f10q_093010-0160.htm

                 SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q
(Mark One)
[x]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

    For the quarterly period ended September 30, 2010
OR
[ ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

    For the transition period from  ________ to ________ 

Commission file number   0-28366

Norwood Financial Corp.
(Exact name of Registrant as specified in its charter)

Pennsylvania
 
23-2828306
(State or other jurisdiction of
Incorporation or organization)
 
(I.R.S. employer identification no.)

717 Main Street, Honesdale, Pennsylvania
 
18431
 
(Address of principal executive offices)
 
(Zip Code)
 

(570) 253-1455
(Registrant’s telephone number, including area code)

NA
(Former name, former address and former fiscal year, if changed since last report))

Indicate by check (x) whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes [x]  No [ ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  [ ]  No   [ ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  o
Accelerated filer  x
Non-accelerated filer   o
Smaller reporting company  o
(Do not check if a smaller reporting company)
 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):    [ ]  Yes[X]  No

Class
 
Outstanding as of November 1, 2010
 
Common stock, par value $0.10 per share
   2,760,895  


 
1

 



NORWOOD FINANCIAL CORP.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2010


   
 
 Page
Number
PART I -
CONSOLIDATED FINANCIAL INFORMATION OF NORWOOD
FINANCIAL CORP.
 
     
Item 1.
Financial Statements
  3
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
18
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
34
Item 4.
Controls and Procedures
35
PART II -
OTHER INFORMATION
 
     
Item 1.
Legal Proceedings
36
Item 1A.
Risk Factors
36
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
36
Item 3.
Defaults upon Senior Securities
36
Item 4.
Reserved
36
Item 5.
Other Information
36
Item 6.
Exhibits
36
     
Signatures
 
38


 
2

 

PART I.  FINANCIAL INFORMATION
Item 1. Financial Statements
NORWOOD FINANCIAL CORP.
Consolidated Balance Sheets  (unaudited)
(dollars in thousands, except per share data)
   
September 30,
   
December 31,
 
   
2010
   
2009
 
ASSETS
           
Cash and due from banks
  $ 9,057     $ 6,498  
Interest bearing deposits with banks
    7,696       7,857  
Federal funds sold
    3,000       3,000  
          Cash and cash equivalents
    19,753       17,355  
                 
Securities available for sale
    139,308       130,577  
Securities held to maturity, fair value 2010:
   $177, 2009: $722
     169        708  
Loans receivable (net of unearned income)
    358,354       363,474  
   Less:  Allowance for loan losses
     5,513       5,453  
Net loans receivable
    352,841       358,021  
Investment in FHLB Stock, at cost
    3,538       3,538  
Bank premises and equipment, net
    5,012       5,189  
Bank owned life insurance
    8,161       7,889  
Accrued interest receivable
    2,342       2,200  
Foreclosed real estate owned
    748       392  
Other assets
    2,685       3,827  
  TOTAL ASSETS
  $ 534,557     $ 529,696  
                 
LIABILITIES
               
  Deposits:
               
      Non-interest bearing demand
  $ 66,331     $ 59,820  
      Interest-bearing
    332,321       331,653  
        Total deposits
    398,652       391,473  
  Short-term borrowings
    24,530       25,803  
  Other borrowings
    38,000       43,000  
  Accrued interest payable
    1,652       2,057  
  Other liabilities
     3,280       2,892  
  TOTAL LIABILITIES
    466,114       465,225  
                 
 STOCKHOLDERS’ EQUITY
               
    Common stock, $.10 par value per share, authorized
      10,000,000; shares issued 2,840,872
     284        284  
    Surplus
    9,815       9,764  
    Retained  earnings
    57,642       54,455  
    Treasury stock at cost: 2010: 79,977 shares, 2009:
      68,436
     (2,437 )     (2,122 )
    Accumulated other comprehensive income
     3,139       2,090  
    TOTAL STOCKHOLDERS’ EQUITY
    68,443       64,471  
    TOTAL LIABILITIES AND
   STOCKHOLDERS’ EQUITY
  $ 534,557     $  529,696  
See accompanying notes to the unaudited consolidated financial statements.

 
3

 

NORWOOD FINANCIAL CORP.
Consolidated Statements of Income (unaudited)
(dollars in thousands, except per share data)

   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
 
 
2010
   
2009
   
2010
   
2009
 
INTEREST INCOME
                       
  Loans receivable, including fees
  $ 5,266     $ 5,382     $ 15,894     $ 16,095  
  Securities
    1,115       1,297       3,477       4,010  
  Other
     14        1       43       8  
  Total interest income
    6,395       6,680       19,414       20,113  
                                 
INTEREST EXPENSE
                               
  Deposits
    1,031       1,433       3,332       4,354  
  Short-term borrowings
    26       60       87       229  
  Other borrowings
     419        421       1,247       1,248  
  Total interest expense
    1,476       1,914       4,666       5,831  
NET INTEREST INCOME
    4,919       4,766       14,748       14,282  
PROVISION FOR LOAN LOSSES
     250        140       730       585  
NET INTEREST INCOME AFTER
  PROVISION FOR LOAN LOSSES
      4,669         4,626        14,018        13,697  
                                 
OTHER INCOME
                               
  Service charges and fees
    587       614       1,680       1,854  
  Income from fiduciary activities
    121       99       300       263  
  Net realized gains on sales of securities
    161       90       380       423  
  Gains on sale of loans and servicing rights
    3       42       208       296  
  Gains on sale of deposits
    -       -       -       150  
  Other
     163        173       485       481  
  Total other income
     1,035        1,018       3,053       3,467  
                                 
OTHER EXPENSES
                               
  Salaries and employee benefits
    1,657       1,611       4,844       4,820  
  Occupancy, furniture & equipment, net
    388       367       1,190       1,231  
  Data processing related
    195       194       607       593  
  Taxes, other than income
    77       139       374       414  
  Professional fees
    81       100       358       302  
  FDIC Insurance assessment
    121       133       357       617  
  Other real estate owned
    3       130       32       148  
  Other
    590       500       1,686       1,644  
  Total other expenses
    3,112       3,174       9,448       9,769  
                                 
INCOME BEFORE INCOME TAXES
    2,592       2,470       7,623       7,395  
INCOME TAX EXPENSE
     702        695       2,118       2,134  
NET INCOME
  $ 1,890     $ 1,775     $ 5,505     $ 5,261  
                                 
BASIC EARNINGS PER SHARE
  $ 0.68     $ 0.64     $ 1.99     $ 1.92  
                                 
DILUTED EARNINGS PER SHARE
  $ 0.68     $ 0.64     $ 1.99     $ 1.90  
                                 
See accompanying notes to the unaudited consolidated financial statements.

 
4

 



NORWOOD FINANCIAL CORP.
Consolidated Statements of Changes in Stockholders’ Equity (unaudited)
Nine months ended September 30, 2010
(dollars in thousands, except share data)

   
 
Common Stock
         
 
Retained
   
 
Treasury Stock
   
Accumulated
Other
Comprehensive
       
   
Shares
   
Amount
   
Surplus
   
Earnings
   
Shares
   
Amount
   
Income
   
Total
 
Balance December 31, 2009
    2,840,872     $ 284     $ 9,764     $ 54,455       68,436     $ (2,122 )   $ 2,090     $ 64,471  
Comprehensive Income:
                                                               
  Net Income
                            5,505                               5,505  
Change in unrealized gains on 
  securities 
 available for sale,
  net of  reclassification
  adjustments and  tax  effects
                                                     1,049        1,049  
Total comprehensive income
                                                          $ 6,554  
                                                                 
                                                                 
Cash dividends declared $.84
  per share
                            (2,318 )                             (2,318 )
Acquisition of  treasury  stock
                                    18,571       (529 )             (529 )
Stock options exercised
                    (103 )             (7,030 )     214               111  
Tax benefit on stock options
  exercised
                    32                                       32  
Compensation expense related
  to stock options
                     122                                        122  
                                                                 
Balance, September 30, 2010
    2,840,872     $ 284     $ 9,815     $ 57,642       79,977     $ (2,437 )   $ 3,139     $ 68,443  
 
See accompanying notes to the unaudited consolidated financial statements.

 
5

 

NORWOOD FINANCIAL CORP.
Consolidated Statements of Cash Flows (Unaudited)
(dollars in thousands)
   
Nine Months Ended
September 30,
 
   
2010
   
2009
 
CASH FLOWS FROM OPERATING ACTIVITIES
           
Net Income
  $ 5,505     $ 5,261  
Adjustments to reconcile net income to net cash provided by operating  activities:
               
  Provision for loan losses
    730       585  
  Depreciation
    347       422  
  Amortization of intangible assets
    39       39  
  Deferred income taxes
    (36 )     779  
  Net amortization of securities premiums and discounts
    273       102  
  Net realized gain on sales of securities
    (380 )     (423 )
  Gain on sale of deposits
    -       (150 )
  Earnings on life insurance
    (270 )     (261 )
  Loss (gain) on sale of bank premises and equipment and foreclosed real estate
    (3 )     118  
  Net gain on sale of mortgage loans and servicing rights
    (208 )     (296 )
  Mortgage loans originated for sale
    (10,537 )     (21,565 )
  Proceeds from sale of mortgage loans originated for sale
    10,745       21,861  
  Compensation expense related to stock options
    122       98  
  Decrease (increase) in accrued interest receivable and other assets
    569       (653 )
  Increase (decrease) in accrued interest payable and other liabilities
    (14 )     862  
    Net cash provided by operating activities
    6,882       6,779  
                 
CASH FLOWS FROM INVESTING ACTIVITIES
               
  Securities available for sale:
               
    Proceeds from sales
    23,778       13,586  
    Proceeds from maturities and principal reductions on mortgage-backed securities
    51,704       34,456  
    Purchases
    (82,518 )     (41,854 )
  Securities held to maturity, proceeds from maturities
    540       -  
  Net (increase) decrease  in loans
    3,886       (10,446 )
  Purchase of bank premises and equipment
    (175 )     (193 )
  Proceeds from sale of bank premises and equipment and foreclosed real estate
    100       121  
  Net cash used in investing activities
    (2,685 )     (4,330 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES
               
  Net increase in deposits
    7,179       26,984  
  Deposits sold
    -       (3,606 )
  Net decrease in short-term borrowings
    (1,274 )     (18,573 )
  Repayment of long-term debt
    (5,000 )     -  
  Stock options exercised
    111       457  
  Tax benefit of stock options exercised
    32       146  
  Acquisition of treasury stock
    (529 )     (68 )
  Cash dividends paid
    (2,318 )     (2,220 )
   Net cash provided by (used in) financing activities
    (1,799 )     3,120  
   Increase in cash and cash equivalents
    2,398       5,569  
                 
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    17,355       6,480  
CASH AND CASH EQUIVALENTS, END OF PERIOD
  $ 19,753     $ 12,049  
See accompanying notes to the unaudited consolidated financial statements.


