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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
 

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2004

Or

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from_____________________ to ___________________

Commission file number 0-13222

CITIZENS FINANCIAL SERVICES, INC.
(Exact name of registrant as specified in its charter)

PENNSYLVANIA 23-2265045
(State or other jurisdiction of incorporation or organization)       (I.R.S. Employer Identification No.)


First Citizens National Bank
15 South Main Street
Mansfield, Pennsylvania 16933
(Address of principal executive offices)(Zip Code)

Registrant's telephone number, including area code: (570) 662-2121

Indicate by checkmark whether the registrant (1) has filed all reports to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes__X___ No_____

Indicate by checkmark whether the registrant is an accelerated filer (as described in Rule 12b-2 of the Exchange Act). Yes____ No __X__

The number of shares outstanding of the Registrant's Common Stock, as of August 1, 2004, 2,840,257 shares of Common Stock, par value $1.00.


 
     
 
Citizens Financial Services, Inc.
Form 10-Q

INDEX
 
PAGE
Part I   FIANCIAL INFORMATION
 
Item I -   Financial Statements (unaudited)
 
Consolidated Balance Sheet as of June 30, 2004 and
   December 31, 2003
1
Consolidated Statement of Income for the
   Three Months and Six Months Ended June 30, 2004 and 2003
2
Consolidated Statement of Comprehensive Income for the
   Three Months and Six Months Ended June 30, 2004 and 2003
3
Consolidated Statement of Cash Flows for the
   Six Months Ended June 30, 2004 and 2003
4
Notes to Consolidated Financial Statements
5-6
Item 2 -   Management’s Discussion and Analysis of Financial
   Condition and Results of Operations
7-19
Item 3 -   Quantitative and Qualitative Disclosure About Market
   Risk
20
Item 4 - Controls and Procedures
20
 
 
Part II   OTHER INFORMATION
 
Item 1 -   Legal Proceedings
21
Item 2 – Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
21
Item 3 -   Defaults upon Senior Securities
21
Item 4 -   Submission of Matters to a Vote of Security Holders
21
Item 5 -   Other Information
21
Item 6 -   Exhibits and Reports on Form 8-K
22
Signatures
23

 
     
 

 
CITIZENS FINANCIAL SERVICES, INC.
 
 
CONSOLIDATED BALANCE SHEET
 
 
(UNAUDITED)
 
 
 
 
 
 
June 30
December 31
(in thousands, except per share data)
2004
2003
ASSETS:
 
 
Cash and due from banks:
 
 
Noninterest-bearing
$ 8,782
$ 9,624
Interest-bearing
3,650
327
Total cash and cash equivalents
12,432
9,951
 
 
 
Available-for-sale securities
98,507
106,587
 
 
Loans (net of allowance for loan losses of $4,129 and $3,620)
346,668
314,037
 
 
Premises and equipment
10,395
10,645
Accrued interest receivable
1,689
1,703
Goodwill
8,605
6,905
Core deposit intangible
1,551
978
Bank owned life insurance
7,299
7,142
Other assets
7,650
5,930
 
TOTAL ASSETS
$ 494,796
$ 463,878
 
LIABILITIES:
 
 
Deposits:
 
 
Noninterest-bearing
$ 47,157
$ 46,820
Interest-bearing
367,754
338,871
Total deposits
414,911
385,691
Borrowed funds
29,813
27,796
Notes payable
7,500
7,500
Accrued interest payable
1,543
1,888
Other liabilities
2,521
2,474
TOTAL LIABILITIES
456,288
425,349
STOCKHOLDERS' EQUITY:
 
 
Common Stock
 
 
$1.00 par value; authorized 10,000,000 shares;
 
 
issued 2,909,849 shares in 2004 and 2003, respectively
2,910
2,910
Additional paid-in capital
10,213
10,213
Retained earnings
28,332
26,455
TOTAL
41,455
39,578
Accumulated other comprehensive income (loss)
(936)
956
Less: Treasury Stock, at cost
 
 
97,262 shares for 2004 and 96,962 shares for 2003, respectively
(2,011)
(2,005)
TOTAL STOCKHOLDERS' EQUITY
38,508
38,529
TOTAL LIABILITIES AND
 
 
STOCKHOLDERS' EQUITY
$ 494,796
$ 463,878
 
 
 
The accompanying notes are an integral part of these unaudited consolidated financial statements.
 
 

 
Page 1     
 

 
CITIZENS FINANCIAL SERVICES, INC.
 
 
 
 
CONSOLIDATED STATEMENT OF INCOME
 
 
 
 
(UNAUDITED)
 
 
 
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
(in thousands, except per share data)
2004
2003
2004
2003
INTEREST INCOME:
 
 
 
 
Interest and fees on loans
$ 5,447
$ 5,315
$ 10,795
$ 10,719
Interest-bearing deposits with banks
3
17
8
21
Investment securities:
 
Taxable
852
871
1,744
1,765
Nontaxable
62
121
147
258
Dividends
67
77
129
159
TOTAL INTEREST INCOME
6,431
6,401
12,823
12,922
INTEREST EXPENSE:
 
 
 
 
Deposits
1,992
2,190
3,956
4,429
Borrowed funds
217
74
430
149
TOTAL INTEREST EXPENSE
2,209
2,264
4,386
4,578
NET INTEREST INCOME
4,222
4,137
8,437
8,344
Provision for loan losses
-
120
-
255
NET INTEREST INCOME AFTER
 
 
 
 
PROVISION FOR LOAN LOSSES
4,222
4,017
8,437
8,089
NON-INTEREST INCOME:
 
 
 
 
Service charges
751
772
1,482
1,482
Trust
177
171
358
295
Gains on loans sold
12
130
21
226
Realized securities gains, net
204
140
491
400
Earnings on bank owned life insurance
79
2
158
2
Other
153
196
260
359
TOTAL NON-INTEREST INCOME
1,376
1,411
2,770
2,764
NON-INTEREST EXPENSES:
 
 
 
 
Salaries and employee benefits
1,847
1,942
3,772
3,836
Occupancy
267
240
553
518
Furniture and equipment
165
176
335
354
Professional fees
158
142
312
304
Amortization
109
109
217
217
Other
1,129
1,022
2,155
2,032
TOTAL NON-INTEREST EXPENSES
3,675
3,631
7,344
7,261
Income before provision for income taxes
1,923
1,797
3,863
3,592
Provision for income taxes
455
415
902
846
NET INCOME
$ 1,468
$ 1,382
$ 2,961
$ 2,746
 
 
 
 
Earnings Per Share
$ 0.52
$ 0.48
$ 1.05
$ 0.96
Cash Dividend Declared
$ 0.195
$ 0.185
$ 0.385
$ 0.365
 
 
 
 
 
Weighted average number of shares outstanding
2,812,834
2,854,688
2,812,861
2,854,688
 
 
 
 
 
The accompanying notes are an integral part of these unaudited consolidated financial statements.
 
 
 
 
 
Page 2     
 
 
CITIZENS FINANCIAL SERVICES, INC.
 
