UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2006

OR

o 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: 333-90273

FIDELITY D & D BANCORP, INC.

 

 

Address of principal executive offices:

BLAKELY & DRINKER ST.

DUNMORE, PENNSYLVANIA 18512

TELEPHONE:

570-342-8281

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subjected to such filing requirements for the past 90 days.

x YES    o NO

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one):

Large accelerated filer o          Accelerated filer o          Non-accelerated filer x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

o YES    x NO

The number of outstanding shares of Common Stock of Fidelity D & D Bancorp, Inc. at July 31, 2006, the latest practicable date, was 2,048,820 shares.

FIDELITY D & D BANCORP, INC.

Form 10-Q June 30, 2006

Index

Part I. Financial Information
Item 1.		Financial Statements:
		Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005
		Consolidated Statements of Income for the three and six months ended June 30, 2006 and 2005
		Consolidated Statements of Changes in Shareholders’ Equity for the six months ended June 30, 2006 and 2005
		Consolidated Statements of Cash Flows for the six months ended June 30, 2006 and 2005
		Notes to Consolidated Financial Statements
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.		Quantitative and Qualitative Disclosure about Market Risk
Item 4.		Controls and Procedures
Part II. Other Information
Item 1.		Legal Proceedings
Item 1A.		Risk Factors
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.		Defaults Upon Senior Securities
Item 4.		Submission of Matters to a Vote of Security Holders
Item 5.		Other Information
Item 6.		Exhibits
Signatures
Exhibit index

 

2

 

PART I – Financial Information

Item 1: Financial Statements

 

FIDELITY D & D BANCORP, INC.

Consolidated Balance Sheets

As of June 30, 2006 and December 31, 2005

 

		June 30, 2006			December 31, 2005
		(unaudited)			(audited)
ASSETS
Cash and due from banks		$	11,960,057		$	12,525,723
Interest-bearing deposits with financial institutions		161,540			68,817
Total cash and cash equivalents		12,121,597			12,594,540
Available-for-sale securities		111,762,272			95,681,654
Held-to-maturity securities		1,785,410			1,996,919
Federal Home Loan Bank Stock		4,558,400			4,628,200
Loans and leases, net (allowance for loan losses of $5,738,470 in 2006; $5,984,649 in 2005)		417,726,617			403,144,095
Loans available-for-sale (fair value $198,935 in 2006; $434,272 in 2005)		195,379			428,584
Bank premises and equipment, net		11,521,561			11,683,148
Cash surrender value of bank owned life insurance		8,033,031			7,891,898
Other assets		4,779,122			4,033,132
Accrued interest receivable		2,591,737			1,959,826
Foreclosed assets held for sale		53,099			18,702
Total assets		$	575,128,225		$	544,060,698
LIABILITIES
Deposits
Non-interest-bearing		$	70,560,800		$	70,361,086
Certificates of deposit of $100,000 or more		63,488,886			76,257,553
Other interest-bearing deposits		288,805,669			232,880,001
Total deposits		422,855,355			379,498,640
Accrued interest payable and other liabilities		3,253,894			3,238,844
Short-term borrowings		31,659,106			28,772,997
Long-term debt		68,324,751			83,704,188
Total liabilities		526,093,106			495,214,669
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS’ EQUITY
Preferred stock authorized 5,000,000 shares with no par value; none issued		—			—
Capital stock authorized 10,000,000 shares with no par value; issued and outstanding 2,048,820 shares in 2006; 2,039,639 shares in 2005		18,417,715			10,594,901
Retained earnings		32,965,248			39,363,461
Accumulated other comprehensive loss		(2,347,844		)	(1,112,333		)
Total shareholders’ equity		49,035,119			48,846,029
Total liabilities and shareholders’ equity		$	575,128,225		$	544,060,698

 

See Notes to Consolidated Financial Statements

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FIDELITY D & D BANCORP, INC.

Consolidated Statements of Income

(unaudited)

 

		Three Months Ended						Six Months Ended
		June 30, 2006			June 30, 2005			June 30, 2006			June 30, 2005
Interest income
Interest and fees on loans and leases:
Taxable		$	6,879,670		$	5,752,647		$	13,378,288		$	11,435,615
Nontaxable		121,462			116,119			253,620			214,529
Interest-bearing deposits with financial institutions		2,239			6,283			4,776			8,971
Investment securities:
U.S. Government agency and corporations		986,083			921,085			1,871,265			1,831,242
States and political subdivisions (nontaxable)		150,274			128,105			291,318			240,560
Other securities		230,802			171,943			429,212			298,758
Federal funds sold		638			6,635			36,126			47,427
Total interest income		8,371,168			7,102,817			16,264,605			14,077,102
Interest expense
Certificates of deposit of $100,000 or more		670,056			697,641			1,336,465			1,373,664
Other deposits		2,080,061			978,115			3,810,558			1,858,331
Securities sold under repurchase agreements		163,426			141,308			298,875			338,117
Other short-term borrowings and long-term debt		1,183,850			963,293			2,309,213			1,904,143
Other		8,351			4,311			13,761			8,894
Total interest expense		4,105,744			2,784,668			7,768,872			5,483,149
Net interest income		4,265,424			4,318,149			8,495,733			8,593,953
Provision for loan losses		175,000			300,000			250,000			380,000
Net interest income, after provision for loan losses		4,090,424			4,018,149			8,245,733			8,213,953
Other income:
Service charges on deposit accounts		635,054			674,210			1,266,781			1,272,531
Gain (loss) on:
Investment securities		2			2,643			(166		)	2,643
Loans		26,858			3,985			41,843			(7,457		)
Leased assets		100			919			15,154			(33,954		)
Foreclosed assets held for sale		216			(8,016		)	621			(7,611		)
Write-down lease residual		—			—			—			(220,000		)
Fees and other service charges		421,722			452,766			886,984			867,968
Total other income		1,083,952			1,126,507			2,211,217			1,874,120
Other expenses:
Salaries and employee benefits		1,974,057			1,753,198			3,980,871			3,496,119
Premises and equipment		823,559			737,021			1,624,410			1,471,476
Advertising		159,904			148,599			288,277			279,808
Professional fees and services		338,685			413,875			621,174			795,918
Other		651,944			559,571			1,354,607			1,134,855
Total other expenses		3,948,149			3,612,264			7,869,339			7,178,176
Income before provision for income taxes		1,226,227			1,532,392			2,587,611			2,909,897
Provision for income taxes		287,607			396,584			617,360			754,700
Net income		$	938,620		$	1,135,808		$	1,970,251		$	2,155,197
Per share data:
Net income - basic		$	0.45		$	0.56		$	0.96		$	1.06
Net income - diluted		$	0.45		$	0.56		$	0.96		$	1.06
Dividends		$	0.22		$	0.20		$	0.44		$	0.40

