ITEM 1. BUSINESS
GENERAL
Chester Valley Bancorp Inc. (the "Holding Company") was incorporated in the Commonwealth of Pennsylvania in August 1989. The business of the Holding Company and its subsidiaries (collectively, the "Company") consists of the operations of First Financial Bank ("First Financial" or the "Bank"), a Pennsylvania-chartered commercial bank founded in 1922 as a savings association, and Philadelphia Corporation for Investment Services ("PCIS"), a full-service investment advisory and securities brokerage firm. Effective September 1, 2001, the Bank converted to a Pennsylvania-chartered commercial bank from a Pennsylvania-chartered savings association. As a consequence of such charter conversion, the Holding Company became a bank holding company that has also been designated as a financial holding company. Prior to such conversion, the Holding Company was a unitary thrift holding company. The Bank provides a wide range of banking services to individual and corporate customers through its twelve full-service branch offices located in Chester County, Pennsylvania. The Bank provides residential real estate, commercial real estate, commercial and consumer lending services, which are primarily funded by retail and business deposits as well as borrowings. PCIS is a registered broker/dealer in all 50 states and the District of Columbia and it is also registered as an investment advisor with the Commission. PCIS provides many additional services, including self-directed and managed retirement accounts, safekeeping, daily sweep money market funds, portfolio and estate valuations, life insurance and annuities, and margin accounts, to individuals and smaller corporate accounts. PCIS' offices are located in Wayne and Philadelphia, Pennsylvania.
References to the Company include its wholly owned subsidiaries, the Bank and PCIS, unless the context of the reference indicates otherwise.
First Financial Bank's customer deposits are insured to the maximum extent provided by law by the Federal Deposit Insurance Corporation ("FDIC") through the Savings Association Insurance Fund ("SAIF"). The Bank is subject to examination and comprehensive regulation by the FDIC and the Pennsylvania Department of Banking ("Department"). Prior to the Bank's conversion to a commercial bank, it was also subject to regulation and examination by the Office of Thrift Supervision ("OTS"). It is a member of the Federal Home Loan Bank of Pittsburgh ("FHLBP"), which is one of the 12 regional banks comprising the FHLB System. The Bank is further subject to regulations of the Board of Governors of the Federal Reserve System ("Federal Reserve Board") governing reserves to be maintained against deposits and certain other matters. The Holding Company, as a registered bank holding company, is subject to examination and regulation of the Federal Reserve Board.
MARKET AREA AND COMPETITION
The Bank's primary market area includes Chester County and sections of the four contiguous counties (Delaware, Montgomery, Berks, and Lancaster) in Pennsylvania. Chester County, in which all of the Bank's offices are located, continues to grow in terms of economic development and population growth. The segment of the market served by the Company from a business perspective is primarily industrially oriented and demographically is comprised of middle and upper income households.
COMPETITION
First Financial encounters strong competition both in the attraction of deposits and in the making of commercial, real estate and other loans. Its most direct competition for deposits has historically come from commercial banks, savings associations, savings banks and credit unions conducting business in its primary market area. The Bank also encounters competition for deposits from money market and other mutual funds, as well as corporate and government securities and insurance companies. The principal methods used by the Bank to attract deposit accounts include offering a variety of services, providing convenient office locations with expanded banking hours and offering extraordinary customer service and competitive interest rates. The Bank's primary competition for commercial, real estate and other loans, comes from other commercial banks, savings institutions, credit unions, mortgage banking companies, insurance companies, and other lenders. First Financial competes successfully for loans through competitive interest rates and maturities and loan fees as well as providing quality service to borrowers and real estate brokers.
PCIS is engaged in securities brokerage and asset management activities, both of which are extremely competitive businesses. Competitors include all of the member organizations of the New York Stock Exchange and other registered securities exchanges, all members of the National Association of Securities Dealers, Inc. (the "NASD"), commercial banks and savings associations, insurance companies, investment companies, and financial consultants. PCIS competes successfully against other firms through its' quality service, excellent reputation, successful track record and competitive pricing.
EMPLOYEES
The Company had 171 full-time employees and 26 part-time employees as of June 30, 2004. None of these employees are covered by a collective bargaining agreement and the Company believes that it enjoys good relations with its personnel.
LENDING ACTIVITIES
LOAN PORTFOLIO COMPOSITION
The Company's net loan portfolio (net of loans in process, deferred fees and allowance for loan losses), including loans held for sale, totaled $395.7 million at June 30, 2004 representing approximately 61.6% of the Company's total assets of $642.1 million at that date.
The following table presents information regarding the composition of the Company's loan portfolio at the dates indicated.
- --------------- (1) Includes construction loans for both residential and commercial real estate properties. (2) Consists primarily of loans secured by accounts receivable, inventory, equipment and general corporate assets. (3) Consists primarily of home equity loans and lines of credit, home improvement, automobile and other personal loans.
CONTRACTUAL MATURITIES
The following table sets forth the contractual principal repayments of the total loan portfolio, including loans in process, of the Company as of June 30, 2004, by categories of loans. Loans are included in the period in which they mature. Loans held for sale are not included.
The following table sets forth, as of June 30, 2004, the dollar amount of all loans contractually due after June 30, 2005, which have fixed interest rates and floating or adjustable rates.
CONTRACTUAL OBLIGATIONS DUE AFTER JUNE 30, 2005 ------------------------------------- FLOATING/ FIXED ADJUSTABLE RATES RATES TOTAL ------------------------------------- (In Thousands) Real estate loans: Residential $ 54,512 $ 8,703 $ 63,215 Commercial 23,835 86,504 110,339 Construction and land acquisition 2,374 22,126 24,500 Commercial business loans 11,642 1,544 13,186 Consumer loans 81,667 712 82,379 ------------------------------------- TOTAL LOANS $174,030 $119,589 $293,619 =====================================
Contractual principal repayments of loans do not necessarily reflect the actual term of the Company's loan portfolio. The average life of mortgage loans is substantially less than their contractual terms because of loan prepayments as well as the enforcement of due-on-sale clauses, which give the Company the right to declare a loan immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase, however, when current mortgage loan rates substantially exceed rates on existing mortgage loans and, conversely, decrease when rates on existing mortgage loans substantially exceed current mortgage loan rates.
ORIGINATION, PURCHASE AND SALE OF LOANS
Commercial, multi-family residential real estate and consumer loans are originated directly by the Bank through salaried loan officers. Salaried employees originated single-family residential real estate loans during part of fiscal 2002 but beginning in the second quarter of fiscal 2002, the Bank outsourced much of this function to a third party. (In February 2004, the Bank changed its third party processor to a Private Label platform, which provides the Bank with better control of its customer base to handle the originations, processing and sale of single-family residential real estate loans.) Substantially all of the residential real estate loans originated by the Bank using the third party processor are immediately sold and the Bank recognizes a gain or loss on the sale.
Prior to changing its method of originating single-family residential loans in 2002, the Bank had periodically identified certain loans as held for sale at the time of origination. These loans consisted primarily of fixed-rate, single-family residential mortgage loans. See "Loans Held for Sale" within Note - - 1 of Notes to the Consolidated Financial Statements set forth at Item 8 hereof.
LOAN PRODUCTS
The Bank offers a broad array of loan products with competitive terms and conditions to both individuals and to businesses. Prior to its' charter conversion to a commercial bank, loan activity had been primarily focused on the origination of mortgage loans collateralized by single-family residential properties. However, in recent years, the Bank has substantially expanded its involvement in commercial real estate and commercial business lending as part of its strategic shift, which shift culminated in the Bank's conversion to a commercial bank in September 2001. As a result of the changing composition of the Bank's loan portfolio, loans secured by single-family properties have declined as a percentage of the total loan portfolio from 46.8% at June 30, 2000 to 17.3% at June 30, 2004. Commercial real estate and commercial business loans in the aggregate increased from 22.7% to 44.5% at the same dates, respectively. The Bank has also continued to remain an active construction and land acquisition loan originator, with such loans accounting for 11.4% of the Bank's total loan portfolio as of June 30, 2004. In order to meet the wide-ranging needs of its customers, the Bank has also marketed aggressively a variety of consumer loans, including home equity loans and lines of credit.
Through its' outsourcing partnerships, the Bank originates residential real estate loans secured by properties located primarily in southeastern Pennsylvania. These loans are both fixed-rate and adjustable-rate loans with amortization periods up to 30 years.
The Bank provides a wide range of commercial lending products. These products include commercial business loans, commercial and multi-family real estate construction, residential development and land acquisition loans. Commercial real estate loans normally are secured by properties located in Chester County or the four counties contiguous to it. The majority of such loans bear adjustable interest rates with amortization terms of 20 years or less.
Commercial business loans are generally made to small and medium sized companies located in the Bank's primary market area. While the Bank does on occasion make unsecured commercial loans, generally these loans are on a secured basis and are collateralized by accounts receivable, inventory, equipment, and/or other general corporate assets of the borrowers. Commercial business loans are originated with both fixed and adjustable rates with the adjustable interest rates generally indexed to the national prime rate. These loans typically carry terms from one to five years.
The Bank's consumer loans are primarily loans to individuals originated through its branch network. The majority of its originations are home equity term and credit lines secured by a first or second mortgage on the primary residence of the borrower. Home equity credit lines are generally indexed to the national prime rate, while home equity term loans generally bear fixed interest rates and have terms of fifteen years or less. Home equity loans and lines of credit aggregated $100.8 million or 23.6% of the total loan portfolio at June 30, 2004.
REGULATORY REQUIREMENTS AND UNDERWRITING POLICIES
Under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA") and pursuant to the parity provisions of the Pennsylvania Banking Code of 1965 ("Banking Code"), the aggregate loans that the Company may make to any borrower and its affiliates is limited to 15% of unimpaired capital for unsecured loans and 25% of capital for loans secured by readily marketable collateral. At June 30, 2004, pursuant to such provisions, the Bank was permitted to extend credit to any one borrower totaling $9.8 million. At June 30, 2004, the Bank's largest loan or group of loans to one borrower, including related entities, aggregated $9.1 million, and is in conformity with the current loans to one borrower regulations described above.
The Bank is currently permitted to lend up to 100% of the appraised value of the real property securing a loan; however, if the amount of a single-family residential first mortgage loan exceeds 90% of the appraised value, the Bank is required by regulation to obtain private mortgage insurance on the portion of the principal amount of the loan that exceeds 80% of the appraised value of the security property. Pursuant to underwriting guidelines adopted by the Board of Directors, private mortgage insurance is normally obtained on all residential loans whose loan-to-value ratios exceed 80%. The Bank will generally lend up to 97% of the appraised value of one-to four-family owner-occupied residential dwellings when the required private mortgage insurance is obtained. The Bank generally originates loans of up to 80% of the appraised value of the properties securing its commercial real estate and commercial business loans and 80% of the appraised value upon completion or sale price, whichever is lower, for construction loans. With respect to construction loans for owner-occupied properties made in connection with the providing of the permanent financing, the Bank will lend up to 90% of the appraised value when the required private mortgage insurance is obtained.
LOAN FEE AND SERVICING INCOME
In addition to interest earned on loans, the Bank receives income through servicing of loans and fees in connection with loan originations, loan modifications, late payments, prepayments, repayments and changes of property ownership and for miscellaneous services related to its loans. Income from these activities varies from period to period with the volume and type of loans made. At June 30, 2004, the Bank was servicing $9.9 million of loans for others, of which $2.5 million consisted of whole loans sold by the Bank to Freddie Mac.
Loan origination fees and certain direct loan origination costs are deferred and amortized over the life of the related loans as an adjustment to the yield of such related loans. However, in the event the related loan is sold or repaid prior to maturity, any deferred loan fees or costs remaining with respect to such loan are taken into income.
NON-PERFORMING LOANS AND REAL ESTATE OWNED
If the delinquency on a mortgage loan exceeds 90 days and is not cured through the Bank's normal collection procedures, or an acceptable arrangement is not worked out with the borrower, the Bank will institute measures to remedy the default, including commencing a foreclosure action or, in special circumstances, accepting from the mortgagor a voluntary deed of the secured property in lieu of foreclosure. However, under Pennsylvania law, a lender is prohibited from accelerating the maturity of a residential mortgage loan, commencing any legal action (including foreclosure proceedings) to collect on such loan, or taking possession of any loan collateral until the lender has first provided the delinquent borrower with at least 30 days prior written notice specifying the nature of the delinquency and the borrower's right to correct such delinquency. This provision of Pennsylvania law, as well as others, may delay for several months the Bank's ability to foreclose upon residential loans secured by real estate located in the Commonwealth of Pennsylvania. In addition, the uniform Fannie Mae/Freddie Mac lending documents used by the Bank, as well as most other residential lenders in Pennsylvania, require notice and a right to cure similar to that provided under Pennsylvania law.
Non-accrual loans are loans on which the accrual of interest ceases when the collection of principal or interest payments is determined to be doubtful by management. It is the policy of the Bank to discontinue the accrual of interest when principal or interest payments are delinquent 90 days or more (unless the loan principal and interest are determined by management to be fully secured and in the process of collection), or earlier, if the financial condition of the borrower raises significant concern with regard to the ability of the borrower to service the debt in accordance with the current loan term. Interest income is not accrued until the financial condition and payment record of the borrower once again demonstrate the ability to service the debt. When a loan is placed on non-accrual status, previously accrued but unpaid interest is deducted from interest income.
If foreclosure is successful, and the Bank acquires the real estate, which is recorded as real estate owned ("REO") at the lower of carrying value or fair value less disposal cost and any write-down resulting there from is charged to the allowance for loan losses. Interest accrual ceases on the date of acquisition and all costs incurred in maintaining the property from that date forward are expensed. Costs incurred for the improvement or development of such property are capitalized to the extent they do not exceed the property's fair value. No loss reserves are maintained on REO and future write-downs for costs beyond the fair value are expensed.
