PENNROCK FINANCIAL SERVICES CORP - 10-Q Quarterly Report

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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

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FORM 10-Q

QUARTERLY REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For Quarter Ended March 31, 2004 Commission File Number 0-15040
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PennRock Financial Services Corp.
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(Exact name of registrant as specified in its charter)

Pennsylvania 23-2400021
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

1060 Main St.
Blue Ball, Pennsylvania 17506
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(Address of principal executive offices) (Zip code)

(717) 354-4541
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Registrant's telephone number, including area code

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

Yes /X/ No / /

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes /X/ No / /

The number of shares outstanding of the registrant's common stock, $2.50 par
value, at the close of business on April 28, 2004 was 7,659,713.

PENNROCK FINANCIAL SERVICES CORP.
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FORM 10-Q
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For the Quarter Ended March 31, 2004

Contents
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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Consolidated Balance Sheets - March 31, 2004 and December 31, 2003.

Consolidated Statements of Income - Three months ended March 31, 2004
and 2003.

Consolidated Statements of Comprehensive Income - Three months ended
March 31, 2004 and 2003.

Condensed Consolidated Statements of Cash Flows - Three months ended
March 31, 2004 and 2003.

Condensed Notes to Consolidated Financial Statements - March 31, 2004.

Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Item 4. Controls and Procedures

PART II. OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K

SIGNATURES

CERTIFICATIONS

PART I. FINANCIAL INFORMATION

For the Quarter Ended March 31, 2004

Item 1. Financial Statements

PENNROCK FINANCIAL SERVICES CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

See accompanying condensed notes to consolidated financial statements.

PENNROCK FINANCIAL SERVICES CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

See accompanying condensed notes to consolidated financial statements.

PENNROCK FINANCIAL SERVICES CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

See accompanying condensed notes to consolidated financial statements.

PENNROCK FINANCIAL SERVICES CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

See accompanying condensed notes to consolidated financial statements.

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
March 31, 2004

NOTE 1. BASIS OF PRESENTATION

The accompanying consolidated financial statements include the accounts of
PennRock Financial Services Corp. and its subsidiaries. All material
intercompany balances and transactions have been eliminated in consolidation.

The information contained in the financial statements is unaudited. In the
opinion of management, all adjustments (consisting of normal recurring
accruals) considered necessary for a fair presentation of the results of
interim periods have been made. These unaudited interim statements are
presented in accordance with the reqirements of Form 10-Q, accordingly,
they do not include all of the information and footnotes required by
accounting principles generally accepted in the United States of America
Operating results for the three months ended March 31, 2004 are not
necessarily indicative of the results that may be expected for the year
ended December 31, 2004. These condensed notes should be read in
conjunction with the Consolidated Financial Statements and Notes thereto
included in PennRock's Annual Report on Form 10-K for the year ended
December 31, 2003.

Earnings per share:

Basic earnings per share is calculated by dividing net income by the
weighted-average number of common shares outstanding during the period.
Diluted earnings per share is calculated by dividing net income by the
weighted-average number of shares outstanding during the period plus
additional common shares that would have been outstanding if dilutive
potential common shares had been issued. Potential common shares that may
be issued consist of outstanding stock options and are determined by using
the treasury stock method.

NOTE 2. BUSINESS

PennRock is a bank holding company incorporated in 1986 under the laws of
Pennsylvania. Blue Ball National Bank ("the Bank"), The National Advisory
Group, Inc. ("National"), Pension Consulting Services, Inc. ("PCS") and 1906
Founders, Inc. are wholly owned subsidiaries of PennRock. The Bank provides
a broad range of banking, trust and other financial services to consumers,
small businesses and corporations in south-central and southeastern
Pennsylvania. PennRock Insurance Group, Inc., a wholly owned subsidiary of
the Bank, began operations in the first quarter of 1999 to offer and sell
annuity and other insurance products. National, established in 1984, is the
parent company of four corporations: National Actuarial Consultants, Ltd.
which provides consulting, actuarial and administrative services to
retirement and employee benefit plans; National Financial Advisors, Inc.
which offers investment, advisory and asset management services to retirement
plan sponsors and participants. 1906 Founders, Inc. owns and manages certain
investment securities.

On April 1, 2004, the net assets of National and each of its subsidiaries and
the net assets of PCS as well as all operations of these companies were
transferred to PennRock Financial Advisors, N.A. ("PFA"), a limited purpose
bank formed as a subsidiary of Blue Ball National Bank. At the same time,
the operations of the Bank's Financial Services Division, including trust
operations, were transferred to PFA. All employees of National and PCS
became employees of the Bank and will be contracted to PFA. The purpose of
the reorganization is to promote operating efficiencies and the cross-selling
of services among the various corporations.

