MANAGEMENT'S
DISCUSSION AND ANALYSIS OF
FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
The
following discussion and analysis
presents the significant changes in financial condition and results of
operations of Citizens Financial Corp. and its subsidiary, Citizens National
Bank of Elkins, for the periods indicated. It should be read in
conjunction with the consolidated financial statements and accompanying notes
thereto, which are included elsewhere in this document. Readers are
also encouraged to obtain our Annual Report on Form 10-K for additional
information. You may obtain our Form 10-K through various internet
sites including
www.cnbelkins.com
.
Description
of Business
Citizens
Financial Corp. is a $246
million Delaware corporation headquartered in Elkins, WV. From there
our wholly-owned subsidiary, Citizens National Bank of Elkins, provides loan,
deposit, trust, brokerage and other banking and related services to customers
in
northcentral and eastern West Virginia and nearby areas through six branch
offices. We conduct no business other than the ownership of our
subsidiary bank.
FORWARD
LOOKING STATEMENTS
This
report contains forward looking
statements which reflect our current expectations based on information available
to us. These forward looking statements involve uncertainties related
to the general economic conditions in our nation and other broad based issues
such as interest rates and regulations as well as to other factors which may
be
more specific to our own operations. Examples of such factors may
include our ability to attract and retain key personnel, implementing new
technological systems, providing new products to meet changing customer and
competitive demands, our ability to successfully manage growth strategies,
controlling costs, maintaining our net interest margin, maintaining good credit
quality, and others. Forward looking statements can be identified by
words such as “may”, “will”, “expect”, “anticipate”, “believe”, “estimate”,
“plans”, “intends”, or similar words. We do not attempt to update any
forward looking statements. When provided, we intend forward looking
information to assist readers in understanding anticipated future operations
and
we include them pursuant to applicable safe harbor provisions of the Private
Securities Litigation Reform Act of 1995. When considering forward
looking statements, you should keep in mind the cautionary statements in this
document and in our other SEC filings, including the “Risk Factors” section in
Item 1A of our 2006 Annual Report on Form 10-K. Although we believe
the expectations reflected in our forward looking statements are reasonable,
actual results could differ materially.
CRITICAL
ACCOUNTING POLICIES
Our
consolidated financial statements
are prepared in accordance with U.S. generally accepted accounting principles
and follow general practices within the financial services
industry. Application of these principles requires us to make
estimates, assumptions, and judgments that affect the amounts reported in our
financial statements and accompanying notes. These estimates,
assumptions, and judgments are based on information available as of the date
of
the financial statements and could change as new information becomes
available. Consequently, later financial statements could reflect
different estimates, assumptions, and judgments.
Some
policies rely more heavily on the
use of estimates, assumptions, and judgments than others and, therefore, have
a
greater possibility of producing results that could be materially different
than
originally reported. Our most significant accounting policies,
including an explanation of how assets and liabilities are valued, may be found
in Note 1 to the consolidated financial statements in our 2006 Annual Report
to
Shareholders and Form 10-K.
The
allowance for loan losses
represents our estimate of probable credit losses inherent in the loan
portfolio. Determining the amount of the allowance requires
significant judgment and the use of estimates related to the amount and timing
of expected future cash flows on impaired loans, the estimated amount of losses
in pools of homogeneous loans and the effect of various economic and business
factors, all of which may be subject to significant change. Due to
these uncertainties, as well as the sensitivity of our financial statements
to
the assumptions and estimates needed to determine the allowance, we have
identified the determination of the allowance for loan losses as a critical
accounting estimate. As such, it could be subject to revision as new information
becomes available. Should this occur, changes to the provision for
loan losses, which may increase or decrease future earnings, may be
necessary. A discussion of the methods we use to determine our
allowance for loan losses is presented later in this report.
OVERVIEW
The
economic climate in the rural area
in which we operate does not always have the same degree of growth or
contraction that a more urban area may experience relative to national trends;
however, during 2007 our economic climate has been somewhat
subdued. A slowdown in our local housing market has impacted our
mortgage loan demand, while the national slowdown in the housing market along
with rising fuel costs have prompted reduced activity in our local lumber,
trucking, and tourism industries. Also, the increase in the federal
minimum wage may strain some of the small businesses in our markets, where
a
significant number of the employed earn wages well-below the national
median. These economic conditions have contributed to our limited
loan growth during 2007 and allowed us to have more than ample
liquidity. We have responded to these factors by reducing our
competitive stance on deposit products in order to limit the influx of
additional liquidity in the form of certificates of deposit.
