UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
Commission file number 0-15786
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[GRAPHIC OMITTED]COMMUNITY BANKS[GRAPHIC OMITTED]
COMMUNITY BANKS, INC.
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(Exact name of registrant as specified in its charter)
Pennsylvania 23-2251762
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
750 East Park Drive, Harrisburg, PA 17111
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Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (717) 920-1698
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Securities registered pursuant to Section 12 (b) of the Act:
None
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Securities registered pursuant to Section 12 (g) of the Act:
Common Stock, par value $5 per share
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Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months, and (2) has been subject to such filing requirements
for the past 90 days.
Yes X No
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Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of the Form 10-K or any amendments to this
Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes X No
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Aggregate market value of the Common Stock, $5 par value, held by non-affiliates
of the registrant, computed by reference to the closing price as of the close of
business on June 30, 2004: $326,000,000
Number of shares of the Common Stock, $5 par value, outstanding as of the close
of business on February 28, 2005: 12,301,000 shares.
Documents Incorporated by Reference: None
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(This page intentionally blank)
2
COMMUNITY BANKS, INC.
FORM 10-K
INDEX
PART I Page
Item 1 Business 4-7
Item 2 Properties 7-8
Item 3 Legal Proceedings 8
Item 4 Submission of Matters to a Vote of Security Holders 8
PART II
Item 5 Market for Registrant's Common Equity, Related Stockholder Matters and Issuer
Purchases of Equity Securities 9
Item 6 Selected Financial Data 10
Item 7 Management's Discussion and Analysis of Financial Condition and Results
of Operations 11-38
Item 7A Quantitative and Qualitative Disclosures About Market Risk 39-41
Item 8 Financial Statements and Supplementary Data 42-71
Item 9 Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure 72
Item 9A Controls and Procedures 72
Item 9B Other Information 72
PART III
Item 10 Directors and Executive Officers of the Registrant 73-75
Item 11 Executive Compensation 75-86
Item 12 Security Ownership of Certain Beneficial Owners and Management 86-88
Item 13 Certain Relationships and Related Transactions 88
Item 14 Principal Accounting Fees and Services 89
PART IV
Item 15 Exhibits, Financial Statement Schedules 90-91
SIGNATURES 92
3
PART I
Item 1. Business:
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Community Banks, Inc., referred to in this report as the "Corporation" or
"Community," is a financial holding company that was formed as a Pennsylvania
corporation in 1982. Community's banking subsidiary is Community Banks, referred
to in this report as the "Bank." Community's non-banking subsidiaries are
Community Bank Investments, Inc. (CBII) and Community Banks Life Insurance
Company, Inc. (CBLIC). The subsidiaries of the Bank are UDNB Investments, Inc.;
PSB Realty Co., Inc.; The Sentinel Agency, LLC; Community Banks Insurance
Services, LLC; CB Services, LLC; and Erie Financial Group, LLC. At December 31,
2004 no non-bank subsidiaries have total assets that exceed 1% of consolidated
total assets. With the exception of Community Bank Investments, Inc. and UDNB
Investments, Inc., each of whose net income was approximately 5% of consolidated
net income, for 2004 no non-bank subsidiary has net income exceeding 1% of
consolidated net income.
On January 1, 2002, Community consolidated the charters of its banking
subsidiaries under the name Community Banks, pursuant to regulatory approvals.
Prior to that time, Community's separate banking organizations operated as
Peoples State Bank (PSB), a state chartered bank with offices throughout York
and Adams Counties; and Community Banks, N.A. (CBNA), a federally chartered bank
headquartered in Dauphin County with offices in central and northeastern
Pennsylvania. The consolidation was designed to facilitate a regional
operational focus that would ease regulatory burdens while, at the same time,
maintain a philosophy of local decision-making.
Community conducts a full service commercial and retail banking business and
provides limited trust services through 48 banking offices in Pennsylvania and
Maryland: 3 offices in Adams County, 3 offices in Cumberland County, 10 offices
in Dauphin County, 3 offices in Luzerne County, 2 offices in Northumberland
County, 7 offices in Schuylkill County, 1 office in Snyder County, and 17
offices in York County, Pennsylvania and 2 offices in Carroll County, Maryland.
At December 31, 2004 there were four additional offices in varying stages of
completion including 2 additional offices in Cumberland County and 1 each in
Dauphin and York counties. There are approximately 700 offices of commercial
banks and savings and loan associations within its market area with which
Community competes. Community currently has a 7% share of the deposit market in
the primary metropolitan statistical areas (MSA) in which it conducts business.
In addition to traditional banking business, we conduct business through various
direct or indirect, non-bank subsidiaries. These subsidiaries are engaged in
activities related to the business of banking.
Like other banking companies, Community has been subjected to competition from
credit unions, brokerage firms, money market funds, consumer finance and credit
card companies and other companies providing financial services and credit to
consumers. The competition is especially fierce with the credit union industry,
particularly in certain segments of Community's markets. The expansion of credit
union activity, now permitted by so-called "community-based" charters, continues
to create mounting competitive pressure. The expansion of "fields of membership"
and credit union activity is thought by most banks to be contributing to an
increasingly unfair competitive situation, largely because of the tax-exempt
status afforded credit unions. Initiatives to further expand the powers of
credit unions to conduct business in areas that go far beyond the original
intent of credit union charters continue to be pressed at both the state and
federal levels.
Over the years, Community has formed special purpose wholly-owned subsidiaries.
In 1986, Community formed CBLIC to provide credit life insurance to its consumer
credit borrowers. In 1985, Community formed CBII to make investments primarily
in equity securities of other banks. In December 2003, Community had formed CMTY
Statutory Capital Trust II to execute a trust preferred issuance of $15 million.
In December 2002, Community had formed CMTY Capital Trust I to execute a
previous pooled trust preferred issuance of $15 million. In 2004, Community
deconsolidated these subsidiary trusts from its financial statements. in
accordance with provisions of FASB Interpretation No. 46, "Consolidation of
Variable Interest Entities, as Interpretation of ARB No. 51" See "Notes to
Consolidated Financial Statements-Subordinated Debt" included in Part II, Item 8
for more information on the deconsolidation
Community and its subsidiaries have approximately 634 full-time equivalent
employees as of December, 2004 and Community considers its employee relations to
be satisfactory.
4
Supervision and Regulation of Community
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The banking industry is subject to extensive state and federal regulation.
Proposals to change laws and regulations governing the banking industry are
frequently raised in Congress, in state legislatures, and in various bank
regulatory agencies. The likelihood and timing that any such changes may have on
Community are difficult to determine with any certainty. Changes in laws or
regulations, or changes in the interpretation of laws or regulations, may have a
material impact on the business, operations and earnings of Community.
Community Banks, Inc. is registered as a financial holding company with the
Federal Reserve Board in accordance with the requirements of the
Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act enables broad-scale
consolidation among banks, securities firms and insurance companies for eligible
bank holding companies that have elected and maintain "financial holding
company" status. Financial holding companies can offer virtually any type of
financial service, including banking, securities underwriting, insurance (both
agency and underwriting) and merchant banking. If a bank holding company does
not become a financial holding company, it will be limited to those activities
previously determined by the Federal Reserve Board to be permissible; i.e.,
"closely related to banking" under the standard set forth in the Bank Holding
Company Act. In order to become a financial holding company, all of a bank
holding company's bank subsidiaries must be well capitalized and well managed
and have a rating under the Community Reinvestment Act of at least
"satisfactory."
Community is subject to regulation by the Federal Reserve Board. The Federal
Reserve Board requires regular reports from Community and is authorized to make
regular examinations of Community and its subsidiaries. The Bank is subject to
supervision and regulation, and is examined regularly, by the Federal Deposit
Insurance Corporation and the state banking departments in the states in which
it operates. To the extent that the Bank's subsidiaries are licensed to engage
in the sale of insurance or the mortgage brokerage business, the subsidiaries
are subject to examination by the respective licensing authorities. Community
and its direct non-banking subsidiaries are affiliates, within the meaning of
applicable banking laws and regulations of the Bank and its subsidiaries. As a
result, the Bank and its subsidiaries are subject to restrictions on loans or
extensions of credit to, purchase of assets from, investments in, and
transactions with Community and its direct non-banking subsidiaries and on
certain other transactions with them or involving their securities.
Capital Adequacy
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The Federal Reserve Board and the FDIC have adopted risk-based capital adequacy
guidelines for financial holding companies and banks under their supervision.
Under these guidelines, "Tier 1 capital" and "Total capital" as a percentage of
risk-weighted assets and certain off-balance sheet instruments must be at least
4% and 8%, respectively. The regulators have also imposed a leverage standard,
which focuses on the institution's ratio of Tier 1 capital to average total
assets, adjusted for goodwill and certain other items, to supplement their
risk-based ratios. This minimum leverage ratio was set at 3% and would apply
only to those banking organizations receiving a regulatory composite 1 rating.
Most banking organizations will be required to maintain a leverage ratio ranging
from 1 to 2 percentage points above the minimum standard.
Community and the Bank are subject to various regulatory capital requirements
administered by federal and state banking agencies. Failure to meet minimum
capital requirements can initiate certain mandatory and possibly additional
discretionary actions by regulators that, if undertaken, could have a direct
material effect on Community's financial statements. Under capital adequacy
guidelines and the regulatory framework for prompt corrective action, each
subsidiary bank must meet specific capital guidelines that involve quantitative
measures of assets, liabilities, and certain off-balance sheet items as
calculated under regulatory accounting practices. The capital amounts and
classification are also subject to qualitative judgments by the regulators about
the risk weightings of components, and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require Community to maintain minimum amounts and ratios of total and Tier 1
capital to risk-weighted assets and of Tier 1 capital to average assets.
Management believes, as of December 31, 2004, that Community and the Bank have
met all capital adequacy requirements to which they are subject. For tables
presenting Community's capital ratios, see "Notes to Consolidated Financial
Statements - Regulatory Matters" included in Part II, Item 8.
5
Sarbanes-Oxley Act of 2002
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The series of business failures and corporate scandals that began with Enron in
2001 caused an abrupt decline in the level of investor confidence in the capital
markets. In response to these developments, Congress passed the Sarbanes-Oxley
Act of 2002 (Sarbanes-Oxley), which was signed into law in July, 2002, and
impacts all companies with securities registered under the Securities Exchange
Act of 1934, including Community. Sarbanes-Oxley created new requirements in the
areas of corporate governance and financial disclosure including, among other
things, (i) increased responsibility for Chief Executive Officers and Chief
Financial Officers with respect to the content of filings with the SEC; (ii)
enhanced requirements for audit committees, including independence and
disclosure of expertise; (iii) enhanced requirements for auditor independence
and the types of non-audit services that auditors can provide; (iv) accelerated
filing requirements for SEC reports; (v) increased disclosure and reporting
obligations for companies, their directors and their executive officers; and
(vi) new and increased civil and criminal penalties for violation of securities
laws.
Certifications of the Chief Executive Officer and the Chief Financial Officer as
required by Sarbanes-Oxley and the resulting SEC rules can be found in the
"Exhibits" section of this document.
Various elements of Sarbanes-Oxley require compliance under a "phased-in"
approach to allow affected companies a sufficient amount of time to meet the
far-reaching provisions of this legislation. For 2004, some of the more sweeping
changes related to the Section 404 provisions of Sarbanes-Oxley, which were
mandated to be in place by the end of that year. Under the Section 404
provisions, management is now required to perform an annual assessment of the
effectiveness of its system of internal control over financial reporting. In
addition, the company's independent registered public accounting firm is
required to issue a report on internal control over financial reporting that
includes both an opinion on managements' assessment, and their own opinion on
the effectiveness of the company's internal control over financial reporting.
Pursuant to the related SEC rules and Auditing Standard No 2, which was
established by the Public Company Accounting Oversight Board, the procedures
required of a company's independent registered public accounting firm are to be
performed in conjunction with the audit of the company's annual financial
statements. The objectives of the Section 404 procedures and the audit of
internal control over financial reporting are to obtain reasonable assurance
about whether any material weaknesses in internal control exists as of the date
of managements' assessment. Community and its independent registered public
accounting firm have complied with the provisions of Section 404 of
Sarbanes-Oxley and the reports can be found at pages 70 and 71.
Merger Activity
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On March 30, 2001, Community completed a merger of the Glen Rock State Bank into
Community's bank subsidiary (then known as Peoples State Bank). As a result of
the Glen Rock merger, Community acquired an additional 5 branch offices located
in York and Adams Counties, Pennsylvania and assets of approximately $190
million.
On November 16, 2004, Community announced the signing of a definitive agreement
pursuant to which it will combine with PennRock Financial Services Corp., parent
company of Blue Ball National Bank. PennRock is a financial holding company
headquartered in Lancaster County, Pennsylvania, and its current banking
franchise is directly east of Community's existing geographic footprint. Blue
Ball, which is PennRock's primary operating subsidiary, has over $1 billion in
assets and 19 banking offices in its network. Following consummation, the joint
banking and financial services franchise will operate nearly 70 banking offices
in 11 counties throughout the center of Pennsylvania. The combination will
dramatically increase Community's presence in the south central Pennsylvania
market, including significant coverage of the vibrant Harrisburg, Lancaster and
York regions, with combined assets totaling over $3 billion. After the
combination, Community is expected to become the 8th largest bank holding
company headquartered in Pennsylvania. Under the terms of the definitive
agreement, each shareholder of PennRock will receive 1.4 shares of Community in
exchange for each share of PennRock common stock. Based upon Community's ten-day
average share price of $29.89 prior to the announcement, the value of the
transaction will approximate $326 million. The completion of the merger is
subject to various regulatory approvals as well as the approval of the
shareholders of both Community and PennRock. Community urges its shareholders
and the shareholders of PennRock Financial Services Corp., as well as other
investors, to read the proxy statement/prospectus that will be included in the
registration statement on Form S-4 which Community will file with the SEC in
connection with the proposed merger. This proxy statement/prospectus will
contain important information about Community, PennRock, the merger, the persons
soliciting proxies in the merger and their interests in the merger and related
matters.
6
Operating Segments
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All of the operations of Community operate and are reported under its one
reportable segment, community banking.
Concentrations, Seasonality
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No portions of Community's businesses are dependent on a single or limited
number of customers, the loss of which would have a material adverse effect on
our business. No substantial portions of loans or investments are concentrated
within a single industry or group of related industries, although a significant
amount of loans are secured by real estate located in south central
Pennsylvania. Community's businesses are not seasonal in nature.
Environmental Compliance
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Community's compliance with federal, state and local environmental protection
laws had no material effect on capital expenditures, earnings or competitive
position in 2004, and is not expected to have a material effect on such
expenditures, earnings or competitive position in 2005.
Other Information
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Community's internet address is www.communitybanks.com. Electronic copies of
Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports
on Form 8-K, and amendments to those reports filed or furnished pursuant to
Section 13(a) or 15(d) of the Exchange Act, are available through the "Investor
Relations" section of Community's website as soon as reasonably practicable
after filing such material with, or furnishing it to, the Securities and
Exchange Commission. Copies of such reports are also available at no charge.
Item 2. Properties
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The following table summarizes the Bank's branch network:
PSB Total
Bank (1) Realty (2) Leased Term (3) Branches
-------- ---------- ------ -------- --------
In Pennsylvania:
Adams County 2 1 - - 3
Cumberland County 1 - 2 2019 3
Dauphin County 7 - 3 2015 10
Luzerne County 1 - 2 2014 3
Northumberland County 2 - - - 2
Schuylkill County 7 - - - 7
Snyder County 1 - - - 1
York County 6 4 7 2020 17
In Maryland:
Carroll County 1 - 1 2007 2
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Total 28 5 15 48
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(1) Properties are owned by the Bank, free and clear of encumbrances.
(2) Properties are owned by PSB Realty Company, a wholly-owned subsidiary of
Community, and are leased to the Bank.
(3) Latest lease term expiration date, excluding renewal options.
(4) In addition to the above, two branches in progress are subject to lease
agreements extending through 2024.
7
From time to time, the Bank also acquires real estate by virtue of foreclosure
proceedings, and such real estate is disposed of in the usual and ordinary
course of business as expeditiously as is prudently possible.
The following table summarizes Community's other significant properties:
Owned / Lease
User Character of Facility Location Leased Expires (1)
---- --------------------- -------- ------ -----------
Community Banks, Inc. Executive Offices Harrisburg, PA Leased 2007
Community Banks Operations Center Halifax, PA Owned
Community Banks Operations Center Hanover, PA Owned
The Sentinel Agency LLC Admin/Sales Harrisburg, PA Leased 2005
CB Insurance Services LLC Admin Mechanicsburg, PA Leased 2005
Erie Financial Group LLC Admin/Sales York, PA Owned
(1) Latest lease term expiration date, excluding renewal options.
Item 3. Legal Proceedings:
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Various actions and proceedings are presently pending to which Community and/or
one or more of its subsidiaries is a party. These actions and proceedings arise
out of routine operations and, in management's opinion, will not have a material
adverse effect on Community's consolidated financial position or results of
operations.
Item 4. Submission of Matters to a Vote of Security Holders:
- -------------------------------------------------------------
No matters were submitted to a vote of security holders during the fourth
quarter of 2004.
8
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and
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Issuer Purchases of Equity Securities:
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Market Information
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The shares of Community are traded on the NASDAQ National Market under the
symbol CMTY and are transferred through local and regional brokerage houses.
Community had approximately 3,426 shareholders of record as of December 31,
2004. The following table sets forth dividends declared per share and the high
and low closing prices for Community common stock as reported by NASDAQ during
the periods indicated.
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2004 2003
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Price Per Share Dividends Price Per Share Dividends
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Low High Declared Low High Declared
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First Quarter $ 28.41 $ 34.52 $ 0.16 $ 20.79 $ 22.51 $ 0.15
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Second Quarter $ 27.02 $ 31.58 $ 0.17 $ 22.11 $ 23.81 $ 0.16
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Third Quarter $ 25.35 $ 29.73 $ 0.17 $ 23.69 $ 26.59 $ 0.16
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Fourth Quarter $ 27.77 $ 31.47 $ 0.17 $ 26.67 $ 32.14 $ 0.16
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Holders of the common stock of Community are entitled to such dividends as may
be declared from time to time by the Board of Directors out of funds legally
available therefor. Community currently expects that it will continue to pay
comparable dividends in the future, subject to regulatory requirements,
Community's financial condition and requirements, future prospects, business
conditions and other factors deemed relevant by the Board of Directors. As noted
in "Capital Adequacy" in Part I, Item 1, Community is subject to various
regulatory capital requirements that limit the amount of capital available for
dividends.
The market prices listed above are based on historical market quotations and
have been restated to reflect stock dividends and splits.
Issuer Purchases of Equity Securities
- -------------------------------------
No shares were purchased during the fourth quarter of 2004 as part of
Community's Share Repurchase Program.
9
Item 6. Selected Financial Data:
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At or for the Year Ended December 31,
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2004 2003 2002 2001 2000
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(dollars in thousands except for per share data)
BALANCE SHEET DATA
At Period End:
Investment securities $ 619,110 $ 646,961 $ 667,801 $ 543,901 $ 389,819
Total loans 1,215,951 1,078,611 904,568 857,278 814,874
Total assets 1,954,799 1,861,063 1,680,362 1,509,734 1,308,713
Total deposits 1,305,537 1,230,685 1,132,913 1,003,225 919,241
Long-term debt 404,662 411,422 320,533 322,155 239,613
Stockholders' equity 152,341 143,406 129,162 111,249 103,978
Average:
Total assets 1,941,096 1,780,679 1,580,046 1,398,521 1,238,870
Total stockholders' equity 145,750 135,773 119,352 111,381 92,225
EARNINGS DATA:
Net interest income 56,557 52,514 50,488 45,935 43,795
Provision for loan losses 3,100 2,500 3,350 5,080 2,863
Net interest income after provision for loan
losses 53,457 50,014 47,138 40,855 40,932
Other income 23,213 20,463 13,975 12,141 8,148
Other expense 49,993 45,718 39,300 36,521 30,463
Provision for income taxes 4,879 4,359 3,367 2,879 4,702
Net income 21,798 20,400 18,446 13,596 13,915
PER SHARE DATA:
Basic earnings per share 1.78 1.68 1.51 1.11 1.15
Diluted earnings per share 1.73 1.63 1.48 1.09 1.14
Cash dividends declared 0.67 0.63 0.54 0.48 0.43
Book value 12.45 11.73 10.67 9.05 8.65
Average diluted shares outstanding 12,574,908 12,497,372 12,491,320 12,461,996 12,231,908
PROFITABILITY RATIOS:
Return on average assets 1.12% 1.15% 1.17% 0.97% 1.12%
Return on average stockholders' equity 14.96% 15.03% 15.46% 12.21% 15.08%
Net interest margin (FTE) 3.44% 3.50% 3.78% 3.83% 4.01%
Efficiency ratio 60.22% 60.47% 56.81% 59.77% 55.42%
CAPITAL AND LIQUIDITY RATIOS:
Stockholders' equity to total assets 7.79% 7.71% 7.69% 7.37% 7.95%
Average equity to average assets 7.51% 7.62% 7.55% 7.96% 7.45%
Dividend payout ratio 37.69% 37.35% 36.07% 43.25% 37.48%
Net loans to assets 61.47% 57.25% 53.10% 55.98% 61.48%
ASSET QUALITY RATIOS:
Allowance for loan losses to total loans
outstanding 1.19% 1.22% 1.36% 1.42% 1.27%
Allowance for loan losses to non-accrual loans 266% 162% 131% 109% 171%
Non-accrual loans to total loans outstanding 0.45% 0.76% 1.04% 1.29% 0.74%
Non-performing assets to total assets 0.38% 0.70% 0.63% 0.78% 0.49%
Net charge-offs to average loans outstanding 0.16% 0.17% 0.35% 0.39% 0.20%
10
Item 7. Management's Discussion and Analysis of Financial Condition and Results
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of Operations:
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MANAGEMENT'S DISCUSSION OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion is being presented to provide a narrative explanation of the
financial statements of Community. The purpose of this presentation is to
enhance the overall financial disclosure and to provide information about
historic financial performance as a means to assess to what extent past
performance can be used to evaluate the prospects for future performance.
Throughout this presentation, net income and yield on earning assets have been
presented on a tax equivalent basis and balances represent average daily
balances unless otherwise indicated. All dollar amounts, except per share
information, are presented in thousands, 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. Financial performance can be affected by any
number of factors that are not predictable or are out of management's direct
control. Examples include:
o the effect of prevailing economic conditions;
o unforeseen or dramatic changes in the general interest rate
environment;
o actions or changes in policies of the Federal Reserve Board and other
government agencies; and
o business risk associated with the management of the credit extension
function and fiduciary activities.
Each of these factors could affect estimates, assumptions, uncertainties and
risks used to develop forward-looking information, and could cause actual
results to differ materially from management's expectations regarding future
performance.
CRITICAL ACCOUNTING POLICIES
Management believes that the application of its accounting policies and
procedures in the determination of the adequacy of the allowance for loan losses
(and the related provision for loan losses) and in the evaluation of "other than
temporary" impairment of investment securities should be considered to be
critical accounting policies to ensure the fair presentation of Community's
financial statements.
o Community applies a systemic methodology in order to estimate the
allowance for loan losses. This methodology incorporates management's judgments
about the credit quality of the loan portfolio through a disciplined process
that is consistently applied. This process requires that a detailed analysis of
the loan portfolio be performed on a quarterly basis. This analysis includes a
specific individual loan review for any and all loans that meet specific
materiality criteria. Such loans are evaluated for impairment under the
provisions of Statement of Financial Accounting Standards (SFAS) No. 114,
"Accounting by Creditors for Impairment of a Loan". The portfolio is further
stratified to analyze groups of homogenous loans with similar risk
characteristics. Such loans are evaluated under the provisions of SFAS No. 5
"Accounting for Contingencies". Management considers all known relevant internal
and external factors that may affect loan collectibility, as well as particular
risks indigenous to specific types of lending. The process is further designed
to consolidate the aggregate loss estimates and to ensure that the allowance for
loan losses is recorded in accordance with generally accepted accounting
principles. The final results are reviewed and approved by executive management.
Results are constantly validated by a review of trends associated with loan
volume, delinquencies, potential concentrations, or other factors that may
influence the methodology used to estimate the allowance for loan losses.
o Investment securities are written down to their net realizable value when
there is an impairment in value that is considered to be "other than temporary."
The determination of whether or not other than temporary impairment exists is a
matter of judgment. Management reviews these investment securities regularly for
possible impairment that is "other than temporary" by analyzing the facts and
circumstances of each investment and the expectations for that investment's
performance. "Other than temporary" impairment in the value of an investment may
be indicated by the
11
length of time and the extent to which market value has been less than cost; the
financial condition and near term prospects of the issuer; or the intent and
ability of Community to retain its investment for a period of time sufficient to
allow for any anticipated recovery in market value.
A summary of the review and application of these critical accounting policies is
included later in this discussion and in the notes to the audited financial
statements.
2004 PERFORMANCE SUMMARY
The year 2004 is destined to go down as a milestone period in the history of
Community. The reliable delivery of strong profit performance, combined with the
execution of critical efforts to facilitate meaningful franchise expansion, is
expected to distinguish Community among its competitors and provide a solid
foundation for future growth and expansion.
Net income reached $21.8 million, a 7.0% increase from the net income of $20.4
million reported in 2003. Similarly, earnings per share reached $ 1.73 per
share, a 6.1% improvement from the $1.63 reported in 2003. Return on average
assets (ROA) and return on average equity (ROE) provide traditional benchmarks
used to compare the relative operating performance of financial service
companies. At the end of 2004, Community produced an ROA of 1.12% and an ROE of
14.96%, which was comparable to the performances of 1.15% and 15.03%,
respectively, in the prior year.
Community produced improved levels of profitability during 2004 by driving
higher loan and deposit volumes, increased fees, strong asset quality and more
modest growth in operating expenses. Across the broader financial services
spectrum, profit performance was directly and indirectly influenced by the
depressed level of interest rates and an unsettled national economy. Rates have
remained lodged near their lowest levels in decades and, when combined with
competitive pressures, produced enduring margin compression and lingering
constraints on net interest income growth. Net interest income, which is defined
as the difference between interest income from earning assets and interest
expense on funding sources, remains the largest single source of revenue for
most community banks. The strain on net interest income growth placed a premium
on increasing market share, maintaining pristine asset quality metrics,
developing new and improved sources of service fee income, and unrelenting
vigilance on the achievement of operating efficiencies. All of these factors
contributed to Community's improved profit performance in 2004. The progress
achieved in these areas served to offset the impact of interest rate compression
on revenue expansion and facilitated earnings growth in an uncertain economic
environment.
At the same time, Community continued to make strategic investments in expanded
operating platforms and delivery channels to support and serve a larger, more
profitable financial services operation. Identifying opportunities for franchise
expansion continued to be a primary objective for Community throughout the year.
On November 16, 2004, Community announced its pending combination with PennRock
Financial Services Corp., the parent of Blue Ball National Bank. This
affiliation will be the single largest merger in Community's history. PennRock,
with assets in excess of $1 billion, serves three important counties within the
south central region of Pennsylvania through its 19 office locations. On a
combined basis, the Community / PennRock affiliation will have a combined
network of nearly 70 offices and over $3 billion in assets and will serve twelve
counties containing over 1.2 million households. Operations will extend from the
Pocono region of northern Pennsylvania to just across the Maryland border, with
an enviable presence in the vibrant south central region of Pennsylvania. The
combined franchise is expected to become the 8th largest bank holding company
headquartered in Pennsylvania. The future for this new and exciting partnership
will be built on a mutual history of sustained profitability and responsible
leadership, both of which were aptly demonstrated during 2004.
FUTURE PERFORMANCE COMPARISONS
Assuming that the companies complete the merger after receiving the necessary
regulatory and shareholder approvals, Community will be recording the merger of
PennRock under the purchase method of accounting for business combinations,
which is now required under generally accepted accounting principles (GAAP).
Traditional measures of performance, like net income, earnings per share, and
return on assets will continue to be presented, but comparability between
post-consummation results and prior years will require careful scrutiny. The
most noticeable effect will be that Community's historical operating results and
statements of condition will not be restated for the impact of the
12
PennRock acquisition for periods prior to consummation. PennRock results will
only be included on a prospective basis, commencing at the date of consummation,
which is expected to occur in mid-2005.
The comparability of other measures, such as ROE, will be dramatically affected
due to the introduction of concepts which are unique to the application of the
purchase method of accounting for business combinations. For example, Community
will recognize certain intangible assets to the extent that the value of the
common stock exchanged with former PennRock shareholders exceeds the book value
of net tangible assets acquired in the transaction. The introduction of more
substantial levels of intangibles arising from the PennRock acquisition will
make historic comparisons of ROE between 2005 and prior periods more difficult
to interpret and assess.
Many of Community's peers and competitors have also experienced growth through
acquisitions that were completed after the mandatory imposition of the
"purchase" method of accounting. In response to these comparability challenges,
many financial institutions have adjusted certain performance measurements in
order to facilitate meaningful comparisons of performance within the financial
services industry. Future presentations of Community's financial performance
will consider these adjusted measures. For example, earnings results will be
reported in both the traditional "net income" format as well as the "operating
income" format. The operating income format will measure earnings by excluding
certain non-operating expenses such as core deposit intangible amortization and
merger-related expenses. Additionally, traditional ROE comparisons will be
augmented with a measure called "return on average tangible equity" (ROTE),
which seeks to eliminate the distortion in comparability that arises from the
accounting implications of acquired intangible assets. To the extent such
measures are considered "non-GAAP" measures of performance, Community will be
required to provide reconciliations designed to highlight and explain the nature
of the differences between traditional "GAAP" measures and those that are
considered "non-GAAP".
The presentations provided in this 2004 discussion will require no GAAP /
non-GAAP reconciliations. The scarcity of significant acquisition activity at
Community since the mandated imposition of the purchase accounting method would
yield few noticeable differences between "GAAP" and "non-GAAP" measures in 2004,
or in comparable earlier periods. Consequently, most results and comparisons in
this analysis are presented on a GAAP basis, unless otherwise indicated.
2004 PERFORMANCE REVIEW
The primary driver of performance in 2004 was growth; more specifically, loan
and deposit growth. While the opportunity for improved pricing and expanded
interest spread was undermined by the compression of interest rates, Community's
ability to achieve organic growth, which includes market share penetration,
resulted in an expansion of net interest income. Community benefited from
marketing efforts in its core markets and from its position as one of the larger
franchises to sustain a deliberate and concentrated focus on central
Pennsylvania. Community's customers, as well as new, influential employees
formerly associated with larger competitors have been attracted to its "local
people...local decisions" philosophy. That operating principle was in stark
contrast to larger competitors, which often appear less intensely focused on
local markets or seem distracted by the potential for opportunities in new or
acquired markets. Average loans grew 15.7% and deposits rose 10.1% and such
growth contributed substantially to a 7.2% increase in net interest income.