For purposes of applying the measurement criteria for impaired loans, the Bank excludes large groups of smaller balance homogeneous loans, primarily consisting of residential real estate loans and consumer loans as well as commercial loans with balances of less than $100,000. For applicable loans, the Bank evaluates the need for impairment recognition when a loan becomes non-accrual or earlier if, based on management's assessment of the relevant facts and circumstances, it is probable that the Bank will be unable to collect all proceeds due according to the contractual terms of the loan agreement. At June 30, 2004, the Bank had $4.0 million in impaired loans as compared to $3.2 million at June 30, 2003. The Bank's policy for the recognition of interest income on impaired loans is the same as for non-accrual loans discussed above. Impaired loans or a portion thereof are charged off when the Bank determines that foreclosure is probable and the fair value less disposal costs of the collateral is less than the recorded investment of the impaired loan.
The following table sets forth information regarding non-accrual loans and REO held by the Bank at the dates indicated. The Bank did not have, at any of the dates presented any (i) loans 90 days or more delinquent as to principal or interest and on which interest is being accrued or (ii) loans classified as restructured troubled debt.
(1) We believe this non-GAAP disclosure is important as this particular loan had been originated prior to the current management of the Bank and we do not believe it is representative of the balance of the portfolio.
At June 30, 2004, non-accrual real estate loans included 8 residential mortgage loans aggregating $591,000, all secured by single-family residential properties as well as a single commercial real estate loan in the amount of $2.9 million. The Loan had not been repaid in accordance with its original maturity and has been extended by the Bank as the borrower attempts to work through its financial difficulties. The Borrower has recently received a commitment from the United States Department of Agriculture to guarantee a portion of the underlying real estate project and is in the process of negotiating a refinance of the project with an independent third party lender. Although the loan is current in the payment of interest as it has been due, since its origination in 1998, and the Bank has received interest prepaid through September 15, 2004, the loan was placed on non-accrual as principal was not repaid in accordance with the original stated maturity, as the borrower has encountered financial difficulties, the underlying real estate is outside the Bank's primary lending area and repayment is dependent upon factors not under the complete control of the borrower. Additionally, June 30, 2004 non-accrual loans include two commercial business loans aggregating $655,000 to a single borrower who has encountered financial difficulties but has continued to maintain the loans in a current status. Cash payments received are reducing the outstanding principal balance on the loans.
The total amount of non-performing loans was $4.2 million, $4.2 million and $944 thousand at June 30, 2004, 2003, and 2002, respectively. If these non-performing loans had been current in accordance with their original terms (or were not placed on non-accrual at the Bank's discretion) and had been outstanding throughout the respective periods, the gross amount of interest income for 2004, 2003, and 2002 that would have been recorded for these loans would have been $734 thousand, $451 thousand, and $195 thousand, respectively. Interest income on these non-performing loans included in income for 2004, 2003, and 2002 amounted to $107 thousand, $353 thousand, and $114 thousand, respectively.
ALLOWANCES FOR LOSSES ON LOANS AND CLASSIFIED LOANS
The allowance for loan losses is maintained at a level that represents management's best estimate of known and inherent losses, which are probable and reasonably determinable based upon an evaluation of the loan portfolio. Homogeneous portfolios of loans, which include residential mortgage, home equity and other consumer loans, are evaluated as a group. Commercial business loans greater than $100,000, commercial mortgage and construction loans are evaluated individually. Specific portions of the allowance are developed by analyzing individual loans for adequacy of collateral, cash flow and other risks unique to that particular loan. General portions of the allowance are developed by grading individual loans in the commercial and construction portfolios and applying loss factors by grade. The general portion of the allowance also includes loss factors applied to the homogeneous portfolios as a group. The loss factors applied to graded loans were developed based on the Company's loss history for loans with similar attributes, local and national economic conditions, as well as input from the Company's primary banking regulators. Loss factors are applied to homogeneous loans based upon prior loss experience of the portfolio, delinquency trends, local and national economic conditions and the volume of non-performing loans. Although management believes it has used the best information available to it in making such determinations, and that the present allowance for loan losses is adequate, future adjustments to the allowance may be necessary, and net income may be adversely affected if circumstances differ substantially from the assumptions used in determining the level of the allowance. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for losses on loans. Such agencies may require the Bank to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. The allowance is increased by the provision for loan losses, which is charged to operations. Loan losses, other than those incurred on loans held for sale, are charged directly against the allowance and recoveries on previously charged-off loans are added to the allowance.
For purposes of applying the measurement criteria for impaired loans, the Company excludes large groups of smaller balance homogeneous loans, primarily consisting of residential real estate loans and consumer loans as well as commercial business loans with balances of less than $100,000. For applicable loans, the Company evaluates the need for impairment recognition when a loan becomes non-accrual or earlier if, based on management's assessment of the relevant facts and circumstances, it is probable that the Company will be unable to collect all proceeds under the contractual terms of the loan agreement. At June 30, 2004, the recorded investment in impaired loans was $4.0 million as compared to $3.2 million at June 30, 2003. The increase is due primarily to the above noted two commercial business loans to the single borrower. The Company's policy for the recognition of interest income on impaired loans is the same as for non-accrual loans. A portion of an impaired loan is charged off when the Company determines that foreclosure is probable and the fair value of the collateral is less than the recorded investment of the impaired loan.
At June 30, 2004, the Bank's allowance for loan losses was $6.3 million or 1.60% of total net loans receivable and 150.4% of total non-performing loans compared to $5.4 million or 1.41% of net loans receivable and 129.3% of total non-performing loans at June 30, 2003. The following table summarizes activity in the Company's allowance for loan losses during the periods indicated.
The following table presents information regarding the Bank's total allowance for losses on loans as well as the allocation of such amounts to the various categories of the loan portfolio.
- ----------------------- (1)See Table on Page 8 for reconciliation.
The Company monitors the quality of its loans on a regular basis and classifies them under a classification system that has three categories: (i) substandard, (ii) doubtful and (iii) loss. A loan may fall within more than one category and a portion of the asset may remain unclassified. The Company is required to review the classification of its loans on a regular basis. In addition, in connection with the examinations of First Financial by the FDIC and the Department, the examiners have the authority to identify problem loans and, if appropriate, classify them and/or require adjustments to the carrying value of such assets.
Loans classified substandard are considered inadequately protected by the current net worth and paying capacity of the obligor or the value of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses. They are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected.
Loans classified doubtful are considered to have all the weaknesses inherent in those classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Loans classified loss are considered uncollectable and of such little value that their continuance as assets is not warranted. After charging off a loan, the Company continues its efforts to obtain a recovery on the loan.
At June 30, 2004, the Company's classified loans, which consisted of loans classified as substandard or doubtful, totaled $10.7 million as compared to $15.3 million at June 30, 2003. Included in the loans classified substandard at June 30, 2004 and June 30, 2003 were all loans 90 days past due, loans which are less than 90 days delinquent but inadequately protected by the current paying capacity of the borrower or of the collateral pledged, and loans which have a well-defined weakness that may jeopardize the liquidation of the debt.
SECURITIES ACTIVITIES
Historically, interest and dividends on securities and interest-bearing deposits have provided the Company with a significant source of revenue. At June 30, 2004, the Company's securities portfolio and interest-bearing deposits aggregated $204.8 million or 31.9% of its total assets.
The Company divides its securities portfolio into three segments: (a) held to maturity; (b) available for sale; and (c) trading. Securities in the held to maturity category are accounted for at amortized cost. Trading securities are accounted for at quoted market prices with changes in market values being recorded as gain or loss in the statement of operations. All other securities are included in the available for sale category and are accounted for at fair value with unrealized gains or losses, net of taxes, being reflected as adjustments to equity. At June 30, 2004, the Company had a net unrealized loss on securities available for sale, net of taxes, of $2.0 million. The following table sets forth the Company's securities portfolio and interest-earning deposits at carrying value at the dates indicated.
(1) The trading account securities are being maintained at PCIS, which is a subsidiary of the Company. (2) The income from municipal notes and bonds is generally non-taxable for federal and state purposes.
The investment security portfolio is a significant tool in the Company's management of its' interest rate risk as well as serving as a secondary source for funding the liquidity needs of the Bank. In that regard, the Company attempts to maximize income within the portfolio while minimizing interest rate risk so that the portfolio is not subject to significant fluctuations in market value.
Included in investment securities available for sale at June 30, 2004 are three non-rated Pennsylvania Municipal Authority bonds that have been classified as substandard. These securities were originally purchased at various times during the period from June 1998 through June 2000. The aggregate book value of the bonds, after write-downs of $955 thousand is $5.6 million. Two of the three bonds with an aggregate book value of $4.9 million at June 30, 2004 are zero coupon bonds with maturities extending up to 2034. Both bonds are secured by the revenue streams of commercial office buildings, which are leased to various agencies of the Commonwealth of Pennsylvania under long-term lease arrangements with renewal options.
A third bond was issued by the Housing Authority of Chester County and has a book balance of $720 thousand at June 30, 2004 and bears interest at rates between 5.60% and 6.00% and matures in June 2019. This bond involves low-income scattered housing in Chester County under a program of the Office of Housing and Urban Development ("HUD"). HUD has committed to provide additional funds to build additional houses, which would be donated to this bond issue. The retirement of the bond issue is dependent upon proceeds from either the rental or sale of the existing and additional houses. This bond is on non-accrual at June 30, 2004.
These classified investments are closely monitored and fairly stated at June 30, 2004 based on available information. There can be no assurance that further subsequent adverse or positive developments may occur and thus could result in further adjustments to the carrying value of these investments.
The amortized cost and estimated fair value of investment securities at June 30, 2004, by contractual maturity, are shown below.
The weighted average yield, based on amortized cost, is presented on a taxable equivalent basis.
As of June 30, 2004, investments in the debt and/or equity securities of any one issuer (excluding U.S. Government and federal agencies) did not exceed 10% of the Company's stockholders' equity.
SOURCES OF FUNDS
GENERAL
Deposits obtained through branch offices have traditionally been the principal source of the Company's funds for use in lending and for other general business purposes. The Company also derives funds from amortization and prepayments of outstanding loans and investments and sales of loans. From time to time, the Company also may borrow funds from the FHLBP and other sources. Borrowings may be used to compensate for reductions in deposits or to support expanded lending and investment activities.
DEPOSITS
The Company obtains deposits primarily from residents of Chester County, and to a lesser extent Berks, Delaware, Lancaster and Montgomery Counties, Pennsylvania. Currently, the principal methods used by First Financial to attract deposit accounts include the offering of services and a wide variety of accounts, competitive interest rates, and convenient office locations and service hours. Other than during times of inverse or flat yield curves, the Bank has adopted a pricing program for its certificate accounts which provides for higher rates of interest on its longer term certificates in order to encourage depositors to invest in certificates with longer maturities, thus reducing the interest rate sensitivity of the Company's deposit portfolio. First Financial also offers a tiered money market account that pays higher interest on higher balances so as to maintain a relatively stable level of core deposits even when its certificate accounts mature.
The Bank's current deposit products include non-interest-bearing accounts, passbook/statement savings accounts, NOW checking accounts, money market deposit accounts, certificates of deposit ranging in terms from 30 days to seven years and certificates of deposit in denominations of $100,000 or more ("jumbo certificates"). Included among these deposit products are individual retirement account certificates ("IRA certificates") and Keogh accounts.
The following table shows the balances of the Company's deposits as of the dates indicated:
The following table shows the balances of certificates of deposit with balances of $100,000 or greater which mature during the periods indicated and the balance at June 30, 2004.
The following table presents the average balance by type of deposit and the average rate paid by type of deposit for the periods indicated.
First Financial's emphasis on core deposit growth (NOW, Savings and Money Market) has resulted in it becoming less dependent on higher costing certificates of deposit and the reduced threat of disintermediation (the flow of funds away from savings institutions into direct investment vehicles such as government and corporate securities). Like many financial institutions, First Financial is susceptible to short-term fluctuations in deposit flows, as customers have become more rate conscious and willing to move funds into higher-yielding accounts. Thus, First Financials ability to attract and maintain deposits, as well as its ability to control its cost of funds, will continue to be affected by economic conditions, the interest rate environment as well as competition from other financial institutions.
First Financial attempts to control the flow of deposits by pricing its accounts to remain generally competitive with other financial institutions in its primary market area, but does not necessarily seek to match the highest rates paid by competing institutions.
First Financial's deposits are obtained primarily from persons who are residents of Pennsylvania and, to a much lesser degree, from governmental entities. First Financial does not advertise for deposits outside of Pennsylvania nor has it to this point accepted brokered deposits. Management believes that at June 30, 2004, an insignificant amount of First Financial's deposits were held by non-residents of Pennsylvania.
BORROWINGS
First Financial may obtain advances from the FHLBP upon the security of the common stock it owns in that bank, its investment security portfolio as well as certain residential mortgage and other loans, provided they meet certain standards established by the FHLBP. See "Regulation - Regulation of the Bank - Federal Home Loan Bank System." Such advances are made pursuant to several different credit programs, with differing interest rates and maturities. FHLBP advances are generally available to meet withdrawals of deposit accounts, to fund expansion of lending and investment activities, as well as to aid the Bank in its asset and liability management. At June 30, 2004, the Company had $121.0 million in FHLBP advances outstanding. In addition, the Company has established a line of credit with the FHLBP at June 30, 2004 in the amount of $10 million, which is subject to certain conditions, including the holding of a predetermined amount of FHLBP stock as collateral. At June 30, 2004, there was no balance outstanding on the line of credit.
The following table presents certain information regarding short-term borrowings (borrowings with a maturity of one year or less) for the periods indicated:
YIELDS EARNED AND RATES PAID
The largest components of the Company's total income and total expense are interest income and interest expense. As a result, the Company's earnings are dependent primarily upon net interest income, which is determined by the Company's net interest rate spread (i.e., the difference between the yields earned on interest-earning assets and the rates paid on interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities.
