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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 September 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 October 31, 2003
CAPITAL STOCK-COMMON 11,606,000
-------------------- ------------------
(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................................... 13-20
Item 3. Quantitative and Qualitative Disclosures About Market Risk.....21-22
Item 4. Controls and Procedures ......................................... 23
PART II - Other Information
Item 1. Legal Proceedings................................................ 24
Item 2. Changes in Securities and Use of Proceeds........................ 24
Item 3. Defaults Upon Senior Securities.................................. 24
Item 4. Submission of Matters to a Vote of Security Holders.............. 24
Item 5. Other Information................................................ 24
Item 6. Exhibits and Reports on Form 8-K.............................. 24-26
SIGNATURES................................................................... 27
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)
September 30, December 31,
2003 2002
-------------- -------------
ASSETS
Cash and due from banks..................................... $ 43,244 $ 36,137
Interest-bearing time deposits in other banks............... 1,179 951
Investment securities, available for sale................... 633,261 667,801
Loans....................................................... 1,068,967 904,568
Less: Allowance for loan losses......................... (13,440) (12,343)
-------------- ------------
Net loans..................................... 1,055,527 892,225
Premises and equipment, net................................. 24,507 24,209
Goodwill and identifiable intangible assets................. 4,699 1,760
Other real estate owned..................................... 572 1,183
Loans held for sale......................................... 6,835 11,483
Accrued interest receivable and other assets................ 46,184 44,149
-------------- -------------
Total assets........................................... $ 1,816,008 $ 1,679,898
============== =============
LIABILITIES
Deposits:
Demand (non-interest bearing)............................ $ 176,068 $ 168,277
Savings.................................................. 433,811 345,598
Time..................................................... 496,764 506,991
Time in denominations of $100,000 or more................ 103,989 112,047
-------------- -------------
Total deposits.......................................... 1,210,632 1,132,913
Short-term borrowings....................................... 92,935 69,125
Long-term debt.............................................. 348,082 320,533
Subordinated debentures..................................... 15,000 15,000
Accrued interest payable and other liabilities.............. 12,649 13,165
-------------- -------------
Total liabilities........................................ 1,679,298 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; 11,854,000 and 9,410,000 shares
issued in 2003 and 2002, respectively.................... 59,266 47,053
Surplus..................................................... 57,389 46,418
Retained earnings........................................... 21,409 35,344
Accumulated other comprehensive income, net of
tax of $2,397 and $3,520, respectively................... 4,451 6,538
Less: Treasury stock of 282,000 and 258,000
shares at cost, respectively............................. (5,805) (6,191)
-------------- -------------
Total stockholders' equity................................ 136,710 129,162
-------------- -------------
Total liabilities and stockholders' equity................ $ 1,816,008 $ 1,679,898
============== =============
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 Nine Months Ended
September 30, September 30,
-------------------------- -------------------------
2003 2002 2003 2002
-------------------------- -------------------------
INTEREST INCOME:
Interest and fees on loans..................................... $ 16,691 $ 16,958 $ 49,121 $ 50,463
Interest and dividends on investment securities:
Taxable..................................................... 4,456 5,000 14,316 14,773
Exempt from federal income tax.............................. 2,618 2,414 7,819 7,284
Other interest income.......................................... 4 41 7 215
---------- ---------- ---------- ----------
Total interest income....................................... 23,769 24,413 71,263 72,735
---------- ---------- ---------- ----------
INTEREST EXPENSE:
Interest on deposits:
Savings..................................................... 825 1,012 2,387 3,257
Time........................................................ 4,046 5,213 12,630 15,824
Time in denominations of $100,000 or more................... 792 911 2,538 2,848
Interest on short-term borrowings and long-term debt........... 4,637 4,234 13,678 12,606
Interest on subordinated debentures............................ 171 --- 526 ---
Federal funds purchased and repo interest...................... 44 95 148 444
---------- ---------- ---------- ----------
Total interest expense..................................... 10,515 11,465 31,907 34,979
---------- ---------- ---------- ----------
Net interest income......................................... 13,254 12,948 39,356 37,756
Provision for loan losses......................................... 900 500 1,900 2,750
---------- ---------- ---------- ----------
Net interest income after provision for loan losses........ 12,354 12,448 37,456 35,006
---------- ---------- ---------- ----------
NON-INTEREST INCOME:
Investment management and trust services....................... 292 260 942 765
Service charges on deposit accounts........................... 1,350 932 3,686 2,508
Other service charges, commissions and fees.................... 799 568 2,329 1,855
Investment security gains ..................................... 302 64 1,849 600
Insurance premium income and commissions....................... 819 331 2,077 1,513
Mortgage banking revenue....................................... 936 310 1,807 796
Other income................................................... 1,003 511 2,206 2,284
---------- ---------- ---------- ----------
Total non-interest income................................... 5,501 2,976 14,896 10,321
---------- ---------- ---------- ----------
