexed Call Option (Swap) contracts with the Federal Home Loan Bank of Pittsburgh (FHLB-Pittsburgh). Under the terms of the Swap contracts, the Corporation must pay FHLB-Pittsburgh quarterly amounts calculated based on the contractual amount of IPCDs issued times a negotiated rate. In return, FHLB-Pittsburgh is obligated to pay the Corporation, at the time of maturity of the IPCDs, an amount equal to 90% of the appreciation (as defined) in the S&P 500 index. If the S&P 500 index does not appreciate over the term of the related IPCDs, the FHLB-Pittsburgh would make no payment to the Corporation. The effect of the Swap contracts is to limit the Corporation's cost of IPCD funds to the market rate of interest paid to FHLB-Pittsburgh. (In addition, the Corporation pays a fee of 0.75% to a consulting firm at inception of each deposit. This fee is amortized to interest expense over the term of the IPCDs.) Swap liabilities are carried at fair value, and included in other liabilities in the consolidated balance sheet. Changes in fair value of swap liabilities are included in other expense in the consolidated income statement. 22 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Amounts recorded as of March 31, 2004 and December 31, 2003, and for the first quarters of 2004 and 2003, related to IPCDs are as follows (in thousands):
MARCH 31, DEC. 31, 2004 2003 Contractual amount of IPCDs (equal to notional amount of Swap contracts) $3,903 $3,593 Carrying value of IPCDs 3,490 3,160 Carrying value of embedded derivative liabilities 360 298 Carrying value of Swap contract liabilities 35 130
3 MONTHS ENDED 3 MONTHS ENDED MARCH 31, MARCH 31, 2004 2003 Interest expense $ 34 $ 29 Other expense 1 -
LIQUIDITY Liquidity is the ability to quickly raise cash at a reasonable cost. An adequate liquidity position permits the Corporation to pay creditors, compensate for unforeseen deposit fluctuations and fund unexpected loan demand. The Corporation maintains overnight borrowing facilities with several correspondent banks that provide a source of day-to-day liquidity. Also, the Corporation maintains borrowing facilities with the Federal Home Loan Bank of Pittsburgh, secured by mortgage loans and various investment securities. At March 31, 2004, the Corporation had unused borrowing availability with correspondent banks and the Federal Home Loan Bank of Pittsburgh totaling approximately $118,073,000. Additionally, the Corporation uses repurchase agreements placed with brokers to borrow funds secured by investment assets, and uses "RepoSweep" arrangements to borrow funds from commercial banking customers on an overnight basis. Historically, one of the tools used to monitor a bank's longer-term liquidity situation has been the loan-to-deposit ratio. As of March 31, 2004, this ratio was 81%, which is a moderate-to-low ratio by banking industry standards, but much higher than the Corporation's position has been in many years. The higher than historical level of loans-to-deposits reflects the Corporation's very strong loan growth over the past few years. The loan-to-deposit ratio was 79% at December 31, 2003, 70% at December 31, 2002 and 65% at December 31, 2001. Management believes the current, higher loan-to-deposit ratio is an indicator that some of the Corporation's historical liquidity "cushion" has been reduced; however, the current position continues to provide sufficient funds for maintenance of a substantial investment securities portfolio. If required to raise cash in an emergency situation, the Corporation could sell non-pledged investment securities to meet its obligations. At March 31, 2004, the carrying value of non-pledged securities was $344,084,000. Management believes the combination of its strong capital position (discussed in the next section), ample available borrowing facilities and low loan to deposit ratio have placed the Corporation in a position of minimal short-term and long-term liquidity risk. STOCKHOLDERS' EQUITY AND CAPITAL ADEQUACY The Corporation and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. For many years, the Corporation and the Bank have maintained strong capital positions. The Corporation's consolidated capital ratios at March 31, 2004 are as follows: 23 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Total capital to risk-weighted assets 20.00% Tier 1 capital to risk-weighted assets 18.12% Tier 1 capital to average total assets 10.73%
