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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, 2003
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: 0-16667
DNB Financial Corporation
(Exact name of registrant as specified in its charter)
PENNSYLVANIA 23-2222567
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
4 BRANDYWINE AVENUE - DOWNINGTOWN, PA 19335
(Address of principal executive offices and Zip Code)
(610) 269-1040
(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.
[X] Yes [ ] No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
[ ] Yes [X] No
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
COMMON STOCK ($1.00 Par Value) 1,799,930
(Class) (Shares Outstanding as of
November 14, 2003)
- ---------------------------------------------------------------------------
DNB FINANCIAL CORPORATION AND SUBSIDIARIES
INDEX
PART I - FINANCIAL INFORMATION PAGE NO.
ITEM 1. FINANCIAL STATEMENTS (Unaudited):
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
September 30, 2003 and December 31, 2002 3
CONSOLIDATED STATEMENTS OF OPERATIONS
Three Months Ended September 30, 2003 and 2002 4
CONSOLIDATED STATEMENTS OF OPERATIONS
Nine Months Ended September 30, 2003 and 2002 5
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended September 30, 2003 and 2002 6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2003 and December 31, 2002 7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS 11
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK 24
ITEM 4. CONTROLS AND PROCEDURES 25
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS 26
ITEM 2. CHANGE IN SECURITIES AND USE OF PROCEEDS 26
ITEM 3. DEFAULTS UPON SENIOR SECURITIES 26
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF 26
SECURITY HOLDERS
ITEM 5. OTHER INFORMATION 26
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 26
SIGNATURES 27
ITEM 1 FINANCIAL STATEMENTS (Unaudited)
DNB FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Dollars in thousands, except share data)
September 30, December 31,
2003 2002
- --------------------------------------------------------------------------------------------------------------------------
ASSETS
Cash and due from banks ..................................................................... $ 12,042 $ 11,551
Federal funds sold .......................................................................... -- 10,473
--------- ---------
Total cash and cash equivalents ............................................................. 12,042 22,024
--------- ---------
Investment securities available for sale, at market value ................................... 147,050 137,365
Investment securities held to maturity (market value $56,459
in 2003 and $22,811 in 2002) ............................................................. 57,207 22,430
Loans, net of unearned income ............................................................... 189,138 187,585
Allowance for loan losses ................................................................... (4,571) (4,546)
--------- ---------
Net loans ................................................................................... 184,567 183,039
--------- ---------
Office property and equipment, net .......................................................... 7,781 8,092
Accrued interest receivable ................................................................. 1,860 1,890
Bank owned life insurance ................................................................... 5,746 5,577
Deferred income taxes ....................................................................... 1,327 980
Other assets ................................................................................ 3,680 2,971
--------- ---------
TOTAL ASSETS ................................................................................ $ 421,260 $ 384,368
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Non-interest-bearing deposits ............................................................... $ 52,226 $ 45,117
Interest-bearing deposits:
NOW accounts ............................................................................. 53,568 50,400
Money market ............................................................................. 56,463 59,457
Savings .................................................................................. 43,775 39,569
Time ..................................................................................... 73,944 93,259
--------- ---------
TOTAL DEPOSITS .............................................................................. 279,976 287,802
--------- ---------
Borrowings .................................................................................. 109,696 63,728
Trust preferred debt securities ............................................................. 5,000 5,000
--------- ---------
TOTAL BORROWINGS ............................................................................ 114,696 68,728
--------- ---------
Accrued interest payable .................................................................... 876 1,164
Other liabilities ........................................................................... 949 466
--------- ---------
TOTAL LIABILITIES ........................................................................... 396,497 358,160
--------- ---------
STOCKHOLDERS' EQUITY
Preferred stock, $10.00 par value;
1,000,000 shares authorized; none issued ................................................. -- --
Common stock, $1.00 par value;
10,000,000 shares authorized; 1,923,725 and 1,902,478
issued, respectively ..................................................................... 1,924 1,902
Treasury stock, at cost (131,315 and 81,427 shares, respectively) ........................... (2,832) (1,687)
Surplus ..................................................................................... 23,645 23,402
Retained earnings ........................................................................... 3,295 3,184
Accumulated other comprehensive loss, net ................................................... (1,269) (593)
--------- ---------
TOTAL STOCKHOLDERS' EQUITY .................................................................. 24,763 26,208
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY .................................................. $ 421,260 $ 384,368
========= =========
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except share amounts) Three Months Ended September 30
- -------------------------------------------- -------------------------------
2003 2002
---------- -------------
INTEREST INCOME:
Interest and fees on loans and leases ............ $ 3,413 $ 3,653
Interest on taxable investment securities ........ 1,064 1,528
Interest on tax-free investment securities ....... 163 47
Interest on tax-preferred equity securities ...... 93 158
Interest on Federal funds sold ................... 2 44
------- -------
Total interest income ............................ 4,735 5,430
------- -------
INTEREST EXPENSE:
Interest on time deposits ........................ 475 877
Interest on NOW, money market and savings ........ 220 464
Interest on FHLB advances ........................ 975 903
Interest on trust preferred debt securities ...... 67 74
Interest on lease obligations .................... 25 25
Interest on Federal funds purchased .............. 7 4
----- -----
Total interest expense ........................... 1,769 2,347
----- -----
NET INTEREST INCOME ................................. 2,966 3,083
Provision for loan losses ........................... -- --
----- -----
Net interest income after provision for loan losses . 2,966 3,083
----- -----
NON-INTEREST INCOME:
Service charges ..................................... 318 277
Wealth management ................................... 173 124
Net (loss) gain on sales of investment securities ... (466) 96
Increase in cash surrender value of BOLI ............ 145 44
Other ............................................... 186 168
----- -----
Total non-interest income ........................... 356 709
----- -----
NON-INTEREST EXPENSE:
Salaries and employee benefits ...................... 2,135 1,552
Furniture and equipment ............................. 426 335
Occupancy ........................................... 225 210
Professional and consulting ......................... 224 145
Marketing ........................................... 93 124
Printing and supplies ............................... 96 65
Other ............................................... 497 395
----- -----
Total non-interest expense .......................... 3,696 2,826
----- -----
(Loss) income before income taxes ................... (374) 966
Income tax (benefit) expense ........................ (272) 236
----- -----
NET (LOSS) INCOME ................................... $ (102) $ 730
===== =====
COMMON SHARE DATA:
EARNINGS PER SHARE:
Basic ............................................... $ (0.06) $ 0.40
Diluted ............................................. (0.06) 0.39
CASH DIVIDENDS PER SHARE ............................ $ 0.13 $ 0.12
WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING:
Basic ............................................ 1,798,247 1,823,956
Diluted .......................................... 1,798,247 1,861,769
See accompanying notes to consolidated financial statements
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except share amounts) Nine Months Ended September 30
- -------------------------------------------- ------------------------------
2003 2002
---------- -----------
INTEREST INCOME:
Interest and fees on loans ........................ $ 9,906 $ 10,696
Interest on taxable investment securities ......... 3,456 4,968
Interest on tax-free investment securities ........ 329 299
Interest on tax-preferred equity securities ....... 325 479
Interest on Federal funds sold .................... 43 89
------ ------
Total interest income ............................. 14,059 16,531
------ ------
INTEREST EXPENSE:
Interest on time deposits ........................ 1,788 2,829
Interest on NOW, money market and savings ........ 812 1,393
Interest on FHLB advances ........................ 2,840 2,678
Interest on trust preferred debt securities ...... 199 227
Interest on lease obligations .................... 74 75
Interest on Federal funds purchased .............. 11 7
----- -----
Total interest expense ........................... 5,724 7,209
----- -----
NET INTEREST INCOME ................................. 8,335 9,322
Provision for loan losses ........................... -- --
----- -----
Net interest income after provision for loan losses . 8,335 9,322
----- -----
NON-INTEREST INCOME:
Service charges ..................................... 923 781
Wealth management ................................... 486 322
Net (loss) gain on sales of investment securities ... (337) 165
Increase in cash surrender value of BOLI ............ 258 142
Other ............................................... 536 472
----- -----
Total non-interest income ........................... 1,866 1,882
----- -----
NON-INTEREST EXPENSE:
Salaries and employee benefits ...................... 5,306 4,656
Furniture and equipment ............................. 1,158 980
Occupancy ........................................... 629 608
Professional and consulting ......................... 460 457
Marketing ........................................... 235 316
Printing and supplies ............................... 261 244
Other ............................................... 1,409 1,273
----- -----
Total non-interest expense .......................... 9,458 8,534
----- -----
Income before income taxes .......................... 743 2,670
Income tax (benefit) expense ........................ (75) 594
----- -----
NET INCOME .......................................... $ 818 $2,076
===== ======
COMMON SHARE DATA:
EARNINGS PER SHARE:
Basic ............................................... $ 0.45 $ 1.14
Diluted ............................................. 0.44 1.11
CASH DIVIDENDS PER SHARE ............................ $ 0.39 $ 0.37
WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING:
Basic ............................................ 1,812,135 1,829,440
Diluted .......................................... 1,852,252 1,867,632
See accompanying notes to consolidated financial statements.
