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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 2003
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: 0-16084
CITIZENS & NORTHERN CORPORATION
(Exact name of Registrant as specified in its charter)
Pennsylvania 23-2451943
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
90-92 Main Street
Wellsboro, Pa. 16901
(Address of principal executive offices) (Zip code)
570-724-3411
(Registrant's telephone number including area code)
Not applicable
(Former name, former address, and former fiscal year,
if changed since last report)
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 check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Securities Exchange Act of 1934).
Yes X No
--- ---
(APPLICABLE ONLY TO CORPORATE REGISTRANTS)
Indicate the number of shares outstanding of each of the registrant's
classes of common stock, as of the latest practicable date.
Title Outstanding
Common Stock ($1.00 par value) 8,013,110 Shares Outstanding November 12, 2003
1
CITIZENS & NORTHERN CORPORATION
Index
Part I. Financial Information
Item 1. Financial Statements
Consolidated Balance Sheet - September 30, 2003 and
December 31, 2002 Page 3
Consolidated Statement of Income - Three Months and Nine
Months Ended September 30, 2003 and 2002 Page 4
Consolidated Statement of Cash Flows - Nine Months
Ended September 30, 2003 and 2002 Page 5
Notes to Consolidated Financial Statements Pages 6 through 8
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations Pages 9 through 22
Item 3. Quantitative and Qualitative Disclosures About
Market Risk Pages 22 through 24
Item 4. Controls and Procedures Page 24
Part II. Other Information Page 25
Signatures Page 26
Exhibit 31.1. Certification Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002 - Chief Executive Officer Page 27
Exhibit 31.2. Certification Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002 - Chief Financial Officer Page 28
Exhibit 32. Certifications Pursuant to 18 U.S.C. Section 1350
as Adopted Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002 Page 29
2
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEET SEPTEMBER 30, DECEMBER 31,
(In Thousands Except Share Data) 2003 2002
(UNAUDITED) (NOTE)
ASSETS
Cash and due from banks:
Noninterest-bearing $ 17,224 $ 14,185
Interest-bearing 1,234 715
----------- -----------
Total cash and cash equivalents 18,458 14,900
Available-for-sale securities 482,064 512,175
Held-to-maturity securities 565 707
Loans, net 500,005 445,356
Bank-owned life insurance 17,310 16,758
Accrued interest receivable 5,888 5,960
Bank premises and equipment, net 12,023 10,333
Foreclosed assets held for sale 78 56
Other assets 13,619 12,523
----------- -----------
TOTAL ASSETS $ 1,050,010 $ 1,018,768
=========== ===========
LIABILITIES
Deposits:
Noninterest-bearing $ 72,391 $ 70,824
Interest-bearing 580,337 569,480
----------- -----------
Total deposits 652,728 640,304
Dividends payable 1,682 1,586
Short-term borrowings 45,167 43,635
Long-term borrowings 216,696 208,214
Accrued interest and other liabilities 11,631 9,192
----------- -----------
TOTAL LIABILITIES 927,904 902,931
----------- -----------
STOCKHOLDERS' EQUITY
Common stock, par value $1.00 per share; authorized 10,000,000
shares; issued 8,226,033 in 2003 and 5,431,021 in 2002 8,226 5,431
Stock dividend distributable -- 1,639
Paid-in capital 20,081 21,153
Retained earnings 84,498 77,584
----------- -----------
Total 112,805 105,807
Accumulated other comprehensive income 11,487 12,146
Unamortized stock compensation (79) (49)
Treasury stock, at cost:
214,751 shares at September 30, 2003 (2,107)
145,415 shares at December 31, 2002 (2,067)
----------- -----------
TOTAL STOCKHOLDERS' EQUITY 122,106 115,837
----------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 1,050,010 $ 1,018,768
=========== ===========
The accompanying notes are an integral part of these consolidated financial
statements.
Note: The balance sheet at December 31, 2002 has been derived from the audited
financial statements at that date but does not include all the information and
notes required by generally accepted accounting principles for complete
financial statements.
3
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
CONSOLIDATED STATEMENT OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
(In thousands, except per share data) 3 MONTHS ENDED FISCAL YEAR TO DATE
(Unaudited) SEPT. 30, SEPT. 30, 9 MONTHS ENDED SEPT. 30,
2003 2002 2003 2002
(CURRENT) (PRIOR YEAR) (CURRENT) (PRIOR YEAR)
INTEREST INCOME
Interest and fees on loans $ 8,164 $ 7,864 $ 24,049 $ 22,663
Interest on balances with depository institutions 1 5 8 18
Interest on loans to political subdivisions 206 143 572 435
Interest on federal funds sold -- 16 8 30
Income from available-for-sale and
held-to-maturity securities:
Taxable 3,027 4,810 10,571 14,598
Tax-exempt 1,859 1,523 5,421 4,291
Dividends 296 314 797 805
---------- ---------- ---------- ----------
Total interest and dividend income 13,553 14,675 41,426 42,840
---------- ---------- ---------- ----------
INTEREST EXPENSE
Interest on deposits 3,470 4,383 11,201 13,008
Interest on short-term borrowings 121 221 362 735
Interest on long-term borrowings 2,064 2,071 6,424 5,993
---------- ---------- ---------- ----------
Total interest expense 5,655 6,675 17,987 19,736
---------- ---------- ---------- ----------
Interest margin 7,898 8,000 23,439 23,104
Provision for loan losses 250 280 850 640
---------- ---------- ---------- ----------
Interest margin after provision for loan losses 7,648 7,720 22,589 22,464
---------- ---------- ---------- ----------
OTHER INCOME
Service charges on deposit accounts 452 453 1,307 1,260
Service charges and fees 91 61 210 194
Trust and financial management income 413 413 1,258 1,358
Insurance commissions, fees and premiums 63 108 220 448
Increase in cash surrender value of life insurance 175 213 552 648
Fees related to credit card operation 207 168 564 450
Other operating income 304 226 762 652
---------- ---------- ---------- ----------
Total other income before realized gains on
securities, net 1,705 1,642 4,873 5,010
Realized gains on securities, net 660 489 3,289 2,496
---------- ---------- ---------- ----------
Total other income 2,365 2,131 8,162 7,506
---------- ---------- ---------- ----------
OTHER EXPENSES
Salaries and wages 2,356 2,467 7,129 7,056
Pensions and other employee benefits 777 716 2,437 1,975
Occupancy expense, net 310 229 967 815
Furniture and equipment expense 345 358 1,029 1,199
Pennsylvania shares tax 196 184 588 550
Other operating expense 1,352 1,356 4,074 4,069
---------- ---------- ---------- ----------
Total other expenses 5,336 5,310 16,224 15,664
---------- ---------- ---------- ----------
Income before income tax provision 4,677 4,541 14,527 14,306
Income tax provision 759 831 2,617 2,938
---------- ---------- ---------- ----------
NET INCOME $ 3,918 $ 3,710 $ 11,910 $ 11,368
========== ========== ========== ==========
PER SHARE DATA:
Net income - basic $ 0.49 $ 0.46 $ 1.49 $ 1.42
Net income - diluted $ 0.49 $ 0.46 $ 1.48 $ 1.42
---------- ---------- ---------- ----------
Dividend per share $ 0.21 $ 0.20 $ 0.63 $ 0.5733
---------- ---------- ---------- ----------
Number shares used in computation - basic 8,010,753 8,006,142 8,008,547 8,009,856
Number shares used in computation - diluted 8,071,173 8,031,880 8,055,627 8,030,398
The accompanying notes are an integral part of these consolidated financial
statements.
4
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
CONSOLIDATED STATEMENT OF CASH FLOWS
(IN THOUSANDS) (UNAUDITED)
SEPTEMBER 30, SEPTEMBER 30,
2003 2002
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 11,910 $ 11,368
Adjustments to reconcile net income to net cash provided by
operating activities:
Provision for loan losses 850 640
Realized gains on securities, net (3,289) (2,496)
Gain on sale of foreclosed assets, net (83) (26)
Depreciation expense 815 1,054
Accretion and amortization, net 1,124 (508)
Increase in cash surrender value of life insurance (552) (648)
Amortization of restricted stock 77 62
Increase in accrued interest receivable and other assets (79) (956)
Increase in accrued interest payable and other liabilities 2,903 3,148
--------- ---------
Net Cash Provided by Operating Activities 13,676 11,638
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturity of held-to-maturity securities 140 616
Proceeds from sales of available-for-sale securities 46,876 25,650
Proceeds from calls and maturities of available-for-sale securities 153,160 110,099
Purchase of available-for-sale securities (168,755) (183,963)
Purchase of Federal Home Loan Bank of Pittsburgh stock (1,178) (125)
Redemption of Federal Home Loan Bank of Pittsburgh stock 168 --
Net increase in loans (55,671) (52,428)
Purchase of premises and equipment (2,505) (1,341)
Proceeds from sale of foreclosed assets 233 477
--------- ---------
Net Cash Used in Investing Activities (27,532) (101,015)
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits 12,424 60,205
Net increase (decrease) in short-term borrowings 1,532 (19,381)
Proceeds from long-term borrowings 46,000 75,153
Repayments of long-term borrowings (37,518) (20,017)
Purchase of treasury stock (174) (238)
Sale of treasury stock 141 60
Dividends paid (4,991) (4,452)
--------- ---------
Net Cash Provided by Financing Activities 17,414 91,330
--------- ---------
INCREASE IN CASH AND CASH EQUIVALENTS 3,558 1,953
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 14,900 16,036
--------- ---------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 18,458 $ 17,989
========= =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Assets acquired through foreclosure of real estate loans $ 172 $ 436
Interest paid $ 14,352 $ 16,422
Income taxes paid $ 2,570 $ 3,599
The accompanying notes are an integral part of these consolidated financial
statements.