 

See Notes to Consolidated Financial Statements

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FIDELITY D & D BANCORP, INC.

Consolidated Statements of Changes in Shareholders’ Equity

For the Six Months Ended June 30, 2006 and 2005

 

										Accumulated other
		Capital stock					Retained			comprehensive
		Shares *		Amount			earnings			income (loss)			Total
Balance, December 31, 2004 (audited)		2,023,529		$	10,072,134		$	36,396,027		$	(101,401	)	$	46,366,760
Total comprehensive income:
Net income							2,155,197						2,155,197
Change in net unrealized holding gains (losses) on available-for-sale securities, net of reclassification adjustment and tax effects										105,656			105,656
Comprehensive income													2,260,853
Issuance of common stock through
Employee Stock Purchase Plan		1,134		31,671									31,671
Dividends reinvested through Dividend
Reinvestment Plan		7,472		240,352									240,352
Cash dividend declared							(810,611		)				(810,611		)
Balance, June 30, 2005 (unaudited)		2,032,135		$	10,344,157		$	37,740,613		$	4,255		$	48,089,025

 

* The number of shares has been adjusted to reflect the retroactive effect of a 10% stock dividend paid on February 15, 2006.

 

										Accumulated other
		Capital stock					Retained			comprehensive
		Shares		Amount			earnings			(loss)			Total
Balance, December 31, 2005 (audited)		1,854,217		$	10,594,901		$	39,363,461		$	(1,112,333	)	$	48,846,029
Total comprehensive income:
Net income							1,970,251						1,970,251
Change in net unrealized holding gains (losses) on available-for-sale securities, net of reclassification adjustment and tax effects										(1,235,511		)	(1,235,511		)
Comprehensive income													734,740
Issuance of common stock through
Employee Stock Purchase Plan		1,571		48,151									48,151
Dividends reinvested through Dividend
Reinvestment Plan		7,638		283,819									283,819
Stock-based compensation expense				28,744									28,744
Cash dividend declared							(898,916		)				(898,916		)
Stock dividend declared		185,394		7,462,100			(7,462,100		)				—
Cash paid for fractional shares on stock dividend							(7,448		)				(7,448		)
Balance, June 30, 2006 (unaudited)		2,048,820		$	18,417,715		$	32,965,248		$	(2,347,844	)	$	49,035,119

 

See Notes to Consolidated Financial Statements

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FIDELITY D & D BANCORP, INC.

Consolidated Statements of Cash Flows

(unaudited)

 

		Six Months Ended
		June 30, 2006			June 30, 2005
Cash flows from operating activities:
Net income		$	1,970,251		$	2,155,197
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		592,613			562,985
Amortization of securities (net of accretion)		40,334			144,482
Provision for loan losses		250,000			380,000
Deferred income tax expense (benefit)		32,967			(85,283		)
Stock-based compensation expense		28,744			—
Amortization of investment in limited partnership		45,000			45,000
Proceeds from sale of loans available-for-sale		4,905,215			807,434
Originations of loans available for sale		(4,630,167		)	(314,686		)
Write-down of foreclosed assets held for sale		—			36,293
Write-down lease residual		—			220,000
Increase in cash surrender value of life insurance		(141,133		)	(128,725		)
Loss (gain) on sale of investment securities		166			(2,643		)
(Gain) loss on sale of loans		(41,843		)	7,457
(Gain) loss on sale of foreclosed assets held-for-sale		(621		)	7,611
Loss on sale of leased assets		—			33,954
Amortization of loan servicing rights		36,557			51,717
Change in:
Accrued interest receivable		(631,911		)	(340,036		)
Other assets		(224,039		)	(701,222		)
Accrued interest payable and other liabilities		15,860			15,051
Net cash provided by operating activities		2,247,993			2,894,586
Cash flows from investing activities:
Held-to-maturity securities:
Proceeds from maturities, calls and principal pay-downs		210,027			349,441
Available-for-sale securities:
Proceeds from sales		1,537,337			19,282,027
Proceeds from maturities, calls and principal pay-downs		3,247,531			7,170,330
Purchases		(22,776,490		)	(21,773,663		)
Net decrease in FHLB stock		69,800			262,600
Net increase in loans and leases		(14,906,819		)	(2,264,772		)
Proceeds from sale of leased assets		—			407,660
Acquisition of bank premises and equipment		(431,026		)	(166,784		)
Proceeds from sale of foreclosed assets held-for-sale		39,711			104,526
Net cash (used in) provided by investing activities		(33,009,929		)	3,371,365
Cash flows from financing activities:
Net increase in non-interest-bearing deposits		199,714			3,875,466
Net decrease in certificates of deposit of $100,000 or more		(12,768,667		)	(4,413,039		)
Net increase in other interest-bearing deposits		55,925,668			4,100,563
Net increase (decrease) in short-term borrowings		2,886,109			(8,267,042		)
Repayments of long-term debt		(15,379,437		)	(386,955		)
Dividends paid, net of dividend reinvestment		(615,097		)	(570,259		)
Proceeds from employee stock purchase plan		48,151			31,671
Cash payments in lieu of fractional shares on stock dividend		(7,448		)	—
Net cash provided by (used in) financing activities		30,288,993			(5,629,595		)
Net (decrease) increase in cash and cash equivalents		(472,943		)	636,356
Cash and cash equivalents, beginning		12,594,540			10,216,394
Cash and cash equivalents, ending		$	12,121,597		$	10,852,750