Consolidated Statements of Cash Flows
(Dollars in thousands) Nine Months Ended September 30
- ---------------------- ------------------------------
2003 2002
------------ -------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income ...................................................... $ 818 $ 2,076
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization ................................... 2,649 1,501
Loss (gain) on sale of investments .............................. 337 (165)
Decrease in accrued interest receivable ......................... 30 600
Increase in investment in BOLI .................................. (169) (142)
(Increase) decrease in other assets ............................. (709) 1,147
Increase in deferred taxes ...................................... -- (79)
Decrease in accrued interest payable ............................ (288) (359)
Decrease in current taxes payables .............................. (442) (88)
Increase in other liabilities ................................... 925 120
-------- --------
NET CASH PROVIDED BY OPERATING ACTIVITIES ....................... 3,151 4,611
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Maturities & paydowns of available for sale securities .......... 56,776 33,514
Maturities & paydowns of held to maturity securities ............ 12,682 25,685
Purchase of available for sale securities ....................... (104,367) (43,224)
Purchase of held to maturity securities ......................... (47,788) (21,902)
Proceeds from sale of available for sale securities ............. 35,013 25,107
Net increase in loans ........................................... (1,528) (7,485)
Purchase of office property and equipment ....................... (476) (922)
--------- --------
NET CASH (USED) PROVIDED BY INVESTING ACTIVITIES ................ (49,688) 10,773
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net decrease in deposits ........................................ (7,826) (5,590)
Increase in FHLB advances ....................................... 42,889 --
Increase in Federal funds purchased ............................. 3,085 --
Decrease in lease obligations ................................... (6) (5)
Purchase of treasury stock ...................................... (1,145) (1,013)
Proceeds from exercise of stock options ......................... 264 147
Dividends paid .................................................. (706) (677)
---- ----
NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES ................ 36,555 (7,138)
-------- --------
NET CHANGE IN CASH AND CASH EQUIVALENTS ......................... (9,982) 8,246
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD ................ 22,024 18,628
-------- --------
CASH AND CASH EQUIVALENTS AT END OF PERIOD ...................... $ 12,042 $ 26,874
======== ========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest ........................................................ $ 6,058 $ 7,568
Taxes ........................................................... 166 686
SUPPLEMENTAL DISCLOSURE OF NON-CASH FLOW INFORMATION:
Change in net unrealized losses on securities- available for sale $ (1,023) $ 758
Change in deferred taxes due to change in net unrealized losses
on securities- available for sale .......................... 347 (253)
See accompanying notes to consolidated financial statements.
DNB FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1: BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements of DNB Financial
Corporation (referred to herein as the "Corporation" or "DNB") and its
subsidiaries, Downingtown National Bank (the "Bank") and DNB Capital Trust I
(the "Trust"), have been prepared in accordance with the instructions for Form
10-Q and therefore do not include certain information or footnotes necessary for
the presentation of financial condition, statement of operations and statement
of cash flows required by generally accepted accounting principles. However, in
the opinion of management, the consolidated financial statements reflect all
adjustments (which consist of normal recurring adjustments) necessary for a fair
presentation of the results for the unaudited periods. Prior amounts not
affecting net income are reclassified when necessary to conform with current
period classifications. The results of operations for the three and nine months
ended September 30, 2003 are not necessarily indicative of the results which may
be expected for the entire year. The consolidated financial statements should be
read in conjunction with the Annual Report and report on Form 10-K for the year
ended December 31, 2002.
In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based
Compensation-Transition and Disclosure ("SFAS 148"). This statement amends SFAS
123, Accounting for Stock-Based Compensation, to provide alternative methods of
transition for a voluntary change to the fair value based method of accounting
for stock-based employee compensation. In addition, this Statement amends the
disclosure requirements of Statement 123 to require prominent disclosures in
both annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. The requirements of Statement No. 148 are effective for fiscal years
ending after December 15, 2002, except for financial reports containing
condensed financial statements for interim periods for which disclosure is
effective for periods beginning after December 31, 2002. DNB applies APB Opinion
No. 25 in accounting for its Stock Option Plan, and accordingly, no compensation
cost has been recognized for its stock options in the financial statements. Had
DNB determined compensation cost based on the fair value at the grant date for
its stock options under SFAS No. 123, DNB's net income and earnings per share
would have been reduced to the pro forma amounts indicated below:
Three Months Ended Nine Months Ended
September 30 September 30
------------------ -----------------
2003 2002 2003 2002
----- ----- ------ ----
Net (loss) income as reported ......................................... $ (102) $730 $ 818 $ 2,076
Total stock based employee compensation expense
determined under fair value based method for
all awards, net of related tax effects ........................... -- -- 68 183
------ ----- ----- -------
Pro forma net (loss) income ........................................... $ (102) $ 730 $ 750 $ 1,893
====== ===== ===== =======
Earnings per share
Basic-as reported ................................................ $ (0.06) $ 0.40 $ 0.45 $ 1.14
Basic-pro forma .................................................. (0.06) 0.40 0.41 1.04
Diluted-as reported .............................................. $(0.06) $ 0.39 $ 0.44 $ 1.11
Diluted-pro forma ................................................ (0.06) 0.39 0.41 1.01
NOTE 2: EARNINGS PER SHARE (EPS)
Basic earnings per share is computed based on the weighted average number of
common shares outstanding during the period. Diluted earnings per share reflect
the potential dilution that could occur from the conversion of common stock
equivalents (i.e., stock options) and is computed using the treasury stock
method. For the three and nine months ended September 30, 2003, 186,052 and
39,032 outstanding stock options were not included because such options were
antidilutive. For the three and nine months ended September 30, 2002, 101,157
and 67,392 outstanding stock options were not included because such options were
antidilutive. These shares may be dilutive in the future. Earnings per share,
dividends per share and weighted average shares outstanding have been adjusted
to reflect the effects of the 5% stock dividend paid in December 2002. Net
income and the weighted average number of shares outstanding for basic and
diluted EPS for the three and nine months ended September 30, 2003 and 2002 are
reconciled as follows:
Three months ended Three months ended
September 30, 2003 September 30, 2002
-------------------------- -------------------------
(Dollars in thousands) Income Shares Amount Income Shares Amount
Basic EPS
Income available to common stockholders ...... $ (102) $1,798 $ (0.06) $ 730 $1,824 $ 0.40
Effect of dilutive common stock equivalents-
stock options ................................ -- -- -- -- 38 (0.01)
------ ------ ------- ------ ------ -------
Diluted EPS .................................. $ (102) $1,798 $ (0.06) $ 730 $1,862 $ 0.39
====== ====== ======= ====== ====== =======
Nine months ended
Nine months ended
September 30, 2003
September 30,
2002.
