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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended September 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 0-49952
NORTHEAST PENNSYLVANIA FINANCIAL CORP.
------------------------------------------------------
(Exact name of registrant as specified in its charter)
DELAWARE 06-1504091
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(State or other jurisdiction of I.R.S. Employer
incorporation or organization) Identification No.)
12 E. BROAD STREET, HAZLETON, PENNSYLVANIA 18201-6591
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (570) 459-3700
Securities registered under Section 12 (b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:
Common stock, par value $0.01 per share
(Title of class)
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 [X] No [ ]
Indicate by a check mark if the disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes [ ] No [X]
The aggregate market value of the voting and non-voting common equity held by
non-affiliates (i.e. persons other than directors and executive officers of the
registrant) was $67,356,015 based upon the closing price of $18.40 on the Nasdaq
Stock Market as of the last business day of the registrant's most recently
completed second fiscal quarter.
The number of shares of common stock outstanding as of December 28, 2004 was
3,660,653.
NORTHEAST PENNSYLVANIA FINANCIAL CORP.
FORM 10-K
TABLE OF CONTENTS
PAGE
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PART I
Item 1 Business..................................................................... 2
Item 2 Properties................................................................... 13
Item 3 Legal Proceedings............................................................ 15
Item 4 Submission of Matters to a Vote of Security Holders.......................... 15
PART II
Item 5 Market for Registrant's Common Equity, Related Stockholder Matters and
Issuer Purchase of Equity Securities........................................ 16
Item 6 Selected Financial Data...................................................... 17
Item 7 Management's Discussion and Analysis of Financial Condition and Results of
Operation................................................................... 19
Item 7A Quantitative and Qualitative Disclosures About Market Risk................... 38
Item 8 Financial Statements and Supplementary Data.................................. 38
Item 9 Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure.................................................................. 74
Item 9A Controls and Procedures...................................................... 74
Item 9B Other Information............................................................ 74
PART III
Item 10 Directors and Executive Officers of the Registrant........................... 75
Item 11 Executive Compensation....................................................... 76
Item 12 Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters......................................................... 80
Item 13 Certain Relationships and Related Transactions............................... 83
Item 14 Principal Accountant Fees and Services....................................... 83
PART IV
Item 15 Exhibits and Financial Statement Schedules................................... 84
SIGNATURES................................................................... 86
PART I
FORWARD LOOKING STATEMENTS
In addition to historical information, our 10-K may include certain
"forward-looking statements" within the meaning of the federal securities laws.
Such forward-looking statements may be identified by the use of such words as
"intend," "believe," "expect," "anticipate," "should," "plan," "estimate" and
"potential." These forward-looking statements include, but are not limited to,
estimates and expectations of future performance based on current management
expectations. Northeast Pennsylvania Financial Corp.'s (the "Company,"
"Northeast Pennsylvania" or the "Registrant") actual results could differ
materially from such management expectations. Factors that could cause future
results to vary from current management expectations include, but are not
limited to, general economic conditions, legislative and regulatory changes,
monetary and fiscal policies of the federal government, changes in tax policies,
rates and regulations of federal, state and local tax authorities, changes in
interest rates, deposit flows, the cost of funds, demand for loan products,
demand for financial services, competition, changes in the quality or
composition of the Company's loan and investment portfolios, changes in
accounting principles, policies or guidelines, and other economic, competitive,
governmental and technological factors affecting the Company's operations,
markets, products, services and prices. Because of the risks and uncertainties
inherent in forward-looking statements, readers are cautioned not to place undue
reliance on them, whether included in this report or made elsewhere from time to
time by the Company or on its behalf. Subject to applicable law and regulation,
the Company assumes no obligation to update any forward-looking statements.
ITEM 1. BUSINESS
GENERAL
The Company is a Delaware corporation and is a thrift holding company
for First Federal Bank (the "Bank"), a federally chartered capital stock savings
bank regulated by the Office of Thrift Supervision ("OTS"), Abstractors, Inc.,
which is a title insurance agency, NEP Trust Co. (the "Trust Co."), which offers
trust, estate and asset management services and products and Higgins Insurance
Associates, Inc. ("Higgins"), which provides insurance and investment products
to individuals and businesses. The Company's executive offices are located at
12 East Broad Street, Hazleton, Pennsylvania 18201.
The Company's operations are primarily conducted through the Bank. These
operations have been and continue to be attracting retail deposits from the
general public in the areas surrounding its 16 full service community offices
and investing those deposits, together with funds generated from operations and
borrowings, primarily in one-to-four family mortgage loans, consumer loans,
commercial loans and multi-family and commercial real estate loans. The Company
has attempted to diversify and expand its loan products to better serve its
customer base by placing a greater emphasis on its consumer lending and
commercial lending, primarily to small businesses and municipalities.
The Company's revenues are derived from four principal business
activities: banking, insurance, investments and trust services. First Federal
Bank's revenues are derived principally from interest on its loans, and to a
lesser extent, interest and dividends on its investment and mortgage-related
securities and through other non-interest income. Investment income is generated
through annuity sales and commissions on investment sales. Insurance premium
income is generated through sales of commercial lines, property and casualty and
employee benefits insurance policies to businesses and individuals. The Trust
Co. continues to expand its customer base with assets under management of
$167.1 million at September 30, 2004. The Company's primary sources of funds are
deposits, principal and interest payments on loans and mortgage related
securities, FHLB advances and other borrowings and proceeds from the sale of
loans.
Effective January 1, 2004, the Bank sold the deposits and property of
its branch office located in Danville, Pennsylvania to the First National Bank
of Berwick, Berwick, Pennsylvania. For further information regarding this sale
and transfer, please see Note 23 to the Consolidated Financial Statements
included in Item 8 of this Form 10-K.
AGREEMENT AND PLAN OF MERGER
On December 8, 2004, KNBT Bancorp, Inc. ("KNBT"), the parent company of
Keystone Nazareth Bank & Trust Company, entered into an Agreement and Plan of
Merger (the "Merger Agreement") pursuant to which the Company will merge with
and into KNBT. Concurrently with the merger, it is expected that the Bank will
merge with and into Keystone Nazareth Bank & Trust Company.
Under the terms of the Agreement, the Company's stockholders may elect
to receive either $23.00 of KNBT common stock or $23.00 in cash in exchange for
their shares of Northeast Pennsylvania common stock, subject to an overall
requirement that 50% of the total outstanding Company Common Stock be exchanged
for KNBT Common Stock and 50% for cash. To the extent they receive shares of
KNBT, the transaction is expected to be tax-free to Northeast Pennsylvania
stockholders.
The number of shares of KNBT common stock into which each Northeast
Pennsylvania share will be exchanged will be based on the price of KNBT common
stock over a measurement period prior to the closing.
Page 2
In addition, each director of Northeast Pennsylvania entered into a
Shareholder Agreement with KNBT, pursuant to which each person agreed, among
other things, to vote his or her shares of Company common stock in favor of the
Merger Agreement at a meeting of shareholders of the Company to be called to
consider and approve the Merger Agreement.
The transaction is expected to close in the second quarter of 2005. It
is subject to certain conditions, including the approval of stockholders and the
receipt of regulatory approval.
MARKET AREA AND COMPETITION
The Company is a community-oriented banking institution offering a
variety of retail financial products and services to meet the needs of the
communities it serves. The Company's lending and deposit gathering is
concentrated in its market area consisting of a seven county region in
Northeastern and Central Pennsylvania.
The Company maintains its headquarters in Hazleton. The Company's six
banking offices in Luzerne County, including Hazleton, accounted for
$299.9 million or 62% of the Company's total deposits at September 30, 2004.
Hazleton is situated approximately 100 miles from Philadelphia and New York City
and approximately 50 miles from Allentown and the Wilkes-Barre/Scranton area.
The Company also maintains two banking offices in Bloomsburg (Columbia County),
one each in Lehighton and Weatherly (both in Carbon County), one in
Brodheadsville (Monroe County) and one each in Frackville, Pottsville,
Shenandoah, and Schuylkill Haven (all in Schuylkill County).
The economy of the greater Hazleton area is characterized by diversified
light manufacturing and is the site of production facilities for several major
manufacturers including Union Camp, Hershey-Cadbury Chocolates, Quebecor and
Hazleton Pumps, Inc. As a consequence, the manufacturing sector employs more
than one third of the area's work force. The Hazleton area has excellent access
to major highway transportation routes including Interstates 80 and 81 as well
as rail transportation. The population of Luzerne County has remained relatively
static and has one of the oldest average ages for all counties in the United
States. The southern end of Schuylkill County is proving to be a growth area as
individuals and companies which were previously based in the Allentown-Berks
county areas are relocating to the southern end of Schuylkill County.
Notwithstanding such growth, the overall population in the Company's market area
is relatively small and, in recent years, has grown slowly, and the unemployment
rate in the area is greater than the national average. Monroe County, the
location of the Brodheadsville banking branch, is dominated by the Pocono
Mountains, making the area one of the Mid-Atlantic's most popular resort areas.
The Company faces significant competition both in generating loans and
in attracting deposits. Its most direct competition for deposits has
historically come from savings banks and associations, commercial banks and
credit unions. In addition, the Bank faces increasing competition for deposits
from non-bank institutions such as brokerage firms and insurance companies in
such investments as short-term money market funds, corporate and government
securities funds, mutual funds and annuities. At June 30, 2004, which is the
most recent date for which data is available from the Federal Deposit Insurance
Corporation, the Bank held approximately 6.25% of the deposits in Luzerne County
and, approximately 5.67% of the deposits in Schuylkill County, which was the
fifth largest market share out of 19 financial institutions with offices in
Luzerne county and the fifth largest market share out of 18 financial
institutions with offices in Schuylkill county. In addition, the Bank's
competition includes banks owned by large bank holding companies, such as PNC
Financial Services Group, Inc., Wachovia Corporation, M&T Bank Corporation and
Bank of America Corporation that are significantly larger and have significantly
greater resources than the Bank that allows them to offer a wider variety of
products and services.
The Company's competition for loans comes principally from commercial
banks, savings banks, credit unions, mortgage brokers, mortgage banking
companies and insurance companies. Its most direct competition for deposits has
historically come from savings banks and associations, commercial banks and
credit unions. In addition, the Bank faces increasing competition for deposits
from non-bank institutions such as brokerage firms and insurance companies in
such instruments as short-term money market funds, corporate and government
securities funds, mutual funds and annuities.
Competition has also increased as a result of the lifting of
restrictions on the interstate operations of financial institutions, as a result
of legislative, regulatory and technological changes and the continuing trend of
consolidation in the financial services industry. Technological advances, for
example, have lowered barriers to market entry, allowed banks to expand their
geographic reach by providing services over the Internet and made it possible
for non-depository institutions to offer products and services that
traditionally have been provided by banks. The Gramm-Leach-Bliley Act, which
permits affiliation among banks, securities firms and insurance companies also
changed the competitive environment in which the Bank conducts business.
In addition, the Company recognizes that its customer base increasingly
focuses on convenience and access to services. The Company has addressed these
customer needs through the implementation of electronic banking services and
enhanced voice response capabilities, a computerized loan origination and
document system and the issuance of debit cards. The Company continues to
evaluate and enhance its service and delivery systems in order to better serve
its retail and business customers.
Page 3
LENDING ACTIVITIES
GENERAL. The information relating to the composition and maturity of the
Bank's loan portfolio appears in "Loans" under Item 7 of this Form 10-K and is
incorporated herein by reference.
ORIGINATION AND SALE OF LOANS. The Bank's lending activities are
conducted primarily by its loan personnel operating at its branch and loan
origination offices. All loans originated by the Bank are underwritten pursuant
to the Bank's policies and procedures. The Bank originates both adjustable-rate
and longer-term and shorter-term fixed-rate loans. The Bank's ability to
originate fixed or adjustable-rate loans is dependent upon the relative customer
demand for such loans, which is affected by the current and expected future
level of interest rates. It is currently the policy of the Bank to sell newly
originated fixed-rate one-to-four family mortgages with maturities greater than
15 years with retained servicing. Additionally, the Bank from time to time may
sell certain loans to manage its interest-rate risk position in light of its
overall asset/liability management strategy.
ONE-TO-FOUR FAMILY MORTGAGE LENDING. The Bank currently offers both
fixed-rate and adjustable-rate mortgage ("ARM") one-to-four family mortgage
loans with maturities up to 30 years. One-to-four family mortgage loan
originations are generally obtained from the Bank's in-house loan
representatives, from existing or past customers, and through referrals from
members of the Bank's local communities.
The origination of ARM loans, as opposed to fixed-rate residential
mortgage loans, helps reduce the Bank's exposure to increases in interest rates.
However, adjustable-rate loans generally pose credit risks not inherent in
fixed-rate loans, primarily because as interest rates rise, the underlying
payments of the borrower rise, thereby increasing the potential for default.
Periodic and lifetime caps on interest rate increases help to reduce the credit
risks associated with adjustable-rate loans but also limit the interest rate
sensitivity of such loans.
Most one-to-four family mortgage loans are underwritten according to
Fannie Mae and Freddie Mac guidelines. In recent years, the Bank began offering
one-to-four family mortgage loans which, when underwritten, did not fully meet
established Fannie Mae or Freddie Mac standards, for example, the standard
regarding income to debt ratios for the borrower and thus are not saleable in
the secondary market. Mortgage loans originated by the Bank generally include
due-on-sale clauses that provide the Bank with the contractual right to deem the
loan immediately due and payable in the event the borrower transfers ownership
of the property without the Bank's consent. Due-on-sale clauses are an important
means of adjusting the yields on the Bank's fixed-rate mortgage loan portfolio
and the Bank has generally exercised its rights under these clauses. The Bank
requires fire, casualty, title and, in certain cases, flood insurance on all
properties securing real estate loans made by the Bank.
MULTI-FAMILY AND COMMERCIAL REAL ESTATE LENDING. The Bank originates
fixed-rate and adjustable-rate multi-family and commercial real estate loans
that generally are secured by properties used for business purposes or a
combination of residential and retail purposes.
Pursuant to the Bank's underwriting policies a multi-family mortgage or
commercial real estate loan may be made in an amount up to 80% of the lower of
the appraised value or sales price of the underlying property with terms
generally ranging from 15 to 25 years.
The factors considered by the Bank in granting these loans include: the
net operating income of the mortgaged premises before debt service and
depreciation; the debt coverage ratio (the ratio of net earnings to debt
service); and the ratio of loan amount to appraised value. The Bank has
generally required that the properties securing commercial real estate loans
have debt service coverage ratios of at least 125%.
The Bank's largest multi-family and commercial real estate loan at
September 30, 2004 was a $593,000 loan secured by real estate and was performing
according to its original terms. Loans secured by multi-family and commercial
real estate generally have larger loan values and involve greater risks than
one- to four-family residential mortgage loans. Payments on loans secured by
such properties are often dependent on successful management and operation of
the properties. Repayment of such loans may be subject to a greater extent to
adverse conditions in the real estate market or the economy. The Bank seeks to
minimize these risks in a variety of ways, including strict adherence to its
underwriting standards, limiting the size of such loans and strictly
scrutinizing the financial condition of the borrower, the quality of the
collateral and the management of the property securing the loan. The Bank also
obtains loan guarantees from financially capable parties. The Bank's lending
personnel or an agent of the Bank inspect all of the properties securing the
Bank's multi-family and commercial real estate loans before the loan is made.
The Bank also obtains appraisals on each property in accordance with applicable
regulations.
Page 4
CONSTRUCTION LENDING. The Bank also offers residential construction
loans. Such loans have been for presold one- to four-family residences for the
construction phase and convert into permanent financing. The Bank generates
residential construction loans primarily through direct contact with borrowers
or home builders, and these loans involve properties located in the Bank's
primary market area. Such loans require that the Bank review plans,
specifications and cost estimates and that the home builder be approved by the
Bank. The amount of construction advances, together with the sum of previous
disbursements, may not exceed the percentage of completion of the construction.
The maximum loan-to-value limit applicable to such loans is generally 80%.
The Bank's largest construction loan at September 30, 2004 was a
$5.0 million loan secured by all of the improved and unimproved building lots
and amenities of a resort community located in Hazleton, Pennsylvania. This loan
was performing according to its original terms at September 30, 2004.
Construction financing is generally considered to involve a higher degree of
credit risk than long-term financing on owner-occupied real estate. The risk of
loss on construction loans is dependent largely upon the accuracy of the value
of the property at completion of the construction compared to the estimated cost
of construction and other assumptions. If the estimate of construction costs
proves to be inaccurate, the Bank may be required to advance funds beyond the
amount originally committed to protect the value of the property.
Construction financing is generally considered to involve a higher
degree of risk of loss than long-term financing on improved, occupied real
estate. Risk of loss on a construction loan depends largely upon the accuracy of
the initial estimate of the property's value at completion of construction and
the estimated cost (including interest) of construction. During the construction
phase, a number of factors could result in delays and cost overruns. If the
estimate of construction costs proves to be inaccurate, the Bank may be required
to advance funds beyond the amount originally committed to permit completion of
the building. If the estimate of value proves to be inaccurate, the Bank may be
confronted, at or before the maturity of the loan, with a building having a
value that is insufficient to assure full repayment. If the Bank is forced to
foreclose on a building before or at completion due to a default, there can be
no assurance that the Bank will be able to recover all of the unpaid balance of,
and accrued interest on, the loan as well as related foreclosure and holding
costs.
CONSUMER LENDING. The Bank offers consumer loans, which include home
equity loans, home equity lines of credit, direct and indirect automobile loans,
education loans and other consumer loans. The Bank's home equity loans are
generated primarily through the Bank's retail branch offices. The Bank generally
offers home equity loans with a term of 180 months or less. The Bank also offers
home equity lines of credit with terms up to 20 years, the last 10 years of
which require full amortization of the principal balance. The maximum loan
amount for both home equity loans and home equity lines of credit, is subject to
a combined loans-to-value ratio of 80%.
The Bank also offers automobile loans, both on a direct and an indirect
basis (through new and used car dealers). The indirect automobile loans are
originated by dealers in accordance with underwriting standards pre-established
by the Bank and are serviced by the Bank. The Bank also offers loans on
recreational vehicles and boats and other consumer loans, deposit-secured loans,
and other personal and unsecured loans.
Consumer loans tend to bear higher rates of interest and have shorter
terms to maturity than first lien residential mortgage loans. Nationally,
consumer loans have historically tended to have a higher rate of default.
Additionally, consumer loans generally involve greater risk than residential
mortgage loans, particularly in the case of loans that are unsecured or secured
by rapidly depreciating assets such as automobiles. In these cases, any
repossessed collateral for a defaulted consumer loan may not provide an adequate
source of repayment of the outstanding loan balance as a result of the greater
likelihood of damage, loss or depreciation. The remaining deficiency often does
not warrant further substantial collection efforts against the borrower beyond
obtaining a deficiency judgment. In addition, consumer loan collections are
dependent on the borrower's continuing financial stability, and thus are more
likely to be adversely affected by job loss, divorce, illness or personal
bankruptcy.
COMMERCIAL LENDING. The Bank makes commercial business loans primarily
in its market area to a variety of professionals, sole proprietorships and small
businesses. The Bank offers a variety of commercial lending products, including
term loans for fixed assets and working capital, revolving lines of credit,
letters of credit, and Small Business Administration guaranteed loans. Interest
rates charged generally are based on the prime rate as published in the Wall
Street Journal. Prior to making commercial business loans, the borrower is
required to provide the Bank with sufficient information to allow a prudent loan
decision to be made. Such information generally includes financial statements
and projected cash flows, and is reviewed to evaluate debt service capability.
Commercial business loans are generally secured by a variety of collateral,
including real estate, personal property and fixed assets and frequently are
supported by personal guarantees. In addition, the Bank actively participates in
industrial loans arranged through the Greater Wilkes-Barre Industrial Fund and
CanDo, Inc. a Hazleton area industrial fund.
The Bank's largest commercial business loan at September 30, 2004 was a
$7.3 million loan secured by the fixed assets at a manufacturing facility. This
loan was performing in accordance with its original terms at September 30, 2004.
Commercial business loans generally involve higher credit risks than loans
secured by real estate. Unlike residential mortgage loans, which generally are
made on the basis of the borrower's ability to make repayment from his or her
employment or other income, and which are secured by real property whose value
tends to be more easily ascertainable, commercial loans are of higher risk and
Page 5
typically are made on the basis of the borrower's ability to make repayment from
the cash flow of the borrower's business. As a result, the availability of funds
for the repayment of commercial loans may be substantially dependent on the
success of the business itself. Further, any collateral securing such loans may
depreciate over time, may be difficult to appraise and may fluctuate in value
based on the success of the business.
LOAN APPROVAL PROCEDURES AND AUTHORITY. The Board of Directors
establishes the lending policies and the levels of loan approval authority for
employees of the Bank and oversees the Bank's lending activities. The Board of
Directors has established an Executive Committee and a Risk Committee which,
among other things, oversee the lending activities of the Bank and manages a
committee of loan officers that have initial oversight over certain loans. All
loans exceeding certain prescribed limits are reported to the Risk Management
and Executive Committee of the Board.
NONPERFORMING ASSETS AND ALLOWANCE FOR LOAN LOSSES. The information
relating to the Bank's nonperforming assets and allowance for loan losses
appears in Item 7 of this Form 10-K the "Nonperforming Assets" and "Allowance
for Loan Losses" sections of Management's Discussion and Analysis of Financial
Condition and Results of Operations and is incorporated herein by reference.
INVESTMENT ACTIVITIES
The above captioned information appears in the "Investment Activities"
section of Management's Discussion and Analysis of Financial Condition and
Results of Operations and is incorporated herein by reference.
SOURCE OF FUNDS
Information relating generally to the Bank's source of funds and a
description of the Bank's deposits appears in Item 7 of this Form 10-K under
"Sources of Funds" section of Management's Discussion and Analysis of Financial
Condition and Results of Operations and is incorporated herein by reference.
BORROWINGS. The Bank utilizes advances from the Federal Home Loan Bank
of Pittsburgh (the "FHLB") as well as other borrowings as a supplement to retail
deposits to fund its operations. Such advances are collateralized primarily by
the Bank's mortgage loans and mortgage-related securities and secondarily by the
Bank's investment in the capital stock of the FHLB of Pittsburgh. FHLB advances
are made pursuant to several different credit programs, each of which has its
own interest rate and range of maturities. The maximum amount that the FHLB of
Pittsburgh will advance to member institutions, including the Bank, fluctuates
from time to time in accordance with the policies of the FHLB of Pittsburgh. See
"Regulation-Federal Home Loan Bank System." At September 30, 2004, the Bank had
$243.9 million in outstanding FHLB advances, compared to $258.9 million at
September 30, 2003. The Bank had $135.3 million of additional borrowing capacity
from the FHLB at September 30, 2004. Other borrowings consist of overnight
retail repurchase agreements, which for the periods presented were immaterial,
and repurchase agreements. Repurchase agreements are treated as financings with
the obligations to repurchase securities sold reflected as a liability in the
balance sheet. The dollar amount of securities underlying the agreements remains
recorded as an asset, although the securities underlying the agreements are
delivered to the brokers who arranged the transactions. In certain instances,
the broker may have sold, loaned, or disposed of the securities to other parties
in the normal course of their operations, and have agreed to deliver to the Bank
substantially similar securities at the maturity of the agreements. Securities
underlying sales of securities under repurchase agreements consisted of
investment securities that had an amortized cost of $21.9 million and a market
value of $22.2 million at September 30, 2004. At September 30, 2004, the Bank
had $20 million in outstanding repurchase agreements. The Bank had no such
agreements outstanding as of September 30, 2003.
The following table sets forth certain information regarding the Bank's borrowed
funds on the dates indicated:
AT OR FOR THE FISCAL YEARS ENDED
SEPTEMBER 30,
------------------------------------------
2004 2003 2002
------------ ------------ ------------
(DOLLARS IN THOUSANDS)
FHLB advances and other borrowings:
Average balance outstanding $ 251,955 $ 210,360 $ 208,579
Maximum amount outstanding at any month-end
during the period 293,688 259,430 215,855
Balance outstanding at end of period 264,293 259,430 211,605
Weighted average interest rate during the period 4.20% 5.69% 5.69%
Weighted average interest rate at end of period 4.44% 4.78% 5.57%
Page 6
SUBSIDIARY ACTIVITIES
The Company has six active wholly-owned subsidiaries: the Bank,
incorporated under the laws of the United States; Abstractors, Inc., the Trust
Co., and Higgins, each of which are incorporated under Pennsylvania law; and NEP
Capital Trust I and NEP Capital Trust II, each of which is incorporated under
Delaware law. Abstractors, Inc. is a title insurance agency with total assets of
$451,000 at September 30, 2004. The Trust Co., offers trust estate and asset
management services and products and had total assets of $1.1 million and
$167.1 million of trust assets under management at September 30, 2004. Higgins
provides insurance and investment products to individuals and businesses and had
total assets of $1.4 million at September 30, 2004. NEP Capital Trust I and NEP
Capital Trust II were established in connection with the issuance of trust
preferred securities. The proceeds of the offerings were used to purchase
debentures from the Company.
PERSONNEL
As of September 30, 2004, the Company had 246 full-time equivalent
employees, none of whom were covered by a collective bargaining agreement.
Management believes that the Company has good relations with its employees and
there are no pending or threatened labor disputes.
REGULATION AND SUPERVISION
As a savings and loan holding company, the Company is required by
federal law to file reports with and otherwise comply with, the rules and
regulations of the OTS. The Bank is subject to extensive regulation, examination
and supervision by the OTS, as its chartering agency, and the Federal Deposit
Insurance Corporation (the "FDIC"), as the deposit insurer. The Bank is a member
of the Federal Home Loan Bank ("FHLB") System. The Bank's deposit accounts are
insured up to applicable limits by the Savings Association Insurance Fund
("SAIF") managed by the FDIC. The Bank must file reports with the OTS and the
FDIC concerning its activities and financial condition in addition to obtaining
regulatory approvals prior to entering into certain transactions such as mergers
with, or acquisitions of, other financial institutions. There are periodic
examinations by the OTS and the FDIC to test the Bank's safety and soundness and
compliance with various regulatory requirements. This regulation and supervision
establishes a comprehensive framework of activities in which an institution can
engage and is intended primarily for the protection of the insurance fund and
depositors. The regulatory structure also gives the regulatory authorities
extensive discretion in connection with their supervisory and enforcement
activities and examination policies, including policies with respect to the
classification of assets and the establishment of adequate loan loss reserves
for regulatory purposes. Any change in such regulatory requirements and
policies, whether by the OTS, the FDIC or the Congress, could have a material
adverse impact on the Company, the Bank and their operations.
Certain of the regulatory requirements applicable to the Bank and to the
Company are referred to below or elsewhere herein. The description of statutory
provisions and regulations applicable to savings associations and their holding
companies set forth in this Form 10-K does not purport to be complete
descriptions of such statutes and regulations and their effects on the Bank and
the Company are qualified in its entirety by reference to such statutes and
regulations.
FEDERAL SAVINGS INSTITUTION AND REGULATIONS
BUSINESS ACTIVITIES. The activities of federal savings institutions are
governed by the federal laws and regulations. These laws and regulations
delineate the nature and extent of the activities in which federal associations
may engage. In particular, many types of lending authority for federal
associations, e.g., commercial, non-residential real property loans and consumer
loans, are limited to a specified percentage of the institution's capital or
assets.
LOANS-TO-ONE-BORROWER. Federal law provides that, savings institutions
are generally subject to the national bank limit on loans-to-one borrower.
Generally, this limit is 15% of the Bank's unimpaired capital and surplus, plus
an additional 10% of unimpaired capital and surplus, if such loan is secured by
specified readily marketable collateral. At September 30, 2004, the largest
aggregate amount of loans-to-one borrower was $7.3 million, which was less than
the Bank's general limit on loans-to-one borrower which was $10.5 million.
QTL TEST. Federal law requires savings institutions to meet a qualified
thrift lending ("QTL") test. Under the test, a savings association is required
to either qualify as a "domestic building and loan association" under the
Internal Revenue Code or maintain at least 65% of its "portfolio assets" (total
assets less: (i) specified liquid assets up to 20% of total assets; (ii)
intangibles, including goodwill; and (iii) the value of property used to conduct
business) in certain "qualified thrift investments" (primarily residential
mortgages and related investments, including certain mortgage-backed and related
securities) in at least 9 months out of each 12-month period. A savings
association that fails the QTL test is subject to certain operating restrictions
and may be required to convert to a bank charter. As of September 30, 2004, the
Bank maintained 92.1% of its portfolio assets in qualified thrift investments
and, therefore, met the QTL test. Recent legislation has expanded the extent to
which education loans, credit card loans and small business loans may be
considered as "qualified thrift investments."
Page 7
LIMITATION ON CAPITAL DISTRIBUTIONS. OTS regulations impose limitations
upon all capital distributions by a savings institution, including cash
dividends, payments to repurchase its shares and payments to stockholders of
another institution in a cash-out merger. Under the regulations, an application
to and the prior approval of the OTS is required before any capital distribution
if the institution does not meet the criteria for "expedited treatment" of
applications under OTS regulations (generally, examination ratings in one of two
top categories), the total capital distributions for the calendar year exceed
net income for that year plus the amount of retained net income for the
preceding two years, the institution would be undercapitalized following the
distribution or the distribution would otherwise be contrary to a statute,
regulation or agreement with the OTS. If an application is not required, the
institution must still give advance notice to the OTS of the capital
distribution, if, like the Bank, it is a subsidiary of a holding company. If the
Bank's capital fell below its regulatory requirements or if the OTS notified it
that it was in need of more than normal supervision, the Bank's ability to make
capital distributions could be restricted. In addition, the OTS could prohibit a
proposed capital distribution, which would otherwise be permitted by regulation,
if the OTS determines that the distribution would be unsafe or unsound practice.
ASSESSMENTS. Savings institutions are required to pay assessments to the
OTS to fund the agency's operations. The general assessments, paid on a
semi-annual basis, are based upon the savings institution's total assets,
including consolidated subsidiaries, as reported in the Bank's latest quarterly
Thrift Financial Report. The assessments paid by the Bank for the year ended
September 30, 2004 totaled $245,000.
BRANCHING. OTS regulations permit federally-chartered savings
associations to branch nationwide under certain conditions. Generally, federal
savings associations may establish interstate networks and geographically
diversify their loan portfolios and lines of business. The OTS authority
preempts any state law purporting to regulate branching by the federal savings
associations.
COMMUNITY REINVESTMENT. Under the Community Reinvestment Act ("CRA"), as
implemented by OTS regulations, a savings institution has a continuing and
affirmative obligation consistent with its safe and sound operation to help meet
the credit needs of its entire community, including low and moderate income
neighborhoods. The CRA does not establish specific lending requirements or
programs for financial institutions nor does it limit an institution's
discretion to develop the types of products and services that it believes are
best suited to its particular community, consistent with the CRA. The CRA
requires the OTS, in connection with its examination of a savings institution,
to assess the institution's record of meeting the credit needs of its community
and to take such record into account in its evaluation of certain applications
by such institution. The CRA also requires all institutions to make public
disclosure of their CRA ratings. The Bank received a "Satisfactory" CRA rating
in its most recent examination.
TRANSACTIONS WITH RELATED PARTIES. The Bank's authority to engage in
transactions with related parties or "affiliates" (i.e., any company that
controls or is under common control with an institution, including the Company
and its non-savings institution subsidiaries) is limited by federal law. The
aggregate amount of covered transactions with any individual affiliate is
limited to 10% of the capital and surplus of the savings institution. The
aggregate amount of covered transactions with all affiliates is limited to 20%
of the savings institution's capital and surplus. Certain transactions with
affiliates are required to be secured by collateral in an amount and of a type
described in federal law. The purchase of low quality assets from affiliates is
generally prohibited. The transactions with affiliates must be on terms and
under circumstances, that are at least as favorable to the institution as those
prevailing at the time for comparable transactions with non-affiliated
companies. In addition, savings institutions are prohibited from lending to any
affiliate that is engaged in activities that are not permissible for bank
holding companies and no savings institution may purchase the securities of any
affiliate other than a subsidiary.
The recently enacted Sarbanes-Oxley Act generally prohibits loans by the
Company to its executive officers and directors. However, the Act contains a
specific exception from such prohibitions for loans by the Bank to its executive
officers and directors in compliance with federal banking regulations
restrictions on such loans. The Bank's authority to extend credit to executive
officers, directors and 10% stockholders ("insiders"), as well as entities such
persons control, is also governed by federal law. Such loans are required to be
made on terms substantially the same as those offered to unaffiliated
individuals and not involve more than the normal risk of repayment. An exception
exists for loans made pursuant to a benefit or compensation program that is
widely available to all employees of the institution and does not give
preference to insiders over other employees. The law limits both the individual
and aggregate amount of loans the Bank may make to insiders based, in part, on
the Bank's capital position and requires certain board approval procedures to be
followed.
ENFORCEMENT. The OTS has primary enforcement responsibility over savings
institutions and has the authority to bring action against the institution and
all "institution-affiliated parties," including stockholders, and any attorneys,
appraisers and accountants who knowingly or recklessly participate in wrongful
action likely to have an adverse effect on an insured institution. Formal
enforcement action may range from the issuance of a capital directive or cease
and desist order to removal of officers or directors, receivership,
conservatorship or termination of deposit insurance. Civil penalties cover a
wide range of violations and can amount to $25,000 per day, or $1 million per
day in especially egregious cases. The FDIC has the authority to recommend to
the Director of the OTS that enforcement action be taken with respect to a
particular savings institution. If action is not taken by the
Page 8
Director, the FDIC has authority to take such action under certain
circumstances. Federal law also establishes criminal penalties for certain
violations.
STANDARDS FOR SAFETY AND SOUNDNESS. The federal banking agencies have
adopted Interagency Guidelines Standards for Safety and Soundness. The
guidelines set forth the safety and soundness standards that the federal banking
agencies use to identify and address problems at insured depository institutions
before capital becomes impaired. If the OTS determines that a savings
institution fails to meet any standard prescribed by the guidelines, the OTS may
require the institution to submit an acceptable plan to achieve compliance with
the standard.
CAPITAL REQUIREMENTS. The OTS capital regulations require savings
institutions to meet three minimum capital standards: a 1.5% tangible capital
ratio, a 4% leverage (core capital) ratio and an 8% risk-based capital ratio.
Core capital is defined as common stockholder's equity (including retained
earnings), certain non-cumulative perpetual preferred stock and related surplus,
minority interests in equity accounts of consolidated subsidiaries less
intangibles other than certain mortgage servicing rights ("MSRs") and credit
card relationships. The OTS regulations require that, in meeting the leverage
ratio, tangible and risk-based capital standards institutions generally must
deduct investments in and loans to subsidiaries engaged in activities not
permissible for a national bank. In addition, the OTS prompt corrective action
standards discussed below also establish, in effect, a minimum 2% tangible
capital standard, a 4% leverage ratio, and, together with the risk-based capital
standards itself, a 4% Tier 1 risk-based capital standard.