 
 
 
 
 
 
 
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
 
 
 
 
 
 
 
 
(UNAUDITED)
 
 
 
 
 
 
 
 
 
Three Months Ended
Six Months Ended
 
 
June 30
 
June 30
 
(in thousands)
 
2004
 
2003
 
2004
 
2003
Net income
 
$ 1,468
 
$ 1,382
 
$ 2,961
 
$ 2,746
Other comprehensive income:
 
 
 
 
 
 
 
 
Unrealized losses on available for sale securities
(2,723)
 
(284)
 
(2,376)
 
(623)
 
Less: Reclassification adjustment for gains included in net income
(204)
(140)
(491)
(400)
Other comprehensive loss before tax
 
(2,927)
 
(424)
 
(2,867)
 
(1,023)
Income tax benefit related to other comprehensive income
 
(995)
 
(144)
 
(975)
 
(348)
Other comprehensive loss, net of tax
 
(1,932)
 
(280)
 
(1,892)
 
(675)
Comprehensive income (loss)
 
$ (464)
 
$ 1,102
 
$ 1,069
 
$ 2,071
 
 
 
 
 
 
 
 
 
The accompanying notes are an integral part of these unaudited consolidated financial statements.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 Page 3    

CITIZENS FINANCIAL SERVICES, INC.
 
 
CONSOLIDATED STATEMENT OF CASH FLOWS
 
 
(UNAUDITED)
Six Months Ended
 
June 30,
(in thousands)
2004
2003
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
Net income
$ 2,961
$ 2,746
Adjustments to reconcile net income to net
 
 
cash provided by operating activities:
 
 
Provision for loan losses
-
255
Depreciation and amortization
458
453
Amortization of intangible assets
217
217
Amortization and accretion of investment securities
501
556
Deferred income taxes
(41)
(136)
Realized gains on securities
(491)
(400)
Realized gains on loans sold
(21)
(226)
Earnings on bank owned life insurance
(158)
(2)
Originations of loans held for sale
(1,213)
(15,440)
Proceeds from sales of loans held for sale
1,314
15,566
Gain on sale of foreclosed assets held for sale
(15)
-
Increase in accrued interest receivable
14
256
Increase in other assets and intangibles
(323)
(863)
Decrease in accrued interest payable
(345)
(451)
Increase in other liabilities
47
28
Net cash provided by operating activities
2,905
2,559
CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
Available-for-sale securities:
 
 
Proceeds from sales of available-for-sale securities
15,007
7,592
Proceeds from maturity and principal repayments of securities
14,434
26,317
Purchase of securities
(24,227)
(30,217)
Net increase in loans
(6,224)
(4,595)
Purchase of loans
(27,340)
-
Purchase of bank owned life insurance
-
(2,333)
Acquisition of premises and equipment
(190)
(333)
Proceeds from sale of premises and equipment
30
-
Proceeds from sale of foreclosed assets held for sale
138
-
Deposit acquisition premium
(2,200)
-
Net cash used in investing activities
(30,572)
(3,569)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
Net increase in deposits
8,557
18,828
Proceeds from long-term borrowings
548
638
Repayments from long-term borrowings
(559)
(303)
Net increase (decrease) in short-term borrowed funds
2,029
(5,505)
Acquisition of treasury stock
(7)
-
Dividends paid
(1,083)
(1,032)
Deposits of acquired branches
20,663
-
Net cash provided by financing activities
30,148
12,626
Net increase in cash and cash equivalents
2,481
11,616
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
9,951
11,594
CASH AND CASH EQUIVALENTS AT END OF PERIOD
$ 12,432
$ 23,210
Supplemental Disclosures of Cash Flow Information:
 
 
Interest paid
$ 4,732
$ 5,030
Income taxes paid
$ 1,050
$ 745
The accompanying notes are an integral part of these unaudited consolidated financial statements.
 
 
 
Page 4     
 
 
CITIZENS FINANCIAL SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
BASIS OF PRESENTATION

Citizens Financial Service, Inc., (individually and collectively, the “Company”) is a Pennsylvania corporation organized as the holding company of its wholly owned subsidiary, First Citizens National Bank (the “Bank”), and its subsidiary, First Citizens Insurance Agency, Inc. All material inter-company balances and transactions have been eliminated in consolidation.
 
The accompanying consolidated financial statements have been prepared pursuant to rules and regulations of the Securities and Exchange Commission (SEC) and in compliance with accounting principles generally accepted in the United States of America. Because this report is based on an interim period, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted.

In the opinion of Management of the registrant, the accompanying interim financial statements for the quarters ended June 30, 2004 and 2003 include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the financial condition and the results of operations for the period. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. The financial performance reported for the Company for the six-month period ended June 30, 2004 is not necessarily indicative of the results to be expected for the full year. This information should be read in conjunction with the Company’s Annual Report to shareholders and Form 10-K for the period ended Decembe r 31, 2003.

EARNINGS PER SHARE

Earnings per share calculations give retroactive effect to a 1 percent stock dividend declared by the Company in July 2003.

INCOME TAX EXPENSE
 
Income tax expense is less than the amount calculated using the statutory tax rate, primarily the result of tax-exempt income earned from state and municipal securities and loans and investment in tax credits.

EMPLOYEE BENEFIT PLANS

Components of Net Periodic Benefit Cost – Defined Benefit Plans
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
For a detailed disclosure on the Company's pension and employee benefits plans, please refer to Note 8 of the Company's
Consolidated Financial Statements included in the 2003 Annual Report on Form 10-K.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
The following sets forth the components of net periodic benefit cost of the defined benefit plans for the six months
 
ended June 30, 2004 and 2003, respectively (dollars presented in thousands).
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Pension Benefits
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
2004
2003
 
 
 
 
 
Service cost
 
 
$168
 
$170
 
 
 
 
 
Interest cost
 
 
148
 
134
 
 
 
 
 
Expected return on plan assets
 
(166)
 
(264)
 
 
 
 
 
Net amortization and deferral
 
12
 
162
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net periodic benefit cost
 
$162
 
$202
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Employer Contributions
 
 
 
 
 
 
 
 
 
The Company expects to contribute $412,000 to its pension plan in 2004. As of June 30, 2004, $115,000
 
of contributions have been made.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 Page 5    
 
ACQUISITIONS
 
On June 4, 2004, the Bank acquired two leased banking facilities of The Legacy Bank located in the Towanda and Sayre area, known hereafter as the “Acquisition”. This Acquisition included loans of $27,340,000, retail core deposits of $20,663,000 and certain fixed assets. This transaction was accounted for under the purchase method and the Bank recorded $2,490,000 as intangible assets. As part of the Acquisition we elected to consolidate the newly acquired Towanda Legacy office into our existing Towanda branch, thus not assuming the existing lease. We also elected to close our existing Sayre branch located on Keystone Avenue and consolidate our current customers with the new Sayre location on Elmira Street. The consolidated results include the operations of the acquired banking offices from the date of acquisition.
On July 15, 2004, subsequent to the Acquisition, we have purchased the Elmira Street property, which was previously leased by The Legacy Bank.