 

See Notes to Consolidated Financial Statements

6

FIDELITY D & D BANCORP, INC.

Notes to Consolidated Financial Statements

(unaudited)

1.             Nature of operations and critical accounting policies

Nature of operations

The Bank is a commercial bank chartered in the Commonwealth of Pennsylvania and a wholly-owned subsidiary of the Company.  Having commenced operations in 1903, the Bank is committed to provide superior customer service, while offering a full range of banking products and financial and trust services, to both our consumer and commercial customers from its main office located in Dunmore and other branches throughout Lackawanna and Luzerne counties.

Principles of consolidation

The accompanying unaudited consolidated financial statements of Fidelity D & D Bancorp, Inc., and its wholly-owned subsidiary, The Fidelity Deposit and Discount Bank (the Bank or collectively, the Company) have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to this Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnote disclosures required by GAAP for complete financial statements.  In the opinion of Management, all normal recurring adjustments necessary for a fair presentation of the financial condition and results of operations for the periods have been included.  All significant inter-company balances and transactions have been eliminated in consolidation.  Prior period amounts are reclassified when necessary to conform to the current period’s presentation.

During the fourth quarter of 2005, the Company changed its classification, within the consolidated statements of cash flows, of the activity associated with loans available-for-sale from investing activities to operating activities.  Accordingly, the cash flows for the six months ended June 30, 2005 have been reclassified to conform to the current year’s quarter presentation.  The effect of the change increased operating cash flows by $508,000 and decreased investing cash flows by $508,000.  The Company believes the change in classification of loans available-for-sale is preferable because it better reflects the primary business purpose of these transactions and complies with the requirements of SFAS 102, Statement of Cash Flows—Exemption of Certain Enterprises and Classification of Cash Flows from Certain Securities Acquired for Resale.  On January 17, 2006, the Board of Directors declared a 10% stock dividend.  The new common shares were distributed on February 15, 2006 to shareholders of record at the close of business on January 30, 2006.  All common stock and per-share data, presented in the prior period, has been adjusted to reflect the retroactive effect of the 10% stock dividend.

The preparation of financial statements in conformity with GAAP requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported periods.  Actual results could differ from those estimates.  For additional information and disclosures required under GAAP, refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

Management is responsible for the fairness, integrity and objectivity of the unaudited financial statements included in this report.  Management prepared the unaudited financial statements in accordance with GAAP.  In meeting its responsibility for the financial statements, Management depends on the Company’s accounting systems and related internal controls.  These systems and controls are designed to provide reasonable, but not absolute, assurance that the financial records accurately reflect the transactions of the Company, the Company’s assets are safeguarded and that financial statements present fairly the financial condition and results of operations of the Company.

In the opinion of Management, the consolidated balance sheets as of June 30, 2006 and December 31, 2005 and the related consolidated statements of income for each of the three- and six-month periods ended June 30, 2006 and June 30, 2005 and changes in shareholders’ equity and cash flows for each of the six month periods ended June 30, 2006 and June 30, 2005 present fairly the financial condition and results of operations of the Company.  All material adjustments required for a fair presentation have been made.  These adjustments are of a normal recurring nature.

As indicated in Note 3, “Stock Plans”, included herein, the Company adopted Statement of Financial Accounting Standard 123R, Share-Based Payment, during the first quarter of 2006.  There have been no other material changes in accounting principles and practices or in the method of application.  Other than the retroactive adjustment of 2005 common stock and the related per-share data, as a result of the 10% stock dividend noted above, there have been no other

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retroactive adjustments during these periods.  The results of operations for interim periods are not necessarily indicative of the results of operations for the entire year.

This Quarterly Report on Form 10-Q should be read in conjunction with the Company’s audited financial statements for the year ended December 31, 2005 and the notes included therein, included within the Company’s Annual Report filed on Form 10-K.

Critical accounting policies

The presentation of financial statements in conformity with GAAP requires Management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates.

A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses (the allowance).  Management believes that the allowance, as of June 30, 2006, is adequate and reasonable.  Given the subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions, and could, therefore calculate a materially different allowance value.  While Management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in the future.  In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance.  Such agencies may require the Company to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.

