SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 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: JUNE 30, 2004
Or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ________ to _________
COMMISSION FILE NO: 0-18833
CHESTER VALLEY BANCORP INC.
---------------------------
(Exact name of registrant as specified in its charter)
PENNSYLVANIA 23-2598554
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
100 E. Lancaster Ave., Downingtown PA 19335
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(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (610) 269-9700
Securities registered pursuant to Section 12(b) of the Act:
NOT APPLICABLE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $1.00 PAR VALUE 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 check mark if 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 amendments to
this Form 10-K. X
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Indicate by check mark whether registrant is an accelerated filer as defined in
Exchange Act Rule 12b-2. YES X NO
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As of September 3, 2004, the aggregate value of the 4,878,515 shares of Common
Stock of the registrant which were issued and outstanding on such date,
excluding 464,122 shares held by all directors and officers of the registrant as
a group, was approximately $92.1 million. This figure is based on the closing
sales price of $20.86 per share of the registrant's Common Stock on September 3,
2004.
Number of shares of Common Stock outstanding as of September 3, 2004: 4,878,515
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Definitive Proxy Statement for the 2004 annual meeting of
shareholders are incorporated into Part III, Items 10-13 of this Form 10-K.
INDEX
PAGE
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PART I
Item 1. Business............................................................... 1
Item 2. Properties............................................................. 31
Item 3. Legal Proceedings...................................................... 33
Item 4. Submission of Matters to a Vote of Security Holders.................... 33
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters................................................................ 33
Item 6. Selected Financial Data................................................ 34
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations.................................................. 35
Item 7A. Quantitative and Qualitative Disclosures About Market Risk............. 48
Item 8. Financial Statements and Supplementary Data............................ 50
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure............................................... 81
Item 9a. Controls and Procedures................................................ 81
PART III
Item 10. Directors and Executive Officers of the Registrant..................... 81
Item 11. Executive Compensation................................................. 81
Item 12. Security Ownership of Certain Beneficial Owners and Management......... 81
Item 13. Certain Relationships and Related Transactions......................... 81
PART IV
Item 14. Principal Accountants Fees and Services................................ 82
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K....... 83
Signatures ....................................................................... 85
FORWARD LOOKING STATEMENTS
In this Annual Report on Form 10-K (the "Form-10-K"), the Company has
included certain "forward looking statements", either express or implied, which
concern anticipated future operations of the Company. It is management's desire
to take advantage of the "safe harbor" provisions of the Private Securities
Litigation Reform Act of 1995. This statement is for the express purpose of
availing the Company of the protections of such safe harbor with respect to all
"forward looking statements" contained in this Form 10-K. The Company may have
used "forward looking statements" to describe certain of its future plans and
strategies including management's current expectations of the Company's future
financial results. Management's ability to predict results or the effect of
future plans and strategy involve certain risks, uncertainties, estimates, and
assumptions, which are subject to factors beyond the Company's control.
Consequently, the Company's actual results could differ materially from
management's expectations. Factors that could affect results include, but are
not limited to, interest rate trends, competition, the general economic climate
in Chester County, the mid-Atlantic region and the United States as a whole,
loan demand, loan delinquency rates and changes in asset quality, changes in
monetary and fiscal policies of the United States Government, changes in federal
and state regulation, changes in accounting policies and practices as may be
adopted by bank regulatory agencies and the Financial Accounting Standards Board
and other uncertainties described in the Company's filings with the Securities
and Exchange Commission (the "Commission"), including this Form 10-K. These
factors should be considered in evaluating the "forward looking statements", and
undue reliance should not be placed on such statements. The Company undertakes
no obligation to update or revise any forward-looking statements, whether
written or oral that may be made from time to time by or on the Company's
behalf.
PART I.
ITEM 1. BUSINESS
GENERAL
Chester Valley Bancorp Inc. (the "Holding Company") was incorporated in the
Commonwealth of Pennsylvania in August 1989. The business of the Holding Company
and its subsidiaries (collectively, the "Company") consists of the operations of
First Financial Bank ("First Financial" or the "Bank"), a Pennsylvania-chartered
commercial bank founded in 1922 as a savings association, and Philadelphia
Corporation for Investment Services ("PCIS"), a full-service investment advisory
and securities brokerage firm. Effective September 1, 2001, the Bank converted
to a Pennsylvania-chartered commercial bank from a Pennsylvania-chartered
savings association. As a consequence of such charter conversion, the Holding
Company became a bank holding company that has also been designated as a
financial holding company. Prior to such conversion, the Holding Company was a
unitary thrift holding company. The Bank provides a wide range of banking
services to individual and corporate customers through its twelve full-service
branch offices located in Chester County, Pennsylvania. The Bank provides
residential real estate, commercial real estate, commercial and consumer lending
services, which are primarily funded by retail and business deposits as well as
borrowings. PCIS is a registered broker/dealer in all 50 states and the District
of Columbia and it is also registered as an investment advisor with the
Commission. PCIS provides many additional services, including self-directed and
managed retirement accounts, safekeeping, daily sweep money market funds,
portfolio and estate valuations, life insurance and annuities, and margin
accounts, to individuals and smaller corporate accounts. PCIS' offices are
located in Wayne and Philadelphia, Pennsylvania.
References to the Company include its wholly owned subsidiaries, the Bank
and PCIS, unless the context of the reference indicates otherwise.
1
First Financial Bank's customer deposits are insured to the maximum extent
provided by law by the Federal Deposit Insurance Corporation ("FDIC") through
the Savings Association Insurance Fund ("SAIF"). The Bank is subject to
examination and comprehensive regulation by the FDIC and the Pennsylvania
Department of Banking ("Department"). Prior to the Bank's conversion to a
commercial bank, it was also subject to regulation and examination by the Office
of Thrift Supervision ("OTS"). It is a member of the Federal Home Loan Bank of
Pittsburgh ("FHLBP"), which is one of the 12 regional banks comprising the FHLB
System. The Bank is further subject to regulations of the Board of Governors of
the Federal Reserve System ("Federal Reserve Board") governing reserves to be
maintained against deposits and certain other matters. The Holding Company, as a
registered bank holding company, is subject to examination and regulation of the
Federal Reserve Board.
MARKET AREA AND COMPETITION
The Bank's primary market area includes Chester County and sections of the
four contiguous counties (Delaware, Montgomery, Berks, and Lancaster) in
Pennsylvania. Chester County, in which all of the Bank's offices are located,
continues to grow in terms of economic development and population growth. The
segment of the market served by the Company from a business perspective is
primarily industrially oriented and demographically is comprised of middle and
upper income households.
COMPETITION
First Financial encounters strong competition both in the attraction of
deposits and in the making of commercial, real estate and other loans. Its most
direct competition for deposits has historically come from commercial banks,
savings associations, savings banks and credit unions conducting business in its
primary market area. The Bank also encounters competition for deposits from
money market and other mutual funds, as well as corporate and government
securities and insurance companies. The principal methods used by the Bank to
attract deposit accounts include offering a variety of services, providing
convenient office locations with expanded banking hours and offering
extraordinary customer service and competitive interest rates. The Bank's
primary competition for commercial, real estate and other loans, comes from
other commercial banks, savings institutions, credit unions, mortgage banking
companies, insurance companies, and other lenders. First Financial competes
successfully for loans through competitive interest rates and maturities and
loan fees as well as providing quality service to borrowers and real estate
brokers.
PCIS is engaged in securities brokerage and asset management activities,
both of which are extremely competitive businesses. Competitors include all of
the member organizations of the New York Stock Exchange and other registered
securities exchanges, all members of the National Association of Securities
Dealers, Inc. (the "NASD"), commercial banks and savings associations, insurance
companies, investment companies, and financial consultants. PCIS competes
successfully against other firms through its' quality service, excellent
reputation, successful track record and competitive pricing.
EMPLOYEES
The Company had 171 full-time employees and 26 part-time employees as of
June 30, 2004. None of these employees are covered by a collective bargaining
agreement and the Company believes that it enjoys good relations with its
personnel.
2
LENDING ACTIVITIES
LOAN PORTFOLIO COMPOSITION
The Company's net loan portfolio (net of loans in process, deferred fees
and allowance for loan losses), including loans held for sale, totaled $395.7
million at June 30, 2004 representing approximately 61.6% of the Company's total
assets of $642.1 million at that date.
The following table presents information regarding the composition of the
Company's loan portfolio at the dates indicated.
AT JUNE 30,
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2004 2003 2002 2001 2000
----------------- ----------------- ----------------- ----------------- -----------------
% OF % OF % OF % OF % OF
TOTAL TOTAL TOTAL TOTAL TOTAL
AMOUNT LOANS AMOUNT LOANS AMOUNT LOANS AMOUNT LOANS AMOUNT LOANS
----------------- ----------------- ----------------- ----------------- -----------------
(Dollars in Thousands)
Real estate loans:
Residential:
Single-family $ 70,126 16.4% $ 99,401 24.1% $ 127,072 32.4% $ 148,805 40.2% $ 167,451 46.8%
Multi-family 3,878 0.9% 2,596 0.6% 6,679 1.7% -- 0.0% -- 0.0%
Commercial 140,721 33.0% 122,207 29.6% 103,985 26.5% 82,890 22.4% 66,221 18.5%
Construction and land
acquisition(1) 48,860 11.4% 57,073 13.8% 48,470 12.3% 46,243 12.5% 42,372 11.8%
--------- ---- --------- ---- --------- ---- --------- ---- --------- ----
Total real estate loans 263,585 61.7% 281,277 68.1% 286,206 72.9% 277,938 75.1% 276,044 77.1%
Commercial business loans(2) 49,142 11.5% 43,059 10.4% 36,774 9.4% 27,653 7.4% 19,358 5.4%
Consumer loans(3) 114,787 26.8% 88,918 21.5% 69,538 17.7% 64,756 17.5% 62,433 17.5%
--------- ---- --------- ---- --------- ---- --------- ---- --------- ----
Total loans receivable 427,514 100.0% 413,254 100.0% 392,518 100.0% 370,347 100.0% 357,835 100.0%
Less:
Loans in process (25,549) (25,944) (22,833) (20,528) (20,908)
Allowance for loan losses (6,331) (5,415) (4,588) (4,264) (3,908)
Deferred loan fees (508) (933) (1,533) (1,592) (1,713)
--------- ---- --------- ---- --------- ---- --------- ---- ---------
Net loans receivable 395,126 380,962 363,564 343,963 331,306
Loans held for sale: single-family
residential mortgages 538 3,866 138 2,350 --
--------- ---- --------- ---- --------- ---- --------- ---- ---------
Net loans receivable and loans
held for sale $ 395,664 $ 384,828 $ 363,702 $ 346,313 $ 331,306
========= ========= ========= ========= =========
- ---------------
(1) Includes construction loans for both residential and commercial
real estate properties.
(2) Consists primarily of loans secured by accounts receivable, inventory,
equipment and general corporate assets.
(3) Consists primarily of home equity loans and lines of credit, home
improvement, automobile and other personal loans.
3
CONTRACTUAL MATURITIES
The following table sets forth the contractual principal repayments of the
total loan portfolio, including loans in process, of the Company as of June 30,
2004, by categories of loans. Loans are included in the period in which they
mature. Loans held for sale are not included.
PRINCIPAL REPAYMENTS
CONTRACTUALLY DUE IN YEAR(S) ENDED JUNE 30,
-------------------------------------------
(In Thousands)
TOTAL
OUTSTANDING
AT 2010
JUNE 30, 2006- AND
2004 2005 2009 THEREAFTER
----------- -------- -------- ----------
Real estate loans:
Residential $ 74,004 $ 10,789 $ 7,642 $ 55,573
Commercial 140,721 30,382 102,378 7,961
Construction and land acquisition 48,860 24,360 12,396 12,104
Commercial business loans 49,142 35,956 9,276 3,910
Consumer loans 114,787 32,408 9,587 72,792
-------- -------- -------- --------
TOTAL LOANS RECEIVABLE $427,514 $133,895 $141,279 $152,340
======== ======== ======== ========
The following table sets forth, as of June 30, 2004, the dollar amount of
all loans contractually due after June 30, 2005, which have fixed interest rates
and floating or adjustable rates.
CONTRACTUAL OBLIGATIONS
DUE AFTER JUNE 30, 2005
-------------------------------------
FLOATING/
FIXED ADJUSTABLE
RATES RATES TOTAL
-------------------------------------
(In Thousands)
Real estate loans:
Residential $ 54,512 $ 8,703 $ 63,215
Commercial 23,835 86,504 110,339
Construction and land acquisition 2,374 22,126 24,500
Commercial business loans 11,642 1,544 13,186
Consumer loans 81,667 712 82,379
-------------------------------------
TOTAL LOANS $174,030 $119,589 $293,619
=====================================
Contractual principal repayments of loans do not necessarily reflect the
actual term of the Company's loan portfolio. The average life of mortgage loans
is substantially less than their contractual terms because of loan prepayments
as well as the enforcement of due-on-sale clauses, which give the Company the
right to declare a loan immediately due and payable in the event, among other
things, that the borrower sells the real property subject to the mortgage and
the loan is not repaid. The average life of mortgage loans tends to increase,
however, when current mortgage loan rates substantially exceed rates on existing
mortgage loans and, conversely, decrease when rates on existing mortgage loans
substantially exceed current mortgage loan rates.
4
ORIGINATION, PURCHASE AND SALE OF LOANS
Commercial, multi-family residential real estate and consumer loans are
originated directly by the Bank through salaried loan officers. Salaried
employees originated single-family residential real estate loans during part of
fiscal 2002 but beginning in the second quarter of fiscal 2002, the Bank
outsourced much of this function to a third party. (In February 2004, the Bank
changed its third party processor to a Private Label platform, which provides
the Bank with better control of its customer base to handle the originations,
processing and sale of single-family residential real estate loans.)
Substantially all of the residential real estate loans originated by the Bank
using the third party processor are immediately sold and the Bank recognizes a
gain or loss on the sale.
Prior to changing its method of originating single-family residential loans
in 2002, the Bank had periodically identified certain loans as held for sale at
the time of origination. These loans consisted primarily of fixed-rate,
single-family residential mortgage loans. See "Loans Held for Sale" within Note
- - 1 of Notes to the Consolidated Financial Statements set forth at Item 8
hereof.
LOAN PRODUCTS
The Bank offers a broad array of loan products with competitive terms and
conditions to both individuals and to businesses. Prior to its' charter
conversion to a commercial bank, loan activity had been primarily focused on the
origination of mortgage loans collateralized by single-family residential
properties. However, in recent years, the Bank has substantially expanded its
involvement in commercial real estate and commercial business lending as part of
its strategic shift, which shift culminated in the Bank's conversion to a
commercial bank in September 2001. As a result of the changing composition of
the Bank's loan portfolio, loans secured by single-family properties have
declined as a percentage of the total loan portfolio from 46.8% at June 30, 2000
to 17.3% at June 30, 2004. Commercial real estate and commercial business loans
in the aggregate increased from 22.7% to 44.5% at the same dates, respectively.
The Bank has also continued to remain an active construction and land
acquisition loan originator, with such loans accounting for 11.4% of the Bank's
total loan portfolio as of June 30, 2004. In order to meet the wide-ranging
needs of its customers, the Bank has also marketed aggressively a variety of
consumer loans, including home equity loans and lines of credit.
Through its' outsourcing partnerships, the Bank originates residential real
estate loans secured by properties located primarily in southeastern
Pennsylvania. These loans are both fixed-rate and adjustable-rate loans with
amortization periods up to 30 years.
The Bank provides a wide range of commercial lending products. These
products include commercial business loans, commercial and multi-family real
estate construction, residential development and land acquisition loans.
Commercial real estate loans normally are secured by properties located in
Chester County or the four counties contiguous to it. The majority of such loans
bear adjustable interest rates with amortization terms of 20 years or less.
Commercial business loans are generally made to small and medium sized
companies located in the Bank's primary market area. While the Bank does on
occasion make unsecured commercial loans, generally these loans are on a secured
basis and are collateralized by accounts receivable, inventory, equipment,
and/or other general corporate assets of the borrowers. Commercial business
loans are originated with both fixed and adjustable rates with the adjustable
interest rates generally indexed to the national prime rate. These loans
typically carry terms from one to five years.
The Bank's consumer loans are primarily loans to individuals originated
through its branch network. The majority of its originations are home equity
term and credit lines secured by a first or second mortgage on the primary
residence of the borrower. Home equity credit lines are generally indexed to the
national prime rate, while home equity term loans generally bear fixed interest
rates and have terms of fifteen years or less. Home equity loans and lines of
credit aggregated $100.8 million or 23.6% of the total loan portfolio at June
30, 2004.
5
REGULATORY REQUIREMENTS AND UNDERWRITING POLICIES
Under the Financial Institutions Reform, Recovery, and Enforcement Act of
1989 ("FIRREA") and pursuant to the parity provisions of the Pennsylvania
Banking Code of 1965 ("Banking Code"), the aggregate loans that the Company may
make to any borrower and its affiliates is limited to 15% of unimpaired capital
for unsecured loans and 25% of capital for loans secured by readily marketable
collateral. At June 30, 2004, pursuant to such provisions, the Bank was
permitted to extend credit to any one borrower totaling $9.8 million. At June
30, 2004, the Bank's largest loan or group of loans to one borrower, including
related entities, aggregated $9.1 million, and is in conformity with the current
loans to one borrower regulations described above.
The Bank is currently permitted to lend up to 100% of the appraised value
of the real property securing a loan; however, if the amount of a single-family
residential first mortgage loan exceeds 90% of the appraised value, the Bank is
required by regulation to obtain private mortgage insurance on the portion of
the principal amount of the loan that exceeds 80% of the appraised value of the
security property. Pursuant to underwriting guidelines adopted by the Board of
Directors, private mortgage insurance is normally obtained on all residential
loans whose loan-to-value ratios exceed 80%. The Bank will generally lend up to
97% of the appraised value of one-to four-family owner-occupied residential
dwellings when the required private mortgage insurance is obtained. The Bank
generally originates loans of up to 80% of the appraised value of the properties
securing its commercial real estate and commercial business loans and 80% of the
appraised value upon completion or sale price, whichever is lower, for
construction loans. With respect to construction loans for owner-occupied
properties made in connection with the providing of the permanent financing, the
Bank will lend up to 90% of the appraised value when the required private
mortgage insurance is obtained.
LOAN FEE AND SERVICING INCOME
In addition to interest earned on loans, the Bank receives income
through servicing of loans and fees in connection with loan originations, loan
modifications, late payments, prepayments, repayments and changes of property
ownership and for miscellaneous services related to its loans. Income from these
activities varies from period to period with the volume and type of loans made.
At June 30, 2004, the Bank was servicing $9.9 million of loans for others, of
which $2.5 million consisted of whole loans sold by the Bank to Freddie Mac.
Loan origination fees and certain direct loan origination costs are
deferred and amortized over the life of the related loans as an adjustment to
the yield of such related loans. However, in the event the related loan is sold
or repaid prior to maturity, any deferred loan fees or costs remaining with
respect to such loan are taken into income.
NON-PERFORMING LOANS AND REAL ESTATE OWNED
If the delinquency on a mortgage loan exceeds 90 days and is not cured
through the Bank's normal collection procedures, or an acceptable arrangement is
not worked out with the borrower, the Bank will institute measures to remedy the
default, including commencing a foreclosure action or, in special circumstances,
accepting from the mortgagor a voluntary deed of the secured property in lieu of
foreclosure. However, under Pennsylvania law, a lender is prohibited from
accelerating the maturity of a residential mortgage loan, commencing any legal
action (including foreclosure proceedings) to collect on such loan, or taking
possession of any loan collateral until the lender has first provided the
delinquent borrower with at least 30 days prior written notice specifying the
nature of the delinquency and the borrower's right to correct such delinquency.
This provision of Pennsylvania law, as well as others, may delay for several
months the Bank's ability to foreclose upon residential loans secured by real
estate located in the Commonwealth of Pennsylvania. In addition, the uniform
Fannie Mae/Freddie Mac lending documents used by the Bank, as well as most other
residential lenders in Pennsylvania, require notice and a right to cure similar
to that provided under Pennsylvania law.
6
Non-accrual loans are loans on which the accrual of interest ceases when
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 current loan term. Interest income is
not accrued until the financial condition and payment record of the borrower
once again demonstrate the ability to service the debt. When a loan is placed on
non-accrual status, previously accrued but unpaid interest is deducted from
interest income.
If foreclosure is successful, and the Bank acquires the real estate, which
is recorded as real estate owned ("REO") at the lower of carrying value or fair
value less disposal cost and any write-down resulting there from is charged to
the allowance for loan losses. Interest accrual ceases on the date of
acquisition and all costs incurred in maintaining the property from that date
forward are expensed. Costs incurred for the improvement or development of such
property are capitalized to the extent they do not exceed the property's fair
value. No loss reserves are maintained on REO and future write-downs for costs
beyond the fair value are expensed.
For purposes of applying the measurement criteria for impaired loans, the
Bank excludes large groups of smaller balance homogeneous loans, primarily
consisting of residential real estate loans and consumer loans as well as
commercial loans with balances of less than $100,000. For applicable loans, the
Bank evaluates the need for impairment recognition when a loan becomes
non-accrual or earlier if, based on management's assessment of the relevant
facts and circumstances, it is probable that the Bank will be unable to collect
all proceeds due according to the contractual terms of the loan agreement. At
June 30, 2004, the Bank had $4.0 million in impaired loans as compared to $3.2
million at June 30, 2003. The Bank's policy for the recognition of interest
income on impaired loans is the same as for non-accrual loans discussed above.
Impaired loans or a portion thereof are charged off when the Bank determines
that foreclosure is probable and the fair value less disposal costs of the
collateral is less than the recorded investment of the impaired loan.
The following table sets forth information regarding non-accrual loans and
REO held by the Bank at the dates indicated. The Bank did not have, at any of
the dates presented any (i) loans 90 days or more delinquent as to principal or
interest and on which interest is being accrued or (ii) loans classified as
restructured troubled debt.
7
AT JUNE 30,
----------------------------------------------
2004 2003 2002 2001 2000
----------------------------------------------
(Dollars in Thousands)
NON-ACCRUAL LOANS:
Residential real estate loans $ 591 $ 968 $ 858 $ 952 $ 735
Commercial and multi-family
residential real estate loans 2,900 3,092 -- -- --
Construction and land loans -- -- -- -- --
Commercial business loans 682 62 -- -- --
Consumer loans 37 65 86 220 207
------ ------ ------ ------ ------
Total non-accrual loans $4,210 $4,187 $ 944 $1,172 $ 942
====== ====== ====== ====== ======
Single commercial real estate loan 2,900 3,092 -- -- --
------ ------ ------ ------ ------
Total non-accrual loans less
single commercial real estate $1,310 $1,095 $ 944 $1,172 $ 942
loan(1)
====== ====== ====== ====== ======
Total non-accrual loans
to total assets 0.66% 0.72% 0.17% 0.22% 0.19%
====== ====== ====== ====== ======
Total non-accrual loans less
single commercial real estate
loan to total assets(1) 0.20% 0.19% 0.17% 0.22% 0.19%
====== ====== ====== ====== ======
Total REO 54 -- 40 -- --
------ ------ ------ ------ ------
Total non-accrual loans and REO
to total assets .66% .72% 0.17% 0.22% 0.19%
====== ====== ====== ====== ======
(1) We believe this non-GAAP disclosure is important as this particular
loan had been originated prior to the current management of the Bank
and we do not believe it is representative of the balance of the
portfolio.
At June 30, 2004, non-accrual real estate loans included 8 residential
mortgage loans aggregating $591,000, all secured by single-family residential
properties as well as a single commercial real estate loan in the amount of $2.9
million. The Loan had not been repaid in accordance with its original maturity
and has been extended by the Bank as the borrower attempts to work through its
financial difficulties. The Borrower has recently received a commitment from the
United States Department of Agriculture to guarantee a portion of the underlying
real estate project and is in the process of negotiating a refinance of the
project with an independent third party lender. Although the loan is current in
the payment of interest as it has been due, since its origination in 1998, and
the Bank has received interest prepaid through September 15, 2004, the loan was
placed on non-accrual as principal was not repaid in accordance with the
original stated maturity, as the borrower has encountered financial
difficulties, the underlying real estate is outside the Bank's primary lending
area and repayment is dependent upon factors not under the complete control of
the borrower. Additionally, June 30, 2004 non-accrual loans include two
commercial business loans aggregating $655,000 to a single borrower who has
encountered financial difficulties but has continued to maintain the loans in a
current status. Cash payments received are reducing the outstanding principal
balance on the loans.
8
The total amount of non-performing loans was $4.2 million, $4.2 million and
$944 thousand at June 30, 2004, 2003, and 2002, respectively. If these
non-performing loans had been current in accordance with their original terms
(or were not placed on non-accrual at the Bank's discretion) and had been
outstanding throughout the respective periods, the gross amount of interest
income for 2004, 2003, and 2002 that would have been recorded for these loans
would have been $734 thousand, $451 thousand, and $195 thousand, respectively.
Interest income on these non-performing loans included in income for 2004, 2003,
and 2002 amounted to $107 thousand, $353 thousand, and $114 thousand,
respectively.
ALLOWANCES FOR LOSSES ON LOANS AND CLASSIFIED LOANS
The allowance for loan losses is maintained at a level that represents
management's best estimate of known and inherent losses, which are probable and
reasonably determinable based upon an evaluation of the loan portfolio.
Homogeneous portfolios of loans, which include residential mortgage, home equity
and other consumer loans, are evaluated as a group. Commercial business loans
greater than $100,000, commercial mortgage and construction loans are evaluated
individually. Specific portions of the allowance are developed by analyzing
individual loans for adequacy of collateral, cash flow and other risks unique to
that particular loan. General portions of the allowance are developed by grading
individual loans in the commercial and construction portfolios and applying loss
factors by grade. The general portion of the allowance also includes loss
factors applied to the homogeneous portfolios as a group. The loss factors
applied to graded loans were developed based on the Company's loss history for
loans with similar attributes, local and national economic conditions, as well
as input from the Company's primary banking regulators. Loss factors are applied
to homogeneous loans based upon prior loss experience of the portfolio,
delinquency trends, local and national economic conditions and the volume of
non-performing loans. Although management believes it has used the best
information available to it in making such determinations, and that the present
allowance for loan losses is adequate, future adjustments to the allowance may
be necessary, and net income may be adversely affected if circumstances differ
substantially from the assumptions used in determining the level of the
allowance. In addition, various regulatory agencies, as an integral part of
their examination process, periodically review the Bank's allowance for losses
on loans. Such agencies may require the Bank 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, other than those incurred
on loans held for sale, are charged directly against the allowance and
recoveries on previously charged-off loans are added to the allowance.
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 loans and consumer loans as well as
commercial business loans with balances of less than $100,000. For applicable
loans, the Company evaluates the need for impairment recognition when a loan
becomes non-accrual or earlier if, based on management's assessment of the
relevant facts and circumstances, it is probable that the Company will be unable
to collect all proceeds under the contractual terms of the loan agreement. At
June 30, 2004, the recorded investment in impaired loans was $4.0 million as
compared to $3.2 million at June 30, 2003. The increase is due primarily to the
above noted two commercial business loans to the single borrower. The Company's
policy for the recognition of interest income on impaired loans is the same as
for non-accrual loans. A portion of an impaired loan is 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.