INTEREST INCOME AND INTEREST SPREAD ANALYSIS
The following table sets forth, for the periods indicated, information regarding (1) the total dollar amount of interest income of the Company from interest-earning assets and the resultant average yields; (2) the total dollar amount of interest expense on interest-bearing liabilities and the resultant average cost; (3) net interest income; (4) interest rate spread; and (5) net interest-earning assets and their net yield. Average balances are determined on a daily basis, which is representative of operations.
- ---------------- (1) Non-accruing loans are included in the average balance. (2) The indicated interest and annual yield and rate are presented on a taxable equivalent basis using the Federal marginal income tax rate of 34% adjusted for the 20% interest expense disallowance (27.2%) for 2004, 2003, and 2002. The following details the tax equivalent adjustments in the above table:
RATE/VOLUME ANALYSIS
The following table presents certain information regarding changes in interest income and interest expense of the Company for the periods indicated. Interest income and the annual rate are calculated on a taxable equivalent basis using the Federal marginal income tax rate of 34% adjusted for the 20% interest expense disallowance (27.2%). For each category of interest-earning assets and interest-bearing liabilities, information is provided with respect to changes attributable to (1) changes in volume (change in volume multiplied by old rate), (2) changes in rate (change in rate multiplied by old volume) and (3) changes in rate/volume (change in rate multiplied by change in volume). The changes in rate/volume are allocated to the change in volume variance and the change in the rate variance on a pro rated basis.
RATIOS
The following table shows certain income and financial condition ratios for the periods indicated. All averages are based on month-end balances, which are representative of operations.
YEAR ENDED JUNE 30, ------------------------------------- 2004 2003 2002 ---------- ---------- ---------- Return on average assets (income divided by average total assets) 1.03% 0.90% 1.02% Return on average equity (income divided by average equity) 12.27% 11.25% 13.24% Equity-to-assets ratio (average equity divided by average assets) 8.42% 8.01% 7.69% Dividend pay-out ratio 31.52% 34.13% 30.65%
SUBSIDIARIES OF FIRST FINANCIAL
The Bank operates (as a wholly owned subsidiary) D & S Service Corporation ("D & S Service"), which has participated in the development for sale of residential properties, in particular condominium conversions, and also the development of commercial properties in order for the Bank to expand its facilities to accommodate its growth. All of such projects have either been located in or within close proximity to the Bank's primary market area. D & S Service operates two wholly owned subsidiaries: Wildman Projects and D & F Projects, Inc. As of June 30, 2004, the Bank had invested $1.8 million in D & S Service and its wholly owned subsidiaries. Additionally, the Bank has a second subsidiary, First Financial Investments, from which the Bank conducts retail investment service activities.
REGULATION
Set forth below is a brief description of certain laws and regulations that relate to the regulation of the Company, the Bank and PCIS in effect as of June 30, 2004. The description of these laws and regulations, as well as descriptions of laws and regulations contained elsewhere herein, do not purport to be complete and is qualified in its entirety by reference to applicable laws and regulations.
REGULATION OF THE HOLDING COMPANY
GENERAL
The Holding Company, as a bank holding company as a result of the conversion effective September 1, 2001 of the Bank from a Pennsylvania chartered thrift to a Pennsylvania-chartered commercial bank, is subject to regulation and supervision by the Federal Reserve Board. Under the Bank Holding Company Act ("BHCA"), a bank holding company is required to file annually with the Federal Reserve Board a report of its operations and, with its subsidiaries, is subject to examination by the Federal Reserve Board.
ACTIVITIES AND OTHER LIMITATIONS
The BHCA generally prohibits a bank holding company from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any bank, or increasing such ownership or control of any bank, without prior approval of the Federal Reserve Board. The Federal Reserve Board generally may approve an application by a bank holding company that is adequately capitalized and adequately managed to acquire control of, or to acquire all or substantially all of the assets of, a bank located in a state other than the home state of such bank holding company, without regard to whether such transaction is prohibited under the law of any state, provided, however, that the Federal Reserve Board may not approve any such application that would have the effect of permitting an out-of-state bank holding company to acquire a bank in a host state that has not been in existence for any minimum period of time, not to exceed five years, specified in the statutory law of the host state.
The BHCA also generally prohibits a bank holding company, with certain exceptions, from acquiring more than 5% of the voting shares of any company that is not a bank and from engaging in any business other than banking or managing or controlling banks. Under the BHCA, the Federal Reserve Board is authorized to approve the ownership of shares by a bank holding company in any company the activities of which the Federal Reserve Board had determined, by regulation or by order, to be so closely related to banking or to managing or controlling banks as to be a proper incident thereto as of November 11, 2000, the day before the date of enactment of the Gramm-Leach-Bliley Act, discussed below. In making such determinations, the Federal Reserve Board is required to weigh the expected benefit to the public, such as greater convenience, increased competition or gains in efficiency, against the possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices.
CAPITAL REQUIREMENTS
The Federal Reserve Board has issued risk-based and leverage capital guidelines applicable to bank holding companies. In addition, the Federal Reserve Board may from time to time require that a bank holding company maintain capital above the minimum levels, whether because of its financial condition or actual or anticipated growth. The Federal Reserve Board's risk-based guidelines define a three-tier capital framework. Tier 1 capital consists of common and qualifying preferred shareholders' equity, less certain intangibles and other adjustments. Tier 2 capital consists of preferred stock not qualifying as Tier 1 capital, subordinated and other qualifying debt, and the allowance for credit losses up to 1.25 percent of risk-weighted assets. Tier 3 capital includes subordinated debt that is unsecured, fully paid, has an original maturity of a least two years, is not redeemable before maturity without prior approval by the Federal Reserve Board and includes a lock-in clause precluding payment of either interest or principal if the payment would cause the issuing entity's risk-based capital ratio to fall or remain below the required minimum. The sum of Tier 1 and Tier 2 capital less investments in unconsolidated subsidiaries represents qualifying total capital, at least 50 percent of which must consist of Tier 1 capital. Risk-based capital ratios are calculated by dividing Tier 1 and total capital by risk-weighted assets. Assets and off-balance sheet exposures are assigned to one of four categories of risk-weights, based primarily on relative credit risk. The minimum Tier 1 capital ratio is 4 percent and the minimum total capital ratio is 8 percent. The leverage ratio is determined by dividing Tier 1 capital by adjusted average total assets. Although the stated minimum ratio is 3 percent, most banking organizations are required to maintain ratios of at least 100 to 200 basis points above 3 percent.
As of June 30, 2004, the Company's capital ratios exceeded applicable requirements. See Note 13 of the Consolidated Financial Statements included in Item 8 hereof.
AFFILIATED INSTITUTIONS
Under Federal Reserve Board policy, the Holding Company is expected to act as a source of financial strength to the Bank and to commit resources to support the Bank in circumstances when it might not do so absent such policy. The Federal Reserve Board takes the position that in implementing this policy it may require bank holding companies to provide such support when the holding company otherwise would not consider itself able to do so.
A bank holding company is a legal entity separate and distinct from its subsidiary bank. Normally, the major source of a holding company's revenue is dividends a holding company receives from its subsidiary bank. The right of a bank holding company to participate as a stockholder in any distribution of assets of its subsidiary bank upon its liquidation or reorganization or otherwise is subject to the prior claims of creditors of such subsidiary bank. The subsidiary bank is subject to claims by creditors for long-term and short-term debt obligations, including substantial obligations for federal funds purchased and securities sold under repurchase agreements, as well as deposit liabilities. Under FIRREA, in the event of a loss suffered by the FDIC in connection with a banking subsidiary of a bank holding company (whether due to a default or the provision of FDIC assistance), other banking subsidiaries of the holding company could be assessed for such loss.
Federal laws limit the transfer of funds by a subsidiary bank to its holding company in the form of loans or extensions of credit, investments or purchases of assets. Transfers of this kind are limited to 10% of a bank's capital and surplus with respect to each affiliate and to 20% in the aggregate, and are also subject to certain collateral requirements. These transactions, as well as other transactions between a subsidiary bank and its holding company, also must be on terms substantially the same as, or at least as favorable as, those prevailing at the time for comparable transactions with non-affiliated companies or, in the absence of comparable transactions, on terms or under circumstances, including credit standards, that would be offered to, or would apply to, non-affiliated companies.
In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51" ("FIN 46"). FIN 46 provided a new framework for identifying variable interest entities ("VIEs") and determining when a company should include the assets, liabilities, non-controlling interests and results of activities of a VIE in its consolidated financial statements. FIN 46 was effective immediately for VIEs created after January 31, 2003 and was effective beginning in the third quarter of 2003 for VIEs created prior to the issuance of the interpretation. The Company adopted the provisions of FIN 46 with no material impact on its financial condition or results of operations, earnings per share or cash flows. For information regarding an ongoing evaluation of the effects of FIN 46 on the treatment of capital securities issued by consolidated subsidiary trusts for regulatory purposes, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital."
FINANCIAL MODERNIZATION
Effective November 12, 1999, the Gramm-Leach-Bliley Act, permits bank holding companies to become financial holding companies and thereby affiliate with securities firms and insurance companies and engage in other activities that are financial in nature. A bank holding company may become a financial holding company if its subsidiary bank is "well capitalized" and "well managed," as defined, and has at least a satisfactory rating under the Community Reinvestment Act by filing a declaration that the bank holding company wishes to become a financial holding company. No regulatory approval is required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board.
The Gramm-Leach-Bliley Act defines "financial in nature" to include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Federal Reserve Board has determined to be closely related to banking. Subsidiary banks of a financial holding company must continue to be well capitalized and well managed in order to continue to engage in activities that are financial in nature without regulatory actions or restrictions, which could include divestiture of the financial in nature subsidiary or subsidiaries. In addition, a financial holding company or a bank may not acquire a company that is engaged in activities that are financial in nature unless each of the subsidiary banks of the financial holding company or the bank has a Community Reinvestment Act rating of satisfactory or better.
In connection with the Holding Company's application to become a bank holding company as a result of the conversion of the Bank to a Pennsylvania-chartered commercial bank, the Company elected to become a financial holding company.
STATE REGULATION
The Company is registered as a Pennsylvania financial institution holding company under Pennsylvania law and as such is subject to regulation and examination by the Superintendent of Banking of the Commonwealth of Pennsylvania.
REGULATION OF PCIS
GENERAL
In the United States, a number of federal regulatory agencies are charged with safeguarding the integrity of the securities and other financial markets and with protecting the interest of customers participating in those markets. The Commission is the federal agency that is primarily responsible for the regulation of broker-dealers and investment advisers doing business in the United States, and the Federal Reserve Board promulgates regulations applicable to securities credit transactions involving broker-dealers and certain other institutions in the Unites States. Much of the regulation of broker-dealers, however, has been delegated to self-regulatory organizations ("SROs"), principally the NASD (and its subsidiaries NASD Regulation, Inc. and the Nasdaq Stock Market), and the national securities exchanges. These SROs, which are subject to oversight by the Commission, adopt rules (which are subject to approval by the Commission) that govern the industry, monitor daily activity and conduct periodic examinations of member broker-dealers.
PCIS is also subject to the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the "USA Patriot Act'), signed into law on October 26, 2001. (See "Recent Legislation") The USA Patriot Act requires financial institutions to adopt and implement policies and procedures designed to prevent and defeat money laundering. PCIS believes it is in compliance with the USA Patriot Act.
Securities firms are also subject to regulation by state securities commissions in the states in which they are required to be registered. PCIS is registered as a broker-dealer with the Commission and in all 50 states and in the District of Columbia, and is a member of, and subject to regulation by, a number of SROs, including the NASD.
As a result of federal and state registration and SRO memberships, PCIS is subject to overlapping schemes of regulation that cover all aspects of its securities business. Such regulations cover matters including capital requirements, uses and safe-keeping of clients' funds, conduct of directors, officers and employees, record-keeping and reporting requirements, supervisory and organizational procedures intended to assure compliance with securities laws and to prevent improper trading on material nonpublic information, employee-related matters, including qualification and licensing of supervisory and sales personnel, limitations on extensions of credit in securities transactions, clearance and settlement procedures, requirements for the registration, underwriting, sale and distribution of securities, and rules of the SROs designed to promote high standards of commercial honor and just and equitable principles of trade. A particular focus of the applicable regulations concerns the relationship between broker-dealers and their customers. As a result, the many aspects of the broker-dealer customer relationship are subject to regulation including, in some instances, "suitability" determinations as to certain customer transactions, limitations on the amounts that may be charged to customers, timing of proprietary trading in relation to customers' trades and disclosures to customers.
PCIS also is subject to "Risk Assessment Rules" imposed by the SEC which require, among other things, that certain broker-dealers maintain and preserve certain information, describe risk management policies and procedures and report on the financial condition of certain affiliates whose financial and securities activities are reasonably likely to have a material impact on the financial and operational condition of the broker-dealers. Certain "Material Associated Persons" (as defined in the Risk Assessment Rules) of the broker-dealers and the activities conducted by such Material Associated Persons may also be subject to regulation by the SEC.
PCIS is registered as an investment adviser with the SEC. As an investment adviser registered with the SEC, it is subject to the requirements of the Investment Advisers Act of 1940 and the SEC's regulations thereunder, as well as certain state securities laws and regulations. Such requirements relate to, among other things, limitations on the ability of an investment adviser to charge performance-based or non-refundable fees to clients, record-keeping and reporting requirements, disclosure requirements, limitations on principal transactions between an adviser or its affiliates and advisory clients, as well as general anti-fraud prohibitions. The state securities law requirements applicable to registered investment advisers are in certain cases more comprehensive than those imposed under the federal securities laws.
In the event of non-compliance with an applicable regulation, governmental regulators and the NASD may institute administrative or judicial proceedings that may result in censure, fine, civil penalties (including treble damages in the case of insider trading violations), the issuance of cease-and-desist orders, the deregistration or suspension of the non-compliant broker-dealer or investment adviser, the suspension or disqualification of the broker-dealer's officers or employees or other adverse consequences. The imposition of any such penalties or orders on PCIS could have a material adverse effect on PCIS' (and thus the Company's) operating results and financial condition.