The continued expansion of banking service offerings also provided an increase
to revenue in the form of higher non-interest income. For example, the more
widespread acceptance of the "OverdraftHonor" program and the success of other
fee-based product distribution initiatives, including annuity sales, brokerage
services and insurance-related commissions, provided measurable revenue
expansion and income stream diversification. During the first half of the year,
Community also recorded substantial increases in gains from the sale of
portfolio securities, primarily gains from the sale of bank stocks. These gains
reflected opportunities to benefit from the favorable valuations of bank equity
securities, particularly early in 2004. Recognition of these gains was
coordinated with expanded marketing efforts to increase the visibility of the
Community franchise. In the third quarter, Community also decided to sell its
credit card portfolio and recognized a gain of $725 thousand. The maturity of
the mono-line credit card industry, combined with the relatively small size of
Community's portfolio, created overwhelming competitive and scale disadvantages
that precipitated the sale.
13
Lessening the effect of these gains and other revenue expansion trends in
non-interest income was the impact of subdued mortgage refinancing activity.
Industry-wide, gains and fees from home mortgage refinancing declined as
previous pent-up demand was largely satisfied in recent years. At the same time,
purchase activity waned in the wake of a tepid economy and the concern over
higher interest rates. As a result of these external factors, growth in mortgage
banking revenue was not as great as in prior years. Growth in complementary
fee-based activities, such as title and settlement services, also lessened, due
in some measure to the outsized mortgage origination activity experienced in
previous years. The net effect of all of these trends was a 12% increase in
income from non-interest sources (excluding security gains), and an 18% increase
excluding nonrecurring gains from both years.
Two highlights of 2004 performance related to asset quality and control over
non-interest expenses. Community has now experienced two consecutive years of
steadily improving metrics in loan quality, including net charge-offs to loans
of only 0.16% in 2004. At the same time, the coverage of problem credits
provided by the allowance reached 266%. As a consequence of these favorable
trends, the provision for loan losses grew modestly, despite substantial growth
in loan balances.
Non-interest expenses were adversely impacted by increased marketing efforts,
including both image and product specific advertising, each of which was
designed to increase Community's visibility within its core markets. Community,
like most publicly-traded companies, also experienced another layer of
regulatory burden in the form of compliance costs arising out of the
Sarbanes-Oxley Act of 2002 (SOX). The most recent wave of requirements resulted
in increased costs associated with Section 404 of SOX, which mandated detailed
review, documentation and testing of internal controls over financial reporting,
and required completion by the end of 2004. Despite these challenges, overall
operating expenses grew only modestly as a result of close management of
incremental spending during 2004. Concern over the impact of a compressed margin
and less robust non-interest revenue projections in areas like mortgage banking
necessitated more proactive and strategic cost control efforts, including
temporary delays of office openings originally planned for 2004.
Economic Climate
In many ways, economic conditions in 2004 reflected an extended version of
issues that had influenced 2003 results. A "new reality" has evolved from the
increased global and domestic threats of terrorism. It began with the attack of
September 11, 2001 and continued with the current occupation of Iraq, and the
seemingly endless hostility in that region of the world. This new reality,
combined with a sluggish domestic economy, became the dominant issues
confronting the country during the 2004 presidential election year. For most
businesses, the fallout from these challenges was exacerbated by previous
corporate scandals that ultimately gave rise to the compliance, testing, and
oversight provisions of SOX. The nation continues to recover and build upon the
progress that has been made in coping with these external factors, but the
economy in many parts of the country remains uninspiring.
The Federal Reserve maintained its accommodative posture on interest rates for
most of 2004, although subtle changes began to emerge over the course of the
year. Productivity improvements, from both technological advances and
inexpensive labor costs from the new, more globally-driven economy, served to
restrain inflationary pressures and supported a stance of continued low interest
rates. The Federal Reserve's posture was also a reflection of its focus on
providing "ongoing support to economic activity". Despite the precipitous rise
in energy prices and a steadily weakening dollar, the Federal Reserve pursued a
restrained mid-year reversal to its accommodative monetary policy. The Federal
Reserve began the year with a federal funds target of 1 percent and ended the
year with an increase of 125 basis points to 2.25 percent by the end of 2004.
This tightening, while directionally significant, did not dramatically alter the
interest rate landscape for most financial institutions as most long-term rates
experienced little or no upward pressure. Since the end of 2003, interest rates
have moved gradually from low rates and a steep yield curve to slightly higher
rates and a flatter yield curve. This steady flattening of the yield curve often
has been viewed as an unfavorable bellwether for financial institutions. The
relatively low rate environment experienced in both 2003 and 2004 continued to
provide a healthy stimulus for credit services, while consumer expectations for
higher deposit rates supported a continuous flow of liquidity into transaction
accounts. This trend corresponded with consumer resistance to locking up funds
in longer term certificates of deposit that provided only modest rate incentives
for customers to extend maturities. The pressure on net interest income was
exacerbated by the inability to achieve significantly higher loan pricing or to
incrementally reduce funding costs to expand net interest spread. As a
consequence, overall interest spreads remained substantially comparable with
2003.
14
In summary, the economic climate during 2004 was mixed, yielding no definitive
or compelling arguments for either an imminent, robust expansion or a near-term
recessionary slowdown. Community operates within a regional economy, and smaller
local economies, that have performed with comparative consistency, seemingly
less vulnerable to major "boom or bust" cycles that often influence other, more
cycle-dependent regions of the country. The mature yet diverse economic
underpinnings of Community's service area have been less predisposed to broad
expansions or deep slumps triggered by national or international economic and
political trends. While these local economies have been characterized by their
reliability, the existence of overarching trends will always have some causal
effect on regional economies. The businesses and individual customers within
Community's markets remain exposed to these pervasive economic developments, but
are characterized most often by their comparative stability. That stability has
been attributed to many factors, including an absence of single industry
concentrations, relatively modest deviations in local employment trends, and
steady profitability performance. In recent years, the influence of these
factors on local economies has contributed considerably to the sound financial
performance of Community Banks.
Emerging Issues for 2005
The single dominant internal issue for 2005 will be the planning and execution
of the successful integration of the Community and PennRock operations. The
first half of 2005 will be dedicated to the coordination and harmonization of
policies, procedures and practices, and to the construction of an operating
platform that will facilitate the combination of these historically successful
franchises. During this process, both entities will maintain a concentrated
focus on the creation of an overall operating platform capable of serving an
even larger, more diverse franchise. This effort will culminate in the
consolidation of most "back-office" operations, including information
technology, loan and deposit operations, and an array of administrative
functions. Prior to consummation and throughout much of 2005, Community will
incur and recognize certain non-operating expenses that will arise as a direct
consequence of the merger. These expenses will include various retention,
conversion and severance benefits to be incurred by Community to ensure fair and
equitable remuneration for employees who are displaced or inconvenienced by the
efforts to combine and integrate the two companies. Community will also incur
certain other merger-based expenses directly related to the overall combination
initiative. Appropriate accounting recognition will be made in order to
segregate the impact of each of these items on 2005 results and provide a clear
picture of the operating performance of the newly-formed Community Banks
franchise.
During 2005, however, the highest priority will be placed on the following:
o minimizing the impact of the combination effort on the convenient,
effective, and efficient delivery of products and service to new and
existing customers, and;
o maintaining the highest possible levels of profitability and operating
efficiency for all of our stakeholders, including both existing
shareholders and those shareholders added through our PennRock
affiliation.
While a great deal of management attention will be devoted to the combination of
the Community and PennRock franchises, these two priorities will remain
corporate imperatives for 2005 and beyond.
NET INTEREST INCOME
Community's major source of revenue continues to be derived from intermediation
activities through its bank subsidiary and is reported as net interest income.
Net interest income is defined as 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 earning assets. Both net
interest income and net interest margin are influenced by the frequency,
velocity, and extent of interest rate changes and by the composition and
absolute volumes of earning assets and funding sources.
15
The following table compares net interest income and net interest margin
components between 2004 and 2003:
2004 2003 Change
----------------------------------------------------------------------------
Yield / Yield / Yield /
Amount Rate Amount Rate Amount Rate
----------------------------------------------------------------------------
Interest income $ 106,338 5.80% $ 101,217 6.02% $ 5,121 (0.22)%
Interest expense 43,242 2.70% 42,351 2.89% 891 (0.19)%
----------------------------------------------------------------------------
Net interest income $ 63,096 $ 58,866 $ 4,230
Interest spread 3.10% 3.13% (0.03)%
Impact of non-interest
funds 0.34% 0.37% (0.03)%
------------ ------------ ------------
Net interest margin 3.44% 3.50% (0.06)%
============ ============ ============
Interest Rates
For the first time since 2000, average interest rates rose. When examined on an
average basis, such increases were comparatively modest and slightly more
conspicuous at the short end and middle segments of the yield curve. In each of
the last three years, it was assumed that rates had declined to levels at, or
near, the trough in the interest rate cycle. In each of those years, despite
predictions for a gradual rise in interest rates, downward pressure remained.
For most of that three year period, declines in short term rates outpaced the
declines in the long end of the curve, producing an increasingly steep yield
curve. During 2004, such trends began to reverse, producing modest upward
pressure on short term rates and a comparatively flatter yield curve. The
following graph provides a comparison of average U.S. Treasury rates for the key
maturity intervals for both 2004 and the preceding year.
Average U.S. Treasury Curve
---------------------------
3 Months 6 Months 1 Year 2 Year 3 Year 5 Year 10 Year
-------- -------- ------ ------ ------ ------ -------
2003 1.028% 1.075% 1.241% 1.651% 2.105% 2.966% 4.014%
2004 1.399% 1.614% 1.888% 2.382% 2.780% 3.426% 4.271%
A more perceptible change in the direction of interest rates emerges from a
comparison of the one-day interest rates in effect at December 31 for each of
the past two years. This comparison, unlike the presentation of average rates,
displays rates in place at discrete points in time. Such comparisons tend to
provide a less revealing overview of trends, largely because they exclude the
more inclusive influence of average rate comparisons and because rates are, by
definition, vulnerable to one-day swings. The following graph demonstrates the
comparative results provided by a presentation of the yield curve at the end of
both 2004 and 2003.
16
Year-Over-Year U.S. Treasury Curve
----------------------------------
3 Months 6 Months 2 Year 3 Year 5 Year 10 Year 30 Year
-------- -------- ------ ------ ------ ------- -------
2003 0.917% 1.012% 1.819% 2.302% 3.247% 4.246% 4.826%
2004 2.212% 2.577% 3.065% 3.219% 3.607% 4.218% 5.073%
Despite its inherent limitations, the above graph does provide an illustration
of the incremental pricing challenges that emerged during 2004 and the impending
challenges likely to be confronted by financial institutions into 2005. This
presentation reveals the comparatively modest interest rate premium available at
the long end of the curve. When coupled with the flatness of the curve, this
trend tends to diminish the bank's appetite for extending maturities on credit
facilities or portfolio investments in order to improve yields. Extending
maturities or granting favorable, long-term pricing concessions close to the low
end of the rate cycle may prove to be problematic if long-term rates were to
subsequently tighten, thus restoring a steeper yield curve. On the funding side,
the consumer's enthusiasm for extending maturities into longer term certificates
of deposits is also diminished near the apparent bottom of the interest rate
cycle. Most importantly, if a flat yield curve is in place for an extended
period of time, it has the potential to yield additional compression in net
interest spread and net interest margin.
Despite these challenges, Community reported little volatility in net interest
margin and actually recorded overall improvement in net interest income when
comparing 2004 and 2003 results. Interest income from earning assets grew 5.1%
while interest expense from the various funding sources increased by 2.1%,
resulting in an increase in net interest income of 7.2%.
Interest Income /Earning Assets
Interest income was $106.3 million in 2004 and grew by $5.1 million as compared
to the $101.2 million recorded in 2003. This represented growth of 5.1% and was
achieved despite the fact that earning asset yields declined from 6.02% in 2003
to 5.80% in 2004. From 2003 to 2004, earning assets grew $151.7 million,
including $155.0 million in loans. Such growth was offset by a slight decline in
investment portfolio balances. Growth in loans accelerated during the year and
was funded by normal runoff in the investment portfolio and by a $118.6 million
increase in the level of deposits, primarily in Community's successful Power
Checking offering. As in recent years, loan growth was focused in the commercial
and commercial real estate categories and was augmented by continued penetration
of the consumer home equity market.
17
Interest Expense / Funding Sources
Interest expense grew modestly during the year despite the overall growth in
funding sources. The overall cost of funding, like the yield on earning assets,
declined from 2.89% in 2003 to 2.70% in 2004. This decline in the relative cost
of funds substantially offset the impact of increased funding levels on interest
expense growth. Interest expense rose from $42.4 million in 2003 to just $43.2
million in 2004, a modest change of only $0.9 million. Total interest-bearing
funding grew by $139.5 million and, combined with the growth in non-interest
funds, provided substantially all of the funding needed for the $155.0 million
in loan growth. As was the case in 2003, Community's longer-term, time deposit
growth patterns were relatively flat throughout most of the year as consumer
preferences were weighted in favor of maintaining adequate liquidity in
anticipation of an impending rise in interest rates. Consumer preferences for
liquidity and flexibility resulted in an increase in Community's popular Power
Checking account offering, which grew by $102.5 million and was the primary
driver of overall deposit growth.
Community continued to make strategic use of other forms of funding in order to
meet the consistent demand for credit extension that occurred throughout the
year. During the year, Community made efforts to strategically realign its
balance sheet composition in preparation for the onset of higher interest rates.
To this end, Community gradually reduced its dependence on selected short-term
funding sources, such as overnight fed funds, which are sensitive to increases
in short term interest rates. At various times during the year, Community also
increased its long-term borrowings, which are composed principally of term
funding available through the Federal Home Loan Bank programs, an important
source of liquidity that is accessed pursuant to risk parameters set forth in
Community's asset / liability management (ALCO) policies and procedures. This
strategy permitted Community to "lock in" longer-term funds at or near a
potential trough in the interest rate cycle. Community experienced a 19.7%
increase in long-term funding, which totaled $436 million at the end of 2004,
and included two $15.5 million subordinated debt instruments issued in equal
amounts at the end of both 2002 and 2003. The issuances were integrated with,
and responsive to, the overall capital management policy discussed later in this
presentation.
Interest Spread and Net Interest Margin
A financial institution's ability to effectively blend the impact of changing
rates, shifting rate indices, customer preferences, and product development
initiatives can be measured by the performance of interest spread, defined as
the difference between earning asset yield and the cost of funding sources. Net
interest margin combines the impact of interest spread with both investment of
non-interest bearing funding sources and management of non-earning assets. As a
result of rate trends and other dynamics specific to Community's balance sheet,
Community reported a modest decline in net interest spread from 3.13% in 2003 to
3.10% in 2004, and a decline in net interest margin from 3.50% to 3.44% over the
same period. The decline in margin was also linked to the impact of reduced
contribution from non-interest funding sources, which declined from 0.37% to
0.34%. During periods of declining interest rates, the contribution from
non-interest funds to net interest margin is reduced since funds are invested at
progressively lower rates. During periods of rising rates, these funds can be
expected to contribute to improvements in net interest margin.
18
Quarterly Performance
The following table provides a comparison of earning asset yields, funding
costs, and other information for each of the four quarters of 2004 and 2003.
2004
---------------------------------------------------------
Fourth Third Second First
Quarter Quarter Quarter Quarter
---------------------------------------------------------
Asset yield 5.90% 5.79% 5.75% 5.77%
Funding cost 2.75% 2.68% 2.64% 2.70%
---------------------------------------------------------
Interest spread 3.15% 3.11% 3.11% 3.07%
---------------------------------------------------------
Net interest margin 3.51% 3.43% 3.44% 3.40%
---------------------------------------------------------
Net interest margin $16,285 $15,906 $15,843 $15,062
=========================================================
2003
---------------------------------------------------------
Fourth Third Second First
Quarter Quarter Quarter Quarter
---------------------------------------------------------
Asset yield 5.81% 5.88% 6.05% 6.38%
Funding cost 2.76% 2.80% 2.94% 3.10%
---------------------------------------------------------
Interest spread 3.05% 3.08% 3.11% 3.28%
---------------------------------------------------------
Net interest margin 3.41% 3.44% 3.49% 3.68%
---------------------------------------------------------
Net interest margin $14,789 $14,878 $14,613 $14,586
=========================================================
Quarterly net interest income and net interest margin trends for both 2004 and
2003 reflected many of the same characteristics noted in the comparisons of full
year performance. Since the beginning of 2003, interest rates continued their
steady pattern of decline through the midpoint of 2004. This drove a
corresponding compression of net interest margin, and a practical constraint on
Community's ability to reflect more substantial increases in net interest income
to accompany its impressive balance sheet growth. For the most part, Community
experienced relatively modest improvement in net interest income on a sequential
quarter basis throughout most of 2003 and 2004. Near mid-year 2004, the Fed
began to slowly reverse its accommodative monetary policy. The pace of the
policy reversal was slowly reflected in the increases in yields on earning
assets and cost of funding sources in the third and fourth quarters of 2004,
though both net interest spread and net interest margin remained compressed. By
the end of the year, a more measurable improvement in pricing began to emerge as
both net interest spread and net interest margin appeared to recover, albeit
modestly, from the nadir of performance reported in the first quarter of 2004,
when margin reached only 3.40%. In the fourth quarter of 2004, Community
recorded its highest quarterly net interest margin (3.51%) in the two year
period.
PROVISION FOR CREDIT LOSSES
One of the high points for the banking industry, and specifically for Community,
was the ongoing stability of the credit quality picture throughout 2004. These
trends have been largely sustained over a two year period, even as Community has
continued to experience dramatic loan growth over that same period. The
provision for loan losses was $3.1 million, which was only slightly higher than
the provision of $2.5 million recorded in 2003. The relationship of the
allowance to loan losses declined, albeit modestly, from 1.22% in 2003 to 1.19%
in 2004. The provision and the allowance are recorded at levels which are
responsive to both the ebb and flow of general credit quality patterns and, more
specifically, to the risks inherent in both seasoned loans and in incremental
additions to Community's growing portfolio. Community undergoes a rigorous and
consistently applied process on a quarterly basis in order to evaluate the
allowance for loan losses and the determination of the quarterly provision for
credit losses. Net charge-offs during 2004 were only $1.9 million or 0.16% of
average loans. Non-accrual loans aggregated just $5.4 million, and remained near
the lowest levels in Community's more recent history. One of the more important
measures of credit quality is the coverage of non-accrual loans provided by the
allowance. At December 31, 2004, this ratio reached 266% compared to 162% at the
end of 2003. See the section of this discussion which addresses the allowance
for loan losses and asset quality for additional information.
19
NON-INTEREST INCOME
Generation of increased levels of non-interest income continues to be an
integral component of Community's operating strategy. The development or
acquisition of new financial service offerings, combined with the enhancement
and expansion of traditional fee-based banking services, have been the catalysts
for steady growth in this vital revenue source. Results for both 2004 and 2003
were influenced by the impact of gains from security transactions and by certain
non-recurring transactions.
Total non-interest revenues grew 13% from 2003 to 2004. Aggregate revenues
reached $23.2 million versus $20.5 million, inclusive of gains from sales of
securities. Excluding the financial impact of both security gains and
non-recurring revenues, comparisons of non-interest income between 2004 and 2003
resulted in a 18% increase in adjusted non-interest income. Non-interest income
adjusted for these items now accounts for 24% of total revenues, which is
defined as the sum of tax-equivalent net interest income and non-interest
income. The following presentation provides a comparative summary, adjusted for
security gains and non-recurring items, of non-interest income between 2003 and
2004:
Change
-------------------------
2004 2003 Amount %
---------------------------------------------------
Investment management and trust services $ 1,510 $ 1,326 $ 184 14%
Service charges on deposit accounts 7,120 5,128 1,992 39%
Other service charges, commissions and fees 3,357 2,958 399 13%
Insurance premium income and commissions 3,260 2,822 438 16%
Mortgage banking activities 2,665 2,532 133 5%
Earnings on investment in life insurance 1,593 1,455 138 9%
Other income (excluding non-recurring) 513 674 (161) (24)%
---------------------------------------------------
20,018 16,895 3,123 18%
Other income--non-recurring:
Gain on branch sale --- 1,144 (1,144)
Pension curtailment --- 497 (497)
Gain on sale of credit card portfolio 725 --- 725
---------------------------------------------------
Subtotal 20,743 18,536 2,207 12%
Investment security gains 2,470 1,927 543 28%
---------------------------------------------------
Total non-interest income $ 23,213 $ 20,463 $ 2,750 13%
===================================================
Investment management and trust revenues include fees derived from the sale of
various retail investment products (annuities, brokerage services, mutual funds,
etc) as well as fees related to Community's trust department activities. Sales
of investment products are facilitated under an arrangement with a national
provider of these services. Consultative sales are conducted through the
community office network. This arrangement provides convenient access to
alternative investment vehicles through licensed employees who live and work in
the communities where customers conduct their normal banking business. This
service has facilitated a more comprehensive approach to meeting the expanding
financial service needs of customers who live within Community's footprint.
Customers are increasingly comfortable with using trusted, competent employees
who work under the umbrella of their primary financial institutions for this
vital service. Trust revenues, which are primarily driven by fees derived from
the administration of personal trust accounts, also experienced more vibrant
growth during 2004. Late in 2003 Community announced its affiliated arrangement
with Bryn Mawr Trust Company, pursuant to which a more competitive investment
management product menu could be offered to new customers. A number of
initiatives were executed in 2004 in furtherance of leveraging this unique
relationship and will continue into 2005.
20
In the first quarter of 2003, Community began to provide a new product offering
which was branded as "OverdraftHonor". Under the benefits provided from this
service, demand deposit customers can avoid the adverse credit implications of
the occasional inadvertent overdraft situation and simultaneously facilitate
timely payment of overdraft items. Since its introduction, Community has
experienced steady increases in the fees derived from this service with a modest
increase in related credit losses. Such growth was related to a number of
factors: the heightened consumer awareness of the benefits of this service;
increased product utilization; and the overall growth in the number of demand
deposit accounts. While Community expects to continue to record increased fees
from this service in 2005, it is anticipated that the pace of growth will
moderate from current levels as the product matures and is more fully saturated
within the core customer base. The vast majority of the $2.0 million increase in
service charges on deposit accounts was derived from fees associated with this
service. The remainder was due to increases in the fee structure for this and
more traditional overdraft fees.
Other service charges include letter of credit fees, credit card interchange
income and safe deposit rentals. The most significant volume of fees in this
category, however, are derived from interchange fees from Community's ATM
network and from debit card transactions, which together provide nearly two
thirds of the total of $3.4 million in fees. Community continues to maintain an
ATM network of nearly 100 ATMs, including those in place under a relationship
with a local convenience store chain operating within Community's geographic
footprint. Transaction counts for non-customer use of the network have remained
constant despite a full-year increase in the standard fee charged for foreign
transactions. The more substantial increase was realized in the interchange fees
associated with retail transactions conducted via the use of debit cards. These
charges aggregated nearly $1.1 million in annual fees, resulting in a 42%
increase over 2003. Nearly all of the increases in these sources of fee income
resulted from increased usage and the consumer's continuing acceptance of these
electronic mediums to augment cash or check-based transactions. Community has
conducted promotional campaigns to encourage the use of debit card transactions
versus traditional check transactions.
Insurance premiums and commissions include agency-based commissions from
commercial and personal lines, fees from credit reinsurance activities related
to consumer lending, and the revenue from title insurance and settlement
activities conducted through Community's title insurance subsidiary, The
Sentinel Agency, LLC (Sentinel). During 2003, Community consummated acquisitions
of ABCO (April, 2003), which is now a division of Sentinel, and Your Insurance
Partner (October, 2003), an insurance agency. The year 2004 represented the
first full year of combined operations from these acquisitions and fueled a 16%
increase in commissions. Growth in commissions was constrained, however, as
title activity declined in a manner that correlated with the decline in mortgage
refinancing activity, an important catalyst for increases in title insurance
services.
Mortgage banking activities in 2004 were adversely impacted by the decline in
mortgage refinancing, which had experienced a dramatic upturn for the last two
to three years. The steady decline in the rates offered on fixed-rate single
family homes had spurred an extraordinary level of refinancing activity.
Although 2004 represented the first full year of activity since the acquisition
of Erie Financial Group, Ltd. (Erie), such activity was hampered by the fact
that much of the pent-up demand for mortgage refinancing had been satisfied in
previous years. Revenues from mortgage banking activities, primarily from
brokerage activities, grew to just $2.7 million compared to $2.5 million in
2003, a rather modest increase of 5% in the first full year of combined
operations of Erie and Community.
Earnings on investment in life insurance represent the increase in cash value of
Bank Owned Life Insurance (BOLI) policies. The BOLI policies of Community are
designed to offset costs of supplemental retirement plans and life insurance for
selected executives and to partially offset the costs of employee benefit plans
including health, group life and disability insurance. Income from BOLI totaled
$1.6 million in 2004 and $1.5 million in 2003. The investment in BOLI totaled
$35.5 million and $28.8 million at December 31, 2004 and 2003. Earnings on BOLI
are affected by fluctuations in interest rates and provide a tax-free return to
Community.
The comparison of non-recurring income provided in the chart on page 20 isolates
the financial impact of the pension curtailment and branch sale which occurred
in 2003 and the gain from the sale of the credit card portfolio in 2004. During
2004, Community analyzed the competitive issues surrounding the viability of
maintaining its credit card portfolio in a business line increasingly driven by
the advantages of scale. Such analysis was considerate of the competitive
challenges presented by the large mono-line credit card providers versus the
potential for meaningful expansion of Community's current customer base.
Although credit cards will continue to be offered to customers via an outsource
arrangement, Community sold its portfolio in the third quarter of 2004 and
realized a gain of $725,000.
21
Gains from the sale of investment securities totaled $2.5 million and increased
by nearly $543 thousand between 2003 and 2004. The majority of gains related to
sales of equity holdings in bank stocks, the majority of which occurred in the
first half of the year. During that time, Community had also embarked on a
simultaneous marketing campaign that focused on increasing its visibility in
core markets and certain product-specific advertising. This resulted in higher
marketing expenditures, particularly in the second quarter of 2004.
NON-INTEREST EXPENSES
Aggregate non-interest expenses grew to $50.0 million in 2004 compared to $45.7
in 2003, an increase of $4.3 million or nearly 10%. The pace of growth in
non-interest expenses was influenced by additional expenses from those
businesses acquired in 2003 that were integrated with existing financial service
activities. Because 2004 represented the first full year of operations for these
businesses (ABCO, Your Insurance Partner, Erie), half of the growth in
non-interest expenses was directly attributable to the incremental expenses of
these businesses incurred from 2003 (partial year) to 2004 (full year). The
following table summarizes the expenses incurred during the last two years and
isolates the year-over-year changes into its two components; those from new
businesses and those from on-going operations (dollars in thousands):
$ Change % Change
----------------------- ------------------------------ --------------------------
2004 2003 New Other Total New Other Total
----------- ----------- ------------------------------ --------------------------
Salaries and employee benefits $ 28,337 $ 25,397 $ 1,635 $ 1,305 $ 2,940 7% 5% 12%
Net occupancy expense 7,980 7,200 229 551 780 3% 8% 11%
Marketing expense 2,325 2,018 14 293 307 1% 14% 15%
Telecommunications expense 1,285 1,302 16 (33) (17) 1% (2)% (1)%
Other operating expense 10,066 9,801 243 22 265 3% --- 3%
----------------------- ------------------------------ --------------------------
Total $ 49,993 $ 45,718 $ 2,137 $ 2,138 $ 4,275 5% 5% 10%
======================= ============================== ==========================
Bifurcation of the increases in non-interest expenses into two distinct
categories facilitated identification of the sources of the $4.3 million
increase by isolating the impact of acquired businesses. Changes in the absolute
dollar amount were found to be equally influenced by the impact of acquired
businesses and the annual increases in the on-going operating expense
categories. Excluding the growth attributed to the full year absorption of
expenses associated with acquired businesses, adjusted year-over year increases
totaled $2.1 million, reflecting a more modest 4.7% increase in operating
expenses from 2003.
The single largest component of costs is salary and benefits, as these expenses
represent nearly 57% of total operating costs. Excluding the impact of salaries
added from the acquired businesses, salary and benefit expenses grew $1.3
million during 2004. During 2004, the average increase for merit bonuses
approximated 3%. However, a number of other factors influenced significant
changes in the composition of salary and benefit expenses.
o Migratory changes have occurred in the compensation structure,
particularly in sales-related positions, whereby portions of
individual compensation have become more heavily weighted toward
incentive-based pay. This approach, particularly in areas such as
mortgage banking, reduced the dependence on guaranteed compensation
and increased reliance on a "pay-for-performance" compensation
structure.
o Increases in group insurance costs for 2004 were less severe than
national trends, primarily due to unusual competitive pressures from
insurance carriers operating within Community's markets. It is
expected that conditions that gave rise to these favorable conditions
will abate during 2005, and are likely to result in increases more
consistent with national trends.
o Participation by acquired employees in Community's discretionary
incentive and retirement programs fueled a disproportionate increase
in benefits expense. Combined benefit costs related to incentive and
retirement programs rose to $3.3 million in 2004, a 22% increase from
2003 and included a more generous discretionary contribution to the
employee retirement plan and the impact of expanded participation in
the management bonus pool. Amounts provided under each of these plans
are dependent on the achievement of pre-defined performance goals.
22
Excluding the impact of acquired businesses, the increase in the total count of
full-time equivalent employees by the end of 2004 was negligible, nearly equal
to the number in place at the end of 2003. More focused efforts to monitor and
manage staffing increases yielded substantial control over staff additions
during the year.
Community has historically followed the intrinsic value accounting method of
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees" (APB 25), which was permitted under SFAS No 123, "Accounting for
Stock Based Compensation" (SFAS 123). All options issued by Community have been
issued at fair value and, accordingly, no compensation expense has been
recognized in the financial statements for stock options issued to employees,
executive officers or directors through the end of 2004. As discussed in the
Notes to the Consolidated Financial Statements, Community has provided the
required pro forma disclosures of the impact of stock compensation on net income
and earnings per share by applying the fair value recognition provisions of SFAS
123. In December of 2004, the FASB issued SFAS No 123R, "Share-Based Payment"
(SFAS 123R), which amended SFAS 123 and will now require financial statement
recognition of compensation cost for stock options and other stock-based awards
for fiscal periods beginning after June 15, 2005.
Community is currently evaluating the various provisions of SFAS 123R and the
optional transition methods that may be applied when adopting this new
accounting standard. It is expected that Community will adopt the modified
prospective method, which requires recognition of compensation expense for the
unvested portion of existing awards and new grants, but does not require a
restatement of prior periods. Additionally, it is also expected that the Company
and its Board of Directors, through its Compensation Committee, will review and
evaluate the continuing role of stock-based compensation in its overall
compensation structure in light of these changes in prescribed accounting.
Pending the decisions of the Compensation Committee, the ability to estimate the
impact of any new options grants to be issued in periods beginning after June
15, 2005 will be affected by the outcome of those decisions. The vesting of
existing option grants will not have a material impact on the financial
statements in the last half of 2005 or in years beyond 2005.
As would be expected, occupancy expenses were also influenced by the full year
impact of offices added during 2003. Community delayed the opening of a limited
number of offices that were scheduled to be opened in 2004. Delays in new office
openings were affected by a number of factors related to the approvals and
timing of new office construction. Increased rentals included carrying costs for
land leases executed in advance of the completion of office construction that
enabled Community to secure prime locations expected to go on line in 2004. The
increase in occupancy expense was also influenced by service contracts
associated with technology-related initiatives.