RECENT ACCOUNTING PRONOUNCEMENTS
 
None

 
 Page 6    
 
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

CAUTIONARY STATEMENT
 
We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties and as such may prove inaccurate. Forward-looking statements include information concerning possible or assumed future results of operations of Citizens Financial Services, Inc., First Citizens National Bank, First Citizens Insurance Agency, Inc. or the combined company. When we use such words as "believes," "expects,” "anticipates," or similar expressions, we are making forward-looking statements. For a variety of reasons, actual results could differ materially from those contained in or implied by forward-looking statements:

INTRODUCTION
 
The following is management's discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in its accompanying consolidated financial statements for Citizens Financial Service, Inc., a bank holding company and its subsidiary (the “Company”). Our Company's consolidated financial condition and results of operations consist almost entirely of our wholly owned subsidiary’s (First Citizens National Bank) financial conditions and results of operations. Management’s discussion and analysis should be read in conjunction with the preceding June 30, 2004 financial information. The results of operations for the six months ended June 30, 2004 and 2003 are not necessarily indicative of the results that can be expected for the full year. First Citizens National Bank is a member of the Federal Reserve Syste m and subject to regulation, supervision and examination by the Office of the Comptroller of the Currency (“OCC”).
 
Our Company currently engages in the general business of banking throughout our service area of Potter, Tioga and Bradford counties in North Central Pennsylvania and Allegany, Steuben, Chemung and Tioga counties in Southern New York. Our lending and deposit products and investment services are offered primarily within the vicinity of our service area.
 
The market area that First Citizens National Bank operates is rural in nature. The customer makeup consists of small businesses and individuals. The state of the economy in the region is mixed with unemployment rates running above the state average over time.
 
Risk identification and management are essential elements for the successful management of the Company. In the normal course of business, the Company is subject to various types of risk, including interest rate, credit and liquidity risk.
 
Interest rate risk is the sensitivity of net interest income and the market value of financial instruments to the direction and frequency of changes in interest rates. Interest rate risk results from various re-pricing frequencies and the maturity structure of the financial instruments owned by the Company. The Company uses its asset/liability management policy to control and manage interest rate risk.
 
 
 Page 7    
 
Credit risk represents the possibility that a customer may not perform in accordance with contractual terms. Credit risk results from loans with customers and purchasing of securities. The Company’s primary credit risk is in the loan portfolio. The Company manages credit risk by adhering to an established credit policy and through a disciplined evaluation of the adequacy of the allowance for loan losses. Also, the investment policy limits the amount of credit risk that may be taken in the investment portfolio.
 
Liquidity risk represents the inability to generate or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and obligations to depositors. The Company has established guidelines within its asset/liability policy to manage liquidity risk. These guidelines include contingent funding alternatives.
 
Readers should carefully review the risk factors described in other documents our Company files, from time to time, with the Securities and Exchange Commission, including the Annual Report on Form 10-K for the year ended December 31, 2003, filed by our Company and any Current Reports on Form 8-K filed by our Company.
 
We face strong competition in the communities we serve from other commercial banks, savings banks, savings and loan associations and credit unions, some of which are substantially larger institutions than our subsidiary. In addition, insurance companies, investment-counseling firms, and other business firms and individuals offer personal and corporate trust services. We also compete with credit unions, issuers of money market funds, securities brokerage firms, consumer finance companies and mortgage brokers. These entities are strong competitors for virtually all types of financial services.
 
The financial services industry continues to experience tremendous change to the competitive barriers between bank and non-bank institutions. We not only must compete with traditional financial institutions, but also with other business corporations that have begun to deliver competing financial services. Competition for banking services is based on price, nature of product, quality of service, and in the case of certain activities, convenience of location.

TRUST AND INVESTMENT SERVICES
 
Our Trust & Investment Department services range from professional estate settlement services through management of complex trust accounts to investment management and custody of securities. Our expanded Retirement and Trust Department manages retirement accounts for many area companies and individuals. We also manage many individual IRAs, both rollover and contributory.
 
The Investment Department offers full service brokerage services in selected locations throughout the Bank’s market area and appointments can be made in any First Citizens National Bank branch.
 
The Bank offers annuities and life insurance through our insurance subsidiary, First Citizens Insurance Agency, Inc.

FINANCIAL CONDITION
 
Total assets (shown in the Consolidated Balance Sheet) have increased 6.7% since year-end 2003 to $494.8 million. Total loans increased 10.4% to $350.8 million and investment securities decreased 7.6% to $98.5 million since year-end 2003. Total deposits increased 7.6% to $414.9 million since year-end 2003. Explanations of variances will be described within the following appropriate sections.

CASH AND CASH EQUIVALENTS
 
Cash and cash equivalents totaled $12,432,000 at June 30, 2004 compared to $9,951,000 on December 31, 2003. Noninterest-bearing cash decreased $842,000 since year-end 2003, while interest-bearing cash increased $3,323,000 during that same period. We continue to experience monthly principal repayments from our mortgage backed securities portfolio along with the recognition of the sale of approximately $4,000,000 of Corporate bonds in June 2004.

 
 Page 8    
 
We believe the liquidity needs of the Company are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources, and the portion of the investment and loan portfolios that mature within one year. These sources of funds will enable the Company to meet cash obligations and off-balance sheet commitments as they come due.
 
INVESTMENTS
 
Our investment portfolio decreased by $8,080,000 or 7.6% from December 31, 2003 to June 30, 2004. Our investment portfolio has decreased primarily as a result of mortgage-backed securities monthly principal payments and selected security sales. We have utilized the cash from those principal payments for loan growth and re-investment purposes. During the first six months, we sold approximately $8,211,000 of U.S. Government Agency Mortgage-backed securities, $5,263,000 of Corporate Bonds, along with $1,533,000 of equity securities. Proceeds from the fore mentioned sales along with monthly principal repayments were re-invested in Agency Mortgage-backed securities, as well as funding the Acquisition.
 
Management monitors the earnings performance and the effectiveness of the liquidity of the investment portfolio on a regular basis. Through active balance sheet management and analysis of the securities portfolio, the Company maintains sufficient liquidity to satisfy depositor requirements and various credit needs of its customers.

LOANS
 
The Company’s loan demand picked up slightly during the first six months of 2004. We anticipate loan demand will continue during the remainder of 2004 as traditionally the first half tends to lag the rest of the year. Signs of an improving economy should also stimulate demand on the commercial side of the equation. The Company’s lending is focused in the north central Pennsylvania market and the southern tier of New York. The composition of our loan portfolio consists principally of retail lending, which includes single-family residential mortgages, other consumer lending and commercial lending primarily to locally owned small businesses. New loans are generated primarily from direct loans to our existing customer base, with new customers generated by referrals from real estate brokers, building contractors, attorneys, accountants and existing customers. < /DIV>
 
As shown in the following tables (dollars in thousands), the change in total loans increased by $33,140,000 or 10.4% for the period compared to December 31, 2003, primarily as the result of the Acquisition. Residential mortgage lending is a principal business activity and one our Company expects to continue by providing a full complement of competitively priced conforming, nonconforming and home equity mortgages.