The risk-based capital standard for savings institutions requires the
maintenance of Tier 1 (core) and total capital (which is defined as core capital
and supplementary capital) to risk-weighted assets of at least 4% and 8%,
respectively. In determining the amount of risk-weighted assets, all assets,
including certain off balance sheet assets, recourse obligations, direct credit
substitutes and other residual interests are multiplied by a risk-weight factor
of 0% to 100%, as assigned by the OTS capital regulation based on the risks OTS
believes are inherent in the type of asset. The components of core capital are
equivalent to those discussed earlier. The components of supplementary capital
currently include cumulative preferred stock, long-term perpetual preferred
stock, mandatory convertible securities, subordinated debt and intermediate
preferred stock, the allowance for loan and lease losses, limited to a maximum
of 1.25% of risk-weighted assets and up to 45% of unrealized gains on
available-for-sale equity securities with readily determinable fair market
value. Overall, the amount of supplementary capital included as part of total
capital cannot exceed 100% of core capital.
The OTS also has authority to establish minimum capital requirements in
appropriate cases upon a determination that an institution's capital levels are
or may become inadequate in light of the particular circumstances. At September
30, 2004, the Bank met each of its capital requirements. The following table
presents the Bank's capital position at September 30, 2004. (Dollars in
thousands)
CAPITAL
ACTUAL REQUIRED EXCESS -------------------------
CAPITAL CAPITAL AMOUNT ACTUAL % REQUIRED %
----------- ----------- ---------- ----------- -----------
Tangible $ 61,331 $ 12,426 $ 48,905 7.40% 1.5%
Core (Leverage) 61,331 33,136 28,195 7.40 4.0
Risk-based 65,827 34,936 30,891 15.07 8.0
PROMPT CORRECTIVE REGULATORY ACTION. The OTS is required to take certain
supervisory actions against undercapitalized institutions, the severity of which
depends upon the institution's degree of under capitalization. Generally, a
savings institution that has a total risk-based capital of less than 8% or a
leverage ratio or a Tier 1 capital ratio that is less than 4% or a ratio of core
capital to total assets of less than 4% (3% or less for institutions with the
higher examination rating) is considered to be undercapitalized. A savings
institution that has a total risk-based capital less than 6%, a Tier 1
risk-based capital ratio of less than 3% or a leverage ratio that is less than
3% is considered to be "significantly undercapitalized" and a savings
institution that has a tangible capital to assets ratio equal to or less than 2%
is deemed to be "critically undercapitalized." Subject to a narrow exception,
the OTS is required to appoint a receiver or conservator for an institution that
is critically undercapitalized within specified time frames. The regulation also
provides that a capital restoration plan must be filed with the OTS within
45 days of the date an association receives notice that it is
"undercapitalized," significantly undercapitalized" or "critically
undercapitalized." Compliance with the plan must be guaranteed by any parent
holding company. In addition, numerous mandatory supervisory actions may become
immediately applicable to an undercapitalized institution, including, but not
limited to, increased monitoring by regulators, restrictions on growth, capital
distributions and expansion. The OTS could also take any one of a number of
discretionary supervisory actions, including the issuance of a capital directive
and the replacement of senior executive officers and directors.
INSURANCE OF DEPOSIT ACCOUNTS. The FDIC maintains a risk-based
assessment system by which institutions are assigned to one of three categories
based on the institution's capitalization and one of three subcategories based
on examination ratings and other supervisory information. An institution's
assessment rate depends on the categories to which it is assigned. Assessment
rates for SAIF member institutions are determined semi-annually and currently
range from 0 basis points, for the healthiest institutions to 27
Page 9
basis points, for the riskiest institutions. The Bank's assessment rate for
the fiscal year 2004 was 3 basis points (not including the FICO payment
discussed below) and the premium paid for this period was $122,442. The FDIC has
authority to increase insurance assessments. A significant increase in SAIF
insurance premiums would likely have an adverse effect on the operating expenses
and results of operations of the Bank. Management cannot predict what insurance
assessment rates will be in the future.
In addition to the assessment for deposit insurance, institutions are
required to make payments on bonds issued in the late 1980s by the Financing
Corporation ("FICO") to recapitalize the predecessor to the SAIF. During 2004,
FICO payments for SAIF members approximated 1.5 basis points.
Insurance of deposits may be terminated by the FDIC upon a finding that
the institution has engaged in unsafe or unsound practices, is in an unsafe or
unsound condition to continue operations or has violated any applicable law,
regulation, rule, order or condition imposed by the FDIC or the OTS. The
management of the Bank does not know of any practice, condition or violation
that might lead to termination of deposit insurance.
FEDERAL HOME LOAN BANK SYSTEM. The Bank is a member of the FHLB System,
which consists of 12 regional FHLBs. The FHLB provides a central credit facility
primarily for member institutions. The Bank, as a member of the FHLB, is
required to acquire and hold shares of capital stock in the FHLB in an amount at
least equal to 1% of the aggregate principal amount of its unpaid residential
mortgage loans and similar obligations at the beginning of each year, or 1/20 of
its advances (borrowings) from the FHLB, whichever is greater. The Bank was in
compliance with this requirement with an investment in FHLB stock at September
30, 2004, of $13.0 million. FHLB advances must be secured by specified types of
collateral and all long-term advances may only be obtained for the purpose of
providing funds for residential housing finance. At September 30, 2004, the Bank
had $243.9 million in FHLB advances.
The FHLBs are required to provide funds for the resolution of insolvent
thrifts and to contribute funds for affordable housing programs. These
requirements could reduce the amount of dividends that the FHLBs pay to their
members and could also result in the FHLBs imposing a higher rate of interest on
advances to their members. For the years ended September 30, 2004, 2003 and 2002
dividends from the FHLB to the Bank amounted to approximately $179,000,
$312,000, and $439,000, respectively. If dividends were reduced, the Bank's net
interest income would likely also be reduced. Recent legislation has changed the
structure of the Federal Home Loan Banks' funding obligations for insolvent
thrifts, revised the capital structure of the Federal Home Loan Banks and
implemented entirely voluntary membership for Federal Home Loan Banks.
Management cannot predict the effect that these changes may have with respect to
its Federal Home Loan Bank membership.
FEDERAL RESERVE SYSTEM
The Federal Reserve Board regulations require savings institutions to
maintain non-interest-earning reserves against their transaction accounts
(primarily NOW and regular checking accounts). The regulations generally require
that reserves be maintained against aggregate transaction accounts as follows:
for accounts aggregating $47.6 million or less (subject to adjustment by the
Federal Reserve Board) the reserve requirement is 3%; and for accounts greater
than $47.6 million, the reserve requirement is 10%. The first $7.0 million of
otherwise reservable balances (subject to adjustment by the Federal Reserve
Board) are exempted from the reserve requirements. The Bank is in compliance
with these requirements.
HOLDING COMPANY REGULATION
The Company is a nondiversified unitary savings and loan holding company
within the meaning of federal law. Under prior law, a unitary savings and loan
holding company, such as the Company, was not generally restricted as to the
types of business activities in which it may engage, provided that the Bank
continues to be a qualified thrift lender, as previously described. The
Gramm-Leach-Bliley Act of 1999 provides that no company may acquire control of a
savings institution after May 4, 1999 unless it engages only in the financial
activities permitted for financial holding companies or those permitted under
the law for multiple savings and loan holding companies as described below.
Further, the Gramm-Leach-Bliley Act specifies that existing savings and loan
holding companies may only engage in such activities. The Gramm-Leach-Bliley
Act, however, grandfathered the unrestricted authority of activities with
respect to unitary savings and loan holding companies existing prior to May 4,
1999, so long as the holding company's savings institution subsidiary continues
to comply with the qualified thrift lender test. The Company qualifies for the
grandfathering. Upon any non-supervisory acquisition by the Company of another
savings institution, or savings bank that meets the qualified thrift lender test
and is deemed to be a savings institution by the Office of Thrift Supervision,
the Company would become a multiple savings and loan holding company (if the
acquired institution is held as a separate subsidiary) and would generally be
limited to activities permissible for bank holding companies under Section
4(c)(8) of the Bank Holding Company Act, subject to the prior approval of the
OTS, and certain activities authorized by OTS regulation. However, the OTS has
issued an interpretation concluding that multiple savings and loan holding
companies may also engage in activities permitted for financial holding
companies.
Page 10
A savings and loan holding company is prohibited from, directly or
indirectly, acquiring more than 5% of the voting stock of another savings
institution, or holding company thereof, without prior written approval of the
OTS and from acquiring or retaining control of a depository institution that is
not insured by the FDIC. In evaluating applications by holding companies to
acquire savings institutions, the OTS must consider the financial and managerial
resources and future prospects of the company and institution involved, the
effect of the acquisition on the risk to the insurance funds, the convenience
and needs of the community and competitive factors.
The OTS may not approve any acquisition that would result in a multiple
savings and loan holding company controlling savings institutions in more than
one state, except: (i) the approval of interstate supervisory acquisitions by
savings and loan holding companies, and (ii) the acquisition of a savings
institution in another state if the laws of the state of the target savings
institution specifically permit such acquisitions. The states vary in the extent
to which they permit interstate savings and loan holding company acquisitions.
Although savings and loan holding companies are not currently subject to
specific capital requirements or specific restriction on the payment of
dividends or other capital distributions, federal regulations do prescribe such
restrictions on subsidiary savings institutions as described below. The Bank
must notify the OTS 30 days before declaring any dividend to the Company. In
addition, the financial impact of a holding company on its subsidiary
institution is a matter that is evaluated by the OTS and the agency has
authority to order cessation of activities or divestiture of subsidiaries deemed
to pose a threat to the safety and soundness of the institution.
ACQUISITION OF THE COMPANY. Under the Federal Change in Bank Control Act
("CIBCA"), a notice must be submitted to the OTS if any person (including a
company), or group acting in concert, seeks to acquire "control" of a savings
and loan holding company. Under certain circumstances, a change of control may
occur, and prior notice is required, upon the acquisition of 10% or more of the
Company's outstanding voting stock, unless the OTS has found that the
acquisition will not result in a change of control of the Company. Under the
CIBCA, the OTS has 60 days from the filing of a complete notice to act, taking
into consideration certain factors, including the financial and managerial
resources of the acquirer and the anti-trust effects of the acquisition. Any
company that so acquires control would then be subject to regulation as a
savings and loan holding company.
TRUST COMPANY REGULATION
The Trust Co. is chartered under the laws of Pennsylvania and the
Pennsylvania Department of Banking is responsible for its regulation,
supervision and examination. Pennsylvania law governs the activities and
investments of the Trust Co. as well as its administration of trust accounts.
The Trust Co. limits its activities to trust, fiduciary and related activities
and is not insured by the FDIC. The Pennsylvania Department of Banking maintains
authority to issue orders and suspend directors, officers or employees for
violations of law or regulations or unsafe practices and to take possession as
receiver or conservator of any institution for violations, unsafe practices or
condition or insolvency. The Trust Co. pays assessments to the Pennsylvania
Department of Banking, which in fiscal 2004 amounted to $2,500.
FEDERAL AND STATE TAXATION
FEDERAL TAXATION
GENERAL. The Company and the Bank report their income on a September 30
fiscal year basis using the accrual method of accounting and are subject to
federal income taxation in the same manner as other corporations with some
exceptions, including particularly the Bank's reserve for bad debts discussed
below. The following discussion of tax matters is intended only as a summary and
does not purport to be a comprehensive description of the tax rules applicable
to the Bank or the Company. Neither the Company nor the Bank has been audited by
the IRS in the past five years.
BAD DEBT RESERVE. Historically, savings institutions such as the Bank
which met certain definitional tests primarily related to their assets and the
nature of their business ("qualifying thrifts") were permitted to establish a
reserve for bad debts and to make annual additions thereto, which may have been
deducted in arriving at their taxable income. The Bank's deductions with respect
to "qualifying real property loans," which are generally loans secured by
certain interest in real property, were computed using an amount based on the
Bank's actual loss experience, or a percentage equal to 8% of the Bank's taxable
income, computed with certain modifications and reduced by the amount of any
permitted addition to the non-qualifying reserve. Due to the Bank's loss
experience, the Bank generally recognized a bad debt deduction equal to 8% of
taxable income.
In August 1996, the provisions repealing the above thrift bad debt rules
were passed by Congress as part of "The Small Business Job Protection Act of
1996." The new rules eliminated the 8% of taxable income method for deducting
additions to the tax bad debt reserves for all thrifts for tax years beginning
after December 31, 1995. These rules also required that all thrift institutions
recapture all or a portion of their bad debt reserves added since the base year
(the last taxable year beginning before January 1, 1988). The Bank had
previously recorded a deferred tax liability equal to the bad debt recapture and
as such, the new rules had no
Page 11
effect on net income or federal income tax expense. For taxable years that began
after December 31, 1995, the Bank's bad debt deduction was equal to net
charge-offs. The new rules allowed an institution to suspend the bad debt
reserve recapture for the 1996 and 1997 tax years if the institution's lending
activity for those years was equal to or greater than the institution's average
mortgage lending activity for the six taxable years preceding 1996. For this
purpose, only home purchase and home improvement loans were included and the
institution could have elected to have the tax years with the highest and lowest
lending activity removed from the average calculation. If an institution was
permitted to postpone the reserve recapture, it had to begin its six year
recapture no later than the 1998 tax year. The unrecaptured base year reserves
were not subject to recapture as long as the institution continued to carry on
the business of banking. In addition, the balance of the pre-1988 bad debt
reserves continued to be subject to a provision of present law referred to below
that required recapture in the case of certain excess distributions to
stockholders.
DISTRIBUTIONS. To the extent that the Bank makes "non-dividend
distributions" to the Company that are considered as made: (i) from the reserve
for losses on qualifying real property loans, to the extent the reserve for such
losses exceeds the amount that would have been allowed under the experience
method, or (ii) from the supplemental reserve for losses on loans ("Excess
Distributions"), then an amount based on the amount distributed will be included
in the Bank's taxable income. Non-dividend distributions include distributions
in excess of the Bank's current and accumulated earnings and profits,
distributions in redemption of stock, and distributions in partial or complete
liquidation. However, dividends paid out of the Bank's current or accumulated
earnings and profits, as calculated for federal income tax purposes, will not be
considered to result in a distribution from the Bank's bad debt reserve. Thus,
any dividends to the Company that would reduce amounts appropriated to the
Bank's bad debt reserve and deducted for federal income tax purposes would
create a tax liability for the Bank. The amount of additional taxable income
created from an Excess Distribution is an amount that, when reduced by the tax
attributable to the income, is equal to the amount of the distribution. Thus if
the Bank makes a "non-dividend distribution," then approximately one and
one-half times the amount so used would be includable in gross income for
federal income tax purposes, assuming a 34% corporate income tax rate (exclusive
of state and local taxes). The Bank does not intend to pay dividends that would
result in a recapture of any portion of its bad debt reserve.
CORPORATE ALTERNATIVE MINIMUM TAX. The Code imposes a tax on alternative
minimum taxable income ("AMTI") at a rate of 20%. Only 90% of AMTI can be offset
by net operating loss carryovers of which the Company currently has none. AMTI
is increased by an amount equal to 75% of the amount by which the Company's
adjusted current earnings exceeds its AMTI (determined without regard to this
preference and prior to reduction for net operating losses). In addition, for
taxable years beginning after June 30, 1986 and before January 1, 1996, an
environmental tax of 0.12% of the excess of AMTI (with certain modifications)
over $2.0 million is imposed on corporations, including the Company, whether or
not an Alternative Minimum Tax ("AMT") is paid. The Company does not expect to
be subject to the AMT.
DIVIDENDS RECEIVED DEDUCTION AND OTHER MATTERS. The Company may exclude
from its income 100% of dividends received from the Bank as a member of the same
affiliated group of corporations. The corporate dividends received deduction is
generally 70% in the case of dividends received from unaffiliated corporations
with which the Company and the Bank will not file a consolidated tax return,
except that if the Company or the Bank owns more than 20% of the stock of a
corporation distributing a dividend then 80% of any dividends received may be
deducted.
STATE AND LOCAL TAXATION
The Company and its non-thrift Pennsylvania subsidiaries are subject to
the Pennsylvania Corporation Net Income Tax and Capital Stock and Franchise Tax.
The state Corporate Net Income Tax rate for fiscal years ended 2004, 2003 and
2002 was 9.99% and was imposed on the Company's and its non-thrift subsidiaries'
unconsolidated taxable income for federal purposes with certain adjustments. In
general, the Capital Stock Tax is a property tax imposed at the rate of .699% of
a corporation's capital stock value, which is determined in accordance with a
fixed formula. The Company is also required to file an annual report with and
pay an annual franchise tax to the State of Delaware.
The Bank is taxed under the Pennsylvania Mutual Thrift Institutions Tax
Act (the "MTIT"), as amended, to include thrift institutions having capital
stock. Pursuant to the MTIT, the Bank's tax rate is 11.5%. The MTIT exempts the
Bank from all other taxes imposed by the Commonwealth of Pennsylvania for state
income tax purposes and from all local taxation imposed by political
subdivisions, except taxes on real estate and real estate transfers. The MTIT is
a tax upon net earnings, determined in accordance with generally accepted
accounting principles prevailing in the United States ("GAAP") with certain
adjustments. The MTIT, in computing GAAP income, allows for the exclusion of
interest earned on Pennsylvania and federal securities, while disallowing a
percentage of a thrift's interest expense deduction in the proportion of
interest income on those securities to the overall interest income of the Bank.
Net operating losses, if any, thereafter can be carried forward three years for
MTIT purposes. Neither the Company nor the Bank have been audited by the
Commonwealth of Pennsylvania in the last five years.
Page 12
ADDITIONAL ITEM. EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth information regarding the executive
officers of the Company and its subsidiaries as of September 30, 2004 who are
not directors.
NAME AGE AS OF 9/30/04 POSITION
- ----------------- ----------------- -----------------------------------------
Jerry D. Holbrook 48 Chief Financial Officer and Secretary of
the Bank and Company since 2003. From
2000 to 2002, Chief Financial Officer of
E-Duction, a financial services start-up
company located in the metropolitan area
of Philadelphia, Pennsylvania. Prior to
2000, 15 years of senior level banking
experience at First USA Bank (JP Morgan
Chase) and WSFS Financial Corporation,
both located in Wilmington, Delaware.
Leo R. Loftus 49 Senior Vice President and Chief Lending
Office at First Federal Bank since
September 2003. Prior to that, Senior
Vice President - Commerical Lender at
First Federal Bank.
ITEM 2. PROPERTIES
The Company currently conducts its business through 16 full service
community offices located in Luzerne, Carbon, Columbia, Monroe and Schuylkill
counties in Northeast Pennsylvania. Abstractors, Inc. and Northeast Pennsylvania
Trust Co. conduct their business in the downtown Hazleton area. The following
table sets forth the Company's offices as of September 30, 2004. The Kingston,
Pennsylvania branch office listed below was opened in December 2004 and,
accordingly, has no book value or deposits at September 30, 2004.
Original Net Book Value of
Year Property or Leasehold
Leased Leased or Date of Lease Improvements at Total Deposits
Location or Owned Acquired Expiration September 30, 2004 September 30,2004
- ---------------------------------- -------- ---------- -------------- --------------------- -----------------
(Dollars In Thousands)
ADMINISTRATIVE/HOME OFFICE:
12 E. Broad Street
Hazleton, PA 18201 Owned 1947 - $ 3,460 $ 159,369
BRANCH OFFICES:
Bloomsburg Office:
17 E. Main Street
Bloomsburg, PA 17815 Owned 1963 - 398 23,750
Shenandoah Office:
5 N. Main Street
Shenandoah, PA 17976 Owned 1968 - 424 41,051
Page 13
Pottsville Office:
111 E. Norwegian Street
Pottsville, PA 17901 Owned 1968 - 652 23,467
Lehighton Office:
111 N. First Street
Lehighton, PA 18235 Owned 1977 - 55 24,416
Schuylkill Mall Office (1):
611 Schuylkill Mall
Frackville, PA 17931 Leased 1978 2004 254 20,565
Laurel Mall Office:
240 Laurel Mall
Hazleton, PA 18201 Leased 1994 2005 181 71,217
Gould's IGA Office:
669 State Route 93, Suite 5
Sugarloaf, PA 18249 Leased 1995 2005 50 19,349
Mountaintop Office:
360 S. Mountain Boulevard
Mountaintop, PA 18707 Owned 1997 - 741 20,753
Scott Township Office:
2691 Columbia Blvd.
Bloomsburg, PA 17815 Owned 1998 - 911 16,294
Brodheadsville Office:
760 Route 209 &
Weir Lake Road
Brodheadsville, PA 18322 Leased 2000 2005 42 8,520
Back Mountain Office:
196 N. Main Street
Shavertown, PA 18708 Owned 2001 - 1,143 14,183
Weatherly Office:
140 Carbon Street
Weatherly, PA 18255 Owned 2001 - 83 13,128
Drums Office:
Route 309, 24 South
Hunter Highway
Drums, PA 18222 Owned 2001 - 218 14,653
Laurel Mall Satellite Office:
345 Laurel Mall, Route 93
Hazleton, PA 18201 Leased 2001 2005 291 397
Schuylkill Haven Office:
333 Center Avenue
Schuylkill Haven, PA 17972 Owned 2002 - 360 12,329
Kingston Office:
183 Market Street
Suite 100
Kingston, PA 18704 Leased 2004 2009 - -
Page 14
TITLE INSURANCE AGENCY
Abstractors, Inc. (2)
25 W. Broad Street
Hazleton, PA 18201 Owned 2001 month-to-month - N/A
TRUST COMPANY
NEP Trust Co. (2)
31 W. Broad Street
Hazleton, PA 18201 Owned 2001 month-to-month - N/A
INSURANCE AGENCY
Higgins Insurance Associates, Inc.
115 S. Centre Street
Pottsville, PA 17901 Leased 2001 2010 - N/A
(1) The Company is presently in negotiations to extend its lease for the
Schuylkill Mall office by one year.
(2) The Bank owns the building and provides intercompany leases to NEP Trust
Company and Abstractors, Inc.
ITEM 3. LEGAL PROCEEDINGS
The Company is not involved in any pending legal proceedings other than
routine legal proceedings occurring in the ordinary course of business. Such
routine legal proceedings, in the aggregate, are believed by management to be
immaterial to the Company's financial condition or results of operation.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
Page 15
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES
MARKET FOR REGISTRANT'S COMMON EQUITY
The Company's common stock is traded on the Nasdaq Stock Market under
the symbol NEPF. At September 30, 2004, the Company had 1,482 registered common
stockholders of record. The following table sets forth the range of high and low
bid information for each quarterly period within the two most recent fiscal
years as well as the quarterly dividends paid.
The closing market price of the common stock at September 30, 2004 was
$16.51.
STOCK PRICE RANGE
------------------
Low High Dividends
-------- -------- ---------
2004
1st quarter $ 17.50 $ 20.00 $ 0.06
2nd quarter 17.01 19.75 0.06
3rd quarter 16.80 18.39 0.06
4th quarter 16.25 17.74 0.06
---------
$ 0.24
2003
1st quarter $ 13.96 $ 17.05 $ 0.12
2nd quarter 14.67 17.42 0.12
3rd quarter 15.00 16.75 0.12
4th quarter 14.77 18.47 0.12
---------
$ 0.48
The Company's dividend policy is impacted by, among other things, our
views on potential future capital requirements relating to balance sheet growth,
the expansion of the Bank's branch distribution channel, investments and
acquisitions and legal risks. The Company is also subject to the requirements of
Delaware law which limits dividends to an amount not to exceed the surplus or
net profits of the Company. Additionally, the Company agreed to limit its
quarterly dividends to $.06 per share in the Definitive Agreement and Plan of
Merger dated December 8, 2004 with KNBT Bancorp, Inc.
RECENT SALES OF UNREGISTERED SECURITIES
Under the Agreement, dated December 7, 2000, by and among, Northeast
Pennsylvania Financial Corp., James Clark, James McCann, Joseph P. Schlitzer,
John W. Sink and Higgins Insurance Associates, Inc., in consideration for the
purchase of Higgins Insurance Associates, Inc., Northeast Pennsylvania is
required to issue on each of the December 31, 2001, 2002, 2003 and 2004, an
amount of shares of common stock equal to $100,000 provided that certain
performance measures have been met. This resulted in the Company issuing
6,568, 6,369, and 5,206 shares of common stock on December 2001, 2002 and 2003,
respectively. These shares were not registered under the Securities Act of 1933,
as amended.
Page 16
PURCHASES OF EQUITY SECURITIES
The following table sets forth information regarding the Company's
repurchases of its common stock during the quarter ended September 30, 2004.
TOTAL NUMBER
OF SHARES
PURCHASED MAXIMUM
AS PART OF NUMBER OF SHARES
TOTAL PUBLICLY THAT MAY YET BE
NUMBER OF AVERAGE ANNOUNCED PURCHASED UNDER
SHARES PRICE PAID PLANS OR THE PLAN OR
PERIOD PURCHASED PER SHARE PROGRAMS PROGRAMS (1)(2)
- --------------------------- --------- ----------- ------------ ----------------
July 2004
Beginning date: July 1 195,000 $ 17.20 195,000 4,000
Ending date: July 31
August 2004
Beginning date: August 1 -- $ -- -- --
Ending date: August 31
September 2004
Beginning date: September 1 1,000 $ 16.50 1,000 3,000
Ending date: September 30
--------- ----------- --------- ---------
Total 196,000 $ 17.20 196,000 N/A
- ----------
(1) On May 26, 2004, the Board of Directors authorized the repurchase of 5% of
the Company's outstanding shares, or approximately 209,000 shares, from time to
time, subject to market conditions. This plan will continue until it is
completed or terminated by the Board of Directors.
(2) The Company agreed to postpone any future repurchases of its common stock on
December 8, 2004 when it executed the Agreement and Plan of Merger with KNBT
Bancorp, Inc.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial and other data of the Company set
forth below is derived in part from, and should be read in conjunction with, the
Consolidated Financial Statements of the Company and Notes thereto presented
elsewhere in this Annual Report on Form 10-K. Prior periods have been restated
to reflect the correction of certain accounting errors which were discovered in
July and September 2003. See Note 2 to the Consolidated Financial Statements for
additional information regarding the restatement.
Page 17
AT SEPTEMBER 30,
-------------------------------------------------------------------
(IN THOUSANDS)
AS RESTATED AS RESTATED AS RESTATED
2004 2003 2002 2001 2000
----------- ----------- ----------- ----------- -----------
SELECTED CONSOLIDATED FINANCIAL DATA:
Total assets $ 836,035 $ 896,295 $ 901,945 $ 807,373 $ 636,490
Cash and cash equivalents 26,938 20,142 25,302 9,060 6,295
Loans, net (1) 403,584 489,986 488,316 498,076 415,315
Securities held-to-maturity:
Investment securities, net 998 3,555 3,652 17,842 30,336
Securities available-for-sale:
Mortgage-related securities, net 326,981 210,965 225,287 138,467 53,076
Investment securities, net 30,242 115,661 102,599 105,181 104,398
Deposits 483,441 547,305 606,412 515,735 419,671
FHLB Advances 243,867 258,901 208,421 204,441 137,461
Total equity 58,458 58,357 65,125 74,380 72,123
Assets acquired through foreclosure 315 1,022 547 390 173
Nonperforming assets and
troubled debt restructurings 7,184 13,501 4,747 5,113 3,672
FOR THE FISCAL YEARS ENDED SEPTEMBER 30,
-------------------------------------------------------------------
(IN THOUSANDS)
AS RESTATED AS RESTATED AS RESTATED
2004 2003 2002 2001 2000
----------- ----------- ----------- ----------- -----------
SELECTED OPERATING DATA:
Total interest income $ 40,962 $ 45,364 $ 52,633 $ 53,398 $ 44,493
Interest expense 19,856 25,188 28,988 31,314 26,531
----------- ----------- ----------- ----------- -----------
Net interest income 21,106 20,176 23,645 22,084 17,962
Provision for loan losses 1,444 6,852 2,766 1,681 1,467
----------- ----------- ----------- ----------- -----------
Net interest income after provision
for loan losses 19,662 13,324 20,879 20,403 16,495
Noninterest income:
Net gain on sale of securities 1,292 1,319 308 333 37
Other 10,043 8,657 7,768 4,982 1,859
Noninterest expense 23,611 29,199 24,639 19,655 14,471
----------- ----------- ----------- ----------- -----------
Income (loss) before income taxes 7,386 (5,899) 4,316 6,063 3,920
Income tax expense (benefit) 2,299 (1,829) 1,620 1,861 373
----------- ----------- ----------- ----------- -----------
Net income (loss) $ 5,087 $ (4,070) $ 2,696 $ 4,202 $ 3,547
=========== =========== =========== =========== ===========
Diluted earnings (loss) per share $ 1.26 $ (1.08) $ 0.63 $ 0.89 $ 0.73
=========== =========== =========== =========== ===========
(See footnotes on next page)
Page 18
AT OR FOR THE FISCAL YEARS ENDED SEPTEMBER 30,
-------------------------------------------------------------------
As Restated As Restated As Restated
2004 2003 2002 2001 2000
----------- ----------- ----------- ----------- -----------
SELECTED OPERATING DATA (2):
PERFORMANCE RATIOS:
Average yield on interest-earning assets (3) 5.05% 5.46% 6.60% 7.52% 7.42%
Average rate paid on interest-bearing
liabilities 2.61 3.21 3.91 4.79 4.81
Average interest rate spread (4) 2.44 2.25 2.69 2.73 2.61
Net interest margin (5) 2.64 2.48 3.01 3.20 3.16
Ratio of interest-earning assets to
interest-bearing liabilities 108.03 107.50 109.15 111.04 112.74
Efficiency ratio (6) 72.78 96.84 77.67 71.74 72.87
Return on average assets 0.59 (0.46) 0.32 0.55 0.55
Return on average equity 8.62 (6.27) 3.89 5.57 4.93
Ratio of average equity to average assets 6.82 7.30 8.13 9.93 11.16
Common stock dividend payout ratio (diluted)(7) 19.05 nm 73.02 42.70 41.10
BANK CAPITAL RATIOS:
Risk-based capital
Tier 1 capital (required 4.0%) 13.82% 9.27% 9.45% 10.72% 15.97%
Total (required 8.0%) 15.07 10.52 10.45 11.65 17.16
Core capital (required 4.0%) 7.40 6.17 5.81 6.50 9.25
OTHER:
Stock price at year end $ 16.51 $ 17.50 $ 14.75 $ 14.45 $ 11.50
Common stock dividends declared per share $ 0.24 $ 0.48 $ 0.46 $ 0.38 $ 0.30
Employees 272 280 283 246 194
(1) Loans, net, represent gross loans receivable net of the allowance for loan
losses, loans in process and deferred loan origination fees and exclude
loans held-for-sale. The allowance for loan losses at September 30, 2004,
2003, 2002, 2001, and 2000 was $8.4 million, $10.2 million, $5.4 million,
$4.5 million, $4.2 million and $2.9 million, respectively.
(2) To the extent applicable, all ratios are based on average daily balances.
(3) Calculations of yield are presented on a taxable equivalent basis using the
combined Federal and state income tax rate of 40%.
(4) The average interest rate spread represents the difference between the
weighted average yield on average interest-earning assets and the weighted
average cost of average interest-bearing liabilities.
(5) The net interest margin represents net interest income as a percent of
average interest-earning assets.
(6) Calculated as non-interest expense divided by the sum of total income less
interest expense.
(7) The dividend payout ratio equals dividends paid per share divided by net
income per share. Since the Company reported a net loss for 2003, this ratio
was not meaningful.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
INTRODUCTION AND BUSINESS
The Company's results of operations are dependent primarily on the results of
operation of the Bank and thus are dependent to a significant extent on net
interest income, which is the difference between the income earned on its loan
and investment portfolios and its cost of funds, consisting of the interest paid
on deposits and borrowings. However, non-interest income has become a
significant contributor to the Company's results of operations mainly due to
fees earned by non-bank subsidiaries. Results of operations are also affected by
the Company's provision for loan losses, loan and security sales activities,
service charges and other fee income, and noninterest expense. The Company's
noninterest expense principally consists of compensation and employee benefits,
office occupancy and equipment expense, data processing, professional fees, and
advertising and business promotion expenses. Results of operations are also
significantly affected by general economic and competitive conditions,
particularly changes in interest rates, government policies and actions of
regulatory authorities.
Page 19
The Company's results of operations have been restated for the years ended
September 30, 2002 through 1998 to reflect the correction of accounting errors
discovered in July and September 2003. These errors primarily related to the
Company's indirect automobile loan portfolio, mortgage and consumer loan
portfolios, employee health and welfare benefit plans and certain operating
expenses, which are more fully described in Note 2 to the Consolidated Financial
Statements. The net effect of such restatements was to reduce net interest
income, increase operating expenses and decrease retained earnings for prior
periods. The following discussion of the Company's business reflects these
restatements.
The following discussion and analysis is presented on a consolidated basis and
focuses on the major components of the Company's operations and significant
changes in the results of operations for the periods presented. The discussion
should be read in conjunction with the Company's Consolidated Financial
Statements and accompanying notes thereto presented elsewhere in this Annual
Report on Form 10-K.
CRITICAL ACCOUNTING POLICIES
The Company has established various accounting policies that govern the
application of principles generally accepted in the United States in the
preparation of its financial statements. Significant accounting policies are
described in the Footnotes to the Consolidated Financial Statements. The Company
believes the allowance for loan losses is a critical accounting policy that
requires the most significant judgments and estimates used in the preparation of
the Consolidated Financial Statements. For further discussion of the allowance
for loan losses, see "Financial Condition - Allowance for Loan Losses." Although
we believe we use the best information available to establish the allowance for
loan losses, future additions to the allowance may be necessary based on
estimates that are susceptible to change as a result of changes in economic
conditions and other factors.
MANAGEMENT STRATEGY
The long-term strategy of the Company has been to become a high-performing
financial service company focusing on its customer needs for high-quality
financial products and services. The Bank provides residential and commercial
real estate, commercial and consumer lending services, as well as retail deposit
and cash management services. Lending activities are funded primarily with
retail deposits and borrowings. To promote long-term financial strength and
profitability, the Company's operating strategy has been focused on originating
high-quality consumer and small-business commercial loans and deposit
relationships. The Company also manages an investment portfolio of high-quality
mortgage-related securities and investment securities, which are funded with
long-term Federal Home Loan Bank advances and deposits. The Company currently
sells newly originated fixed-rate residential mortgages in the secondary market.