NON-INTEREST EXPENSES:
Salaries and employee benefits................................. 6,623 5,638 18,799 15,968
Net occupancy expense.......................................... 1,820 1,528 5,364 4,333
Other operating expense........................................ 3,135 2,397 9,593 8,712
---------- ---------- ---------- ----------
Total non-interest expenses................................. 11,578 9,563 33,756 29,013
---------- ---------- ---------- ----------
Income before income taxes.................................. 6,277 5,861 18,596 16,314
Income taxes ..................................................... 1,130 1,121 3,372 2,504
---------- ---------- ---------- ----------
Net income.................................................. $ 5,147 $ 4,740 $ 15,224 $ 13,810
========== ========== ========== ==========
CONSOLIDATED PER SHARE DATA:
Basic earnings per share....................................... $ .45 $ .41 $ 1.32 $ 1.19
Diluted earnings per share..................................... $ .43 $ .40 $ 1.28 $ 1.16
Dividends declared............................................. $ .17 $ .14 $ .49 $ .41
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)
Nine Month Periods Ended September 30
-------------------------------------
Accumulated
Other
Common Retained Comprehensive Treasury Total
Stock Surplus Earnings Income(Loss) Stock Equity
------------------------------------------------------------------------------------
Balance, January 1, 2002................. $44,839 $35,906 $36,923 $(4,024) $(2,395) $111,249
Comprehensive income:
Net income......................... 13,810 13,810
Unrealized gain on securities, net
of reclassification adjustment .. 11,704 11,704
--------
Total comprehensive income.......... 25,514
Cash dividends ($.41 per share).......... (4,824) (4,824)
5% stock dividend declared in February
2002 (440,000 shares)................. 2,241 10,177 (12,418) ---
Purchases of treasury stock
(198,000 shares)...................... (5,142) (5,142)
Issuance of additional shares
(81,000 net shares of treasury
stock reissued and 4,000 shares
of common stock canceled)............. (21) (486) 1,760 1,253
------- ------- ------- ------- ------- --------
Balance, September 30, 2002.............. $47,059 $46,083 $33,005 $ 7,680 $(5,777) $128,050
======= ======= ======= ======= ======= ========
Balance, January 1, 2003................. $47,053 $46,418 $35,344 $ 6,538 $(6,191) $129,162
Comprehensive income:
Net income.......................... 15,224 15,224
Unrealized loss on securities, net
of reclassification adjustments.. (2,087) (2,087)
--------
Total comprehensive income.......... 13,137
Cash dividends ($.49 per share).......... (5,678) (5,678)
5% stock dividend declared in
February 2003 (470,000 shares)...... 2,346 10,612 (12,984) (26)
20% stock split payable in the form of a
stock dividend, declared in
November 2003 (1,976,000 shares).... 9,878 (9,878) ---
Purchases of treasury stock
(138,000 shares)..................... (3,275) (3,275)
Issuance of additional shares
(179,000 net shares of treasury
stock reissued and 2,000 shares
of common stock canceled)............ (11) 359 (619) 3,661 3,390
------- ------- ------- ------- ------- --------
Balance, September 30, 2003.............. $59,266 $57,389 $21,409 $ 4,451 $(5,805) $136,710
======= ======= ======= ======= ======= ========
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)
Nine Months Ended
September 30,
--------------------------------------
2003 2002
--------------------------------------
Operating Activities:
Net income........................................................ $ 15,224 $ 13,810
Adjustments to reconcile net income to net cash
provided by operating activities:
Provision for loan losses....................................... 1,900 2,750
Depreciation and amortization................................... 2,309 1,971
Amortization of security premiums and discounts, net............ 2,109 69
Investment security gains....................................... (1,849) (600)
Loans originated for sale....................................... (58,880) (39,811)
Proceeds from sales of loans.................................... 64,866 43,925
Gains on loan sales............................................. (1,338) (796)
Change in other assets, net..................................... 2,845 (2,408)
Change in accrued interest payable and
other liabilities, net......................................... (2,913) 780
----------- -----------
Net cash provided by operating activities...................... 24,273 19,690
----------- -----------
Investing Activities:
Net increase in interest-bearing time
deposits in other banks.......................................... (228) (193)
Proceeds from sales of investment securities...................... 153,233 117,267
Proceeds from maturities of investment securities................. 126,803 57,081
Purchases of investment securities................................ (248,966) (232,590)
Net increase in total loans....................................... (165,852) (52,165)
Additions to premises and equipment............................... (2,311) (2,533)
Other............................................................. (2,584) (880)
----------- -----------
Net cash used by investing activities............................ (139,905) (114,013)
----------- -----------
Financing Activities:
Net increase in total deposits.................................... 77,719 112,170
Net increase in short-term borrowings............................. 23,810 13,727
Proceeds from issuance of long-term debt.......................... 30,000 ---
Repayment of long-term debt....................................... (2,451) (26,384)
Cash dividends and cash paid in lieu of fractional shares......... (5,704) (4,824)
Purchases of treasury stock....................................... (3,275) (5,142)
Proceeds from issuance of common stock............................ 2,640 1,253
----------- -----------
Net cash provided by financing activities........................ 122,739 90,800
----------- -----------
Increase (decrease) in cash and cash equivalents.................... 7,107 (3,523)
Cash and cash equivalents at beginning of period..................... 36,137 44,764
----------- -----------
Cash and cash equivalents at end of period........................... $ 43,244 $ 41,241
=========== ===========
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.