NET CAPITAL REQUIREMENTS
As a broker-dealer registered with the SEC and as a member firm of the NASD, PCIS is subject to the capital requirements of the SEC and the NASD. These capital requirements specify minimum levels of capital that PCIS is required to maintain and also limit the amount of leverage that each firm is able to obtain in its respective business.
As of June 30, 2004, PCIS was required to maintain minimum net capital, in accordance with SEC rules, of $250,000 and had total net capital of $977,000 or $747,000 in excess of the minimum amount required. PCIS is required to maintain a net capital ratio, in accordance with SEC rules, not to exceed 15 to 1. At June 30, 2004, PCIS' net capital ratio was .25 to 1.
A failure of a broker-dealer to maintain its minimum required net capital or net capital ratio would require it to cease executing customer transactions until it came back into compliance, and could cause it to lose its NASD membership, its registration with the SEC or require its liquidation. Further, the decline in a broker-dealer's net capital below certain "early warning levels," even though above minimum net capital requirements, could cause material adverse consequences to the broker-dealer.
PCIS is a member of the Securities Investor Protection Corporation ("SIPC"), which is a non-profit corporation that was created by the United States Congress under the Securities Protection Act of 1970. SIPC protects customers of member broker-dealers against losses caused by the financial failure of the broker-dealer but not against a change in the market value of securities in customers' accounts at the broker-dealer. In the event of the inability of a member broker-dealer to satisfy the claims of its customers in the event of its failure, the SIPC's funds are available to satisfy the remaining claims up to maximum of $500,000 per customer, including up to $100,000 on claims for cash. In addition, PCIS' clearing broker carries private insurance that provides similar coverage up to $25 million per customer.
REGULATION OF THE BANK
GENERAL
As a Pennsylvania-chartered commercial bank, the Bank is subject to regulation and examination by the FDIC, which insures the deposits of the Bank to the maximum extent permitted by law, certain requirements established by the Federal Reserve Board and by the Pennsylvania Department of Banking. The federal laws and regulations which are applicable to state-chartered banks regulate, among other things, the scope of their business, their investments, their reserves against deposits, the timing of the availability of deposited funds and the nature and amount of and collateral for loans. Prior to the Bank's conversion from a state-chartered savings association to a commercial bank, it was subject also to regulation and examination by the Office of Thrift Supervision.
CAPITAL REQUIREMENTS
The Bank is subject to regulatory capital requirements of the FDIC, which are substantially comparable to the regulatory capital requirements of the Federal Reserve Board applicable to the Holding Company, as discussed above. At June 30, 2004, the Bank's regulatory capital substantially exceeded applicable requirement. See Note 13 to the Consolidated Financial Statements included in Item 8 hereof.
PROMPT CORRECTIVE ACTION
Section 38 of the Federal Deposit Insurance Act ("FDIA") provides the federal banking regulators with broad power to take "prompt corrective action" to resolve the problems of undercapitalized institutions. The extent of the regulators' powers depends on whether the institution in question is "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" or "critically undercapitalized." Under regulations adopted by the federal banking regulators, an institution shall be deemed to be (i) "well capitalized" if it has total risk-based capital ratio of 10.0% or more, has a Tier I risk-based capital ratio of 6.0% or more, has a Tier I leverage capital ratio of 5.0% or more and is not subject to specified requirements to meet and maintain a specific capital level for any capital measure; (ii) "adequately capitalized" if it has a total risk-based capital ratio of 8.0% or more, a Tier I risk-based capital ratio of 4.0% or more a Tier I leverage capital ratio of 4.0% or more (3.0% under certain circumstances) and does not meet the definition of "well capitalized"; (iii) "undercapitalized" if it has a total risk-based capital ratio that is less than 8.0%, a Tier I risk-based capital ratio that is less than 4.0% or a Tier I leverage capital ratio that is less than 4.0% (3.0% under certain circumstances), (iv) "significantly undercapitalized" if it has a total risk-based capital ratio that is less than 6.0%, a Tier I risk-based capital ratio that is less than 3.0% or a Tier I leverage capital ratio that is less than 3.0%, and (v) "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%. The regulations also provide that a federal banking regulator may, after notice and an opportunity for a hearing, reclassify a "well capitalized" institution as "adequately capitalized" and may require an "adequately capitalized" institution or an "undercapitalized" institution to comply with supervisory actions as if it were in the next lower category if the institution is in an unsafe or unsound condition or engaging in an unsafe or unsound practice. The federal banking regulator may not, however, reclassify a "significantly undercapitalized" institution as "critically undercapitalized."
At June 30, 2004, the Bank's capital levels qualified it as a "well capitalized" institution under applicable laws and regulations.
FDIC INSURANCE PREMIUMS
The Bank is a member of the Savings Association Insurance Fund ("SAIF") administered by the FDIC rather than the Bank Insurance Fund ("BIF") since it was formerly a savings association.
As an FDIC-insured institution, the Bank is required to pay deposit insurance premiums to the FDIC. Effective January 1, 1997, the assessment schedule for both BIF and SAIF ranges from 0 basis points (subject to a $2,000 annual minimum) to 27 basis points of the balance of insured deposits. In addition, both BIF-insured institutions and SAIF-insured institutions are assessed amounts in order for a federally chartered Financing Corporation to make payments on it bonds. These assessments will continue until the Financing Corporation bonds mature in 2019.
BROKERED DEPOSITS
The Federal Deposit Insurance Act ("FDIA") restricts the use of brokered deposits by certain depository institutions. Under the FDIA and applicable regulations, (i) a "well capitalized insured depository institution" may solicit and accept, renew or roll over any brokered deposit without restriction, (ii) an "adequately capitalized insured depository institution" may not accept, renew or roll over any brokered deposit unless it has applied for and been granted a waiver of this prohibition by the FDIC and (iii) an "undercapitalized insured depository institution" may not (s) accept, renew or roll over any brokered deposit or (y) solicit deposits by offering an effective yield that exceeds by more than 75 basis points the prevailing effective yields on insured deposits of comparable maturity in such institution's normal market area or in the market area in which such deposits are being solicited. The term "undercapitalized insured depository institution" is defined to mean any insured depository institution that fails to meet the minimum regulatory capital requirement prescribed by its appropriate federal banking agency. The FDIC may, on a case-by-case basis and upon application by an adequately capitalized insured depository institution, waive the restriction on brokered deposits upon a finding that the acceptance of brokered deposits does not constitute an unsafe or unsound practice with respect to such institution. At June 30, 2004, the Bank did not have any brokered deposits.
COMMUNITY INVESTMENT AND CONSUMER PROTECTION LAWS
In connection with its lending activities, the Bank is subject to a variety of federal laws designed to protect borrowers and promote lending to various sectors of the economy and population. Included among these are the Federal Home Mortgage Disclosure Act, Real Estate Settlement Procedures Act, Truth-in-Lending Act, Equal Credit Opportunity Act, Fair Credit Reporting Act and Community Reinvestment Act ("CRA"). In order to better direct and monitor the Bank's CRA efforts, a committee of the Board of Directors specific to Community Reinvestment was formed during the current fiscal year.
The CRA requires insured institutions to define the communities that they serve, identify the credit needs of those communities and adopt and implement a "Community Reinvestment Act Statement" pursuant to which they offer credit products and take other actions that respond to the credit needs of the community. The responsible federal banking regulator must conduct regular CRA examinations of insured financial institutions and assign to them a CRA rating of "outstanding," "satisfactory," "needs improvement" or "unsatisfactory." In last CRA rating of the Bank dated August 26, 2002, the Bank was rated "Satisfactory".
LIMITATIONS ON DIVIDENDS
The Holding Company is a legal entity separate and distinct from its banking and other subsidiaries. The Holding Company's principal source of funds is cash dividends from its subsidiaries, including the Bank. Banking regulations impose minimum capital and other regulatory restrictions on the Holding Company and the Bank, affecting both entities ability to pay dividends. For a more detailed discussion see "Regulation of the Company - Capital Requirements", "Regulation of the Bank - Capital Requirements" and Note 13 to the Consolidated Financial Statements.
MISCELLANEOUS
Federal laws strictly limit the ability of banks to engage in transactions with their affiliates, including their bank holding companies. Such transactions between a subsidiary bank and its parent company or the non-bank subsidiaries of the bank holding company are limited to 10% of a bank subsidiary's capital and surplus and, with respect to such parent company and all such non-bank subsidiaries, to an aggregate of 20% of the bank subsidiary's capital and surplus. Further, loans and extensions of credit generally are required to be secured by eligible collateral in specified amounts. Federal law also requires that all transactions between a bank and its affiliates be on terms as favorable to the bank as transactions with non-affiliates.
REGULATORY ENFORCEMENT AUTHORITY
The enforcement powers available to federal banking regulators are substantial and include, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions against banking organizations and institution-affiliated parties, as defined. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with regulatory authorities.
FEDERAL HOME LOAN BANK SYSTEM
The Bank is a member of the FHLBP, which is one of 12 regional FHLBs that administer the home financing credit function of savings associations and commercial banks. Each FHLB serves as a source of liquidity for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes loans to members (i.e., advances) in accordance with policies and procedures established by its Board of Directors. As of June 30, 2004, the Bank's advances from the FHLBP amounted to $121.0 million.
As a member, the Bank is required to purchase and maintain stock in the FHLBP in an amount equal to the greater of 1% of its aggregate unpaid residential mortgage loans, home purchase contracts or similar obligations at the beginning of each year or 5% of total advances. At June 30, 2004, the Bank had $6.7 million in FHLB stock, which was in compliance with this requirement.
RECENT LEGISLATION
THE USA PATRIOT ACT
In response to the events of September 11, 2001, President George W. Bush signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA PATRIOT Act, on October 26, 2001. The USA PATRIOT Act gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money transfer agents and parties registered under the Commodity Exchange Act. Among other requirements, Title III of the USA PATRIOT Act imposes the following requirements with respect to financial institutions:
(a) Pursuant to Section 352, all financial institutions must establish anti-money laundering programs that include, at minimum: (1) internal policies, procedures, and controls, (2) specific designation of an anti-money laundering compliance officer, (3) ongoing employee training programs, and
(4) an independent audit function to test the anti-money laundering program. Rules promulgated under Section 352 were required to be adopted by April 24, 2002
(b) Section 326 authorizes the Secretary of the Department of Treasury, in conjunction with other bank regulators, to issue regulations by October 26, 2002 that provide for minimum standards with respect to customer identification at the time new accounts are opened.
(c) Section 312 requires financial institutions that establish, maintain, administer, or manage private banking accounts or correspondent accounts in the United States for non-United States persons or their representatives (including foreign individuals visiting the United States) to establish appropriate, specific, and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report money laundering. Rules promulgated under Section 312 were due by April 24, 2002, to be effective by July 23, 2002.
(d) Effective December 25, 2001, financial institutions are prohibited from establishing, maintaining, administering or managing correspondent accounts for foreign shell banks (foreign banks that do not have a physical presence in any country), and will be subject to certain record-keeping obligations with respect to correspondent accounts of foreign banks.
(e) Bank regulators are directed to consider a holding company's effectiveness in combating money laundering when ruling on Federal Reserve Act and Bank Merger Act applications.
SARBANES-OXLEY ACT OF 2002
On July 30, 2002, the President signed into law the Sarbanes-Oxley Act of 2002 implementing legislative reforms intended to address corporate and accounting fraud. In addition to the establishment of a new accounting oversight board which will enforce auditing, quality control and independence standards and will be funded by fees from all publicly traded companies, the bill restricts provision of both auditing and consulting services by accounting firms. To ensure auditor independence, any non-audit services being provided to an audit client will require pre-approval by the company's audit committee members. In addition, the audit partners must be rotated. The bill requires chief executive officers and chief financial officers, or their equivalent, to certify to the accuracy of periodic reports filed with the SEC, subject to civil and criminal penalties if they knowingly or willfully violate this certification requirement. In addition, under the Act, counsel will be required to report evidence of a material violation of the securities laws or a breach of fiduciary duty by a company to its chief executive officer or its chief legal officer, and, if such officer does not appropriately respond, to report such evidence to the audit committee or other similar committee of the board of directors or the board itself.
Longer prison terms will also be applied to corporate executives who violate federal securities laws, the period during which certain types of suits can be brought against a company or its officers has been extended, and bonuses issued to top executives prior to restatement of a company's financial statements are now subject to disgorgement if such restatement was due to corporate misconduct. Executives are also prohibited from insider trading during retirement plan "blackout" periods, and loans to company executives are restricted. In addition, a provision directs that civil penalties levied by the SEC as a result of any judicial or administrative action under the Act be deposited to a fund for the benefit of harmed investors. The Federal Accounts for Investor Restitution ("FAIR") provision also requires the SEC to develop methods of improving collection rates. The legislation accelerates the time frame for disclosures by public companies, as they must immediately disclose any material changes in their financial condition or operations. Directors and executive officers must also provide information for most changes in ownership in a company's securities within two business days of the change.
The Act also increases the oversight of, and codifies certain requirements relating to audit committees of public companies and how they interact with the company's "registered public accounting firm" ("RPAF"). Audit Committee members must be independent and are barred from accepting consulting, advisory or other compensatory fees from the issuer. In addition, companies must disclose whether at least one member of the committee is a "financial expert" (as such term is defined by the SEC) and if not, why not. Under the Act, a RPAF is prohibited from performing statutorily mandated audit services for a company if such company's chief executive officer, chief financial officer, comptroller, chief accounting officer or any person serving in equivalent positions has been employed by such firm and provided services in the audit of such company within one year of the filing of the Company's prior year Form 10-K. The Act also prohibits any officer or director of a company or any other person acting under their direction from taking any action to fraudulently influence, coerce, manipulate or mislead any independent public or certified accountant engaged in the audit of the company's financial statements for the purpose of rendering the financial statement's materially misleading. The Act also requires the SEC to prescribe rules requiring inclusion of a disclosure control report and assessment by management in the annual report to shareholders. The Act requires the RPAF that issues the audit report to attest to and report on management's assessment of the company's internal controls. In addition, the Act requires that each financial report required to be prepared in accordance with (or reconciled to) generally accepted accounting principles and filed with the SEC reflect all material correcting adjustments that are identified by a RPAF in accordance with generally accepted accounting principles and the rules and regulations of the SEC.
