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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
---------
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Quarter Ended June 30, 2003
No. 0-15786
(Commission File Number)
COMMUNITY BANKS, INC.
--------------------
(Exact Name of Registrant as Specified in its Charter)
PENNSYLVANIA 23-2251762
- ------------------------ ------------------------
(State of Incorporation) (IRS Employer ID Number)
750 East Park Dr., Harrisburg, PA 17111
- ------------------------------------------ -----------
(Address of Principal Executive Offices) (Zip Code)
(717) 920-1698
-------------------------------
(Registrant's Telephone Number)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Sections 12, 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 Exchange Act). YES X NO
---- ----
Number of shares outstanding as of July 31, 2003
CAPITAL STOCK-COMMON 9,640,000
- -------------------- ---------------------
(Title of Class) (Outstanding Shares)
COMMUNITY BANKS, INC. and SUBSIDIARIES
INDEX 10-Q
PART I - Financial Information
Item 1. Financial Statements
Consolidated Interim Balance Sheets.................................. 3
Consolidated Interim Statements of Income............................ 4
Consolidated Interim Statements of Changes in Stockholders' Equity... 5
Consolidated Interim Statements of Cash Flows........................ 6
Notes to Consolidated Interim Financial Statements................... 7-12
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operation....................................13-19
Item 3. Quantitative and Qualitative Disclosures About Market Risk.....20-21
Item 4. Controls and Procedures ....................................... 22
PART II - Other Information
Item 1. Legal Proceedings.............................................. 23
Item 2. Changes in Securities and Use of Proceeds...................... 23
Item 3. Defaults Upon Senior Securities................................ 23
Item 4. Submission of Matters to a Vote of Security Holders............ 23
Item 5. Other Information.............................................. 23
Item 6. Exhibits and Reports on Form 8-K...............................23-25
SIGNATURES................................................................. 26
2
COMMUNITY BANKS, INC. AND SUBSIDIARIES
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
- -----------------------------
Consolidated Interim Balance Sheets
(Unaudited)
(Dollars in thousands except per share data)
June 30, December 31,
2003 2002
-------------- -------------
ASSETS
Cash and due from banks..................................... $ 58,364 $ 36,137
Interest-bearing time deposits in other banks............... 1,040 951
Investment securities, available for sale................... 713,516 667,801
Loans....................................................... 1,004,067 904,568
Less: Allowance for loan losses......................... (12,922) (12,343)
-------------- -------------
Net loans..................................... 991,145 892,225
Premises and equipment, net................................. 24,323 24,209
Goodwill.................................................... 1,754 1,031
Identifiable intangible assets.............................. 692 729
Other real estate owned..................................... 359 1,183
Loans held for sale......................................... 6,780 11,483
Accrued interest receivable and other assets................ 44,710 44,149
-------------- -------------
Total assets........................................... $ 1,842,683 $ 1,679,898
============== =============
LIABILITIES
Deposits:
Demand (non-interest bearing)............................ $ 184,410 $ 168,277
Savings.................................................. 399,022 345,598
Time..................................................... 500,760 506,991
Time in denominations of $100,000 or more................ 110,033 112,047
-------------- -------------
Total deposits.......................................... 1,194,225 1,132,913
Short-term borrowings....................................... 156,015 69,125
Long-term debt.............................................. 319,112 320,533
Subordinated debentures..................................... 15,000 15,000
Accrued interest payable and other liabilities.............. 16,269 13,165
-------------- -------------
Total liabilities........................................ 1,700,621 1,550,736
-------------- -------------
STOCKHOLDERS' EQUITY
Preferred stock, no par value; 500,000 shares
authorized; no shares issued and outstanding............. --- ---
Common stock-$5.00 par value; 20,000,000
shares authorized; 9,878,000 and 9,881,000 shares
issued in 2003 and 2002, respectively.................... 49,388 47,053
Surplus..................................................... 57,318 46,418
Retained earnings........................................... 28,097 35,344
Accumulated other comprehensive income, net of
tax of $7,336 and $3,520, respectively................... 13,626 6,538
Less: Treasury stock of 262,000 and 271,000
shares at cost, respectively............................. (6,367) (6,191)
-------------- -------------
Total stockholders' equity................................ 142,062 129,162
-------------- -------------
Total liabilities and stockholders' equity................ $ 1,842,683 $ 1,679,898
============== =============
Issued and treasury shares have been restated to reflect the stock dividend paid
April 30, 2003.
The accompanying notes are an integral part of the consolidated
interim financial statements.
3
COMMUNITY BANKS, INC. AND SUBSIDIARIES
Consolidated Interim Statements of Income
(Unaudited)
(Dollars in thousands except per share data)
Three Months Ended Six Months Ended
June 30, June 30,
-------------------------- -------------------------
2003 2002 2003 2002
-------------------------- -------------------------
INTEREST INCOME:
Interest and fees on loans..................................... $ 16,364 $ 16,897 $ 32,430 $ 33,505
Interest and dividends on investment securities:
Taxable..................................................... 4,749 4,818 9,860 9,773
Exempt from federal income tax.............................. 2,609 2,363 5,201 4,870
Other interest income.......................................... 1 137 3 174
---------- ---------- ---------- ----------
Total interest income....................................... 23,723 24,215 47,494 48,322
---------- ---------- ---------- ----------
INTEREST EXPENSE:
Interest on deposits:
Savings..................................................... 807 1,121 1,562 2,245
Time........................................................ 4,206 5,412 8,584 10,611
Time in denominations of $100,000 or more................... 861 970 1,746 1,937
Interest on short-term borrowings and long-term debt........... 4,600 4,192 9,041 8,372
Interest on subordinated debentures............................ 176 --- 355 ---
Federal funds purchased and repo interest...................... 44 181 104 349
---------- ---------- ---------- ----------
Total interest expense..................................... 10,694 11,876 21,392 23,514
---------- ---------- ---------- ----------
Net interest income......................................... 13,029 12,339 26,102 24,808
Provision for loan losses......................................... 600 650 1,000 2,250
---------- ---------- ---------- ----------
Net interest income after provision for loan losses........ 12,429 11,689 25,102 22,558
---------- ---------- ---------- ----------
NON-INTEREST INCOME:
Investment management and trust services....................... 333 304 650 505
Service charges on deposit accounts........................... 1,295 816 2,336 1,576
Other service charges, commissions and fees.................... 776 636 1,530 1,287
Investment security gains ..................................... 500 18 1,547 536
Insurance premium income and commissions....................... 848 652 1,258 1,182
Gains on loan sales............................................ 445 101 871 486
Other income................................................... 809 1,136 1,203 1,773
---------- ---------- ---------- ----------
Total non-interest income................................... 5,006 3,663 9,395 7,345
---------- ---------- ---------- ----------
NON-INTEREST EXPENSES:
Salaries and employee benefits................................. 6,276 5,178 12,176 10,330
Net occupancy expense.......................................... 1,778 1,609 3,544 2,805
Other operating expense........................................ 3,335 3,240 6,458 6,315
---------- ---------- ---------- ----------
Total non-interest expenses................................. 11,389 10,027 22,178 19,450
---------- ---------- ---------- ----------
Income before income taxes.................................. 6,046 5,325 12,319 10,453
Income taxes ..................................................... 1,070 706 2,242 1,383
---------- ---------- ---------- ----------
Net income.................................................. $ 4,976 $ 4,619 $ 10,077 $ 9,070
========== ========== ========== ==========
CONSOLIDATED PER SHARE DATA:
Basic earnings per share....................................... $ .52 $ .48 $ 1.05 $ .93
Diluted earnings per share..................................... $ .50 $ .46 $ 1.02 $ .91
Dividends declared................................................ $ .20 $ .17 $ .39 $ .32
Per share data has been restated to reflect the stock dividend paid April 30,
2003.
