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FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549



    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003

Commission file number: 0-20050


PRINCETON NATIONAL BANCORP, INC.
(Exact name of registrant as specified in its charter)


DELAWARE 36-32110283
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

606 S. Main Street
Princeton, IL 61356
(Address of principal executive offices) (Zip Code)

(815) 875-4444
(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 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  ü No o

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

As of October 20, 2003, the registrant had outstanding 3,148,945 shares of its $5 par value common stock.



Page 1 of 22 pages




                         
                         
        Part I: FINANCIAL INFORMATION        
                         
                         
       The unaudited consolidated financial statements of Princeton National Bancorp, Inc. and Subsidiary and      
  management's discussion and analysis of financial condition and results of operations are presented in the      
schedules as follows:      
        Schedule 1: Consolidated Balance Sheets        
        Schedule 2: Consolidated Statements of Income and Comprehensive Income  
        Schedule 3: Consolidated Statements of Stockholders’ Equity      
        Schedule 4: Consolidated Statements of Cash Flows        
        Schedule 5: Notes to Consolidated Financial Statements      
        Schedule 6: Management's Discussion and Analysis of      
          Financial Condition and Results of Operations      
        Schedule 7: Controls and Procedures          
                       
                         
        Part II: OTHER INFORMATION          
                         
                       
  Item 6. Exhibits and Reports on Form 8-K              
  (a)    Exhibits :                  
                       
    31.1   Certification of Tony J. Sorcic required by Rule 13a-14(a).      
    31.2   Certification of Todd D. Fanning required by Rule 13a-14(a).      
    32.1   Certificaton of Tony J. Sorcic required by Rule 13a-14(b) and Section 906 of the  
        Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.      
    32.2   Certificaton of Todd D. Fanning required by Rule 13a-14(b) and Section 906 of the  
        Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.      
                         
  (b) The Corporation filed an 8-K on July 30, 2003 related to the announcement of third quarter 2003 earnings.
 
    The Corporation filed an 8-K on August 1, 2003 related to the announcement of a shareholders’ rights plan.
                         
                         
                         
          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.      
                         
            PRINCETON NATIONAL BANCORP, INC.    
                         
                       
  Date:  November 7, 2003     By   /s/ Tony J. Sorcic          
Tony J. Sorcic
       
              President & Chief Executive Officer    
                         
                         
  Date:  November 7, 2003     By   /s/ Todd D. Fanning          
Todd D. Fanning
       
              Vice-President & Chief Financial Officer    
                         
                         
                         
                         
                         
                         
                         

Schedule 1

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS

(Unaudited)
(dollars in thousands, except share data)

September 30,
2003
December 31,
2002


ASSETS            
Cash and due from banks   $ 14,390   $ 13,939  
Interest-bearing deposits with financial institutions    566    1,706  
Federal funds sold    5,600    3,225  


          Total cash and cash equivalents    20,556    18,870  

Loans held for sale, at lower of cost or market
    3,497    6,761  
Investment securities:  
      Available-for-sale, at fair value    145,548    157,881  
      Held-to-maturity, at amortized cost    17,456    11,437  


          Total investment securities    163,004    169,318  


Loans:  
      Loans, net of unearned interest    375,770    357,359  
      Allowance for loan losses    (2,378 )  (2,660 )


          Net loans    373,392    354,699  


Premises and equipment, net of accumulated depreciation    14,118    13,388  
Bank-owned life insurance    14,266    13,566  
Interest receivable    4,908    5,180  
Goodwill, net of accumulated amortization    1,355    1,355  
Intangible assets, net of accumulated amortization    1,576    1,732  
Other real estate owned    42    75  
Other assets    2,450    2,431  


        TOTAL ASSETS    $ 599,164   $ 587,375  


LIABILITIES   
Deposits:  
     Demand   $ 55,485   $ 58,655  
     Interest-bearing demand    175,713    155,549  
     Savings    56,531    51,750  
     Time    236,655    245,313  


            Total deposits    524,384    511,267  

Borrowings:
  
     Customer repurchase agreements    11,487    10,044  
     Advances from the Federal Home Loan Bank    5,300    5,750  
     Interest-bearing demand notes issued to the U.S. Treasury    762    2,397  
     Note payable    1,151    1,300  


