Item 1. Business
FORWARD LOOKING STATEMENTS
Certain matters disclosed herein may be deemed to be forward-looking statements that involve risks and uncertainties, including regulatory policy changes, interest rate fluctuations, loan demand, loan delinquencies and losses, and other risks. Actual strategies and results in future time periods may differ materially from those currently expected. Such forward-looking statements represent management's judgment as of the current date. LCNB Corp. disclaims, however, any intent or obligation to update such forward-looking statements.
DESCRIPTION OF LCNB CORP.'S BUSINESS
General Description
LCNB Corp. ("LCNB"), an Ohio corporation formed in December, 1998, is a financial holding company headquartered in Lebanon, Ohio. Through its subsidiaries, Lebanon Citizens National Bank ("the Bank") and Dakin Insurance Agency, Inc. ("Dakin"), LCNB is engaged in the commercial banking and insurance agency businesses.
The predecessor of LCNB, the Bank, was formed as a national banking association in 1877. On May 19, 1999, the Bank became a wholly owned subsidiary of LCNB. The Bank's main office is located in Warren County, Ohio and 19 branch offices are located in Warren, Butler, Clinton, Clermont, and Hamilton Counties, Ohio. In addition, the Bank operates 30 automated teller machines ("ATMs") in its market area.
The Bank is a full service community bank offering a wide range of commercial and personal banking services. Deposit services include checking accounts, NOW accounts, savings accounts, Christmas and vacation savings, money market deposit accounts, Classic 50 accounts (a Senior Citizen program), individual retirement accounts, and certificates of deposit. Deposits of the Bank are insured up to applicable limits by the Bank Insurance Fund, which is administered by the Federal Deposit Insurance Corporation (the “FDIC”).
Loan products offered include commercial loans, commercial and residential real estate loans, construction loans, various types of consumer loans, Small Business Administration loans, and commercial leases. The Bank's residential mortgage lending activities consist primarily of loans for purchasing or refinancing personal residences, home equity lines of credit, and loans for commercial or consumer purposes secured by residential mortgages. Consumer lending activities include automobile, boat, home improvement and personal loans. The Bank also offers indirect financing through various automotive, boat, and lawn and garden dealers.
The Trust and Investment Management Division of the Bank performs complete trust administrative functions and offers agency and trust services, retirement savings products, and mutual fund investment products to individuals, partnerships, corporations, institutions and municipalities.
Security brokerage services were first offered by the Bank in April, 2002 through arrangements with UVEST Investment Services, Inc., a registered broker/dealer. Two licensed brokers offer a full range of investment services and products, including financial needs analysis, mutual funds, securities trading, annuities, and life insurance.
Other services offered include safe deposit boxes, night depositories, U.S. savings bonds, travelers' checks, money orders, cashier's checks, bank-by-mail, ATMs, cash and transaction services, debit cards, wire transfers, electronic funds transfer, utility bill collections, notary public service, personal computer based cash management services, 24 hour telephone banking, PC Internet banking, and other services tailored for both individuals and businesses.
The Bank is not dependent upon any one significant customer or specific industry. Business is not seasonal to any material degree.
The address of the main office of the Bank is 2 North Broadway, Lebanon, Ohio 45036; telephone (513) 932-1414. Its primary market area encompasses all of Butler and Warren Counties and portions of Clinton, Clermont and Hamilton Counties.
Dakin, an Ohio corporation, has been an independent insurance agency in Lebanon, Ohio since 1876. Its primary office is at 24 East Mulberry Street, Lebanon, Ohio 45036; telephone (513) 932-4010. Since being acquired by LCNB on April 11, 2000, Dakin now maintains additional offices in the Bank's Columbus Avenue, Maineville, and Mason offices. Dakin is engaged in selling and servicing personal and commercial insurance products and annuity products and is regulated by the Ohio Department of Insurance.
Effective September 1, 2002, Dakin purchased substantially all of the insurance renewal rights and client list of an insurance agency located in Dayton, Ohio. As part of the purchase, Dakin will receive all commission income received after September 1, 2002, and assignments of agency agreements that the agency has with insurers with whom Dakin does not already have an agreement. In consideration for the assets purchased, Dakin will pay to the seller certain percentages of the commissions received from the agency's customer base over a four-year period.
Competition
The Bank faces strong competition both in making loans and attracting deposits. The deregulation of the banking industry and the wide spread enactment of state laws that permit multi-bank holding companies as well as the availability of nationwide interstate banking has created a highly competitive environment for financial services providers. The Bank competes with other national and state banks, savings and loan associations, credit unions, finance companies, mutual funds, insurance companies, brokerage and investment banking companies, and other financial intermediaries operating in its market and elsewhere, many of whom have substantially larger financial and managerial resources.
- 4 -
The Bank seeks to minimize the competitive effect of other financial corporations through a community banking approach that emphasizes direct customer access to the Bank's president and other officers in an environment conducive to friendly, informed, and courteous personal services. Management believes that the Bank is well positioned to compete successfully in its primary market area. Competition among financial institutions is based upon interest rates offered on deposit accounts, interest rates charged on loans and other credit and service charges, the quality and scope of the services rendered, the convenience of the banking facilities, and, in the case of loans to commercial borrowers, relative lending limits.
Management believes the commitment of the Bank to personal service, innovation, and involvement in the communities and primary market areas it serves, as well as its commitment to quality community banking service, are factors that contribute to its competitive advantage.
Dakin competes with numerous other independent and exclusive insurance agencies (an exclusive agent sells for only one insurance company) and with insurance companies that sell direct to individuals and businesses without using agents. Dakin competes by representing high quality insurance companies, providing personalized and responsive service to its clients, and providing convenient office locations.
Supervision and Regulation
The Sarbanes-Oxley Act of 2002 ("SOA") was signed into law by President George W. Bush on July 30, 2002. The purpose of SOA is to strengthen accounting oversight and corporate accountability by enhancing disclosure requirements, increasing accounting and auditor regulation, creating new federal crimes, and increasing penalties for existing federal crimes. SOA directly impacts publicly traded companies, certified public accounting firms auditing public companies, attorneys who work for public companies or have public companies as clients, brokerage firms, investment bankers, and financial analysts who work for brokerage firms or investment bankers. Key provisions affecting LCNB include:
1.
Certification of financial reports by chief executive officers ("CEOs") and chief financial officers ("CFOs"), who are responsible for designing and monitoring internal controls to ensure that material information relating to the issuer and its consolidated subsidiaries is made known to the certifying officers by others within the company;
2.
Inclusion of an internal controls report in annual reports that include management's assessment of the effectiveness of a company's internal controls over financial reporting and a report by the company's auditors attesting to management's assessment of internal controls;
3.
Accelerated reporting of stock trades on Form 4 by directors and executive officers;
4.
Disgorgement requirements of incentive pay or stock-based compensation profits received within twelve months of the release of financial statements if the company is later required to restate those financial statements due to material noncompliance with any financial reporting requirement that resulted from misconduct;
5.
Disclosure in a company's periodic reports stating if it has adopted a code of ethics for its CFO and principal accounting officer or controller and, if such code of ethics has been implemented, immediate disclosure of any change in or waiver of the code of ethics;
- 5 -
6.
Disclosure in a company's periodic reports stating if at least one member of the audit committee is a "financial expert," as that term is defined by the Securities and Exchange Commission (the "SEC"); and
7.
Implementation of new duties and responsibilities for a company's audit committee, including independence requirements, the direct responsibility to appoint the outside auditing firm and to provide oversight of the auditing firm's work, and a requirement to establish procedures for the receipt, retention, and treatment of complaints from a company's employees regarding questionable accounting, internal control, or auditing matters.