Operating results for the nine months ended September 30, 2003, are not
necessarily indicative of the results that may be expected for the year ended
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 and Montgomery Counties 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 $2.6
million and $2.9 million and $32.0 million and $35.6 million for income taxes
and interest, respectively, for each of the nine month periods ended September
30, 2003 and 2002. Excluded from the consolidated statements of cash flows for
the periods ended September 30, 2003 and 2002 was the effect of certain non-cash
activities. The company acquired real estate through foreclosure totaling
$650,000 and $2.7 million, respectively.
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 principles 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.
(Dollars in thousands, except per share data)
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------- -------------------------
2003 2002 2003 2002
-------------------------- -------------------------
Net income, as reported......................................... $ 5,147 $ 4,740 $ 15,224 $ 13,810
Deduct: Total stock-based compensation
expense determined under fair value based
method for all awards, net of related tax effect.......... (127) (99) (380) (296)
---------- ---------- ---------- ----------
Pro forma net income............................................ $ 5,020 $ 4,641 $ 14,844 $ 13,514
========== ========== ========== ==========
Earnings per share:
Basic - as reported.......................................... $ .45 $ .41 $ 1.32 $ 1.19
Basic - pro forma............................................ $ .43 $ .40 $ 1.29 $ 1.16
Diluted - as reported........................................ $ .43 $ .40 $ 1.28 $ 1.16
Diluted - pro forma.......................................... $ .42 $ .39 $ 1.25 $ 1.13
Recent Accounting Developments - In January 2003, the Financial Accounting
Standards Board issued FASB Interpretation No. (FIN) 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 December 31, 2003 for VIEs acquired before February 1, 2003.
In its current form, FIN 46 may require Community to deconsolidate its
investment in CMTY Capital Trust I (the Trust) on the December 31, 2003,
effective date. The potential deconsolidation of subsidiary trusts of bank
holding companies formed in connection with the issuance of trust preferred
securities, like the Trust, appears to be an unintended consequence of FIN 46.
It is currently unknown if, or when, the FASB will address this issue. In July
2003, the Board of Governors of the Federal Reserve System issued a supervisory
letter instructing bank holding companies to continue to include the trust
preferred securities in their Tier 1 capital for regulatory capital purposes
until notice is given to the contrary. The Federal Reserve intends to review the
regulatory implications of any accounting treatment changes and, if necessary or
warranted, provide further appropriate guidance. If the outcome is that the
Trust is no longer included in consolidated results, the Corporation will still
meet all regulatory capital requirements.