            Total borrowings    18,700    19,491  

Other liabilities
    4,522    5,543  


       TOTAL LIABILITIES     547,606    536,301  


STOCKHOLDERS’ EQUITY   
Common stock: $5 par value, 7,000,000 shares  
     authorized; 4,139,841 issued    20,699    20,699  
Surplus    6,953    6,612  
Retained earnings    38,452    35,255  
Accumulated other comprehensive income, net of tax    1,515    2,218  
Less: Cost of 990,896 and 906,155 treasury shares at  
     September 30, 2003 and December 31, 2002, respectively    (16,061 )  (13,710 )


       TOTAL STOCKHOLDERS’ EQUITY     51,558    51,074  


       TOTAL LIABILITIES AND   
           STOCKHOLDERS’ EQUITY    $ 599,164   $ 587,375  


See accompanying notes to consolidated financial statements

3


Schedule 2

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
(dollars in thousands, except share data)

For the Three Months
Ended September 30
For the Nine Months
Ended September 30
2003 2002 2003 2002




Interest income:                    
     Interest and fees on loans   $ 5,916   $ 6,170   $ 17,858   $ 18,715  
     Interest and dividends on investment securities    1,505    1,925    3,942    5,736  
     Interest on federal funds sold    12    37    60    107  
     Interest on interest-bearing time deposits in other banks    8    29    46    73  




   
            Total interest income    7,441    8,161    21,906    24,631  
   
Interest expense:   
     Interest on deposits    2,381    3,316    7,822    9,975  
     Interest on borrowings    101    132    316    405  




   
            Total interest expense    2,482    3,448    8,138    10,380  




   
Net interest income     4,959    4,713    13,768    14,251  
Provision for loan losses    100    50    365    425  




   
Net interest income after provision   
     for loan losses     4,859    4,663    13,403    13,826  
   
Non-interest income:   
     Trust & farm management fees    315    312    955    895  
     Service charges on deposit accounts    774    706    2,242    2,031  
     Other service charges    264    261    802    760  
     Gain on sales of securities available-for-sale    0    98    935    138  
     Brokerage fee income    143    157    410    501  
     Mortgage banking income, net    611    167    1,554    531  
     Bank-owned life insurance income    139    206    439    576  
     Other operating income    12    20    97    125  




   
            Total non-interest income    2,258    1,927    7,434    5,557  
   
Non-interest expense:   
     Salaries and employee benefits    2,747    2,534    8,001    7,405  
     Occupancy    320    292    942    892  
     Equipment expense    405    393    1,198    1,120  
     Federal insurance assessments    50    53    159    159  
     Intangible assets amortization    52    52    156    156  
     Data processing    171    188    531    559  
     Advertising    87    130    304    348  
     Other operating expense    896    976    2,637    2,468  




   
            Total non-interest expense    4,728    4,618    13,928    13,107  




   
Income before income taxes     2,389    1,972    6,909    6,276  
Income tax expense    680    444    1,943    1,647  




   
Net income    $ 1,709   $ 1,528   $ 4,966   $ 4,629  




   
   
Net income per share:   
     Basic    0.54    0.46    1.55    1.40  
     Diluted    0.53    0.46    1.54    1.39  
   
Basic weighted average shares outstanding    3,171,527    3,292,127    3,194,049    3,300,654  
Diluted weighted average shares outstanding    3,213,331    3,314,705    3,229,696    3,319,401  

See accompanying notes to consolidated financial statements

4


Schedule 2

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
(dollars in thousands, except share data)

For the Three Months
Ended September 30
  For the Nine Months
Ended September 30
2003  2002  2003  2002




Net income     $ 1,709   $ 1,528   $ 4,966   $ 4,629  

  Other comprehensive income (loss), net of tax
  

          Unrealized holding gains (losses) arising during the period
    (517 )  1,044    (130 )  2,285  
           Less: Reclassification adjustment for realized gains  
                        included in net income    0    (60 )  (573 )  (85 )





  Other comprehensive income (loss)
    (517 )  984    (703 )  2,200  





Comprehensive income
   $ 1,192   $ 2,512   $ 4,263   $ 6,829  




See accompanying notes to consolidated financial statements

5


Schedule 3

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(Unaudited)
(dollars in thousands, except per share data)