5
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF INTERIM PRESENTATION
The financial information included herein, with the exception of the
consolidated balance sheet dated December 31, 2002, is unaudited; however, such
information reflects all adjustments (consisting solely of normal recurring
adjustments) that are, in the opinion of management, necessary for a fair
presentation of the financial position, results of operations and cash flows for
the interim periods.
Results reported for the three-month and nine-month periods ended September 30,
2003 might not be indicative of the results for the year ending December 31,
2003.
This document has not been reviewed or confirmed for accuracy or relevance by
the Federal Deposit Insurance Corporation or any other regulatory agency.
2. PER SHARE DATA
Net income per share is based on the weighted-average number of shares of common
stock outstanding. The number of shares used in calculating net income and cash
dividends per share reflect the retroactive effect of stock splits and dividends
for all periods presented. The following data show the amounts used in computing
net income per share and the weighted average number of shares of dilutive stock
options. As shown in the table that follows, diluted earnings per share is
computed using weighted average common shares outstanding, plus weighted-average
common shares available from the exercise of all dilutive stock options, less
the number of shares that could be repurchased with the proceeds of stock option
exercises based on the average share price of the Corporation's common stock
during the period.
WEIGHTED-
AVERAGE EARNINGS
NET COMMON PER
INCOME SHARES SHARE
NINE MONTHS ENDED SEPTEMBER 30, 2003
Earnings per share - basic $ 11,910,000 8,008,547 $ 1.49
Dilutive effect of potential common stock
arising from stock options:
Exercise of outstanding stock options 197,322
Hypothetical share repurchase at $23.68 (150,242)
------------ --------- --------
Earnings per share - diluted $ 11,910,000 8,055,627 $ 1.48
============ ========= ========
NINE MONTHS ENDED SEPTEMBER 30, 2002
Earnings per share - basic $ 11,368,000 8,009,856 $ 1.42
Dilutive effect of potential common stock
arising from stock options:
Exercise of outstanding stock options 137,249
Hypothetical share repurchase at $19.29 (116,707)
------------ --------- --------
Earnings per share - diluted $ 11,368,000 8,030,398 $ 1.42
============ ========= ========
6
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
WEIGHTED-
AVERAGE EARNINGS
NET COMMON PER
INCOME SHARES SHARE
QUARTER ENDED SEPTEMBER 30, 2003
Earnings per share - basic $ 3,918,000 8,010,753 $ 0.49
Dilutive effect of potential common stock
arising from stock options:
Exercise of outstanding stock options 216,930
Hypothetical share repurchase at $26.01 (156,510)
----------- --------- --------
Earnings per share - diluted $ 3,918,000 8,071,173 $ 0.49
=========== ========= ========
QUARTER ENDED SEPTEMBER 30, 2002
Earnings per share - basic $ 3,710,000 8,006,142 $ 0.46
Dilutive effect of potential common stock
arising from stock options:
Exercise of outstanding stock options 137,249
Hypothetical share repurchase at $20.19 (111,511)
----------- --------- --------
Earnings per share - diluted $ 3,710,000 8,031,880 $ 0.46
=========== ========= ========
3. STOCK COMPENSATION PLANS
As permitted by Accounting Principles Board Opinion No. 25, the Corporation uses
the intrinsic value method of accounting for stock compensation plans. Utilizing
the intrinsic value method, compensation cost is measured by the excess of the
quoted market price of the stock as of the grant date (or other measurement
date) over the amount an employee or director must pay to acquire the stock.
Stock options issued under the Corporation's stock option plans have no
intrinsic value, and accordingly, no compensation cost is recorded for them.
The Corporation has also made awards of restricted stock. Compensation cost
related to restricted stock is recognized based on the market price of the stock
at the grant date over the vesting period.
The following table illustrates the effect on net income and earnings per share
if the Corporation had applied the fair value provisions of Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-based
Compensation," to stock options.
7
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
(IN THOUSANDS)
3 MONTHS ENDED FISCAL YEAR-TO-DATE
SEPT. 30, 9 MONTHS ENDED SEPT. 30,
2003 2002 2003 2002
Net income, as reported $ 3,918 $ 3,710 $ 11,910 $ 11,368
Deduct: Total stock option compensation
expense determined under fair value
method for all awards, net of tax effects (9) (11) (115) (178)
--------- --------- ---------- ----------
Pro forma net income $ 3,909 $ 3,699 $ 11,795 $ 11,190
========= ========= ========== ==========
Earnings per share-basic:
As reported $ 0.49 $ 0.46 $ 1.49 $ 1.42
Pro forma $ 0.49 $ 0.46 $ 1.47 $ 1.40
Earnings per share-diluted:
As reported $ 0.49 $ 0.46 $ 1.48 $ 1.42
Pro forma $ 0.48 $ 0.46 $ 1.46 $ 1.39
4. COMPREHENSIVE INCOME
Accounting principles generally require that recognized revenue, expenses, gains
and losses be included in net income. Although certain changes in assets and
liabilities, such as unrealized gains and losses on available-for-sale
securities, are reported as a separate component of the equity section of the
balance sheet, such items, along with net income, are components of
comprehensive income.
Comprehensive income is calculated as follows:
3 MONTHS ENDED 9 MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
(IN THOUSANDS) 2003 2002 2003 2002
Net income $ 3,918 $ 3,710 $ 11,910 $ 11,368
Other comprehensive (loss)/income:
Unrealized holding (losses)/gains on available-for-sale
securities:
(Losses)/Gains arising during the period (4,199) 6,387 2,291 14,461
Reclassification adjustment for realized gains (660) (489) (3,289) (2,496)
-------- -------- -------- --------
Other comprehensive (loss)/income before income tax (4,859) 5,898 (998) 11,965
Income tax related to other comprehensive (loss)/income 1,651 (2,005) 339 (4,068)
-------- -------- -------- --------
Other comprehensive (loss)/income (3,208) 3,893 (659) 7,897
-------- -------- -------- --------
Comprehensive income $ 710 $ 7,603 $ 11,251 $ 19,265
======== ======== ======== ========
5. CONTINGENCIES
In the normal course of business, the Corporation may be subject to pending and
threatened lawsuits in which claims for monetary damages could be asserted. In
management's opinion, the Corporation's financial position and results of
operations would not be materially affected by the outcome of such pending legal
proceedings.
8
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
PART I - FINANCIAL INFORMATION (CONTINUED)
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Certain statements in this section and elsewhere in Form 10-Q are
forward-looking statements. Citizens & Northern Corporation and its wholly-owned
subsidiaries (collectively, the Corporation) intend such forward-looking
statements to be covered by the safe harbor provisions for forward-looking
statements contained in the Private Securities Reform Act of 1995.
Forward-looking statements, which are based on certain assumptions and describe
future plans, business objectives and expectations, and are generally not
historical facts, are identifiable by the use of words such as, "believe",
"expect", "intend", "anticipate", "estimate", "project", and similar
expressions. These forward-looking statements are subject to risks and
uncertainties that are difficult to predict, may be beyond management's control
and could cause results to differ materially from those currently anticipated.
Factors which could have a material adverse impact on the operations and future
prospects of the Corporation include, but are not limited to, the following:
- - changes in monetary and fiscal policies of the Federal Reserve Board and the
U. S. Government, particularly related to changes in interest rates
- - decline in market value of available-for-sale securities
- - changes in general economic conditions
- - legislative or regulatory changes
- - downturn in demand for loan, deposit and other financial services in the
Corporation's market area
- - increased competition from other banks and non-bank providers of financial
services
- - technological changes and increased technology-related costs
- - changes in accounting principles, or the application of generally accepted
accounting principles.
These risks and uncertainties should be considered in evaluating forward-looking
statements and undue reliance should not be placed on such statements.
REFERENCES TO 2003 AND 2002
Unless otherwise noted, all references to "2003" in the following discussion of
operating results are intended to mean the nine months ended September 30, 2003,
and similarly, references to "2002" are intended to mean the nine months ended
September 30, 2002.