--------------------------- ----------------------------
(Dollars in thousands) Income Shares Amount Income Shares Amount
Basic EPS
Income available to common stockholders....... $ 818 $1,812 $0.45 $2,076 $1,829 $1.14
Effect of dilutive common stock equivalents-
stock options................................. -- 40 (0.01) - 39 (0.03)
----- ------ ------ ------ ------ ------
Diluted EPS................................... $ 818 $1,852 $0.44 $2,076 $1,868 $1.11
===== ====== ====== ====== ====== ======
NOTE 3: COMPREHENSIVE INCOME
Comprehensive income includes all changes in stockholders' equity during the
period, except those resulting from investments by owners and distributions to
owners. Comprehensive income for all periods consisted of net income and other
comprehensive income relating to the change in unrealized gains on investment
securities available for sale, as shown in the following tables:
(Dollars in thousands) Three months ended Sept. 30 Nine months ended Sept. 30
--------------------------- --------------------------
2003 2002 2003 2002
---- ---- ---- ----
COMPREHENSIVE INCOME:
Net (loss) income ................................ $ (102) $ 730 $ 818 $2,076
Other comprehensive income (loss), net of tax,
relating to net unrealized losses on investments 365 376 (676) 505
------ ------ ----- ------
Total comprehensive income ....................... $ 263 $1,106 $ 142 $2,581
====== ====== ===== ======
NOTE 4: TRUST PREFERRED DEBT SECURITIES
On July 20, 2001, DNB's subsidiary DNB Capital Trust I (the "Trust"), a Delaware
business trust in which DNB owns all of the common equity, issued $5.0 million
of floating rate (6 month Libor plus 3.75% to a cap of 12%) capital preferred
securities ("TRuPS") to a qualified institutional buyer. The proceeds of these
securities were used by the Trust, along with DNB's capital contribution, to
purchase $5.2 million principal amount of DNB's floating rate junior
subordinated debentures (the "debentures"). The debentures are the sole asset of
the Trust. DNB's obligations under the TRuPS and related documents, taken
together, constitute a full and unconditional guarantee by DNB of the Trust's
obligation under the preferred securities. The preferred securities are
redeemable by DNB on or after July 25, 2006, or earlier in the event of certain
adverse tax or bank regulatory developments. The preferred securities must be
redeemed upon maturity of the subordinated debentures on July 25, 2031.
NOTE 5: RECENT ACCOUNTING PRONOUNCEMENTS
In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with
Exit or Disposal Activities ("SFAS 146"). This Statement addresses financial
accounting and reporting for costs associated with exit or disposal activities
and nullifies Emerging Issues Task Force (EITF) Issue No. 94.3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a Restructuring)." The provisions
of this Statement are effective for exit or disposal activities that are
initiated after December 31, 2002, with early application encouraged. The
adoption of this statement had no impact on DNB's financial condition, equity,
results of operations or disclosures.
In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based
Compensation-Transition and Disclosure ("SFAS 148"). This statement amends SFAS
123, Accounting for Stock-Based Compensation, to provide alternative methods of
transition for a voluntary change to the fair value based method of accounting
for stock-based employee compensation. The Statement also amends the disclosure
requirements of Statement 123 to require prominent disclosures in both annual
and interim financial statements about the method of accounting for stock-based
employee compensation and the effect of the method used on reported results.
This statement is effective for fiscal years ending after December 15, 2002. The
disclosures required by this filing have been included in this filing. This
Statement announces that "in the near future, the Board plans to consider
whether it should propose changes to the U.S. standards on accounting for
stock-based compensation". There was no impact of this statement on DNB's
financial condition, equity, or results of operations. The annual and interim
disclosure requirements of this statement have been complied with.
In April 2003, the FASB issued SFAS No. 149, Amendment to Statement 133 on
Derivative Instruments and Hedging Activities ("SFAS No. 149"). This statement
amends and clarifies accounting for derivative instruments, including certain
derivative instruments embedded in other contracts, and for hedging activities
under SFAS No. 133. The statement is applied prospectively and is effective for
contracts entered into or modified after June 30, 2003, except for SFAS No. 133
implementation issues that have been effective for fiscal quarters that began
prior to June 15, 2003 and certain provisions relating to forward purchases and
sales on securities that do not yet exist. The adoption on April 1, 2003 of the
components of this statement which address SFAS No. 133 implementation issues
that have been effective for fiscal quarters that began prior to June 15, 2003
did not have a material impact on the DNB's consolidated interim financial
position and results of operations. The adoption of the remaining components of
SFAS No. 149 is not anticipated to have a material impact on DNB's financial
condition, equity or results of operations.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity ("SFAS No.
150"). This statement establishes standards for how an issuer classifies and
measures certain financial instruments with characteristics of both liabilities
and equity. It requires that an issuer classify a financial instrument that is
within its scope as a liability (or an asset in some circumstances). Some of the
provisions of this Statement are consistent with the current definition of
liabilities in FASB Concepts Statement No. 6, "Elements of Financial
Statements". The remaining provisions of this Statement are consistent with the
Board's proposal to revise that definition to encompass certain obligations that
a reporting entity can or must settle by issuing its own equity shares,
depending on the nature of the relationship established between the holder and
the issuer. This statement is effective for financial instruments entered into
or modified after May 31, 2003, and otherwise is effective at the beginning of
the first interim period beginning after June 15, 2003. The adoption of this
statement had no impact on DNB's financial condition, equity, results of
operations or disclosures.
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
DESCRIPTION OF DNB'S BUSINESS
DNB Financial Corporation is a bank holding company whose bank subsidiary,
Downingtown National Bank (the "Bank"), is a nationally chartered commercial
bank with trust powers, and a member of the FDIC. DNB has nine full service
offices located in Chester County, Pennsylvania. In addition to its main office
at 4 Brandywine Avenue, they are: Little Washington Office (Intersection of
Route 322 and Culbertson Run Road, Downingtown), East End Office (701 East
Lancaster Avenue, Downingtown), Exton Office (410 Exton Square Parkway, Exton),
Lionville Office (Intersection of Route 100 and Welsh Pool Road, Exton),
Ludwig's Corner Office (Intersection of Routes 100 and 401, Uwchland), Caln
Office (1835 East Lincoln Highway, Coatesville), West Goshen Office (1115 West
Chester Pike, West Chester), Kennett Square Office (215 E. Cypress St., Kennett
Square). The Bank also has a limited service office at Tel Hai Retirement
Community (Beaver Dam Road, Honey Brook). Through its DNB Advisors division,
Downingtown National Bank provides wealth management and trust services to
individuals and businesses throughout Chester County. The Bank and its
subsidiary, DNB Financial Services, Inc., make available certain nondepositary
products and services, such as securities brokerage, mutual funds, life
insurance and annuities. Customers may also visit DNB on its website at
http://www.dnb4you.com.