For the Nine Months
Ended September 30
2003 2002


Balance, January 1     $ 51,074   $ 47,500  

     Net income
    4,966    4,629  
     Cash dividends ($0.47 per share in 2003, and $.40 per share in 2002)    (1,506 )  (1,322 )
     Other comprehensive income (loss), net of tax    (703 )  2,200  
     Purchases of treasury stock (111,000 shares in 2003, and 57,300 shares in 2002)    (2,627 )  (1,151 )
     Exercise of stock options and re-issuance of treasury stock  
               (22,936 shares in 2003 and 6,689 shares in 2002)    275    105  
     Sales of treasury stock (3,323 shares in 2003, and 3,549 shares in 2002)    79    70  



Balance, September 30
   $ 51,558   $ 52,031  





See accompanying notes to consolidated financial statements

6


Schedule 4

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)
(dollars in thousands)

For the Nine Months Ended
Ended September 30
2003 2002


       Operating activities:            
            Net income   $4,966   $4,629  
            Adjustments to reconcile net income to net  
                 cash provided by operating activities:  
                     Depreciation    1,059    950  
                     Provision for loan losses    365    425  
                     Amortization of other intangible assets    156    156  
                     Amortization of premiums on investment  
                        securities, net of accretion    2,310    698  
                     Gain on securities transactions, net    (935 )  (138 )
                     Gain on sale of premises and equipment    (2 )  0  
                     FHLB stock dividends    (49 )  (67 )
                     Loans originated for sale    (82,175 )  (23,015 )
                     Proceeds from sales of loans originated for sale    85,439    27,588  
                     Decrease in interest payable    (576 )  (367 )
                     Decrease in interest receivable    272    86  
                     Increase in other assets    (686 )  (1,127 )
                     Decrease in other liabilities    (1 )  (431 )


   
                       Net cash provided by operating activities     10,143    9,387  


   
       Investing activities:   
            Proceeds from sales of investment securities available-for-sale    9,681    3,863  
            Proceeds from maturities of investment securities available-for-sale    70,315    31,243  
            Purchase of investment securities available-for-sale    (76,229 )  (53,510 )
            Proceeds from maturities of investment securities held-to-maturity    989    1,244  
            Purchase of investment securities held-to-maturity    (915 )  (1,501 )
            Proceeds from sales of premises and equipment    2    0  
            Net increase in loans    (19,058 )  (19,486 )
            Purchases of premises and equipment    (1,789 )  (631 )


                       Net cash used in investing activities     (17,004 )  (38,778 )
   


       Financing activities:   
            Net increase in deposits    13,117    17,789  
            Net decrease in borrowings    (791 )  (835 )
            Dividends paid    (1,506 )  (1,322 )
            Purchases of treasury stock    (2,627 )  (1,151 )
            Exercise of stock options    275    105  
            Sales of treasury stock    79    70  


   
                       Net cash provided by financing activities     8,547    14,656  
   


       Increase (decrease) in cash and cash equivalents     1,686    (14,735 )
       Cash and cash equivalents at beginning of period     18,870    33,726  


   
       Cash and cash equivalents at September 30    $20,556   $18,991  



   
       Supplemental disclosures of cash flow information:  
                     Cash paid during the period for:  
                           Interest   $8,714   $10,747  
                           Income taxes   $1,799   $1,798  

       Supplemental disclosures of non-cash flow activities:
  
                      Loans transferred to other real estate owned   $71   $3,413  

See accompanying notes to consolidated financial statements

7


Schedule 5

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
(Unaudited)

The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include all of the information required by accounting principles generally accepted in the United States of America for complete financial statements and related footnote disclosures. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered for a fair presentation of the results for the interim period have been included. For further information, refer to the consolidated financial statements and notes included in the Registrant’s 2002 Annual Report on Form 10-K. Results of operations for interim periods are not necessarily indicative of the results that may be expected for the year. Certain amounts in the 2002 consolidated financial statements have been reclassified to conform to the 2003 presentation.