Asset
growth over the first nine months
of 2007 has been conservative with an increase of $3.4 million to $246.4
million. Net loans have increased by $5.2 million to $171.4 million
with most of that growth being in commercial credits, and most of that growth
occurring in the third quarter of 2007. Similarly, deposit growth was
$5.5 million and was centered in interest bearing checking.
The
first nine months of 2007 resulted
in net income of $1,156,000 which was $498,000 or 30.1% less than the same
period last year. The decrease in earnings was largely attributable
to an increase in our provision for loan losses of $530,000 which primarily
reflects the risk in one particular credit, as well as $318,000 of increased
costs associated with the operation, valuation, and disposition of other real
estate acquired in satisfaction of loans.
A
more detailed discussion of the
factors impacting our financial condition and results of operations
follows. Amounts and percentages used in that discussion have been
rounded.
RESULTS
OF OPERATIONS
NET
INTEREST INCOME
Net
interest income is the primary
component of our earnings. It is the difference between interest and fee income
generated by interest earning assets and interest expense incurred to carry
interest bearing liabilities. Net interest income is affected by changes in
balance sheet composition and interest rates. We attempt to maximize
net interest income by determining the optimal product mix in light of current
and expected yields on assets, cost of funds and economic conditions while
maintaining an acceptable degree of risk.
Net
interest margin for the first three
quarters of 2007 is 4.21%, slightly higher than our peer banks’ average margin
of 4.14%, however this is 14 basis points lower than our margin for the same
period last year. The margin compression we have experienced over the
last year is primarily the result of our efforts to remain competitive in our
markets with certificate of deposit rates. During the first quarter
of 2007 we implemented a strategy to help limit further compression in the
short-term by reducing our offering rates on some of our certificates of
deposit. We have been successful at maintaining a 4.21% margin
consistently throughout the first nine months of 2007.
The
increase in interest expense on
interest bearing liabilities was maintained at $810,000 in the first nine months
of 2007, and was largely the result of the competitive interest rate pressures
described above. Along with this strategy, higher interest rates and
growth in the average balance of interest earning assets produced an increase
in
interest income of $703,000, resulting in a net interest income decrease of
only
$107,000. Furthermore, net interest income only decreased $15,000 in
the third quarter as we continued to closely monitor rates on our certificates
of deposit to control interest expense.
With
the recent rate reductions in the
federal funds target rate, we have experienced some reduction in the competitive
pressure to price our deposit products higher. However, this rate
reduction will also affect interest income on our variable rate loan
portfolio. We will continue to employ strategies to minimize our
margin compression.
PROVISION
FOR LOAN LOSSES
The
provision for loan losses is
management’s estimate of the amount which must be charged against current
earnings in order to maintain the allowance for loan losses at a level
considered adequate to provide for losses which are inherent in the loan
portfolio. Because of this, the amount of the provision is subject to
the estimation techniques and judgments involved in assessing the allowance
which may cause the provision to increase or decrease in the
future. We determine the amount of the provision, as well as the
adequacy of the allowance for loan losses, quarterly.
Through
the first nine months of the
year the provision for loan losses has increased $530,000 to $805,000, including
a third quarter increase of $80,000. The primary reason for the
increase lies with one particular commercial credit. Additional
information on this credit can be found in the “Credit Quality and Allowance for
Loan Losses” section of this report.
The
amount of the provision for loan
losses is a function of our overall assessment of loan quality and the adequacy
of the allowance for loan losses, which itself relies on a
significant use of judgment and estimates, therefore, the provision for loan
losses expense may increase or decrease in the future. Please refer
to the “Credit Quality and Allowance for Loan Losses” section of this report for
more information on the quality of our loan portfolio and for further discussion
of the estimation methods and assumptions we use in analyzing the
allowance.
NONINTEREST
INCOME
Noninterest
income includes all
revenues other than those related to earning assets. Through
September 30 noninterest income totaled $1,363,000, up 17.2% from $1,163,000
at
the same point last year. The third quarter total of $447,000 was
15.8% higher than last year as well.
The
largest component of noninterest
income is service fees where increases in overdraft and ATM and debit card
program fees have contributed to a $144,000 improvement so far this
year. Our brokerage and trust programs continue to be major
contributors to noninterest income, collectively accounting for a $40,000
increase in 2007. However, our secondary market loan program which is also
a
major contributor to noninterest income remained flat. The reasons
for the third quarter improvement are very similar to year-to-date
performance.
NONINTEREST
EXPENSE
Noninterest
expense includes all items
of expense other than interest expense, the provision for loan losses, and
income taxes. Historically our level of noninterest expense has been
higher than average, partly due to the relatively smaller branch facilities
we
operate. Therefore, controlling noninterest expense is a key factor
to achieving higher earnings.