In September 2003, the Board of Directors initiated several management and
operational changes including appointing two seasoned bank executives to lead
the Company. Thomas Petro was appointed as President and Chief Executive Officer
after the resignation of the former President and Chief Executive Officer and
Jerry Holbrook was appointed as Chief Financial Officer. The Company's new
management team has repositioned the balance sheet and improved earnings by
divesting certain fixed-rate residential mortgage loans and investment
securities and reinvesting these proceeds in similar assets that are
interest-rate sensitive. The Company also evaluated alternatives to restructure
a portion of its long-term fixed-rate FHLB borrowings to improve net interest
income and effectively manage the Bank's interest-rate risk position. This
resulted in the Bank entering into interest-rate swap contracts whereby such
long-term fixed-rate advances were swapped to variable rates. In addition, the
Bank has developed loan and deposit pricing systems to support its long-term
strategy of increasing core deposits in its local market areas while expanding
the loan portfolio through new originations, commercial loan participations and
strategic purchases of high-quality loan receivables.
MANAGEMENT OF INTEREST RATE RISK AND MARKET RISK ANALYSIS
The principal objective of the Bank's interest rate risk management is to
evaluate the interest rate risk included in certain balance sheet accounts,
determine the level of risk appropriate given the Bank's business strategy,
operating environment, capital and liquidity requirements and performance
objectives, and manage the risk consistent with approved guidelines. Through
such management, the Bank seeks to reduce the vulnerability of its operations to
changes in interest rates. The Bank's Asset Liability Committee (the "ALCO") is
responsible for reviewing the Bank's asset/liability policies and interest rate
risk position. The ALCO meets on a monthly basis and reports trends and the
Bank's interest rate risk position to the Risk Management Committee of the Board
of Directors. The extent of the movement of interest rates is an uncertainty
that could have a negative impact on the earnings of the Bank.
Management believes that reducing its exposure to interest rate fluctuations
within certain limits will enhance long-term profitability. However, the Bank's
strategies may adversely impact net interest income due to lower initial yields
on some of its adjustable rate loans and securities in comparison to longer-term
fixed-rate investments and whole loans. To promote a higher yield on its
investment securities, while at the same time addressing the Bank's interest
rate risk management policies, the Bank has
Page 20
invested a portion of its portfolio of investment securities in longer-term
(more than five years) Federal agency obligations, which have call features.
Given the rates of such securities in comparison to current market interest
rates, the Bank anticipates the majority of such securities may be called prior
to their contractual maturity. The Bank also uses the derivatives markets to
manage interest-rate risk from time-to-time primarily by engaging in interest
rate swaps to manage interest rate risk on its borrowings. Under the Agreement
and Plan of Merger, the Bank must obtain KNBT's approval before entering into or
modifying any interest rate caps on swap agreements or arrangements. At
September 30, 2004, there were $40.0 million in notional amount of derivative
contracts in effect.
NET PORTFOLIO VALUE. The Company's interest rate sensitivity is primarily
monitored by management through the use of a model, which generates estimates of
the change in the Company's net portfolio value ("NPV") over a range of interest
rate scenarios. NPV is the present value of expected cash flows from assets,
liabilities, and off-balance sheet contracts. The NPV ratio, under any interest
rate scenario, is the NPV divided by the market value of assets in the same
scenario. The model estimates loan prepayment rates, reinvestment rates, and
deposit decay rates. The Office of Thrift Supervision ("OTS") also produces a
similar analysis using its own model, based upon data submitted on the Bank's
quarterly Thrift Financial Reports, the results of which vary from the Company's
internal model primarily due to differences in assumptions utilized.
The following table sets forth the Company's NPV model as of September 30, 2004.
NPV AS % OF PORTFOLIO
Change in NET PORTFOLIO VALUE VALUE OF ASSETS
Interest Rates -----------------------------------------------------------
In Basis Points NPV
(Rate Shock) Amount $ Change % Change Ratio Change(1)
- --------------- --------- --------- -------- --------- ---------
($ in thousands)
+300 $ 65,965 $ (18,984) (22.35)% 8.41% (171)
+200 74,005 (10,944) (12.88) 9.21 (91)
+100 80,862 (4,087) (4.81) 9.83 (29)
0 84,949 - - 10.12 -
-100 83,649 (1,300) (1.53) 9.82 (30)
(1) Expressed in basis points.
The following table sets forth the Company's NPV model as of September 30, 2003.
NPV AS % OF PORTFOLIO
Change in NET PORTFOLIO VALUE VALUE OF ASSETS
Interest Rates -----------------------------------------------------------
In Basis Points NPV
(Rate Shock) Amount $ Change % Change Ratio Change(1)
- --------------- --------- --------- -------- --------- ---------
($ in thousands)
+300 $ 63,654 $ (39,635) (38.37)% 7.58% (361)
+200 75,326 (27,963) (27.07) 8.71 (248)
+100 83,779 (19,510) (18.89) 9.44 (175)
0 103,289 - - 11.19 -
-100 87,614 (15,675) (15.18) 9.48 (171)
(1) Expressed in basis points.
The change in the NPV model between 2004 and 2003 reflects changes in the
balance sheet mix and the move to a more neutral repricing gap position as a
result of shortening the duration of interest-earning assets and lengthening the
duration of interest-bearing liabilities. This change resulted in the Bank
becoming less sensitive to rising interest rates. Certain shortcomings are
inherent in the methodology used in NPV interest rate risk measurements.
Modeling changes in NPV require the making of certain assumptions that may or
may not reflect the manner in which actual yields and costs respond to changes
in market interest rates. In this regard, the NPV presented assumes that the
composition of the Company's interest sensitive assets and liabilities existing
at the beginning of a period remain constant over the period being measured and
also assumes that a particular change in interest rates is reflected uniformly
across the yield curve regardless of the duration to maturity or repricing of
specific assets and liabilities. Accordingly, NPV measurements provide an
indication of the Company's interest rate risk exposure at a particular point in
time. Such measurements are not intended to, and do not, provide a precise
forecast of the effect of changes in market interest rates on the Company's net
interest income and will differ from actual results.
Page 21
ANALYSIS OF NET INTEREST INCOME
Net interest income is the most significant component of operating income to the
Company. Net interest income represents the difference between income on
interest-earning assets and expense on interest-bearing liabilities. Net
interest income also depends upon the relative amounts of interest-earning
assets and interest-bearing liabilities and the interest rate earned or paid on
them. The interest rate spread is influenced by regulatory, economic and
competitive factors that affect interest rates, loan demand and deposit flows.
Additionally, the level of nonperforming loans impacts the interest rate spread
by reducing the overall yield on the loan portfolio.
AVERAGE BALANCE SHEET. The following table sets forth certain information
relating to the Company for the fiscal years ended September 30, 2004, 2003 and
2002. The average yields and costs are derived by dividing income or expense by
the average balance of interest-earning assets or interest-bearing liabilities,
respectively, for the periods shown. Average balances are derived from average
daily balances. The yields and costs include fees which are considered
adjustments to yields.
Page 22
FOR THE FISCAL YEARS ENDED SEPTEMBER 30,
---------------------------------------------------------------------
(IN THOUSANDS)
2004 2003
--------------------------------- ---------------------------------
Average Average
Average Yield/ Average Yield/
Balance Interest Rate Balance Interest Rate
--------- --------- --------- --------- --------- ---------
INTEREST-EARNING ASSETS:
Loans (1):
Real estate:
Taxable $ 198,150 $ 12,741 6.43% $ 253,061 $ 17,357 6.86%
Non-taxable (2) 3,791 316 8.34 3,972 326 8.21
Commercial:
Taxable 33,816 1,628 4.82 37,011 2,134 5.77
Non-taxable (2) 6,946 491 7.07 8,244 530 6.43
Consumer 208,751 12,444 5.96 195,959 13,136 6.70
--------- --------- --------- --------- --------- ---------
Total loans $ 451,454 $ 27,620 6.12% $ 498,247 $ 33,483 6.72%
Mortgage-related securities (3) 276,282 10,383 3.76 199,915 6,528 3.27
Investment securities (4):
Taxable 67,294 2,588 3.85 98,362 4,506 4.58
Non-taxable (2) 11,602 859 7.40 19,469 1,376 7.07
Interest-earning deposits 15,370 88 0.57 28,186 220 0.78
--------- --------- --------- --------- --------- ---------
Total interest-earning assets 822,002 $ 41,538 5.05% 844,179 $ 46,113 5.46%
Noninterest-earning assets 43,554 45,522
--------- ---------
Total assets $ 865,556 $ 889,701
========= =========
INTEREST-BEARING LIABILITIES:
Deposits:
Money market and
NOW accounts $ 168,099 $ 1,399 0.83% $ 197,074 $ 2,807 1.42
Savings accounts 95,022 94 0.10 98,278 395 0.40
Certificates of deposit 204,030 6,364 3.12 258,796 8,956 3.46
Brokered CDs 19,470 356 1.83 - - -
--------- --------- --------- --------- --------- ---------
Total deposits $ 486,621 $ 8,213 1.69 $ 554,148 $ 12,158 2.19
FHLB advances and other
borrowings 251,955 10,570 4.20 210,360 11,978 5.69
Trust preferred debt 22,341 1,073 4.80 20,782 1,052 5.06
--------- --------- --------- --------- --------- ---------
Total interest-bearing
liabilities 760,917 19,856 2.61 785,290 25,188 3.21
Non-interest-bearing
liabilities 45,648 39,454
--------- ---------
Total liabilities $ 806,565 $ 824,744
Equity 58,991 64,957
--------- ---------
Total liabilities and equity $ 865,556 $ 889,701
========= =========
Net interest-earning assets $ 61,085 $ 58,889
Net interest income/interest rate
spread (5) $ 21,682 2.44% $ 20,925 2.25%
--------- ---------
Net interest margin (6) 2.64% 2.48%
--------- ---------
Ratio of interest-earning assets to
interest-bearing liabilities 108.03% 107.50%
--------- ---------
FOR THE FISCAL YEARS ENDED
SEPTEMBER 30,
---------------------------------
(in thousands)
AS RESTATED
2002
---------------------------------
Average
Average Yield/
Balance Interest Rate
--------- --------- ---------
INTEREST-EARNING ASSETS:
Loans (1):
Real estate:
Taxable $ 283,768 $ 21,118 7.44%
Non-taxable (2) 4,018 332 8.26
Commercial:
Taxable 26,978 1,885 6.99
Non-taxable (2) 6,623 456 6.88
Consumer 177,832 13,779 7.75
--------- --------- ---------
Total loans $ 499,219 $ 37,570 7.53%
Mortgage-related securities (3) 177,373 8,701 4.91
Investment securities (4):
Taxable 95,787 5,507 5.75
Non-taxable (2) 19,708 1,411 7.16
Interest-earning deposits 16,636 171 1.03
--------- --------- ---------
Total interest-earning assets $ 808,723 $ 53,360 6.60%
Noninterest-earning assets 43,130
---------
Total assets $ 851,853
=========
INTEREST-BEARING LIABILITIES:
Deposits:
Money market and
NOW accounts $ 132,896 $ 2,457 1.85%
Savings accounts 93,114 1,141 1.22
Certificates of deposit 303,365 13,324 4.39
Brokered CDs - - -
--------- --------- ---------
Total deposits $ 529,375 $ 16,922 3.20
FHLB advances and other
borrowings 208,579 11,859 5.69
Trust preferred debt 2,973 207 6.93
--------- --------- ---------
Total interest-bearing
liabilities 740,927 28,988 3.91
Non-interest-bearing
liabilities 41,636
---------
Total liabilities $ 782,563
Equity 69,290
---------
Total liabilities and equity $ 851,853
=========
Net interest-earning assets $ 67,796
Net interest income/interest rate
spread (5) $ 24,372 2.69%
---------
Net interest margin (6) 3.01%
---------
Ratio of interest-earning assets to
interest-bearing liabilities 109.15%
---------
(1) Balances are net of deferred loan origination costs, undisbursed proceeds of
construction loans in process, but include non-performing loans and loans
held-for-sale.
(2) Interest and Yield/Rate are presented on a tax-equivalent basis using a tax
rate of 40%.
(3) Includes mortgage-related securities available-for-sale and
held-to-maturity.
(4) Includes investment securities available for sale and held to maturity,
stock in the FHLB, Freddie Mac and Fannie Mae securities.
(5) Net interest rate spread represents the difference between the
weighted-average yield on interest-earning assets and the weighted average
cost of interest-bearing liabilities.
(6) Net interest margin represents net interest income as a percentage of
average interest-earning assets.
Page 23
RATE/VOLUME ANALYSIS. The following table presents the extent to which changes
in interest rates and changes in the volume of interest-earning assets and
interest-bearing liabilities have affected the Company's interest income and
interest expense during the periods indicated. Information is provided in each
category with respect to: (i) changes attributable to changes in volume (changes
in volume multiplied by prior rate); (ii) changes attributable to changes in
rate (changes in rate multiplied by prior volume); and (iii) the net change. The
changes attributable to the combined impact of volume and rate have been
allocated on a proportional basis between changes in rate and volume.
YEAR ENDED SEPTEMBER 30,
-------------------------------------------------------------------------------
(IN THOUSANDS)
2004 VS 2003 2003 VS 2002
-------------------------------------- --------------------------------------
Increase Increase
(Decrease) due to (Decrease) due to
--------------------- Total Increase --------------------- Total Increase
Rate Volume (Decrease) Rate Volume (Decrease)
--------- --------- -------------- --------- --------- --------------
INTEREST-EARNING ASSETS:
Loans (1):
Real Estate:
Taxable $ (1,033) $ (3,583) $ (4,616) $ (1,580) $ (2,181) $ (3,761)
Non Taxable (2) 5 (15) (10) (2) (4) (6)
Commercial:
Taxable (332) (174) (506) (221) 470 249
Non Taxable (2) 67 (106) (39) (27) 101 74
Consumer (1,687) 995 (692) (2,634) 1,991 (643)
--------- --------- -------------- --------- --------- --------------
Total loans (2,980) (2,883) (5,863) (4,464) 377 (4,087)
Mortgage-related securities (3) 1,092 2,763 3,855 (3,506) 1,333 (2,173)
Investment securities (4):
Taxable (646) (1,272) (1,918) (1,154) 153 (1,001)
Non Taxable (2) 69 (586) (517) (18) (17) (35)
Interest-earning deposits (49) (83) (132) (26) 75 49
--------- --------- -------------- --------- --------- --------------
Total interest-earning assets (2,514) (2,061) (4,575) (9,168) 1,921 (7,247)
========= ========= ============== ========= ========= ==============
INTEREST-BEARING LIABILITIES:
Deposits:
Money market and NOW accounts (1,040) (368) (1,408) (318) 668 350
Savings accounts (288) (13) (301) (813) 67 (746)
Certificates of deposit (825) (1,767) (2,592) (2,580) (1,788) (4,368)
Brokered CDs - 356 356 - - -
--------- --------- -------------- --------- --------- --------------
Total deposits (2,153) (1,792) (3,945) (3,711) (1,053) (4,764)
FHLB advances and other borrowings (5,693) 4,285 (1,408) 10 109 119
Trust preferred debt (45) 66 21 (40) 886 846
--------- --------- -------------- --------- --------- --------------
Total interest-bearing liabilities (7,891) 2,559 (5,332) (3,741) (58) (3,799)
--------- --------- -------------- --------- --------- --------------
Increase (decrease) in net interest
income $ 5,377 $ (4,620) $ 757 $ (5,427) $ 1,979 $ (3,448)
========= ========= ============== ========= ========= ==============
(1) Balances are net of deferred loan origination costs, undisbursed proceeds of
construction loans in process, but include nonperforming loans.
(2) Presented on a taxable equivalent basis using the combined Federal and state
income tax marginal rate of 40%.
(3) Includes mortgage-related securities available-for-sale and
held-to-maturity.
(4) Includes investment securities available-for-sale and held-to-maturity,
stock in FHLB, Freddie Mac and Fannie Mae.
Page 24
RESULTS OF OPERATIONS
GENERAL. The Company reported net income of $5.1 million for fiscal 2004
compared to a net loss of $4.1 million and net income of $2.7 million for fiscal
years 2003 and 2002, respectively. The increase between fiscal 2003 and fiscal
2004 was primarily attributable to a $5.4 million decrease in the provision for
loan losses, a $1.0 million increase in net interest income, a $1.4 million
increase in non-interest income and a $5.6 million decrease in non-interest
expense.
The Company experienced a $6.8 million decrease in net income between fiscal
2002 and fiscal 2003, which was primarily attributable to a $4.1 million
increase in the provision for loan losses, a $4.6 million increase in
non-interest expense and a $3.5 million decrease in net interest income, offset
by a $1.9 million increase in non-interest income.
NET INTEREST INCOME. Net interest income increased $1.0 million, or 5%, to
$21.1 million in fiscal 2004 compared to $20.2 million in fiscal 2003. Total
interest income decreased $4.4 million between fiscal 2003 and fiscal 2004,
primarily due to a decrease in the yield on total loans of 60 basis points
offset by an increase of 49 basis points in mortgage-related securities. Such
declines in loan yields were responsible for a $4.4 million decrease in interest
income during 2004. Average long-term market interest rates remained lower in
2004 than in 2003.
Interest expense on deposits decreased $3.9 million from 2003 to 2004, primarily
due to a decrease in the average cost of deposits of 50 basis points from 2.19%
to 1.69%. The decline in interest expense was significantly impacted by the
relatively low market interest rates in 2004 as well as a shift in the deposit
mix from certificates of deposit to shorter-term money market and NOW accounts.
The rates paid on borrowings also decreased by 149 basis points between 2004 and
2003. The reduction in the rates paid on borrowings was due to the Bank entering
into several derivative contracts, which swapped the fixed rate the Bank pays on
$40.0 million of FHLB advances to variable rates. Additionally, certain
long-term, fixed rate higher average rate advances matured during 2004 and were
replaced with lower rate borrowings with similar terms.
Between 2002 and 2003, interest income decreased $7.3 million while interest
expense decreased by $3.8 million. The decreases were largely due to overall
lower market interest rates in 2003 compared to 2002. Interest expense on FHLB
advances and trust-preferred debt increased between 2003 and 2002 as the Bank
increased such borrowings.
PROVISION FOR LOAN LOSSES. The Company records a provision for loan losses in
order to maintain the allowance for loan losses at a level which management
considers its best estimate of known and probable inherent losses. Management's
evaluation is based upon a continuing review of the portfolio and requires
significant management judgment. For the year ended September 30, 2004, the
Company recorded a provision for loan losses of $1.4 million compared to $6.9
million in 2003 and $2.8 million in 2002. The decrease in the provision for the
twelve month period ended September 30, 2004 was due to a reduction in
nonperforming loans, a decrease in loans charged-off, the sale of lower credit
quality indirect automobile loans and decreases in total loans outstanding from
$502.8 million at September 30, 2003 to $413.1 million at September 30, 2004.
The decrease in the provision was due to a significant decrease in nonperforming
loans over the levels previously recorded. As of September 30, 2004,
nonperforming loans totaled $6.9 million, a decrease of $5.6 million, or 45%,
from the $12.5 million of such loans at September 30, 2003. Total nonperforming
commercial loans totaled $5.3 million at September 30, 2004 compared to $10.6
million at September 30, 2003. This $5.3 million decrease was primarily the
result of several large commercial loans and commercial mortgage loans being
reduced to cash collections. Additionally, foreclosed assets were reduced by
$707,000 between fiscal 2004 and fiscal 2003 due to the sale of several
one-to-four family properties.
The provision for loan losses was $6.9 million in fiscal year 2003 compared to a
$2.8 million provision in fiscal 2002. The increase in fiscal 2003 was largely
due to higher levels of nonperforming loans and charge-offs. See the
Nonperforming Assets and the Allowance for Loan Loss sections of Management's
Discussion and Analysis for a further discussion of asset quality.
NON-INTEREST INCOME. Non-interest income increased $1.3 million, or 14%, from
$10.0 million in 2003 to $11.3 million in 2004. The increase was largely a
result of a $798,000 gain on the sale of the Danville branch in January 2004 and
the impact of a $1.5 million impairment loss on an equity investment in 2003.
For further discussion of this loss, see Note 18 to the Consolidated Financial
Statements. The 2004 increases were offset by reduced insurance premium income
and lower levels of gains on the sale of residential mortgage loans as loan
originations and sales decreased due to lower volumes.
The Company experienced a $1.9 million increase in non-interest income for
fiscal 2003. The increase was largely due to increased service charges and other
fee income of $663,000, increased insurance premium income of $801,000 and
increased gains on the sale of securities of $1.0 million as part of a
restructuring of the investment portfolio. These increases were offset by the
recognition of a $1.5 million loss on an equity investment.
NON-INTEREST EXPENSE. Non-interest expense decreased $5.6 million, or 19%, from
$29.2 million in 2003 to $23.6 million in 2004. This decrease was primarily due
to reductions in salaries and benefits as the Company reduced staff in 2003 as
part of a
Page 25
restructuring effort to better align the Bank's operational processes with its
product offerings. The 2003 period also included a $900,000 charge to earnings
for one-time severance costs related to the resignation of the Company's former
President and Chief Executive Officer. Occupancy costs and amortization of
intangibles also decreased as a result of the branch closings and the sale of
the Bank's Danville branch. Data processing costs increased between periods due
to the Bank outsourcing its data processing to a third-party vendor in November
2003.
Total non-interest expense increased $4.6 million, or 19%, from $24.6 million in
2002 to $29.2 million in 2003. This increase was due primarily to an increase in
salaries and employee benefits of $2.5 million. Approximately $900,000 of this
increase related to one-time severance costs resulting from the resignations of
the Company's former President and Chief Executive Officer, Chief Financial
Officer and Senior Vice President. Additionally, $1.2 million related to
increased salaries for new employees hired in the first half of the fiscal year
to staff growth in the Company's businesses.
Additionally in September 2003, the Company incurred additional severance
charges of approximately $200,000 in connection with the termination of 33
employees. These reductions represent a realignment of the banking operations in
light of the management changes. Professional fees increased by $417,000 during
2003, or 30%, primarily due to the restatement of prior period earnings and
increased consulting services during the transition between chief financial
officers. Other expenses increased by $1.6 million due to costs for closing
three bank offices as well as costs associated with increased levels of
nonperforming assets combined with general increases in other operating
expenses.
INCOME TAXES. The Company recorded a $2.3 million income tax provision for the
fiscal year ended September 30, 2004, compared to an income tax benefit of $1.8
million and an income tax provision of $1.6 million for the years ended
September 30, 2003 and 2002, respectively. The increase in 2004 was primarily
due to $7.4 in million pre-tax net income the Company recorded. The Company's
effective tax rate for 2004, 2003 and 2002 was 31%, (31)% and 38%, respectively.
The decrease in 2003 was primarily due to the $5.9 million pre-tax net loss the
Company recorded offset by an increase in the deferred tax valuation allowance
related to the Company's inability to use a charitable contribution
carryforward. Also during 2003, the Company recorded a $1.5 million impairment
loss which is a capital loss for income tax purposes and did not result in a tax
benefit.
FINANCIAL CONDITION
Total assets decreased $60.3 million to $836.0 million at September 30, 2004
compared to $896.3 million at September 30, 2003. The decrease was primarily due
to a decrease in loans of $86.4 million offset by an increase in cash and cash
equivalents of $6.8 million and an increase in investment securities
available-for-sale of $30.6 million.
Net loans decreased $86.4 million from $490.0 million at September 30, 2003 to
$403.6 million at September 30, 2004. Residential one-to-four family mortgage
loans decreased by approximately $37.6 million, or 25%, due in part to the sale
of $16.2 million in modified fixed-rate residential mortgage loans as well as a
policy to sell all newly-originated fixed-rate loans. Construction loans
decreased by $17.5 million to $4.9 million at September 30, 2004 compared to
$22.4 million at September 30, 2003. The decrease was due to pricing changes
made to reduce the interest-rate risk inherent with construction loan financing,
which resulted in lower originations. Automobile loans decreased by $35.0
million to $101.1 million at September 30, 2004 as a result of the sale of
approximately $19.2 million of lower credit quality indirect automobile loans,
representing substantially all of the Company's lower credit quality indirect
automobile loans. In addition, the Bank ceased originating non-prime indirect
automobile loans in October 2003.
Total liabilities decreased $60.3 million from $837.9 million at September 30,
2003 to $777.6 million at September 30, 2004. During the year, deposits
decreased by $63.9 million due to the continued lower interest rate environment
and a decision to lower interest rates on certain deposit products offered by
the Bank. This resulted in a decrease of $33.9 million in certificates of
deposits less than $100,000 and a decrease of $20.8 million in money market
accounts.
The reductions in deposits were offset by increased borrowings of $19.9 million,
primarily repurchase agreements.
Total equity increased by $101,000 to $58.5 million at September 30, 2004 from
$58.4 million at September 30, 2003. Earnings of $5.1 million increased equity
and were offset by treasury stock repurchases of $3.5 million and net reductions
in other comprehensive income of $1.8 million.
Page 26
INVESTMENT ACTIVITIES
The investment policy of the Company, as approved by the Board of Directors,
requires management to maintain adequate liquidity, generate a favorable return
on investments without incurring undue interest rate and credit risk and to
complement the Company's lending activities. The Company primarily utilizes
investments in securities for liquidity management and as a method of deploying
excess funds not utilized for loan originations or purchases. Generally, the
Company's investment policy is more restrictive than the OTS regulations allow
and, accordingly, the Company has invested primarily in U.S. Government and
agency securities, which qualify as liquid assets under the OTS regulations,
Federal funds and U.S. Government-sponsored agency-issued mortgage-backed
securities. As required by SFAS No. 115, the Company has established an
investment portfolio of securities that are categorized as held-to-maturity or
available-for-sale. The Company does not currently maintain a portfolio of
trading securities. At September 30, 2004, the available-for-sale securities
portfolio totaled $357.2 million, or 43% of assets, and the held-to-maturity
portfolio totaled $1.0 million, or 0.1% of assets.
The following table sets forth certain information regarding the amortized cost
and fair value of the Company's securities at the dates indicated.
AT SEPTEMBER 30,
---------------------------------------------------------------------------
(IN THOUSANDS)
2004 2003 2002
----------------------- ----------------------- -----------------------
Amortized Fair Amortized Fair Amortized Fair
Cost Value Cost Value Cost Value
---------- ---------- ---------- ---------- ---------- ----------
INVESTMENT SECURITIES:
Debt securities held-to-maturity:
Municipal securities $ 998 $ 1,015 $ 3,555 $ 3,622 $ 3,553 $ 3,608
Certificates of Deposit - - - - 99 99
---------- ---------- ---------- ---------- ---------- ----------
Total $ 998 $ 1,015 $ 3,555 $ 3,622 $ 3,652 $ 3,707
---------- ---------- ---------- ---------- ---------- ----------
Debt securities available-for-sale:
Obligations of U.S. Government
agencies $ 10,384 $ 10,321 $ 26,089 $ 26,289 $ 24,032 $ 24,446
Municipal securities 4,767 4,812 66,506 68,504 61,396 62,842
---------- ---------- ---------- ---------- ---------- ----------
Total $ 15,151 $ 15,133 $ 92,595 $ 94,793 $ 85,428 $ 87,288
---------- ---------- ---------- ---------- ---------- ----------
EQUITY SECURITIES AVAILABLE-FOR-SALE:
FHLB stock $ 13,009 $ 13,009 $ 12,987 $ 12,987 $ 10,971 $ 10,971
FHLMC stock - - 2,241 1,937 2,241 2,068
FNMA stock 2,000 2,005 6,000 5,850 2,000 1,992
Other equity securities 79 95 78 94 284 280
---------- ---------- ---------- ---------- ---------- ----------
Total equity securities
available-for-sale $ 15,088 $ 15,109 $ 21,306 $ 20,868 $ 15,496 $ 15,311
---------- ---------- ---------- ---------- ---------- ----------
Total debt and equity securities $ 31,237 $ 31,257 $ 117,456 $ 119,283 $ 104,576 $ 106,306
========== ========== ========== ========== ========== ==========
MORTGAGE-RELATED SECURITIES
AVAILABLE-FOR-SALE:
FHLMC $ 73,885 $ 73,530 $ 34,549 $ 34,749 $ 17,577 $ 18,041
FNMA 194,299 194,319 111,676 112,040 52,615 54,021
GNMA 2,380 2,422 3,627 3,692 5,930 6,065
Collateralized mortgage obligations 57,004 56,710 60,292 60,484 116,596 118,455
Other securities - - - - 28,665 28,705
---------- ---------- ---------- ---------- ---------- ----------
Total mortgage-related securities
available-for-sale $ 327,568 $ 326,981 $ 210,144 $ 210,965 $ 221,383 $ 225,287
---------- ---------- ---------- ---------- ---------- ----------
Total mortgage-related securities $ 327,568 $ 326,981 $ 210,144 $ 210,965 $ 221,383 $ 225,287
========== ========== ========== ========== ========== ==========
Total securities $ 358,805 $ 358,238 $ 327,600 $ 330,248 $ 325,959 $ 331,593
========== ========== ========== ========== ========== ==========
Page 27
The table below sets forth certain information regarding the carrying value,
weighted-average yields and contractual maturities of the Company's debt
securities as of September 30, 2004.
Maturing Maturing
after after
Maturing one year but 5 years but Maturing
within one within 5 within 10 after 10
year years years years Total
------------ ------------ ------------ ------------ ------------
(IN THOUSANDS)
AVAILABLE-FOR-SALE DEBT SECURITIES:
Municipal securities $ - $ 640 $ - $ 4,127 $ 4,767
Obligations of U.S. Government agencies - 10,030 - 354 10,384
Mortgage-related securities - 1,477 106,917 219,174 327,568
------------ ------------ ------------ ------------ ------------
Total debt securities at amortized cost $ - $ 12,147 $ 106,917 $ 223,655 $ 342,719
============ ============ ============ ============ ============
Total debt securities at fair value $ - $ 12,135 $ 106,117 $ 223,862 $ 342,114
============ ============ ============ ============ ============
Weighted-Average Yield - 3.00% 3.71% 4.07% 3.92%
HELD-TO-MATURITY DEBT SECURITIES:
Municipal securities $ - $ - $ - $ 998 $ 998
Total debt securities at amortized cost $ - $ - $ - $ 998 $ 998
============ ============ ============ ============ ============
Total debt securities at fair value $ - $ - $ - $ 1,015 $ 1,015
============ ============ ============ ============ ============
Weighted-Average Yield - - - 4.39% 4.39%
Expected maturities will differ from contractual maturities because borrowers
may have the right to call or prepay obligations with or without call or
prepayment penalties. Weighted-average yields are based on amortized cost
including municipal securities, which are not reported on a tax-equivalent
basis.
Page 28
LOANS
The following table sets forth the composition of the Company's loan portfolio
in dollar amounts and as a percentage of the portfolio at the dates indicated.
AT SEPTEMBER 30,
---------------------------------------------------------------------------------------------
(IN THOUSANDS)
2004 2003 2002 2001
--------------------- --------------------- --------------------- ---------------------
Percent Percent Percent Percent
Amount of Total Amount of Total Amount of Total Amount of Total
--------- --------- --------- --------- --------- --------- --------- ---------
REAL ESTATE LOANS:
One-to-four family $ 112,186 27.16% $ 149,741 29.84% $ 197,349 39.85% $ 220,796 43.78%
Multi-family and
commercial 71,138 17.22 64,343 12.82 75,912 15.33 65,095 12.91
Construction 4,899 1.19 22,384 4.46 7,157 1.45 13,690 2.71
--------- --------- --------- --------- --------- --------- --------- ---------
Total real estate
loans $ 188,223 45.57% $ 236,468 47.12% $ 280,418 56.63% $ 299,581 59.40%
--------- --------- --------- --------- --------- --------- --------- ---------
CONSUMER LOANS:
Home equity loans
and lines of
credit $ 69,400 16.80% $ 73,036 14.56% $ 79,167 15.98% $ 79,840 15.84%
Automobile 101,148 24.49 136,182 27.14 80,016 16.16 78,307 15.53
Education - - - - - - 2,846 0.56
Unsecured lines
of credit 4,424 1.07 3,455 0.69 2,297 0.46 1,884 0.37
Other 9,387 2.27 9,421 1.88 10,376 2.09 10,288 2.04
--------- --------- --------- --------- --------- --------- --------- ---------
Total consumer
loans $ 184,359 44.63% $ 222,094 44.27% $ 171,856 34.69% $ 173,165 34.34%
--------- --------- --------- --------- --------- --------- --------- ---------
COMMERCIAL LOANS $ 40,473 9.80% $ 43,203 8.61% $ 43,014 8.68% $ 31,588 6.26%
--------- --------- --------- --------- --------- --------- --------- ---------
Total loans $ 413,055 100.00% $ 501,765 100.00% $ 495,288 100.00% $ 504,334 100.00%
========= ========= ========= ========= ========= ========= ========= =========
Less:
Deferred loan
origination fees $ 1,025 $ 1,583 $ 1,523 $ 1,686
Allowance for
loan losses 8,446 10,196 5,449 4,497
--------- --------- --------- ---------
Total loans, net $ 403,584 $ 489,986 $ 488,316 $ 498,151
========= ========= ========= =========
AT SEPTEMBER 30,
---------------------
(IN THOUSANDS)
2000
---------------------
Percent
Amount of Total
--------- ---------
REAL ESTATE LOANS:
One-to-four family $ 205,834 48.89%
Multi-family and
commercial 43,784 10.40
Construction 11,993 2.85
--------- ---------
Total real estate
loans $ 261,611 62.14%
--------- ---------
CONSUMER LOANS:
Home equity loans
and lines of
credit $ 72,474 17.21%
Automobile 51,114 12.14
Education 3,516 0.84
Unsecured lines
of credit 1,817 0.43
Other 8,021 1.90
--------- ---------
Total consumer
loans $ 136,942 32.52%
--------- ---------
COMMERCIAL LOANS $ 22,481 5.34%
--------- ---------
Total loans $ 421,034 100.00%
========= =========
Less:
Deferred loan
origination fees $ 1,536
Allowance for
loan losses 4,162
---------
Total loans, net $ 415,336
=========
Page 29
LOAN MATURITY. The following table shows the remaining contractual maturity of
the Company's total loans at September 30, 2004. The table does not include the
effect of future principal prepayments.