(1) EARNINGS PER SHARE CALCULATION

        The following table sets forth the computation of basic and diluted earnings per share for the periods indicated (in thousands, except share data):

Three Months Ended
September 30,
  Nine Months Ended
September 30,
2003 2002 2003 2002




Numerator:                    
         Net income   $ 1,709   $ 1,528   $ 4,966   $ 4,629  

Denominator:
  
         Basic earnings per share-  
         weighted average shares    3,171,527    3,292,127    3,194,049    3,300,654  
         Effect of dilutive securities-  
         stock options    41,804    22,578    35,647    18,747  




         Diluted earnings per share-  
         adjusted weighted average shares    3,213,331    3,314,705    3,229,696    3,319,401  

Net income per share:
  

         Basic
   $ 0.54   $ 0.46   $ 1.55   $ 1.40  

         Diluted
   $ 0.53   $ 0.46   $ 1.54   $ 1.39  


8


(2) GOODWILL AND INTANGIBLE ASSETS

        The balance of goodwill, net of accumulated amortization, totaled $1,355,000 at September 30, 2003 and December 31, 2002. The balance of intangible assets, net of accumulated amortization, totaled $1,576,000 and $1,732,000 at September 30, 2003 and December 31, 2002, respectively.

        The following table summarizes the Corporation’s intangible assets, which are subject to amortization, as of September 30, 2003 and December 31, 2002.

2003  2002
Gross Carrying
Amount
  Accumulated
Amortization
  Gross Carrying
Amount
  Accumulated
Amortization




Core deposit intangible     $ 2,968   $ (1,451 ) $ 2   $ (1,303 )
Other intangible assets    160    (101 )  160    (93 )




         Total   $ 3,128   $ (1,552 ) $ 3,128   $ (1,396 )




        Amortization expense totaled $52,000 and $156,000 both for the three and nine months ended September 30, 2003 and September 30, 2002, respectively. The amortization expense will be approximately $52,000 for the remainder of 2003 and will be approximately $205,000 for each of the next five years.

        The Corporation’s other intangible assets consist of originated mortgage servicing rights which are included in other assets on the consolidated balance sheets. Mortgage servicing rights are amortized in proportion to, and over the period of, estimated net servicing income similar to the interest method using an accelerated amortization method and are subject to periodic impairment testing. As of September 30, 2003 no impairment had been recorded. Changes in the carrying value of capitalized mortgage servicing rights are summarized as follows:

(in thousands)        

Balance, January 1
   $ 970  
         Servicing rights capitalized    80  
         Amortization of servicing rights    (488 )
         Impairment of servicing rights    0  

Balance, September 30   $ 1,288  

        Amortization expense for the mortgage servicing rights asset are based on assumptions made during each reporting period. Such assumptions include, but are not limited to, the current level of interest rates and the forecasted prepayment speeds. Actual amortization expense is also affected by the amount of loans sold with servicing retained.

9


        The Corporation services loans for others with unpaid principal balances at September 30, 2003 and December 31, 2002 of approximately $133,444,000, and $94,678,000, respectively.

        The following table shows the future estimated amortization expense for mortgage servicing rights based on existing balances as of September 30, 2003. The Corporation’s actual amortization expense in any given period may be significantly different from the estimated amounts displayed depending on the amount of additional servicing rights, changes in mortgage interest rates, estimated prepayment speeds, and market conditions.

Estimated Amortization Expense:

Amount (in thousands)
For the three months ended December 31, 2003     $ 114  
For the year ended December 31, 2004    344  
For the year ended December 31, 2005    273  
For the year ended December 31, 2006    210  
For the year ended December 31, 2007    149  
For the year ended December 31, 2008    96  
Thereafter    102  

(3) STOCK OPTION PLAN

        The Corporation accounts for the stock-based compensation plan under APB Opinion No. 25. For the stock option program, no compensation cost is recognized in connection with the granting of stock options with an exercise price equal to the fair market value of the stock on the date of the grant. In accordance with the disclosure requirements of FAS 123, as amended by FAS 148, the following table provides the pro forma effect on net income and earnings per share if the fair value method of accounting for stock-based compensation had been used for all awards:

For the Three Months Ended Sept. 30 For the Nine Months Ended Sept. 30,
(in thousands, except per share data) 2003 2002 2003 2002

Net Income as reported
    $ 1,709   $ 1,528   $ 4,966   $ 4,629  
Deduct: Stock-based compensation, net of  
         tax, that would have been reported  
         if the fair value based method had  
         been applied to all awards    (59 )  (30 )  (179 )  (90 )