EARNINGS OVERVIEW
Net income for 2003 was $11,910,000, or $1.49 per share - basic and $1.48 per
share - diluted. This represents an increase of 4.9% in net income per share -
basic and an increase of 4.2% in net income per share - diluted over 2002.
Return on average assets was 1.54% in 2003, down from 1.63% in 2002. Return on
average equity decreased to 13.10% in 2003 from 14.39% in 2002.
The most significant income statement changes between 2003 and 2002 were as
follows:
- - Net realized gains on securities were $3,289,000 in 2003, compared to
$2,496,000 in 2002. In both years, the gains were mainly from sales of bank
stocks. These sales resulted from circumstances specific to each underlying
company, and the proceeds have been reinvested in other bank stocks. Total
gains from sales of bank stocks amounted to $1,972,000 in 2003 and
$1,789,000 in 2002. Other security gains (net) from debt securities amounted
to $1,317,000 in 2003 and $710,000 in 2002, and consisted mainly of sales
and calls of municipal and U.S. Agency bonds.
- - The interest margin increased by $335,000, or 1.5%, to $23,439,000 in 2003
from $23,104,000 in 2002. Average interest rates on deposits and borrowed
funds have been substantially lower in 2003 than in 2002. However, the
Corporation has experienced significant growth in loans, which has more than
offset the effects of lower yields in 2003. Changes in the net interest
margin are discussed in more detail later in Management's Discussion and
Analysis under "Net Interest Margin".
9
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
- - Other (noninterest) expenses increased $560,000, or 3.6%, in 2003 compared
to 2002. The increase reflects increases in payroll costs and employee
benefits. As described in more detail in the "Noninterest Expense" section
of Management's Discussion and Analysis, these cost increases reflect a
higher number of employees, as well as increases in costs related to
employee health insurance and the defined benefit pension plan.
- - The income tax provision decreased to $2,617,000 in 2003 from $2,938,000 in
2002. While pre-tax income has increased, the Corporation's effective tax
rate fell to 18.0% in 2003 from 20.5% in 2002. This lower effective tax rate
resulted mainly from management's decision to increase the weighting of
tax-exempt obligations of states and political subdivisions, as a percentage
of total assets.
THIRD QUARTER 2003
- ------------------
Net income for the third quarter 2003 was $3,918,000, an increase of $208,000
(5.6%) over the third quarter 2002. Net income per share was $0.49 (Basic and
Diluted) for the third quarter 2003, as compared to $0.46 (Basic and Diluted)
for the third quarter 2002.
Net Income for the third quarter 2003 is slightly less than the $3,920,000
reported in the second quarter and $4,072,000 reported in the first quarter
2003. As you can see in Table I, the interest margin increased $44,000 in the
third quarter over the second quarter, and $167,000 in the second quarter over
the first quarter. However, net realized security gains were $248,000 lower in
the third quarter than the second quarter, and $813,000 lower in the second
quarter than in the first quarter.
TABLE I - QUARTERLY FINANCIAL DATA
(IN THOUSANDS)
SEPT. 30, JUNE 30, MAR. 31, DEC. 31, SEPT. 30, JUNE 30, MAR. 31,
2003 2003 2003 2002 2002 2002 2002
Interest income $13,553 $13,943 $13,930 $14,445 $14,675 $14,523 $13,642
Interest expense 5,655 6,089 6,243 6,579 6,675 6,745 6,316
------- ------- ------- ------- ------- ------- -------
Interest margin 7,898 7,854 7,687 7,866 8,000 7,778 7,326
Provision for loan losses 250 250 350 300 280 180 180
------- ------- ------- ------- ------- ------- -------
Interest margin after provision for loan
losses 7,648 7,604 7,337 7,566 7,720 7,598 7,146
Other income 1,705 1,628 1,540 1,614 1,642 1,681 1,687
Securities gains 660 908 1,721 392 489 781 1,226
Other expenses 5,336 5,356 5,532 5,185 5,310 5,248 5,106
------- ------- ------- ------- ------- ------- -------
Income before income tax provision 4,677 4,784 5,066 4,387 4,541 4,812 4,953
Income tax provision 759 864 994 796 831 992 1,115
------- ------- ------- ------- ------- ------- -------
Net income $ 3,918 $ 3,920 $ 4,072 $ 3,591 $ 3,710 $ 3,820 $ 3,838
======= ======= ======= ======= ======= ======= =======
Net income per share - basic $ 0.49 $ 0.49 $ 0.51 $ 0.45 $ 0.46 $ 0.48 $ 0.48
======= ======= ======= ======= ======= ======= =======
Net income per share - diluted $ 0.49 $ 0.49 $ 0.51 $ 0.45 $ 0.46 $ 0.48 $ 0.48
======= ======= ======= ======= ======= ======= =======
The number of shares used in calculating net income per share for each quarter
presented in Table I reflects the retroactive effect of stock splits and
dividends.
PROSPECTS FOR THE REMAINDER OF 2003
- -----------------------------------
Management believes earnings prospects for the fourth quarter 2003 are good. Net
loans are up 17.6% as of September 30, 2003 compared to September 30, 2002. The
Corporation's major concentration continues to be real estate secured loans,
with significant growth over the last 12 months in both residential and
commercial loans outstanding.
With interest rates at or near forty-year lows throughout most of 2003,
interest-earning assets have been repricing faster than interest-bearing
liabilities. In that interest rate environment, it is a challenge to maintain or
grow the interest margin while limiting interest rate risk to a prudent level.
While short-term interest rates remain at or near historically low levels,
10
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
longer-term rates (such as the 10-year U.S. Treasury bond yield) have risen
during the third quarter 2003 from their position in June 2003. Higher long-term
rates, along with several positive economic reports in recent weeks, could be an
indicator that short-term interest rates will rise over the next year or so.
Although rising short-term rates would probably not have a significant effect on
fourth quarter 2003 earnings, the Corporation's results for 2004 may be affected
by the expected slowdowns in prepayments on loans and mortgage-backed securities
and by higher interest costs on deposits and borrowed funds. The Corporation's
interest rate risk is discussed in more detail in Item 3 of Form 10-Q.
The other major variable that could affect fourth quarter 2003 earnings is
securities gains and losses. The Corporation's management makes decisions
regarding sales of securities based on a variety of factors, with an overall
goal of maximizing portfolio return over a long-term horizon. It is possible
that management may sell some investment securities in the fourth quarter 2003
in an effort to address the possible further effects of rising interest rates.
It is difficult to predict, with any degree of precision, the amounts of
securities gains and losses that may be realized during the fourth quarter 2003.
CRITICAL ACCOUNTING ESTIMATES
The presentation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect many of the reported amounts and disclosures. Actual results could differ
from these estimates.
A material estimate that is particularly susceptible to significant change is
the determination of the allowance for loan losses. Management believes that the
allowance for loan losses is adequate and reasonable. The Corporation's
methodology for determining the allowance for loan losses is described in a
separate section later in Management's Discussion and Analysis. Given the very
subjective nature of identifying and valuing loan losses, it is likely that
well-informed individuals could make materially different assumptions, and
could, therefore, calculate a materially different allowance value. While
management uses available information to recognize losses on loans, changes in
economic conditions may necessitate revisions in future reporting periods. In
addition, various regulatory agencies, as an integral part of their examination
process, periodically review the Corporation's allowance for loan losses. Such
agencies may require the Corporation to recognize adjustments to the allowance
based on their judgments of information available to them at the time of their
examination. Further, in June 2003, the American Institute of Certified Public
Accountants issued an exposure draft of a statement of position that would
establish detailed implementation guidance for calculating the allowance for
loan losses. The exposure draft of this statement of position calls for
implementation of its provisions in 2004. Implementation of this detailed
guidance, if it is approved, could result in an adjustment to the Corporation's
allowance.
Another material estimate is the calculation of fair values of the Corporation's
debt securities. The Corporation receives estimated fair values of debt
securities from an independent valuation service, or from brokers. In developing
these fair values, the valuation service and the brokers use estimates of cash
flows, based on historical performance of similar instruments in similar
interest rate environments. Based on experience, management is aware that
estimated fair values of debt securities tend to vary among brokers and other
valuation services. Accordingly, when selling debt securities, management
typically obtains price quotes from more than one source. The large majority of
the Corporation's securities are classified as available-for-sale. Accordingly,
these securities are carried at fair value on the consolidated balance sheet,
with unrealized gains and losses excluded from earnings and reported separately
through accumulated other comprehensive income (included in stockholders'
equity).
NET INTEREST MARGIN
The Corporation's primary source of operating income is represented by the net
interest margin. The net interest margin is equal to the difference between the
amounts of interest income and interest expense. Tables II, III and IV include
information regarding the Corporation's net interest margin for 2003 and 2002.