NOTE 3. COMMITMENTS AND CONTINGENT LIABILITIES

The financial statements do not reflect various commitments and contingent
liabilities, such as commitments to extend credit, letters of credit,
guarantees, and liability for assets held in Trust, which arise in the normal
course of business. Commitments under outstanding letters of credit amounted
to $50.2 million and commitments to extend credit totaled $141.0 million at
March 31, 2004. Management does not anticipate any significant loss as a
result of these transactions.

NOTE 4. STOCK-BASED EMPLOYEE COMPENSATION

In December 2002, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and
Disclosure - an Amendment of FASB Statement No. 123." This statement amends
SFAS No. 123, "Accounting for Stock-Based Compensation," to provide
alternative methods of transition for a voluntary change from the intrinsic
value method to the fair value method of accounting for stock-based employee
compensation. In addition, this statement amends the disclosure requirements
of SFAS No. 123 to require prominent disclosures in both annual and interim
financial statements about the method of accounting for stock-based employee
compensation and the effect of the method used on reported results.

Pro forma information regarding net income and earnings per share has been
determined as if we had accounted for all stock-based compensation under the
fair value method of SFAS 123. There were no options granted in the first
quarters of 2004 or 2003.

Three Months Ended
(Amounts in thousands except March 31,
per share data) --------------------
2004 2003
-------- --------

Net income as reported $4,119 $3,596
Deduct: Total stock-based employee
compensation expense determined
under fair value method for all
awards, net of tax effect (49) (55)
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Pro-forma net income $4,070 $3,541
======= =======
Earnings per share:
Basic - as reported $0.54 $0.47
Basic - pro-forma 0.53 0.47
Diluted - as reported 0.53 0.46
Diluted - pro-forma 0.52 0.46

NOTE 5. SECURITIES AVAILABLE FOR SALE

The amortized cost and estimated fair value of securities available for sale
are as follows:

(Amounts in thousands)

(Amounts in thousands)

The amortized cost and estimated fair value of debt securities as of March 31,
2004 by contractual maturity, are shown below. Expected maturities may differ
from contractual maturities because issuers may have the right to call or
prepay obligations with or without call or prepayment penalties.

(Amounts in thousands)

NOTE 6. PURCHASES OF EQUITY SECURITIES

On June 25, 2003, the Board of Directors authorized the repurchase of up to
300,000 of its common stock to be used for future stock dividends and splits,
employee benefit plans and other appropriate corporate purposes. The
following table shows the repurchases of common stock by PennRock during the
first quarter of 2004. All purchases made in the first quarter were part of
the publicly announced plan.

Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations

This section presents management's discussion and analysis of the financial
condition and results of operations of PennRock Financial Services Corp. and
its subsidiaries. This discussion should be read in conjunction with the
financial statements which appear elsewhere in this report.

Forward Looking Statements

In this report, we may have included certain forward looking statements
relating to such matters as anticipated financial performance, business
prospects, technological developments, new products and similar matters. The
Private Securities Litigation Reform Act of 1995 provides a safe harbor for
forward looking statements. In order to comply with the terms of the safe
harbor, we must inform you that a variety of factors could cause PennRock's
actual results and experiences to differ materially from the anticipated
results or other expectations expressed in these forward looking statements.
Our ability to predict the results or the effect of future plans and
strategies is inherently uncertain. Factors that could affect future
results include changes in market interest rates, local and national economic
trends and conditions, competition for products and services, changes in
customer preferences, legislative and regulatory changes, delinquency rates
on loans, changes in accounting principles, policies or guidelines, or the
failure of major customers, vendors or suppliers. You should consider these
factors in evaluating any forward looking statements and not place undue
reliance on such statements. We are not obligated to publicly update any
forward looking statements we may make in this report to reflect the impact
of subsequent events.

CRITICAL ACCOUNTING POLICIES

PennRock's financial position and results of operations are impacted by
management's application of accounting policies involving judgments made to
arrive at the carrying value of certain assets. In implementing its
policies, management must make estimates and assumptions about the effect of
matters that are inherently less than certain. Actual results could differ
significantly from these estimates which could materially affect the amounts
of our assets, liabilities, income and expenses. A variety of estimates
impact the carrying value of the loan portfolio, including the amount of the
allowance for loan losses, the placement of loans on non-accrual status, and
the valuation of mortgages held for sale and mortgage servicing rights. For
a more detailed discussion on critical accounting policies, see "Critical
Accounting Policies" in PennRock's Annual Report on Form 10-K for the year
ended December 31, 2003.