 
June 30,
December 31,
 
2004
2003
 
Amount
%
Amount
%
Real estate:
 
 
 
 
Residential
$ 193,464
55.1
$ 186,117
58.6
Commercial
73,422
20.9
57,370
18.1
Agricultural
7,819
2.2
7,594
2.4
Loans to individuals
 
 
 
 
for household, family and other purchases
12,493
3.6
13,145
4.1
Commercial and other loans
28,500
8.1
16,219
5.1
State & political subdivision loans
35,099
10.0
37,212
11.7
Total loans
350,797
100.0
317,657
100.0
Less allowance for loan losses
4,129
 
3,620
 
Net loans
$ 346,668
 
$ 314,037
 

 
June 30, 2004/
 
December 31, 2003
 
Change
 
Amount
%
Real estate:
 
 
Residential
$ 7,347
3.9
Commercial
16,052
28.0
Agricultural
225
3.0
Loans to individuals
 
 
for household, family and other purchases
(652)
(5.0)
Commercial and other loans
12,281
75.7
State & political subdivision loans
(2,113)
(5.7)
Total loans
$ 33,140
10.4
 
 
 Page 9    
 
 
Although loan demand has slowed compared to the refinancing boom we have experienced the last several years, we expect to continue to generate additional loan volume through the expanding of existing relationships, especially from the new recently acquired relationships and the hiring of a new commercial lender in our east region.
 
Consistent with the past several years, our focus on commercial lending continues to expand with the establishment of a core group of commercial lenders to handle a higher volume of small business loans. As can be seen from the table above, the majority of the loans acquired from the Acquisition are commercial in nature. This reemphasizes our focus on the small business customer base.

ALLOWANCE FOR LOAN LOSSES
 
As shown in the following table (dollars in thousands), the Allowance for Loan Losses as a percentage of loans was 1.18% and 1.14%, at June 30, 2004 and December 31, 2003, respectively. The dollar amount of the reserve increased $509,000, since year-end 2003. The increase is a result of a valuation allowance of $290,000 being recorded and added to goodwill as a result of the Acquisition during the first six months, less net recoveries. Gross charge-offs for the first six months of 2004 were $91,000, while recoveries were $310,000, of which $299,000 was related to one borrower. This loan was previously charged-off in the third quarter of 2003.

 
June 30,
December 31,
2004
2003
2002
2001
2000
Balance, at beginning of period
$ 3,620
$ 3,621
$ 3,250
$ 2,777
$ 2,270
Provision charged to income
-
435
435
445
610
Valuation allowance related to the Acquisition
290
-
-
-
-
Recoveries on loans previously
 
 
 
 
 
charged against the allowance
310
116
115
175
55
 
4,220
4,172
3,800
3,397
2,935
Loans charged against the allowance
(91)
(552)
(179)
(147)
(158)
Balance, at end of year
$ 4,129
$ 3,620
$ 3,621
$ 3,250
$ 2,777
 
 
 
 
 
 
Allowance for loan losses as a percent
 
 
 
 
 
of total loans
1.18%
1.14%
1.21%
1.20%
1.06%
Allowance for loan losses as a percent
 
 
 
 
 
of non-performing loans
161.73%
134.62%
119.94%
149.56%
382.51%
 
The adequacy of the allowance for loan losses is subject to a formal analysis by management of the Company. Management deems the allowance to be adequate to absorb inherent losses probable in the portfolio, as of June 30, 2004. The Company has disclosed in its annual report on Form 10-K the process and methodology supporting the loan loss provision.

BANK OWNED LIFE INSURANCE
 
During the second quarter of 2003 the Company elected to purchase $7,000,000 of bank owned life insurance to offset future employee benefit costs. The use of life insurance policies will provide the bank with an asset that will generate earnings to partially offset the current costs of benefits, and eventually (at the death of the insureds) provide partial recovery of cash outflows associated with the benefits.

DEPOSITS
 
Traditional deposits continue to be the most significant source of funds for the Company. As shown in the following tables (dollars in thousands), deposits increased $29,220,000 or 7.6%, since December 31, 2003, again, primarily the result of the Acquisition. As of June 30, 2004, non-interest-bearing deposits increased by $337,000, while NOW, savings and certificates of deposits increased by $7,177,000, $4,988,000 and $13,537,000, respectively.
 
June 30,
December 31,
 
2004
2003
 
Amount
%
Amount
%
Non-interest-bearing deposits
$ 47,157
11.4
$ 46,820
12.1
NOW accounts
64,278
15.5
57,101
14.8
Savings deposits
42,617
10.3
37,629
9.8
Money market deposit accounts
45,763
11.0
42,582
11.0
Certificates of deposit
215,096
51.8
201,559
52.3
Total
$ 414,911
100.0
$ 385,691
100.0

 
 Page 10    
 
 
 
June 30, 2004/
 
December 31, 2003
 
Change
 
Amount
%
Non-interest-bearing deposits
$ 337
0.7
NOW accounts
7,177
12.6
Savings deposits
4,988
13.3
Money market deposit accounts
3,181
7.5
Certificates of deposit
13,537
6.7
Total
$ 29,220
7.6
BORROWED FUNDS

Borrowed funds increased $2,017,000 during the first six months of 2004. The increase occurred primarily within our repurchase agreements with customers as a result of daily activity. The Company's daily cash requirements or short-term investments are met by using the financial instruments available through the Federal Home Loan Bank.
 
In September 2003, the Company borrowed $1.1 million from its line of credit with an unrelated financial institution to buy back 41,800 shares of treasury stock from an estate. This line is expected to be paid off in August 2004, as monthly principal payments have been made since December 2003.
 
NOTES PAYABLE
 
In December 2003, the Company formed a special purpose entity; Citizens Financial Statutory Trust I (“the Entity”), to issue $7,500,000 of floating rate obligated mandatory redeemable securities as part of a pooled offering. The rate is determined quarterly and floats based on the 3 month LIBOR plus 2.80%. At June 30, 2004, the rate was 4.36%. The Entity may redeem them, in whole or in part, at face value after December 17, 2008. The Company borrowed the proceeds of the issuance from the Entity in December 2003 in the form of a $7,500,000 note payable, which is included in the liabilities section of the Company’s balance sheet. Debt issue costs of $75,000 have been capitalized and are being amortized through the first call date.
 
Under current accounting rules, the Company’s minority interest in the Entity was recorded at the initial investment amount and is included in the other assets section of the balance sheet. The Entity is not consolidated as part of the Company’s consolidated financial statements.

STOCKHOLDERS’ EQUITY
 
We evaluate stockholders’ equity in relation to total assets and the risk associated with those assets. The greater the capital resources, the more likely a corporation is able to meet its cash obligations and absorb unforeseen losses. For these reasons, capital adequacy has been, and will continue to be, of paramount importance.
 
Total Stockholders’ Equity was $38,508,000, at June 30, 2004 compared to $38,529,000, at December 31, 2003, a decrease of $21,000 or .05%. In the first six months, the Company earned $2,961,000 and declared dividends of $1,083,000, a dividend payout ratio of 36.6% of net income.
 
All of the Company’s investment securities are classified as available-for-sale making this portion of the Company’s balance sheet more sensitive to the changing market value of investments. Accumulated other comprehensive income decreased $1,892,000 compared to December 31, 2003 as result of interest rate movements.