Some SOA provisions became effective upon enactment; others have delayed implementation; and others awaited rulemaking by the SEC, which is now substantially complete. In addition, the SEC adopted final rules on September 5, 2002, requiring accelerated filing of quarterly and annual reports by a newly defined class of "accelerated filers." After an initial phase-in period, accelerated filers will be required to file their annual reports on Form 10-K no later than 60 days after fiscal year end and their quarterly reports on Form 10-Q no later than 35 days after fiscal quarter ends. LCNB meets the requirements for accelerated filing.
LCNB and the Bank are subject to an extensive array of banking laws and regulations that are intended primarily for the protection of the customers and depositors of LCNB's subsidiaries rather than holders of LCNB's securities. These laws and regulations govern such areas as permissible activities, loans and investments, and rates of interest that can be charged on loans and reserves. LCNB and the Bank also are subject to general U.S. federal laws and regulations and to the laws and regulations of the State of Ohio. Set forth below are brief descriptions of selected laws and regulations applicable to LCNB and the Bank.
LCNB, as a financial holding company, is regulated under the Bank Holding Company Act of 1956, as amended (the "Act"), and is subject to the supervision and examination of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). The Act requires the prior approval of the Federal Reserve Board for a bank or financial holding company to acquire or hold more than a 5% voting interest in any bank and restricts interstate banking activities.
On September 29, 1994, the Act was amended by the Interstate Banking and Branch Efficiency Act of 1994, which authorizes interstate bank acquisitions anywhere in the country, effective one year after the date of enactment, and interstate branching by acquisition and consolidation, effective June 1, 1997, in those states that have not opted out by that date.
The Gramm-Leach-Bliley Act, which amended the Bank Holding Company Act of 1956 and other banking related laws, was signed into law on November 12, 1999. The Gramm-Leach-Bliley Act repealed certain sections of the Glass-Steagall Act and substantially eliminated the barriers separating the banking, insurance, and securities industries. Effective March 11, 2000, qualifying bank holding companies could elect to become financial holding companies. Financial holding companies have expanded investment powers, including affiliating with securities and insurance firms and engaging in other activities that are "financial in nature or incidental to such financial activity" or "complementary to a financial activity." The Gramm-Leach-Bliley Act defines "financial in nature" to include:
- 6 -
a.
securities underwriting, dealing, and market making;
b.
sponsoring mutual funds and investment companies;
c.
insurance underwriting and agency;
d.
merchant banking activities; and
e.
other activities that the Federal Reserve Board, in consultation with and subject to the approval of the Treasury Department, determines are financial in nature.
Financial holding companies may commence the activities listed above or acquire a company engaged in any of those activities without additional approval from the Federal Reserve. Notice of the commencement or acquisition must be provided to the Federal Reserve within thirty days of the start of the activity. Sixty days advance notice is required before the start of any activity that is "complementary to a financial activity."
The Financial Reform, Recovery and Enforcement Act of 1989 ("FIRREA") provides that a holding company and its controlled insured depository institutions are liable for any loss incurred by the FDIC in connection with the default of any FDIC assisted transaction involving an affiliated insured bank or savings association.
The Bank is subject to the provisions of the National Bank Act. The Bank is subject to primary supervision, regulation and examination by the Office of the Comptroller of the Currency (the "OCC"). The Bank is also subject to the rules and regulations of the Board of Governors of the Federal Reserve System and the FDIC. Under the Bank Holding Company Act of 1956, as amended, and under Regulations of the Federal Reserve Board pursuant thereto, a bank or financial holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit.
The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") substantially revised the bank regulatory and funding provisions of the Federal Deposit Insurance Act and several other federal banking statutes. Among its many reforms, FDICIA:
1.
Required regulatory agencies to take "prompt corrective action" with financial institutions that do not meet minimum capital requirements;
2.
Established five capital tiers: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized;
3.
Imposed significant restrictions on the operations of a financial institution that is not rated well-capitalized or adequately capitalized;
4.
Prohibited a depository institution from making any capital distributions, including payments of dividends, or paying any management fee to its holding company if the institution would be undercapitalized as a result;
5.
Implemented a risk-based premium system;
6.
Required an audit committee to be comprised of independent, outside directors;
7.
Required a financial institution with more than $500 million in total assets to issue annual, audited financial statements prepared in conformity with U.S. generally accepted accounting principles; and
- 7 -
8.
Required a financial institution with more than $500 million in total assets to document, evaluate, and report on the effectiveness of the entity's internal control system and required an independent public accountant to attest to management's assertions concerning the bank's internal control system.
At December 31, 2004, the Bank was well capitalized based on FDICIA's guidelines.
LCNB and the Bank are also subject to the state banking laws of Ohio. Ohio adopted nationwide reciprocal interstate banking effective October, 1988. However, banking laws of other states may restrict branching of banks to other counties within the state and acquisitions or mergers involving banks and bank holding companies located in other states. Additionally, Dakin Insurance Agency, Inc. is subject to State of Ohio insurance regulations and rules and its activities are regulated by The State of Ohio Department of Insurance.
Noncompliance with laws and regulations by bank holding companies and banks can lead to monetary penalties and/or an increased level of supervision or a combination of these two items. Management is not aware of any current instances of noncompliance with laws and regulations and does not anticipate any problems maintaining compliance on a prospective basis. Recent regulatory inspections and examinations of LCNB and the Bank have not disclosed any significant instances of noncompliance.
The earnings and growth of LCNB are affected not only by general economic conditions, but also by the fiscal and monetary policies of the federal government and its agencies, particularly the Federal Reserve Board. Its policies influence the amount of bank loans and deposits and the interest rates charged and paid thereon and thus have an effect on earnings. The nature of future monetary policies and the effect of such policies on the future business and earnings of LCNB and the Bank cannot be predicted.
A substantial portion of LCNB's cash revenues is derived from dividends paid by the Bank. These dividends are subject to various legal and regulatory restrictions. Generally, dividends are limited to the aggregate of current year net income plus the retained net earnings, as defined, of the two most previous prior years. In addition, dividend payments may not reduce capital levels below minimum regulatory guidelines.
Employees
As of December 31, 2004, LCNB, the Bank, and Dakin employed 218 full-time equivalent employees. LCNB is not a party to any collective bargaining agreement. Management considers its relationship with its employees to be very good. Employee benefits programs are considered by Management to be competitive with benefits programs provided by other financial institutions and major employers within LCNB’s market area.
- 8 -
Availability of Financial Information
LCNB files unaudited quarterly financial reports on Form 10-Q, annual financial reports on Form 10-K, current reports on Form 8-K, and amendments to these reports filed or furnished pursuant to Section 13(a) or 15 (d) of the Securities Exchange Act of 1934 with the SEC. Copies of these reports are available free of charge in the shareholder information section of the Bank's web site, www.lcnb.com, as soon as reasonably practicable after they are electronically filed or furnished to the SEC, or by writing to:
Steve P. Foster
Executive Vice President, CFO
LCNB Corp.
2 N. Broadway
P.O. Box 59
Lebanon, Ohio 45036
Financial reports and other materials filed by LCNB with the SEC may also be read and copied at the SEC's Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained from the SEC by calling 1-800-SEC-0330. The SEC also maintains an internet site (www.sec.gov) that contains reports, proxy and information statements, and other information regarding registrants that file reports electronically, as LCNB does.
FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT
SALES
LCNB and its subsidiaries do not have any offices located in foreign countries and have no foreign assets, liabilities or related income and expense for the years presented.
STATISTICAL INFORMATION
The following tables and certain tables appearing in Item 7, Management's Discussion and Analysis, present additional statistical information about LCNB Corp. and its operations and financial condition. They should be read in conjunction with the consolidated financial statements and related notes and the discussion included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and Item 7A, Quantitative and Qualitative Disclosures about Market Risk.
Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Interest Differential
The table presenting an average balance sheet, interest income and expense, and the resultant average yield for average interest-earning assets and average interest-bearing liabilities is included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.