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Total assets of PennRock decreased $10.1 million or 0.9% since the end of
2003. Securities available for sale decreased $17.7 million and loans
declined by $2.3 million. Deposits increased $24.9 million from year end
2003 while borrowed funds decreased $40.0 million.

Net income for the quarter was $4.1 million or $.54 per share compared with
$3.6 million or $.47 per share for the first quarter of 2003, an increase of
$523,000 or 14.5%. Interest income declined by $21,000 from the first
quarter of 2003, while funding costs declined $501,000. Non-interest income
grew $725,000 from the first quarter of last year. Non-interest expenses
increased $377,000. The return on average assets was 1.49% for the first
quarter of 2004 compared with 1.46% in 2003. The return on average equity
was 16.56% this quarter and 16.44% last year.

Dividends declared for the quarter totaled $1.5 million or $.20 per share.
This represented 37.1% of net income. Dividends declared during the first
quarter of last year were $1.4 million or $.18 per share.

NET INTEREST INCOME

Net interest income is the product of the volume of average earning assets
and the average rates earned on them, less the volume of average interest
bearing liabilities and the average rates paid on them. The amount of net
interest income is affected by changes in interest rates, volumes and the mix
of earning assets and paying liabilities. For analytical purposes, net
interest income is adjusted to a taxable equivalent basis. This adjustment
allows for a more accurate comparison among taxable and tax-exempt assets by
increasing tax-exempt income by an amount equivalent to the federal income
tax which would have been paid if this income were taxable at the statutory
rate of 35%.

Table 1 presents net interest income on a fully taxable equivalent basis for
the first quarters of 2004 and 2003. For the first quarter of 2004, net
interest income on a fully taxable equivalent basis totaled $9.6 million, an
increase of $581,000 or 6.5% from $9.0 million earned for the same period of
2003.

TABLE 1 - NET INTEREST INCOME

Three Months Ended
(Amounts in thousands) March 31,
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2004 2003
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Total interest income $13,335 $13,356
Total interest expense 4,312 4,813
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Net interest income 9,023 8,543
Tax equivalent adjustment 552 451
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Net interest income
(fully taxable equivalent) $ 9,575 $ 8,994
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The amount of non-taxable interest earned determines the size of tax
equivalent adjustment necessary to convert net interest income into fully
taxable equivalent net interest income. The sources of non-taxable interest
income for PennRock are from interest earned on municipal bonds, dividends
from Fannie Mae and Federal Home Loan Mortgage Corporation ("FHLMC")
preferred stock and, to a smaller degree, from loans which qualify for tax-
exempt status. The dividends earned on Fannie Mae and FHLMC preferred stock
are 70% tax-free.

Table 2 presents the average balances, taxable equivalent interest income and
expense and rates for PennRock's assets and liabilities for the three months
ended March 31, 2004 and 2003. For the first quarter of 2004 compared with
the first quarter of 2003, interest income decreased as a result of a decline
in the yield on earning assets which decreased from 6.15% last year to
5.45%. Interest expense also decreased due a decline in the cost of funds
which decreased from 2.50% last year to 2.02% this year. Both the net
interest margin and interest rate spread decreased during the first quarter
of 2004 compared with last year. However, the yields on earning assets as
well as cost of funds seem to have stabilized over the past several months
so any additional significant margin compression is unlikely unless market
rates decline further.

TABLE 2 - AVERAGE BALANCES, RATES, AND INTEREST INCOME AND EXPENSE

Three Months Ended March 31,
(Amounts in thousands) -------------------------------------------------------
2004 2003
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Average Yield/ Average Yield
Balance Interest Rate Balance Interest Rate
---------- -------- ------- -------- -------- -------