 
6

 
Notes to the Unaudited Consolidated Financial Statements

1.           Basis of Presentation

The unaudited consolidated financial statements include the accounts of Norwood Financial Corp. (Company) and its wholly-owned subsidiary, Wayne Bank (Bank) and the Bank’s wholly-owned subsidiaries, WCB Realty Corp., Norwood Investment Corp. and WTRO Properties.   All significant intercompany transactions have been eliminated in consolidation.

The accompanying unaudited consolidated  financial statements have been prepared in conformity with generally accepted accounting principles for interim financial statements and with instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In preparing the 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 balance sheet and revenues and expenses for the period.  Actual results could differ from those estimates.  The financial statements reflect, in the opinion of management, all normal, recurring adjustments necessary to present fairly the financial position and results of operations of the Company.  The operating results for the three and nine month periods ended September 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010 or any other future interim period.

These statements should be read in conjunction with the consolidated financial statements and related notes which are incorporated by reference in the Company’s Annual Report on Form 10-K for the year-ended December 31, 2009.

2.           Earnings Per Share

Basic earnings per share represents income available to common stockholders divided by the weighted average number of common shares outstanding during the period.  Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance.  Potential common shares that may be issued by the Company relate solely to outstanding stock options and are determined using the treasury stock method.

The following table sets forth the weighted average shares outstanding used in the computations of basic and diluted earnings per share:

(in thousands)
   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Basic EPS weighted average shares outstanding
    2,760       2,757       2,762       2,745  
Dilutive effect of stock options
    4       20       5       18  
Diluted EPS weighted average shares outstanding
    2,764       2,777       2,767       2,763  

Stock options which had no intrinsic value, because their effect would be anti-dilutive and therefore would not be included in the diluted EPS calculation were 113,150 and 103,000 as of September 30, 2010 and 2009, respectively based upon the closing price of Norwood stock on September 30, 2010 of $28.00 per share.



 
7

 

3.  Stock-Based Compensation

  The Company’s shareholders approved the Norwood Financial Corp 2006 Stock Option Plan at the annual meeting on April 25, 2006 and the Company awarded 47,700 options in 2006, 22,000 options in 2007, 24,000 options in 2008, 27,000 options in 2009 and 1,000 options in 2010, all of which have a twelve month vesting period. As of September 30, 2010, there was $41,000 of total unrecognized compensation cost related to non-vested options granted in 2009 and 2010 under the plan, which will be fully amortized by December 31, 2010.

A summary of stock options from all plans, adjusted for stock dividends declared, is shown below.

 
Options
 
Weighted Average Exercise Price
Per Share
Weighted Average
Remaining
Contractual Term
 
Aggregate
Intrinsic Value ($000)
 
                       
Outstanding at January 1, 2010
170,915
 
$
28.07
 
6.8 Yrs.
.
 
$
286
 
Granted
1,000
   
26.88
 
9.7 Yrs.
.
   
1
 
Exercised
(7,030)
   
 15.94
 
1.3 Yrs.
 
   
80
 
Outstanding at September 30, 2010
164,885
 
$
28.57
 
6.2 Yrs.
 
 
$
         169
 
                       
Exercisable at September 30, 2010
140,885
 
$
28.37
 
4.8 Yrs.
 
 
$
          168
 
                       

Intrinsic value represents the amount by which the market price of the stock on the measurement date exceeded the exercise price of the option.  The stock price was $28.00 as of September 30, 2010 and $28.59 as of December 31, 2009.  The intrinsic value of options exercised during the nine months ended September 30, 2010 was $80,000, cash received from such exercises was $111,000 and the tax benefit recognized was $32,000.

4.           Cash Flow Information

For the purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, interest-bearing deposits with banks all of which mature within 90 days and federal funds sold.

Cash payments for interest for the nine months ended September 30, 2010 and 2009 were $5,071,000 and $5,713,000, respectively.  Cash payments for income taxes for the periods ending September 30, 2010 and 2009 were $1,990,000 and $1,838,000, respectively.  Non-cash investing activity for 2010 and 2009 included repossession of other assets and foreclosed mortgage loans transferred to real estate owned of $564,000 and $213,000, respectively.

5.           Comprehensive Income

Accounting principles generally accepted in the United States of America require that recognized revenue, expenses, gains and losses be included in net income.  Although certain changes in assets and liabilities such as unrealized gains and losses on available for sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income.  The components of other comprehensive income and related tax effects are as follows:

 
8

 


   
Three Months Ended
   
Nine Months Ended
 
(in thousands)
 
September 30,
   
September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Unrealized holding gains
  on available for sale securities
  $  908     $  1,989     $  1,970     $  2,522  
Reclassification adjustment for gains
  Realized in income
    (161 )     (90 )     (380 )     (423 )
Net unrealized gains
    747       1,899       1,590       2,099  
Income tax expense
    254       646       541       718  
Other comprehensive income
  $ 493     $ 1,253     $ 1,049     $ 1,381  
                                 

6.           Off-Balance Sheet Financial Instruments and Guarantees

The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit and letters of credit.  Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments.  The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

A summary of the Bank’s financial instrument commitments is as follows:

(in thousands)
 
September 30,
 
   
2010
   
2009
 
 
Commitments to grant loans
  $  19,867     $  11,686  
Unfunded commitments under lines of credit
    30,992       35,117  
Standby letters of credit
    3,195       2,060  
                 
    $ 54,054     $ 48,863  

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since some of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements.  The Bank evaluates each customer’s credit worthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the customer and generally consists of real estate.

The Bank does not issue any guarantees that would require liability recognition or disclosure, other than its standby letters of credit.  Standby letters of credit written are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party.  Generally, all letters of credit, when issued, have expiration dates within one year.  The credit risk involved in issuing letters of credit is essentially the same as those that are involved in extending loan facilities to customers.  The Bank, generally, holds collateral and/or personal guarantees supporting these commitments.  Management believes that the proceeds obtained through a liquidation of collateral and the enforcement of guarantees would be sufficient to cover the potential amount of
 
 
9

 
 
 future payments required under the corresponding guarantees.  The current amount of the liability as of September 30, 2010 for guarantees under standby letters of credit issued is not material.

7. Securities

The amortized cost and fair value of securities were as follows:

   
September 30, 2010
 
   
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Value
 
   
(In Thousands)
 
Available for Sale:
                       
U.S. Government agencies
  $ 30,196     $ 526     $ -     $ 30,722  
States and political subdivisions
    46,802       1,944       -       48,746  
Corporate obligations
    4,025       281       -       4,306  
Mortgage-backed securities
    53,200       1,663       (74 )     54,789  
      134,223       4,414       (74 )     138,563  
Equity securities
    324       425       (4 )     745  
    $ 134,547     $ 4,839     $ (78 )   $ 139,308  
Held to Maturity:
                               
States and political subdivisions
  $ 169     $ 8     $ -     $ 177  
                                 


   
December 31, 2009
 
   
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Value
 
   
(In Thousands)
 
Available for Sale:
                       
U.S. Government agencies
  $ 39,607     $ 295     $ (130 )   $ 39,772  
States and political subdivisions
    30,872       780       (17 )     31,635  
Corporate obligations
    5,043       200       (3 )     5,240  
Mortgage-backed securities
    51,554       1,618       (18 )     53,154  
      127,076       2,893       (168 )     129,801  
Equity securities
    330       451       (5 )     776  
    $ 127,406     $ 3,344     $ (173 )   $ 130,577  
Held to Maturity:
                               
States and political subdivisions
  $ 708     $ 14     $ -     $ 722  
                                 


 
10

 


The following tables show the Company’s investments’ gross unrealized losses and fair value aggregated by length of time that individual securities have been in a continuous unrealized loss position (in thousands):

   
September 30, 2010
 
   
Less than 12 Months
   
12 Months or More
   
Total
 
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
 
U.S. Government agencies
  $  -     $   -     $  -     $  -     $  -     $   -  
States and political subdivisions
     -        -        -        -        -        -  
Mortgage-backed securities
     11,751       (74 )      -        -        11,751       (74 )
Equity securities
    50       (2 )     5       (2 )     55       (4 )
    $ 11,801     $ (76 )   $ 5     $ (2 )   $ 11,806     $ (78 )
                                                 

The Company has five securities in an unrealized loss position in the less than twelve months category and no securities in the twelve months or more category.  In Management’s opinion the unrealized losses less than twelve months on mortgage-backed securities principally reflect changes in interest rates subsequent to the acquisition of specific securities.  The Company holds a small amount of equity securities in other financial institutions.  The value of these equity securities has been impacted by the overall weakness in the financial sector, one of which has been in a loss position for greater than one year and two which has been in a loss position for less than twelve months.  During the fourth quarter of 2009, the Company recorded an other-than-temporary impairment charge on two equity holdings totaling $31,000.  Management believes that all other unrealized losses represent temporary impairment of the securities as the Company does not have the intent to sell these securities and it is more likely than not that it will not have to sell the securities before recovery of their cost basis.