For
the first nine months of 2007
noninterest expense has increased $399,000 or 7.1% to $5,997,000 over the same
period last year. Likewise, third quarter noninterest expense has
increased $192,000 or 10.1% to $2,089,000. Both the quarterly
increase, as well as the year-to-date increase are largely attributable to
costs
associated with the operation, valuation, and disposition of other real estate
acquired in satisfaction of loans. These costs totaled $451,000 for
2007 and account for $318,000 of the increase in total noninterest
expense. At June 30, the bank had remaining foreclosed properties
valued at $1.2 million. During the third quarter the bank disposed of
all remaining foreclosed properties with the exception of two properties with
a
total value of $55,000. Three properties were sold at public auction
resulting in a $269,000 loss on sale for the third quarter.
Salaries
and employee benefits have
increased by only $45,000 or 1.6% to $2,895,000 during the first nine months
of
2007 despite the addition of a chief credit officer, retail banking manager,
and
credit analyst. The salaries for all of these professionals were not
present in the first half of 2006. With management’s continued effort
to become more efficient and realign workflow, salaries and benefits expense
improved by $38,000 or 3.9% in the third quarter compared to last
year.
Other
noninterest expense accounts for
$70,000 of the increase in total noninterest expense for the first three
quarters of 2007 primarily related to additional Delaware franchise tax and
increased expenses due to regulatory requirements. On a quarterly
basis, other noninterest expense actually improved by $34,000 to $258,000 as
we
had made a normal contribution to a local educational institution in the second
quarter rather than the typical third quarter contribution.
INCOME
TAXES
Our
provision for income taxes for the
first nine months of 2007 of $439,000 includes both federal and state income
taxes. At this level taxes were 27.5% of pretax
income. Quarterly taxes were $160,000. Through nine months
of 2006 income tax expense totaled $777,000 or 32.0% of pretax
income. Except for income earned on loans to and bonds issued by
municipalities and earnings on certain life insurance policies, all of our
income is taxable. The decrease in the tax rate in 2007 is primarily
attributable to higher earnings from our increasing investment in municipal
bonds. We are not subject to the alternative minimum tax,
however.
FINANCIAL
CONDITION
LOAN
PORTFOLIO
As
mentioned earlier in this report, we
have experienced a slower economic climate in 2007 resulting in limited loan
growth. While growth has been slower than what we normally
experience, we have been careful not to accept loans of lower quality in
exchange for higher loan volumes. Instead, we remain committed to
increasing our loan portfolio with proper attention to credit
quality.
Loan
growth for the third quarter was
$3.7 million while year-to-date growth was $5.2 million or 3.1%. The
increase is primarily centered in commercial lending as has been the case for
Citizens for several years. Commercial real estate loans have
increased $9.3 million in 2007 despite the overall reduced loan demand we have
experienced. This is mainly a result of a $5 million transfer of
construction to permanent financing, as well as our partnering with another
community bank outside our marketing area in order to provide funding for two
separate commercial real estate projects. Other commercial loans not
secured by real estate have decreased by $1 million since
year-end. The majority of our commercial loans are secured by real
property, regardless of whether repayment is linked to cash generated by the
use
or sale of the real estate. In cases where repayment is linked to
such use, the timing and stability of the cash flow, secondary sources of
repayment, loan guarantees, and collateral valuations are all important
considerations in granting the loan.
Retail
lending or lending to consumers
for autos, homes, or other purposes has been difficult for Citizens over the
past several years. Auto manufacturers and specialized mortgage
lenders have become very aggressive in attracting consumers away from
traditional banking institutions. The residential mortgage portfolio
has remained relatively level since year-end at $61 million. Citizens
has been successful in stabilizing our installment loan portfolio by adopting
an
automobile loan promotion in the latter part of 2006 and converting this
promotion into a regular product offering in 2007. Prior to this
initiative, installment loans had been declining for several
years. Citizens will continue to actively seek strategies to increase
retail loans. These efforts aimed at portfolio diversification will
not only open up new lending opportunities and reduce loan risk, they will
also
reduce the risk that falling interest rates may pose.
CREDIT
QUALITY AND ALLOWANCE FOR LOAN LOSSES
After
recognizing an increase in the
level of our credit risk in 2006 we took aggressive actions to improve our
ability to manage that risk. Among them were the hiring of a chief
credit officer and credit analyst, assigning our most crucial credits to one
of
our senior lenders, adopting a new loan policy and grading system, improving
our
exception tracking, and outsourcing our loan review function. We have
also centralized our loan processing to improve efficiency and maintain
underwriting consistency in all of our branches. All of these
improvements enable us to increase the quality of our loan portfolio and our
ability to control the associated risks.