ASSETS
Interest earning assets
Short-term investments $ 5,652 $ 17 1.21% $ 4,111 $ 16 1.58%
Mortgages held for sale 1,093 21 7.71% 8,666 140 6.55%
Securities available for sale 302,782 3,210 4.25% 294,047 3,273 4.51%
Loans:
Mortgage 413,495 6,490 6.30% 347,444 6,387 7.46%
Commercial 202,030 2,799 5.56% 168,445 2,518 6.06%
Consumer 96,027 1,350 5.64% 88,494 1,473 6.75%
---------- ------- -------- -------
Total loans 711,552 10,639 6.00% 604,363 10,378 6.98%
---------- ------- -------- -------
Total earning assets 1,021,079 13,887 5.45% 911,187 13,807 6.15%
Other assets 89,023 ------- 85,586 -------
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$1,110,102 $996,773
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LIABILITIES AND STOCKHOLDERS' EQUITY
Interest bearing deposits:
Demand $ 219,029 545 1.00% $216,050 654 1.23%
Savings 90,016 168 0.75% 82,466 203 1.00%
Time 343,003 2,090 2.44% 312,733 2,049 2.66%
---------- ------- -------- -------
Total interest bearing deposits 652,048 2,803 1.72% 611,249 2,906 1.93%
Short-term borrowings 102,307 286 1.12% 43,475 126 1.18%
Long-term debt 102,000 1,223 4.81% 127,000 1,781 5.69%
---------- ------- -------- -------
Total interest bearing liabilities 856,355 4,312 2.02% 781,724 4,813 2.50%
Non-interest bearing deposits 141,845 ------- 115,946 -------
Other liabilities 11,860 10,392
Stockholders' equity 100,042 88,711
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Total liabilities and stockholders'
equity $1,110,102 $996,773
========== ========
Net interest income $ 9,575 $ 8,994
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Interest rate spread 3.44% 3.65%
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Net interest margin 3.76% 4.00%
====== =====

NON-INTEREST INCOME

Table 3 indicates changes in the major categories of non-interest income for
the first quarters of 2004 and 2003. PennRock generates non-interest income
in connection with fees charged on deposits and other products, asset
management and trust services, retirement plan administration fees, sales of
securities through the implementation of management's asset/liability policy,
increases in the cash surrender value of bank-owned life insurance, sale and
servicing of mortgage loans, and merchant, ATM and debit card fees.

TABLE 3 - NON-INTEREST INCOME

(Amounts in thousands)

Total non-interest income increased $725,000 or 22% in the first quarter of
2004 over the first quarter of 2003. Excluding net security gains, non-
interest income increased $336,000 or 11%. The increase in security gains
reflects minor restructuring of the security portfolio in anticipation of
potentially higher interest rates later in 2004. The decrease in earnings on
the bank owned life insurance reflect a decrease in yield of the underlying
secrities.

NON-INTEREST EXPENSE

Table 4 indicates changes in the major categories of non-interest expense for
the first quarters of 2004 and 2003.

TABLE 4 - NON-INTEREST EXPENSE

(Amounts in thousands)

Total non-interest expense for the first quarter of 2004 increased $377,000
or 5% over the first quarter of 2003. Salaries and employee benefits
increased $413,000 million or 9%. The number of full-time equivalent
employees increased by 8, from 336 in March 31, 2003 to 344 at March 31,
2004. All other non-interest expenses decreased by a net $36,000 or 1% from
last year. Included in the other non-interest expense category are legal,
consulting and other professional fees, supplies, liability insurance, fees
for outsourced services and shares tax expense.

PROVISION AND ALLOWANCE FOR LOAN LOSSES

The provision for loan losses charged to earnings was $398,000 for the first
quarter of 2004 and $450,000 in 2003. Net credit losses totaled $92,000 for
the first quarter of 2004 and $304,000 for the first quarter of 2003.
Management reviews the adequacy of the allowance in light of past loan loss
experience, current market conditions, size and characteristics of the loan
portfolio, volume of non-performing and delinquent loans and other relevant
information. For a more detailed discussion of PennRock's methodology for
determining the adequacy of the allowance, see "Allowance for Loan Losses"
on page 23 of PennRock's Annual Report on Form 10-K for the year ended
December 31, 2003.

TABLE 5 - ANALYSIS OF ALLOWANCE FOR LOAN LOSSES

NON-PERFORMING ASSETS

Table 6 reflects PennRock's non-performing assets at March 31, 2004 and
December 31, 2003. PennRock's policy is to discontinue the accrual of
interest on loans for which the principal or interest is past due 90 days
or more unless the loan is well secured and corrective action has begun
or the loan is in the process of collection. When a loan is placed on
non-accrual status, any unpaid interest is charged against income. Other
real estate owned represents property acquired through foreclosure.

TABLE 6 - NON-PERFORMING ASSETS

Non-performing loans decreased by $532,000 or 33.9% from year-end 2003 as
several non-performing loans paid off late in the first quarter. The
proportion of non-performing loans relative to total loans decreased from
0.23% at year-end to 0.15% at the end of the first quarter. The coverage
ratio of the allowance for loan losses to non-performing loans increased from
551.21% at year-end to 863.80% at the end of the first quarter.
which resulted in the decline discussed . As a result of the decrease
in non-performing loans, management lowered the amount of the provision to
be charged against income in the second quarter of 2004.