ECONOMIC OUTLOOK AND BUSINESS STRATEGY
DNB's year-to-date net interest margin and earnings have been impacted by the
historically low interest rate environment and recent economic uncertainties.
Banks nationwide have experienced margin compression, slow loan growth and
significant cash outflows from prepayments of their assets backed by residential
loans. This current environment, as well as the market's outlook for a stronger
economy and higher long-term interest rates were critical factors in
management's initial step in a comprehensive plan designed to reposition its
balance sheet and improve core earnings. During the quarter DNB sold $20 million
of investment securities and invested the proceeds in higher yielding securities
which management expects to provide improved cash flows. As further steps in the
plan, DNB's management currently intends to reduce substantially the size of its
investment portfolio during the next eighteen months and expand its loan
portfolio through new originations, increased loan participations, as well as
strategic loan and lease receivable purchases. Management also intends to reduce
the absolute level of borrowings with cash flows from existing loans and
investments as well from new core deposit growth. With regard to DNB's balance
sheet repositioning, the degree to which these steps can be accomplished will
depend on a number of factors, including changes in the interest rate
environment for loans, investments and deposits, loan prepayments, market
opportunities for new loan and participation originations, and the availability
of loan and lease receivables for purchase at attractive prices and yields, as
well as management's assessment of the timing of each of these opportunities and
steps in light of future, unknown developments affecting DNB's business
generally.
Also during the last six months, two key additions were made to DNB's management
team. William J. Hieb joined the Bank as Executive Vice President and Chief
Operating Officer in April and Richard M. Wright joined DNB in September to head
up the Bank's retail network. In addition to these two important changes,
management is in the process of expanding its lending and support staff to
facilitate loan growth as part of its balance sheet restructuring plan.
CRITICAL ACCOUNTING POLICIES
The following discussion and analysis of our financial condition and results of
operations is based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States of America. The preparation of these financial statements requires
management to make estimates and judgments that affect the reported amounts of
assets and liabilities, revenues and expenses, and related disclosures of
contingent assets and liabilities at the date of our financial statements.
Actual results may differ from these estimates under different assumptions or
conditions.
In management's opinion, the most critical accounting policies impacting DNB's
consolidated financial statements are:
1. Determination of the allowance for loan losses. Loan loss allowance policies
involve significant judgments and assumptions by management which may have a
material impact on the carrying value of net loans and, potentially, on the net
income recognized by DNB from period to period. For a description of DNB's
accounting policies in connection with its allowance for loan losses, see,
"Provision for Loan Losses," below.
2. Accrual and recognition of interest on loans. These policies involve
significant judgments and assumptions by management which may have a material
impact on the interest income recognized by DNB from period to period. For a
description of DNB's accounting policies in connection with accrual and
recognition of interest on loans, see, "Asset Quality," below.
3. Realization of deferred income tax items. Estimates of deferred tax assets
and deferred tax liabilities make up the asset category titled, " net deferred
tax asset." These estimates involve significant judgments and assumptions by
management which may have a material impact on the carrying value of net
deferred tax assets for financial reporting purposes. For a more detailed
description of these items and estimates, see Note 11 (Federal Income Taxes) to
DNB's audited consolidated financial statements for the fiscal year ended
December 31, 2002 (the "Annual Financial Statements"), incorporated in DNB's
10-K for the year ended December 31, 2002.
The Notes to DNB's consolidated financial statements set forth herein and in
DNB's Annual Financial Statements identify other significant accounting policies
used in the development and presentation of its financial statements. This
discussion and analysis, the significant accounting policies, and other
financial statement disclosures identify and address key variables and other
qualitative and quantitative factors that are necessary for an understanding and
evaluation of DNB and its results of operations.
FINANCIAL CONDITION
DNB's total assets were $421.3 million at September 30, 2003 compared to $384.4
million at December 31, 2002. Investment securities (AFS and HTM) increased
$44.5 million or 27.8% to $204.3 million at September 30, 2003. Trust preferred
securities decreased $19.6 million while US Agency and US Agency CMO's increased
a combined $46.4 million and tax-free securities increased $23.4 million as DNB
restructured its investment portfolio to achieve higher yields and provide
improved cash flows. US Agency mortgage-backed securities and other CMO's
decreased a combined $26.4 million due to high levels of prepayments in the low
interest rate environment.
Total loans increased $1.6 million or 0.8% to $189.1 million at September 30,
2003, compared to $187.6 million at December 31, 2002. Significant increases
occurred in the commercial and commercial mortgage portfolios, which grew a
combined $6.8 million or 5.3%. In addition, consumer loans increased $3.6
million or 12.4%, as customers took advantage of historically low home equity
rates. These increases were largely offset by a $8.8 million or 33.4% decline in
residential mortgage loans, as customer refinancings reached unprecedented
levels.
Deposits at September 30, 2003 totaled $280.0 million, down $7.8 million or 2.7%
from $287.8 million at December 31, 2002. Time deposits were down $19.3 million
and money market accounts decreased $3.0 million. Non-interest-bearing, savings
and NOW accounts increased $7.1 million, $4.2 million and $3.2 million,
respectively, reflecting customer preferences for short-term deposits in this
low interest rate environment. Total borrowings increased $46.0 million to
$114.7 million at September 30, 2003, compared to $68.7 million at December 31,
2003. Federal funds purchased rose $3.1 million and short-term FHLB advances
rose $42.9 million as DNB borrowed to meet short-term liquidity needs.
At September 30, 2003, stockholders' equity was $24.8 million or $13.81 per
share, compared to $26.2 million or $14.33 per share at December 31, 2002. The
decrease in stockholders' equity was the result of a $676,000 decrease in the
fair market value of available-for-sale securities, net of taxes, as well as the
purchase of 49,888 shares to be held as treasury stock ($1.1 million) and
dividends paid of approximately $706,000 or $.39 per share, partially offset by
net income of $818,000 for the nine months ended September 30, 2003.
RESULTS OF OPERATIONS
NET INTEREST INCOME
DNB's earnings performance is primarily dependent upon its level of net interest
income, which is the excess of interest revenue over interest expense. Interest
revenue includes interest earned on loans (net of interest reversals on
non-performing loans), investments, Federal funds sold and interest-earning
cash, as well as net loan fee amortization and dividend income. Interest expense
includes the interest cost for deposits, FHLB advances, Federal funds purchased
and other borrowings.
On a tax-equivalent basis, net interest income decreased $93,000 or 3.0% to $3.1
million, and $1.0 million or 10.8% to $8.6 million, respectively, for the three
and nine month periods ended September 30, 2003, compared to the same periods in
2002. As shown in the following tables, the decrease in net interest income was
largely attributable to rate changes, as interest-earning assets repriced less
favorably and more quickly than interest-bearing liabilities. The effects of
these rate changes reduced net interest income by $200,000 and $1.3 million,
respectively, for the periods. Volume changes resulted in a $107,000 and
$298,000 benefit to net interest income for the respective periods.
The following tables sets forth, among other things, the extent to which changes
in interest rates and changes in the average balances of interest-earning assets
and interest-bearing liabilities have affected interest income and expense
during the three and nine months ended September 30, 2003 compared to the same
periods in 2002 (tax-exempt yields and yields on agency-preferred stock that
have a 70% dividend received deduction have been adjusted to a tax equivalent
basis using a 34% tax rate). For each category of interest-earning assets and
interest-bearing liabilities, information is provided with respect to changes
attributable to (i) changes in rate (change in rate multiplied by old volume)
and (ii) changes in volume (change in volume multiplied by old rate). The net
change attributable to the combined impact of rate and volume has been allocated
proportionately to the change due to rate and the change due to volume.