During the last two years, Community expanded its marketing expenditures and the
communication channels used to reach its base of customers and non-customers.
These efforts have complemented the introduction of new office locations within
core markets in past years. These efforts also coincided with a more cohesive
and strategic branding approach designed to take advantage of the disruption
caused by the acquisitions of several well-known, local financial institutions
that compete with Community on a day-to-day basis. This elevated marketing focus
has contributed to an increase in overall visibility and has generated the
momentum needed for core franchise growth and an increased share of market.
Telecommunications expenses were elevated in 2003 due to the costs of upgrades
for communications and data connectivity improvements for Community's growing
office network. During 2004, Community underwent an intensive study with an
outside vendor specializing in the review and analysis of telecommunications
strategy. These efforts identified cost savings which moderated
telecommunications expense in 2004 and are expected to continue to do so into
2005.
Other operating costs remained relatively stable between 2003 and 2004.
Increases were almost entirely related to the first full year of expenses
associated with acquired businesses during 2003.
INCOME TAXES
Income taxes grew from $4.4 million in 2003 to $4.9 million in 2004, an increase
of nearly 12%. The increase was commensurate with the increase in pretax income,
resulting in an effective tax rate of approximately 18% in both years. The
relative rate of tax exempt income influences the reported income tax rates and
remains the primary reason for the difference between the effective tax rate and
the statutory federal tax rate for corporations.
23
BALANCE SHEET: OVERVIEW
At December 31, 2004, Community's total assets reached $1.95 billion, reflecting
a change of 5% from the $1.86 billion of assets recorded at the end of 2003.
Average assets reached $1.94 billion for 2004 compared to $1.78 billion for
2003, resulting in growth of 9% from 2003. Growth in average assets was fueled
by a nearly 16% increase in average loans. The disparity in growth from average
loans versus the growth in average assets was influenced by investment balances,
which actually declined between the two periods. The liquidity provided by
runoff of the investment portfolio combined with a 10% increase in deposits to
provide the funding necessary to absorb the accelerated growth in the loan
portfolio. Community benefited from increased demand for credit in both the
consumer and commercial sectors. While consumer demand for credit was influenced
by both low rates and sustained consumer confidence, growth in the commercial
sector was more directly related to Community's ability to garner market share
from larger, less nimble financial institutions. The growth trends experienced
in each of the last two years provide a validation of Community's commitment to
staying close to its core markets and to using its local presence and
responsiveness as a competitive advantage.
INVESTMENTS
Community has established corporate investment policies that address various
aspects of portfolio management, including quality standards, liquidity and
maturity limits, investment concentrations and regulatory guidelines.
Community's objective with respect to investment management includes maintenance
of appropriate asset liquidity, facilitation of asset/liability strategy and
maximization of return. Compliance with investment policy is regularly reported
to the Board of Directors.
Community actively manages its investment portfolio and, accordingly, classifies
all investment securities as "available for sale". Under current policy, if
management has the intent and Community has the ability to hold securities until
maturity, securities are classified as "held-to-maturity" investments at the
time of purchase and carried at adjusted historical cost. Securities to be held
for indefinite periods of time are classified as available for sale and carried
at fair value. Such securities are intended to be used as part of Community's
asset/liability management strategy, and may be sold in response to changes in
interest rates, prepayment risk and other factors affecting overall investment
strategy.
Over the last year, balance sheet dynamics have reflected only modest changes in
the investment portfolio as liquidity from scheduled maturity or cash flow
runoff was often redeployed into the loan portfolio in order to satisfy the
steady demand for credit facilities. During 2004, the average balance in the
investment portfolio was reduced from $674 million to $666 million, a decrease
of 1%. This decrease followed two consecutive years of double-digit growth in
investment portfolio balances when the generation of funding sources, including
increases in deposit balances, provided funding in excess of amounts needed to
keep pace with loan demand. As loan demand continued to increase in 2004,
scheduled runoff in the investment portfolio was utilized to provide the
additional liquidity needed to meet customer credit needs, forestalling growth
in the investment portfolio. From 2003 to 2004, the relative mix of investments
to earning assets dropped from 40% to 36%, while the mix of loans to earning
assets grew from 60% to 63%. This shift also served to bolster earning asset
yields as the loan portfolio provided a higher yield premium by comparison to
alternate investment portfolio yields.
The pretax unrealized net gain within the investment portfolio at December 31,
2004 was $8.5 million. As required, this fair value adjustment was recorded in
other comprehensive income (adjusted for income taxes) in the stockholders'
equity section of the statement of condition. As previously discussed, all
securities included in Community's investment portfolio are classified as
"available for sale". Securities totaling $407 million have a fair value that
exceeded the adjusted historical cost, with unrealized pretax gains totaling
$11.7 million. Alternatively, the portfolio also included $212 million of
investments that have a fair value less than the adjusted historical cost,
including unrealized losses of $3.2 million. Special consideration was given to
those securities which were affected by unrealized losses to ensure the losses
were temporary.
In early 2003, the Emerging Issues Task Force (EITF) addressed the issue of
accounting for impairments of certain investments in debt and equity securities
in EITF 03-1. This authoritative guidance sought to clarify existing recognition
and measurement principles to be applied to valuation impairments of securities
for reporting periods beginning after June 15, 2004. In December of 2004, this
new guidance was temporarily deferred to enable the
24
Financial Accounting Standards Board (FASB) additional time to further
deliberate on the impact of this guidance. In concert with the delay, companies
holding investments were encouraged to apply existing guidance for
"other-than-temporary" impairments in evaluating the realizable value of
investments with unrealized losses. Specifically, companies were encouraged to
perform an assessment for those securities in an unrealized loss position and
were to determine whether that impairment was "other-than-temporary". In
performing this assessment, it was suggested that companies review several
factors in assessing the possibility of an "other-than-temporary" impairment.
Factors to be considered included, but were not limited to, the following:
o The length of time and the extent to which market value has been less
than cost;
o The financial condition and near term prospects of the issuer;
o The intent and ability of the holder to retain its investment for a
period of time sufficient to allow for any anticipated recovery in
market value.
In those instances whereby Community had identified securities which reflected
unrealized losses, a systematic methodology was applied in order to perform an
assessment of the potential for "other-than-temporary" impairment. The aggregate
portfolio of $619 million included $212 million of investment securities with
unrealized losses totaling $3.2 million. Of that amount, $54 million of
securities, with an unrealized loss of $1.9 million, had been impaired for a
period exceeding one year. Management believes that these unrealized losses were
entirely attributable to changes in interest rates in periods subsequent to the
acquisition of the specific securities, and did not reflect any deterioration of
the credit worthiness of the issuing entities. Generally, those securities with
unrealized loss included in Community's portfolio are debt securities of
investment grade or are equity securities with characteristics of debt
securities, including a specific repricing date. In all cases, it was determined
that investments that were to be considered for "other-than-temporary"
impairment: (1) had a specified maturity or repricing date; (2) were generally
expected to be redeemed at par, and (3) were expected to achieve a recovery in
market value within a reasonable period of time. Consequently, the impairments
identified and subjected to the assessment were deemed to be temporary and
required no further adjustment to the financial statements.
The following tables summarize amortized cost and estimated fair values at
December 31, 2004, 2003, and 2002 and maturity distribution of securities at
December 31, 2004.
----------------------------------------------------- --------------------------
2004 2003 2002
Amortized Fair Amortized Fair Amortized Fair
Cost Value Cost Value Cost Value
--------------------------------------------------------------------------------
U.S. government and federal agency $ 126,056 $ 125,541 $ 173,651 $ 173,292 $ 130,947 $ 134,334
Mortgage-backed, primarily federal agency 178,437 179,314 121,853 123,395 206,450 210,825
State and municipal 180,110 186,366 177,546 184,481 172,391 177,135
Corporate 58,928 60,043 95,461 97,987 95,022 93,094
Equity 67,085 67,846 65,070 67,806 50,610 52,413
--------------------------------------------------------------------------------
Total $ 610,616 $ 619,110 $ 633,581 $ 646,961 $ 655,420 $ 667,801
================================================================================
MATURITY DISTRIBUTION OF SECURITIES
One Five Weighted
Within One Through Through After Average Average
Year Five Years Ten Years Ten Years Total Maturity Yield(a)
---------------------------------------------------------------------------------------------
U.S. Government and federal $ 3,077 $ 25,339 $ 156,704 $ 119,373 $ 304,493 11yr. 1 mos. 4.50%
agencies
State and municipal --- 829 12,451 166,830 180,110 15yr. 6 mos. 4.89%
Other 4,999 14,149 11,172 28,608 58,928 13yr. 11mos. 5.72%
---------------------------------------------------------------------
Total $ 8,076 $ 40,317 $ 180,327 $ 314,811 $ 543,531 12yr. 11mos. 4.77%
=====================================================================
Percentage of total 1.49% 7.42% 33.18% 57.92% 100.0%
=====================================================================
Weighted average yield (a) 6.00% 4.83% 4.47% 4.89% 4.77%
=====================================================================
(a) Weighted average yields, based on amortized cost, were computed on a tax
equivalent basis using a federal tax rate of 35%.
25
LOANS
Average loans grew 15.7% to nearly $1.2 billion for 2004 compared to $1.0
billion for 2003. The following table provides a summary of the increases in the
various categories of loans (dollars in thousands).
Change
2004 2003 Amount %
-------------------------------------------------------------------
Commercial $ 404,653 $ 338,907 $ 65,746 19%
Commercial real estate 310,769 268,470 42,299 16%
Residential real estate 95,547 102,545 (6,998) (7)%
Consumer 342,964 287,268 55,696 19%
-------------------------------------------------------------------
Total $ 1,153,933 $ 997,190 $ 156,743 16%
===================================================================
For the last several years, Community has focused on leveraging its position as
one of the larger financial institutions that remains headquartered in central
Pennsylvania. Community has improved its visibility within its core markets,
particularly in the commercial and commercial real estate sectors. The addition
of experienced lenders with long-term ties to the business communities in these
markets has enhanced Community's profile and increased its access to commercial
lending opportunities. Brisk activity in construction and land development
lending as well as traditional consumer real estate financing fueled the
substantial increases in these categories. Commercial lending activity continues
to be driven almost exclusively by in-market transactions. Community has also
increased the volume of lending to various governmental bodies within its market
as the creation of a governmental banking unit has increased its focus in this
sector.
At the same time, efforts were also made to become a more competitive consumer
lender within Community's footprint. During 2004, promotions for revolving home
equity lines of credit with preferential terms created significant interest and
generated substantial increases in consumer lending opportunities and expansion
of customer relationships. Increases were also noted in the volume of home
equity loans with specified terms. Community has centralized the administration
and oversight of consumer lending activities which has produced a more strategic
approach to expansion of activity in the consumer lending sector.
Residential real estate lending, which is composed primarily of loans to
single-family creditors, has experienced a steady decline as a result of the
increasing accessibility of secondary market liquidity through mortgage banking
activities. Community-based banks continue to provide a convenient avenue for
consumers to access funding for residential lending, but most fixed-rate,
conforming mortgages continue to be sold in the secondary market. This strategy
has reduced the interest rate risk associated with consumer preferences for
long-term, fixed rate lending, and provided valuable liquidity for other forms
of relationship lending.
ALLOWANCE FOR LOAN LOSSES AND CREDIT QUALITY
The following sets forth activity within the allowance for loan losses for the
last three years (dollars in thousands).
------------------------------------------------
2004 2003 2002
------------------------------------------------
Balance at January 1, $ 13,178 $ 12,343 $ 12,132
Loans charged off (2,910) (2,839) (4,180)
Recoveries 1,053 1,174 1,041
Provision charged to operations 3,100 2,500 3,350
------------------------------------------------
Balance at December 31, $ 14,421 $ 13,178 $ 12,343
================================================
Allowance for credit losses to loans 1.19% 1.22% 1.36%
26
For the last two years, the credit quality profile of Community Banks has shown
substantial improvement despite significant growth in loans, growth that was
particularly evident in the commercial and commercial real estate sectors. The
ratio of net charge-offs to loans for 2003 and 2004 was 0.17 % and 0.16 %,
respectively. In the two years prior to 2003, net charge-off levels were more
than double those amounts. This performance was particularly notable because
aggregate loan balances increased 15.7% in 2004 and 12.4% in 2003, providing
some indication of the relative quality of loans being added to the portfolio
over these periods. Community also monitors the level of the coverage of
non-accrual loans provided by the allowance for loan losses. At December 31,
2004, the allowance provided 2.66 times coverage of those loans included as
non-accrual loans. At the end of 2003, this same ratio was 1.62 times. These
measures, as well as a number of other key measures, serve to demonstrate the
continuing improvement in the overall credit quality profile of the loan
portfolio.
The following sets forth loan loss experience for the last five years:
----------------------------------------------------------------------------
2004 2003 2002 2001 2000
----------------------------------------------------------------------------
Loans at year-end $ 1,215,951 $ 1,078,611 $ 904,568 $ 857,278 $ 814,874
============================================================================
Average loans balance $ 1,153,933 $ 997,190 $ 886,808 $ 838,178 $ 768,204
============================================================================
Balance, allowance for loan losses, January
1 $ 13,178 $ 12,343 $ 12,132 $ 10,328 $ 8,976
Loans charged off:
Commercial, financial and agricultural 300 253 1,878 2,275 303
Real estate-commercial mortgage 1,087 1,336 1,337 484* 521*
Real estate-retail mortgage 160 212 110 --- ---
Consumer and other 1,363 1,038 855 1,017 1,101
----------------------------------------------------------------------------
Total 2,910 2,839 4,180 3,776 1,925
----------------------------------------------------------------------------
Loans recovered:
Commercial, financial and agricultural 324 240 644 120 23
Real estate-commercial mortgage 240 606 7 108* 83*
Real estate-retail mortgage 17 83 18 --- ---
Consumer and other 472 245 372 272 308
----------------------------------------------------------------------------
Total 1,053 1,174 1,041 500 414
----------------------------------------------------------------------------
Net charge-offs (1,857) (1,665) (3,139) (3,276) (1,511)
Provision for loan losses 3,100 2,500 3,350 5,080 2,863
----------------------------------------------------------------------------
Balance, allowance for loan losses,
December 31 $ 14,421 $ 13,178 $ 12,343 $ 12,132 $ 10,328
============================================================================
Net charge-offs to loans at year end 0.15% 0.15% 0.35% 0.38% 0.19%
Net charge-offs to average loans 0.16% 0.17% 0.35% 0.39% 0.20%
Balance of allowance for loan losses
to loans at year end 1.19% 1.22% 1.36% 1.42% 1.27%
* Prior breakouts of historical information could not be readily
reconstructed from predecessor banks' records. Breakouts from 2000 to 2001
are assumed to approximate current mix trends.
The ratio of the allowance to loans declined modestly from 1.22% at the end of
2003 to 1.19 % at the end of 2004. This decline occurred despite a $1.2 million
increase in the absolute balance of the allowance, which grew from $13.2 million
at the end of 2003 to $14.4 million at the end of 2004. The decline in the ratio
of the allowance to loans was primarily attributed to the rapid increase in loan
balances. This increase influenced the increase in the provision for loan
losses, which rose from $2.5 million to $3.1 million even as the level of
identified problem loans declined.
27
The allowance for loan losses is based upon management's continuing evaluation
of the loan portfolio. A review as to loan quality, current macro-economic
conditions and delinquency status is performed on a quarterly basis. The
provision for loan losses is adjusted quarterly based upon current review. The
following table presents an allocation by loan categories of the allowance for
loan losses at December 31 for the last five years.
------------------------------------------------------------------------
2004 2003 2002 2001 2000
------------------------------------------------------------------------
Loans:
Commercial, financial and agricultural $ 7,899 $ 7,090 $ 6,305 $ 9,285 $ 5,268
Real estate-construction --- --- --- 10 14
Real estate-mortgage 2,099 2,313 1,936 965 1,593
Installment 3,202 2,184 1,767 1,030 1,748
Unallocated 1,221 1,591 2,335 842 1,705
------------------------------------------------------------------------
Balance $ 14,421 $ 13,178 $ 12,343 $ 12,132 $ 10,328
========================================================================
The amount of the allowance assigned to each component of the loan portfolio is
derived from a combination of factors. Estimation methods and assumptions used
in the process are reviewed periodically by both management and the Board of
Directors.
Community's allowance for loan losses is based upon management's quarterly
review of the loan portfolio utilizing a consistent valuation methodology. The
purpose of the review is to assess loan quality, identify impaired loans,
analyze delinquencies, ascertain loan growth, evaluate potential charge-offs and
recoveries, and assess general economic conditions in the markets served.
Commercial and commercial real estate loans are individually risk-rated by
Community's loan officers and periodically reviewed by independent loan review
personnel. Consumer and residential real estate loans are generally analyzed in
homogeneous pools utilizing historical loan charge-off information.
To determine the allowance and corresponding loan loss provision, an amount is
allocated to specific loans. For certain commercial and construction loans, this
amount is based upon specific borrower data and supporting collateral determined
by reviewing individual non-performing, delinquent, or potentially troubled
credits. For the majority of the loans that are individually reviewed for
impairment, this analysis is based on a comparison of the loan's carrying amount
to the net realizable value of the collateral. The portion of the allowance
attributable to specific impaired loans was $593 thousand at December 31, 2004.
The remaining commercial as well as consumer, and residential real estate loans
are evaluated as part of various pools. These pool reserves, generally are based
upon historic charge-offs and delinquency history, other known trends and
expected losses over the remaining lives of these loans, as well as the
condition of local, regional and national economies and other qualitative
factors.
To ensure adequacy to a higher degree of confidence, a portion of the allowance
for loan losses is considered unallocated. The unallocated portion of the
allowance is intended to provide for probable losses that are not otherwise
identifiable, for possible imprecise estimates in assessing potential losses on
commercial loans or in the calculation of pool reserves, and for the extenuating
influence of current factors, such as economic uncertainties. This unallocated
portion is available to absorb losses sustained anywhere within the loan
portfolio. The combined allocated and unallocated portions bring the total
allowance to an amount deemed prudent and reasonable by management at that time.
Risk Elements
The following sets forth information regarding various segments of the loan
portfolio, collectively referred to as risk elements. These segments include
both nonperforming assets and those loans past due for 90 days or more.
Non-performing assets include non-accrual loans, restructurings, and other real
estate. Non-accrual loans are loans for which interest income is not accrued due
to concerns about the collection of interest and/or principal. Restructured
loans may involve renegotiated interest rates, repayment terms, or both, because
of deterioration in the financial condition of the borrower. The only credits
that would have qualified as restructured loans at the end of both years were
already classified in the more severe non-accrual category. The following table
provides a comparative summary of nonperforming assets and total risk elements
at the end of each of the last five years.
28
-----------------------------------------------------------------------
2004 2003 2002 2001 2000
-----------------------------------------------------------------------
Loans on which accrual of interest has
been discontinued:
Commercial, financial and agricultural $ 1,748 $ 3,066 $ 2,257 $ 3,783 $ 2,042
Mortgages 2,894 4,054 6,609 6,952 3,445
Other 786 1,031 527 355 356
-----------------------------------------------------------------------
5,428 8,151 9,393 11,090 5,843
-----------------------------------------------------------------------
Loans renegotiated with borrowers --- --- --- --- 205
-----------------------------------------------------------------------
Total non-accrual loans 5,428 8,151 9,393 11,090 6,048
Foreclosed real estate 2,094 4,865 1,183 631 416
-----------------------------------------------------------------------
Total non-performing assets 7,522 13,016 10,576 11,721 6,464
Loans past due 90 days or more:
Commercial, financial and agricultural --- 4 97 1,002 8
Mortgages --- 40 770 405 495
Consumer and other --- 46 94 252 109
-----------------------------------------------------------------------
--- 90 961 1,659 612
-----------------------------------------------------------------------
Total risk elements $ 7,522 $ 13,106 $ 11,537 $ 13,380 $ 7,076
=======================================================================
Ending allowance for loan losses $ 14,421 $ 13,178 $ 12,343 $ 12,132 $ 10,328
=======================================================================
Ending allowance to non-accrual loans 266% 162% 131% 109% 171%
Despite improvement in most categories of problem credits, there was a
substantial increase in foreclosed real estate from 2002 to 2003. The balance in
this category grew from $1.2 million at December 31, 2002 to $4.9 million at the
end of 2003. Nearly all of the increase was related to the reclassification of
two large credits that had been made to a single borrower. Pursuant to the
provisions of the original loan agreements, Community took possession of two
collateral properties in the fourth quarter of 2003, due to borrower default. A
new, unrelated borrower purchased one of the properties in January, 2004,
resulting in the return of nearly $2.6 million of loans to accrual status.
Amounts included in foreclosed real estate are stated at the lower of cost or
market and no losses are expected from the final disposition of these
properties.
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.
The approximate amount that would have been accrued on those loans for which
interest was discontinued in 2004 was $360,000.
Overall Assessment
Community has assessed all of the above factors in the establishment of the
allowance for loan losses. The determination as to the adequacy of the allowance
reflects management's judgment, and was based upon collateral, local market
conditions, various estimates, and other information that requires subjective
analysis. These factors, which are prone to change, are monitored by management
to evaluate their potential impact on management's assessment of the adequacy of
the allowance. Based on its evaluation of loan quality, management believes that
the allowance for loan losses at December 31, 2004 was adequate to absorb
probable losses within the loan portfolio.
29
DEPOSITS
Deposit balances remain the primary source of funding for financial institutions
and Community recognized steady growth of nearly 10% in this important
core-funding source, with average balances summarized as follows:
Change
------
2004 2003 Amount %
---- ---- ------ -
Demand $ 178,084 $ 167,315 $ 10,769 6%
Savings & NOW accounts 495,968 401,805 94,163 23%
Time 510,046 498,005 12,041 2%
Time $100,000 or more 111,879 110,231 1,648 1%
----------------------------------------------------------------
$ 1,295,977 $ 1,177,356 $ 118,621 10%
================================================================
As in 2003, deposit trends were influenced by consumer preferences for
liquidity. The scarcity of opportunities available to achieve higher returns by
extending maturities stunted growth in most time deposit categories. Deposit
growth in 2004 was concentrated in savings deposits, more specifically
Community's Power Checking account. This account, which has characteristics of
both a money market and checking account, has grown steadily throughout both
2004 and 2003. Consumer preferences were clearly weighted in favor of
maintaining adequate liquidity in anticipation of a future increase in rates.
This was influenced, in part, by concerns over the presidential election and any
possible impact that may have on expectations for the pace and velocity of
chances in interest rates. Despite the fact that most interest rates declined
steadily through mid-year, most depositors were reluctant to extend time deposit
maturities to obtain only marginally higher rates. The consistent downward
pressure on rates, combined with lack of confidence in other more risky
investment vehicles, increased consumer preference for the flexibility,
liquidity and guaranteed return provided by these accounts.
The following table summarizes the maturity distribution of time deposits of
$100,000 or more as of December 31, 2004.
Remaining Time to Maturity:
Less than three months $ 19,365
Three months to six months 12,157
Six months to twelve months 20,506
More than twelve months 53,980
-----------------
$ 106,008
=================
BORROWED FUNDS
Community makes tactical use of Federal Home Loan Bank (FHLB) advances and other
borrowed funds to augment its funding needs. The largest component of borrowed
funds comes from FHLB advances. FHLB borrowings, which are collateralized by
residential mortgages or other qualified securities, include a variety of credit
products available to Community through its membership in the Federal Home Loan
Bank. At December 31, 2004, the amount available for borrowing under FHLB
arrangements totaled $158.3 million. The use of advances and borrowed funds is a
by-product of Community's overall asset / liability management strategy and is
influenced by a number of factors, which are discussed more fully in the section
titled "Asset / Liability Management and Liquidity".
CAPITAL ADEQUACY
Capital strength is an important measure with which to judge the overall
stability of a financial institution. A strong capital base is 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.
Community believes that capital is a valuable, albeit limited resource whose
availability moderates with changes in the business cycle. Community has
developed an extensive capital management policy designed to consider all
aspects of
30
capital management. This policy is mindful of the responsibilities to
Community's shareholders, employees, regulators, and other constituencies to
ensure that capital is well-managed. The policy considers the impact of numerous
capital management issues, including: the maintenance of key financial ratios;
the need for an adequate return to shareholders in terms of both dividend payout
and capital appreciation; the flexibility to apply techniques that will
accommodate either equity expansion or contraction; and the restraint required
to avoid accumulation of unsustainable levels of intangible assets. Community
also continuously examines its options with regard to capital management in the
context of intrinsic factors, including its prospects for growth, the potential
for earnings disruption, and others. Maintenance of appropriate capital levels
may require the application of techniques designed to help Community meet or
exceed regulatory guidelines and to correlate capital levels with a given asset
growth rate. Community's capital management and planning process is reviewed and
approved by its Board of Directors.
In addition to internal guidelines, regulators have established standards for
the monitoring and maintenance of appropriate levels of capital for financial
institutions. All regulatory capital guidelines are 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 of Community and its bank subsidiary at the end of
2004, along with an indication of the various regulatory capital requirements.
December 31, "Well "Regulatory
2004 Capitalized" Minimums"
---- ------------ ---------
Leverage ratio
Community Banks, Inc. 8.80% n/a 4%
Bank only 8.22% 5% 4%
Tier 1 capital ratio
Community Banks, Inc. 11.62% n/a 4%
Bank only 10.85% 6% 4%
Total risk-based capital ratio
Community Banks, Inc. 12.62% n/a 8%
Bank only 11.83% 10% 8%
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. Throughout the year, Community's earnings trends
supported a return of capital to existing shareholders in the form of the
traditional cash dividend. Community also made strategic use of share repurchase
as another efficient means of returning capital to shareholders. At the end of
both 2002 and 2003, Community executed separate issuances of $15.5 million of
subordinated debentures and the total subordinated debentures balances remained
at $30.9 million as of the end of 2004. Community places no significant reliance
on these instruments to meet regulatory capital requirements. In the aggregate,
these various strategies and techniques have allowed management to maintain
capital at levels that represented an efficient use of this valuable resource.
Community does not presently have any commitments for significant capital
expenditures.
ASSET/LIABILITY MANAGEMENT AND LIQUIDITY
The process by which financial institutions manage earning assets and funding
sources under different interest rate environments is called asset/liability
management. The primary goal of asset/liability management is to increase net
interest income through the prudent control of market risk, liquidity, interest
rate risk and capital. Two important barometers of performance are net interest
margin and liquidity. Net interest margin is increased by widening interest
spread while controlling interest rate sensitivity. The adequacy of liquidity is
determined by the ability to meet the cash flow requirements of both depositors
and customers requesting bank credit. Community's Board of Directors and the
Audit Committee of the Board govern and monitor asset/liability management
processes and liquidity as part of the overall risk management process and
delegate the responsibility for management of these processes to the corporate
Asset/Liability Management Committee (ALCO).
Liquidity is defined as the ability to meet maturing obligations and customers'
demand for funds on a continuous basis. Good liquidity exists when an entity can
meet its potential cash obligations without liquidating its franchise assets.
Poor liquidity exists when a company lacks the liquid assets to cover short term
liabilities. Liquidity is sustained by
31
stable core deposits, a diversified mix of liabilities, strong credit perception
and the presence of sufficient assets convertible to cash without material loss
or disruption of normal operations. Bank liquidity could contract from current
comparatively strong positions if there were reversals in trends that
contributed to recent deposit growth. Community actively manages liquidity
within a defined range and has developed reasonable liquidity contingency plans,
ensuring availability of alternate funding sources to maintain adequate
liquidity under a variety of business conditions. Community's investing and
financing activities are conducted within the overall constraints of its
liquidity management policy and practices.
Community utilizes a variety of techniques to assist management and the Board of
Directors in the management and monitoring of interest rate risk. In order to
quantify the impact of changes in interest rates on net interest income,
Community conducts a quarterly interest rate shock simulation that projects the
impact of interest rate changes on net interest income over the next year. These
simulations are utilized to assess whether management should consider corrective
actions in order to minimize Community's exposure or vulnerability to a
particular trend in interest rates. Management has established acceptable
tolerance limits for the impact of changes in interest rates on the volatility
of net interest income, and is authorized to pursue mitigating strategies in
order to minimize unfavorable impact under a variety of scenarios. Such
simulations are conducted under a variety of assumptions that require estimates
of the velocity and extent of interest rate changes, including an assessment of
the impact of such changes on those assets and liabilities that have
indeterminate maturity or repricing characteristics. Simulation of earnings is
used primarily to measure Community's earning exposure for the ensuing year.
Current policy limits unfavorable exposure of simulated net interest income to
10% of the base case net interest income in either a rising or falling rate
"shock" scenario (immediate repricing) of 200 basis points. The following is a
summary of the rate "shock" results conducted under these various assumptions as
December 31, 2004:
Annual
Simultaneous Change
Rate in Net Interest %
"Shock" Income Change
--------------------------------------------------------------------------------
+300bp +$5.0 million +8.35%
+200bp +$3.5 million +5.84%
+100bp +$1.8 million +2.98%
-100bp -$3.2 million -5.26%
Management augments its simulation process with two other techniques, GAP
analysis and economic value of equity (EVE) computations. The most practical
tool for day-to-day management of interest rate risk is GAP analysis, which
provides an array of various timeframes during which earning assets and funding
sources can be expected to mature or reprice. This information is ordinarily
examined in the context of the results derived from the quarterly rate shock
simulations. Management uses such information to identify specific "cause and
effect" relationships that can be reviewed, analyzed, managed, or changed to
ensure maximization of net revenue from intermediation activities. The
combination of GAP analysis and rate shock simulations provides the most
practical measurement tools for monitoring and managing of the largest source of
revenue for community banks. As with the simulation or "shock" analysis,
Community has established a policy limit for the cumulative twelve month GAP of
"plus or minus" 15% of total assets. At December 31, 2004, the twelve month GAP
fell well within this policy limit for each of the time intervals less than one
year, as shown in the following summary:
Cumulative GAP
Interval (Expressed as % of Assets)
---------------------------------------------------------------------------
0-90 days + 11.18%
91-180 days + 10.94%
181-365 days + 10.28%
EVE computations provide a longer-term assessment of interest rate risk, but are
more practical for evaluating long-term, strategic decision-making. EVE has
several limitations, including: (1) the intrinsic value of assets and
liabilities does not necessarily represent the fair value of financial
instruments since it does not include credit risk and liquidity;
32
(2) estimated cash flows are required for non-maturity financial instruments and
are, by their nature, inexact; and (3) the future structure of Community's
balance sheet does not consider increased loan and deposit activities from core
business within its present value assessment. The results derived from EVE
computations, however, provide a valuable framework for managing longer-term
balance sheet exposures and interest rate volatility trends. At the end of 2004,
all measures of EVE fell within the policy limits established via the
asset/liability management policy, as approved by the Board of Directors.
