FORM 10-K

 

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

ý                                 ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended            December 31, 2003

 

OR

 

o                                 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)

 

For the transition period from                                  to                                 

 

Commission file number            0-17077

 

PENNS WOODS BANCORP, INC.

(exact name of registrant as specified in its charter)

 

 

300 Market Street, P.O. Box 967

Williamsport, Pennsylvania 17703-0967

(Address of principal executive offices)

 

Registrant’s telephone number, including area code        (570) 322-1111

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities to be registered pursuant to Section 12(g) of the Act:

 

Common Stock, par value $10 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    ý     No    o

 

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 amendment to this Form 10-K.  ý

 

Indicate by check marke whether the registrant is an accelerated filer as of defined in Rule 12b-2 of the Act.     Yes   ý  No   o

State the aggregate market value of the voting stock held by non-affiliates of the registrant $117,137,176 at June 30, 2003.

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

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DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s definitive proxy statement prepared in connection with its annual meeting of shareholders to be held on April 28, 2004 are incorporated by reference in Part III hereof.

 

INDEX

 

PART I
ITEM
Item 1.	Business.
Item 2.	Properties.
Item 3.	Legal Proceedings
Item 4.	Submission of Matters to a Vote of Security Holders.
PART II
Item 5.	Market for the Registrant’s Common Stock, Related Stockholder Matters, and Issuer Purchase of Equity Securities
Item 6.	Selected Financial Data
Item 7.	Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations
Item 7.A	Quantitative and Qualitative Disclosure About Market Risk
Item 8.	Financial Statements and Supplementary Data
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
Item 9A.	Controls and Procedures
PART III
Item 10.	Directors and Executive Officers of the Registrant.
Item 11.	Executive Compensation.
Item 12.	Security Ownership and Certain Beneficial Owners and Management
Item 13.	Certain Relationships and Related Transactions.
Item 14.	Principal Accountant Fees and Services.
PART IV
Item 15.	Exhibits, Financial Statement Schedules and Reports on Form 8-K
Index to Exhibits
Signatures and Certifications

 

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PART I

 

ITEM 1   BUSINESS

 

A.  General Development of Business and History

 

On January 7, 1983, Penns Woods Bancorp, Inc. (the “Company”) was incorporated under the laws of the Commonwealth of Pennsylvania as a bank holding company.  The Jersey Shore State Bank (the “Bank”) became a wholly owned subsidiary of the Company, and each outstanding share of Bank common stock was converted into one share of Company common stock.  This transaction was approved by the shareholders of the Bank on April 11, 1983 and was officially effective on July 12, 1983.  The Company’s business has consisted primarily of managing and supervising the Bank, and its principal source of income has been dividends paid by the Bank.  The Company’s two other wholly-owned subsidiaries are Woods Real Estate Development Co, Inc. and Woods Investment Co., Inc.

 

The Bank is engaged in commercial and retail banking and the taking of time and regular savings and demand deposits, the making of commercial and consumer loans and mortgage loans, and safe deposit services.  Auxiliary services, such as cash management, are provided to commercial customers.  The Bank operates full banking services with eleven branch offices and a Mortgage/Loan Center in Northcentral Pennsylvania.

 

In October 2000, the Bank acquired The M Group, Inc. D/B/A The Comprehensive Financial Group (“The M Group”). The M Group, which operates as a subsidiary of the Bank, offers insurance and securities brokerage services. Securities are offered by The M Group through ING Financial Partners, Inc., a registered broker-dealer.

 

Neither the Company nor the Bank anticipates that compliance with environmental laws and regulations will have any material effect on capital expenditures, earnings, or on its competitive position.  The Bank is not dependent on a single customer or a few customers, the loss of whom would have a material effect on the business of the Bank.

 

The Bank employed approximately 150 persons as of December 31, 2003.  The Company does not have any employees.  The principal officers of the Bank also serve as officers of the Company.

 

A copy of the Code of Ethics and Code of Conduct for the Corporation can be requested from Sonya E. Scott, the Secretary of the Corporation, at 300 Market Street, Williamsport, PA  17701.  A link with access to the Corporation’s SEC 10K filings, annual reports, and quarterly filings cand be found at www.jssb.com.

 

B.  Regulation and Supervision

 

The Company is also subject to the provisions of the Bank Holding Company Act of 1956, as amended (the “BHCA”) and to supervision and examination by the Board of Governors of the Federal Reserve System (the “FRB”).  The Bank is subject to the supervision and examination by the Federal Deposit Insurance Corporation (the “FDIC”), as its primary federal regulator and as the insurer of the Bank’s deposits.  The Bank is also regulated and examined by the Pennsylvania Department of Banking (the “Department”).

 

The insurance activities of The M Group are subject to regulation by the insurance departments of the various states in which The M Group conducts business including principally the Pennsylvania Department of Insurance. The securities brokerage activities of The M Group are subject to regulation by federal and state securities commissions.

 

The FRB has issued regulations under the BHCA that require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks.  As a result, the FRB, pursuant to such regulations, may require the Company to stand ready to use its resources to provide adequate capital funds to the Bank during periods of financial stress or adversity.  The BHCA requires the Company to secure the prior approval of the FRB before it can acquire all or substantially all of the assets of any bank, or acquire ownership or control of 5% or more of any voting shares of any bank.  Such a transaction would also require approval of the Department.

 

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A bank holding company is prohibited under the BHCA from engaging in, or acquiring direct or indirect control of, more than 5% of the voting shares of any company engaged in non-banking activities unless the FRB, by order or regulation, has found such activities to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.  Under the BHCA, the FRB has the authority to require a bank holding company to terminate any activity or relinquish control of a non-bank subsidiary (other than a non-bank subsidiary of a bank) upon the FRB’s determination that such activity or control constitutes a serious risk to the financial soundness and stability of any bank subsidiary of the bank holding company.

 

Bank holding companies are required to comply with the FRB’s risk-based capital guidelines.  The risk-based capital rules are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies and to minimize disincentives for holding liquid assets.  Currently, the required minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) is 8%.  At least half of the total capital is required to be Tier 1 capital, consisting principally of common shareholders’ equity, less certain intangible assets.  The remainder (“Tier 2 capital”) may consist of certain preferred stock, a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, 45% of net unrealized gains on marketable equity securities and a limited amount of the general loan loss allowance.  The risk-based capital guidelines are required to take adequate account of interest rate risk, concentration of credit risk, and risks of nontraditional activities.

 

In addition to the risk-based capital guidelines, the FRB requires each bank holding company to comply with the leverage ratio, under which the bank holding company must maintain a minimum level of Tier 1 capital to average total consolidated assets of 3% for those bank holding companies which have the highest regulatory examination ratings and are not contemplating or experiencing significant growth or expansion.  All other bank holding companies are expected to maintain a leverage ratio of at least 4% to 5%.  The Bank is subject to similar capital requirements adopted by the FDIC.

 

C.  Regulation of the Bank

 

From time to time, various types of federal and state legislation have been proposed that could result in additional regulation of, and restrictions of, the business of the Bank.  It cannot be predicted whether any such legislation will be adopted or how such legislation would affect the business of the Bank.  As a consequence of the extensive regulation of commercial banking activities in the United States, the Bank’s business is particularly susceptible to being affected by federal legislation and regulations that may increase the costs of doing business.