In each of these tables, the amounts of interest income earned on tax-exempt
securities and loans have been adjusted to a fully taxable-equivalent basis.
Accordingly, the net interest margin amounts reflected in these tables exceed
the amounts presented in the consolidated financial statements. The discussion
that follows is based on amounts in the Tables.
The net interest margin, on a tax-equivalent basis, was $26,238,000 in 2003, an
increase of $958,000, or 3.8%, over 2002. As reflected in Table IV, the increase
in net interest margin was caused by the growth in volume. Increased interest
income from higher volumes of earning assets exceeded increases in interest
expense attributable to higher volumes of interest-bearing liabilities by
$3,306,000 in 2003 compared to 2002. Table IV also shows that interest rate
changes had the effect of decreasing net interest income $2,348,000 in 2003
compared to 2002. As presented in Table III, the "Interest Rate Spread" (excess
of average rate of return on interest-bearing assets over average cost of funds
on interest-bearing
11
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
liabilities) shrunk to 3.29% for the first 9 months of 2003, from 3.38% for the
year ended December 31, 2002 and 3.43% for the first 9 months of 2002.
INTEREST INCOME AND EARNING ASSETS
As indicated in Table II, interest income decreased slightly to $44,225,000 in
2003 from $45,016,000 in 2002. Income from available-for-sale securities
decreased $2,331,000, or 10.8% while interest from loans increased $1,590,000 or
6.8%. Overall, the majority of the increase in interest income resulted from
higher volumes of loans, which more than offset the effect of lower interest
rates.
As indicated in Table III, average available-for-sale securities in 2003
amounted to $476,096,000, an increase of 3.0% over 2002. In total,
available-for-sale securities grew because management was able to identify
opportunities to borrow funds and invest the proceeds in securities at a
positive spread in 2002. These opportunities were available because of the
"steep yield curve" (longer-term interest rates much higher than shorter-term
rates) that existed throughout most of 2002 and the first 9 months of 2003. The
average rate of return on available-for-sale securities was 5.42% for 2003,
considerably lower than the 6.26% level in 2002.
Table III also shows changes in the composition of the available-for-sale
securities portfolio. The average balance of U.S. Government agency securities
fell to 14% of the average balance of the total portfolio in 2003 from 17% in
the first 9 months of 2002. The average balance of mortgage-backed securities
has also fallen to 38% of the total portfolio in 2003 from 46% in the first 9
months of 2002. In 2002 and 2003, as a result of declining interest rates,
substantial amounts of U.S. Government agency securities were called. This rate
environment also led to increased prepayments on mortgage-backed securities. The
Corporation reinvested much of the proceeds in obligations of state and
political subdivisions (municipal bonds). Municipal bonds were a larger portion
of the portfolio in 2003 than in 2002. The average balance of municipal bonds
grew to $142,813,000, or 30% of the portfolio, in 2003 from $109,556,000, or 24%
of the portfolio, in the first 9 months of 2002. On a taxable equivalent basis,
municipal bonds are the highest yielding category of available-for-sale
security. The Corporation determines the levels of its municipal bond holdings
based on income tax planning and other considerations.
Other securities consist of corporate obligations, mainly "Trust Preferred
Securities" issued by financial institutions. Trust Preferred Securities are
long-term obligations (usually 20-40 year maturities, often callable at the
issuer's option after 5-10 years), which bear interest at fixed or variable
rates. The average balance of other securities increased to $55,284,000 in 2003
from $33,481,000 for the first 9 months of 2002, primarily as a result of
purchases of Trust Preferred Securities.
The average balance of gross loans increased 18.6% in 2003 over the first 9
months of 2002, to $475,830,000 from $401,302,000. The largest area of growth
was real estate secured loans, with substantial increases in both residential
and commercial mortgages. The average rate of return on loans fell to 6.99% in
2003 from 7.76% in the first 9 months of 2002, due to lower market rates. The
Corporation experienced a great deal of refinancing and rate modification
activity in 2002 and early 2003, which has negatively impacted loan yields, and
probably will result in loan yields that are low by historical standards for the
next few years.
INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES
Interest expense fell $1,749,000, or 8.9%, to $17,987,000 in 2003 from
$19,736,000 in 2002. Overall, the impact of lower interest rates was more than
the impact of higher volumes of interest-bearing liabilities in 2003 compared to
2002. In Table IV, you can see the impact of lower interest rates on the
Corporation's major categories of interest-bearing deposits - principally, CDs
and money market accounts. In contrast, interest expense on IRAs increased
$527,000 in 2003, to $3,858,000. In late 2002, the Corporation lowered the
minimum interest rate on IRAs from 5% to 3%; however, this change will not
affect most accounts until the second quarter 2004.
As you can calculate from Table III, total average deposits (interest-bearing
and noninterest-bearing) increased to $650,396,000 in the first 9 months of 2003
from $604,677,000 in the first 9 months of 2002. This represents an increase of
7.6%. Of the increase in average deposits, the largest growth categories were
money market accounts (growth in average balance of $20,136,000, or 11.9%) and
IRA's ($15,854,000, or 17.7%). Table III also reflects the downward trend in
interest rates incurred on liabilities, as the overall cost of funds on
interest-bearing liabilities fell to 2.90% for 2003, from 3.46% for the year
ended December 31, 2002 and 3.50% for 2002.
12
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
TABLE II - ANALYSIS OF INTEREST INCOME AND EXPENSE
NINE MONTHS ENDED
SEPTEMBER 30, INCREASE/
(IN THOUSANDS) 2003 2002 (DECREASE)
INTEREST INCOME
Available-for-sale securities:
U.S. Treasury securities $ -- $ 75 $ (75)
Securities of other U.S. Government agencies
and corporations 2,461 3,696 (1,235)
Mortgage-backed securities 5,717 8,768 (3,051)
Obligations of states and political subdivisions 7,952 6,266 1,686
Equity securities 797 805 (8)
Other securities 2,366 2,014 352
------- ------- -------
Total available-for-sale securities 19,293 21,624 (2,331)
------- ------- -------
Held-to-maturity securities:
U.S. Treasury securities 13 23 (10)
Securities of other U.S. Government agencies
and corporations 11 16 (5)
Mortgage-backed securities 3 6 (3)
------- ------- -------
Total held-to-maturity securities 27 45 (18)
------- ------- -------
Interest-bearing due from banks 8 18 (10)
Federal funds sold 8 30 (22)
Loans:
Real estate loans 20,212 18,830 1,382
Consumer 2,177 2,186 (9)
Agricultural 148 148 --
Commercial/industrial 1,463 1,440 23
Other 45 50 (5)
Political subdivisions 839 636 203
Leases 5 9 (4)
------- ------- -------
Total loans 24,889 23,299 1,590
------- ------- -------
Total Interest Income 44,225 45,016 (791)
------- ------- -------
INTEREST EXPENSE
Interest checking 207 330 (123)
Money market 2,113 3,008 (895)
Savings 355 380 (25)
Certificates of deposit 4,653 5,933 (1,280)
Individual Retirement Accounts 3,858 3,331 527
Other time deposits 15 26 (11)
Federal funds purchased 67 33 34
Other borrowed funds 6,719 6,695 24
------- ------- -------
Total Interest Expense 17,987 19,736 (1,749)
------- ------- -------
Net Interest Income $26,238 $25,280 $ 958
======= ======= =======
Note: Interest income from tax-exempt securities and loans has been adjusted to
a fully tax-equivalent basis, using the Corporation's marginal federal income
tax rate of 34%.