AT SEPTEMBER 30, 2004
--------------------------------------------------------------------------------
(IN THOUSANDS)
Multi-
One-to- Family and
Four Commercial Total
Family Real Estate Construction(1) Consumer Commercial Loans
--------- ----------- --------------- ---------- ---------- ----------
Amount due in:
One year or less $ 214 $ 1,455 $ 465 $ 1,788 $ 9,765 $ 13,687
More than one year to five years 4,609 7,447 16 103,275 9,052 124,399
More than five years 107,363 62,236 4,418 79,296 21,656 274,969
--------- ----------- --------------- ---------- ---------- ----------
Total amount due $ 112,186 $ 71,138 $ 4,899 $ 184,359 $ 40,473 $ 413,055
========= =========== =============== ========== ========== ==========
(1) Construction loans, which consist of loans for the construction of one-
to four-family residences, automatically convert to permanent financing upon
completion of the construction phase.
The following table sets forth, at September 30, 2004, the dollar amount of
loans contractually due after September 30, 2005, and whether such loans have
fixed or adjustable interest rates.
DUE AFTER SEPTEMBER 30, 2005
------------------------------------
(IN THOUSANDS)
Fixed Adjustable Total
---------- ---------- ----------
Real estate loans:
One-to-four family $ 68,835 $ 43,137 $ 111,972
Multi-family and commercial
real estate 11,195 58,488 69,683
Construction 2,981 1,453 4,434
---------- ---------- ----------
Total real estate loans 83,011 103,078 186,089
---------- ---------- ----------
Consumer loans 144,904 37,667 182,571
Commercial loans 10,511 20,197 30,708
---------- ---------- ----------
Total loans $ 238,426 $ 160,942 $ 399,368
========== ========== ==========
NONPERFORMING ASSETS. Nonperforming assets, which include nonaccruing loans,
real estate owned and repossessed assets can negatively affect the Company's
results of operations. Nonaccruing loans are those on which the accrual of
interest has ceased. Loans are placed on nonaccrual status immediately if, in
the opinion of management, collection is doubtful, or when principal or interest
is past due 90 days or more and the value of the collateral is insufficient to
cover the repayment of principal and interest. Interest accrued but not
collected at the date a loan is placed on nonaccrual status is reversed and
charged against interest income. In addition, the amortization of net deferred
loan fees is suspended when a loan is placed on nonaccrual status. Subsequent
cash receipts are applied either to the outstanding principal balance or
recorded as interest income, depending on management's assessment of the
ultimate collectibility of principal and interest. Past due loans are loans
contractually past due 90 days or more as to principal or interest payments but
which remain in accrual status because they are considered well secured and in
the process of collection. For the years ended September 30, 2004, 2003 and
2002, the amount of additional interest income that would have been recognized
on nonaccrual loans if such loans had continued to perform in accordance with
their contractual terms was $535,000, $646,000 and $464,000, respectively. The
amount of interest income on such loans included in net income in fiscal years
2004, 2003 and 2002 was $233,000, $290,000 and $131,000, respectively.
Page 30
The following table sets forth information regarding nonperforming assets and
past due loans at the dates indicated:
AT SEPTEMBER 30,
---------------------------------------------------------------------
(IN THOUSANDS)
2004 2003 2002 2001 2000 1999
--------- --------- --------- --------- --------- ---------
NONPERFORMING ASSETS:
Residential $ 1,163 $ 1,622 $ 2,171 $ 1,902 $ 869 $ 848
Consumer 436 254 290 771 240 261
Commercial 5,270 10,603 1,739 2,050 2,390 262
--------- --------- --------- --------- --------- ---------
Total nonperforming loans 6,869 12,479 4,200 4,723 3,499 1,371
Real estate owned 277 962 419 249 51 19
Other repossessed assets (1) 38 60 128 141 122 79
--------- --------- --------- --------- --------- ---------
Total nonperforming assets $ 7,184 $ 13,501 $ 4,747 $ 5,113 $ 3,672 $ 1,469
========= ========= ========= ========= ========= =========
Troubled debt restructurings - - 55 60 - -
--------- --------- --------- --------- --------- ---------
Troubled debt restructurings and
total nonperforming assets $ 7,184 $ 13,501 $ 4,802 $ 5,173 $ 3,672 $ 1,469
========= ========= ========= ========= ========= =========
Total nonperforming loans and
troubled debt restructurings as
a percentage of total loans 1.66% 2.49% 0.97% 0.95% 0.83% 0.37%
Total nonperforming assets and
troubled debt restructurings as a
percentage of total assets 0.86% 1.51% 0.53% 0.64% 0.58% 0.24%
(1) Real estate owned balances and other repossessed assets are shown net of
related loss allowances.
ALLOWANCE FOR LOAN LOSSES. The Company maintains allowances for loan losses and
charges losses to these allowances when such losses are realized. The
determination of the allowance for loan losses requires significant management
judgment reflecting management's best estimate of probable loan losses related
to specifically identified loans as well as probable loan losses in the
remaining loan portfolio. Management's evaluation is based upon a continuing
review of the loan portfolio, with consideration given to examinations performed
by regulatory authorities.
Management establishes the loan loss allowance in accordance with accounting
principles generally accepted in the United States of America and the guidance
provided in the Securities and Exchange Commission's Staff Accounting Bulletin
102 (SAB 102). Its methodology for assessing the appropriateness of the
allowance consists of several key elements which include: specific allowances
for identified problem loans; formula allowances for commercial and commercial
real estate loans; and allowances for pooled homogenous loans.
Specific reserves are established for certain loans in cases where management
has identified significant conditions or circumstances related to a specific
credit that management believes indicate the probability that a loss has been
incurred.
The formula allowances for commercial and commercial real estate loans are
calculated by applying loss factors to outstanding loans in each case based on
the internal risk grade of loans. Changes in risk grades of both performing and
nonperforming loans affect the amount of the formula allowance. Loss factors by
risk grade have a basis in the Bank's historical loss experience for such loans
and may be adjusted for significant factors that, in management's judgment,
affect the collectability of the portfolio as of the evaluation date.
Pooled loans are loans that are usually smaller, not individually graded and
homogenous in nature, such as consumer installment loans, indirect automobile
loans and residential mortgages. Pooled loan loss allowances are based on
historical net charge-offs, delinquency trends, average credit scores and the
average time frame between the occurrence of a default event and the resulting
default and loss realization. Default events include job loss, divorce, medical
crises and death. The average loss allowance per homogenous pool is based on the
product of the average annual historical loss rate and the average estimated
duration of the pool multiplied by the pool balances. These risk pools are then
assigned a reserve for losses based upon this historical loss information, as
adjusted for historical loss adjustment factors, as adjusted based on
management's evaluation of various current conditions. The evaluation of the
inherent loss with respect to these more current conditions is subject to a
higher degree of uncertainty because they are not identified with specific
credits. The more current conditions, analyzed in connection with the adjustment
factors, include an evaluation of the following:
Page 31
o General economic and business conditions affecting the Bank's key
lending areas,
o Credit quality trends (including trends in nonperforming loans expected
to result from existing conditions),
o Recent loss experience in particular segments of the portfolio,
o Collateral values and loan-to-value ratios,
o Loan volumes and concentration, including changes in the composition of
the loan portfolio,
o Age of the loan portfolio,
o Specific industry conditions within portfolio segments,
o Bank regulatory examination results, and
o Other factors, including changes in quality of the loan origination,
servicing and risk management processes.
As of September 30, 2004, the Company's allowance for loan losses was $8.4
million, or 2.04% of total loans compared to $10.2 million, or 2.03% of total
loans as of September 30, 2003. The decrease in the allowance was due to a $1.6
million transfer in connection with the sale of $19.2 million of lower credit
quality indirect automobile loans and $1.6 million in net charge-offs, offset by
an additional provision of $1.4 million.
The Bank's loan officers and risk managers meet monthly to discuss and review
the conditions and risks associated with individual problem loans and loan
portfolios with higher risk concentrations. The Bank also has a third-party
review its analysis of such loans and its respective risk gradings quarterly. By
assessing the probable estimated losses inherent in the loan portfolio on a
routine basis, management is able to adjust specific and inherent loss estimates
based on more recent information. While the Company continues to monitor and
modify its allowance for loan losses as conditions change, there can be no
assurance that the loan loss allowance will be sufficient to absorb all such
future credit losses.
Page 32
The following table sets forth activity in the Company's allowance for loan
losses for the periods indicated.
AT OR FOR THE FISCAL YEARS ENDED SEPTEMBER 30,
---------------------------------------------------------
(IN THOUSANDS)
2004 2003 2002 2001 2000
--------- --------- --------- --------- ---------
Allowance for loan losses,
beginning of year $ 10,196 $ 5,449 $ 4,497 $ 4,162 $ 2,924
Charged-off loans:
One- to four-family real estate 281 224 56 - 3
Consumer 1,585 1,183 205 566 244
Commercial 240 844 1,732 1,621 -
--------- --------- --------- --------- ---------
Total charged-off loans 2,106 2,251 1,993 2,187 247
--------- --------- --------- --------- ---------
Recoveries on loans previously charged-off:
One- to four-family real estate 26 12 - - -
Consumer 429 65 179 24 18
Commercial 14 69 - - -
--------- --------- --------- --------- ---------
Total recoveries 469 146 179 24 18
--------- --------- --------- --------- ---------
Net loans charged-off 1,637 2,105 1,814 2,163 229
Provision for loan losses 1,444 6,852 2,766 1,681 1,467
Transfer for the sale of indirect auto loans (1,557) - - - -
Additional allowance from acquisition
of Security Savings - - - 817 -
--------- --------- --------- --------- ---------
Allowance for loan losses,
end of period $ 8,446 $ 10,196 $ 5,449 $ 4,497 $ 4,162
========= ========= ========= ========= =========
Net loans charged-off to average
loans 0.36% 0.42% 0.36% 0.38% 0.06%
--------- --------- --------- --------- ---------
Allowance for loan losses
to total loans 2.04% 2.03% 1.10% 0.89% 0.99%
--------- --------- --------- --------- ---------
Allowance for loan losses to
non-performing loans and troubled
debt restructuring 122.96% 81.71% 128.06% 94.02% 118.95%
--------- --------- --------- --------- ---------
Net loans charged-off to allowance
for loan losses 19.38% 20.65% 33.29% 48.09% 5.50%
--------- --------- --------- --------- ---------
Recoveries to charge-offs 22.27% 6.49% 8.98% 1.10% 7.29%
--------- --------- --------- --------- ---------
Page 33
The following table sets forth the Company's allowance for loan losses in each
of the categories listed at the dates indicated and the percentage of such
amounts to the total allowance and to total loans. These allocations are
estimates and are subject to revision as conditions change. The change in the
allowance from 2002 to 2003 reflects increased levels of nonaccrual loans and
consumer (indirect automobile loans) charge-offs. The change in the allowance
from 2001 to 2002 reflects increased activity in commercial and consumer lending
and increased levels of nonaccrual loans.
AT SEPTEMBER 30, 2004
(IN THOUSANDS)
------------------------------
% of % of
Allowance Loans
in each in each
Category Category
to Total to Total
Amount Allowance Loans
------- --------- --------
Real Estate $ 511 6.05% 45.57%
Consumer 2,875 34.04 44.63
Commercial 5,058 59.89 9.80
Unallocated 2 0.02 -
------- --------- --------
Total allowance
for loan losses $ 8,446 100.00% 100.00%
======= ========= ========
AT SEPTEMBER 30, 2003 AT SEPTEMBER 30, 2002
------------------------------- ------------------------------
(IN THOUSANDS) (IN THOUSANDS)
% of % of % of % of
Allowance Loans Allowance Loans
in each in each in each in each
Category Category Category Category
to Total to Total to Total to Total
Amount Allowance Loans Amount Allowance Loans
-------- --------- -------- ------- --------- --------
Real Estate $ 2,013 19.74% 47.13% $ 1,641 30.12% 56.69%
Consumer 2,657 26.06 44.26 1,015 18.63 34.65
Commercial 5,526 54.20 8.61 2,297 42.15 8.66
Unallocated - - - 496 9.10 -
-------- --------- -------- ------- --------- --------
Total allowance
for loan losses $ 10,196 100.00% 100.00% $ 5,449 100.00% 100.00%
======== ========= ======== ======= ========= ========
AT SEPTEMBER 30, 2001 AT SEPTEMBER 30, 2000
------------------------------- ------------------------------
(IN THOUSANDS) (IN THOUSANDS)
% of % of % of % of
Allowance Loans Allowance Loans
in each in each in each in each
Category Category Category Category
to Total to Total to Total to Total
Amount Allowance Loans Amount Allowance Loans
-------- --------- -------- ------- --------- --------
Real Estate $ 1,391 30.93% 59.40% $ 979 23.52% 62.14%
Consumer 739 16.43 34.34 489 11.75 32.52
Commercial 1,951 43.38 6.26 2,108 50.65 5.34
Unallocated 416 9.26 - 586 14.08 -
-------- --------- -------- ------- --------- --------
Total allowance
for loan losses $ 4,497 100.00% 100.00% $ 4,162 100.00% 100.00%
======== ========= ======== ======= ========= ========
Page 34
SOURCES OF FUNDS
GENERAL. Deposits, loan repayments and prepayments, proceeds from sales of loans
and securities, cash flows generated from operations, FHLB advances and other
borrowings are the primary sources of the Company's funds for use in lending,
investing and for other general purposes.
DEPOSITS. The Company offers a variety of deposit products with a range of
interest rates and terms. The Company's deposits consist of checking, money
market, savings, NOW, certificate accounts and Individual Retirement Accounts.
More than 41% of the Company's deposits at September 30, 2004 are in certificate
of deposit accounts. At September 30, 2004, core deposits (savings, NOW, money
market accounts and non-interest bearing deposits) represented 59% of total
deposits. The flow of deposits is influenced significantly by general economic
conditions, changes in money market rates, prevailing interest rates and
competition. The Company's deposits are obtained predominantly from the areas in
which the Company's offices are located. The Company has historically relied
primarily on customer service and long-standing relationships with customers to
attract and retain these deposits; however, market interest rates and rates
offered by competing financial institutions significantly affect the Company's
ability to attract and retain deposits. The Company uses traditional means of
advertising its deposit products, including radio and print media, and generally
does not solicit retail deposits from outside its market area. At September 30,
2004, the Company had $10.0 million of brokered certificates of deposit.
At September 30, 2004, the Company had $26 million in certificate accounts in
amounts of $100,000 or more maturing as follows:
MATURITY PERIOD AMOUNT
------------------------ --------------
(IN THOUSANDS)
Three months or less $ 3,117
Over 3 through 6 months 1,228
Over 6 through 12 months 2,338
Over 12 months 19,363
---------------
Total $ 26,046
==============
The above maturity schedule does not include $10 million of brokered CD's with
an average maturity of 18 months.
BORROWINGS. The Bank utilizes advances from the FHLB of Pittsburgh as an
alternative to deposits to fund its operations as part of its operating
strategy. These borrowings are collateralized primarily by certain mortgage
loans and mortgage-related securities of the Bank and secondarily by the Bank's
investment in capital stock of the FHLB of Pittsburgh. FHLB advances are made
pursuant to several different credit programs, each of which has its own
interest rate and range of maturities. The maximum amount that the FHLB of
Pittsburgh will advance to member institutions, including the Bank, fluctuates
from time to time in accordance with the policies of the FHLB of Pittsburgh. At
September 30, 2004, the Bank had $243.9 million in outstanding FHLB advances,
compared to $258.9 million at September 30, 2003. Other borrowings, which
consist of overnight retail and wholesale repurchase agreements, increased $19.9
million from approximately $500,000 at September 30, 2003 to $20.4 million at
September 30, 2004.
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary sources of funds on a long-term and short-term basis are
deposits, principal and interest payments on loans, mortgage-backed and
investment securities and FHLB advances. The Company uses the funds generated to
support its lending and investment activities as well as any other demands for
liquidity such as deposit outflows. While maturities and scheduled amortization
of loans are predictable sources of funds; deposit flows, loan prepayments and
the exercise of call features are greatly influenced by general interest rates,
economic conditions and competition.
The Bank's most liquid assets are cash and cash equivalents and its investment
and mortgage-related securities available-for-sale. The levels of these assets
are dependent on the Bank's operating, financing, lending and investing
activities during any given period. At September 30, 2004, cash and cash
equivalents and investment and mortgage-related securities available-for-sale
totaled $353.9 million, or 42.3% of total assets.
The Bank has other sources of liquidity if a need for additional funds arises,
including FHLB advances and other borrowings. At September 30, 2004, the Bank
had $243.9 million in advances outstanding from the FHLB, and had an additional
overall borrowing capacity from the FHLB of $135.3 million. Depending on market
conditions, the pricing of deposit products and FHLB advances, the Bank may
continue to rely on such borrowings to fund asset growth.
At September 30, 2004, the Company had commitments to originate and purchase
loans, unused outstanding lines of credit and
Page 35
undisbursed proceeds of construction mortgages totaling $60.9 million. The
Company anticipates that it will have sufficient funds available to meet its
current loan origination commitments. Certificate accounts, including Individual
Retirement Accounts ("IRA") and KEOGH accounts, which are scheduled to mature in
less than one year from September 30, 2003, totaled $62.9 million. Based on past
experience, the Company expects that a substantial portion of maturing
certificate accounts will be retained by the Company at maturity.
The primary sources of funding for the Company are dividend payments from the
Bank, the offering of trust-preferred securities, sales and maturities of
investment securities and, to a lesser extent, earnings on investments and
deposits held by the Company. Dividend payments by the Bank have primarily been
used to fund stock repurchase programs and to pay cash dividends. The Bank's
ability to pay dividends and other capital distributions to the Company is
generally limited by the regulations of the OTS. Additionally, the OTS may
prohibit the payment of dividends which are otherwise permissible by regulation
for safety and soundness reasons.
In June 2004, the Board of Directors authorized the repurchase of 209,000 shares
(approximately 5%) of the Company's outstanding common stock. As of December 15,
2004, management has purchased 206,000 shares under the repurchase program at an
average price of $17.22. This repurchase program has been suspended pending the
merger of the Company into KNBT Bancorp, Inc.
At September 30, 2004, the Bank exceeded all of its regulatory capital
requirements with a tangible capital level of $61.3 million, or 7.4% of total
assets, which is above the required level of $12.4 million, or 1.5%; core
capital of $61.3 million, or 7.4% of total assets, which is above the required
level of $33.1 million, or 4.0%; and risk-based capital of $65.8 million, or
15.07% of risk-weighted assets, which is above the required level of $34.9
million, or 8.0%. An institution with a ratio of risk-based capital to
risk-weighted assets of greater than or equal to 10.0%, a ratio of tier 1
capital to risk-weighted assets of greater than or equal to 6.0% and a ratio of
core capital to total assets of greater than or equal to 5.0% is considered to
be "well-capitalized" pursuant to OTS regulations.
OFF-BALANCE SHEET ARRANGEMENTS
For a discussion of the Company's off-balance sheet arrangements, see Footnote
13, "Commitments and Contingencies" and Footnote 15 "Derivative Financial
Instruments" in the Consolidated Financial Statements.
CONTRACTUAL OBLIGATIONS
The following table sets forth information relating to the Company's payments
due under contractual obligations at September 30, 2004.
Payments due by period
------------------------------------------------------------------------------------
Less Than More Than
Contractual Obligations Total 1 Year 1-3 Years 3-5 Years 5 Years
- -------------------------------- -------------- ------------- ------------- ------------- -------------
Operating Lease Obligations $ 481,095 $ 238,624 $ 129,551 $ 96,864 $ 16,056
Repurchase Agreements 20,426,000 426,000 20,000,000 - -
FHLB Advances 243,867,000 52,000,000 142,080,000 10,000,000 39,787,000
Trust Preferred 22,681,000 - - - 22,681,000
Other Long-Term Obligations (1) 2,292,000 582,000 1,172,000 538,000 -
-------------- ------------- ------------- ------------- -------------
Total $ 289,747,095 $ 53,246,624 $ 163,381,551 $ 10,634,864 $ 62,484,056
============== ============= ============= ============= =============
(1) Includes obligations to the Company's third party data processing provider.
IMPACT OF INFLATION AND CHANGING PRICES
The Consolidated Financial Statements and Notes thereto presented herein have
been prepared in accordance with generally accepted accounting principles
("GAAP"), which requires the measurement of financial position and operating
results generally in terms of historical dollar amounts without considering the
changes in the relative purchasing power of money over time due to inflation.
The impact of inflation is reflected in the increased cost of the Company's
operations. Unlike industrial companies, nearly all of the assets and
liabilities of the Company are monetary in nature. As a result, interest rates
have a greater impact on the Company's performance than do the effects of
general levels of inflation. Interest rates do not necessarily move in the same
direction or to the same extent as the prices of goods and services.
IMPACT OF RECENT ACCOUNTING STANDARDS
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities." This Statement addresses financial accounting
and reporting for costs associated with exit or disposal activities and
nullifies Emerging Issues Task
Page 36
Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity (including Certain
Costs Incurred in a Restructuring)." The provisions of this Statement are
effective for exit or disposal activities that are initiated after December 31,
2002, with early application encouraged. The adoption of this Statement did not
have an impact on the Company's financial position or results of operations.
On October 1, 2002, the FASB issued SFAS No. 147, "Acquisitions of Certain
Financial Institutions," effective for all business combinations initiated after
October 1, 2002. This Statement addresses the financial accounting and reporting
for the acquisition of all or part of a financial institution, except for a
transaction between two or more mutual enterprises. This Statement removes
acquisitions of financial institutions, other than transactions between two or
more mutual enterprises, from the scope of SFAS No. 72, "Accounting for Certain
Acquisitions of Banking or Thrift Institutions," and FASB Interpretation No. 9,
"Applying APB Opinions No. 16 and 17, "When a Savings and Loan Association or a
Similar Institution Is Acquired in a Business Combination Accounted for by the
Purchase Method." The acquisition of all or part of a financial institution that
meets the definition of a business combination shall be accounted for by the
purchase method in accordance with SFAS No. 141, "Business Combinations," and
SFAS No. 142, "Goodwill and Other Intangible Assets. ." SFAS No. 142 was adopted
on October 1, 2001. This Statement also provides guidance on the accounting for
the impairment or disposal of acquired long-term customer-relationship
intangible assets (such as depositor- and borrower-relationship intangible
assets and credit cardholder intangible assets), including those acquired in
transactions between two or more mutual enterprises. Upon early adoption of this
statement, as of October 1, 2001, the carrying amount of the previously
recognized unidentifiable intangible asset related to the Schuylkill Savings
branch acquisitions that was reclassified to goodwill was $200,000, while the
related 2002 amortization expense that was reversed was $81,000, pre-tax. The
Company will continue to review the remaining goodwill on an annual basis for
impairment. However, $7.9 million in core deposit intangible will continue to be
amortized and reviewed for impairment in accordance with SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets."
In December 2002, the FASB issued Statement No. 148, "Accounting for Stock-Based
Compensation--Transition and Disclosure--an amendment of FASB Statement No.
123." This statement amends FASB Statement No.123, "Accounting for Stock-Based
Compensation," to provide alternative methods of transition for a voluntary
change to the fair value based method of accounting for stock-based employee
compensation. The Statement also amends the disclosure requirements of Statement
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. This statement is
effective for fiscal years ending after December 15, 2002, except for financial
reports containing condensed financial statements for interim periods for which
disclosure is effective for periods beginning after December 15, 2002. This
Statement announces, "in the near future, the Board plans to consider whether it
should propose changes to the U.S. standards on accounting for stock-based
compensation." As permitted, the Company continues to account for stock options
with the methodology prescribed by Accounting Principles Board No. 25.
In April 2003, the FASB issued SFAS No. 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 under SFAS
No. 133. The amendments set forth in SFAS No. 149 require that contracts with
comparable characteristics be accounted for similarly. In particular, this
statement clarifies under what circumstances a contract with an initial net
investment meets the characteristic of a derivative as discussed in SFAS No.
133. In addition, it clarifies when a derivative contains a financing component
that warrants special reporting in the statement of cash flows. SFAS No. 149
amends certain other existing pronouncements. Those changes will result in more
consistent reporting of contracts that are derivatives in their entirety or that
contain embedded derivatives that warrant separate accounting. This statement is
effective for contracts entered into or modified after June 30, 2003, except as
stated below and for hedging relationships designated after June 30, 2003. The
guidance should be applied prospectively. The provisions of this statement that
relate to SFAS No. 133 Implementation Issues that have been effective for fiscal
quarters that began prior to June 15, 2003, should continue to be applied in
accordance with their respective effective dates. In addition, certain
provisions relating to forward purchases or sales of when-issued securities or
other securities that do not yet exist, should be applied to existing contracts
as well as new contracts entered into after June 30, 2003. The adoption of this
statement did not have a material effect on the Company's financial position or
results of operations.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity." This Statement
establishes how an issuer classifies financial instruments with characteristics
of both liabilities and equity. It requires that an issuer classify these
financial instruments as a liability (or, in certain circumstances, an asset).
Previously these financial instruments would have been classified entirely as
equity, or between the liabilities section and equity section of the statement
of financial condition. This Statement also addresses questions about the
classification of certain financial instruments that embody obligations to issue
equity shares. The provisions of this Statement are effective for interim
periods beginning after June 15, 2003. The adoption of this statement did not
have a material impact on the Company's financial position or results of
operations.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting
and Disclosure requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others." This interpretation elaborates on the disclosures to be
made by a
Page 37
guarantor in its interim and annual financial statements about its obligations
under certain guarantees that it has issued. This interpretation clarifies that
a guarantor is required to disclose (a) the nature of the guarantee, including
the approximate term of the guarantee, how the guarantee arose, and the events
or circumstances that would require the guarantor to perform under the
guarantee; (b) the maximum potential amount of future payments under the
guarantee; (c) the carrying amount of the liability, if any, for the guarantor's
obligations under the guarantee; and (d) the nature and extent of any recourse
provisions or available collateral that would enable the guarantor to recover
the amounts paid under the guarantee. This interpretation also clarifies that a
guarantor is required to recognize, at the inception of a guarantee, a liability
for the obligations it has undertaken in issuing the guarantee, including its
ongoing obligation to stand ready to perform over the term of the guarantee in
the event that the specified triggering events or conditions occur. The
objective of the initial measurement of that liability is the fair value of the
guarantee at its inception. The initial recognition and initial measurement
provisions of this interpretation are applicable on a prospective basis to
guarantees issued or modified after December 31, 2002, irrespective of the
guarantor's fiscal year-end. The disclosure requirements in this interpretation
are effective for financial statements of interim or annual periods ending after
December 15, 2002. The adoption of this interpretation did not have a material
effect on the Company's financial position or results of operations.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities," (FIN 46) in an effort to expand upon and strengthen
existing accounting guidance that addresses when a company should include in its
financial statements the assets, liabilities and activities of another entity.
The objective of this interpretation is not to restrict the use of variable
interest entities but to improve financial reporting by companies involved with
variable interest entities. Until now, one company generally has included
another entity in its consolidated financial statements only if it controlled
the entity through voting interests. This interpretation changes that by
requiring a variable interest entity to be consolidated by a company if that
company is subject to a majority of the risk of loss from the variable interest
entity's activities or entitled to receive a majority of the entity's residual
returns or both. The consolidation requirement of this interpretation apply
immediately to variable interest entities created after January 31, 2003. The
consolidation requirements apply to older entities in the first fiscal year or
interim period beginning after June 15, 2003. Certain of the disclosure
requirements apply in all financial statements issued after January 31, 2003,
regardless of when the variable interest entity was established. As a result of
the adoption of FIN 46, the Company deconsolidated its Capital Trusts in the
second fiscal quarter of 2004. The result was an increase in the junior debt of
$681,000.
In March 2004, the FASB issued Emerging Issues Task Force (EITF) Issue No. 03-1,
"The Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments." This statement provides guidance for evaluating whether an
investment is other-than-temporarily impaired and was effective for the
other-than-temporary impairment evaluations made in the reporting periods
beginning after June 15, 2004. The FASB staff has issued a proposed
Board-directed FASB Staff Position, FSP EITF Issue 03-1-a, Implementation
Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1. The
proposed FSP would provide implementation guidance with respect to debt
securities that are impaired solely due to interest rates and/or sector spreads
and analyzed for other-than-temporary impairment under paragraph 16 of Issue
03-1. Based on comment letters received by constituents, the Board decided to
further consider whether application guidance is necessary for all securities
analyzed for impairment under paragraph 10-20 of Issue 03-1. The Company will
delay the effective application until the implementation guidance is finalized.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The above-captioned information appears in Item 7 under the heading
"Management's Discussion and Analysis of Financial Condition and Results of
Operations"-"Management of Interest Rate Risk and Market Risk Analysis" and is
incorporated herein by reference.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
KPMG LLP
1601 Market Street
Philadelphia PA 19103-7212
The Board of Directors and Stockholders of
Northeast Pennsylvania Financial Corp.:
We have audited the accompanying consolidated statements of financial condition
of Northeast Pennsylvania Financial Corp. and subsidiaries (the "Company") as of
September 30, 2004 and 2003 and the related consolidated statements of
operations, comprehensive income (loss), changes in equity, and cash flows for
each of the years in the three year period ended September 30, 2004. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
Page 38
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Northeast
Pennsylvania Financial Corp. and subsidiaries as of September 30, 2004 and 2003,
and the results of their operations and their cash flows for each of the years
in the three year period ended September 30, 2004, in conformity with U.S.
generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, the Company has
restated their consolidated statements of operations, comprehensive income
(loss), changes in equity, and cash flows for the year ended September 30, 2002.
/s/ KPMG LLP
- ------------------
Philadelphia, PA
October 26, 2004
Page 39
[LOGO OF NORTHEAST PENNSYLVANIA FINANCIAL CORP.]
NORTHEAST PENNSYLVANIA FINANCIAL CORP.
12 E. BROAD STREET HAZLETON, PA 18201-6591 PHONE (570) 459-3700
FAX (570) 450-6110
MANAGEMENT'S STATEMENT ON FINANCIAL REPORTING
To Our Stockholders:
The management of Northeast Pennsylvania Financial Corp. (the "Company") is
responsible for establishing and maintaining effective internal control over
financial reporting presented in conformity with accounting principles generally
accepted in the United States of America, including controls over safeguarding
assets. This internal control contains monitoring mechanisms, and actions are
taken to correct deficiencies identified.
There are inherent limitations in any internal control, including the
possibility of human error and the circumvention or overriding of controls.
Accordingly, even effective internal control can provide only reasonable
assurance with respect to financial statement preparation. Further, because of
changes in conditions, the effectiveness of internal control may vary over time.
In July 2003, while evaluating the Company's internal controls and procedures,
the former president and chief executive officer and chief financial officer
concluded that the Company's disclosures and internal controls were not
effective. This review discovered that the Company's financial statements for
fiscal years 1998 through 2002 and for the quarters ended December 31, 2002 and
March 31, 2003 required restatement as described in Management's Discussion and
Analysis and Note 2 to the audited Consolidated Financial Statements included in
this report.
Subsequent to the discovery of the errors, management implemented staffing,
system and procedural changes designed to improve the training of the
individuals involved in implementing and reviewing the controls and procedures
to strengthen the review and authorization process so that differences, if any,
are detected and corrected on a timely basis. These changes resulted in the
identification of additional accounting errors as described in Note 2 to the
Consolidated Financial Statements included in this report.
Management assessed the Company's internal control over financial reporting
presented in conformity with accounting principles generally accepted in the
United States of America as of September 30, 2004. This assessment was based on
criteria for effective internal control over financial reporting established in
Internal Control -- Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Based on this assessment, management
believes that, as of September 30, 2004, the Company maintained effective
internal control over financial reporting presented in conformity with
accounting principles generally accepted in the United States of America.
The Company assessed its compliance with the designated laws and regulations
relating to safety and soundness. Based on this assessment, management believes
that the Company complied, in all material respects, with the designated laws
and regulations related to safety and soundness for the year ended September 30,
2004.
/s/ Thomas M. Petro /s/ Jerry D. Holbrook
- ----------------------- ------------------------
Thomas M. Petro Jerry D. Holbrook
President and Chief Financial Officer
Chief Executive Officer
Page 40
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
SEPTEMBER 30,
-----------------------
(IN THOUSANDS)
(EXCEPT SHARE AND
PER SHARE DATA)
2004 2003
---------- ----------
ASSETS
Cash and cash equivalents $ 26,938 $ 20,142
Investment securities available-for-sale 357,223 326,626
Investment securities held-to-maturity
(estimated market value of $1,015 at
September 30, 2004 and $3,622 at
September 30, 2003) 998 3,555
Loans held for sale - 1,073
Loans (less allowance for loan loss of $8,446 at
September 30, 2004 and $10,196 at
September 30, 2003) 403,584 489,986
Accrued interest receivable 2,731 3,892
Assets acquired through foreclosure 315 1,022
Property and equipment, net 10,820 12,152
Goodwill 3,255 3,255
Intangible assets 7,129 8,556
Bank-owned life insurance 11,362 10,875
Other assets 11,680 15,161
---------- ----------
Total assets $ 836,035 $ 896,295
========== ==========
LIABILITIES AND EQUITY
Deposits $ 483,441 $ 547,305
Federal Home Loan Bank advances 243,867 258,901
Trust preferred debt 22,681 22,000
Other borrowings 20,426 529
Advances from borrowers for taxes and insurance 1,178 1,239
Accrued interest payable 1,380 1,318
Other liabilities 4,604 6,646
---------- ----------
Total liabilities 777,577 837,938
---------- ----------
Preferred stock ($.01 par value; 2,000,000
authorized shares; none issued) - -
Common stock ($.01 par value; 16,000,000
authorized shares; 6,427,350 shares issued) 64 64
Additional paid-in capital 62,307 61,879
Common stock acquired by stock benefit plans (2,668) (3,772)
Retained earnings - substantially restricted 33,245 29,368
Accumulated other comprehensive income (loss), net (99) 1,730
Treasury stock, at cost (2,451,551 shares at
September 30, 2004 and 2,250,756 shares at
September 30, 2003) (34,391) (30,912)
---------- ----------
Total equity 58,458 58,357
---------- ----------
Total liabilities and equity $ 836,035 $ 896,295
========== ==========
See accompanying notes to consolidated financial statements.