CONTRACTUAL OBLIGATIONS
Significant contractual obligations at December 31, 2004 are summarized in the
following table:
Payments due by period
-------------------------------------------------------------------------------
Less than 1-3 3-5 More than
Dollars in thousands Total 1 year years years 5 years
-----------------------------------------------------------------------------------------------------------------------
Long-term debt $ 404,662 $ 42,243 $ 69,229 $ 32,878 $ 260,312
Operating lease obligations 11,350 1,223 1,833 1,261 7,033
Subordinated debt 30,928 --- --- --- 30,928
Time deposits 623,803 275,992 257,143 89,716 952
-----------------------------------------------------------------------------------------------------------------------
Total $ 1,070,743 $ 319,458 $ 328,205 $ 123,855 $ 299,225
-----------------------------------------------------------------------------------------------------------------------
OFF-BALANCE SHEET COMMITMENTS
As of December 31, 2004, Community had unfunded commitments totaling $484.2
million. For details of these off-balance sheet commitments, see "Notes to
Consolidated Financial Statements - Commitments and Contingencies" included in
Part II, Item 9
REGULATORY MATTERS
Community and its affiliates are subject to periodic examinations by the various
regulatory agencies. These examinations include, but are not limited to,
procedures designed to review lending practices, risk management, credit
quality, liquidity, compliance and capital adequacy. During 2004, the
Pennsylvania State Department of Banking, the Federal Deposit Insurance
Corporation, and the Federal Reserve performed various examinations of Community
and its banking subsidiaries pursuant to their regular, periodic regulatory
reviews. No comments were received from these various bodies that would have a
material adverse effect on Community's liquidity, capital resources, or
operations.
INFLATION
Community's ability to cope with the impact of inflation is best measured by its
ability to respond to changing interest rates and manage non-interest income and
expense. Within its ALCO processes, Community manages the mix of interest
rate-sensitive assets and liabilities in order to limit the impact of changing
interest rates on net interest income. Inflation also has a direct impact on
non-interest income and expense such as service fee income, salary and benefits
expenses, and other overhead expenses. Inflationary pressures over the last
several years have been relatively modest but more recent trends suggest the
potential for emerging inflationary pressure. Management will continue to
monitor the potential for inflation and its impact on the pricing of products
and services.
PERFORMANCE REVIEW: 2003 VERSUS 2002
Community completed a year of record performance in 2003, reporting the highest
net income and earnings per share in its history up to that point. At the same
time, Community made significant progress in its continuing effort to evolve
into a "community-focused" and integrated financial services corporation. Net
income reached $20.4 million, an 11% increase from the net income of $18.4
million reported in 2002. Similarly, diluted earnings per share reached $1.63, a
10% improvement from the $1.48 reported in 2002. At the end of 2003, Community
produced an ROA of 1.15% and an ROE of 15.03%, which were comparable to the
performances of 1.17% and 15.46% in the prior year.
33
Interest Income
Interest income was $101.2 million in 2003, only slightly below the $102.5
million recorded in 2002, despite the fact that earning asset yields declined
from 6.89% to 6.02% between the two years. Earning asset growth, fueled
principally by loan growth, forged a 13.0% increase from $1.49 billion to $1.68
billion and helped to offset the compression that would normally accompany lower
earning asset yields. From 2002 to 2003, earning assets grew $193 million,
including $111 million in loans and $89 million in portfolio investment
securities. Growth in loans accelerated during the year and was funded by both
runoff in the investment portfolio and by an $86 million increase in the level
of deposits, most of which occurred in Community's successful Power Checking
offering.
Interest Expense
Interest expense on deposits declined dramatically during 2003 and was a major
contributor to the nearly 5% increase in net interest income. Despite increases
in loan mix and an overall increase in the level of earning assets, Community
was not able to achieve improvement in interest income due to the impact of
lower rates. Fortunately, that same rate environment permitted most banks to
reduce interest rates on deposit funding and enabled Community to reduce its
overall funding costs from $46.2 million in 2002 to $42.3 million in 2003, a
decline of $3.9 million or 8%. Simultaneously, most banks continued to enjoy an
influx of deposit funding as consumers opted for the security and short-term
liquidity of bank deposits. Total deposits grew by $86 million. For the first
time in several years, Community realized no growth in its time deposit
categories as consumers were reluctant to extend maturities for relatively
unattractive rate premiums.
Community also made strategic use of other forms of funding in order to meet the
consistent demand for credit extension that occurred in 2003. Incremental
borrowing rates on federal funds influenced the pricing of all short-term
sources of funds and made these borrowings far less expensive than other funding
sources. At various times during the year, Community also increased its
long-term borrowings, which are composed principally of term funding available
through the Federal Home Loan Bank programs. Community experienced a 17%
increase in long-term funding, which included the first full year of $15 million
in trust preferred instruments issued under a pooled arrangement in December of
2002. Community executed an additional $15 million in these instruments at the
end of 2003, bringing its total issuances to $30 million.
Net Interest Income
Despite the decline in earning asset yields, interest income stabilized during
most of the year as earning assets were redeployed from lower-yielding, maturing
investments to comparatively higher-yielding loans. The increasing affordability
of credit created increased demand for both business and consumer credit
products, resulting in an overall increase in earning assets. At the same time,
most banks continued to benefit from an influx of deposit funding. The paucity
of competitive returns in either the equity markets or other investment yields
made bank deposits a viable short-term alternative given consumer preferences
for liquidity in anticipation of future rate increases. Most consumers were
understandably averse to commit funds into longer maturity instruments given the
expectation of higher rates. The net impact was that interest expense declined
by 8% while interest income declined by only 1%, resulting in an increase in net
interest income of nearly 5% , from $56.3 million in 2002 to $58.9 million in
2003.
As a result of rate trends and other dynamics specific to Community's balance
sheet, Community reported a decline in net interest spread from 3.29% in 2002 to
3.13% in 2003, and a decline in net interest margin from 3.78% to 3.50% over the
same period. The decline in margin was also linked to the impact of reduced
contribution from non-interest funding sources, which declined from 0.49% to
0.37%. During periods of declining interest rates, the contribution from
non-interest funds to net interest margin is reduced since funds are invested at
progressively lower rates.
Provision for Credit Losses
For the second consecutive year, Community reported a decline in the provision
for loan losses, which reflected the steady improvement in the overall asset
quality metrics of its loan portfolio. The provision declined from $3.4 million
in 2002 to $2.5 million in 2003, while the relationship of the allowance for
loan losses to loans declined from 1.36% at December 31, 2002 to 1.22% at the
end of 2003. The provision, and the level of the allowance, was responsive to
the
34
changing credit quality conditions. Net charge-offs during 2003 were only $1.7
million, or 0.17% of average loans, and reflected a significant decline from
charge off levels of the past two years. Non-accrual loans aggregated $8.2
million, the lowest absolute level since the beginning of 2001.
Non-Interest Income
This increasingly vital component of the revenue stream grew substantially
during 2003 as important steps were undertaken to solidify and expand
Community's integrated businesses and complementary banking services. Excluding
the impact from sales of investment securities, non-interest revenue grew 43%,
from $12.9 million in 2002 to over $18.5 million in 2003. The income recorded
during 2003, however, included two nonrecurring gains without which Community
would still have recorded an increase of 37%, as adjusted for these items in
both years. Amounts recorded in 2003 included a gain from the curtailment of a
legacy, defined benefit plan in the third quarter and the recognition of a gain
from the sale of an office, inclusive of both loans and deposits, in the fourth
quarter. Community had recognized a similar gain from the sale of two offices
and related deposits in 2002.
Non-Interest Expenses
Total non-interest expenses reached $45.7 million in 2003 and reflected a 16%
increase, or $6.4 million, from the $39.3 million recorded in 2002. The growth
was influenced by two major factors. Over 25% of the increase of $6.4 million,
or $1.7 million, was directly related to increased expenses from the integrated
businesses acquired at different points during 2003. These increases included
the expenses from ABCO, Erie, and incremental insurance agency activity.
Excluding the portion of the increase related to acquired businesses, 2003
operating expenses increased $4.7 million or 12% over 2002 expenses. This second
component of the increase was more directly related to the costs associated with
expansion of the core banking franchise. Since the end of 2001, Community had
added a total of seven new banking facilities while selling three offices in
markets with less robust growth characteristics. This selective expansion of the
Community Banks franchise had a significant influence on the operating expense
structure. At the same time, this expansion had also been an important catalyst
for the growth in loan and deposit balances since the end of 2001.
Excluding the impact of salaries added from the acquired businesses, salary and
benefit expenses grew nearly $2.5 million from 2002 to 2003. Of this increase,
over $1 million was attributed to the effect of the 3% average salary increase
and to a heavier reliance on employee incentives. Payroll taxes and employee
insurance costs were influenced by personnel added in both banking and acquired
businesses, and by increases in health insurance rates. The remainder of the
increase, less than $1 million, was affected by personnel added as a result of
the new branch offices, the increased cost of the customer service center, and
by the addition of new lenders for certain key growth markets.
Expenses not related to employee-related costs also grew. Occupancy expenses
were influenced by increased costs associated with community office expansion
and rose by just over $1 million. Marketing and promotional expenses increased
over $900 thousand. These costs were undertaken in order to increase Community's
market share in new markets and to preserve and expand share in its legacy
communities. Marketing campaigns were undertaken to expand awareness, image and
lead product advertising, especially in the first half of 2003. Community also
reflected a $300 thousand increase in its communications and data connection
expenses during the year.
The following tables are provided as a supplement to Management's Discussion and
Analysis of Financial Condition and Results of Operations:
* Distribution of Assets, Liabilities and Stockholders' Equity; Interest
Rates and Interest Differential
* Rate/Volume Analysis - Tax Equivalent Basis
* Loan Account Composition as of December 31, 2004, 2003, 2002, 2001,
and 2000.
* Maturities and Sensitivity to Changes in Interest Rates for
Commercial, Financial, and Agricultural Loans as of December 31, 2004.
35
Distribution of Assets, Liabilities, and Stockholders' Equity; Interest Rates and Interest Differential
Income and Rates on a Tax Equivalent Basis (b) for the Years Ended December 31, 2004, 2003, and 2002
2004 2003 2002
---------------------------------------------------------------------------------------------------------
Average Average Average
Interest Rates Interest Rates Interest Rates
Average Income/ Earned/ Average Income/ Earned/ Average Income/ Earned/
Balance(c) Expense(a) Paid (a) Balance(c) Expense(a) Paid (a) Balance(c) Expense(a) Paid (a)
---------------------------------------------------------------------------------------------------------
Assets:
Earning assets:
Interest-bearing
deposits in other banks $ 2,325 $ 20 0.86% $ 1,160 $ 9 0.78% $ 1,742 $ 26 1.49%
Investment securities:
Taxable 456,478 19,624 4.30 466,316 18,607 3.99 384,097 19,602 5.10
Tax-exempt (b) 209,170 15,856 7.58 207,627 15,957 7.69 200,419 14,955 7.46
----------- ----------- -----------
Total investment
securities 665,648 673,943 584,516
----------- ----------- -----------
Federal funds sold 7,801 117 1.50 4,015 40 1.00 11,126 193 1.73
Loans (b) (d) 1,156,107 70,721 6.12 1,001,086 66,604 6.65 889,912 67,712 7.61
---------------------------------------------------------------------------------------------------------
Total earning assets 1,831,881 106,338 5.80 1,680,204 101,217 6.02 1,487,296 102,488 6.89
---------------------------------------------------------------------------------------------------------
Cash and due from banks 37,316 36,451 36,982
Allowance for loan losses (14,156) (13,016) (12,689)
Premises, equipment,
and other assets 86,055 77,040 68,457
----------- ----------- -----------
Total assets $1,941,096 $ 1,780,679 $ 1,580,046
=========== =========== ===========
Liabilities:
Interest-bearing
liabilities:
Savings deposits $ 167,428 413 0.25 $ 164,207 690 0.42 $ 149,066 1,864 1.25
Money market deposits 62,591 377 0.60 74,156 624 0.84 82,793 1,289 1.56
NOW accounts 265,949 3,484 1.31 163,442 2,006 1.23 90,773 998 1.10
Time deposits:
$100,000 or greater 111,879 110,231 107,523
Other 510,046 498,005 498,159
----------- ----------- -----------
Total time deposits 621,925 18,249 2.93 608,236 19,777 3.25 605,682 24,498 4.04
----------- ----------- -----------
Total interest-bearing
deposits 1,117,893 1,010,041 928,314
----------- ----------- -----------
Short-term borrowings 59,303 739 1.25 97,837 1,243 1.27 54,178 977 1.80
Long-term debt 394,944 18,382 4.65 339,564 17,256 5.08 301,922 16,560 5.48
Subordinated debt 30,928 1,598 5.17 16,148 755 4.68 484 26 5.37
---------------------------------------------------------------------------------------------------------
Total interest-bearing
liabilities 1,603,068 43,242 2.70 1,463,590 42,351 2.89 1,284,898 46,212 3.60
---------------------------------------------------------------------------------------------------------
Demand deposits 178,084 167,315 163,434
Accrued interest, taxes
and other liabilities 14,194 14,001 12,362
----------- ----------- -----------
Total liabilities 1,795,346 1,644,906 1,460,694
----------- ----------- -----------
Stockholders' equity 145,750 135,773 119,352
----------- ----------- -----------
Total liabilities and
stockholders' equity $1,941,096 $ 1,780,679 $ 1,580,046
=========== =========== ===========
Interest income to earning assets 5.80% 6.02% 6.89%
Interest expense to earning assets 2.36 2.52 3.11
----- ----- -----
Effective interest differential $ 63,096 3.44% $ 58,866 3.50% $ 56,276 3.78%
================= ================== =================
(a) Loan fees are included in interest income and rate calculations.
(b) Interest income on all tax-exempt securities and loans have been adjusted
to a tax equivalent basis utilizing a Federal tax rate of 35% in 2004,
2003, and 2002.
(c) Averages are a combination of monthly and daily averages.
(d) Includes non-accrual loans and interest-earning education loans held for
sale.
36
Rate/Volume Analysis-Tax Equivalent Basis (a)
For the Years Ended December 31, 2004 and 2003
---------------------------------------------------------------------------------------
2004 vs 2003 2003 vs 2002
---------------------------------------------------------------------------------------
Volume Rate Total Volume Rate Total
---------------------------------------------------------------------------------------
Favorable (Unfavorable)
Increase (decrease) in interest income:
Loans $ 9,767 $ (5,650) $ 4,117 $ 7,935 $ (9,043) $ (1,108)
Investment securities:
Taxable (399) 1,416 1,017 3,734 (4,729) (995)
Tax exempt 118 (219) (101) 545 457 1,002
---------------------------------------------------------------------------------------
Total (281) 1,197 916 4,279 (4,272) 7
Federal funds sold 50 27 77 (92) (61) (153)
Interest-bearing deposits in other
banks 10 1 11 (7) (10) (17)
---------------------------------------------------------------------------------------
Total 9,546 (4,425) 5,121 12,115 (13,386) (1,271)
---------------------------------------------------------------------------------------
(Increase) decrease in interest expense:
Savings deposits (806) (148) (954) (877) 1,708 831
Time deposits (437) 1,965 1,528 (102) 4,823 4,721
Short-term borrowings 480 24 504 (615) 349 (266)
Long-term debt (2,658) 1,532 (1,126) (1,959) 1,263 (696)
Subordinated debt (757) (86) (843) (732) 3 (729)
---------------------------------------------------------------------------------------
Total (4,178) 3,287 (891) (4,285) 8,146 3,861
---------------------------------------------------------------------------------------
Increase (decrease) in effective interest
differential $ 5,368 $ (1,138) $ 4,230 $ 7,830 $ (5,240) $ 2,590
=======================================================================================
(a) Table shows approximate effect on the effective interest differential of
volume and rate changes for the years 2004 and 2003. The effect of a change in
average volume has been determined by applying the average yield or rate in the
earlier period to the change in average volume during the period. The effect of
a change in rate has been determined by applying the change in rate during the
period to the average volume of the prior period. Any resulting unallocated
amount was allocated ratably between the volume and rate components. Non-accrual
loans have been included in the average volume of each period. Tax-exempt income
is shown on a tax equivalent basis assuming a federal income tax rate of 35% in
2004, 2003, and 2002.
37
LOAN ACCOUNT COMPOSITION
as of December 31
-----------------
2004 2003 2002 2001 2000
-----------------------------------------------------------------------------------------------------
Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent
-----------------------------------------------------------------------------------------------------
Commercial, financial and
agricultural $ 409,105 33.7% $ 367,444 34.1% $ 295,506 32.7% $ 158,223 18.4% $ 135,612 16.6%
Real estate-construction 8,703 0.7 7,338 0.7 2,615 0.3 21,225 2.5 22,403 2.7
Real estate-commercial 356,871 29.3 283,661 26.3 246,533 27.2 554,354 * 64.7 540,639 * 66.4
mortgage
Real estate-retail mortgage 83,979 6.9 91,485 8.5 106,882 11.8 --- --- --- ---
Consumer-home equity 53,921 4.4 38,299 3.5 28,169 3.1 --- --- --- ---
Consumer-installment and other 303,372 25.0 290,384 26.9 224,863 24.9 123,476 14.4 116,220 14.3
-----------------------------------------------------------------------------------------------------
Total loans 1,215,951 100.0% 1,078,611 100.0% 904,568 100.0% 857,278 100.0% 814,874 100.0%
===== ====== ====== ====== ======
Allowance for loan losses (14,421) (13,178) (12,343) (12,132) (10,328)
---------- ---------- --------- --------- ---------
Loans, net $1,201,530 $1,065,433 $ 892,225 $ 845,146 $ 804,546
========== ========== ========= ========= =========
* Prior breakouts of historical information could not be readily reconstructed
from predecessor banks' records. Breakouts from 2000 to 2001 are assumed to
approximate current mix trends.
Community's loan activity is principally with customers located within its local
market area. Community continues to maintain a diversified loan portfolio and
has no significant loan concentration in any economic sector. Commercial,
financial, and agricultural loans consist principally of commercial lending
secured by financial assets of businesses including accounts receivable,
inventories and equipment, and, in most cases, include liens on real estate.
Real estate construction and mortgage loans are primarily 1 to 4 family
residential loans secured by residential properties within the bank's market
area. Personal-installment loans consist principally of secured loans for items
such as automobiles, property improvement, household and other consumer goods.
Community continues to sell fixed rate mortgages in the secondary market to
manage interest rate risk. Historically, relative credit risk of commercial,
financial and agricultural loans has generally been greater than that of other
types of loans.
MATURITIES AND SENSITIVITY TO CHANGES IN INTEREST
RATES FOR COMMERCIAL, FINANCIAL AND AGRICULTURAL
AND REAL-ESTATE CONSTRUCTION LOANS
as of December 31, 2004
-----------------------
Maturity Distribution
---------------------
One Year One to Over Five
or Less Five Years Years Total
----------------------------------------------------------
Commercial, financial and agricultural $ 72,248 $ 159,420 $ 177,437 $ 409,105
Real estate-construction 593 606 7,504 8,703
Real estate-commercial mortgage 34,991 137,266 184,614 356,871
----------------------------------------------------------
$ 107,832 $ 297,292 $ 369,555 $ 774,679
==========================================================
Interest Sensitivity
--------------------
Variable Fixed Total
-------------------------------------------
Due in one year or less $ 57,947 $ 49,885 $ 107,832
Due after one year 391,511 275,336 666,847
-------------------------------------------
$ 449,458 $ 325,221 $ 774,679
===========================================
38
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
- --------------------------------------------------------------------
A portion of the information related to quantitative and qualitative disclosures
about market risk is included under Management's Discussion and Analysis (MD&A)
under the heading of Asset/Liability Management and Liquidity. The purpose of
this presentation is to augment the discussion contained in MD&A.
Market risk is defined as the exposure to economic loss that arises from changes
in the values of certain financial instruments pursuant to factors arising out
of the various categories of market risk. Market risk can include a number of
categories, including interest rate risk, foreign currency risk, exchange rate
risk, commodity price risk, etc. For domestic, community-based banks, the vast
majority of market risk is related to interest rate risk. Financial institutions
use a number of techniques to attempt to measure the impact of interest rate
risk which includes GAP analysis, interest rate "shock simulation" and economic
value of equity. Each of these techniques is used to help quantify market risk
attributable to the inherent sensitivity of both interest earning assets and
interest bearing liabilities.
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.
The following table provides a measure of interest rate sensitivity for each
category of interest earning assets and interest bearing liabilities at December
31, 2004.
39
Interest Rate Sensitivity
-------------------------------------------------------------------------------------------------------------
At December 31, 2004 1-90 90-180 180-365 1 year
Dollars in thousands days days days or more Total
-------------------------------------------------------------------------------------------------------------
Assets
Interest-bearing deposits in
other banks $ 1,787 $ --- $ --- $ --- $ 1,787
Loans held for sale --- --- --- 1,269 1,269
Investment securities 134,452 18,755 29,018 436,885 619,110
Loans (a) 453,673 64,579 98,057 599,642 1,215,951
-------------------------------------------------------------------------------------------------------------
Earning assets 589,912 83,334 127,075 1,037,796 1,838,117
Non-earning assets 236 --- --- 116,446 116,682
-------------------------------------------------------------------------------------------------------------
Total assets $ 590,148 $ 83,334 $ 127,075 $ 1,154,242 $ 1,954,799
-------------------------------------------------------------------------------------------------------------
Liabilities
Savings $ 209,550 $ --- $ --- $ 287,825 $ 497,375
Time 70,633 64,185 90,687 292,290 517,795
Time in denominations of
$100,000 or more 19,265 12,157 20,506 54,080 106,008
Short-term borrowings 47,116 --- --- --- 47,116
Long-term debt 1,812 11,812 28,624 362,414 404,662
Subordinated debt 23,196 --- --- 7,732 30,928
-------------------------------------------------------------------------------------------------------------
Interest bearing liabilities 371,572 88,154 139,817 1,004,341 1,603,884
Other liabilities and equity --- --- --- 350,915 350,915
-------------------------------------------------------------------------------------------------------------
Total liabilities and equity $ 371,572 $ 88,154 $ 139,817 $ 1,355,256 $ 1,954,799
-------------------------------------------------------------------------------------------------------------
Interest Sensitivity GAP
Periodic $ 218,576 $ (4,820) $ (12,742) $ (201,014)
Cumulative 213,756 201,014 ---
Cumulative GAP as a
percentage of total assets
11.18% 10.93% 10.28% 0%
(a) Includes non-accrual loans.
Community seeks to maximize net interest income and minimize earnings volatility
by managing the level of interest rate sensitivity. Interest rate sensitivity is
influenced by the repricing characteristic of both assets and liabilities and
includes the volume of assets and liabilities repricing, the timing of repricing
and the relative magnitude of the repricing. While GAP measurement provides an
important tool to quantify the level of interest rate sensitivity at a specific
point in time, its utility is constrained by the inherent limitations of GAP
measurement for a number of reasons. First, changes in the level of interest
rates cannot be expected to affect all assets and liabilities equally nor will
they all be impacted at the same time. Second, assets and liabilities that are
eligible to be repriced within a specific time frame may, in fact, not reprice
or may not reprice to the same extent. Third, the measurement of GAP is
inherently limited in that it provides a representation of the repricing
characteristics of assets and liabilities at a specific point in time while
actual sensitivity of assets and liabilities are undergoing constant change.
Finally, much of the presentation of GAP is, by necessity, based upon estimates
and assumptions for certain assets and liabilities. For example, savings, NOW
accounts, and other forms of core deposits do not have defined maturities or
repricing dates and therefore require estimates to be made based upon historical
deposit decay rate analysis or other forms of approximation.
Interest rate sensitivity, and the measurement thereof, are also influenced by
the optionality of certain earning assets and interest bearing liabilities. For
example, a substantial portion of Community'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
40
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 Community of FHLB borrowings and
subordinated notes prior to maturity.
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
Community'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 is 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.
The following table reflects the estimated present value of assets, liabilities
and equity using the model for Community as of December 31, 2004 at current
interest rates and hypothetically, higher and lower interest rates of one and
two percent.
Base
-2% -1% Present Value +1% +2%
-------------------------------------------------------------------------------
Assets: (dollars in thousands)
Cash, interest-bearing time deposits,
and federal funds sold $ 45,273 $ 45,273 $ 45,273 $ 45,273 $ 45,273
Loans held for sale 1,967 1,572 1,269 1,037 858
Investment securities 659,156 638,739 619,110 597,907 577,490
Loans 1,233,854 1,219,788 1,201,530 1,175,453 1,152,107
Other assets 87,617 87,617 87,617 87,617 87,617
-------------------------------------------------------------------------------
Total assets $ 2,027,867 $ 1,992,989 $ 1,954,799 $ 1,907,287 $ 1,863,345
===============================================================================
Liabilities:
Deposits $ 1,323,663 $ 1,314,529 $ 1,305,537 $ 1,296,675 $ 1,288,089
Short-term borrowings 47,116 47,116 47,116 47,116 47,116
Long-term debt 448,801 427,813 404,662 389,766 372,519
Subordinated debt 30,928 30,928 30,928 30,928 30,928
Other liabilities 14,215 14,215 14,215 14,215 14,215
-------------------------------------------------------------------------------
Total liabilities 1,864,723 1,834,601 1,802,458 1,778,700 1,752,867
-------------------------------------------------------------------------------
Total stockholders' equity 163,144 158,388 152,341 128,587 110,478
-------------------------------------------------------------------------------
Total liabilities and stockholders'
equity $ 2,027,867 $ 1,992,989 $ 1,954,799 $ 1,907,287 $ 1,863,345
===============================================================================
41
Item 8. Financial Statements and Supplementary Data:
- -----------------------------------------------------
Community Banks, Inc. and Subsidiaries
CONSOLIDATED BALANCE SHEETS
At December 31, 2004 and 2003
(Dollars in thousands except per share data)
-------------------------------------------------
2004 2003
-------------------------------------------------
ASSETS
Cash and due from banks $ 43,486 $ 42,790
Federal funds sold --- 17,097
---------------------- --------------------
Cash and cash equivalents 43,486 59,887
Interest-bearing deposits in other banks 1,787 3,301
Investment securities, available for sale 619,110 646,961
Loans held for sale 1,505 6,067
Loans, net of allowance for loan losses of $14,421 and $13,178 1,201,530 1,065,433
Premises and equipment, net 25,517 24,153
Accrued interest receivable and other assets 61,864 55,261
---------------------- --------------------
Total assets $ 1,954,799 $ 1,861,063
====================== ====================
LIABILITIES
Deposits:
Non-interest bearing $ 184,359 $ 165,174
Interest bearing 1,121,178 1,065,511
---------------------- --------------------
Total deposits 1,305,537 1,230,685
Short-term borrowings 47,116 27,764
Long-term debt 404,662 411,422
Subordinated debt 30,928 30,928
Accrued interest payable and other liabilities 14,215 16,858
---------------------- --------------------
Total liabilities 1,802,458 1,717,657
---------------------- --------------------
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; 12,421,000 and 11,851,000 shares issued 62,107 59,256
Surplus 73,304 57,563
Retained Earnings 18,134 24,297
Accumulated other comprehensive income , net of tax 3,211 6,596
Treasury stock; 185,000 and 203,000 shares, at cost (4,415) (4,306)
---------------------- --------------------
Total stockholders' equity 152,341 143,406
---------------------- --------------------
Total liabilities and stockholders' equity $ 1,954,799 $ 1,861,063
====================== ====================
The accompanying notes are an integral part of the consolidated financial
statements.
42
Community Banks, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF INCOME
For the Years Ended December 31, 2004, 2003, and 2002
(dollars in thousands except per share data)
---------------------------------------------------
2004 2003 2002
---------------------------------------------------
INTEREST INCOME:
Loans, including fees $ 69,732 $ 65,837 $ 67,158
Investment securities:
Taxable 18,999 17,532 18,478
Tax exempt 8,847 8,957 8,457
Dividends 2,084 2,490 2,388
Other 137 49 219
-------------- --------------- --------------
Total interest income 99,799 94,865 96,700
-------------- --------------- --------------
INTEREST EXPENSE:
Deposits 22,523 23,097 28,649
Short-term borrowings 739 1,243 977
Long-term debt 18,382 17,256 16,560
Subordinated debt 1,598 755 26
-------------- --------------- --------------
Total interest expense 43,242 42,351 46,212
-------------- --------------- --------------
Net interest income 56,557 52,514 50,488
Provision for loan losses 3,100 2,500 3,350
-------------- --------------- --------------
Net interest income after provision for loan 53,457 50,014 47,138
losses
-------------- --------------- --------------
NON-INTEREST INCOME:
Investment management and trust services 1,510 1,326 993
Service charges on deposit accounts 7,120 5,128 3,440
Other service charges, commissions and fees 3,357 2,958 2,471
Investment security gains 2,470 1,927 1,034
Insurance premium income and commissions 3,260 2,822 2,016
Mortgage banking activities 2,665 2,532 1,221
Earnings on investment in life insurance 1,593 1,455 1,476
Other 1,238 2,315 1,324
-------------- --------------- --------------
Total non-interest income 23,213 20,463 13,975
-------------- --------------- --------------
NON-INTEREST EXPENSES:
Salaries and employee benefits 28,337 25,397 21,636
Net occupancy 7,980 7,200 6,051
Marketing expense 2,325 2,018 1,090
Telecommunications expense 1,285 1,302 995
Other 10,066 9,801 9,528
-------------- --------------- --------------
Total non-interest expenses 49,993 45,718 39,300
-------------- --------------- --------------
Income before income taxes 26,677 24,759 21,813
Income taxes 4,879 4,359 3,367
-------------- --------------- --------------
Net income $ 21,798 $ 20,400 $ 18,446
============== =============== ==============
EARNINGS PER SHARE:
Basic $ 1.78 $ 1.68 $ 1.51
Diluted $ 1.73 $ 1.63 $ 1.48
The accompanying notes are an integral part of the consolidated financial
statements.
43
Community Banks, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
For the Years Ended December 31, 2004, 2003, and 2002
(dollars in thousands except per share data)
Accumulated
Other
Outstanding Common Retained Comprehensive Treasury Total
Shares Stock Surplus Earnings Income (Loss) Stock Equity
-------------------------------------------------------------------------------------------
Balance, December 31, 2001 8,849 $ 44,839 $ 35,906 $ 36,923 $ (4,024) $ (2,395) $ 111,249
Comprehensive income (loss):
Net income 18,446 18,446
Unrealized gain on securities, net
of reclassification adjustment
and tax effect 11,151 11,151
Change in unfunded pension
liability, net of tax (589) (589)
----------
Total comprehensive income 29,008
Cash dividends (6,654) (6,654)
5% stock dividend 440 2,241 10,177 (12,418) ---
Purchases of treasury stock (224) (5,828) (5,828)
Exercise of common stock options and
issuances under stock purchase plan 86 (27) (953) 2,032 1,052
Tax benefits from employee stock
transactions 335 335
-------------------------------------------------------------------------------------------
Balance, December 31, 2002 9,151 47,053 46,418 35,344 6,538 (6,191) 129,162
Comprehensive income (loss):
Net income 20,400 20,400
Unrealized gain on securities, net
of reclassification adjustment
and tax effect 626 626
Change in unfunded pension
liability, net of tax (568) (568)
----------
Total comprehensive income 20,458
Cash dividends (7,619) (7,619)
5% stock dividend 458 2,346 10,612 (12,984) (26)
Stock split paid in the form of a 20%
stock dividend 1,944 9,878 (9,878) ----
Purchases of treasury stock (125) (3,627) (3,627)
Stock issued in connection with
acquisition 26 106 644 750
Exercise of common stock options and
issuances under stock purchase plan 194 (21) (966) 4,868 3,881
Tax benefits from employee stock
transactions 427 427
-------------------------------------------------------------------------------------------
Balance, December 31, 2003 11,648 59,256 57,563 24,297 6,596 (4,306) 143,406
Comprehensive income (loss):
Net income 21,798 21,798
Unrealized loss on securities,
net of reclassification
adjustment and tax effect (3,140) (3,140)
Change in unfunded pension
liability, net of tax (245) (245)
---------
Total comprehensive income 18,413
Cash dividends (8,215) (8,215)
5% stock dividend 584 2,949 15,103 (18,110) (58)
Purchases of treasury stock (144) (4,151) (4,151)
Exercise of common stock options and
issuances under stock purchase plan 148 (98) (1,636) 4,042 2,308
Tax benefits from employee stock
transactions 638 638
-------------------------------------------------------------------------------------------
Balance, December 31, 2004 12,236 $ 62,107 $ 73,304 $ 18,134 $ 3,211 $ (4,415) $ 152,341
===========================================================================================
The accompanying notes are an integral part of the consolidated financial
statements.