The table analyzing changes in interest income and expense by volume and rate is included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.
- 9 -
Investment Portfolio
The following table presents the carrying values of securities for the years indicated:
- 10 -
Contractual maturities of debt securities at December 31, 2004, were as follows. Actual maturities may differ from contractual maturities when issuers have the right to call or prepay obligations.
(1)
Yields on tax-exempt obligations are computed on a tax equivalent basis based upon a 34% statutory Federal income tax rate.
Excluding holdings in U.S. Treasury securities and U.S. Government Agencies, there were no investments in securities of any issuer that exceeded 10% of LCNB's consolidated shareholders' equity at December 31, 2004.
- 11 -
Loan Portfolio
The following table summarizes the distribution of the loan portfolio for the years indicated:
As of December 31, 2004, there were no concentrations of loans exceeding 10% of total loans that are not already disclosed as a category of loans in the above table.
The following table summarizes the commercial and agricultural loan maturities and sensitivities to interest rate change at December 31, 2004:
- 12 -
Risk Elements
Generally, a loan is placed on non-accrual status when there is an indication that the borrower's cash flow may not be sufficient to meet payments as they become due, unless the loan is well secured and in the process of collection. Subsequent cash receipts on a non-accrual loan are recorded as a reduction of principal, and interest income is recorded once principal recovery is reasonably assured. The current year's accrued interest on loans placed on non-accrual status is charged against earnings. Previous years' accrued interest is charged against the allowance for loan losses.
The following table summarizes non-accrual, past-due, and restructured loans for the dates indicated:
The restructured loan at December 31, 2004 consists of a commercial loan whose predecessor loans were classified as loans past due 90 days or more and still accruing at December 31, 2003, at which time they had a total balance of $2,030,000. Information received during the first quarter, 2004, raised uncertainties concerning the collectibility of certain collateral and management transferred the loans to the non-accrual classification, where they remained until they were re-written in October, 2004. The $213,000 difference in the loan balances at December 31, 2004 and 2003 is due to principal payments received. All related interest due on the predecessor loans was paid during October, 2004, and the loans were re-written at that time. Such interest has been recorded on a cash basis as received. The restructured loan is secured by a combination of mortgages and other collateral.
Non-accrual loans at December 31, 2003 included a commercial loan in the amount of $564,000, which was paid in full during the second quarter, 2004; a consumer loan in the amount of $146,000; and residential real estate mortgage loans in the amount of $84,000. Interest income that would have been recorded during 2003 if loans on a non-accrual status at December 31, 2003 had been current and in accordance with their original terms was approximately $72,000.
The following is a summary of information pertaining to loans considered to be impaired in accordance with SFAS No. 114 (000’s):
- 13 -
The average balance of impaired loans during 2004 and 2003 was $2,629,000 and $2,857,000, respectively. During 2004 LCNB received and recognized $164,000 of interest income on impaired loans. During 2003 LCNB accrued interest income totaling $183,000 on impaired loans classified as past due 90 days or more and still accruing because they were considered well secured and in the process of collection. This accrued interest was received during the first quarter, 2004.
LCNB is not committed to lend additional funds to debtors whose loans have been modified to provide a reduction or deferral of principal or interest because of deterioration in the financial position of the borrower.
At December 31, 2004, there were no material additional loans not already disclosed as non-accrual, restructured, or accruing loans past due 90 days or more where known information about possible credit problems of the borrowers causes management to have serious doubts as to the ability of such borrowers to comply with present loan repayment terms.
- 14 -
Summary of Loan Loss Experience
The table summarizing the activity related to the allowance for loan losses is included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.
The following table presents the allocation of the allowance for loan loss:
This allocation is made for analytical purposes. The total allowance is available to absorb losses from any category of the portfolio. The decrease in the allocation to the commercial and industrial category at December 31, 2004 as compared to December 31, 2003 reflects decreased delinquencies. There is not an allocation to the credit card category for 2004 because this portfolio was sold during the first quarter, 2004. Allocations to the consumer and credit card categories were less at December 31, 2003 as compared to December 31, 2002 because of general economic improvements in late 2003.
- 15 -
Deposits
The statistical information regarding average amounts and average rates paid for the deposit categories is included in the "Distribution of Assets, Liabilities and Shareholders' Equity" table included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.
The following table presents the contractual maturity of time deposits of $100,000 or more at December 31, 2004:
Return on Equity and Assets
The statistical information regarding the return on assets, return on equity, dividend payout ratio, and equity to assets ratio is presented in Item 6, Selected Financial Data.
- 16 -
Item 2.
Item 2. Properties
The Bank conducts its business from the following offices:
Name of Office
Address
1.
Main Office
2 North Broadway
Lebanon, Ohio 45036
Owned
2.
Auto Bank
36 North Broadway
Lebanon, Ohio 45036
Owned
3.
Columbus Avenue Office
730 Columbus Avenue
Lebanon, Ohio 45036
Owned
(2)
4.
Fairfield Office
765 Nilles Road
Fairfield, Ohio 45014
Leased
5.
Goshen Office
6726 Dick Flynn Blvd.
Goshen, Ohio 45122
Owned
6.
Hamilton Office
794 NW Washington Blvd.
Hamilton, Ohio 45013
Owned
7.
Hunter Office
3878 State Route 122
Franklin, Ohio 45005
Owned
8.
Loveland Office
615 West Loveland Avenue
Loveland, Ohio 45140
Owned
9.
Maineville Office
7795 South State Route 48
Maineville, Ohio 45039
Owned
(2)
10.
Mason/West Chester Office
1050 Reading Road
Mason, Ohio 45040
Owned
(2)
11.
Middletown Office
4441 Marie Drive
Middletown, Ohio 45044
Owned
12.
Okeana Office
6225 Cincinnati-Brookville Road
Okeana, Ohio 45053
Owned
13.
Otterbein Office
State Route 741
Lebanon, Ohio 45036
Leased
14.
Oxford Office
30 West Park Place
Oxford, Ohio 45056
- 17 -
(1) (3)
Name of Office
Address
15.
Rochester/Morrow Office
Route 22-3 at 123
Morrow, Ohio 45152
Owned
16.
South Lebanon Office
209 East Forest Street
South Lebanon, Ohio 45065
Leased
17.
Springboro/Franklin Office
525 West Central Avenue
Springboro, Ohio 45066
Owned
18.
Warrior Office
Lebanon High School
1916 Drake Road
Lebanon, Ohio 45036
Leased
19.
Waynesville Office
9 North Main Street
Waynesville, Ohio 45068
Owned
20.
Wilmington Office
1243 Rombach Avenue
Wilmington, Ohio 45177
Owned
(1)
Excess space in this office is leased to third parties.
(2)
A Dakin office is located in this office.
(3)
The Bank owns the Oxford office building and leases the land.
Dakin owns its main office at 20 & 24 East Mulberry Street, Lebanon, Ohio 45036. Excess space in this office is leased to third parties. Dakin's three other offices are located in the Bank's branch offices.
Item 3.
Item 3. Legal Proceedings
Except for routine litigation incident to their businesses, LCNB and its subsidiaries are not a party to any material pending legal proceedings and none of their property is the subject of any such proceedings.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None
- 18 -
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities.
LCNB had approximately 655 registered holders of its Common Stock as of December 31, 2004. The number of shareholders includes banks and brokers who act as nominees, each of whom may represent more than one shareholder. The Common Stock is currently traded on the Nasdaq Over-The-Counter Bulletin Board service under the symbol "LCNB". Several market-makers facilitate the trading of the shares of Common Stock. Trade prices for shares of LCNB Common Stock, reported through registered securities dealers, are set forth below. Trades have occurred during the periods indicated without the knowledge of LCNB. The trade prices shown below are interdealer without retail markups, markdowns or commissions. Prices have been restated to reflect a 100% stock dividend, which was accounted for as a stock split, paid on April 30, 2004.