The accompanying notes are an integral part of the consolidated interim
financial statements.
4
COMMUNITY BANKS, INC. AND SUBSIDIARIES
Consolidated Interim Statements of Changes in Stockholders' Equity
(Unaudited)
(Dollars in thousands except per share data)
Six Month Periods Ended June 30
Accumulated
Other
Common Retained Comprehensive Treasury Total
Stock Surplus Earnings Income Stock Equity
------------------------------------------------------------------------------------
Balance, January 1, 2002................. $44,839 $35,906 $36,923 $ (4,024) $ (2,395) $111,249
Comprehensive income:
Net income......................... 9,070 9,070
Unrealized gain on securities,
net of reclassification
adjustments...................... 6,526 6,526
--------
Total comprehensive income.......... 15,596
Cash dividends ($.32 per share).......... (3,161) (3,161)
5% stock dividend (448,000 shares)....... 2,241 10,177 (12,418)
Purchases of treasury stock
(103,000 shares)...................... (2,493) (2,493)
Issuance of additional shares
(54,000 net shares of treasury
stock reissued and 3,000 shares
of common stock canceled)............. (16) (389) 1,076 671
------- ------- ------- -------- -------- --------
Balance, June 30, 2002................... $47,064 $46,083 $30,025 $ 2,502 $ (3,812) $121,862
======= ======= ======= ======== ======== ========
Balance, January 1, 2003................. $47,053 $46,418 $35,344 $ 6,538 $ (6,191) $129,162
Comprehensive income:
Net income.......................... 10,077 10,077
Unrealized gain on securities,
net of reclassification
adjustments...................... 7,088 7,088
---------
Total comprehensive income.......... 17,165
Cash dividends ($.39 per share).......... (3,750) (3,750)
5% stock dividend (470,000 shares)....... 2,346 10,612 (12,984) ( 26)
Purchases of treasury stock
(100,000 shares)...................... (2,822) (2,822)
Issuance of additional shares
(109,000 net shares of treasury
stock reissued and 2,000 shares
of common stock canceled)............ (11) 288 (590) 2,646 2,333
------- ------- ------- -------- -------- --------
Balance, June 30, 2003................... $49,388 $57,318 $28,097 $ 13,626 $ (6,367) $142,062
======= ======= ======= ======== ======== ========
Per share data has been restated to reflect the stock dividend paid April 30,
2003.
The accompanying notes are an integral part of the consolidated interim
financial statements.
5
COMMUNITY BANKS, INC. AND SUBSIDIARIES
Consolidated Interim Statements of Cash Flows
(Unaudited)
(Dollars in thousands)
Six Months Ended
June 30,
--------------------------------------
2003 2002
--------------------------------------
Operating Activities:
Net income..................................................... $ 10,077 $ 9,070
Adjustments to reconcile net income to net cash
provided by operating activities:
Provision for loan losses.................................... 1,000 2,250
Depreciation and amortization................................ 1,532 1,207
Amortization of security premiums and discounts, net......... 1,436 117
Investment security gains.................................... (1,547) (536)
Loans originated for sale.................................... (39,711) (28,027)
Proceeds from sales of loans................................. 45,284 33,983
Gains on loan sales.......................................... (871) (486)
Change in other assets, net.................................. 3,447 (667)
Change in accrued interest payable and
other liabilities, net...................................... (4,234) (932)
----------- -----------
Net cash provided by operating activities.................... 16,413 15,979
----------- -----------
Investing Activities:
Net (increase) decrease in interest-bearing time
deposits in other banks....................................... (89) 754
Proceeds from sales of investment securities................... 110,442 134,510
Proceeds from maturities of investment securities.............. 73,013 3,127
Purchases of investment securities............................. (218,154) (152,434)
Net increase in total loans.................................... (100,170) (29,880)
Additions to premises and equipment......................... (1,448) (1,413)
Other.......................................................... (322) ---
----------- -----------
Net cash used by investing activities.......................... (136,728) (45,336)
----------- -----------
Financing Activities:
Net increase in total deposits................................. 61,312 110,451
Net increase (decrease) in short-term borrowings............... 86,890 (17,080)
Repayment of long-term debt.................................... (1,421) (21,377)
Cash dividends................................................. (3,750) (3,161)
Purchases of treasury stock.................................... (2,822) (2,493)
Proceeds from issuance of common stock......................... 2,333 671
----------- -----------
Net cash provided by financing activities................... 142,542 67,011
----------- -----------
Increase in cash and cash equivalents........................ 22,227 37,654
Cash and cash equivalents at beginning of period............... 36,137 44,764
----------- -----------
Cash and cash equivalents at end of period..................... $ 58,364 $ 82,418
=========== ===========
The accompanying notes are an integral part of the consolidated interim
financial statements.
6
COMMUNITY BANKS, INC. AND SUBSIDIARIES
Notes to Consolidated Interim Financial Statements
(Unaudited)
1. Summary of Significant Accounting Policies
Basis of Presentation - The accompanying unaudited consolidated financial
statements of Community Banks, Inc. and Subsidiaries ("Community") have been
prepared in accordance with accounting principles generally accepted in the
United States for interim financial information and instructions to Form 10-Q
and Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by accounting principles generally accepted
in the United States for complete financial statements. In the opinion of
management, all adjustments, consisting of normal recurring accruals, considered
necessary for a fair presentation have been included.
The preparation of financial statements in accordance with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
Operating results for the six months ended June 30, 2003, are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2003.
For further information, refer to the audited consolidated financial
statements, and footnotes thereto, included in the Annual Report on Form 10-K,
for the year ended December 31, 2002.
Community Banks, Inc. (Community) is a financial holding company whose
wholly-owned subsidiaries include Community Banks, Community Bank Investments,
Inc. (CBII), Community Banks Life Insurance Co. (CBLIC) and CMTY Capital Trust
I. Community Banks provides a wide range of services through its network of
offices in Adams, Cumberland, Dauphin, Luzerne, Northumberland, Schuylkill,
Snyder, and York Counties in Pennsylvania and Carroll County in Maryland.
Statement of Cash Flows - Cash and cash equivalents include cash and due
from banks and federal funds sold. The company made cash payments of $1.3
million and $1.8 million and $21.4 million and $23.8 million for income taxes
and interest, respectively, for each of the six month periods ended June 30,
2003 and 2002. Excluded from the consolidated statements of cash flows for the
periods ended June 30, 2003 and 2002 was the effect of certain non-cash
activities. The company acquired real estate through foreclosure totaling
$251,000 and $2.4 million, respectively.
Acquisitions - During the quarter ended June 30, 2003, Community completed
its acquisition of the Abstracting Company of York County and the Schultz
Insurance Agency. In July 2003, Community completed its acquisition of Erie
Financial Group, LTD a mortgage banking company. All acquisitions were accounted
for under the purchase method of accounting and did not have a material effect
on Community's financial position or results of operation.