44
Community Banks, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2004, 2003, and 2002
(dollars in thousands)
--------------------------------------------------
2004 2003 2002
--------------------------------------------------
Operating Activities:
Net income $ 21,798 $ 20,400 $ 18,446
Adjustments to reconcile net income to net cash
provided by operating activities:
Provision for loan losses 3,100 2,500 3,350
Deferred income tax benefit (481) (152) (192)
Depreciation and amortization 3,310 3,075 2,541
Net amortization of securities 1,106 2,431 779
Realized gains on sales of available-for-sale securities, (2,470) (1,927) (1,034)
net
Loans originated for sale (10,959) (66,976) (66,158)
Proceeds from sales of loans held for sale 15,923 73,957 66,375
Gains on loan sales (1,125) (1,565) (1,221)
Earnings on investment in life insurance (1,593) (1,455) (1,476)
Pension curtailment gain --- (497) ---
Net change in other assets 3,646 1,799 (652)
Net change in accrued interest payable and other liabilities (2,982) 2,848 (862)
Tax benefits from employee stock transactions 638 427 335
--------------------------------------------------
Net cash provided by operating activities 29,911 34,865 20,231
--------------------------------------------------
Investing Activities:
Net change in interest-bearing deposits in other banks 1,515 (2,350) 421
Activity in available-for-sale securities:
Sales 119,390 165,513 147,610
Maturities, prepayments and calls 125,440 145,221 83,605
Purchases (220,501) (289,398) (337,706)
Net increase in total loans (144,509) (180,725) (54,094)
Proceeds from sale of credit card portfolio 4,556 --- ---
Investment in life insurance (5,000) --- (5,000)
Net additions to premises and equipment (4,206) (2,677) (4,037)
Other (325) (2,717) (880)
--------------------------------------------------
Net cash used by investing activities (123,640) (167,133) (170,081)
--------------------------------------------------
Financing Activities:
Net increase in deposits 74,852 97,773 129,688
Net change in short-term borrowings (5,648) (41,361) 9,123
Proceeds from issuance of long-term debt 35,000 98,751 34,767
Proceeds from subordinated debt --- 15,464 15,464
Repayment of long-term debt (16,760) (7,862) (36,389)
Cash dividends and cash paid in lieu of fractional shares (8,273) (7,645) (6,654)
Payments to acquire treasury stock (4,151) (3,627) (5,828)
Proceeds from issuance of common stock 2,308 4,525 1,052
--------------------------------------------------
Net cash provided by financing activities 77,328 156,018 141,223
--------------------------------------------------
Net change in cash and cash equivalents (16,401) 23,750 (8,627)
Cash and cash equivalents at beginning of period 59,887 36,137 44,764
--------------------------------------------------
Cash and cash equivalents at end of period $ 43,486 $ 59,887 $ 36,137
==================================================
Cash paid during the year for:
Interest $ 42,426 $ 42,311 $ 46,617
Income taxes $ 3,738 $ 4,170 $ 4,304
The accompanying notes are an integral part of the consolidated financial
statements.
45
Community Banks, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
ORGANIZATION AND BASIS OF PRESENTATION:
Community Banks, Inc. ("Community" or the "Corporation") is a financial holding
company whose wholly-owned subsidiaries include Community Banks, Community Bank
Investments, Inc. (CBII), and Community Banks Life Insurance Company (CBLIC).
All significant intercompany transactions have been eliminated in consolidation.
Community operates through its executive office in Harrisburg, Pennsylvania, and
through 48 branch banking offices located in Adams, Cumberland, Dauphin,
Luzerne, Northumberland, Schuylkill, Snyder, and York Counties in Pennsylvania,
and Carroll County in Maryland. Community Banks provides a wide range of
services through its network of offices. Lending services include secured and
unsecured commercial loans, residential and commercial mortgages and various
forms of consumer lending. Deposit services include a variety of checking,
savings, time and money market deposits. Community also provides specialized
services through its wholly-owned subsidiaries. Community and its subsidiaries
are subject to the regulations of certain Federal and state agencies and undergo
periodic examinations by such regulatory authorities.
USE OF ESTIMATES:
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. The
principal material estimates that are particularly susceptible to significant
change in the near term relate to the determination of the allowance for loan
losses and the evaluation of other than temporary impairment of investment
securities.
CASH FLOWS INFORMATION:
Cash and cash equivalents include cash and due from banks and federal funds
sold. Noncash transactions included the issuance of $750,000 of common stock for
an acquisition in 2003. During 2004, $25 million of maturing long-term FHLB
advances were repaid through short term borrowings with the FHLB.
SIGNIFICANT GROUP CONCENTRATIONS OF CREDIT RISK:
Most of Community's activities are with customers located within Northeast /
Central Pennsylvania and Northern Maryland. Note 2 discusses the types of
securities in which Community invests. Note 3 discusses the types of lending
engaged in by Community. Community does not have any significant concentrations
to any one industry or customer.
INVESTMENT SECURITIES:
Community classifies debt and equity securities as either "held-to-maturity,"
"available-for-sale," or "trading." Investments for which management has the
intent, and Community has the ability, to hold to maturity are carried at cost
adjusted for amortization of premium and accretion of discount. Amortization and
accretion are calculated principally on the interest method. Securities bought
and held primarily for the purpose of selling them in the near term are
classified as trading and reported at fair value. Changes in unrealized gains
and losses on trading securities are recognized in the Consolidated Statements
of Income. At December 31, 2004 and 2003, there were no securities identified as
held-to-maturity or trading. All other securities are classified as
available-for-sale securities and reported at fair value. Changes in unrealized
gains and losses on available-for-sale securities, net of applicable taxes, are
recorded as a component of stockholders' equity. Quoted market values, when
available, are used to determine the fair value of available-for-sale
securities. If quoted market prices are not available, then fair values are
estimated using quoted prices of instruments with similar characteristics.
Securities classified as available-for-sale include those investments management
intends to use as part of its asset/liability management strategy and may be
sold in response to changes in interest rates, resultant prepayment risk and
other factors. Declines in the fair value of available-for-sale securities below
their cost that are deemed to be "other-than-temporary" are reflected in the
Consolidated Statements of Income as realized losses. In estimating
"other-than-temporary" impairment losses, management considers (1) the length of
time and the extent to which the fair value has been less than cost, (2) the
financial condition and near-term prospects of the issuer, and (3) the intent
and ability of Community to retain its investment in the issuer for a period of
time sufficient to allow for any
46
anticipated recovery in fair value. Realized gains and losses on the sale of
securities are recognized using the specific identification method and are
included in Non-Interest Income in the Consolidated Statements of Income.
Equity securities include Federal Home Loan Bank (FHLB) stock at December 31,
2004 and 2003 of $22.3 million and $21.2 million, and represent equity interests
in the FHLB. Such securities, which are carried at cost, do not have a readily
determinable fair value because ownership is restricted and can be sold back
only to the FHLB or to another member institution. The FHLB requires Community
to maintain certain amounts of FHLB stock based on its balance of FHLB advances.
LOANS HELD FOR SALE:
Loans held for sale, consisting primarily of fixed rate mortgages and education
loans, are valued at the lower of cost or fair value, determined on an aggregate
basis.
LOANS AND REVENUE RECOGNITION:
Loans are stated at their principal amount outstanding adjusted for charge-offs
and certain origination fees or costs. Interest income on loans is recorded on
the interest method. Non-accrual loans are those on which the accrual of
interest has ceased and where all previously accrued and unpaid interest is
reversed. Loans, other than consumer loans, are placed on non-accrual status
when principal or interest is past due 90 days or more and the collateral may be
inadequate to recover principal and interest, or immediately, if in the opinion
of management, full collection is doubtful. Generally, the uncollateralized
portions of consumer loans past due 90 days or more are charged-off. Interest
accrued but not collected as of the date of placement on non-accrual status is
reversed and charged against current income. Subsequent cash payments received
are applied either to the outstanding principal balance or recorded as interest
income, depending upon management's assessment of the ultimate collectibility of
principal and interest. Nonaccrual loans are restored to accrual status when all
delinquent principal and interest become current or the loan is considered
secured and in the process of collection. Delinquency status is based on the
contractual terms of the loan. Loan origination fees and certain direct
origination costs are being deferred and the net amount amortized as an
adjustment of the yield on the related loan under the interest method, generally
over the contractual life.
ALLOWANCE FOR LOAN LOSSES:
The allowance for loan losses is established as losses are estimated to have
occurred through a provision for loan losses charged to earnings. Loan losses
are charged against the allowance when management believes the uncollectibility
of a loan balance is confirmed. Subsequent recoveries, if any, are credited to
the allowance.
The allowance for loan losses is evaluated on a quarterly basis by management
using a systemic methodology that incorporates management's judgments about the
credit quality of the loan portfolio through a disciplined process that is
consistently applied. Management considers all known relevant internal and
external factors that may affect loan collectibility, as well as particular
risks indigenous to specific types of lending. The final results of the process
are reviewed and approved by executive management. Results are regularly
validated by a review of trends associated with loan volume, delinquencies, and
other factors that may influence the methodology used to estimate the allowance
for loan losses. This evaluation is inherently subjective as it requires
estimates that are susceptible to significant revision as additional information
becomes available.
The allowance consists of specific, general and unallocated components. The
specific component relates to loans that are classified as doubtful, substandard
or special mention. For such loans that are also classified as impaired, an
allowance is established when the realizable value of the collateral, or
discounted cash flows, or obtainable market price, is lower than the carrying
value of that loan. The general component covers non-classified loans that are
evaluated as part of various pools. The allowance for these pools is based on
historical loss experience adjusted for qualitative factors. An unallocated
component is maintained in the allowance to cover uncertainties that could
affect management's estimate of probable losses. The unallocated component of
the allowance reflects the margin of imprecision inherent in the underlying
assumptions used in the methodologies for estimating specific and general losses
in the portfolio.
A loan is considered impaired when, based on current information and events, it
is probable that Community will be unable to collect the scheduled payments of
principal or interest when due, according to the contractual terms of the loan
agreement. Factors considered by management in determining impairment include
payment status, collateral value, and the probability of collecting scheduled
principal and interest payments when due. Loans that experience insignificant
payment delays and payment shortfalls generally are not classified as impaired.
Management determines
47
Community Banks, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued):
the significance of payment delays and payment shortfalls on a case-by-case
basis, taking into consideration all of the circumstances surrounding the loan
and the borrower, including the length of the delay, the reasons for the delay,
the borrower's prior payment record, and the amount of the shortfall in relation
to the principal and interest owed. Impairment is measured on a loan-by-loan
basis for commercial and construction loans over $250,000 by either the fair
value of the collateral if the loan is collateral dependent, the present value
of expected future cash flows discounted at the loan's effective interest rate,
or the loan's obtainable market price.
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, unless such loans are
part of a restructuring agreement.
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
related valuation allowance, and subsequent recoveries, if any, are credited to
the valuation allowance.
PREMISES AND EQUIPMENT:
Premises and equipment are stated at cost, less accumulated depreciation and
amortization. Depreciation is calculated using straight-line methods over the
estimated useful lives of the related assets as follows: banking premises, 20 to
40 years; furniture, fixtures, and equipment, 3 to 5 years. Leasehold
improvements are amortized over the shorter of the lease term or 20 years.
Long-lived assets are reviewed for impairment whenever events or changes in
business circumstances indicate the carrying value of the assets may not be
recovered. Maintenance and repairs are expensed as incurred, while major
additions and improvements are capitalized. Gain or loss on retirement or
disposal of individual assets is recorded as income or expense in the period of
retirement or disposal.
GOODWILL AND IDENTIFIABLE INTANGIBLE ASSETS:
The costs of acquired companies in excess of the fair value of net assets at
acquisition date is recorded as goodwill. Goodwill is tested at least annually
for impairment. Identifiable intangible assets relate to acquisitions of branch
offices from other banks and customer lists and other intangibles related to
acquisitions of insurance agencies and mortgage origination entities. Goodwill
and identifiable intangible assets totaled $5.1 million at December 31, 2004,
and $4.8 million at December 31, 2003 and are included in other assets.
Identifiable intangible assets are amortized over their estimated useful lives.
Amortization of other intangibles was $161 thousand, $94 thousand, and $73
thousand for 2004, 2003, and 2002.
FORECLOSED REAL ESTATE:
Real estate acquired through foreclosure is initially carried at fair value,
typically derived from the current appraised value of the property at transfer
date less estimated selling cost. Prior to foreclosure, the recorded amount of
the loan is written down, if necessary, to the appraised value of the real
estate to be acquired by charging the allowance for loan losses. During 2004,
2003, and 2002 transfers from loans to foreclosed real estate totaled $1.5
million, $5.0 million, and $3.7 million.
Subsequent to foreclosure, gains or losses on the sale of and losses on the
periodic revaluation of foreclosed real estate are credited or charged to other
expense. Costs of maintaining and operating foreclosed property are expensed as
incurred.
RETIREMENT PLANS:
Community has a noncontributory defined benefit pension plan covering current
and former employees of a predecessor bank. Pension costs are funded currently
subject to the full funding limitation imposed under federal income tax
regulations. The defined benefit pension plan was amended during 2001 to
discontinue the admittance of any future participants into the plan. During the
third quarter of 2003, the plan was amended to curtail future eligibility
services and affected participants will no longer accrue benefits in the future.
Community uses a September 30 measurement date for its plan.
48
Community maintains a 401(k) savings plan covering substantially all employees
which allows employees to invest a percentage of their earnings, matched to a
certain amount specified by Community. The expense related to this savings plan
was $1.5 million in 2004, $1.1 million in 2003, and $1.3 million in 2002, and
has been included in salaries and benefits expense.
Community maintains supplemental retirement plans and life insurance for
selected executives. The supplemental life insurance plans replaced other
insurance coverage. The expense associated with these plans was $ 379 thousand
for 2004, $181 thousand for 2003, and $277 thousand for 2002. The accrued
liability was $1.9 million at December 31, 2004, and $1.6 million at December
31, 2003. Investment in bank owned life insurance policies was used to finance
the supplemental benefit plans, and provide a tax-exempt return to Community.
INCOME TAXES:
Deferred income taxes are accounted for by the liability method, wherein
deferred tax assets and liabilities are calculated on the differences between
the basis of assets and liabilities for financial statement purposes versus tax
purposes (temporary differences) using enacted tax rates in effect for the year
in which the differences are expected to reverse.
STOCK-BASED COMPENSATION:
At December 31, 2004, Community has a stock-based compensation plan, which is
described more fully in Note 12. Community 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 FAS No. 123, "Accounting for Stock-Based Compensation," to
stock-based compensation.
Years Ended December 31,
(In Thousands, Except Per Share Data)
--------------------------------------------
2004 2003 2002
------------ ------------ ------------
Net income, as reported $ 21,798 $ 20,400 $ 18,446
Deduct: Total stock-based compensation
expense determined under fair value based
method for all awards, net of related tax effect (1,418) (822) (644)
------------ ------------ ------------
Pro forma net income $ 20,380 $ 19,578 $ 17,802
============ ============ ============
Earnings per share:
Basic - as reported $ 1.78 $ 1.68 $ 1.51
Basic - pro forma $ 1.67 $ 1.61 $ 1.46
Diluted - as reported $ 1.73 $ 1.63 $ 1.48
Diluted - pro forma $ 1.62 $ 1.57 $ 1.43
In late 2004, FAS No. 123 was replaced by the issuance of Statement No. 123(R),
"Share-Based Payment," which will be effective for periods beginning after June
15, 2005 and is more fully addressed under "Recent Accounting Pronouncements" in
this section.
EARNINGS PER SHARE:
Basic earnings per share represents income available to common stockholders
divided by the weighted-average number of common shares outstanding during the
period. Diluted earnings per share reflects additional common shares that would
have been outstanding if dilutive potential common shares had been issued, as
well as any adjustment to income that would result from the assumed issuance.
Potential common shares that may be issued by Community relate solely to
outstanding stock options, and are determined using the treasury stock method.
All share and per share amounts are restated for stock splits and stock
dividends that occur prior to the issuance of the financial statements.
49
Community Banks,Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued):
Earnings per share for the years ended December 31, 2004, 2003 and 2002 have
been computed as follows (in thousands, except per share data):
-------------------------------------------
2004 2003 2002
-------------------------------------------
Net income $ 21,798 $ 20,400 $ 18,446
============ =========== ============
Weighted average shares outstanding (basic) 12,231 12,139 12,205
Effect of dilutive stock options 344 358 286
------------ ----------- ------------
Weighted average shares outstanding (diluted) 12,575 12,497 12,491
============ =========== ============
Per share information:
Basic earnings per share $ 1.78 $ 1.68 $ 1.51
Diluted earnings per share 1.73 1.63 1.48
Antidilutive options excluded from the above earnings per share calculations
totaled 168,000 for 2004, and 10,000 for both 2003 and 2002.
COMPREHENSIVE INCOME:
Community reports comprehensive income in accordance with Statement of Financial
Accounting Standard No. 130, "Reporting Comprehensive Income." The components of
other comprehensive income (loss) and related tax effects for years ended
December 31 are as follows (in thousands):
--------------------------------------------------
2004 2003 2002
--------------------------------------------------
Unrealized holding gains (losses)
on available-for-sale securities $ (2,362) $ 2,891 $ 18,189
Reclassification adjustments for
(gains) included in net income (2,470) (1,927) (1,034)
-------------- -------------- -------------
Net unrealized gains (losses) (4,832) 964 17,155
Tax effect 1,692 (338) (6,004)
-------------- -------------- -------------
Net-of-tax amount (3,140) 626 11,151
-------------- -------------- -------------
Increase in unfunded pension liability (377) (874) (906)
Tax effect 132 306 317
-------------- -------------- -------------
Net-of-tax amount (245) (568) (589)
-------------- -------------- -------------
$ (3,385) $ 58 $ 10,562
============== ============== =============
50
The components of accumulated other comprehensive income, included in
stockholders' equity, are as follows at December 31 (in thousands):
------------------------------------------
2004 2003
------------------------------------------
Net unrealized gain on
available-for-sale securities $ 8,515 $ 13,347
Tax effect (2,980) (4,672)
------------------- -------------------
Net-of-tax amount 5,535 8,675
------------------- -------------------
Unfunded pension liability (3,576) (3,199)
Tax effect 1,252 1,120
------------------- -------------------
Net-of-tax amount (2,324) (2,079)
------------------- -------------------
Accumulated other comprehensive income $ 3,211 $ 6,596
=================== ===================
SEGMENT REPORTING:
Community has determined its only reportable segment is community banking.
Community's non-banking activities have been determined to be insignificant and
do not require separate disclosure.
TRANSFERS OF FINANCIAL ASSETS:
Transfers of financial assets are accounted for as sales, when control over the
assets has been surrendered. Control over transferred assets is deemed to be
surrendered when (1) the assets have been isolated from Community, (2) the
transferee obtains the right (free of conditions that constrain it from taking
advantage of that right) to pledge or exchange the transferred assets, and (3)
Community does not maintain effective control over the transferred assets
through an agreement to repurchase them before their maturity.
RECENT ACCOUNTING PROUNCEMENTS:
FAS 123(R) - In December 2004, the Financial Accounting Standards Board (FASB)
issued Statement No. 123(R), "Share-Based Payment." Statement No. 123(R)
replaces Statement No. 123, "Accounting for Stock-Based Compensation," and
supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees."
Statement No. 123(R) requires compensation costs related to share-based payment
transactions to be recognized in the financial statements over the period that
an employee provides service in exchange for the award. Public companies are
required to adopt the new standard using a modified prospective method and may
elect to restate prior periods using the modified retrospective method. Under
the modified prospective method, companies are required to record compensation
cost for new and modified awards over the related vesting period of such awards
prospectively and record compensation cost prospectively for the unvested
portion, at the date of adoption, of previously issued and outstanding awards
over the remaining vesting period of such awards. No change to prior periods
presented is permitted under the modified prospective method. Under the modified
retrospective method, companies record compensation costs for prior periods
retroactively through restatement of such periods using the exact pro forma
amounts disclosed in the companies' footnotes. Also, in the period of adoption
and after, companies record compensation cost based on the modified prospective
method. Statement No. 123(R) is effective for periods beginning after June 15,
2005. Early application of Statement No. 123(R) is encouraged, but not required.
Community is currently evaluating the various provisions of SFAS 123(R) and the
optional transition methods that may be applied when adopting this new
accounting standard. It is expected that Community will adopt the modified
prospective method on July 1, 2005. Total stock-based compensation expense, net
of related tax effects, for existing option grants will not have a material
impact on the financial statements in the last half of 2005 or in years beyond
2005. The impact of future option or stock grants is dependent upon the quantity
and nature of stock-based compensation Community decides to grant.
51
Community Banks, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued):
SAB 105 - In March 2004, the SEC released Staff Accounting Bulletin (SAB) No.
105, "Application of Accounting Principles to Loan Commitments." SAB 105
provides guidance about the measurements of loan commitments recognized at fair
value under FASB Statement No. 133, "Accounting for Derivative Instruments and
Hedging Activities." SAB 105 also requires companies to disclose their
accounting policy for those loan commitments including methods and assumptions
used to estimate fair value and associated hedging strategies. SAB 105 is
effective for all loan commitments accounted for as derivatives that are entered
into after March 31, 2004. The adoption of SAB 105 did not have a material
effect on Community's consolidated financial statements.
SOP 03-3 - In December 2003, the Accounting Standards Executive Committee issued
Statement of Position 03-3 (SOP 03-3), "Accounting for Certain Loans or Debt
Securities Acquired in a Transfer." SOP 03-3 addresses accounting for
differences between contractual cash flows and cash flows expected to be
collected from an investor's initial investment in loans or debt securities
acquired in a transfer, including business combinations, if those differences
are attributable, at least in part, to credit quality. SOP 03-3 is effective for
loans and debt securities acquired in fiscal years beginning after December 15,
2004. Community adopted the provisions of SOP 03-3 effective January 1, 2005,
and the initial implementation did not have a material effect on Community's
consolidated financial statements. Such guidance, however, will have an effect
on the accounting for future business combinations after the effective date.
RECLASSIFICATIONS:
Certain amounts reported in prior years have been reclassified to conform with
the 2004 presentation. These reclassifications did not materially impact
Community's financial condition or results of operations.
52
2. INVESTMENT SECURITIES:
The amortized cost and fair value of investment securities at December 31, 2004
and 2003 are as follows (in thousands):
--------------------------------------------------------------------------------------------------
2004 2003
--------------------------------------------------------------------------------------------------
Gross Gross Gross Gross
Amortized Unrealized Unrealized Fair Amortized Unrealized Unrealized Fair
Cost Gains Losses Value Cost Gains Losses Value
--------------------------------------------------------------------------------------------------
Securities Available-For-Sale
- ---------------------------------
Debt securities:
U.S. Government and federal
agency $ 126,056 $ 807 $ (1,322) $ 125,541 $ 173,651 $ 1,923 $ (2,282) $ 173,292
Mortgage-backed, primarily
federal agency 178,437 1,517 (640) 179,314 121,853 1,817 (275) 123,395
State and municipal 180,110 6,616 (360) 186,366 177,546 7,217 (282) 184,481
Corporate 58,928 1,388 (273) 60,043 95,461 3,283 (757) 97,987
--------------------------------------------------------------------------------------------------
Total debt securities 543,531 10,328 (2,595) 551,264 568,511 14,240 (3,596) 579,155
Equity securities 67,085 1,390 (629) 67,846 65,070 2,961 (225) 67,806
--------------------------------------------------------------------------------------------------
Total securities
available-for-sale $ 610,616 $ 11,718 $ (3,224) $ 619,110 $ 633,581 $ 17,201 $ (3,821) $ 646,961
==================================================================================================
The following table shows gross unrealized losses and fair value, aggregated by
investment category and length of time that individual securities have been in a
continuous unrealized loss position, at December 31, 2004 (in thousands):
----------------------------------------------------------
Less Than 12 Months 12 Months or More
----------------------------------------------------------
Unrealized Unrealized
Fair Value Losses Fair Value Losses
----------------------------------------------------------
Securities Available-For-Sale
-----------------------------------------------
Debt securities:
U.S. Government and federal agency $ 31,125 $ (315) $ 29,866 $ (1,007)
Mortgage-backed, primarily federal agency 84,099 (552) 11,170 (88)
State and municipal 20,171 (185) 5,451 (175)
Corporate 6,688 (60) 6,189 (213)
----------------------------------------------------------
Total debt securities 142,083 (1,112) 52,676 (1,483)
Equity securities 16,085 (209) 1,080 (420)
----------------------------------------------------------
Total temporarily impaired securities $ 158,168 $ (1,321) $ 53,756 $ (1,903)
==========================================================
The above table represents 99 investment securities where the current fair value
is less than the related amortized cost. Management believes that the unrealized
losses reflect changes in interest rates subsequent to the acquisition of
specific securities and do not reflect any deterioration of the credit
worthiness of the issuing entities. Generally, securities with an unrealized
loss are investment grade debt securities with a maturity date and are expected
to be paid in full at maturity or are equity securities with characteristics of
debt securities, including a specific repricing date. As management has the
ability to hold securities for the foreseeable future, no declines are deemed to
be other than temporary.
The amortized cost and fair value of debt securities by contractual maturity, at
December 31, 2004, follows. Expected maturities will differ from contractual
maturities because obligors may have the right to call or repay obligations with
or without call or prepayment penalties.
Amortized Fair
Cost Value
-------------------------------
(in thousands)
Within 1 year $ 8,076 $ 8,115
Over 1 year and through 5 years 31,107 31,479
Over 5 years through 10 years 125,474 125,369
Over 10 years 200,437 206,987
-------------------------------
365,094 371,950
Mortgage-backed securities 178,437 179,314
-------------------------------
$ 543,531 $ 551,264
===============================
53
Community Banks, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. INVESTMENT SECURITIES (Continued):
Gross investment security gains and losses of $4.1 million and $ 1.6 million,
respectively were recognized in 2004. Gross gains and losses of $2.8 million and
$907 thousand, respectively, were recognized in 2003. Gross gains and losses of
$1.9 million and $865 thousand, respectively were recognized in 2002. The tax
provision applicable to these net realized gains amounted to $865 thousand in
2004, $674 thousand in 2003 and $362 thousand in 2002.
At December 31, 2004 and 2003, investment securities with carrying amounts of
$197.9 million and $227.5 million, respectively, were pledged to collateralize
public deposits and for other purposes required or permitted by law. At December
31, 2004 and 2003, the carrying amount of securities pledged to secure
repurchase agreements was $42.8 million and $68.8 million.
3. LOANS:
The composition of loans outstanding by lending classification as of December 31
is as follows (in thousands):
--------------------------------
2004 2003
--------------------------------
Commercial $ 409,105 $ 367,444
Real estate-construction 8,703 7,338
Real estate-mortgage
Residential 83,979 91,485
Commercial 356,871 283,661
Consumer 357,293 328,683
--------------------------------
$ 1,215,951 $ 1,078,611
================================
Changes in the allowance for loan losses for years ended December 31 are as
follows (in thousands):
------------------------------------------------
2004 2003 2002
------------------------------------------------
Balance, January 1 $ 13,178 $ 12,343 $ 12,132
Provision for loan losses 3,100 2,500 3,350
Loan charge-offs (2,910) (2,839) (4,180)
Recoveries 1,053 1,174 1,041
------------------------------------------------
Balance, December 31 $ 14,421 $ 13,178 $ 12,343
================================================
The following table summarizes risk elements as of December 31 (in thousands):
-------------------------------
2004 2003
-------------------------------
Loans on which accrual of interest has
been discontinued $ 5,428 $ 8,151
Foreclosed real estate 2,094 4,865
-------------------------------
Total non-performing assets 7,522 13,016
Loans past due 90 days or more and still
accruing interest --- 90
-------------------------------
Total risk elements $ 7,522 $ 13,106
===============================
The following is a summary of information pertaining to impaired loans as of
December 31 (in thousands):
----------------------------
2004 2003
----------------------------
Impaired loans without a valuation allowance $ 1,927 $ 3,644
Impaired loans with a valuation allowance 2,018 2,112
----------------------------
Total impaired loans $ 3,945 $ 5,756
============================
Valuation allowance related to impaired loans $ 593 $ 546
============================
54
Impaired loans are included in nonaccrual loans. For the years ended December
31, 2004, 2003 and 2002, the average recorded investment in impaired loans
approximated $4.2 million, $7.8 million, and $6.6 million. Interest recognized
on impaired loans for the years ending December 31, 2004, 2003 and 2002 was not
significant.
4. PREMISES AND EQUIPMENT:
Premises and equipment are comprised of the following as of December 31 (in
thousands):
------------------------------
2004 2003
------------------------------
Banking premises $ 27,017 $ 25,279
Furniture, fixture, and equipment 21,755 20,310
Leasehold improvements 1,924 1,793
Construction-in-progress 951 279
------------------------------
51,647 47,661
Less accumulated depreciation and
amortization (26,130) (23,508)
------------------------------
$ 25,517 $ 24,153
==============================
Depreciation and amortization expense related to premises and equipment charged
to operations totaled $2.8 million, $3.0 million, and $2.5 million in 2004,
2003, and 2002.
Certain branch offices, land, and equipment are leased under agreements which
expire at varying dates through 2024. Most leases contain renewal provisions at
Community's option. Total rental expense was approximately $1.2 million in 2004,
$1.1 million in 2003 and $853 thousand in 2002. Future minimum payments as of
December 31, 2004 under noncancelable operating leases are as follows (in
thousands):
2005 $ 1,223
2006 1,009
2007 824
2008 628
2009 633
Thereafter 7,033
--------------
$ 11,350
==============
5. DEPOSITS:
Deposits consisted of the following as of December 31 (in thousands):
----------------------------
2004 2003
----------------------------
Non-interest bearing deposits $ 184,359 $ 165,174
Savings deposits 160,505 162,908
Money market deposits 52,718 72,778
NOW accounts 284,152 221,002
Time deposits 623,803 608,823
----------------------------
Total $ 1,305,537 $ 1,230,685
============================
55
Community Banks, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. DEPOSITS (Continued):
The aggregate amount of time deposits with minimum denominations of $100,000 or
more totaled $106 million and $114 million at December 31, 2004 and 2003.