   
December 31, 2009
 
   
Less than 12 Months
   
12 Months or More
   
Total
 
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
 
 
U.S. Government agencies
  $  15,366     $ (130 )   $  -     $  -     $  15,366     $ (130 )
States and political subdivisions
     1,413       (17 )      -        -        1,413       (17 )
Corporate obligations
    997       (3 )     -       -       997       (3 )
Mortgage-backed securities
     3,655       (18 )      -        -        3,655       (18 )
Equity securities
    49       (3 )     5       (2 )     54       (5 )
    $ 21,480     $ (171 )   $ 5     $ (2 )   $ 21,485     $ (173 )
                                                 



 
11

 

The amortized cost and fair value of debt securities as of September 30, 2010 by contractual maturity are shown below.  Expected maturities may differ from contractual maturities because borrowers may have the right to prepay obligations with or without call or prepayment penalties.

   
Available for Sale
   
Held to Maturity
 
   
Amortized Cost
   
Fair Value
   
Amortized Cost
   
Fair Value
 
   
(In Thousands)
 
Due in one year or less
  $ 1,006     $ 1,020     $ -     $ -  
Due after one year through five years
    33,279       34,159       169       177  
Due after five years through ten years
    19,225       19,992       -       -  
Due after ten years
    27,513       28,603    
-
   
-
 
      81,023       83,774       169       177  
Mortgage-backed securities
    53,200       54,789    
-
   
-
 
    $ 134,223     $ 138,563     $ 169     $ 177  

Gross realized gains and gross realized losses on sales of securities available for sale were as follows (in thousands):

   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Gross realized gains
  $ 161     $ 90     $ 380     $ 526  
Gross realized losses
 
-
   
-
      -       (103 )
Net realized gain/(loss)
  $ 161     $ 90     $ 380     $ 423  
Proceeds from sales of securities
  $ 11,091     $ 2,445     $ 23,778     $ 13,586  

8.           Fair Value Measurements

Generally accepted accounting principles in the United States of America established a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value.  The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).  The three levels of the fair value hierarchy are as follows:


 
Level 1:
Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.
     
 
Level 2:
Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability.
     
 
Level 3:
Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported with little or no market activity).

An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.


 
12

 
 
For financial assets measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2010 and December 31, 2009 are as follows:

   
Fair Value Measurement Reporting Date Using
 
 
 
 
 
Description
 
 
 
 
Total
   
(Level 1)
Quoted Prices in
Active Markets
For Identical
Assets
   
(Level 2)
Significant
Other
Observable
Inputs
   
(Level 3)
Significant
Unobservable
Inputs
 
   
(In thousands)
 
September 30, 2010
                       
Available for Sale:
                       
US Government agencies
  $ 30,722     $ -     $ 30,722     $ -  
States and political subdivisions
    48,746     -       48,746       -  
Corporate securities
    4,306      -       4,306       -  
Mortgage-backed securities
    54,789      -       54,789       -  
Equity securities
    745       745    
-
   
-
 
Total available for sale
    139,308       745       138,563       -  
Mortgage servicing rights
    247       -       -       247  
Total
  $ 139,555     $ 745     $ 138,563     $ 247  
                                 
December 31, 2009
                               
Available for Sale:
                               
US Government agencies
  $ 39,772     $ -     $ 39,772     $ -  
States and political subdivisions
    31,635       -       31,635       -  
Corporate securities
    5,240        -       5,240       -  
Mortgage-backed securities
    53,154        -       53,154       -  
Equity securities
    776       776    
-
   
-
 
Total available for sale
    130,577       776       129,801       -  
Mortgage servicing rights
    179       -       -       179  
Total
  $ 130,756     $ 776     $ 129,801     $ 179  

For financial assets measured at fair value on a nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2010 and December 31, 2009 are as follows:

      Fair Value Measurement Reporting Date Using  
Description
 
Total
   
(Level 1)
Quoted Price in Active Markets For Identical
Assets
   
(Level 2)
Significant Other Observable Inputs
   
(Level 3)
Significant Unobservable
Inputs
 
September 30, 2010
     
Impaired Loans
  $ 13,343     $  -     $ 13,343     $ -  
Foreclosed Real Estate Owned
    748      -       748      -  
    $ 14,091     $ -     $ 14,091     $ -  
                                 
December 31, 2009
                               
Impaired Loans
  $ 7,991     $ -     $ 7,991     $ -  
Foreclosed Real Estate Owned
    392       -       392       -  
    $ 8,383     $ -     $ 8,383     $ -  

The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of the Company’s assets and liabilities.  Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company’s disclosures and those of other companies may not be meaningful.  The following methods and assumptions were used to estimate the fair values of the Company’s financial instruments at September 30, 2010 and December 31, 2009.

 
13

 
Cash and cash equivalents (carried at cost):

The carrying amounts reported in the consolidated balance sheet for cash and short-term instruments approximate those assets’ fair values.
 
Securities:

The fair value of securities available for sale (carried at fair value) are determined by obtaining quoted market prices on nationally recognized securities exchanges (Level 1), or matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices.  For certain securities which are not traded in active markets or are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence (Level 2).  Internal cash flow models using a present value formula that includes assumptions market participants would use along with indicative exit pricing obtained from broker/dealers (where available) are used to support fair values of certain (Level 3) investments, if applicable.

Loans receivable (Carried at cost):

The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the credit and interest rate-risk inherent in the loans.  Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal.  Generally, for variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.

The Company measured impairment generally based on the fair value of the loan’s collateral.  Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based upon the expected proceeds.  These assets are included as either Level 2 or Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.

As of September 30, 2010, the fair value investment in impaired loans totaled $13,343,000 which includes four loans for $8.8 million for which a valuation allowance has been provided based on current collateral values and four loans for $4.5 million which do not require a valuation allowance since the current collateral value exceeds the loan value.  As of September 30, 2010, the Company has recognized charge-offs against the allowance for loan losses on impaired loans in the amount of $690,000 over the life of the loans.

As of December 31, 2009, the fair value investment in impaired loans was $7,991,000 which included two loans for $1.0 million for which a valuation allowance had been provided based on the estimated value of the collateral and five loans for $7.0 million which did not require a valuation allowance since the estimated realizable value of the collateral exceeded the recorded investment in the loan.  As of December 31, 2009, the Company had recognized a cumulative charge-off against the allowance for loans losses in the amount of $634,000 on impaired loans.

 
14

 


   
September 30, 2010
 
 
(in thousands)
 
Carrying Value
   
Valuation Allowance
   
Cumulative
Charge-offs Recognized
 
Impaired loans requiring a valuation
  allowance
  $  8,827     $  1,268     $  480  
Impaired loans not requiring a valuation
  allowance
     4,516        -        210  
                         
Total
  $ 13,343     $ 1,268     $ 690  

 
 
   
December 31, 2009
 
   
Carrying Value
   
Valuation Allowance
   
Cumulative
Charge-offs Recognized
 
Impaired loans requiring a valuation
  allowance
  $  1,029     $  36     $  480  
Impaired loans not requiring a valuation
  allowance
     6,962        -        154  
                         
Total
  $ 7,991     $ 36     $ 634  

Foreclosed real estate owned

Real estate properties acquired through, or in lieu of loan foreclosure are to be sold and are carried at fair value less cost to sell.  Fair value is based upon independent market prices, appraised value of the collateral or management’s estimation of the value of the collateral.  These assets are included in Level 2 fair value based upon the lowest level of input that is significant to the fair value measurement.

Restricted investment in Federal Home Loan Bank stock (carried at cost):

Restricted stock which represents required investment in the common stock of correspondent banks is carried at cost and as of September 30, 2010 and December 31, 2009, consists of the common stock of the Federal Home Loan Bank of Pittsburgh.  In December 2008, the FHLB of Pittsburgh notified member banks that it was suspending dividend payments and the repurchase of excess capital stock.

Management evaluates the restricted stock for impairment.  Management’s determination of whether these investments are impaired is based on their assessment of the ultimate recoverability of their cost rather than by recognizing temporary declines in value.  The determination of whether a decline affects the ultimate recoverability of their cost is influenced by criteria such as (1) the significance of the decline in net assets of the FHLB as compared to the capital stock amount for the FHLB and the length of time this situation has persisted, (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB, and (3) the impact of legislative and regulatory changes on institutions and, accordingly, on the customer base of the FHLB.  Management believes no impairment charge is necessary related to FHLB stock as of September 30, 2010.

Accrued interest receivable and payable (carried at cost):

The carrying amount of accrued interest receivable and accrued interest payable approximates its fair value.


 
15

 

Deposit liabilities (carried at cost):

The fair values disclosed for demand deposits (e.g., interest and noninterest checking, passbook savings and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts).  Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Short-term borrowings (carried at cost):

The carrying amounts of short-term borrowings approximate their fair values.

Other borrowings (carried at cost):

Fair values of FHLB advances are estimated using discounted cash flow analysis, based on quoted prices for new FHLB advances with similar credit risk characteristics, terms and remaining maturity.  These prices obtained from this active market represent a market value that is deemed to represent the transfer price if the liability were assumed by a third party.

Off-balance sheet financial instruments (disclosed at cost):

Fair values for the Company’s off-balance sheet financial instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account, the remaining terms of the agreements and the counterparties’ credit standing.

The estimated fair values of the Bank’s financial instruments were as follows at September 30, 2010 and December 31, 2009.
 
   
September 30, 2010
   
December 31, 2009
 
   
Carrying
   
Fair
   
Carrying
   
Fair
 
   
Amount
   
Value
   
Amount
   
Value
 
Financial assets:
                       
Cash and due from banks, interest-bearing
  deposits with banks and federal funds sold
  $  19,753     $  19,753     $  17,355     $  17,355  
Securities
    139,477       139,485       131,285       131,299  
Loans receivable, net
    352,841       366,940       358,021       368,180  
Investment in FHLB stock
    3,538       3,538       3,538       3,538  
Accrued interest receivable
    2,342       2,342       2,200       2,200  
                                 
Financial liabilities:
                               
Deposits
    398,652       400,109       391,473       392,445  
Short-term borrowings
    24,530       24,530       25,803       25,803  
Other borrowings
    38,000       40,998       43,000       45,591  
Accrued interest payable
    1,652       1,652       2,057       2,057  
                                 
Off-balance sheet financial instruments:
 Commitments to extend credit and  outstanding letters of credit
     -        -        -        -  


 
16

 

9.           New and Recently Adopted Accounting Pronouncements

In December 2009, the FASB issued ASU 2009-16, Accounting for Transfer of Financial Assets.  ASU 2009-16 provides guidance to improve the relevance, representational faithfulness, and comparability of the information that an entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets.  ASU 2009-16 is effective for annual periods beginning after November 15, 2009 and for interim periods within those fiscal years.  The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation.
 