Another material estimate is the calculation of fair values of the Company’s investment securities.  The Company receives estimated fair values of investment securities from an independent valuation service.  In developing these fair values, the valuation service uses estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments.  Based on experience, Management is aware that estimated fair values of investment securities tend to vary among valuation services.  Accordingly, when selling investment securities, Management may obtain price quotes from more than one source.  Available-for-sale (“AFS”) securities are carried at fair value on the consolidated balance sheet, with unrealized gains and losses, net of income tax, reported separately within shareholders’ equity through accumulated other comprehensive income (loss).

The fair value of residential mortgage loans, classified as AFS, is obtained from the Federal National Mortgage Association (“FNMA”) or the Pennsylvania Housing Finance Authority (“PHFA”).  To determine the fair value of student loans, classified as AFS, the Bank uses the pricing obtained from the most recent student loans sold from its AFS portfolio.  From time-to-time, the Bank may originate Small Business Administration (“SBA”) loans AFS.  The fair value of SBA loans, classified as AFS, is obtained from an outside pricing source.  The market to which the Bank sells mortgage and other loans is restricted and price quotes from other sources are not typically obtained.  As of June 30, 2006 and December 31, 2005, the AFS loan portfolio consisted of residential mortgages and student loans.

2.             Earnings per share

Basic earnings per share (EPS) is computed by dividing income available to common shareholders by the weighted-average number of common stock outstanding for the period.  Diluted EPS is computed in the same manner as basic EPS but reflects the potential dilution that could occur if stock options to issue additional common stock were exercised, which would then result in additional stock outstanding to share or dilute the earnings of the Company.  The Company maintains two share-based compensation plans that may generate additional potential dilutive common shares. Generally, dilution would occur if Company-issued stock options were exercised and converted into common stock.

In the computation of diluted EPS, the Company uses the treasury stock method to determine the dilutive effect of its granted but unexercised stock options.  Under this method, the assumed proceeds received from shares issued, in a hypothetical stock option exercise, are assumed to be used to purchase treasury stock.  Pursuant to the guidance of Statement of Financial Accounting Standard (“SFAS”) No. 128, Earning Per Share, proceeds include: proceeds from the exercise of outstanding stock options; compensation cost for future service that the Company has not yet recognized; and any “windfall” tax benefits that would be credited directly to shareholders’ equity when the grant generates a tax deduction (or a reduction in proceeds if there is a charge to equity).  For a further discussion on the Company’s stock option plans, see note 3, below.

The following table illustrates the data used in computing basic EPS and a reconciliation to derive at the components of diluted EPS for the periods indicated:

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3.             Stock plans

In December 2004, the Financial Accounting Standard Board, (the “FASB”) issued SFAS 123R, Share-Based Payment, which replaces SFAS 123, Accounting for Stock-Based Compensation, and supersedes Accounting Principles Bulletin Opinion 25, Accounting for Stock Issued to Employees.  SFAS 123R requires that the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements.  SFAS 123R applies to all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share options, or other equity instruments (except for those held by an ESOP) or by incurring liabilities (1) in amounts based (even in part) on the price of the entity’s shares or other equity instruments, or (2) that require (or may require) settlement by the issuance of an entity’s shares or other equity instruments.

On January 1, 2006, the Company implemented the provisions SFAS 123R using the Modified Prospective Application transition method (the “MPA”).  The MPA requires the Company to apply the provisions of SFAS 123R to: (a) new awards granted after its adoption; (b) any awards that were granted after the first fiscal year beginning after December 15, 1994 that have not vested by the date the Company adopts SFAS 123R; and (c) any outstanding liability awards.  Under the MPA, the Company is not required to adjust prior years’ financial statements.  In addition, as of December 31, 2005, all of the Bank’s stock option awards granted, prior to that date, were fully vested and therefore the Bank is not required to apply the provisions of SFAS 123R to these previously granted share-based awards.  Therefore, the following discussion will be most applicable to share-based awards issued during 2006.

The Company has two stock-based compensation plans (the “plans”).  The plans were shareholder-approved and permit the grant of share-based compensation awards to its directors, key officers and certain other employees.  The Company believes that these plans better align the interest of its directors, key officers and employees with the interest of its shareholders.  The Company further believes that the granting of share-based awards, under the provisions of the plans, is necessary to retain the knowledge base, continuity and expertise of its directors, key officers and certain employees.

The Company established the 2000 Independent Directors Stock Option Plan and has reserved 55,000 shares of its un-issued capital stock for issuance under the plan.  Under the 2000 Independent Directors Stock Option Plan, each outside director is awarded stock options to purchase 500 shares of the Company’s common stock on the first business day of January, each year, at the fair market value on date of grant.  No stock options were awarded during the first half of 2006 or for each of the years ended December 31, 2005, 2004 and 2003 due to the directors’ voluntary election to forego the award.  At June 30, 2006 and December 31, 2005, there were 14,850 unexercised stock options outstanding under this plan.

The Company has also established the 2000 Stock Incentive Plan and has reserved 55,000 shares of its un-issued capital stock for issuance under the plan.  Under the 2000 Stock Incentive Plan, key officers and certain other employees are eligible to be awarded qualified stock options to purchase the Company’s common stock at the fair market value on the date of grant.  During the first quarter of 2006, 2,200 shares were issued under the 2000 Stock Incentive plan.  No stock options were awarded for each of the years ended December 31, 2005, 2004 and 2003.  As of June 30, 2006 and December 31, 2005, there were 5,830 and 5,280, respectively, unexercised stock options outstanding under this plan.