High
Low
First Quarter
$
36.25
$
34.525
Second Quarter
40.00
35.250
Third Quarter
40.00
36.000
Fourth Quarter
38.90
37.000
First Quarter
$
27.50
$
24.750
Second Quarter
29.25
26.000
Third Quarter
42.50
29.000
Fourth Quarter
38.00
32.625
The following table presents cash dividends per share declared and paid in the periods shown. Amounts have been restated to reflect the 100% stock dividend referred to above.
First Quarter
$
0.275
0.2625
Second Quarter
0.280
0.2625
Third Quarter
0.280
0.2625
Fourth Quarter
0.280
0.2750
Total
$
1.115
1.0625
It is expected that LCNB will continue to pay dividends on a similar schedule, to the extent permitted by business and other factors beyond management's control. LCNB depends on dividends from its subsidiaries for the majority of its liquid assets, including the cash needed to pay dividends to its shareholders. National banking law limits the amount of dividends the Bank may pay to the sum of retained net income, as defined, for the current year plus net income retained for the previous two years. Prior approval from the OCC, the Bank’s primary regulator, would be necessary for the Bank to pay dividends in excess of this amount. In addition, dividend payments may not reduce capital levels below minimum regulatory guidelines. Management believes the Bank will be able to pay anticipated dividends to LCNB without needing to request approval.
- 19 -
On April 17, 2001, LCNB's Board of Directors authorized three separate stock repurchase programs, two phases of which continue. The shares purchased will be held for future corporate purposes.
Under the "Market Repurchase Program" LCNB will purchase up to 100,000 shares of its stock through market transactions with a selected stockbroker. Through December 31, 2004, 62,531 shares had been purchased under this program. The following table shows information relating to the repurchase of shares under the Market Repurchase Program during the twelve months ended December 31, 2004:
The "Private Sale Repurchase Program" is available to shareholders who wish to sell large blocks of stock at one time. Because LCNB's stock is not widely traded, a shareholder releasing large blocks may not be able to readily sell all shares through normal procedures. Purchases of blocks will be considered on a case-by-case basis and will be made at prevailing market prices. There is no limit to the number of shares that may be purchased under this program. A total of 160,144 shares have been purchased under this program since its inception. The following table shows information relating to private sale repurchases during the twelve months ended December 31, 2004:
- 20 -
- 21 -
Item 6.
Item 6. Selected Financial Data
The following represents selected consolidated financial data of LCNB for the years ended December 31, 2000 through 2004 and are derived from LCNB's consolidated financial statements. This data should be read in conjunction with the consolidated financial statements and the notes thereto included in Item 8 of this Form 10-K and Management's Discussion and Analysis of Financial Condition and Results of Operations and Quantitative and Qualitative Disclosures about Market Risk included in Items 7 and 7A, respectively, of this Form 10-K, and are qualified in their entirety thereby and by other detailed information elsewhere in this Form 10-K.
- 22 -
(1)
All per share data have been adjusted to reflect a 100% stock dividend accounted for as a stock split in 2004.
- 23 -
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Introduction
The following is management's discussion and analysis of the consolidated financial condition and consolidated results of operations of LCNB Corp. ("LCNB"). It is intended to amplify certain financial information regarding LCNB and should be read in conjunction with the Consolidated Financial Statements and related Notes and the Financial Highlights contained in the 2004 Annual Report to Shareholders.
Forward Looking Statements
Certain matters disclosed herein may be deemed to be forward-looking statements that involve risks and uncertainties, including regulatory policy changes, interest rate fluctuations, loan demand, loan delinquencies and losses, and other risks. Actual strategies and results in future time periods may differ materially from those currently expected. Such forward-looking statements represent management's judgment as of the current date. LCNB disclaims, however, any intent or obligation to update such forward-looking statements.
Overview
LCNB earned $6,596,000 in 2004, compared to $6,737,000 in 2003 and $6,540,000 in 2002. Basic and diluted earnings per share for 2004, 2003, and 2002 were $1.97, $1.97, and $1.90, respectively. Performance ratios for 2004, 2003, and 2002 included:
Return on average assets
1.29%
1.31%
1.32%
Return on average equity
12.56%
12.64%
13.00%
Net interest income for 2004, 2003, and 2002 was $18,280,000, $18,757,000, and $19,493,000, respectively. A primary factor in the decline in net interest income during these years was continued, historically low market interest rates, as indicated in LCNB’s net interest margin for these years. The net interest margin, which is calculated by dividing taxable-equivalent net interest income by average interest-earning assets, was 4.02%, 4.09%, and 4.39% for 2004, 2003, and 2002, respectively.
Total non-interest income grew from $5,623,000 for 2002 to $6,797,000 for 2003 and $7,659,000 for 2004. Two primary drivers of this upward trend were trust income, primarily from growth in trust assets managed, and increases in service charges and fees, primarily due to the introduction of a new overdraft protection program in August, 2003 and an increase in non-sufficient fund check fees initiated in November, 2002.
- 24 -
Total non-interest expense also increased, but not as much as the increase in non-interest income. Total non-interest expense for 2002 was $15,705,000, compared to $15,725,000 in 2003 and $16,404,000 in 2004. Normal salary and wage increases and increased employee benefit costs comprised a significant portion of this increase. LCNB’s continual investments in facilities improvements and data processing system upgrades also was responsible for expense increases, primarily through increased depreciation and computer maintenance and supply costs.
Net Interest Income
The amount of net interest income earned by LCNB is influenced by the dollar amount ("volume") and mix of interest earning assets and interest bearing liabilities and the rates earned or paid on each. The following table presents, for the years indicated, the distribution of average assets, liabilities and shareholders' equity, as well as the total dollar amounts of interest income from average interest earning assets and the resultant yields on a fully taxable equivalent basis, and the dollar amounts of interest expense and average interest-bearing liabilities and the resultant rates paid.
- 25 -
(1)
Includes non-accrual loans if any. Income from tax-exempt loans is included in interest income on a taxable equivalent basis, using an incremental rate of 34%.
(2)
Income from tax-exempt securities is included in interest income on a taxable equivalent basis. Interest income has been divided by a factor comprised of the complement of the incremental tax rate of 34%.
(3)
The net interest spread is the difference between the average rate on total interest-earning assets and interest-bearing liabilities.
(4)
The net interest margin is the taxable-equivalent net interest income divided by average interest-earning assets.
- 26 -
The following table presents the changes in interest income and expense for each major category of interest-earning assets and interest-bearing liabilities and the amount of change attributable to volume and rate changes for the years indicated. Changes not solely attributable to rate or volume have been allocated to volume and rate changes in proportion to the relationship of absolute dollar amounts of the changes in each.
(1)
Non-accrual loans, if any, are included in average loan balances.
(2)
Change in interest income from non-taxable loans and investment securities is computed based on interest income determined on a taxable equivalent yield basis. Interest income has been divided by a factor comprised of the complement of the incremental tax rate of 34%.
- 27 -
2004 vs. 2003. Tax equivalent interest income decreased $1,873,000 primarily due to a 33 basis point (a basis point equals 0.01%) decline in the average rate earned on average interest-earning assets. The average rate earned decreased primarily because of continued historically low market rates.
Interest expense decreased $1,312,000 primarily due to a 28 basis point decrease in the average rate paid for deposits and borrowings and secondarily due to an $11.8 million decrease in average interest-bearing liabilities. The decrease in average rates paid was also due to general market rates. The decrease in average interest-bearing liabilities was due to a $9.8 million decrease in average NOW and money fund deposits, a $3.0 million decrease in average IRA and time certificates, and a $2.1 million decrease in average long-term borrowings. Comparing the same periods, average savings deposits increased approximately $3.1 million. The decrease in NOW and money fund deposits is primarily due to a new trust account that was obtained near year end, 2003. Approximately $15.5 million of the trust funds were temporarily deposited in a liquid account at LCNB until the trust department could invest them in other instruments during early 2004. Management believes that, in the current economic rate environment, investors are showing a preference for highly liquid short-term instruments. This means much of the growth in savings deposits during the past several years could be quickly withdrawn if interest rates increase. Management is attempting to lock-in a portion of these funds by offering special rates and terms on selected certificate of deposit products.