In January 2010, the FASB issued ASU 2010-01, Equity (Topic 505): Accounting for Distributions to Shareholders with Components of Stock and Cash – a consensus of the FASB Emerging Issues Task Force. ASU 2010-01 clarifies that the stock portion of a distribution to shareholders that allows them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected in EPS prospectively and is not a stock dividend.  ASU 2010-01 is effective for interim and annual periods ending on or after December 15, 2009 and should be applied on a retrospective basis.  The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation. 
 
In January 2010, the FASB issued ASU 2010-05, Compensation – Stock Compensation (Topic 718): Escrowed Share Arrangements and the Presumption of Compensation. ASU 2010-05 updates existing guidance to address the SEC staff’s views on overcoming the presumption that for certain shareholders escrowed share arrangements represent compensation.  ASU 2010-05 is effective January 15, 2010.  The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation. 
 
In January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. ASU 2010-06 amends Subtopic 820-10 to clarify existing disclosures, require new disclosures, and includes conforming amendments to guidance on employers’ disclosures about postretirement benefit plan assets. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years.  The Company has presented the necessary disclosures in Note 8 herein.
 
In February 2010, the FASB issued ASU 2010-08, Technical Corrections to Various Topics. ASU 2010-08 clarifies guidance on embedded derivatives and hedging. ASU 2010-08 is effective for interim and annual periods beginning after December 15, 2009. The adoption of this guidance did not have a material impact on the Company’s financial position or results of operation.
 
In March 2010, the FASB issued ASU 2010-11, Derivatives and Hedging.  ASU 2010-11 provides clarification and related additional examples to improve financial reporting by resolving potential ambiguity about the breadth of the embedded credit derivative scope exception in ASC 815-15-15-8.  ASU 2010-11 is effective at the beginning of the first fiscal quarter beginning after June 15, 2010. The adoption of this guidance did not have a significant impact on the Company’s financial statements.
 
In April 2010, the FASB issued ASU 2010-18, Receivables (Topic 310):  Effect of a Loan Modification When the Loan is a Part of a Pool That is Accounted for as a Single Asset – a consensus of the FASB Emerging Issues Task Force.  ASU 2010-18 clarifies the treatment for a modified loan that was acquired as part of a pool of assets.  Refinancing or restructuring the loan does not make it eligible for removal from the pool, the FASB said.  The amendment will be effective for loans that are part of an asset pool and are modified during financial
 
 
17

 
 
reporting periods that end July 15, 2010 or later and is not expected to have a significant impact on the Company’s financial statements.
 
In July 2010, FASB issued ASU No. 2010-20, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.  ASU 2010-20 is intended to provide additional information to assist financial statement users in assessing an entity’s credit risk exposures and evaluating the adequacy of its allowance for credit losses. The disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010.  The amendments in ASU 2010-20 encourage, but do not require, comparative disclosures for earlier reporting periods that ended before initial adoption. However, an entity should provide comparative disclosures for those reporting periods ending after initial adoption.  The Company is currently evaluating the impact the   adoption of this guidance will have on the Company’s financial position or results of operations.
 
In August, 2010, the FASB issued ASU 2010-21, Accounting for Technical Amendments to Various SEC Rules and Schedules.  This ASU amends various SEC paragraphs pursuant to the issuance of Release No. 33-9026:  Technical Amendments to Rules, Forms, Schedules, and Codification of Financial Reporting Policies and is not expected to have a significant impact on the Company’s financial statements.
 
 
In August, 2010, the FASB issued ASU 2010-22, Technical Corrections to SEC Paragraphs – An announcement made by the staff of the U.S. Securities and Exchange Commission.  This ASU amends various SEC paragraphs based on external comments received and the issuance of SAB 112, which amends or rescinds portions of certain SAB topics and is not expected to have a significant impact

10.           Branch Closure

On December 26, 2008, the Company filed notifications with the Pennsylvania Department of Banking and the FDIC, requesting authorization to discontinue branch operations at its Hamlin Office, as the lease for the location expired in 2009, with no renewal options available. The Company entered into an agreement with NBT Bank to assume the deposits of the Hamlin location and the office was closed.  The Company recorded a net payable to NBT Bank of $3,607,000, which was paid subsequent to March 31, 2009.  The gain on the transaction was $150,000 with expense related to the closing, including final lease payments, of $46,000, included in other expense in the consolidated income statement.
 
Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

           The Private Securities Litigation Reform Act of 1995 contains safe harbor provisions regarding forward-looking statements.  When used in this discussion, the words believes, anticipates, contemplates, expects, and similar expressions are intended to identify forward-looking statements.  Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected.  Those risks and uncertainties include changes in federal and state laws, changes in interest rates, risks associated with the effect of opening a new branch, the ability to control costs and expenses, demand for real estate and general economic conditions.  The Company undertakes no obligation to publicly release the results of any revisions to those forward-looking statements which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.


 
18

 

Critical Accounting Policies

Note 2 to the Company’s consolidated financial statements for the year ended December 31, 2009 (incorporated by reference in Item 8 of the Form 10-K) lists significant accounting policies used in the development and presentation of its financial statements.  This discussion and analysis, the significant accounting policies, and other financial statement disclosures identify and address key variables and other qualitative and quantitative factors that are necessary for an understanding and evaluation of the Company and its results of operations.

Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, potential impairment of restricted stock, accounting for stock options, the valuation of deferred tax assets and the determination of other-than-temporary impairment losses on securities.  Please refer to the discussion of the allowance for loan losses calculation under “Allowance for Loan Losses and Non-performing Assets” in the “Changes in Financial Condition” section.

The Company uses the modified prospective transition method to account for stock based compensation.  Under this method companies are required to record compensation expense, based on the fair value of options over the vesting period.

The Deferred income taxes reflect temporary differences in the recognition of the revenue and expenses for tax reporting and financial statement purposes, principally because certain items are recognized in different periods for financial reporting and tax return purposes.  Although realization is not assured, the Company believes that it is more likely than not that all deferred tax assets will be realized.

Restricted stock which represents required investment in the common stock of correspondent banks is carried at cost and as of September 30, 2010 and December 31, 2009, consists of the common stock of the Federal Home Loan Bank of Pittsburgh.  In December 2008, the FHLB of Pittsburgh notified member banks that it was suspending dividend payments and the repurchase of excess capital stock.

Management evaluates the restricted stock for impairment.  Management’s determination of whether these investments are impaired is based on their assessment of the ultimate recoverability of their cost rather than by recognizing temporary decline in value.  The determination of whether a decline affects the ultimate recoverability of their cost is influenced by criteria such as (1) the significance of the decline in net assets of the FHLB as compared to the capital stock amount for the FHLB and length of time this situation has persisted, (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB, and (3) the impact of legislative and regulatory changes on institutions and, accordingly, on the customer base of the FHLB.  Management believes no impairment charge is necessary related to the restricted stock as of September 30, 2010 and December 31, 2009
 
 
In estimating other-than-temporary impairment losses on securities, the Company considers 1) the length of time and extent to which the fair value has been less than cost 2) the financial condition of the issuer and 3) the intent and ability of the Company to hold the security to allow for a recovery to fair value.  During the fourth quarter of 2009, the Company recorded an other-than-temporary impairment charge on two equity holdings totaling $31,000.  The Company believes that the unrealized losses on all other securities at September 30, 2010 and December 31, 2009 represent temporary impairment of the securities, related to changes in interest rates.


 
19

 

Changes in Financial Condition

General

Total assets as of September 30, 2010 were $534.6 million compared to $529.7 million as of December 31, 2009 an increase of $4.9 million.  The increase was due primarily to a $7.2 million increase in total deposits which was utilized to fund security purchases and also contributed to an increase in cash and cash equivalents.

Cash and Cash Equivalents

Cash and cash equivalents totaled $19.8 million compared to $17.4 million as of December 31, 2009, an increase of $2.4 million.  The increase in cash and cash equivalents was driven by an increase in deposits and proceeds from the sale and maturity of loans.

Securities

The fair value of securities available for sale as of September 30, 2010 was $139.3 million compared to $130.6 million as of December 31, 2009.  The Company purchased $82.5 million of securities using the proceeds from $76.0 million of securities sold, called, maturities and principal reductions as well as cash received from an increase in total deposits and from the sale of residential mortgage loans.

U.S. Government Agency securities decreased $9.1 million to $30.7 million due to sales and calls while obligations of States and political subdivisions increased $16.6 million to $48.9 million.

The carrying value of the Company’s securities portfolio (Available-for Sale and Held-to Maturity) consisted of the following:

   
September 30, 2010
   
December 31, 2009
 
(dollars in thousands)
 
Amount
   
% of portfolio
   
Amount
   
% of portfolio
 
                         
US Government agencies
  $ 30,722       22.0 %   $ 39,772       30.3 %
States and political subdivisions
    48,915       35.1       32,343       24.6  
Corporate securities
    4,306       3.1       5,240       4.0  
Mortgage-backed securities
    54,789       39.3       53,154       40.5  
Equity securities
     745       0.5        776        0.6  
  Total
  $ 139,477       100.0 %   $ 131,285       100.0 %

The Company has securities in an unrealized loss position.  In management’s opinion, the unrealized losses in the mortgage-backed securities reflect changes in interest rates subsequent to the acquisition of specific securities.  The Company holds a small amount of equity securities in other financial institutions, the value of which has been impacted by the weakening conditions of the financial markets.  During the fourth quarter of 2009, the Company recorded an other-than-temporary impairment charge on two equity holdings totaling $31,000.  Management believes that all other unrealized losses represent temporary impairment of the securities as the Company does not have the intent to sell these securities and it is more likely than not that it will not have to sell the securities before recovery of their cost basis.