The Company has also complied with standards of well capitalized mandated by the banking regulators. The Company’s primary regulators have established “risk-based” capital requirements designed to measure capital adequacy. Risk-based capital ratios reflect the relative risks associated with various assets entities hold in their portfolios. A weight category of 0% (lowest risk assets), 20%, 50%, or 100% (highest risk assets), is assigned to each asset on the balance sheet. The Company’s computed risk-based capital ratios are as follows (dollars in thousands):

 
 Page 11    
 
 
 
June 30,
December 31,
2004
2003
Total capital (to risk-weighted assets)
Amount
 
Ratio
Amount
 
Ratio
Company
$ 40,341
 
12.68%
$ 40,655
 
14.07%
For capital adequacy purposes
25,459
 
8.00%
23,115
 
8.00%
To be well capitalized
31,824
 
10.00%
28,894
 
10.00%
 
 
 
 
 
 
 
Tier I capital (to risk-weighted assets)
 
 
 
 
 
 
Company
$ 36,356
 
11.42%
$ 37,042
 
12.82%
For capital adequacy purposes
12,730
 
4.00%
11,557
 
4.00%
To be well capitalized
19,094
 
6.00%
17,336
 
6.00%
 
 
 
 
 
 
 
Tier I capital (to average assets)
 
 
 
 
 
 
Company
$ 36,356
 
7.81%
$ 37,042
 
8.50%
For capital adequacy purposes
18,625
 
4.00%
17,437
 
4.00%
To be well capitalized
23,281
 
5.00%
21,796
 
5.00%
 
On April 4, 2001, our Company filed a Registration Statement on Form S-3 establishing a Dividend Re-Investment Plan (DRIP), which was effective for the second quarter dividend in 2001. As of June 30, 2004 we have 412 shareholders participating in the plan, representing 335,388 shares and the total number of shares purchased since the inception of the plan is 20,522.
OFF BALANCE SHEET ACTIVITIES
 
Some financial instruments, such as loan commitments, credit lines, letters of credit and overdraft protection, are issued to meet customer financing needs. The contractual amount of financial instruments with off-balance sheet risk was as follows at June 30, 2004:


Commitments to extend credit
 
$ 46,613
Standby letters of credit
 
1,440
 
 
 
 
$ 48,053


RESULTS OF OPERATIONS

OVERVIEW OF THE INCOME STATEMENT

The Company had net income of $1,468,000 and $2,961,000 for the second quarter and first six months of 2004, respectively. Earnings per share, for the respective periods were $0.52 and $1.05. Net income was $1,382,000 and $2,746,000 for the second quarter and first six months of 2003, which equates to earnings per share of $0.48 and $0.96, respectively. The annualized return on average assets and the return on average equity, for the first six months of 2004, were 1.26% and 15.41%, respectively. Details of the reasons for this change are discussed on the following pages.


NET INTEREST INCOME
 
Net interest income, the most significant component of earnings, is the amount by which interest generated from earning assets exceeds interest expense on interest-bearing liabilities.
 
Net interest income, after provision for loan losses, totaled $4,222,000 in the second quarter, an increase of $205,000 or 5.1%, over the second quarter of 2003 and totaled $8,437,000 for the six months of 2004, an increase of $348,000 or 4.3% over the prior year. The Bank experienced an increase in earning assets in the past six months of 7.2%, which came primarily from the fore mention Acquisition and our continued efforts to grow our existing offices.

 The following table sets forth the average balances of, and the interest earned or incurred on, each principal category of assets, liabilities and stockholders’ equity, the related rates, net interest income and rate “spread” created:


 
 
 
 
 
 
 
 
 
 
 
June 30, 2004
 
June 30, 2003
 
June 30, 2002
 
 
Average
 
Average
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
(dollars in thousands)
$
$
%
$
$
%
$
$
%
ASSETS
 
 
 
 
 
 
 
 
 
Short-term investments:
 
 
 
 
 
 
 
 
 
Interest-bearing deposits at banks
1,747
8
0.92
3,924
21
1.08
4,066
31
1.54
Total short-term investments
1,747
8
0.92
3,924
21
1.08
4,066
31
1.54
Investment securities:
 
 
 
 
 
 
 
 
 
Taxable
99,226
1,911
3.85
86,170
1,972
4.58
91,869
2,746
5.98
Tax-exempt (3)
6,590
223
6.77
11,529
390
6.77
15,490
533
6.88
Total investment securities
105,816
2,134
4.03
97,699
2,362
4.84
107,359
3,279
6.11
Loans:
 
 
 
 
 
 
 
 
 
Residential mortgage loans
188,482
6,569
7.03
179,430
6,551
7.36
168,340
6,564
7.86
Commercial & farm loans
85,944
2,920
6.85
75,295
2,883
7.72
70,836
2,794
7.95
Loans to state & political subdivisions
36,858
1,129
6.18
33,032
1,044
6.37
25,719
891
6.99
Other loans
12,343
553
9.03
12,926
586
9.14
13,625
655
9.69
Loans, net of discount (2)(3)(4)
323,627
11,171
6.96
300,683
11,064
7.42
278,520
10,904
7.89
Total interest-earning assets
431,190
13,313
6.23
402,306
13,447
6.74
389,945
14,214
7.35
Cash and due from banks
8,478
 
 
9,183
 
 
9,246
 
 
Bank premises and equipment
10,518
 
 
11,122
 
 
11,764
 
 
Other assets
18,252
 
 
9,394
 
 
10,665
 
 
Total non-interest earning assets
37,248
 
 
29,699
 
 
31,675
 
 
Total assets
468,438
 
 
432,005
 
 
421,620
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
 
 
 
 
 
Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
NOW accounts
60,265
102
0.34
53,291
118
0.45
50,916
149
0.59
Savings accounts
38,325
54
0.28
35,421
71
0.40
34,048
88
0.52
Money market accounts
44,189
206
0.94
47,249
282
1.20
48,971
414
1.70
Certificates of deposit
205,251
3,594
3.53
204,475
3,958
3.90
200,164
4,513
4.55
Total interest-bearing deposits
348,030
3,956
2.29
340,436
4,429
2.62
334,099
5,164
3.12
Other borrowed funds
33,469
430
2.59
12,252
149
2.45
13,478
191
2.86
Total interest-bearing liabilities
381,499
4,386
2.32
352,688
4,578
2.62
347,577
5,355
3.11
Demand deposits
43,874
 
 
39,081
 
 
37,208
 
 
Other liabilities
4,648
 
 
3,707
 
 
3,732
 
 
Total non-interest-bearing liabilities
48,522
 
 
42,788
 
 
40,940
 
 
Stockholders' equity
38,417
 
 
36,529
 
 
33,103
 
 
Total liabilities & stockholders' equity
468,438
 
 
432,005
 
 
421,620
 
 
Net interest income
 
8,927
 
 
8,869
 
 
8,859
 
Net interest spread (5)
 
 
3.91%
 
 
4.12%
 
 
4.24%
Net interest income as a percentage
 
 
 
 
 
 
 
 
 
of average interest-earning assets
 
 
4.17%
 
 
4.45%
 
 
4.58%
Ratio of interest-earning assets
 
 
 
 
 
 
 
 
 
to interest-bearing liabilities
 
 
1.13
 
 
1.14
 
 
1.12
 
 
 
 
 
 
 
 
 
 
(1) Averages are based on daily averages.
 
 
 
 
 
 
 
 
 
(2) Includes loan origination and commitment fees.
 
 
 
 
 
 
 
 
 
(3) Tax exempt interest revenue is shown on a tax equivalent basis for proper comparison using
 
 
 
 
 
 
 
 
 
a statutory federal income tax rate of 34%.
 
 
 
 
 
 
 
 
 
(4) Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets.
 