Average long-term borrowings decreased primarily due to the maturation and payment in December, 2003 of a $2.0 million Federal Home Loan Bank ("FHLB") note bearing an interest rate of 3.61%. An additional $2.0 million FHLB note bearing a 4.40% rate matured in December, 2004.
The net interest margin decreased from 4.09% during 2003 to 4.02% during 2004 primarily because of the 33 basis point decrease in average rates earned from interest- earning assets, partially offset by the 28 basis point decrease in average rates for interest bearing liabilities.
2003 vs. 2002. Tax equivalent interest income decreased $2,597,000 primarily due to an 81 basis point decline in the average rate earned on average interest-earning assets, partially offset by a $19.3 million increase in average interest-earning assets. The increase in average interest-earning assets was due to increases in the investment securities portfolio, which grew $31.5 million on an average basis. The average rate earned decreased primarily because of continued general market wide decreases in interest rates.
Interest expense decreased $1,990,000 because of a 57 basis point decrease in the average rate paid for deposits and borrowings, partially offset by a $9.9 million increase in average interest-bearing liabilities. The decrease in average rates paid was also due to the general decline in market rates discussed above. The increase in average interest-bearing liabilities was in average savings deposits, which increased $11.1 million, and in average NOW and money fund deposits, which increased $10.7 million. IRA and time certificates decreased $8.0 million and long term borrowings decreased $3.6 million.
Average long-term borrowings decreased primarily due to the early payoff in August, 2002 of $4.0 million in FHLB notes with an average interest rate of 7.72%, which otherwise would have been due in June, 2004 and June, 2005. The prepayment fees on the early payoffs totaled approximately $425,000, which is included in other non-interest expenses in the 2002 consolidated statements of income.
- 28 -
To negate the financial impact of the prepayment fees, LCNB sold $17.7 million of U.S. Agency securities bearing an average coupon rate of 5.24% during August, 2002 and recorded a gain of $408,000 from the sales. At approximately the same time as the sales, LCNB purchased securities totaling $19.9 million and bearing an average tax-equivalent coupon rate (some of the securities purchased were tax-exempt municipals) of 4.94%. The transactions described were consummated to minimize the anticipated decline in net interest margin.
The net interest margin decreased from 4.39% during 2002 to 4.09% during 2003 primarily because of the 81 basis point decrease in average rates earned from interest- earning assets, partially offset by the 57 basis point decrease in average rates for interest bearing liabilities.
Provisions and Allowance for Loan Losses
The provision for loan losses is determined by management based upon it's evaluation of the amount needed to maintain the allowance for loan losses at a level considered appropriate in relation to the estimated risk of losses inherent in the portfolio. In addition to historic charge-off percentages, factors taken into consideration to determine the adequacy of the allowance for loan losses include the nature, volume and consistency of the loan portfolio, overall portfolio quality, a review of specific problem loans, and current economic conditions that may affect borrowers’ ability to pay. The following table presents the total loan provision and the other changes in the allowance for loan losses for the years 2000 through 2004.
- 29 -
The commercial and industrial loan charge-off of $126,000 during 2004 is due to one company that had filed bankruptcy. Consumer loan charge-offs included $41,000 during 2004 and and $25,000 during 2003 that were due to a yacht that was subsequently repossessed and sold in 2004. The balance of increased consumer loan charge-offs during 2004 and 2003 are due to a greater number of troubled loans.
- 30 -
Non-Interest Income
2004 vs. 2003. Total non-interest income for 2004 was $862,000 or 12.7% more than for 2003. The increase was primarily due to gains from the sales of investment securities and LCNB’s credit card portfolio and increases in trust income and service charges and fees. These increases were partially offset by decreases in insurance agency income and gains from sales of mortgage loans.
Trust income increased $236,000 primarily due to an increase in the market value of assets under management, on which fees are based, and secondarily to fees received for brokerage services, a new service first offered in April, 2002. The market value of trust assets under management grew $14.6 million or 8.8% during 2004, partially due to increased market values and partially due to new clients. During the same period, brokerage accounts managed grew $11.2 million or 82.4%.
Service charges and fees increased $710,000 primarily due to the introduction of a new overdraft protection program in August, 2003.
The net gain on sales of securities increased $297,000. LCNB sold $36.0 million in securities available for sale during 2004 as compared with $1.8 million in sales during 2003. The proceeds from the 2004 sales were primarily used to purchase securities with slightly longer maturities and higher average interest rates than the ones sold and to fund loan growth.
Insurance agency income decreased $105,000 primarily due to a decrease in contingency commissions recognized by Dakin during 2004 as compared to 2003. Contingency commissions are profit-sharing arrangements on property and casualty policies between the originating agency and the underwriter and are generally based on underwriting results and written premium. As such, the amount received each year can vary significantly depending on loss experience. The decrease in contingency commissions was partially offset by an increase in sales commissions, primarily due to the placement of new policies. Total written premium produced by Dakin for 2004 totaled $8,806,000, which was $296,000 or 3.5% greater than for 2003.
Gains from sales of mortgage loans decreased $706,000 due to decreased activity in the real estate mortgage loan secondary market during 2004 as compared to 2003. Loans sold during 2004 totaled $2.2 million, compared with $35.1 million for 2003. Historically low residential mortgage rates during 2002 and 2003 created a surge in refinancing activity. During this period, LCNB sold most fixed-rate residential mortgage loans originated to the Federal Home Loan Mortgage Corporation. Market rates for real estate mortgage loans began increasing during the fourth quarter, 2003 and the volume of refinance activity decreased. Along with the decrease in refinancing activity, LCNB added most loans that were originated during 2004 to its loan portfolio, resulting in minimal loan sales.
During 2004, LCNB exited the credit card market and sold its receivables to MBNA America Bank, N.A. (“MBNA”), recognizing a $403,000 gain from the sale. LCNB management decided to exit the credit card market because of the high administrative costs of servicing a small portfolio. LCNB will continue to offer credit card products under a marketing agreement with MBNA.
- 31 -
2003 vs. 2002. Total non-interest income for 2003 was $1,174,000 or 20.9% more than for 2002. Trust income increased $163,000 due to an increase in the market value of assets under management, on which fees are based, and to fees received for brokerage services. The market value of trust assets under management grew $46.2 million or 38.8% during 2003, partially due to increased market values and partially due to new clients. During the same period, brokerage accounts managed grew $10.0 million or 274.06%.
Service charges and fees increased $605,000 primarily due to the introduction of a new overdraft protection program in August, 2003 and to an increase in non-sufficient fund check fees initiated in November, 2002.
Insurance agency income increased $300,000 primarily due to an increase in the volume of policies written and secondarily to an $83,000 increase in contingency commissions recognized. The increase in policies written was partially due to the purchase on September 1, 2002, of substantially all of the insurance renewal rights and client list of an insurance agency located in Dayton, Ohio. As part of the purchase, Dakin will receive all commission income received after September 1, 2002, and assignments of agency agreements that the agency has with insurers with whom Dakin does not already have an agreement. In consideration for the assets purchased, Dakin will pay to the seller certain percentages of the commissions received from the agency's customer base over a four-year period.
Historically low interest rates during 2003 created an increase in residential mortgage loan refinancing activity, providing LCNB with the opportunity to sell approximately $35.1 million of residential fixed-rate mortgage loans in the secondary market. Gains booked on these sales totaled $758,000. During 2002 LCNB sold $20.9 million in loans and recognized $235,000 in gains from the sales.