Three Months Ended
September 30, 2003
Compared to 2002
-------------------------
Increase (Decrease) Due to
--------------------------
(Dollars in Thousands) Rate Volume Total
----- ------ -----
Interest-earning assets:
Loans ............................................................................................. $ (63) $(179) $(242)
Investment securities-taxable ..................................................................... (706) 242 (464)
Investment securities-tax exempt .................................................................. (47) 212 165
Investment securities-tax preferred ............................................................... (99) 11 (88)
Federal funds sold ................................................................................ (12) (30) (42)
------ ------ ------
Total ........................................................................................ $(927) $ 256 $(671)
------ ------ ------
Interest-bearing liabilities:
Savings, NOW and money market deposits ............................................................ $(259) $ 15 $(244)
Time deposits ..................................................................................... (264) (139) (403)
Federal funds purchased ........................................................................... (5) 9 4
Trust preferred securities ........................................................................ (7) -- (7)
FHLB advances ..................................................................................... (192) 264 72
------ ------ -----
Total ........................................................................................ (727) 149 (578)
------ ------ -----
Net interest income/interest rate spread .......................................................... $(200) $ 107 $ (93)
====== ====== =====
Nine Months Ended
September 30, 2003
Compared to 2002
--------------------------
Increase (Decrease) Due to
--------------------------
(Dollars in Thousands) Rate Volume Total
----- ------- -----
Interest-earning assets:
Loans ........................................................................................... $ (553) $ (237) $ (790)
Investment securities-taxable ................................................................... (2,300) 788 (1,512)
Investment securities-tax exempt ................................................................ (48) 86 38
Investment securities-tax preferred ............................................................. (267) 57 (210)
Federal funds sold .............................................................................. (23) (23) (46)
------- ------- -------
Total ...................................................................................... $(3,191) $ 671 $(2,520)
------- ------- -------
Interest-bearing liabilities:
Savings, NOW and money market deposits .......................................................... $ (613) $ 33 $ (580)
Time deposits ................................................................................... (746) (295) (1,041)
FHLB advances ................................................................................... (465) 626 161
Trust preferred securities ...................................................................... (28) -- (28)
Federal funds purchased ......................................................................... (6) 10 4
Lease obligations ............................................................................... -- (1) (1)
------- ------- -------
Total ...................................................................................... (1,858) 373 (1,485)
------- ------- -------
Net interest income/interest rate spread ........................................................ $(1,333) $ 298 $(1,035)
======= ======= =======
PROVISION FOR LOAN LOSSES
To provide for known and inherent losses in the loan portfolio, DNB maintains an
allowance for loan losses. Provisions for loan losses are charged against income
to increase the allowance when necessary. Loan losses are charged directly
against the allowance and recoveries on previously charged-off loans are added
to the allowance. In establishing its allowance for loan losses, management
considers the size and risk exposure of each segment of the loan portfolio, past
loss experience, present indicators of risk such as delinquency rates, levels of
nonaccruals, the potential for losses in future periods, and other relevant
factors. Management's evaluation of the loan portfolio generally includes
reviews, on a sample basis, of individual borrowers regardless of size and
reviews of problem borrowers of $100,000 or greater. Consideration is also given
to examinations performed by regulatory agencies, primarily the Office of the
Comptroller of the Currency ("OCC").
In determining the allowance, DNB utilizes a methodology which includes an
analysis of historical loss experience for the commercial real estate,
commercial, residential real estate, home equity and consumer installment loan
pools to determine a historical loss factor. The historical loss factors are
then applied to the current portfolio balances to determine the required reserve
percentage for each loan pool based on risk rating. In addition, specific
allocations are established for loans where loss is probable and reasonably
identifiable, based on management's judgment and an evaluation of the individual
credit, which includes various factors mentioned above. The allocated portion of
the reserve is then determined as a result of an analysis of the loan pools and
specific allocations.
In establishing and reviewing the allowance for adequacy, emphasis has been
placed on utilizing the methodology prescribed in the OCC's Handbook (which
utilizes BC 201 qualitative risk factors). As a result, management has taken
into consideration factors and variables which may influence the risk of loss
within the loan portfolio, including: (i) trends in delinquency and nonaccrual
loans; (ii) changes in the nature and volume of the loan portfolio; (iii)
effects of any changes in lending policies; (iv) experience, ability, and depth
of management/quality of loan review; (v) national and local economic trends and
conditions; (vi) concentrations of credit; and (vii) effect of external factors
on estimated credit losses. The unallocated portion of the allowance is intended
to provide for probable losses that are not otherwise identifiable using the
BC201 risk factors such as (i) the effect of expansion into new markets or lines
of business that are not as familiar as DNB's current market or business lines;
(ii) the risk that the information we receive from our borrowers is inaccurate
or misleading and (iii) the non-qualifiable impact that a terrorist action or
threat of action may have on a particular industry.
There were no provisions made during the nine months ended September 30, 2003
based on management's analysis of the loan portfolio and the level of net
charge-offs compared to the total allowance. Net loan recoveries were $25,000
for the nine months ended September 30, 2003, compared to net loan charge-offs
of $263,000 for the year ended December 31, 2002 and net loan charge-offs of
$33,000 for the nine months ended September 30, 2002. The percentage of net
recoveries (charge-offs) to total average loans was .02%, (0.14)% and (.02)% for
the same respective periods. Another measure of the allowance is the coverage
ratio of the allowance to non-performing loans, which was 357.5% at September
30, 2003, compared to 176.6% at September 30, 2002 and 117.5% at December 31,
2002. In addition, the ratio of non-performing loans to total loans was 0.7% at
September 30, 2003, compared to 1.4% at September 30, 2002 and 2.1% at December
31, 2002.
The following table summarizes the changes in the allowance for loan losses for
the periods indicated. Real estate includes both residential and commercial real
estate.
9 Months Year 9 Months
Ended Ended Ended
(Dollars in Thousands) 9/30/03 12/31/02 9/30/02
------- -------- -------
Beginning balance .................................................... $ 4,546 $ 4,809 $ 4,809
Provisions ........................................................... -- -- --
Loans charged off:
Real estate ................................................... (11) -- --
Commercial .................................................... (204) (221) --
Consumer ...................................................... (89) (89) (72)
------ ------- -------
Total charged off ......................................... (304) (310) (72)
------ ------- -------
Recoveries:
Real estate ................................................... 110 18 15
Commercial .................................................... 198 18 15
Consumer ...................................................... 21 11 9
-- -- -------
Total recoveries .......................................... 329 47 39
--- -- -------
Net recoveries (charge-offs) ......................................... 25 (263) (33)
------- ------- -------
Ending balance ....................................................... $ 4,571 $ 4,546 $ 4,776
======= ======= =======
NON-INTEREST INCOME
Total non-interest income includes service charges on deposit products; fees
received in connection with the sale of nondepository products and services,
including fiduciary and investment advisory services offered through DNB
Advisors; securities brokerage products and services and insurance brokerage
products and services offered through DNB Financial Services; and other sources
of income such as increases in the cash surrender value of bank owned life
insurance, net gains on sales of investment securities and other real estate
owned ("OREO") properties. In addition, DNB receives fees for cash management,
merchant services, debit cards, safe deposit box rentals, check cashing, lockbox
services and similar activities.