 
 
 
 
 
 
 
 
(5) Interest rate spread represents the difference between the average rate earned on interest-earning assets
 
 
 
 
 
 
 
 
 
and the average rate paid on interest-bearing liabilities.
 
 
 
 
 
 
 
 
 
 
We continued to experience an attractive interest margin percentage during the first six months of 2004; however our margin is continuing to narrow as compared to the same time period in 2003 and 2002. Currently, the yield curve is extremely steep beyond 3 months. Most of the Company's investments, loans, deposits and borrowings are priced or re-priced along the three month to five-year portion of the yield curve and a more normal yield curve should enable us to maintain our current favorable net interest margin. We continue to review various pricing and investment strategies to enhance deposit growth while maintaining or expanding the current interest margin.
 
 Page 13    
 
 
The following table shows the effect of changes in volume and rate on interest income and expense. Tax-exempt interest revenue is shown on a tax-equivalent basis for proper comparison using a statutory federal income tax rate of 34%, for the six month period ended June 30 (dollars in thousands):

 
2004 vs. 2003 (1)
2003 vs. 2002 (1)
 
Change in
Change
Total
Change in
Change
Total
 
Volume
in Rate
Change
Volume
in Rate
Change
Interest Income:
 
 
 
 
 
 
Short-term investments:
 
 
 
 
 
 
Interest-bearing deposits at banks
$ (9)
$ (4)
$ (13)
$ (1)
$ (9)
$ (10)
Investment securities:
 
 
 
 
 
 
Taxable
276
(337)
(61)
(185)
(589)
(774)
Tax-exempt
(167)
-
(167)
(134)
(9)
(143)
Total investments
109
(337)
(228)
(319)
(598)
(917)
Loans:
 
 
 
 
 
 
Residential mortgage loans
323
(305)
18
419
(432)
(13)
Commercial & farm loans
382
(345)
37
172
(83)
89
Loans to state & political subdivisions
118
(33)
85
237
(84)
153
Other loans
(26)
(7)
(33)
(53)
(16)
(69)
Total loans, net of discount
797
(690)
107
775
(615)
160
Total Interest Income
897
(1,031)
(134)
455
(1,222)
(767)
Interest Expense:
 
 
 
 
 
 
Interest-bearing deposits:
 
 
 
 
 
 
NOW accounts
14
(30)
(16)
6
(37)
(31)
Savings accounts
5
(22)
(17)
4
(21)
(17)
Money Market accounts
(20)
(56)
(76)
(16)
(116)
(132)
Certificates of deposit
16
(380)
(364)
96
(650)
(554)
Total interest-bearing deposits
14
(488)
(473)
90
(824)
(734)
Other borrowed funds
273
8
281
(22)
(20)
(42)
Total interest expense
288
(480)
(192)
68
(844)
(776)
Net interest income
$ 609
$ (551)
$ 58
$ 387
$ (378)
$ 9
 
 
 
 
 
 
 
(1) The portion of the total change attributable to both volume and rate changes during the year has been allocated
 
to volume and rate components based upon the absolute dollar amount of the change in each component prior to allocation.
 
As can be seen from the preceding tables, tax equivalent net interest income rose from $8,859,000, in 2002, to $8,869,000, in 2003, and increased to $8,927,000 through June 2004. In the period ending June 30, 2004, net interest income increased $58,000, while overall spread decreased from 4.12% to 3.91%. The increased volume of interest-earning assets generated an increase in interest income of $897,000 while increased volume of interest-bearing liabilities produced $287,000 of interest expense. The change in volume resulted in an increase of $609,000 in net interest income. The net change in rate resulted in a negative $551,000. Combining the increase due to volume and the decrease due to rate, net interest income increased $58,000 in 2004 compared to 2003. The yield on interest-earning assets decreased 51 basis points from 6.74% to 6.23% and the average interest rate on interest-bearing liabilities decreased 30 basis points, from 2.62% to 2.32%, because of the previously described changes to the yield curve.

 
 Page 14    
 
 
PROVISION FOR LOAN LOSSES

For the three month and six month period ended June 30, 2004 we did not provide any provision as a result of our quarterly review of the allowance for loan losses being adequately reserved, compared to $120,000 and $255,000, for the same periods in 2003.

This provision was appropriate given management's quarterly review of the allowance for loan losses that are based on the following information: migration analysis of delinquent and non-accrual loans, estimated future losses on loans, recent review of large problem credits, local and national economic conditions, historical loss experience, OCC qualitative adjustments and peer comparisons.

NON-INTEREST INCOME
 
Non-interest income, as detailed below, decreased $35,000 or 2.5% and increased $6,000 or .2% in the second quarter and the first six months of 2004, respectively, when compared to the same periods in 2003. Service charge income continues to be the primary source of non-interest income. For the first six months, account service charges totaled $1,482,000, the same as last year. Other income decreased $99,000 for the first six months of 2004, when compared to the same period in 2003. This decrease is due to $121,000 less mortgage servicing income being recognized in the first six months of 2004 as a direct result of less loans being originated for sale on the secondary market. Gains on loans sold decreased $205,000 for the first six months of 2004, when compared to the same period in 2003, also as a direct result of a decrease in recent refinancing activity.
 
The following tables shows the breakdown of non-interest income for the three months and six months ended June 30, 2004 and 2003(dollars in thousands):

 
Three months ended
 
 
 
June 30,
Change
 
2004
2003
Amount
%
Service charges
$ 751
$ 772
$ (21)
(2.7)
Trust
177
171
6
3.5
Gains on loans sold
12
130
(118)
(90.8)
Realized securities gains, net
204
140
64
45.7
Earnings on bank owned life insurance
79
2
77
N/A
Other
153
196
(43)
(21.9)
Total
$ 1,376
$ 1,411
$ (35)
(2.5)


 
Six months ended
 
 
 
June 30,
Change
 
2004
2003
Amount
%
Service charges
$ 1,482
$ 1,482
$ -
-
Trust
358
295
63
21.4
Gains on loans sold
21
226
(205)
(90.7)
Realized securities gains, net
491
400
91
22.8
Earnings on bank owned life insurance
158
2
156
7,800.0
Other
260
359
(99)
(27.6)
Total
$ 2,770
$ 2,764
$ 6
0.2
 
In an effort to take advantage of current market conditions, we elected to sell approximately $15,007,000 of investment securities in the first six months of 2004, which resulted in $491,000 of security gains.
 
We continue to evaluate means of increasing non-interest income. Our approach is to apply service charges on business transaction accounts by charging fees on transaction activity (reduced by earnings credit based on customers' balances) to more equitably recover costs. We expect to continue this analysis for our other products, along with reviewing additional revenue sources.

 
Page 15     
 
 
NON-INTEREST EXPENSES
 
Total non-interest expense, as detailed below, increased $44,000 or 1.2% during the second quarter of 2004 and $83,000 or 1.1% in the first six months of 2004 when compared to the same periods in 2003. The decrease in salaries and employee benefits is primarily the result of a decrease of $96,000 of salary expense which is the direct result of no chief executive officer (CEO) salary for the six months of 2004. This is offset by an increase in pension expense of $15,000. Management expects salary and benefits expense to increase through the remainder of 2004, as a result of the recent Acquisition and the filling of the CEO position and other retail positions. The increase in other is a direct result of merger and acquisition costs associated with the fore mentioned Acquisition.