Management expects the Corporation and the Bank to maintain capital levels that exceed the regulatory standards for well-capitalized institutions for the next 12 months and for the foreseeable future. Planned capital expenditures (discussed in the "Earnings Overview" section of Management's Discussion and Analysis) during the next 12 months are not expected to have a detrimental effect on capital ratios or results of operations. INFLATION Over the last several years, direct inflationary pressures on the Corporation's payroll-related and other noninterest costs have been modest. The Corporation is significantly affected by the Federal Reserve Board's efforts to control inflation through changes in interest rates. Management monitors the impact of economic trends, including any indicators of inflationary or deflationary pressure, in managing interest rate and other financial risks. PART I - FINANCIAL INFORMATION (CONTINUED) ITEM 3. INTEREST RATE RISK AND MARKET RISK ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK MARKET RISK The Corporation's two major categories of market risk, interest rate and equity securities risk, are discussed in the following sections. INTEREST RATE RISK Business risk arising from changes in interest rates is a significant factor in operating a bank. The Corporation's assets are predominantly long-term, fixed rate loans and debt securities. Funding for these assets comes principally from short-term deposits and borrowed funds. Accordingly, there is an inherent risk of lower future earnings or decline in fair value of the Corporation's financial instruments when interest rates change. The Bank uses a simulation model to calculate the potential effects of interest rate fluctuations on net interest income and the market value of portfolio equity. Only assets and liabilities of the Bank are included in management's monthly simulation model calculations. Since the Bank makes up more than 90% of the Corporation's total assets and liabilities, and because the Bank is the source of the most volatile interest rate risk, management does not consider it necessary to run the model for the remaining entities within the consolidated group. For purposes of these calculations, the market value of portfolio equity includes the fair values of financial instruments, such as securities, loans, deposits and borrowed funds, and the book values of nonfinancial assets and liabilities, such as premises and equipment and accrued expenses. The model measures and projects potential changes in net interest income, and calculates the discounted present value of anticipated cash flows of financial instruments, assuming an immediate increase or decrease in interest rates. Management ordinarily runs a variety of scenarios within a range of plus or minus 50-300 basis points of current rates. The Bank's Board of Directors has established policy guidelines for acceptable levels of interest rate risk, based on an immediate increase or decrease in interest rates of 200 basis points. The policy limit for fluctuation in net interest income is minus 20% from the baseline one-year scenario. The policy limit for market value variance is minus 30% from the baseline one-year scenario. The most sensitive scenario presented in Table XI below is the "+200 basis points" scenario. As Table XI shows, as of March 31, 2004, the result of the Bank's net interest income calculation is well within the policy threshold. However, if interest rates were to immediately increase 200 basis points, the Bank's calculations based on the model show that the market value of portfolio equity would decrease 38.0%, which exceeds the policy threshold. Management continues to evaluate whether to make any changes to asset or liability holdings in an effort to reduce exposure to decline in market value in a rising interest rate environment. 24 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q The table that follows was prepared using the simulation model described above. The model makes estimates, at each level of interest rate change, regarding cash flows from principal repayments on loans and mortgage-backed securities and call activity on other investment securities. Actual results could vary significantly from these estimates, which could result in significant differences in the calculations of projected changes in net interest margin and market value of portfolio equity. Also, the model does not make estimates related to changes in the composition of the deposit portfolio that could occur due to rate competition and the table does not necessarily reflect changes that management would make to realign the portfolio as a result of changes in interest rates. TABLE XI - THE EFFECT OF HYPOTHETICAL CHANGES IN INTEREST RATES
PERIOD ENDING MARCH 31, 2005 (IN THOUSANDS) MARCH 31, 2004 DATA CURRENT PLUS 200 MINUS 200 INTEREST BASIS BASIS RATES POINTS POINTS SCENARIO AMOUNT % CHANGE AMOUNT % CHANGE Interest income $ 55,251 $ 58,802 $ 50,352 Interest expense 20,902 25,663 16,733 --------------------------------------------------------------------------------- ---------- Net Interest Income $ 34,349 $ 33,139 -3.5% $ 33,619 -2.1% ==================================================================================================================== Market Value of Portfolio Equity at Mar. 31, 2004 $ 127,722 $ 79,200 -38.0% $ 158,129 23.8% ====================================================================================================================