7
COMMUNITY BANKS, INC. AND SUBSIDIARIES
Notes to Consolidated Interim Financial Statements, Continued
(Unaudited)
Stock-Based Compensation - Community has a stock-based compensation plan
and accounts for this plan under the recognition and measurement principle of
APB No. 25, "Accounting for Stock Issued to Employees," and related
Interpretations. No stock-based compensation cost is reflected in net income, as
all options granted under this plan had an exercise price equal to the market
value of the underlying common stock on the date of grant. The following table
illustrates the effect on net income and earnings per share if Community had
applied the fair value recognition provisions of FASB No. 123, "Accounting for
Stock-Based Compensation," to stock-based compensation (in thousands, except per
share data):
Three Months Ended June 30, Six Months Ended June 30,
2003 2002 2003 2002
--------------------------- ----------------------
Net income, as reported 4,976 4,619 10,077 9,070
Deduct: Total stock-based
compensation expense determined
under fair value based method for
all awards, net of related tax effect 127 99 253 197
------ ------ ------ ------
Pro forma net income $4,849 $4,520 $9,824 $8,873
====== ====== ====== ======
Earnings per share:
Basic-as reported $ .52 $ .48 $ 1.05 $ .93
===== ===== ====== =====
Basic-pro forma $ .50 $ .47 $ 1.02 $ .91
===== ===== ====== =====
Diluted-as reported $ .50 $ .46 $ 1.02 $ .91
===== ===== ====== =====
Diluted-pro forma $ .49 $ .45 $ 1.00 $ .89
===== ===== ====== =====
Recent Accounting Developments - In January 2003, the Financial Accounting
Standards Board issued FASB Interpretation No. 46, "Consolidation of Variable
Interest Entities, an Interpretation of ARB No. 51." This interpretation
provides new guidance for the consolidation of variable interest entities (VIEs)
and requires such entities to be consolidated by their primary beneficiaries if
the entities do not effectively disperse risk among parties involved. The
interpretation also adds disclosure requirements for investors that are involved
with unconsolidated VIEs. The disclosure requirements apply to all financial
statements issued after January 31, 2003. The consolidation requirements apply
immediately to VIEs created after January 31, 2003 and are effective for the
first fiscal year or interim period beginning after June 15, 2003 for VIEs
acquired before February 1, 2003. The adoption of this interpretation did not
have any impact on Community's financial condition or results of operations.
SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and
Hedging Activities," was issued in April 2003. SFAS 149 amends and clarifies
financial accounting and reporting for derivatives instruments, including
certain derivative instruments embedded in other contracts (collectively
referred to as derivatives) and for hedging activities under SFAS 133,
"Accounting for Derivative Instruments and Hedging Activities." SFAS 149 was
effective for contracts entered into or modified after June 30, 2003. The
adoption of this standard did not have a material impact on results of
operations, financial position, or liquidity.
SFAS No. 150, "Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity," was issued in May 2003. SFAS
150 requires that an issuer classify a financial instrument that is within its
scope as a liability. Many of these instruments were previously classified as
equity. SFAS 150 was effective for financial instruments entered into or
modified after May 31, 2003 and otherwise was effective beginning July 1, 2003.
The adoption of this standard did not have any impact on results of operations,
financial position, or liquidity.
8
COMMUNITY BANKS, INC. AND SUBSIDIARIES
Notes to Consolidated Interim Financial Statements, Continued
(Unaudited)
2. Investment Securities
---------------------
The amortized cost and fair values of investment securities at June 30,
2003 and December 31, 2002 were as follows(Dollars in thousands):
June 30, 2003
---------------
Amortized Fair
Cost Value
---------- -----------
U.S. Treasury and federal agencies ...................................... $ 172,055 $ 177,180
Mortgage-backed U.S. government agencies................................. 159,614 163,035
Obligations of states and political subdivisions......................... 184,263 194,776
Corporate securities..................................................... 107,444 108,341
Equity securities........................................................ 66,855 70,184
---------- -----------
Total............................................................... $ 690,231 $ 713,516
========== ===========
December 31, 2002
-----------------
Amortized Fair
Cost Value
---------- -----------
U.S. Treasury and federal agencies ...................................... $ 130,947 $ 134,334
Mortgage-backed U.S. government agencies................................. 206,450 210,825
Obligations of states and political subdivisions......................... 172,391 177,135
Corporate securities..................................................... 95,022 93,094
Equity securities........................................................ 50,610 52,413
---------- -----------
Total............................................................... $ 655,420 $ 667,801
========== ===========
9
COMMUNITY BANKS, INC. AND SUBSIDIARIES
Notes to Consolidated Interim Financial Statements, Continued
(Unaudited)
3. Allowance for loan losses
-------------------------
Changes in the allowance for loan losses are as follows (Dollars in
thousands):
Six Months Ended Year Ended Six Months Ended
June 30, December 31, June 30,
2003 2002 2002
------------------ -------------- ------------------
Balance, January 1................................... $ 12,343 $12,132 $12,132
Provision for loan losses............................ 1,000 3,350 2,250
Loan charge-offs..................................... (796) (4,180) (2,046)
Recoveries........................................... 375 1,041 290
--------- -------- --------
Balance, June 30, 2003, December 31,
2002, and June 30, 2002............................. $ 12,922 $12,343 $12,626
========= ======= =======
RISK ELEMENTS (a)
June 30, December 31, June 30,
2003 2002 2002
--------- ------- -------
Loans on which accrual of interest has been
discontinued:
Commercial................................................ $ 3,071 $ 757 $ 4,643
Residential and commercial mortgages...................... 7,450 8,250 4,237
Other..................................................... 760 386 214
--------- ------- -------
11,281 9,393 9,094
--------- ------- -------
Other real estate.............................................. 359 1,183 411
--------- ------- -------
Total non-performing assets............................. 11,640 10,576 9,505
Loans past due 90 days or more and still accruing interest:
Commercial................................................ --- 817 495
Residential and commercial mortgages..................... 38 49 440
Consumer................................................. 23 95 46
--------- ------- -------
61 961 981
--------- ------- -------
Total risk elements..................................... $ 11,701 $11,537 $10,486
========= ======= =======
(a) The determination to discontinue the accrual of interest on
non-performing loans is made on the individual case basis. Such factors as the
character and size of the loan, quality of the collateral and the historical
creditworthiness of the borrower and/or guarantors are considered by management
in assessing the collectibility of such amounts.
Impaired Loans
- --------------
At June 30, 2003 and December 31, 2002, the recorded investment in loans
for which impairment has been recognized totaled $8.9 million and $7.0 million,
respectively. The valuation allowance for impaired loans totaled $486,000 and
$326,000 at June 30, 2003 and December 31, 2002, respectively. For the six
months ended June 30, 2003, and 2002 the average recorded investment in impaired
loans approximated $8.1 million and $7.6 million, respectively. Interest
recognized on impaired loans on the cash basis for the six month periods ending
June 30, 2003 and 2002 was not significant.
10
COMMUNITY BANKS, INC. AND SUBSIDIARIES
Notes to Consolidated Interim Financial Statements, Continued
(Unaudited)
4. Earnings Per Share:
The following table sets forth the calculations of Basic and Diluted
Earnings Per Share for the periods indicated:
Three Months Ended June 30,
----------------------------------------------------------------
2003 2002
----------------------------------------------------------------
Per-Share Per-Share
Income Shares Amount Income Shares Amount
----------------------------------------------------------------
(In thousands except per share data)
Basic EPS:
Net income available to common stockholders................ $ 4,976 9,625 $ .52 $4,619 9,715 $.48
======= ===== ====== ====
Effect of Dilutive Securities:
Incentive stock options outstanding........................ 243 237
---- -----
Diluted EPS:
Income available to common stockholders &
assumed conversion...................................... $ 4,976 9,868 $ .50 $4,619 9,952 $.46
======= ===== ====== ====
Six Months Ended June 30,
-----------------------------------------------------------------------
2003 2002
-----------------------------------------------------------------------
Per-Share Per-Share
Income Shares Amount Income Shares Amount
-----------------------------------------------------------------------
(In thousands except per share data)
Basic EPS:
Net income available to common stockholders................ $10,077 9,612 $1.05 $9,070 9,723 $.93
======= ===== ====== ====
Effect of Dilutive Securities:
Incentive stock options outstanding........................ 230 231
------ -----
Diluted EPS:
Income available to common stockholders &
assumed conversion...................................... $10,077 9,842 $1.02 $9,070 9,954 $.91
======= ===== ====== ====
Per share and share data has been adjusted to reflect stock dividends.