On June 5, 2003, the Commission issued final rulings regarding (i) internal controls over financial reporting and (ii) the certifications made by Chief Executive Officers and Chief Financial Officers under Sections 302 and 906 of the Act. The new rule implements Section 404 of the Act, which requires public companies to include in their annual reports on Form 10-K or 10-KSB, a report of management on the company's internal controls over financial reporting. This report must contain, at a minimum, (i) a statement that it is management's responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting and (ii) an assessment, as of the end of the Company's most recent fiscal year, of the effectiveness of the Company's internal control structure and procedures for financial reporting. Section 404 also requires every RPAF to attest to, and report on, the assessment made by management. The provisions of the final rule are effective for accelerated public company filers of their Form 10-K for fiscal years ending on or after November 15, 2004.
NASD RULE - SHAREHOLDER APPROVAL OF EQUITY COMPENSATION PLANS
On June 30, 2003, the Commission approved changes to rules proposed by the NASD, requiring shareholder approval when adopting any stock option plan, purchase plan or other equity compensation agreement or when making a material amendment to any such plan. While the new rules are effective immediately, most currently existing plans are grandfathered, unless a material amendment is made to these plans. Generally, a material amendment is any:
o Material increase in the number of shares available under the plan; o Material increase in benefits to participants, including amendments to allow option re-pricing; o Material expansion of the class of participants; o Expansion of the types of awards under the plan; or o Material extensions of the terms of the plan.
Certain exceptions will continue to be permitted including options granted as a material inducement to the hiring of a new employee.
TAXATION
The Company and its subsidiaries are subject to those rules of federal income taxation generally applicable to corporations under the Internal Revenue Code of 1986, as amended (the "Code"). The Company and its subsidiaries, as members of an affiliated group of corporations within the meaning of Section 1504 of the Code, file a consolidated federal income tax return, which has the effect of eliminating or deferring the tax consequences of inter-company distributions, including dividends, in the computation of consolidated taxable income.
The Company and the Bank are also subject to various forms of state taxation under the laws of Pennsylvania.
ITEM 2.
ITEM 2. PROPERTIES
OFFICES AND OTHER MATERIAL PROPERTIES
At June 30, 2004, the Bank conducted its business from its main office in Downingtown, Pennsylvania, which is also a branch office, and eleven other full-service branch offices. PCIS conducts its business from two offices.
The following table sets forth certain information with respect to the offices of the Company as of June 30, 2004
In addition, the Company currently owns four developed properties adjacent to its main office. One of these properties is used as the Bank's data center and approximately 25% of another property is rented to a third party. The remaining two properties are currently being leased to other users and may be used for future banking facilities. The net book value of four properties at June 30, 2004 was approximately $837 thousand.
In September 1989, the Bank entered into a 10-year operating lease for the Bank's Westtown office. The lease contains two five-year options to renew. The lease has been extended to 2004.
In October 1990, the Bank entered into a 10-year lease agreement in connection with the relocation of its existing branch in Thorndale to a new site in the Thorndale area. The lease includes two five-year options to extend the lease. The lease has been extended to 2005.
In May 1994, the Bank entered into a 10-year lease agreement for land in connection with the construction of the Airport Village branch. The lease includes three five-year options to extend the lease.
In April 1995, the Bank entered into a 15-year lease agreement for the Bank's Brandywine Square office.
In February 2002, the Bank entered into a 10-year lease agreement for the Bank's Kennett Square office.
In December 2001, the Bank entered into a 15-year lease agreement for the Bank's Eagle office.
In February 2004, the Bank entered into a 2-year lease agreement for the Bank's West Chester office.
In December 1997, PCIS entered into a five-year lease agreement for PCIS's Wayne office. The lease has been extended to 2007.
In June 1999, PCIS entered into a five-year lease agreement for PCIS's Philadelphia office. In June 2004, the lease was extended for an additional five years.
First Financial operates and participates in the STAR (formerly MAC(R)), Money Access Service shared Automated Teller Machine ("ATM") network system. In addition, First Financial operates ten office ATMs under the STAR(R) system and one remote ATM location.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company, the Bank and two employees (together "the parties") have been sued in the Court of Common Pleas in Philadelphia, County by a former employee to recover damages for wrongful termination of his employment. The Company denies any wrongdoing and intends to aggressively defend its actions. The matter has been referred to the Company's insurance carrier, who has engaged counsel to defend its actions. The policy carries a $100,000 deductible, which includes cost of defense. The $100,000 was expensed as of June 30, 2003. The Company believes it will be successful in its defense; however, in the event the parties are unsuccessful in their defense, the Company does not believe the lawsuit would have a material adverse effect on the financial condition of the Company as insurance coverage was and is in place.
The Company is involved in other routine, non-material legal proceedings occurring in the ordinary course of business which management believes will not have a material adverse effect on the financial condition or operations of the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
As of September 3, 2004, the Holding Company's Common Stock was held by approximately 2,008 shareholders of record not including the number of persons or entities holding stock in nominee or street name through various brokers and banks. Any broker or any NASD member can be contacted for the latest quotations of the Holding Company's Common Stock. The Holding Company's NASDAQ Stock Market symbol is "CVAL". The transfer agent for the stock is American Stock Transfer and Trust Company, New York, New York. During fiscal 2004 and 2003, the Holding Company paid aggregate annual dividends of $0.42 and $0.38, respectively, adjusted for stock dividends and stock splits during those periods.
The following table sets forth the high and low closing prices for the periods described. For comparability purposes, the closing prices shown below have been adjusted to reflect the 5% stock dividends paid in fiscal 2004 and 2003.
FISCAL 2004 LOW HIGH -------------------------------------------------------------------------- FIRST QUARTER $18.50 $24.50 SECOND QUARTER 21.66 23.50 THIRD QUARTER 21.40 23.65 FOURTH QUARTER 19.89 22.35 FISCAL 2003 LOW HIGH -------------------------------------------------------------------------- First Quarter $13.65 $15.72 Second Quarter 15.88 21.73 Third Quarter 19.01 21.67 Fourth Quarter 18.34 24.46
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
(1) Includes loans held for sale (2) Includes Federal Home Loan Bank advances, Securities sold under agreements to repurchase and trust preferred securities. (3) Adjusted to reflect 5% stock dividends paid in September 2003, 2002, 2001, and 2000.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
The Company's results of operations depend primarily on its net interest income, which is the difference between interest income on interest-earning assets, which consists principally of loans and investment securities, and interest expense on interest-bearing liabilities, which consist of deposits and borrowings. Net interest income is determined by the Company's interest rate spread (the difference between the yields earned on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities.
The Company's results of operations also are affected by the provision for loan losses resulting from management's assessment of the allowance for loan losses; the level of its non-interest income, including investment service fees, account service fees and related income and gains and losses from the sales of loans and securities; the level of its non-interest expense, including salaries and employee benefits, occupancy and equipment expense, data processing services, deposit insurance premiums, advertising, other operating costs; and income tax expense.
The Bank is a community-oriented bank, which emphasizes customer service and convenience. As part of this strategy, the Bank offers products and services designed to meet the needs of its customers. The Company generally has sought to achieve long-term financial growth and strength by increasing the amount and stability of its net interest income and non-interest income and by maintaining a high level of asset quality. In pursuit of these goals, the Company has adopted a business strategy emphasizing growth in basic financial services. The focus is on commercial and construction lending, commercial deposits and treasury management, consumer deposits and loans and trust and investment management.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Discussion and analysis of the financial condition and results of operations are based on the consolidated financial statements of the Company, which are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Bank to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. The Company evaluates estimates on an on-going basis, including those related to the allowance for loan losses, non-accrual loans, other real estate owned, other than temporary impairments of investment securities, pension and post-retirement benefits, the stock option plan, recourse liabilities and income taxes. The Company bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
The Company believes the following critical accounting policies affect its more significant judgments and estimates used in preparation of its consolidated financial statements: allowance for loan losses, income taxes, and other than temporary impairment of investment securities. Each estimate is discussed below. The financial impact of each estimate is discussed in the applicable subsections of "Management's Discussion and Analysis of Financial Condition and Operations."
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at a level that represents management's best estimate of known and inherent losses, which are probable and reasonably estimable based upon an evaluation of the loan portfolio as of the date of the balance sheet. Homogeneous portfolios of loans, which include residential mortgage, home equity and other consumer loans, are evaluated as a group. Commercial business loans greater than $100,000, commercial mortgage and construction loans are evaluated individually. Specific portions of the allowance are developed by analyzing individual loans for adequacy of collateral, cash flow and other risks unique to that particular loan. General portions of the allowance are developed by grading individual loans in the commercial and construction portfolios and applying loss factors by grade. The general portion of the allowance also includes loss factors applied to the homogeneous portfolios as a group. The loss factors applied to graded loans were developed based on the Company's loss history for loans with similar attributes, local and national economic conditions as well as input from the Company's primary banking regulators. Loss factors are applied to homogeneous loans based upon prior loss experience of the portfolio as well as delinquency trends, local and national economic conditions as well as the volume of non-performing loans, the volume of classified and watch-list loans and trends in concentration of loans to single borrowers. Although management believes it has used the best information available to it in making such determinations, and that the present allowance for loan losses is adequate, future adjustments to the allowance may be necessary, and net income may be adversely affected if circumstances differ substantially from the assumptions used in determining the level of the allowance. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for losses on loans. Such agencies may require the Bank to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. The allowance is increased by the provision for loan losses, which is charged to operations. Loan losses, other than those incurred on loans held for sale, are charged directly against the allowance and recoveries on previously charged-off loans are added to the allowance.
For purposes of applying the measurement criteria for impaired loans, the Company excludes large groups of smaller balance homogeneous loans, primarily consisting of residential real estate loans and consumer loans as well as commercial business loans with balances of less than $100,000. For applicable loans, the Company evaluates the need for impairment recognition when a loan becomes non-accrual or earlier if, based on management's assessment of the relevant facts and circumstances, it is probable that the Company will be unable to collect all proceeds under the contractual terms of the loan agreement. At June 30, 2004, the recorded investment in impaired loans was $4.0 million as compared to $3.2 million at June 30, 2003. The increase is due primarily to the aforementioned two commercial loans to a single borrower who has encountered recent financial difficulties. The Company's policy for the recognition of interest income on impaired loans is the same as for non-accrual loans. A portion of an impaired loan is charged off when the Company determines that foreclosure is probable and the fair value less estimated disposition costs of the collateral is less than the recorded investment of the impaired loan.
INCOME TAXES
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to the difference between the financial statement carrying amounts of existing assets and liabilities and their respective tax base, as well as tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established against deferred tax assets when in the judgment of management, it is more likely than not that such deferred tax assets will not become available. Based on management's evaluation of the likelihood of realization, no valuation allowance has been established. Because the judgment about the level of future taxable income is dependent to a great extent on matters that may, at least in part, be beyond the Company's control, it is at least reasonably possible that management's judgment about the need for a valuation allowance for deferred taxes could change in the near term.
OTHER THAN TEMPORARY IMPAIRMENT OF INVESTMENT SECURITIES
Securities are evaluated periodically to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term "other than temporary" is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support realizable value equal to or greater than carrying value of the investment. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.
BUSINESS STRATEGY
GROWTH. The Company seeks to increase its assets through internal growth and by expanding its operations.
In 2004, the Company's assets increased by $57.6 million, or 9.9% from $584.5 million at June 30, 2003 to $642.1 million at June 30, 2004 resulting mainly from $14.2 million growth in the loan portfolio as well as a $41.9 million increase in the investment security portfolio. Such loan and investment growth was funded primarily with a growth in core deposits as well as Federal Home Loan Bank advances.
EMPHASIS ON COMMERCIAL LENDING. The Company has been and will continue to expand its higher yielding portfolios of commercial business and commercial real estate loans. This strategy is reflected in the shifting composition of the Company's loan portfolio. The Company's commercial real estate, commercial business and construction and land acquisition loans comprised 55.9% of its total loan portfolio at June 30, 2004 compared to 53.8% at June 30, 2003. Single-family and multi-family residential loans comprised 17.3% of the Company's loan portfolio at June 30, 2004 as compared to 24.7% at June 30, 2003.
MAINTAIN LOAN QUALITY. Management believes that maintaining high loan quality is key to achieving and sustaining long-term financial success. Accordingly, the Company has sought to maintain a high level of asset quality and moderate credit risk by using underwriting standards which management believes are conservative and by generally limiting its origination of loans to its market area. The Company's non-accrual loans totaled $4.2 million at both June 30, 2004 and June 30, 2003. Both years contained a single commercial real estate loan in the amount of $2.9 million and $3.1 million, respectively. Although the loan is current in the payment of interest as it has been due since its origination in 1998 and the next quarterly payment has been prepaid, the loan was placed on non-accrual as principal was not repaid in accordance with the original stated maturity, the borrower has encountered financial difficulties which it continues to attempt to work-out, the underlying real estate is outside the Bank's primary lending area and repayment is largely dependent upon factors not under the complete control of the borrower. Excluding this loan, the Company's ratio of non-performing assets to total assets at June 30, 2004 and June 30, 2003 was 0.20% and 0.19%, respectively - See reconciliation on page 8. Also included in the current year are two commercial loans to a single borrower aggregating $655,000. The borrower has encountered financial difficulties but continues to maintain current debt service payments. The loans were placed on non-accrual due to a potential collateral short-fall in the event that collateral liquidation would be required to satisfy the loans.