 

Prompt Corrective Action - The FDIC has specified the levels at which an insured institution will be considered “well- capitalized,” “adequately capitalized,” “undercapitalized,” and “critically undercapitalized.” In the event an institution’s capital deteriorates to the “undercapitalized” category or below, the Federal Deposit Insurance Act (the “FDIA”) and FDIC regulations prescribe an increasing amount of regulatory intervention, including: (1)  the institution of a capital restoration plan by a bank and a guarantee of the plan by a parent institution; and (2) the placement of a hold on increases in assets, number of branches or lines of business. If capital has reached the significantly or critically undercapitalized levels, further material restrictions can be imposed, including restrictions on interest payable on accounts, dismissal of management and (in critically undercapitalized situations) appointment of a receiver.  For well-capitalized institutions, the FDIA provides authority for regulatory intervention where the institution is deemed to be engaging in unsafe or unsound practices or receives a less than satisfactory examination report rating for asset quality, management, earnings or liquidity.

 

Deposit Insurance - There are two deposit insurance funds administered by the FDIC - the Savings Association Insurance Fund (“SAIF”) and the Bank Insurance Fund (“BIF”).  The Bank’s deposits are insured under the BIF; however, the deposits assumed by the Bank in connection with the merger of Lock Haven Savings Bank are treated and assessed as SAIF-insured deposits.  The FDIC has implemented a risk-related premium schedule for all insured depository institutions that results in the assessment of premiums based on capital and

 

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supervisory measure.  Under the risk-related premium schedule, the FDIC assigns, on a semiannual basis, each institution to one of three capital groups (well-capitalized, adequately capitalized or undercapitalized) and further assigns such institution to one of three subgroups within a capital group. The institution’s subgroup assignment is based upon the FDIC’s judgment of the institution’s strength in light of supervisory evaluations, including examination reports, statistical analyses and other information relevant to gauging the risk posed by the institution.  Only institutions with a total capital to risk-adjusted assets ratio of 10.0% or greater, a Tier 1 capital to risk-adjusted assets ratio of 6.0% or greater and a Tier 1 leverage ratio of 5.0% or greater, are assigned to the well-capitalized group.   As of December 31, 2003, the Bank’s ratios were well above required minimum ratios.

 

Both the BIF and SAIF are presently fully funded at more than the minimum amount required by law. Accordingly, the BIF and SAIF assessment rates range from zero for those institutions with the least risk, to $0.27 for every $100 of insured deposits for institutions deemed to have the highest risk.  The Bank is in the category of institutions that presently pay nothing for deposit insurance.  The FDIC adjusts the rates every six months.  The FDIC indicated that all banks may again be required to pay deposit insurance premiums in the future if the current trend of the size of the deposit insurance funds relative to all insured deposits continues.

 

While the Bank presently pays no premiums for deposit insurance, it is subject to assessments to pay the interest on Financing Corporation (“FICO”) bonds.  FICO was created by Congress to issue bonds to finance the resolution of failed thrift institutions.  The current annual FICO assessment for the Bank (and all banks) is $.0154 $100 of BIF deposits.

 

Other Legislation

 

The Fair and Accurate Credit Transactions Act (“FACT”) was signed into law on December 4, 2003.  This law extends the previously existing Fair Credit Reporting Act.  New provisions added by FACT address the growing problem of identifying theft.  Consumers will be able to initiate a fraud alert when they are victims of identity theft, and credit reporting agencies will have additional duties.  Consumers will also be entitled to obtain free credit reports, and will be granted certain additional privacy rights.  Regulators will be issuing rules to implement FACT over the next year, and some of these rules will likely impose additional duties on the Bank, although the Company does not believe that the application of these new rules will have a material effect on its operations.

 

The Sarbanes-Oxley Act of 2002 was enacted to enhance penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures under the federal securities laws.  The Sarbanes-Oxley Act generally applies to all companies, including the Company, that file or are required to file periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934, or the Exchange Act.  The legislation includes provisions, among other things, governing the services that can be provided by a public company’s independent auditors and the procedures for approving such services, requiring the chief executive officer and chief financial officer to certify certain matters relating to the company’s periodic filings under the Exchange Act, requiring expedited filings of reports by insiders of their securities transactions and containing other provisions relating to insider conflicts of interest, increasing disclosure requirements relating to critical financial accounting policies and their application, increasing penalties for securities law violations, and creating a new public accounting oversight board, a regulatory body subject to SEC jurisdiction with broad powers to set auditing, quality control and ethics standards for accounting firms.  In response to the legislation, the national securities exchanges and NASDAQ have adopted new rules relating to certain matters, including the independence of members of a company’s audit committee as a condition to listing or continued listing.  The Company does not believe that the application of these new rules to the Company will have a material effect on its results of operations.

 

In addition, Congress is often considering some financial industry legislation. The Company cannot predict how any new legislation, or new rules adopted by the federal banking agencies, may affect its business in the future.

 

In addition to federal banking law, the Bank is subject to the Pennsylvania Banking Code. The Banking Code was amended in late 2000 to provide more complete “parity” in the powers of state-chartered institutions compared to national banks and federal savings banks doing business in Pennsylvania. Pennsylvania banks have all the same ability to form financial subsidiaries authorized by the Gramm-Leach-Bliley Act, as do national banks.

 

Environmental Laws

 

Environmentally related hazards have become a source of high risk and potential liability for financial institutions relating to their loans.  Environmentally contaminated

 

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properties owned by an institution’s borrowers may result in a drastic reduction in the value of the collateral securing the institution’s loans to such borrowers, high environmental clean up costs to the borrower affecting its ability to repay the loans, the subordination of any lien in favor of the institution to a state or federal lien securing clean up costs, and liability to the institution for clean up costs if it forecloses on the contaminated property or becomes involved in the management of the borrower.  The Company is not aware of any borrower who is currently subject to any environmental investigation or clean up proceeding which is likely to have a material adverse effect on the financial condition or results of operations of the Company.

 

Effect of Government Monetary Policies

 

The earnings of the Company are and will be affected by domestic economic conditions and the monetary and fiscal policies of the United States Government and its agencies.   The monetary policies of the FRB have had, and will likely continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession.  The FRB has a major effect upon the levels of bank loans, investments and deposits through its open market operations in the United States Government securities and through its regulation of, among other things, the discount rate on borrowing of member banks and the reserve requirements against member bank deposits.  It is not possible to predict the nature and impact of future changes in monetary and fiscal policies.

 

DESCRIPTION OF BANK

 

a.  History and Business

 

Jersey Shore State Bank “(“Bank”)” was incorporated under the laws of the Commonwealth of Pennsylvania as a state bank in 1934 and became a wholly owned subsidiary of the Company on July 12, 1983.

 

As of December 31, 2003, the Bank had total assets of $511,634,000; total shareholders’ equity of $54,130,000 and total deposits of $334,828,000.  The Bank’s deposits are insured by the Federal Deposit Insurance Corporation for the maximum amount provided under current law.

 

The Bank engages in business as a commercial bank, doing business at several locations in Lycoming, Clinton and Centre Counties, Pennsylvania.  The Bank offers insurance and securities brokerage services        through its wholly owned subsidiary, The M Group, Inc. D/B/A The Comprehensive Financial Group.

 

Services offered by the Bank include accepting time, demand and savings deposits including Super NOW accounts, regular savings accounts, money market accounts, investment certificates, fixed rate certificates of deposit and club accounts.  Its services also include making secured and unsecured commercial and consumer loans, financing commercial transactions, making construction and mortgage loans and the renting of safe deposit facilities.  Additional services include making residential mortgage loans, revolving credit loans with overdraft protection, small business loans, etc.  Business loans include seasonal credit collateral loans and term loans.