Pro forma net income   $ 1,650   $ 1,498   $ 4,787   $ 4,539  





Basic Earnings Per Share
  
                           As Reported   $ 0.54   $ 0.46   $ 1.55   $ 1.40  
                           Pro Forma    0.52    0.46    1.50    1.38  

Diluted Earnings Per Share
  
                           As Reported   $ 0.53   $ 0.46   $ 1.54   $ 1.39  
                           Pro Forma    0.51    0.45    1.48    1.37  

10


Schedule 6

PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
For the quarter and nine months ended September 30, 2003 and 2002

        The following discussion provides information about Princeton National Bancorp, Inc.‘s (“PNBC” or the “Corporation”) financial condition and results of operations for the quarter and nine months ended September 30, 2003 and 2002. This discussion should be read in conjunction with the attached consolidated financial statements and notes thereto. Certain statements in this report constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, but not limited to those statements that include the words “believes”, “expects”, “anticipates”, “estimates”, or similar expressions. PNBC cautions that such forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those expressed or implied. Such risks and uncertainties include potential change in interest rates, competitive factors in the financial services industry, general economic conditions, the effect of new legislation, and other risks detailed in documents filed by the Corporation with the Securities and Exchange Commission from time to time.

RESULTS OF OPERATIONS

        Net income for the third quarter of 2003 was $1,709,000, or basic earnings per share of $0.54 (diluted earnings per share of $0.53), as compared to net income of $1,528,000 in the third quarter of 2002, or basic and diluted earnings per share of $0.46. This represents an increase of $181,000 (11.9%) or $.08 per basic share and $.07 per diluted share. An increase in non-interest income along with an improving net interest margin more than offset increases in non-interest expenses causing the increase in net income. Net income for the first nine months of 2003 was $4,966,000, or basic earnings per share of $1.55 (diluted earnings per share of $1.54), compared to net income of $4,629,000, or basic earnings per share of $1.40 (diluted earnings per share of $1.39) for the first nine months of 2002. This represents an increase of $337,000 (or 7.3%) during the first nine months of 2003 over the same period in 2002, and an increase of $.15 per basic and diluted share (or 10.7% and 10.8%, respectively). The increase in net income for the first nine months of 2003 is a result of a 33.8% increase in non-interest income, partially offset by a 6.3% increase in non-interest expense and a lower net interest margin. The annualized return on average assets and return on average equity were 1.13% and 13.50%, respectively, for the third quarter of 2003, compared with 1.05% and 11.82% for the third quarter of 2002. For the nine-month periods, the annualized return on average assets and average equity were 1.12% and 13.06%, respectively for 2003, compared to 1.11% and 12.54%, respectively for 2002.

        Net interest income before provision for loan losses was $4,959,000 for the third quarter of 2003, compared to $4,713,000 for the third quarter of 2002 (an increase of $246,000 or 5.2%). This increase is a result of both an increase in average interest-earning assets and an improving net interest margin. For the three months ended September 30, 2003, average interest-earning assets were $547.7 million compared to $522.5 million for the three months ended September 30, 2002. The resulting net yield on interest-earning assets (on a fully taxable equivalent basis) increased from 3.83% in the third quarter of 2002 to 3.84% in the third quarter of 2003. For the first nine months of 2003, the net yield on interest-earning assets (on a fully

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taxable equivalent basis) decreased to 3.62% from 4.02% for the first nine months of 2002 . This decrease resulted from premium amortization of $1,184,000 recorded in the second quarter of 2003 due to accelerated prepayments in the collateralized mortgage obligation (“CMO”) portfolio causing the yield on taxable investment securities to decrease from 5.07% for the nine months ended September 30, 2002 to 2.43% for the nine months ended September 30, 2003.

        PNBC recorded a loan loss provision of $100,000 in the third quarter of 2003 compared to $50,000 in the third quarter of 2002. For the nine-month comparable periods, PNBC recorded a loan loss provision of $365,000 in 2003 and $425,000 in 2002. The provision expense recorded each quarter is determined by management’s evaluation of the risk characteristics of the loan portfolio. For the third quarter of 2003, PNBC had net charge-offs of $152,000, compared to net charge-offs of $28,000 for the third quarter of 2002. For the nine-month comparable periods, PNBC had net charge-offs of $647,000 in 2003 and net recoveries of $22,000 in 2002.