We
continue to closely monitor loans
which carry the greatest risk and develop detailed strategies to manage those
credits. Over the last nine months we have improved our position with
regard to several such loans. In some cases this involved foreclosing
on the collateral securing the loans. We have had foreclosures in
2007 approximating $1.2 million, but currently only two properties valued at
$55,000 remain. For the first nine months of 2007 our costs
associated with these properties totals $451,000 and includes net losses,
valuation adjustments, and other expenses related to the maintenance or
disposition of the properties. Despite the added charges we have
incurred by engaging in the foreclosure process, we believe that gaining control
of these assets was ultimately the most financially sound process for seeking
a
return on our investment and securing our interest in these assets.
At
September 30, 2007 past due loans
totaled $2.8 million or 1.6% of gross loans. At this level past dues
have improved by $2.5 million since year-end 2006 when past due loans totaled
$5.3 million or 3.2%. Also, within the improvement in overall past
dues, loans past due more than ninety days has also decreased by $730,000 to
$346,000. These improvements are due to both the foreclosure process
mentioned above, as well as increased collection efforts and enhanced monitoring
processes.
Despite
the improvement in past dues,
loans in a nonaccrual status have increased by $2.4 million to $4.6 million
since year-end. The majority of this increase is related to one
particular commercial credit carrying a balance of $2.7 million. This
loan has remained and continues to remain current without becoming past due,
however, the business continues to have significant risk and we continue to
monitor this situation closely.
Our
current credit risk remains higher
than desired, however, we believe we are continuing to take appropriate actions
and that our portfolio risk is being systematically
reduced. Attention to credit quality will continue to be our primary
focus for the remainder of 2007.
Our
allowance for loan losses is
determined quarterly by evaluating specific larger loans as well as pools of
similar homogeneous loans. Adjustments to pooled factors for various
trends, economic conditions, changes in our credit management practices and
abilities, and other factors may also be made. By employing a
disciplined methodology we arrive at an allowance for loan losses that we
estimate is adequate to provide for the inherent losses in our loan
portfolio.
At
the end of the third quarter, our
allowance for loan losses was $2,098,000 or 1.21% of gross loans, compared
to
$1,873,000 or 1.11% at year-end. Despite improving past due trends
and our continued attention to credit quality, we found it necessary to increase
the allowance estimate during the second quarter due to an increased specific
reserve associated with the $2.7 million nonaccrual credit described
above. Despite this loan’s continued trend of timely payment, our
analysis and monitoring has revealed that the business risk associated with
this
credit continues to be greater than we would like. Therefore, we
recognize the greater inherent risk and continue to carry a large specific
reserve on this credit at September 30.
Even
though we are experiencing a
period of increased risks in our loan portfolio, in many cases our collateral
position helps limit our exposure to losses. We believe we are
well-equipped to manage and resolve the risks contained in our
portfolio. Based on the information available to us, we believe that
our analyses are comprehensive and our allowance is adequate as of the report
date. However, there can be no assurance that changes to our
allowance for loan losses will not be required in the future as a result of
changes in the assumptions which underlie our estimations or changes in economic
conditions or the business conditions of individual borrowers.
SECURITIES
PORTFOLIO AND FEDERAL FUNDS SOLD
Funds
which are not needed to satisfy loan demand or operating needs are invested
in
securities as a means of improving earnings while also providing liquidity
and
balancing interest sensitivity concerns. The securities we purchase
are limited to U.S. government agency issues, including mortgage backed issues
of U.S. agencies, obligations of state and political subdivisions and investment
grade corporate debt. All of our securities are classified as
available for sale. The Board of Directors is informed of all
securities transactions each month and a series of policy statements limit
the
amount of credit and interest rate risk we may take.
During
the first nine months of 2007
our securities portfolio decreased by $3 million to $56.7 million, while federal
funds sold and interest bearing deposits with other banks increased from $30,000
to $2.9 million. Maturing securities totaled $13.7 million for the
first nine months of 2007. Of this amount, $12.8 million were federal agency
bonds. The limited loan growth we have experienced in 2007 coupled
with the relatively flat nature of the yield curve have prompted Citizens to
reinvest much of the funds from these maturities in municipal instruments with
higher yields and longer maturities. This strategy will help to
extend the duration of the portfolio, improve the portfolio yield, and also
provide some shielding to the declining interest rates we have recently
experienced. Of the $11.9 million in security purchases, $8.6 million
were municipal instruments. The average duration of our securities
portfolio has increased from 1.9 to 2.5 years since year-end, while we have
also
increased the portfolio yield by 47 basis points on a fully tax equivalent
basis.