At June 30, 2004, the Bank's allowance for loan losses was $6.3 million or
1.60% of total net loans receivable and 150.4% of total non-performing loans
compared to $5.4 million or 1.41% of net loans receivable and 129.3% of total
non-performing loans at June 30, 2003. The following table summarizes activity
in the Company's allowance for loan losses during the periods indicated.
9
AS OF JUNE 30,
-------------------------------------------------------
2004 2003 2002 2001 2000
------- ------- ------- ------- -------
(In Thousands)
Allowance at beginning of period $ 5,415 $ 4,588 $ 4,264 $ 3,908 $ 3,651
Loans charged off against the allowance:
Residential real estate -- (7) (142) (29) (8)
Commercial business (29) -- -- -- (131)
Consumer (102) (69) (87) (75) (32)
-------- -------- -------- -------- --------
Total charge-offs (131) (76) (229) (104) (171)
Recoveries:
Residential real estate 5 -- -- 4 --
Commercial business -- -- -- 2 2
Consumer 26 24 6 9 6
-------- -------- -------- -------- --------
Total recoveries 31 24 6 15 8
Net charge-offs (100) (52) (223) (89) (163)
Provision for loan losses charged to
operating expenses 971 879 547 445 420
-------- -------- -------- -------- --------
Allowance acquired in Coatesville
branch acquisition 45 -- -- -- --
-------- -------- -------- -------- --------
Allowance at year end $ 6,331 $ 5,415 $ 4,588 $ 4,264 $ 3,908
======== ======== ======== ======== ========
Ratio of net charge-offs to
average loans outstanding 0.02% 0.01% 0.06% 0.03% 0.05%
======== ======== ======== ======== ========
Ratio of allowance to period-end
net loans 1.60% 1.41% 1.26% 1.23% 1.18%
======== ======== ======== ======== ========
10
The following table presents information regarding the Bank's total
allowance for losses on loans as well as the allocation of such amounts to the
various categories of the loan portfolio.
AT JUNE 30,
--------------------------------------------------------------------------------------------
2004 2003 2002 2001 2000
---------------- ---------------- ---------------- ---------------- ----------------
% OF % OF % OF % OF % OF
LOANS LOANS LOANS LOANS LOANS
TO TOTAL TO TOTAL TO TOTAL TO TOTAL TO TOTAL
AMOUNT LOANS AMOUNT LOANS AMOUNT LOANS AMOUNT LOANS AMOUNT LOANS
----------------- ----------------- ---------------- ---------------- ----------------
(In Thousands)
Residential real estate loans $ 272 17.3% $ 372 24.7% $ 402 34.1% $ 537 40.2% $ 700 46.8%
Commercial real estate loans 2,830 33.0% 2,613 29.6% 1,707 26.5% 1,547 22.4% 1,553 18.5%
Construction and land loans 338 11.4% 380 13.8% 279 12.3% 200 12.5% 241 11.8%
Commercial business loans 1,825 11.5% 1,231 10.4% 1,450 9.4% 1,267 7.4% 632 5.4%
Consumer loans 1,066 26.8% 819 21.5% 750 17.7% 713 17.5% 782 17.5%
----------------- ----------------- ---------------- ---------------- -----------------
Total allowance for loan losses $ 6,331 100.0% $ 5,415 100.0% $ 4,588 100.0% $ 4,264 100.0% $ 3,908 100.0%
================= ================= ================= ================= =================
Total allowance for loan losses
to total non-performing loans 150.4% 129.3% 486.0% 363.8% 414.9%
======= ======= ======= ======= =======
Total allowance for loan losses
to total non-performing loans
less single commercial real
estate loan1 483.3% 495.0% 486.0% 363.8% 414.9%
======= ======= ======= ======= =======
Total non-performing loans $4,210 $4,187 $ 944 $ 1,172 $ 942
======= ======= ======= ======= =======
- -----------------------
(1)See Table on Page 8 for reconciliation.
11
The Company monitors the quality of its loans on a regular basis and
classifies them under a classification system that has three categories: (i)
substandard, (ii) doubtful and (iii) loss. A loan may fall within more than one
category and a portion of the asset may remain unclassified. The Company is
required to review the classification of its loans on a regular basis. In
addition, in connection with the examinations of First Financial by the FDIC and
the Department, the examiners have the authority to identify problem loans and,
if appropriate, classify them and/or require adjustments to the carrying value
of such assets.
Loans classified substandard are considered inadequately protected by the
current net worth and paying capacity of the obligor or the value of the
collateral pledged, if any. Loans so classified must have a well-defined
weakness or weaknesses. They are characterized by the distinct possibility that
the insured institution will sustain some loss if the deficiencies are not
corrected.
Loans classified doubtful are considered to have all the weaknesses
inherent in those classified substandard with the added characteristic that the
weaknesses make collection or liquidation in full, on the basis of currently
existing facts, conditions, and values, highly questionable and improbable.
Loans classified loss are considered uncollectable and of such little value
that their continuance as assets is not warranted. After charging off a loan,
the Company continues its efforts to obtain a recovery on the loan.
At June 30, 2004, the Company's classified loans, which consisted of loans
classified as substandard or doubtful, totaled $10.7 million as compared to
$15.3 million at June 30, 2003. Included in the loans classified substandard at
June 30, 2004 and June 30, 2003 were all loans 90 days past due, loans which are
less than 90 days delinquent but inadequately protected by the current paying
capacity of the borrower or of the collateral pledged, and loans which have a
well-defined weakness that may jeopardize the liquidation of the debt.
SECURITIES ACTIVITIES
Historically, interest and dividends on securities and interest-bearing
deposits have provided the Company with a significant source of revenue. At June
30, 2004, the Company's securities portfolio and interest-bearing deposits
aggregated $204.8 million or 31.9% of its total assets.
The Company divides its securities portfolio into three segments: (a) held
to maturity; (b) available for sale; and (c) trading. Securities in the held to
maturity category are accounted for at amortized cost. Trading securities are
accounted for at quoted market prices with changes in market values being
recorded as gain or loss in the statement of operations. All other securities
are included in the available for sale category and are accounted for at fair
value with unrealized gains or losses, net of taxes, being reflected as
adjustments to equity. At June 30, 2004, the Company had a net unrealized loss
on securities available for sale, net of taxes, of $2.0 million. The following
table sets forth the Company's securities portfolio and interest-earning
deposits at carrying value at the dates indicated.
12
AT JUNE 30,
------------------------------------------
2004 2003 2002
--------- --------- ---------
(Dollars in Thousands)
Interest-bearing deposits $ 15,352 $ 9,438 $ 29,163
Trading account securities(1) 8 10 16
Investment securities held to maturity:
U.S. Government and agency obligations 32,513 130 6,376
Municipal notes and bonds(2) 14,884 13,793 8,215
Mortgage-backed securities 3,366 8,520 16,725
Collateralized mortgage obligations 885 1,934 4,585
Debt securities 1,003 3,216 --
Other 6,733 5,797 5,279
--------- --------- ---------
Total investment securities held to maturity 59,384 33,390 41,180
AT JUNE 30,
------------------------------------------
2004 2003 2002
--------- --------- ---------
Investment securities available for sale:
U.S. Government and agency obligations 7,336 2,074 3,401
Municipal notes and bonds(2) 11,606 26,767 30,195
Mortgage-backed securities 40,934 31,672 24,696
Collateralized mortgage obligations 35,568 25,545 23,319
Equity securities 688 1,236 1,346
Debt securities 17,021 24,916 18,436
Asset-backed securities 13,040 -- --
Other 3,896 2,010 --
--------- --------- ---------
Total investment securities available for sale 130,089 114,220 101,393
--------- --------- ---------
Total securities and interest-bearing deposits $ 204,833 $ 157,058 $ 171,752
========= ========= =========
(1) The trading account securities are being maintained at PCIS, which is
a subsidiary of the Company.
(2) The income from municipal notes and bonds is generally non-taxable for
federal and state purposes.
The investment security portfolio is a significant tool in the Company's
management of its' interest rate risk as well as serving as a secondary source
for funding the liquidity needs of the Bank. In that regard, the Company
attempts to maximize income within the portfolio while minimizing interest rate
risk so that the portfolio is not subject to significant fluctuations in market
value.
Included in investment securities available for sale at June 30, 2004 are
three non-rated Pennsylvania Municipal Authority bonds that have been classified
as substandard. These securities were originally purchased at various times
during the period from June 1998 through June 2000. The aggregate book value of
the bonds, after write-downs of $955 thousand is $5.6 million. Two of the three
bonds with an aggregate book value of $4.9 million at June 30, 2004 are zero
coupon bonds with maturities extending up to 2034. Both bonds are secured by the
revenue streams of commercial office buildings, which are leased to various
agencies of the Commonwealth of Pennsylvania under long-term lease arrangements
with renewal options.
A third bond was issued by the Housing Authority of Chester County and has
a book balance of $720 thousand at June 30, 2004 and bears interest at rates
between 5.60% and 6.00% and matures in June 2019. This bond involves low-income
scattered housing in Chester County under a program of the Office of Housing and
Urban Development ("HUD"). HUD has committed to provide additional funds to
build additional houses, which would be donated to this bond issue. The
retirement of the bond issue is dependent upon proceeds from either the rental
or sale of the existing and additional houses. This bond is on non-accrual at
June 30, 2004.
13
These classified investments are closely monitored and fairly stated at
June 30, 2004 based on available information. There can be no assurance that
further subsequent adverse or positive developments may occur and thus could
result in further adjustments to the carrying value of these investments.
The amortized cost and estimated fair value of investment securities at
June 30, 2004, by contractual maturity, are shown below.
WEIGHTED
AMORTIZED ESTIMATED AVERAGE
COST FAIR VALUE YIELD
---------- ---------- --------
(Dollars in Thousands)
HELD TO MATURITY
Due in one year or less $ 1,003 $ 1,012 5.75%
Due after one year through five years 127 127 6.00%
Due after five years through ten years 22,094 21,325 4.17%
Due after ten years 29,427 28,582 4.88%
No stated maturity 6,733 6,733 1.50%
---------- ---------- -------
TOTAL HELD TO MATURITY $ 59,384 $ 57,779 4.25%
---------- ---------- -------
AVAILABLE FOR SALE
Due in one year or less $ 115 $ 116 3.53%
Due after one year through five years 6,701 6,570 4.69%
Due after five years through ten years 24,000 23,387 4.87%
Due after ten years 99,751 97,427 4.07%
No stated maturity 2,615 2,589 3.93%
---------- ---------- -------
TOTAL AVAILABLE FOR SALE $ 133,182 $ 130,089 4.24%
---------- ---------- -------
TOTAL INVESTMENT SECURITIES $ 192,566 $ 187,868 4.25%
========== ========== =======
The weighted average yield, based on amortized cost, is presented on a
taxable equivalent basis.
As of June 30, 2004, investments in the debt and/or equity securities of
any one issuer (excluding U.S. Government and federal agencies) did not exceed
10% of the Company's stockholders' equity.
SOURCES OF FUNDS
GENERAL
Deposits obtained through branch offices have traditionally been the
principal source of the Company's funds for use in lending and for other general
business purposes. The Company also derives funds from amortization and
prepayments of outstanding loans and investments and sales of loans. From time
to time, the Company also may borrow funds from the FHLBP and other sources.
Borrowings may be used to compensate for reductions in deposits or to support
expanded lending and investment activities.
14
DEPOSITS
The Company obtains deposits primarily from residents of Chester
County, and to a lesser extent Berks, Delaware, Lancaster and Montgomery
Counties, Pennsylvania. Currently, the principal methods used by First Financial
to attract deposit accounts include the offering of services and a wide variety
of accounts, competitive interest rates, and convenient office locations and
service hours. Other than during times of inverse or flat yield curves, the Bank
has adopted a pricing program for its certificate accounts which provides for
higher rates of interest on its longer term certificates in order to encourage
depositors to invest in certificates with longer maturities, thus reducing the
interest rate sensitivity of the Company's deposit portfolio. First Financial
also offers a tiered money market account that pays higher interest on higher
balances so as to maintain a relatively stable level of core deposits even when
its certificate accounts mature.
The Bank's current deposit products include non-interest-bearing accounts,
passbook/statement savings accounts, NOW checking accounts, money market deposit
accounts, certificates of deposit ranging in terms from 30 days to seven years
and certificates of deposit in denominations of $100,000 or more ("jumbo
certificates"). Included among these deposit products are individual retirement
account certificates ("IRA certificates") and Keogh accounts.
The following table shows the balances of the Company's deposits as of the
dates indicated:
AT JUNE 30,
-------------------------------------------------------------------------------
2004 2003 2002
------------------------- ------------------------- -------------------------
(Dollars in Thousands)
% OF % OF % OF
AMOUNT DEPOSITS AMOUNT DEPOSITS AMOUNT DEPOSITS
------------ ----------- ------------ ----------- ------------ -----------
Non-interest-bearing accounts $ 69,132 16.2% $ 59,906 15.0% $ 44,890 11.6%
NOW checking accounts 64,638 15.1% 61,828 15.4% 55,307 14.3%
Passbook/statementsavings
accounts 34,762 8.1% 31,107 7.8% 31,560 8.2%
Money market deposits accounts 151,204 35.5% 101,112 25.2% 65,411 17.0%
Certificates of deposit less than
$100,000 82,119 19.2% 99,003 24.7% 120,810 31.3%
Certificates of deposit with
$100,000 minimum balance 25,248 5.9% 47,630 11.9% 68,002 17.6%
------------ ----------- ------------ ----------- ------------ -----------
Total deposits $ 427,103 100.0% $ 400,586 100.0% $ 385,980 100.0%
============ =========== ============ =========== ============ ===========
The following table shows the balances of certificates of deposit with
balances of $100,000 or greater which mature during the periods indicated and
the balance at June 30, 2004.
BALANCES AT JUNE 30, 2004 MATURING
-----------------------------------------------------
(In Thousands)
AT Within Three Six to After
JUNE 30, Three to Six Twelve Twelve
2004 Months Months Months Months
-------- ------- ------- ------- -------
Certificates of deposit with $100,000
minimum balance $25,248 $ 3,586 $ 2,910 $ 8,690 $10,062
======== ======= ======= ======= =======
15
The following table presents the average balance by type of deposit and the
average rate paid by type of deposit for the periods indicated.
YEAR ENDED JUNE 30,
--------------------------------------------------------------------------
2004 2003 2002
---------------------- ----------------------- -----------------------
(Dollars in Thousands)
AVERAGE AVERAGE AVERAGE
AVERAGE RATE AVERAGE RATE AVERAGE RATE
BALANCE PAID BALANCE PAID BALANCE PAID
----------- --------- --------- ---------- --------- ---------
NOW Checking accounts $ 64,187 0.24% $ 56,928 0.53% $ 48,644 0.89%
Passbook/statement savings accounts 32,041 0.23% 30,527 0.66% 27,524 1.16%
Money market deposit accounts 125,035 1.30% 80,707 1.72% 63,651 2.25%
Certificates of deposit less
than $100,000 86,457 2.79% 114,221 3.51% 119,072 4.49%
Certificates of deposit with
$100,000 minimum balance 35,194 2.92% 65,617 3.15% 88,105 4.15%
First Financial's emphasis on core deposit growth (NOW, Savings and Money
Market) has resulted in it becoming less dependent on higher costing
certificates of deposit and the reduced threat of disintermediation (the flow of
funds away from savings institutions into direct investment vehicles such as
government and corporate securities). Like many financial institutions, First
Financial is susceptible to short-term fluctuations in deposit flows, as
customers have become more rate conscious and willing to move funds into
higher-yielding accounts. Thus, First Financials ability to attract and maintain
deposits, as well as its ability to control its cost of funds, will continue to
be affected by economic conditions, the interest rate environment as well as
competition from other financial institutions.
First Financial attempts to control the flow of deposits by pricing its
accounts to remain generally competitive with other financial institutions in
its primary market area, but does not necessarily seek to match the highest
rates paid by competing institutions.
First Financial's deposits are obtained primarily from persons who are
residents of Pennsylvania and, to a much lesser degree, from governmental
entities. First Financial does not advertise for deposits outside of
Pennsylvania nor has it to this point accepted brokered deposits. Management
believes that at June 30, 2004, an insignificant amount of First Financial's
deposits were held by non-residents of Pennsylvania.
BORROWINGS
First Financial may obtain advances from the FHLBP upon the security of the
common stock it owns in that bank, its investment security portfolio as well as
certain residential mortgage and other loans, provided they meet certain
standards established by the FHLBP. See "Regulation - Regulation of the Bank -
Federal Home Loan Bank System." Such advances are made pursuant to several
different credit programs, with differing interest rates and maturities. FHLBP
advances are generally available to meet withdrawals of deposit accounts, to
fund expansion of lending and investment activities, as well as to aid the Bank
in its asset and liability management. At June 30, 2004, the Company had $121.0
million in FHLBP advances outstanding. In addition, the Company has established
a line of credit with the FHLBP at June 30, 2004 in the amount of $10 million,
which is subject to certain conditions, including the holding of a predetermined
amount of FHLBP stock as collateral. At June 30, 2004, there was no balance
outstanding on the line of credit.
16
The following table presents certain information regarding short-term
borrowings (borrowings with a maturity of one year or less) for the periods
indicated:
YEAR ENDED JUNE 30,
------------------------------------------
2004 2003 2002
---------- ---------- ----------
(Dollars in Thousands)
SHORT-TERM BORROWINGS:
Balance outstanding at end of period $ 40,858 $ 29,458 $ 28,750
Weighted average interest rate at end of period 1.29% 0.96% 5.88%
Average balance outstanding 27,915 27,610 28,606
Maximum amount outstanding at any month-end
during the period 40,858 59,244 35,250
Weighted average interest rate during the period 1.15% 2.44% 5.63%
YIELDS EARNED AND RATES PAID
The largest components of the Company's total income and total expense are
interest income and interest expense. As a result, the Company's earnings are
dependent primarily upon net interest income, which is determined by the
Company's net interest rate spread (i.e., the difference between the yields
earned on interest-earning assets and the rates paid on interest-bearing
liabilities) and the relative amounts of interest-earning assets and
interest-bearing liabilities.
17
INTEREST INCOME AND INTEREST SPREAD ANALYSIS
The following table sets forth, for the periods indicated, information
regarding (1) the total dollar amount of interest income of the Company from
interest-earning assets and the resultant average yields; (2) the total dollar
amount of interest expense on interest-bearing liabilities and the resultant
average cost; (3) net interest income; (4) interest rate spread; and (5) net
interest-earning assets and their net yield. Average balances are determined on
a daily basis, which is representative of operations.
YEAR ENDED JUNE 30,
-------------------------------------------------------------------------------------------
2004 2003 2002
----------------------------- ------------------------------ ------------------------------
AVERAGE YIELD/ AVERAGE YIELD/ AVERAGE YIELD/
BALANCE(1) INTEREST(2) RATE(2 BALANCE(1) INTEREST(2) RATE(2) BALANCE(1) INTEREST(2) RATE(2)
---------- ----------- ------ ---------- ----------- ------- ---------- ----------- -------
(Dollars in Thousands)
Assets:
Loans and loans held for sale $ 403,030 $ 23,467 5.82% $ 377,027 $ 25,640 6.80% $ 359,725 $ 26,756 7.44%
Securities and other investments 170,762 7,084 4.15% 163,758 6,814 4.16% 156,800 8,520 5.43%
--------- --------- ----- --------- --------- ----- --------- -------- -----
Total interest-earning assets 573,792 30,551 5.32% 540,785 32,454 6.00% 516,525 35,276 6.83%
--------- --------- ----- --------- --------- ----- --------- -------- -----
Non-interest earning assets 36,712 43,285 31,436
--------- --------- ---------
Total assets $ 610,504 $ 584,070 $ 547,961
========= ========= =========
Liabilities and Stockholders'
Equity:
Deposits and repurchase agreements $ 379,434 $ 5,407 1.43% $ 380,434 $ 8,152 2.14% $ 369,600 $ 11,340 3.07%
FHLB advances and other
Borrowings 127,831 5,311 4.15% 108,426 5,740 5.30% 93,153 5,024 5.39%
--------- --------- ----- --------- --------- ----- --------- -------- -----
Total interest-bearing liabilities 507,265 10,718 2.11% 488,860 13,892 2.84% 462,753 16,364 3.54%
--------- --------- ----- --------- --------- ----- --------- -------- -----
Non-interest-bearing liabilities 51,822 48,423 43,085
Stockholders' equity 51,417 46,787 42,123
--------- --------- ---------
Total liabilities and stockholders' $ 610,504 $ 584,070 $ 547,961
equity ========= ========= =========
Net interest income/interest
rate spread $ 19,833 3.21% $ 18,562 3.16% $ 18,912 3.29%
========= ===== ========= ===== ======== =====
Net interest-earning assets/net
yield on interest-earning assets $ 66,527 3.46% $ 51,925 3.43% $ 53,772 3.66%
========= ===== ========= ===== ========= =====
Ratio of average interest-earning
assets to interest-bearing
liabilities 113% 111% 112%
==== ==== ====
- ----------------
(1) Non-accruing loans are included in the average balance.
(2) The indicated interest and annual yield and rate are presented on a taxable
equivalent basis using the Federal marginal income tax rate of 34% adjusted
for the 20% interest expense disallowance (27.2%) for 2004, 2003, and 2002.
The following details the tax equivalent adjustments in the above table:
18
YEAR ENDED JUNE 30,
-------------------------------------------------------------------------------------------------------------
2004 2003 2002
----------------------------------- ---------------------------------- ------------------------------------
INTEREST TAX ADJUSTED INTEREST TAX ADJUSTED INTEREST TAX ADJUSTED
INCOME ADJUSTMENT INCOME INCOME ADJUSTMENT INCOME INCOME ADJUSTMENT INCOME
-------------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Loans $ 23,406 $ 61 $ 23,467 $ 25,560 $ 80 $ 25,640 $ 26,658 $ 98 $ 26,756
Investments 6,462 622 7,084 6,155 659 6,814 7,812 708 8,520
----------------------------------- ---------------------------------- ------------------------------------
Total $ 29,868 $ 683 $ 30,551 $ 31,715 $ 739 $ 32,454 $ 34,470 $ 806 $ 35,276
=================================== =================================== ===================================
RATE/VOLUME ANALYSIS
The following table presents certain information regarding changes in
interest income and interest expense of the Company for the periods indicated.
Interest income and the annual rate are calculated on a taxable equivalent basis
using the Federal marginal income tax rate of 34% adjusted for the 20% interest
expense disallowance (27.2%). For each category of interest-earning assets and
interest-bearing liabilities, information is provided with respect to changes
attributable to (1) changes in volume (change in volume multiplied by old rate),
(2) changes in rate (change in rate multiplied by old volume) and (3) changes in
rate/volume (change in rate multiplied by change in volume). The changes in
rate/volume are allocated to the change in volume variance and the change in the
rate variance on a pro rated basis.
2004 COMPARED TO 2003 2003 COMPARED TO 2002
INCREASE (DECREASE) DUE TO INCREASE (DECREASE) DUE TO
-------------------------------- -----------------------------------
VOLUME RATE TOTAL VOLUME RATE TOTAL
-------- --------- --------- ------- --------- ---------
(Dollars in Thousands)
Interest income on interest-
earning assets:
Loans and loans held for sale $ 1,689 $ (3,862) $ (2,173) $ 1,251 $ (2,367) $ (1,116)
Securities and other investments 286 (16) 270 363 (2,069) (1,706)
-------- --------- --------- -------- --------- ---------
Total interest income 1,975 (3,878) (1,903) 1,614 (4,436) (2,822)
-------- --------- --------- -------- --------- ---------
Interest expense on interest-bearing
liabilities:
Deposits and repurchase agreements (21) (2,724) (2,745) 325 (3,515) (3,190)
FHLB advances and other borrowings 933 (1,362) (429) 804 (86) 718
-------- --------- --------- -------- --------- ---------
Total interest expense 912 (4,086) (3,174) 1,129 (3,601) (2,472)
-------- --------- --------- -------- --------- ---------
Net change in net interest income $ 1,063 $ 208 $ 1,271 $ 485 $ (835) $ (350)
======== ========= ========= ======= ========= =========
19
RATIOS
The following table shows certain income and financial condition ratios for
the periods indicated. All averages are based on month-end balances, which are
representative of operations.
YEAR ENDED JUNE 30,
-------------------------------------
2004 2003 2002
---------- ---------- ----------
Return on average assets
(income divided by average
total assets) 1.03% 0.90% 1.02%
Return on average equity
(income divided by average equity) 12.27% 11.25% 13.24%
Equity-to-assets ratio
(average equity divided by
average assets) 8.42% 8.01% 7.69%
Dividend pay-out ratio 31.52% 34.13% 30.65%
SUBSIDIARIES OF FIRST FINANCIAL
The Bank operates (as a wholly owned subsidiary) D & S Service Corporation
("D & S Service"), which has participated in the development for sale of
residential properties, in particular condominium conversions, and also the
development of commercial properties in order for the Bank to expand its
facilities to accommodate its growth. All of such projects have either been
located in or within close proximity to the Bank's primary market area. D & S
Service operates two wholly owned subsidiaries: Wildman Projects and D & F
Projects, Inc. As of June 30, 2004, the Bank had invested $1.8 million in D & S
Service and its wholly owned subsidiaries. Additionally, the Bank has a second
subsidiary, First Financial Investments, from which the Bank conducts retail
investment service activities.
REGULATION
Set forth below is a brief description of certain laws and regulations that
relate to the regulation of the Company, the Bank and PCIS in effect as of June
30, 2004. The description of these laws and regulations, as well as descriptions
of laws and regulations contained elsewhere herein, do not purport to be
complete and is qualified in its entirety by reference to applicable laws and
regulations.
REGULATION OF THE HOLDING COMPANY
GENERAL
The Holding Company, as a bank holding company as a result of the
conversion effective September 1, 2001 of the Bank from a Pennsylvania chartered
thrift to a Pennsylvania-chartered commercial bank, is subject to regulation and
supervision by the Federal Reserve Board. Under the Bank Holding Company Act
("BHCA"), a bank holding company is required to file annually with the Federal
Reserve Board a report of its operations and, with its subsidiaries, is subject
to examination by the Federal Reserve Board.
20
ACTIVITIES AND OTHER LIMITATIONS
The BHCA generally prohibits a bank holding company from acquiring direct
or indirect ownership or control of more than 5% of the voting shares of any
bank, or increasing such ownership or control of any bank, without prior
approval of the Federal Reserve Board. The Federal Reserve Board generally may
approve an application by a bank holding company that is adequately capitalized
and adequately managed to acquire control of, or to acquire all or substantially
all of the assets of, a bank located in a state other than the home state of
such bank holding company, without regard to whether such transaction is
prohibited under the law of any state, provided, however, that the Federal
Reserve Board may not approve any such application that would have the effect of
permitting an out-of-state bank holding company to acquire a bank in a host
state that has not been in existence for any minimum period of time, not to
exceed five years, specified in the statutory law of the host state.