        Non-interest income totaled $2,258,000 for the third quarter of 2003, as compared to $1,927,000 during the third quarter of 2002, an increase of $331,000 (or 17.2%). This is a result of an increase in mortgage banking income of $444,000 (or 265.9%) due to fee income generated from continued origination/refinancing and subsequent sales and servicing of mortgage loans in the secondary market. Additionally, there was $98,000 in gains on sales of available-for-sale securities in the third quarter of 2002, but none in the third quarter of 2003. Year-to-date in 2003, non-interest income totals $7,434,000 compared to $5,557,000 for the first nine months of 2002 (an increase of $1,877,000 or 33.8%). Mortgage banking income has increased by $1,023,000 in the comparable periods, while gains on sales of securities have increased by $797,000 during the first three quarters of 2003. Other notable increases have been seen in service charges on deposit accounts ($211,000 or 10.4%) and in trust and farm management fees ($60,000 or 6.7%).

        Total non-interest expense for the third quarter of 2003 was $4,728,000, an increase of $110,000 (or 2.4%) from $4,618,000 in the third quarter of 2002. The largest increases was in salaries/employee benefits, which increased $213,000 (or 8.4%) due to increases in commissions from mortgage banking operations as well as increased insurance costs. Collectively, all other categories of non-interest expense decreased $103,000 (or 4.9%). Year-to-date non-interest expenses for 2003 of $13,928,000 have increased $821,000 (or 6.3%) from the year-to-date totals at September 30, 2002. The most notable increases are again in salaries/employee benefits ($596,000 or 8.1%), other operating expense ($169,000 or 6.9%), and in equipment expense, which increased $78,000 (7.0%) due to increased depreciation from the upgrade of bank technology. Additionally impacting other operating expense was the Corporation’s decision to outsource the internal audit function.

INCOME TAXES

        Income tax expense totaled $680,000 for the third quarter of 2003, as compared to $444,000 for the third quarter of 2002. The effective tax rate was 28.5% for the three months ended September 30, 2003 compared to 22.5% for the three months ended September 30, 2002. Income tax expense totaled $1,943,000 for the first nine months of 2003, as compared to $1,647,000 for the same time period of 2002. The effective tax rate was 28.1% for the nine months ended September 30, 2003 compared to 26.2% for the nine months ended September 30, 2002.

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ANALYSIS OF FINANCIAL CONDITION

        Total assets at September 30, 2003 increased to $599,164,000 from $587,375,000 at December 31, 2002 (an increase of $11.8 million or 2.0%). Total deposits at September 30, 2003 increased to $524,384,000 from $511,267,000 at December 31, 2002 (an increase of $13.1 million or 2.6%). As interest rates have decreased, there continues to be a shift to savings and interest-bearing demand deposits (which would include money market and interest checking accounts) away from time deposits. Comparing categories of deposits at September 30, 2003 to the December 31, 2002 totals: interest-bearing demand deposits increased $20.2 million (or 13.0%) and savings deposits increased $4.8 million (or 9.2%). Conversely, time deposits decreased $8.7 million (or 3.5%); and demand deposits decreased by $3.2 million (or 5.4%). Borrowings, consisting of customer repurchase agreements, notes payable, treasury, tax, and loan (“TT&L”) deposits, federal funds purchased, and Federal Home Loan Bank advances, decreased from $19,491,000 at December 31, 2002 to $18,700,000 at September 30, 2003 (a decrease of $791,000 or 4.1%). Investments totaled $163,004,000 at September 30, 2003, compared to $169,318,000 at December 31, 2002 (a decrease of $6.3 million or 3.7%).

        Loan balances, net of unearned interest, increased to $379,267,000 at September 30, 2003, compared to $364,120,000 at December 31, 2002 (an increase of $15.1 million or 4.2%). Non-performing loans totaled $2,839,000 or 0.75% of net loans at September 30, 2003, as compared to $3,820,000 or 1.07% of net loans at December 31, 2002.