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 September
30, 2003 and December 31, 2002 were as follows:
September 30, 2003
------------------
Amortized Fair
Cost Value
---- -----
U.S. Treasury and federal agencies ...................................... $ 152,188 $ 151,933
Mortgage-backed U.S. government agencies................................. 117,658 118,945
Obligations of states and political subdivisions......................... 178,896 184,015
Corporate securities..................................................... 106,074 106,793
Equity securities........................................................ 69,275 71,575
----------- -----------
Total............................................................... $ 624,091 $ 633,261
=========== ===========
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:
Nine Months Ended Year Ended Nine Months Ended
September 30, December 31, September 30,
2003 2002 2002
----------------- ------------ -----------------
Balance, January 1................................... $ 12,343 $ 12,132 $ 12,132
Provision for loan losses............................ 1,900 3,350 2,750
Loan charge-offs..................................... (1,360) (4,180) (2,623)
Recoveries........................................... 557 1,041 510
--------- --------- ---------
Balance, September 30, 2003, December 31,
2002, and September 30, 2002........................ $ 13,440 $ 12,343 $ 12,769
========= ========= =========
RISK ELEMENTS (a)
September 30, December 31, September 30,
2003 2002 2002
------------ ----------- -----------
Loans on which accrual of interest has been
discontinued:
Commercial................................................ $ 3,437 $ 2,257 $ 4,471
Residential and commercial mortgages...................... 6,972 6,609 3,600
Other..................................................... 901 527 569
--------- --------- ---------
11,310 9,393 8,640
--------- --------- ---------
Other real estate.............................................. 572 1,183 684
--------- --------- ---------
Total non-performing assets............................. 11,882 10,576 9,324
Loans past due 90 days or more and still accruing interest:
Commercial................................................ --- 817 578
Residential and commercial mortgages..................... 40 49 78
Consumer................................................. 31 95 35
--------- --------- ---------
71 961 691
--------- --------- ---------
Total risk elements..................................... $ 11,953 $ 11,537 $ 10,015
========= ========= =========
(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 September 30, 2003 and December 31, 2002, the recorded investment in
loans for which impairment has been recognized totaled $9.1 million and $7.0
million, respectively. The valuation allowance for impaired loans totaled
$739,000 and $326,000 at September 30, 2003 and December 31, 2002, respectively.
For the nine months ended September 30, 2003, and 2002 the average recorded
investment in impaired loans approximated $8.5 million and $6.5 million,
respectively. Interest recognized on impaired loans on the cash basis for the
nine month periods ending September 30, 2003 and 2002 was not significant.
10
COMMUNITY BANKS, INC. AND SUBSIDIARIES
Notes to Consolidated Interim Financial Statements, Continued
(Unaudited)
4. Pension Plan:
-------------
Community has a noncontributory defined benefit pension plan covering
current and former employees of a predecessor bank. During the third quarter of
2003, the plan was amended to curtail future eligibility service. As a result of
the curtailment, Community recognized a gain of $497,000 ($323,000 after taxes).
5. Earnings Per Share:
-------------------
The following table sets forth the calculations of Basic and Diluted
Earnings Per Share for the periods indicated:
Three Months Ended September 30,
----------------------------------------------------------------
2003 2002
----------------------------------------------------------------
Per-Share Per-Share
Income Shares Amount Income Shares Amount
----------------------------------------------------------------
(In thousands except per share data)
Basic EPS:
Income available to common stockholders....................... $ 5,147 11,561 $ .45 $ 4,740 11,627 $ .41
======= ===== ======= =====
Effect of Dilutive Securities: ...............................
Incentive stock options outstanding........................... 345 268
------ ------
Diluted EPS:
Income available to common stockholders &
assumed conversion......................................... $ 5,147 11,906 $ .43 $ 4,740 11,895 $ .40
======= ===== ======= =====
Nine Months Ended September 30,
----------------------------------------------------------------
2003 2002
----------------------------------------------------------------
Per-Share Per-Share
Income Shares Amount Income Shares Amount
----------------------------------------------------------------
(In thousands except per share data)
Basic EPS:
Income available to common stockholders....................... $15,224 11,543 $1.32 $13,810 11,654 $1.19
======= ===== ======= =====
Effect of Dilutive Securities: ...............................
Incentive stock options outstanding........................... 313 266
----- -----
Diluted EPS:
Income available to common stockholders &
assumed conversion......................................... $15,224 11,856 $1.28 $13,810 11,920 $1.16
======= ===== ======= =====
Per share and share data have been adjusted to reflect the 5% stock dividend
declared on February 11, 2003, and the 20% stock split to be paid in the form of
a stock dividend declared on November 4, 2003.
11
COMMUNITY BANKS, INC. AND SUBSIDIARIES
Notes to Consolidated Interim Financial Statements, Continued
(Unaudited)
6. 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 $25.1 million of
standby letters of credit as of September 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 September 30, 2003 for guarantees under standby letters
of credit issued after December 31, 2002 is not material.