The BHCA also generally prohibits a bank holding company, with certain
exceptions, from acquiring more than 5% of the voting shares of any company that
is not a bank and from engaging in any business other than banking or managing
or controlling banks. Under the BHCA, the Federal Reserve Board is authorized to
approve the ownership of shares by a bank holding company in any company the
activities of which the Federal Reserve Board had determined, by regulation or
by order, to be so closely related to banking or to managing or controlling
banks as to be a proper incident thereto as of November 11, 2000, the day before
the date of enactment of the Gramm-Leach-Bliley Act, discussed below. In making
such determinations, the Federal Reserve Board is required to weigh the expected
benefit to the public, such as greater convenience, increased competition or
gains in efficiency, against the possible adverse effects, such as undue
concentration of resources, decreased or unfair competition, conflicts of
interest or unsound banking practices.
CAPITAL REQUIREMENTS
The Federal Reserve Board has issued risk-based and leverage capital
guidelines applicable to bank holding companies. In addition, the Federal
Reserve Board may from time to time require that a bank holding company maintain
capital above the minimum levels, whether because of its financial condition or
actual or anticipated growth. The Federal Reserve Board's risk-based guidelines
define a three-tier capital framework. Tier 1 capital consists of common and
qualifying preferred shareholders' equity, less certain intangibles and other
adjustments. Tier 2 capital consists of preferred stock not qualifying as Tier 1
capital, subordinated and other qualifying debt, and the allowance for credit
losses up to 1.25 percent of risk-weighted assets. Tier 3 capital includes
subordinated debt that is unsecured, fully paid, has an original maturity of a
least two years, is not redeemable before maturity without prior approval by the
Federal Reserve Board and includes a lock-in clause precluding payment of either
interest or principal if the payment would cause the issuing entity's risk-based
capital ratio to fall or remain below the required minimum. The sum of Tier 1
and Tier 2 capital less investments in unconsolidated subsidiaries represents
qualifying total capital, at least 50 percent of which must consist of Tier 1
capital. Risk-based capital ratios are calculated by dividing Tier 1 and total
capital by risk-weighted assets. Assets and off-balance sheet exposures are
assigned to one of four categories of risk-weights, based primarily on relative
credit risk. The minimum Tier 1 capital ratio is 4 percent and the minimum total
capital ratio is 8 percent. The leverage ratio is determined by dividing Tier 1
capital by adjusted average total assets. Although the stated minimum ratio is 3
percent, most banking organizations are required to maintain ratios of at least
100 to 200 basis points above 3 percent.
As of June 30, 2004, the Company's capital ratios exceeded applicable
requirements. See Note 13 of the Consolidated Financial Statements included in
Item 8 hereof.
AFFILIATED INSTITUTIONS
Under Federal Reserve Board policy, the Holding Company is expected to act
as a source of financial strength to the Bank and to commit resources to support
the Bank in circumstances when it might not do so absent such policy. The
Federal Reserve Board takes the position that in implementing this policy it may
require bank holding companies to provide such support when the holding company
otherwise would not consider itself able to do so.
21
A bank holding company is a legal entity separate and distinct from its
subsidiary bank. Normally, the major source of a holding company's revenue is
dividends a holding company receives from its subsidiary bank. The right of a
bank holding company to participate as a stockholder in any distribution of
assets of its subsidiary bank upon its liquidation or reorganization or
otherwise is subject to the prior claims of creditors of such subsidiary bank.
The subsidiary bank is subject to claims by creditors for long-term and
short-term debt obligations, including substantial obligations for federal funds
purchased and securities sold under repurchase agreements, as well as deposit
liabilities. Under FIRREA, in the event of a loss suffered by the FDIC in
connection with a banking subsidiary of a bank holding company (whether due to a
default or the provision of FDIC assistance), other banking subsidiaries of the
holding company could be assessed for such loss.
Federal laws limit the transfer of funds by a subsidiary bank to its
holding company in the form of loans or extensions of credit, investments or
purchases of assets. Transfers of this kind are limited to 10% of a bank's
capital and surplus with respect to each affiliate and to 20% in the aggregate,
and are also subject to certain collateral requirements. These transactions, as
well as other transactions between a subsidiary bank and its holding company,
also must be on terms substantially the same as, or at least as favorable as,
those prevailing at the time for comparable transactions with non-affiliated
companies or, in the absence of comparable transactions, on terms or under
circumstances, including credit standards, that would be offered to, or would
apply to, non-affiliated companies.
In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation
of Variable Interest Entities, an Interpretation of ARB No. 51" ("FIN 46"). FIN
46 provided a new framework for identifying variable interest entities ("VIEs")
and determining when a company should include the assets, liabilities,
non-controlling interests and results of activities of a VIE in its consolidated
financial statements. FIN 46 was effective immediately for VIEs created after
January 31, 2003 and was effective beginning in the third quarter of 2003 for
VIEs created prior to the issuance of the interpretation. The Company adopted
the provisions of FIN 46 with no material impact on its financial condition or
results of operations, earnings per share or cash flows. For information
regarding an ongoing evaluation of the effects of FIN 46 on the treatment of
capital securities issued by consolidated subsidiary trusts for regulatory
purposes, see "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Capital."
FINANCIAL MODERNIZATION
Effective November 12, 1999, the Gramm-Leach-Bliley Act, permits bank
holding companies to become financial holding companies and thereby affiliate
with securities firms and insurance companies and engage in other activities
that are financial in nature. A bank holding company may become a financial
holding company if its subsidiary bank is "well capitalized" and "well managed,"
as defined, and has at least a satisfactory rating under the Community
Reinvestment Act by filing a declaration that the bank holding company wishes to
become a financial holding company. No regulatory approval is required for a
financial holding company to acquire a company, other than a bank or savings
association, engaged in activities that are financial in nature or incidental to
activities that are financial in nature, as determined by the Federal Reserve
Board.
The Gramm-Leach-Bliley Act defines "financial in nature" to include
securities underwriting, dealing and market making; sponsoring mutual funds and
investment companies; insurance underwriting and agency; merchant banking
activities; and activities that the Federal Reserve Board has determined to be
closely related to banking. Subsidiary banks of a financial holding company must
continue to be well capitalized and well managed in order to continue to engage
in activities that are financial in nature without regulatory actions or
restrictions, which could include divestiture of the financial in nature
subsidiary or subsidiaries. In addition, a financial holding company or a bank
may not acquire a company that is engaged in activities that are financial in
nature unless each of the subsidiary banks of the financial holding company or
the bank has a Community Reinvestment Act rating of satisfactory or better.
22
In connection with the Holding Company's application to become a bank
holding company as a result of the conversion of the Bank to a
Pennsylvania-chartered commercial bank, the Company elected to become a
financial holding company.
STATE REGULATION
The Company is registered as a Pennsylvania financial institution holding
company under Pennsylvania law and as such is subject to regulation and
examination by the Superintendent of Banking of the Commonwealth of
Pennsylvania.
REGULATION OF PCIS
GENERAL
In the United States, a number of federal regulatory agencies are charged
with safeguarding the integrity of the securities and other financial markets
and with protecting the interest of customers participating in those markets.
The Commission is the federal agency that is primarily responsible for the
regulation of broker-dealers and investment advisers doing business in the
United States, and the Federal Reserve Board promulgates regulations applicable
to securities credit transactions involving broker-dealers and certain other
institutions in the Unites States. Much of the regulation of broker-dealers,
however, has been delegated to self-regulatory organizations ("SROs"),
principally the NASD (and its subsidiaries NASD Regulation, Inc. and the Nasdaq
Stock Market), and the national securities exchanges. These SROs, which are
subject to oversight by the Commission, adopt rules (which are subject to
approval by the Commission) that govern the industry, monitor daily activity and
conduct periodic examinations of member broker-dealers.
PCIS is also subject to the Uniting and Strengthening America by Providing
Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the
"USA Patriot Act'), signed into law on October 26, 2001. (See "Recent
Legislation") The USA Patriot Act requires financial institutions to adopt and
implement policies and procedures designed to prevent and defeat money
laundering. PCIS believes it is in compliance with the USA Patriot Act.
Securities firms are also subject to regulation by state securities
commissions in the states in which they are required to be registered. PCIS is
registered as a broker-dealer with the Commission and in all 50 states and in
the District of Columbia, and is a member of, and subject to regulation by, a
number of SROs, including the NASD.
As a result of federal and state registration and SRO memberships, PCIS is
subject to overlapping schemes of regulation that cover all aspects of its
securities business. Such regulations cover matters including capital
requirements, uses and safe-keeping of clients' funds, conduct of directors,
officers and employees, record-keeping and reporting requirements, supervisory
and organizational procedures intended to assure compliance with securities laws
and to prevent improper trading on material nonpublic information,
employee-related matters, including qualification and licensing of supervisory
and sales personnel, limitations on extensions of credit in securities
transactions, clearance and settlement procedures, requirements for the
registration, underwriting, sale and distribution of securities, and rules of
the SROs designed to promote high standards of commercial honor and just and
equitable principles of trade. A particular focus of the applicable regulations
concerns the relationship between broker-dealers and their customers. As a
result, the many aspects of the broker-dealer customer relationship are subject
to regulation including, in some instances, "suitability" determinations as to
certain customer transactions, limitations on the amounts that may be charged to
customers, timing of proprietary trading in relation to customers' trades and
disclosures to customers.
23
PCIS also is subject to "Risk Assessment Rules" imposed by the SEC which
require, among other things, that certain broker-dealers maintain and preserve
certain information, describe risk management policies and procedures and report
on the financial condition of certain affiliates whose financial and securities
activities are reasonably likely to have a material impact on the financial and
operational condition of the broker-dealers. Certain "Material Associated
Persons" (as defined in the Risk Assessment Rules) of the broker-dealers and the
activities conducted by such Material Associated Persons may also be subject to
regulation by the SEC.
PCIS is registered as an investment adviser with the SEC. As an investment
adviser registered with the SEC, it is subject to the requirements of
the Investment Advisers Act of 1940 and the SEC's regulations thereunder, as
well as certain state securities laws and regulations. Such requirements relate
to, among other things, limitations on the ability of an investment adviser to
charge performance-based or non-refundable fees to clients, record-keeping and
reporting requirements, disclosure requirements, limitations on principal
transactions between an adviser or its affiliates and advisory clients, as well
as general anti-fraud prohibitions. The state securities law requirements
applicable to registered investment advisers are in certain cases more
comprehensive than those imposed under the federal securities laws.
In the event of non-compliance with an applicable regulation, governmental
regulators and the NASD may institute administrative or judicial proceedings
that may result in censure, fine, civil penalties (including treble damages in
the case of insider trading violations), the issuance of cease-and-desist
orders, the deregistration or suspension of the non-compliant broker-dealer or
investment adviser, the suspension or disqualification of the broker-dealer's
officers or employees or other adverse consequences. The imposition of any such
penalties or orders on PCIS could have a material adverse effect on PCIS' (and
thus the Company's) operating results and financial condition.
NET CAPITAL REQUIREMENTS
As a broker-dealer registered with the SEC and as a member firm of the
NASD, PCIS is subject to the capital requirements of the SEC and the NASD. These
capital requirements specify minimum levels of capital that PCIS is required to
maintain and also limit the amount of leverage that each firm is able to obtain
in its respective business.
As of June 30, 2004, PCIS was required to maintain minimum net capital, in
accordance with SEC rules, of $250,000 and had total net capital of $977,000 or
$747,000 in excess of the minimum amount required. PCIS is required to maintain
a net capital ratio, in accordance with SEC rules, not to exceed 15 to 1. At
June 30, 2004, PCIS' net capital ratio was .25 to 1.
A failure of a broker-dealer to maintain its minimum required net capital
or net capital ratio would require it to cease executing customer transactions
until it came back into compliance, and could cause it to lose its NASD
membership, its registration with the SEC or require its liquidation. Further,
the decline in a broker-dealer's net capital below certain "early warning
levels," even though above minimum net capital requirements, could cause
material adverse consequences to the broker-dealer.
PCIS is a member of the Securities Investor Protection Corporation
("SIPC"), which is a non-profit corporation that was created by the United
States Congress under the Securities Protection Act of 1970. SIPC protects
customers of member broker-dealers against losses caused by the financial
failure of the broker-dealer but not against a change in the market value of
securities in customers' accounts at the broker-dealer. In the event of the
inability of a member broker-dealer to satisfy the claims of its customers in
the event of its failure, the SIPC's funds are available to satisfy the
remaining claims up to maximum of $500,000 per customer, including up to
$100,000 on claims for cash. In addition, PCIS' clearing broker carries private
insurance that provides similar coverage up to $25 million per customer.
24
REGULATION OF THE BANK
GENERAL
As a Pennsylvania-chartered commercial bank, the Bank is subject to
regulation and examination by the FDIC, which insures the deposits of the Bank
to the maximum extent permitted by law, certain requirements established by the
Federal Reserve Board and by the Pennsylvania Department of Banking. The federal
laws and regulations which are applicable to state-chartered banks regulate,
among other things, the scope of their business, their investments, their
reserves against deposits, the timing of the availability of deposited funds and
the nature and amount of and collateral for loans. Prior to the Bank's
conversion from a state-chartered savings association to a commercial bank, it
was subject also to regulation and examination by the Office of Thrift
Supervision.
CAPITAL REQUIREMENTS
The Bank is subject to regulatory capital requirements of the FDIC, which
are substantially comparable to the regulatory capital requirements of the
Federal Reserve Board applicable to the Holding Company, as discussed above. At
June 30, 2004, the Bank's regulatory capital substantially exceeded applicable
requirement. See Note 13 to the Consolidated Financial Statements included in
Item 8 hereof.
PROMPT CORRECTIVE ACTION
Section 38 of the Federal Deposit Insurance Act ("FDIA") provides the
federal banking regulators with broad power to take "prompt corrective action"
to resolve the problems of undercapitalized institutions. The extent of the
regulators' powers depends on whether the institution in question is "well
capitalized," "adequately capitalized," "undercapitalized," "significantly
undercapitalized" or "critically undercapitalized." Under regulations adopted by
the federal banking regulators, an institution shall be deemed to be (i) "well
capitalized" if it has total risk-based capital ratio of 10.0% or more, has a
Tier I risk-based capital ratio of 6.0% or more, has a Tier I leverage capital
ratio of 5.0% or more and is not subject to specified requirements to meet and
maintain a specific capital level for any capital measure; (ii) "adequately
capitalized" if it has a total risk-based capital ratio of 8.0% or more, a Tier
I risk-based capital ratio of 4.0% or more a Tier I leverage capital ratio of
4.0% or more (3.0% under certain circumstances) and does not meet the definition
of "well capitalized"; (iii) "undercapitalized" if it has a total risk-based
capital ratio that is less than 8.0%, a Tier I risk-based capital ratio that is
less than 4.0% or a Tier I leverage capital ratio that is less than 4.0% (3.0%
under certain circumstances), (iv) "significantly undercapitalized" if it has a
total risk-based capital ratio that is less than 6.0%, a Tier I risk-based
capital ratio that is less than 3.0% or a Tier I leverage capital ratio that is
less than 3.0%, and (v) "critically undercapitalized" if it has a ratio of
tangible equity to total assets that is equal to or less than 2.0%. The
regulations also provide that a federal banking regulator may, after notice and
an opportunity for a hearing, reclassify a "well capitalized" institution as
"adequately capitalized" and may require an "adequately capitalized" institution
or an "undercapitalized" institution to comply with supervisory actions as if it
were in the next lower category if the institution is in an unsafe or unsound
condition or engaging in an unsafe or unsound practice. The federal banking
regulator may not, however, reclassify a "significantly undercapitalized"
institution as "critically undercapitalized."
At June 30, 2004, the Bank's capital levels qualified it as a "well
capitalized" institution under applicable laws and regulations.
FDIC INSURANCE PREMIUMS
The Bank is a member of the Savings Association Insurance Fund ("SAIF")
administered by the FDIC rather than the Bank Insurance Fund ("BIF") since it
was formerly a savings association.
25
As an FDIC-insured institution, the Bank is required to pay deposit
insurance premiums to the FDIC. Effective January 1, 1997, the assessment
schedule for both BIF and SAIF ranges from 0 basis points (subject to a $2,000
annual minimum) to 27 basis points of the balance of insured deposits. In
addition, both BIF-insured institutions and SAIF-insured institutions are
assessed amounts in order for a federally chartered Financing Corporation to
make payments on it bonds. These assessments will continue until the Financing
Corporation bonds mature in 2019.
BROKERED DEPOSITS
The Federal Deposit Insurance Act ("FDIA") restricts the use of brokered
deposits by certain depository institutions. Under the FDIA and applicable
regulations, (i) a "well capitalized insured depository institution" may solicit
and accept, renew or roll over any brokered deposit without restriction, (ii) an
"adequately capitalized insured depository institution" may not accept, renew or
roll over any brokered deposit unless it has applied for and been granted a
waiver of this prohibition by the FDIC and (iii) an "undercapitalized insured
depository institution" may not (s) accept, renew or roll over any brokered
deposit or (y) solicit deposits by offering an effective yield that exceeds by
more than 75 basis points the prevailing effective yields on insured deposits of
comparable maturity in such institution's normal market area or in the market
area in which such deposits are being solicited. The term "undercapitalized
insured depository institution" is defined to mean any insured depository
institution that fails to meet the minimum regulatory capital requirement
prescribed by its appropriate federal banking agency. The FDIC may, on a
case-by-case basis and upon application by an adequately capitalized insured
depository institution, waive the restriction on brokered deposits upon a
finding that the acceptance of brokered deposits does not constitute an unsafe
or unsound practice with respect to such institution. At June 30, 2004, the Bank
did not have any brokered deposits.
COMMUNITY INVESTMENT AND CONSUMER PROTECTION LAWS
In connection with its lending activities, the Bank is subject to a variety
of federal laws designed to protect borrowers and promote lending to various
sectors of the economy and population. Included among these are the Federal Home
Mortgage Disclosure Act, Real Estate Settlement Procedures Act, Truth-in-Lending
Act, Equal Credit Opportunity Act, Fair Credit Reporting Act and Community
Reinvestment Act ("CRA"). In order to better direct and monitor the Bank's CRA
efforts, a committee of the Board of Directors specific to Community
Reinvestment was formed during the current fiscal year.
The CRA requires insured institutions to define the communities that they
serve, identify the credit needs of those communities and adopt and implement a
"Community Reinvestment Act Statement" pursuant to which they offer credit
products and take other actions that respond to the credit needs of the
community. The responsible federal banking regulator must conduct regular CRA
examinations of insured financial institutions and assign to them a CRA rating
of "outstanding," "satisfactory," "needs improvement" or "unsatisfactory." In
last CRA rating of the Bank dated August 26, 2002, the Bank was rated
"Satisfactory".
LIMITATIONS ON DIVIDENDS
The Holding Company is a legal entity separate and distinct from its
banking and other subsidiaries. The Holding Company's principal source of funds
is cash dividends from its subsidiaries, including the Bank. Banking regulations
impose minimum capital and other regulatory restrictions on the Holding Company
and the Bank, affecting both entities ability to pay dividends. For a more
detailed discussion see "Regulation of the Company - Capital Requirements",
"Regulation of the Bank - Capital Requirements" and Note 13 to the Consolidated
Financial Statements.
26
MISCELLANEOUS
Federal laws strictly limit the ability of banks to engage in transactions
with their affiliates, including their bank holding companies. Such transactions
between a subsidiary bank and its parent company or the non-bank subsidiaries of
the bank holding company are limited to 10% of a bank subsidiary's capital and
surplus and, with respect to such parent company and all such non-bank
subsidiaries, to an aggregate of 20% of the bank subsidiary's capital and
surplus. Further, loans and extensions of credit generally are required to be
secured by eligible collateral in specified amounts. Federal law also requires
that all transactions between a bank and its affiliates be on terms as favorable
to the bank as transactions with non-affiliates.
REGULATORY ENFORCEMENT AUTHORITY
The enforcement powers available to federal banking regulators are
substantial and include, among other things, the ability to assess civil money
penalties, to issue cease-and-desist or removal orders and to initiate
injunctive actions against banking organizations and institution-affiliated
parties, as defined. In general, these enforcement actions may be initiated for
violations of laws and regulations and unsafe or unsound practices. Other
actions or inactions may provide the basis for enforcement action, including
misleading or untimely reports filed with regulatory authorities.
FEDERAL HOME LOAN BANK SYSTEM
The Bank is a member of the FHLBP, which is one of 12 regional FHLBs that
administer the home financing credit function of savings associations and
commercial banks. Each FHLB serves as a source of liquidity for its members
within its assigned region. It is funded primarily from proceeds derived from
the sale of consolidated obligations of the FHLB System. It makes loans to
members (i.e., advances) in accordance with policies and procedures established
by its Board of Directors. As of June 30, 2004, the Bank's advances from the
FHLBP amounted to $121.0 million.
As a member, the Bank is required to purchase and maintain stock in the
FHLBP in an amount equal to the greater of 1% of its aggregate unpaid
residential mortgage loans, home purchase contracts or similar obligations at
the beginning of each year or 5% of total advances. At June 30, 2004, the Bank
had $6.7 million in FHLB stock, which was in compliance with this requirement.
RECENT LEGISLATION
THE USA PATRIOT ACT
In response to the events of September 11, 2001, President George W. Bush
signed into law the Uniting and Strengthening America by Providing Appropriate
Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA
PATRIOT Act, on October 26, 2001. The USA PATRIOT Act gives the federal
government new powers to address terrorist threats through enhanced domestic
security measures, expanded surveillance powers, increased information sharing,
and broadened anti-money laundering requirements. By way of amendments to the
Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to
encourage information sharing among bank regulatory agencies and law enforcement
bodies. Further, certain provisions of Title III impose affirmative obligations
on a broad range of financial institutions, including banks, thrifts, brokers,
dealers, credit unions, money transfer agents and parties registered under the
Commodity Exchange Act. Among other requirements, Title III of the USA PATRIOT
Act imposes the following requirements with respect to financial institutions:
(a) Pursuant to Section 352, all financial institutions must establish
anti-money laundering programs that include, at minimum:
(1) internal policies, procedures, and controls,
(2) specific designation of an anti-money laundering compliance
officer,
(3) ongoing employee training programs, and
27
(4) an independent audit function to test the anti-money laundering
program. Rules promulgated under Section 352 were required to be
adopted by April 24, 2002
(b) Section 326 authorizes the Secretary of the Department of Treasury, in
conjunction with other bank regulators, to issue regulations by
October 26, 2002 that provide for minimum standards with respect to
customer identification at the time new accounts are opened.
(c) Section 312 requires financial institutions that establish, maintain,
administer, or manage private banking accounts or correspondent
accounts in the United States for non-United States persons or their
representatives (including foreign individuals visiting the United
States) to establish appropriate, specific, and, where necessary,
enhanced due diligence policies, procedures, and controls designed to
detect and report money laundering. Rules promulgated under Section
312 were due by April 24, 2002, to be effective by July 23, 2002.
(d) Effective December 25, 2001, financial institutions are prohibited
from establishing, maintaining, administering or managing
correspondent accounts for foreign shell banks (foreign banks that do
not have a physical presence in any country), and will be subject to
certain record-keeping obligations with respect to correspondent
accounts of foreign banks.
(e) Bank regulators are directed to consider a holding company's
effectiveness in combating money laundering when ruling on Federal
Reserve Act and Bank Merger Act applications.
SARBANES-OXLEY ACT OF 2002
On July 30, 2002, the President signed into law the Sarbanes-Oxley Act of
2002 implementing legislative reforms intended to address corporate and
accounting fraud. In addition to the establishment of a new accounting oversight
board which will enforce auditing, quality control and independence standards
and will be funded by fees from all publicly traded companies, the bill
restricts provision of both auditing and consulting services by accounting
firms. To ensure auditor independence, any non-audit services being provided to
an audit client will require pre-approval by the company's audit committee
members. In addition, the audit partners must be rotated. The bill requires
chief executive officers and chief financial officers, or their equivalent, to
certify to the accuracy of periodic reports filed with the SEC, subject to civil
and criminal penalties if they knowingly or willfully violate this certification
requirement. In addition, under the Act, counsel will be required to report
evidence of a material violation of the securities laws or a breach of fiduciary
duty by a company to its chief executive officer or its chief legal officer,
and, if such officer does not appropriately respond, to report such evidence to
the audit committee or other similar committee of the board of directors or the
board itself.
Longer prison terms will also be applied to corporate executives who
violate federal securities laws, the period during which certain types of suits
can be brought against a company or its officers has been extended, and bonuses
issued to top executives prior to restatement of a company's financial
statements are now subject to disgorgement if such restatement was due to
corporate misconduct. Executives are also prohibited from insider trading during
retirement plan "blackout" periods, and loans to company executives are
restricted. In addition, a provision directs that civil penalties levied by the
SEC as a result of any judicial or administrative action under the Act be
deposited to a fund for the benefit of harmed investors. The Federal Accounts
for Investor Restitution ("FAIR") provision also requires the SEC to develop
methods of improving collection rates. The legislation accelerates the time
frame for disclosures by public companies, as they must immediately disclose any
material changes in their financial condition or operations. Directors and
executive officers must also provide information for most changes in ownership
in a company's securities within two business days of the change.
28
The Act also increases the oversight of, and codifies certain requirements
relating to audit committees of public companies and how they interact with the
company's "registered public accounting firm" ("RPAF"). Audit Committee members
must be independent and are barred from accepting consulting, advisory or other
compensatory fees from the issuer. In addition, companies must disclose whether
at least one member of the committee is a "financial expert" (as such term is
defined by the SEC) and if not, why not. Under the Act, a RPAF is prohibited
from performing statutorily mandated audit services for a company if such
company's chief executive officer, chief financial officer, comptroller, chief
accounting officer or any person serving in equivalent positions has been
employed by such firm and provided services in the audit of such company within
one year of the filing of the Company's prior year Form 10-K. The Act also
prohibits any officer or director of a company or any other person acting under
their direction from taking any action to fraudulently influence, coerce,
manipulate or mislead any independent public or certified accountant engaged in
the audit of the company's financial statements for the purpose of rendering the
financial statement's materially misleading. The Act also requires the SEC to
prescribe rules requiring inclusion of a disclosure control report and
assessment by management in the annual report to shareholders. The Act requires
the RPAF that issues the audit report to attest to and report on management's
assessment of the company's internal controls. In addition, the Act requires
that each financial report required to be prepared in accordance with (or
reconciled to) generally accepted accounting principles and filed with the SEC
reflect all material correcting adjustments that are identified by a RPAF in
accordance with generally accepted accounting principles and the rules and
regulations of the SEC.
On June 5, 2003, the Commission issued final rulings regarding (i) internal
controls over financial reporting and (ii) the certifications made by Chief
Executive Officers and Chief Financial Officers under Sections 302 and 906 of
the Act. The new rule implements Section 404 of the Act, which requires public
companies to include in their annual reports on Form 10-K or 10-KSB, a report of
management on the company's internal controls over financial reporting. This
report must contain, at a minimum, (i) a statement that it is management's
responsibility for establishing and maintaining an adequate internal control
structure and procedures for financial reporting and (ii) an assessment, as of
the end of the Company's most recent fiscal year, of the effectiveness of the
Company's internal control structure and procedures for financial reporting.
Section 404 also requires every RPAF to attest to, and report on, the assessment
made by management. The provisions of the final rule are effective for
accelerated public company filers of their Form 10-K for fiscal years ending on
or after November 15, 2004.