For the three and nine month periods ended September 30, 2003, non-interest
income was $356,000 and $1.9 million, respectively, compared to $709,000 and
$1.9 million for the same periods in 2002. Service charges increased $41,000 and
$142,000, to $318,000 and $923,000 for the three and nine month periods ended
September 30, 2003, compared with the same periods in 2002. Much of the increase
in this category came from non-sufficient funds ("NSF") fees, which rose $23,000
and $82,000, respectively, due to an increase in the volume of accounts as well
as a concerted effort by management to reduce the waived fee percentage on
deposit account overdrafts. ATM income also contributed to increased income with
increases of $7,000 and $27,000 for the three and nine month periods ended
September 30, 2003, compared with the same periods in 2002.
Income from Wealth Management rose $49,000 or 39% to $173,000 and $164,000 or
51% to $486,000 for the three and nine month periods, respectively. (Losses)
gains and from sales of investments were ($466,000) and ($337,000) in 2003 and
$96,000 and $165,000 in 2002 for the three and nine month periods, respectively.
In addition, income from bank owned life insurance was $145,000 and $258,000,
respective, for the three and nine month periods ending on September 30, 2002,
an increase of $101,000 and $116,000 over the same respective periods in 2002.
Other non-interest income increased $18,000 and $65,000 to $186,000 and $536,000
for the three and nine month periods ended September 30, 2003, respectively. The
increase in other income for the three and nine month periods reflected higher
commissions on STAR/Visa debit card products and cash management fees.
NON-INTEREST EXPENSE
Non-interest expense includes salaries & employee benefits, furniture &
equipment, occupancy, professional & consulting fees as well as printing &
supplies, marketing and other less significant expense items.
Non-interest expenses increased $870,000 to $3.7 million and $924,000 to $9.5
million for the three and nine month periods ended September 30, 2003, compared
to the same periods in 2002. The increase during the three and nine month
periods was due to increases in a majority of the expense categories, as
discussed below.
Salaries & employee benefits increased $583,000 or 38.0% to $2.1 million and
$650,000 or 14.0% to $5.3 million for the three and nine months ended September
30, 2003, compared to $1.6 million and $4.7 million for the same periods in
2002. The increase in this category reflects higher levels of salaries, medical
insurance benefits, and pension costs. Officer and employee salaries rose
$199,000 year-over-year due to the increase in full-time equivalent employees,
as well as normal merit increases. Medical insurance benefits expense increased
$89,000 due to higher premiums, reflecting increased medical claims. Pension
expense rose $350,000 as a direct result of increased service cost coupled with
lower returns on plan assets.
Furniture & equipment expense increased $91,000 or 27.1% to $426,000 and
$179,000 or 18.2% to $1.2 million for the three and nine months ended September
30, 2003, respectively. This compars to $335,000 and $980,000 for the same
periods in 2002. The increase for the three and nine month periods in these
categories was due to higher levels of equipment depreciation relating to a new
bank-wide voice-mail system and depreciation on other recent equipment/software
upgrades.
Occupancy expense increased approximately $15,000 or 7.2% to $225,000 and
$21,000 or 3.4% to $629,000 for the three and nine months ended September 30,
2003, compared to $210,000 and $608,000 for the same periods in 2002. The modest
increase was due to higher levels of depreciation and utility costs.
Marketing expense declined $32,000 or 25.4% to $93,000 and $81,000 or 25.4% to
$235,000 for the three and nine months ended September 30, 2003, respectively,
compared to $124,000 and $316,000 for the same periods in 2002.
Professional & consulting expense increased $79,000 or 55.2% to $224,000 for the
three month period ended September 30, 2003, compared to $145,000 for the same
period in 2002. The increase was due to costs incurred in the third quarter for
services relating to human resources, legal services and other professional
services. Professional & consulting expense increased slightly to $460,000 for
the nine month period ended September 30, 2003, compared to $457,000 for the
same period in 2002.
Printing & supplies expense increased $30,000 or 46.0% to $96,000 for the three
month period ended September 30, 2003 compared to $65,000 same period in 2002.
Printing & supplies expense increased $17,000 or 6.8% to $261,000 for the nine
month period ended September 30, 2003, compared to $244,000 for the same period
in 2002.
Other expenses include such items as postage, PA shares tax, insurance, ATM
charges, OREO expense, satisfaction fees, appraisal fees, telephone & fax, and
other miscellaneous expenses. Other expenses increased $102,000 or 25.8% and
$136,000 or 10.6% to $497,000 and $1.4 million for the three and nine months
ended September 30, 2003 compared to $395,000 and $1.3 million for the same
periods in 2002.
INCOME TAXES
Income tax (benefit) expense was ($272,000) and ($75,000) for the three and nine
months ending September 30, 2003 compared with $236,000 and $594,000 for the
three and nine months ending September 30, 2002. The effective tax rate was
(73%) and (10%) for the three and nine month period ending September 30, 2003,
respectively, compared to 24% and 22% for the three and nine month periods
ending September 30, 2002. The effective tax rates for both periods were less
than the statutory rate due to the effect of tax-exempt income, tax credits
recognized on a low-income housing limited partnership and income from
bank-owned life insurance policies, relative to DNB's pre-tax income.
ASSET QUALITY
Non-performing assets are comprised of nonaccrual loans, loans delinquent over
ninety days and still accruing and Other Real Estate Owned ("OREO"). Nonaccrual
loans are loans for which the accrual of interest ceases when the collection of
principal or interest payments is determined to be doubtful by management. It is
the policy of DNB to discontinue the accrual of interest when principal or
interest payments are delinquent 90 days or more (unless the loan principal and
interest are determined by management to be fully secured and in the process of
collection), or earlier, if considered prudent. Interest received on such loans
is applied to the principal balance, or may in some instances, be recognized as
income on a cash basis. A nonaccrual loan may be restored to accrual status when
management expects to collect all contractual principal and interest due and the
borrower has demonstrated a sustained period of repayment performance in
accordance with the contractual terms. OREO consists of real estate acquired by
foreclosure or deed in lieu of foreclosure. OREO is typically carried at the
lower of cost or estimated fair value, less estimated disposition costs. Any
significant change in the level of nonperforming assets is dependent, to a large
extent, on the economic climate within DNB's market area.
The following table sets forth those assets that are on nonaccrual status or
contractually delinquent by 90 days or more and still accruing for the periods
presented. DNB had no OREO at the end of all reported periods.