Page 41
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED SEPTEMBER 30,
------------------------------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
AS RESTATED
2004 2003 2002
---------- ---------- -----------
INTEREST INCOME:
Interest and fees on loans $ 27,341 $ 33,196 $ 37,309
Mortgage-related securities 10,383 6,528 8,701
Investment securities:
Taxable 2,676 4,726 5,679
Non-taxable 562 914 944
---------- ---------- -----------
Total interest income 40,962 45,364 52,633
---------- ---------- -----------
INTEREST EXPENSE:
Deposits 8,213 12,158 16,922
Federal Home Loan Bank advances and other borrowings 10,570 11,978 11,859
Trust-preferred debt 1,073 1,052 207
---------- ---------- -----------
Total interest expense 19,856 25,188 28,988
---------- ---------- -----------
Net interest income 21,106 20,176 23,645
Provision for loan losses 1,444 6,852 2,766
---------- ---------- -----------
Net interest income after provision for loan losses 19,662 13,324 20,879
---------- ---------- -----------
NONINTEREST INCOME:
Service charges and other fees 2,852 2,840 2,177
Insurance premium income 3,698 3,937 3,136
Trust income 875 864 719
Gain (loss) on sale of:
Branch 798 - -
Assets acquired through foreclosure 39 134 (58)
Loans 833 1,025 1,028
Available-for-sale securities 1,292 1,319 308
Impairment loss on equity investment - (1,488) -
Other 948 1,345 766
---------- ---------- -----------
Total noninterest income 11,335 9,976 8,076
---------- ---------- -----------
NONINTEREST EXPENSE:
Salaries and employee benefits 12,833 15,480 12,947
Occupancy costs 2,741 3,229 3,059
Amortization of intangibles 872 1,061 1,008
Data processing 1,111 803 697
Advertising 448 831 981
Professional fees 1,433 1,816 1,399
Federal Home Loan Bank and other charges 937 1,059 1,243
Other 3,236 4,920 3,305
---------- ---------- -----------
Total noninterest expense 23,611 29,199 24,639
---------- ---------- -----------
Income (loss) before income taxes 7,386 (5,899) 4,316
Income taxes (benefit) 2,299 (1,829) 1,620
---------- ---------- -----------
Net income (loss) $ 5,087 $ (4,070) $ 2,696
========== ========== ===========
Earnings (loss) per share:
Basic $ 1.32 $ (1.08) $ 0.67
Diluted 1.26 (1.08) 0.63
See accompanying notes to consolidated financial statements.
Page 42
CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY
FOR THE YEARS ENDED SEPTEMBER 30, 2004, 2003, AND 2002
-----------------------------------------------------------------------------------------
(IN THOUSANDS)
Common Stock Accumulated
Additional Acquired by Other
Common Paid In Stock Benefit Retained Comprehensive Treasury Total
Stock Capital Plans Earnings Income (Loss) Stock Equity
------ ------------ ------------- -------- ------------- --------- ---------
Balance, As Restated, September 30, 2001 $ 64 $ 62,142 $ (5,213) $ 34,679 $ 894 $ (18,186) $ 74,380
ESOP shares committed to be released 243 515 758
Stock awards (46) 542 496
Stock compensation tax benefit 110 110
Stock options exercised (38,714 shares) (402) 826 424
Treasury stock reissuance (6,568 shares) 96 96
Net changes in gains on securities
available for sale, net of tax 2,439 2,439
Net change in gains on retained interest
on asset securitization, net of tax 111 111
Treasury stock at cost (812,903 shares) (14,421) (14,421)
Cash dividend paid (1,964) (1,964)
Net income, as restated 2,696 2,696
------ ------------ ------------- -------- ------------- --------- ---------
Balance, As Restated, September 30, 2002 $ 64 $ 62,047 $ (4,156) $ 35,411 $ 3,444 $ (31,685) $ 65,125
------ ------------ ------------- -------- ------------- --------- ---------
ESOP shares committed to be released (79) 789 710
Stock awards 5 709 714
Stock compensation tax benefit (112) (112)
Stock options exercised (41,812 shares) 696 (10) 686
Stock employee compensation trust
(69,133 shares) (1,810) (1,810)
Treasury stock reissuance (6,369 shares) 18 82 100
Net changes in gains on -
securities available for sale,
net of tax (1,714) (1,714)
Treasury stock at cost (806,534 shares) 701 701
Cash dividend paid (1,973) (1,973)
Net income (loss) (4,070) (4,070)
------ ------------ ------------- -------- ------------- --------- ---------
Balance, September 30, 2003 $ 64 $ 61,879 $ (3,772) $ 29,368 $ 1,730 $ (30,912) $ 58,357
------ ------------ ------------- -------- ------------- --------- ---------
ESOP shares committed to be released 413 497 910
Stock awards 23 118 141
Stock compensation tax benefit 33 33
Stock options exercised (34,609 shares) (41) 513 472
Stock employee compensation trust
(39,531 shares) (24) 31 7
Treasury stock reissuance (5,206) 67 67
Net changes in gains on -
securities available for sale,
net of tax (1,829) (1,829)
Treasury stock at cost (206,000 shares) (3,546) (3,546)
Cash dividend paid (1,241) (1,241)
Net income 5,087 5,087
------ ------------ ------------- -------- ------------- --------- ---------
Balance, September 30, 2004 $ 64 $ 62,307 $ (2,668) $ 33,245 $ (99) $ (34,391) $ 58,458
====== ============ ============= ======== ============= ========= =========
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
AS RESTATED
2004 2003 2002
--------- --------- -----------
Net income (loss) $ 5,087 $ (4,070) $ 2,696
Other comprehensive income (loss), net of tax
Unrealized gains (losses) on securities and on retained
interest on asset securitization:
Unrealized holding gains (losses) arising
during the period (1,036) (842) 2,752
Less: Reclassification adjustment for gains
included in net income (loss) 793 872 202
--------- --------- -----------
Other comprehensive income (loss) $ (1,829) $ (1,714) $ 2,550
--------- --------- -----------
Comprehensive income (loss) $ 3,258 $ (5,784) $ 5,246
========= ========= ===========
See accompanying notes to consolidated financial statements.
Page 43
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED SEPTEMBER 30,
-------------------------------------
(IN THOUSANDS)
AS RESTATED
2004 2003 2002
---------- ---------- -----------
OPERATING ACTIVITIES:
Net Income (Loss) $ 5,087 $ (4,070) $ 2,696
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Provision for assets acquired through foreclosure 254 208 132
Provision for loan losses 1,444 6,852 2,766
Depreciation 1,167 1,418 1,437
Amortization of intangibles 872 1,061 1,008
Deferred income tax provision (benefit) (612) (2,066) 582
ESOP shares committed to be released 910 710 758
Stock award expense 141 714 496
Purchase of shares for stock employee compensation trust 7 (1,810) -
Bank-owned life insurance income (487) (572) -
Origination of loans held for sale (27,879) (53,206) (64,595)
Proceeds from loans sold 47,729 65,642 65,938
Deconsolidation of capital trust 681 - -
Amortization and accretion on:
Held-to-maturity securities (23) (2) (9)
Available-for-sale securities 3,723 5,238 1,419
Amortization of deferred loan fees (518) (595) (653)
(Gain) loss on sale of:
Assets acquired through foreclosure (39) (134) 58
Loans (833) (1,025) (1,028)
Available-for-sale securities (1,292) (1,319) (308)
Branch (798) - -
Disposal of property and equipment 12 53 21
Impairment loss on equity investment - 1,488 -
Changes in assets and liabilities:
Decrease (increase) in accrued interest receivable 1,162 406 (740)
Decrease (increase) in other assets 4,714 (5,359) (1,970)
Increase (decrease) in accrued interest payable 62 (140) (672)
Increase (decrease) in accrued income taxes payable - - (2,716)
Increase in other liabilities (1,975) (781) 1,061
---------- ---------- -----------
Net cash provided by operating activities $ 33,509 $ 12,711 $ 5,681
---------- ---------- -----------
INVESTING ACTIVITIES:
Net (increase) decrease in loans $ 66,130 $ (20,844) $ 5,327
Proceeds from sale of:
Available-for-sale securities 57,456 122,853 31,243
FHLB stock 5,501 - -
Assets acquired through foreclosure 1,999 754 991
Proceeds from repayments of held-to-maturity securities 2,580 99 14,199
Proceeds from repayments of available-for-sale securities 93,679 147,144 85,738
Net cash proceeds from business acquisitions - - 104
Proceeds from disposal of fixed assets 135 - 1
Proceeds from sale of Danville branch (8,244) - -
Purchase of:
Available-for-sale securities (187,304) (264,267) (197,413)
Office properties and equipment (634) (783) (2,133)
Regulatory stock (5,523) (6,334) (800)
Purchase of bank-owned life insurance - - (10,000)
---------- ---------- -----------
Net cash provided by (used in) investing activities $ 25,775 $ (21,378) $ (72,743)
---------- ---------- -----------
See accompanying notes to consolidated financial statements.
Page 44
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED SEPTEMBER 30,
---------------------------------------
(IN THOUSANDS)
AS RESTATED
2004 2003 2002
---------- ---------- -----------
FINANCING ACTIVITIES:
Net increase (decrease) in deposit accounts $ (53,520) $ (59,107) $ 89,231
Increase (decrease) in Federal Home Loan Bank
short-term advances (57,500) 50,500 (6,000)
Borrowings of Federal Home Loan Bank
long-term advances 42,978 (20) 9,980
Net increase (decrease) in other borrowings 19,897 (2,655) (1,360)
Net increase (decrease) in advances from
borrowers for taxes and insurance (61) 387 206
Proceeds from issuance of trust-preferred securities - 15,000 7,000
Exercise of stock options 405 548 424
Stock compensation tax benefit (expense) 33 26 110
Purchase of treasury stock (3,546) 701 (14,421)
Treasury stock reissuance 67 100 96
Cash dividend on common stock (1,241) (1,973) (1,962)
---------- ---------- -----------
Net cash provided by financing activities $ (52,488) $ 3,507 $ 83,304
---------- ---------- -----------
Increase (decrease) in cash and cash equivalents $ 6,796 (5,160) 16,242
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 20,142 25,302 9,060
---------- ---------- -----------
CASH AND CASH EQUIVALENTS, END OF YEAR $ 26,938 $ 20,142 $ 25,302
========== ========== ===========
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Interest on deposits and borrowings $ 18,806 $ 22,498 $ 29,660
Income taxes $ 1,723 $ 1,420 $ 1,179
Supplemental disclosure - non-cash and financing information:
Transfer from loans to asset acquired through foreclosure $ 1,402 $ 1,303 $ 1,206
Net change in other comprehensive income $ 1,829 $ 1,714 $ 2,550
Purchase of business acquisitions:
Loans $ - $ - $ 11,396
Other assets - - 872
Deposits - - (13,017)
Other liabilities - - 19
See accompanying notes to consolidated financial statements.
Page 45
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES.
BUSINESS. Northeast Pennsylvania Financial Corp. (the "Company") is a thrift
holding company organized under the laws of the state of Delaware. The Company's
principal subsidiary, First Federal Bank (the "Bank") is a federal savings bank
organized under the laws of the United States. The Bank provides a wide range of
financial products and services to individual and corporate customers through
its community offices in Northeastern and Central Pennsylvania. Such products
include checking accounts, savings accounts, certificates of deposit, commercial
and consumer loans, real estate loans and home equity loans. The Bank is subject
to competition from other financial institutions and other companies that
provide financial services. The Company is subject to the regulations of certain
federal bank regulatory agencies and undergoes periodic examinations by those
regulatory authorities.
PRINCIPLES OF CONSOLIDATION AND PRESENTATION. The accompanying financial
statements of the Company include the accounts of the Bank, Abstractors, Inc.,
NEP Trust Co. (the "Trust Co."), Higgins Insurance Associates, Inc. ("Higgins"),
NEP Capital Trust I and NEP Capital Trust II. The Bank, Abstractors, Inc., the
Trust Co. and Higgins are wholly-owned subsidiaries of Northeast Pennsylvania
Financial Corp. Abstractors, Inc. is a title insurance agency. The Trust Co.
offers trust, estate and asset management services and products. Higgins
provides insurance and investment products to individuals and businesses. NEP
Capital Trust I and NEP Capital Trust II are subsidiaries established in
connection with trust preferred offerings. All material inter-company balances
and transactions have been eliminated in consolidation. Prior period amounts are
reclassified, when necessary, to conform with the current year's presentation.
Such reclassifications had no effect on net income (loss) or stockholders'
equity and do not relate to the restatement described in Footnote 2.
The Company follows accounting principles and reporting practices which are
generally accepted in the United States of America ("GAAP"). The preparation of
financial statements in conformity with GAAP requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ significantly from
those estimates. Material estimates that are particularly susceptible to
significant change in the near-term relate to determination of the allowance for
loan losses, the evaluation and realizability of deferred taxes and the
evaluation of other than temporary impairment for investments.
RISKS AND UNCERTAINTIES. In the normal course of its business, the Company
encounters two significant types of risk: economic and regulatory. There are
three main components of economic risk: interest rate risk, credit risk and
market risk. The Company is subject to interest rate risk to the degree that its
interest-bearing liabilities mature or reprice at different speeds, or on
different bases from its interest-earning assets. The Company's primary credit
risk is the risk of defaults in the Company's loan portfolio that result from
borrowers inability or unwillingness to make contractually required payments.
The Company's lending activities are concentrated in Pennsylvania. The largest
concentration of the Company's loan portfolio is located in Northeastern
Pennsylvania. The ability of the Company's borrowers to repay amounts owed is
dependent on several factors, including the economic conditions in the
borrowers' geographic regions and the borrowers' financial conditions. Market
risk reflects changes in the value of the collateral underlying loans, the
valuation of real estate held by the Company, and the valuation of loans held
for sale, securities, mortgage servicing assets and other investments.
The Bank is subject to the regulations of various government agencies. These
regulations can and do change significantly from period to period. The Bank also
undergoes periodic examinations by the regulatory agencies which may subject it
to further changes with respect to asset valuations, amounts of required loss
allowances and operating restrictions resulting from the regulators' judgments
based on information available to them at the time of their examination.
CASH AND CASH EQUIVALENTS. For the purpose of the consolidated statements of
cash flows, cash and cash equivalents include cash and interest-bearing deposits
with an original maturity of three months or less.
SECURITIES. The Company divides its securities portfolio into two segments: (a)
held-to-maturity and (b) available-for-sale. Securities in the held-to -maturity
category are accounted for at cost, adjusted for amortization of premiums and
accretion of discounts, using the level yield method, based on the Company's
intent and ability to hold the securities until maturity. All other securities
are included in the available-for-sale category and are reported at fair value,
with unrealized gains or losses excluded from earnings and reported, net of tax,
as a component of stockholders' equity. At the time of purchase, the Company
makes a determination as to whether or not it will hold the securities to
maturity, based upon an evaluation of the probability of future events.
Securities which the Company believes may be involved in interest rate risk,
liquidity or other asset/liability management decisions, which might reasonably
result in such securities not being held to maturity, are classified as
available for sale. If securities are sold, a gain or loss is determined by
specific identification and reflected in the operating results in the period the
trade occurs.
Page 46
OTHER INVESTMENT. The Company had a $1.5 million investment in the preferred
stock of a start-up venture. Prior to June 2003, since the investment did not
have a readily determinable market value, the Company was not accounting for the
investment under SFAS No. 115. The accounting for this security was initially
guided by EITF Topic No. D-68, EITF Topic No. 98-13 and EITF Topic No. 99-10,
which, in essence, provide that investee losses should be absorbed by
investments in other securities once an investee's common equity has been
exceeded by net losses. However, during the Company's 2001 third fiscal quarter
the investee issued additional equity and entered into certain other business
relationships which reduced the Company's influence over the investee and
resulted in the Company prospectively utilizing the cost method of accounting
for its remaining investment. During 2003, the Company wrote off its remaining
$1.5 million equity investment in this start-up venture since the venture was
unable to obtain additional equity financing to support its operations and the
impairment was deemed permanent.
ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses is maintained at a
level representing management's best estimate of known and inherent losses in
the portfolio, based upon management's evaluation of the portfolio's
collectibility. Management's evaluation is based upon an analysis of the
portfolio, past loss experience, current economic conditions and other relevant
factors. While management uses the best information available to make
evaluations, such evaluations are highly subjective, and future adjustments to
the allowance may be necessary if conditions differ substantially from the
assumptions used in making the evaluations. In addition, various regulatory
agencies, as an integral part of their examination process, periodically review
the Company's allowance for losses on loans. Such agencies may require the
Company to recognize additions to the allowance, based on their judgments about
information available to them at the time of their examination. The allowance is
increased by the provision for loan losses, which is charged to operations. Loan
losses are charged directly against the allowance, and recoveries on previously
charged-off loans are added to the allowance.
Loans are deemed to be "impaired" if upon management's assessment of the
relevant facts and circumstances, it is probable that the Company will be unable
to collect all proceeds due according to the contractual terms of the loan
agreement. For purposes of applying the measurement criteria for impaired loans,
the Company excludes large groups of smaller balance homogeneous loans,
primarily consisting of residential real estate and consumer loans, as well as
commercial loans with balances of less than $100,000.
The Company's policy for the recognition of interest income on impaired loans is
the same as for non-accrual loans discussed below. Impaired loans are charged
off when the Company determines that foreclosure is probable, and the fair value
of the collateral is less than the recorded investment of the impaired loan or
in the case of unsecured loans, management determines the loan to be
uncollectable.
LOANS, LOAN ORIGINATION FEES, AND UNCOLLECTED INTEREST. Loans are recorded at
cost, net of unearned discounts, deferred fees and allowances. Discounts or
premiums on purchased loans are amortized using the interest method over the
remaining contractual life of the portfolio, adjusted for actual prepayments.
Loan origination fees and certain direct origination costs are deferred and
amortized using the level yield method over the contractual life of the related
loans as an adjustment of the yield on the loans.
Uncollected interest receivable on loans is accrued to income as earned.
Non-accrual loans are loans on which the accrual of interest has ceased because
the collection of principal or interest payments is determined to be doubtful by
management. It is the policy of the Bank to discontinue the accrual of interest
when principal or interest payments are delinquent 90 days or more (unless the
loan principal and interest are determined by management to be fully secured and
in the process of collection), or earlier if the financial condition of the
borrower raises significant concern with regard to the ability of the borrower
to service the debt in accordance with the terms of the loan. Interest income on
such loans is not accrued until the financial condition and payment record of
the borrower demonstrates the ability to service the debt.
LOAN SECURITIZATION. In June 2002, the Bank sold automobile loan receivables
through a securitization transaction. A transfer of financial assets in which
the transferor surrenders control over those assets is accounted for as a sale
to the extent that consideration, other than beneficial interests in the
transferred assets, is received in exchange. Liabilities and derivatives
incurred or obtained by transferors as part of a transfer of financial assets
are initially measured at fair value, if practicable. Servicing assets and other
retained interests in the transferred assets are measured by allocating the
previous carrying amount between the assets sold, if any, and retained
interests, if any, based on their relative fair values at the date of the
transfer.
The Company allocates the previous carrying amount of the securitized automobile
loan receivables plus any other transferred assets between the assets sold and
the retained interests (principally an interest-only strip net of a recourse
obligation (the "Interest-Only Strip") and a cash reserve), based on their
relative estimated fair values at the date of sale. A gain or loss is recognized
at the time of sale equal to the excess of the fair value of the assets obtained
(principally cash) over the allocated fair value of the assets sold.
Page 47
Over the term of the securitized assets, securitization income includes the
yield of the retained interests, which includes certain fees from the underlying
assets as well as fees resulting from the Company's right to service the
underlying assets.
Due to prepayment risk, the Interest-Only Strips are measured like
available-for-sale securities. Accordingly, the Interest-Only Strips are
reported at their fair value which approximates the net carrying amount of such
assets. Unrealized holding gains or losses on the Interest-Only Strips, if any,
are excluded from earnings and reported, net of taxes, as a separate component
of shareholders' equity, except that, if a decline in fair value is judged to be
other than temporary, such a decline is accounted for as a realized loss and is
presented as a reduction of securitization income in the accompanying
consolidated statement of operations.
The Company estimates the fair value of the Interest-Only Strip at the date of
the transfer based on a discounted cash flow analysis. The cash flows of the
Interest-Only Strip are estimated as the excess of the cash inflows of the loans
sold over the sum of the pass-through interest rate plus the servicing fee, a
trustee fee, credit enhancement costs and an estimate of future credit losses
over the life of the loans. These cash flows are estimated over the life of the
loans using prepayment, default and interest rate assumptions that market
participants would use for financial instruments subject to similar levels of
prepayment, credit and interest rate risk.
The cash reserve account is not subject to prepayment risk and is initially
recorded at the allocated carrying amount based on its fair value as estimated
by management at the date of transfer using the "cash-out" method.
Management discounts the net cash flows of the Interest-Only Strips and cash
reserve accounts at interest rates that management believes a purchaser
unrelated to the seller of such a financial instrument would demand. The
discount on the cash reserve account is accreted and recorded in the results of
operations.
LOANS HELD FOR SALE. Mortgage loans originated and intended for sale in the
secondary market are carried at the lower of cost or estimated fair value in the
aggregate. Net unrealized losses are recognized by charges to operations.
MORTGAGE SERVICING RIGHTS. Upon the sale of a mortgage loan where the Company
retains servicing rights, a mortgage servicing right is recorded which is
included in other assets on the statement of financial condition. Mortgage
servicing rights are amortized into income over the average life of the loans
sold using the level yield method of amortization. Such assets are subject to
disaggregated impairment tests.
ASSETS ACQUIRED THROUGH FORECLOSURE. Real estate and other repossessed
collateral acquired through foreclosure or by deed in lieu of foreclosure are
classified as assets acquired through foreclosure. Assets acquired through
foreclosure are carried at the lower of cost or fair value less selling
expenses. Costs relating to the development or improvement of the property are
capitalized; holding costs are charged to expense.
PROPERTY AND EQUIPMENT. Property and equipment are stated at cost less
accumulated depreciation. Depreciation for each class of depreciable asset is
computed using the straight-line method over the estimated useful lives of the
assets (generally 39 years for buildings and 3 to 7 years for furniture and
equipment). When assets are retired, or otherwise disposed of, the cost and
related accumulated depreciation are removed from the accounts. The cost of
maintenance and repairs is charged to expense as incurred and renewals and
betterments are capitalized. Leasehold improvements are depreciated using the
straight line method over the shorter of the useful life of the improvement or
the remaining life of the lease.
INTANGIBLE ASSETS. Intangible assets include core deposit intangibles and
certain other deferrable acquisition costs. The core deposit intangibles are
being amortized to expense over a 10- to 31-year life on an accelerated basis
and other intangible assets are being amortized to expense on an accelerated
basis over a period of 3.7 to 5 years. The recoverability of the carrying value
of intangible assets is evaluated on an ongoing basis, and permanent declines in
value, if any, are charged to expense.
GOODWILL. Goodwill is the excess of cost over the fair value of assets acquired
in connection with business acquisitions and was being amortized on the
straight-line method over 5, 6 and 20 years, prior to October 1, 2001. On
October 1, 2001, the Company adopted SFAS No. 142, Goodwill and Other Intangible
Assets, which changed the accounting for goodwill from an amortization method to
an impairment-only approach. This statement eliminates the regularly scheduled
amortization of goodwill and replaces this method with a two-step process for
testing the impairment of goodwill on at least an annual basis. This approach
could cause more volatility in the Company's reported net income because
impairment losses, if any, could occur irregularly and in varying amounts. The
Company, upon adoption of this Statement, stopped amortizing existing goodwill
of $3.0 million. During 2002, the Company performed its initial impairment
analysis of goodwill and other intangible assets and determined that the
estimated fair value exceeded the carrying amount. During 2004 and 2003, the
Company performed its annual analysis of goodwill and other intangible assets
and recognized a $25,000 and $39,000 impairment, respectively, related to its
acquisition of an insurance book of business.
Page 48
INCOME TAXES. The Company accounts for income taxes under the asset/liability
method. Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases, as well as operating loss and tax credit carryforwards. Deferred tax
assets and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are expected to
be recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date. A valuation allowance is established against deferred tax assets
when in the judgment of management, it is more likely than not that such
deferred tax assets will not become available. Because the judgment about the
level of future taxable income is dependent to a great extent on matters that
may, at least in part be beyond the Company's control, it is at least reasonably
possible that management's judgment about the need for a valuation allowance for
deferred taxes could change in the near term.
Retained earnings at September 30, 2004 and 2003 include approximately $10.2
million, for which no provision for Federal income tax has been made. These
amounts represent allocations of earnings to bad debt reserves for tax purposes
and are a restriction upon retained earnings. If, in the future, this portion of
retained earnings is reduced for any purpose other than tax bad debt losses,
Federal income taxes may be imposed at the then-applicable rates.
EARNINGS (LOSS) PER SHARE.
Earnings (loss) per share (EPS), basic and diluted, were $1.32 and $1.26,
respectively for the year ended September 30, 2004, $(1.08) and $(1.08),
respectively for the year ended September 30, 2003 and $0.67 and $0.63,
respectively, for the year ended September 30, 2002.
The Company provides dual presentation of basic and diluted earnings per share.
Basic earnings per share is calculated utilizing net income (loss) as reported
in the numerator and average shares outstanding in the denominator. The
computation of diluted earnings per share differs in that the dilutive effects
of any stock options, warrants, and convertible securities are adjusted in the
denominator.
The following table presents the reconciliation of the numerators and
denominators of the basic and diluted EPS computations:
AS RESTATED
FOR THE YEAR FOR THE YEAR FOR THE YEAR
ENDED ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
2004 2003 2002
-------------- -------------- --------------
BASIC:
Net income (loss) (in thousands) $ 5,087 $ (4,070) $ 2,696
-------------- -------------- --------------
Weighted average shares outstanding 4,135,078 4,173,655 4,485,674
Average common stock acquired by stock benefit plans:
Stock employee compensation trust (47,738) (87,499) (18,999)
Stock awards unallocated, net (24,856) (75,636) (117,814)
ESOP shares unallocated, net (205,500) (244,235) (299,762)
-------------- -------------- --------------
Basic weighted-average shares outstanding 3,856,984 3,766,285 4,049,099
-------------- -------------- --------------
Earnings (loss) per share - basic $ 1.32 $ (1.08) $ 0.67
============== ============== ==============
DILUTED(1):
Net income (loss) (in thousands) $ 5,087 $ (4,070) $ 2,696
-------------- -------------- --------------
Basic weighted-average shares outstanding 3,856,984 3,766,285 4,049,099
Dilutive Instruments:
Dilutive effect of outstanding stock options 194,287 170,307 193,699
Dilutive effect of stock awards 1 11,317 24,808
-------------- -------------- --------------
Diluted weighted-average shares outstanding 4,051,272 3,947,909 4,267,606
-------------- -------------- --------------
Earnings (loss) per share - diluted $ 1.26 $ (1.08) $ 0.63
============== ============== ==============
(1) Diluted earnings per share include the dilutive effect of the Company's
weighted-average stock options/awards
Page 49
outstanding using the Treasury Stock method. The Company had 76,500, 60,550
and 8,735 anti-dilutive common stock options outstanding as of September
30, 2004, 2003 and 2002, respectively. These options are not included in
the calculation of diluted earnings per share for the periods presented.
COMPREHENSIVE INCOME. The Company is required to present comprehensive income in
a full set of general purpose financial statements for all periods presented.
Other comprehensive income is comprised of unrealized holding gains (losses) on
the available-for-sale securities portfolio and on the retained interest on
asset securitization.
STOCK OPTIONS. The Company maintains stock option plans for officers, employees,
and directors. When the exercise price of the Company's stock options is greater
than or equal to the market price of the underlying stock on the date of the
grant, no compensation expense is recognized in the Company's financial
statements.
In October 1995, the FASB issued SFAS No. 123, "Accounting for Stock-Based
Compensation." This Statement encourages, but does not require, the adoption of
fair-value accounting for stock-based compensation to employees. The Company, as
permitted, has elected not to adopt the fair-value accounting provisions of SFAS
No. 123, and has instead continued to apply APB Opinion No. 25 and related
interpretations in accounting for the plans and to provide the required proforma
disclosures of SFAS No. 123; accordingly, no expense is recognized in the
Consolidated Statement of Operations. Pro forma net income and earnings per
share are presented to reflect the impact of the stock option plan assuming
compensation expense had been recognized based on the fair value of the stock
options granted under the plan.
The following table represents the effect on net income and earnings per share
had the Company applied the fair value recognition provisions of SFAS No. 123 to
stock-based employee compensation:
YEAR ENDED SEPTEMBER 30,
------------------------------------------------
AS RESTATED
2004 2003 2002
-------------- -------------- --------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Net income (loss), as reported: $ 5,087 $ (4,070) $ 2,696
Less: proforma expense related
to stock options (200) (358) (394)
-------------- -------------- --------------
Proforma net income (loss) $ 4,887 $ (4,428) $ 2,302
============== ============== ==============
Basic net income (loss) per common share:
As reported $ 1.32 $ (1.08) $ 0.67
Pro forma 1.27 (1.18) 0.56
Diluted net income (loss) per common share:
As reported $ 1.26 $ (1.08) $ 0.63
Pro forma 1.21 (1.12) 0.53
The effects on pro forma net income and diluted earnings per share of applying
the disclosure requirement of SFAS No. 123 in past years may not be
representative of the future pro forma effects on net income and EPS due to the
vesting provisions of the options and future awards that are available to be
granted.
2. EFFECTS OF RESTATEMENT
The Consolidated Financial Statements for the fiscal years ended September 30,
2002, 2001, 2000, 1999 and 1998 have been restated to reflect the correction of
accounting errors for the Company's indirect automobile, mortgage and consumer
loan portfolios. Such errors were discovered in July 2003 and were primarily the
result of computer coding errors and did not impact any loan customers.
In September 2003, the Company completed a review of its accounting records and
discovered additional accounting errors. As such, the Company has further
restated its financial statements for the fiscal year ended September 30, 2002
to reflect the correction of additional accounting errors related to an
adjustment to deferred loan fees, an underaccrual in the Company's health and
welfare benefit plans, the write-off of improperly deferred advertising and
professional fees and the improper recording of a receivable related to the sale
of indirect automobile loans. Such errors resulted in a decrease in interest and
fees on loans, an increase in salaries and employee benefits, advertising,
professional fees and other expense.
These errors had no material effect on the Company's cash flows for operating,
investing or financing activities.
Page 50
The following table describes the cumulative effects of the restatements on net
income and earnings per share for the year ended September 30, 2002.
TWELVE MONTHS ENDED
SEPTEMBER 30, 2002
-------------------
Net income prior to restatements $ 4,498
Adjustment for interest and fees on loans, net of tax benefit (1,029)
Adjustment for gain on sale of loans, net of tax benefit (204)
-------------------
Net income after 1st restatement 3,265
Adjustment for interest and fees on loans, net of tax benefit (20)
Adjustment for salaries and employee benefits, net of
tax benefit (210)
Adjustment for advertising, net of tax benefit (45)
Adjustment for professional fees, net of tax benefit (26)
Adjustment for other expense, net of tax benefit (268)
-------------------
NET INCOME, AS ADJUSTED, AFTER 2ND RESTATEMENT $ 2,696
===================
EARNINGS PER SHARE (EPS)
TWELVE MONTHS ENDED
SEPTEMBER 30, 2002
------------------
Basic EPS prior to restatements $ 1.11
Adjustment for interest and fees on loans, net of tax benefit (0.25)
Adjustment for gains on sale of loans, net of tax benefit (0.05)
-------------------
Basic EPS after 1st restatement $ 0.81
Adjustment for interest and fees on loans, net of tax benefit -
Adjustment for salaries and employee benefits, net of
tax benefit (0.05)
Adjustment for advertising, net of tax benefit (0.02)
Adjustment for professional fees, net of tax benefit -
Adjustment for other expense, net of tax benefit (0.07)
-------------------
Basic EPS, as adjusted, net of tax benefit, after 2nd restatement $ 0.67
===================
Diluted EPS prior to restatements $ 1.05
Adjustment for interest and fees on loans, net of tax benefit (0.24)
Adjustment for gain on sale of loans, net of tax benefit (0.05)
-------------------
Diluted EPS after 1st restatement 0.76
Adjustment for interest and fees on loans, net of tax benefit -
Adjustment for salaries and employee benefits, net of
tax benefit (0.05)
Adjustment for advertising, net of tax benefit (0.01)
Adjustment for professional fees, net of tax benefit -
Adjustment for other expense, net of tax benefit (0.07)
-------------------
Diluted EPS, as adjusted, net of tax benefit, after 2nd restatement $ 0.63
===================
Page 51
The cumulative effect of these accounting errors on stockholders' equity is as
follows for the period presented:
AT SEPTEMBER 30,
2002
----------------
Stockholders' Equity, prior to restatements $ 68,385
Cumulative effect of interest and fees on loans, net of tax benefit (2,487)
Cumulative effect of gain on sale of loans, net of tax benefit (204)
Stockholders' Equity, as adjusted by 1st restatement $ 65,694
Cumulative effect of interest and fees on loans, net of tax benefit (20)
Cumulative effect of salaries and employee benefits, net of tax benefit (210)
Cumulative effect of advertising, net of tax benefit (45)
Cumulative effect of professional fees, net of tax benefit (26)
Cumulative effect of other expenses, net of tax benefit (268)
----------------
Stockholders' Equity, as adjusted by 2nd restatement $ 65,125
================
3. SECURITIES
The following table summarizes the estimated fair value of securities with gross
unrealized losses at September 30, 2004, segregated between securities that have
been in a continuous unrealized loss position for less than twelve months and
those that have been in a continuous unrealized loss position for twelve months
or longer.
Less Than Twelve Months
Twelve Months Or Longer Total
----------------------- ----------------------- -----------------------
Unrealized Unrealized Unrealized
Fair Value Losses Fair Value Losses Fair Value Losses
----------------------- ----------------------- -----------------------
(in thousands)
Municipal securities $ 638 $ (2) $ - $ - $ 638 $ (2)
Obligations of U.S. Government agencies 10,321 (63) - - 10,321 (63)
Mortgage-related securities 162,688 (1,824) 33,493 (479) 196,181 (2,303)
---------- ---------- ---------- ---------- ---------- ----------
Total debt securities 173,647 (1,889) 33,493 (479) 207,140 (2,368)
Other equity securities - - 10 (7) 10 (7)
---------- ---------- ---------- ---------- ---------- ----------
Total equity securities - - 10 (7) 10 (7)
---------- ---------- ---------- ---------- ---------- ----------
Total $ 173,647 $ (1,889) $ 33,503 $ (486) $ 207,150 $ (2,375)
========== ========== ========== ========== ========== ==========
Management does not believe any individual unrealized loss as of September 30,
2004 represents an other-than-temporary impairment. The temporary impairment is
directly related to changes in market interest rates. In general, as interest
rates rise, the fair value of fixed-rate securities will decrease and, as
interest rates fall, the fair value of fixed-rate securities will increase. The
severity of the impairment as a percent of the total investment position is
nominal and the duration of the impairment to date is short. The impairments are
deemed temporary based on the direct relationship of the decline in fair value
to movements in interest rates, as well as the relatively short duration of the
investments and their high credit quality.
Securities that have been impaired greater than twelve months include primarily
mortgage-related securities. The decline in the market value of these securities
was deemed temporary due to positive factors supporting the recoverability of
these investments. Positive factors considered include timely principal and
interest payments and the financial health of the issuer.