7. Comprehensive Income (dollars in thousands):
--------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- -------------------------
2003 2002 2003 2002
--------------------------- -------------------------
Investment securities:
Unrealized holding gains (losses)
arising during the period ........................... $ (13,813) $ 8,030 $ (1,362) $ 18,606
Reclassification adjustments for
(gains) included in net income.......................... (302) (64) (1,849) (600)
----------- ---------- ---------- ----------
Other comprehensive income (loss)............................. (14,115) 7,966 (3,211) 18,006
Tax effect.................................................... (4,940) 2,788 (1,124) 6,302
----------- ---------- ---------- ----------
Other comprehensive income (loss), net of tax........... $ (9,175) $ 5,178 $ (2,087) $ 11,704
=========== ========== ========== ==========
12
COMMUNITY BANKS, INC. AND SUBSIDIARIES
Part 1 - 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 nine months of
2003 compared to the same period of 2002 unless otherwise indicated. Per share
and number of share amounts reflect the 20% stock split payable in the form of a
stock dividend on January 30, 2004, which was declared by the board of directors
in November, 2003.
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 to the allowance
for loan losses, and subsequent recoveries, if any, are credited to the
allowance for loan losses.
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
Earnings per share and net income reached $0.43 and nearly $5.2 million,
respectively, for the third quarter of 2003, resulting in increases of over 8%
in per share earnings and nearly 9% in net income compared to results reported
in the third quarter of 2002. This performance provided a return on average
assets of 1.12% and a return on average equity of 14.95% for the period, nearly
equal to the 1.17% and 15.09% reported in the year earlier quarter.
Results for the first nine months of 2003 reflected a trend similar to the
quarter to quarter comparisons. Earnings per share and net income for the nine
months ended September 30, 2003 reached $1.28 and $15.2 million, respectively,
reflecting an increase of almost 11% in earnings per share and 10% in net income
over the first nine months of 2002. Year-to-date return on average assets was
1.15% and return on average equity was 15.12%.
The current interest rate environment continues to present formidable
barriers to achieving significant expansion of revenues from net interest
spread, or the difference between interest earned on loans and investments and
interest paid on deposits and other borrowings. Community has augmented its net
interest spread by expanding its fee-based income from more traditional banking
services and by continuing to add to its menu of integrated services, including
sales of annuities, mutual funds and other brokerage products; title insurance
and settlement services; and mortgage origination activities.
Community has embarked on a corporate plan to actively pursue strategic
acquisitions of nonbank financial service providers that will expand the
fee-based revenue stream and facilitate integration of such services with
traditional banking relationships. During the third quarter, Community completed
its previously announced acquisitions of Erie Financial Group, a leading
provider of mortgage origination services operating largely within Community's
current footprint, and Your Insurance Partner, another locally-based insurance
agency that is expected to help accelerate the expansion of the company's
fledgling insurance agency service capabilities. Mortgage generation activities,
and related title insurance services, continued to be robust during the quarter
as the market was fueled by the lower interest rates and the affordability of
financing for both new and existing homes. The addition of Erie has
significantly enhanced Community's mortgage origination capacity and
proficiency.
Meanwhile, Community continues to focus on a deliberate and measured
expansion of its delivery network, which has resulted in the addition of 14
offices in the last three years, bringing its total number of service outlets to
46. Since September 30, 2003, Community has announced the addition of three more
branches. Community has consistently emphasized targeted expansion into high
growth markets and simultaneously evaluated its legacy delivery system, which
resulted in the sales of two less profitable offices since the beginning of 2002
and a third completed in the fourth quarter of 2003. Community's growing
presence and improved visibility in its core markets contributed substantially
to market share growth in both loans and deposits over the last several years
and in the first nine months of 2003.
Despite conflicting signals in the national economy, Community generated an
increase in average loans of 14.0% in the third quarter and 10.3% for the first
nine months of 2003, with total loans reaching nearly $1.1 billion by September
30, 2003. In those same periods, average total deposits grew over 7% and now
stand at $1.2 billion. Recent benchmark economic measures now point to the
potential for a modest recovery following the economic slowdown of the last
three years. On a local level, the markets served by the Community franchise
have been less adversely affected by national trends and have remained
relatively stable by comparison to other sectors of the country. At the same
time, Community aggressively monitored and improved the condition of its asset
quality metrics, which has been a critical component of profitability throughout
2003. The company experienced some isolated deterioration in asset quality prior
to 2003, which resulted in higher levels of charge-offs, higher problem loan
totals and higher loan loss provisions in both 2001 and 2002. Since the end of
2002, asset quality metrics have experienced substantial improvement, resulting
in declines in charge-offs, reduced loan loss provisions, and improved
profitability.