NASD RULE - SHAREHOLDER APPROVAL OF EQUITY COMPENSATION PLANS
On June 30, 2003, the Commission approved changes to rules proposed by the
NASD, requiring shareholder approval when adopting any stock option plan,
purchase plan or other equity compensation agreement or when making a material
amendment to any such plan. While the new rules are effective immediately, most
currently existing plans are grandfathered, unless a material amendment is made
to these plans. Generally, a material amendment is any:
o Material increase in the number of shares available under the plan;
o Material increase in benefits to participants, including amendments to
allow option re-pricing;
o Material expansion of the class of participants;
o Expansion of the types of awards under the plan; or
o Material extensions of the terms of the plan.
29
Certain exceptions will continue to be permitted including options granted
as a material inducement to the hiring of a new employee.
TAXATION
The Company and its subsidiaries are subject to those rules of federal
income taxation generally applicable to corporations under the Internal Revenue
Code of 1986, as amended (the "Code"). The Company and its subsidiaries, as
members of an affiliated group of corporations within the meaning of Section
1504 of the Code, file a consolidated federal income tax return, which has the
effect of eliminating or deferring the tax consequences of inter-company
distributions, including dividends, in the computation of consolidated taxable
income.
The Company and the Bank are also subject to various forms of state
taxation under the laws of Pennsylvania.
30
ITEM 2. PROPERTIES
OFFICES AND OTHER MATERIAL PROPERTIES
At June 30, 2004, the Bank conducted its business from its main office in
Downingtown, Pennsylvania, which is also a branch office, and eleven other
full-service branch offices. PCIS conducts its business from two offices.
The following table sets forth certain information with respect to the
offices of the Company as of June 30, 2004
NET BOOK VALUE OF
LEASE PROPERTY AND LEASEHOLD
OWNED OR EXPIRATION IMPROVEMENTS AT
LEASED DATE JUNE 30, 2004 DEPOSITS
---------- -------------------------------------------------------
FIRST FINANCIAL BANK: (Dollars in Thousands)
MAIN OFFICE
100 E. Lancaster Avenue
Downingtown, PA 19335 Own -- $ 5,187 $ 66,431
BRANCH OFFICES:
Exton-Lionville
- -------------------------------------
601 N. Pottstown Pike
Exton, PA 19341 Own -- 167 65,867
Frazer-Malvern
- -------------------------------------
200 W. Lancaster Avenue
Frazer, PA 19355 Own -- 592 43,758
Thorndale
- -------------------------------------
3909 Lincoln Highway
Downingtown, PA 19335 Lease 09/30/05 32 48,474
Westtown
- -------------------------------------
1197 Wilmington Pike
West Chester, PA 19382 Lease 11/30/05 88 71,778
Airport Village
- -------------------------------------
102 Airport Road Own Bldg.
Coatesville, PA 19320 Lease Land 11/30/04 254 28,170
Brandywine Square
- -------------------------------------
82 Quarry Road
Downingtown, PA 19335 Lease 08/14/11 57 33,600
Devon
- -------------------------------------
414 Lancaster Avenue
Devon, PA 19333 Own -- 1,216 20,749
Kennett Square
- -------------------------------------
838 E. Baltimore Pike
Kennett Square, PA 19348 Lease 01/31/12 575 16,112
Eagle
- -------------------------------------
300 Simpson Drive
Chester Springs, PA 19425 Lease 04/30/18 61 12,499
Coatesville
- -------------------------------------
112-114 Old Lincoln Highway
Coatesville, PA 19320 Own -- 566 19,665
West Chester (Private Banking)
- -------------------------------------
16 East Market Street
West Chester, PA 19382 Lease 01/31/06 -- --
----------- ---------
Total $ 8,795 $427,103
=========== =========
31
PCIS
Philadelphia
- -------------------------------------
One Liberty Place, Suite 3050
1650 Market Street
Philadelphia, PA 19103 Lease 05/31/09 -- --
Wayne
- -------------------------------------
485 Devon Park Drive, Suite 109
Wayne, PA 19087 Lease 11/30/07 -- --
In addition, the Company currently owns four developed properties adjacent
to its main office. One of these properties is used as the Bank's data center
and approximately 25% of another property is rented to a third party. The
remaining two properties are currently being leased to other users and may be
used for future banking facilities. The net book value of four properties at
June 30, 2004 was approximately $837 thousand.
In September 1989, the Bank entered into a 10-year operating lease for
the Bank's Westtown office. The lease contains two five-year options to renew.
The lease has been extended to 2004.
In October 1990, the Bank entered into a 10-year lease agreement in
connection with the relocation of its existing branch in Thorndale to a new site
in the Thorndale area. The lease includes two five-year options to extend the
lease. The lease has been extended to 2005.
In May 1994, the Bank entered into a 10-year lease agreement for land in
connection with the construction of the Airport Village branch. The lease
includes three five-year options to extend the lease.
In April 1995, the Bank entered into a 15-year lease agreement for the
Bank's Brandywine Square office.
In February 2002, the Bank entered into a 10-year lease agreement for the
Bank's Kennett Square office.
In December 2001, the Bank entered into a 15-year lease agreement for the
Bank's Eagle office.
In February 2004, the Bank entered into a 2-year lease agreement for the
Bank's West Chester office.
In December 1997, PCIS entered into a five-year lease agreement for PCIS's
Wayne office. The lease has been extended to 2007.
In June 1999, PCIS entered into a five-year lease agreement for PCIS's
Philadelphia office. In June 2004, the lease was extended for an additional five
years.
First Financial operates and participates in the STAR (formerly MAC(R)),
Money Access Service shared Automated Teller Machine ("ATM") network system. In
addition, First Financial operates ten office ATMs under the STAR(R) system and
one remote ATM location.
32
ITEM 3. LEGAL PROCEEDINGS
The Company, the Bank and two employees (together "the parties") have been
sued in the Court of Common Pleas in Philadelphia, County by a former employee
to recover damages for wrongful termination of his employment. The Company
denies any wrongdoing and intends to aggressively defend its actions. The matter
has been referred to the Company's insurance carrier, who has engaged counsel to
defend its actions. The policy carries a $100,000 deductible, which includes
cost of defense. The $100,000 was expensed as of June 30, 2003. The Company
believes it will be successful in its defense; however, in the event the parties
are unsuccessful in their defense, the Company does not believe the lawsuit
would have a material adverse effect on the financial condition of the Company
as insurance coverage was and is in place.
The Company is involved in other routine, non-material legal proceedings
occurring in the ordinary course of business which management believes will not
have a material adverse effect on the financial condition or operations of the
Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
MARKET INFORMATION
As of September 3, 2004, the Holding Company's Common Stock was held by
approximately 2,008 shareholders of record not including the number of persons
or entities holding stock in nominee or street name through various brokers and
banks. Any broker or any NASD member can be contacted for the latest quotations
of the Holding Company's Common Stock. The Holding Company's NASDAQ Stock Market
symbol is "CVAL". The transfer agent for the stock is American Stock Transfer
and Trust Company, New York, New York. During fiscal 2004 and 2003, the Holding
Company paid aggregate annual dividends of $0.42 and $0.38, respectively,
adjusted for stock dividends and stock splits during those periods.
The following table sets forth the high and low closing prices for the
periods described. For comparability purposes, the closing prices shown below
have been adjusted to reflect the 5% stock dividends paid in fiscal 2004 and
2003.
FISCAL 2004 LOW HIGH
--------------------------------------------------------------------------
FIRST QUARTER $18.50 $24.50
SECOND QUARTER 21.66 23.50
THIRD QUARTER 21.40 23.65
FOURTH QUARTER 19.89 22.35
FISCAL 2003 LOW HIGH
--------------------------------------------------------------------------
First Quarter $13.65 $15.72
Second Quarter 15.88 21.73
Third Quarter 19.01 21.67
Fourth Quarter 18.34 24.46
33
ITEM 6. SELECTED FINANCIAL DATA
AT OR FOR THE YEAR ENDED JUNE 30,
-----------------------------------------------------------------------------
2004 2003 2002 2001 2000
------------ ------------ ------------ ------------ ------------
(Dollars in Thousands Except per Share Data)
SELECTED FINANCIAL CONDITION DATA
Total assets $642,108 $584,528 $566,032 $544,705 $507,150
Net loans receivable(1) 395,664 384,828 363,702 346,313 331,306
Investment securities 189,481 147,620 142,589 154,740 145,127
Deposits 427,103 400,586 385,980 413,352 378,478
Borrowings(2) 158,489 131,407 130,703 82,906 87,151
Stockholders' equity 52,257 49,571 44,171 40,098 35,502
Book value per common share(3) 10.72 10.85 9.78 8.81 7.85
SELECTED OPERATIONS DATA
Interest income $ 29,868 $ 31,715 $ 34,470 $ 37,330 $33,837
Interest expense 10,718 13,892 16,364 22,218 18,975
------------ ------------ ------------ ------------ ------------
Net interest income 19,150 17,823 18,106 15,112 14,862
Provision for loan losses 971 879 547 445 420
Non-interest income 9,086 7,574 5,348 5,930 5,536
Non-interest expense 18,940 17,629 15,977 16,030 14,164
Net income 6,310 5,262 5,575 4,003 4,557
Basic earnings per share 1.30 1.10 1.17 0.84 0.96
Diluted earnings per share 1.26 1.06 1.16 0.83 0.96
Dividends per share(3) .42 .38 .36 .30 .29
------------ ------------ ------------ ------------ ------------
(1) Includes loans held for sale
(2) Includes Federal Home Loan Bank advances, Securities sold under agreements
to repurchase and trust preferred securities.
(3) Adjusted to reflect 5% stock dividends paid in September 2003, 2002, 2001,
and 2000.
AT OR FOR THE YEAR ENDED JUNE 30,
-----------------------------------------------------------------------------
2004 2003 2002 2001 2000
------------ ------------ ------------ ------------ ------------
OTHER SELECTED DATA
Average interest rate spread 3.21% 3.16% 3.29% 2.71% 2.95%
Net yield on average
interest-earning assets 3.46% 3.43% 3.66% 3.19% 3.49%
Ratio of non-performing loans and
REO to total assets at end of
Period .66% .72% .17% .22% .19%
Number of bank offices
at end of period 12 10 9 8 8
34
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
GENERAL
The Company's results of operations depend primarily on its net interest
income, which is the difference between interest income on interest-earning
assets, which consists principally of loans and investment securities, and
interest expense on interest-bearing liabilities, which consist of deposits and
borrowings. Net interest income is determined by the Company's interest rate
spread (the difference between the yields earned on its interest-earning assets
and the rates paid on its interest-bearing liabilities) and the relative amounts
of interest-earning assets and interest-bearing liabilities.
The Company's results of operations also are affected by the provision
for loan losses resulting from management's assessment of the allowance for loan
losses; the level of its non-interest income, including investment service fees,
account service fees and related income and gains and losses from the sales of
loans and securities; the level of its non-interest expense, including salaries
and employee benefits, occupancy and equipment expense, data processing
services, deposit insurance premiums, advertising, other operating costs; and
income tax expense.
The Bank is a community-oriented bank, which emphasizes customer service
and convenience. As part of this strategy, the Bank offers products and services
designed to meet the needs of its customers. The Company generally has sought to
achieve long-term financial growth and strength by increasing the amount and
stability of its net interest income and non-interest income and by maintaining
a high level of asset quality. In pursuit of these goals, the Company has
adopted a business strategy emphasizing growth in basic financial services. The
focus is on commercial and construction lending, commercial deposits and
treasury management, consumer deposits and loans and trust and investment
management.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Discussion and analysis of the financial condition and results of
operations are based on the consolidated financial statements of the Company,
which are prepared in accordance with accounting principles generally accepted
in the United States. The preparation of these financial statements requires the
Bank to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. The Company evaluates estimates on an on-going basis, including
those related to the allowance for loan losses, non-accrual loans, other real
estate owned, other than temporary impairments of investment securities, pension
and post-retirement benefits, the stock option plan, recourse liabilities and
income taxes. The Company bases its estimates on historical experience and
various other factors and assumptions that are believed to be reasonable under
the circumstances, the results of which form the basis for making judgments
about the carrying values of assets and liabilities that are not readily
apparent from other sources. Actual results may differ from these estimates
under different assumptions or conditions.
The Company believes the following critical accounting policies affect its
more significant judgments and estimates used in preparation of its consolidated
financial statements: allowance for loan losses, income taxes, and other than
temporary impairment of investment securities. Each estimate is discussed below.
The financial impact of each estimate is discussed in the applicable subsections
of "Management's Discussion and Analysis of Financial Condition and Operations."
35
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at a level that represents
management's best estimate of known and inherent losses, which are probable and
reasonably estimable based upon an evaluation of the loan portfolio as of the
date of the balance sheet. Homogeneous portfolios of loans, which include
residential mortgage, home equity and other consumer loans, are evaluated as a
group. Commercial business loans greater than $100,000, commercial mortgage and
construction loans are evaluated individually. Specific portions of the
allowance are developed by analyzing individual loans for adequacy of
collateral, cash flow and other risks unique to that particular loan. General
portions of the allowance are developed by grading individual loans in the
commercial and construction portfolios and applying loss factors by grade. The
general portion of the allowance also includes loss factors applied to the
homogeneous portfolios as a group. The loss factors applied to graded loans were
developed based on the Company's loss history for loans with similar attributes,
local and national economic conditions as well as input from the Company's
primary banking regulators. Loss factors are applied to homogeneous loans based
upon prior loss experience of the portfolio as well as delinquency trends, local
and national economic conditions as well as the volume of non-performing loans,
the volume of classified and watch-list loans and trends in concentration of
loans to single borrowers. Although management believes it has used the best
information available to it in making such determinations, and that the present
allowance for loan losses is adequate, future adjustments to the allowance may
be necessary, and net income may be adversely affected if circumstances differ
substantially from the assumptions used in determining the level of the
allowance. In addition, various regulatory agencies, as an integral part of
their examination process, periodically review the Bank's allowance for losses
on loans. Such agencies may require the Bank 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, other than those incurred
on loans held for sale, are charged directly against the allowance and
recoveries on previously charged-off loans are added to the allowance.
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 loans and consumer loans as well as
commercial business loans with balances of less than $100,000. For applicable
loans, the Company evaluates the need for impairment recognition when a loan
becomes non-accrual or earlier if, based on management's assessment of the
relevant facts and circumstances, it is probable that the Company will be unable
to collect all proceeds under the contractual terms of the loan agreement. At
June 30, 2004, the recorded investment in impaired loans was $4.0 million as
compared to $3.2 million at June 30, 2003. The increase is due primarily to the
aforementioned two commercial loans to a single borrower who has encountered
recent financial difficulties. The Company's policy for the recognition of
interest income on impaired loans is the same as for non-accrual loans. A
portion of an impaired loan is charged off when the Company determines that
foreclosure is probable and the fair value less estimated disposition costs of
the collateral is less than the recorded investment of the impaired loan.
INCOME TAXES
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to the difference between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
base, as well as tax credit carry forwards. 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. Based on management's evaluation of the likelihood of
realization, no valuation allowance has been established. 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.
36
OTHER THAN TEMPORARY IMPAIRMENT OF INVESTMENT SECURITIES
Securities are evaluated periodically to determine whether a decline in
their value is other than temporary. Management utilizes criteria such as the
magnitude and duration of the decline, in addition to the reasons underlying the
decline, to determine whether the loss in value is other than temporary. The
term "other than temporary" is not intended to indicate that the decline is
permanent, but indicates that the prospects for a near-term recovery of value is
not necessarily favorable, or that there is a lack of evidence to support
realizable value equal to or greater than carrying value of the investment. Once
a decline in value is determined to be other than temporary, the value of the
security is reduced and a corresponding charge to earnings is recognized.
BUSINESS STRATEGY
GROWTH. The Company seeks to increase its assets through internal growth
and by expanding its operations.
In 2004, the Company's assets increased by $57.6 million, or 9.9% from
$584.5 million at June 30, 2003 to $642.1 million at June 30, 2004 resulting
mainly from $14.2 million growth in the loan portfolio as well as a $41.9
million increase in the investment security portfolio. Such loan and investment
growth was funded primarily with a growth in core deposits as well as Federal
Home Loan Bank advances.
EMPHASIS ON COMMERCIAL LENDING. The Company has been and will continue to
expand its higher yielding portfolios of commercial business and commercial real
estate loans. This strategy is reflected in the shifting composition of the
Company's loan portfolio. The Company's commercial real estate, commercial
business and construction and land acquisition loans comprised 55.9% of its
total loan portfolio at June 30, 2004 compared to 53.8% at June 30, 2003.
Single-family and multi-family residential loans comprised 17.3% of the
Company's loan portfolio at June 30, 2004 as compared to 24.7% at June 30, 2003.
MAINTAIN LOAN QUALITY. Management believes that maintaining high loan
quality is key to achieving and sustaining long-term financial success.
Accordingly, the Company has sought to maintain a high level of asset quality
and moderate credit risk by using underwriting standards which management
believes are conservative and by generally limiting its origination of loans to
its market area. The Company's non-accrual loans totaled $4.2 million at both
June 30, 2004 and June 30, 2003. Both years contained a single commercial real
estate loan in the amount of $2.9 million and $3.1 million, respectively.
Although the loan is current in the payment of interest as it has been due since
its origination in 1998 and the next quarterly payment has been prepaid, the
loan was placed on non-accrual as principal was not repaid in accordance with
the original stated maturity, the borrower has encountered financial
difficulties which it continues to attempt to work-out, the underlying real
estate is outside the Bank's primary lending area and repayment is largely
dependent upon factors not under the complete control of the borrower. Excluding
this loan, the Company's ratio of non-performing assets to total assets at June
30, 2004 and June 30, 2003 was 0.20% and 0.19%, respectively - See
reconciliation on page 8. Also included in the current year are two commercial
loans to a single borrower aggregating $655,000. The borrower has encountered
financial difficulties but continues to maintain current debt service payments.
The loans were placed on non-accrual due to a potential collateral short-fall in
the event that collateral liquidation would be required to satisfy the loans.
STABLE SOURCE OF LIQUIDITY. The Company purchases investment securities
that management believes to be appropriate for liquidity, yield and credit
quality in order to achieve a managed and more predictable source of liquidity
to meet loan demand and, to a lesser extent, a stable source of interest income.
The portfolio totaled, in the aggregate, $189.5 million at June 30, 2004
compared to $147.6 million at June 30, 2003.
37
EMPHASIS ON DEPOSITS AND CUSTOMER SERVICE. The Company, as a
community-based financial institution, is largely dependent upon its base of
competitively priced core deposits to provide a stable source of funding. The
Company has retained many loyal customers over the years through a combination
of high quality service, competitively priced service fees, customer
convenience, an experienced staff and a strong commitment to the communities in
which it serves. Lower costing deposits, which exclude time deposits, totaled
$319.7 million or 74.9% of the Company's total deposits at June 30, 2004, as
compared to $254.0 million at June 30, 2003, a $65.8 million or 25.9% increase.
Included in the $65.7 million are $12.8 million in core deposits (additional
$6.7 in certificates were acquired as well) acquired in the Bank's acquisition
of the Coatesville branch from PNC National Bank. Management believes that this
acquisition enhances the Bank's existing Chester County branch network and
positions it well to participate in the revitalization currently underway in the
City of Coatesville. This increase in lower costing deposits is primarily
attributable to the continuing effort to grow core deposits. Pursuant to the
Company's strategy, the major focus in 2005 will continue to be on increasing
commercial and consumer core deposits and to a lesser extent certificates of
deposit which may become more attractive to the consumer in a rising interest
rate environment. In addition, the Company has not used brokered deposits as a
source of funds and presently has no plans to do so in the future.
CONTRACTUAL OBLIGATIONS, COMMITMENTS, CONTINGENT LIABILITIES AND OFF-BALANCE
SHEET ITEMS
The following table presents, at June 30, 2004, the Company's significant fixed
and determinable contractual obligations by payment date. Such amounts do not
include any unamortized premium, discounts or other similar carrying value
adjustments. For additional discussion, see notes to consolidated financial
statements.
Payments Due In
------------------------------------------------------------------------
Over two Over three
One year or Over one to years to years to Over four
(In Thousands) less two years three years four years years Total
- ------------------------------- ----------- ----------- ----------- ---------- --------- ---------
Core deposits $ 319,736 $ -- $ -- $ -- $ -- $ 319,736
Certificates of deposit 61,723 15,742 11,261 4,635 14,006 107,367
FHLBP advances 13,500 1,550 10,691 3,350 91,872 120,963
Repurchase agreements 27,216 -- -- -- -- 27,216
rust preferred securities -- -- -- -- 10,310 10,310
Operating leases 790 675 543 483 2,357 4,848
The Company also entered into three separate forward starting interest rate swap
agreements whereby the Company is required at a future date to make periodic
variable rate payments; indexed to the three month LIBOR rate, to the swap
counter-party while receiving fixed rate payments based upon an aggregate
notional amount of $41 million. Additionally, in August 2003, the Bank purchased
a $30 million notional amount 3.50% Three Month LIBOR interest rate cap while
simultaneously selling a $30 million notional amount 6.00% Three Month LIBOR
interest rate cap ("Interest Rate Corridor"). The Company paid a net premium,
which entitles it to receive the difference between Three Month LIBOR from 3.50%
to 6.00% times the $30 million notional amount. Derivative contracts are carried
at fair value on the consolidated balance sheet. See Asset/Liability Management
as well as Note 14 to consolidated financial statements for additional
information on derivative contracts.
38
A schedule of significant commitments at June 30, 2004 follows:
Contract or
Amount at
(In Thousands) June 30, 2004
----------------------------------------------------------------
Commitments to originate loans $ 10,041
Undisbursed loans in process - construction 25,549
Undisbursed lines of credit 83,210
Commercial letters of credit 1,128
-------------
Total $ 119,928
=============
ASSET/LIABILITY MANAGEMENT
The primary asset/liability management goal of the Company is to manage and
control the interest rate risk of the bank subsidiary, thereby reducing its
exposure to fluctuations in interest rates, and achieving sustainable growth in
net interest income over the long term. Other objectives of asset/liability
management include: (1) ensuring adequate liquidity and funding, (2) maintaining
a strong capital base and (3) maximizing net interest income opportunities.
In general, interest rate risk is mitigated by closely matching the
maturities or re-pricing periods of interest-sensitive assets and liabilities to
ensure a favorable interest rate spread. Management regularly reviews the Bank's
interest-rate sensitivity, and uses a variety of strategies as needed to adjust
that sensitivity within acceptable tolerance ranges established by the Board of
Directors. Changing the relative proportions of fixed-rate and adjustable-rate
assets and liabilities is one of the primary strategies utilized by the Company
to accomplish this objective.
Additionally, the Company may from time to time utilize off-balance sheet
instruments such as interest rate swaps, interest rate collars, interest rate
floors, interest rate swaptions or combinations thereof to assist in its
asset/liability management. At June 30, 2004, the Company was positively gapped
whereby its interest-earning assets were re-pricing at a quicker rate than its'
interest-bearing liabilities. To partially offset the negative impact of the
current low market interest rate environment, the Company entered into three
separate interest rate swap transactions aggregating $41 million notional amount
to hedge certain of its' higher rate FHLBP Advances. The swaps had the effect of
converting the higher fixed rate Advances to lower adjustable rate borrowings,
which positively impacts the Company's net interest margin in the current
interest rate environment. Further, since the Company is positively gapped; if
the balance sheet were to remain static, future increases should have similar
impacts to the earnings and costs of the interest-earning assets and
interest-bearing liabilities. Additionally, in August 2003, the Bank purchased a
$30 million notional amount 3.50% Three Month LIBOR interest rate cap while
simultaneously selling a $30 million notional amount 6.00% Three Month LIBOR
interest rate cap ("Interest Rate Corridor"). The Company paid a net premium,
which entitles it to receive the difference between Three Month LIBOR from 3.50%
to 6.00% times the $30 million notional amount. The Interest Rate Corridor is
being used to hedge the cash flows of $10.3 million in floating rate Trust
Preferred Securities as well as the cash flows of certain borrowings, which
could negatively impact earnings in a rising interest rate environment.
The matching of assets and liabilities may be analyzed by examining the
extent to which such assets and liabilities are "interest-rate sensitive" and by
monitoring an institution's interest-sensitivity gap. An interest-sensitivity
gap is considered positive when the amount of interest-rate sensitive assets
exceeds the amount of interest-rate sensitive liabilities re-pricing within a
defined period and is considered negative when the amount of interest-rate
sensitive liabilities exceeds the amount of interest-rate sensitive assets
re-pricing within a defined period.
39
To provide a more accurate one-year gap position of the Company, certain
deposit classifications are based on the interest-rate sensitive attributes and
not on the contractual re-pricing characteristics of these deposits. Management
estimates, based on historical trends of the Bank's deposit accounts, that a
portion of money market, NOW accounts and savings deposits are partially
sensitive to interest rate changes. Accordingly, the interest-sensitive portions
of these deposits are classified in the less than one-year categories with the
remainder spread over a five-year period. Deposit products with interest rates
based on a particular index, if any, are classified according to the specific
re-pricing characteristic of the index. Deposit rates other than time deposit
rates are variable, and changes in deposit rates are typically subject to local
market conditions and management's discretion and are not indexed to any
particular rate.
Generally, during a period of rising interest rates, a positive gap would
result in an increase in net interest income while a negative gap would
adversely affect net interest income. However, the interest-sensitivity table
that follows does not provide a comprehensive representation of the impact of
interest rate changes on net interest income. Each category of assets or
liabilities will not be affected equally or simultaneously by changes in the
general level of interest rates. Even assets and liabilities, which
contractually re-price within the same period may not, in fact, re-price at the
same price or the same time or with the same frequency. It is also important to
consider that the table represents a specific point in time. Asset/liability
management is a dynamic process that is actively monitored and managed and thus
variations can occur as the Company adjusts the interest-sensitivity position
for the Bank throughout the year.
40
INTEREST RATE SENSITIVITY ANALYSIS AT JUNE 30, 2004 FOR THE BANK
(Dollars in thousands)
More
More Than Than More Than
Three Six One Year More Than
Three Months Months Through Three Years
Months Through Through Three Through More Than
or Less Six Months One Year Years Five Years Five Years Total
---------- ------------ ----------- ----------- ----------- ----------- -----------
INTEREST-EARNING ASSETS
Loans (1)
Real estate (2) $ 64,643 $ 14,332 $ 25,946 $ 68,380 $ 46,453 $ 18,312 $ 238,066
Commercial 35,455 1,657 2,856 6,949 2,225 -- 49,142
Consumer 50,057 4,484 8,148 23,803 13,134 15,161 114,787
Securities and interest-bearing
deposits 75,907 21,265 16,455 36,970 29,757 25,625 205,979
---------- ---------- ---------- ---------- ---------- ---------- ----------
TOTAL INTEREST-EARNING ASSETS $ 226,062 $ 41,738 $ 53,405 $ 136,102 $ 91,569 $ 59,098 $ 607,974
---------- ---------- ---------- ---------- ---------- ---------- ----------
INTEREST-BEARING LIABILITIES
Savings accounts $ 1,728 $ 1,729 $ 3,462 $ 13,888 $ 13,955 $ -- $ 34,762
NOW accounts 1,674 1,675 3,352 13,449 13,513 30,781 64,444
Money market accounts 127,973 1,745 3,500 10,746 7,486 -- 151,450
Certificate accounts 23,669 12,504 25,545 27,004 15,866 2,779 107,367
Borrowings(3) 68,412 4,531 9,077 12,119 24,345 29,695 148,179
---------- ---------- ---------- ---------- ---------- ---------- ----------
TOTAL INTEREST-BEARING LIABILITIES $ 223,456 $ 22,184 $ 44,936 $ 77,206 $ 75,165 $ 63,255 $ 506,202
---------- ---------- ---------- ---------- ---------- ---------- ----------
Cumulative excess of interest-earning
assets to interest-bearing liabilities $ 2,606 $ 22,160 $ 30,629 $ 89,525 $ 105,929 $ 101,772 $ 101,772
========== ========== ========== ========== ========== ========== ==========
Cumulative ratio of interest rate-sensitive
assets to interest rate-sensitive
liabilities 101.2% 109.0% 110.5% 124.3% 123.9% 120.1% 120.1%
========== ========== ========== =========== ========== =========== ==========
CUMULATIVE DIFFERENCE AS A PERCENTAGE
OF TOTAL ASSETS 0.4% 3.5% 4.8% 14.0% 16.6% 15.9% 15.9%
========== ========== ========== ========== ========== ========== ==========
(1) Net of loans in process.