At December 31, 2004 scheduled maturities of time deposits were as follows (in
thousands):
2005 $ 275,992
2006 135,047
2007 122,096
2008 41,045
2009 48,671
Thereafter 952
-------------
$ 623,803
=============
6. SHORT-TERM BORROWINGS AND LONG-TERM DEBT:
Short-term borrowings consist of the following as of December 31 (dollars in
thousands):
---------------------------------------------------
2004 Rate 2003 Rate
---------------------------------------------------
Securities sold under agreements to repurchase $ 25,472 1.81% $ 23,732 0.75%
Treasury tax and loan note 1,926 1.94% 2,032 0.76%
Other --- --- 2,000 2.42%
FHLB borrowings 19,718 2.21% --- ---
------------ ------------
$ 47,116 $ 27,764
============ ============
Securities sold under agreements to repurchase, which are classified as secured
borrowings, generally mature within one to four days from the transaction date.
Securities sold under agreements to repurchase are reflected at the amount of
cash received in connection with the transaction. Community may be required to
provide additional collateral based on the fair value of the underlying
securities.
The maximum short-term FHLB borrowings outstanding at any month-end during 2004
and 2003 was $48.1 million and $139.3 million; the average amounts outstanding
during the year were $8.2 million and $73.1 million; and the weighted average
interest rate during the year approximated 1.50% and 1.35%.
At December 31, 2004, additional amounts available for borrowing under non-FHLB
line of credit arrangements totaled approximately $50 million. Additional
amounts available for borrowing at the FHLB totaled $158.3 million at December
31, 2004.
56
Long-term debt consists of the following as of December 31 (in thousands):
-----------------------------
2004 2003
-----------------------------
Outstanding advances from the FHLB of Pittsburgh are currently fixed
rate and mature from 2005 to 2016. The advances are collateralized by FHLB
stock, certain first mortgage loans and both agency and mortgage-backed
securities. The advance rates range from 1.84% to 6.36%, with a weighted
average interest rate of 4.56%. Advances totaling $289.5 million are
convertible advances. Under the terms of these arrangements, the FHLB
retains the option to convert the advances from fixed to variable rate. If
the FHLB were to convert their options, Community has the ability to prepay
the advances at no penalty. At the current time no advances have been
converted, and remain at a fixed rate of interest. $ 404,364 $ 411,117
Other long-term debt has an interest rate of 4% and matures in 2017. 298 305
-----------------------------
$ 404,662 $ 411,422
=============================
Maturities on long-term debt at December 31, 2004 are as follows (in
thousands):
2005 $ 42,243
2006 37,243
2007 31,986
2008 32,797
2009 81
Thereafter 260,312
----------------
$ 404,662
================
7. SUBORDINATED DEBT:
Community has issued floating rate junior subordinated deferrable interest
debentures to two non-consolidated subsidiary trusts, CMTY Capital Trust I
(Trust I) for $15.5 million and CMTY Statutory Capital Trust II (Trust II) for
$15.4 million. Community owns all of the common equity of each trust. The
debentures held by each trust are the sole assets of that trust.
The trusts issued mandatorily redeemable preferred securities to third-party
investors. Community's obligations under the debentures and related documents,
taken together, constitute a full and unconditional guarantee by Community of
the Trusts' obligations under the preferred securities. The junior subordinated
debt securities pay interest quarterly; Trust I at 3-month LIBOR plus 3.35% and
Trust II at 3-month LIBOR plus 2.84%. The preferred securities are redeemable by
Community at 100% of principal plus accrued interest; Trust I on or after
January 7, 2008 and Trust II on or after December 16, 2008. The preferred
securities must be redeemed upon maturity of the debentures; Trust I on January
7, 2033, and Trust II on December 16, 2033.
In 2004, as a result of applying the provisions of FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51",
which represented new accounting guidance governing when an equity interest
should be consolidated, Community was required to deconsolidate these subsidiary
trusts from its financial statements. Prior periods have been restated. The
deconsolidation of the net assets and results of operations of the trusts had
virtually no impact on Community's financial statements or liquidity position
since Community continues to be obligated to repay the debentures held by the
trusts and guarantees repayment of the preferred securities issued by the
trusts. Community's total debt obligation related to the trusts did increase,
however, from $30 million to $30.9 million upon deconsolidation, with the
difference representing Community's common ownership interest in the trusts,
which is now reported in "Other assets."
57
Community Banks, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. INCOME TAXES:
The provision for income taxes for the years ended December 31 consists of the
following (in thousands):
---------------------------------------------
2004 2003 2002
---------------------------------------------
Current $ 5,360 $ 4,511 $ 3,559
Deferred (481) (152) (192)
---------------------------------------------
$ 4,879 $ 4,359 $ 3,367
=============================================
A reconciliation of income tax expense and the amounts which would have been
recorded based upon statutory rates (35%) is as follows (in thousands):
---------------------------------------------
2004 2003 2002
---------------------------------------------
Provision on pre-tax income at statutory rate $ 9,337 $ 8,666 $ 7,635
Tax-exempt interest income (3,409) (3,284) (2,939)
Earnings on investment in insurance (514) (473) (481)
Other, net (535) (550) (848)
---------------------------------------------
Total provision for income taxes $ 4,879 $ 4,359 $ 3,367
=============================================
The components of the net deferred tax asset, included in other assets as of
December 31, were as follows (in thousands):
-------------------------------
2004 2003
-------------------------------
Deferred tax assets:
Allowance for loan losses $ 5,047 $ 4,542
Non-accrual loan interest income 136 230
Unfunded pension adjustment 1,252 1,120
Deferred loan fees 233 211
Deferred compensation 752 586
Alternative minimum tax 225 250
Other 42 35
-------------------------------
Total 7,687 6,974
-------------------------------
Deferred tax liabilities
Depreciation 898 1,053
Unrealized gain on available for sale securities 2,980 4,672
Prepaid pension cost 738 647
Life insurance company reserves 163 404
Prepaid expenses 290 ---
Other 144 28
-------------------------------
Total deferred tax liabilities 5,213 6,804
-------------------------------
Net deferred tax asset $ 2,474 $ 170
===============================
As of December 31, 2004 and 2003, Community had not established any valuation
allowance against deferred tax assets since these tax benefits are realizable
either through carry-back availability against prior years' taxable income or
the reversal of existing deferred tax liabilities.
58
Community Banks, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. COMMITMENTS AND CONTINGENCIES:
In the normal course of business, Community is a party to financial instruments
with off-balance sheet risk to meet the financing needs of its customers and to
reduce its own exposure to fluctuations in interest rates. These financial
instruments include commitments to originate loans and standby letters of
credit, which involve, to varying degrees, elements of credit and interest rate
risk in excess of the amount recognized in the Consolidated Balance Sheets.
Financial instruments with off-balance sheet risk at December 31 are as follows
(in thousands):
-----------------------------------
Contract Amount
-----------------------------------
2004 2003
-----------------------------------
Commitments to fund loans $ 55,672 $ 76,499
Unused lines of credit $ 338,313 $ 292,813
Standby letters of credit $ 36,256 $ 34,974
Unadvanced portions of construction loans $ 53,962 $ 28,443
Substantially all of Community's unused commitments to originate loans and
unused lines of credit are at variable rates or will be provided at the
prevailing fixed rate when the loans are originated or the lines are used.
Commitments to extend credit are agreements to lend to a customer provided there
is no violation of any condition established in the contract. Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee. Lines of credit are similar to commitments as they
have fixed expiration dates and are driven by certain criteria contained within
the loan agreement. Lines of credit normally do not extend beyond a period of
one year. Community evaluates each customer's credit worthiness on a
case-by-case basis. The amount of collateral obtained, if deemed necessary by
Community upon extension of credit, is based on management's credit evaluation
of the borrower. Collateral held varies but may include accounts receivable,
inventory, and plant and equipment and personal guarantees.
Standby letters of credit are conditional commitments issued by the subsidiary
bank to guarantee the financial or performance obligation 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. 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 amount of the liability as of December 31, 2004 and 2003 for guarantees
under standby letters of credit issued is not material.
Since a portion of the commitments are expected to expire without being drawn
upon, the total commitment amount does not necessarily represent future cash
requirements.
From time to time, Community and its subsidiaries may be defendants in legal
proceedings relating to the conduct of their business. Most of such legal
proceedings are a normal part of doing business, and in management's opinion,
the financial position and results of operations of Community would not be
affected materially by the outcome of such legal proceedings.
59
Community Banks, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10. REGULATORY MATTERS:
The dividends that may be paid by Community Banks, the subsidiary bank, to
Community are subject to certain legal and regulatory limitations. Under such
limitations, the total amount available for payment of dividends by Community
Banks was approximately $157 million at December 31, 2004. Dividends by
Community Banks to Community would also be prohibited if payment would reduce
Community Bank's capital below applicable minimum capital requirements presented
below.
Under current Federal Reserve regulations, Community Banks is limited in the
amount it may loan to affiliates, including Community. Loans to a single
affiliate may not exceed 10%, and the aggregate of loans to all affiliates may
not exceed 20% of bank capital and surplus. At December 31, 2004, the maximum
amount available for transfer from Community Banks to Community in the form of
loans was approximately $159 million.
Community Banks and Community are subject to various regulatory capital
requirements administered by banking regulators. Failure to meet minimum capital
requirements can initiate certain mandatory - and possibly additional
discretionary - actions by regulators that, if undertaken, could have a direct
material effect on Community's financial statements. Under capital adequacy
guidelines and the regulatory framework for prompt corrective action, Community
Banks must meet specific capital guidelines that involve quantitative measures
of the bank's assets, liabilities, and certain off-balance sheet items as
calculated under regulatory accounting practices. Community Banks capital
amounts and classification are also subject to qualitative judgments by the
regulators about components, risk weightings and other factors.
Quantitative measures established by regulations to ensure capital adequacy
require Community Banks and Community to maintain minimum amounts and ratios of
total and Tier 1 capital to risk-weighted assets, and of Tier 1 capital to
average assets (as defined in the regulations). Management believes, as of
December 31, 2004, that Community Banks and Community meet the capital adequacy
requirements to which they are subject.
As of December 31, 2004, the most recent notification from the Federal Deposit
Insurance Corporation categorized Community Banks as "well capitalized" under
the regulatory framework for prompt corrective action. In order to be "well
capitalized", the bank must maintain minimum total risk-based, Tier 1
risk-based, and Tier 1 leverage ratios as set forth in the following table.
There are no conditions or events since December 31, 2004 that management
believes have changed the bank's classification.
The following tables present the total risk-based, Tier 1 risk-based and Tier 1
leverage requirements for Community and Community Banks as of December 31, 2004
and 2003 (dollars in thousands):
-----------------------------------------------------------------------------
As of December 31, 2004
-----------------------------------------------------------------------------
Actual Regulatory Minimum "Well Capitalized"
------ ------------------ ------------------
Amount Ratio Amount Ratio Amount Ratio
------ ----- ------ ----- ------ -----
Leverage ratio
Community Banks, Inc. $ 171,755 8.8% $ 78,088 4% n/a n/a
Bank only $ 159,677 8.2% $ 77,712 4% $ 97,140 5%
Tier 1 capital ratio
Community Banks, Inc. $ 171,755 11.6% $ 59,135 4% n/a n/a
Bank only $ 159,677 10.8% $ 58,881 4% $ 88,322 6%
Total risk-based capital ratio
Community Banks, Inc. $ 186,513 12.6% $ 118,269 8% n/a n/a
Bank only $ 174,098 11.8% $ 117,762 8% $ 147,203 10%
60
-----------------------------------------------------------------------------
As of December 31, 2003
-----------------------------------------------------------------------------
Actual Regulatory Minimum "Well Capitalized"
------ ------------------ ------------------
Amount Ratio Amount Ratio Amount Ratio
------ ----- ------ ----- ------ -----
Leverage ratio
Community Banks, Inc. $ 159,958 8.8% $ 72,736 4% n/a n/a
Bank only $ 138,569 7.7% $ 72,295 4% $ 90,369 5%
Tier 1 capital ratio
Community Banks, Inc. $ 159,958 11.6% $ 55,176 4% n/a n/a
Bank only $ 138,569 10.1% $ 54,956 4% $ 82,434 6%
Total risk-based capital ratio
Community Banks, Inc. $ 174,367 12.6% $ 110,352 8% n/a n/a
Bank only $ 152,605 11.1% $ 109,912 8% $ 137,390 10%
Community Banks is required to maintain reserves, in the form of cash and
balances with the Federal Reserve Bank, against its deposit liabilities. The
amounts of such reserves totaled $5.6 million at December 31, 2004 and $6.2
million at December 31, 2003.
11. PENSION PLAN:
Community maintains a defined benefit pension plan for employees of a
predecessor bank which covers less than 25% of the current aggregate employee
base. Effective at the end of the third quarter of 2003, the Board of Directors
of Community approved a curtailment of this pension plan and, in connection
therewith, recorded a gain of $497 thousand related to the recognition of a
previously unrecognized prior service benefit, which was recorded as other
income.
The determination of pension expense for each of the last three years is as
follows:
-----------------------------------------------------------------------------------------------------------
(dollars in thousands) 2004 2003 2002
-----------------------------------------------------------------------------------------------------------
Components of net periodic benefit cost:
Service cost benefit earned during the year --- $ 115 $ 107
Interest cost on projected benefit obligation 416 428 401
Actual return on plan assets (249) (549) (453)
Net amortization and deferral:
Net transition asset --- --- (4)
Prior service benefit --- (103) (103)
Net loss 252 239 156
Gain (loss) deferred (161) 150 ---
---------------------------------------------
Pension cost $ 258 $ 280 $ 104
=============================================
Increase in minimum liability included in other
comprehensive income $ 377 $ 874 $ 906
=============================================
61
Community Banks, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
11. PENSION PLAN (Continued):
The following table sets forth the pension plan's funded status:
-------------------------------------------------------------------------------------------
(dollars in thousands) 2004 2003
-------------------------------------------------------------------------------------------
Change in benefit obligation:
Benefit obligation at beginning of year $ 6,807 $ 6,238
Service cost --- 115
Interest cost 416 428
Benefits paid (291) (314)
Change in assumptions 452 662
Experience loss 16 156
Curtailment --- (478)
-----------------------------
Benefit obligation at end of year 7,400 6,807
-----------------------------
Change in plan assets:
Fair value of plan assets at beginning of year 4,904 4,511
Actual return on plan assets 249 549
Employer contributions 930 158
Benefits paid (291) (314)
-----------------------------
Fair value of plan assets at end of year 5,794 4,904
-----------------------------
Funded status, end of year (1,606) (1,903)
Unrecognized net cost 3,576 3,199
Recognition of additional minimum liability (3,576) (3,199)
-----------------------------
Accrued pension liability $ (1,606) $ (1,903)
=============================
Amounts recognized in the consolidated balance sheet consist of:
Prepaid benefit cost $ 1,970 $ 1,296
Accumulated other comprehensive income adjustment (3,576) (3,199)
-----------------------------
Net accrued pension liability $ (1,606) $ (1,903)
=============================
Accumulated benefit obligation $ 7,400 $ 6,807
=============================
Assumptions used in the determination of the funded status of the plan at
December 31, 2004 and 2003 and pension expense for each of the last three years
were as follows:
------------------------------------------
2004 2003 2002
------------------------------------------
Discount rate 5.75% 6.25% 7.0%
Expected long-term return on plan assets 8.5% 9.0% 9.0%
Annual salary increase n/a 4.0% 4.0%
Estimated future benefit payments are as follows (in thousands):
2005 $ 375
2006 372
2007 386
2008 389
2009 428
Years 2010 - 2014 2,331
62
Community maintains a pension investment policy which addresses the assumptions
required for the various aspects of plan management and plan accounting. Plan
assumptions are determined by management pursuant to the guidance provided by
the investment policy and through consultation with plan actuaries.
Targeted allocations of plan assets have been developed as a component of the
investment policy and are responsive to the investment goals, risk management
practices and the relationship between plan assets and benefit obligations. The
current investment style favors an emphasis on growth given that the plan has
been curtailed and a substantial portion of the benefited employees are not
receiving pension benefits at the current time. Pursuant to that policy, the
following targeted allocations and actual asset allocations at the end of each
of the last two years are provided.
Target At December 31,
Asset --------------------
Allocation Range 2004 2003
---------- ----- --------------------
Equity 60% 50-70% 63% 64%
Fixed income 35% 25-45% 25% 28%
Cash and/or equivalents 5% 2-10% 12% 8%
---------------
100%
===============
The expected long-term rate of return on plan assets is based upon historical
returns of specified benchmark investment categories that are weighted by
targeted allocations of plan assets. The following presentation provides an
indication of targeted asset allocation, which is specified within the
investment policy, and a comparison to historical annualized returns that
provide support for the assumed expected long term rate of return on plan
assets.
Targeted 10 yrs (12/31/04) 15 yrs (12/31/04)
Asset Annualized Annualized
Allocation Benchmarks Returns Returns
---------- ---------- ------- -------
Equities 60% S&P 500 12.07% 10.93%
Fixed income 35% Lehman Bros Aggregate 7.74% 7.72%
Cash equivalents 5% 3 mo T-Bill 4.15% 4.50%
-----------------
Total pension 100% 10.16% 9.49%
=================
The plan currently maintains no investment in the common stock of Community.
Community anticipates no adverse funding issues associated with the plan. The
curtailment of the plan is expected to limit future increases in pension expense
as eligible employees are no longer accruing benefits associated with future
service.
63
Community Banks, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
12. STOCK-BASED PLANS:
Community has a Long-term Incentive Plan (the "Plan") that allows Community to
grant to employees, executive officers and directors stock awards in the form of
Incentive Stock Options, Nonqualified Stock Options or Stock Appreciation
Rights. The stock options can be granted at prices not less than the fair market
value in the case of Incentive Stock Options and not less than 80% of the fair
market value in the case of Nonqualified Stock Options. Community has elected to
follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued
to Employees" ("APB 25"), and related interpretations in accounting for its
stock-based compensation and to provide the disclosures required under SFAS No.
123, "Accounting for Stock Based Compensation" ("SFAS 123"). All options to date
have been issued at fair value. Accordingly, no compensation expense has been
recognized for stock options issued under the Plan.
In electing to follow APB 25 for expense recognition purposes, Community is
obliged to provide the expanded disclosures required under SFAS No. 123 for
stock-based compensation granted. The weighted average fair values at date of
grant for options granted during fiscal years 2004, 2003, and 2002 were $9.45,
$7.90, and $5.66, and were estimated using the Black-Scholes option valuation
model with the following weighted average assumptions for 2004, 2003, and 2002:
dividend yield of 2.4%, 2.0%, and 2.6%; volatility of 33%, 22%, and 26%; risk
free interest rates of 4.0%, 3.9%, and 3.8%; and expected life in years of 7.8,
7.9, and 8.4.
As of December 31, 2004, 828,000 shares were authorized but not awarded under
the Plan. The stock options generally vest from six months to five years from
the date of grant, and expire no later than ten years after the date of grant.
The changes in outstanding options are as follows:
Weighted
Shares Under Average
Option Exercise Price
(in thousands) Per Share
--------------------------------------------------------------------------------------
Balance December 31, 2001 990 $ 13.50
Issued 165 21.06
Exercised (110) 11.22
Forfeited (5) 16.37
--------------------------------------------------------------------------------------
Balance December 31, 2002 1,040 $ 14.95
Issued 170 30.40
Exercised (173) 12.30
Forfeited (10) 17.87
--------------------------------------------------------------------------------------
Balance December 31, 2003 1,027 $ 17.90
Issued 193 28.89
Exercised (142) 13.34
Forfeited (5) 23.06
--------------------------------------------------------------------------------------
Balance December 31, 2004 1,073 $ 20.44
--------------------------------------------------------------------------------------
The following table provides certain information about stock options outstanding
and exercisable at December 31, 2004:
Options Outstanding Options Exercisable
-----------------------------------------------------------------------------------
Weighted Weighted Weighted
Average Average Average
Number Exercise Remaining Number Exercise
Outstanding Price Contractual Exercisable Price
Range of exercise prices per share (in thousands) Per Share Life in Years (in thousands) Per Share
- ------------------------------------------------------------------------------------------------------------------------
Under $12.16 95 $ 7.76 1.5 95 $ 7.76
$12.17 - $15.20 264 $ 14.06 4.9 245 $ 14.12
$15.21 - $18.24 65 $ 15.64 2.9 65 $ 15.64
$18.25 - $21.28 288 $ 20.10 7.4 171 $ 19.99
$27.36 - $30.40 361 $ 29.59 9.5 168 $ 30.40
- ------------------------------------------------------------------------------------------------------------------------
$6.08 - $30.40 1,073 $ 20.44 6.7 744 $ 18.46
- ------------------------------------------------------------------------------------------------------------------------
64
Community has a dividend reinvestment plan for shareholders under which
additional shares of Community common stock may be purchased at a 5% discount
off market prices with reinvested dividends and voluntary cash payments.
Approximately 1.4 million shares of common stock have been reserved for this
plan and approximately 1.3 million shares remain unissued. Purchases of
Community common stock pursuant to this plan totaled 45,000 shares in 2004,
64,000 shares in 2003, and 6,000 shares in 2002.
Community has an Employee Stock Purchase Plan under which shares of Community
common stock may be purchased at a 10% discount off market prices with voluntary
cash payments. Approximately 116,000 shares of common stock have been reserved
for this plan and approximately 88,000 shares remain unissued. Purchases of
Community common stock pursuant to this plan totaled 9,000 shares in 2004, 6,000
shares in 2003, and 5,000 shares in 2002.
13. RELATED PARTY TRANSACTIONS:
Certain directors and their business affiliates (defined as the beneficial
ownership of at least a 10 percent interest), executive officers and their
families are indebted to Community Banks for loans made in the ordinary course
of business. In the opinion of management, such loans are consistent with sound
banking practices and are within applicable regulatory lending limitations. The
aggregate dollar amount of these loans was $13.0 million and $14.3 million at
December 31, 2004 and 2003. During 2004, $3.2 million of new advances were made
and repayments totaled $4.5 million.
Certain directors are owners or employees of entities that provide services to
Community in the ordinary course of business. Fees for those services totaled
$334 thousand in 2004, $310 thousand in 2003, and $268 thousand in 2002.
In January 2004, Community entered into new employment agreements with its
executive officers that, among other provisions, provide for certain payments to
the executives if they terminate their employment for certain reasons, primarily
a change in the nature of their duties, a reduction in compensation, or a change
in control of Community.
14. FAIR VALUES OF FINANCIAL INSTRUMENTS:
The following methodologies and assumptions were used by Community to estimate
its fair value disclosures:
CASH AND DUE FROM BANKS, INTEREST-BEARING DEPOSITS, AND FEDERAL FUNDS SOLD:
The fair values for cash and due from banks, interest-bearing deposits, and
federal funds sold is deemed to be the same as those assets' carrying amounts.
INVESTMENT SECURITIES:
Fair values for investment securities are based on quoted market prices, where
available. If quoted market prices are not available, fair values are based on
quoted market prices of comparable instruments.
ACCRUED INTEREST RECEIVABLE AND PAYABLE:
The fair values of accrued interest receivable and payable approximate their
carrying amounts.
LOANS:
For variable-rate loans that reprice frequently with no significant change in
credit risk, fair value equals carrying amount. The fair values of all other
loans held in portfolio and loans held for sale are estimated by discounting the
future cash flows using comparable current rates at which similar loans would be
made to borrowers with similar credit risk.
65
Community Banks, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
14. FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued):
DEPOSIT LIABILITIES:
The fair values of demand and savings deposits equal their carrying values. The
carrying amounts for variable rate money market accounts approximate their fair
values at the reporting date. Fair values for fixed-rate certificates of deposit
are estimated by discounting expected future cash flows using rates currently
offered for similar deposits.
SHORT-TERM BORROWINGS AND TRUST PREFERRED SECURITIES:
The fair values of short-term borrowings and trust preferred securities
approximate their carrying amounts.
LONG-TERM DEBT:
The fair values of Community's long-term borrowings are estimated using
discounted cash flows analyses, based on rates available to Community for
similar types of borrowings.
OFF-BALANCE SHEET INSTRUMENTS:
Fair values for off-balance sheet, credit-related financial instruments are
based on fees currently charged to enter into similar agreements, taking into
account the remaining terms of the agreements and the counterparties' credit
standing.
The following table summarizes the carrying amounts and fair values of financial
instruments at December 31, 2004 and 2003:
------------------------------------------------------------------
2004 2003
------------------------------------------------------------------
Estimated Estimated
Carrying Fair Carrying Fair
Amount Value Amount Value
------------------------------------------------------------------
(in thousands)
Financial assets:
Cash and due from banks, interest-bearing
deposits, and federal funds sold $ 45,273 $ 45,273 $ 63,188 $ 63,188
Investment securities 619,110 619,110 646,961 646,961
Loans held for sale 1,505 1,505 6,067 6,067
Net loans 1,201,530 1,198,973 1,065,433 1,070,977
Accrued interest receivable 9,077 9,077 8,819 8,819
Financial liabilities:
Deposits $ 1,305,537 $ 1,305,486 $ 1,230,685 $ 1,237,438
Short-term borrowings 47,116 47,116 27,764 27,764
Long-term debt 404,662 408,168 411,422 420,306
Trust preferred securities 30,928 30,928 30,928 30,928
Accrued interest payable 4,105 4,105 3,289 3,289
Off-balance sheet instruments --- --- --- ---
66
15. CONDENSED FINANCIAL INFORMATION OF COMMUNITY BANKS, INC. (PARENT ONLY)
----------------------------
2004 2003
----------------------------
(in thousands)
Condensed Balance Sheets:
Cash $ 4,256 $ 1,241
Interest bearing deposits in other banks 72 64
Investment securities, available for sale 1,324 17,130
Investment in banking subsidiary 169,773 150,688
Investment in nonbank subsidiaries 6,147 5,518
Other assets 1,906 1,914
----------------------------
Total assets $ 183,478 $ 176,555
============================
Short-term borrowings $ --- $ 2,000
Long-term debt 30,928 30,928
Other liabilities 209 221
Stockholders' equity 152,341 143,406
----------------------------
Total liabilities and stockholders' equity $ 183,478 $ 176,555
============================
-------------------------------------------
2004 2003 2002
-------------------------------------------
(in thousands)
Condensed Statements of Income:
Dividends from:
Banking subsidiary $ --- $ --- $ 5,000
Other income (expense) (1,215) (830) (354)
-------------------------------------------
Income(loss) before equity in undistributed earnings of subsidiaries (1,215) (830) 4,646
-------------------------------------------
Equity in undistributed earnings of:
Banking subsidiary 21,861 20,118 13,416
Nonbank subsidiaries 1,152 1,112 384
-------------------------------------------
23,013 21,230 13,800
-------------------------------------------
Net income $ 21,798 $ 20,400 $ 18,446
===========================================
Condensed Statements of Cash Flows:
Operating activities:
Net income $ 21,798 $ 20,400 $ 18,446
Adjustments to reconcile net cash provided by operating activities:
Undistributed earnings of:
Banking subsidiary (21,861) (20,118) (13,416)
Nonbank subsidiaries (1,152) (1,112) (384)
Other, net 391 (398) (1,433)
-------------------------------------------
Net cash provided (used) by operating activities (824) (1,228) 3,213
-------------------------------------------
Investing activities:
Purchases of investment securities (2,706) (17,304) (8,494)
Proceeds from maturities and sales of investment securities 18,661 8,862 ---
Investment in unconsolidated trust subsidiaries --- (464) (464)
-------------------------------------------
Net cash provided (used) by investing activities 15,955 (8,906) (8,958)
-------------------------------------------
Financing activities:
Net change in short-term borrowings (2,000) 2,000 ---
Proceeds from issuance of long term debt --- 15,464 15,464
Proceeds from issuance of common stock 2,308 4,525 1,052
Purchases of treasury stock (4,151) (3,627) (5,828)
Cash dividends (8,273) (7,645) (6,654)
-------------------------------------------
Net cash provided by (used) by financing activities (12,116) 10,717 4,034
-------------------------------------------
Net change in cash and cash equivalents 3,015 583 (1,711)
Cash and cash equivalents at beginning of period 1,241 658 2,369
-------------------------------------------
Cash and cash equivalents at end of period $ 4,256 $ 1,241 $ 658
===========================================
67
Community Banks, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
16. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED):
The following is a summary of the quarterly results of operations for the years
ended December 31, 2004 and 2003:
Three Months Ended
-----------------------------------------------------------------------------------------------
2004 2003
-----------------------------------------------------------------------------------------------
Dec. 31 Sept. 30 June 30 Mar. 31 Dec. 31 Sept. 30 June 30 Mar. 31
-----------------------------------------------------------------------------------------------
(dollars in thousands, except per share data)
Interest income $ 25,710 $ 25,227 $ 24,882 $ 23,980 $ 23,602 $ 23,769 $ 23,723 $ 23,771
Interest expense 11,089 10,934 10,678 10,541 10,428 10,520 10,699 10,703
-----------------------------------------------------------------------------------------------
Net interest income 14,621 14,293 14,204 13,439 13,174 13,249 13,024 13,068
Provision for loan losses 750 750 750 850 600 900 600 400
-----------------------------------------------------------------------------------------------
Net interest income after
provision for loan losses 13,871 13,543 13,454 12,589 12,574 12,349 12,424 12,668
Investment security gains, net 186 108 844 1,332 78 302 500 1,047
Mortgage banking activities 652 558 828 627 725 936 445 426
Other income 4,584 5,346 4,484 3,664 4,748 4,268 4,066 2,921
Other expenses 12,618 12,530 12,962 11,883 11,962 11,578 11,389 10,789
-----------------------------------------------------------------------------------------------
Income before income taxes 6,675 7,025 6,648 6,329 6,163 6,277 6,046 6,273
Income taxes 1,135 1,379 1,211 1,154 987 1,130 1,070 1,172
-----------------------------------------------------------------------------------------------
Net income $ 5,540 $ 5,646 $ 5,437 $ 5,175 $ 5,176 $ 5,147 $ 4,976 $ 5,101
===============================================================================================
Basic earnings per share $ 0.45 $ 0.46 $ 0.45 $ 0.42 $ 0.43 $ 0.42 $ 0.41 $ 0.42
Diluted earnings per share $ 0.44 $ 0.45 $ 0.43 $ 0.41 $ 0.41 $ 0.41 $ 0.40 $ 0.41
Cash dividends declared $ 0.17 $ 0.17 $ 0.17 $ 0.16 $ 0.16 $ 0.16 $ 0.16 $ 0.15
17. ACQUISITIONS:
In April 2003, Community completed the acquisition of Abstracting Company of
York County (ABCO), a title insurance abstracting company. Shareholders of ABCO
received 25,760 shares of Community's common stock for the 96,920 shares of
outstanding ABCO common shares in a tax-free exchange.
The following cash acquisitions were completed during 2003: In June, Community
acquired The Shultz Agency, an insurance agency providing both commercial and
personal lines of insurance; in July, Community acquired Erie Financial Group,
LTD., a company providing mortgage origination services; and in September,
Community acquired Your Insurance Partnership, an insurance agency group
specializing in personal insurance services.