13
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
TABLE IIL - ANALYSIS OF AVERAGE DAILY BALANCES AND RATES
(DOLLARS IN THOUSANDS)
9 MONTHS YEAR 9 MONTHS
ENDED RATE OF ENDED RATE OF ENDED RATE OF
9/30/2003 RETURN/ 12/31/2002 RETURN/ 9/30/2002 RETURN/
AVERAGE COST OF AVERAGE COST OF AVERAGE COST OF
BALANCE FUNDS % BALANCE FUNDS % BALANCE FUNDS %
EARNING ASSETS
Available-for-sale securities, at amortized cost:
U.S. Treasury securities $ - 0.00% $ 1,241 6.04% $ 1,659 6.04%
Securities of other U.S. Government agencies and
corporations 68,743 4.79% 75,646 6.25% 77,348 6.39%
Mortgage-backed securities 181,935 4.20% 209,539 5.30% 213,752 5.48%
Obligations of states and political subdivisions 142,813 7.44% 113,540 7.61% 109,556 7.65%
Equity securities 27,321 3.90% 21,858 5.25% 21,307 5.05%
Other securities 55,284 5.72% 43,826 6.79% 38,481 7.00%
---------- ---- --------- ---- --------- ----
Total available-for-sale securities 476,096 5.42% 465,650 6.16% 462,103 6.26%
---------- ---- --------- ---- --------- ----
Held-to-maturity securities:
U.S. Treasury securities 320 5.43% 511 5.28% 566 5.43%
Securities of other U.S. Government agencies and
corporations 226 6.51% 331 6.04% 342 6.25%
Mortgage-backed securities 71 5.65% 131 6.87% 142 5.65%
---------- ---- --------- ---- --------- ----
Total held-to-maturity securities 617 5.85% 973 5.76% 1,050 5.73%
---------- ---- --------- ---- --------- ----
Interest-bearing due from banks 1,463 0.73% 1,444 1.18% 1,513 1.59%
Federal funds sold 890 1.20% 2,698 1.56% 2,455 1.63%
Loans:
Real estate loans 390,911 6.91% 338,133 7.53% 329,870 7.63%
Consumer 32,090 9.07% 29,720 10.01% 29,286 9.98%
Agricultural 2,859 6.92% 2,556 7.79% 2,520 7.85%
Commercial/industrial 32,720 5.98% 28,182 6.86% 27,765 6.93%
Other 904 6.66% 1,028 6.71% 982 6.81%
Political subdivisions 16,265 6.90% 10,929 7.85% 10,751 7.91%
Leases 81 8.25% 122 9.02% 128 9.40%
---------- ---- --------- ---- --------- ----
Total loans 475,830 6.99% 410,670 7.67% 401,302 7.76%
---------- ---- --------- ---- --------- ----
Total Earning Assets 954,896 6.19% 881,435 6.84% 868,423 6.93%
Cash 13,345 13,318 13,531
Unrealized gain/loss on securities 20,666 12,462 10,703
Allowance for loan losses (5,877) (5,453) (5,386)
Bank premises and equipment 10,696 10,246 10,218
Other assets 35,912 30,993 31,591
---------- ---- --------- ---- ---------
Total Assets $1,029,638 $ 943,001 $ 929,080
========== ==== ========= ==== =========
INTEREST-BEARING LIABILITIES
Interest checking $ 37,675 0.73% $ 37,984 1.12% $ 37,934 1.16%
Money market 189,751 1.49% 171,767 2.31% 169,615 2.37%
Savings 54,523 0.87% 49,779 1.01% 49,735 1.02%
Certificates of deposit 192,405 3.23% 195,099 3.97% 193,322 4.10%
Individual Retirement Accounts 105,198 4.90% 90,856 4.96% 89,344 4.98%
Other time deposits 1,941 1.03% 1,814 1.98% 2,112 1.65%
Federal funds purchased 6,778 1.32% 2,347 1.87% 2,255 1.96%
Other borrowed funds 239,758 3.75% 211,092 4.29% 208,785 4.29%
---------- ---- --------- ---- --------- ----
Total Interest-bearing Liabilities 828,029 2.90% 760,738 3.46% 753,102 3.50%
Demand deposits 68,903 66,093 62,615
Other liabilities 11,506 8,575 8,055
---------- ---- --------- ---- --------- ----
Total Liabilities 908,438 835,406 823,772
---------- ---- --------- ---- --------- ----
Stockholders' equity, excluding other comprehensive
income/loss 107,561 99,361 98,239
Other comprehensive income/loss 13,639 8,234 7,069
---------- ---- --------- ---- --------- ----
Total Stockholders' Equity 121,200 107,595 105,308
---------- ---- --------- ---- --------- ----
Total Liabilities and Stockholders' Equity $1,029,638 $ 943,001 $ 929,080
========== ==== ========= ==== ========= ====
Interest Rate Spread 3.29% 3.38% 3.43%
Net Interest Income/Earning Assets 3.67% 3.85% 3.91%
(1) Rates of return on tax-exempt securities and loans are presented on a fully
taxable-equivalent basis. (2) Nonaccrual loans have been included with loans for
the purpose of analyzing net interest earnings.
14
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
TABLE IV - ANALYSIS OF VOLUME AND RATE CHANGES
(IN THOUSANDS) 9 MONTHS ENDED 9/30/03 VS. 9/30/02
CHANGE IN CHANGE IN TOTAL
VOLUME RATE CHANGE
EARNING ASSETS
Available-for-sale securities:
U.S. Treasury securities $ (38) $ (37) $ (75)
Securities of other U.S. Government agencies
and corporations (379) (856) (1,235)
Mortgage-backed securities (1,186) (1,865) (3,051)
Obligations of states and political subdivisions 1,856 (170) 1,686
Equity securities 198 (206) (8)
Other securities 766 (414) 352
------- ------- -------
Total available-for-sale securities 1,217 (3,548) (2,331)
------- ------- -------
Held-to-maturity securities:
U.S. Treasury securities (10) -- (10)
Securities of other U.S. Government agencies
and corporations (6) 1 (5)
Mortgage-backed securities (3) -- (3)
------- ------- -------
Total held-to-maturity securities (19) 1 (18)
------- ------- -------
Interest-bearing due from banks (1) (9) (10)
Federal funds sold (15) (7) (22)
Loans:
Real estate loans 3,267 (1,885) 1,382
Consumer 199 (208) (9)
Agricultural 19 (19) --
Commercial/industrial 237 (214) 23
Other (4) (1) (5)
Political subdivisions 292 (89) 203
Leases (3) (1) (4)
------- ------- -------
Total loans 4,007 (2,417) 1,590
------- ------- -------
Total Interest Income 5,189 (5,980) (791)
------- ------- -------
INTEREST-BEARING LIABILITIES
Interest checking (2) (121) (123)
Money market 325 (1,220) (895)
Savings 35 (60) (25)
Certificates of deposit (28) (1,252) (1,280)
Individual Retirement Accounts 582 (55) 527
Other time deposits (2) (9) (11)
Federal funds purchased 48 (14) 34
Other borrowed funds 925 (901) 24
------- ------- -------
Total Interest Expense 1,883 (3,632) (1,749)
------- ------- -------
Net Interest Income $ 3,306 $(2,348) $ 958
======= ======= =======
(1) Changes in income on tax-exempt securities and loans is presented on a fully
taxable-equivalent basis, using the Corporation's marginal federal income tax
rate of 34%.
(2) The change in interest due to both volume and rates has been allocated to
volume and rate changes in proportion to the relationship of the absolute dollar
amount of the change in each.
15
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
TABLE V - COMPARISON OF NONINTEREST INCOME
(IN THOUSANDS) 9 MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2003 2002
Service charges on deposit accounts $1,307 $1,260
Service charges and fees 210 194
Trust and financial management revenue 1,258 1,358
Insurance commissions, fees and premiums 220 448
Increase in cash surrender value of life insurance 552 648
Fees related to credit card operation 564 450
Other operating income 762 652
------ ------
Total other operating income, before realized
gains on securities, net 4,873 5,010
Realized gains on securities, net 3,289 2,496
------ ------
Total Other Income $8,162 $7,506
====== ======
Total noninterest income increased $656,000, or 8.7%, in 2003 compared to 2002.
The most significant change - the increase in net realized security gains - is
discussed in the "Earnings Overview" section of Management's Discussion and
Analysis. Other items of significance are as follows:
- - Trust and financial management revenue decreased $100,000, or 7.4%, for 2003
versus 2002. Trust and financial management revenue is affected
significantly by the market value of assets under management. Throughout
approximately the first 5 months of 2003, depressed equity market values
reduced the market value of assets under management. However, in the second
quarter and during the third quarter 2003, equity market prices rallied and
as of September 30, 2003, the value of trust assets under management
increased to $307,623,000, or 13.8% higher than September 30, 2002.
- - Insurance commissions and fees dropped $228,000, or 50.9%, for 2003 compared
to 2002. The decrease in insurance-related revenues had 2 components: (1) a
decrease in revenues of $173,000 from Bucktail Life Insurance Company
("Bucktail"), a subsidiary of the Corporation that reinsures credit and
mortgage life and accident and health insurance, and (2) a decrease in
revenues of $55,000 from the insurance division of C & N Financial Services
Corporation ("C&NFSC"). The decrease in Bucktail revenues is mainly
attributed to timing items which are not expected to be indicative of a
long-term decline. The chief reason for the decline in Bucktail revenues is
the implementation of credit insurance changes to comply with the Home
Owners Equity Protection Act (HOEPA) that became effective October 1, 2002.
Under HOEPA, it is necessary to provide insurance protection on an
outstanding daily balance method, rather than on a single premium basis.
C&NFSC, a subsidiary of Citizens & Northern Bank, began its insurance agency
operations in 2000, with limited activity to date. C&NFSC insurance revenues
amounted to $85,000 in 2003 and $140,000 in 2002. Management continues to
explore opportunities to expand insurance related revenues.