(2) Includes commercial mortgage loan.
(3) Reflects the impact of $40 million notional amount interest rate swap
See Managements Discussion and Analysis of Financial Condition and Operations
for Rate Shock Analysis.
41
OPERATING RESULTS
INTEREST INCOME (TAXABLE-EQUIVALENT BASIS) - SEE TABLE RECONCILIATION ON
PAGE 18.
Interest income is analyzed on a tax-equivalent basis, i.e., an adjustment
is made for analysis purposes only, to increase interest income by the amount of
savings of Federal income taxes, which the Company realizes by investing in
certain tax-free municipal securities and by making loans to certain tax-exempt
organizations. In this way, the ultimate economic impact of earnings from
various assets can be more readily compared.
Total interest income decreased $1.9 million to $30.6 million from $32.5
million for the years ended June 30, 2004 and 2003, respectively. The reduction
was attributed largely to a decline on the yield on loans. A year over year
comparison for the twelve months ended June 30, 2004 and 2003 shows a decline in
the yield on loans of 0.98% (6.80% to 5.82%) due largely to the general movement
in market interest rates and repayment of higher rate loans. The impact of the
aforementioned decline in yield was partially offset by increases in average
outstanding loan and investment balances of $26.0 million and $7.0 million,
respectively. Total interest income decreased $2.8 million to $32.5 million from
$35.3 million for the years ended June 30, 2003 and 2002, respectively. The
reduction was attributed largely to a similar decline on the yield on both loans
and investments. A year over year comparison for the twelve months ended June
30, 2003 and 2002 shows a decline in the yield on loans of 0.64% (7.44% to
6.80%) and a decline in the yield on investments of 1.27% (5.43% to 4.16%).
These declines are in-line with the general movement in market interest rates.
The impact of the aforementioned decline in yields was partially offset by
increases in average outstanding loan and investment balances of $17.3 million
and $7.0 million, respectively. The weighted average yield on average
interest-earning assets was 5.32%, 6.00% and 6.83% for fiscal 2004, 2003 and
2002, respectively, reflecting the decline in general market rates of interest
throughout the periods.
INTEREST EXPENSE
Total interest expense decreased $3.2 million to $10.7 million from
$13.9 million for the years ended June 30, 2004 and 2003, respectively. The
primary reason for the decline is due to a 0.71% reduction in the cost of
interest-bearing deposits due to both the general decline in market interest
rates as well as the Bank's focused effort to shift the deposit mix from higher
costing certificates of deposit to lower costing core deposits (demand deposits,
savings and money market accounts). Additionally, the cost on FHLB advances and
other borrowings declined by 1.15% due partially to the implementation of the
aforementioned Interest Rate Swap and Interest Rate Corridor transactions which
reduced interest expense by $712,000 or 0.56% as well as the Bank securing lower
costing borrowings to fund the previously noted asset growth. This reduction was
partially offset by an increase in average outstanding interest-bearing deposit
balances as well as average outstanding borrowing balances. Total interest
expense decreased $2.5 million to $13.9 million from $16.4 million for the years
ended June 30, 2003 and 2002, respectively. The primary reason for the decline
is due to a 0.97% reduction in the cost of interest-bearing deposits due to both
the general decline in market interest rates as well as the Bank's focused
effort to shift the deposit mix from higher costing certificates of deposit to
lower costing core deposits (demand deposits, savings and money market
accounts). This reduction was partially offset by an increase in average
outstanding interest-bearing deposit balances as well as average outstanding
borrowing balances.
NET INTEREST INCOME
Net interest income is the difference between interest income on
interest-earning assets and interest expense on interest-bearing liabilities.
Net interest income, on a fully tax equivalent basis, increased by $1.3 million
due principally to the continued growth in core deposits as well as the Interest
Rate Swap and Interest Rate Corridor transactions referred to above. Also,
contributing to the increase was an increase in average earning assets of $33.1
million. From fiscal 2003 to fiscal 2004, the yield on interest-earning assets
declined by 0.68% while the cost of interest-bearing liabilities declined by
0.73%. Net interest income, on a fully tax equivalent basis, declined by $350
thousand due principally to the fact that the Bank had more assets re-price
during the year as compared to the re-pricing of interest-bearing liabilities.
The yield on interest-earning assets declined by 0.83%, from 6.83% to 6.00% from
fiscal 2002 as compared to fiscal 2003. During the same period, the cost of
interest-bearing liabilities declined by 0.70%, from 3.54% to 2.84%.
42
PROVISION FOR LOAN LOSSES
The Company's provision for loan losses was $971 thousand, $879 thousand
and $547 thousand, during fiscal 2004, 2003 and 2002, respectively. These
additions to the allowance for loan losses are due to the Company's continued
focus on building a larger portfolio of commercial and industrial loans, which
typically carry a greater risk of loss than the Company's traditional loan
portfolios, such as mortgages and real estate loans. This change in the
character of the loan portfolio, the increase in non-performing loans as well as
management's on-going assessment of the inherent risk of loss existing in the
loan portfolio determined the amount necessary to increase the allowance for
loan losses to an appropriate level. At June 30, 2004, the allowance for loan
losses totaled $6.3 million or 1.60% of net loans compared to $5.4 million or
1.41% of net loans at June 30, 2003.
The Company establishes provisions for loan losses, which are charged to
operations, in order to maintain the allowance for loan losses at a level which
management believes covers all known and inherent losses in the loan portfolio.
In establishing the provision, management considers among other things, the
portfolio mix, delinquency trends, volume of non-performing loans, volume of
classified loans and historical loss experience of the portfolio as well as
current economic conditions, and other relevant factors. Although management
believes it has used the best information available to it in making such
determinations, and that the present allowance for loan losses is adequate,
future adjustments to the allowance may be necessary, and net income may be
adversely affected if the circumstances differ substantially from the
assumptions used in determining the level of the allowance for loan losses. In
addition, various regulatory agencies, as an integral part of their examination
process, periodically review the Bank'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.
NON-INTEREST INCOME
Total non-interest income increased by $1.5 million or 20.0% to $9.1
million for the year ended June 30, 2004 compared to the prior fiscal year. The
primary reason for the increase was due to an increase in investment services
income of $561 thousand due primarily to increased commissions at PCIS resulting
from increased client trading volume, an increase in deposit service fees of
$236 thousand due to the continued increase in the Bank's core deposit base,
which deposits are traditionally more fee oriented as compared to certificates
of deposit and an increase in gains realized upon the sale of securities
available for sale of $203 thousand due largely to the liquidation of a large
portion of a community bank stock portfolio owned by the Holding Company. The
stocks were sold as the Banks were acquired during the current fiscal year at
prices significantly greater than the Company's acquisition cost. Another
contributing factor was a reduction of $383 thousand in investment security
impairment write-downs as the Bank recorded a $383 thousand loss in fiscal 2003,
on an other than temporary impairment write-down of a revenue bond backed by the
revenue stream of a public play golf course in Bedford County, Pennsylvania.
This bond was subsequently sold in the current fiscal year at an approximate
additional loss of $68,000 and is net against gains realized on securities
available for sale. Total non-interest income increased by $2.2 million or 41.6%
to $7.6 million for the year ended June 30, 2003 compared to the prior fiscal
year. The primary reason for the increase was due to an increase in deposit
service fees of $944 thousand, as the Bank continued, during fiscal year 2003,
to increase its core deposit base, which deposits are traditionally more fee
oriented as compared to certificates of deposit and an increase in gains
realized upon the sale of securities available for sale of $576 thousand. Also
contributing to the increase was a reduction of $572 thousand in investment
security impairment write-downs to $383 thousand compared to $955 thousand in
the prior year. During the year, the Bank recorded a $383 thousand loss on an
other than temporary impairment write-down of a revenue bond backed by the
revenue stream of a public play golf course in Bedford County, Pennsylvania.
This compares to the $955 thousand loss incurred in the prior fiscal year.
43
OPERATING EXPENSES
Total operating expenses increased by $1.3 million or 7.4% to $18.9 million
for the year ended June 30, 2004 as compared to $17.6 million for the fiscal
year 2003. Salaries and employee benefits increased $919 thousand or 9.3% to
$10.8 million from $9.9 million for the year ended June 30, 2004 compared to the
prior year ended June 30, 2003. In addition to normal salary increases, the
increase is due largely to having a full years salary for the Eagle branch
opened in fiscal 2003, the compensation costs associated with the Coatesville
branch acquisition which occurred on March 31, 2004 and additional incentive
compensation paid to employees as a result of the increased profitability and
performance of the Company. Additionally, marketing expense increased by $135
thousand as the Bank implemented a special marketing campaign designed to
increase consumer checking accounts and other operating expenses increased by
$212 due largely to a Sarbanes-Oxley review conducted by outside counsel on
behalf of the audit committee and increased State of Pennsylvania shares tax due
to the increased net worth of the Bank as well as an increase in insurance costs
in line with that experienced within the insurance industry. Total operating
expenses increased by $1.6 million or 10.3% to $17.6 million for the year ended
June 30, 2003 as compared to $16.0 million for the fiscal year 2002. Salaries
and employee benefits increased $781 thousand or 8.6% to $9.9 million from $9.1
million for the year ended June 30, 2003 compared to the prior year ended June
30, 2002. In addition to normal salary increases, the increase is due largely to
having a full years salary for the Kennett Square branch opened in February 2002
as well as salaries for the Eagle branch opened in fiscal 2003. Additionally,
management infrastructure was added to further accommodate the shift to a
commercial bank. Occupancy and equipment increased $333 thousand or 13.4% from
fiscal 2002 to 2003 due primarily to the aforementioned branch expansions. Other
operating expenses increased by $603 thousand or 19.5% from $3.1 million for the
year ended June 30, 2002 as compared to $3.7 million for the year ended June 30,
2003. The increase is due largely to increased legal costs of $237 thousand
resulting from the lawsuit instituted by a former employee (See Legal Matters -
Page 29), increased State of Pennsylvania shares tax due to the increased net
worth of the Bank as well as an increased period of assessment due to the timing
of the commercial bank conversion, increased audit and tax fees resultant from
additional outsourced internal audit functions and increased insurance costs in
line with that experienced within the insurance industry.
INCOME TAXES
Income tax expense for the year ended June 30, 2004 was $2.0 million, an
increase of $388 thousand or 23.9% from fiscal 2003 to fiscal 2004. The
effective tax rate for fiscal 2004 was 24.2% as compared to an effective tax
rate of 23.6% for fiscal year 2003. The increase in the effective tax rate was
the result of a lower portion of the Company's pre-tax income being comprised of
tax-free interest income. Pre-tax income increased $1.4 million or 20.8% from
fiscal 2003 to fiscal 2004. Income tax expense for the year ended June 30, 2003
was $1.6 million, an effective tax rate of 23.6% as compared to an effective tax
rate of 19.6% for fiscal year 2002. The increase in the effective tax rate was
the result of a lower portion of the Company's pre-tax income being comprised of
tax-free interest income. Pre-tax income was comparable from fiscal 2003 to
fiscal 2002.
CAPITAL RESOURCES
Total assets at June 30, 2004 aggregated $642.1 million as compared to
$584.5 million at June 30, 2003, a 9.9% increase year on year. The increase is
due principally to a $14.2 million increase in outstanding loans receivable and
a $41.9 million increase in investment security balances. Total liabilities
increased $54.9 million from June 30, 2003 to June 30, 2004 driven primarily
from deposit growth of $26.5 million ($19.5 million resulted from the
Coatesville branch acquisition); primarily in the lower costing core deposits,
which increased $65.8 million. Additionally, FHLBP Advances increased $26.9
million, as the Company was able to lock in low rates for longer terms. These
borrowings were utilized rather than certificates of deposits as consumers were
not willing to lock in to comparable term certificates at the current rate
levels. Total assets at June 30, 2003 aggregated $584.5 million as compared to
$566.0 million at June 30, 2002, a 3.3% increase year on year. The increase is
due principally to a $21.1 million increase in outstanding loans receivable
(including loans held for sale), a $5.0 million increase in investment
securities and a $5.5 million increase in other assets resulting primarily from
the purchase of the BOLI. These increases were offset by a $13.6 million
reduction in cash and cash equivalents as funds were deployed in higher earning
assets. Total liabilities increased $13.1 million from June 30, 2002 to June 30,
2003 driven primarily from deposit growth of $14.6 million; primarily in the
lower costing core deposits. Additionally, securities sold under repurchase
agreements ("repurchase agreements") increased $9.1 million as more commercial
customers took advantage of this relatively new product. The deposit and
repurchase agreement increases were partially offset by a reduction in FHLBP
Advances of $8.4 million.
45
Stockholders' equity increased $2.7 million at June 30, 2004 to $52.3
million from $49.6 million at June 30, 2003. The increase is due primarily to
net income for the year ended June 30, 2004 of $6.3 million and the issuance of
common stock from the exercise of stock options aggregating $1.2 million. These
increases were offset by the payment of cash dividends totaling $1.9 million and
a change in the net unrealized loss on securities available for sale of $2.7
million. Stockholders' equity increased $5.4 million at June 30, 2003 to $49.6
million from $44.2 million at June 30, 2002. The increase is due primarily to
net income for the year ended June 30, 2003 of $5.3 million, the issuance of
common stock aggregating $1.1 million and changes in the unrealized gain (loss)
of securities available for sale of $1.3 million. These increases were offset by
the payment of cash dividends totaling $1.8 million and the repurchase of common
stock totaling $452 thousand.
ASSET QUALITY
Non-performing loans totaled $4.2 million at both June 30, 2004 and June
30, 2003. Non-performing loans to total assets was 0.66% at June 30, 2004,
compared to 0.72% at June 30, 2003. Non-performing loans at June 30, 2004,
consisted of 8 residential mortgage loans in the amount of $591 thousand, as
well as a single commercial real estate loan in the amount of $2.9 million.
Although the loan is current in the payment of interest as it has been due since
its origination in 1998 and the next quarterly interest payment has been
prepaid, the loan was placed on non-accrual as principal was not repaid in
accordance with the original stated maturity and the Bank has extended the loan
as the borrower attempts to work through its financial difficulties and
re-finance the project with another lender. Additionally, June 30, 2004
non-performing loans include two commercial loans to a single borrower who has
encountered recent financial difficulties. Although the borrower has kept the
loan current in accordance with its terms, the loan was placed on non-accrual as
the Bank feels there may be a potential collateral short-fall if the collateral
is required to be liquidated to satisfy the loans. Real estate owned at June 30,
2004 is $54 thousand and consists of one single-family residential property.
At June 30, 2004 and 2003, the Company's classified loans, which
consisted of loans classified as substandard, doubtful, loss, and REO, totaled
$10.7 million and $15.3 million, respectively. Included in the assets classified
substandard at June 30, 2004 and 2003, were all loans 90 days past due and loans
which are less than 90 days delinquent, but inadequately protected by the
current paying capacity of the borrower or of the collateral pledged, as well as
a well-defined weakness that may jeopardize the liquidation of the debt.
Additionally, total loans delinquent 30 days or more to outstanding loans
approximate 0.50% at both June 30, 2004 and June 30, 2003.
In addition to non-performing loans and REO, classified assets include
three non-rated Pennsylvania Municipal Authority Bonds that have been classified
as substandard. These bonds were originally purchased during the period from
June 1998 through June 2000. The aggregate book value of the bonds; after
write-downs of $955 thousand, are $5.6 million. Two of the three bonds with an
aggregate book value of $4.9 million are zero coupon bonds with maturities
extending up to 2034. Both bonds are secured by the revenue streams of
commercial office buildings, which are leased to various agencies of the
Commonwealth of Pennsylvania under long-term lease arrangements with renewal
options.
The third bond was issued by the Housing Authority of Chester County
and has a book balance of $720 thousand at June 30, 2004 and bears interest at
rates between 5.60% and 6% and matures in June 2019. This bond involves
low-income scattered housing in Chester County under a program of the Office of
Housing and Urban Development ("HUD"). HUD has committed to provide additional
funds to build additional houses, which would be donated to this bond issues.
The retirement of the bond issue is dependent upon proceeds from either the
rental or sale of the existing and additional houses. This bond is on
non-accrual at June 30, 2004.
45
A fourth bond was classified at June 30, 2003 but was sold during the
current fiscal year at an approximate loss of $68,000 (subsequent to a $383
thousand write-down taken in fiscal 2003).
These classified investments are closely monitored and fairly stated at
June 30, 2004 based on available information. There can be no assurance that
further subsequent adverse or positive developments may occur and thus could
result in further adjustments to the carrying value of these investments.
LIQUIDITY AND CAPITAL RESOURCES
Management monitors liquidity daily and maintains funding sources to meet
unforeseen changes in cash requirements. The Company's primary sources of funds
are deposits, borrowings, repayments, prepayments and maturities of outstanding
loans and mortgage-backed securities, sales of assets available for sale,
maturities and calls of investment securities and other short-term investments,
and funds provided from operations. While scheduled loan and mortgage-backed
securities repayments and maturing investment securities and short-term
investments are relatively predictable sources of funds, deposit flows, loan
prepayments and callable investments are greatly influenced by the movement of
interest rates in general, economic conditions and competition. The Company
manages the pricing of its deposits to maintain a deposit balance deemed
appropriate and desirable. Although the Company's deposits represent the
majority of its total liabilities, the Company has also utilized other borrowing
sources, namely FHLBP advances. In addition to its ability to obtain advances
from the FHLBP under several different credit programs, the Company has
established a line of credit with the FHLBP, in an amount of $10 million. This
line of credit is available for liquidity purposes. At June 30, 2004 there was
no outstanding balance on this line of credit.
Liquidity management is both a daily and long-term function. Excess
liquidity is generally invested in short-term investments such as FHLBP
overnight deposits. On a longer term basis, the Company maintains a strategy of
investing in various lending and investment securities products. During the year
ended June 30, 2004, the Company used its sources of funds to primarily fund
loan commitments and maintain a substantial portfolio of investment securities,
and to meet its ongoing commitments to pay maturing savings certificates and
savings withdrawals. As of June 30, 2004, the Company had $10.0 million in
commitments to fund loan originations. The Company anticipates that the majority
of these commitments will be funded by December 31, 2004. In addition, as of
June 30, 2004, the Company had un-disbursed loans in process for construction
loans of $25.5 million and $83.2 million in un-disbursed lines of credit. The
Company has also issued $1.1 million in commercial letters of credit fully
secured by deposit accounts or real estate at June 30, 2004. The management of
the Company believes that the Company has adequate resources, including
principal prepayments and repayments of loans and investment securities and
borrowing capacity, to fund all of its commitments to the extent required.
For regulatory purposes, liquidity is defined as a ratio of cash and
certain marketable securities that can be readily converted into cash to total
deposits and short-term borrowings. At June 30, 2004, liquidity for the Bank as
defined under these guidelines was 39.7%.
IMPACT OF INFLATION AND CHANGING PRICES
The Consolidated Financial Statements and related Notes presented elsewhere
herein have been prepared in accordance with generally accepted accounting
principles ("GAAP") which generally require the measurement of financial
position and operating results in terms of historical dollars without
considering changes in the relative purchasing power of money over time due to
inflation. Unlike many industrial companies, substantially all of the assets and
liabilities of the Company on a consolidated basis are monetary in nature. As a
result, interest rates have a more significant impact on the Company's
performance than the general level of inflation. Over a short period of time,
interest rates may not necessarily move in the same direction or with the same
magnitude as inflation.
46
OTHER INFORMATION
DESCRIPTION OF STOCK
The holders of the Common Stock of the Holding Company possess exclusive
voting rights in the corporation. Each holder of shares of Common Stock is
entitled to one vote for each share held, in accordance with the articles of
incorporation and bylaws, including voting on the election of directors. Of the
10.0 million shares of Common Stock authorized by the Holding Company, 5.1
million shares remain un-issued. In addition, none of the 5.0 million shares of
Preferred Stock authorized by the articles of incorporation have been issued.
DIVIDEND POLICY
The Board of Directors of the Company intends to continue the policy of
paying dividends when the directors deem it prudent to do so. The Board of
Directors will consider payment of dividends on a quarterly basis, after giving
consideration to all relevant factors. On August 25, 2004, the Board of
Directors of the Company declared a $.105 per share cash dividend and a 5% stock
dividend based on the their review and evaluation of financial results of the
quarter ended June 30, 2004. The cash dividend will be calculated on shares held
before the issuance of the stock dividend. During fiscal 2004, 2003, and 2002
the Company paid a total of $2.0 million, $1.8 million, and $1.7 million,
respectively, in cash dividends and a 5% stock dividend in each year. Cash
dividends from the Holding Company are primarily dependent upon dividends paid
to it by the Bank or PCIS, which, in turn, are subject to certain restrictions
established by federal regulators and Pennsylvania law. (See Notes to
Consolidated Financial Statements.)
47
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and
rates. The Company's market risk arises primarily from the interest rate risk
inherent in its lending, investment and deposit taking activities. To that end,
management actively monitors and manages its interest rate risk exposure.
Until recently, market interest rates have steadily declined beginning in
December 2001 resulting in the lowest interest rate environment in over 40
years. Even with the recent increase, interest rates remain at historically low
levels. As a result, loans, which are linked to an index such as the London
Interbank Offered Rate ("Libor") or Prime Rate, were re-priced at lower interest
rates and deposit products have re-priced as deposits rates are adjusted. The
principal source of deposits, the certificates of deposit, will adjust only when
they mature and are renewed by the customers.
The Company's profitability is affected by fluctuations in interest rates.
A sudden and substantial change in interest rates may adversely impact the
Company's earnings to the extent that the yields on interest-sensitive assets
and interest-sensitive liabilities do not change at the same speed, to the same
extent, or on the same basis. The Company monitors the impact of changes in
interest rates between assets and liabilities as discussed in the
"Asset/Liability Management" in Item 7 hereof. Although interest rate
sensitivity gap analysis is a useful measurement tool and contributes towards
effective asset liability management, it is difficult to predict the effect of
changing interest rates based solely on that measure.
The Company utilizes an income simulation modeling to measure the Company's
interest rate risk and to manage its interest rate sensitivity. Income
simulation considers not only the impact of changing market interest rates on
forecasted net interest income, but also other factors such as yield curve
relationships, the volume and mix of assets and liabilities, customer
preferences and general market conditions.
Through the use of income simulation modeling the Company is able to
calculate an estimate of net interest income for the year ending June 30, 2005,
based upon the assets, liabilities and off-balance sheet financial instruments
in existence at June 30, 2004. The Company has also estimated changes to that
estimated net interest income based upon interest rates rising or falling in
monthly increments ("rate ramps"). Rate ramps assume that all interest rates
increase or decrease in monthly increments evenly throughout the period modeled.
Economic value of equity ("EVE") estimates the discounted present value of
asset and liability cash flows. Discount rates are based upon market prices for
comparable assets and liabilities. Upward and downward rate shocks are used to
measure volatility in relation to such interest rate movements in relation to an
unchanged environment. This method of measurement primarily evaluates the
longer-term re-pricing risks and options in the Company's balance sheet. The
following table reflects the estimated economic value of equity at risk and the
ratio of EVE adjusted equity to EVE adjusted assets at June 30, 2004, resulting
from shocks to interest rates.
48
YEAR ENDED JUNE 30, 2004
- --------------------------------------------------------------------------------------------------
CHANGE IN INTEREST ECONOMIC VALUE
RATES IN BASIS POINTS OF EQUITY EVE RATIO
- --------------------------------------------------------------------------------------------------
EVE EQUITY/
(RATE SHOCK) AMOUNT $ CHANGE % CHANGE EVE ASSETS/ CHANGE
- --------------------------------------------------------------------------------------------------
(Dollars in Thousands)
300 $82,897 $(6,246) (7.0)% 12.38% (0.49%)
200 88,748 (395) (0.4)% 13.02% 0.16%
100 92,420 3,277 3.7% 13.38% 0.52%
Static 89,143 -- -- 12.87% --
(25) 84,475 (4,668) (5.2)% 12.25% (0.62%)
(50) 81,957 (7,186) (8.1)% 11.90% (0.96%)
Certain shortcomings are inherent in the methodology used in the above
interest rate risk measurements. Modeling changes in net present value ("NPV")
require the making of certain assumptions, which 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 table presented above assumes that the
composition of the Company's interest sensitive assets and liabilities existing
at the beginning of a period remains 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 re-pricing of
specific assets and liabilities. Accordingly, although the NPV table provides 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.
The Company's primary objective in managing interest rate risk is to
minimize the adverse impact of changes in interest rates on the Company's net
interest income and capital, while structuring the Company's asset/liability
structure to obtain the maximum yield/cost spread on that structure. The Company
relies primarily on its asset/liability structure to control interest rate risk.
The Company continually evaluates interest rate risk management
opportunities, including the use of derivative financial instruments. At June
30, 2004, the Company was positively gapped whereby its' interest-earning assets
were re-pricing at a quicker rate than its interest-bearing liabilities. To
partially offset the negative impact of the current low market interest rate
environment, the Company entered into three separate interest rate swap
transactions aggregating $41 million notional amount to hedge certain of its'
higher rate FHLBP Advances. The swaps had the effect of converting the higher
fixed rate Advances to lower adjustable rate borrowings, which positively
impacts the Company's net interest margin in the current interest rate
environment. Further, since the Company is positively gapped; if the balance
sheet were to remain static, future increases should have similar impacts to the
earnings and costs of the interest-earning assets and interest-bearing
liabilities. Additionally, in August 2003, the Bank purchased a $30 million
notional amount 3.50% Three Month LIBOR interest rate cap while simultaneously
selling a $30 million notional amount 6.00% Three Month LIBOR interest rate cap
("Interest Rate Corridor"). The Company paid a net premium, which entitles it to
receive the difference between Three Month LIBOR from 3.50% to 6.00% times the
$30 million notional amount. The Interest Rate Corridor is being used to hedge
the cash flows of $10.3 million in floating rate Trust Preferred Securities as
well as the cash flows of certain borrowings, which could negatively impact
earnings in a rising interest rate environment. .