Page 52
Securities are summarized as follows:
SEPTEMBER 30, 2004
--------------------------------------------------
(IN THOUSANDS)
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
---------- ---------- ---------- ----------
AVAILABLE-FOR-SALE SECURITIES:
Municipal securities $ 4,767 $ 47 $ (2) $ 4,812
Obligations of U.S. Government agencies 10,384 - (63) 10,321
Mortgage-related securities 327,568 1,716 (2,303) 326,981
---------- ---------- ---------- ----------
Total debt securities 342,719 1,763 (2,368) 342,114
FHLB Stock 13,009 - - 13,009
FNMA Stock 2,000 5 - 2,005
Other equity securities 79 23 (7) 95
---------- ---------- ---------- ----------
Total equity securities 15,088 28 (7) 15,109
Total $ 357,807 $ 1,791 $ (2,375) $ 357,223
========== ========== ========== ==========
HELD-TO-MATURITY SECURITIES:
Municipal securities 998 17 - 1,015
---------- ---------- ---------- ----------
Total $ 998 $ 17 $ - $ 1,015
========== ========== ========== ==========
SEPTEMBER 30, 2003
--------------------------------------------------
(IN THOUSANDS)
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
---------- ---------- ---------- ----------
AVAILABLE-FOR-SALE SECURITIES:
Municipal securities $ 14,983 $ 151 $ - $ 15,134
Obligations of U.S. Government agencies 26,089 204 (4) 26,289
Mortgage-related securities 210,144 1,652 (831) 210,965
Trust Preferred securities 12,754 474 (429) 12,799
Corporate Bonds 38,769 1,814 (12) 40,571
---------- ---------- ---------- ----------
Total debt securities 302,739 4,295 (1,276) 305,758
FHLB Stock 12,987 - - 12,987
FHLMC Stock 2,241 - (304) 1,937
FNMA Stock 6,000 20 (170) 5,850
Other equity securities 78 22 (6) 94
---------- ---------- ---------- ----------
Total equity securities 21,306 42 (480) 20,868
Total $ 324,045 $ 4,337 $ (1,756) $ 326,626
========== ========== ========== ==========
HELD-TO-MATURITY SECURITIES:
Municipal securities $ 3,555 $ 67 $ - $ 3,622
---------- ---------- ---------- ----------
Total $ 3,555 $ 67 $ - $ 3,622
========== ========== ========== ==========
Page 53
The amortized cost and estimated fair value of debt securities by contractual
maturity are as follows:
SEPTEMBER 30, 2004
--------------------------------------------------------------------------
(IN THOUSANDS)
Maturing
Maturing after one year Maturing after Maturing
within one but within 5 5 years but after 10
year years within 10 years years Total
---------- -------------- --------------- ----------- ------------
AVAILABLE-FOR-SALE DEBT SECURITIES:
Municipal securities $ - $ 640 $ - $ 4,127 $ 4,767
Obligations of U.S. Government agencies - 10,030 - 354 10,384
Mortgage-related securities - 1,477 106,917 219,174 327,568
---------- -------------- --------------- ----------- -----------
Total debt securities at amortized cost $ - $ 12,147 $ 106,917 $ 223,655 $ 342,719
========== ============== =============== =========== ============
Total debt securities at fair value $ - $ 12,135 $ 106,117 $ 223,862 $ 342,114
========== ============== =============== =========== ============
Weighted-Average Yield - 3.00% 3.71% 4.07% 3.92%
HELD-TO-MATURITY DEBT SECURITIES:
Municipal securities $ - $ - $ - $ 998 $ 998
Total debt securities at amortized cost $ - $ - $ - $ 998 $ 998
========== ============== =============== =========== ============
Total debt securities at fair value $ - $ - $ - $ 1,015 $ 1,015
========== ============== =============== =========== ============
Weighted-Average Yield - - - 4.39% 4.39%
Expected maturities will differ from contractual maturities because borrowers
may have the right to call or prepay obligations with or without call or
prepayment penalties. Weighted average yields are based on amortized cost
including municipal securities which are not reported on a tax-equivalent basis.
Proceeds from sales of securities available for sale during the year ended
September 30, 2004 were $59.8 million resulting in gross realized gains of $2.0
million and gross realized losses of $712,000. Proceeds from sales of securities
available for sale during the year ended September 30, 2003 were $122.9 million
resulting in gross realized gains of $1.6 million and gross realized losses of
$255,000. Proceeds from sales of securities available for sale during the year
ended September 30, 2002 were $31.2 million resulting in gross realized gains of
$513,000 and gross realized losses of $205,000.
Securities classified as agencies and mortgage-related securities, with an
amortized cost of $171.8 million and a fair value of approximately $172.0
million at September 30, 2004, were pledged to secure public deposits as
required by law.
Page 54
4. LOANS
Loans are summarized as follows:
AT SEPTEMBER 30,
------------------------
(IN THOUSANDS)
2004 2003
---------- ----------
REAL ESTATE LOANS:
One- to four-family $ 112,186 $ 149,741
Multi-family and commercial 71,138 64,343
Construction 4,899 22,384
---------- ----------
Total real estate loans $ 188,223 $ 236,468
---------- ----------
CONSUMER LOANS:
Home equity loans and lines of credit $ 69,400 $ 73,036
Automobile 101,148 136,182
Unsecured lines of credit 4,424 3,455
Other 9,387 9,421
---------- ----------
Total consumer loans $ 184,359 $ 222,094
---------- ----------
COMMERCIAL LOANS $ 40,473 $ 43,203
---------- ----------
Total loans $ 413,055 $ 501,765
---------- ----------
LESS:
Allowance for loan losses (8,446) (10,196)
Deferred loan origination fees (1,025) (1,583)
---------- ----------
Total loans, net $ 403,584 $ 489,986
========== ==========
At September 30, 2004, the Company had a $22.5 million recorded investment in
impaired loans, which had specific loan loss allowances totaling $4.1 million.
At September 30, 2003, there was $30.1 million of impaired loans, which had
specific loan loss allowances totaling $6.3 million. The average net recorded
investment in impaired loans for the years ended September 30, 2004, 2003 and
2002 was $24.0 million, $15.4 million and $5.6 million, respectively. The
related amount of interest income recognized on impaired loans was $1.3 million,
$969,000 and $375,000 for the years ended September 30, 2004, 2003 and 2002,
respectively.
Non-accrual loans totaled $6.9 million, $12.5 million and $4.2 million at
September 30, 2004, 2003 and 2002, respectively. There were $0, $0 and $55,000
in troubled debt restructuring loans at September 30, 2004, 2003 and 2002,
respectively. The Bank has no commitments to lend additional funds to borrowers
whose loans were classified as non-performing or as a troubled debt
restructuring.
The activity in the allowance for loan losses is as follows:
SEPTEMBER 30,
--------------------------------------
2004 2003 2002
---------- ---------- ----------
Balance, beginning $ 10,196 $ 5,449 $ 4,497
Transfer due to sale of indirect
automobile loans (1,557) - -
Provision charged to income 1,444 6,852 2,766
Charge-offs (2,106) (2,251) (1,993)
Recoveries 469 146 179
---------- ---------- ----------
Balance, ending $ 8,446 $ 10,196 $ 5,449
========== ========== ==========
An analysis of the activity of loans to directors and executive officers is as
follows:
Page 55
SEPTEMBER 30,
------------------------
(IN THOUSANDS)
2004 2003
---------- ----------
Balance, beginning of year $ 4,511 $ 2,152
New loans and line of credit advances 448 3,086
Repayments (2,891) (727)
---------- ----------
Balance end of year $ 2,068 $ 4,511
========== ==========
5. MORTGAGE SERVICING ACTIVITY
Mortgage servicing rights are included in other assets on the Consolidated
Statements of Financial Condition. A summary of mortgage servicing rights
activity follows:
YEARS ENDED SEPTEMBER 30,
--------------------------------------
(IN THOUSANDS)
2004 2003 2002
---------- ---------- ----------
Balance, beginning of year $ 715 $ 465 $ 493
Originated servicing rights 345 562 143
Amortization (246) (312) (171)
---------- ---------- ----------
Balance, end of year $ 814 $ 715 $ 465
========== ========== ==========
At September 30, 2004, 2003 and 2002, the Bank serviced loans for others of
$117.2 million, $92.9 million and $67.2 million, respectively. Loans serviced by
others for the Bank as of September 30, 2004, 2003 and 2002 were $8.5 million,
$12.9 million and $31.5 million, respectively.
6. PROPERTIES AND EQUIPMENT
Properties and equipment by major classification are summarized as follows:
SEPTEMBER 30,
------------------------
(IN THOUSANDS)
2004 2003
---------- ----------
Land $ 2,051 $ 2,287
Buildings and improvements 11,027 11,285
Furniture, fixtures and equipment 7,277 8,452
Leasehold improvements 636 844
---------- ----------
Total $ 20,991 $ 22,868
---------- ----------
Less: accumulated depreciation (10,171) (10,716)
---------- ----------
Net $ 10,820 $ 12,152
========== ==========
The Company has entered into operating leases for several of its branch
facilities and operating departments. The minimum annual rental payments under
these leases at September 30, 2004 are as follows:
Page 56
YEARS ENDING SEPTEMBER 30,
--------------------------
2005 $ 238,624
2006 80,790
2007 48,761
2008 48,432
2009 48,432
2010 and after 16,056
---------
Total $ 481,095
=========
Rent expense was $262,000, $272,000 and $312,000 for the years ended September
30, 2004, 2003 and 2002, respectively.
7. ASSET SECURITIZATION
In June 2002, the Bank sold $50.0 million in automobile loan receivables through
a securitization transaction. In the transaction, automobile loan receivables
were transferred to an independent trust (the "Trust") that issued certificates
representing ownership interests in the Trust, primarily to institutional
investors. Although the Bank continues to service the underlying accounts and
maintain the customer relationships, this transaction is treated as a sale for
financial reporting purposes to the extent of the investors' interest in the
Trust. Accordingly, the receivables associated with the investors' interests are
not reflected on the Consolidated Statement of Financial Condition. In
connection with this transaction, the Bank enhanced the credit protection of the
certificate holders by funding a cash reserve account.
In connection with this June 2002 transaction, the Bank originally recorded a
pre-tax gain on the sale of auto loans of $854,000, which was included in gain
on sale of loans in the Consolidated Statement of Operations. In July 2003, the
Company discovered that computer coding errors related to the indirect
automobile loan portfolio also impacted the original gains related to this
securitization. As such, the Company has retroactively adjusted the original
gain, as well as key assumptions, to collectively reflect a pre-tax gain of
$407,000. At the time of the transaction, the Bank also recognized a retained
interest related to the loan sale, which includes an Interest-Only Strip and
cash reserve account. The cash reserve account is subject to liens by the
providers of the credit enhancement facilities for the securitizations.
As of September 30, 2004, the balance of automobile loan receivables in the
Trust was $10.8 million. Because the historical performance of the receivables
met the established criteria as of September 30, 2003, the balance of the cash
reserve account was reduced from 4.75% to 3.00% of the original balance at that
time. The aggregate balance of the retained interest totaled approximately $1.4
million at September 30, 2004.
The key assumptions used in measuring the fair value of the retained interest
and cash collateral account for the transaction is shown in the following table:
Retained interest
Average annual repayment rate 1.5%
Average annual expected default rate 3.0%
Discount rate 10.0%
Weighted average life of underlying automobile
loans 26 months
The key economic assumptions and the sensitivity of the fair value of the
retained interest asset to an immediate adverse change of 10% and 20% to those
assumptions are as follows for the period indicated:
SEPTEMBER 30, 2004
------------------
(IN THOUSANDS)
Fair value of retained interest $ 1,420
Weighted-average repayment rate assumption:
Pre-tax decrease to earnings due to a 10% adverse change $ 9
Pre-tax decrease to earnings due to a 20% adverse change $ 8
Weighted-average expected default rate:
Pre-tax decrease to earnings due to a 10% adverse change $ 17
Pre-tax decrease to earnings due to a 20% adverse change $ 34
Weighted-average discount rate:
Pre-tax decrease to earnings due to a 10% adverse change $ 12
Pre-tax decrease to earnings due to a 20% adverse change $ 24
Page 57
The terms of the transaction included provisions related to the performance of
the underlying receivables and other specific conditions that could result in an
early payout of invested amounts to the certificate holders.
Changes in fair value based on a 10% adverse variation in assumptions generally
cannot be extrapolated because the relationship of the change in assumption to
the change in fair value may not be linear. Also, the effect of an adverse
variation on a particular assumption on the fair value of the retained interest
is calculated without changing any other assumption. However, changes in one
factor may result in changes in another (for example, increases in market
interest rates may result in lower prepayments and increased credit losses),
which might magnify or counteract the sensitivities.
8. DEPOSITS
Deposits consist of the following major classifications:
AT OR FOR THE YEAR ENDED SEPTEMBER 30,
------------------------------------------------------------------------------
(IN THOUSANDS)
2004 2003
------------------------------------- -------------------------------------
WEIGHTED- WEIGHTED-
AVERAGE PERCENT OF AVERAGE PERCENT OF
RATE AMOUNT TOTAL RATE AMOUNT TOTAL
---------- ---------- ---------- ---------- ---------- ----------
Savings accounts (passbook, statement, clubs) 0.14% $ 92,626 19.16% 0.06% $ 97,499 17.81%
Money market accounts 0.90 75,164 15.55 0.96 95,972 17.54
Certificates of deposit less than $100,000 3.07 161,779 33.46 3.19 195,669 35.75
Certificates of deposit $100,000 and greater 3.56 26,046 5.39 3.78 33,584 6.14
Brokered CD's 2.50 10,000 2.07 - - -
NOW Accounts 0.77 81,150 16.78 0.92 88,130 16.10
Non-interest-bearing deposits - 36,676 7.59 - 36,451 6.66
---------- ---------- ---------- ---------- ---------- ----------
Total deposits at end of period 1.57% $ 483,441 100.00% 1.79% $ 547,305 100.00%
========== ========== ========== ========== ========== ==========
Certificates of deposit are frequently renewed at maturity rather than
liquidated; a summary of certificates by contractual maturity at September 30,
2004 follows:
YEARS ENDING SEPTEMBER 30,
----------------------------------------
(IN THOUSANDS)
Amount
-----------
2005 $ 67,929
2006 113,597
2007 5,050
2008 7,405
2009 3,844
2010 and after -
-----------
Total $ 197,825
===========
Page 58
Interest expense on deposits is comprised of the following:
YEARS ENDED SEPTEMBER 30,
------------------------------------
(IN THOUSANDS)
2004 2003 2002
---------- ---------- ----------
Savings accounts $ 94 $ 395 $ 1,141
Money market accounts 806 1,674 1,436
Certificates of deposit 6,720 8,956 13,324
NOW Accounts 593 1,133 1,021
---------- ---------- ----------
Total $ 8,213 $ 12,158 $ 16,922
========== ========== ==========
9. FEDERAL HOME LOAN BANK ADVANCES
Under terms of its collateral agreement with the Federal Home Loan Bank of
Pittsburgh (the "FHLB"), the Bank maintains otherwise unencumbered qualifying
assets (principally one-to-four family residential mortgage loans and U.S.
Government and Agency notes and bonds) in the amount of at least as much as its
advances from the FHLB. The Bank's FHLB stock is also pledged to secure these
advances. At September 30, 2004, such advances mature as follows:
DUE BY SEPTEMBER 30, WEIGHTED-AVERAGE RATE SEPTEMBER 30, 2004
- --------------------- --------------------- ------------------
(IN THOUSANDS)
2005 6.34% $ 52,000
2006 3.50 102,000
2007 3.26 40,080
2008 4.89 10,000
2009 - -
Thereafter 5.40 39,787
---- ------------------
Total FHLB advances 4.43% $ 243,867
==== ==================
The Bank has included in the preceding tables annually renewable lines of credit
totaling $75.0 million. At September 30, 2004, there were no such borrowings
outstanding at FHLB. The Bank, from time to time, has used lines of credit to
meet liquidity needs. There were $27.5 million in borrowings outstanding at
September 30, 2003 under such lines of credit with an interest rate at the
overnight FHLB borrowing rate of 1.31%.
At September 30, 2004, the Bank had outstanding advances from the FHLB of $140.0
million which have callable features. Such advances have a fixed rate for a
specified period of time after which the FHLB can, at its option, convert the
advance to a variable rate. The Bank, at the same time, can repay the advance
without a prepayment fee.
10. TRUST PREFERRED DEBT
On April 10, 2002, NEP Capital Trust I, a Delaware statutory business trust,
issued $7.0 million of floating rate capital securities through a pooled trust
preferred securities offering. The proceeds from this issuance, along with the
Company's $217,000 payment for the Trust's common securities, were used to
acquire $7.2 million aggregate principal amount of the Company's floating rate
junior subordinated deferrable interest debentures due April 22, 2032 (the
"Debentures"), which constitute the sole asset of the Trust. The interest rate
on the Debentures and the distribution rate on the capital securities are
variable and adjust semi-annually at 3.70% over the six-month LIBOR, with an
initial rate of 6.02%. A rate cap of 11% is effective through April 11, 2007.
The stated maturity of the Debentures is April 22, 2032. In addition, the
Debentures are subject to redemption at par at the option of the Company,
subject to prior regulatory approval, in whole or in part on any interest
payment date after April 22, 2007. In 2002, the Company recognized an
amortizable intangible asset with a value of $220,000 relating to the issuance
costs of these trust preferred securities.
On October 29, 2002, NEP Capital Trust II, a Delaware statutory business trust,
issued $15.0 million in the form of floating rate capital securities through a
pooled trust preferred securities offering. The proceeds from this issuance,
along with the Company's $464,000 payment for the Trust's common securities,
were used to acquire $15.5 million aggregate principal amount of the Company's
floating rate junior subordinated deferrable interest debentures due November 7,
2032 (the "Debentures"), which constitute the sole asset of the Trust. The
interest rate on the Debentures and the distribution rate on the capital
securities are variable and adjust quarterly at 3.45% over the three-month
LIBOR, with an initial rate of 5.27%. A rate cap of 12.5% is effective
Page 59
through November 7, 2007. The stated maturity of the Debentures is November 7,
2032. In addition, the Debentures are subject to redemption at par at the option
of the Company, subject to prior regulatory approval, in whole or in part on any
interest payment date after August 7, 2007. The Company recognized an
amortizable intangible asset with a value of $450,000 relating to the issuance
costs of these trust preferred securities.
In December 2003, the FASB revised Financial Interpretation No. ("FIN") 46,
Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulletin No. 51 (the Interpretation). The Interpretation requires the
consolidation of entities in which an enterprise absorbs a majority of the
entity's expected losses, receives a majority of the entity's expected residual
returns, or both, as a result of ownership, contractual or other financial
interests in the entity. Previously, entities were generally consolidated by an
enterprise when it has a controlling financial interest through ownership of a
majority voting interest in the entity. Application of this Interpretation is
required in financial statements of public entities that have interests in
variable interest entities or potential variable interest entities commonly
referred to as special purpose entities for periods ending after December 15,
2003. Application by public entities for all other types of entities is required
in financial statements for periods ending after March 15, 2004. As a result of
the adoption of FIN 46, the Company deconsolidated its Capital Trusts in the
second fiscal quarter of 2004. The result was an increase in the junior debt of
$681,000.
A summary of the trust securities issued and outstanding at September 30, 2004
is as follows:
Prepayment Distribution
Amount Option Payment
Name Outstanding Rate Date Maturity Frequency
- -------------------- ------------ --------- ------------ ------------ -------------
NEP Capital Trust I $ 7,217,000 5.07% 4/22/2007 4/22/2032 Semi-annually
NEP Capital Trust II $ 15,464,000 5.16% 11/7/2007 11/7/2032 Quarterly
11. INCOME TAXES
The Small Business Job Protection Act of 1996, enacted on August 20, 1996,
repealed the tax bad debt deduction computed under the percentage of taxable
income method. Upon repeal, the Bank was required to recapture into income, over
a six-year period, the portion of its tax bad debt reserves that exceeded its
base year reserves (i.e., tax reserves for tax years beginning before 1988). The
base year tax reserves, which may be subject to recapture if the Bank ceases to
qualify as a savings bank for Federal income tax purposes, are restricted with
respect to certain distributions. The Bank's total tax bad debt reserves at
September 30, 2004 were approximately $10.2 million, of which $10.2 million
represents the base year amount and $0 is subject to recapture currently.
The provision (benefit) for income taxes is summarized as follows:
YEAR ENDED SEPTEMBER 30,
--------------------------------------
(IN THOUSANDS)
AS RESTATED
2004 2003 2002
---------- ---------- -----------
Current:
Federal $ 1,209 $ 216 $ 815
State 478 21 223
Deferred:
Federal 311 (1,765) 582
State 301 (301) -
---------- ---------- -----------
Total $ 2,299 $ (1,829) $ 1,620
========== ========== ===========
Page 60
The provision (benefit) for income taxes differs from the statutory rate due to
the following:
YEAR ENDED SEPTEMBER 30,
---------------------------------------
(IN THOUSANDS)
AS RESTATED
2004 2003 2002
---------- ---------- -----------
Federal income tax at
statutory rate $ 2,512 $ (2,006) $ 1,467
Tax exempt interest, net (371) (444) (419)
State taxes, net of Federal benefit 616 (287) 147
Excess ESOP compensation expense 92 102 35
Bank-owned life insurance (171) (184) (99)
Excess Officer Compensation - 159 -
Adjustment for prior year taxes (250) - -
Other, net (129) (3) 2
Increase in valuation allowance for
deferred tax assets - 834 487
---------- ---------- -----------
Total provision (benefit) $ 2,299 $ (1,829) $ 1,620
========== ========== ===========
The components of the net deferred tax liability (asset) are as follows:
SEPTEMBER 30,
------------------------
(IN THOUSANDS)
2004 2003
---------- ----------
Deferred tax assets:
ESOP funding difference $ (132) $ (132)
Recognition and retention plan - (130)
Deferred compensation (384) (470)
Accrued hospitalization (136) (261)
Book bad debt reserves - loans (2,905) (3,505)
Intangibles amortization (56) (226)
Investment writedown (680) (680)
AMT credit carryforward (601) (30)
Net operating loss carryover - (356)
Purchase accounting adjustment-loans (90) (160)
Capital loss carryover (66) (28)
Employee Retirement Reserves (3) (52)
Unrealized loss on available for sale securities (62) -
Accrued Expenses (116) (19)
---------- ----------
Total deferred tax assets (5,231) (6,049)
Valuation allowance 680 680
---------- ----------
Net deferred tax asset $ (4,551) $ (5,369)
---------- ----------
Deferred tax liabilities:
Depreciation / Amortization $ 99 $ 133
Accretion 152 183
Recognition and retention plan 29 -
Title plant 26 26
Loan fees and costs 19 51
Unrealized gain on available-for-sale securities - 988
Purchase accounting adjustment-deposits 2,176 2,377
---------- ----------
Total deferred tax liabilities 2,501 3,758
---------- ----------
Net deferred tax liability (asset) $ (2,050) $ (1,611)
========== ==========
Page 61
Deferred income taxes reflect the net tax-effect of temporary differences
between the carrying amount of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Based on the Company's
history of prior operating earnings and its expectation of the future,
management believes that taxable income will more likely than not be
insufficient to realize all of the Company's gross deferred tax assets at
September 30, 2004 and 2003. Valuation allowance increases of $834,000 were
established during the year ended September 30, 2003 to offset a portion of the
charitable contribution carryforward that management believes may not be
realized. The cumulative amount of the valuation allowance that has been
established related to the unused charitable contribution carryforward is
$1,175,000 through September 30, 2003. The charitable contribution carryover has
expired as of September 30, 2003 and is no longer available for usage after this
date. Accordingly, this valuation allowance, along with the tax benefit
associated with the gross amount of the unused charitable contribution
carryover, has been removed as of September 30, 2003. As of September 30, 2004
and September 30, 2003, $680,000 of the valuation allowance has been established
to offset the entire amount of tax benefits associated with an impaired
investment.
For federal income tax purposes, the Company has approximately $145,000 of net
capital loss carryforwards resulting in a deferred tax asset of $66,000 as of
September 30, 2004. The Company also has alternative minimum tax credits of
$601,000 that have an indefinite life.
12. STOCK OPTION PLANS
The Company maintains a stock-based incentive plan ("the 1998 Plan") for
officers, directors and certain employees of the Company and its subsidiaries.
Pursuant to the terms of the 1998 Plan, the number of common shares reserved for
the issuance of options was 642,735. All options were issued at not less than
fair market value at the date of grant and expire 10 years from date of grant.
The majority of stock options granted in the 1998 Plan vest over a five year
period from the date of grant. In January 2000, the Company adopted the 2000
Stock Option Plan ("the 2000 Plan"). The 2000 Plan reserved an additional
173,624 shares for issuance under terms similar to the 1998 Plan. At September
30, 2004, 10,000 shares subject to option remain available for grant under the
2000 plan. In February 2004, the Company adopted the 2004 Stock Plan. The number
of shares of restricted stock and stock options that may be awarded under the
Plan to employees is 185,000 and the amount of shares of restricted stock and
stock options that can be awarded to Directors under the Plan is 20,000. The
maximum number of shares of restricted stock awards which can be granted is
100,000. No stock options can be granted under the Plan for less than fair
market value on the date of grant. The maximum annual grant of options or
restricted shares under the Plan to any one individual shall not exceed one and
a half percent (1.5%) of the total outstanding shares of common stock of
company, in the aggregate, per calendar year.
A summary of the status of the Company's outstanding stock option plans as of
September 30, 2004, 2003 and 2002 and changes during the years then ended is
presented below:
2004 2003 2002
----------------------------- ----------------------------- ---------------------------
AVERAGE WEIGHTED- AVERAGE WEIGHTED- AVERAGE WEIGHTED-
SHARES EXERCISE PRICE SHARES EXERCISE PRICE SHARES EXERCISE PRICE
---------- --------------- ----------- -------------- --------- --------------
STOCK OPTIONS:
Outstanding at beginning of year 680,711 $ 12.44 686,960 $ 11.88 718,189 $ 11.42
Granted 95,000 18.25 72,100 16.84 15,085 16.44
Forfeited (15,691) 18.81 (36,537) 12.38 (7,600) 11.75
Exercised (30,909) 11.92 (41,812) 11.89 (38,714) 10.73
---------- --------------- ----------- -------------- --------- --------------
Outstanding at end of year 729,111 $ 13.08 680,711 $ 12.44 686,960 $ 11.88
Exercisable at end of year 592,981 $ 12.10 601,774 404,667
Weighted-average fair value
of options granted $ 3.43 $ 5.06 $ 4.21
Page 62
The following table summarizes all stock options outstanding for the plans as of
September 30, 2004, segmented by range of exercise prices:
OUTSTANDING
-----------------------------
WEIGHTED- WEIGHTED-
AVERAGE AVERAGE
EXERCISE REMAINING
NUMBER PRICE CONTRACTUAL LIFE
------- ---------- ----------------
STOCK OPTIONS:
$10.00-$10.50 17,419 $ 10.35 5.1 years
$10.51-$11.00 2,209 $ 10.63 4.7
$11.01-$11.50 4,955 $ 11.38 4.7
$11.51-$12.00 491,610 $ 11.75 4.2
$12.01-$12.50 44,738 $ 12.25 6.3
$12.51-$13.00 2,000 $ 12.75 4.4
$14.00-$14.50 1,845 $ 14.20 7.0
$15.00-$15.50 14,100 $ 15.26 8.0
$15.51-$16.00 1,000 $ 15.95 8.8
$16.01-$16.50 435 $ 16.41 7.5
$16.51-$17.00 8,750 $ 16.93 7.3
$17.50-$18.00 117,050 $ 17.80 9.2
$18.50-$19.00 22,000 $ 18.75 9.1
$19.01-$19.50 1,000 $ 19.10 9.3
------- ---------- ----------------
729,111 $ 13.08 5.8 years
13. COMMITMENTS AND CONTINGENCIES
LENDING OPERATIONS
The Company is party to financial instruments with off-balance-sheet risk in the
normal course of business primarily to meet the financing needs of its customers
and to reduce its own exposure to fluctuations in interest rates. Commitments to
originate loans amounted to $5.6 million as of September 30, 2004, of which $3.3
million was for variable-rate loans. The balance of the commitments represent
fixed-rate loans with interest rates ranging from 5.38% to 6.25%. In addition,
at September 30, 2004, the Company had undisbursed loans in process of $12.0
million and $50.9 million in undisbursed lines of credit. These instruments
involve, to varying degrees, elements of credit, interest rate or liquidity risk
in excess of the amount recognized in the balance sheet. The contract or
notional amounts of these commitments reflect the extent of involvement the
Company has in particular classes of financial instruments.
In addition, the Company also has an obligation of $743,000 in standby letters
of credit.
The Company's exposure to credit loss from nonperformance by the other party to
the financial instruments for commitments to extend credit is represented by the
contractual amount of those instruments. The Company uses the same credit
policies in making commitments as it does for balance-sheet instruments.
Commitments to extend credit are legally-binding agreements to lend to
customers. Commitments generally have fixed expiration dates or other
termination clauses and may require payment of fees. Since many of the
commitments are expected to expire without being drawn upon, the total
commitment amounts do not necessarily represent future liquidity requirements.
The Company evaluates each customer's credit-worthiness on a case-by-case basis.
The amount of collateral obtained, if deemed necessary by the Company on
extensions of credit, is based on management's credit assessment of the
counterparty. At September 30, 2004, the Company expects all commitments to be
funded within 60 days.
DERIVATIVES
At September 30, 2004, there were $40.0 million in notional amount of derivative
contracts in effect, see Footnote 15 for detail.
LEGAL PROCEEDINGS
The Company is commonly subject to various pending and threatened legal actions
which involve claims for monetary relief. Based upon information presently
available to the Company, it is the Company's opinion that any legal and
financial responsibility arising from such claims will not have a material
adverse effect on the Company's results of operations.
Page 63
DATA PROCESSING OPERATIONS
In August 2003, the Company entered into a 5-year contract with Aurum Technology
for data processing and other related services. The projected future minimum
annual contractual payments for the remaining term of the Agreement are as
follows:
2005 $ 582,000
2006 $ 586,000
2007 $ 586,000
2008 $ 538,000
14. FAIR VALUE OF FINANCIAL INSTRUMENTS.
The reported fair values of financial instruments are based on a variety of
factors. Estimates of fair value are made at a specific point in time based
upon, where available, relevant market prices and information about the
financial instrument. Such estimates do not include any premium or discount that
could result from offering for sale at one time the Company's entire holdings of
a particular financial instrument. For a substantial portion of the Company's
financial instruments, no quoted market exists. Therefore, estimates of fair
value are necessarily based on a number of significant assumptions. Such
assumptions include assessments of current economic conditions, perceived risks
associated with these financial instruments and their counterparties, future
expected loss experience and other factors. Given the uncertainties surrounding
these assumptions, the reported fair values represent estimates only, and
therefore cannot be compared to the historical accounting model. Use of
different assumptions or methodologies is likely to result in significantly
different fair value estimates.
The estimated fair values presented neither include nor give effect to the
values associated with the Company's banking, or other businesses, existing
customer relationships, extensive branch banking network, property, equipment,
goodwill or certain tax implications related to the realization of unrealized
gains or losses. Also, the fair value of non-interest-bearing demand deposits,
savings, NOW accounts and money market deposit accounts is equal to the carrying
amount because these deposits have no stated maturity. Obviously, this approach
to estimating fair value excludes the significant benefit that results from the
low-cost funding provided by such deposit liabilities, as compared to
alternative sources of funding. As a consequence, the fair value of individual
assets and liabilities may not be reflective of the fair value of a banking
organization that is a going concern.
The following methods and assumptions were used to estimate the fair value of
each major classification of financial instruments at September 30, 2004 and
2003.
CASH AND CASH EQUIVALENTS. Current carrying amounts approximate estimated fair
value.
INVESTMENTS AND MORTGAGE-BACKED SECURITIES. Current quoted market prices were
used to determine fair value.
LOANS. Fair values were estimated for portfolios of loans with similar financial
characteristics. Loans were segregated by type and each loan category was
further segmented by fixed-and adjustable-rate interest terms. The estimated
fair value of the segregated portfolios was calculated by discounting cash flows
through the estimated maturity using estimated prepayment speeds while using
estimated market discount rates that reflect credit and interest rate risk
inherent in the loans. The estimate of the maturities and prepayment speeds was
based on the Company's historical experience. Cash flows were discounted using
market rates adjusted for portfolio differences.
ACCRUED INTEREST RECEIVABLE. Current carrying amounts approximate estimated fair
value.
BANK-OWNED LIFE INSURANCE. The fair value is equal to the cash surrender value
of the life insurance policies.
DEPOSITS WITH NO STATED MATURITY. Current carrying amounts approximate estimated
fair value.
CERTIFICATES OF DEPOSIT. Fair values were estimated by discounting the
contractual cash flows using current market rates offered in the Company's
market area for deposits with comparable terms and maturities.
FEDERAL HOME LOAN BANK ADVANCES. The fair value of borrowings was estimated
using rates currently available to the Company for debt with similar terms and
remaining maturities.
OTHER BORROWINGS. The fair value was estimated by discounting the contractual
cash flows using rate currently available for similar debt with comparable terms
and maturities.
ACCRUED INTEREST PAYABLE. Current carrying amounts approximate estimated fair
value.
Page 64
TRUST PREFERRED DEBT. The fair value was estimated by discounting the
contractual cash flows using rates currently available for similar debt with
comparable terms and maturities.
INTEREST RATE SWAPS. The fair value of the interest rate swaps are equal to the
estimated market prices.
COMMITMENTS TO EXTEND CREDIT. The majority of the Company's commitments to
extend credit carry current market interest rates if converted to loans. Because
commitments to extend credit are generally unassignable by either the Company or
the borrower, they only have value to the Company and the borrower. The fair
value of commitments to extend credit is estimated using the fees currently
charged to enter into similar agreements, taking into account the remaining
terms of the agreements and the present creditworthiness of the counter parties.