Loans Receivable

Loans receivable totaled $358.4 million at September 30, 2010 compared to $363.5 million as of December 31, 2009.  Residential real estate loans, including construction financing, decreased $6.3 million due to the sale of $10.5 million of residential mortgages and principal repayments.  The loans were sold for interest rate risk management to shorten the average life of the mortgage loan portfolio and to reduce the risk to rising
 
 
20

 
 
interest rates.  Commercial loans including commercial real estate loans increased $1.9 million during the period while all other loans decreased $700,000.

Set forth below is selected data relating to the composition of the loan portfolio at the dates indicated:

Types of loans
                       
(dollars in thousands)
 
September 30, 2010
   
December 31, 2009
 
                         
Real Estate-Residential
  $ 126,745       35.3 %   $ 130,318       35.8 %
                Commercial
    181,635       50.6       180,266       49.5  
                Construction
    11,633       3.2       14,405       4.0  
Commercial, financial and agricultural
    24,645       6.9       24,116       6.6  
Consumer loans to individuals
    14,171       4.0       14,850       4.1  
  Total loans
    358,829       100.0 %     363,955       100.0 %
                                 
  Deferred fees (net)
    (475 )             (481 )        
 
    358,354               363,474          
  Allowance for loan losses
    (5,513 )             (5,453 )        
  Net loans receivable
  $ 352,841             $ 358,021          

Allowance for Loan Losses and Non-performing Assets

Following is a summary of changes in the allowance for loan losses for the periods indicated:

   
Three Months Ended
   
Nine Months Ended
 
 (dollars in thousands)
 
September 30,
   
September 30,
 
 
 
2010
   
2009
   
2010
   
2009
 
Balance, beginning
  $ 5,421     $ 4,574     $ 5,453     $ 4,233  
Provision for loan losses
    250       140       730       585  
Charge-offs
    (166 )     (58 )     (690 )     (190 )
Recoveries
    8       7       20       35  
  Net charge-offs
    (158 )     (51 )     (670 )     (155 )
Balance, ending
  $ 5,513     $ 4,663     $ 5,513     $ 4,663  
                                 
Allowance to total loans
    1.54 %     1.30 %     1.54 %     1.30 %
  Net (charge-offs) recoveries to average loans
    (annualized)
    .18 %     .06 %     .25 %     .06 %

The allowance for loan losses totaled $5,513,000 as of September 30, 2010 and represented 1.54% of total loans, compared to $5,453,000 and 1.50% of total loans at year end, and $4,663,000 or 1.30% of total loans, as of September 30, 2009.  The Company had net charge-offs for the nine months ended September 30, 2010 of $670,000 compared to $155,000 in the comparable period in 2009.  The charge-offs during the nine months ended September 30, 2010 included $607,000 of losses on loans that were previously carried in nonaccrual status.  The Company’s loan review process assesses the adequacy of the allowance for loan losses on a quarterly basis.  The process includes an analysis of the risks inherent in the loan portfolio.  It includes an analysis of impaired loans and a historical review of credit losses by loan type.  Other factors considered include:  concentration of credit in specific industries; economic and industry conditions; trends in delinquencies and loan classifications, large dollar exposures and loan growth.  Management considers the allowance adequate at September 30, 2010 based on the Company’s criteria.  However, there can be no assurance that the allowance for loan losses will be adequate to cover significant losses, if any, that might be incurred in the future.

 
21

 
As of September 30, 2010, non-performing loans totaled $3,651,000, which is 1.02% of total loans.  Included in the total are five commercial real estate loans for $2.6 million; six consumer loans for $762,000; one commercial loan for $18,000 and three residential mortgage loans for $281,000.  At December 31, 2009, non-performing loans totaled $5,015,000, or 1.38% of total loans.  Included in this total were five commercial real estate loans for $3.1 million; six consumer loans totaling $996,000; two commercial loans for $695,000 and three residential mortgage loans totaling $87,000.  The decrease was principally due to the resolution and payoff of two commercial credits.
 
    Included in total non-performing loans as of September 30, 2010 were six loans in the amount of $2.7 million which have been determined to be impaired in accordance with generally accepted accounting principles.  A loan is considered impaired when, based upon current information and events, it is more probable than not that all amounts due according to the contractual terms of the loan will not be collected.  As of December 31, 2009, there were six loans totaling $3.9 million in this category. Additionally, the company has determined that three other loan relationships totaling $10.6 million were impaired as of September 30, 2010. These loans have not been transferred to nonaccrual status and therefore are not classified as non-performing.  The three loans in question have been restructured and have made all payments under their modified terms.  The subject loans have not been transferred to nonaccrual status since they have not been delinquent and do not meet the definition of nonaccrual loan as per the Company’s loan policy.  As of December 31, 2009, there were two loans in this category totaling $4.2 million Details regarding the $10.6 million of performing impaired loans as of September 30, 2010 are as follows:
 
      •  
Two loans with a combined current balance of $1,051,000 were granted to a food service corporation in December, 2003.  We have addressed an issue with the customer which we believe to be a temporary cash flow deficiency and the terms of the loans were modified.  Our modification was made before the loan was past due based on ongoing discussions with the customer.  There was no interest rate concession made in the modification. As of September 30, 2010, the borrower is current with all payments under the modified terms of the loan. Based on the current circumstances, management believes that the company will collect all principal and interest due.
       
      •  
A loan with a current balance of $3,047,000 was granted to a limited liability company in August, 2006 for the purpose of operating a hotel. We have addressed an issue with the customer which we believe to be a temporary cash flow deficiency and the terms of the loan were modified.  Our modification was made before the loan was past due based on ongoing discussions with the customer.  There was no interest rate concession made in the modification. As of September 30, 2010, the borrower is current with all payments under the modified terms of the loan. Based on the current circumstances, management believes that the company will collect all principal and interest due.
       
      •  
A loan with a current balance of $6,500,000 was granted to a limited liability company in December, 2009 for the purpose of refinancing two prior commercial real estate loans. We have addressed an issue with the customer which we believe to be a temporary cash flow deficiency and the terms of the loan were modified.  Our modification was made before the loan was past due based on ongoing discussions with the customer.  Since the modification included an interest rate concession, the loan is considered a troubled debt restructuring. As of September 30, 2010, the borrower is current with all payments under the modified terms of the loan.  Based on the current circumstances, management believes that the company will collect all principal and interest due.



 
22

 

The following table sets forth information regarding non-performing loans and foreclosed real estate at the dates indicated:

    September 30,      December 31,  
(dollars in thousands)
 
2010
   
2009
 
  Loans accounted for on a non-accrual basis:
           
   Commercial and all other
  $ 18     $ -  
   Real Estate-Commercial
    2,590       3,833  
                       Residential
    281       1,083  
   Consumer
     762        -  
   Total
    3,651       4,916  
                 
Accruing loans which are contractually
               
  past due 90 days or more
     0        99  
Total non-performing loans
    3,651       5,015  
Foreclosed real estate
     748        392  
Total non-performing assets
  $ 4,399     $ 5,407  
Allowance for loans losses    5,513      5,453  
Coverage of non-performing loans
    1.51x        1.09x  
Non-performing loans to total loans
    1.02 %     1.38 %
Non-performing loans to total assets
    .68 %     .95 %
Non-performing assets to total assets
    .82 %     1.02 %
 
Deposits

Total deposits as of September 30, 2010 were $398.7 million compared to $391.5 million as of December 31, 2009, an increase of $7.2 million.  During the period, interest bearing demand deposits, including money market deposits, increased $23.3 million, savings deposits increased $4.9 million and non-interest bearing demand balances increased $6.5 million to offset a $27.5 million reduction in certificates of deposit.  The decrease in certificates includes $15.5 million of certificates of deposit over $100,000 due to the seasonality of municipal deposits and $12.0 million of retail certificates due to the maturity of certificates which were generated through deposit promotions.
 
 
The following table sets forth deposit balances as of the dates indicated:

    September 30,     December 31,   
(dollars in thousands)
 
2010
   
2009
 
             
Non-interest bearing demand
  $ 66,331     $ 59,820  
Interest bearing demand
    39,438       34,410  
Money market deposit accounts
    78,336       60,035  
Savings
    49,283       44,423  
Time deposits <$100,000
    114,127       126,154  
Time deposits >$100,000
     51,137        66,631  
                 
     Total
  $ 398,652     $ 391,473  
                 


 
23

 

Borrowings

Short-term borrowings as of September 30, 2010 totaled $24.5 million compared to $25.8 million as of December 31, 2009.  Securities sold under agreements to repurchase declined $1.3 million principally due to the seasonality of municipal cash management accounts.  Short-term borrowings consist of the following:

    September 30,     December 31,  
   
2010
   
2009
 
(dollars in thousands)
           
Securities sold under agreements to repurchase
  $ 24,339     $ 25,606  
U.S. Treasury demand notes
     191        197  
    $ 24,530     $ 25,803  

Other borrowings consisted of the following:

(dollars in thousands)
    September 30,     December 31,   
   
2010
   
2009
 
Notes with the FHLB:
           
Fixed rate note due September 2010 at 3.53%
  $ -     $ 5,000  
Convertible note due January 2011 at 5.24%
    3,000       3,000  
Convertible note due August 2011 at 2.69%
    10,000       10,000  
Fixed rate note due September 2011 at 4.06%
    5,000       5,000  
Convertible note due October 2012 at 4.37%
    5,000       5,000  
Convertible note due May 2013 at 3.015%
    5,000       5,000  
Convertible note due January 2017 at 4.71%
    10,000       10,000  
    $ 38,000     $ 43,000  

The convertible notes contain an option which allows the FHLB, at quarterly intervals to change the note to an adjustable-rate advance at three month LIBOR plus 11 to 19 basis points.  If the notes are converted, the option allows the Bank to put the funds back to the FHLB at no charge.

Off-Balance Sheet Arrangements

The Bank is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit and letters of credit.  Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.  Commitments to grant loans totaled $19.9 million as of September 30, 2010 compared to $17.7 million as of December 31, 2009.