Sept. 30 Dec. 31 Sept. 30
(Dollars in Thousands) 2003 2002 2002
------- ------ -------
Nonaccrual Loans:
Residential mortgage ...................................................... $ 322 $ 285 $ 247
Commercial mortgage ....................................................... 190 1,057 190
Commercial ................................................................ 146 1,758 1,506
Consumer .................................................................. 16 254 253
------- ------- -------
Total nonaccrual loans ......................................................... 674 3,354 2,196
Loans 90 days past due and still accruing ...................................... 605 514 512
------- ------- -------
Total non-performing assets .................................................... $ 1,279 $ 3,868 $ 2,708
======= ======= =======
The following table sets forth the DNB's asset quality and allowance coverage
ratios at the dates indicated: Sept. 30 Dec. 31 Sept. 30 2003 2002 2002
Non-performing Loans/Total Loans ............................................... 0.7% 2.1% 1.4%
Non-performing Assets/Total Assets ............................................. 0.3 1.0 0.7
Allowance for Loan Losses/Total Loans .......................................... 2.5 2.4 2.5
Allowance for Loan Losses/Total Loans and OREO ................................. 2.5 2.4 2.5
Allowance for Loan Losses/Non-performing Assets ................................ 176.4 117.5 176.4
Allowance for Loan Losses/Non-performing Loans ................................. 176.4 117.5 176.4
If interest income had been recorded on nonaccrual loans, interest would have
increased as shown in the following table:
9 Months Year 9 Months
Ended Ended Ended
(Dollars in thousands) 9/30/03 12/31/02 9/30/02
Interest income which would have been recorded
under original terms .................................................... $ 66 $ 230 $ 117
Interest income recorded during the period ..................................... (47) (159) (47)
------- ------- -------
Net impact on interest income .................................................. $ 19 $ 71 $ 70
======= ======= =======
9 Months Year 9 Months
Ended Ended Ended
(Dollars in thousands) 9/30/03 12/31/02 9/30/02
Total recorded investment ...................................................... $ 255 $ 2,400 $ 1,620
Average recorded investment .................................................... 382 2,000 1,194
Specific ALLL allocation ....................................................... -- -- --
Total cash collected ........................................................... 3 47 123
Interest income recorded ....................................................... $ -- $ 21 $ 21
LIQUIDITY AND CAPITAL RESOURCES
For a financial institution, liquidity is a measure of the ability to fund
customers' needs for loans and deposit withdrawals. Management regularly
evaluates economic conditions in order to maintain a strong liquidity position.
One of the most significant factors considered by management when evaluating
liquidity requirements is the stability of DNB's core deposit base. In addition
to cash, DNB maintains a portfolio of short-term investments to meet its
liquidity requirements. DNB has historically relied on cash flow from operations
and other financing activities. Liquidity is provided by investing activities,
including the repayment and maturing of loans and investment securities.
At September 30, 2003 DNB has $17.7 million in commitments to fund commercial
real estate, construction and land development. In addition, DNB had commitments
to fund $6.9 million in home equity lines of credit and $5.8 million in other
unused commitments. Management anticipates the majority of these commitments
will be funded by means of normal cash flows. In addition, $25.3 million of time
deposits at DNB are scheduled to mature during the three months ending December
31, 2003. Management believes that the majority of such deposits will be
reinvested with DNB and that certificates that are not renewed will be funded by
a reduction in Federal funds sold or by paydowns and maturities of loans and
investments.
On July 25, 2001, DNB authorized the buyback of up to 175,000 shares of its
Common Stock over an indefinite period. The buyback, if fully completed, would
reduce the number of outstanding shares by approximately 10%. The repurchases
are conducted through open market or privately negotiated transactions. Shares
purchased in the program are held as treasury stock. Through September 30, 2003,
DNB had repurchased 131,315 shares of its Common Stock pursuant to the program
at a total cost of $2,832,000.
Stockholders' equity was $24.8 million or $13.81 per share, compared to $26.2
million or $14.33 per share at December 31, 2002. The decrease in stockholders'
equity was the result of a $676,000 decrease in the fair market value of
available-for-sale securities, net of taxes, as well as the purchase of 49,888
shares of treasury stock ($1.1 million) and dividends paid of approximately
$706,000 or $.39 per share, partially offset by net income of $818,000 for the
nine months ended September 30, 2003. The Corporation's common equity position
at September 30, 2003 exceeds the regulatory required minimums. The following
table summarizes data and ratios pertaining to the Corporation and the Bank's
capital structure.
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
----------------- ----------------- --------------------
(Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio
- ---------------------- ------ ----- ------- ------ --------- ------
DNB Financial Corporation
As of September 30, 2003:
Total risk-based capital ................. $ 32,063 13.60% $20,362 8.00% $25,452 10.00%
Tier 1 capital ........................... 28,864 11.34 10,181 4.00 15,271 6.00
Tier 1 (leverage) capital ................ 28,864 7.24 15,953 4.00 19,941 5.00
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
---------------- ----------------- -----------------
(Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio
------ ----- ------ ----- ------- -----
Downingtown National Bank
As of September 30, 2003:
Total risk-based capital $30,575 12.02% $20,351 8.00% $25,439 10.00%
Tier 1 capital .......... 27,378 10.76 10,175 4.00 15,263 6.00
Tier 1 (leverage) capital 27,378 6.87 15,947 4.00 19,934 5.00
In addition, the Federal Reserve Bank (the "FRB") leverage ratio rules require
bank holding companies to maintain a minimum level of "primary capital" to total
assets of 5.5% and a minimum level of "total capital" to total assets of 6%. For
this purpose, (i) "primary capital" includes, among other items, common stock,
certain perpetual debt instruments such as eligible Trust preferred securities,
contingency and other capital reserves, and the allowance for loan losses, (ii)
"total capital" includes, among other things, certain subordinated debt, and
"total assets" is increased by the allowance for loan losses. DNB's primary
capital ratio and its total capital ratio are both 7.2%, well in excess of FRB
requirements.
REGULATORY MATTERS
Dividends payable to the Corporation by the Bank are subject to certain
regulatory limitations. Under normal circumstances, the payment of dividends in
any year without regulatory permission is limited to the net profits (as defined
for regulatory purposes) for that year, plus the retained net profits for the
preceding two calendar years.
OPERATING ENVIRONMENT AND CERTAIN TRENDS
DNB operates its franchise throughout Chester County, PA. Chester County has
extremely attractive demographics, which makes it one of the fastest growing
counties in Pennsylvania. Due to these factors, the operating environment is
very competitive as Chester County hosts over 40 banks, thrifts and credit
unions. In addition, brokerage firms, mutual fund companies and boutique
investment firms dot the landscape. This intense competition continually puts
pressures on DNB's margins and operating results as competitors offer a full
range of loan, deposit and investment products and services. In addition, many
of these competitors are much larger than DNB and consistently outspend the Bank
in marketing to attract new customers. We anticipate these pressures will
continue to adversely affect our margins.
FACTORS THAT MAY AFFECT FUTURE RESULTS
As a financial institution, DNB's earnings are significantly affected by general
business and economic conditions. These conditions include short-term and
long-term interest rates, inflation, monetary supply, fluctuations in both debt
and equity capital markets, and the strength of the United States economy and
local economies in which we operate. For example, an economic downturn, increase
in unemployment, or other events that negatively impact household
and/or corporate incomes could decrease the demand for DNB's loan and non-loan
products and services and increase the number of customers who fail to pay
interest or principal on their loans.
The Financial Accounting Standards Board's Interpretation No. 46 and its
Statement of Financial Accounting Standards ("SFAS") 150 will affect certain
special-purpose entities ("SPEs") that banking and other companies hold off the
balance sheet. Companies with SPEs may be required to consolidate them onto
their balance sheets. One of the potential results of this change could be to
reclassify trust-preferred securities as debt rather than equity. This raises
the question whether, as a result, bank regulatory agencies would begin to treat
trust preferred securities as debt not qualifying for Tier 1 capital status for
purposes of calculating certain regulatory capital ratios of bank holding
companies and federally insured depository institutions. On July 2, 2003, the
Federal Reserve Board announced that, for the time being, bank holding companies
should continue to include trust preferred securities as elements of Tier 1
capital. However, it is uncertain whether the Federal Reserve Board will
maintain this position indefinitely or, if it decides to disqualify trust
preferred securities as elements of Tier 1 capital, whether the Federal Reserve
Board will "grandfather" the Tier 1 capital status of existing issues of trust
preferred securities. If the Federal Reserve Board were to change its treatment
of trust preferred securities and not grandfather existing issues, DNB (and not
the Bank) would be required to reduce its Tier 1 capital for regulatory
purposes. Management does not believe that such an adjustment would have a
material adverse impact on DNB or the Bank.