5. Letters of Credit:
------------------
Outstanding letters of credit written are conditional commitments issued by
the bank subsidiary to guarantee the performance of a customer to a third party.
Community's exposure to credit loss in the event of nonperformance by the other
party to the financial instrument for standby letters of credit is represented
by the contractual amount of those instruments. Community had $23.6 million of
standby letters of credit as of June 30, 2003. The subsidiary bank uses the same
credit policies in making conditional obligations as it does for on-balance
sheet instruments.
The majority of these standby letters of credit expire within the next
twelve months. The credit risk involved in issuing letters of credit is
essentially the same as that involved in extending other loan commitments. The
subsidiary bank requires collateral and personal guarantees supporting these
letters of credit as deemed necessary. Management believes that the proceeds
obtained through a liquidation of such collateral and the enforcement of
personal guarantees would be sufficient to cover the maximum potential amount of
future payments required under the corresponding guarantees. The current amount
of the liability as of June 30, 2003 for guarantees under standby letters of
credit issued after December 31, 2002 is not material.
11
6. Comprehensive Income (Dollars in thousands):
--------------------------------------------
Three Months Ended Six Months Ended
June 30, June 30,
-------------------------- -------------------------
2003 2002 2003 2002
-------------------------- -------------------------
Investment Securities:
Unrealized holding gains
arising during the period.......................... $12,822 $ 13,516 $ 12,451 $ 10,576
Reclassification adjustments for
(gains) included in net income..................... (1,047) (518) (1,547) (536)
Unfunded pension liability................................. - - - -
------- ---------- ---------- ----------
Other comprehensive income.......................... 11,775 12,998 10,904 10,040
Tax effect................................................. 4,121 4,549 3,816 3,514
------- ---------- ---------- ----------
Other comprehensive income,
net of tax............................................ $ 7,654 $ 8,449 $ 7,088 $ 6,526
======= ========== ========== ==========
12
COMMUNITY BANKS, INC. AND SUBSIDIARIES
Part I - Item 2. Management's Discussion and Analysis of Financial Condition
-----------------------------------------------------------
and Results of Operations
-------------------------
Overview
The purpose of this review is to provide additional information necessary
to fully understand the consolidated financial condition and results of
operations of Community. Throughout this review, net interest income and the
yield on earning assets are stated on a fully taxable-equivalent basis and
balances represent average daily balances unless otherwise indicated. In
addition, income statement comparisons are based on the first six months of 2003
compared to the same period of 2002 unless otherwise indicated.
Forward-Looking Statements
Periodically, Community has made and will continue to make statements that
may include forward-looking information. Community cautions that forward-looking
information disseminated through financial presentations should not be construed
as guarantees of future performance. Furthermore, actual results may differ from
expectations contained in such forward-looking information as a result of
factors that are not predictable. Examples of factors that may not be
predictable or may be out of management's control include: the effect of
prevailing economic conditions; unforeseen or dramatic changes in the general
interest rate environment; actions or changes in policies of the Federal Reserve
Board and other government agencies; and business risk associated with the
management of the credit extension function and fiduciary activities. Each of
these factors could affect estimates, assumptions, uncertainties and risk used
to develop forward-looking information, and could cause actual results to differ
materially from management's expectations regarding future performance.
Critical Accounting Policies
The following is a summary of those accounting policies that Community
considers to be most important to the portrayal of its financial condition and
results of operations, as they require management's most difficult judgments as
a result of the need to make estimates about the effects of matters that are
inherently uncertain.
Provision and Allowance for Loan Losses - The allowance for loan losses is
evaluated on a regular basis by management and is based upon management's
periodic review of the collectibility of the loans in light of historical
experience, the nature and volume of the loan portfolio, adverse situations that
may affect the borrower's ability to repay, estimated value of any underlying
collateral and prevailing economic conditions. This evaluation is inherently
subjective as it requires estimates that are susceptible to significant revision
as additional information becomes available.
Impairment is measured on a loan by loan basis for commercial and
construction loans over $250,000 by either the present value of expected future
cash flows discounted at the loan's effective interest rate, the loan's
obtainable market price, or the fair value of the collateral if the loan is
collateral dependent.
Large groups of smaller balance homogeneous loans are collectively
evaluated for impairment. Accordingly, Community does not separately identify
individual consumer and residential loans for impairment disclosures.
Loans continue to be classified as impaired unless they are brought fully
current and the collection of scheduled interest and principal is considered
probable. When an impaired loan or portion of an impaired loan is determined to
be uncollectible, the portion deemed uncollectible is charged against the
allowance for loan losses, and subsequent recoveries, if any, are credited to
the valuation allowance.
13
COMMUNITY BANKS, INC. AND SUBSIDIARIES
PART I - Item 2. Management's Discussion and Analysis of Financial Condition
-----------------------------------------------------------
and Results of Operations (Continued)
-------------------------------------
Summary of Financial Results
Community, the parent company of Community Banks, continued to report
improved earnings performance for both the second quarter and first half of
2003. In the second quarter, earnings per share rose to $0.50, or nearly 9% over
the $0.46 reported in the same quarter of 2002. At the same time, net income for
the period rose to almost $5.0 million compared with $4.6 million in the second
quarter of the year earlier period. Results for the second quarter of 2003
produced a return on average assets and return on average equity, two common
measures of financial institution performance, of 1.12% and 14.62%,
respectively.
While steady improvement was recorded on a quarterly basis, year-to-date
performance rose more substantially as earnings per share for the first six
months of 2003 reached $1.02, a 12% increase over the $0.91 recorded in the
first half of 2002. Net income for the first half of 2003 was in excess of $10
million. Results for both the second quarter and first half of 2003 were
influenced by a number of factors, including an uncertain economic climate, a
record decline in the level of interest rates, and ongoing efforts to reposition
the investment portfolio to accommodate improved loan demand. Declines in key
benchmark interest rates continued to compress net interest margin performance
and constrained the overall rate of growth in net interest income. Despite the
influence of these negative extrinsic factors, profit performance was enhanced
by renewed loan growth trends, by a sustained credit quality focus, and by the
continued diversification of the non-interest fee and service income revenue
base. Operating expenses have continued to increase at a level commensurate with
the rate of increase in related revenue generation activities, and also included
the impact of a marketing campaign to promote brand awareness during the first
half of the year.
Growth trends in loans and overall earning assets rebounded during the
quarter, reversing a period of less robust growth experienced since the economic
downturn that began in early 2002. Quarter-over-quarter average loan growth was
10.5% in the second quarter of 2003 compared to the same period of 2002. Deposit
growth, though steady, was 6.9%, while earning assets grew 14.5%. These growth
measures exceeded the rate of growth in the first quarter of the current year,
suggesting that the economic slowdown may have begun to exhibit signs of
abatement. Total assets grew to $1.8 billion by the end of the second quarter
while loans and deposits reached $1.0 billion and $1.2 billion, respectively at
June 30, 2003. Mortgage generation activities continued to be vigorous as
origination income was fueled by the lower interest rates and the affordability
of financing for both new and existing homes.
Performance continues to be favorably influenced by a credit quality
profile that has reflected substantial improvement from the year earlier period.
During both the first and second quarters of 2003, net charge-offs remained
substantially below the amounts recorded throughout 2002, when net charge-offs
reached .35% of total loans. Annualized net charge-offs in the first half of
2003 were .09%, reflecting Community's solid asset quality.