STABLE SOURCE OF LIQUIDITY. The Company purchases investment securities that management believes to be appropriate for liquidity, yield and credit quality in order to achieve a managed and more predictable source of liquidity to meet loan demand and, to a lesser extent, a stable source of interest income. The portfolio totaled, in the aggregate, $189.5 million at June 30, 2004 compared to $147.6 million at June 30, 2003.
EMPHASIS ON DEPOSITS AND CUSTOMER SERVICE. The Company, as a community-based financial institution, is largely dependent upon its base of competitively priced core deposits to provide a stable source of funding. The Company has retained many loyal customers over the years through a combination of high quality service, competitively priced service fees, customer convenience, an experienced staff and a strong commitment to the communities in which it serves. Lower costing deposits, which exclude time deposits, totaled $319.7 million or 74.9% of the Company's total deposits at June 30, 2004, as compared to $254.0 million at June 30, 2003, a $65.8 million or 25.9% increase. Included in the $65.7 million are $12.8 million in core deposits (additional $6.7 in certificates were acquired as well) acquired in the Bank's acquisition of the Coatesville branch from PNC National Bank. Management believes that this acquisition enhances the Bank's existing Chester County branch network and positions it well to participate in the revitalization currently underway in the City of Coatesville. This increase in lower costing deposits is primarily attributable to the continuing effort to grow core deposits. Pursuant to the Company's strategy, the major focus in 2005 will continue to be on increasing commercial and consumer core deposits and to a lesser extent certificates of deposit which may become more attractive to the consumer in a rising interest rate environment. In addition, the Company has not used brokered deposits as a source of funds and presently has no plans to do so in the future.
CONTRACTUAL OBLIGATIONS, COMMITMENTS, CONTINGENT LIABILITIES AND OFF-BALANCE SHEET ITEMS
The following table presents, at June 30, 2004, the Company's significant fixed and determinable contractual obligations by payment date. Such amounts do not include any unamortized premium, discounts or other similar carrying value adjustments. For additional discussion, see notes to consolidated financial statements.
The Company also entered into three separate forward starting interest rate swap agreements whereby the Company is required at a future date to make periodic variable rate payments; indexed to the three month LIBOR rate, to the swap counter-party while receiving fixed rate payments based upon an aggregate notional amount of $41 million. Additionally, in August 2003, the Bank purchased a $30 million notional amount 3.50% Three Month LIBOR interest rate cap while simultaneously selling a $30 million notional amount 6.00% Three Month LIBOR interest rate cap ("Interest Rate Corridor"). The Company paid a net premium, which entitles it to receive the difference between Three Month LIBOR from 3.50% to 6.00% times the $30 million notional amount. Derivative contracts are carried at fair value on the consolidated balance sheet. See Asset/Liability Management as well as Note 14 to consolidated financial statements for additional information on derivative contracts.
A schedule of significant commitments at June 30, 2004 follows:
Contract or Amount at (In Thousands) June 30, 2004 ---------------------------------------------------------------- Commitments to originate loans $ 10,041 Undisbursed loans in process - construction 25,549 Undisbursed lines of credit 83,210 Commercial letters of credit 1,128 ------------- Total $ 119,928 =============
ASSET/LIABILITY MANAGEMENT
The primary asset/liability management goal of the Company is to manage and control the interest rate risk of the bank subsidiary, thereby reducing its exposure to fluctuations in interest rates, and achieving sustainable growth in net interest income over the long term. Other objectives of asset/liability management include: (1) ensuring adequate liquidity and funding, (2) maintaining a strong capital base and (3) maximizing net interest income opportunities.
In general, interest rate risk is mitigated by closely matching the maturities or re-pricing periods of interest-sensitive assets and liabilities to ensure a favorable interest rate spread. Management regularly reviews the Bank's interest-rate sensitivity, and uses a variety of strategies as needed to adjust that sensitivity within acceptable tolerance ranges established by the Board of Directors. Changing the relative proportions of fixed-rate and adjustable-rate assets and liabilities is one of the primary strategies utilized by the Company to accomplish this objective.
Additionally, the Company may from time to time utilize off-balance sheet instruments such as interest rate swaps, interest rate collars, interest rate floors, interest rate swaptions or combinations thereof to assist in its asset/liability management. At June 30, 2004, the Company was positively gapped whereby its interest-earning assets were re-pricing at a quicker rate than its' interest-bearing liabilities. To partially offset the negative impact of the current low market interest rate environment, the Company entered into three separate interest rate swap transactions aggregating $41 million notional amount to hedge certain of its' higher rate FHLBP Advances. The swaps had the effect of converting the higher fixed rate Advances to lower adjustable rate borrowings, which positively impacts the Company's net interest margin in the current interest rate environment. Further, since the Company is positively gapped; if the balance sheet were to remain static, future increases should have similar impacts to the earnings and costs of the interest-earning assets and interest-bearing liabilities. Additionally, in August 2003, the Bank purchased a $30 million notional amount 3.50% Three Month LIBOR interest rate cap while simultaneously selling a $30 million notional amount 6.00% Three Month LIBOR interest rate cap ("Interest Rate Corridor"). The Company paid a net premium, which entitles it to receive the difference between Three Month LIBOR from 3.50% to 6.00% times the $30 million notional amount. The Interest Rate Corridor is being used to hedge the cash flows of $10.3 million in floating rate Trust Preferred Securities as well as the cash flows of certain borrowings, which could negatively impact earnings in a rising interest rate environment.
The matching of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are "interest-rate sensitive" and by monitoring an institution's interest-sensitivity gap. An interest-sensitivity gap is considered positive when the amount of interest-rate sensitive assets exceeds the amount of interest-rate sensitive liabilities re-pricing within a defined period and is considered negative when the amount of interest-rate sensitive liabilities exceeds the amount of interest-rate sensitive assets re-pricing within a defined period.
To provide a more accurate one-year gap position of the Company, certain deposit classifications are based on the interest-rate sensitive attributes and not on the contractual re-pricing characteristics of these deposits. Management estimates, based on historical trends of the Bank's deposit accounts, that a portion of money market, NOW accounts and savings deposits are partially sensitive to interest rate changes. Accordingly, the interest-sensitive portions of these deposits are classified in the less than one-year categories with the remainder spread over a five-year period. Deposit products with interest rates based on a particular index, if any, are classified according to the specific re-pricing characteristic of the index. Deposit rates other than time deposit rates are variable, and changes in deposit rates are typically subject to local market conditions and management's discretion and are not indexed to any particular rate.
Generally, during a period of rising interest rates, a positive gap would result in an increase in net interest income while a negative gap would adversely affect net interest income. However, the interest-sensitivity table that follows does not provide a comprehensive representation of the impact of interest rate changes on net interest income. Each category of assets or liabilities will not be affected equally or simultaneously by changes in the general level of interest rates. Even assets and liabilities, which contractually re-price within the same period may not, in fact, re-price at the same price or the same time or with the same frequency. It is also important to consider that the table represents a specific point in time. Asset/liability management is a dynamic process that is actively monitored and managed and thus variations can occur as the Company adjusts the interest-sensitivity position for the Bank throughout the year.
(1) Net of loans in process. (2) Includes commercial mortgage loan. (3) Reflects the impact of $40 million notional amount interest rate swap
See Managements Discussion and Analysis of Financial Condition and Operations for Rate Shock Analysis.
OPERATING RESULTS
INTEREST INCOME (TAXABLE-EQUIVALENT BASIS) - SEE TABLE RECONCILIATION ON PAGE 18.
Interest income is analyzed on a tax-equivalent basis, i.e., an adjustment is made for analysis purposes only, to increase interest income by the amount of savings of Federal income taxes, which the Company realizes by investing in certain tax-free municipal securities and by making loans to certain tax-exempt organizations. In this way, the ultimate economic impact of earnings from various assets can be more readily compared.
Total interest income decreased $1.9 million to $30.6 million from $32.5 million for the years ended June 30, 2004 and 2003, respectively. The reduction was attributed largely to a decline on the yield on loans. A year over year comparison for the twelve months ended June 30, 2004 and 2003 shows a decline in the yield on loans of 0.98% (6.80% to 5.82%) due largely to the general movement in market interest rates and repayment of higher rate loans. The impact of the aforementioned decline in yield was partially offset by increases in average outstanding loan and investment balances of $26.0 million and $7.0 million, respectively. Total interest income decreased $2.8 million to $32.5 million from $35.3 million for the years ended June 30, 2003 and 2002, respectively. The reduction was attributed largely to a similar decline on the yield on both loans and investments. A year over year comparison for the twelve months ended June 30, 2003 and 2002 shows a decline in the yield on loans of 0.64% (7.44% to 6.80%) and a decline in the yield on investments of 1.27% (5.43% to 4.16%). These declines are in-line with the general movement in market interest rates. The impact of the aforementioned decline in yields was partially offset by increases in average outstanding loan and investment balances of $17.3 million and $7.0 million, respectively. The weighted average yield on average interest-earning assets was 5.32%, 6.00% and 6.83% for fiscal 2004, 2003 and 2002, respectively, reflecting the decline in general market rates of interest throughout the periods.
INTEREST EXPENSE
Total interest expense decreased $3.2 million to $10.7 million from $13.9 million for the years ended June 30, 2004 and 2003, respectively. The primary reason for the decline is due to a 0.71% reduction in the cost of interest-bearing deposits due to both the general decline in market interest rates as well as the Bank's focused effort to shift the deposit mix from higher costing certificates of deposit to lower costing core deposits (demand deposits, savings and money market accounts). Additionally, the cost on FHLB advances and other borrowings declined by 1.15% due partially to the implementation of the aforementioned Interest Rate Swap and Interest Rate Corridor transactions which reduced interest expense by $712,000 or 0.56% as well as the Bank securing lower costing borrowings to fund the previously noted asset growth. This reduction was partially offset by an increase in average outstanding interest-bearing deposit balances as well as average outstanding borrowing balances. Total interest expense decreased $2.5 million to $13.9 million from $16.4 million for the years ended June 30, 2003 and 2002, respectively. The primary reason for the decline is due to a 0.97% reduction in the cost of interest-bearing deposits due to both the general decline in market interest rates as well as the Bank's focused effort to shift the deposit mix from higher costing certificates of deposit to lower costing core deposits (demand deposits, savings and money market accounts). This reduction was partially offset by an increase in average outstanding interest-bearing deposit balances as well as average outstanding borrowing balances.
NET INTEREST INCOME
Net interest income is the difference between interest income on interest-earning assets and interest expense on interest-bearing liabilities. Net interest income, on a fully tax equivalent basis, increased by $1.3 million due principally to the continued growth in core deposits as well as the Interest Rate Swap and Interest Rate Corridor transactions referred to above. Also, contributing to the increase was an increase in average earning assets of $33.1 million. From fiscal 2003 to fiscal 2004, the yield on interest-earning assets declined by 0.68% while the cost of interest-bearing liabilities declined by 0.73%. Net interest income, on a fully tax equivalent basis, declined by $350 thousand due principally to the fact that the Bank had more assets re-price during the year as compared to the re-pricing of interest-bearing liabilities. The yield on interest-earning assets declined by 0.83%, from 6.83% to 6.00% from fiscal 2002 as compared to fiscal 2003. During the same period, the cost of interest-bearing liabilities declined by 0.70%, from 3.54% to 2.84%.
PROVISION FOR LOAN LOSSES
The Company's provision for loan losses was $971 thousand, $879 thousand and $547 thousand, during fiscal 2004, 2003 and 2002, respectively. These additions to the allowance for loan losses are due to the Company's continued focus on building a larger portfolio of commercial and industrial loans, which typically carry a greater risk of loss than the Company's traditional loan portfolios, such as mortgages and real estate loans. This change in the character of the loan portfolio, the increase in non-performing loans as well as management's on-going assessment of the inherent risk of loss existing in the loan portfolio determined the amount necessary to increase the allowance for loan losses to an appropriate level. At June 30, 2004, the allowance for loan losses totaled $6.3 million or 1.60% of net loans compared to $5.4 million or 1.41% of net loans at June 30, 2003.
The Company establishes provisions for loan losses, which are charged to operations, in order to maintain the allowance for loan losses at a level which management believes covers all known and inherent losses in the loan portfolio. In establishing the provision, management considers among other things, the portfolio mix, delinquency trends, volume of non-performing loans, volume of classified loans and historical loss experience of the portfolio as well as current economic conditions, and other relevant factors. Although management believes it has used the best information available to it in making such determinations, and that the present allowance for loan losses is adequate, future adjustments to the allowance may be necessary, and net income may be adversely affected if the circumstances differ substantially from the assumptions used in determining the level of the allowance for loan losses. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for losses on loans. Such agencies may require the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.
NON-INTEREST INCOME
Total non-interest income increased by $1.5 million or 20.0% to $9.1 million for the year ended June 30, 2004 compared to the prior fiscal year. The primary reason for the increase was due to an increase in investment services income of $561 thousand due primarily to increased commissions at PCIS resulting from increased client trading volume, an increase in deposit service fees of $236 thousand due to the continued increase in the Bank's core deposit base, which deposits are traditionally more fee oriented as compared to certificates of deposit and an increase in gains realized upon the sale of securities available for sale of $203 thousand due largely to the liquidation of a large portion of a community bank stock portfolio owned by the Holding Company. The stocks were sold as the Banks were acquired during the current fiscal year at prices significantly greater than the Company's acquisition cost. Another contributing factor was a reduction of $383 thousand in investment security impairment write-downs as the Bank recorded a $383 thousand loss in fiscal 2003, on an other than temporary impairment write-down of a revenue bond backed by the revenue stream of a public play golf course in Bedford County, Pennsylvania. This bond was subsequently sold in the current fiscal year at an approximate additional loss of $68,000 and is net against gains realized on securities available for sale. Total non-interest income increased by $2.2 million or 41.6% to $7.6 million for the year ended June 30, 2003 compared to the prior fiscal year. The primary reason for the increase was due to an increase in deposit service fees of $944 thousand, as the Bank continued, during fiscal year 2003, to increase its core deposit base, which deposits are traditionally more fee oriented as compared to certificates of deposit and an increase in gains realized upon the sale of securities available for sale of $576 thousand. Also contributing to the increase was a reduction of $572 thousand in investment security impairment write-downs to $383 thousand compared to $955 thousand in the prior year. During the year, the Bank recorded a $383 thousand loss on an other than temporary impairment write-down of a revenue bond backed by the revenue stream of a public play golf course in Bedford County, Pennsylvania. This compares to the $955 thousand loss incurred in the prior fiscal year.