- - The increase in cash surrender value of life insurance fell $96,000 to
$552,000 in 2003 from $648,000 in 2002. The Corporation's policy return is
determined, in part, by the amount of earnings generated from a pooled
separate investment trust held by the life insurance company. In 2003,
earnings on that pooled separate trust fund have been lower than in 2002,
which is reflective of lower market yields on debt securities.
- - Credit card fee income has increased mainly due to the formation of a
"Reward Card Program" which pays users a rebate for using their credit card.
This program was started in April of 2003 and has had the desired effect of
raising card usage. This, along with an increased rate on interchange fees,
has raised overall credit card fees 25.3% in 2003.
- - Other operating income has increased 16.9% due mainly to an increase of
$38,000 in gains from the sales of other real estate and from the receipt of
a grant of $33,000 for staff training.
16
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
TABLE VI- COMPARISON OF NONINTEREST EXPENSE
(IN THOUSANDS) 9 MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2003 2002
Salaries and wages $ 7,129 $ 7,056
Pensions and other employee benefits 2,437 1,975
Occupancy expense, net 967 815
Furniture and equipment expense 1,029 1,199
Pennsylvania shares tax 588 550
Other operating expense 4,074 4,069
------- -------
Total Other Expense $16,224 $15,664
======= =======
Salaries and wages increased $73,000, or 1.0%, for 2003 compared to 2002. The
increase is mainly the result of annual merit raises, generally ranging from
2%-5%, and an increase in number of employees. Included in salaries and wages
expense is an estimate of incentive bonuses. The incentive bonus plan provides
for compensation to be paid to certain key officers, with the payment amounts
based on a combination of personal and corporate performance. The estimate of
such expense for 2003 decreased $349,000 from the accrual recorded for 2002.
Excluding incentive bonus expense, salaries and wages increased 6.3% in 2003
over 2002.
Pensions and other employee benefits increased $462,000, or 23.4%, in 2003 over
2002. A portion of this increase is directly related to the increase in salaries
and wages. Also, pension expense from the Corporation's defined benefit pension
plan increased $190,000 in 2003 over 2002. Although the defined benefit pension
plan remains adequately funded, a decline in the market value of plan assets,
along with an increased number of covered employees, contributed to the increase
in expense in 2003. Group health insurance expense increased $80,000 in 2003,
mainly due to increases in rates.
Occupancy expense increased $152,000, or 18.7%, in 2003 over 2002. The greatest
portion of the increase in occupancy expense is attributable to increased costs
of $43,000 for building maintenance and repairs. Depreciation expense also rose
$33,000 from last year's level, insurance premiums increased over $25,000 and
total energy costs increased nearly $24,000.
Furniture and equipment expense decreased $170,000, or 14.2%, in 2003 compared
to 2002. The largest decrease within this category was in depreciation expense,
which decreased $188,000 or 25.9%. There were several substantial capital
expenditures, which became fully depreciated in 2002, reducing the expense for
the first 9 months of 2003.
FINANCIAL CONDITION
Significant changes in the average balances of the Corporation's earning assets
and interest-bearing liabilities are described in the "Net Interest Margin"
section of Management's Discussion and Analysis. Table VII provides a summary of
investment securities held at September 30, 2003 and December 31, 2002. As
reflected in Table VII, the carrying value (fair value) of available-for-sale
securities fell to $482,064,000 at September 30, 2003 from $512,175,000 at
December 31, 2002. Much of the reduction was caused by rapid principal payments
on mortgage-backed securities, due to declining interest rates. The allowance
for loan losses and stockholders' equity are discussed in separate sections of
Management's Discussion and Analysis.
17
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
TABLE VII - INVESTMENT SECURITIES
(In Thousands)
SEPTEMBER 30, 2003 DECEMBER 31, 2002
AMORTIZED FAIR AMORTIZED FAIR
COST VALUE COST VALUE
AVAILABLE-FOR-SALE SECURITIES:
Obligations of other U.S. Government agencies $ 63,331 $ 63,399 $ 71,657 $ 72,348
Obligations of states and political subdivisions 156,399 158,189 127,690 130,879
Other securities 47,784 49,833 62,296 63,592
Mortgage-backed securities 166,559 168,529 207,244 212,276
-------- -------- -------- --------
Total debt securities 434,073 439,950 468,887 479,095
Marketable equity securities 30,584 42,114 24,886 33,080
-------- -------- -------- --------
Total $464,657 $482,064 $493,773 $512,175
======== ======== ======== ========
HELD-TO-MATURITY SECURITIES:
Obligations of the U.S. Treasury $ 320 $ 356 $ 321 $ 359
Obligations of other U.S. Government agencies 197 218 297 322
Mortgage-backed securities 48 50 89 93
-------- -------- -------- --------
Total $ 565 $ 624 $ 707 $ 774
======== ======== ======== ========
CASH FLOWS
The consolidated statement of cash flows depicts the Corporation's sources and
uses of cash. In 2003, net cash provided by operating activities totaled
$13,676,000, up from $11,638,000 in 2002.
Other major sources or uses of cash are changes in available-for-sale
securities, loans, deposits and borrowings. In 2003, a significant source of
cash was from available-for-sale securities, for which sales, calls and
maturities exceeded purchases by $31,281,000. Also in 2003, deposits increased
$12,424,000 and short-term and long-term borrowings increased (net) $10,014,000.
These sources of cash helped fund loan growth, as the net increase in loans, as
presented in the consolidated statement of cash flows, was $55,671,000. In 2002,
the net increases in deposits of $60,205,000 and short-term and long-term
borrowings of $35,755,000 helped fund growth in available-for-sale securities
(excess of purchases over proceeds from sales, calls or maturities) of
$48,214,000 and loans of $52,428,000.
PROVISION AND ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses includes two components, allocated and
unallocated. The allocated component of the allowance for loan losses reflects
probable losses resulting from the analysis of individual loans and historical
loss experience, as modified for identified trends and concerns, for each loan
category. The historical loan loss experience element is determined based on the
ratio of net charge-offs to average loan balances over a five-year period, for
each significant type of loan, modified for risk adjustment factors identified
by management for each type of loan. The charge-off ratio is then applied to the
current outstanding loan balance for each type of loan (net of other loans that
are individually evaluated).
The unallocated portion of the allowance is determined based on management's
assessment of general economic conditions as well as specific economic factors
in the market area. This determination inherently involves a higher degree of
uncertainty and considers current risk factors that may not have yet manifested
themselves in the Bank's historical loss factors used to determine the allocated
component of the allowance, and it recognizes that management's knowledge of
specific losses within the portfolio may be incomplete.
The allowance for loan losses was $5,898,000 at September 30, 2003, an increase
of $109,000 from the balance at December 31, 2002. As you can see in Table VIII,
net charge-offs totaled $741,000 in the first nine months of 2003, which is
relatively high compared to the amounts of net charge-offs in each of the prior
5 years. Net charge-offs for 2003 included $212,000 in the third quarter,
$83,000 in the second quarter and $446,000 in the first quarter. Most of the
18
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
charge-off amounts for the first quarter 2003 were from loans that had been
identified as impaired in 2002, and for which an appropriate allowance had been
provided in 2002.
Table IX presents a summary of the allocated allowance by loan type, as well as
the unallocated portion of the allowance. The allowance for impaired loans was
$1,526,000 at September 30, 2003, as compared to $1,362,000 at June 30, 2003 and
$1,877,000 at December 31, 2002. The allowance for impaired loans is adjusted
based on management's assessment of individual loans. Table IX also shows that
the unallocated portion of the allowance was $1,998,000 at September 30, 2003,
down from the unallocated allowance balance of $2,219,000 at June 30, 2003, but
still higher than the unallocated allowance of $1,759,000 at December 31, 2002.
Management has maintained a higher unallocated allowance throughout most of
2003, as compared to the end of 2002, because of concerns related to the high
level of charge-offs in 2003.
The provision for loan losses increased to $850,000 in the nine months ended
September 30, 2003 from $640,000 in 2002. The amount of the provision in each
period is determined based on the amount required to maintain an appropriate
allowance in light of the factors described above. In 2003, the higher provision
for loan losses resulted, in part, from the increase in the unallocated portion
of the allowance.
Tables VIII, IX and X present an analysis of the allowance for loan losses, the
allocation of the allowance and a five-year summary of loans by type.