During the first half of 2003, Community completed its acquisitions of the
Abstracting Company of York County, a title insurance and abstracting company,
and Shultz Insurance Agency in Hanover, Pennsylvania. In July 2003, Community
announced its agreement to acquire Your Insurance Partner, an insurance agency
with offices in Mechanicsburg and Dillsburg, Pennsylvania, and the completion of
its acquisition of Erie Financial Group, Ltd., a York, Pennsylvania-based
mortgage banking company. The Corporation also opened its first banking facility
in downtown Harrisburg in July. Community now operates a community office
network of 47 branches, combined with an expansive ATM network and a variety of
financial services offered through both its banking offices and through
specialized subsidiaries.
14
COMMUNITY BANKS, INC. AND SUBSIDIARIES
PART I - Item 2. Management's Discussion and Analysis of Financial Condition
-----------------------------------------------------------
and Results of Operations (Continued)
--------------------------------------
Average Statement of Condition
The average balance sheets for the six months ended June 30, 2003 and 2002 were
as follows (Dollars in thousands):
Change
2003 2002 Volume %
- -------------------------------------------------------------------------------------------------------------------------
Cash and due from banks $ 35,187 36,818 $ (1,631) (4)%
Federal funds sold and other 1,036 20,207 (19,171) (95)%
Investments 690,799 551,028 139,771 25%
Loans 947,413 873,771 73,642 8%
Allowance for loan losses 12,750 12,610 140 1%
- -------------------------------------------------------------------------------------------------------------------------
Net loans 934,663 861,161 73,502 9%
Goodwill and identifiable intangibles 1,953 992 961 97%
Loans held for sale 8,335 6,887 1,448 21%
Other assets 69,161 64,956 4,205 6%
- -------------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $ 1,741,134 $ 1,542,049 $ 199,085 13%
- -------------------------------------------------------------------------------------------------------------------------
Noninterest-bearing deposits $ 163,674 $ 160,092 $ 3,582 2%
Interest-bearing deposits 985,415 906,393 79,022 9%
Short-term borrowings 110,752 48,305 62,447 129%
Long-term debt 319,906 300,270 19,636 7%
Subordinated debentures 15,000 --- 15,000 n/a
Other liabilities 12,742 11,687 1,055 9%
- -------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES 1,607,489 1,426,747 180,742 13%
- -------------------------------------------------------------------------------------------------------------------------
STOCKHOLDERS' EQUITY 133,645 115,302 18,343 16%
- -------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY $ 1,741,134 $ 1,542,049 $ 199,085 13%
- -------------------------------------------------------------------------------------------------------------------------
Loan growth trends have been steady since the second quarter of 2002.
Quarterly average loan growth has been between 6% and 7% on an annualized basis
for each quarter from the second quarter of 2002 through the first quarter of
2003. In the quarter ended June 30, 2003, loan growth was more robust as growth
during the second quarter over the same quarter of 2002 reached nearly 11%. This
helped push the six-month growth rate to 8% for the first half of 2003.
Commercial loan growth remains strong in the commercial real estate market, and
general commercial lending has also shown recent growth. Residential real estate
lending, composed primarily of loans to single-family creditors, has experienced
a steady decline as a result of refinancing activity and the accessibility of
secondary market liquidity, with most new credits being sold in the secondary
market. This strategy reduces the interest rate risk associated with consumer
preferences for long term, fixed rate lending, and provides valuable liquidity
for other forms of relationship lending. Consumer demand for credit facilities
continues to be a significant contributing factor to sustaining lending. In
March of 2003, Community began offering a longer-term equity loan with bi-weekly
payments as an alternative to consumers seeking low cost financing.
Deposit balances remain the primary source of funding for financial
institutions and Community recognized growth of 7.8% in this important
core-funding source. Throughout 2002, deposit growth occurred evenly between
core accounts and time deposits. In 2003, deposit products such as Community's
higher interest PowerNOW Plus accounts contributed to more growth within the
interest bearing deposit accounts than in demand deposits or time deposits.
15
COMMUNITY BANKS, INC. AND SUBSIDIARIES
PART I - Item 2. Management's Discussion and Analysis of Financial Condition
-----------------------------------------------------------
and Results of Operations (Continued)
-------------------------------------
Community has made strategic use of short-tem funding sources at historic
low rates to augment its funding needs. Increases in overnight fed funds
borrowings have been used to fund earning asset growth short-term. Community
monitors its funding needs and the benefits of this currently low cost source of
funds and considers it in relation to its ability to generate funding through
increased deposits and term borrowings. Subsequent to June 30, 2003, overnight
borrowings through the Federal Home Loan Bank have begun to decrease. In
December of 2002, Community executed a pooled trust preferred issuance of $15
million in order to increase its amount of regulatory capital. The use of these
alternative funding vehicles continues to provide the excess liquidity necessary
to fund earning asset growth.
Net Interest Income
The following table summarizes, on a fully taxable equivalent basis,
changes in net interest income and net interest margin for the six months ended
June 30, 2003 and 2002 (Dollars in thousands):
2003 2002 Increase (Decrease)
Amount Yield/rate Amount Yield/rate Amount Yield/rate
- -------------------------------------------------------------------------------------------------------------------------
Interest income $ 50,601 6.21% $ 51,217 7.13% $ (616) (.92)
Interest expense 21,392 3.01% 23,514 3.78% (2,122) (.77)
- -------------------------------------------------------------------------------------------------------------------------
Net interest income $ 29,209 $ 27,703 $ 1,506
Interest spread 3.20% 3.35% (.15)
Impact of non-interest funds .39% 0.51% (.12)
- -------------------------------------------------------------------------------------------------------------------------
Net interest margin 3.59% 3.86% (.27)
- -------------------------------------------------------------------------------------------------------------------------
Community's major source of revenue is derived from intermediation
activities and is reflected as net interest income. Net interest income
represents the difference between interest income on earning assets and interest
expense on deposits and borrowed funds. Net interest margin is a relative
measure of a financial institution's ability to efficiently deliver net interest
income from a given level of earnings assets. Both net interest income and net
interest margin are influenced by the frequency and velocity of interest rate
changes and by the composition and absolute volumes of earning assets and
funding sources.
Net interest income increased $1.5 million, or 5.4% in 2003 compared to
2002. Both earning asset and interest-bearing liability levels increased and a
decline in asset yields outpaced the decline in funding costs. As such, the net
interest spread decreased 15 basis points.
Interest income decreased $616,000 or 12% during the first half of 2003. An
increase in earning assets of approximately $195 million was offset by a
decrease in the yield on loans and investments, which decreased in line with a
general decline in overall rates. Interest expense declined more substantially,
by $2.1 million, or 9.0%. Although interest-bearing liabilities increased
approximately $176 million, the benefit of a lower interest rate environment
resulted in a decrease in the total rate paid on funding sources of 77 basis
points. Given the reduction in interest rates since last year, the contribution
from non-interest funding sources declined from 51 basis points to 39 basis
points and added to the decrease in net interest margin.
In isolating second quarter 2003 performance, net interest margin declined
from the levels achieved in the prior quarter and from a year ago. Second
quarter net interest margin for 2003 reached 3.49% compared to 3.68% in the
first quarter and 3.76% in the second quarter of 2002.
Within the scope of its asset/liability management policy, Community has
repositioned its balance sheet posture in anticipation of a gradual rise in
interest rates. Expectations are that further substantial declines in overall
interest rates are considered to be unlikely and that Community is well
positioned to benefit from a measured increase in the rate environment in 2003
and 2004.