 
24

 

A summary of the contractual amount of the Company’s financial instrument commitments is as follows:

   
September 30,
   
December 31,
 
   
2010
   
2009
 
   
(in thousands)
 
Commitments to grant loans
  $ 19,867     $ 17,713  
Unfunded commitments under lines of credit
    30,992       36,809  
Standby letters of credit
    3,195        3,679  
                 
    $ 54,054     $ 58,201  
                 

Stockholders’ Equity and Capital Ratios

As of September 30, 2010, stockholders’ equity totaled $68.4 million, compared to $64.5 million as of December 31, 2009.   The net change in stockholders’ equity included $5,505,000 in net income, that was partially offset by $2,317,000 of dividends declared and a $529,000 reduction due to an increase in Treasury Stock.  In addition, accumulated other comprehensive income increased $1,049,000 due to an increase in fair value of securities in the available for sale portfolio, net of tax.  This increase in fair value is the result of a change in interest rates, which may impact the value of the securities. Because of interest rate volatility, the Company’s accumulated other comprehensive income could materially fluctuate for each interim and year-end period.

A comparison of the Company’s regulatory capital ratios is as follows:
 
             
   
September 30, 2010
   
December 31, 2009
 
Tier 1 Capital
           
    (To average assets)
    12.18 %     11.87 %
Tier 1 Capital
               
    (To risk-weighted assets)
    18.14 %     16.97 %
Total Capital
               
    (To risk-weighted assets)
    19.45 %     18.27 %
                 
 
The minimum capital requirements imposed by the FDIC on the Bank for leverage, Tier 1 and Total Capital are 4%, 4% and 8%, respectively.  The Company has similar capital requirements imposed by the Board of Governors of the Federal Reserve System (FRB).  The Bank is also subject to more stringent Pennsylvania Department of Banking (PDB) guidelines.  The Bank’s capital ratios do not differ significantly from the Company’s ratios.  Although not adopted in regulation form, the PDB utilizes capital standards requiring a minimum of 6.5% leverage capital and 10% total capital.  The Company and the Bank were in compliance with FRB, FDIC and PDB capital requirements as of September 30, 2010 and December 31, 2009.

Liquidity

As of September 30, 2010, the Company had cash and cash equivalents of $19.8 million in the form of cash, due from banks, Federal Funds sold and short-term deposits with other institutions.  In addition, the Company had total securities available for sale of $139.3 million which could be used for liquidity needs.  This totals $159.1 million and represents 29.8% of total assets compared to $147.9 million and 27.9% of total assets as of December 31, 2009.  The Company also monitors other liquidity measures, all of which were within the Company’s policy guidelines as of September 30, 2010 and December 31, 2009.  Based upon these measures, the Company believes its liquidity is adequate.

 
25

 
Capital Resources

The Company has a line of credit commitment available from the Federal Home Loan Bank (FHLB) of Pittsburgh for borrowings of up to $20,000,000 which expires in December 2011.  There were no borrowings under this line at September 30, 2010 and December 31, 2009.

The Company has a line of credit commitment from Atlantic Central Bankers Bank for $7,000,000 which expires on June 30, 2011.  There were no borrowings under this line as of September 30, 2010 and December 31, 2009.
 
 
The Company has a line of credit commitment available which has no stated expiration date from PNC for $16,000,000.  Borrowings under this line were $-0- as of September 30, 2010 and December 31, 2009.

The Bank’s maximum borrowing capacity with the FHLB was approximately $183,000,000 as of September 30, 2010, of which $38,000,000 was outstanding at September 30, 2010 and $43,000,000 was outstanding at December 31, 2009.  Advances from the FHLB are secured by qualifying assets of the Bank.

Non-GAAP Financial Measures

This report contains or references fully taxable-equivalent (fte) interest income and net interest income, which are non-GAAP financial measures.  Interest income (fte) and net interest income (fte) are derived from GAAP interest income and net interest income using an assumed tax rate of 34%.  We believe the presentation of interest income (fte) and net interest income (fte) ensures comparability of interest income and net interest income arising from both taxable and tax-exempt sources and is consistent with industry practice.  Net interest income (fte) is reconciled to GAAP net interest income on page 27 and 31.  Although the Company believes that these non-GAAP financial measures enhance investors’ understanding of our business and performance, these non-GAAP financial measures should not be considered an alternative to GAAP measures.


 
26

 

Results of Operations
NORWOOD FINANCIAL CORP.
Consolidated Average Balance Sheets with Resultant Interest and Rates

 
(Tax-Equivalent Basis, dollars in thousands)
 
 Three Months Ended September 30,
 
   
 2010
   
 2009
 
   
Average Balance
(2)
   
 
Interest
(1)
   
Average
 Rate
(3)
   
Average
Balance
(2)
   
 
Interest
(1)
   
Average
 Rate
(3)
 
Assets
                                   
Interest-earning assets:
                                   
Federal funds sold
  $ 3,000     $ 2       0.27 %   $ 1,052     $ 1       0.38 %
Interest bearing deposits with banks
    16,529       12       0.29       185       -       -  
Securities held-to-maturity
    169       3       7.10       708       15       8.47  
Securities available for sale:
                                               
     Taxable
    96,562       687       2.85       97,696       990       4.05  
     Tax-exempt(1)
    44,583       646       5.80       30,775       450       5.85  
        Total securities available for 
    sale (1)
    141,145       1,333       3.78       128,471       1,440       4.48  
     Loans receivable (4) (5)
    353,953       5,318       6.01       358,644       5,431       6.06  
        Total interest earning assets
    514,796       6,668       5.18       489,060       6,887       5.63  
Non-interest earning assets:
                                               
   Cash and due from banks
    7,642                       7,664                  
   Allowance for loan losses
    (5,481 )                     (4,626 )                
   Other assets
    23,261                       17,352                  
        Total non-interest earning assets
    25,422                       20,390                  
Total Assets
  $ 540,218                     $ 509,450                  
Liabilities and Stockholders' Equity
                                               
Interest bearing liabilities:
                                               
   Interest bearing demand and money market
  $ 115,553       152       0.53     $ 99,990       188       0.75  
   Savings
    49,759       27       0.22       44,709       42       0.38  
   Time
    171,240       852       1.99       172,787       1,203       2.78  
      Total interest bearing deposits
    336,552       1,031       1.23       317,486       1,433       1.81  
Short-term borrowings
    23,933       26       0.43       19,437       60       1.23  
Other borrowings
    42,891       419       3.92       43,000       421       3.92  
   Total interest bearing liabilities
    403,376       1,476       1.46       379,923       1,914       2.02  
Non-interest bearing liabilities:
                                               
   Demand deposits
    64,512                       61,551                  
   Other liabilities
    5,508                       5,382                  
      Total non-interest bearing liabilities
    70,020                       66,933                  
   Stockholders' equity
    66,822                       62,594                  
Total Liabilities and Stockholders' Equity
  $ 540,218                     $ 509,450                  
                                                 
Net interest income (tax equivalent basis)
            5,192       3.72 %             4,973       3.62 %
Tax-equivalent basis adjustment
            (273 )                     (207 )        
Net interest income
          $ 4,919                     $ 4,766          
Net interest margin (tax equivalent basis)
                    4.03 %                     4.07 %
(1)  Interest and yields are presented on a tax-equivalent basis using a marginal tax rate of 34%.
(2)  Average balances have been calculated based on daily balances.
(3)  Annualized
(4)  Loan balances include non-accrual loans and are net of unearned income.
(5)  Loan yields include the effect of amortization of deferred fees, net of costs.
 

 
27

 


Rate/Volume Analysis.  The following table shows the fully taxable equivalent effect of changes in volumes and rates on interest income and interest expense.

   
Increase/(Decrease)
 
 
 
Three months ended September 30, 2010 Compared to
 Three months ended September 30, 2009
 Variance due to
 
     Volume      Rate      Net  
    (dollars in thousands)  
                   
Interest earning assets:
 
 
   
 
       
Federal funds sold......................................
  $ 3     $ (2 )   $ 1  
Interest bearing deposits with banks…………..
    12       -       12  
Securities held to maturity............................
    (10 )     (2 )     (12 )
Securities available for sale:
                       
Taxable...................................................
    (11 )     (292 )     (303 )
Tax-exempt securities..................................
     224       (28 )     196  
Total securities..........................................
    213       (320 )     (107 )
Loans receivable........................................
    (71 )     (42 )     (113 )
Total interest earning assets...........................
     147       (366 )     (219 )
                         
Interest bearing liabilities:
                       
Interest-bearing demand and money market….
    142       (178 )     (36 )
Savings................................................
    27       (42 )     (15 )
Time...................................................
     (11 )     (340 )     (351 )
Total interest bearing deposits.......................
    158       (560 )     (402 )
Short-term borrowings................................
    73       (107 )     (34 )
Other borrowings......................................
     (2 )     -       (2 )
Total interest bearing liabilities.....................
     229       (667 )     (438 )
Net interest income (tax-equivalent basis).........
  $ (82 )   $ 301     $ 219  
                         

Changes in net interest income that could not be specifically identified as either a rate or volume change were allocated proportionately to changes in volume and changes in rate.


 
28

 


Comparison of Operating Results for The Three Months Ended September 30, 2010 to September 30, 2009

General

For the three months ended September 30, 2010, net income totaled $1,890,000 compared to $1,775,000 earned in the similar period in 2009.  Earnings per share for the current period were $.68 for basic and fully diluted compared to $.64 per share basic and diluted for the three months ended September 30, 2009.  The resulting annualized return on average assets and annualized return on average equity for the three months ended September 30, 2010 was 1.39% and 10.98%, respectively, compared to 1.40% and 11.25%, respectively, for the similar period in 2009.
 
 
The following table sets forth changes in net income:

   
Three months ended
 
   
September 30, 2010 to
 
(dollars in thousands)
 
September 30, 2009
 
Net income three months ended September 30, 2009
  $ 1,775  
Change due to:
       
Net interest income
    153  
Provision for loan losses
    (110 )
Gain on sales of loans, securities & deposits
    32  
Other income
    (15 )
Salaries and employee benefits
    (46 )
Occupancy, furniture and equipment
    (21 )
FDIC insurance assessment
    12  
Other real estate owned
    127  
All other expenses
    (10 )
Income tax expense
    (7 )
         
Net income three months ended  September 30, 2010
  $ 1,890  
         

Net Interest Income

Net interest income on a fully taxable equivalent basis (fte) for the three months ended September 30, 2010, totaled $5,192,000, an increase of $219,000 or 4.4% over the similar period in 2009.  The fte net interest spread and net interest margin were 3.72% and 4.03%, respectively, for the three months ended September 30, 2010 compared to 3.62% and 4.07%, respectively, for the similar period in 2009.