 

The Bank’s loan portfolio mix can be classified into four principal categories of real estate, agricultural, commercial and consumer.

 

Real estate loans can be further segmented into construction and land development, farmland, one-to-four family residential, multi-family and commercial or industrial.  Qualified borrowers are defined by policy or by industry underwriting standards.   Owner provided equity requirements range from 20% to 30% with a first lien status required.  Terms are restricted to between 10 and 20 years with the exception of construction and land development, which is limited to one to five years.  Appraisals, verifications and visitations comply with industry standards.

 

Financial information that is required on all commercial mortgages includes the most current three years’ balance sheets and income statements and projections on income to be developed through the project.  In the case of corporations and partnerships, the principals are often asked to indebt themselves personally as well.  Residential mortgages, repayment ability

 

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is determined from information contained in the application and recent income tax returns.   Emphasis is on credit, employment, income and residency verification.  Broad hazard insurance is always required and flood insurance where applicable.  In the case of construction mortgages, builders risk insurance is requested.

 

Agricultural loans for the purchase or improvement of real estate must meet the Bank’s real estate underwriting criteria.  The only permissible exception is when a Farmers Home Loan Administration guaranty is obtained.  Agricultural loans made for the purchase of equipment are usually payable in five years, but never more than seven, depending upon the useful life of the purchased asset.  Minimum borrower equity required is 20%.  Livestock financing criteria depends upon the nature of the operation.  A dairy herd could be financed over three years, but a feeder operation would require cleanup in intervals of less than one year.  Agricultural loans are also made for crop production purposes.  Such loans are structured to repay within the production cycle and not carried over into a subsequent year.   General purpose working capital loans are also a possibility with repayment expected within one year.  It is also a general policy to collateralize non-real estate loans with not only the asset purchased but also junior liens on all other available assets.  Insurance and credit criteria is the same as mentioned previously.  In addition, annual visits are made to our agricultural customers to determine the general condition of assets.   Personal credit requirements are handled as consumer loans.

 

Commercial loans are made for the acquisition and improvement of real estate, purchase of equipment and for working capital purposes on a seasonal or revolving basis.  Criteria was discussed under real estate financing for such loans, but it is important to note that such loans may be made in conjunction with the Pennsylvania Industrial Development Authority.  Caution is also exercised in taking industrial property for collateral by requiring, on a selective basis, environmental audits.

 

Equipment loans are generally amortized over three to seven years, with an owner equity contribution required of at least 20% of the purchase price.  Unusually expensive pieces may be financed for a longer period depending upon the asset’s useful life.  The increased cash flow resulting from the additional piece, through improved income or greater depreciation expense, serves in establishing the terms.  Insurance coverage with the Bank as loss payee is required, especially in the case where the equipment is rolling stock.

 

Seasonal and revolving lines of credit are offered for working capital purposes.  Collateral for such a loan includes the pledge of inventory and/or receivables.  Drawing availability is usually 50% of inventory and 75% of eligible receivables.  Eligible receivables are defined as invoices less than 90 days delinquent.  Exclusive reliance is very seldom placed on such collateral, therefore, other lienable assets are also taken into the collateral pool.  Where reliance is placed on inventory and accounts receivable, the applicant must provide financial information including agings on a monthly basis.  In addition, the guaranty of the principals is usually obtained.

 

It is unusual for the Bank to make unsecured commercial loans.  But when such a loan is a necessity, credit information in the file must support that decision.

 

Letter of Credit availability is limited to standbys where the customer is well known to the Bank.  Credit criteria is the same as that utilized in making a direct loan and collateral is obtained in most cases, and whenever the expiration date is for more than one year.

 

Consumer loan products include second mortgages, automobile financing, small loan requests, overdraft check lines and PHEAA referral loans.  Our policy includes standards used in the industry on debt service ratios and terms are consistent with prudent underwriting standards and the use of proceeds.   Verifications are made of employment and residency, along with credit history.  Second mortgages are confined to equity borrowing and home improvements.  Terms are generally ten years or less and rates are fixed.  Loan to collateral value criteria is 80% or less and verifications are made to determine values.   Automobile financing is generally restricted to five years and done on a direct basis.  The Bank, as a practice, does not floor plan and therefore does not discount dealer paper.  Small loan requests are to accommodate personal needs such as the purchase of small appliances or for

 

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the payment of taxes.  Overdraft check lines are limited to $5,000 or less.

 

The Bank’s investment portfolio is analyzed and priced on a      monthly basis. Investments are made in U.S. Treasuries, U.S. Agency issues, bank qualified municipal bonds, corporate bonds and corporate stocks which consist of Pennsylvania bank stocks.  Bonds with BAA or better ratings are used, unless a local issue is purchased that has a lesser or no rating.

 

Factors taken into consideration when investments are made include liquidity, the Company’s tax position and the policies of the Asset/Liability Committee.

 

The Bank has experienced deposit growth in the range of .96% to 11.37% over the last five years.  This growth has primarily come in the form of core deposits.  Although the Bank has regular opportunities to bid on pools of funds of $100,000 or more in the hands of municipalities, hospitals and others, it does not rely on these monies to fund loans on intermediate or longer-term investments.  Minor seasonal growth in deposits is experienced at or near the year-end.

 

It is the policy of the Bank to generally maintain a rate sensitive asset (RSA) to rate sensitive liability (RSL) ratio of 150% of equity for a 6-month time horizon, 150% of equity for a 2-year time horizon and 150% of equity for a 5-year time horizon.

 

The Bank operates eleven full service offices in Lycoming, Clinton, and Centre Counties, Pennsylvania, and a Mortgage/Loan Center in Centre County, Pennsylvania.  The economic base of the region is developed around service, light manufacturing industries and agriculture.  The banking environment in Lycoming, Clinton and Centre Counties, Pennsylvania is highly competitive.  The Bank competes for loans and deposits with commercial banks, savings and loan associations and other financial institutions.

 

The Bank has a relatively stable deposit base and no material amount of deposits is obtained from a single depositor or group of depositors (including federal, state and local governments).  The Bank has not experienced any significant seasonal fluctuations in the amount of its deposits.

 

b.  Supervision and Regulation

 

The earnings of the Bank are affected by the policies of regulatory authorities including the FDIC and the FRB. An important function of the FRB is to regulate the money supply and interest rates.  Among the instruments used to implement these objectives are open market operations in U.S. Government Securities, changes in reserve requirements against member bank deposits and limitations on interest rates that member banks may pay on time and savings deposits.  These instruments are used in varying combinations to influence overall growth and distribution of bank loans, investments on deposits, and their use may also affect interest rates charged on loans or paid for deposits.

 

The policies and regulations of the FRB have had and will probably continue to have a significant effect on the Bank’s deposits, loans and investment growth, as well as the rate of interest earned and paid, and are expected to affect the Bank’s operation in the future.  The effect of such policies and regulations upon the future business and earnings of the Bank cannot accurately be predicted.