16
COMMUNITY BANKS, INC. AND SUBSIDIARIES
PART I - Item 2. Management's Discussion and Analysis of Financial Condition
-----------------------------------------------------------
and Results of Operations (Continued)
-------------------------------------
Provision for Loan Losses
Community remains attuned to the influence of unfolding economic conditions
and their potential impact on credit conditions and the adequacy of the
allowance for loan losses. The provision for loan losses charged to income in
2003 was $1.0 million compared to $2.3 million in 2002. Net loan charge-offs in
2003 were $421,000, or .08% of average loans annualized, compared to $1.8
million, or .40% of average loans annualized, in the first half of 2002.
Non-accrual loans of $11.3 million at June 30, 2003, increased from $9.1 million
a year earlier, reflecting in part a migration of loans from the 90 days past
due category, but also an increase in commercial accounts. Loans 90 days past
due but still accruing interest showed a dramatic decline to $61,000 at June 30,
2003, from $981,000 at June 30, 2002. Overall credit quality trends continue to
reflect the underlying credit quality standards applied to Community's lending
function.
Non-Interest Income
Non-interest income continued to improve on a year-over-year basis,
reflecting Community's continuing emphasis on the expansion of products and
services. Non-interest income, exclusive of security gains, increased $1.0
million, or 15%, in the first half of 2003 compared to the first half of 2002.
Service charges on deposit accounts increased $760,000, or 48.2%, in the
first half of 2003 compared to 2002. Service charges include the impact of fees
associated with insufficient funds, deposit service fees, and other similar
fee-based products. In 2003, Community instituted an overdraft program, which
fees accounted for a portion of the increase in deposit account service charges
Insurance premium income and commissions increased $76,000, or 1.1%, in
2003 from 2002 and reflected an increase in title insurance activity offset
partially by a decrease in fees earned through Community's captive insurance
business. Consistent with the growth in mortgage related activity, title
insurance volume reached an all-time high and included the impact of the April
2003 acquisition of the Abstracting Company of York County. During the latter
part of 2002, changes in federal regulations required that all banks convert
from a single premium to a monthly premium on credit insurance, which will
require income recognition over the life of the related loan. Previously, such
fees could be recognized upon remittance of the single premium. Over time, this
change in income recognition is not expected to adversely affect fees from this
service. Insurance premium income and commissions of $848,000 in the second
quarter of 2003 increased $438,000, or 106.8%, over the $410,000 recognized in
the first quarter.
Community derives revenue from the origination and sale of mortgage loans
into the secondary market. Gains on loan sales increased $385,000, or 79.2% in
2003 as a result of continued demand for fixed-rate real estate loans in this
historically low interest rate environment.
Investment security gains of $1.5 million were recognized in the first half
of 2003 compared to $536,000 in 2002. Such gains were realized pursuant to
management's ongoing effort to review investment holdings and portfolio
strategy. During the first half of 2003, Community recognized gains arising from
discrete sales of certain callable investments, which were likely to be called
in the near term. Other gains resulted from the sale of equity securities of
other financial institutions that had been recently acquired.
Other income for the first half of 2003 totaled $1.2 million compared to
$1.8 million for the first half of 2002. In 2002, a gain on the sale of two
branches was recognized. In July 2003, Community announced the sale of one
branch, which is expected to be consummated during the third quarter. Community
constantly monitors the performance of its office locations, using its ongoing
analysis and rationalization of its current office structure in its
consideration of maintaining existing markets, as well as expansion into markets
with more vibrant growth characteristics. Other income for the second quarter of
2003 totaled $809,000, an increase of $415,000 over first quarter income of
$394,000. During the second quarter, Community recognized a one-time fee
associated with a change in its check-printing vendor for customer checks. This
enabled Community to unify its entire customer base under a single service
provider.
17
COMMUNITY BANKS, INC. AND SUBSIDIARIES
PART I - Item 2. Management's Discussion and Analysis of Financial Condition
-----------------------------------------------------------
and Results of Operations (Continued)
-------------------------------------
Non-Interest Expenses
The increase in salaries and employee benefits of $1.8 million or 17.8% for
2003 compared to 2002 was affected by a number of factors including the annual
merit increase and employees added through the expansion of both Community's
office network, its fee-based activities, and corporate acquisitions.
The increase in occupancy expense of $739,000, or 26.4%, includes the
effect of branch expansion and the opening of the Southern Operations Center in
2002, as well as increased costs of facilities maintenance associated with the
harsh winter weather experienced throughout Community's geographic region in the
first quarter of 2003.
Other operating expense increased $143,000 or 2.3% in the first half of
2003. Marketing costs increased approximately $475,000 in the first half of 2003
and will continue to increase throughout 2003 as part of a plan to broaden
customer awareness of Community Banks and the services it provides in targeted
markets. Community continues to execute a targeted strategic marketing campaign
that includes radio, billboard, direct mail, and television mediums. The timing
of these expenditures is intended to correspond with market expansion
opportunities within several of the markets currently experiencing disruption
from merger activity.
Income Taxes
Income tax expense for the first six months of 2003 was $2.2 million,
resulting in an effective tax rate of 18.2%. The relative level of tax-exempt
income influences Community's effective income tax rates and is largely
responsible for the difference between the effective tax rate for 2003 and 2002
and the statutory federal tax rate for corporations.
Stockholders' Equity
Capital strength is a critical metric with which to judge the overall
stability of a financial institution. A strong capital base is also a
prerequisite for sustaining franchise growth through both internal expansion and
strategic acquisition opportunities. Regulatory authorities impose constraints
and restrictions on bank capital levels that are designed to help ensure the
vitality of the nation's banking system.
The most fundamental source of capital is earnings and earnings retention.
This cornerstone of capital adequacy can be augmented by a number of capital
management strategies, many of which were used in 2002 and which will continue
in 2003. As it has for a number of years, the Board approved the issuance of a
5% dividend in the first quarter of 2003. Community's strong earnings supported
an increase in the return of capital to existing shareholders in the form of an
increase in the traditional cash dividend. Community also continues to make
strategic use of share repurchase as another efficient means of returning
capital to shareholders. These strategies and techniques allow management to
maintain capital at levels that represent an efficient use of this valuable
resource.
Regulators have established standards for the monitoring and maintenance of
appropriate levels of capital for financial institutions. All regulatory capital
guidelines are now based upon a risk-based supervisory approach that has been
designed to ensure effective management of capital levels and associated
business risk. The following table provides the risk-based capital positions at
June 30, 2003 for Community and its banking subsidiary, CommunityBanks, along
with a comparison to the various regulatory capital requirements:
18
COMMUNITY BANKS, INC. AND SUBSIDIARIES
PART I - Item 2. Management's Discussion and Analysis of Financial Condition
-----------------------------------------------------------
and Results of Operations (Continued)
-------------------------------------
June 30, Regulatory "Well
2003 Minimums Capitalized"
---- ------------ --------
Leverage ratio
--------------
Community Banks, Inc. 7.85% 4% N/A
CommunityBanks 7.59% 4% 5%
Tier 1 capital ratio
--------------------
Community Banks, Inc. 10.51% 4% N/A
CommunityBanks 9.94% 4% 6%
Total risk-based capital ratio
------------------------------
Community Banks, Inc. 11.60% 8% N/A
CommunityBanks 10.97% 8% 10%
At June 30, 2003, total stockholders' equity reflected accumulated other
comprehensive income of $13.6 million compared to the accumulated other
comprehensive income of $6.5 million reflected in total stockholder's equity at
year-end 2002. This increase can be attributed to the change in the net
unrealized gain on investment securities available for sale, net of taxes.
During the early portion of the third quarter of 2003, interest rate trends
began to reverse. Such a pattern, if sustained, would have the effect of eroding
the unrealized gains reflected in stockholders' equity. Community reissued
approximately 108,000 shares and purchased approximately 100,000 shares of
treasury stock during the first six months of 2003. Community currently has
board approval to purchase an additional 182,000 shares through it share
repurchase plan.