Interest income (fte) totaled $6,669,000 with a yield on average earning assets of 5.18% compared to $6,887,000 and 5.63% for the 2009 period.  The decrease in yield was due to the reinvestment of securities cash flow and new purchases of securities at lower than historical rates, resulting in a 120 basis point decrease in the yield earned on taxable securities.  The yields earned on money market investments, tax-exempt securities and loans were comparable to the third quarter of 2009.  The total yield earned was also impacted by a $16.3 million increase in average interest bearing deposits with banks at an average return of .29%.  Average earning assets totaled $514.8 million for the three months ended September 30, 2010, an increase of $25.7 million over the average for the similar period in 2009.  This increase in average earning assets helped offset the decline in asset yields.

 
29

 
Interest expense for the three months ended September 30, 2010 totaled $1,477,000 at an average cost of 1.46% compared to $1,914,000 and 2.02% for the similar period in 2009.  As a result of the continued low rate environment, the Company further reduced rates paid on most deposit products.  The cost of time deposits, which is the most significant component of funding, declined to 1.99% from 2.78% for the similar period in the prior year.  As time deposits matured, they repriced at the current lower rates resulting in the decrease.

Other Income

Other income totaled $1,035,000 for the three months ended September 30, 2010 compared to $1,018,000 for the similar period in 2009.  The current period includes $3,000 of servicing rights compared to $42,000 in gains on the sale of $5.9 million of mortgages in the similar period of 2009.  The current period also includes a $161,000 gain on the sale of investment securities compared to a $90,000 gain in the third quarter of 2009.  Service charges and fees decreased $27,000 compared to the same quarter of last year due primarily to a reduction in overdraft fees.

Provision for Loan Losses

The company’s loan review process assesses the adequacy of the allowance for loan losses on a quarterly basis.  The process includes a review of the risks inherent in the loan portfolio.  It includes an analysis of impaired loans and an historical review of losses.  Other factors considered in the analysis include; concentrations of credit in specific industries in the commercial portfolio; the local and regional economic condition; trends in delinquencies, internal risk rating classification, large dollar loans of over $2 million and growth in the portfolio.  For the three month period ending September 30, 2010, a provision of $250,000 was added to the allowance for loan losses.  Management has determined that the allowance was adequate as of the reporting date.  During the three months ended September 30, 2009, a provision of $140,000 was added to the allowance.
 
 
Other Expense

Other expense for the three months ended September 30, 2010 totaled $3,112,000, a decrease of $62,000 from $3,174,000 for the similar period in 2009.  In 2010, the decrease in costs is due primarily to a $127,000 reduction in costs related to Other Real Estate Owned.

Income Tax Expense

Income tax expense totaled $702,000 for an effective tax rate of 27.0% for the three month period ending September 30, 2010 compared to $695,000 for an effective tax rate of 28.1% for the similar period in 2009.


 
30

 


Results of Operations
NORWOOD FINANCIAL CORP.
Consolidated Average Balance Sheets with Resultant Interest and Rates

(Tax-Equivalent Basis, dollars in thousands)
 
Nine Months Ended September 30,
 
   
2010
   
2009
 
   
Average
Balance
(2)
   
 
Interest
(1)
   
Average
Rate
(3)
   
Average
Balance
(2)
   
 
Interest
(1)
   
Average
Rate
(3)
 
Assets
                                   
Interest-earning assets:
                                   
   Federal funds sold
  $ 3,000     $ 7       0.31 %   $ 1,712     $ 8       0.62 %
   Interest bearing deposits with banks
    16,712       36       0.29       165       -       -  
   Securities held-to-maturity(1)
    317       20       8.41       707       46       8.68  
   Securities available for sale:
                                               
     Taxable
    96,307       2,372       3.28       99,786       3,164       4.23  
     Tax-exempt(1)
    37,821       1,655       5.83       28,298       1,237       5.83  
        Total securities available for
    sale (1)
    134,128       4,027       4.00       128,084       4,401       4.58  
     Loans receivable (4) (5)
    355,368       16,037       6.02       354,775       16,213       6.09  
        Total interest earning assets
    509,525       20,127       5.27       485,443       20,668       5.68  
Non-interest earning assets:
                                               
   Cash and due from banks
    7,235                       9,024                  
   Allowance for loan losses
    (5,445 )                     (4,477 )                
   Other assets
    22,190                       17,422                  
   Total non-interest earning assets
    23,980                       21,969                  
Total Assets
  $ 533,505                     $ 507,412                  
Liabilities and Stockholders' Equity
                                               
Interest bearing liabilities:
                                               
   Interest bearing demand and money market
  $ 106,993       449       0.56     $ 99,520       571       0.77  
   Savings
    48,260       84       0.23       44,822       125       0.37  
   Time
    179,546       2,799       2.08       169,260       3,658       2.88  
      Total interest bearing deposits
    334,799       3,332       1.33       313,602       4,354       1.85  
Short-term borrowings
    23,790       87       0.49       26,039       229       1.17  
Other borrowings
    42,963       1,247       3.87       43,000       1,248       3.87  
   Total interest bearing liabilities
    401,552       4,666       1.55       382,641       5,831       2.03  
Non-interest bearing liabilities:
                                               
   Demand deposits
    61,819                       58,870                  
   Other liabilities
    5,012                       4,770                  
      Total non-interest bearing liabilities
    66,831                       63,640                  
   Stockholders' equity
    65,122                       61,131                  
Total Liabilities and Stockholders' Equity
  $ 533,505                     $ 507,412                  
                                                 
Net interest income (tax equivalent basis)
            15,461       3.72 %             14,837       3.64 %
Tax-equivalent basis adjustment
            (713 )                     (555 )        
Net interest income
          $ 14,748                     $ 14,282          
Net interest margin (tax equivalent basis)
                    4.05 %                     4.08 %
(1)   Interest and yields are presented on a tax-equivalent basis using a marginal tax rate of 34%.
(2)   Average balances have been calculated based on daily balances.
(3)   Annualized
(4)   Loan balances include non-accrual loans and are net of unearned income.
(5)   Loan yields include the effect of amortization of deferred fees, net of costs.


 
31

 

Rate/Volume Analysis

The following table shows the fully taxable equivalent effect of changes in volumes and rates on interest income and interest expense. Changes in net interest income that could not be specifically identified as either a rate or volume change were allocated proportionately to changes in volume and changes in rate.


   
Increase/(Decrease)
 
    Nine Months Ended September 30, 2010 Compared to  
    Nine Months Ended September 30, 2009  
    Variance due to  
     Volume      Rate     Net   
    (dollars in thousands)  
Interest earning assets:
 
 
   
 
       
Federal funds sold
  $ 6     $ (7 )   $ (1 )
Interest bearing deposits with banks
    36       -       36  
Securities held to maturity
    (25 )     (1 )     (26 )
Securities available for sale:
                       
Taxable
    (107 )     (685 )     (792 )
Tax-exempt securities
    417       1       418  
Total securities
    310       (684 )     (374 )
Loans receivable
    43       (219 )     (176 )
Total interest earning assets
    370       (911 )     (541 )
                         
Interest bearing liabilities:
                       
Interest-bearing demand and money market
    63       (185 )     (122 )
Savings
    14       (55 )     (41 )
Time
    333       (1,192 )     (859 )
Total interest bearing deposits
    410       (1,432 )     (1,022 )
Short-term borrowings
    (18 )     (124 )     (142 )
Other borrowings
     (1 )      0       (1 )
Total interest bearing liabilities
    391       (1,556 )     (1,165 )
Net interest income (tax-equivalent basis)
  $ (21 )   $ 645     $ 624  
                         

Comparison of Operating Results for Nine Months Ended September 30, 2010 and September 30, 2009
 
 
General

For the nine months ended September 30, 2010, net income totaled $5,505,000 compared to $5,261,000 earned in the similar period of 2009.  Earnings per share for the current period were $1.99 per share for both basic and diluted compared to $1.92 per share basic and $1.90 per share diluted for the nine months ended September 30, 2009.  The resulting annualized return on average assets and annualized return on average equity for the nine months ended September 30, 2010 was 1.38% and 11.04% compared to 1.39% and 11.51%, respectively, for the similar period in 2009.


 
32

 

The following table sets forth changes in net income:

   
Nine Months Ended
 
   
September 30, 2010 to
 
   
September 30, 2009
 
(dollars in thousands)
 
 
 
Net income nine months ended September 30, 2009
  $ 5,261  
         
Change due to:
       
Net interest income
    466  
Provision for loan losses
    (145 )
Gain on sales of loans, securities & deposits
    (281 )
Other income
    (133 )
Salaries and employee benefits
    (24 )
Occupancy, furniture and equipment expense, net
    41  
FDIC insurance assessment
    260  
Other real estate owned
    116  
All other expenses
    (72 )
Income tax expense
     16  
         
Net income nine months ended  September 30, 2010
  $ 5,505  
         

Net Interest Income

Net interest income on a fully taxable equivalent basis (fte) for the nine months ended September 30, 2010 totaled $15,461,000, an increase of $624,000, or 4.2% over the similar period in 2009.  The fte net interest spread and net interest margin were 3.72% and 4.05% respectively, compared to 3.64% and 4.08% respectively for the similar period in 2009.

Interest income (fte) totaled $20,127,000 with a yield on average earning assets of 5.27% compared to $20,668,000 and 5.68% for the similar period in 2009.  The decrease in yield was due to a $16.5 million increase in average interest bearing deposits with banks at an average yield of .29%.  In addition, residential mortgage rates have declined causing a portion of the portfolio to refinance at lower rates.  As a result, the fte yield on average loans in the current period was 6.02% down from 6.09% in the 2009 period.  The yield on investment securities also declined 58 basis points reflecting the reinvestment of cash flow, maturities and calls at the current lower rate.  Average earning assets totaled $509.5 million for the nine months ended September 30, 2010 an increase of $24.1 million over the similar period in 2009.  The growth in average earning assets helped offset the decline in asset yields.
 