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 nine months ended September 30, 2003 and 2002
were as follows (in thousands):
Change
2003 2002 Volume %
- -------------------------------------------------------------------------------------------------------------------------
Cash and due from banks $ 35,804 $ 38,386 $ (2,582) (6.7)%
Federal funds sold and other 1,116 16,931 (15,815) (93.4)%
Investments 688,069 565,898 122,171 21.6%
Loans 973,752 882,621 91,131 10.3%
Allowance for loan losses 12,874 12,706 168 1.3%
- -------------------------------------------------------------------------------------------------------------------------
Net loans 960,878 869,915 90,963 10.5%
Goodwill and identifiable intangibles 2,375 1,087 1,288 118.5%
Loans held for resale 8,048 6,509 1,539 23.6%
Other assets 69,544 64,068 5,476 8.5%
- -------------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $ 1,765,834 $ 1,562,794 $ 203,040 13.0%
- -------------------------------------------------------------------------------------------------------------------------
Noninterest-bearing deposits $ 167,130 $ 164,145 $ 2,985 1.8%
Interest-bearing deposits 997,885 918,245 79,640 8.7%
Short-term borrowings 115,357 51,641 63,716 123.4%
Long-term debt 322,774 298,789 23,985 8.0%
Subordinated debentures 15,000 --- 15,000 n/a
Other liabilities 13,066 11,876 1,190 10.0%
- -------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES 1,631,212 1,444,696 186,516 12.9%
- -------------------------------------------------------------------------------------------------------------------------
STOCKHOLDERS' EQUITY 134,622 118,098 16,524 14.0%
- -------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY $ 1,765,834 $ 1,562,794 $ 203,040 13.0%
- -------------------------------------------------------------------------------------------------------------------------
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 second quarter of 2003, loan growth picked up, reaching 11%
compared to the same quarter of 2002. Robust growth continued in the quarter
ended September 30, 2003, reaching 14% over the same quarter of 2002. This
helped push the nine-month growth rate to 10% for the first nine months of 2003.
Commercial loan growth remains strong in the commercial real estate market, and
small business 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
home equity loan product with bi-weekly payments to consumers seeking low cost
financing.
Deposit balances remain the primary source of funding for financial
institutions and Community recognized nine-month growth of 7.6% 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-term 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. In the third quarter of 2003, Community began to
extend the maturities of overnight borrowings through the Federal Home Loan Bank
to take advantage of lower long-term rates on longer term borrowings. In
December of 2002, Community executed a pooled trust preferred issuance of $15
million to facilitate cash needs for acquisition opportunities and to increase
regulatory capital levels. The use of these alternative funding vehicles
continues to provide the excess liquidity necessary to fund earning asset
growth.
Contractual Obligations
Significant long-term funding obligations at September 30, 2003 are:
Less than 1-3 3-5 More than
Dollars in thousands Total 1 year years years 5 years
- --------------------------------------------------------------------------------
Long-term debt $348,082 $ 10,114 $30,229 $45,365 $262,374
Subordinated debentures 15,000 --- --- --- 15,000
Time deposits 600,753 329,040 184,497 85,240 1,976
- --------------------------------------------------------------------------------
Total $963,835 $339,154 $214,726 $130,605 $279,350
- --------------------------------------------------------------------------------
16
COMMUNITY BANKS, INC. AND SUBSIDIARIES
PART I - Item 2. Management's Discussion and Analysis of Financial Condition
- --------------------------------------------------------------------------------
and Results of Operations (Continued)
- --------------------------------------
Net Interest Income
The following table summarizes, on a fully taxable equivalent basis,
changes in net interest income and net interest margin for the nine months ended
September 30, 2003 and 2002 (in thousands):
- --------------------------------------------------------------------------------------------------------------------------
2003 2002 Increase (Decrease)
Amount Yield/rate Amount Yield/rate Amount Yield/rate
- --------------------------------------------------------------------------------------------------------------------------
Interest income $76,000 6.10% $77,076 7.02% $(1,076) (.92)
Interest expense 31,907 2.94% 34,979 3.69% (3,072) (.75)
- --------------------------------------------------------------------------------------------------------------------------
Net interest income $44,093 $42,097 $ 1,996
Interest spread 3.16% 3.33% (.17)
Impact of non-interest funds 0.38% 0.50% (.12)
- --------------------------------------------------------------------------------------------------------------------------
Net interest margin 3.54% 3.83% (.29)
- --------------------------------------------------------------------------------------------------------------------------
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 $2.0 million, or 4.7% in 2003 compared to
2002. Both earning asset and interest-bearing liability levels increased. A
decline in asset yields outpaced the decline in funding costs resulting in a
reduction in net interest spread of 17 basis points.