PERIOD ENDING DECEMBER 31, 2004 (IN THOUSANDS) DECEMBER 31, 2003 DATA CURRENT PLUS 200 MINUS 200 INTEREST BASIS BASIS RATES POINTS POINTS SCENARIO AMOUNT % CHANGE AMOUNT % CHANGE Interest income $ 54,126 $ 58,319 $ 48,386 Interest expense 20,676 26,047 16,343 ------------------------------------------------------------------------------- ------------ Net Interest Income $ 33,450 $ 32,272 -3.5% $ 32,043 -4.2% ==================================================================================================================== Market Value of Portfolio Equity at Dec. 31, 2003 $ 123,499 $ 79,649 -35.5% $ 152,462 23.5% ====================================================================================================================
EQUITY SECURITIES RISK The Corporation's equity securities portfolio consists primarily of investments in stock of banks and bank holding companies located mainly in Pennsylvania. The Corporation also owns some other stocks and mutual funds. Included in "Other Equity Securities" in the table that follows are preferred stocks issued by U.S. Government agencies with a fair value of $9,919,000 at March 31, 2004 and $11,347,000 at December 31, 2003. Investments in bank stocks are subject to the risk factors that affect the banking industry in general, including competition from nonbank entities, credit risk, interest rate risk and other factors, which could result in a decline in market prices. Also, losses could occur in individual stocks held by the Corporation because of specific circumstances related to each bank. Further, because of the concentration of bank and bank holding companies located in Pennsylvania, these investments could decline in market value if there is a downturn in the state's economy. 25 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Equity securities held as of March 31, 2004 and December 31, 2003 are presented in Table XII.
TABLE XII - EQUITY SECURITIES (IN THOUSANDS) HYPOTHETICAL HYPOTHETICAL 10% 20% DECLINE IN DECLINE IN FAIR MARKET MARKET AT MARCH 31, 2004 COST VALUE VALUE VALUE Banks and bank holding companies $ 16,470 $ 28,610 $ (2,861) $ (5,722) Other equity securities 13,522 13,803 (1,380) (2,761) --------------------------------------------------------------------------------------------------------------- Total $ 29,992 $ 42,413 $ (4,241) $ (8,483) ===============================================================================================================
HYPOTHETICAL HYPOTHETICAL 10% 20% DECLINE IN DECLINE IN FAIR MARKET MARKET AT DECEMBER 31, 2003 COST VALUE VALUE VALUE Banks and bank holding companies $ 16,375 $ 29,288 $ (2,929) $ (5,858) Other equity securities 13,576 13,400 (1,340) (2,680) --------------------------------------------------------------------------------------------------------------- Total $ 29,951 $ 42,688 $ (4,269) $ (8,538) ===============================================================================================================
PART I - FINANCIAL INFORMATION (CONTINUED) ITEM 4. CONTROLS AND PROCEDURES The Corporation's Chief Executive Officer and Chief Financial Officer carried out an evaluation of the design and effectiveness of the Corporation's disclosure controls and procedures as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Securities Exchange Act of 1934 as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the evaluation date, the Corporation's disclosure controls and procedures are effective to ensure that information required to be disclosed in reports the Corporation files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. There were no changes in the Corporation's internal control over financial reporting that occurred during the period covered by this report that have materially affected, or that are reasonably likely to materially affect, our internal control over financial reporting. 26 CITIZENS & NORTHERN CORPORATION - FORM 10 - Q PART II - OTHER INFORMATION Item 1. Legal Proceedings The Corporation and the Bank are involved in various legal proceedings incidental to their business. Management believes the aggregate liability, if any, resulting from such pending and threatened legal proceedings will not have a material, adverse effect on the Corporation's financial condition or results of operations. Item 2. Not Applicable Item 3. Not Applicable Item 4. Not Applicable Item 5. Not Applicable Item 6. Exhibits and Reports on Form 8 - K a. Exhibits:
Page ---- Exhibit 31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Chief Executive Officer 29 Exhibit 31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Chief Financial Officer 30 Exhibit 32 Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 31
b. A Current Report on Form 8-K under Items 7 and 12, dated January 9, 2004, was furnished to report the Corporation's consolidated earnings results for the three-month and annual periods ended December 31, 2003. 27 CITIZENS AND NORTHERN CORPORATION - FORM 10 - Q Signature Page 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. CITIZENS & NORTHERN CORPORATION May 6, 2004 By: Craig G. Litchfield /s/ ----------- ----------------------- Date Chairman, President and Chief Executive Officer May 6, 2004 By: Mark A. Hughes /s/ ----------- ------------------ Date Treasurer and Chief Financial Officer 28