The carrying amounts and estimated fair values of the Company's financial
instruments were as follows:
AT SEPTEMBER 30,
-----------------------------------------------------
(IN THOUSANDS)
2004 2003
------------------------- -------------------------
CARRYING ESTIMATED CARRYING ESTIMATED
AMOUNT FAIR VALUE AMOUNT FAIR VALUE
----------- ----------- ----------- -----------
Financial Assets:
Cash and cash equivalents $ 26,938 $ 26,938 $ 20,142 $ 20,142
Securities available-for-sale 357,223 357,223 326,626 326,626
Securities held-to-maturity 998 1,015 3,555 3,622
Loans, net 403,584 406,878 491,059 502,668
Accrued interest receivable 2,731 2,731 3,892 3,892
Bank owned life insurance 11,362 11,362 10,875 10,875
Financial Liabilities:
Deposits with no stated maturity which
consist of savings, money market, NOW
and non-interest bearing deposits $ 285,616 $ 285,616 $ 318,052 $ 318,052
Certificates of deposit 197,825 203,178 229,253 239,971
Federal Home Loan Bank advances 243,867 254,791 258,901 272,984
Other borrowings 20,426 20,461 529 529
Accrued interest payable 1,380 1,380 1,318 1,318
Trust preferred debt 22,681 23,339 22,000 22,033
CONTRACTUAL ESTIMATED CONTRACTUAL ESTIMATED
AMOUNT FAIR VALUE AMOUNT FAIR VALUE
----------- ----------- ----------- -----------
Off balance sheet assets:
Loan commitments $ 17,585 $ 16 $ 25,687 $ 134
Unsecured lines of credit 33,033 - 29,541 -
Unsecured Commercial lines of credit 17,905 - 17,533 -
Letters of Credit 743 7 - -
Interest Rate Swaps 40,000 (512) - -
15. DERIVATIVE FINANCIAL INSTRUMENTS
The Bank uses interest rate swaps to hedge the impact of changing interest rates
on market values of certain fixed-rate FHLB borrowings. Under the terms of the
swaps, the Bank receives fixed rate payments and pays variable-rate payments
based on 3-month LIBOR. The fixed-rate interest swap payments received by the
Bank equal the amounts payable to the FHLB, effectively converting the FHLB
borrowings to a variable rate. Changes in the fair value of the swaps are highly
effective in offsetting changes in the fair value of the FHLB borrowings, since
the structure of the critical terms of the swaps match the FHLB borrowings.
The following table summarizes the Bank's derivative financial instruments as of
September 30, 2004:
NOTIONAL MARKET RECEIVE PAY
AMOUNT VALUE MATURITY FIXED FLOATING
- ---------- ---------- ---------- ---------- ---------------------
(IN THOUSANDS)
$ 5,000 $ (32) 2/23/2011 5.1800% 3 month LIBOR + 1.74%
5,000 (75) 2/23/2011 4.9900% 3 month LIBOR + 1.74%
10,000 (137) 4/23/2014 5.4050% 3 month LIBOR + 1.73%
20,000 (268) 5/21/2014 5.6000% 3 month LIBOR + 1.87%
- ---------- ----------
$ 40,000 $ (512)
- ---------- ----------
Page 65
Since the terms of the interest rate swap mirror those of the hedged items, the
Bank has adopted the short cut method of accounting for these transactions.
Therefore, no hedge ineffectiveness was recognized in earnings related to these
fair value hedges.
16. CAPITAL AND REGULATORY MATTERS
The Bank is subject to various regulatory capital requirements administered by
Federal banking agencies. Failure to meet minimum capital requirements can
initiate certain mandatory - and possible additional discretionary - actions by
regulators that, if undertaken, could have a direct material effect on the
Company's financial statements. Under capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific
capital guidelines that involve quantitative measures of the Bank's assets,
liabilities and certain off-balance-sheet items as calculated under regulatory
accounting practices. The Bank's capital amounts and classification are also
subject to qualitative judgments by the regulators about components, risk
weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Bank to maintain minimum amounts and ratios (set forth in the table
below) of total and Tier I capital (as defined in the regulations) to
risk-weighted assets (as defined), and of Tier I capital and tangible capital
(as defined) to total assets (as defined). Management believes, as of September
30, 2004, that the Bank met all capital adequacy requirements to which it was
subject. As of September 30, 2004, the most recent notification from the Office
of Thrift Supervision categorized the Bank as well capitalized under the
regulatory framework for prompt corrective action. To be categorized as well
capitalized, the Bank must maintain minimum ratios as set forth in the table
below. There are no conditions or events since that notification that management
believes have changed the institution's category.
The Bank's actual capital amounts and ratios at September 30, 2004 and 2003 are
presented in the following table:
AS OF SEPTEMBER 30, 2004
----------------------------------------------------------------------------
($ IN THOUSANDS)
TO BE WELL CAPITALIZED
FOR CAPITAL UNDER PROMPT CORRECTIVE
ACTUAL ADEQUACY PURPOSES ACTION PROVISIONS
----------------------- ----------------------- -----------------------
AMOUNT RATIO(1) AMOUNT RATIO(1) AMOUNT RATIO(1)
---------- --------- ---------- --------- ---------- ---------
Risk-based Capital
(Total Capital to risk-weighted assets) $ 65,827 15.07% $ 34,936 >8.00% $ 43,670 >10.00%
Tier I Capital
(to risk-weighted assets) 60,331 13.82% 17,468 >4.00% 26,202 >6.00%
Core Capital
(Tier I Capital to adjusted total assets) 61,331 7.40% 33,136 >4.00% 41,420 >5.00%
Tangible Capital
(Tangible capital to tangible assets) 61,331 7.40% 12,426 >1.50% N/A N/A
AS OF SEPTEMBER 30, 2003
----------------------------------------------------------------------------
($ IN THOUSANDS)
TO BE WELL CAPITALIZED
FOR CAPITAL UNDER PROMPT CORRECTIVE
ACTUAL ADEQUACY PURPOSES ACTION PROVISIONS
----------------------- ----------------------- -----------------------
AMOUNT RATIO(1) AMOUNT RATIO(1) AMOUNT RATIO(1)
---------- --------- ---------- --------- ---------- ---------
Risk-based Capital
(Total Capital to risk-weighted assets) $ 59,411 10.52% $ 45,205 >8.00% $ 56,506 >10.00%
Tier I Capital
(to risk-weighted assets) 52,406 9.27% 22,602 >4.00% 33,904 >6.00%
Core Capital
(Tier I Capital to adjusted total assets) 54,053 6.17% 35,045 >4.00% 43,806 >5.00%
Tangible Capital
(Tangible capital to tangible assets) 54,053 6.17% 13,142 >1.50% N/A N/A
(1) For the periods presented the components of tangible capital were the
same as those of core capital. Tangible and core capital are computed as a
percentage of adjusted total assets and tangible assets of $828 million and
$876 million at September 30, 2004 and 2003, respectively. Risk-based
capital and Tier I capital are computed as a percentage of risk-weighted
assets of $437 million and $565 million at September 30, 2004 and 2003,
respectively. Tier I capital is reduced by the amount of low-level recourse
and residual interests to compute Tier I capital.
The Bank established a liquidation account at the time of its conversion from a
Federally-chartered mutual savings and loan association to a Federally-chartered
stock savings bank (the "Conversion"). This liquidation account was initially
established in an amount equal to the equity of the Bank as of September 30,
1997, the date of its latest balance sheet date contained in the final
Prospectus used in connection with the Conversion. In the unlikely event of a
complete liquidation of the Bank, (and only in such an event), eligible
depositors who continue to maintain accounts at the Bank shall be entitled to
receive a distribution from the liquidation account. The total amount of the
liquidation account, which decreases if the balances of eligible deposits
decrease at the
Page 66
annual determination dates, approximated $4.3 million at September 30, 2004.
The Company may not declare nor pay dividends on its stock if such declaration
and payment would violate statutory or regulatory requirements.
In addition to the 16,000,000 authorized shares of common stock, the Company
authorized 2,000,000 shares of preferred stock with a par value of $.01 per
share. The Board of Directors is authorized, subject to any limitations by law,
to provide for the issuance of the shares of preferred stock in series, to
establish from time to time the number of shares to be included in each such
series, and to fix the designation, powers, preferences and rights of the shares
of each such series and any qualifications, limitations or restrictions thereof.
As of September 30, 2004, there were no shares of preferred stock issued.
17. EMPLOYEE BENEFIT PLANS
DEFINED BENEFIT PLAN
The Company participates in a multi-employer defined benefit pension plan
covering all employees who are age 21 and have one year of service with the
Company. Because of the multi-employer nature of the plan, information regarding
the Company's portion of present values of vested and nonvested benefits is not
available. The Company amended the plan and froze the benefits for current
participants as of October 1, 2003. As such, the Company has limited its future
obligations to the plan. For the year ended September 30, 2004 and 2003, the
Company accrued $181,000 and $107,000, for its obligations under this plan. The
plan was fully funded and no contributions were required during the year ended
September 30, 2002.
401(K) PLAN
The Bank maintains a Section 401(k) defined contribution plan which covers
substantially all of its employees. The Company made contributions to this plan
of approximately $187,000, $223,000, and $205,000 for the years ended September
30, 2004, 2003 and 2002, respectively.
EMPLOYEE STOCK OWNERSHIP PLAN
The Bank maintains an Employee Stock Ownership Plan ("ESOP"). The Plan is
designed to provide retirement benefits for eligible employees. Because the ESOP
invests in the stock of the Company, it gives eligible employees an opportunity
to acquire an ownership interest in the Company. Employees are eligible to
participate in the Plan after reaching age 21 and completing six months of
service. Benefits become 100% vested after four years, with a 25% vesting
occurring each year.
The ESOP purchased 8.0% or 514,188 shares of the common stock issued in the
Conversion. The ESOP borrowed 100% of the aggregate purchase price of the common
stock, or $5.1 million, from the Company. The loan has a 10 year term, with an
annual interest rate of prime (4.75% at September 30, 2004) and will be repaid
principally from the Bank's contributions to the ESOP. The Company recognized
$910,000, $710,000, and $758,000 in compensation and benefit expense related to
the ESOP for the years ended September 30, 2004, 2003 and 2002, respectively,
offset by dividends in the amount of $134,000, $232,000, and $214,000,
respectively.
Shares purchased by the ESOP were pledged as collateral for the loan and are
held in a suspense account until they are released annually in an amount
proportional to the repayment of the ESOP loan for each plan year. The released
shares are allocated among the accounts of participants on the basis of the
participant's compensation for the year of allocation.
At September 30, 2004, the ESOP held 430,200 shares of the Company's stock of
which 224,524 shares were allocated to participant accounts. The unallocated
ESOP shares are presented as a reduction of stockholders' equity in the
consolidated financial statements. At September 30, 2004, the unallocated ESOP
shares had a fair market value of $3.4 million.
STOCK AWARDS
The Company maintains a stock-based award plan (The 1998 Plan) for officers,
directors and certain employees of the Company and its subsidiaries, under which
257,094 shares of common stock were available for grant. All awards granted vest
over a five-year period from the date of grant and result in compensation
expense during the vesting period. The Board of Directors of the Company has
adopted the 2004 Stock Plan ("Plan"). The number of shares of restricted stock
and stock options that may be awarded under the Plan to employees is 185,000 and
the amount of shares of restricted stock and stock options that can be awarded
to Directors under the Plan is 20,000. The maximum number of shares of
restricted stock awards which can be granted is 100,000. The maximum annual
grant of options or restricted shares under the Plan to any one individual shall
not exceed one and a half percent (1.5%) of the total outstanding shares of
common stock of company, in the aggregate, per calendar year.
The Company recognized $141,000, $714,000 and $496,000 in compensation and
benefit expense related to the stock awards for the fiscal years ended September
30, 2004, 2003 and 2002, respectively. A total of 133,748 shares, 54,780 shares,
and 42,178 shares vested in fiscal 2004, fiscal 2003 and fiscal 2002,
respectively. At September 30, 2004, 9,470 shares of restricted stock remain
unawarded in the 1998 Plan and 97,000 shares remain unawarded in the 2004 Plan.
Page 67
OPTION PLANS
For a full description of the Company's option plans, see Footnote 12.
18. GOODWILL AND INTANGIBLE ASSETS
A summary of goodwill is as follows:
AT SEPTEMBER 30, 2004 AND 2003
-----------------------------------
GROSS NET
CARRYING ACCUMULATED CARRYING
AMOUNT AMORTIZATION AMOUNT
-------- ------------ --------
(in thousands)
Acquisition of:
Abstractors $ 248 $ (160) $ 88
Security Savings Association of
Hazleton 571 (28) 543
Higgins Insurance Associates, Inc. 2,519 (95) 2,424
Schuylkill Savings and Loan
Association 200 - 200
-------- ------------ --------
Total goodwill $ 3,538 $ (283) $ 3,255
======== ============ ========
At September 30, 2004 and 2003, $75,000 of the Company's acquired intangible
assets were considered to be indefinite lived and not subject to amortization.
This intangible represents title plant related to the acquisition of
Abstractors. The components for intangible assets were as follows:
SEPTEMBER 30, 2004 SEPTEMBER 30, 2003
----------------------------------- -----------------------------------
GROSS NET GROSS NET
CARRYING ACCUMULATED CARRYING CARRYING ACCUMULATED CARRYING
OTHER INTANGIBLE ASSETS AMOUNT AMORTIZATION AMOUNT AMOUNT AMORTIZATION AMOUNT
- ----------------------------------- -------- ------------ -------- -------- ------------ --------
(in thousands) (in thousands)
Omega core deposit intangible $ - $ - $ - $ 1,537 $ (950) $ 587
Security Savings Association of
Hazleton core deposit intangible 9,086 (2,684) 6,402 9,086 (2,094) 6,992
Schuylkill Savings and Loan
Association core deposit intangible 255 (74) 181 255 (50) 205
Other intangibles 942 (471) 471 966 (269) 697
-------- ------------ -------- -------- ------------ --------
Total amortizing intangibles 10,283 (3,229) 7,054 11,844 (3,363) 8,481
Nonamortizing intangible assets
Other intangible assets 75 - 75 75 - 75
-------- ------------ -------- -------- ------------ --------
Total other intangible assets $ 10,358 $ (3,229) $ 7,129 $ 11,919 $ (3,363) $ 8,556
======== ============ ======== ======== ============ ========
Amortization expense of other amortizing intangible assets and impairment losses
on goodwill for the year ended September 30, 2004, 2003 and 2002 are as follows:
2004 2003 2002
---------- ---------- ----------
(IN THOUSANDS)
Core deposit intangibles $ 670 $ 888 $ 954
Other amortizing intangibles 177 134 54
Impairment loss on goodwill 25 39 -
---------- ---------- ----------
Total amortizing intangibles $ 872 $ 1,061 $ 1,008
========== ========== ==========
Page 68
The estimated amortization expense of amortizing intangible assets for each of
the five succeeding fiscal years is as follows:
CORE OTHER TOTAL
DEPOSIT AMORTIZING AMORTIZING
INTANGIBLES INTANGIBLES INTANGIBLES
------------ ------------ ------------
(IN THOUSANDS)
Estimated Annual Amortization Expense
For the year ended September 30, 2005 $ 727 $ 145 $ 872
For the year ended September 30, 2006 704 134 838
For the year ended September 30, 2007 663 112 775
For the year ended September 30, 2008 619 - 619
For the year ended September 30, 2009 570 - 570
There were no intangible assets acquired in the year ended September 30, 2004.
19. IMPAIRMENT LOSS ON EQUITY INVESTMENT
The Company had a $2.0 million equity investment in the convertible preferred
stock of a private entity, which makes loans to and provides services to
residential construction builders in the Eastern United States. The Company had
previously been accounting for such investment on a cost method. During June
2003, the Company recognized an impairment loss of the entire remaining $1.5
million investment in this entity since efforts by it to raise additional equity
capital have proven unsuccessful. While this entity and its lending programs
continue to operate, the Bank is no longer a lender in such programs.
Additionally, no tax benefit has been recognized for the current impairment loss
since such loss is a capital loss and is deductible only against other capital
gains.
20. RECENT ACCOUNTING PRONOUNCEMENTS
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities." This Statement addresses financial accounting
and reporting for costs associated with exit or disposal activities and
nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a Restructuring)." The provisions
of this Statement are effective for exit or disposal activities that are
initiated after December 31, 2002, with early application encouraged. The
adoption of this Statement did not have an impact on the Company's financial
position or results of operations.
On October 1, 2002, the FASB issued SFAS No. 147, "Acquisitions of Certain
Financial Institutions," effective for all business combinations initiated after
October 1, 2002. This Statement addresses the financial accounting and reporting
for the acquisition of all or part of a financial institution, except for a
transaction between two or more mutual enterprises. This Statement removes
acquisitions of financial institutions, other than transactions between two or
more mutual enterprises, from the scope of SFAS No. 72, "Accounting for Certain
Acquisitions of Banking or Thrift Institutions," and FASB Interpretation No. 9,
"Applying APB Opinions No. 16 and 17, "When a Savings and Loan Association or a
Similar Institution Is Acquired in a Business Combination Accounted for by the
Purchase Method." The acquisition of all or part of a financial institution that
meets the definition of a business combination shall be accounted for by the
purchase method in accordance with SFAS No. 141, "Business Combinations," and
SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 142 was adopted
on October 1, 2001. This Statement also provides guidance on the accounting for
the impairment or disposal of acquired long-term customer-relationship
intangible assets (such as depositor- and borrower-relationship intangible
assets and credit cardholder intangible assets), including those acquired in
transactions between two or more mutual enterprises. Upon early adoption of this
statement, as of October 1, 2001, the carrying amount of the previously
recognized unidentifiable intangible asset related to the Schuylkill Savings
branch acquisitions that was reclassified to goodwill was $200,000, while the
related 2002 amortization expense that was reversed was $81,000, pre-tax. The
Company will continue to review the remaining goodwill on an annual basis for
impairment. However, $7.9 million in core deposit intangible will continue to be
amortized and reviewed for impairment in accordance with SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets."
In December 2002, the FASB issued Statement No. 148, "Accounting for Stock-Based
Compensation--Transition and Disclosure--an amendment of FASB Statement No.
123." This statement amends FASB Statement No.123, "Accounting for Stock-Based
Compensation," to provide alternative methods of transition for a voluntary
change to the fair value based method of accounting for stock-based employee
compensation. The Statement also amends the disclosure requirements of Statement
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. This statement is
effective for fiscal years ending after December 15, 2002, except for financial
reports containing condensed financial statements for interim periods for which
disclosure is effective for periods beginning after December 15, 2002. This
Statement announces, "in the near future, the Board plans to
Page 69
consider whether it should propose changes to the U.S. standards on accounting
for stock-based compensation." As permitted, the Company continues to account
for stock options with the methodology prescribed by Accounting Principles Board
No. 25. In April 2003, the FASB issued SFAS No. 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 under SFAS
No. 133. The amendments set forth in SFAS No. 149 require that contracts with
comparable characteristics be accounted for similarly. In particular, this
statement clarifies under what circumstances a contract with an initial net
investment meets the characteristic of a derivative as discussed in SFAS No.
133. In addition, it clarifies when a derivative contains a financing component
that warrants special reporting in the statement of cash flows. SFAS No. 149
amends certain other existing pronouncements. Those changes will result in more
consistent reporting of contracts that are derivatives in their entirety or that
contain embedded derivatives that warrant separate accounting. This statement is
effective for contracts entered into or modified after June 30, 2003, except as
stated below and for hedging relationships designated after June 30, 2003. The
guidance should be applied prospectively. The provisions of this statement that
relate to SFAS No. 133 Implementation Issues that have been effective for fiscal
quarters that began prior to June 15, 2003, should continue to be applied in
accordance with their respective effective dates. In addition, certain
provisions relating to forward purchases or sales of when-issued securities or
other securities that do not yet exist, should be applied to existing contracts
as well as new contracts entered into after June 30, 2003. The adoption of this
statement did not have a material effect on the Company's financial position or
results of operations.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity." This Statement
establishes how an issuer classifies financial instruments with characteristics
of both liabilities and equity. It requires that an issuer classify these
financial instruments as a liability (or, in certain circumstances, an asset).
Previously these financial instruments would have been classified entirely as
equity, or between the liabilities section and equity section of the statement
of financial condition. This Statement also addresses questions about the
classification of certain financial instruments that embody obligations to issue
equity shares. The provisions of this Statement are effective for interim
periods beginning after June 15, 2003. The adoption of this statement did not
have a material impact on the Company's financial position or results of
operations.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting
and Disclosure requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others." This interpretation elaborates on the disclosures to be
made by a guarantor in its interim and annual financial statements about its
obligations under certain guarantees that it has issued. This interpretation
clarifies that a guarantor is required to disclose (a) the nature of the
guarantee, including the approximate term of the guarantee, how the guarantee
arose, and the events or circumstances that would require the guarantor to
perform under the guarantee; (b) the maximum potential amount of future payments
under the guarantee; (c) the carrying amount of the liability, if any, for the
guarantor's obligations under the guarantee; and (d) the nature and extent of
any recourse provisions or available collateral that would enable the guarantor
to recover the amounts paid under the guarantee. This interpretation also
clarifies that a guarantor is required to recognize, at the inception of a
guarantee, a liability for the obligations it has undertaken in issuing the
guarantee, including its ongoing obligation to stand ready to perform over the
term of the guarantee in the event that the specified triggering events or
conditions occur. The objective of the initial measurement of that liability is
the fair value of the guarantee at its inception. The initial recognition and
initial measurement provisions of this interpretation are applicable on a
prospective basis to guarantees issued or modified after December 31, 2002,
irrespective of the guarantor's fiscal year-end. The disclosure requirements in
this interpretation are effective for financial statements of interim or annual
periods ending after December 15, 2002. The adoption of this interpretation did
not have a material effect on the Company's financial position or results of
operations.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities," (FIN 46) in an effort to expand upon and strengthen
existing accounting guidance that addresses when a company should include in its
financial statements the assets, liabilities and activities of another entity.
The objective of this interpretation is not to restrict the use of variable
interest entities but to improve financial reporting by companies involved with
variable interest entities. Until now, one company generally has included
another entity in its consolidated financial statements only if it controlled
the entity through voting interests. This interpretation changes that by
requiring a variable interest entity to be consolidated by a company if that
company is subject to a majority of the risk of loss from the variable interest
entity's activities or entitled to receive a majority of the entity's residual
returns or both. The consolidation requirements of this interpretation apply
immediately to variable interest entities created after January 31, 2003. The
consolidation requirements apply to older entities in the first fiscal year or
interim period beginning after June 15, 2003. Certain of the disclosure
requirements apply in all financial statements issued after January 31, 2003,
regardless of when the variable interest entity was established. As a result of
the adoption of FIN 46, the Company deconsolidated its Capital Trusts in the
second fiscal quarter of 2004. The result was an increase in the junior debt of
$681,000.
In March 2004, the FASB issued Emerging Issues Task Force (EITF) Issue No. 03-1,
"The Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments." This statement provides guidance for evaluating whether an
investment is other-than-temporarily impaired and was effective for the
other-than-temporary impairment evaluations made in the reporting periods
beginning after June 15, 2004. The FASB staff has issued a proposed
Board-directed FASB Staff Position, FSP EITF Issue 03-1-a, Implementation
Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1. The
proposed FSP would provide implementation guidance with respect to debt
securities that are impaired solely due to interest rates and/or sector spreads
and
Page 70
analyzed for other-than-temporary impairment under paragraph 16 of Issue 03-1.
In September 2004, based on comment letters received by constituents, the Board
decided to further consider whether application guidance is necessary for all
securities analyzed for impairment under paragraph 10-20 of Issue 03-1. The
delay did not include the disclosure provisions which will remain in effect
until the full reconsideration of Issue 03-01 guidance is completed. The Company
will delay the effective application until the implementation guidance is
finalized.
21. RELATED PARTY TRANSACTIONS
In the ordinary course of business, executive officers and directors of the
Company may have consumer and commercial loans issued by the Bank. Pursuant to
the Company's policy, such loans are issued on the same terms as those
prevailing at the time for comparable loans to unrelated persons and do not
involve more than the normal risk of collectibility.
The Company's Chairman of the Board of Directors is also a partner in a law firm
that provides general legal counsel to the Company. The Company paid
professional fees to this law firm during the years ended September 30, 2004,
2003 and 2002 of $117,000, $124,000 and $74,000, respectively.
In prior years, the Company paid rent for its Pottsville insurance office to a
partnership in which a director of the Company has a one-third ownership
interest. Such rents totaled $14,000 and $21,000 for the years ended September
30, 2003 and 2002, respectively. The building was sold in May 2003 and therefore
no rents were paid to the director in the year ending September 30, 2004.
22. ACQUISITIONS
During 2002, the Company purchased three banking offices from Schuylkill Savings
and Loan Association and Higgins acquired the DeAndrea Agency which specializes
in personal and commercial insurance. These acquisitions resulted in the Company
recognizing an amortizable core deposit intangible of $255,000 and amortizable
other intangible assets of $435,000.
23. DISPOSITIONS
In January 2004, the Bank sold $650,000 of real estate and transferred $10.3
million of deposits at its Danville, Pennsylvania branch to the First National
Bank of Berwick, Pennsylvania. This sale resulted in a pre-tax gain of $798,000.
24. SUBSEQUENT EVENTS
On December 8, 2004, KNBT Bancorp, Inc. ("KNBT"), the parent company of Keystone
Nazareth Bank & Trust Company, and Northeast Pennsylvania Financial Corp.
("Northeast Pennsylvania"), the parent company of First Federal Bank, entered
into an Agreement and Plan of Merger (the "Merger Agreement") pursuant to which
Northeast Pennsylvania will merge with and into KNBT. Concurrently with the
merger, it is expected that First Federal Bank will merge with Keystone Nazareth
Bank & Trust Company.
Under the terms of the Agreement, the Company's stockholders may elect to
receive either $23.00 of KNBT common stock or $23.00 in cash in exchange for
their shares of Northeast Pennsylvania common stock, subject to an overall
requirement that 50% of the total outstanding Company Common Stock be exchanged
for KNBT Common Stock and 50% for cash. To the extent they receive shares of
KNBT, the transaction is expected to be tax-free to Northeast Pennsylvania
stockholders.
The number of shares of KNBT common stock into which each Northeast Pennsylvania
share will be exchanged will be based on the price of KNBT common stock over a
measurement period prior to closing.
In addition, each director of Northeast Pennsylvania entered into a Shareholder
Agreement with KNBT, pursuant to which each such person agreed, among other
things, to vote his or her shares of NEPF common stock in favor of the Merger
Agreement at a meeting of stockholders of NEPF to be called to consider and
approve the Merger Agreement. The merger also requires appropriate regulatory
approvals. Additionally, the Agreement contains certain operating restrictions
on the Company from the date of the Merger Agreement until the closing.
Page 71
25. PARENT COMPANY FINANCIAL INFORMATION
CONDENSED STATEMENT OF FINANCIAL CONDITION
SEPTEMBER 30,
-----------------------
(IN THOUSANDS)
2004 2003
---------- ----------
Assets:
Cash $ 3,901 $ 4,826
Investment in subsidiaries 70,689 65,621
Securities available for sale 62 6,567
Accrued interest receivable - 140
Due from affiliates 601 (162)
Other assets 6,374 3,811
---------- ----------
Total Assets $ 81,627 $ 80,803
========== ==========
Liabilities and stockholders' equity:
Trust preferred debt $ 22,681 $ 22,000
Other liabilities 488 446
---------- ----------
Total Liabilities 23,169 22,446
---------- ----------
Total stockholders' equity 58,458 58,357
---------- ----------
Total Liabilities and Stockholders' Equity $ 81,627 $ 80,803
========== ==========
CONDENSED STATEMENT OF OPERATIONS
FOR THE YEARS ENDED SEPTEMBER 30,
---------------------------------------
(IN THOUSANDS)
AS RESTATED
2004 2003 2002
---------- ---------- -----------
Income:
Interest income $ 257 $ 369 $ 445
Impairment loss on equity investment - (1,488) -
Other income (expense) 256 (12) (37)
Equity in undistributed income (loss)
of subsidiaries 6,036 (1,106) 3,494
---------- ---------- -----------
Total income 6,549 (2,237) 3,902
---------- ---------- -----------
Expenses:
Interest expense 1,073 1,060 244
Other operating expenses 878 922 749
---------- ---------- -----------
Total expense 1,951 1,982 993
---------- ---------- -----------
Income (loss) before income taxes 4,598 (4,219) 2,909
Income tax expense (benefit) (489) (149) 213
---------- ---------- -----------
Net income (loss) $ 5,087 $ (4,070) $ 2,696
========== ========== ===========
Page 72
CONDENSED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED SEPTEMBER 30,
---------------------------------------
(IN THOUSANDS)
AS RESTATED
2004 2003 2002
---------- ---------- -----------
OPERATING ACTIVITIES:
Net Income $ 5,087 $ (4,070) $ 2,696
Adjustments to reconcile net income (loss) to net cash provided by
Operating activities:
Equity in undistributed income (loss) of subsidiaries (6,035) (2,548) 3,494
Deferred income tax (benefit) provision (728) 347 2,061
Reduction in unallocated ESOP shares 910 710 758
Stock award expense 141 714 496
Stock compensation trust 7 - -
Amortization for intangibles 134 (1,810) -
Amortization and accretion on:
Available-for-sale securities 9 55 38
(Gain) loss on sale of:
Available-for-sale securities (343) (146) 37
Impairment loss on equity investment - 1,488 -
Changes in assets and liabilities:
(Increase) decrease in other assets (2,482) 1,584 (980)
Increase (decrease) in other liabilities 109 (705) 790
---------- ---------- -----------
Net cash provided by operating activities $ (3,191) $ (4,381) $ 9,390
---------- ---------- -----------
INVESTING ACTIVITIES:
Increase in investment in subsidiaries - $ (3,314) $ (3,709)
Proceeds from sale of:
Available-for-sale securities 4,548 367 4,880
Proceeds from repayments of available-for-sale securities 2,000 - 1,000
Purchase of Security Savings - - -
Purchase of available-for-sale securities - (2,000) (3,243)
---------- ---------- -----------
Net cash used in investing activities $ 6,548 $ (4,947) $ (1,072)
---------- ---------- -----------
FINANCING ACTIVITIES:
Borrowings of note payable $ - $ - $ 1,000
Repayment of note payable - (1,000) -
Repayment of long-term debt - - -
Proceeds issuance trust-preferred securities - 15,000 7,000
Stock options exercised 405 548 424
Stock compensation tax benefit (expense) 33 26 110
Purchase of treasury stock (3,546) 701 (14,421)
Issuance of treasury stock 67 100 96
Cash dividend on common stock (1,241) (1,973) (1,962)
---------- ---------- -----------
Net cash provided by (used in) financing activities $ (4,282) $ 13,402 $ (7,753)
---------- ---------- -----------
Increase (decrease) in cash and cash equivalents (925) 4,074 565
Cash and cash equivalents, beginning of year 4,826 752 187
---------- ---------- -----------
Cash and cash equivalents, end of year $ 3,901 $ 4,826 $ 752
========== ========== ===========
Page 73
Quarterly Financial Data (unaudited) (in thousands, except per share amounts)
FIRST SECOND THIRD FOURTH
2004 QUARTER QUARTER QUARTER QUARTER
- ------------------------- ---------- ---------- ---------- ----------
Net Interest Income $ 5,259 $ 5,476 $ 5,293 $ 5,078
Provision for Loan Losses 677 485 232 50
Non-Interest Income 2,685 3,910 2,528 2,212
Non-Interest Expense 5,998 5,986 5,824 5,803
---------- ---------- ---------- ----------
Net Income $ 1,039 $ 2,090 $ 1,027 $ 931
========== ========== ========== ==========
Earnings Per Share
Basic $ 0.27 $ 0.53 $ 0.26 $ 0.25
Diluted $ 0.25 $ 0.51 $ 0.25 $ 0.24
2003 (1)
- -------------------------
Net Interest Income $ 5,282 $ 5,059 $ 4,962 $ 4,873
Provision for Loan Losses 370 610 850 5,022
Non-Interest Income 2,618 3,728 1,715 1,915
Non-Interest Expense 6,624 6,747 6,952 8,876
---------- ---------- ---------- ----------
Net Income $ 669 $ 920 $ (1,193) $ (4,466)
========== ========== ========== ==========
Earnings Per Share
Basic $ 0.18 $ 0.24 $ (0.32) $ (1.19)
Diluted $ 0.17 $ 0.23 $ (0.32) $ (1.19)
(1) Certain amounts have been restated to reflect the correction of accounting
errors as more fully described in Note 2 to the Consolidated Financial
Statements.
ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
Not Applicable.
ITEM 9A. CONTROLS AND PROCEDURES
During the initial preparation and review of the Form 10-Q for the June
30, 2003 period, the Registrant discovered that its financial statements for its
fiscal years 1998 through 2002 and for the December 2002 and March 2003 quarters
required restatement. The Company believes that it maintained effective controls
and procedures designed to ensure that information required to be disclosed in
its reports filed under the Securities Exchange Act of 1934 with respect to
those prior periods, except that the individuals responsible for implementing
such controls and procedures, including reviewing the work performed and
authorizing the final results, failed to detect material errors, including a
computer coding error related to the Company's indirect automobile loan
portfolio, which required the restatement. Consequently, the new management
conducted an exhaustive analysis of the Company's accounting records. This
review discovered additional accounting errors, which were included in the
restatements. Subsequent to the discovery of these errors in June and September,
management implemented staffing, system and procedural changes designed to
improve the training of the individuals involved in implementing and reviewing
the controls and procedures to strengthen the review and authorization process
so that such errors do not occur in the future.
The Company's management, including the Company's principal executive
officer and principal financial officer, have evaluated the effectiveness of the
Company's "disclosure controls and procedures," as such term is defined in Rule
13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended,
(the "Exchange Act"). Based upon their evaluation, the principal executive
officer and principal financial officer concluded that, as of the end of the
period covered by this report, the Company's disclosure controls and procedures
were effective for the purpose of ensuring that the information required to be
disclosed in the reports that the Company files or submits under the Exchange
Act with the Securities and Exchange Commission (the "SEC) (1) is recorded,
processed, summarized and reported within the time periods specified in the
SEC's rules and forms, and (2) is accumulated and communicated to the Company's
management, including its principal executive and principal financial officers,
as appropriate to allow timely decisions regarding required disclosure.
ITEM 9B. OTHER INFORMATION
None.
Page 74
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
DIRECTORS
Information regarding each of the directors is contained below. Unless
otherwise stated, each individual has held his current occupation for the last
five years. The age listed in each nominee's biography is as of September 30,
2004. There are no family relationships among the directors or executive
officers. The indicated period for service as a director includes service as a
director of the Bank.
Barbara M. Ecker. Ms. Ecker was a certified public accountant with the
Greater Hazleton Health Alliance from 1993 until her retirement in April 2003.
Ms. Ecker also holds an MBA in Finance and has taught banking and finance at
local universities. Age 63. Director since 1987.
R. Peter Haentjens, Jr. Mr. Haentjens is President of Weir Hazleton,
Inc., a manufacturing company located in Hazleton, Pennsylvania. Age 59.
Director since 1981.