Interest income decreased $1.1 million or 1.4% during the first nine months
of 2003. An increase in earning assets of approximately $198 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 $3.1 million, or 8.8%. Although interest-bearing liabilities
increased approximately $182 million, the benefit of a lower interest rate
environment resulted in a decrease in the total rate paid on funding sources of
75 basis points. Given the reduction in interest rates since last year, the
contribution from non-interest funding sources declined from 50 basis points to
38 basis points and added to the decrease in net interest margin.
In isolating third quarter 2003 performance, net interest margin declined
from the levels achieved in the prior quarter and from a year ago. Third quarter
net interest margin for 2003 was 3.45% compared to 3.49% in the most recent
second quarter and 3.78% in the third 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.
17
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 $1.9 million compared to $2.8 million in 2002. Net loan charge-offs in
2003 were $803,000, or .11% of average loans annualized, compared to $2.1
million, or .32% of average loans annualized, in the first nine months of 2002.
Non-accrual loans of $11.3 million at September 30, 2003, increased from $8.6
million a year earlier, reflecting in part a migration of loans from the 90 days
past due category, but also an increase in commercial mortgage accounts. Loans
90 days past due but still accruing interest showed a dramatic decline to
$71,000 at September 30, 2003, from $691,000 at September 30, 2002. Overall
credit quality trends continue to reflect the underlying credit quality
standards applied within 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 $3.3
million, or 34%, in the first nine months of 2003 compared to the first nine
months of 2002.
Service charges on deposit accounts increased $1.2 million, or 47%, in the
first nine months 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 $564,000, or 37.3%, 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. Unlike title agency
fees, Community's captive insurance revenues actually decreased in 2003. 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
requires 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.
Community derives revenue from the origination and sale of mortgage loans
into the secondary market. Mortgage banking revenues increased $1.0 million, or
127% in 2003. This increase reflects a continued demand for fixed-rate real
estate loans in this historically low interest rate environment, as well as
Community's acquisition of Erie Financial Group in July of 2003. Mortgage
origination fees earned by Erie in the third quarter of 2003 accounted for
approximately one-half of the increase in year-to-date revenue compared to the
prior year. Mortgage banking revenues may diminish if interest rates rise.
Investment security gains of $1.8 million were recognized in the first nine
months of 2003 compared to $600,000 in 2002. Such gains were realized pursuant
to management's ongoing effort to review investment holdings and portfolio
strategy, particularly in light of the current interest rate environment. During
the first nine months 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.
Other income for the first nine months of 2003 totaled $2.2 million
compared to $2.3 million for the first nine months of 2002. Other income for the
third quarter of 2003 totaled $1.0 million and included nonrecurring income of
$497,000 resulting from a curtailment of benefits in its defined benefit pension
plan. In 2002, a gain on the sale of two branches was recognized. In July 2003,
Community announced the sale of an additional branch, which was consummated in
November of 2003 at a gain of approximately $1 million. 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.
18
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 $2.8 million or 17.7% 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 $1.0 million, or 23.8%, includes the
effect of branch expansion and the opening of the Southern Operations Center in
2002, as well as incremental 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 $881,000 or 10.1% in the first nine
months of 2003. Marketing costs increased approximately $700,000 in the first
nine months of 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 nine months of 2003 was $3.4 million,
resulting in an effective tax rate of 18.1%. 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 sources of capital are 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% stock dividend in the first quarter of 2003. A 20% stock split
to be paid in the form of a stock dividend to be paid in January, 2004 was
declared in November, 2003. In addition to these stock dividends, 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. Such regulatory guidelines are continually under review and are
expected to undergo some change as a result of the Basel II capital accords
which are currently under review by U.S. banking regulators. The following table
provides the risk-based capital positions of Community and its banking
subsidiary, Community Banks, at September 30, 2003, along with a comparison to
the various current regulatory capital requirements:
19
COMMUNITY BANKS, INC. AND SUBSIDIARIES
PART I - Item 2. Management's Discussion and Analysis of Financial Condition
- --------------------------------------------------------------------------------
and Results of Operations (Continued)
- -------------------------------------
September 30, Regulatory "Well
2003 Minimum Capitalized"
---- ------- ------------
Leverage ratio
--------------
Community Banks, Inc.................... 7.79 % 4% n/a
Community Banks......................... 7.45 % 4% 5%
Tier 1 capital ratio
--------------------
Community Banks, Inc..................... 10.32 % 4% n/a
Community Banks......................... 9.87 % 4% 6%
Total risk-based capital ratio
------------------------------
Community Banks, Inc..................... 11.38 % 8% n/a
Community Banks.......................... 10.88 % 8% 10%
At September 30, 2003, total stockholders' equity reflected accumulated
other comprehensive income of $4.5 million compared to the accumulated other
comprehensive income of $6.5 million reflected in total stockholder's equity at
year-end 2002. This decrease can be attributed to the change in the net
unrealized gain on investment securities available for sale, net of taxes.