OPERATING EXPENSES
Total operating expenses increased by $1.3 million or 7.4% to $18.9 million for the year ended June 30, 2004 as compared to $17.6 million for the fiscal year 2003. Salaries and employee benefits increased $919 thousand or 9.3% to $10.8 million from $9.9 million for the year ended June 30, 2004 compared to the prior year ended June 30, 2003. In addition to normal salary increases, the increase is due largely to having a full years salary for the Eagle branch opened in fiscal 2003, the compensation costs associated with the Coatesville branch acquisition which occurred on March 31, 2004 and additional incentive compensation paid to employees as a result of the increased profitability and performance of the Company. Additionally, marketing expense increased by $135 thousand as the Bank implemented a special marketing campaign designed to increase consumer checking accounts and other operating expenses increased by $212 due largely to a Sarbanes-Oxley review conducted by outside counsel on behalf of the audit committee and increased State of Pennsylvania shares tax due to the increased net worth of the Bank as well as an increase in insurance costs in line with that experienced within the insurance industry. Total operating expenses increased by $1.6 million or 10.3% to $17.6 million for the year ended June 30, 2003 as compared to $16.0 million for the fiscal year 2002. Salaries and employee benefits increased $781 thousand or 8.6% to $9.9 million from $9.1 million for the year ended June 30, 2003 compared to the prior year ended June 30, 2002. In addition to normal salary increases, the increase is due largely to having a full years salary for the Kennett Square branch opened in February 2002 as well as salaries for the Eagle branch opened in fiscal 2003. Additionally, management infrastructure was added to further accommodate the shift to a commercial bank. Occupancy and equipment increased $333 thousand or 13.4% from fiscal 2002 to 2003 due primarily to the aforementioned branch expansions. Other operating expenses increased by $603 thousand or 19.5% from $3.1 million for the year ended June 30, 2002 as compared to $3.7 million for the year ended June 30, 2003. The increase is due largely to increased legal costs of $237 thousand resulting from the lawsuit instituted by a former employee (See Legal Matters - Page 29), increased State of Pennsylvania shares tax due to the increased net worth of the Bank as well as an increased period of assessment due to the timing of the commercial bank conversion, increased audit and tax fees resultant from additional outsourced internal audit functions and increased insurance costs in line with that experienced within the insurance industry.
INCOME TAXES
Income tax expense for the year ended June 30, 2004 was $2.0 million, an increase of $388 thousand or 23.9% from fiscal 2003 to fiscal 2004. The effective tax rate for fiscal 2004 was 24.2% as compared to an effective tax rate of 23.6% for fiscal year 2003. The increase in the effective tax rate was the result of a lower portion of the Company's pre-tax income being comprised of tax-free interest income. Pre-tax income increased $1.4 million or 20.8% from fiscal 2003 to fiscal 2004. Income tax expense for the year ended June 30, 2003 was $1.6 million, an effective tax rate of 23.6% as compared to an effective tax rate of 19.6% for fiscal year 2002. The increase in the effective tax rate was the result of a lower portion of the Company's pre-tax income being comprised of tax-free interest income. Pre-tax income was comparable from fiscal 2003 to fiscal 2002.
CAPITAL RESOURCES
Total assets at June 30, 2004 aggregated $642.1 million as compared to $584.5 million at June 30, 2003, a 9.9% increase year on year. The increase is due principally to a $14.2 million increase in outstanding loans receivable and a $41.9 million increase in investment security balances. Total liabilities increased $54.9 million from June 30, 2003 to June 30, 2004 driven primarily from deposit growth of $26.5 million ($19.5 million resulted from the Coatesville branch acquisition); primarily in the lower costing core deposits, which increased $65.8 million. Additionally, FHLBP Advances increased $26.9 million, as the Company was able to lock in low rates for longer terms. These borrowings were utilized rather than certificates of deposits as consumers were not willing to lock in to comparable term certificates at the current rate levels. Total assets at June 30, 2003 aggregated $584.5 million as compared to $566.0 million at June 30, 2002, a 3.3% increase year on year. The increase is due principally to a $21.1 million increase in outstanding loans receivable (including loans held for sale), a $5.0 million increase in investment securities and a $5.5 million increase in other assets resulting primarily from the purchase of the BOLI. These increases were offset by a $13.6 million reduction in cash and cash equivalents as funds were deployed in higher earning assets. Total liabilities increased $13.1 million from June 30, 2002 to June 30, 2003 driven primarily from deposit growth of $14.6 million; primarily in the lower costing core deposits. Additionally, securities sold under repurchase agreements ("repurchase agreements") increased $9.1 million as more commercial customers took advantage of this relatively new product. The deposit and repurchase agreement increases were partially offset by a reduction in FHLBP Advances of $8.4 million.
Stockholders' equity increased $2.7 million at June 30, 2004 to $52.3 million from $49.6 million at June 30, 2003. The increase is due primarily to net income for the year ended June 30, 2004 of $6.3 million and the issuance of common stock from the exercise of stock options aggregating $1.2 million. These increases were offset by the payment of cash dividends totaling $1.9 million and a change in the net unrealized loss on securities available for sale of $2.7 million. Stockholders' equity increased $5.4 million at June 30, 2003 to $49.6 million from $44.2 million at June 30, 2002. The increase is due primarily to net income for the year ended June 30, 2003 of $5.3 million, the issuance of common stock aggregating $1.1 million and changes in the unrealized gain (loss) of securities available for sale of $1.3 million. These increases were offset by the payment of cash dividends totaling $1.8 million and the repurchase of common stock totaling $452 thousand.
ASSET QUALITY
Non-performing loans totaled $4.2 million at both June 30, 2004 and June 30, 2003. Non-performing loans to total assets was 0.66% at June 30, 2004, compared to 0.72% at June 30, 2003. Non-performing loans at June 30, 2004, consisted of 8 residential mortgage loans in the amount of $591 thousand, as well as a single commercial real estate loan in the amount of $2.9 million. Although the loan is current in the payment of interest as it has been due since its origination in 1998 and the next quarterly interest payment has been prepaid, the loan was placed on non-accrual as principal was not repaid in accordance with the original stated maturity and the Bank has extended the loan as the borrower attempts to work through its financial difficulties and re-finance the project with another lender. Additionally, June 30, 2004 non-performing loans include two commercial loans to a single borrower who has encountered recent financial difficulties. Although the borrower has kept the loan current in accordance with its terms, the loan was placed on non-accrual as the Bank feels there may be a potential collateral short-fall if the collateral is required to be liquidated to satisfy the loans. Real estate owned at June 30, 2004 is $54 thousand and consists of one single-family residential property.
At June 30, 2004 and 2003, the Company's classified loans, which consisted of loans classified as substandard, doubtful, loss, and REO, totaled $10.7 million and $15.3 million, respectively. Included in the assets classified substandard at June 30, 2004 and 2003, were all loans 90 days past due and loans which are less than 90 days delinquent, but inadequately protected by the current paying capacity of the borrower or of the collateral pledged, as well as a well-defined weakness that may jeopardize the liquidation of the debt. Additionally, total loans delinquent 30 days or more to outstanding loans approximate 0.50% at both June 30, 2004 and June 30, 2003.
In addition to non-performing loans and REO, classified assets include three non-rated Pennsylvania Municipal Authority Bonds that have been classified as substandard. These bonds were originally purchased during the period from June 1998 through June 2000. The aggregate book value of the bonds; after write-downs of $955 thousand, are $5.6 million. Two of the three bonds with an aggregate book value of $4.9 million are zero coupon bonds with maturities extending up to 2034. Both bonds are secured by the revenue streams of commercial office buildings, which are leased to various agencies of the Commonwealth of Pennsylvania under long-term lease arrangements with renewal options.
The third bond was issued by the Housing Authority of Chester County and has a book balance of $720 thousand at June 30, 2004 and bears interest at rates between 5.60% and 6% and matures in June 2019. This bond involves low-income scattered housing in Chester County under a program of the Office of Housing and Urban Development ("HUD"). HUD has committed to provide additional funds to build additional houses, which would be donated to this bond issues. The retirement of the bond issue is dependent upon proceeds from either the rental or sale of the existing and additional houses. This bond is on non-accrual at June 30, 2004.
A fourth bond was classified at June 30, 2003 but was sold during the current fiscal year at an approximate loss of $68,000 (subsequent to a $383 thousand write-down taken in fiscal 2003).
These classified investments are closely monitored and fairly stated at June 30, 2004 based on available information. There can be no assurance that further subsequent adverse or positive developments may occur and thus could result in further adjustments to the carrying value of these investments.
LIQUIDITY AND CAPITAL RESOURCES
Management monitors liquidity daily and maintains funding sources to meet unforeseen changes in cash requirements. The Company's primary sources of funds are deposits, borrowings, repayments, prepayments and maturities of outstanding loans and mortgage-backed securities, sales of assets available for sale, maturities and calls of investment securities and other short-term investments, and funds provided from operations. While scheduled loan and mortgage-backed securities repayments and maturing investment securities and short-term investments are relatively predictable sources of funds, deposit flows, loan prepayments and callable investments are greatly influenced by the movement of interest rates in general, economic conditions and competition. The Company manages the pricing of its deposits to maintain a deposit balance deemed appropriate and desirable. Although the Company's deposits represent the majority of its total liabilities, the Company has also utilized other borrowing sources, namely FHLBP advances. In addition to its ability to obtain advances from the FHLBP under several different credit programs, the Company has established a line of credit with the FHLBP, in an amount of $10 million. This line of credit is available for liquidity purposes. At June 30, 2004 there was no outstanding balance on this line of credit.
Liquidity management is both a daily and long-term function. Excess liquidity is generally invested in short-term investments such as FHLBP overnight deposits. On a longer term basis, the Company maintains a strategy of investing in various lending and investment securities products. During the year ended June 30, 2004, the Company used its sources of funds to primarily fund loan commitments and maintain a substantial portfolio of investment securities, and to meet its ongoing commitments to pay maturing savings certificates and savings withdrawals. As of June 30, 2004, the Company had $10.0 million in commitments to fund loan originations. The Company anticipates that the majority of these commitments will be funded by December 31, 2004. In addition, as of June 30, 2004, the Company had un-disbursed loans in process for construction loans of $25.5 million and $83.2 million in un-disbursed lines of credit. The Company has also issued $1.1 million in commercial letters of credit fully secured by deposit accounts or real estate at June 30, 2004. The management of the Company believes that the Company has adequate resources, including principal prepayments and repayments of loans and investment securities and borrowing capacity, to fund all of its commitments to the extent required.
For regulatory purposes, liquidity is defined as a ratio of cash and certain marketable securities that can be readily converted into cash to total deposits and short-term borrowings. At June 30, 2004, liquidity for the Bank as defined under these guidelines was 39.7%.
IMPACT OF INFLATION AND CHANGING PRICES
The Consolidated Financial Statements and related Notes presented elsewhere herein have been prepared in accordance with generally accepted accounting principles ("GAAP") which generally require the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation. Unlike many industrial companies, substantially all of the assets and liabilities of the Company on a consolidated basis are monetary in nature. As a result, interest rates have a more significant impact on the Company's performance than the general level of inflation. Over a short period of time, interest rates may not necessarily move in the same direction or with the same magnitude as inflation.
OTHER INFORMATION
DESCRIPTION OF STOCK
The holders of the Common Stock of the Holding Company possess exclusive voting rights in the corporation. Each holder of shares of Common Stock is entitled to one vote for each share held, in accordance with the articles of incorporation and bylaws, including voting on the election of directors. Of the 10.0 million shares of Common Stock authorized by the Holding Company, 5.1 million shares remain un-issued. In addition, none of the 5.0 million shares of Preferred Stock authorized by the articles of incorporation have been issued.
DIVIDEND POLICY
The Board of Directors of the Company intends to continue the policy of paying dividends when the directors deem it prudent to do so. The Board of Directors will consider payment of dividends on a quarterly basis, after giving consideration to all relevant factors. On August 25, 2004, the Board of Directors of the Company declared a $.105 per share cash dividend and a 5% stock dividend based on the their review and evaluation of financial results of the quarter ended June 30, 2004. The cash dividend will be calculated on shares held before the issuance of the stock dividend. During fiscal 2004, 2003, and 2002 the Company paid a total of $2.0 million, $1.8 million, and $1.7 million, respectively, in cash dividends and a 5% stock dividend in each year. Cash dividends from the Holding Company are primarily dependent upon dividends paid to it by the Bank or PCIS, which, in turn, are subject to certain restrictions established by federal regulators and Pennsylvania law. (See Notes to Consolidated Financial Statements.)
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
Market risk is the risk of loss from adverse changes in market prices and rates. The Company's market risk arises primarily from the interest rate risk inherent in its lending, investment and deposit taking activities. To that end, management actively monitors and manages its interest rate risk exposure.
Until recently, market interest rates have steadily declined beginning in December 2001 resulting in the lowest interest rate environment in over 40 years. Even with the recent increase, interest rates remain at historically low levels. As a result, loans, which are linked to an index such as the London Interbank Offered Rate ("Libor") or Prime Rate, were re-priced at lower interest rates and deposit products have re-priced as deposits rates are adjusted. The principal source of deposits, the certificates of deposit, will adjust only when they mature and are renewed by the customers.