 

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EXECUTIVE OFFICERS OF THE REGISTRANT:

 

NAME		AGE		FIVE-YEAR ANALYSIS OF DUTIES
Ronald A. Walko		57		President and Chief Executive Officer of the Company; the Bank; The M Group; and Woods Investment Company, Inc.; Vice President of Woods Real Estate Development Co, Inc.; and Federal Bank examiner prior to 1986 for an eighteen-year period.
Hubert A. Valencik		62		Senior Vice President of the Company; Senior Vice President and Operations Officer of the Bank; Vice President of Woods Real Estate Development Co, Inc.; Vice President - Operations of The M Group; Vice President with another bank prior to 1985 for a fourteen-year period.
Sonya E. Scott		44		Secretary of the Company; Senior Vice President and Chief Financial Officer of the Bank; Secretary and Treasurer of Woods Real Estate Development Co, Inc.; Woods Investment Co.,Inc.; and The M Group.

 

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ITEM  2    PROPERTIES

 

The Company owns and leases its properties.  Listed herewith are the locations of properties owned or leased, in which the banking offices and Financial Center are located; all properties are in good condition and adequate for the Bank’s purposes:

 

Office		Address
Main		115 South Main Street		Owned
		P.O. Box 5098
		Jersey Shore, Pennsylvania 17740
Bridge Street		112 Bridge Street		Owned
		Jersey Shore, Pennsylvania 17740
DuBoistown		2675 Euclid Avenue		Under Lease
		DuBoistown, Pennsylvania 17702
Williamsport		300 Market Street		Owned
		P.O. Box 967
		Williamsport, Pennsylvania  17703-0967

 

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Montgomery		9094 Rt 405 Highway		Under Lease
		Montgomery, Pennsylvania 17752
Lock Haven		4 West Main Street		Owned
		Lock Haven, Pennsylvania 17745
Mill Hall		(Inside Wal-Mart), 167 Hogan Boulevard		Under Lease
		Mill Hall, Pennsylvania 17751
Spring Mills		Ross Hill Road, P.O. Box 66		Owned
		Spring Mills, Pennsylvania 16875
Centre Hall		2842 Earlystown Road		Land Under Lease
		Centre Hall, Pennsylvania 16828
Zion		100 Cobblestone Road		Under Lease
		Bellefonte, Pennsylvania 16823
Jersey Shore State Bank		1952 Waddle Road, Suite 106		Under Lease
Financial Center		State College, Pennsylvania 16803
State College
The M Group, Inc. D/B/A The Comprehensive Financial Group		705 Washington Boulevard Williamsport, Pennsylvania 17701		Under Lease
State College		(Inside Wal-Mart), 1665 North Atherton Place		Under Lease
		State College, Pennsylvania 16803

 

ITEM  3    LEGAL PROCEEDINGS

 

In the normal course of business, various lawsuits and claims arise against the Company and its subsidiary.  There are no such legal proceedings or claims currently pending or threatened.

 

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ITEM  4    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

No matters were submitted to a vote of security holders during the fourth quarter of 2003.

 

PART II

 

ITEM  5    MARKET FOR THE REGISTRANT’S COMMON STOCK, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASE OF EQUITY SECURITIES

 

		HIGH			LOW			Dividends Declared
2001
First quarter		$	30.45		$	24.77		$	0.23
Second quarter		30.00			24.77			0.23
Third quarter		29.09			27.95			0.23
Fourth quarter		32.27			28.32			0.42
2002
First quarter		$	31.82		$	29.39		$	0.25
Second quarter		33.06			30.00			0.25
Third quarter		32.45			29.27			0.25
Fourth quarter		33.50			30.00			0.49
2003
First quarter		$	41.27		$	32.86		$	0.27
Second quarter		47.43			37.71			0.27
Third quarter		42.32			38.64			0.27
Fourth quarter		47.91			40.85			0.68

 

The Common Stock is listed on the Nasdaq National Market under symboe “PWOD”.  The following table sets forth (1) the quarterly high and low prices for a share of the Company’s Common Stock during the periods indicated, and (2) quarterly dividends on a share of the Common Stock with respect to each quarter since January 1, 2001.  The following quotations represent prices between buyers and sellers and do not include retail markup, markdown or commission.  They may not necessarily represent actual transactions.

 

The Bank has paid cash dividends since 1941.  The Company has paid dividends since the effective date of its formation as a bank holding company.  It is the present intention of the Registrant’s Board of Directors to continue the dividend payment policy; however, further dividends must necessarily depend upon earnings, financial condition, appropriate legal restrictions and other factors relevant at the time the Board of Directors of the Registrant considers dividend policy.  Cash available for dividend distributions to shareholders of the Registrant must initially come from dividends paid by the Bank to the Company.  Therefore, the restrictions on the Bank’s dividend payments are directly applicable to the Company.

 

Under the Pennsylvania Business Corporation Law of 1988 a corporation may not pay a dividend, if after giving effect thereto, the corporation would be unable to pay its debts as they become due in the usual course of business and after giving effect thereto the total assets of the corporation would be less than the sum of its total liabilities plus the amount that would be needed, if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of the shareholders whose preferential rights are superior to those receiving the dividend.

 

As of March 5, 2004, the Registrant had approximately 1,224 shareholders of record.

 

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ITEM  6    SELECTED FINANCIAL DATA

 

The following table sets forth certain financial data as of and for each of the years in the five-year period ended December 31, 2003.

 

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		2003			2002			2001			2000			1999
		(Dollars in thousands, except per share amounts)
Consolidated Statement of Income Data:
Interest income		$	29,052		$	29,104		$	28,736		$	28,454		$	26,030
Interest expense		9,265			10,846			12,481			12,778			10,518
Net interest income		19,787			18,258			16,255			15,676			15,512
Provision for loan losses		255			365			372			286			286
Net interest income after provision for loan losses		19,532			17,893			15,883			15,390			15,226
Other income		8,634			5,453			5,109			2,615			3,527
Other expense		13,289			12,213			11,272			9,820			9,339
Income before income taxes		14,877			11,133			9,720			8,185			9,414
Applicable income taxes		3,703			2,247			1,978			1,619			2,224
Net Income		$	11,174		$	8,886		$	7,742		$	6,566		$	7,190
Consolidated Balance Sheet at End of Period:
Total assets		$	527,381		$	472,206		$	424,810		$	394,913		$	373,742
Loans		275,828			257,845			251,623			244,798			231,815
Allowance for loan losses		(3,069		)	(2,953		)	(2,927		)	(2,879		)	(2,823		)
Deposits		334,318			339,848			305,150			278,134			255,573
Long-term debt — other		70,878			51,778			41,778			31,778			27,278
Shareholders’ equity		69,769			63,142			55,252			50,514			46,085
Per Share Data:
Net income
Earnings per share - Basic		$	3.35		$	2.66		$	2.30		$	1.91		$	2.09
Earnings per share - Diluted		3.35			2.66			2.30			1.91			2.09
Cash dividends declared		1.49			1.24			1.11			1.00			0.92
Adjusted Book value		21.00			18.94			16.53			14.83			13.41
Number of shares outstanding, at end of period		3,321,560			3,031,329			3,039,590			3,097,293			3,123,372
Average number of shares outstanding		3,330,585			3,336,312			3,371,845			3,431,494			3,433,554
Selected financial ratios:
Return on average shareholders’ equity		16.60		%	15.00		%	14.38		%	13.77		%	14.96		%
Return on average total assets		2.24		%	2.01		%	1.95		%	1.74		%	1.99		%
Net interest income to average interest earning assets		4.28		%	4.45		%	4.39		%	4.35		%	4.63		%
Dividend payout ratio		44.76		%	46.40		%	48.17		%	52.18		%	44.20		%
Average shareholders’ equity to average total assets		13.51		%	13.39		%	13.54		%	12.62		%	13.81		%
Loans to deposits, at end of period		83.94		%	76.65		%	83.77		%	88.62		%	90.39		%

 

Per share data and number of shares outstanding have been adjusted in each reporting period to give retroactive effect to a stock split effected in the form of a 10% stock dividend issued October 30,2003.