George J. Hayden. Mr. Hayden is President of George J. Hayden, Inc., an
electrical contracting firm, and President of several fast food restaurants. Age
67. Mr. Hayden has been a director of the Bank since 2000.
Thomas L. Kennedy. Mr. Kennedy has been a practicing attorney for over
30 years. He is the President of the law firm of Kennedy & Lucadamo, P.C. Mr.
Kennedy serves as Chairman of the Board and General Counsel of the Company and
the Bank. Age 60. Director since 1985.
The Honorable John P. Lavelle. Judge Lavelle served as the President
Judge for the Court of Common Pleas of Carbon County, Pennsylvania from 1978
until his retirement in February 2001. Age 73. Director since 1972.
Michael J. Leib. Mr. Leib is the President of Weatherly Casting &
Machine Company, located in Weatherly, Pennsylvania. Mr. Leib served as the
President of WCM, International Inc., a foreign sales corporation for exported
cast products located in Weatherly, Pennsylvania from February 1992 until August
2002. Age 56. Director since 1989.
Thomas M. Petro. Mr. Petro served as Executive Vice President of the
Company and the Bank from June 2003 before being named President and Chief
Executive Officer of the Company and the Bank on September 13, 2003. Prior to
joining the Company, Mr. Petro was a principal with S.R. Snodgrass, LLC, a
public accounting and consulting firm, located in Wexford, Pennsylvania, from
June 2002 to May 2003. Mr. Petro also served as Executive Vice President of The
Bryn Mawr Trust Company and President of the Bryn Mawr Brokerage Company, both
of which are located in Bryn Mawr, Pennsylvania, from 1990 to 2001. Age 46.
Director since 2003.
Joseph P. Schlitzer. Mr. Schlitzer has been President of Higgins since
1976. He has also served as Treasurer of Pinebrook-Higgins Realty since 2001. Mr
Schlitzer was also President of CBHA, Inc., a real estate company, from 1976 to
2001. Mr. Schlitzer also served on the Board of Directors of Heritage Bancorp,
Inc. and its successor Main Street Bancorp, Inc. from 1995 to 2000. Mr.
Schlitzer was appointed as a director of the Company on November 28, 2000 in
connection with the Company's acquisition of Higgins. Age 52.
William J. Spear. Mr. Spear is the President of Hazle Drugs, Inc., a
retail pharmacy located in Hazleton, Pennsylvania. Age 68. Director since 1981.
EXECUTIVE OFFICERS
The information relating to the officers of the Company is incorporated
herein by reference to the section captioned "Executive Officers" in Part 1 of
this Annual Report on Form 10-K.
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934 requires the
Company's executive officers and directors, and persons who own more than 10% of
any registered class of the Company's equity securities, to file reports of
ownership and changes in ownership with the Securities and Exchange Commission.
Executive officers, directors and greater than 10% stockholders are required by
regulation to furnish the Company with copies of all Section 16(a) reports they
file.
Based solely on its review of the copies of the reports it has received
and written representations provided to the Company from the individuals
required to file the reports, the Company believes that each of its executive
officers and directors has complied
Page 75
with applicable reporting requirements for transactions in Company common stock
during the fiscal year ended September 30, 2004, with the exception of one late
report by Mr. Schlitzer with regard to shares issued to him in connection with
the acquisition of Higgins.
CODE OF CONDUCT
The Company has adopted a Code of Conduct that is designed to promote
the highest standards of ethical conduct by the Company's directors, executive
officers and employees. The Code of Conduct requires that the Company's
directors, executive officers and employees avoid conflicts of interest, comply
with all laws and other legal requirements, conduct business in an honest and
ethical manner and otherwise act with integrity and in the Company's best
interest. Under the terms of the Code of Conduct, directors, executive officers
and employees are required to report any conduct that they believe in good faith
to be an actual or apparent violation of the Code of Conduct. In addition, the
Company has adopted a Code of Ethics for Financial Professionals.
As a mechanism to encourage compliance with the Code of Conduct and Code
of Ethics for Financial Professionals, the Company has established procedures to
receive, retain and address complaints received regarding accounting, internal
accounting controls or auditing matters. These procedures ensure that
individuals may submit concerns regarding questionable accounting or auditing
matters in a confidential and anonymous manner. The Code of Conduct also
prohibits the Company from retaliating against any director, executive officer
or employee who reports actual or apparent violations of the Code of Conduct.
A copy of the Code of Conduct and Code of Ethics for Financial
Professionals is available, without charge, upon written request to Jerry D.
Holbrook, Corporate Secretary, Northeast Pennsylvania Financial Corp., 12 E.
Broad Street, Hazleton, Pennsylvania 18201.
ITEM 11. EXECUTIVE COMPENSATION
SUMMARY COMPENSATION TABLE
The following information is furnished for the chief executive officer
and the other executive officers of the Company and its subsidiaries who
received salary, commissions and bonus of $100,000 or more during the fiscal
year ended September 30, 2004. The table does not include certain additional
benefits, the aggregate amount of which do not exceed 10% of salary and bonus
for the named executive officers.
LONG-TERM COMPENSATION
ANNUAL COMPENSATION AWARDS
----------------------- ---------------------------
SECURITIES
RESTRICTED UNDERLYING ALL OTHER
STOCK AWARDS OPTIONS/SARS COMPENSATION
NAME AND PRINCIPAL POSITIONS YEAR SALARY($)(1) BONUS($) ($)(2) (#) (3)
- -------------------------------- ---- ------------ ---------- ------------ ------------ ------------
Thomas M. Petro 2004 $ 214,222 $ 125,000 $ 234,910 32,000 $ 19,484
President and Chief Executive 2003 49,808 -- 45,150 30,000 -
Officer (4)
Thomas L. Kennedy (5) 2004 $ 242,488 $ -- $ 35,720 5,000 $ 74,110
Chairman of the Board 2003 154,143 -- -- 3,000 64,750
2002 162,168 -- -- 2,650 37,089
Joseph P. Schlitzer (6) 2004 $ 385,221 $ -- $ -- -- $ 34,516
President of Higgins 2003 297,301 -- -- -- 27,360
2002 313,900 -- -- -- 26,303
Jerry D. Holbrook (7) 2004 $ 188,558 $ 105,000 $ 53,580 11,000 $ 19,137
Chief Financial Officer 2003 -- -- -- 40,000 -
Leo R. Loftus 2004 $ 101,276 $ 25,000 $ 17,860 4,000 $ 16,384
Senior Vice President, 2003 92,025 -- -- -- 12,250
Chief Lending Officer 2002 87,668 -- -- -- 12,651
- ----------
(1) Includes directors' fees for Messrs. Petro, Kennedy and Schlitzer.
Page 76
(2) Reflects 13,000, 2,000, 0, 3,000 and 1,000 shares of restricted stock
granted to Messrs. Petro, Kennedy, Schlitzer, Holbrook and Loftus,
respectively. The dollar amount set forth in the table represents the market
value of the shares on the date of grant. The restricted stock awards vest
in three equal annual installments commencing on the first anniversary of
the date of grant. When shares become vested and are distributed from the
trust in which they are held, the recipient will also receive an amount
equal to accumulated cash and stock dividends (if any) paid with respect
thereto, plus earnings thereon. The number and value of all unvested shares
of restricted stock held by each named executive officer as of September 30,
2004 is as follows:
NUMBER OF VALUE OF
UNVESTED SHARES UNVESTED SHARES
--------------- ---------------
Mr. Petro 13,000 $ 214,630
Mr. Kennedy 2,000 33,020
Mr. Schlitzer -- --
Mr. Holbrook 3,000 9,530
Mr. Loftus 1,000 16,510
(3) Details of the amounts reported in the All Other Compensation column for
2004 is provided in the table below.
MR. MR. MR. MR. MR.
ITEM PETRO KENNEDY SCHLITZER HOLBROOK LOFTUS
- ------------------------------------------------ ---------- ---------- ---------- ---------- ----------
Employer contribution to 401(k) plan $ 4,208 $ 4,353 $ 6,298 $ 3,842 $ 3,023
Market value of allocations under the employee
stock ownership plan - 30,292 27,693 - 13,025
Imputed income under split-dollar life insurance
policies 276 1,627 215 295 336
Relocation payments 15,000 - - 15,000 -
Interest credited on deferred salary - 33,426 310 - -
Other fringe benefits - 4,412 - - -
---------- ---------- ---------- ---------- ----------
Total $ 19,484 $ 74,110 $ 34,516 $ 19,137 $ 16,384
========== ========== ========== ========== ==========
(4) Mr. Petro became affiliated with the Company when he was named Executive
Vice President and Chief Operating Officer on June 16, 2003. He was
appointed President and Chief Executive Officer on September 13, 2003.
(5) Includes $85,720 in deferred compensation payments to Mr. Kennedy during
2004.
(6) Includes $270,864, $235,426 and $263,900 in sales commissions for fiscal
2004, 2003 and 2002, respectively. Also includes $49,857 in deferred
compensation payments during fiscal 2004.
(7) Mr. Holbrook joined the Company on September 15, 2003.
EMPLOYMENT AGREEMENTS
The Company and the Bank maintain an employment agreement with each of
Mr. Petro and Mr. Kennedy and Higgins maintains an employment agreement with Mr.
Schlitzer. The employment agreements are intended to ensure that the Company,
the Bank and Higgins will be able to maintain a stable and competent management
base. The continued success of the Company, the Bank and Higgins depends to a
significant degree on the skills and competence of Messrs. Petro, Kennedy and
Schlitzer.
The Company and Bank employment agreements provide for twelve month
terms for each executive, while the Higgins employment agreement provides for a
four-year term. The terms of the employment agreements are renewable annually.
The Company and Bank employment agreements provide for a base salary of $214,500
for Mr. Petro and $156,768 for Mr. Kennedy. In addition to the base salary, the
Company and Bank employment agreements provide for, among other things,
participation in stock benefit plans and other fringe benefits applicable to
similarly-situated executive personnel. The Higgins employment agreement
provides that Mr. Schlitzer will receive $50,000 in base salary plus sales
commissions and other fringe benefits applicable to similarly-situated executive
personnel.
Page 77
The employment agreements provide for termination for cause, as defined
in the employment agreements, at any time. If the executive's employment is
terminated for reasons other than for cause, or if the executive resigns after
specified circumstances that would constitute constructive termination, the
executive, or if the executive dies, his or her beneficiary, would be entitled
to receive a severance payment. Under Mr. Petro's employment agreement, the
payment would be equal to six months of base salary if the termination occurs
during the first year of the agreement, one year of base salary if such
termination occurs during the second year of the agreement and two years of base
salary thereafter. Under Mr. Kennedy's agreement, the payment would be equal to
two years of base salary. Mr. Schlitzer will receive an amount equal to the
remaining payments due to him and the contributions that would have been made on
his behalf to any employee benefit plans during the remaining term of the
employment agreement. The Company and Bank employment agreements restrict each
executive's right to compete against the Bank or the Company for one year from
the date of termination of the agreement (six months in the case of Mr. Petro if
he is terminated within the first year of the employment agreement) if his
employment is terminated without cause, except if termination follows a change
in control. The Higgins employment agreement restricts Mr. Schlitzer's right to
compete with Higgins for two years from the expiration of the agreement.
Under the Company and the Bank and Higgins employment agreements, if
involuntary or, under certain circumstances, voluntary termination follows a
change in control, the executive, or if the executive dies, his or her
beneficiary, would be entitled to a severance payment equal to the greater of:
(1) the payments due for the remaining term of the agreement; or (2) three times
the average of the three (five in the case of Higgins) preceding taxable years'
annual compensation. The executive's life, health, and disability coverage would
also continue for sixty and thirty-six months under the Company and the Bank and
Higgins employment agreements, respectively.
All reasonable costs and legal fees paid or incurred by the executive
pursuant to any dispute or question of interpretation relating to the Company
and Bank employment agreements will be paid by the Company or the Bank,
respectively, if the executive is successful on the merits pursuant to a legal
judgment, arbitration or settlement. The Company and Bank employment agreements
also provide that the Company and the Bank shall indemnify the executive to the
fullest extent allowable under Delaware and federal law, as applicable.
The Bank maintains an employment agreement with Mr. Holbrook. The
agreement provides for a twelve month term, renewable annually. The employment
agreement also provides for a base salary of $185,000 per year, as well as
participation in stock benefit plans and other fringe benefits applicable to
senior executives of the Bank.
The Bank may terminate Mr. Holbrook's employment for cause at any time.
If Mr. Holbrook's employment is terminated for reasons other than cause, or if
he resigns after special circumstances that would constitute constructive
termination (as defined in the agreement), he would be entitled to a severance
payment of six months of base salary during the first year of the employment
agreement and one year of base salary thereafter. Mr. Holbrook will also receive
continued life and disability coverage for the remaining term of his agreement.
If involuntary or, under certain circumstances, involuntary termination
follows a change in control, Mr. Holbrook would receive the greater of payments
due to him for the remaining term of the agreement or three (3) times his base
salary (including incentive compensation) on the date of termination. However,
the agreement limits payable upon a change in control to one dollar less than
the maximum amount deductible by the Bank in accordance with Section 280G of the
Internal Revenue Code.
The employment agreement restricts Mr. Holbrook's right to compete with
the Bank for six months during the first year of the agreement or one year
thereafter, unless termination follows a change in control. The agreement also
provides for indemnification of the executive to the maximum extent permissible
under applicable law.
CHANGE IN CONTROL AGREEMENT
First Federal maintains a change in control agreement with Leo R.
Loftus, a Senior Vice President of First Federal. The change in control
agreement will continue indefinitely until discontinued by the Board of
Directors. If, following a change in control of the Company or First Federal,
Mr. Loftus' employment is terminated for reasons other than for cause, or if Mr.
Loftus voluntarily resigns upon the occurrence of circumstances specified in
this agreement, Mr. Loftus will receive a severance payment under his agreement
equal to one time his average annual compensation for the three most recent
taxable years. First Federal will also continue Mr. Loftus' health and welfare
benefit coverage for 24 months following his termination of employment.
Page 78
RETIREMENT PLAN
The Bank participates in the Financial Institutions Retirement Fund (the
"Retirement Plan") to provide retirement benefits for eligible employees.
However, the accrual of benefits under the Retirement Plan was frozen as of
October 1, 2003. Employees are generally eligible to participate in the
Retirement Plan if they are 21 years old and have completed 12 consecutive
months of employment with the Bank. Hourly paid employees are excluded from
participating in the Retirement Plan. Benefits payable to a participant under
the Retirement Plan are based on the participant's years of service and salary.
The formula for normal retirement benefits payable annually under the Retirement
Plan is 1% multiplied by years of benefit service multiplied by the
participant's career average salary paid by the Bank. A participant may elect
early retirement as early as age 45. However, such participant's normal
retirement benefits will be reduced by an early retirement factor based on the
participant's age at early retirement. Participants generally become 100% vested
in the accrued benefits under the Retirement Plan following the completion of
five years of service with the Bank, or when they turn 65, die or terminate
employment due to a disability.
The following table sets forth the estimated annual benefits payable
upon retirement at age 65 for the period ended September 30, 2004.
YEARS OF BENEFIT SERVICE
CAREER AVERAGE --------------------------------------------------------------
COMPENSATION 15 20 25 30 35
- --------------- ---------- ---------- ---------- ---------- ----------
$ 75,000 $ 11,300 $ 15,000 $ 18,800 $ 22,500 $ 26,300
100,000 15,000 20,000 25,000 30,000 35,000
125,000 18,800 25,000 31,300 37,500 43,800
150,000 22,500 30,000 37,500 45,000 52,500
175,000 26,300 35,000 43,800 52,500 61,300
200,000 30,000 40,000 50,000 60,000 70,000
250,000 37,500 50,000 62,500 75,000 87,500
300,000 45,000 60,000 75,000 90,000 105,000
350,000 52,500 70,000 87,500 105,000 122,500
The benefits listed in the foregoing table for the Retirement Plan are
not subject to a deduction for Social Security benefits or any other offset
amount. As of September 30, 2004, Mr. Kennedy had 4 years, 10 months of credited
service and Mr. Loftus had 4 years, 3 months of credited service. Messrs. Petro,
Schlitzer and Holbrook do not participate in the Retirement Plan.
SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN
The Bank maintains a non-qualified supplemental executive retirement
plan (the "SERP") to provide certain officers of the Bank and its affiliates,
including the Company, with additional retirement benefits. The SERP is intended
to make up benefits lost under the ESOP when a participant retires prior to the
complete repayment of the ESOP loan. When a participant retires, the benefits
under the SERP are determined by: (1) projecting the number of shares that would
have been allocated to the participant under the ESOP if they had been employed
throughout the period of the ESOP loan (measured from the participant's first
date of ESOP participation) and reducing such number by the number of shares
actually allocated to the participant's account under the ESOP; and (2)
multiplying such number of shares by the average fair market value of the
Company common stock over the preceding five years. Benefits under the SERP vest
in five equal annual installments commencing as of the date of a participant's
participation in the SERP. The vested portion of the SERP participant's benefits
are payable to the participant upon retirement (as defined in the ESOP) or to
the participant's beneficiary if the participant dies. As of September 30, 2004,
only Mr. Kennedy participated in the SERP.
OPTION GRANTS IN LAST FISCAL YEAR
The following table lists all options granted to the executive officers
named in the Summary Compensation Table (the "Named Executive Officers") during
fiscal 2004 and contains certain information about the potential value of those
options based upon certain assumptions as to the appreciation of the Company's
common stock over the life of the option.
Page 79
POTENTIAL REALIZABLE
VALUE AT ASSUMED
% OF TOTAL ANNUAL RATE OF
NUMBER OF OPTIONS STOCK PRICE
SECURITIES GRANTED TO APPRECIATION FOR
UNDERLYING EMPLOYEES EXERCISE OR OPTIONS (2)
OPTIONS GRANTED IN BASE PRICE EXPIRATION ------------------------------
Name (#) (1) FISCAL YEAR PER SHARE DATE 5% 10%
- ------------------- --------------- --------------- --------------- ---------------- ------------ ---------------
Thomas M. Petro 10,000 10.53% $ 18.75 November 5, 2013 $ 117,900 $ 298,800
22,000 23.16 17.86 March 2, 2014 247,105 626,120
Thomas L. Kennedy 5,000 5.26 17.86 March 2, 2014 56,150 142,300
Joseph P. Schlitzer -- -- -- -- -- --
Jerry D. Holbrook 10,000 10.53 18.75 November 5, 2013 117,900 298,800
11,000 11.58 17.86 March 2, 2014 123,553 313,060
Leo R. Loftus 4,000 4.21 17.86 March 2, 2014 44,920 113,840
(1) The options granted will vest in three equal annual installments beginning
on the first anniversary of the date of grant. The options granted will be
immediately exercisable if the optionee terminates employment following a
change in control of the Company, or due to death or disability.
(2) The dollar gains under these columns result from calculations required by
the Securities and Exchange Commission's rules and are not intended to
forecast future price appreciation of the Company's common stock. It is
important to note that options have value only if the price of the Company's
common stock increases above the exercise price shown in the table during
the effective option period. To realize the potential values set forth in
the 5% and 10% columns in the table, the price per share of the Company's
common stock would have to be approximately $30.54 and $48.63, respectively,
as of the expiration date of the options granted in November 2003, and
$29.09 and $46.32, respectively, as of the expiration date of the options
granted in March 2004.
FISCAL YEAR-END OPTION VALUE
The named executive officers exercised no stock options during the
fiscal year ended September 30, 2004. The following table provides certain
information with respect to the number and value of shares of common stock
represented by outstanding options held by the named executive officers as of
September 30, 2004.
NUMBER OF SECURITIES
UNDERLYING UNEXERCISED VALUE OF UNEXERCISED
OPTIONS AT FISCAL IN-THE-MONEY OPTIONS
YEAR-END(#)(1) AT FISCAL YEAR-END($)
--------------------------- ---------------------------
NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ------------------- ----------- ------------- ----------- -------------
Thomas M. Petro 10,001 51,999 $ -- $ --
Thomas L. Kennedy 156,266 6,500 728,422 9,210
Joseph P. Schlitzer 39,360 -- 167,374 --
Jerry D. Holbrook 10,000 41,000 -- --
Leo R. Loftus 2,000 4,000 10,270 --
(1) Value of unexercised in-the-money stock options equals the market value of
the shares covered by in-the-money options on September 30, 2004, less the
option exercise price. Options are in-the-money if the market value of shares
covered by the options is greater than the exercise price.
DIRECTORS' COMPENSATION
DIRECTORS' FEES. Under the 2004 stock plan each non-employee director
was to receive stock options to purchase at least 500 shares of common stock and
at least 500 shares of restricted stock in lieu of an annual retainer. However,
due to execution of the merger agreement with KNBT, these payments will not be
made in fiscal 2005.
OPTION GRANTS. On February 20, 2004, each non-employee director received
stock options to acquire 500 shares of common stock at an exercise price of
$17.781, the fair market value of the common stock on the date of grant.
Additionally, on that date, each non-employee director received 500 shares of
restricted stock. The options become exercisable and the shares of restricted
stock vest on February 20, 2005.
ITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
STOCK OWNERSHIP
The following table provides information as of December 20, 2004 with
respect to persons believed by us to be the beneficial owners of more than 5% of
our outstanding common stock based upon reports of beneficial ownership filed
with the Securities and Exchange Commission. A person may be considered to
beneficially own any shares of common stock over which he or she has, directly
or indirectly, sole or shared voting or investing power.
Page 80
NUMBER OF SHARES PERCENT OF COMMON
NAME AND ADDRESS OWNED STOCK OUTSTANDING
- ------------------------------------------- ---------------- -----------------
First Federal Bank Employee Stock Ownership 448,470(1) 11.28%
Plan and Trust
12 E. Broad Street
Hazleton, Pennsylvania 18201
First Federal Charitable Foundation 208,300(2) 5.24
12 E. Broad Street
Hazleton, Pennsylvania 18201
Jeffrey L. Gendell 323,124(3) 8.13
Tontine Financial Partners, L.P.
Tontine Management, L.L.C
55 Railroad Avenue, 3rd Floor
Greenwich, Connecticut 06830
Thomas L. Kennedy 274,642(4) 6.64
Chairman of the Board and General Counsel
Northeast Pennsylvania Financial Corp.
12 E. Broad Street
Hazleton, Pennsylvania 18201
Joseph P. Schlitzer 216,757(4) 5.40
President
Higgins Insurance Associates, Inc.
115 South Centre Street
Pottsville, Pennsylvania 17901
(1) Includes 205,676 shares that have not been allocated to participants'
accounts. Under the terms of the ESOP, the ESOP trustee will vote shares
allocated to participants' accounts in the manner directed by participants.
The ESOP trustee, subject to its fiduciary responsibilities, will vote
unallocated shares and allocated shares for which no timely voting
instructions are received in the same proportion as shares for which the
trustee has received voting instructions from participant
(2) The foundation's gift instrument requires that all shares of common stock
held by the foundation be voted in the same ratio as all other shares of our
common stock on all matters considered by stockholders.
(3) Based on information in a Schedule 13D filed with the Securities and
Exchange Commission on November 17, 2003.
(4) See table on the following page for additional information regarding Messrs.
Kennedy's and Schlitzer's beneficial ownership of common stock.
The following table provides information about the shares of our common
stock that may be considered to be beneficially owned by each director or
nominee for director of the Company, by the executive officers named in the
Summary Compensation Table and by all directors and executive officers of the
Company as a group as of December 20, 2004. A person may be considered to
beneficially own any shares of common stock over which he or she has, directly
or indirectly, sole or shared voting or investment power. Unless otherwise
indicated, each of the named individuals has sole voting and investment power
with respect to the shares shown.
Page 81
NUMBER OF
SHARES THAT
NUMBER OF MAY BE
SHARES ACQUIRED WITHIN
OWNED 60 DAYS BY PERCENT OF
(EXCLUDING OPTIONS)(1) EXERCISING COMMON STOCK
NAME (2) OPTIONS OUTSTANDING(3)
- ------------------------------------ ---------------------- --------------- --------------
DIRECTORS
Barbara M. Ecker 40,065(4) 22,500 1.56%
R. Peter Haentjens, Jr. 30,535 22,500 1.33
George J. Hayden 27,617 500 *
John P. Lavelle 27,501 22,650 1.25
Michael J. Leib 41,525(5) 22,500 1.60
William J. Spear 30,575(6) 22,500 1.33
NAMED EXECUTIVE OFFICERS
Jerry D. Holbrook 4,050 13,334 *
Thomas L. Kennedy 116,876(7) 157,766 6.64
Thomas M. Petro 18,000 13,334 *
Joseph P. Schlitzer 177,397 39,360 5.40
Leo R. Loftus 5,705(8) 2,000 *
All Executive Officers and 521,147 339,611 19.95
Directors as a Group (13 persons)
- ----------
* Less than 1% of shares outstanding
(1) Includes shares held under the ESOP, with respect to which the beneficial
owner has voting but not investment power as follows: Mr. Kennedy--9,168
shares; Mr. Schlitzer--2,486 shares; and Mr. Loftus--2,957 shares.
(2) Includes unvested shares of restricted stock held in trust, with respect to
which the beneficial owner has voting but not investment power as follows:
Ms. Ecker and Messrs. Haentjens, Hayden, Lavelle, Leib and Spear--500
shares; Mr. Holbrook--3,000 shares; Mr. Kennedy--2,000 shares; Mr.
Petro--10,666 shares; and Mr. Loftus--1,000 shares.
(3) Based on 3,975,799 common stock outstanding and entitled to vote as of
December 20, 2004, plus for each person, the number of shares that such
person may acquire within 60 days by exercising stock options.
(4) Includes 14,329 shares owned by Ms. Ecker's spouse and 700 shares owned by
Ms. Ecker's mother over which Ms. Ecker has power of attorney.
(5) Includes 18,536 shares held by Mr. Leib's spouse.
(6) Includes 2,245 shares held by Mr. Spear's spouse.
(7) Includes 8,750 shares owned by Mr. Kennedy's spouse.
(8) Includes 1,000 shares owned by Mr. Loftus' spouse.
EQUITY COMPENSATION PLAN INFORMATION
The following table sets forth information about Company common stock
that may be issued upon exercise of options, warrants and rights under all of
the Company's equity compensation plans as of September 30, 2004.
NUMBER OF SECURITIES NUMBER OF SECURITIES REMAINING
TO BE ISSUED UPON WEIGHTED-AVERAGE AVAILABLE FOR FUTURE ISSUANCE
EXERCISE OF OUTSTANDING EXERCISE PRICE OF UNDER EQUITY COMPENSATION PLANS
OPTIONS, WARRANTS AND OUTSTANDING OPTIONS, (EXCLUDING SECURITIES REFLECTED
RIGHTS WARRANTS AND RIGHTS IN COLUMN (A))
PLAN CATEGORY (A) (B) (C)
- ------------------------ ----------------------- -------------------- -------------------------------
EQUITY COMPENSATION
PLANS APPROVED BY
SECURITYHOLDERS 729,111 $ 13.08 187,245
EQUITY COMPENSATION
PLANS NOT APPROVED BY
SECURITYHOLDERS - - -
TOTAL 729,111 $ 13.08 187,245
Page 82
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
TRANSACTIONS WITH MANAGEMENT
LOANS AND EXTENSIONS OF CREDIT. The recently enacted Sarbanes-Oxley Act
generally prohibits loans by the Company to its executive officers and
directors. However, the Act contains a specific exemption from such prohibition
for loans by the Bank to its executive officers and directors in compliance with
federal banking regulations restrictions on such loans. Federal regulations
require that all loans or extensions of credit to executive officers and
directors of insured institutions must be made on substantially the same terms,
including interest rates and collateral, as those prevailing at the time for
comparable transactions with other persons, except for loans made under programs
generally available to all employees, and must not involve more than the normal
risk of repayment or present other unfavorable features. The Bank is therefore
prohibited from making any new loans or extensions of credit to executive
officers and directors at different rates or terms than those offered to the
general public, except for loans made pursuant to programs generally available
to all employees. In addition, loans made to a director or executive officer in
an amount that, when aggregated with all other loans to such person or his or
her related interests, are in excess of the greater of $25,000 or 5% of the
Bank's capital and surplus (up to a maximum of $500,000) must be approved in
advance by a majority of the disinterested members of the Board of Directors.
OTHER TRANSACTIONS. Kennedy & Lucadamo, P.C., of which Thomas L. Kennedy
is President, performs legal services for the Company and First Federal. In
fiscal 2004, the Company and First Federal paid a total of $117,000 in legal
fees to Kennedy & Lucadamo, P.C.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
The following table sets forth the fees billed to the Company for the
fiscal years ending September 30, 2004 and 2003 by KPMG LLP:
2004 2003
---------- ----------
Audit fees $ 247,071 $ 325,173
Audit related fees (1) 36,875 157,687
Tax fees (2) 16,328 46,636
All other fees -- --
- ----------
(1) Audit related fees consists primarily of discussion and research of
accounting issues, due diligence assistance, review of securities filings,
issuance of consents and audits of financial statements of employee benefit
plans.
(2) Other non-audit related fees consisted of tax-related services.
Page 83
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
The following documents are filed as a part of this report
(1) Consolidated Financial Statements of the Company are included in Item 8
of this Form 10-K.
(2) All schedules are omitted because they are not required or applicable,
or the required information is shown in the consolidated financial
statements or the notes thereto included in Item 8 of this Form 10-K.
(3) Exhibits
(a) The following exhibits are filed as part of this report.
2.1 Agreement and Plan of Merger dated December 8, 2004 by and
between KNBT Bancorp, Inc. and Northeast Pennsylvania Financial
Corp. (1)
3.1 Certificate of Incorporation of Northeast Pennsylvania Financial
Corp. (2)
3.2 Bylaws of Northeast Pennsylvania Financial Corp. (3)
4.0 Form of Stock Certificate of Northeast Pennsylvania Financial
Corp. (2)
10.1 Employment Agreement between Northeast Pennsylvania Financial
Corp., First Federal Bank and Thomas M. Petro (4)
10.2 Employment Agreement between Northeast Pennsylvania Financial
Corp., First Federal Bank and Thomas L. Kennedy (4)
10.3 Employment Agreement between Higgins Insurance Associates, Inc.
and Joseph P. Schlitzer (5)
10.4 Amendment to Employment Agreement between Higgins Insurance
Associates, Inc. and Joseph P. Schlitzer (4)
10.5 Employment Agreement between Northeast Pennsylvania Financial
Corp., First Federal Bank and Jerry D. Holbrook (4)
10.6 Form of First Federal Bank Supplemental Executive Retirement
Plan (4)
10.7 Form of Shareholder Agreement between KNBT and the directors of
Northeast Pennsylvania Financial Corp. (1)
10.8 Northeast Pennsylvania Financial Corp. 1998 Stock-Based
Incentive Plan (6)
10.9 Northeast Pennsylvania Financial Corp. 2000 Stock Option Plan
(7)
10.10 Registration Rights Agreement, dated as of December 31, 2000, by
and among Northeast Pennsylvania Financial Corp., James Clark,
James McCann, Joseph Schlitzer and John W. Sink (8)
10.11 Termination and Release Agreement, dated December 8, 2004, by
and among Northeast Pennsylvania Financial Corp., First Federal
Bank, KNBT Bancorp, Inc. and Thomas L. Kennedy (1)
10.12 Termination and Release Agreement, dated December 8, 2004, by
and among Northeast Pennsylvania Financial Corp., First Federal
Bank, KNBT Bancorp, Inc. and Thomas M. Petro (1)
10.13 Termination and Release Agreement, dated December 8, 2004, by
and among Northeast Pennsylvania Financial Corp., First Federal
Bank, KNBT Bancorp, Inc. and Jerry D. Holbrook (1)
10.14 First Federal Bank Employee Severance Compensation Plan, as
amended.
10.15 Northeast Pennsylvania Financial Corp. 2004 Stock Plan. (9)
10.16 Change in Control Agreement between First Federal Bank and Leo
R. Loftus.
11.0 Statement regarding Computation of Per Share Earnings (See Notes
to Consolidated Financial Statements)
21.0 Subsidiary information is incorporated by reference to "Part I -
Subsidiaries"
23.0 Consent of KPMG LLP
31.1 Rule 13a-14(a)/15d-14(a) Certification of Chief Executive
Officer
31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief Financial
Officer
32.1 Section 1350 Certifications
- ----------
1. Incorporated by reference into this document from the Exhibits to the
Company's Form 8-K/A filed on December 16, 2004.
2. Incorporated herein by reference into this document from the Exhibits to the
Form S- 1 Registration Statement, and any amendments thereto, Registration
No. 333-43281
3. Incorporated herein by reference into this document from the Exhibits to the
Company's Form 10-K/A for the year ended September 30, 2002.
4. Incorporated herein by reference into this document from the Exhibits to the
Company's Form 10-K for the year ended September 30, 2003.
Page 84
5. Incorporated herein by reference into this document from the Exhibits to the
Company's Form 10-K for the year ended September 30, 2001.
6. Incorporated herein by reference into this document from the Proxy Statement
for the 1998 Special Meeting of Stockholders dated September 9, 1998.
7. Incorporated herein by reference into this document from the proxy statement
for the 2000 Annual Meeting of Stockholders dated December 20, 1999.
8. Incorporated herein by reference into this document from the Exhibits to the
Company's Form 10-Q for the quarter ended March 31, 2002.
9. Incorporated herein by reference into this document from the Proxy Statement
for the 2004 Annual Meeting of Stockholders dated January 15, 2004.
Page 85
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned thereunto duly authorized.
Northeast Pennsylvania Financial Corp.
By /s/ Thomas M. Petro December 29, 2004
----------------------------------
Thomas M. Petro
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
/s/ Thomas M. Petro December 29, 2004
- -------------------------------------
Thomas M. Petro
President, Chief Executive Officer
and Director
(Principal Executive Officer)
/s/ Barbara Ecker December 29, 2004
- -------------------------------------
Barbara Ecker
Director
/s/ R. Peter Haentjens, Jr. December 29, 2004
- -------------------------------------
R. Peter Haentjens, Jr.
Director
/s/ George J. Hayden December 29, 2004
- -------------------------------------
George J. Hayden
Director
/s/ Thomas L. Kennedy December 29, 2004
- -------------------------------------
Atty. Thomas L. Kennedy
Chairman of the Board
/s/ John P. Lavelle December 29, 2004
- -------------------------------------
Honorable John P. Lavelle
Director
/s/ Michael J. Leib December 29, 2004
- -------------------------------------
Michael J. Leib
Director
/s/ William J. Spear December 29, 2004
- -------------------------------------
William J. Spear
Director
/s/ Joseph Schlitzer December 29, 2004
- -------------------------------------
Joseph Schlitzer
Director
/s/ Jerry D. Holbrook December 29, 2004
- -------------------------------------
Jerry D. Holbrook
Chief Financial Officer and Secretary
(Principal Accounting and Financial
Officer)
Page 86