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Under both plans, options are granted with an exercise price equal to the market price of the Company’s stock at the date of grant.  The awards vest based on six months of continuous service from the date of grant and have 10-year contractual terms.  Generally, all shares that are granted become fully vested.

The Company does not have stock options that are traded on organized capital exchanges.  As such, the estimated fair value of options awarded under its plans is determined, on the date of grant, using the Black-Scholes Option Pricing Valuation Model.  For the options granted during the first quarter of 2006, the model incorporated the assumptions noted in the following table:

Expected volatility		16.00	%
Expected dividend		2.41	%
Risk-free interest rate		4.35	%
Expected term		5.25	years

 

The expected volatility was determined based on the daily five-year historical volatility of the Company’s stock.  Management believes the five-year historical volatility measurement closely resembles the fluctuation of its stock under most economic conditions and cycles.  Because of the relatively short vesting period, the model assumes that all options granted will fully vest.  The risk-free rate is for the period within the expected term of the options based on the U.S. Treasury yield curve.  The Company used the simplified method to determine the term in which options are expected to be outstanding.

A summary of the status of the Company’s stock option plans as of June 30, 2006, December 31, 2005 and December 31, 2004 and changes during the periods is presented below:

							Weighted-
				Weighted-			average
				average			remaining		Aggregate
				exercise			contractual		intrinsic
		Options		price *			term (yrs)		value
Outstanding, December 31, 2004		20,570		$	32.29		5.7
Granted		—
Exercised		—
Forfeited or expired		(440	)	34.09
Outstanding, December 31, 2005		20,130		32.25			4.7
Granted		2,200		36.59
Exercised		—
Forfeited or expired		(1,650	)	33.07
Outstanding, June 30, 2006		20,680		$	32.64		4.8		$	52,212
Exercisable, June 30, 2006		20,680		$	32.64		4.8		$	52,212

 

* Includes options with exercise prices ranging from $28.18 to $36.59 per share.

 

No options have been granted under the 2000 Independent Directors Stock Option Plan since 2002 and all options previously granted and outstanding are fully vested.  As of June 30, 2006, no options have been exercised under the provisions of this plan.

Under the 2000 Stock Incentive Plan, the grant-date fair value of the options granted was determined to be $6.21 per share.  Approximately $13,700 of stock-based compensation expense was recorded during the first half of 2006 and is included as a component of salaries and employee benefits in the consolidated income statement.  Since the plan is a qualified option plan under the Internal Revenue Code, no tax benefit will be recorded until the shares are exercised by the recipients.  No options were exercised during the periods presented.  Since the Company adopted SFAS 123R on January 1, 2006, under the MPA, the comparable data for the previous periods is not required to be reported.  As of June 30, 2006, all options issued under the plan were fully vested and therefore, there is no unrecognized compensation expense related to non-vested share-based compensation agreements under the plan as of June 30, 2006.

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In addition to the two stock option plans above, the Company has established the 2002 Employee Stock Purchase Plan (the “ESPP”) and has reserved 110,000 shares of its un-issued capital stock for issuance under the plan.  The plan was designed to promote broad-based employee ownership of the Company’s stock.  Under the 2002 ESPP, employees may have automatic payroll deductions to purchase the Company’s capital stock at a discounted price based on the fair market value of the Company’s capital stock on either the commencement date or termination date.  At June 30, 2006, 6,051 shares have been issued under the plan.  The ESPP is considered a compensatory plan and, as such, is required to comply with the provisions of SFAS 123R.  The Company recognizes compensation expense on its ESPP Plan on the date the shares are purchased.  For the six months ended June 30, 2006, compensation expense related to the ESPP approximated $15,000 and is included as a component of salaries and employee benefits in the consolidated income statement.

4.             Bank Premises and Equipment

During the second quarter of 2006, the Bank entered into a long-term facility lease agreement in concert with the construction and relocation of one of its branch offices.  Under the lease agreement, the Bank has committed to an initial 15-year term with options to renew for two consecutive periods of five years each.  Under this agreement, the Bank will recognize approximately $36,000 of rent expense in 2006 and a total of $1,384,000 through the expiration of the second renewal option on August 31, 2031.

Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following is Management’s discussion and analysis of the significant changes in the consolidated financial condition of the Company as of June 30, 2006 compared to December 31, 2005 and the results of operations for the three and six months ended June 30, 2006 and June 30, 2005.  Current performance may not be indicative of future results.  This discussion should be read in conjunction with the Company’s 2005 Annual Report filed on Form 10-K.

Forward looking statements

This Interim Report on Form 10-Q contains a number of forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act.  These statements may be identified by the use of the words “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “outlook,” “plan,” “potential,” “predict,” “project,” “should,” “will,” “would” and similar terms and phrases, including references to assumptions.  Forward looking statements include risks and uncertainties.

Forward-looking statements are based on various assumptions and analyses made by us in light of Management’s experience and its perception of historical trends, current conditions and expected future developments, as well as other factors Management believes are appropriate under the circumstances.  These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors (many of which are beyond our control) that could cause actual results to differ materially from future results expressed or implied by such forward-looking statements.  These factors include, without limitation, the following:

·                  the timing and occurrence or non-occurrence of events may be subject to circumstances beyond our control;

·                  there may be increases in competitive pressure among financial institutions or from non-financial institutions;

·                  changes in the interest rate environment may reduce interest margins;

·                  changes in deposit flows, loan demand or real estate values may adversely affect our business;

·                  changes in accounting principles, policies or guidelines may cause our financial condition to be perceived differently;

·                  general economic conditions, either nationally or locally in some or all areas in which we do business, or conditions in the securities markets or the banking industry may be less favorable than we currently anticipate;

·                  legislative or regulatory changes may adversely affect our business;

·                  technological changes may be more rapid, difficult or expensive than we anticipate;

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·                  success or consummation of new business initiatives may be more difficult or expensive than we anticipate;

·                  acts of war or terrorism; or

·                  natural disaster.