19
COMMUNITY BANKS, INC. AND SUBSIDIARIES
PART I - Item 3. Quantitative and Qualitative Disclosures About Market Risk
- -------------------------------------------------------------------------------
Community Banks, Inc. has virtually no involvement with derivative
financial instruments and does not use them for trading purposes. Any
derivatives are embedded in their host contract and are not required to be
bifurcated. The business of Community and the composition of its balance sheet
consist of investments in interest-earning assets (primarily loans,
mortgage-backed securities and investment securities), which are primarily
funded by interest-bearing liabilities (deposits and borrowings). Such financial
instruments have varying levels of sensitivity to changes in market interest
rates resulting in market risk. Other than loans which are originated and held
for sale, all of the financial instruments of Community are for other than
trading purposes.
Interest rate sensitivity results when the maturity or repricing intervals
of interest-earning assets, interest-bearing liabilities, and off-balance sheet
financial instruments are different, creating a risk that changes in the level
of market interest rates will result in disproportionate changes in the value
of, and the net earnings generated from, Community's interest-earning assets,
interest-bearing liabilities, and off-balance sheet financial instruments.
Community's exposure to interest rate sensitivity is managed primarily through
Community's strategy of selecting the types and terms of interest-earning assets
and interest-bearing liabilities which generate favorable earnings, while
limiting the potential negative effects of changes in market interest rates.
Since Community's primary source of interest-bearing liabilities is customer
deposits, its ability to manage the types and terms of such deposits may be
somewhat limited by customer preferences in the market areas in which it
operates. Borrowings, which include Federal Home Loan Bank (FHLB) advances and
short-term loans, subordinated notes, and other short-term and long-term
borrowings are generally structured with specific terms which in management's
judgment, when aggregated with the terms for outstanding deposits and matched
with interest-earning assets, mitigate Community's exposure to interest rate
sensitivity.
The rates, terms and interest rate indices of Community's interest-earning
assets result primarily from its strategy of investing in loans and securities
(a substantial portion of which have adjustable-rate terms) which permit
Community to limit its exposure to interest rate sensitivity, together with
credit risk, while at the same time achieving a positive interest rate spread
compared to the cost of interest-bearing liabilities.
Significant Assumptions Utilized in Managing Interest Rate Sensitivity
----------------------------------------------------------------------
Managing the Corporation's exposure to interest rate sensitivity involves
significant assumptions about the exercise of embedded options and the
relationship of various interest rate indices of certain financial instruments.
Embedded Options
----------------
A substantial portion of the Corporation's loans and mortgage-backed
securities and residential mortgage loans contain significant embedded options,
which permit the borrower to prepay the principal balance of the loan prior to
maturity ("prepayments") without penalty. A loan's propensity for prepayment is
dependent upon a number of factors, including the current interest rate and
interest rate index (if any) of the loan, the financial ability of the borrower
to refinance, the economic benefit to be obtained from refinancing, availability
of refinancing at attractive terms, as well as economic and other factors in
specific geographic areas which affect the sales and price levels of residential
property. In a changing interest rate environment, prepayments may increase or
decrease on fixed and adjustable-rate loans pursuant to the current relative
levels and expectations of future short and long-term interest rates.
Investment securities, other than mortgage-backed securities and those with
early call provisions, generally do not have significant embedded options and
repay pursuant to specific terms until maturity. While savings and checking
deposits generally may be withdrawn upon the customer's request without prior
notice, a continuing relationship with such customers is generally predictable
resulting in a dependable and uninterrupted source of funds. Time deposits
generally have early withdrawal penalties, while term FHLB borrowings and
subordinated notes have prepayment penalties, which discourage customer
withdrawal of time deposits and prepayment by the Corporation of FHLB borrowings
and subordinated notes prior to maturity.
20
COMMUNITY BANKS, INC. AND SUBSIDIARIES
PART I - Item 3. Quantitative and Qualitative Disclosures About Market Risk
-----------------------------------------------------------
(Continued)
-----------
Interest Rate Indices
---------------------
The Corporation's loans and mortgage-backed securities are primarily
indexed to the national interest indices. When such loans and mortgage-backed
securities are funded by interest-bearing liabilities which are determined by
other indices, usually deposits and FHLB borrowings, a changing interest rate
environment may result in different levels of changes in the indices leading to
disproportionate changes in the value of, and net earnings generated from, the
Corporation's financial instruments. Each index is unique and is influenced by
different external factors, therefore, the historical relationships in various
indices may not be indicative of the actual change which may result in a
changing interest rate environment.
Interest Rate Sensitivity Measurement
-------------------------------------
In addition to periodic GAP reports comparing the sensitivity of
interest-earning assets and interest-bearing liabilities to changes in interest
rates, management also utilizes a report which measures the exposure of the
Corporation's economic value of equity to interest rate risk. The model
calculates the present value of assets, liabilities and equity at current
interest rates, and at hypothetically higher and lower interest rates at one
percent intervals. The present value of each major category of financial
instruments is calculated by the model using estimated cash flows based on
prepayments, early withdrawals, weighted average contractual rates and terms,
and discount rates for similar financial instruments. The resulting present
value of longer term fixed-rate financial instruments are more sensitive to
change in a higher or lower interest rate scenario, while adjustable-rate
financial instruments largely reflect only a change in present value
representing the difference between the contractual and discounted rates until
the next interest rate repricing date. The information provided by these
analyses provides some indication of the potential for interest rate adjustment,
but does not necessarily mean that the rate adjustment will occur or that it
will occur in accordance with the assumptions. Despite these inherent
limitations, Community believes that the tools used to manage its level of
interest rate risk provide an appropriate measure of market risk exposure.
Interest Rate Sensitivity at June 30, 2003
- ------------------------------------------
1-90 90-180 180-365 1 year
Dollars in thousands days days days or more Total
- -----------------------------------------------------------------------------------------------------------------------
Assets
Interest-bearing deposits in
other banks $ 1,040 --- --- --- $ 1,040
Investment securities 97,780 $ 49,259 $ 113,672 $ 452,805 713,516
Loans, net of unearned income 354,768 82,809 105,356 461,134 1,004,067
Loans held for sale 3,179 96 192 3,313 6,780
- -----------------------------------------------------------------------------------------------------------------------
Total $456,767 $ 132,164 $ 219,220 $ 917,252 $1,725,403
- -----------------------------------------------------------------------------------------------------------------------
Liabilities
Savings $399,022 $ --- $ --- $ --- $ 399,022
Time 91,685 64,000 86,026 259,049 500,760
Time in denominations of
$100,000 or more 30,424 16,949 19,306 43,354 110,033
Short-term borrowings 156,015 --- --- --- 156,015
Long-term debt 849 5,849 1,698 310,716 319,112
Subordinated debentures 15,000 --- --- --- 15,000
- -----------------------------------------------------------------------------------------------------------------------
Total $692,995 $ 86,798 $ 107,030 $ 613,119 $1,499,942
- -----------------------------------------------------------------------------------------------------------------------
Interest Sensitivity Gap
Periodic (236,228) $ 45,366 $ 112,190 $ 304,133
Cumulative (190,862) (78,672) 225,461
Cumulative gap as a percentage
of earning assets (14)% (11)% (5)% 13%
The negative GAP between interest-earning assets and interest-bearing
liabilities maturing or repricing within one year approximated 5% at both June
30, 2003, and December 31, 2002. Community's interest rate risk posture has
remained relatively constant since the end of the year.