The following tables reflect the breakdown of non-interest expense and professional fees for the three months ended June 30, 2004 and 2003(dollars in thousands):

 
Three months ended
 
 
 
June 30,
Change
 
2004
2003
Amount
%
Salaries and employee benefits
$ 1,847
$ 1,942
$ (95)
(4.9)
Occupancy
267
240
27
11.3
Furniture and equipment
165
176
(11)
(6.3)
Professional fees
158
142
16
11.3
Amortization
109
109
-
-
Other
1,129
1,022
107
10.5
Total
$ 3,675
$ 3,631
$ 44
1.2

 
Three months ended
 
 
 
June 30,
Change
2004
2003
Amount
%
Other professional fees
$ 86
$ 101
$ (15)
(14.9)
Legal fees
34
17
17
100.0
Examinations and audits
38
24
14
58.3
Total
$ 158
$ 142
$ 16
11.3

 The following tables reflect the breakdown of other operating expense and professional fees for the six months ended June 30, 2004 and 2003(dollars in thousands):

 
Six months ended
 
 
 
June 30,
Change
 
2004
2003
Amount
%
Salaries and employee benefits
$ 3,772
$ 3,836
$ (64)
(1.7)
Occupancy
553
518
35
6.8
Furniture and equipment
335
354
(19)
(5.4)
Professional fees
312
304
8
2.6
Amortization
217
217
-
-
Other
2,155
2,032
123
6.1
Total
$ 7,344
$ 7,261
$ 83
1.1


 
Six months ended
 
 
 
June 30,
Change
2004
2003
Amount
%
Other professional fees
$ 189
$ 214
$ (25)
(11.7)
Legal fees
50
40
10
25.0
Examinations and audits
73
50
23
46.0
Total
$ 312
$ 304
$ 8
2.6

 
 Page 16    
 
 
PROVISION FOR INCOME TAXES
 
The provision for income taxes was $455,000 for the second quarter of 2004 compared to $415,000 in the second quarter of 2003. For the six-month period comparisons, the provision for income taxes was $902,000 in 2004 and $846,000 in 2003. The increase was primarily a result of increased levels of taxable income.
 
We have entered into two limited partnership agreements to establish low-income housing projects in our market area. As a result of these agreements for tax purposes, we have recognized $343,000 out of a total $911,000 of tax credits from one project and $96,000 out of a total $385,000 on the second project. A total of approximately $1,290,000 of tax credits is anticipated over a ten-year period.

LIQUIDITY
 
Liquidity is a measure of our Company's ability to efficiently meet normal cash flow requirements of both borrowers and depositors. To maintain proper liquidity, we use funds management policies along with our investment policies to assure we can meet our financial obligations to depositors, credit customers and stockholders. Liquidity is needed to meet depositors' withdrawal demands, extend credit to meet borrowers' needs, provide funds for normal operating expenses and cash dividends, and fund other capital expenditures.
 
Our Company's historical activity in this area can be seen in the Consolidated Statement of Cash Flows from investing and financing activities.
 
Cash generated by operating activities, investing activities and financing activities influences liquidity management. The most important source of funds is the deposits that are primarily core deposits (deposits from customers with other relationships). Short-term debt from the Federal Home Loan Bank supplements our Company's availability of funds. Another source of short-term liquidity is the sale of loans if needed.
 
Our Company's use of funds is shown in the investing activity section of the Consolidated Statement of Cash Flows, where the net loan activity is presented. Other significant uses of funds include capital expenditures. Surplus funds are then invested in investment securities.
 
Capital expenditures during the first six months of 2004 were $190,000, $143,000 less than the same period in 2003.
 
Our Company achieves additional liquidity primarily from temporary or short-term investments in the Federal Home Loan Bank of Pittsburgh, PA, and investments that mature in less than one year. The Company also has a maximum borrowing capacity at the Federal Home Loan Bank of approximately $189 million as an additional source of liquidity.

Apart from those matters described above, management does not currently believe that there are any current trends, events or uncertainties that would have a material impact on capital.

CREDIT QUALITY RISK
 
The following table identifies amounts of loan losses and non-performing loans. Past due loans are those that were contractually past due 90 days or more as to interest or principal payments (dollars in thousands):

 
June 30,
December 31,
 
2004
2003
2002
2001
2000
Non-performing loans:
 
 
 
 
 
Non-accruing loans
$ 476
$ 578
$ 1,064
$ 985
$ 488
Impaired loans
961
1,926
1,916
1,077
199
Accrual loans - 90 days or
 
 
 
 
 
more past due
1,116
185
39
111
39
Total non-performing loans
2,553
2,689
3,019
2,173
726
Foreclosed assets held for sale
746
305
221
408
508
Total non-performing assets
$ 3,299
$ 2,994
$ 3,240
$ 2,581
$ 1,234
Non-performing loans as a percent of loans
 
 
 
 
 
net of unearned income
0.73%
0.85%
1.01%
0.80%
0.28%
Non-performing assets as a percent of loans
 
 
 
 
 
net of unearned income
0.94%
0.94%
1.09%
0.95%
0.47%
 
 Page 17    
 
 
Interest does not accrue on non-accrual loans. Subsequent cash payments received are applied to the outstanding principal balance or recorded as interest income, depending upon management's assessment of its ultimate ability to collect principal and interest.
 
Loans 90 days past due increased $931,000 from June 30, 2003 to June 30, 2004. This is predominately due to a $725,000 relationship that was not put on non-accrual due to the subsequent refinancing with another bank.

INTEREST RATE AND MARKET RISK MANAGEMENT

The objective of interest rate sensitivity management is to maintain an appropriate balance between the stable growth of income and the risks associated with maximizing income through interest sensitivity imbalances and the market value risk of assets and liabilities.

Because of the nature of our operations, we are not subject to foreign currency exchange or commodity price risk and, since our Company has no trading portfolio, it is not subject to trading risk.

Currently, our Company has equity securities that represent only 3.8% of our investment portfolio and, therefore, equity risk is not significant.

The primary components of interest-sensitive assets include adjustable-rate loans and investments, loan repayments, investment maturities and money market investments. The primary components of interest-sensitive liabilities include maturing certificates of deposit, IRA certificates of deposit and short-term borrowings. Savings deposits, NOW accounts and money market investor accounts are considered core deposits and are not short-term interest sensitive (except for the top-tier money market investor accounts which are paid current market interest rates).
Gap analysis, one of the methods used by us to analyze interest rate risk, does not necessarily show the precise impact of specific interest rate movements on our Company's net interest income because the re-pricing of certain assets and liabilities is discretionary and is subject to competitive and other pressures. In addition, assets and liabilities within the same period may, in fact, be repaid at different times and at different rate levels. We have not experienced the kind of earnings volatility that might be indicated from gap analysis.

Our Company currently uses a computer simulation model to better measure the impact of interest rate changes on net interest income. We use the model as part of our risk management process that will effectively identify, measure, and monitor our Company's risk exposure.

We use numerous interest rate simulations employing a variety of assumptions to evaluate our interest rate risk exposure. A shock analysis during the first quarter of 2004 indicated that a 200 basis point movement in interest rates in either direction would have a minor impact on our Company's anticipated net interest income over the next twenty-four months.