During the first nine months of 2003, Community reissued approximately 179,000
shares and purchased approximately 138,000 shares of treasury stock. Community
currently has board approval to purchase an additional 200,000 shares through it
share repurchase plan.
20
COMMUNITY BANKS, INC. AND SUBSIDIARIES
PART I - Item 3. Quantitative and Qualitative Disclosures About Market Risk
- -------------------------------------------------------------------------------
Community Banks, Inc. has minimal involvement with derivative financial
instruments and does not use them for trading purposes. Interest rate risk
associated with locked commitments on mortgages to be held for sale is mitigated
through the use of forward sales, which lock in the price with the secondary
market investor on the same date Community's customer locks in the rate. 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.
21
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 September 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 $ 1,179 --- --- --- $ 1,179
Investment securities 104,644 $ 74,723 $ 64,686 $ 389,208 633,261
Loans, net of unearned income 383,482 64,951 93,466 527,068 1,068,967
Loans held for sale 2,587 96 192 3,960 6,835
- -----------------------------------------------------------------------------------------------------------------------------
Total $ 491,892 $ 139,770 $ 158,344 $ 920,236 $ 1,710,242
- -----------------------------------------------------------------------------------------------------------------------------
Liabilities
Savings $ 433,811 $ --- $ --- $ --- $ 433,811
Time 78,563 60,800 121,403 235,998 496,764
Time in denominations of
$100,000 or more 26,385 11,606 30,855 35,143 103,989
Short-term borrowings 92,935 --- --- --- 92,935
Long-term debt 6,278 1,278 2,558 337,968 348,082
Subordinated debentures 15,000 --- --- --- 15,000
- -----------------------------------------------------------------------------------------------------------------------------
Total $ 652,972 $ 73,684 $ 154,816 $ 609,109 $ 1,490,581
- -----------------------------------------------------------------------------------------------------------------------------
Interest Sensitivity Gap
Periodic $ (161,080) $ 66,086 $ 3,528 $ 311,127
Cumulative (94,994) (91,466) 219,661
Cumulative gap as a percentage
of earning assets (9)% (6)% (5)% 13%
The negative GAP between interest-earning assets and interest-bearing
liabilities maturing or repricing within one year approximated 5% at both
September 30, 2003, and December 31, 2002. Community's interest rate risk
posture has remained relatively constant since the end of the year.
22
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 its disclosure controls and
procedures as of September 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 have not been any
changes in the Company's internal control over financial reporting (as such term
is defined in Rules 13a-15(f)and 15d-15(f) under the Exchange Act) during the
fiscal quarter to which this report relates that have materially affected, or
are reasonably likely to materially affect, the Company's internal control over
financial reporting.
23
COMMUNITY BANKS, INC. and SUBSIDIARIES
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings
- --------------------------
Management is not aware of any 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
- ------------------------------------------------------------
Not applicable.
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)
24
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)
10.10Salary 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)
10.11Salary 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)
10.12Salary 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)
10.13Salary 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)
10.14Rights 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
10.15Community 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)
10.16Survivor Income Agreement, with Split Dollar Addendum thereto,
of Eddie L. Dunklebarger
10.17Survivor Income Agreement, with Split Dollar Addendum thereto,
of Robert W. Lawley
10.18Survivor Income Agreement, with Split Dollar Addendum thereto,
of Anthony N. Leo
10.19Survivor Income Agreement, with Split Dollar Addendum thereto,
of Jeffrey M. Seibert
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)
25
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
September 30, 2003:
Report Dated July 17, 2003
--------------------------
Registrant announced its earnings for the period ended June 30, 2003.
Report Dated August 5, 2003
---------------------------
Registrant announced the declaration of a third quarter dividend.
26
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 November 14, 2003 /s/ Eddie L. Dunklebarger
------------------------ --------------------------
Eddie L. Dunklebarger
Chairman and President
(Chief Executive Officer)
Date November 14, 2003 /s/ Donald F. Holt
------------------------ --------------------------
Donald F. Holt
Executive Vice President
(Chief Financial Officer)
27