21
COMMUNITY BANKS, INC. AND SUBSIDIARIES
PART I - Item 4. Controls and Procedures
- -----------------------------------------
Under the supervision and with the participation of the Company's
management, including its Chief Executive Officer and Chief Financial Officer,
the Company has evaluated the effectiveness of the design and operation of its
disclosure controls and procedures as of June 30, 2003. Based upon this
evaluation, the Chief Executive Officer and Chief Financial Officer have
concluded that the Company's disclosure controls and procedures are adequate and
effective to ensure that material information relating to the Company and its
consolidated subsidiaries is made known to them by others within those entities,
particularly during the period in which this quarterly report was prepared.
There were no significant changes in the Company's internal controls or in other
factors that could significantly affect these controls during the quarter ended
June 30, 2003.
22
COMMUNITY BANKS, INC. and SUBSIDIARIES
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings
There are no material pending legal actions, other than litigation
incidental to the business of Community, to which Community is a
party.
Item 2 - Changes in Securities and Use of Proceeds
Not applicable.
Item 3 - Defaults Upon Senior Securities
Not applicable.
Item 4 - Submission of Matters to a Vote of Security Holders
The annual meeting of shareholders of Community Banks, Inc. was held
on May 1, 2003 for the purpose of considering and voting upon the
following matter:
To elect four (4) directors: Robert W. Rissinger, John W.
Taylor, Jr., Wayne H. Mummert, and Scott J. Newkam, to serve
until the 2007 annual meeting of shareholders. Each director
received affirmative votes representing at least 77.13% of
the shares outstanding.
Item 5 - Other Information
Not applicable.
Item 6 - Exhibits and Reports on Form 8-K
(a) Exhibits
3(i) Amended Articles of Incorporation (Incorporated by reference
to Exhibit 3.1, attached to Registrant's registration on
Form 8-A, filed on May 13, 2002)
3(ii) Amended By-Laws (Incorporated by reference to Exhibit 3.2,
attached to Community's Quarterly Report on Form 10-Q for
the quarter ended March 31, 2003)
4 Instruments defining the rights of the holders of trust
capital securities and sold by Community in December 2002
are not attached, as the amount of such securities is less
than 10% of the consolidated assets of Community and its
subsidiaries, and the securities have not been registered.
Community agrees to provide copies of such instruments to
the SEC upon request.
10.1 2000 Directors' Stock Option Plan, incorporated by reference
to Exhibit 4 to Community's registration on Form S-8, filed
on May 17, 2000 (Incorporated by reference to Exhibit 10.1
to Community's Annual Report on Form 10-K for the year ended
December 31, 2002, filed with the Commission on March 28,
2003)
10.2 1998 Long-Term Incentive Plan, incorporated by reference to
Exhibit 4 to Community's registration on Form S-8, filed on
June 18, 1998(Incorporated by reference to Exhibit 10.2 to
Community's Annual Report on Form 10-K for the year ended
December 31, 2002, filed with the Commission on March 28,
2003)
23
COMMUNITY BANKS, INC. AND SUBSIDIARIES
PART II - Item 6. Exhibits and Reports on Form 8-K - (a) Exhibits (Continued)
- --------------------------------------------------------------------------------
10.3 Form of Stock Option Agreement - Directors Stock Option Plan
(Incorporated by reference to Exhibit 10.3 to Community's
Annual Report on Form 10-K for the year ended December 31,
2002, filed with the Commission on March 28, 2003)
10.4 Form of Stock Option Agreement - Long-Term Incentive Plan
(Incorporated by reference to Exhibit 10.4 to Community's
Annual Report on Form 10-K for the year ended December 31,
2002, filed with the Commission on March 28, 2003)
10.5 Employment Agreement of Eddie L. Dunklebarger (Incorporated
by reference to Exhibit 10.5 to Community's Annual Report on
Form 10-K for the year ended December 31, 2002, filed with
the Commission on March 28, 2003)
10.6 Employment Agreement of Donald F. Holt (Incorporated by
reference to Exhibit 10.6 to Community's Annual Report on
Form 10-K for the year ended December 31, 2002, filed with
the Commission on March 28, 2003)
10.7 Employment Agreement, and amendment thereto, of Robert W.
Lawley (Incorporated by reference to Exhibit 10.7 to
Community's Annual Report on Form 10-K for the year ended
December 31, 2002, filed with the Commission on March 28,
2003)
10.8 Employment Agreement, and amendment thereto, of Anthony N.
Leo (Incorporated by reference to Exhibit 10.8 to
Community's Annual Report on Form 10-K for the year ended
December 31, 2002, filed with the Commission on March 28,
2003)
10.9 Employment Agreement, and amendment thereto, of Jeffrey M.
Seibert (Incorporated by reference to Exhibit 10.9 to
Community's Annual Report on Form 10-K for the year ended
December 31, 2002, filed with the Commission on March 28,
2003)
10.10 Salary Continuation Agreement, and amendment thereto, of
Eddie L. Dunklebarger (Incorporated by reference to Exhibit
10.10 to Community's Annual Report on Form 10-K for the year
ended December 31, 2002, filed with the Commission on March
28, 2003)
10.11 Salary Continuation Agreement, and amendment thereto, of
Robert W. Lawley (Incorporated by reference to Exhibit 10.11
to Community's Annual Report on Form 10-K for the year ended
December 31, 2002, filed with the Commission on March 28,
2003)
10.12 Salary Continuation Agreement, and amendment thereto, of
Anthony N. Leo (Incorporated by reference to Exhibit 10.12
to Community's Annual Report on Form 10-K for the year ended
December 31, 2002, filed with the Commission on March 28,
2003)
10.13 Salary Continuation Agreement, and amendment thereto, of
Jeffrey M. Seibert (Incorporated by reference to Exhibit
10.13 to Community's Annual Report on Form 10-K for the year
ended December 31, 2002, filed with the Commission on March
28, 2003)
10.14 Rights Agreement between Community Banks, Inc. and Community
Banks, dated February 28, 2002, incorporated by reference to
Exhibit 1 to Community's registration on Form 8-A, filed on
February 27, 2002
10.15 Community Banks, Inc. 401(k) Plan (Incorporated by reference
to Exhibit 10.15 to Community's Annual Report on Form 10-K
for the year ended December 31, 2002, filed with the
Commission on March 28, 2003)
31.1 Rule 13a-14(a)/15d-14(a) Certification (Chief Executive
Officer)
31.2 Rule 13a-14(a)/15d-14(a) Certification (Chief Financial
Officer)
32.1 Section 1350 Certification (Chief Executive Officer)
32.2 Section 1350 Certification (Chief Financial Officer)
24
COMMUNITY BANKS, INC. AND SUBSIDIARIES
PART II - Item 6 - Exhibits and Reports on Form 8-K (Continued)
- ---------------------------------------------------------------
(b) Reports on Form 8-K
- ----------------------------
Registrant filed the following reports on Form 8-K during the quarter
ended June 30, 2003:
Report Dated April 17, 2003
---------------------------
Registrant announced its earnings for the period ended March 31, 2003.
Report Dated May 1, 2003
------------------------
Registrant announced the declaration of a second quarter
dividend.
Registrant also reported that its annual shareholders'
meeting was held on May 1, 2003.
Report Dated June 4, 2003
-------------------------
Registrant engaged Beard Miller Company LLP as its independent
accountant, replacing PriceWaterHouseCoopers LLP.
25
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 hereunto duly authorized.
COMMUNITY BANKS, INC.
(Registrant)
Date August 14, 2003 /s/ Eddie L. Dunklebarger
------------------ ----------------------------
Eddie L. Dunklebarger
Chairman and President
(Chief Executive Officer)
Date August 14, 2003 /s/ Donald F. Holt
------------------ ----------------------------
Donald F. Holt
Executive Vice President
(Chief Financial Officer)
26