        For the nine months ended September 30, 2003, the subsidiary bank charged off $792,000 of loans and had recoveries of $145,000, compared to charge-offs of $391,000 and recoveries of $413,000 during the nine months ended September 30, 2002. The allowance for loan losses is based on factors that include the overall composition of the loan portfolio, types of loans, underlying collateral, past loss experience, loan delinquencies, substandard and doubtful credits, and such other factors that, in management’s reasonable judgment, warrant consideration. The adequacy of the allowance is monitored monthly. At September 30, 2003, the allowance was $2,378,000 which is 83.8% of non-performing loans and 0.63% of total loans, compared with $2,660,000 which was 69.6% of non-performing loans and 0.73% of total loans at December 31, 2002.

        At September 30, 2003, impaired loans totaled $1,755,000 compared to $2,230,000 at December 31, 2002. Loans 90 days or more past due and still accruing interest at September 30, 2003 were $0, compared to $23,000 at December 31, 2002. The balances of non-performing and impaired loans continue to be below industry averages. There is a specific loan loss reserve of $462,000 established for impaired loans as of September 30, 2003 compared to a specific loan loss reserve of $173,000 at December 31, 2002. PNBC’s management analyzes the allowance for loan losses monthly and believes the current level of allowance is adequate to meet probable losses as of September 30, 2003.

CAPITAL RESOURCES

        Federal regulations require all financial institutions to evaluate capital adequacy by the risk-based capital method, which makes capital requirements more sensitive to the differences in the level of risk assets. At September 30, 2003 total risk-based capital of PNBC was 11.57%, compared to 11.74% at December 31, 2002. The Tier 1 capital ratio increased from 7.80% at December 31, 2002, to 7.88% at September 30, 2003. Total stockholders’ equity to total assets at September 30, 2003 decreased to 8.60% from 8.70% at December 31, 2002.

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LIQUIDITY

        Liquidity is measured by a financial institution’s ability to raise funds through deposits, borrowed funds, capital, or the sale of assets. Additional sources of liquidity include cash flow from the repayment of loans and the maturity of investment securities. Major uses of cash include the origination of loans and purchase of investment securities. Cash flows provided by operating and financing activities, offset by those used in investing activities, resulted in a net increase in cash and cash equivalents of $1,686,000 from December 31, 2002 to September 30, 2003. This increase was primarily due to a net increase in deposits and a net decrease in investments, offset by a net increase in loans. For more detailed information, see PNBC’s Consolidated Statements of Cash Flows.

FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK

        The subsidiary bank is party to financial instruments with off balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract amounts of those instruments reflect the extent of involvement the subsidiary bank has in particular classes of financial instruments.

        The subsidiary bank’s exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The subsidiary bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. At September 30, 2003 commitments to extend credit and standby letters of credit were approximately $94,952,000 and $2,781,000, respectively.

        Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The subsidiary bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary, by the subsidiary bank upon extension of credit is based on management’s credit evaluation of the counter party. Collateral held varies, but may include real estate, accounts receivable, inventory, property, plant and equipment, and income-producing properties.

        Standby letters of credit are conditional commitments issued by the subsidiary bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers. The subsidiary bank secures the standby letters of credit with the same collateral used to secure the loan.

EXPANSION PLANS

        The Corporation has signed a sales contract for the purchase of property in Aurora, Illinois. The purchase of this property should occur prior to year-end 2003 and construction of the new bank facility will begin in the spring of 2004. Once this facility is completed, a facility will be built on the Elburn, Illinois property which was purchased in July of 2003.

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LEGAL PROCEEDINGS

        There are various claims pending against PNBC’s subsidiary bank, arising in the normal course of business. Management believes, based upon consultation with legal counsel, that liabilities arising from these proceedings, if any, will not be material to PNBC’s financial condition.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

        There has been no material change in market risk since December 31, 2002, as reported in PNBC’s 2002 Annual Report on Form 10-K.

NEW ACCOUNTING PRONOUNCEMENTS

        In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, “Consolidation of Variable Interest Entities” which provides new accounting guidance on when to consolidate a variable interest entity. A variable interest entity exists when either the total equity investment at risk is not sufficient to permit the entity to finance its activities by itself, or the equity investors lack one of three characteristics associated with owning a controlling financial interest. Those characteristics include the direct or indirect ability to make decisions about an entity’s activities through voting rights or similar rights, the obligation to absorb the expected loss of an entity if they occur, and the right to receive the expected residual return of the entity to occur. The Corporation does not expect the adoption of the Interpretation will have any impact on the consolidated financial statements.