TABLE VIII- ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
(IN THOUSANDS)
9 MONTHS 9 MONTHS
ENDED ENDED
SEPT. 30, SEPT. 30, YEARS ENDED DECEMBER 31,
2003 2002 2002 2001 2000 1999 1998
Balance, beginning of year $5,789 $5,265 $5,265 $5,291 $5,131 $4,820 $4,913
------ ------ ------ ------ ------ ------ ------
Charge-offs:
Real estate loans 162 102 123 144 272 81 257
Installment loans 299 100 116 138 77 138 144
Credit cards and related plans 137 156 190 200 214 192 264
Commercial and other loans 303 123 123 231 53 219 301
------ ------ ------ ------ ------ ------ ------
Total charge-offs 901 481 552 713 616 630 966
------ ------ ------ ------ ------ ------ ------
Recoveries:
Real estate loans 69 17 30 6 26 81 12
Installment loans 46 26 30 27 23 60 43
Credit cards and related plans 14 14 18 20 28 30 40
Commercial and other loans 31 14 58 34 23 10 15
------ ------ ------ ------ ------ ------ ------
Total recoveries 160 71 136 87 100 181 110
------ ------ ------ ------ ------ ------ ------
Net charge-offs 741 410 416 626 516 449 856
Provision for loan losses 850 640 940 600 676 760 763
------ ------ ------ ------ ------ ------ ------
Balance, end of period $5,898 $5,495 $5,789 $5,265 $5,291 $5,131 $4,820
====== ====== ====== ====== ====== ====== ======
19
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
TABLE IX - ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES BY TYPE
(IN THOUSANDS)
AS OF AS OF
SEPT. 30, JUNE 30, AS OF DECEMBER 31:
2003 2003 2002 2001 2000 1999 1998
Commercial $1,495 $1,434 $1,315 $1,837 $1,612 $2,081 $ 650
Consumer mortgage 512 488 460 674 952 834 97
Impaired loans 1,526 1,362 1,877 83 273 609 290
Consumer 367 357 378 494 471 437 702
All other commitments -- -- -- -- -- 150 202
Unallocated 1,998 2,219 1,759 2,187 1,983 1,020 2,879
------ ------ ------ ------ ------ ------ ------
Total Allowance $5,898 $5,860 $5,789 $5,265 $5,291 $5,131 $4,820
====== ====== ====== ====== ====== ====== ======
TABLE X - SUMMARY OF LOANS BY TYPE
(IN THOUSANDS)
AS OF
SEPT. 30, AS OF DECEMBER 31,
2003 2002 2001 2000 1999 1998
Real estate - construction $ 1,159 $ 103 $ 1,814 $ 452 $ 649 $ 1,004
Real estate - mortgage 414,592 370,453 306,264 263,325 247,604 230,815
Consumer 32,824 31,532 29,284 28,141 29,140 30,924
Agricultural 3,167 3,024 2,344 1,983 1,899 1,930
Commercial 34,722 30,874 24,696 20,776 18,050 17,630
Other 1,290 2,001 1,195 948 1,025 1,062
Political subdivisions 18,076 13,062 13,479 12,462 12,332 7,449
Lease receivables 73 96 152 218 222 218
--------- -------- --------- --------- --------- ---------
Total 505,903 451,145 379,228 328,305 310,921 291,032
Less: unearned discount -- -- -- -- (29) (29)
--------- -------- --------- --------- --------- ---------
505,903 451,145 379,228 328,305 310,892 291,003
Less: allowance for loan
losses (5,898) (5,789) (5,265) (5,291) (5,131) (4,820)
--------- -------- --------- --------- --------- ---------
Loans, net $ 500,005 $ 445,356 $ 373,963 $ 323,014 $ 305,761 $ 286,183
========= ========= ========= ========= ========= =========
DERIVATIVE FINANCIAL INSTRUMENTS
The Corporation utilizes derivative financial instruments related to a
certificate of deposit product called the "Index Powered Certificate of Deposit"
(IPCD). IPCDs have a term of 5 years, with interest paid at maturity based on
90% of the appreciation (as defined) in the S&P 500 index. There is no
guaranteed interest payable to a depositor of an IPCD - however, assuming an
IPCD is held to maturity, a depositor is guaranteed the return of his or her
principal, at a minimum.
Statement of Financial Accounting Standards No. 133 requires the Corporation to
separate the amount received from each IPCD issued into 2 components: (1) an
embedded derivative, and (2) the principal amount of each deposit. Embedded
derivatives are derived from the Corporation's obligation to pay each IPCD
depositor a return based on appreciation in the S&P 500 index. Embedded
derivatives are carried at fair value, and are included in other liabilities in
the consolidated balance sheet. Changes in fair value of the embedded derivative
are included in other expense in the consolidated income statement. The
difference between the contractual amount of each IPCD issued, and the amount of
the embedded derivative, is recorded as the initial deposit (included in
interest-bearing deposits in the consolidated balance sheet). Interest expense
is added to principal ratably over the term of each IPCD at an effective
interest rate that will increase the principal balance to equal the contractual
IPCD amount at maturity.
20
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
In connection with IPCD transactions, the Corporation has entered into Equity
Indexed Call Option (Swap) contracts with the Federal Home Loan Bank of
Pittsburgh (FHLB-Pittsburgh). Under the terms of the Swap contracts, the
Corporation must pay FHLB-Pittsburgh quarterly amounts calculated based on the
contractual amount of IPCDs issued times a negotiated rate. In return,
FHLB-Pittsburgh is obligated to pay the Corporation, at the time of maturity of
the IPCDs, an amount equal to 90% of the appreciation (as defined) in the S&P
500 index. If the S&P 500 index does not appreciate over the term of the related
IPCDs, the FHLB-Pittsburgh would make no payment to the Corporation. The effect
of the Swap contracts is to limit the Corporation's cost of IPCD funds to the
market rate of interest paid to FHLB-Pittsburgh. (In addition, the Corporation
pays a fee of 0.75% to a consulting firm at inception of each deposit. This fee
is amortized to interest expense over the term of the IPCDs.) Swap liabilities
are carried at fair value, and included in other liabilities in the consolidated
balance sheet. Changes in fair value of swap liabilities are included in other
expense in the consolidated income statement.
Amounts recorded as of September 30, 2003 and December 31, 2002, and for 2003
and 2002, related to IPCDs are as follows (in thousands):
SEPT. 30, DEC. 31,
2003 2002
Contractual amount of IPCDs (equal
to notional amount of Swap contracts) $ 3,408 $ 3,028
Carrying value of IPCDs 2,977 2,572
Carrying value of embedded derivative liabilities 214 156
Carrying value of Swap contract liabilities 222 309
9 MONTHS ENDED 9 MONTHS ENDED
SEPT. 30, SEPT. 30,
2003 2002
Interest expense $ 89 $ 61
Other expense 8 1
LIQUIDITY
Liquidity is the ability to quickly raise cash at a reasonable cost. An adequate
liquidity position permits the Corporation to pay creditors, compensate for
unforeseen deposit fluctuations and fund unexpected loan demand. The Corporation
maintains overnight borrowing facilities with several correspondent banks that
provide a source of day-to-day liquidity. Also, the Corporation maintains
borrowing facilities with the Federal Home Loan Bank of Pittsburgh, secured by
mortgage loans and various investment securities. At September 30, 2003, the
Corporation had unused borrowing availability with correspondent banks and the
Federal Home Loan Bank of Pittsburgh totaling approximately $174,095,000.
Additionally, the Corporation uses repurchase agreements placed with brokers to
borrow funds secured by investment assets, and uses "RepoSweep" arrangements to
borrow funds from commercial banking customers on an overnight basis.
On a longer-term basis, one of the tools used to measure liquidity is the loan
to deposit ratio. As of September 30, 2003, this ratio was 74%, which (by
banking industry standards) is a relatively low ratio (which indicates a
relatively high level of liquidity). This low loan to deposit ratio permits the
Corporation to utilize "excess" funds to purchase investment securities. If
required to raise cash in an emergency situation, the Corporation could sell
non-pledged investment securities to meet its obligations.
Management believes the combination of its strong capital position (discussed in
the next section), ample available borrowing facilities and low loan to deposit
ratio have placed the Corporation in a position of minimal short-term and
long-term liquidity risk.
21
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
STOCKHOLDERS' EQUITY AND CAPITAL ADEQUACY
The Corporation and the Bank are subject to various regulatory capital
requirements administered by the federal banking agencies. For many years, the
Corporation and the Bank have maintained strong capital positions. The following
table presents consolidated capital ratios at September 30, 2003:
TABLE X - CAPITAL RATIOS
9/30/2003
CITIZENS & REGULATORY STANDARDS:
NORTHERN
CORPORATION WELL MINIMUM
(ACTUAL) CAPITALIZED STANDARD
- --------------------------------------------------------------------------------
Total capital to risk-weighted assets 20.55% 10% 8%
Tier 1 capital to risk-weighted assets 18.68% 6% 4%
Tier 1 capital to average total assets 10.74% 5% 4%
Management expects the Corporation and the Bank to maintain capital levels that
exceed the regulatory standards for well-capitalized institutions for the next
12 months and for the foreseeable future. Planned capital expenditures during
the next 12 months are not expected to have a detrimental effect on capital
ratios or results of operations.