Offsetting the increases described above was a $420,000 decrease in net gain on sales of securities. Most of the decrease relates to a $408,000 gain recognized in August, 2002 and more fully described in a previous section of this document titled "Net Interest Income, 2003 vs. 2002."
Non-Interest Expense
2004 vs. 2003. Total non-interest expense increased $679,000 or 4.3% during 2004 compared with 2003. Contributing to the increase were a $147,000 or 2.2% increase in salaries and wages, a $138,000 or 7.9% increase in pension and other employee benefits, and a $197,000 or 6.9% increase in other non-interest expense.
Salaries and wages increased due to normal pay increases. Pension and other employee benefits increased primarily due to increased pension expense and an increase in payroll-related taxes and other employee benefits. Items contributing to the increase in other non-interest expenses included increased outside services, increased professional expenses, and increased telephone expenses.
2003 vs. 2002. Total non-interest expense increased $20,000 or 0.1% during 2003 compared with 2002. Contributing to the increase were a $277,000 or 4.2% increase in salaries and wages, a $144,000 or 16.4% increase in equipment expenses, an $86,000 or 8.4% increase in occupancy expense, and a $124,000 or 51.7% increase in computer costs. Offsetting the increases were a $120,000 or 29.1% decrease in ATM expense and a $541,000 or 16.0% decrease in other non-interest expenses.
- 32 -
Salaries and wages increased due to normal pay increases. Equipment expenses increased primarily due to rental costs for a new phone system installed during 2002 and to depreciation charges on new furniture purchased during 2003 and computer hardware and software purchased as part of the conversion to a new data processing system that occurred during September, 2002. Contributing to the increase in computer costs were the increased number and cost of maintenance contracts required by the new data processing system.
ATM expense decreased primarily due to a change in the ATM transaction processor. The decrease in other non-interest expenses was primarily due to the absence during 2003 of a $425,000 prepayment fee on Federal Home Loan Bank notes recognized during 2002 and previously discussed in the section titled "Net Interest Income, 2003 vs. 2002" and the absence during 2003 of a $263,000 charge for training and conversion expenses related to Lebanon Citizen's conversion to a new data processing system in September, 2002.
Income Taxes
LCNB's effective tax rates for the years ended December 31, 2004, 2003, and 2002 were 27.08%, 26.54%, and 27.84%, respectively. The difference between the statutory rate of 34.00% and the effective tax rate is primarily due to tax-exempt interest income.
Assets
Securities available for sale decreased approximately $37.5 million or 24.8%, which supported an increase in the loan portfolio of $18.8 million or 5.9% and a $9.8 million or 43.2% increase in federal funds sold. In addition, $10.0 million was used to purchase bank owned life insurance in December, 2004, which is included in other assets in the consolidated balance sheet.
Most of the growth in the loan portfolio was in the residential real estate loan category, which increased $20.0 million. During 2004, sales of residential real estate loans in the secondary market were minimal and most loans originated were added to the portfolio. Commercial and industrial loans grew $2.4 million and commercial loans secured by real estate grew $7.7 million. Partially offsetting the growth in residential and commercial loans were an $8.6 million decrease in consumer loans and a $2.7 million decrease in credit card loans due to the sale of the credit card portfolio during 2004.
Net premises and equipment increased due to additions during 2004 totaling $1,306,000. This increase was partially offset by depreciation expense of $1,080,000. The additions were primarily due to a major renovation of the Main Office’s second and third floors and the purchase of new furniture for the renovated areas.
- 33 -
Deposits
Total deposits grew $867,000 during 2004, with noninterest-bearing deposits growing $7,258,000 and interest-bearing deposits declining $6,391,000. Savings deposits grew $1,696,000 and IRA and time certificates grew $8,475,000, while NOW and money fund deposits declined $16,562,000. The decrease in NOW and money fund deposits is primarily due to a new trust account that was obtained near year end, 2003. Approximately $15.5 million of the trust funds were temporarily deposited in a liquid account at LCNB until the trust department could invest them in other instruments during early 2004.
Liquidity
Liquidity is the ability to have funds available at all times to meet the commitments of LCNB. These commitments may include paying dividends to shareholders, funding new loans for borrowers, funding withdrawals by depositors, paying general and administrative expenses, and funding capital expenditures. Sources of liquidity include growth in deposits, principal payments received on loans, proceeds from the sale of loans, the sale or maturation of investment securities, cash generated by operating activities, and the ability to borrow funds. Management closely monitors the level of liquid assets available to meet ongoing funding requirements. It is management's intent to maintain adequate liquidity so that sufficient funds are readily available at a reasonable cost. LCNB experienced no liquidity or operational problems during the past year as a result of current liquidity levels.
Commitments to extend credit at December 31, 2004, totaled $68.2 million and standby letters of credit totaled $6.2 million and are more fully described in Note 10 to LCNB's Financial Statements. Since many commitments to extend credit may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
Capital expenditures may include the construction or acquisition of new office buildings, improvements to LCNB's twenty offices, purchases of furniture and equipment, and additions or improvements to LCNB’s information technology system. Material commitments for capital expenditures outstanding as of December 31, 2004 totaled approximately $835,000.
The liquidity of LCNB is enhanced by the fact that 86.4% of total deposits at December 31, 2004, were "core" deposits. Core deposits, for this purpose, are defined as total deposits less public funds and certificates of deposit greater than $100,000.
An additional source of funding is borrowings from the Federal Home Loan Bank ("FHLB"). Total borrowings from the FHLB at December 31, 2004 were $2.0 million. The total remaining borrowing capacity from the FHLB at that date was approximately $79 million.
Liquid assets include cash, federal funds sold and securities available for sale. Except for investments in the stock of the Federal Reserve Bank and FHLB, all of LCNB's investment portfolio is classified as "available for sale" and can be readily sold to meet liquidity needs. At December 31, 2004, LCNB's liquid assets amounted to $156.6 million or 30.0% of total gross assets, down from $185.3 million or 35.4% of total gross assets at December 31, 2003. The primary reason for the decrease was a reduction in securities available for sale.
- 34 -
The following table provides information concerning LCNB's contractual obligations at December 31, 2004:
The following table provides information concerning LCNB's commercial commitments at December 31, 2004:
- 35 -
Capital Resources
LCNB and Lebanon Citizens National Bank (the “Bank”) are required by banking regulators to meet certain minimum levels of capital adequacy. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on LCNB's and the Bank's financial statements. These minimum levels are expressed in the form of certain ratios. Capital is separated into Tier 1 capital (essentially shareholders' equity less goodwill and other intangibles) and Tier 2 capital (essentially the allowance for loan losses limited to 1.25% of risk-weighted assets). The first two ratios, which are based on the degree of credit risk in the Bank's assets, provide for weighting assets based on assigned risk factors and include off-balance sheet items such as loan commitments and stand-by letters of credit. The ratio of Tier 1 capital to risk-weighted assets must be at least 4.00% and the ratio of Total capital (Tier 1 capital plus Tier 2 capital) to risk-weighted assets must be at least 8.00%. The capital leverage ratio supplements the risk-based capital guidelines. Banks are required to maintain a minimum ratio of Tier 1 capital to adjusted quarterly average total assets of 3.00%. A table summarizing the regulatory capital of LCNB and the Bank at December 31, 2004 and 2003, is included in Note 13, "Regulatory Matters", of the 2004 Annual Report to Shareholders.
The FDIC, the insurer of deposits in financial institutions, has adopted a risk-based insurance premium system based in part on an institution's capital adequacy. Under this system, a depository institution is required to pay successively higher premiums depending on its capital levels and its supervisory rating by its primary regulator. It is management's intention to maintain sufficient capital to permit the Bank to maintain a "well capitalized" designation (the FDIC's highest rating).