 
Interest expense for the nine months ended September 30, 2010 totaled $4,666,000 with an average cost of 1.55% compared to $5,831,000 and 2.03% for the 2009 period. The Company reduced rates paid on its deposits by 52 basis points and short-term borrowings by 68 basis points.  The cost of time deposits which is the largest component of interest expense was 2.08% for the 2010 period decreasing from 2.88% in 2009.  This reflects time deposits maturing and repricing at the current lower rates.

 
33

 

Other Income

Other income totaled $3,053,000 for the nine months ended September 30, 2010 compared to $3,467,000 for the similar period in 2009.  The current period includes $208,000 in gains on sales of loans and servicing rights on the sale of $10.5 million of residential mortgage loans compared to $296,000 in similar gains on the sales of $21.6 million of mortgage loans in the 2009 period.  Gains on the sale investment securities totaled $380,000 on sales of $23.7 million for the 2010 period compared to $423,000 of gains on sales of $13.6 million in the similar 2009 period.  The proceeds from investment securities sales were reinvested to maintain a fully invested position.  The Company also had a gain of $150,000 on the sale of deposits related to a branch closure in 2009 period.

Provision for Loan Losses

The company’s loan review process assesses the adequacy of the allowance for loan losses on a quarterly basis.  The process includes a review of the risks inherent in the loan portfolio.  It includes an analysis of impaired loans and an historical review of losses.  Other factors considered in the analysis include; concentrations of credit in specific industries in the commercial portfolio; the local and regional economic condition; trends in delinquencies, internal risk rating classification, large dollar loans of over $2 million and growth in the portfolio.  For the nine month period ending September 30, 2010, a provision of $730,000 was added to the allowance for loan losses.  Management has determined that the allowance was adequate as of the reporting date.  During the nine months ended September 30, 2009, a provision of $585,000 was added to the allowance.

Other Expenses

Other expense totaled $9,448,000 for the nine months ended September 30, 2010 a decrease of $321,000 compared to $9,769,000 for the similar period in 2009.  Higher FDIC insurance assessments, including a $225,000 special assessment was included in the 2009 costs.  The efficiency ratio for the 2010 period was 50.4% compared to 52.3% in the 2009 period.

Income Tax Expense

Income tax expense totaled $2,118,000 for an effective tax rate of 27.8% in the 2010 period compared to $2,134,000 and 28.9% in 2009.  The decrease in the effective tax rate was principally due to a higher level of tax-exempt income related to purchases of municipal obligations held in the available-for-sale portfolio.

Item 3.  Quantitative and Qualitative Disclosures about Market Risk

Market Risk

Interest rate sensitivity and the repricing characteristics of assets and liabilities are managed by the Asset and Liability Management Committee (ALCO).  The principal objective of ALCO is to maximize net interest income within acceptable levels of risk, which are established by policy.  Interest rate risk is monitored and managed by using financial modeling techniques to measure the impact of changes in interest rates.

Net interest income, which is the primary source of the Company’s earnings, is impacted by changes in interest rates and the relationship of different interest rates.  To manage the impact of the rate changes, the balance sheet must be structured so that repricing opportunities exist for both assets and liabilities at approximately the same time intervals.  The Company uses net interest simulation to assist in interest rate risk management.  The process includes simulating various interest rate environments and their impact on net interest income.  As of September 30, 2010, the level of net interest income at risk in a 200 basis points change
 
 
34

 
 
in interest rates was within the Company’s policy limits.  The Company’s policy allows for a decline of no more than 8% of net interest income for a ± 200 basis point shift in interest rates.

Imbalance in repricing opportunities at a given point in time reflects interest-sensitivity gaps measured as the difference between rate-sensitive assets (RSA) and rate-sensitive liabilities (RSL).  These are static gap measurements that do not take into account any future activity, and as such are principally used as early indications of potential interest rate exposures over specific intervals.

As of September 30, 2010, the Bank had a positive 90 day interest sensitivity gap of $61.2 million or 11.5% of total assets, increasing from $26.3 million or 5.0% of total assets as of December 31, 2009. The change was principally due to a $12.1 million increase in loans repricing within 90 days combined with lower level of time deposits maturing in the 90 day time frame in the amount of $35.7 million.  A positive gap means that rate-sensitive assets are greater than rate-sensitive liabilities at the time interval.  This would indicate that in a rising rate environment, the yield on interest-earning assets could increase faster than the cost of interest-bearing liabilities in the 90 day time frame.  The repricing intervals are managed by ALCO strategies, including adjusting the average life of the investment portfolio, pricing of deposit liabilities to attract longer term time deposits, loan pricing to encourage variable rate products and evaluation of loan sales of long-term fixed rate mortgages.

September 30, 2010
Rate Sensitivity Table
   (dollars in thousands)
 
3 Months
   
3-12 Months
   
1 to 3 Years
   
Over 3 Years
   
Total
 
Federal funds sold and interest bearing deposits
  $ 10,123     $ --     $ 250     $ --     $ 10,373  
Securities
    16,850       22,924       43,347       55,133       138,254  
Loans Receivable
    94,118       58,912       101,107       104,217       358,354  
  Total RSA
    121,091       81,836       144,704       159,350       506,981  
                                         
Non-maturity interest-bearing deposits
    26,946       29,567       78,776       31,768       167,057  
Time Deposits
    27,317       71,032       49,955       16,960       165,264  
Other
    5,672       26,311       20,546       10,000       62,529  
  Total RSL
    59,935       126,910       149,277       58,728       394,850  
                                         
Interest Sensitivity Gap
  $ 61,156     $ (45,074 )   $ (4,573 )   $ 100,622     $ 112,131  
Cumulative Gap
    61,156       16,082       11,509       112,131          
RSA/RSL-cumulative
    202.0 %     108.6 %     103.4 %     128.4 %        
                                         
December 31, 2009
                                       
                                         
Interest Sensitivity Gap
  $ 26,256     $ (35,423 )   $ (20,986 )   $ 135,313     $ 105,160  
Cumulative Gap
    26,256       (9,167 )     (30,153 )     105,160          
RSA/RSL-cumulative
    128.9 %     95.5 %     91.2 %     126.3 %        

Item 4.  Controls and Procedures

The Company’s management evaluated, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, the effectiveness of the Company’s disclosure controls and procedures, as of the end of the period covered by this report.  Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

There were no changes in the Company’s internal control over financial reporting that occurred during the Company’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.


 
35

 

Part II.  OTHER INFORMATION

Item 1. Legal Proceedings

Not applicable

Item 1A. Risk Factors

There have been no material changes in the risk factors affecting the Company that were identified in Item 1A of Part 1 of the Company’s Form 10-K for the year ended December 31, 2009.

Item 2. Unregistered Sales of Equity Sales and Use of Proceeds

Not applicable

Item 3.  Defaults Upon Senior Securities

Not applicable

Item 4.  Reserved

Item 5.  Other Information

None

Item 6.  Exhibits

No.
Description
   
3(i)
Articles of Incorporation of Norwood Financial Corp.(1)
3(ii)
Bylaws of Norwood Financial Corp. (2)
4.0
Specimen Stock Certificate of Norwood Financial Corp. (1)
10.1†
Employment Agreement with Lewis J. Critelli (2)
10.2†
Change in Control Severance Agreement with William S. Lance (2)
10.3†
Norwood Financial Corp. Stock Option Plan (4)
10.4†
Salary Continuation Agreement between the Bank and William W. Davis, Jr. (3)
10.5†
Salary Continuation Agreement between the Bank and Lewis J. Critelli (3)
10.6†
Salary Continuation Agreement between the Bank and Edward C. Kasper (3)
10.7†
1999 Directors Stock Compensation Plan (3)
10.8†
Salary Continuation Agreement between the Bank and Joseph A. Kneller (4)
10.9†
Salary Continuation Agreement between the Bank and John H. Sanders (4)
10.10†
2006 Stock Option Plan (5)
10.11†
First and Second Amendments to Salary Continuation Agreement with William W. Davis, Jr. (6)
10.12†
First and Second Amendments to Salary Continuation Agreement with Lewis J. Critelli (6)
10.13†
First and Second Amendments to Salary Continuation Agreement with Edward C. Kasper (6)
10.14†
First and Second Amendments to Salary Continuation Agreement with Joseph A. Kneller (6)
10.15†
First and Second Amendments to Salary Continuation Agreement with John H. Sanders (6)
31
Rule 13a-14(a)/15d-14(a) Certification of CEO and CFO
32
Certification pursuant to 18 U.S.C. §1350, as adopted pursuant to §906 of Sarbanes Oxley Act of 2002


 
36

 


_________
(1)
Incorporated herein by reference to the identically numbered exhibits of the Registrant’s Form 10 Registration Statement initially filed with the Commission on April 29, 1996.
   
(2)
Incorporated herein by reference to the identically numbered exhibit to the Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2009 filed with the Commission on March 15, 2010.
   
(3)
Incorporated herein by reference to the identically numbered exhibits of the Registrant’s Form 10-K filed with the Commission on March 23, 2000.
   
(4)
Incorporated herein by reference to the identically numbered exhibit to the Registrants Form 10-K filed with the Commission on March 22, 2004.
   
(5)
Incorporated herein by reference to the Registrant’s Form 8-K filed with the Commission on April 25, 2006.
   
(6)
Incorporated herein by reference from the Exhibits to the Registrant’s Current Report on Form 8-K filed on April 4, 2006.
   



 
37

 

Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



   
NORWOOD FINANCIAL CORP.
     
     
Date:November 5, 2010
   
     
By:
/s/ Lewis J. Critelli
       
Lewis J. Critelli
       
President and Chief Executive Officer
       
(Principal Executive Officer)
         
         
         
Date:November 5, 2010
 
By:
/s/ William S. Lance
       
William S. Lance
       
Senior Vice President, and
       
Chief Financial Officer
       
(Principal Financial Officer)

38