Management cautions readers not to place undue reliance on forward-looking statements, which reflect analyses only as of the date of this document.  We have no obligation to update any forward-looking statements to reflect events or circumstances after the date of this document.  Readers should review the risk factors described in other documents that we file or furnish, from time to time, with the Securities and Exchange Commission, including Annual Reports to Shareholders, Annual Reports filed on Form 10-K and other current reports filed or furnished on Form 8-K.

General

The Company’s principal revenues are derived from interest, dividends and fees earned on its interest-earning assets, which are comprised of loans, securities and other short-term investments.  The Company’s principal expenses consist of interest paid on its interest-bearing liabilities, which are comprised of deposits, short-and long-term borrowings and operating and general expenses.  The Company’s profitability depends primarily on its net interest income, which is the difference between interest income generated from its interest-earning assets and the interest expense incurred on its interest-bearing liabilities.  Net interest income is dependent upon the interest-rate spread, which is the difference between the average yield earned on interest-earning assets and the average rate paid on interest-bearing liabilities.  When interest-earning assets approximate or exceed interest-bearing liabilities, any positive rate spread will generate net interest income.  The interest rate spread is significantly impacted by changes in interest rates and market yield curves and their related impact on cash flows from loans, investments, customer deposit flows and loan demand.  The interest rate spread is further influenced by the composition and characteristics of interest-earning assets and interest-bearing liabilities and by the competition in our marketplace.  Additionally, the interest rate spread and the changes in the interest rate spread, from period-to-period, is affected by differences in the maturity and re-pricing characteristics of the assets compared to the maturity and re-pricing characteristics of the liabilities that fund them.

In addition to net interest income, profitability is affected by the level of its non-interest income and expenses, provision for loan losses and provision for income taxes.  Non-interest income consists mostly of service charges on the Bank’s loan and deposit products, trust and asset management service fees, increases in the cash surrender value of the bank owned life insurance (“BOLI”), net gains or losses from sales of leases, securities and loans AFS and from the sale of other real estate (“ORE”) properties.  Non-interest expense consists of compensation and related employee benefit expenses, occupancy, equipment, data processing, advertising, marketing, professional fees, insurance and other operating overhead.

The Company’s profitability is significantly affected by general economic and competitive conditions, changes in market interest rates, government policies and actions of regulatory authorities.  The Company’s loan portfolio is comprised principally of commercial and commercial real estate loans.  The properties underlying the Company’s mortgages are concentrated in Northeastern Pennsylvania.  Credit risk, which represents the possibility of the Company not recovering amounts due from its borrowers, is significantly related to local economic conditions in the areas the properties are located as well as the Company’s underwriting standards.  Economic conditions affect the market value of the underlying collateral as well as the levels of adequate cash flow and revenue generation from income-producing commercial and multi-family properties.

COMPARISON OF RESULTS OF OPERATIONS

THREE AND SIX MONTHS ENDED JUNE 30, 2006 AND JUNE 30, 2005

Overview

Net income for the second quarter of 2006 was $939,000, a decrease of $197,000 or 17%, from the $1,136,000 recorded in the same quarter in 2005.  Diluted earnings per share was $0.45 and $0.56 for each of the respective periods.  For the six months ended June 30, 2006, net income was $1,970,000, or $0.96 per diluted share, compared to $2,155,000, or $1.06 per diluted share for the six months ended June 30, 2005.  The decline in net income in the second quarter was the result of a decrease in net interest and other non-interest income and increased operating expenses.  The decline in net income for the six month comparison was due mostly to a decrease in net interest income and an increase in operating expenses.  During both periods, the provision for loan losses decreased $125,000 and $130,000, respectively.

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The decline in net income was the primary cause of the decline in return on average assets (“ROA”) and return on average shareholders’ equity (“ROE”) to 0.66% and 7.66%, respectively, for the three months ended June 30, 2006, compared to 0.86% and 9.65, respectively, for the same period in 2005.  For the six months ended June 30, 2006 ROA and ROE were 0.70% and 8.08% compared to 0.81% and 9.26% for the six months ended June 30, 2005.

Net interest income and interest sensitive assets / liabilities

Net interest income decreased $53,000, or 1%, to $4,265,000 for the second quarter of 2006, from $4,318,000 recorded in the same period of 2005.  The decrease was principally due to the effect rising interest rates had on the rates paid on average interest-bearing liabilities compared to the effect rising interest rates had on our interest-earning assets.  Rates paid increased 95 basis points, to 3.65%, for the three months ended June 30, 2006 compared to 2.70% for the same 2005 period.  In addition to the increase in rates paid, there was an increase in the average interest-bearing liabilities of $37,510,000 for the comparable periods.  To maintain its pursuit to attract and retain core deposits, the Bank has continued to deploy various marketing and rate enhancing techniques.  From these efforts, average core deposits, which excludes time deposits of greater than $100,000, increased approximately $54,744,000 compared to the quarter ended June 30, 2005.  As a result, interest expense on deposits increased $1,074,000, or 64%, during the second quarter of 2006 compared to the second quarter of 2005.  Interest expense on borrowings increased $247,000, or 22%, due predominantly to an increase in the average balance in the 2006 quarter compared to the 2005 quarter.  Average balances of non-interest bearing deposits (“DDAs”) increased from year-end December 31, 2005 levels.  DDAs are an important funding source as they help reduce the cost of money that is used to fund interest-earning assets.  Management has committed to continue the campaign to attract and retain these core-deposits and will further implement deposit-gathering strategies throughout 2006.