INFLATION
Over the last several years, direct inflationary pressures on the Corporation's
payroll-related and other noninterest costs have been modest. In fact, some
economists have warned of the risk of deflationary pressures. The Corporation is
significantly affected by the Federal Reserve Board's efforts to control
inflation through changes in interest rates. Management monitors the impact of
economic trends, including any indicators of inflationary or deflationary
pressure, in managing interest rate and other financial risks.
PART I - FINANCIAL INFORMATION (CONTINUED)
ITEM 3. INTEREST RATE RISK AND MARKET RISK
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
- ------------------------------------------------------------------
MARKET RISK
The Corporation's two major categories of market risk, interest rate and equity
securities risk, are discussed in the following sections.
INTEREST RATE RISK
Business risk arising from changes in interest rates is a significant factor in
operating a bank. The Corporation's assets are predominantly long-term, fixed
rate loans and debt securities. Funding for these assets comes principally from
short-term deposits and borrowed funds. Accordingly, there is an inherent risk
of lower future earnings or decline in fair value of the Corporation's financial
instruments when interest rates change.
The Bank uses a simulation model to calculate the potential effects of interest
rate fluctuations on net interest income and the market value of portfolio
equity. Only assets and liabilities of the Bank are included in management's
monthly simulation model calculations. Since the Bank makes up more than 90% of
the Corporation's total assets and liabilities, and because the Bank is the
source of the most volatile interest rate risk, management does not consider it
necessary to run the model for the remaining entities within the consolidated
group. For purposes of these calculations, the market value of portfolio equity
includes the fair values of financial instruments, such as securities, loans,
deposits and borrowed funds, and the book values of nonfinancial assets and
liabilities, such as premises and equipment and accrued expenses. The model
measures and projects potential changes in net interest income, and calculates
the discounted present value of anticipated cash flows of financial instruments,
assuming an immediate increase or decrease in interest rates. Management
ordinarily runs a variety of scenarios within a range of plus or minus 50-300
basis points of current rates.
22
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
The Bank's Board of Directors has established policy guidelines for acceptable
levels of interest rate risk, based on an immediate increase or decrease in
interest rates of 200 basis points. The policy limit for fluctuation in net
interest income is minus 20% from the baseline one-year scenario. The policy
limit for market value variance is minus 30% from the baseline one-year
scenario. As Table XII shows, as of September 30, 2003, the Bank's net interest
income calculations show a decrease of 1.4% in the +200 basis point scenario and
a decrease of 4.2% in the -200 basis point scenario. Both of these levels are
well within the policy threshold. However, if interest rates were to immediately
increase 200 basis points, the Bank's calculations based on the model show that
the market value of portfolio equity would decrease 38.2%, which exceeds the
policy threshold and is indicative of a long-term sensitivity to rising rates.
In the fourth quarter 2003, management will evaluate whether to restructure the
securities portfolio or make other changes to asset or liability holdings in an
effort to reduce exposure to decline in market value in a rising interest rate
environment.
The table that follows was prepared using the simulation model described above.
The model makes estimates, at each level of interest rate change, regarding cash
flows from principal repayments on loans and mortgage-backed securities and call
activity on other investment securities. Actual results could vary significantly
from these estimates, which could result in significant differences in the
calculations of projected changes in net interest margin and market value of
portfolio equity. Also, the model does not make estimates related to changes in
the composition of the deposit portfolio that could occur due to rate
competition and the table does not necessarily reflect changes that management
would make to realign the portfolio as a result of changes in interest rates.
TABLE XII - THE EFFECT OF HYPOTHETICAL CHANGES IN INTEREST RATES
PERIOD ENDING SEPTEMBER 30, 2004
(IN THOUSANDS)
SEPTEMBER 30, 2003 DATA
CURRENT PLUS 200 MINUS 200
INTEREST BASIS BASIS
RATES POINTS POINTS
SCENARIO AMOUNT % CHANGE AMOUNT % CHANGE
Interest income $ 53,215 $ 57,589 $ 47,767
Interest expense 20,716 25,556 16,619
- ------------------------------------------------------------------------------- ---------------
Net Interest Income $ 32,499 $ 32,033 -1.4% $ 31,148 -4.2%
====================================================================================================================
Market Value of Portfolio Equity at Sept. 30, 2003 $111,598 $ 68,949 -38.2% $ 141,401 26.7%
====================================================================================================================
PERIOD ENDING DECEMBER 31, 2003
(IN THOUSANDS)
DECEMBER 31, 2002 DATA
CURRENT PLUS 200 MINUS 200
INTEREST BASIS BASIS
RATES POINTS POINTS
SCENARIO AMOUNT % CHANGE AMOUNT % CHANGE
Interest income $ 54,989 $ 59,608 $ 49,607
Interest expense 24,132 29,320 19,083
- ------------------------------------------------------------------------------ ---------------
Net Interest Income $ 30,857 $ 30,288 -1.8% $ 30,524 -1.1%
====================================================================================================================
Market Value of Portfolio Equity at Dec. 31, 2002 $108,144 $ 71,117 -34.2% $ 130,764 20.9%
====================================================================================================================
EQUITY SECURITIES RISK
The Corporation's equity securities portfolio consists primarily of investments
in stock of banks and bank holding companies located mainly in Pennsylvania. The
Corporation also owns some other stocks and mutual funds.
Investments in bank stocks are subject to the risk factors that affect the
banking industry in general, including competition from nonbank entities, credit
risk, interest rate risk and other factors, which could result in a decline in
market prices. Also,
23
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
losses could occur in individual stocks held by the Corporation because of
specific circumstances related to each bank. Further, because of the
concentration of bank and bank holding companies located in Pennsylvania, these
investments could decline in market value if there is a downturn in the state's
economy.
Equity securities held as of September 30, 2003 and December 31, 2002 are
presented in Table XIII.
TABLE XIII - EQUITY SECURITIES
(IN THOUSANDS) HYPOTHETICAL HYPOTHETICAL
10% 20%
DECLINE IN DECLINE IN
FAIR MARKET MARKET
AT SEPTEMBER 30, 2003 COST VALUE VALUE VALUE
Banks and bank holding companies $ 16,975 $ 28,805 $ (2,881) $ (5,761)
Other equity securities 13,609 13,308 (1,331) (2,662)
- -----------------------------------------------------------------------------------------------------
Total $ 30,584 $ 42,113 $ (4,212) $ (8,423)
=====================================================================================================
HYPOTHETICAL HYPOTHETICAL
10% 20%
DECLINE IN DECLINE IN
FAIR MARKET MARKET
AT DECEMBER 31, 2002 COST VALUE VALUE VALUE
Banks and bank holding companies $ 16,336 $ 24,511 $ (2,451) $ (4,902)
Other equity securities 8,550 8,569 (857) (1,714)
- -----------------------------------------------------------------------------------------------------
Total $ 24,886 $ 33,080 $ (3,308) $ (6,616)
=====================================================================================================
PART I - FINANCIAL INFORMATION (CONTINUED)
ITEM 4. CONTROLS AND PROCEDURES
The Corporation's Chief Executive Officer and Chief Financial Officer carried
out an evaluation of the design and effectiveness of the Corporation's
disclosure controls and procedures pursuant to Rule 13a-15(e) and Rule 15d-15(e)
of the Securities Exchange Act of 1934 as of the end of the period covered by
this report. Based upon that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that the Corporation's disclosure controls and
procedures are effective to ensure that information required to be disclosed in
reports the Corporation files or submits under the Securities Exchange Act of
1934 is recorded, processed, summarized and reported, within the time periods
specified in the Securities and Exchange Commission's rules and forms.
There were no significant changes in the Corporation's internal control over
financial reporting that occurred during the period covered by this report that
has materially affected, or that is reasonably likely to materially affect, our
internal control over financial reporting.
24
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
The Corporation and the Bank are involved in various legal
proceedings incidental to their business. Management believes the
aggregate liability, if any, resulting from such pending and
threatened legal proceedings will not have a material, adverse effect
on the Corporation's financial condition or results of operations.
Item 2. Not Applicable
Item 3. Not Applicable
Item 4. Not Applicable
Item 5. Other Information
a. None
Item 6. Exhibits and Reports on Form 8 - K
a. Exhibits:
Page
----
Exhibit 31.1 Certification Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002 - Chief Executive Officer 27
Exhibit 31.2 Certification Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002 - Chief Financial Officer 28
Exhibit 32 Certification Pursuant to 18 U.S.C. Section 1350 as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 29
b. A Current Report on Form 8-K under Item 12, dated July 10, 2003, was
furnished to report the Corporation's consolidated earnings results for
the second quarter 2003.
25
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q
Signature Page
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
CITIZENS & NORTHERN CORPORATION
November 13, 2003 By: Craig G. Litchfield /s/
- ----------------- -----------------------
Date Chairman, President and Chief
Executive Officer
November 13, 2003 By: Mark A. Hughes /s/
- ----------------- ------------------
Date Treasurer and Chief Financial Officer
26