As
illustrated in Note 3 to the
condensed consolidated financial statements, a number of our securities have
fair values which are less than their amortized book value as a result of
changing interest rates. All of the issuers carry good to exceptional
credit rating and are of sound financial condition. The quality of
the issuer, as well as our intent and ability to hold these investments until
maturity, support that we do not consider these investments to be other than
temporarily impaired. As a result, we do not have nor do we expect
any negative income consequences in the future related to our securities
portfolio.
DEPOSITS
AND OTHER FUNDING SOURCES
Total
deposits increased by $5.5
million to $202 million during 2007. Nearly all of this increase is
in interest bearing checking as we have seen a seasonal increase in deposits
from local taxing authorities as well as some of our larger commercial
clients.
The
level of our noninterest bearing as
well as other interest bearing deposits has experienced little fluctuation
throughout 2007. We usually experience the most deposit growth in
certificates of deposit. However, in 2007 we have successfully
employed strategies to limit that growth and control the increasing costs of
these products, as our loan demand and loan growth has been somewhat subdued
compared to recent years. By limiting the influx of deposits, we are
successfully managing our liquidity needs and preventing further net interest
margin compression. Recent Federal Reserve reductions in the federal
funds target rate may prompt us to take a different approach to our pricing
strategy as we see competitive pressure on deposit pricing easing in our
markets.
Historically
our borrowings have
consisted of repurchase agreements, Federal Home Loan Bank borrowings, and,
when
necessary, overnight borrowings such as federal funds purchased. At
September 30, 2007, we had total borrowings of $20.7 million compared to $23.3
million at year-end. The $2.6 million decrease is mainly attributable
to the limited loan demand we have experienced and the excess liquidity in
the
form of overnight funds that have prevented us from being in an overnight
borrowing position at September 30. Our level and type of future
borrowings will depend on the need to fund additional asset growth and the
availability and cost of alternative funds, including deposits as described
above. Should a need arise, we have ample sources of funding
available to us as explained later in this report.
CAPITAL
RESOURCES
Our
total capital of $21,005,000, or
8.5% of assets has increased by $727,000 since December 31, 2006 when capital
was $20,278,000 or 8.3%. We believe this level of capital, as well as
our capital structure, is appropriate to support current and anticipated future
operations. Banking regulations have established other capital
measures based on the general risk characteristics of the bank’s asset
base. We continue to exceed all such regulatory capital measures and
know of no events or trends which are likely to materially impair future capital
levels.
LIQUIDITY
The
objective of our liquidity
management program is to ensure the continuous availability of funds to meet
the
withdrawal demands of customers, the credit needs of borrowers, and to provide
for other operational needs. Liquidity is provided by various sources
including unpledged investment securities, federal funds sold, loan repayments,
a stable and growing deposit base and, when necessary, external
borrowings.
We
monitor liquidity on a regular basis
by preparing projected balance sheets and analyzing our sources and uses of
funds. Historically, we have satisfied our liquidity needs through
internal sources with the exception of certain loans which have been funded
by
borrowing funds from the Federal Home Loan Bank of Pittsburgh and the use of
overnight borrowings for short-term needs. Currently, we have access
to approximately $101 million through various FHLB programs in addition to
available borrowing facilities with other correspondent banks.
During
2007 our limited loan growth has
resulted in ample liquidity. We expect to continue to satisfy our
liquidity needs primarily through internal sources of funds. Should a
liquidity need arise, we may increase the competitiveness of certificate of
deposit rates or use funds from maturing securities.
IMPACT
OF INFLATION
The
consolidated financial statements
and related data included in this report were prepared in accordance with
accounting principles generally accepted in the United States of America, which
require our financial position and results of operations to be measured in
terms
of historical dollars except for the available for sale securities portfolio.
Consequently, the relative value of money generally is not considered. Nearly
all of our assets and liabilities are monetary in nature and, as a result,
interest rates and competition in the market area tend to have a more
significant impact on our performance than the effect of inflation.
However,
inflation does affect
noninterest expenses such as personnel costs and the cost of services and
supplies we use. We attempt to offset increasing costs by controlling
the level of noninterest expenditures and increasing levels of noninterest
income. Because inflation rates have generally been low during the
time covered by the accompanying consolidated financial statements, the impact
of inflation on our earnings has not been significant. Based on
current Federal Reserve policy and economic conditions, we do not expect
inflation to significantly impact our financial position or results of
operations in the foreseeable future.