On April 17, 2001, LCNB's Board of Directors authorized three separate stock repurchase programs, two phases of which continue. The shares purchased will be held for future corporate purposes.
Under the "Market Repurchase Program" LCNB will purchase up to 100,000 shares of its stock through market transactions with a selected stockbroker. Through December 31, 2004, 62,531 shares had been purchased under this program.
The "Private Sale Repurchase Program" is available to shareholders who wish to sell large blocks of stock at one time. Because LCNB's stock is not widely traded, a shareholder releasing large blocks may not be able to readily sell all shares through normal procedures. Purchases of blocks will be considered on a case-by-case basis and will be made at prevailing market prices. A total of 160,144 shares had been purchased under this program at December 31, 2004.
LCNB established an Ownership Incentive Plan during 2002 that allows for stock-based awards to eligible employees. The awards may be in the form of stock options, share awards, and/or appreciation rights. The plan provides for the issuance of up to 100,000 shares. No awards were granted during 2002. Stock options for 4,054 and 5,528 shares were granted to key executive officers of LCNB during the first quarters of 2004 and 2003, respectively.
The exercise price for stock options granted shall not be less than the fair market value of the stock on the date of grant. Options vest ratably over a five-year period and the maximum term for each grant will be specified by the Board of Directors, but cannot be greater than ten years from the date of grant. In the event of an optionee's death, incapacity, or retirement, all outstanding options held by that optionee shall immediately vest and be exercisable.
- 36 -
Critical Accounting Policies
Allowance for Loan Losses. The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely. The allowance is an amount that management believes will be adequate to absorb possible losses on loans that may become uncollectible, based on evaluations of the collectibility of loans and prior loan loss experience. The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrowers' ability to pay.
The allowance consists of specific, general, and unallocated components. The specific component relates to loans that are classified as either doubtful, substandard, or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows or collateral value or observable market price of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
Loans are considered impaired when management believes, based on current information and events, it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans are measured by the present value of expected future cash flows using the loan's effective interest rate. Impaired collateral-dependent loans may be measured based on collateral value. Smaller-balance homogenous loans, including residential mortgage and consumer installment loans, are collectively evaluated for impairment.
Based on its evaluations, management believes that the allowance for loan losses will be able to absorb estimated losses inherent in the current loan portfolio.
Accounting for Intangibles. Approximately $1.9 million of LCNB's intangible assets at December 31, 2004, represent the unamortized intangible related to LCNB's 1997 acquisition of three branch offices from another bank. Management does not believe this acquisition meets the definition of a business combination, as described in SFAS No. 147, Acquisitions of Certain Financial Institutions, and is amortizing the intangible over ten years, subject to periodic review for impairment in accordance with SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets.
Another $260,000 of LCNB's intangible assets at December 31, 2004 is comprised of mortgage servicing rights recorded from sales of mortgage loans to the Federal Home Loan Mortgage Corporation ("FHLMC"). The rights are amortized to loan servicing income in proportion to and over the period of estimated servicing income, subject to periodic review for impairment.
- 37 -
Recent Accounting Pronouncements
SFAS No. 153, Exchanges of Nonmonetary Assets - an amendment of APB Opinion No. 29, was issued in December, 2004. It amends the guidance in Accounting Principles Board Opinion No. 29, Accounting for Nonmonetary Transactions, to eliminate an exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. Under SFAS No. 153, a nonmonetary exchange will have commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. This statement is not expected to have a material impact on LCNB’s financial statements.
SFAS No. 123 (revised 2004), Share-Based Payment, was issued in December, 2004 and replaces SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes APB No. 25, Accounting for Stock Issued to Employees. SFAS No. 123 (revised) focuses primarily on accounting for transactions where employees receive share-based compensation, but also covers transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of equity instruments. SFAS No. 123 (revised) generally requires an entity to recognize expense for the grant-date fair value of share-based compensation, where the original SFAS No. 123 encouraged but did not require an entity to recognize expense for such transactions. The estimated cost of share-based compensation is to be recognized over the period during which an employee is required to provide service in exchange for the award, usually the vesting period. SFAS No. 123 (revised) is effective for the first interim or annual reporting period that begins after June 15, 2005. LCNB will be required to adopt SFAS No. 123 (revised) no later than July 1, 2005. LCNB intends to adopt the provisions of SFAS No. 123 (revised) in the first quarter of 2005 using the modified prospective approach as allowed by SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of FASB Statement No. 123. Adoption of SFAS No. 123 (revised) is not expected to have a material short-term impact on LCNB’s financial statements because of its relatively limited use of options.
- 38 -
Other non-interest income for the three months ended March 31, 2004 includes the $403,000 gain from the sale of LCNB’s credit card portfolio.
- 39 -
Other non-interest income declined in the three months ended December 31, 2004 as compared to the three months ended December 31, 2003 primarily due to a decline in trust income and insurance agency contingency commissions. Contingency commissions are received from insurance underwriters on an annual basis, and the amount received can vary significantly depending on many general insurance industry related performance factors. No contingency commissions were awarded in the fourth quarter of 2004, compared with approximately $98,000 in the fourth quarter of 2003.
- 40 -
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Market risk for LCNB is primarily interest rate risk. LCNB attempts to mitigate this risk through asset/liability management strategies designed to decrease the vulnerability of its earnings to material and prolonged changes in interest rates. LCNB does not use derivatives such as interest rate swaps, caps or floors to hedge this risk. LCNB has not entered into any market risk instruments for trading purposes.
Interest Rate Sensitivity Gap Analysis
A traditional gap analysis provides a point-in-time measurement of the relationship between the amounts of interest rate sensitive assets and liabilities in a given time period. An asset or liability is interest rate sensitive within a specific time period if it will mature or reprice within that time period. If liabilities mature or reprice more quickly or to a greater extent than assets, net interest income would tend to decrease during periods of rising interest rates but increase during periods of falling interest rates. Conversely, if liabilities mature or reprice more slowly or to a lesser extent than assets, net interest income would tend to increase during periods of rising interest rates but decrease during periods of falling interest rates.
The following table reflects LCNB's gap analysis at December 31, 2004. The amounts reported in the table are the principal cash flows of rate sensitive assets and liabilities by expected maturity or repricing timeframe. Also presented is the related weighted average interest rate. Fixed rate real estate mortgage loans and mortgage-backed securities are allocated to the various maturity/repricing periods based on contractual maturities adjusted for expected prepayments under the current market interest rate environment. Deposit liabilities without contractual maturities such as NOW and savings accounts are allocated to the various repricing periods based on an analysis of forecasted account run-off that takes into consideration the relatively stable nature of these core deposits. The gap analysis indicates that LCNB's earnings are sensitive to the repricing of assets in the first year and the second through the fifth years.
- 41 -
Ratio of rate sensitive assets to rate sensitive liabilities:
First twelve months
150.23%
Years two through five
137.30%
Thereafter
76.02%
(1)
Exclude adjustments for allowance for loan losses.
(2)
At amortized cost.
(3)
Rates for tax-exempt securities are adjusted to a taxable equivalent rate.
- 42 -
Interest Rate Sensitivity and Economic Value of Equity Analyses
The Bank's Asset and Liability Management Committee ("ALCO") primarily uses a combination of Interest Rate Sensitivity Analysis (IRSA) and Economic Value of Equity (EVE) analysis for measuring and managing interest rate risk. The IRSA model is used to estimate the effect on net interest income during a one-year period of instantaneous and sustained movements in interest rates, also called interest rate shocks, of 100, 200, and 300 basis points. The base projection uses a current interest rate scenario. As shown below, the December 31, 2004 IRSA indicates that an increase in interest rates would have a positive effect on net interest income, and a decrease in rates would have a negative effect on net interest income. The changes in net interest income for the up and down 100 and 200 rate assumptions are within LCNB’s acceptable ranges. The changes in net interest income for up and down 300 basis points are slightly outside LCNB’s policy range of a 10% change, but management has determined the changes are acceptable in the current economic environment.