Interest income increased $1,268,000, or 18%, partially offsetting the increase in interest expense during the second quarter of 2006 compared to the second quarter of 2005.  This improvement was primarily due to a 53 basis point increase in the yield earned on its average interest-earning assets which also experienced growth during the second quarter of 2006 compared to the second quarter of 2005.  During this period, the loan portfolio grew by $33,815,000 on average and yielded 59 basis points more during the current year quarter than in the same quarter of 2005.  The increase in the loan portfolio was from the successful implementation of various sales campaigns and programs targeted at mortgage and home equity lending products and increased production in commercial lending.

During the second quarter of 2006, the Bank’s tax-equivalent margin and spread both decreased 28 and 42 basis points, respectively, compared to the second quarter of 2005.  The decline in margin and spread is the result of the rates paid on the Bank’s interest-bearing liabilities increasing at a faster pace than the increase in the yields earned on interest-earning assets.

Similar to the second quarter comparisons, the Bank’s tax-equivalent margin and spread decreased 21 and 35 basis points, respectively, during the first half of 2006 compared to the first half of 2005.  For the first half of 2006, net interest income declined $98,000, or 1%, to $8,496,000 from $8,594,000 recorded in the first half of 2005.  The decrease was due to a combination of a net increase in average interest-bearing liabilities of $27,520,000 and to a more significant degree, an increase in the average rate paid of 87 basis points.  As a result, total interest expense increased $2,286,000, or 42%, for the six months ended June 30, 2006 compared to the six months ended June 30, 2005.

Interest income increased $2,188,000, or 16%, for the first six months of 2006 compared to the same period in 2005.  The dominate factor leading to the improvement was an increase in the book yield on average-earning assets of 51 basis points with a $30,089,000 increase in average interest-earning assets.

The increasing interest rate environment, that has been prevalent for approximately two years, and the more recent increases in short-term levels compounded with a flat-to-inverted market interest rate yield curve, has pressured the Bank’s net interest income.  However, our successful deposit gathering strategies will help position the Bank’s ability to optimize net interest income during this challenging rate environment and should be even further enhanced when the shape of the yield curve returns to a more normal slope.

The following table sets forth, a comparison of average balance sheet amounts and their corresponding tax-equivalent interest income and expense and annualized tax-equivalent yield and cost for the periods indicated (dollars in thousands):

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In the table above, interest income was adjusted to a tax-equivalent basis to recognize the income from the various tax-exempt assets as if the interest was fully taxable.  This treatment allows a uniform comparison among the yields on interest-earning assets.  The calculations were computed on a fully tax-equivalent basis using the corporate federal tax rate of 34%.  Net interest spread represents the difference between the yield on interest-earning assets and the rate on interest-bearing liabilities.  Net interest margin represents the ratio of net interest income to total average interest-earning assets.

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Provision for loan losses

The provision for loan losses represents the necessary amount to charge against current earnings, the purpose of which is to increase the allowance for loan losses to a level that represents Management’s best estimate of known and inherent losses in the Bank’s loan and lease portfolio.  Loans and leases determined to be uncollectible are charged-off against the allowance for loan losses.

The required amount of the provision for loan losses, based upon the adequate level of the allowance for loan losses, is subject to ongoing analysis of the loan portfolio. The Bank’s Special Asset Committee meets periodically to review problem loans and leases.  The committee is comprised of Bank Management, including the chief risk officer, loan workout officers and collection personnel.  The committee reports quarterly to the Credit Administration Committee of the Board of Directors.

Management continuously reviews the risks inherent in the loan and lease portfolio.  Specific factors used to evaluate the adequacy of the loan loss provision during the formal process include:

·                  Specific loans that could have loss potential

·                  Levels of and trends in delinquencies and non-accrual loans

·                  Levels of and trends in charge-offs and recoveries

·                  Trends in volume and terms of loans

·                  Changes in risk selection and underwriting standards

·                  Changes in lending policies, procedures and practices

·                  Experience, ability and depth of lending management

·                  National and local economic trends and conditions

·                  Changes in credit concentrations

The provision for loan losses was $175,000, for the three months ended June 30, 2006, compared to $300,000 for the three months ended June 30, 2005.  The decrease in the provision for loan losses resulted in part due to the reduced level of non-performing loans, which consist of loans past due 90 days or more and non-accrual loans.  The balance of non-performing loans declined year to year by $2,845,000 to $7,750,000 at June 30, 2006 compared to $10,595,000 at June 30, 2005.   The non accrual component of the non performing loans showed a $2,585,000 decline in the same period.  During the same period, the 90 past due delinquent loans component declined as well to $277,000 at June 30, 2006 compared to $538,000 the prior year.  The efforts of our collections department staff have enabled us to keep delinquencies at lower levels.