FUTURE OUTLOOK

With interest rates at historically low levels, the Company is beginning to experience pressure on earnings resulting from a lower net interest margin percentage when compared to 2003. Without the impact of the recent Acquisition, net interest income could have shown little or no growth in the remainder of 2004 if interest rates remained at present levels or moved lower. However short-term rates have moved higher as a result of the Federal Reserve (Fed) meeting in June when the Fed moved the fed funds rate up 25 basis points, thus creating a flatter yield curve. A flatter yield curve will continue to put additional pressure on our current net interest margin. Management continues to focus on growth by increasing market share utilizing deposit acquisition strategies to gain additional business from existing customers along with mortgage lending as core banking services aug mented by the sale of other income producing products and services. The Bank is focused on providing an array of financial products including fixed annuities and brokerage services to generate additional non-interest income over the remainder of the year. Management also continues to focus on loan growth with the generation of commercial loans throughout its market. It is anticipated that the recently hired commercial lender in our east region will produce additional growth.
 
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Management expects loan growth (excluding the Acquisition) for the year to be between 5 and 8 percent. The Company’s loan to deposit ratio has increased through the first six months to 84.55% compared to 82.36% at year-end 2003 as deposit growth has been good during the first six months and is expected to remain favorable throughout 2004. Overall, deposits are expected to grow approximately 6% for the year.
 
Enhancing non-interest income and controlling non-interest expense are important factors in the success of the company and is measured in the financial services industry by the efficiency ratio, calculated according to the following: non-interest expense (less amortization of intangibles) as a percentage of fully tax equivalent net interest income and non-interest income (less non-recurring income). For the six months ended June 30, 2004, the Bank’s efficiency ratio was 61.82% compared to 61.84% for the same period last year.
 
Management concentrates on return on average equity and earnings per share evaluations, plus other methods, to measure and direct the performance of the Company. While past results are not an indication of future earnings, management feels the Company is positioned to enhance performance of normal operations through the remainder of 2004.

GENERAL
 
The majority of assets and liabilities of a financial institution are monetary in nature and, therefore, differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation does have an important impact on the growth of total assets and on non-interest expenses, which tend to rise during periods of general inflation. The recent action by the Federal Reserve of increasing short-term interest rates will help ensure that the level of inflation remains at a relatively low level.
 
Various congressional bills have been passed and other proposals have been made for significant changes to the banking system, including provisions for: limitation on deposit insurance coverage; changing the timing and methods financial institutions use to pay for deposit insurance; and tightening the regulation of bank derivatives' activities.
 
Aside from those matters described above, we do not believe that there are any trends, events or uncertainties, which would have a materially adverse impact on future operating results, liquidity or capital resources. We are not aware of any current recommendations by the regulatory authorities (except as described herein) which, if they were to be implemented, would have such an effect, although the general cost of compliance with numerous and multiple federal and state laws and regulations does have, and in the future may have, a negative impact on our Company's results of operations.
 
 
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Item 3-Quantitative and Qualitative Disclosure About Market Risk

In the normal course of conducting business activities, the Company is exposed to market risk, principally interest rate risk, through the operations of its banking subsidiary. Interest rate risk arises from market driven fluctuations in interest rates that affect cash flows, income, expense and values of financial instruments and was discussed previously in this Form 10-Q. Management and a committee of the board of directors manage interest rate risk.

No material changes in market risk strategy occurred during the current period. A detailed discussion of market risk is provided in the SEC Form 10-K for the period ended December 31, 2003.

Item 4-Control and Procedures

We maintain a system of controls and procedures designed to provide reasonable assurance as to the reliability of the financial statements and other disclosures included in this report, as well as to safeguard assets from unauthorized use or disposition. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, within 90 days prior to the filing date of this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in our periodic Securities and Exchange Commission filings. No significant changes were made to our internal controls or other factors that could significantly affect these controls subsequent to the date of their evaluation.
 
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PART II - OTHER INFORMATION AND SIGNATURES

Item 1 - Legal Proceedings

Management is not aware of any litigation that would have a materially adverse effect on the consolidated financial position of the Company. Any pending proceedings are ordinary, routine litigation incidental to the business of the Company and its subsidiary. In addition, no material proceedings are pending or are known to be threatened or contemplated against the Company and its subsidiary by government authorities.
 
Item 2 - Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities


ISSUER PURCHASES OF EQUITY SECURITIES
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Period
 
Total Number of Shares (or units Purchased)
 
Average Price Paid per Share (or Unit)
 
Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans of Programs
 
Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs
 
 
 
 
 
 
 
 
 
4/1/04 to 4/30/04
 
-
 
-
 
 
 
 
5/1/04 to 5/31/04
 
-
 
-
 
 
 
 
6/1/04 to 6/30/04
 
300
 
$ 22.95
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
On June 14, 2004, the Company purchased 300 shares of stock in the open market.
 
 


Item 3 - Defaults Upon Senior Securities – Not applicable

Item 4 - Submission of Matters to a Vote of Security Holders

Citizens Financial Services held its Annual Meeting of Shareholders on April 20, 2004, for the purpose of electing three directors and to transact such other business as would properly come before the meeting. Results of shareholder voting on these individuals were as follows:

1.Election of Class 3 Directors whose term will expire in 2007

   For Withhold Authority 
 John E. Novak  2,281,654  56,075
 Rudolph J. van der Hiel  2,281,419  56,309
 Mark L. Dalton      2,278,619  59,109

   
The total shares voted at the annual meeting were 2,337,729.

Item 5 - Other Information – None
 
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Item 6 -Exhibits and Reports on Form 8-K.

  (a)  Exhibits.  
   (3)(i) -  Articles of Incorporation of the Corporation, as amended. (Incorporated by Reference to Exhibit (3)(ii) to the Quarterly Report of Form 10-Q for the period ended December 31, 1999, as filed with the Commission on May 11,2000.)
   (3)(ii)-  By-laws of the Corporation, as amended. (Incorporated by Reference to Exhibit (3)(ii) to the Annual Report of Form 10-K for the fiscal year ended December 31, 2003, as filed with the Commission on April 29, 2004.)
 
   (4) -  Instruments Defining the Rights of Stockholders. (Incorporated by reference to the Registrant's Registration Statement No.2-89103 on Form S-14, as filed with the Commission on February 17, 1984.)
   (10) -  Material Contracts. Consulting and Non-Compete Agreement with Richard E. Wilber, Former Executive Officer of our company. (Incorporated by Reference to Exhibit (10) to the Annual Report of Form 10-K for the fiscal year ended December 31, 2003, as filed with the Commission on March 18, 2004.)
   (31.1) -  302 Certification of Principal Executive Officer
   (32.1) -  Certification of Principal Executive Officer
   (99.1) -  Independent accountant's review of financial statements for the period ended June 30, 2004.
 (b)  Reports on Form 8-K –  Earnings release entitled “Citizens Financial Services, Inc. Reports Second Quarter earnings Increased By 6.2% Over One Year Ago” filed July 19, 2004.

 
 
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Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the undersigned Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

     
 

Citizens Financial Services, Inc. (Registrant)

 
 		  
 		  
 
August 4, 2004 By:   /s/ Randall E. Black 
 
Randall E. Black
  President (Principal Executive Officer)

 

 
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