Rate Shock Scenario in Basis Points
Amount
$ Change in IRSA
% Change in IRSA
Up 300
$
20,319
1,902
10.33%
Up 200
19,700
1,283
6.97%
Up 100
19,097
3.69%
Base
18,417
-
-%
Down 100
17,660
(757)
-4.11%
Down 200
17,005
(1,412)
-7.67%
Down 300
16,467
(1,950)
-10.59%
IRSA shows the affect on net interest income during a one-year period only. A more long-range model is the EVE analysis, which shows the estimated present value of future cash inflows from interest-earning assets less the present value of future cash outflows for interest-bearing liabilities for the same rate shocks. The EVE analysis at December 31, 2004 is shown below. The changes in the economic value of equity for these rate assumptions are within LCNB’s acceptable ranges.
Rate Shock Scenario in Basis Points
Amount
$ Change in EVE
% Change in EVE
Up 300
$
74,232
(2,332)
-3.05%
Up 200
76,321
(243)
-0.32%
Up 100
77,658
1,094
1.43%
Base
76,564
-
-%
Down 100
73,064
(3,500)
-4.57%
Down 200
67,347
(9,217)
-12.04%
Down300
64,728
(11,836)
-15.46%
The IRSA and EVE simulations discussed above are not projections of future income or equity and should not be relied on as being indicative of future operating results. Assumptions used, including the nature and timing of interest rate levels, yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, and reinvestment or replacement of asset and liability cash flows, are inherently uncertain and, as a result, the models cannot precisely measure future net interest income or equity. Furthermore, the models do not reflect actions that borrowers, depositors, and management may take in response to changing economic conditions and interest rate levels.
- 43 -
Item 8.
Item 8. Financial Statements and Supplementary Data
The Financial Statements and Supplementary Data required by this item are incorporated herein by reference to pages 4 through 31 of the Registrants 2004 LCNB Corp. Annual Report attached to this filing as Exhibit 13.
Item 9.
Item 9. Disagreements with Accountants on Accounting and Financial Disclosures
None
- 44 -
Item 9A.
Item 9A. Controls and Procedures
REPORT ON MANAGEMENT’S ASSESSMENT OF
INTERNAL CONTROL OVER FINANCIAL REPORTING
LCNB Corp. ("LCNB") is responsible for the preparation, integrity, and fair presentation of the consolidated financial statements included in this annual report. Management of LCNB and its subsidiaries is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). LCNB’s internal control over financial reporting is a process designed under the supervision of LCNB’s Chief Executive Officer and the Chief Financial Officer. The purpose is to provide reasonable assurance to the Board of Directors regarding the reliability of financial reporting and the preparation of LCNB’s financial statements for external purposes in accordance with U.S. generally accepted accounting principles.
Management maintains internal controls over financial reporting. The internal controls contain control processes and actions are taken to correct deficiencies as they are identified. The internal controls are evaluated on an ongoing basis by LCNB’s Management, and Audit Committee. Even effective internal controls, no matter how well designed, have inherent limitations - including the possibility of circumvention or overriding of controls - and therefore can provide only reasonable assurance with respect to financial statement preparation. Also, because of changes in conditions, internal control effectiveness may vary over time.
Management assessed LCNB’s internal controls as of December 31, 2004, in relation to criteria for effective internal control over financial reporting described in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on this assessment, management believes that, as of December 31, 2004, LCNB’s internal control over financial reporting met the criteria.
J.D. Cloud & Co. L.L. P., an independent registered public accounting firm, has issued an attestation report on management’s assessment of the effectiveness of LCNB’s internal control over financial reporting as of December 31, 2004.
Submitted by:
LCNB Corp.
/s/ Stephen P. Wilson __________
/s/ Steve P. Foster_____________
Stephen P. Wilson,
Steve P. Foster,
President/CEO
Chief Financial Officer
February 14, 2005
- 45 -
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
LCNB Corp. and subsidiaries
Lebanon, Ohio
We have audited management’s assessment, included in the accompanying Report on Management Assessment of Internal Control over Financial Reporting, that LCNB Corp. and subsidiaries (“LCNB”) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). LCNB’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
- 46 -
In our opinion, management’s assessment that LCNB maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets and the related consolidated statements of income, shareholders’ equity and cash flows of LCNB Corp. and subsidiaries, and our report dated February 14, 2005 expressed an unqualified opinion.
/s/ J.D. Cloud & Co. L.L.P.
Certified Public Accountant
Cincinnati, Ohio
February 14, 2005
Item 9B.
Item 9B. Other Information
None
- 47 -
PART III
Portions of the Proxy Statement included in the Notice of Annual Meeting of Shareholders to be held April 12, 2005, dated March 10, 2005, are incorporated by reference into Part III.
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information contained in the Notice of Annual Meeting of Shareholders and Proxy Statement (dated March 10, 2005), relating to "Directors and Executive Officers of the Registrant", is incorporated herein by reference.
Item 11.
Item 11. Executive Compensation
The information contained in the Notice of Annual Meeting of Shareholders and Proxy Statement (dated March 10, 2005), relating to "Compensation of Directors and Executive Officers", is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information contained in the Notice of Annual Meeting of Shareholders and Proxy Statement (dated March 10, 2005), relating to "Section 16(a) Beneficial Ownership Reporting Compliance" is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information contained in the Notice of Annual Meeting of Shareholders and Proxy Statement (dated March 10, 2005), relating to "Certain Relationships and Related Transactions", is incorporated herein by reference.
Item 14.
Item 14. Principal Accounting Fees and Services
The information contained in the Notice of Annual Meeting of Shareholders and Proxy Statement (dated March 10, 2005), relating to "Principal Accounting Fees and Services", is incorporated herein by reference.
- 48 -
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(1)
Incorporated by reference to Registrant's 1999 Form 10-K, Exhibit 3.1.
(2)
Incorporated by reference to Registrant's Registration Statement on Form S-4, Exhibit 3.2, Registration No. 333-70913
(3)
Incorporated by reference to Registrant's Form DEF 14A Proxy Statement pursuant to Section 14(a), dated March 15, 2002, Exhibit A.
(4)
Incorporated by reference to Registrant’s 2003 Form 10-K, Exhibit 14.1.
(5)
Incorporated by reference to Registrant’s 2003 Form 10-K, Exhibit 14.2
- 49 -
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
LCNB Corp.
(Registrant)
/s/Stephen P. Wilson
President and Chairman of Board
of Directors
February 28, 2005
Pursuant to the requirements of the Securities Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated:
/s/Stephen P. Wilson
/s/George L. Leasure
Stephen P. Wilson
President and Chairman
(Principal Executive Officer)
February 28, 2005
George L. Leasure
Director
February 28, 2005
/s/Steve P. Foster
/s/James B. Miller
Stephen P. Foster
Executive Vice President and
Chief Financial Officer
(Principal Financial and
Accounting Officer)
February 28, 2005
James B. Miller
Director
February 28, 2005
/s/David S. Beckett
/s/Joseph W. Schwarz
David S. Beckett
Director
February 28, 2005
Joseph W. Schwarz
Director
February 28, 2005
/s/Rick L. Blossom
/s/Kathleen Porter Stolle
Rick L. Blossom
Director
February 28, 2005
Kathleen Porter Stolle
Director
February 28, 2005
/s/Robert C. Cropper
/s/Howard E. Wilson
Robert C. Cropper
Director
February 28, 2005
Howard E. Wilson
Director
February 28, 2005
/s/William H. Kaufman
/s/Marvin E. Young
William H. Kaufman
Director
February 28, 2005
Marvin E. Young
Director
February 28, 2005
- 50 -