49
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
MANAGEMENT'S REPORT ON EFFECTIVENESS
OF INTERNAL CONTROL OVER FINANCIAL REPORTING
To Our Shareholders:
The management of First Financial Bank (the "Bank") 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 the safeguarding of 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 the controls. Accordingly,
even an effective internal control can provide only reasonable assurance with
respect to financial statement preparation. Further, because of changes in
conditions, the degree of effectiveness of an internal control structure may
vary over time.
Management assessed the Bank's internal control structure over financial
reporting presented in conformity with accounting principles generally accepted
in the United States of America, including controls over the safeguarding of
assets, as of June 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 June 30, 2004, the Bank maintained effective internal
control over financial reporting presented in conformity with accounting
principles generally accepted in the United States of America, including the
safeguarding of assets.
Management is also responsible for compliance with the federal laws and
regulations concerning dividend restrictions and loans to insiders designated by
the Federal Deposit Insurance Corporation as safety and soundness laws and
regulations.
The Bank assessed its compliance with the designated laws and regulations
relating to safety and soundness. Based on this assessment, management believes
that First Financial Bank complied, in all material respects, with the
designated laws and regulations related to safety and soundness as of June 30,
2004.
/s/ Donna M. Coughey
Donna M. Coughey
President and Chief Executive Officer
/s/ Joseph T. Crowley
Joseph T. Crowley
Chief Financial Officer
50
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Chester Valley Bancorp Inc.
We have audited the accompanying consolidated statements of financial condition
of Chester Valley Bancorp Inc. and subsidiaries (the "Bank") as of June 30, 2004
and 2003, and the related statements of operations, changes in stockholders'
equity and comprehensive income, and cash flows for each of the years in the
three year period ended June 30, 2004. These consolidated financial statements
are the responsibility of the Bank's management. Our responsibility is to
express an opinion on these consolidated financial statements based on our
audits.
We conducted our audits in accordance with standards of the Public 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 Chester Valley
Bancorp, Inc. and subsidiaries as of June 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 June 30, 2004 in conformity with accounting principles generally
accepted in the United States of America.
/s/ KPMG LLP
Philadelphia, Pennsylvania
July 28, 2004
51
CHESTER VALLEY BANCORP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Dollars in Thousands)
AT JUNE 30,
----------------------
2004 2003
--------- ---------
ASSETS
Cash in banks $ 12,844 $ 16,311
Interest-bearing deposits 15,352 9,438
--------- ---------
TOTAL CASH AND CASH EQUIVALENTS 28,196 25,749
--------- ---------
Trading account securities 8 10
Investment securities available for sale 130,089 114,220
Investment securities held to maturity (fair value -
June 30, 2004, $57,779
June 30, 2003, $34,432) 59,384 33,390
Loans held for sale 538 3,866
Loans receivable 401,965 387,310
Deferred fees (508) (933)
Allowance for loan losses (6,331) (5,415)
--------- ---------
Loans receivable, net 395,126 380,962
--------- ---------
Accrued interest receivable 2,652 2,428
Property and equipment - net 13,009 12,349
Bank owned life insurance 5,414 5,164
Real estate owned 54 --
Goodwill and other intangibles 1,555 --
Other assets 6,083 6,390
--------- ---------
TOTAL ASSETS $ 642,108 $ 584,528
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Deposits $ 427,103 $ 400,586
Securities sold under agreements to repurchase 27,216 27,358
Advance payments by borrowers for taxes and insurance 1,433 2,038
Federal Home Loan Bank advances 120,963 94,049
Trust preferred securities 10,310 10,000
Accrued interest payable 679 652
Other liabilities 2,147 274
--------- ---------
TOTAL LIABILITIES 589,851 534,957
--------- ---------
Commitments and contingencies (Note 10)
Stockholders' Equity:
Preferred stock - $1.00 par value;
5,000,000 shares authorized; none issued -- --
Common stock - $1.00 par value;
10,000,000 shares authorized;
4,876,484 and 4,570,437 shares issued and outstanding
at June 30, 2004 and June 30, 2003, respectively 4,876 4,571
Additional paid-in capital 36,247 30,315
Retained earnings - partially restricted 13,303 14,064
Treasury stock (583 and 556 shares at June 30, 2004 and 2003,
respectively, at cost) (13) (13)
Accumulated other comprehensive income (loss) (2,156) 634
--------- ---------
TOTAL STOCKHOLDERS' EQUITY 52,257 49,571
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 642,108 $ 584,528
========= =========
See accompanying notes to consolidated financial statements.
52
CHESTER VALLEY BANCORP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in Thousands, Except Per Share Data)
YEAR ENDED JUNE 30,
-----------------------------------------
2004 2003 2002
-----------------------------------------
INTEREST INCOME:
Loans $ 23,406 $ 25,560 $ 26,658
Mortgage-backed securities 1,535 1,748 1,116
Interest-bearing deposits 66 260 459
Investment securities:
Taxable 3,196 2,574 4,341
Non-taxable 1,665 1,573 1,896
----------- ----------- -----------
TOTAL INTEREST INCOME 29,868 31,715 34,470
----------- ----------- -----------
INTEREST EXPENSE:
Deposits 5,300 7,973 11,182
Securities sold under agreements to repurchase 107 179 158
Short-term borrowings 214 497 1,613
Long-term borrowings 5,097 5,243 3,411
----------- ----------- -----------
TOTAL INTEREST EXPENSE 10,718 13,892 16,364
----------- ----------- -----------
NET INTEREST INCOME 19,150 17,823 18,106
Provision for loan losses 971 879 547
----------- ----------- -----------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 18,179 16,944 17,559
----------- ----------- -----------
NON-INTEREST INCOME:
Investment services income, net 4,255 3,694 3,818
Service charges and fees 3,073 2,837 1,911
Gain (loss) on the sale of loans 237 118 115
Gain on sale of trading account securities, net (2) -- 4
Gain on sale of available for sale securities, net 1,068 865 289
Loss for impairment of securities -- (383) (955)
Other 455 443 166
----------- ----------- -----------
TOTAL NON-INTEREST INCOME 9,086 7,574 5,348
----------- ----------- -----------
OPERATING EXPENSES:
Salaries and employee benefits 10,836 9,917 9,136
Occupancy and equipment 2,895 2,811 2,478
Data processing 983 1,020 1,035
Advertising 260 125 167
Deposit insurance premiums 62 64 72
Other 3,904 3,692 3,089
----------- ----------- -----------
TOTAL OPERATING EXPENSES 18,940 17,629 15,977
----------- ----------- -----------
Income before income taxes 8,325 6,889 6,930
Income tax expense 2,015 1,627 1,355
----------- ----------- -----------
NET INCOME $ 6,310 $ 5,262 $ 5,575
=========== =========== ===========
EARNINGS PER SHARE (*)
Basic $ 1.30 $ 1.10 $ 1.17
=========== =========== ===========
Diluted $ 1.26 $ 1.06 $ 1.16
=========== =========== ===========
WEIGHTED AVERAGE SHARES OUTSTANDING (*)
Basic 4,840,709 4,770,679 4,774,324
=========== =========== ===========
Diluted 5,017,222 4,941,213 4,804,672
=========== =========== ===========
(*) Earnings per share and weighted average shares outstanding have been
restated to reflect the effects of the 5% stock dividends paid in September
2003, 2002, and 2001.
See accompanying notes to consolidated financial statements.
53
CHESTER VALLEY BANCORP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME STATEMENT
(Dollars in Thousands)
RETAINED ACCUMULATED
ADDITIONAL EARNINGS OTHER TOTAL
COMMON PAID-IN PARTIALLY TREASURY COMPREHENSIVE STOCKHOLDERS'
STOCK CAPITAL RESTRICTED STOCK INCOME (LOSS) EQUITY
- ------------------------------------------------------------------------------------------------------------------------------
Balance as of June 30, 2001 $ 4,123 $ 24,207 $ 13,136 $ (5) $ (1,363) $ 40,098
Net income -- -- 5,575 -- -- 5,575
Cash dividends paid ($0.40 per share) -- -- (1,709) -- -- (1,709)
Issuance of stock dividend 206 2,676 (2,882) -- -- --
Cash payment for fractional shares -- -- (5) -- -- (5)
Common stock issued 6 2 -- 154 -- 162
Common stock repurchased -- -- -- (664) -- (664)
Change in unrealized loss on
securities available for sale -- -- -- -- 714 714
- ------------------------------------------------------------------------------------------------------------------------------
Balance as of June 30, 2002 $ 4,335 $ 26,885 $ 14,115 $ (515) $ (649) 44,171
- ------------------------------------------------------------------------------------------------------------------------------
Net income -- -- 5,262 -- -- 5,262
Cash dividends paid ($0.40 per share) -- -- (1,796) -- -- (1,796)
Issuance of stock dividend 216 3,301 (3,517) -- -- --
Cash payment for fractional shares -- -- -- -- -- --
Common stock issued 20 129 -- 954 -- 1,103
Common stock repurchased -- -- -- (452) -- (452)
Change in unrealized loss on
securities available for sale -- -- -- -- 1,283 1,283
- ------------------------------------------------------------------------------------------------------------------------------
Balance as of June 30, 2003 $ 4,571 $ 30,315 $ 14,064 $ (13) $ 634 $ 49,571
- ------------------------------------------------------------------------------------------------------------------------------
Net income -- -- 6,310 -- -- 6,310
Cash dividends paid ($0.42 per share) -- -- (1,989) -- -- (1,989)
Issuance of stock dividend 228 4,847 (5,075) -- -- --
Cash payment for fractional shares -- -- (7) -- -- (7)
Common stock issued 77 1,085 -- -- -- 1,162
Common stock repurchased -- -- -- -- -- --
Change in unrealized loss on
securities available for sale
Change in unrealized loss on -- -- -- -- (2,678) (2,678)
cash flow hedge (112) (112)
- --------------------------------------------------------------------------------------------------------------------------------
Balance as of June 30, 2004 $ 4,876 $ 36,247 $ 13,303 $ (13) $ (2,156) $ 52,257
- --------------------------------------------------------------------------------------------------------------------------------
OTHER COMPREHENSIVE INCOME, NET OF TAX: 2004 2003 2002
-----------------------------------------
Net income $ 6,310 $ 5,262 $ 5,575
Net unrealized holding gains (losses) on securities available for sale during
the period (1,974) 1,597 277
Net unrealized holding losses on cash flow hedge (112) -- --
Less reclassification adjustment for losses (gains) included in net income (704) 314 437
--------- --------- --------
COMPREHENSIVE INCOME $ 3,520 $ 6,545 $ 6,289
========= ========= ========
See accompanying notes to consolidated financial statements.
54
CHESTER VALLEY BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
TWELVE MONTHS ENDED JUNE 30,
-----------------------------------
2004 2003 2002
--------- --------- ---------
Net income $ 6,310 $ 5,262 $ 5,575
Add (deduct) items not affecting cash flows from operating activities:
Depreciation 989 1,078 1,010
Provision for loan losses 971 879 547
Gain on trading account securities -- -- (4)
(Gain) loss on sale of securities available for sale (1,068) (865) (289)
Loss for impairment of securities -- 383 955
Increase in loans held for sale (21,573) (33,128) (12,067)
Proceeds from sale of loans held for sale 25,138 29,518 14,394
Gain on sale of loans held for sale (237) (118) (115)
Amortization of deferred loan fees, discounts and premiums (44) (121) (649)
Decrease(increase) in trading account securities 2 6 4
Decrease (increase) in accrued interest receivable (224) 115 1,010
Decrease (increase) in other assets 1,376 (1,967) 381
Increase in the value of bank owned life insurance (250) (164) --
(Decrease) increase in other liabilities 1,867 (1,191) (2,379)
Increase in real estate owned (54) -- --
(Decrease) increase in accrued interest payable 27 (230) (936)
- -------------------------------------------------------------------------------------------------------------
Net cash flows from (used in) operating activities 13,230 (543) 7,437
- -------------------------------------------------------------------------------------------------------------
Cash flows from (used in) investment activities:
Capital expenditures (1,101) (662) (3,435)
Net increase in loans (10,828) (17,578) (19,584)
Net cash and cash equivalents received in branch acquisition 13,536 -- --
Purchase of investment securities held to maturity (40,185) (12,267) (34,368)
Proceeds from maturities, payments and calls of investment 14,286 19,993 34,749
Purchase of securities available for sale (115,875) (136,578) (65,281)
Proceeds from sales and calls of securities available for sale 97,276 125,617 77,612
Purchase of bank owned life insurance -- (5,000) --
- -------------------------------------------------------------------------------------------------------------
Net cash flows used in investment activities (42,891) (26,475) (10,307)
- -------------------------------------------------------------------------------------------------------------
Cash flows from financing activities:
Net (decrease) increase in deposits before interest credited 2,346 7,587 (37,384)
Interest credited to deposits 4,602 7,019 10,012
(Decrease) Increase in securities sold under agreements to repurchase (142) 9,109 15,821
Proceeds from FHLB advances 69,393 35,126 30,926
Repayments of FHLB advances (42,479) (43,531) (8,709)
Net decrease in other borrowings -- -- (241)
Increase (decrease) in advance payments by borrowers for taxes and (605) (793) 144
Proceeds from trust preferred securities -- -- 10,000
Cash dividends on common stock (1,989) (1,796) (1,709)
Common stock repurchased as treasury stock -- (452) (664)
Payment for fractional shares (7) -- (5)
Stock options exercised 989 364 162
Common stock issued -- 739 --
- -------------------------------------------------------------------------------------------------------------
Net cash flows from financing activities 32,108 13,372 18,353
- -------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents 2,447 (13,646) 15,483
CASH AND CASH EQUIVALENTS:
Beginning of period 25,749 39,395 23,912
- -------------------------------------------------------------------------------------------------------------
End of period $ 28,196 $ 25,749 $ 39,395
=============================================================================================================
SUPPLEMENTAL DISCLOSURES:
Cash payments during the year for:
Income taxes $ 1,696 $ 1,672 $ 1,633
Interest $ 10,691 $ 14,122 $ 17,300
NON-CASH ITEMS:
Stock dividend issued $ 5,075 $ 3,518 $ 2,882
Net unrealized (loss) gain on investment securities available for sale
and cash flow
hedge, net of tax $ (2,790) $ 1,283 $ 714
Cost to issue treasury shares for the exercise of stock options $ -- $ 216 $ --
See accompanying notes to consolidated financial statements
55
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BUSINESS
Chester Valley Bancorp Inc. (the "Holding Company") was incorporated in the
Commonwealth of Pennsylvania in August 1989. Effective September 1, 2001, the
Holding Company became a bank holding company as a result of the conversion of
First Financial Bank ("First Financial" or the "Bank") from a Pennsylvania
chartered savings association to a Pennsylvania chartered commercial bank. The
Bank holding company has also been designated as a financial holding company.
The business of the Holding Company and its subsidiaries (collectively the
"Company") consists of the operations of First Financial and Philadelphia
Corporation for Investment Services ("PCIS"), a full service investment advisory
and securities brokerage firm. The Bank provides a wide range of banking
services to individual and corporate customers through its ten branch banks in
Chester County, Pennsylvania. All of the branches are full service and offer
commercial and retail products. These products include checking accounts
(non-interest and interest-bearing), savings accounts, certificates of deposit,
commercial and installment loans, real estate mortgages, and home equity loans.
The Bank also offers ancillary services that complement these products. The Bank
is subject to competition from other financial institutions and other companies
that provide financial services. PCIS is registered as a broker/dealer in all 50
states and Washington, DC and it is also registered as an investment advisor
with the Securities Exchange Commission. PCIS provides many additional services,
including self-directed and managed retirement accounts, safekeeping, daily
sweep money market funds, portfolio and estate valuations, life insurance and
annuities, and margin accounts to individuals and smaller corporate accounts.
The Company is subject to the regulations of various federal and state agencies
and undergoes periodic examinations by those regulatory authorities.
PRINCIPLES OF CONSOLIDATION AND PRESENTATION
The accompanying consolidated financial statements include the accounts of the
Holding Company and its wholly owned subsidiaries, First Financial and PCIS. The
accounts of the First Financial include its wholly-owned subsidiary, D & S
Service Corp., which owns D & F Projects and Wildman Projects, Inc., both of
which are wholly-owned subsidiaries and First Financial Investments. All
material intercompany balances and transactions have been eliminated in
consolidation. Prior period amounts are reclassified when necessary to conform
to the current year's presentation.
The Company follows accounting principles and reporting practices, which are in
accordance with accounting principles generally accepted in the United States of
America. In preparing the consolidated financial statements, management is
required to make estimates and assumptions that affect the reported amounts of
assets and liabilities as of the date of the statement of financial condition
and revenues and expenses for the period. Actual results could differ
significantly from those estimates. Material estimates that are particularly
susceptible to significant change in the near-term relate to the determination
of the allowance for loan losses, income taxes, and the valuation of investment
securities. Management believes that the allowance for loan losses, the balances
in the income tax accounts, and the valuation of investment securities are
adequate. Various regulatory agencies, as an integral part of their examination
process, periodically review the Bank's allowance for loan losses and valuations
of real estate owned. Such agencies may require the Bank to recognize additions
to the allowance or adjustments to the valuations based on their judgments about
information available to them at the time of their examination.
56
RECENT ACCOUNTING PRONOUNCEMENTS
ACQUISITIONS OF CERTAIN FINANCIAL INSTITUTIONS
In October 2002, the FASB issued Statement No. 147, Acquisitions of Certain
Financial Institutions, which amends SFAS No. 72, Accounting for Certain
Acquisitions of Banking or Thrift Institutions, SFAS No.144, Accounting for the
Impairment or Disposal of Long-Lived Assets, and FASB Interpretation No. 9.
Except for transactions between two or more mutual enterprises, this Statement
removes acquisitions of financial institutions from the scope of both Statement
No. 72 and Interpretation 9 and requires that those transactions be accounted
for in accordance with FASB Statements No. 141, Business Combinations, and No.
142, Goodwill and Other Intangible Assets. Thus, the requirement in paragraph 5
of Statement No. 72 to recognize any excess of the fair value of liabilities
assumed over the fair value of tangible and identifiable intangible assets
acquired as an unidentifiable intangible asset of a business no longer applies
to acquisitions within the scope of this Statement. In addition, this Statement
amends Statement No. 144 to include in its scope long-term customer-relationship
intangible assets of financial institutions such as depositor and
borrower-relationship intangible assets and credit cardholder intangible assets.
Consequently, those intangible assets are subject to the same undiscounted cash
flow recoverability test and impairment loss recognition and measurement
provisions that Statement No. 144 requires for other long-lived assets that are
held and used.
With some exceptions, the requirements of Statement No. 147 became effective
October 1, 2002. The adoption of this Statement did not have an impact on the
Company's consolidated earnings, financial condition, or equity.
ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company, as permitted, has elected not to adopt the fair value accounting
provisions of SFAS No. 123 "Accounting for Stock-based Compensation", and has
instead continued to apply APB Opinion 25 and related Interpretations in
accounting for plans and provide the required pro-forma disclosures of SFAS
No.123. Had the grant-date fair-value provisions of SFAS No.123 been adopted,
the Company would have recognized the following:
(Dollars in thousands, except per share items)
Year Ended June 30
------------------------
2004 2003 2002
---- ---- ----
Net income, as reported $6,310 $5,262 $5,575
Deduct: Total stock based employee
Compensation expense determined
Under fair-value methods for all awards,
Net of related tax effects 266 579 333
------ ------ ------
Pro-forma net income $6,044 $4,683 $5,242
====== ====== ======
Earnings per share:
Basic - as reported $1.30 $1.10 $1.17
Basic - pro-forma $1.25 $1.03 $1.15
Diluted - as reported $1.26 $1.06 $1.16
Diluted - pro-forma $1.20 $1.00 $1.15
57
The effects of pro-forma net income and diluted earnings per share of applying
the disclosure requirements of SFAS 123 for past fiscal years may not be
representative of the future pro-forma effects on net income and earnings per
share due to the vesting provisions of the options and future awards that are
available to be granted.
In December 2002, the FASB issued Statement No. 148, Accounting for Stock-Based
Compensation - Transition and Disclosure, which amends FASB Statement No. 123,
Accounting for Stock-Based Compensation. This statement provides alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. In addition, this Statement
amends the disclosure requirements of Statement 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.
The requirements of Statement No. 148 are effective for financial statements for
fiscal years beginning after December 15, 2003; the disclosure requirements for
the annual period financial statements of the Statement are included in this
report.
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES - AMENDMENT OF STATEMENT 133
In April 2003, the FASB issued Statement No.149, Amendment of Statement No.133
on Derivative Instruments and Hedging Activities, which establishes accounting
and reporting standards for derivative instruments, including derivatives
imbedded in other contracts and hedging activities. This Statement amends
Statement No. 133 for decisions made by the FASB as part of its Derivatives
Implementation Group process. This Statement also amends Statement No. 133 to
incorporate clarifications of the definition of a derivative. The Statement is
effective for contracts entered into or modified and hedging relationships
designated after June 30, 2003. The provisions of this Statement did not have a
material impact on the Company's consolidated earnings, financial condition or
equity.
ACCOUNTING FOR CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH
LIABILITIES AND EQUITY
In May 2003, the FASB issued Statement No. 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity, which
establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. It
requires that an issuer classify a financial instrument that is within its scope
as a liability (or an asset in some circumstances). Some of the provisions of
this Statement are consistent with the current definition of liabilities in FASB
Concepts Statement No. 6, Elements of Financial Statements. The remaining
provisions of this Statement are consistent with the FASB's proposal to revise
that definition to encompass certain obligations that a reporting entity can or
must settle by issuing its own equity shares, depending on the nature of the
relationship established between the holder and the issuer. For nonpublic
entities, mandatorily redeemable financial instruments are subject to the
provisions of this Statement for the first fiscal period beginning after
December 15, 2003. The adoption of this Statement did not have a material impact
on its financial position or results of operations.
CONSOLIDATION OF VARIABLE INTEREST ENTITIES
In December 2003, the Financial Accounting Standards Board revised
Interpretation No. 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 Chester Valley Statutory Trust in the first quarter of 2004. The
result was an increase in the junior debt of $310 thousand.
58
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 generally three months or less.
SECURITIES
The Company divides its securities portfolio into three segments: (a) held to
maturity; (b) available for sale; and (c) trading. At the time of purchase, the
Company makes a determination on whether or not it will hold the investments to
maturity, based upon an evaluation of the probability of the occurrence of
future events. Securities classified as held to maturity are accounted for at
amortized cost adjusted for amortization of premiums and accretion of discounts
using a method which approximates a level yield, based on the Company's intent
and ability to hold the securities until maturity. Trading securities are
accounted for at quoted market prices with changes in market values thereof
being recorded as gain or loss in the statement of operations. All other
securities, including investment 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 until
maturity, are included in the available for sale category and are accounted for
at fair value with unrealized gains or losses, net of taxes, being reflected as
adjustments to accumulated other comprehensive income. If investment securities
are sold, any gain or loss is determined by specific identification and
reflected in the operating results for the period in which the sale occurs.
OTHER THAN TEMPORARY IMPAIRMENT OF INVESTMENT SECURITIES
Securities are evaluated periodically to determine whether a decline in their
value is other than temporary. Management utilizes criteria such as the
magnitude and duration of the decline, in addition to the reasons underlying the
decline, to determine whether the loss in value is other than temporary. The
term "other than temporary" is not intended to indicate that the decline is
permanent, but indicates that the prospects for a near-term recovery of value is
not necessarily favorable, or that there is a lack of evidence to support
realizable value equal to or greater than carrying value of the investment. Once
a decline in value is determined to be other than temporary, the value of the
security is reduced and a corresponding charge to earnings is recognized.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at a level that represents
management's best estimate of known and inherent losses, which are probable and
reasonably determinable based upon an evaluation of the loan portfolio.
Homogeneous portfolios of loans, which include residential mortgage, home equity
and other consumer loans, are evaluated as a group. Commercial business loans
greater than $100,000, commercial mortgage and construction loans are evaluated
individually. Specific portions of the allowance are developed by analyzing
individual loans for adequacy of collateral, cash flow and other risks unique to
that particular loan. General portions of the allowance are developed by grading
individual loans in the commercial and construction portfolios and applying loss
factors by grade. The general portion of the allowance also includes loss
factors applied to the homogeneous portfolios as a group. The loss factors
applied to graded loans were developed based on the Company's loss history for
loans with similar attributes, local and national economic conditions as well as
input from the Company's primary banking regulators. Loss factors are applied to
homogeneous loans based upon prior loss experience of the portfolio, local and
national economic conditions, delinquency trends and the volume of
non-performing loans. Although management believes it has used the best
information available to it in making such determinations, and that the present
allowance for loan losses is adequate, future adjustments to the allowance may
be necessary, and net income may be adversely affected if circumstances differ
substantially from the assumptions used in determining the level of the
allowance. In addition, various regulatory agencies, as an integral part of
their examination process, periodically review the Bank's allowance for losses
on loans. Such agencies may require the Bank 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, other than those incurred
on loans held for sale, are charged directly against the allowance and
recoveries on previously charged-off loans are added to the allowance.
59
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 loans and consumer loans as well as
commercial business loans with balances of less than $100,000. For applicable
loans, the Company evaluates the need for impairment recognition when a loan
becomes non-accrual or earlier if, based on management's assessment of the
relevant facts and circumstances, it is probable that the Company will be unable
to collect all proceeds under the contractual terms of the loan agreement. At
and during the years ended June 30, 2004, 2003 and 2002, the recorded investment
in impaired loans was not significant. The Company's policy for the recognition
of interest income on impaired loans is the same as for non-accrual loans. A
portion of an impaired loan is 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.
LOANS, LOAN ORIGINATION FEES AND UNCOLLECTED INTEREST
Loans (other than loans held for sale) are recorded at cost net of unearned
discounts, deferred fees and allowances. Discounts and 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 over the life of
the related loans as an adjustment of the yield on the loans using a level yield
method of accounting.
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 Company 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 current loan terms.
The Company uses the contractual due date in determining the delinquent status
of a loan. Interest income on such loans is not accrued until the financial
condition and payment record of the borrower once again demonstrate the ability
to service the debt.
LOANS HELD FOR SALE
The Company originates certain loans that are designated as held for sale at the
time of their origination. These loans are immediately sold with servicing
released and the company does not retain any interest or obligation after the
loans are sold. These loans consist primarily of fixed-rate, single-family
residential mortgage loans which meet the underwriting characteristics of
certain government-sponsored enterprises (conforming loans). Loans held for sale
are carried at the lower of aggregate cost or fair value, with any resulting
loss included in non-interest income for the period. Realized gains or losses
are included in non-interest income for the period. The Company recognizes
servicing fee income when payments are received.
60
REAL ESTATE OWNED ("REO")
Real estate acquired through foreclosure or by deed in lieu of foreclosure is
classified as REO. REO is carried at the lower of cost (lesser of carrying value
of the loan or fair value of the property at date of acquisition) 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 is computed using the straight-line method over the estimated
useful lives of the assets, which range from 15 to 30 years for property and 3
to 7 years for 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.