        In April 2003, the FASB issued FAS 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” This Statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. This Statement is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. Adoption of this Statement did not have a material effect on the Corporation’s consolidated financial statements.

        In May 2003, the FASB issued FAS 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This statement would require that certain financial instruments with characteristics of both liabilities and equity be classified on the consolidated balance sheet as liabilities. The Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. Adoption of this Statement did not have a material effect on the Corporation’s consolidated financial statements.

EFFECTS OF INFLATION

        The consolidated financial statements and related consolidated financial data presented herein have been prepared in accordance with accounting principles generally accepted in the United States of America and practices within the banking industry which require the measurement of financial condition and operating results in terms of historical dollars, without considering the changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution’s performance than the effects of general levels of inflation.

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PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY

        The following table sets forth (in thousands) details of average balances, interest income and expense, and resulting annualized rates for the Corporation for the periods indicated, reported on a fully taxable equivalent basis, using a tax rate of 34%.

Nine Months Ended, September 30, 2003 Nine Months Ended, September 30, 2002
Average
Balance
Interest Yield/
Cost
Average
Balance
Interest Yield/
Cost
Average Interest-Earning Assets                            






Interest-bearing deposits   $ 5,829   $ 46    1.05 % $ 6,134   $ 73    1.59 %
Taxable investment securities    111,746    2,030    2.43 %  102,642    3,896    5.07 %
Tax-exempt investment securities    54,302    2,897    7.13 %  49,746    2,788    7.49 %
Federal funds sold    7,197    60    1.12 %  8,958    107    1.60 %
Net loans    365,824    17,868    6.53 %  339,151    18,733    7.38 %


 

 

              Total interest-earning assets
    544,898    22,902    5.62 %  506,631    25,597    6.76 %


 

 

Average non-interest earning assets
    50,056            52,314   

   
   

              Total average assets
   $ 594,954           $558,945    

   
   

Average Interest-Bearing Liabilities
  

Interest-bearing demand deposits
   $ 163,848    1,553    1.27 % $ 125,420    1,747    1.86 %
Savings deposits    55,462    249    0.60 %  54,480    531    1.30 %
Time deposits    245,250    6,019    3.28 %  253,326    7,697    4.06 %
Interest-bearing demand notes  
   issued to the U.S. Treasury    827    6    0.96 %  1,108    13    1.57 %
Federal funds purchased and  
   securities repurchase agreements    9,129    48    0.70 %  10,885    91    1.12 %
Advances from Federal Home Loan Bank    5,599    232    5.54 %  6,236    258    5.53 %
Borrowings    1,241    31    3.36 %  1,499    43    3.84 %


 

 
              Total interest-bearing liabilities    481,356    8,138    2.26 %  452,954    10,380    3.06 %


 

 

Net yield on average interest-earning assets
        $ 14,764    3.62 %      $ 15,217    4.02 %
 
   
 

Average non-interest-bearing liabilities
    62,756            56,635  

Average stockholders’ equity
    50,842            49,356  

   
   

              Total average liabilities and
  
                 stockholders’ equity   $ 594,954           $558,945

   
   

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Schedule 7. Controls and Procedures

  (a)   Disclosure controls and procedures. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2003. Our disclosure controls and procedures are the controls and other procedures that we designed to ensure that we record, process, summarize and report in a timely manner the information we must disclose in reports that we file with or submit to the SEC. Tony J. Sorcic, President and Chief Executive Officer, and Todd D. Fanning, Vice-President and Chief Financial Officer, reviewed and participated in this evaluation. Based on this evaluation, Messrs. Sorcic and Fanning concluded that, as of the date of their evaluation, our disclosure controls were effective.

  (b)   Internal controls. There have not been any significant changes in our internal accounting controls or in other factors during the quarter ended September 30, 2003 that could significantly affect those controls.

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INDEX TO EXHIBITS

Exhibit
Number
Exhibit
31.1 Certification of Tony J. Sorcic required by Rule 13a-14(a).

31.2

Certification of Todd D. Fanning required by Rule 13a-14(a).

32.1

Certification of Tony J. Sorcic required by Rule 13a-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.

32.2

Certification of Todd D. Fanning required by Rule 13a-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.

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