 

15

 

ITEM 7     MANAGEMENT’S DISCUSSIONA AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

 

RESULTS OF OPERATIONS

 

NET INTEREST INCOME

 

Net interest income is determined by calculating the difference between the yields earned on interest-earning assets and the rates paid on interest-bearing liabilities.  To compare the tax-exempt asset yields to taxable yields, amounts are adjusted to pretax equivalents based on the marginal corporate federal tax rate of 34%.  The tax equivalent adjustment to net interest income for 2003, 2002, and 2001 were $1,367,000, $1,739,000, and $1,689,000, respectively.

 

2003 vs 2002

 

Reported net interest income increased $1,529,000 or 8.4% from year end 2002 to year end 2003.  The decrease in total interest income of $52,000 is the result of an increase of $44,185,000 in the average balance of investment securities held for the current period relative to the same period a year ago offset by a decrease in the return on loans of approximately 62 basis points.  Overall, interest income generated from the net increase in volume of interest earning assets was offset by a decline in rates of approximately 94 basis points.

 

On a tax equivalent basis, net interest income increased 5.8% or $1,157,000, to $21,154,000 in a period when both average interest earning assets and average interest-bearing liabilities increased.  The increase of taxable security income of $2,646,000 is due to the significant purchase of U.S. Government securities over the past year, with the average of these securities increasing $70,159,000, while the decrease in the average of tax-exempt State & Political securities decreased tax equivalent interest income $2,082,000.  The investment portfolio has been repositioned from longer term assets to shorter term assets to take advantage of the cash flow opportunities for reinvestment in anticipation of rising rates.  The net growth in the volume of investment holdings has generated additional interest income that has offset the 111 basis point decline in the overall portfolios weighted average interest rates.

 

Within the loan portfolio, a 62 basis point decrease of the tax equivalent return on loans was partially offset by an increase of $7,612,000 in the average balance of loans when comparing the year 2003 to the year 2002.  Variable rate loans within the portfolio and other new loan originations at lower effective rates aided in the reduction of new income compared to a year ago because of the historically low rates.

 

For the year ended December 31, 2003, reported interest expense decreased $1,581,000 or 14.6% over the same period of 2002.  Lower rates for all deposit accounts contribute the most substantial decrease in interest expense.  The weighted average rate on interest paid on deposits declined 92 basis points for the year 2003 since the year end 2002.  The overall average balance of savings deposits increased $17,925,000, offset by a decrease in the weighted average rate for a net decrease in the related interest expense of $997,000. Interest expense on time deposits decreased  $1,204,000 due to both the 76 basis point decline in the weighted average rate and the decrease in the average balance of $5,453,000.

 

Favorable long-term borrowing rates offer opportunities to reduce interest expenses over the coming years.  Throughout 2003, the Company borrowed an additional $19.1 million in long term advances through the FHLB to minimize future borrowing costs and to enhance liability positioning.  These additional borrowings were utilized by management to take advantage of current investment opportunities while minimizing interest rate risk.  The $693,000 increase in expense on long-term borrowings is the result of these additional advances with average balances of $20,986,000 partially offset by the 64 basis point decline in the resulting weighted average interest rate for the year ending December 31, 2003 compared to the same period in 2002.  Interest paid on short-term borrowings decreased $73,000 as a result of an overall decline in the weighted average interest rate of 131 basis points while the average balances outstanding during the year increased $8,322,000.  The increase in short-term borrowings is the result of taking advantage of the opportunity to borrow from Federal Home Loan Bank at historically low rates.

 

16

 

2002 vs 2001

 

Fully taxable equivalent net interest income increased $2,053,000 or 11.44% to $19,997,000 during the year 2002. The net interest income growth was the result of an increase in interest income of $418,000 and a decrease in interest expense of $1,635,000.

 

The effective interest differential increased 3 basis points to 4.87% from December 31, 2001 to December 31, 2002.  Prime rates and federal funds rates held steady most of the year declining 50 basis points in November.  The low rates had a greater impact on the repricing of deposits than they had on loans and investment securities.  The Company’s assets and liabilities were positioned to benefit from the rate environment.  Overall, rates had a positive impact on earnings.  Although interest-earning assets suffered a reduction in income due to rates of $2,033,000, interest expense relating to interest-bearing liabilities also declined by $2,326,000.  The net effect was an increase in income of $293,000 due to rates.

 

Total average interest earning assets increased $39,805,000 during 2002 which contributed $2,451,000 to net interest income.

 

Interest income on loans decreased during 2002 by $1,055,000.  This was the result of a decrease in interest income of $1,669,000 due to rate offset by an increase in interest income of $614,000 due to volume.  Total average loans increased from 2001 to 2002 by $7,021,000 which contributed to the volume increase.  Although the volume increased, as loans were paid off and new loans originated, low prime rates caused a reduction in interest income.  Bank prime rates remained relatively low in 2002 compared to historical standards and were directly responsible for the decline in interest income of $1,669,000.  This is evident by the decline of the average rate on total loans from 8.92% in 2001 to 8.26% in 2002.

 

Investment securites interest income contributed $1,473,000 of additional income in 2002 relative to 2001.  Taxable securities income represented the majority of the increase at $1,390,000 while tax-exempt investment securities added $83,000.  Together, an increase of investment securities income of $1,837,000 due to volume more than offset a decrease of $364,000 due to rates.  Total average securities increased $32,784,000 or 26.53% from 2001 to 2002.  This increase explains the substantial increase in income related to volume.

 

Total average interest-bearing liabilities increased $35,898,000 or 12.26% during 2002.  The interest expense related to volume increased $691,000 while rates subtracted interest expenses totaling $2,326,000.

 

Due to successful marketing strategies and market penetration in the Centre County region, the bank increased total average deposits by $31,166,000.  Average savings deposits increased $35,893,000 while average time deposits decreased $9,010,000.  Non-interest-bearing demand deposits increased $4,283,000.  Deposit rates held steady through most of 2002.  Savings deposits had little change in average rate while other time deposits repriced throughout the year into the current low rates.  The average rate on other time deposits declined from 5.28% in 2001 to 3.77% in 2002.

 

The increase in funding due to deposits added to an increase in average other borrowings of $12,672,000 and offset the reduction of average short-term borrowings of $3,657,000.   The bank had less need for overnight borrowings to fund assets with the increase of deposits and other borrowings.  The bank acquired two loans totaling $10,000,000 with the Federal Home Loan Bank that are reflected in the increase of other borrowings.  The Federal Home Loan Bank borrowings were intended to match investment security purchases that generate long-term interest income with minimal risk.

 

17

 

AVERAGE BALANCES AND INTEREST RATES

 

The following tables set forth certain information relating to the Company’s average balance sheet and reflects the average yield on assets and average cost of liabilities for the periods indicated and the average yields earned and rates paid.  Such yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods presented.