DERIVATIVE FINANCIAL INSTRUMENTS
The Company may utilize certain derivative instruments as a tool in its
asset/liability management. At June 30, 2004, the Company was positively gapped
whereby its' interest-earning assets were re-pricing at a quicker rate than its'
interest-bearing liabilities. To partially offset the negative impact of the
current low market interest rate environment, the Company entered into three
separate interest rate swaps aggregating $41 million notional amount to hedge
certain of its' higher rate FHLBP Advances. The swap had the effect of
converting the higher fixed rate Advances to lower adjustable rate borrowings,
which positively impacts the Company's net interest margin in the current
interest rate environment. As the terms of the Swap match that of the FHLBP
Advances, the Swap is deemed a perfect hedge in accordance with SFAS No. 133 and
changes in the fair market value of the Swap will increase (decrease) a Swap
asset or liability with a corresponding offset to the FHLBP Advances. The
interest differential paid or received is reflected as an increase (decrease) to
the interest expense on the FHLBP Advances. Further, since the Company is
positively gapped; if the balance sheet were to remain static, future increases
should have similar impacts to the earnings and costs of the interest-earning
assets and interest-bearing liabilities. Additionally, in August 2003, the Bank
purchased a $30 million notional amount 3.50% Three Month LIBOR interest rate
cap while simultaneously selling a $30 million notional amount 6.00% Three Month
LIBOR interest rate cap ("Interest Rate Corridor"). The Company paid a net
premium, which entitles it to receive the difference between Three Month LIBOR
from 3.50% to 6.00% times the $30 million notional amount. The Interest Rate
Corridor is being used to hedge the cash flows of $10.3 million in floating rate
Trust Preferred Securities as well as the cash flows of certain borrowings,
which could negatively impact earnings in a rising interest rate environment.
DEFERRED INCOME TAXES
The Company accounts for income taxes under the asset and 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 and for operating losses and tax credit carry-forwards. 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.
61
EARNINGS PER SHARE
The dilutive effect of stock options is excluded from basic earnings per share,
but included in the computation of diluted earnings per share. Earnings per
share and weighted average shares outstanding have been adjusted to reflect the
effects of the 5% stock dividends paid in September 2003, 2002, and 2001. The
following table sets forth the computation of basic and diluted earnings per
share (Dollars in thousands, except per share data):
YEAR ENDED JUNE 30,
------------------------
2004 2003 2002
------ ------ ------
Numerator:
Net income $6,310 $5,262 $5,575
------ ------ ------
Denominator:
Denominator for basic earnings per share-weighted
average shares 4,841 4,771 4,774
Effect of dilutive securities:
Employee stock options 176 170 21
------ ------ ------
Denominator for diluted earnings per share-adjusted
weighted average shares and assumed exercise 5,017 4,941 4,805
====== ====== ======
Basic earnings per share $ 1.30 $ 1.10 $ 1.17
====== ====== ======
Diluted earnings per share $ 1.26 $ 1.06 $ 1.16
====== ====== ======
GOODWILL AND OTHER INTANGIBLES
Goodwill represents the excess of the purchase price over the fair value of net
assets acquired in accordance with the purchase method of accounting. Other
intangibles represent primarily the net present value of the future economic
benefits to be derived from the purchase of core deposits ("core deposit
intangible"), which are being amortized on an accelerated basis over their
estimated useful lives of approximately eight years. Effective July 1, 2001, the
Company adopted certain provisions of Statement of Financial Accounting
Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets," as required
for goodwill and intangible assets resulting from business combinations
consummated after June 30, 2001. For all business combinations completed after
June 30, 2001, such as the acquisition of the Coatesville Branch from PNC
National Bank (see note 2), goodwill is deemed to have an indefinite life and is
therefore not amortized, but is subject to annual impairment tests.
The Company adopted the remaining provisions of SFAS No. 142 on April 1, 2002.
Under these rules, all goodwill and intangible assets deemed to have indefinite
lives are no longer amortized, but are subject to annual impairment tests in
accordance with the provisions of SFAS No. 142. Other intangible assets continue
to be amortized over their estimated useful lives.
62
NOTE 2 - ACQUISITIONS
Effective March 31, 2004, in order to further enhance its existing branch
network, First Financial Bank acquired the Coatesville, Chester County,
Pennsylvania branch of PNC National Bank. As a result of the acquisition, First
Financial Bank assumed approximately $19.6 million of deposit liabilities and
acquired $4.0 million in consumer and commercial loans and buildings of
$550,000. Additionally, the Company recorded an approximate $400,000 Core
Deposit Intangible and $1.2 million in goodwill. The acquisition was accounted
for using the purchase method of accounting. The following table details the
assets acquired and liabilities assumed as a result of the branch acquisition
(Dollars in thousands):
ASSETS ACQUIRED:
Cash on hand $ 13,536
Loans 3,955
Premise and equipment 550
Goodwill 1,171
Core deposit intangible 395
------------
Total assets acquired $ 19,607
============
Deposits $ 19,607
------------
Total liabilities assumed $ 19,607
============
NOTE 3 - INVESTMENT SECURITIES
The following table summarizes the estimated fair value of securities with gross
unrealized losses at June 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 (Dollars in thousands).
LESS THAN TWELVE MONTHS
TWELVE MONTHS OR LONGER TOTAL
------------------------ ------------------------ -----------------------
UNREALIZED UNREALIZED UNREALIZED
FAIR VALUE LOSSES FAIR VALUE LOSSES FAIR VALUE LOSSES
------------------------ ------------------------ -----------------------
U.S. government agency
notes and bonds $ 38,114 $ 1,944 $ -- $ -- $ 38,114 $ 1,944
Municipal notes and bonds 8,515 263 229 46 8,744 309
Mortgage-backed securities 66,008 1,859 5,643 220 71,651 2,079
Equity securities 1,995 5 -- -- 1,995 5
Assets-backed securities 22,353 470 7,708 254 30,061 724
Other -- -- 1,901 99 1,901 99
----------------------- ----------------------- -----------------------
Total temporarily impaired
securities $ 136,985 $ 4,541 $ 15,481 $ 619 $152,466 $ 5,160
======================= ======================= =======================
Management does not believe any individual unrealized loss as of June 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.
63
Securities that have been impaired greater than twelve months include primarily
trust preferred corporate debt and preferred stock. 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 credit ratings, timely interest payments, dividend payments, and the
financial health of the issuer.
Investment securities are summarized (Dollars in thousands) as follows:
AT JUNE 30, 2004
--------------------------------------------
GROSS GROSS ESTIMATED
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
--------- ---------- ---------- ---------
HELD TO MATURITY:
U.S. government agency notes and bonds $ 32,513 $ -- $ 1,735 $ 30,778
Federal Home Loan Bank of Pittsburgh stock 6,696 -- -- 6,696
Municipal notes and bonds 14,884 274 119 15,039
Mortgage-backed securities 3,366 40 9 3,397
Collateralized mortgage obligations 885 -- 65 820
Debt securities 1,003 9 -- 1,012
Other 37 -- -- 37
--------- ---------- ---------- ---------
Total held to maturity $ 59,384 $ 323 $ 1,928 $ 57,779
========= ========== ========== =========
AVAILABLE FOR SALE:
U.S. government agency notes and bonds $ 7,545 $ -- $ 209 $ 7,336
Municipal notes and bonds 11,783 13 190 11,606
Asset-backed securities 13,290 -- 250 13,040
Collateralized mortgage obligations 36,639 53 1,124 35,568
Mortgage-backed securities 41,815 -- 881 40,934
Equity securities 615 73 -- 688
Debt securities 17,495 -- 474 17,021
Other 4,000 -- 104 3,896
--------- ---------- ---------- ---------
$ 133,182 $ 139 $ 3,232 $ 130,089
========= ========== ========== =========
64
AT JUNE 30, 2003
--------------------------------------------
GROSS GROSS ESTIMATED
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
--------- ---------- ---------- ---------
HELD TO MATURITY:
U.S. government agency notes and bonds $ 130 $ 7 $ -- $ 137
Federal Home Loan Bank of Pittsburgh stock 5,760 -- -- 5,760
Municipal notes and bonds 13,793 204 -- 13,997
Collateralized mortgage obligations 1,934 33 -- 1,967
Mortgage-backed securities 8,520 656 20 9,156
Debt securities 3,216 162 -- 3,378
Other 37 -- -- 37
--------- ---------- ---------- ---------
Total held to maturity $ 33,390 $ 1,062 $ 20 $ 34,432
========= ========== ========== =========
AVAILABLE FOR SALE:
U.S. government agency notes and bonds $ 2,000 $ 74 $ -- $ 2,074
Municipal notes and bonds 25,770 1,004 7 26,767
Collateralized mortgage obligations 25,440 197 92 25,545
Mortgage-backed securities 31,161 528 17 31,672
Equity securities 1,121 115 -- 1,236
Debt securities 25,996 189 1,269 24,916
Agency-backed securities 2,000 10 -- 2,010
--------- ---------- ---------- ---------
$ 113,488 $ 2,117 $ 1,385 $ 114,220
========= ========== ========== =========
The amortized cost and estimated fair value of investment securities at June 30,
2004 by contractual maturity, are shown below (Dollars in thousands).
WEIGHTED
AMORTIZED ESTIMATED AVERAGE
COST FAIR VALUE YIELD
--------- ---------- --------
HELD TO MATURITY
Due in one year or less $ 1,003 $ 1,012 5.75%
Due after one year through five years 127 127 6.00%
Due after five years through ten years 22,094 21,325 4.17%
Due after ten years 29,427 28,582 4.88%
No stated maturity 6,733 6,733 1.50%
-------- -------- --------
TOTAL HELD TO MATURITY 59,384 57,779 4.25%
-------- -------- --------
AVAILABLE FOR SALE
Due in one year or less 115 116 3.53%
Due after one year through five years 6,701 6,570 4.69%
Due after five years through ten years 24,000 23,387 4.87%
Due after ten years 99,751 97,427 4.07%
No stated maturity 2,615 2,589 3.93%
-------- -------- --------
TOTAL AVAILABLE FOR SALE 133,182 130,089 4.24%
-------- -------- --------
TOTAL INVESTMENT SECURITIES $192,566 $187,868 4.25%
======== ======== ========
Expected maturities may differ from contractual maturities because borrowers
generally have the right to call or prepay obligations without prepayment
penalties. The weighted average yield, based on amortized cost, is presented on
a taxable equivalent basis using the Federal marginal rate of 34% adjusted for
the 20% interest expense disallowance (27.2%). Proceeds from sales and calls of
investment securities available for sale during fiscal 2004, 2003, and 2002,
were $97.3 million, $125.6 million and $77.6 million, respectively. Gross gains
of $1.1 million, $865 thousand and $454 thousand, in fiscal 2004, 2003 and 2002,
respectively, and gross losses, including impairment losses, of $68 thousand,
$383 thousand, and $1.1 million, in fiscal 2004, 2003, and 2002, respectively,
were realized on those sales. Accrued interest receivable on investments
amounted to $1.2 million and $908 thousand at June 30, 2004 and 2003,
respectively. At June 30, 2004, $41.8 million of investment securities were
pledged as collateral for Municipal savings deposits with the Bank, for
securities sold under agreements to repurchase, and for the Bank's treasury, tax
and loan account with the Federal Reserve.
65
Included in investment securities available for sale at June 30, 2004 are three
non-rated Pennsylvania Municipal Authority Bonds that have been classified as
substandard. These bonds were originally purchased during the period from June
1998 through June 2000. The aggregate book value of the bonds; after write-downs
of $955 thousand, is $5.6 million. Two of the three bonds with an aggregate book
value of $4.9 million are zero coupon bonds with maturities extending up to
2034. Both bonds are secured by the revenue streams of commercial office
buildings, which are leased to various agencies of the Commonwealth of
Pennsylvania under long-term lease arrangements with renewal options.
The third bond was issued by the Housing Authority of Chester County and has a
book balance of $720 thousand and bears interest at rates between 5.60% and 6%
and matures in June 2019. This bond involves low-income scattered housing in
Chester County under a program of the Office of Housing and Urban Development
("HUD"). HUD has committed to provide additional funds to build additional
houses, which would be donated to this bond issues. The retirement of the bond
issue is dependent upon proceeds from either the rental or sale of the existing
and additional houses. This bond is on non-accrual at June 30, 2004
These classified investments are closely monitored and fairly stated at June 30,
2004 based on available information. There can be no assurance that further
subsequent adverse or positive developments may occur and thus could result in
further adjustments to the carrying value of these investments.
Debt securities included in available for sale securities at June 30, 2004 and
2003 primarily consist of long term Corporate Debt obligations with investment
grade ratings and most of these obligations are floating rates tied to movements
in the Treasury markets.
NOTE 4 - LOANS RECEIVABLE
Loans receivable, (Dollars in thousands) are summarized as follows:
AT JUNE 30,
--------------------
2004 2003
--------- ---------
First mortgage loans:
Residential $ 74,004 $ 101,997
Construction - residential 18,745 22,877
Land acquisition and development 13,928 17,964
Commercial 140,721 122,207
Construction-commercial 16,187 16,232
Commercial business 49,142 43,059
Consumer 114,787 88,918
--------- ---------
Total loans 427,514 413,254
Less:
Undisbursed loan proceeds
Construction - residential (16,223) (22,359)
Construction - commercial (9,326) (3,585)
Deferred loan fees (508) (933)
Allowance for loan losses (6,331) (5,415)
--------- ---------
Net loans $ 395,126 $ 380,962
========= =========
Accrued interest receivable on loans amounted to $1.5 million at both June 30,
2004 and 2003. At June 30, 2004, 2003, and 2002, the Company serviced loans for
others totaling $9.9 million, $18.0 million and $23.7 million, respectively.
66
The aggregate amount of loans by the Company to its directors and executive
officers was $255 thousand and $3.0 million at June 30, 2004 and 2003,
respectively. These loans were made in the ordinary course of business at
substantially the same terms and conditions as those with other borrowers. An
analysis of the activity of these loans, in millions, follows:
Balance at July 1, 2003 $3.0
New loans .2
Repayments (2.9)
------------
Balance at June 30, 2004 $ 0.3
============
The total amount of non-performing loans was $4.2 million, $4.2 million, and
$944 thousand, at June 30, 2004, 2003 and 2002, respectively. If these
non-performing loans had been current in accordance with their original terms
and had been outstanding throughout the period, the gross interest income for
fiscal 2004, 2003, and 2002 that would have been recorded for these loans was
$734 thousand, $451 thousand, and $195 thousand, respectively. Interest income
on these non-performing loans included in income for fiscal 2004, 2003, and 2002
amounted to $107 thousand, $353 thousand, and $114 thousand, respectively. The
total balance of impaired loans at June 30, 2004 and 2003 were $4.0 million and
$3.2 million, respectively. The allowance for loan losses on impaired loans at
June 30, 2004 was $1.3 million as compared to $644 thousand at June 30, 2003.
The activity in the allowance for loan losses (Dollars in thousands) was as
follows:
YEAR ENDED JUNE 30,
------------------------------
2004 2003 2002
-------- -------- --------
Balance, beginning of period $ 5,415 $ 4,588 $ 4,264
Provision for loan losses 971 879 547
Acquired with branch acquisition 45 -- --
Loans charged off (131) (76) (229)
Recoveries 31 24 6
------- ------- -------
Balance, end of period $ 6,331 $ 5,415 $ 4,588
======= ======= =======
NOTE 5 - PROPERTY AND EQUIPMENT
Property and equipment by major classification are summarized (Dollars in
thousands) as follows:
2004 2003
--------- ---------
Land $ 1,569 $ 1,521
Buildings and improvements 12,678 11,653
Furniture, fixtures and equipment 5,580 5,004
-------- --------
Total 19,827 18,178
Less accumulated depreciation (6,818) (5,829)
-------- --------
Net $ 13,009 $ 12,349
======== ========
67
NOTE 6 - DEPOSITS
Deposits (Dollars in thousands) consist of the following major classifications:
AT JUNE 30,
----------------------------------------------------------------------------
2004 2003
---------------------------------- ----------------------------------
WEIGHTED PERCENT WEIGHTED PERCENT
AVERAGE OF AVERAGE OF
RATE AMOUNT TOTAL RATE AMOUNT TOTAL
-------- --------- ------- -------- --------- -------
Non-interest bearing -- % $ 69,132 16.2% -- % $ 59,906 15.0%
-------- --------- ------- -------- --------- -------
Interest-bearing:
NOW checking accounts 0.25% 64,638 15.1% 0.24% 61,828 15.4%
Money market deposit accounts 1.36% 151,204 35.5% 1.23% 101,112 25.2%
Savings accounts 0.23% 34,762 8.1% 0.24% 31,107 7.8%
Certificates less than $100,000 2.68% 82,119 19.2% 3.10% 99,003 24.7%
Certificates $100,000 and greater 2.70% 25,248 5.9% 3.03% 47,630 11.9%
-------- --------- ------- -------- --------- -------
Total interest-bearing deposits 1.45% 357,971 83.8% 1.76% 340,680 85.00%
-------- --------- ------- -------- --------- -------
TOTAL DEPOSITS 1.21% $ 427,103 100.0% 1.49% $ 400,586 100.0%
======== ========= ======= ======== ========= =======
At June 30, 2004 and 2003, municipal deposits totaled $11.6 million and $31.0
million, respectively, which are collateralized with pledged investments.
A summary of certificates by contractual maturity (Dollars in thousands) at June
30, 2004 is as follows:
YEARS ENDING JUNE 30, AMOUNT
------------------------------------- ----------
2005 $ 61,723
2006 15,742
2007 11,261
2008 4,635
2009 11,228
2010 and thereafter 2,778
-----------
$107,367
==========
Interest expense on deposits (Dollars in thousands) is comprised of the
following:
YEAR ENDED JUNE 30,
-------------------------------------
2004 2003 2002
------- ------- --------
NOW checking accounts $ 153 $ 304 $ 433
Money market deposit accounts 1,630 1,390 1,430
Savings accounts 75 202 320
Certificates less than $100,000 2,413 4,008 5,347
Certificates $100,000 & greater 1,029 2,069 3,652
------- ------- --------
$ 5,300 $ 7,973 $ 11,182
======= ======= ========
68
NOTE 7 - ADVANCES FROM FEDERAL HOME LOAN BANK OF PITTSBURGH ("FHLBP")
Under the terms of its collateral agreement with the FHLBP, the Company
maintains otherwise unencumbered qualifying assets (principally 1-4 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 FHLBP. The Company's
FHLBP stock is also pledged to secure these advances. At June 30, 2004 and 2003,
such advances (Dollars in thousands) mature as follows:
WEIGHTED WEIGHTED
AVERAGE JUNE 30, AVERAGE JUNE 30,
DUE BY JUNE 30, RATE 2004 DUE BY JUNE 30, RATE 2003
- ---------------------- -------- --------- ---------------------- -------- ---------
2005 2.48% $ 13,500 2004 4.36% $ 2,100
2006 5.19% 1,550 2005 5.16% 3,000
2007 3.29% 10,691 2006 5.19% 1,550
2008 5.74% 3,350 2007 4.64% 4,536
2009 4.35% 22,586 2008 5.72% 3,350
Thereafter 5.26% 69,286 Thereafter 5.37% 79,513
- ---------------------- -------- --------- ---------------------- -------- --------
Total FHLBP advances 4.63% $ 120,963 Total FHLBP advances 5.31% $ 94,049
====================== ======== ========= ====================== ======== ========
Included in the table above at June 30, 2004 are $81.0 million of convertible
advances whereby the FHLBP (Federal Home Loan Bank of Pittsburgh) has the option
at a predetermined time to convert the fixed interest rate to an adjustable rate
tied to LIBOR (London Inter Bank Offering Rate). The Bank has the option to
prepay these advances if the FHLBP converts the interest rate. These advances
are included in the year of their stated maturity.
The Company has a line of credit of $10 million with the FHLBP. The Company,
from time to time, will use the line of credit to meet liquidity needs. At June
30, 2004 and 2003, there were no balances outstanding on the line of credit.
NOTE 8 - TRUST PREFERRED SECURITIES
On March 26, 2002, the Company issued $10.3 million of Junior Subordinated
Debentures to Chester Valley Statutory Trust, a Pennsylvania Business Trust, in
which the Company owns all of the common equity. The Trust then issued $10.0
million of Trust Preferred Securities, which pay interest quarterly at
three-month Libor plus 3.60% to investors, which are secured by the Junior
Subordinated Debentures and the guarantee of the Company. The Junior
Subordinated Debentures are treated as debt of the Company but they qualify as
Tier I capital, subject to certain limitations under the risk-based capital
guidelines of the Federal Reserve. The Trust Preferred Securities are callable
by the Company on March 26, 2007, or at any time in the event the deduction of
related interest for federal income taxes is prohibited, the treatment as Tier I
capital is no longer permitted or under certain other circumstances. The Trust
Preferred Securities must be redeemed by the Company; upon their maturity, in
2032.
69
NOTE 9 -INCOME TAXES
The provision (and benefit) for income taxes is summarized as follows (Dollars
in thousands):
AT JUNE 30,
------------------------------
2004 2003 2002
-------- -------- --------
Current:
Federal $ 2,016 $ 1,923 $ 1,471
State 82 68 97
Deferred - Federal (83) (364) (213)
-------- -------- --------
Total $ 2,015 $ 1,627 $ 1,355
======== ======== ========
In addition to amounts applicable to income before taxes, the following income
tax expense (benefit) amounts were recorded in shareholder's equity (Dollars in
thousands):
AT JUNE 30,
------------------------------
2004 2003 2002
-------- -------- --------
Compensation expense for tax purposes
in excess of amounts recognized for
financial statement purposes (173) $ (137) $ (27)
Other comprehensive results (1,516) 802 465
-------- -------- --------
Total income tax expense (benefit) (1,689) $ 665 $ 438
======== ======== ========
The provision for income taxes differs from the statutory rate due to the
following (Dollars in thousands):
AT JUNE 30,
------------------------------
2004 2003 2002
-------- -------- --------
Federal income taxes at statutory rate $ 2,830 $ 2,342 $ 2,356
Tax exempt interest and dividends, net (619) (578) (796)
State taxes, net of federal benefit 54 45 64
Increase in cash value of BOLI (85) (56) --
Low income housing tax credits (139) (139) (270)
Other, net (26) 13 1
-------- -------- --------
$ 2,015 $ 1,627 $ 1,355
======== ======== ========
70
The deferred tax assets and liabilities at June 30, 2004 and 2003 consisted of
the following (Dollars in thousands):
AT JUNE 30,
---------------------
2004 2003
---------------------
Deferred tax assets:
Tax credit carry-forward $ -- $ 221
Allowance for loan losses 2,153 1,841
Deferred compensation 138 59
Uncollected interest 150 78
Net unrealized loss on securities
available for sale 1,106 --
Investment in joint ventures 87 49
Write-down investment securities -- 130
Other 38 31
------ ------
Gross deferred tax assets 3,672 2,409
------ ------
Deferred tax liabilities:
Tax bad debt reserves -- 27
Loan discount 46 60
Net unrealized gain on
securities available
for sale -- 410
Goodwill amortization 7 --
Depreciation 286 178
------ ------
Gross deferred tax liabilities 339 675
------ ------
Net deferred tax assets $3,333 $1,734
====== ======
The realization of deferred tax assets is dependent upon a variety of factors,
including the generation of future taxable income, the existence of taxes paid
and recoverable, the reversal of deferred tax liabilities and tax planning
strategies. Based upon these and other factors, management believes it is more
likely than not that the Company will realize the benefits of these deferred tax
assets.
The Small Business Job Protection Act of 1996 ("Act"), enacted on August
20,1996, provides for the repeal of the tax bad debt deduction computed under
the percentage of taxable income method. The repeal of the use of this method is
effective for tax years beginning after December 31, 1995. Prior to the change
in law, the Bank had qualified under the provisions of the Code, which permitted
it to deduct from taxable income an allowance for bad debts based on 8% of
taxable income.
Upon repeal, the Bank is required to recapture into income, over a six-year
period, the portion of its tax bad debt reserves that exceed 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 bank for federal income tax purposes, are restricted with respect to certain
distributions. The Bank's total tax bad debt reserves at June 30, 2004, are
approximately $2.6 million of which $2.6 million represents the base year amount
and $0 is subject to recapture. The Company has previously recorded a deferred
tax liability for the excess base year reserves to be recaptured; therefore,
this recapture will not impact the statement of operations.
NOTE 10 - COMMITMENTS AND CONTINGENCIES
Financial instruments with off-balance-sheet risk:
- --------------------------------------------------
In the normal course of business, the Company is a party to financial
instruments with off-balance-sheet risk, which meet the financing needs of its
customers and to reduce its own exposure to fluctuations in interest rates.
Commitments to originate loans amounted to $10.0 million as of June 30, 2004,
which represent fixed-rate loans with interest rates ranging 6.00% to 6.75%. At
June 30, 2004, the Company had undisbursed loans in process for construction
loans of $25.5 million and $83.2 million in undisbursed lines of credit. In
addition, at such date the Company has issued $1.1 million in commercial letters
of credit fully secured by deposit accounts or real estate.
71
Concentration of credit risk:
- -----------------------------
The Company is principally a local lender and therefore has a significant
concentration of residential and commercial real estate loans as well as
consumer and commercial business loans to borrowers who reside in and/or which
are collateralized by real estate located primarily in Chester County,
Pennsylvania. The ability of such customers to honor these obligations is
dependent, in varying degrees, on the overall economic performance of this
diversified area.
Other commitments and contingencies:
- ------------------------------------
The Bank and PCIS have entered into operating leases for several of their branch
and office facilities. The minimum annual rental payments under these leases at
June 30, 2004, (Dollars in thousands) are as follows:
MINIMUM LEASE
YEAR PAYMENTS
------------------------ ------------------
2005 $ 790
2006 675
2007 522
2008 468
2009 445
2010 and thereafter 1,912
Rent expense under these leases for each of the years ended June 30, 2004, 2003,
and 2002, was $893 thousand, $737 thousand, and $639 thousand, respectively.
The Company, the Bank and two employees (together "the parties") have been sued
in the Court of Common Pleas in Philadelphia, County by a former employee to
recover damages for breach of contract and other matters. The Company adamantly
denies any wrongdoing and intends to aggressively defend its actions. The matter
has been referred to the Company's insurance carrier, who has engaged counsel to
defend its actions. The policy carries a $100,000 deductible, which includes
cost of defense. The $100,000 was expensed as of June 30, 2003. The Company
believes it will be successful in its defense; however, in the event the parties
are unsuccessful in their defense, the Company does not believe the lawsuit
would have a material adverse effect on the financial condition of the Company
as insurance coverage was and is in place.
The Company is involved in other routine, non-material legal proceedings
occurring in the ordinary course of business which management believes will not
have a material adverse effect on the financial condition or operations of the
Company.
NOTE 11 - AFFILIATED TRANSACTIONS
Two directors of the Company are a principal and a partner in law firms which
the Company retained during fiscal years 2004, 2003, and 2002, and which the
Company intends to retain during fiscal year 2005. The amount of legal fees paid
to the law firms did not exceed 5% of those firms' gross revenues for any such
year.
A director of the Company is a director and president of a mortgage-banking firm
from which the Company purchased single-family residential mortgage loans during
fiscal year 2000, and the Company may resume the business relationship during
fiscal year 2005.
72
NOTE 12 - STOCKHOLDERS' EQUITY
At the time of its conversion from a state-chartered mutual association to a
state-chartered capital stock association, the Bank established a liquidation
account in an amount equal to $4.8 million at September 30, 1986. The
liquidation account is maintained for the benefit of eligible savings account
holders who have maintained their savings account in the Bank after conversion.