Geopolitical conditions can also affect DNB's earnings. Acts or threats of
terrorism, actions taken by the United States or other governments in response
to acts or threats of terrorism and our military conflicts including the
aftermath of the war with Iraq, could impact business conditions in the United
States.
FORWARD-LOOKING STATEMENTS
This report contains statements, that are not of historical facts and may
pertain to future operating results or events or management's expectations
regarding those results or events. These are "forward-looking statements" within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities and Exchange Act of 1934. These forward-looking statements may
include, but are not limited to, statements about our plans, objectives,
expectations and intentions and other statements contained in this report that
are not historical facts. When used in this report, the words "expects",
"anticipates", "intends", "plans", "believes", "seeks", "estimates", or words of
similar meaning, or future or conditional verbs, such as "will", "would",
"should", "could", or "may" are generally intended to identify forward-looking
statements. These forward-looking statements are inherently subject to
significant business, economic and competitive uncertainties and contingencies,
many of which are either beyond our control or not reasonably capable of
predicting at this time. In addition, these forward-looking statements are
subject to assumptions with respect to future business strategies and decisions
that are subject to change. Actual results may differ materially from the
results discussed in these forward-looking statements. Readers of this report
are accordingly cautioned not to place undue reliance on forward-looking
statements. DNB disclaims any intent or obligation to update publicly any of the
forward-looking statements herein, whether in response to new information,
future events or otherwise.
ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
To measure the impacts of longer-term asset and liability mismatches beyond two
years, DNB utilizes Modified Duration of Equity and Economic Value of Portfolio
Equity ("EVPE") models. The modified duration of equity measures the potential
price risk of equity to changes in interest rates. A longer modified duration of
equity indicates a greater degree of risk to rising interest rates. Because of
balance sheet optionality, an EVPE analysis is also used to dynamically model
the present value of asset and liability cash flows, with rates ranging up or
down 200 basis points. The economic value of equity is likely to be different if
rates change. Results falling outside prescribed ranges require action by
management. At September 30, 2003 and December 31, 2002, DNB's variance in the
economic value of equity as a percentage of assets with an instantaneous and
sustained parallel shift of 200 basis points was within its negative 3%
guideline, as shown in the tables below. However, the change as a percentage of
the present value of equity with a 200 basis point decline at December 31, 2002,
was negative 35.1% and outside of DNB's negative 25% policy. This occurred as
the duration of DNB's assets shortened more quickly than the duration of DNB's
liabilities. Subsequent to December 31, 2002, management has taken the necessary
steps to move this ratio within policy guidelines, including but not limited to
reducing the level of Federal funds sold, purchasing municipal securities with
positive convexity, promoting five year fixed rate lending and attempting to
shorten the overall duration of deposits through pricing. At September 30, 2003
DNB's change as a percentage of the present value of equity with a 200 basis
point rise was negative 28.3% and out of compliance. This occurred as the
duration of DNB's liabilities shortened more quickly than the duration of DNB's
assets. Management has focused on reducing the amount of its short-term
borrowings and reducing the duration of its investment portfolio to bring this
measure within policy guidelines.
September 30, 2003 December 31, 2002
------------------------- -------------------------------
Change in rates ........................................... Flat -200bp +200bp Flat -200bp +200 bp
------ ------- ------- -------- -------- -------
EVPE ...................................................... $ 29,444 $ 26,617 $ 21,112 $ 27,381 $ 17,760 $ 28,553
Change .................................................... (2,827) (8,332) (9,621) 1,172
Change as a % of assets ................................ (0.7%) (2.0%) (2.5%) 0.3%
Change as a % of PV equity ................................ (9.6%) (28.3%) (35.1%) 4.3%
ITEM 4 - CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
The Company's Chief Executive Officer and Chief Financial Officer have reviewed
and evaluated the effectiveness of our disclosure controls and procedures (as
defined in Exchange Act Rules 240.13a-14(c) and 15d-14(c)) as of September 30,
2003. Based on that evaluation, the Chief Executive Officer and the Chief
Financial Officer have concluded that the Company's current disclosure controls
and procedures are effective and timely, providing them with material
information relating to the Company required to be disclosed in the reports we
file or submit under the Exchange Act.
CHANGES IN INTERNAL CONTROLS
Management and the Board of Directors of the Bank recently reviewed recent
declines in the Bank's net interest margin and return on average assets, and in
that connection evaluated the Bank's funds management practices to assess the
quantity and quality of risk management over interest rate risk and liquidity
risk. In that connection, management and the Board of Directors determined that
the decline in net interest margin and the relatively high level of interest
rate risk resulted from a number of factors. Those factors, and the related
actions management and the Board of Directors presently intend to take include
the following: improving the Bank's strategic plan and related controls to
address recent slow loan growth, reduce dependency on investment portfolio
income and improve the net income contribution of the loan portfolio; completing
a review of the Bank's liquidity, asset and liability management policy and
revising it where necessary; strengthening management of the investment
portfolio, particularly to mitigate risks of future prepayments; reducing
reliance on wholesale borrowings to fund investments; increasing monitoring and
assessment of leverage strategies; strengthening asset-liability and interest
rate risk management with regular monitoring; making greater use of available
outside resources for monitoring and managing interest rate risk and
asset-liability risks; evaluating asset-liability policies to determine that
risk limits are appropriate; and providing for independent periodic evaluation
of information and methods used in asset-liability and interest rate risk
management. These proposed actions are subject to change in the future as
management and the Board of Directors complete their evaluation of appropriate
adjustments to the Bank's policies and procedures.
With the exception of the foregoing, there have not been any significant changes
in the Company's internal controls or in other factors that could significantly
affect these controls subsequent to the date of their evaluation, and management
is not aware of any significant deficiencies or material weaknesses, and
therefore no corrective actions other than as described above were taken.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Not Applicable
ITEM 2. CHANGES IN SECURITIES
Not Applicable
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not Applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not Applicable
ITEM 5. OTHER INFORMATION
Not Applicable
ITEM 6.
(a) EXHIBITS:
31.1 Certification Pursuant to Section 302 of the Sarbanes-
Oxley Act of 2002 for the Chief Executive Officer.
31.2 Certification Pursuant to Section 302 of the Sarbanes-
Oxley Act of 2002 for the Chief Financial Officer.
32 Certification of Chief Executive Officer and Chief
Financial Officer pursuant to Section 906 of Sarbanes-
Oxley Act of 2002.
(b) REPORTS ON FORM 8-K
Current report on Form 8-K dated and filed July 31, 2003. Items 7 and
12, DNB Financial Corporation discloses the Company's press release
announcing second quarter 2003 earnings. Item 9, Regulation FD
Disclosure - Sarbanes-Oxley Section 906 Certifications.
Current report on Form 8-K dated and filed August 28, 2003. Items 7,
The Board of Directors of DNB Financial Corporation declared a cash
dividend of $0.13 per share for the third quarter of 2003 to
shareholders of record on September 10, 2003. Item 9, Regulation FD
Disclosure - Sarbanes-Oxley Section 906 Certifications.
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.
DNB FINANCIAL CORPORATION
(Registrant)
DATE: November 14, 2003 /S/ Henry F. Thorne
Henry F. Thorne, President
and Chief Executive Officer
DATE: November 14, 2003 /S/ Bruce E. Moroney
Bruce E. Moroney
Chief Financial Officer