 

AVERAGE BALANCES AND INTEREST RATES

(INCOME AND RATES ON A FULLY TAXABLE EQUIVALENT BASIS)

(IN THOUSANDS)

 

		2003									2002								2001
		AVERAGE BALANCE(2)				INTEREST			AVERAGE RATE		AVERAGE BALANCE(2)			INTEREST			AVERAGE RATE		AVERAGE BALANCE			INTEREST			AVERAGE RATE
ASSETS:
Interest-earning assets:
Securities:
U.S. Treasury and federal agency		$		124,849		$	5,584		4.47	%	$	54,690		$	2,923		5.34	%	$	22,877		$	1,466		6.41	%
State and political subdivisions(4)		50,822				3,952			7.78	%	77,216			6,034			7.81	%	75,556			5,951			7.88	%
Other		24,872				897			3.61	%	24,452			912			3.73	%	25,141			979			3.89	%
Total securities		200,543				10,433			5.20	%	156,358			9,869			6.31	%	123,574			8,396			6.79	%
LOANS:
Tax-exempt loans(4)		1,008				68			6.75	%	2,309			185			8.01	%	3,935			322			8.18	%
All other loans, net of discount where applicable		260,532				19,918			7.65	%	251,619			20,789			8.26	%	242,972			21,707			8.93	%
Total loans(1),(3)		261,540				19,986			7.64	%	253,928			20,974			8.26	%	246,907			22,029			8.92	%
Total interest-earning assets		462,083				$	30,419		6.58	%	410,286			$	30,843		7.52	%	370,481			$	30,425		8.21	%
Other assets		36,297									31,977								27,081
TOTAL ASSETS		$	498,380								$	442,263							$	397,562
LIABILITIES AND SHAREHOLDERS’ EQUITY:
Interest-bearing liabilities:
Deposits:
Savings		$	147,169			$	1,704		1.16	%	$	129,244		$	2,701		2.09	%	$	93,351		$	1,961		2.10	%
Other time		131,360				3,952			3.01	%	136,813			5,156			3.77	%	145,823			7,696			5.28	%
Total interest-bearing deposits		278,529				5,656			2.03	%	266,057			7,857			2.95	%	239,174			9,657			4.04	%
Short-term borrowings		24,787				428			1.73	%	16,465			501			3.04	%	20,122			903			4.49	%
Other borrowings		67,285				3,181			4.73	%	46,299			2,488			5.37	%	33,627			1,921			5.71	%
Total interest-bearing liabilities		370,601				$	9,265		2.50	%	328,821			$	10,846		3.30	%	292,923			$	12,481		4.26	%
Demand deposits		56,672									50,877								46,594
Other liabilities		3,780									3,334								4,214
Shareholders’ equity		67,327									59,231								53,831
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY		$	498,380								$	442,263							$	397,562
Interest rate margin									4.08	%							4.22	%							3.95	%
Effective interest differential						$	21,154		4.58	%				$	19,997		4.87	%				$	17,944		4.84	%

 

(1).  Fees on loans are included with interest on loans.  Loan fees are included in interest income as follows:  2003 $1,032,000, $, 2002, $803,000, 2001, $668,000

(2).  Information on this table has been calculated using average daily balance sheets to obtain average balances.

(3).  Nonaccrual loans have been included with loans for the purpose of analyzing net interest earnings.

(4).  Income and rates on a fully taxable equivalent basis include an adjustment for the difference between annual income from tax-exempt obligations and the taxable equivalent of such income at the standard 34% tax rate (derived by dividing tax-exempt interest by 66%).

 

 

18

 

(IN THOUSANDS)

 

Rate/Volume Analysis

 

The table below sets forth certain information regarding changes in our interest income and interest expense for the periods indicated. For interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (changes in average volume multiplied by old rate); (ii) changes in rates (changes in rate multiplied by old average volume). Increases and decreases due to both rate and volume, which cannot be separated, have been allocated proportionally to the change due to volume and the change due to rate.

 

		Year Ended December 31,
		2003 vs 2002 Increase (Decrease) Due to									2002 vs 2001 Increase (Decrease) Due to
		Volume			Rate			Net			Volume			Rate			Net
Interest income:
Taxable investment securities		$	3,223		$	(577	)	$	2,646		$	1,707		$	(317	)	$	1,390
Tax-exempt investment securities		(2,054		)	(28		)	(2,082		)	130			(47		)	83
Loans		616			(1,604		)	(988		)	614			(1,669		)	(1,055		)
Total interest-earning assets		$	1,785		$	(2,209	)	$	(424	)	$	2,451		$	(2,033	)	$	418
Interest expenses:
Savings deposits		$	335		$	(1,332	)	$	(997	)	$	750		$	(10	)	$	740
Other time deposits		(216		)	(988		)	(1,204		)	(514		)	(2,026		)	(2,540		)
Short-term borrowings		194			(267		)	(73		)	(232		)	(170		)	(402		)
Other borrowings		1,021			(328		)	693			687			(120		)	567
Total interest-bearing liabilities		$	1,334		$	(2,915	)	$	(1,581	)	$	691		$	(2,326	)	$	(1,635	)
Change in net interest income		$	451		$	706		$	1,157		$	1,760		$	293		$	2,053

 

PROVISION FOR LOAN LOSSES

 

2003 vs 2002

 

The provision for loan losses is based upon management’s quarterly review of the loan portfolio.  The purpose of the review is to assess loan quality, identify impaired loans, analyze delinquencies, ascertain loan growth, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets served.  An external independent loan review is also performed annually for the Bank.  Management remains committed to an aggressive program of problem loan identification and resolution.

 

The allowance is calculated by applying loss factors to outstanding loans by type, excluding loans for which a specific allowance has been determined.  Loss factors are based on management’s consideration of the nature of the portfolio segments, changes in mix and volume of the loan portfolio, and historical loan loss experience.  In addition, management considers industry standards and trends with respect to nonperforming loans and its knowledge and experience with specific lending segments.

 

Although management believes that it uses the best information available to make such determinations and that the allowance for loan losses was adequate at December 31, 2003, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making the initial determinations.  A downturn in the local economy, employment and delays in receiving financial information from borrowers could result in increased levels of nonperforming assets and charge-offs, increased loan loss

 

19

 

provisions and reductions in income.  Additionally, as an integral part of the examination process, bank regulatory agencies periodically review the Bank’s loan loss allowance.  The banking agencies could require the recognition of additions to the loan loss allowance based on their judgement of information available to them at the time of their examination.

 

The allowance for loan losses increased 3.9% or $116,000 from fiscal 2002 after net charge-offs of $139,000 contributing to a year-end allowance for loan losses of  $3,069,000 or 1.1% of total loans.

 

2002 vs 2001

 

The allowance for loan losses increased 0.9% or $26,000 from fiscal 2001 after net charge-offs of $339,000 contributing to a year-end allowance for loan losses of  $2,953,000 or 1.1% of total loans.  This percentage is consistent with the guidelines of regulators and peer banks.  Management’s conclusion is that the provision for loan loss is adequate.