All of the above acquisitions were accounted for as purchases, and accordingly,
the results of operations of each entity are included in Community's
consolidated statements of income from the date of acquisition. The
acquisitions, individually and in the aggregate, are immaterial to Community's
financial position and results of operations. Goodwill arising from the
acquisitions is subject to periodic impairment testing and other intangibles are
amortized over their estimated useful lives.
In November 2004, Community and PennRock Financial Services Corp announced the
signing of a definitive agreement pursuant to which Community and PennRock will
combine under Community's charter. PennRock, the parent company of Blue Ball
National Bank, is a financial holding company with approximately $1.2 billion in
assets at December 31, 2004. Under the terms of the definitive agreement, each
shareholder of PennRock will receive 1.4 shares of Community in exchange for
each share of PennRock common stock. Based upon Community's ten-day average
share price of $29.89 prior to the announcement, the value of the transaction
will approximate $326 million. The merger is subject to required regulatory
approvals and separate voting by the shareholders of both Community and
PennRock.
68
[GRAPHIC OMITTED]
Beard Miller Company LLP
Certified Public Accountants and Consultants
[GRAPHIC OMITTED]
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Community Banks, Inc.
Harrisburg, Pennsylvania
We have audited the accompanying consolidated balance sheets of Community Banks,
Inc. and subsidiaries as of December 31, 2004 and 2003, and the related
consolidated statements of income, changes in stockholders' equity, and cash
flows for the years then ended. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits. The
consolidated financial statements of Community Banks, Inc. for the year ended
December 31, 2002 was audited by other auditors, whose report dated January 24,
2003, expressed an unqualified opinion on those statements.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the 2004 and 2003 consolidated financial statements referred to
above present fairly, in all material respects, the financial position of
Community Banks, Inc. and subsidiaries as of December 31, 2004 and 2003 and the
results of their operations and their cash flows for the years then ended in
conformity with accounting principles generally accepted in the United States of
America.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of Community
Banks, Inc.'s internal control over the financial reporting as of December 31,
2004, based on criteria established in Internal Control-Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission
("COSO") and our report dated March 7, 2005 expressed an unqualified opinion on
management's assessment of internal control over financial reporting and an
unqualified opinion on the effectiveness of internal control over financial
reporting.
/s/ Beard Miller Company LLP
Harrisburg, Pennsylvania
March 7, 2005
69
[GRAPHIC OMITTED]Community Banks[GRAPHIC OMITTED]
Management's Report on Internal Controls
----------------------------------------
The management of Community Banks, Inc. is responsible for designing,
implementing, documenting, and maintaining an adequate system of internal
control over financial reporting. An adequate system of internal control over
financial reporting encompasses the processes and procedures that have been
established by management to:
o maintain records that accurately reflect the company's transactions;
o prepare financial statement and footnote disclosures in accordance
with GAAP that can be relied upon by external users;
o prevent and detect unauthorized acquisition, use, or disposition of
the company's assets that could have a material effect on the
financial statements.
Management is also responsible to perform an annual evaluation of the system of
internal control over financial reporting, including an assessment of the
effectiveness of that system. Management's assessment is based upon the control
framework established by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO). The COSO framework identifies five defining
characteristics of a system of internal control as follows: an appropriate
control environment; an adequate risk assessment process; sufficient control
activities; satisfactory communication of pertinent information; and proper
monitoring controls.
Management performed an assessment of the effectiveness of its internal control
over financial reporting in accordance with the COSO framework. As part of this
process, consideration was given to the potential existence of deficiencies in
either the design or operating effectiveness of controls. Based on this
assessment, management believes that Community maintained effective internal
controls over financial reporting, including disclosure controls and procedures,
as of December 31, 2004. Furthermore, during the conduct of its assessment,
management identified no material weakness in its financial reporting control
system.
The Board of Directors of Community, through its Audit Committee, provides
oversight to management's conduct of the financial reporting process. The Audit
Committee, which is composed entirely of independent directors, is also
responsible to recommend the appointment of independent public accountants. The
Audit Committee also meets with management, the internal audit staff, and the
independent public accountants throughout the year to provide assurance as to
the adequacy of the financial reporting process and to monitor the overall scope
of the work performed by the internal audit staff and the independent public
accountants.
The consolidated financial statements of Community have been audited by Beard
Miller Company LLP, an independent registered public accounting firm, who was
engaged to express an opinion as to the fairness of presentation of such
financial statements. In connection therewith, Beard Miller Company LLP is
required to issue an attestation report on management's assessment of internal
control over financial reporting and, in addition, is required to form its own
opinion as to the effectiveness of those controls. Their opinion on the fairness
of the financial statement presentation, and their attestation and opinion on
internal controls over financial reporting are included herein.
/s/ Eddie L. Dunklebarger /s/ Donald F. Holt
Chairman of the Board and Executive Vice President and
Chief Executive Officer Chief Financial Officer
Community Banks, Inc. o 750 East Park Drive, 2nd Floor o Harrisburg, PA 17111 o
Phone 717-920-1698
70
[GRAPHIC OMITTED]
Beard Miller Company LLP
Certified Public Accountants and Consultants
[GRAPHIC OMITTED]
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Community Banks, Inc.
Harrisburg, Pennsylvania
We have audited management's assessment, included in the accompanying
Management's Report on Internal Controls, that Community Banks, Inc. maintained
effective internal control over financial reporting as of December 31, 2004,
based on criteria established in Internal Control--Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission
("COSO"). Community Bank's management is responsible for maintaining effective
internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility
is to express an opinion on management's assessment and an opinion on the
effectiveness of the company's internal control over financial reporting based
on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, evaluating management's assessment, testing and evaluating
the design and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
In our opinion, management's assessment that Community Banks, Inc. maintained
effective internal control over financial reporting as of December 31, 2004, is
fairly stated, in all material respects, based on criteria established in
Internal Control--Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Also in our opinion, Community Banks,
Inc. maintained, in all material respects, effective internal control over
financial reporting as of December 31, 2004, based on criteria established in
Internal Control--Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated balance sheets of
Community Banks, Inc. and subsidiaries as of December 31, 2004 and 2003, and the
related consolidated statements of income, changes in stockholders' equity, and
cash flows for the years then ended and our report dated March 7, 2005,
expressed an unqualified opinion thereon.
/s/ Beard Miller Company LLP
Harrisburg, Pennsylvania
March 7, 2005
71
Item 9. Changes in and Disagreements With Accountants on Accounting and
- --------------------------------------------------------------------------------
Financial Disclosure:
- ---------------------
Disclosure relating to a change in accountants is set forth in a Current Report
on Form 8-K dated June 9, 2003 previously filed by the Registrant.
Item 9A. Controls and Procedures:
- ----------------------------------
Under the supervision and with the participation of Community's management,
including its Chief Executive Officer and Chief Financial Officer, Community has
evaluated the effectiveness of its disclosure controls and procedures as of
December 31, 2004. Based upon this evaluation, the Chief Executive Officer and
Chief Financial Officer have concluded that Community's disclosure controls and
procedures are adequate and effective to ensure that material information
relating to Community and its consolidated subsidiaries is made known to them by
others within those entities, particularly during the period in which this
report was prepared. There have not been any changes in Community'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 most recent fiscal quarter that
have materially affected, or are reasonably likely to materially affect,
Community's internal control over financial reporting.
Because of inherent limitations, our disclosure controls and procedures may not
prevent or detect misstatements. A control system, no matter how well conceived
and operated, can provide only reasonable, not absolute, assurance that the
objectives of the control system are met. Because of the inherent limitations in
all control systems, no evaluation of controls can provide absolute assurance
that all control issues and instances of fraud, if any, have been detected.
Management's report on internal controls can be found at page 70.
Item 9B. Other Information:
- ----------------------------
None.
72
PART III
Item 10. Directors and Executive Officers of the Registrant:
-------------------------------------------------------------
Name Age Position
---- --- --------
Eddie L. Dunklebarger 51 Director, Chairman of the Board,
President and Chief Executive Officer
Ronald E. Boyer 67 Director
Samuel E. Cooper 70 Director
Peter DeSoto 65 Director
Thomas W. Long 75 Director
Donald L. Miller 75 Director
Thomas L. Miller 72 Director
Earl L. Mummert 59 Director
Wayne H. Mummert 70 Director
Scott J. Newkam 54 Director
Robert W. Rissinger 78 Director
Allen Shaffer 79 Director
John W. Taylor, Jr. 74 Director
James A. Ulsh 58 Director
Donald F. Holt 48 Executive Vice President, Chief Financial
Officer
Robert W. Lawley 50 Executive Vice President, Operations
Anthony N. Leo 44 Executive Vice President, Financial
Services and Administration
Jeffrey M. Seibert 45 Executive Vice President, Banking Services
Directors to Continue in Office until the 2005 Annual Meeting
- -------------------------------------------------------------
Samuel E. Cooper has been a director of Community since 1992. From 1972 to 1996,
Mr. Cooper was the superintendent of the Warrior Run School District in
Turbotville, Pennsylvania. He has been retired since 1996. Mr. Cooper has
indicated that he does not intend to stand for reelection.
Thomas W. Long has been a director of the Bank since 1981 and of Community since
its formation in 1983. From 1958 until his retirement in 1997, Mr. Long was a
principal and owner of Millersburg Hardware Company, Inc., a retail hardware
business based in Millersburg, Pennsylvania. Mr. Long will not stand for
reelection, due to the requirement in Community's bylaws that directors may not
stand for reelection after they have reached age 75.
Donald L. Miller has been a director of the Bank since 1981 and of Community
since its formation in 1983. From 1953 to 2003, Mr. Miller was engaged in the
ownership and operation of Miller Brothers Dairy, inc., based in Millersburg,
Pennsylvania, a business engaged in milk production and sales. He has been
retired since 2003. Mr. Miller will not stand for reelection, due to the
requirement in Community's bylaws that directors may not stand for reelection
after they have reached age 75.
Eddie L. Dunklebarger has been a member of Community's Board of Directors since
1998. He has served as President and CEO of Community since 1998 and became
Chairman in 2002. Mr. Dunklebarger has also been President and CEO of
Community's banking subsidiary since 1999. If Mr. Dunklebarger is reelected at
the 2005 annual meeting of shareholders, as proposed by the Community board of
directors, his term will extend until the 2009 annual meeting.
Directors to Continue in Office until the 2006 Annual Meeting of Shareholders
- -----------------------------------------------------------------------------
Earl L. Mummert has been a director of Community since 1998. Since 1976, Mr.
Mummert has been employed as a consulting actuary by Conrad Siegel, Inc., a
company which provides a broad array of services to companies and employee
benefit plans in Harrisburg, Pennsylvania.
73
Allen Shaffer has been a director of Community and its predecessor since 1960.
Mr. Shaffer is a partner in Shaffer & Engle Law Offices and has practiced law in
Millersburg and Harrisburg, Pennsylvania, since 1952.
John W. Taylor, Jr. has been a director of Community since 1998. Since 1980, Mr.
Taylor has been president of Air Brake & Power Equipment Company, based in
Pottsville, Pennsylvania, a company which distributes truck and industrial parts
and equipment. Pursuant to Community's bylaws, Mr. Taylor's term of office will
expire on the day before the 2006 annual meeting.
Directors to Continue in Office until the 2007 Annual Meeting of Shareholders
- ------------------------------------------------------------------------------
Wayne H. Mummert has been a director since 1998. Mr. Mummert has been a farmer
since 1952 and from 1960 to 1991 was employed by the U. S. Postal Service. Mr.
Mummert has indicated that if the merger between Community and PennRock is
completed, he will resign as a director in order to create a vacancy that will
enable the Community board to achieve the board composition agreed upon in the
merger agreement.
Scott J. Newkam has been a director since 2003. Since September 1999, Mr. Newkam
has been the president and CEO of Hershey Entertainment & Resorts Company, a
company which owns and operates resort and entertainment facilities in Hershey,
Pennsylvania. From 1997 to September 1999, Mr. Newkam was executive vice
president and chief operating officer of the company. Mr. Newkam has supervised
and been actively involved in the preparation of financial statements.
Robert W. Rissinger has been a director of Community and its predecessor since
1961. Since 1977, Mr. Rissinger has been the Secretary/Treasurer of Alvord-Polk,
Inc., based in Millersburg, Pennsylvania, a company which manufactures cutting
tools. Since 1978, he has also been a principal in and owner of Engle-Rissinger
Auto Group, Inc., a retail vehicle sales business also based in Millersburg,
Pennsylvania.
Directors to Continue in Office until the 2008 Annual Meeting of Shareholders
- -----------------------------------------------------------------------------
Ronald E. Boyer has been a director of Community and its predecessor since 1981.
Since 1977, Mr. Boyer has been the president of Alvord-Polk, Inc., based in
Millersburg, Pennsylvania, a company which manufactures cutting tools.
Peter DeSoto has been a director of Community and its predecessor since 1981.
Since 1997, Mr. DeSoto has been the CEO of J. T. Walker Industries, Inc., parent
of M.I. Home Products based in Elizabethville, Pennsylvania, a company which
manufactures vinyl, aluminum and cellular composite windows and doors.
Thomas L. Miller has been a director of Community and its predecessor since
1966. From 1967 to 1998, Mr. Miller was the president and CEO of the Bank and,
from 1983 to 1998, president and CEO of Community. Mr. Miller retired his
positions as president and CEO in 1998. Mr. Miller has indicated that if the
merger between Community and PennRock is completed, he will resign as a director
in order to create a vacancy that will enable the Community board to achieve the
board composition agreed upon in the merger agreement.
James A. Ulsh has been a director of Community and its predecessor since 1977.
Since 1973, Mr. Ulsh has been employed as an attorney with the Harrisburg,
Pennsylvania law firm of Mette, Evans & Woodside.
Executive Officers of Community
- -------------------------------
The following executive officers are expected to continue in their respective
offices pursuant to the terms and conditions of their employment agreements,
which are discussed below beginning on page 80.
Donald F. Holt is Community's chief financial officer and executive vice
president of finance, a position he has held since December 31, 2001. He was
employed by Keystone Financial, Inc. as its senior vice president and controller
from 1987 - 1998 and as executive vice president and chief financial officer
from 1999-2000. During 2001, Mr. Holt served as vice president of finance and
administration of the Pennsylvania Chamber of Business and Industry.
Robert W. Lawley is Community's executive vice president of operations. He has
been an executive vice president of Community since 1984.
74
Anthony N. Leo is Community's executive vice president of financial services and
administration. He has been an executive vice president of Community since 1998.
Jeffrey M. Seibert is Community's executive vice president of banking services.
He has been an executive vice president of Community since 1998.
Audit Committee
The members of the audit committee are Scott J. Newkam (Chairman), Ronald E.
Boyer, Samuel E. Cooper, Earl L. Mummert and Wayne H. Mummert. The Committee met
six times in 2004. The Board has adopted a charter for the Committee, which can
be found on the investor relations section of Community's website at
www.communitybanks.com. Each member of the committee is independent, as defined
by the NASDAQ Marketplace Rules and applicable rules of the Securities and
Exchange Commission. The Board has determined that Mr. Newkam is an audit
committee financial expert, as defined by the Securities and Exchange
Commission.
Nominating and Corporate Governance Committee
The Board has established a nominating and corporate governance committee, whose
members are Robert W. Rissinger (Chair), Earl L. Mummert and Scott J. Newkam.
Each member of the Committee is independent, as defined by the NASDAQ
Marketplace Rules. The functions of the committee are to provide assistance to
the Community board of directors in fulfilling its responsibility to the
shareholders, potential shareholders and investment community by identifying
individuals qualified to become directors and recommending that the Board of
Directors select the candidates for all directorships to be filled by the board
of directors or by the shareholders; developing and recommending to the Board a
set of corporate governance principles applicable to Community and otherwise
taking a leadership role in shaping the corporate governance of Community. A
copy of the charter that the committee has adopted can be found under the
investor relations section on Community's website, at www.communitybanks.com.
Before recommending candidates for election to the board, the committee will
consider the candidate's character, judgment, business experience, expertise and
acumen, as well as any other criteria contained in the Community bylaws for
membership on the Board. The committee met four times in 2004.
Code of Ethics
Community has adopted a Code of Ethics that is applicable to Community's chief
executive officer, chief financial officer, principal accounting officer, and
other designated senior officers and a code of conduct that is applicable to all
employees and directors of Community. Copies of the code of ethics and code of
conduct can be found under the corporate governance section of Community's
website at www.communitybanks.com.
Shareholder Communications with the Board
Stockholders who wish to communicate directly with Community's Board may direct
such communications in writing, via facsimile and/or letter to: Audit Committee
Chair, c/o Community Banks, Inc., 750 East Park Drive, Harrisburg, PA 17111 (Fax
# 717-920-1683). The Audit Committee Chair will convey any and all such
communications to the full Board for consideration and review.
Item 11. Executive Compensation:
- ---------------------------------
The following tables and reports apply to the compensation Community paid to the
President/CEO and Community's four other most highly compensated officers. These
five individuals are referred to in Item 11 as the "Named Executive Officers."
The following Summary Compensation Table shows the annual salary and other
compensation for the Named Executive Officers for the last three years.
75
Summary Compensation Table
------------------------------------------------------
Long Term
Compensation
Annual Compensation(1) Awards(2)
- --------------------------------------------------------------------------------------------------------------------
Securities
Underlying All Other
Name and Principal Options/SARs Compensation
Position Year Salary ($) Bonus($) (#)(3) ($)(4)
- --------------------------------------------------------------------------------------------------------------------
Eddie L. Dunklebarger 2004 350,000 175,000 30,000 127,506
President & CEO of 2003 325,000 161,500 25,200 58,383
Community and Community 2002 300,000 218,900 26,460 57,162
Banks
- --------------------------------------------------------------------------------------------------------------------
Donald F. Holt 2004 160,000 66,000 10,000 37,716
Executive Vice- 2003 150,000 53,800 7,560 12,000
President/Finance 2002 135,000 67,000 7,938 11,916
- --------------------------------------------------------------------------------------------------------------------
Robert W. Lawley 2004 160,000 66,000 10,000 58,379
Executive 2003 150,000 53,800 7,560 27,266
Vice-President/Operations 2002 137,080 73,000 7,938 28,824
- --------------------------------------------------------------------------------------------------------------------
Anthony N. Leo 2004 160,000 66,000 10,000 36,058
Executive 2003 150,000 53,800 7,560 21,759
Vice-President/Financial 2002 135,000 73,000 7,938 23,469
Services and Administration
- --------------------------------------------------------------------------------------------------------------------
Jeffrey M. Seibert 2004 160,000 66,000 10,000 38,221
Executive 2003 150,000 53,800 7,560 22,655
Vice-President/Banking 2002 135,000 84,000 7,938 24,288
Services
- --------------------------------------------------------------------------------------------------------------------
(1) The total personal benefits provided by Community and its subsidiaries for
any Named Executive Officer, individually, or all Named Executive Officers as a
group did not exceed the lesser of $50,000 or 10% of the salary and bonus of the
officer for any of the years shown. This does not include benefits that are
available to all salaried officers, directors and employees on a
non-discriminatory basis.
(2) Community has not issued any restricted stock awards to any executive
officer. Additionally, Community does not maintain any Long-Term Incentive Plan
other than a stock option plan, and grants to Named Executive Officers pursuant
to that plan are reported in the Stock Option Grant Table.
(3) When appropriate, stock options shown above have been adjusted for
subsequent stock dividends and stock splits.
(4) "All other compensation" includes the following:
Mr. Dunklebarger - Director fees of $10,000 for 2004, $10,000 for 2003 and
$5,400 for 2002; employer contributions to Community's 401(k) Plan of $14,350 in
2004, $12,000 in 2003 and $18,000 in 2002; SERP accruals of $103,156 in 2004,
$36,383 in 2003 and $33,762 in 2002.
Mr. Holt - Employer contributions to Community's 401(k) Plan of $14,350 in 2004,
$12,000 in 2003 and $11,916 in 2002; SERP accruals of $23,366 in 2004.
Mr. Lawley - Employer contributions to Community's 401(k) Plan of $14,350 in
2004, $12,000 in 2003 and $14,587 in 2002; SERP accruals of $44,029 in 2004,
$15,266 in 2003, and $14,237 in 2002.
Mr. Leo - Employer contributions to Community's 401(k) Plan of $14,350 in 2004,
$12,000 in 2003 and $14,413 in 2002; SERP accruals of $21,708 in 2004, $9,759 in
2003 and $9,056 in 2002.
Mr. Seibert - Employer contributions to Community's 401(k) Plan of $14,350 in
2004, $12,000 in 2003 and $14,400 in 2002; SERP accruals of $23,871 in 2004,
$10,655 in 2003, and $9,888 in 2002.
76
Stock Options
- -------------
In 1998, the shareholders of Community adopted the Community Banks, Inc.
Long-Term Incentive Plan. This plan allows Community to issue awards to key
officers of Community. Awards may be made in the form of incentive stock options
(ISOs), non-qualified stock options (NQSOs) and stock appreciation rights
(SARs).
Incentive Stock Options
The Internal Revenue Code requires all ISOs to be granted at a price not less
than 100% of the fair market value of Community common stock on the date the ISO
is granted. ISOs are not transferable, except upon death by will or descent and
distribution, and may not have a term of exercise longer than ten years. In
addition, no ISO may be exercised for a period of at least six months after the
ISO is granted.
The plan requires adjustment of the options to reflect changes in the number of
outstanding shares caused by events such as the declaration and payment of a
stock dividend. Consequently, the option price of and number of shares subject
to all ISOs granted has been adjusted each time a stock dividend has been
declared and paid.
Non-Qualified Stock Options (NQSO)
NQSOs may or may not have a vesting schedule, depending on the terms of the
grant as determined by the Committee administering the plan. Although tax
treatment of ISOs and NQSOs may differ, the plan imposes the same general
conditions and restrictions on NQSOs as it does on ISOs. These conditions are
described above. To date, all NQSOs granted have an option price equal to the
fair market value of Community common stock on the date the NQSO was granted.
Stock Option Grants
The following table shows:
o the number of stock options granted to Named Executive Officers in
2004;
o the percentage which the executive's options bears in relation to the
total options granted to all employees during the year;
o the option price;
o the expiration of the option; and
o the potential realizable value of the options assuming certain rates
of stock appreciation:
Stock Option Grants in Last Fiscal Year
------------------------------------------------------------------------------------------------------------------------
Potential Realizable
Value At Assumed Annual
Individual Grants Rates Of Stock Price
Appreciation For Option
Term
------------------------------------------------------------------------------------------------------------------------
(a) (b) (c) (d) (e) (f) (g)
% Of Total
Number Of Options
Securities Granted To Exercise
Underlying Employees Or Base
Options In Fiscal Price Expiration
Name Granted (#) Year ($/Sh)(1) Date 5% ($)(2) 10% ($)(2)
------------------------------------------------------------------------------------------------------------------------
Eddie L. Dunklebarger (CEO) 30,000 16.5 28.89 12/6/2014 545,063 1,381,297
Donald F. Holt 10,000 5.55 28.89 12/6/2014 181,687 460,432
Robert W. Lawley 10,000 5.55 28.89 12/6/2014 181,687 460,432
Anthony N. Leo 10,000 5.55 28.89 12/6/2014 181,687 460,432
Jeffrey M. Seibert 10,000 5.55 28.89 12/6/2014 181,687 460,432
------------------------------------------------------------------------------------------------------------------------
77
(1) Options were granted in December, 2004, each with an exercise price of
$28.89 per share. The option prices in all events equal the fair market
value of Community common stock on the date of the grant. The options
granted in December, 2004 were for the year 2004.
(2) Applicable Securities and Exchange Commission regulations require us to
disclose the potential appreciation in options granted to executive
officers, assuming annualized rates of stock price appreciation of 5% and
10% over the term of the option. Appreciation is determined as of the
expiration date of the option. The figures shown above assume 5% and 10%
rates of appreciation on an annual basis, with annual compounding of the
appreciation rate, beginning with the original option price of $28.89.
Stock Option Exercises
The following table shows:
o all options exercised by the Named Executive Officers during 2004;
o the number of shares acquired on exercise;
o the value realized by the Named Executive Officer upon exercise; and
o the number of exercisable and un-exercisable options outstanding for
each Named Executive Officer, and the value of those options, as of
December 31, 2004:
Aggregated Option Exercises In Last Fiscal Year And Fiscal Year-End Option Values
-------------------------------------------------------------------------------------------------------------------------
(a) (b) (c) (d) (e)
Number Of Securities Value Of Unexercised
Underlying Unexercised In-The-Money Options At
Shares Options At FY-End (#) FY-End ($)
Acquired On Exercisable/Unexercisable Exercisable/Unexercisable
Name Exercise (#) Value Realized($) (1) (1)(2)
-------------------------------------------------------------------------------------------------------------------------
Eddie L. Dunklebarger
(CEO) 2,500 52,700 200,495 / 46,581 2,461,308 / 271,621
Donald F. Holt 0 0 10,498 / 14,763 22,543 / 33,817
Robert W. Lawley 3,800 70,604 40,889 / 19,556 405,942 / 86,007
Anthony N. Leo 0 0 40,562 / 19,556 398,442 / 86,007
Jeffrey M. Seibert 0 0 70,128 / 19,556 976,673 / 86,007
-------------------------------------------------------------------------------------------------------------------------
(1) All options granted through December 31, 2004 are reported. Exercisable
options are fully vested. Options which will vest in the future are
reported as unexercisable.
(2) The dollar values shown above were calculated by determining the
difference between the closing trading price of Community common stock at
December 31, 2004, which was $28.16 per share, and the option price of each
option as of December 31, 2004.
Pension Plan
- ------------
The Bank maintains a pension plan for certain individuals who were employed by
Community Banks, N.A., a predecessor of Community's subsidiary bank. Employees
hired by Community Banks, N.A. prior to December 31, 1998 became participants in
the pension plan on January 1 or July 1 after completing one year of service (12
continuous months and 1,000 hours worked) and reaching age 21. The cost of the
pension is actuarially determined and paid by the bank. The amount of monthly
pension is equal to 1.15% of average monthly pay, plus .60% of average monthly
pay in excess of $650, multiplied by the number of years of service completed by
an employee. The years of service for the additional portion are limited to a
maximum of 37. Average monthly pay is based upon the five consecutive plan years
of highest pay in the last ten years. The maximum amount of annual compensation
used in determining retirement benefits is $205,000. A participant is eligible
for early retirement after reaching age 60 and completing five years of service.
The early retirement benefit is the actuarial equivalent of the pension accrued
to the date of early retirement. As of December 31, 2004, the only Named
Executive Officer who participates in the plan and who has been credited with
years of service is Robert W. Lawley (twenty-nine years of service).
78
In 1999, the Board of directors amended the plan so that pension benefits will
be offset by employer contributions to Community's 401(k) Plan. Employees hired
after December 31, 1998 are not eligible to participate in the pension plan. In
2003, the board of directors amended the plan so that all benefit accruals under
the Plan shall cease as of December 31, 2003 and all participants will be 100%
vested in their accrued benefit effective as of December 31, 2003. The amount
shown on the following table assumes an annual retirement benefit for an
employee who chose a straight life annuity and who will retire at age 65. These
amounts are not yet offset for the employer contribution in the 401(k) Plan.
Pension Plan Table
----------------------------------------------------------------------------------------------------------------------
Remuneration ($) Years Of Service
----------------------------------------------------------------------------------------------------------------------
15 20 25 30 35
35,000 $ 8,486 $ 11,314 $ 14,143 $ 16,971 $ 19,800
55,000 $ 13,736 $ 18,314 $ 22,893 $ 27,471 $ 32,050
75,000 $ 18,986 $ 25,314 $ 31,643 $ 37,971 $ 44,300
95,000 $ 24,236 $ 32,314 $ 40,393 $ 48,471 $ 56,550
115,000 $ 29,486 $ 39,314 $ 49,143 $ 58,971 $ 68,800
135,000 $ 34,736 $ 46,314 $ 57,893 $ 69,471 $ 81,050
150,000 $ 38,673 $ 51,564 $ 64,455 $ 77,346 $ 90,237
175,000 $ 45,236 $ 60,314 $ 75,393 $ 90,471 $105,550
200,000 and above $ 51,798 $ 69,064 $ 86,330 $103,596 $120,862
----------------------------------------------------------------------------------------------------------------------
(a) The compensation covered by the pension plan includes salary and bonus
compensation, as reported under the heading "Annual Compensation" in the
Summary Compensation Table, appearing elsewhere in Item 11 of this Form
10-K.
(b) Of the Named Executive Officers, only Mr. Lawley participates in the
Pension Plan. As of December 31, 2004, Mr. Lawley had twenty-nine years of
credited service under the Plan.
(c) The estimated benefits shown in the table above were computed assuming
that participants would elect to receive straight line annuity payments.
The amounts shown on the above table do not take into account any
deductions for Social Security or other offset amounts.
Board Compensation Committee Report On Executive Compensation
The members of the committee are Earl L. Mummert (Chair), Peter DeSoto, Donald
L. Miller, Robert W. Rissinger and John W. Taylor, Jr. The committee met twice
in 2004. The functions of the committee are to evaluate Community's compensation
policies and plans, review and evaluate the individual performance of executive
officers, establish the compensation of the President/CEO and make
recommendations on the compensation of the remaining named executive officers.
Each of the members of the committee is independent, as defined in the NASDAQ
Marketplace Rules.
Through our executive compensation policy, we seek to achieve the following
goals in determining compensation of our executive officers:
o integrate compensation with Community's annual and long-term
performance goals;
o reward exceptional performance;
o recognize individual initiative and achievements;
o attract and retain qualified executives;
o provide compensation packages competitive with those offered by other
similar bank holding companies and banks; and
o encourage stock ownership by executive officers.
79
The compensation committee believes that compensation for Community's executive
officers can best be accomplished through a combination of techniques,
including:
o salary;
o Community's bonus program;
o the Long-Term Incentive Plan; and
o appropriate fringe benefits.
Community's Bonus Program
- -------------------------
Community maintains a bonus program for the executive officers of Community and
its subsidiaries. Pursuant to this program, a certain percentage of net income
is placed in a bonus pool. Bonuses paid to the executive officers are determined
by the compensation committee pursuant to guidelines established by the
Committee. The guidelines are based upon the level of net income Community
achieves during the year. The remainder of the bonus pool is distributed to
other officers of Community or its subsidiaries. The compensation committee
delegates to the Chief Executive Officer the distribution of the remainder of
the bonus pool. In 2004, Eddie L. Dunklebarger, President and CEO, earned a
bonus of $175,000. The total amount of bonuses earned by all Named Executive
Officers, including the amount paid to Mr. Dunklebarger, was $439,000.
Long-Term Incentive Plan
- ------------------------
In 1998, Community adopted a Long-Term Incentive Plan. Under the plan, Community
can issue incentive stock options, stock appreciation rights, and non-qualified
stock options. The compensation committee believes that stock ownership by
management helps align management's interests with the interests of the
shareholders in enhancing and increasing the value of Community's common stock.
The compensation committee considers the same criteria in awarding stock options
that it considers in making other compensation decisions.