For the six months ended June 30, 2006, the provision for loan losses was $250,000, compared to $380,000 for the six months ended June 30, 2005.  As a result, after taking into account charge-offs and recoveries during the period, the allowance was $5,738,000 at June 30, 2006 compared to $5,873,000 at June 30, 2005.  The decrease in the provision for loan losses was driven by the substantial decrease in non-performing loans.   The decrease was mainly attributable to the collection and pay-offs of non-performing loans.  Our Special Assets Department has developed and carried out exit strategies and/or resolution plans for each of the non-performing loans which have resulted in the attainment of these reductions.

Other income

Total other (non-interest) income declined $43,000, or 4%, for the three months ended June 30, 2006 compared to the same period in 2005.  Fees and service charges on deposit related accounts and other fees and service charges decreased $70,000 or 6%, due primarily to less ATM related charges. Partially offsetting the various fees was an increase in gain on loans sold of $23,000, due to increased sales volume.

For the six months ended June 30, 2006, other income increased $337,000, or 18%, compared to the six months ended June 30, 2005.  During 2005, the Bank recognized an estimated impairment charge of $220,000 in anticipation of projected realized losses from the future sales of its leased vehicles.  The Bank’s automobile lease finance business concluded in 2005, and similar impairment charges from this activity will not recur.  For the first six months of 2006, the Bank recognized $15,000 of gains from successful residual insurance claims on the automobile leasing business, which will curtail in 2006.  During the first half of 2005, sales of leased vehicles yielded a net loss of $34,000.  Finally, during the first half of 2006, the Bank sold more loans into the secondary market resulting in gains of $42,000 compared to losses of $7,000 in the first half of 2005.

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Other operating expenses

For the quarter ended June 30, 2006, other (non-interest) expenses increased $336,000, or 9%, compared to the same 2005 quarter.  Salary and employee benefits increased $221,000, or 12%, due to an increase in the number of full-time equivalent employees and merit pay increases.  The increase in premises and equipment was caused by recognizing lease expense on long-term facility rental agreements, equipment depreciation, repair and maintenance.  The $75,000, or 18%, decrease in professional service fees was due to the high-level management and sales training in 2005 that did not recur in 2006.  The $92,000, or 17%, increase in the other component of operating expenses was caused by increased expenses related to our loan collection efforts, ATM processing costs and telecommunication charges.

For the first six months of 2006, other expenses increased $691,000, or 10%, from the first half of 2005.  Salary and employee benefits increased $485,000, or 14%, due to pay increases, increased number of full-time equivalent employees, one-time voluntary separation benefit payments and stock-based compensation expense (see footnote 3, “Stock Plans”, of the consolidated financial statements, included herein for a discussion on the Company’s adoption of SFAS 123R).  The increase in premises and equipment was caused by the aforementioned increase in lease expense and increased equipment depreciation, repair and additional core processing maintenance costs.  The decrease in professional service fees was caused mostly by non-recurring expenses associated with the 2005 Bank-wide participation in management skills development and sales training programs as well as a decrease in outside consulting fees for Sarbanes-Oxley compliance documentation procedures.

Income tax provision

Compared to 2005, income before provision for income taxes for the second quarter and first six months of 2006 decreased $306,000 and $322,000, respectively.  The effective federal income tax rate was 23.4% and 23.9% for the three and six months ended June 30, 2006, compared to 25.9% for each of the respective 2005 periods.  The effective tax rate decrease is attributable to lower pre-tax earning and an increase in tax-free interest income from municipal securities, tax-free loans and tax-free earnings from the BOLI, collectively representing a larger portion of pre-tax earnings.

COMPARISON OF FINANCIAL CONDITION AT

JUNE 30, 2006 AND DECEMBER 31, 2005

 

Overview

Consolidated assets increased $31,068,000, or 6%, during the six months ended June 30, 2006 to $575,128,000.  The increase resulted from an increase in total deposits of $43,357,000, partially offset by a net decrease in combined short-and long-term borrowings of $12,493,000.  Total investments and net loans increased $15,869,000 and $14,349,000, respectively, since December 31, 2005.

Investment securities

At the time of purchase, the Bank classifies investment securities into one of three categories: trading, AFS or held-to- maturity (“HTM”).  To date, Management has not purchased any securities for trading purposes.  Management classifies most securities as AFS even though it has no immediate intent to sell them.  The AFS designation affords Management the flexibility to sell securities and adjust the balance sheet in response to capital levels, liquidity needs, structuring strategies and/or changes in market conditions.  Securities AFS are carried at net fair market value in the consolidated balance sheet with an adjustment to stockholders’ equity, net of tax, which is presented under the caption “Accumulated other comprehensive income (loss).”  Securities designated as HTM are carried at amortized cost.

At June 30, 2006, the carrying value of investment securities totaled $113,547,000, or 20%, of total assets compared to $97,679,000 or 18%, as of December 31, 2005.  The increase in investments was due to the deployment of deposit inflow, mostly into short-term U.S. government agency securities, to meet regulatory requirements.  At June 30, 2006, approximately 34% of the carrying value of the investment portfolio was comprised of mortgage-backed securities that amortize and provide monthly cash flow.  Also, at June 30, 2006, agency and municipal bonds comprised 45% and 13%, respectively, of the investment portfolio.

As illustrated in the following table of amortized cost and fair market value of investment securities, the portfolio is comprised of HTM and AFS securities with carrying values of $1,785,000 and $111,762,000, respectively.  At June 30, 2006, the AFS debt securities were recorded with a net unrealized loss in the amount of $3,735,000 and equity securities were recorded with an unrealized gain of $176,000:

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