 

		YEAR ENDED DECEMBER 31, (IN THOUSANDS)
		2003			2002			2001			2000			1999
Balance at beginning of period		$	2,953		$	2,927		$	2,879		$	2,823		$	2,681
Charge-offs:
Domestic:
Real estate		63			262			154			165			50
Commercial and industrial.		37			80			122			38			28
Installment loans to individuals.		116			60			82			66			98
Total charge-offs.		216			402			358			269			176
Recoveries:
Real estate		42			25			9			8			4
Commercial and industrial.		16			21			8			20			11
Installment loans to individuals.		19			17			17			11			17
Total recoveries.		77			63			34			39			32
Net charge-offs		139			339			324			230			144
Additions charged to operations.		255			365			372			286			286
Balance at end of period.		$	3,069		$	2,953		$	2,927		$	2,879		$	2,823
Ratio of net charge-offs during the period to average loans outstanding during the period.		0.05		%	0.13		%	0.13		%	0.10		%	0.06		%

 

OTHER INCOME

 

2003 vs 2002

 

Total other income for 2003 was $8,634,000, an increase of $3,181,000 from the prior year.  Excluding security gains of $3,659,000 in 2003 and $233,000 in 2002, other income decreased $245,000.  Service charges increased 4.58% or $84,000 to $1,917,000 in 2003.

 

Decreases in commission income from the sale of financial products sold by the Bank’s subsidiary, The M Group,  accounted for $209,000 of the total decrease of other operating income. Other operating income decreased $108,000 primarily due to a non-recurring life insurance income item included in 2002, but not in 2003, resulting in a $116,00 decrease.

 

2002 vs 2001

 

Total other income for 2002 was $5,453,000, an increase of $344,000 from the prior year.  Excluding security gains of $233,000 in 2002 and $1,033,000 in 2001, other income increased $1,144,000.  Service charges increased 17.12% or $268,000 to $1,833,000 in 2002. 

 

20

 

The rate charged for overdraft fees was increased in 2002 which resulted in $229,000 additional service charge income.

 

Other operating income increased $876,000 from 2001 to 2002.  Commission income growth from the sale of financial products sold by the Bank’s subsidiary, The M Group,  account for $401,000 of the total increase of other operating income.  Income on cash surrender value adjustments on bank owned life insurance increased $242,000.  The year 2002 was the first full year the life insurance policies were in effect, resulting in a greater adjustment.  Life insurance proceeds also added $102,000.  The remaining contributors were credit card merchant machine processing fees, debit card fees and ATM surcharge revenue.

 

OTHER EXPENSES

 

2003 vs 2002

 

Total other expenses increased $1,076,000 or 8.81% from the year ended December 31, 2002 to December 31, 2003. Salaries and employee benefits increased of $318,000.  This change was the result of the decline in commission earned by the M Group and the retirement of an executive officer offset by the standard cost of living salary increases and an extra pay paid in 2003 when compared to 2002.  Expenses such as rent, maintenance, and utilities for the new State College Wal-Mart Branch caused the majority of the $46,000 increase to occupancy expense.  The depreciation of a new Wide Area Network has resulted in most of the  $162,000 increase to furniture and equipment expense.  Advertising expense increased $16,000 due to a decrease in normal advertising expenses offset by the purchase of new brochures for $22,000.  Other operating expenses increased $490,000 consistent with the addition of the aforementioned branch.

 

2002 vs 2001

 

Total other expenses increased $941,000 or 8.35% from the year ended December 31, 2001 to December 31, 2002.  Salaries and employee benefits increased $1,152,000, the most substantial of the other expenses category.  Employee salaries and benefits increased more than $500,000 as a result of increased salaries that correspond with the growth in sales of financial products offered by The M Group and the cost of staff at the new State College Wal-Mart Branch.  The Bank’s pension expense increased $320,000 in 2002.  The remaining expenses were due to normal wage increases. The new branch also caused the majority of the $44,000  increase to occupancy expense.  The Bank has substantially upgraded its computer networking capabilities which has resulted in most of the  $98,000 increase to furniture and equipment expense.  Other operating expenses decreased $353,000.  The elimination of goodwill amortization as per the adoption of FAS No. 142 represents $221,000 of the decrease in expenses.  Bookkeeping expenses increased due to securities transactions and maintenance.  The other miscellaneous operating expenses decrease was additionally offset by a $55,000 expense as a result of a check kiting incident.

 

INCOME TAXES

 

2003 vs 2002

 

The provision for income taxes for the year ended December 31, 2003 resulted in an effective income tax rate of 24.9% compared to 20.2% for 2002.  This increase is the result of management’s current investment strategy of reinvesting proceeds from tax-exempt portfolio into other U.S. Government securities.

 

2002 vs 2001

 

The provision for income taxes for the year ended December 31, 2002 resulted in an effective income tax rate of 20.2% compared to 20.3% for 2001.

 

21

 

FINANCIAL CONDITION

 

INVESTMENTS

 

2003

 

The investment portfolio increased $33,680,000 or 19% in 2003.  The growth is largely attributed to management’s strategic plan to benefit from the low borrowing rates by taking advantage of over a 200 basis point interest rate spread of investments with similar maturity periods. The bank borrowed $19,100,000 in long-term FHLB advances to purchase securities and take advantage of interest rate imbalances in the market.  Short-term borrowing funded the balance of the additional investment securities purchased.  Most of the increase is attributable to an increase of $61,980,000 in U.S. Government agencies category, and a $10,331,000 increase in the equity securities category.  There was a $185,000 decrease in other bonds, notes and debentures, $1,168,000 decrease in U.S. Treasury securities category, and State and Political subdivisions catergory decreased $37,278,000.  The investment portfolio at year-end 2003 was comprised of 70.9% U.S. Government agency and Treasury securities, 16.2% state and political subdivisions, 12.0% equity securities, and .9% other bonds, notes and debentures.  Held to maturity securities had a carrying value of $686,000.  Available for sale securities occupied 99.66% of the total portfolio and had an amoritized cost of $201,321,000 with an estimated market value of $210,611,000.  The unrealized gain of $9,290,000 effected shareholders’ equity by $6,132,000, net of deferred taxes.

 

2002

 

The investment portfolio increased $44,330,000 or 33.3% in 2002.  Deposits grew faster than loan demand with the excess funding the purchase of additional investment securities.  Most of the increase is attributable to an increase of  $62,906,000 in U.S. Government agencies category, $975,000 in other bonds, notes and debentures and $170,000 in U.S. Treasury securities category.  State and Political subdivisions category decreased $12,575,000 and a $7,146,000 decrease was also found in the equity securities category.  The investment portfolio at year-end 2002 comprised of 50.2% U.S. Government agency and Treasury securities, 40.2% state and political subdivisions, 8.4% equity securities, and 1.2% other bonds, notes and debentures.  Held to maturity securities had a carrying value of $1,181,000. Available for sale securities occupied 99% of the total portfolio and had an amortized cost of $168,641,000 with an estimated market value of $176,436,000.  The unrealized gain of $7,795,000 effected shareholders’ equity by $5,145,000, net of deferred taxes.