LIQUIDITY

The purpose of liquidity management is to ensure that there are sufficient
cash flows available to meet a variety of needs. These include financial
commitments such as satisfying the credit needs of our borrowers and
withdrawals by our depositors, the ability to capitalize on investment and
business opportunities as they occur, and the funding of PennRock's own
operations. Liquidity is provided by maturities and sales of investment
securities, loan payments and maturities and liquidating money market
investments such as federal funds sold. Liquidity is also provided by short-
term lines of credit with various correspondents and fixed and variable rate
advances from the Federal Home Loan Bank of Pittsburgh and other
correspondent banks. However, PennRock's primary source of liquidity lies in
PennRock's ability to renew, replace and expand its base of core deposits
(consisting of demand, NOW, money market, savings, and time deposits of less
than $100,000).

Total deposits increased $24.9 million or 3.2% since year end while total
borrowed funds decreased $40.0 million. Borrowed funds represented 191% of
tier one capital at the end of the first quarter of 2004 and 234% of tier
one capital at year end 2003. Management's policy is to limit borrowed
funds to no more than 250% of tier one capital.

Table 7 reflects the changes in the major classifications of deposits and
borrowings.

TABLE 7 - DEPOSITS AND BORROWINGS BY MAJOR CLASSIFICATION
(Amounts in thousands)

The decline in short-term borrowings is a result an increase in deposits
along with a net decline in both loans and investments during the first
quarter.

CAPITAL RESOURCES:

Total stockholders' equity increased by $3.0 million or 3.0% since year-end
2003. Stockholders' equity is impacted by changes in the unrealized market
gains and losses of the securities available for sale portfolio, net of
deferred taxes and is shown on the consolidated balance sheets as a
component of stockholders' equity as accumulated other comprehensive
income (loss), net of tax. This portfolio had net unrealized losses
at year-end 2003 and the end of the first quarter.

Table 8 shows PennRock's capital resources at March 31, 2004 and at December
31, 2003. PennRock and its subsidiary bank exceed all minimum capital
guidelines.

TABLE 8 - CAPITAL RESOURCES

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Market risk is the risk of loss from adverse changes in market prices and
rates. Our primary market risk arises from interest-rate risk. We acquire
interest earning assets (loans and securities) and fund them with interest-
bearing liabilities (deposits and borrowings). These financial instruments
have varying degrees of sensitivity to changes in market interest rates. The
disparity of sensitivity between these financial assets and liabilities
creates interest rate risk. We believe there have been no material changes
in the levels of interest rate risk exposure since year-end 2003. Further
information on interest rate risk can be found under the caption
"Quantitative and Qualitative Disclosures About Market Risk" on page 29 in
PennRock's 2003 Annual Report on Form 10-K.

Item 4. Controls and Procedures

An evaluation of the effectiveness of the design and operation of PennRock's
disclosure controls and procedures (as defined in Section 13(a)-14(c) of the
Securities and Exchange Act of 1934) was carried out by PennRock, as of
period end under the supervision and with the participation of PennRock's
management, including the Chief Executive Officer and Chief Financial
Officer. Based on that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that PennRock's disclosure controls and
procedures have been designed and are being operated in a manner that
provides reasonable assurance that the information required to be disclosed
by PennRock in reports filed under the Securities Exchange Act of 1934 is
recorded, processed, summarized and reported within the time periods
specified in the SEC's rules and forms. A controls system, no matter how
well designed and operated, cannot provide absolute assurance that the
objectives of the controls system are met, and no evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, within a company have been detected. Subsequent to the date of the most
recent evaluation of PennRock's internal controls, there were no significant
changes in PennRock's internal controls or in other factors that could
significantly affect the internal controls, including any corrective actions
with regard to significant deficiencies and material weaknesses.

PART II. OTHER INFORMATION
---------------------------
For the Quarter ended March 31, 2004

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits.

31.1 Certification of the Chief Executive Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.

31.2 Certification of the Chief Financial Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.

32 Certifications of the Chief Executive Officer and Chief Financial
Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.

(b) Reports on Form 8-K

A current report on Form 8-K was filed on January 16, 2004 relating to a
January 16, 2004 press release which announced earnings for the fourth
quarter and year ended December 31, 2003.

A current report on Form 8-K was filed on March 10, 2004 relating to a
March 10, 2004 press release which announced the declaration of a first
quarter dividend for 2004.

SIGNATURES

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

PennRock Financial Services Corp.
---------------------------------
(Registrant)

Date: May 6, 2004 By: /s/Melvin Pankuch
- ----------------------- -----------------------------------------------
Melvin Pankuch
Executive Vice President and
Chief Executive Officer

Date: May 6, 2004 By: /s/George B. Crisp
- ------------------------ -----------------------------------------------
George B. Crisp
Vice President and Treasurer
(Principal Financial and Accounting Officer)

Exhibit Index
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