In the unlikely event of a complete liquidation, each eligible savings account
holder will be entitled to receive a liquidation distribution from the
liquidation account, in the amount of the then current adjusted sub-account
balance for savings accounts held, before any liquidation distribution may be
made with respect to capital stock.
Except for the repurchase of stock and payment of dividends by the Bank, the
existence of the liquidation account does not restrict the use or application of
such net worth. The Company may not declare or pay a cash dividend on, or
repurchase, any of its common stock if the effect thereof would cause the net
worth of the Bank to be reduced below the amount required for the liquidation
account.
In September 2003, 2002 and 2001, the Company paid 5% common stock dividends in
the amounts of 228,000 shares, 216,000 shares and 206,000 shares, respectively,
from authorized but unissued common stock with fractional shares being paid in
the form of cash.
NOTE 13 - REGULATORY CAPITAL
The Bank is subject to various regulatory capital requirements administered by
the federal banking agencies. As a result of the Holding Company's designation
as a bank holding company, it will also become subject to regulatory capital
requirements. Failure to meet minimum capital requirements can initiate certain
mandatory and possibly additional discretionary actions by regulators that, if
undertaken, could have a direct material effect on the Company's and the Bank'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 1 capital (as defined in the regulations) to
risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average
assets (as defined). At June 30, 2004 and 2003 the Bank was in compliance with
all such requirements and is deemed a "well-capitalized" institution for
regulatory purposes. There are no conditions or events since June 30, 2003 that
management believes have changed the institution's category.
73
The Company's and the Bank's actual capital amounts and ratios for June 30, 2004
and June 30, 2003, as calculated under FDIC regulations are presented in the
table as follows (Dollars in thousands).
TO BE WELL CAPITALIZED
FOR CAPITAL UNDER PROMPT CORRECTIVE
ACTUAL ADEQUACY PURPOSES ACTION PROVISIONS
------------------------- ------------------------ -------------------------
AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
AS OF JUNE 30, 2004: ----------- ---------- ----------- --------- ----------- ----------
COMPANY:
Total Capital $68,619 14.85% $36,966 8.00% $46,208 10.00%
(to Risk-Weighted Assets)
Tier 1 Capital $62,838 13.60% $18,482 4.00% $27,723 6.00%
(to Risk-Weighted Assets)
Tier 1 Capital $62,838 9.95% $25,261 4.00% $31,577 5.00%
(to Average Assets)
BANK:
Total Capital
(to Risk-Weighted Assets) $65,563 14.14% $37,101 8.00% $46,377 10.00%
Tier 1 Capital
(to Risk-Weighted Assets) $59,759 12.89% $18,551 4.00% $27,826 6.00%
Tier 1 Capital
(to Average Assets) $59,759 9.50% $25,151 4.00% $31,439 5.00%
AS OF JUNE 30, 2003:
COMPANY:
Total Capital $64,243 15.14% $33,946 8.00% $42,433 10.00%
(to Risk-Weighted Assets)
Tier 1 Capital $58,937 13.89% $16,972 4.00% $25,459 6.00%
(to Risk-Weighted Assets)
Tier 1 Capital $58,937 10.29% $22,910 4.00% $28,638 5.00%
(to Average Assets)
BANK:
Total Capital
(to Risk-Weighted Assets) $60,424 14.26% $33,901 8.00% $42,377 10.00%
Tier 1 Capital
(to Risk-Weighted Assets) $55,126 13.01% $16,951 4.00% $25,426 6.00%
Tier 1 Capital
(to Average Assets) $55,126 9.67% $22,814 4.00% $28,518 5.00%
NOTE 14 - FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company is required to disclose estimated fair values for its financial
instruments.
Limitations
- -----------
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 (many of
which involve events outside the control of management). Such assumptions
include assessments of current economic conditions, perceived risks associated
with these financial instruments and their counterparts, 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 are likely to result in significantly different
fair value estimates.
74
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 values of non-interest-bearing demand deposits,
savings and NOW accounts and money market deposit accounts are equal to the
carrying amount because these deposits have no stated maturity. 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 financial
services organization that is a going concern.
The following methods and assumptions were used to estimate the fair value of
each major classification of financial instrument at June 30, 2004 and 2003:
Cash and cash equivalents:
- -------------------------
Current carrying amounts approximate estimated fair value.
Trading account securities, securities held to maturity and securities available
- --------------------------------------------------------------------------------
for sale:
- --------
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 and prepayment speeds while using estimated
market discount rates that reflected credit and interest risk inherent in the
loans. The estimate of the maturities and prepayment speeds was based on the
Company's historical experience.
Deposits:
- --------
The fair value of deposits with no stated maturity, such as non-interest-bearing
deposits, savings, NOW and money market accounts, as well as repurchase
agreements, is equal to the amount payable on demand. The fair value of
certificates of deposit was 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.
Borrowed Funds:
- --------------
The fair value of borrowings was estimated using rates currently available to
the Company for debt with similar terms and remaining maturities.
Off-Balance Sheet Instruments:
- -----------------------------
The fair value of off-balance sheet instruments, including commitments to extend
credit and stand-by letters of credit, is estimated using the fees currently
charged to enter into similar agreements with comparable remaining terms and
reflects the present creditworthiness of the counterparties.
75
The Company may utilize certain derivative instruments as a tool in its
asset/liability management. To partially offset the negative impact of the
current low market interest rate environment, the Company entered into three
separate interest rate swaps aggregating $41 million notional amount to hedge
certain of its' higher rate FHLBP Advances. The swaps had the effect of
converting the higher fixed rate Advances to lower adjustable rate borrowings,
which positively impacts the Company's net interest margin in the current
interest rate environment. As the terms of the Swap match that of the FHLBP
Advances, the Swap is deemed a perfect hedge in accordance with SFAS No. 133 and
changes in the fair market value of the Swap will increase (decrease) a Swap
asset or liability with a corresponding offset to the FHLBP Advances. The
interest differential paid or received is reflected as an increase (decrease) to
the interest expense on the FHLBP Advances. Further, since the Company is
positively gapped; if the balance sheet were to remain static, future increases
should have similar impacts to the earnings and costs of the interest-earning
assets and interest-bearing liabilities. Additionally, in August 2003, the Bank
purchased a $30 million notional amount 3.50% Three Month LIBOR interest rate
cap while simultaneously selling a $30 million notional amount 6.00% Three Month
LIBOR interest rate cap ("Interest Rate Corridor"). The Company paid a net
premium, which entitles it to receive the difference between Three Month LIBOR
from 3.50% to 6.00% times the $30 million notional amount. The Interest Rate
Corridor is being used to hedge the cash flows of $10.3 million in floating rate
Trust Preferred Securities as well as the cash flows of certain borrowings,
which could negatively impact earnings in a rising interest rate environment.
The carrying amounts and estimated fair values of the Company's financial
instruments were as follows (Dollars in thousands):
AT JUNE 30,
-----------------------------------------------
2004 2003
----------------------- ----------------------
CARRYING ESTIMATED CARRYING ESTIMATED
AMOUNT FAIR VALUE AMOUNT FAIR VALUE
--------- ---------- --------- ----------
Financial Assets:
Cash and cash equivalents $ 28,196 $ 28,196 $ 25,749 $ 25,749
Trading account securities 8 8 10 10
Investments securities available for sale 130,089 130,089 114,220 114,220
Investment securities 59,384 57,779 33,390 34,432
Loans receivable, net 395,664 413,081 384,828 396,934
Interest rate swap (1,016) 4,511 376 376
Accrued interest receivable 2,652 2,652 2,428 2,428
--------- --------- --------- ---------
Total financial assets $ 614,977 $ 636,316 $ 561,001 $ 574,149
========= ========= ========= =========
Financial Liabilities:
Deposits and repos $ 454,319 $ 451,781 $ 427,944 $ 431,367
Borrowed funds 120,963 144,914 94,049 107,040
Trust preferred securities 10,310 10,310 10,000 10,000
Accrued interest payable 679 679 652 652
--------- --------- --------- ---------
Total financial liabilities $ 586,271 $ 607,684 $ 532,645 $ 549,059
========= ========= ========= =========
The estimated fair value of the Company's off-balance sheet financial
instruments is as follows (Dollars in thousands):
AT JUNE 30,
-----------------------------------------------
2004 2003
----------------------- ----------------------
NOTIONAL ESTIMATED NOTIONAL ESTIMATED
AMOUNT FAIR VALUE AMOUNT FAIR VALUE
--------- --------- --------- ---------
Commitments to extend credit $ 118,700 $ 1,187 $ 50,900 $ 509
Standby letters of credit 1,128 11 3,200 32
76
NOTE 15 - EMPLOYEE BENEFITS
Stock Compensation Program
- --------------------------
The Company has two stock option plans (collectively, the "Plans") -- the 1993
Plan and the 1997 Plan. At June 30, 2004, an aggregate of 0 and 134,082,
respectively, options were available for grant under the 1993 Plan and the 1997
Plans, respectively. As of June 30, 2004, there were 297,621 and 615,313 options
granted under the 1993 and 1997 Plans, respectively. Under the Plans, the option
price per share for options granted may not be less than the fair market value
of the common stock on the date of grant. Options may be granted under the 1993
Plan and the 1997 Plan during the ten-year periods ending August 2003 and August
2007, respectively, and options granted under the Plans are exercisable up to
ten years from the date of grant. Rights to exercise options under the Plans may
be limited by imposition of vesting schedules at the time the options are
granted.
The following table is a summary of option transactions since June 30, 2001.
These options and option prices for the years 2004, 2003, and 2002 have been
adjusted to reflect the stock dividends.
2004 2003 2002
----------------------- ---------------------- ----------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
----------------------- ---------------------- ----------------------
Number outstanding at
beginning of year 746,652 $ 15.08 623,227 $ 13.64 411,692 $ 13.12
Granted 47,250 23.08 215,924 18.06 261,117 13.92
Exercise (77,601) 12.75 (58,827) 11.86 (17,979) 7.48
Forfeited (34,996) 14.76 (33,672) 13.07 (31,603) 12.74
--------- -------- --------- -------- --------- --------
Outstanding at end of year 681,305 15.92 746,652 15.08 623,227 13.64
Exercisable at end of year 475,195 14.85 477,927 14.33 349,728 13.44
Weighted-average fair
value of options granted $ 7.08 $ 5.72 $ 5.51
At June 30, 2004, the range of exercise prices was $6.92 to $23.33 and the
weighted average remaining contractual life of the outstanding options is 7.2
years. The Black-Scholes option-pricing model was used to determine the
grant-date fair value of options. Significant assumptions used in the model
included a weighted average risk free rate of return of 3.52% in 2004, 3.25% in
2003, and 5.09% in 2002; expected option life of 6 years for 2004, 2003, and
2002 ; expected stock price volatility of 32.83% for 2004, 34.33% for 2003, and
32.37% for 2002, and expected dividends of 1.96%, 2.55%, and 2.59%, for 2004,
2003, and 2002, respectively.
Employee Stock Ownership Plan (ESOP)
- ------------------------------------
The Bank maintains an ESOP for all employees of the Bank with at least one year
of credited service. Benefits become 20% vested after three years of service,
increasing to 100% after seven years. Forfeitures are reallocated amongst
remaining participating employees. Vested benefits are generally payable upon
retirement, disability or separation from service.
The ESOP is subject to the requirements of the Employee Retirement Income
Security Act of 1974, as amended, and the regulations of the Internal Revenue
Service and the Department of Labor.
The ESOP has been funded by contributions from the Bank, and benefits to
participants are normally paid in cash or whole shares of common stock.
The ESOP plan was established in October 1987. Contributions to the ESOP and
forfeited shares were allocated among members on the basis of compensation.
Dividends received on the ESOP shares are allocated to participants based on the
number of shares held by each participant. A total of 16,755; 9,197 and 13,466
shares were allocated in fiscal 2004, 2003 and 2002, respectively. The shares of
stock allocated by the ESOP during the three years ended June 30, 2004 were
purchased by the plan from Company contributions and dividends received on the
ESOP shares.
77
Contributions by the Bank to the ESOP in fiscal 2004, 2003 and 2002 amounted to
$25 thousand, $24 thousand and $50 thousand, respectively, and are included in
the accompanying consolidated statements of operations in salaries and employee
benefits. The ESOP loans matured and were paid in April 1999.
Pension Plan
- ------------
The Bank has a noncontributory defined benefit pension plan, which is fully
funded through a multi-employer investment trust covering qualified salaried
employees. Costs recognized for the years ended June 30, 2004, 2003, and 2002,
totaled $378 thousand, $260 thousand, and $209 thousand, respectively.
Information relative to the financial status of the Bank's portion of the Plan
is not currently available.
NOTE 16 - SEGMENT REPORTING
The Company has two reportable segments: the Bank and PCIS. The Bank operates a
branch bank network with twelve full-service banking offices and provides
deposits and loan services to customers. Additionally, the Bank offers trust
services at its Downingtown headquarters. PCIS operates a full service
investment advisory and securities brokerage firm through two offices. Both
segments operate primarily in southeastern Pennsylvania.
The Company evaluates performance based on profit or loss from operations after
income taxes not including nonrecurring gains and losses. There are no material
intersegment sales or transfers. The Company's reportable segments have
traditionally been two independent financial services institutions. The two
segments are managed separately. All senior officers from PCIS prior to the
acquisition have been retained to manage the segment.
The following table highlights income statement and balance sheet information
for each of the segments at or for the years ended June 30, 2004, 2003, and 2002
(Dollars in thousands):
FOR THE YEAR ENDED JUNE 30, 2004: BANK PCIS TOTAL
------------------------------------------------------------------
Net interest income $ 19,142 $ 8 $ 19,150
Other income 5,353 3,733 9,086
Total Net income 5,927 383 6,310
Total assets 640,493 1,615 642,108
Total interest-bearing deposits 14,028 1,324 15,352
Total trading securities -- 8 8
FOR THE YEAR ENDED JUNE 30, 2003: BANK PCIS TOTAL
------------------------------------------------------------------
Net interest income $ 17,810 $ 13 $ 17,823
Other income 4,223 3,351 7,574
Total Net income 4,949 313 5,262
Total assets 582,665 1,863 584,528
Total interest-bearing deposits 8,047 1,391 9,438
Total trading securities -- 10 10
FOR THE YEAR ENDED JUNE 30, 2002: BANK PCIS TOTAL
------------------------------------------------------------------
Net interest income $ 18,073 $ 33 $ 18,106
Other income 1,826 3,522 5,348
Total Net income 5,214 361 5,575
Total assets 564,368 1,664 566,032
Total interest-bearing deposits 27,862 1,301 29,163
Total trading securities -- 16 16
78
NOTE 17 - SUMMARIZED QUARTERLY FINANCIAL DATA FOR FISCAL 2004 AND 2003
(UNAUDITED) (Dollars in thousands except per share data)
2004 2003
--------------------------------------- ---------------------------------------
First Second Third Fourth First Second Third Fourth
Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
------- ------- ------- ------- ------- ------- ------- -------
Interest income $7,427 $7,438 $7,369 $7,634 $8,420 $8,047 $7,672 $7,576
Interest expense 2,719 2,695 2,624 2,680 3,777 3,709 3,292 3,114
------- ------- ------- ------- ------- ------- ------- -------
Net interest income 4,708 4,743 4,745 4,954 4,643 4,338 4,380 4,462
Provision for loan losses 380 296 180 115 411 101 (68) 705
------- ------- ------- ------- ------- ------- ------- -------
Net interest income after
provision for loan losses 4,328 4,447 4,565 4,839 4,502 4,237 4,448 3,757
Other income 2,014 2,570 2,313 2,189 1,773 2,076 1,826 1,899
Operating expenses 4,387 4,912 4,744 4,897 4,321 4,396 4,385 4,527
------- ------- ------- ------- ------- ------- ------- -------
Income before income taxes 1,955 2,105 2,134 2,131 1,954 1,917 1,889 1,129
Income tax expense
(benefit) 441 507 528 539 489 494 408 236
------- ------- ------- ------- ------- ------- ------- -------
NET INCOME $1,514 $1,598 $1,606 $1,592 $1,465 $1,423 $1,481 $893
======= ======= ======= ======= ======= ======= ======= =======
EARNINGS PER COMMON SHARE (1)
Basis $0.31 $0.33 $0.33 $0.33 $0.32 $0.31 $0.33 $0.20
======= ======= ======= ======= ======= ======= ======= =======
Diluted $0.30 $0.32 $0.32 $0.32 $0.32 $0.30 $0.31 $0.19
======= ======= ======= ======= ======= ======= ======= =======
(1) Earnings per share have been restated to reflect the effects of the 5%
stock dividends paid in September 2003 and 2002.
NOTE 18 - PARENT COMPANY FINANCIAL INFORMATION (in thousands)
Financial information of Chester Valley Bancorp Inc. (parent company only)
follows:
STATEMENTS OF FINANCIAL CONDITION JUNE 30,
---------------------
2004 2003
-------- --------
ASSETS
On deposit with subsidiaries $ 1,162 $ 454
Securities available for sale 688 1,236
Investment in subsidiaries 60,667 57,741
Other assets 141 466
-------- --------
TOTAL ASSETS $ 62,658 $ 59,897
======== ========
LIABILITIES
Other liabilities $ 91 $ 16
Subordinated debentures 10,310 10,310
-------- --------
TOTAL LIABILITIES 10,401 10,326
STOCKHOLDERS' EQUITY 52,257 49,571
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 62,658 $ 59,897
======== ========
79
STATEMENTS OF OPERATIONS YEAR ENDED JUNE 30,
--------------------------------
2004 2003 2002
-------- -------- --------
INCOME
Dividends from subsidiaries $ 940 $ 1,250 $ 1,540
Equity in undistributed income of subsidiaries 5,716 4,461 4,199
Gain on sale of securities available for sale 353 -- --
Interest and other income 45 218 69
-------- -------- --------
TOTAL INCOME 7,054 5,929 5,808
EXPENSE
Other expense 744 667 233
-------- -------- --------
NET INCOME $ 6,310 $ 5,262 $ 5,575
======== ======== ========
STATEMENTS OF CASH FLOWS YEAR ENDED JUNE 30,
--------------------------------
2004 2003 2002
-------- -------- --------
OPERATING ACTIVITIES:
Net income $ 6,310 $ 5,262 $ 5,575
Add (deduct) items not affecting cash flows from operating activities:
Equity in undistributed income of subsidiaries (5,716) (4,461) (4,199)
Loss (Gain) on sale of investment securities (353) (147) 24
(Increase) decrease in other assets, net 148 (221) (274)
Increase (decrease) in other liabilities 75 (59) 75
-------- -------- --------
NET CASH FLOWS FROM OPERATING ACTIVITIES 464 374 1,201
-------- -------- --------
INVESTMENT ACTIVITIES:
Purchase of securities available for sale -- -- --
Proceeds from sales and calls of securities available for sale 1,078 1,105 --
-------- -------- --------
Net cash flows used in investment activities 1,078 1,105 --
-------- -------- --------
FINANCING ACTIVITIES:
Capital contribution to subsidiaries -- -- (9,760)
Proceeds from the issuance of subordinated debentures -- -- 10,310
Cash dividends (1,989) (1,796) (1,709)
Payment for fractional shares (7) -- (5)
Common stock repurchased -- (452) (664)
Proceeds from exercise of stock options, net of tax benefit 1,162 364 141
Proceeds from issuance of common stock -- 739 --
-------- -------- --------
Net cash flows used in financing activities (834) (1,145) (1,687)
-------- -------- --------
NET INCREASE (DECREASE) IN CASH 708 334 (486)
CASH AND CASH EQUIVALENTS:
BEGINNING OF PERIOD 454 120 606
-------- -------- --------
END OF PERIOD $ 1,162 $ 454 $ 120
======== ======== ========
NON-CASH ITEMS:
Net unrealized (loss) gain on investment securities available for sale, net of taxes $ 2,156 $ 634 $ (649)
======== ======== ========
Stock dividend issued $ 5,075 $ 3,518 $ 2,882
======== ======== ========
80
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None
ITEM 9a. CONTROLS AND PROCEDURES
Our management evaluated, with the participation of our Chief Executive
Officer and Chief Financial Officer, the effectiveness of our disclosure
controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the
Securities Exchange Act of 1934) as of the end of the period covered by this
report. Based on such evaluation, our Chief Executive Officer and Chief
Financial Officer have concluded that our disclosure controls and procedures are
designed to ensure that information required to be disclosed by us in the
reports that we file or submit under the Securities Exchange Act of 1934 is
recorded, processed, summarized and reported within the time periods specified
in the SEC's rules and regulations and are operating in an effective manner.
No change in our internal control over financial reporting (as defined in
Rules 13a-15(f) or 15(d)-15(f) under the Securities Exchange Act of 1934)
occurred during the most recent fiscal quarter that has materially affected, or
is reasonably likely to materially affect, our internal control over financial
reporting.
PART III
--------
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required herein is incorporated by reference from pages 4
to 8 of the Company's Definitive Proxy Statement for the Annual meeting of
Stockholders to be held on October 25, 2004, which was filed with the SEC on
September 10, 2004 ("Definitive Proxy Statement").
The Company has adopted a code of ethics policy, which applies to its'
principal executive officer, principal financial officer, principal accounting
officer, as well as its' directors and employees generally. The Company will
provide a copy of its' code of ethics to any person, free of charge, upon
request. Any requests for a copy should be made to our shareholder relations
administrator, Chester Valley Bancorp, 100 E. Lancaster Avenue, Downingtown, Pa
19335.
ITEM 11. EXECUTIVE COMPENSATION
The information required herein is incorporated by reference on pages 9 to
14 of the Company's Definitive Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required herein is incorporated by reference from pages 2
to 3 of the Company's Definitive Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required herein is incorporated by reference to page 15
through page 18 of the Definitive Proxy Statement.
81
ITEM 14. PRINCIPAL ACCOUNTANTS FEES AND SERVICES
The information required herein is incorporated by reference to page 18 of
the Definitive Proxy Statement.
82
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report:
(1) The following consolidated financial statements and report of
Independent Auditors of Chester Valley Bancorp Inc. and Subsidiaries
are included in Item 8 of this Annual Report on Form 10-K:
(a) Consolidated Statements of Financial Condition at June 30, 2004
and 2003.
(b) Consolidated Statements of Operations for the Years Ended June
30, 2004, 2003, and 2002.
(c) Consolidated Statements of Stockholders' Equity and Comprehensive
Income for the Years Ended June 30, 2004, 2003, and 2002.
(d) Consolidated Statements of Cash Flows for the Years Ended June
30, 2004, 2003 and 2002.
(e) Notes to Consolidated Financial Statements.
(f) Report of Independent Auditors.
(2) Financial statement schedules for which provision is made in the
applicable accounting regulations of the SEC are omitted because of
the absence of the conditions under which they are required or because
the required information is set forth in the Consolidated Financial
Statements or Notes thereto.
(b) The following reports on Form 8-K have been filed in the last quarter of
this report:
(1) Current report on Form 8-K with respect to Items 12 and 7 filed on
April 3, 2004.
(2) Current report on Form 8-K with respect to Items 5 and 7 filed on May
27, 2004.
(3) Current report on Form 8-K with respect to items 7 and 9 filed on June
17, 2004.
(c) The following exhibits are filed as a part of this Form 10-K.
INDEX TO EXHIBITS
Number Description of Documents
- ------ ------------------------
3a Restated Articles of Incorporation**
3b Bylaws, as amended (filed herewith)
4 Specimen Stock Certificate*
10a Key Employee Stock Compensation Program, as amended**
10b Employee Stock Ownership Plan**
10c Employment Agreement By and Between the Holding Company, the Bank and
Donna M. Coughey*****
10d Employment Agreement By and Between the Holding Company, the Bank and
Colin N. Maropis**
10e Amendment No. 1 to the Employment Agreement By and Between the Holding
Company, the Bank and Colin N. Maropis ***
10f Change in Control Agreement By and Between the Holding Company, the
Bank and Joseph T. Crowley******
10g Change in Control Agreement By and Between the Holding Company, the
Bank and Michael Sexton******
10h Form of Change in Control Agreement By and Between the Holding Company,
the Bank and G. Richard Bertolet, Christopher Breslin, Matthew Kelly,
Margaret Leimkuhler and Thomas Varley******
10i 1997 Stock Option Plan as amended ****
10j 1993 Stock Option Plan as amended ****
83
11 Statement re: computation of per share earnings - reference is made to
Item 8 hereof
21 Subsidiaries of the Registrant - Reference is made to Item, 1, Business
- Subsidiaries," for the required information
23 Consent of Registered Independent Public Accounting Firm (filed
herewith)
31.1 Certification of the Chief Executive Officer pursuant to Rule 13a-14 of
the Securities Exchange Act of 1934, as amended, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002 dated September 10, 2004
(filed herewith)
31.2 Certification of the Chief Financial Officer pursuant to Rule 13a-14 of
the Securities Exchange Act of 1934, as amended, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002 dated September 10, 2004
(filed herewith)
32.1 Certification of the Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002 dated September 10, 2004 (filed herewith)
32.2 Certification of the Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002 dated September 10, 2004 (filed herewith)
(*) Incorporated herein by reference from the Company's Registration
Statement on Form S-4 (33-30433) dated August 10, 1989
(**) Incorporated herein by reference from the Company's Annual Report on
Form 10-KSB for the year ended June 30, 1990
(***) Incorporated herein by reference from the Company's Annual Report on
Form 10-KSB for the year ended June 30, 1992
(****) Incorporated herein by reference from the Company's Annual Report on
Form 10-KSB for the year ended June 30, 1997
(*****) Incorporated by reference from the Company's Annual Report on Form 10-K
for the year ended June 30, 2001.
(******) Incorporated by reference from the Company's Annual Report on Form 10-K
for the year ended June 30, 2003.
(d) Not Applicable
84
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this amended report to be
signed on its behalf by the undersigned, thereunto duly authorized.
CHESTER VALLEY BANCORP INC.
Dated: September 10, 2004 By: /s/ Donna M. Coughey
----------------------------------------
Donna M. Coughey
Director, President and
Chief Executive Officer
Pursuant to the requirements of the Securities and Exchange Act of 1934, this
report has been signed by the following persons in the capacities and on the
dates indicated.
Name Title Date
/s/ Edward T. Borer Director September 10, 2004
- -----------------------------------
Edward T. Borer
/s/ James J. Clarke, Director September 10, 2004
- -----------------------------------
James J. Clarke, Ph.D.
/s/ Donna M. Coughey Director, President and Chief September 10, 2004
- ----------------------------------- Executive Officer
Donna M. Coughey
/s/ John J. Cunningham, III Director September 10, 2004
- -----------------------------------
John J. Cunningham, III
/s/ Gerard F. Griesser Director September 10, 2004
- -----------------------------------
Gerard F. Griesser
/s/ James E. McErlane Director and Chairman of September 10, 2004
- ----------------------------------- the Board
James E. McErlane
/s/ Emory S. Todd Director September 10, 2004
- -----------------------------------
Emory S. Todd
/s/ Madeleine Wing Adler Director September 10, 2004
- -----------------------------------
Madeleine Wing Adler
/s/ William M. Wright Director September 10, 2004
- -----------------------------------
William M. Wright
/s/ Joseph T. Crowley Chief Financial Officer September 10, 2004
- -----------------------------------
Joseph T. Crowley
85