 

22

 

The carrying amounts of investment securities at the dates indicated are summarized as follows (in thousands):

 

		DECEMBER 31,
		2003			2002			2001
U.S. Treasury securities:
Available for Sale		$	3,128		$	4,296		$	4,126
U.S. Government agencies:
Held to Maturity		75			94			196
Available for Sale		146,701			84,702			21,694
State and political subdivisions:
Held to Maturity		347			796			796
Available for Sale		33,852			70,681			83,256
Other bonds, notes and debentures:
Held to Maturity		264			291			310
Available for Sale		1,652			1,810			816
Total bonds, notes and debentures		186,019			162,670			111,194
Corporate stock - Available for Sale		25,278			14,947			22,093
Total		$	211,297		$	177,617		$	133,287

 

The following table shows the maturities and repricing of investment securities at December 31, 2003 and the weighted average yields (for tax-exempt obligations on a fully taxable basis assuming a 34% tax rate) of such securities (in thousands):

 

		WITHIN ONE YEAR			AFTER ONE BUT WITHIN FIVE YEARS			AFTER FIVE BUT WITHIN TEN YEARS			AFTER TEN YEARS
U.S. Treasury securities:
AFS Amount		$	2,061		$	1,067		$	—		$	—
Yield		4.37		%	3.43		%	—		%	—		%
U.S. Government agencies:
HTM Amount		—			—			—			75
Yield		—		%	—		%	—		%	8.80		%
AFS Amount		1,026			3,718			44,372			97,585
Yield		4.96		%	4.00		%	4.43		%	5.25		%
State and political subdivisions:
HTM Amount		—			—			—			347
Yield		—		%	—		%	—		%	8.26		%
AFS Amount		—			—			15			33,837
Yield		—		%	—		%	6.58		%	7.67		%
Other bonds, notes and debentures:
HTM Amount		—			125			139			—
Yield		—		%	7.05		%	7.04		%	—		%
AFS Amount		—			—			—			1,652
Yield		—		%	—		%	—		%	7.36		%
Total Amount		$	3,087		$	4,910		$	44,526		$	133,496
Total Yield		4.57		%	3.95		%	4.44		%	5.90		%

 

All yields represent weighted average yields expressed on a tax equivalent basis.  They are calculated on the basis of the cost, adjusted for amortization of premium and accretion of discount and effective yields weighted for the scheduled maturity of each security.  The taxable equivalent adjustment represents the difference between annual income from tax-exempt obligations and the taxable equivalent of such income at the standard 34% tax rate (derived by dividing tax-exempt interest by 66%).

 

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LOAN PORTFOLIO

 

2003

 

Gross loans for the year ended December 31, 2003, were $275,828,000 or $17,983,000 (6.97%) more than the prior year.  Real estate mortgages increased $ 18,103,000 as a whole with residential, commercial and conuction real estate loans increasing $6,902,000, $6,905,000, and $4,296,000 respectively.  Commercial and agricultural loans decreased $185,000,  while installment loans to individuals increased $65,000.  Given the current market conditions, management has directed its conservative lending approach toward well collateralized real estate loans.

 

2002

 

Gross loans for the year ended December 31, 2002, were $257,845,000 or $6,222,000 (2.47%) more than the prior year.  Real estate mortgages increased $8,128,000 as a whole with residential and commercial real estate loans increasing $49,000 and $8,800,000, respectively.  Construction real estate mortgages decreased $721,000.  Commercial and agricultural loans increased $1,079,000,  while installment loans to individuals decreased $2,985,000.

 

The amount of loans outstanding at the indicated dates are shown in the following table according to type of loan (in thousands):

 

		December 31,
		2003			2002			2001			2000			1999
Domestic:
Commercial and agricultural		$	23,523		$	23,708		$	22,629		$	26,471		$	31,735
Real estate mortgage:
Residential		147,697			140,724			140,614			131,761			121,734
Commercial		82,896			75,892			67,038			60,856			51,641
Construction		7,652			3,356			4,077			4,748			3,732
Installment loans to individuals		15,000			14,934			17,896			21,503			23,470
Less: Net deferred loan fees		940			769			631			541			497
Gross loans		$	275,828		$	257,845		$	251,623		$	244,798		$	231,815

 

The amount of domestic loans at December 31, 2003 are presented below by category and maturity (in thousands):

 

		REAL ESTATE			COMMERCIAL AND OTHER			INSTALLMENT LOANS TO INDIVIDUALS			TOTAL
Loans with floating interest rates:
1 year or less		$	11,859		$	8,145		$	1,526		$	21,530
1 through 5 years		6,180			2,799			18			8,997
5 through 10 years		26,730			3,088			208			30,026
After 10 years		112,351			672			6			113,029
Sub Total		157,120			14,704			1,758			173,582
Loans with predetermined interest rates:
1 year or less		3,822			867			1,146			5,835
1 through 5 years		22,060			7,295			10,532			39,887
5 through 10 years		23,488			111			1,561			25,160
After 10 years		30,804			546			14			31,364
Sub Total		80,174			8,819			13,253			102,246
Total		$	237,294		$	23,523		$	15,011		$	275,828

 

(1)          The loan maturity information is based upon original loan terms and is not adjusted for “rollovers.”  In the ordinary course of business, loans maturing within one year may be

 

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renewed, in whole or in part, as to principal amount at interest rates prevailing at the date of renewal.

(2) Scheduled repayments are reported in maturity categories in which the payment is due.

 

The Bank does not make loans that provide for negative amortization nor do any loans contain conversion features. The Bank does not have any foreign loans outstanding at December 31, 2003.

 

ALLOWANCE FOR LOAN LOSSES

2003

 

The allowance for loan losses represents the amount that management estimates is adequate to provide for probable losses inherent in the loan portfolio as of the balance sheet date.  Accordingly, all loan losses are charged to the allowance, and all recoveries are credited to it.  The allowance for loan losses is established through a provision for loan losses, which is charged to operations.  The provision is based on management’s quarterly evaluation of the adequacy of the allowance for loan losses, taking into account the overall risk characteristics of the various portfolio segments, past experience with losses, the impact of economic conditions on borrowers, and other relevant factors.  Underwriting continues to emphasize the need for security and adequate collateral margins.  The total allowance for loan losses is a combination of a specific allowance for identified problem loans, and a homogeneous pool allowance.

 

At December 31, 2003, the allowance for loan losses as a percent of gross loans remained the same as December 31, 2002 at 1.1%.  Gross loans increased by $17,983,000 from $257,845,000 at December 31, 2002 to $275,828,000 at December 31, 2003.

 

Nonaccruing loans decreased $44,000 from year-end 2002. Overall nonperforming loans decreased $840,000 to $1,256,000 from fiscal year end 2002.

 

Based on management’s loan-by-loan review, the past performance of the borrowers and current economic conditions, including recent business closures and bankruptcy levels, management does not anticipate any current losses related to nonaccrual, nonperforming, or classified loans above that have already been considered in its overall judgment of the adequacy of the reserve.

 

2002

 

At December 31, 2002, the allowance for loan losses as a percent of gross loans declined from December 31, 2001 to 1.1%.  Gross loans increased by $6,222,000 from $251,623,000 at December 31, 2001 to $257,845,000 at December 31, 2002.

 

Nonaccruing loans increased $590,000 to $871,000 from year-end 2001. Overall nonperforming loans increased $1,477,000 to $2,096,000 from fiscal 2001.

 

The following table presents information concerning nonperforming loans.  The accrual of interest will be discontinued when the principal or interest of a loan is in default for 90 days or more, or as soon as payment is questionable, unless the loan is well secured and in the process of collection.  Consumer loans and residential real estate loans secured by 1 to 4 family dwellings shall ordinarily not be subject to those guidelines.  The reversal of previously accrued but uncollected interest applicable to any loan placed in a nonaccrual status and the treatment of subsequent payments of either principal or interest will be handled in accordance with accounting principles generally accepted in the United States of America.  These principles do not require a write-off of previously accrued interest if principal and interest are ultimately protected by sound collateral values.  A nonperforming loan may be restored to an accruing status when:

 

1.  Principal and interest is no longer due and unpaid.

2.  It becomes well secured and in the process of collection.

3.  Prospects for future contractual payments are no longer in doubt.

 

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