Employment Agreements
- ---------------------
On January 1, 2004, Community entered into employment agreements with our Named
Executive Officers that replaced prior employment agreements. The agreements
provide that the executives are employed for a period of three years beginning
January 1, 2004. Upon each anniversary of the agreement, the employment
automatically extends for an additional year (resulting in successive three-year
terms) unless, no later than ninety days prior to the expiration date, either
Community or the executive gives written notification to the other of an intent
not to renew the employment agreement. In the event of a change of control in
Community, the agreement automatically extends to a three-year term.
Community may terminate the agreement for cause or if the executive becomes
permanently disabled. After a termination for one of those reasons, or if the
executive terminates his employment without good reason, Community would be
obligated to pay the executive the compensation that he had earned through the
date of termination. The agreement also requires Community to pay the executive
120% of his salary for the remainder of the term of the agreement, in the event
that the executive terminates his employment for certain reasons, such as a
reassignment of duties, a reduction in compensation, Community's breach of the
agreement or the removal of the executive from his current position. If the
executive terminates his employment as the result of a change of control, he is
entitled to a lump-sum payment of an amount equal to three times the average of
his salaries and bonuses in the three years preceding the termination. The
executive and his family would also be entitled in that situation either to
participate in the employee benefit plans of the successor company until he
reaches the age of 65 or to be paid an amount that would enable the executive to
purchase comparable benefits.
Pursuant to the agreements, each executive officer receives an annual salary,
which is subject to increase as the compensation committee and the board of
directors deem appropriate. Under the terms and conditions of the agreements,
the executives are entitled to participate in Community's executive bonus
program, receive benefits under all of Community's employment benefit plans and
participate in Community's existing stock option plan. The executives are also
entitled to other benefits and perquisites as Community's board of directors
deems appropriate.
80
Executive Compensation
- ----------------------
The compensation committee seeks to attract and retain qualified executive
officers by offering compensation competitive with that offered by similar bank
holding companies. The compensation committee considers objective and subjective
criteria. Among other things, the Committee considers data from the SNL
Executive Compensation Review and data compiled by Human Resource Partners,
which used a peer analysis of similarly sized Pennsylvania bank holding
companies. The SNL Executive Compensation Review compares:
o asset size;
o return on assets;
o the salaries of the chief executive officer and other executive
officers;
o return on average assets; and
o return on average equity.
The compensation committee also considers the performance of Community's common
stock on the NASDAQ Stock Market, particularly compared with the performance of
the stock of other comparable bank holding companies.
The compensation committee does not make its recommendations based solely on
corporate performance. The Committee also considers subjective factors. However,
the Committee considers peer group information and corporate performance to be
significant factors in determining executive compensation.
Mr. Dunklebarger
For 2004, Mr. Dunklebarger received an annual salary of $350,000. He was also a
participant in the Community Banks, Inc. Long Term Incentive Plan and
Community's Bonus Program. Mr. Dunklebarger earned a bonus of $175,000. Pursuant
to Community's Long Term Incentive Plan, Mr. Dunklebarger was awarded options to
purchase 30,000 shares of Community's common stock at an exercise price of
$28.89 per share. These options, granted in December of 2004, were based on 2004
performance.
Other Executive Officers
With respect to the compensation of Community's other executive officers, the
compensation committee considers information provided by the Chief Executive
Officer about each executive officer including:
1) level of individual performance;
2) contribution to the consolidated organization; and
3) salary history.
The Compensation committee also considers:
4) the earnings of Community on a consolidated basis;
5) the peer group compensation information discussed above;
6) individual performance factors; and
7) its subjective evaluation of the services provided by each executive
officer.
You can see the compensation paid to Community's other executive officers in the
Summary Compensation Table appearing elsewhere in Item 11 of this Form 10-K.
This report is given by the Compensation committee, consisting of Earl L.
Mummert (Chair), Peter DeSoto, Donald L. Miller, Robert W. Rissinger, and John
W. Taylor, Jr.
81
Other Compensation Arrangements for Named Executive Officers
Community Banks, Inc. 401(k) Profit Sharing Plan
- ------------------------------------------------
Employees are eligible to participate in Community's 401(k) plan after they have
completed three months of service and have reached their twenty-first birthday.
The plan offers both immediate and future benefits to employees in the program.
The plan was submitted to the Internal Revenue Service for favorable
determination as a tax deferred retirement program.
Community allocates for participating accounts an annual amount based on
Community's earnings at the end of each calendar year. The amount allocated to
an employee's account is based on the relationship of the employee's annual
compensation to the total annual compensation paid by Community to all employees
participating in the plan. Subject to limitations of the plan and the trustees
under the plan, an employee can receive a percentage (to be determined in the
discretion of the board of directors) of his or her annual compensation as a
contribution to the plan account each year. The monies allocated to each
employee's account are held and invested by the trustee for the plan. Employees
become fully vested in the plan after five years of service. Upon retirement,
employees will be eligible to withdraw their vested interest in the plan
according to the plan provisions. Should the participant become disabled or upon
his or her death, the plan allows for other payment options. As a participant in
the plan, the employee has the right to direct the investment of all of his or
her funds. An employee may split his or her investment between two or more types
of investments or instruct the administrator to place the entire amount in one
investment account.
In order to allow participants the opportunity to increase their retirement
income, each participant may, at the discretion of the administrator, elect to
voluntarily contribute no less than 1% and no more than 70% (subject to certain
limitations) of his or her total compensation earned while a participant under
the plan. The amounts in each participant's voluntary contribution account are
fully vested at all times and are not subject to forfeiture for any reason. The
normal retirement age under the plan is age 65.
Survivor Income Agreements
- --------------------------
On June 1, 1994, Community Banks, N.A. entered into a Survivor Income Agreement
with Robert W. Lawley. On February 5, 1999, The Peoples State Bank and Community
entered into similar agreements with Eddie L. Dunklebarger, Anthony N. Leo and
Jeffrey M. Seibert. On December 31, 2001, Community Banks, N.A. and The Peoples
State Bank merged to form one bank named Community Banks, Community's subsidiary
bank. On August 29, 2002, Community Banks entered into a similar agreement with
Donald F. Holt. For the purpose of describing the provisions of these
agreements, Community Banks and its predecessors will each be referred to as the
"Bank." In these agreements, the Bank promised to pay to each executive
employee's designated beneficiary a survivor income benefit. The survivor's
income benefit is payable only if the executive employee dies before terminating
employment with the Bank and only to the extent that the Bank owns life
insurance policies on the executive employee's life at the time of his or her
death.
The base death benefit is equal to the lesser of:
o three times the executive employee's base salary for the calendar year
in which the executive's death occurs; or
o the amount of life insurance proceeds received by the Bank due to the
executive's death.
The base death benefit, however, will be increased by an amount equal to the
death benefit multiplied by Community's projected highest marginal federal
income tax rate for the year in which the executive's death occurs. The
survivor's income benefit will be paid in a lump sum within 60 days after the
executive employee's death. These agreements are funded by life insurance
policies on each executive employee's life.
The life insurance policies are owned by the Bank, and are in place of each
executive employee's participation in the Bank's group life insurance plan. A
split dollar insurance agreement goes into effect after the executive employee
reaches the age of 65, as long he has completed ten (10) years of service.
Pursuant to the terms of the split dollar agreement, the executive employee has
the right to designate the beneficiary of the death proceeds of the policy to
the extent the proceeds exceed the cash surrender value of the policy on the
date before the executive employee's death.
82
Supplemental Executive Retirement Plans
- ---------------------------------------
Community maintains Supplemental Executive Retirement Plans providing key man
life insurance on the lives of certain executive employees. Pursuant to the
plans, Community has purchased key man life insurance policies with death
benefits payable to Community if an executive dies in the course of his
employment with Community, in initial net amounts of:
o $2,911,000 covering the life of Eddie L. Dunklebarger;
o $1,076,000 covering the life of Donald F. Holt;
o $3,124,000 covering the life of Robert W. Lawley;
o $2,373,000 covering the life of Anthony N. Leo; and
o $2,530,000 covering the life of Jeffrey M. Seibert.
The plans also provide salary continuation benefits for the executives pursuant
to Salary Continuation Agreements entered into between Community and the
executives. If the executive remains employed by Community until he reaches age
62, then the executive will be entitled to salary continuation for twenty years
after retirement. Pursuant to their respective agreements, the following
individuals are entitled to the following amounts:
o Eddie L. Dunklebarger - $180,000 per year;
o Donald F. Holt - $48,000 per year;
o Robert W. Lawley - $80,000 per year.
o Anthony N. Leo - $75,000 per year;
o Jeffrey M. Seibert - $75,000 per year.
If the executive's employment with Community is terminated before age 62, the
executive will receive reduced benefits at age 62 in accordance with accrual of
benefits schedules set forth in the respective agreements. Benefits will not be
paid if an executive's employment is terminated for cause (as defined in the
respective agreements). In the event of termination due to disability, Community
may elect to pay the accrued benefit immediately in a lump sum, discounted to
present value. In the event that an executive is terminated after a change in
control but prior to age 62, the executive will receive at age 62 his accrued
benefit, plus an additional benefit equal to three years additional accrual in
the case of Mr. Dunklebarger, and two years additional accrual in the cases of
Messrs. Holt, Leo, Seibert and Lawley. If the executive dies prior to or during
the benefit payment period, normal retirement benefits will be payable to the
executive's beneficiaries beginning within one month after the executive's
death.
Directors and Senior Management Deferred Compensation Plan
On January 1, 2004, Community adopted the Community Banks, Inc. Directors and
Senior Management Deferred Compensation Plan, effective January 1, 2004, to
assist directors and executives in establishing a program to provide
supplemental retirement benefits. This plan is a voluntary variable deferred
compensation plan. The amount deferred from salary or bonus by Community's chief
executive officer and the four most highly compensated executives is included in
the Summary Compensation Table under the Salary column, as having been earned in
2004.
83
DIRECTORS
Attendance Fees
- ---------------
In 2004, each Company director received a quarterly fee of $1,250. Each director
who was not an executive officer also received $500 for each board and committee
meeting attended. Members of the executive committee of Community's board were
also paid an annual retainer of $2,500. Directors of Community's bank subsidiary
(which include some of the directors of Community) receive the following
additional fees:
o $5,000 annual retainer; and
o $400 fee for each board and committee meeting attended.
Directors' Stock Option Plan
- ----------------------------
In 2000, the shareholders of Community approved the Directors' Stock Option
Plan. The purpose of the Directors' Stock Option Plan is to attract and retain
non-employee directors who have outstanding abilities. The plan enables the
directors to purchase shares on terms which will give the directors a direct and
continuing interest in the success of Community. The price of the options must
equal at least the fair market value of Community shares on the date the options
are granted. Directors may not exercise the options before the first anniversary
of the option grant or a change of control in Community, whichever first occurs.
The options will expire in ten years, unless they are exercised.
On December 6, 2004, Community granted options to all non-employee directors,
except emeritus directors, to purchase 600 shares at a price of $28.89 per
share. Each non-employee member of the executive committee of the board was
awarded options to purchase an additional 300 shares, and each chairman of a
board committee received options to purchase an additional 100 shares.
STOCK PERFORMANCE GRAPH
The following graph shows the yearly percentage change in Community's cumulative
total shareholder return on its common stock from December 31, 1999 to December
31, 2004 compared with the cumulative total return of the NASDAQ Stock Market
(U.S. Companies), and a self-determined peer group consisting of twelve bank
holding companies. The bank holding companies in the peer group are Bryn Mawr
Bank Corp., Columbia Bancorp, Comm Bancorp, Inc., Community Bank System, Inc.,
Harleysville National Corp., KNBT Bancorp, Inc., Leesport Financial Corp.,
National Penn Bancshares, Inc., Omega Financial Corp., S & T Bancorp, Inc.,
Sandy Spring Bancorp, Inc., and Sterling Financial Corp. Community selected
these companies because they conduct a community banking business in similar
markets and they are similar to Community in asset size and market
capitalization. Two of the companies that were in the peer group used in the
stock performance graph in Community's 2004 proxy statement have been deleted.
PennRock was deleted because of the merger that is discussed in this document.
Sun Bancorp, Inc. was deleted, because it has merged into another bank holding
company, and the necessary stock price information is no longer available for
it. In place of these two entities, Community has added Community Bank System,
Inc., a $4.4 billion financial institution based in New York, and KNBT Bancorp,
Inc., a $2.4 billion financial institution based in Bethlehem, Pennsylvania.
84
Comparison of Five-Year Cumulative Total Returns
Performance Graph for Community Banks, Inc.
12/1999 12/2000 12/2001 12/2002 12/2003 12/2004
------- ------- ------- ------- ------- -------
Community Banks, Inc. 100.0 97.2 138.2 153.0 233.8 216.0
NASDAQ Stock Market 100.0 60.3 47.8 33.1 49.4 53.8
(US Companies)
Self-Determined Peer Group 100.0 90.7 121.6 144.1 190.3 210.9
85
Compensation Committee Interlocks and Insider Participation
-----------------------------------------------------------
None of the committee members has been an officer or employee of Community or
any of its subsidiaries at any time. Earl L. Mummert is a consulting actuary
with Conrad M. Siegel, Inc. which provides actuarial services for Community. As
is the case with other board members, any indebtedness of the members of the
compensation committee to Community's bank subsidiary is on the same terms,
including interest rate and collateral on loans, as those prevailing at the time
of corporate transactions with others and does not involve more than the normal
risk of collectibility or present other unfavorable features.
Item 12. Security Ownership of Certain Beneficial Owners and Management:
- -------------------------------------------------------------------------
The following table provides information regarding the common stock of Community
that is available for issuance under equity compensation plans.
Equity Compensation Plan Information
- ------------------------------------
- ------------------------------------------------------------------------------------------------------------------------------------
Plan Category (a) (b) (c)
Number of securities
remaining available for
Number of securities to be future issuance under equity
issued upon exercise of Weighted average exercise compensation plans (excluding
outstanding options, warrants price of outstanding options, securities reflected in
and rights warrants and rights column (a))
- ------------------------------------------------------------------------------------------------------------------------------------
Equity compensation plans
approved by security holders 1,073,000 $20.44 916,000 (1)
- ------------------------------------------------------------------------------------------------------------------------------------
Equity compensation plans not
approved by security holders (2) None n/a n/a
- ------------------------------------------------------------------------------------------------------------------------------------
Total 1,073,000 $20.44 916,000
- ------------------------------------------------------------------------------------------------------------------------------------
(1) Includes 88,000 shares available for future issuance under Community's
Employee Stock Purchase Plan.
(2) Community does not maintain equity compensation plans that have not
been approved by its stockholders.
86
The following table shows the number of shares of common stock owned by each of
Community's directors and Named Executive Officers and by the directors and
Named Executive Officers as a group, as of February 28, 2005. Common stock is
the only class of equity securities that is outstanding. No one owns more than
5% of Community's common stock.
----------------------------------------------------------------------------------------------------------------
Percentage of
Number of Shares Outstanding
Name of Beneficial Owner and Position Beneficially Owned (1) Common Stock
------------------------------------- ---------------------- ------------
Directors
Ronald E. Boyer 47,903 (2) *
Samuel E. Cooper 8,124 (3) *
Peter DeSoto 79,967 (4) *
Eddie L. Dunklebarger, Chairman, President and CEO 334,426 (5) 2.677%
Thomas W. Long 21,567 (6) *
Donald L. Miller 141,262 (7) 1.148%
Thomas L. Miller 63,307 (8) *
Earl L. Mummert 40,246 (9) *
Wayne H. Mummert 89,154 (10) *
Scott J. Newkam 1,207 (11) *
Robert W. Rissinger 393,166 (12) 3.196%
Allen Shaffer 163,966 (13) 1.332%
John W. Taylor, Jr. 42,372 (14) *
James A. Ulsh 31,417 (15) *
Named Executive Officers (other than Mr. Dunklebarger)
Donald F. Holt, Executive Vice President and CFO 10,738 (16) *
Robert W. Lawley, Executive Vice President 41,094 (17) *
Anthony N. Leo, Executive Vice President 51,678 (18) *
Jeffrey M. Seibert, Executive Vice President 105,422 (19) *
Directors and Named Executive Officers as a group 1,654,974 (20) 13.018%
-------------------------------------------------
*Indicates less than one percent (1%)
---------------------------------------------------------------- ------------------------------ ------------------
Notes to Security Ownership Table
---------------------------------
(1) The securities "beneficially owned" by an individual are determined in
accordance with the definition of "beneficial ownership" set forth in the
regulations of the Securities and Exchange Commission. Accordingly, they
may include securities owned by or for, among others, the wife and/or minor
children of the individual and any other relative who has the same home as
such individual, as well as other securities as to which the individual has
or shares voting or investment power or has the right to acquire under
outstanding stock options within 60 days after February 28, 2005.
Beneficial ownership may be disclaimed as to certain of the securities.
(2) Includes shares 12,041 shares owned by Alvord Polk, Inc. , the stock of
which is held 50% by Ronald Boyer and 50% by Robert Rissinger; 1,797 shares
owned by Mr. Boyer's wife; and stock options to acquire 4.855 shares.
(3) Includes stock options to acquire 4,176 shares.
(4) Includes 3,780 shares held in Mr. DeSoto's IRA and stock options to acquire
5,170 shares.
(5) Includes 13,926 shares held in Mr. Dunklebarger's IRA; 4,828 shares held in
an ESPP; 20,804 shares held in his 401K; 516 shares held by his wife;
17,977 shares held by his children; and stock options (ISOs and
Non-Qualified Stock Options) to acquire 193,292 shares.
(6) Includes 20,681 shares held in Revocable Trusts and stock options to
acquire 630 shares.
(7) Includes stock options to acquire 5,170 shares.
(8) Includes 58,134 shares held in Revocable Trusts and stock options to
acquire 5,170 shares.
87
(9) Includes 28,116 shares held by Mr. Mummert's IRA and stock options to
acquire 6,163 shares.
(10) Includes 21,005 shares held by Mr. Mummert's wife and stock options to
acquire 5,170 shares.
(11) Includes stock options to acquire 945 shares.
(12) Includes 12,041 shares owned by Alvord Polk, Inc., the stock of which is
held 50% by Robert Rissinger and 50% by Ronald Boyer. Also includes 26,833
shares held by Engle Ford, Inc.; 114,972 shares held in Mr. Rissinger's
IRA; 69,674 shares held by Mr. Rissinger's wife and stock options to
acquire 6,163 shares.
(13) Includes 88,434 shares owned by the Polk Foundation, of which Mr. Shaffer
is chairman, and for which Mr. Shaffer holds voting and investment power;
and stock options to acquire 5,170 shares.
(14) Includes 1,388 shares held in Mr. Taylor's IRA; 1,941 shares held by his
wife; 213 shares held by his wife as custodian in Uniform Gift to Minor Act
accounts for minor grandchildren; and stock options to acquire 5,170
shares.
(15) Includes 2,772 shares held in Mr. Ulsh's 401K, and stock options to acquire
5,170 shares.
(16) Includes 3 shares held in Mr. Holt's IRA and stock options to acquire
10,735 shares.
(17) Includes 131 shares held in Mr. Lawley's ESPP; 4 shares held in his 401K;
69 shares held by his children; and stock options to acquire 40,889 shares.
(18) Includes 335 shares held by Mr. Leo's ESPP; 9,872 shares held in his 401K;
and stock options to acquire 40,562 shares.
(19) Includes 12,036 shares held in Mr. Seibert's IRA; 3,538 shares held in his
ESPP; 9,197 shares held in his 40K; and stock options to acquire 67,184
shares.
(20) Includes 282,938 shares that are indirectly held. The 12,041 shares held by
Alvord Polk, Inc. are counted only once in this total, as Alvord Polk, Inc.
is 50% owned by Robert W. Rissinger and 50% owned by Ronald E. Boyer. Thus,
these shares are indicated above as being beneficially owned by both Mr.
Rissinger and Mr. Boyer.
Section 16(a) Beneficial Ownership Reporting Compliance
Our directors and executive officers must file reports with the Securities and
Exchange Commission indicating the number of shares of Community common stock
they beneficially own and changes in their beneficial ownership. To the best of
our knowledge, all such reports were filed on a timely basis, except for one
late filing by Thomas L. Miller relating to an acquisition of two hundred shares
by his spouse.
Item 13. Certain Relationships and Related Transactions:
- ---------------------------------------------------------
Transactions with Officers and Directors
During 2004, the Bank had, and expects to have in the future, banking
transactions in the ordinary course of business with directors and officers of
Community and their associates on substantially the same terms, including
interest rates and collateral on loans, as those prevailing at the time for
comparable transactions with other persons. Management believes that these loans
present no more than the normal risk of collectibility or other unfavorable
features.
Allen Shaffer, a director of Community, is a partner in Shaffer & Engle Law
Offices with offices in Harrisburg and Millersburg, Pennsylvania, who has been
retained in the last fiscal year by Community and who Community proposes to
retain in the current fiscal year. James A. Ulsh, a director of Community, is a
shareholder/employee of the law firm of Mette, Evans & Woodside, Harrisburg,
Pennsylvania, which Community has retained in the last fiscal year and proposes
to retain in the current fiscal year. Earl L. Mummert, a director of Community,
is an actuarial consultant with Conrad M. Siegel, Inc., Harrisburg,
Pennsylvania, which provides actuarial services to Community.
88
Item 14. Principal Accounting Fees and Services:
- -------------------------------------------------
Community's Audit Committee engaged Beard Miller Company LLP ("Beard Miller") to
act as Community's auditor for 2003 and 2004. The Sarbanes Oxley Act of 2002 and
the auditor independence rules of the United States Securities and Exchange
Commission require all public accounting firms who audit public companies to
obtain pre-approval from their respective Audit Committees in order to provide
professional services without impairing independence. Before Beard Miller
performs any services for Community, the Audit Committee is informed that such
services are necessary and is advised of the estimated costs of such services.
The Audit Committee then decides whether to approve Beard Miller's performance
of the services. In 2004, all services performed by Beard Miller were approved
in advance pursuant to these procedures. The Audit Committee has determined that
the performance by Beard Miller of tax services is compatible with maintaining
that firm's independence.
Beard Miller has previously issued engagement letters to or obtained formal
approval from Community's Audit Committee for certain services. These services
are summarized below.
Fees Billed By Independent Certified Public Accountants
Community's principal accountants billed the following fees in the last two
fiscal years:
Audit-
Year Audit (1) Related (2) Tax (3) All Other Fees
---- --------- ------------- ------- --------------
PricewaterhouseCoopers LLP
------------------------------------------------------------------------------------------------------
2003 $ 9,452 $ 21,985 $ 28,199 ---
Beard Miller Company LLP
------------------------------------------------------------------------------------------------------
2003 $ 115,967 $ 8,195 $ 425 ---
2004 139,990 19,062 10,713 ---
(1) Includes professional services rendered for the audit of Community's
annual financial statements and review of financial statements
included in Forms 10-Q, FDICIA attestation, Sarbanes Oxley attestation
and out-of-pocket expenses.
(2) Includes separate audit reports on subsidiaries of Community and
assistance on matters of accounting and due diligence related to
proposed acquisitions.
(3) Includes the review of state and federal tax returns and assistance
with various tax matters.
89
PART IV
Item 15. Exhibits, Financial Statements Schedules:
- ---------------------------------------------------
(a) The following documents are filed as part of this report.
1. Financial Statements - The following consolidated financial statements
of Community Banks, Inc. and Subsidiaries are incorporated herein by
reference in response to Item 8 above:
(i) Consolidated Balance Sheets at December 31, 2004 and 2003
(ii) Consolidated Statements of Income for the Years Ended December 31,
2004, 2003 and 2002
(iii)Consolidated Statements of Changes in Stockholders' Equity for the
Years Ended December 2004, 2003, and 2002.
(iv) Consolidated Statements of Cash Flows for the Years Ended December 31,
2004, 2003 and 2002.
(v) Notes to Consolidated Financial Statements
(vi) Report of Beard Miller Company LLP, Independent Registered Public
Accounting Firm
2. Financial Statements Schedules - All financial statement schedules for
which provision is made in the applicable accounting regulations of
the Securities and Exchange Commission are not required under the
related instructions or are inapplicable and have therefore been
omitted.
3. Exhibits
2.1 Agreement and Plan of Reorganization, dated November 7, 2000, among
Community Banks, Inc.; The Peoples State Bank; and The Glen Rock State
Bank, not including schedules. Community will furnish the omitted
schedules to the Securities and Exchange Commission upon request.
(Incorporated by reference to Exhibit 2 to Community's registration
statement on Form S-4, filed on January 17, 2001)
2.2 Merger agreement between PennRock Financial Services Corp. and
Community Banks, Inc., dated November 16, 2004, not including
schedules. Community will furnish the omitted schedules to the
Securities and Exchange Commission upon request. (Incorporated by
reference to Exhibit 10.1 to Community's Current Report on Form 8-K,
filed with the Commission on November 22, 2004)
3(i) Amended Articles of Incorporation (Incorporated by reference to
Exhibit 3.1, attached to Community'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, filed with the Commission on May 15, 2003)
4 Instruments defining the rights of the holders of trust capital
securities and sold by Community in December 2002 and in December 2003
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, 2003, filed with
the Commission on March 28, 2003)
10.3 Form of Stock Option Agreement - Directors Stock Option Plan
(Incorporated by reference to 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 for Eddie L. Dunklebarger (Incorporated by
reference to Exhibit 10.1 to Community's Quarterly Report on Form 10-Q
for the quarter ended September 30, 2004, filed with the Commission on
November 9, 2004)*
10.6 Employment Agreement for Donald F. Holt (Incorporated by reference to
Exhibit 10.2 to Community's Quarterly Report on Form 10-Q for the
quarter ended September 30, 2004, filed with the Commission on
November 9, 2004)*
10.7 Employment Agreement for Robert W. Lawley (Incorporated by reference
to Exhibit 10.3 to Community's Quarterly Report on Form 10-Q for the
quarter ended September 30, 2004, filed with the Commission on
November 9, 2004)*
10.8 Employment Agreement for Anthony N. Leo (Incorporated by reference to
Exhibit 10.4 to Community's Quarterly Report on Form 10-Q for the
quarter ended September 30, 2004, filed with the Commission on
November 9, 2004)*
10.9 Employment Agreement for Jeffrey M. Seibert (Incorporated by reference
to Exhibit 10.5 to Community's Quarterly Report on Form 10-Q for the
quarter ended September 30, 2004, filed with the Commission on
November 9, 2004)*
90
10.10Amended and Restated Salary Continuation Agreement of Eddie L.
Dunklebarger (Incorporated by reference to Exhibit 10.1 to Community's
Quarterly Report on Form 10-Q for the quarter ended March 31, 2004,
filed with the Commission on May 10, 2004)*
10.11Salary Continuation Agreement of Donald F. Holt (Incorporated by
reference to Exhibit 10.2 to Community's Quarterly Report on Form 10-Q
for the quarter ended March 31, 2004, filed with the Commission on May
10, 2004)*
10.12Amended and Restated Salary Continuation Agreement of Robert W.
Lawley (Incorporated by reference to Exhibit 10.3 to Community's
Quarterly Report on Form 10-Q for the quarter ended March 31, 2004,
filed with the Commission on May 10, 2004)*
10.13Amended and Restated Salary Continuation Agreement of Anthony N. Leo
(Incorporated by reference to Exhibit 10.4 to Community's Quarterly
Report on Form 10-Q for the quarter ended March 31, 2004, filed with
the Commission on May 10, 2004)*
10.14Amended and Restated Salary Continuation Agreement of Jeffrey M.
Seibert (Incorporated by reference to Exhibit 10.5 to Community's
Quarterly Report on Form 10-Q for the quarter ended March 31, 2004,
filed with the Commission on May 10, 2004)*
10.15Rights 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)
10.16Community 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)
10.17Survivor Income Agreement, with Split Dollar Addendum thereto, of
Eddie L. Dunklebarger (Incorporated by reference to Exhibit to 3.2,
attached to Community's Quarterly Report on Form 10-Q for the quarter
ended September 30, 2003)*
10.18Survivor Income Agreement, with Split Dollar Addendum thereto, of
Donald F. Holt (Incorporated by reference to Exhibit to 10.6, attached
to Community's Quarterly Report on Form 10-Q for the quarter ended
March 31, 2004)*
10.19Survivor Income Agreement, with Split Dollar Addendum thereto, of
Robert W. Lawley (Incorporated by reference to Exhibit to 3.2,
attached to Community's Quarterly Report on Form 10-Q for the quarter
ended September 30, 2003)*
10.20Survivor Income Agreement, with Split Dollar Addendum thereto, of
Anthony N. Leo (Incorporated by reference to Exhibit to 3.2, attached
to Community's Quarterly Report on Form 10-Q for the quarter ended
September 30, 2003)*
10.21Survivor Income Agreement, with Split Dollar Addendum thereto, of
Jeffrey M. Seibert (Incorporated by reference to Exhibit to 3.2,
attached to Community's Quarterly Report on Form 10-Q for the quarter
ended September 30, 2003)*
21 Subsidiaries of the Registrant (See Item 1, page #3)
23.1 Consent of Independent Registered Public Accounting Firm - Beard
Miller Company LLP
23.2 Consent of Independent Registered Public Accounting Firm -
PricewaterhouseCoopers LLP 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)
99 Report of Independent Registered Public Accounting Firm -
PricewaterhouseCoopers LLP
* identifies a management contract or compensatory plan or arrangement
(b)Exhibits - The exhibits required to be filed as part of this report are
submitted as a separate section of this report.
(c)Financial Statements Schedules - None required.
91
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
Community Banks, Inc.
By: /S/ (Eddie L. Dunklebarger)
----------------------------
(Eddie L. Dunklebarger)
Chairman of the Board, President, Chief Executive Officer and Director
Date: March 9, 2005
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
/S/ (Donald F. Holt) Ex. Vice President and 3/9/05
- -------------------------------- Chief Financial Officer
(Donald F. Holt) (Principal Accounting Officer)
/S/ (Ronald E. Boyer) Director 3/9/05
- --------------------------------
(Ronald E. Boyer)
/S/ (Samuel E. Cooper) Director 3/9/05
- --------------------------------
(Samuel E. Cooper)
/S/ (Peter DeSoto) Director 3/9/05
- --------------------------------
(Peter DeSoto)
/S/ (Thomas W. Long) Director 3/9/05
- --------------------------------
(Thomas W. Long)
/S/ (Donald L. Miller) Director 3/9/05
- --------------------------------
(Donald L. Miller)
/S/ (Thomas L. Miller) Director 3/9/05
- --------------------------------
(Thomas L. Miller)
/S/ (Earl L. Mummert) Director 3/9/05
- --------------------------------
(Earl L. Mummert)
/S/ (Wayne H. Mummert) Director 3/9/05
- --------------------------------
(Wayne H. Mummert)
/S/ (Scott J. Newkam) Director 3/9/05
- --------------------------------
(Scott J. Newkam)
/S/ (Robert W. Rissinger) Director 3/9/05
- --------------------------------
(Robert W. Rissinger)
/S/ (Allen Shaffer) Director 3/9/05
- --------------------------------
(Allen Shaffer)
/S/ (John W. Taylor, Jr.) Director 3/9/05
- --------------------------------
(John W. Taylor, Jr.)
/S/ (James A. Ulsh) Director 3/9/05
- --------------------------------
(James A. Ulsh)
92