The Company's profitability is affected by fluctuations in interest rates. A sudden and substantial change in interest rates may adversely impact the Company's earnings to the extent that the yields on interest-sensitive assets and interest-sensitive liabilities do not change at the same speed, to the same extent, or on the same basis. The Company monitors the impact of changes in interest rates between assets and liabilities as discussed in the "Asset/Liability Management" in Item 7 hereof. Although interest rate sensitivity gap analysis is a useful measurement tool and contributes towards effective asset liability management, it is difficult to predict the effect of changing interest rates based solely on that measure.
The Company utilizes an income simulation modeling to measure the Company's interest rate risk and to manage its interest rate sensitivity. Income simulation considers not only the impact of changing market interest rates on forecasted net interest income, but also other factors such as yield curve relationships, the volume and mix of assets and liabilities, customer preferences and general market conditions.
Through the use of income simulation modeling the Company is able to calculate an estimate of net interest income for the year ending June 30, 2005, based upon the assets, liabilities and off-balance sheet financial instruments in existence at June 30, 2004. The Company has also estimated changes to that estimated net interest income based upon interest rates rising or falling in monthly increments ("rate ramps"). Rate ramps assume that all interest rates increase or decrease in monthly increments evenly throughout the period modeled.
Economic value of equity ("EVE") estimates the discounted present value of asset and liability cash flows. Discount rates are based upon market prices for comparable assets and liabilities. Upward and downward rate shocks are used to measure volatility in relation to such interest rate movements in relation to an unchanged environment. This method of measurement primarily evaluates the longer-term re-pricing risks and options in the Company's balance sheet. The following table reflects the estimated economic value of equity at risk and the ratio of EVE adjusted equity to EVE adjusted assets at June 30, 2004, resulting from shocks to interest rates.
Certain shortcomings are inherent in the methodology used in the above interest rate risk measurements. Modeling changes in net present value ("NPV") require the making of certain assumptions, which may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. In this regard, the NPV table presented above assumes that the composition of the Company's interest sensitive assets and liabilities existing at the beginning of a period remains constant over the period being measured and also assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration to maturity or re-pricing of specific assets and liabilities. Accordingly, although the NPV table provides an indication of the Company's interest rate risk exposure at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on the Company's net interest income and will differ from actual results.
The Company's primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on the Company's net interest income and capital, while structuring the Company's asset/liability structure to obtain the maximum yield/cost spread on that structure. The Company relies primarily on its asset/liability structure to control interest rate risk.
The Company continually evaluates interest rate risk management opportunities, including the use of derivative financial instruments. At June 30, 2004, the Company was positively gapped whereby its' interest-earning assets were re-pricing at a quicker rate than its interest-bearing liabilities. To partially offset the negative impact of the current low market interest rate environment, the Company entered into three separate interest rate swap transactions aggregating $41 million notional amount to hedge certain of its' higher rate FHLBP Advances. The swaps had the effect of converting the higher fixed rate Advances to lower adjustable rate borrowings, which positively impacts the Company's net interest margin in the current interest rate environment. Further, since the Company is positively gapped; if the balance sheet were to remain static, future increases should have similar impacts to the earnings and costs of the interest-earning assets and interest-bearing liabilities. Additionally, in August 2003, the Bank purchased a $30 million notional amount 3.50% Three Month LIBOR interest rate cap while simultaneously selling a $30 million notional amount 6.00% Three Month LIBOR interest rate cap ("Interest Rate Corridor"). The Company paid a net premium, which entitles it to receive the difference between Three Month LIBOR from 3.50% to 6.00% times the $30 million notional amount. The Interest Rate Corridor is being used to hedge the cash flows of $10.3 million in floating rate Trust Preferred Securities as well as the cash flows of certain borrowings, which could negatively impact earnings in a rising interest rate environment. .
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
MANAGEMENT'S REPORT ON EFFECTIVENESS OF INTERNAL CONTROL OVER FINANCIAL REPORTING
To Our Shareholders:
The management of First Financial Bank (the "Bank") is responsible for establishing and maintaining effective internal control over financial reporting presented in conformity with accounting principles generally accepted in the United States of America, including controls over the safeguarding of assets. This internal control contains monitoring mechanisms, and actions are taken to correct deficiencies identified.
There are inherent limitations in any internal control including the possibility of human error and the circumvention or overriding the controls. Accordingly, even an effective internal control can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the degree of effectiveness of an internal control structure may vary over time.
Management assessed the Bank's internal control structure over financial reporting presented in conformity with accounting principles generally accepted in the United States of America, including controls over the safeguarding of assets, as of June 30, 2004. This assessment was based on criteria for effective internal control over financial reporting established in "Internal Control-Integrated Framework" issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that, as of June 30, 2004, the Bank maintained effective internal control over financial reporting presented in conformity with accounting principles generally accepted in the United States of America, including the safeguarding of assets.
Management is also responsible for compliance with the federal laws and regulations concerning dividend restrictions and loans to insiders designated by the Federal Deposit Insurance Corporation as safety and soundness laws and regulations.
The Bank assessed its compliance with the designated laws and regulations relating to safety and soundness. Based on this assessment, management believes that First Financial Bank complied, in all material respects, with the designated laws and regulations related to safety and soundness as of June 30, 2004.
/s/ Donna M. Coughey Donna M. Coughey President and Chief Executive Officer
/s/ Joseph T. Crowley Joseph T. Crowley Chief Financial Officer
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Chester Valley Bancorp Inc.
We have audited the accompanying consolidated statements of financial condition of Chester Valley Bancorp Inc. and subsidiaries (the "Bank") as of June 30, 2004 and 2003, and the related statements of operations, changes in stockholders' equity and comprehensive income, and cash flows for each of the years in the three year period ended June 30, 2004. These consolidated financial statements are the responsibility of the Bank's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with standards of the Public Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Chester Valley Bancorp, Inc. and subsidiaries as of June 30, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three year period ended June 30, 2004 in conformity with accounting principles generally accepted in the United States of America.
/s/ KPMG LLP Philadelphia, Pennsylvania July 28, 2004
See accompanying notes to consolidated financial statements.
(*) Earnings per share and weighted average shares outstanding have been restated to reflect the effects of the 5% stock dividends paid in September 2003, 2002, and 2001. See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BUSINESS
Chester Valley Bancorp Inc. (the "Holding Company") was incorporated in the Commonwealth of Pennsylvania in August 1989. Effective September 1, 2001, the Holding Company became a bank holding company as a result of the conversion of First Financial Bank ("First Financial" or the "Bank") from a Pennsylvania chartered savings association to a Pennsylvania chartered commercial bank. The Bank holding company has also been designated as a financial holding company. The business of the Holding Company and its subsidiaries (collectively the "Company") consists of the operations of First Financial and Philadelphia Corporation for Investment Services ("PCIS"), a full service investment advisory and securities brokerage firm. The Bank provides a wide range of banking services to individual and corporate customers through its ten branch banks in Chester County, Pennsylvania. All of the branches are full service and offer commercial and retail products. These products include checking accounts (non-interest and interest-bearing), savings accounts, certificates of deposit, commercial and installment loans, real estate mortgages, and home equity loans. The Bank also offers ancillary services that complement these products. The Bank is subject to competition from other financial institutions and other companies that provide financial services. PCIS is registered as a broker/dealer in all 50 states and Washington, DC and it is also registered as an investment advisor with the Securities Exchange Commission. PCIS provides many additional services, including self-directed and managed retirement accounts, safekeeping, daily sweep money market funds, portfolio and estate valuations, life insurance and annuities, and margin accounts to individuals and smaller corporate accounts. The Company is subject to the regulations of various federal and state agencies and undergoes periodic examinations by those regulatory authorities.
PRINCIPLES OF CONSOLIDATION AND PRESENTATION
The accompanying consolidated financial statements include the accounts of the Holding Company and its wholly owned subsidiaries, First Financial and PCIS. The accounts of the First Financial include its wholly-owned subsidiary, D & S Service Corp., which owns D & F Projects and Wildman Projects, Inc., both of which are wholly-owned subsidiaries and First Financial Investments. All material intercompany balances and transactions have been eliminated in consolidation. Prior period amounts are reclassified when necessary to conform to the current year's presentation.
The Company follows accounting principles and reporting practices, which are in accordance with accounting principles generally accepted in the United States of America. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the statement of financial condition and revenues and expenses for the period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses, income taxes, and the valuation of investment securities. Management believes that the allowance for loan losses, the balances in the income tax accounts, and the valuation of investment securities are adequate. Various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses and valuations of real estate owned. Such agencies may require the Bank to recognize additions to the allowance or adjustments to the valuations based on their judgments about information available to them at the time of their examination.
RECENT ACCOUNTING PRONOUNCEMENTS
ACQUISITIONS OF CERTAIN FINANCIAL INSTITUTIONS
In October 2002, the FASB issued Statement No. 147, Acquisitions of Certain Financial Institutions, which amends SFAS No. 72, Accounting for Certain Acquisitions of Banking or Thrift Institutions, SFAS No.144, Accounting for the Impairment or Disposal of Long-Lived Assets, and FASB Interpretation No. 9. Except for transactions between two or more mutual enterprises, this Statement removes acquisitions of financial institutions from the scope of both Statement No. 72 and Interpretation 9 and requires that those transactions be accounted for in accordance with FASB Statements No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets. Thus, the requirement in paragraph 5 of Statement No. 72 to recognize any excess of the fair value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired as an unidentifiable intangible asset of a business no longer applies to acquisitions within the scope of this Statement. In addition, this Statement amends Statement No. 144 to include in its scope long-term customer-relationship intangible assets of financial institutions such as depositor and borrower-relationship intangible assets and credit cardholder intangible assets. Consequently, those intangible assets are subject to the same undiscounted cash flow recoverability test and impairment loss recognition and measurement provisions that Statement No. 144 requires for other long-lived assets that are held and used.
With some exceptions, the requirements of Statement No. 147 became effective October 1, 2002. The adoption of this Statement did not have an impact on the Company's consolidated earnings, financial condition, or equity.
ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company, as permitted, has elected not to adopt the fair value accounting provisions of SFAS No. 123 "Accounting for Stock-based Compensation", and has instead continued to apply APB Opinion 25 and related Interpretations in accounting for plans and provide the required pro-forma disclosures of SFAS No.123. Had the grant-date fair-value provisions of SFAS No.123 been adopted, the Company would have recognized the following: (Dollars in thousands, except per share items)
Year Ended June 30 ------------------------ 2004 2003 2002 ---- ---- ----
Net income, as reported $6,310 $5,262 $5,575 Deduct: Total stock based employee Compensation expense determined Under fair-value methods for all awards, Net of related tax effects 266 579 333 ------ ------ ------ Pro-forma net income $6,044 $4,683 $5,242 ====== ====== ======
Earnings per share: Basic - as reported $1.30 $1.10 $1.17 Basic - pro-forma $1.25 $1.03 $1.15
Diluted - as reported $1.26 $1.06 $1.16 Diluted - pro-forma $1.20 $1.00 $1.15
The effects of pro-forma net income and diluted earnings per share of applying the disclosure requirements of SFAS 123 for past fiscal years may not be representative of the future pro-forma effects on net income and earnings per share due to the vesting provisions of the options and future awards that are available to be granted.
In December 2002, the FASB issued Statement No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, which amends FASB Statement No. 123, Accounting for Stock-Based Compensation. This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.
The requirements of Statement No. 148 are effective for financial statements for fiscal years beginning after December 15, 2003; the disclosure requirements for the annual period financial statements of the Statement are included in this report.
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES - AMENDMENT OF STATEMENT 133
In April 2003, the FASB issued Statement No.149, Amendment of Statement No.133 on Derivative Instruments and Hedging Activities, which establishes accounting and reporting standards for derivative instruments, including derivatives imbedded in other contracts and hedging activities. This Statement amends Statement No. 133 for decisions made by the FASB as part of its Derivatives Implementation Group process. This Statement also amends Statement No. 133 to incorporate clarifications of the definition of a derivative. The Statement is effective for contracts entered into or modified and hedging relationships designated after June 30, 2003. The provisions of this Statement did not have a material impact on the Company's consolidated earnings, financial condition or equity.
ACCOUNTING FOR CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH LIABILITIES AND EQUITY
In May 2003, the FASB issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, which establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Some of the provisions of this Statement are consistent with the current definition of liabilities in FASB Concepts Statement No. 6, Elements of Financial Statements. The remaining provisions of this Statement are consistent with the FASB's proposal to revise that definition to encompass certain obligations that a reporting entity can or must settle by issuing its own equity shares, depending on the nature of the relationship established between the holder and the issuer. For nonpublic entities, mandatorily redeemable financial instruments are subject to the provisions of this Statement for the first fiscal period beginning after December 15, 2003. The adoption of this Statement did not have a material impact on its financial position or results of operations.
CONSOLIDATION OF VARIABLE INTEREST ENTITIES
In December 2003, the Financial Accounting Standards Board revised Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51 (the Interpretation). The Interpretation requires the consolidation of entities in which an enterprise absorbs a majority of the entity's expected losses, receives a majority of the entity's expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity. Previously, entities were generally consolidated by an enterprise when it has a controlling financial interest through ownership of a majority voting interest in the entity. Application of this Interpretation is required in financial statements of public entities that have interests in variable interest entities or potential variable interest entities commonly referred to as special purpose entities for periods ending after December 15, 2003. Application by public entities for all other types of entities is required in financial statements for periods ending after March 15, 2004. As a result of the adoption of FIN 46, the Company deconsolidated Chester Valley Statutory Trust in the first quarter of 2004. The result was an increase in the junior debt of $310 thousand.
CASH AND CASH EQUIVALENTS
For the purpose of the consolidated statements of cash flows, cash and cash equivalents include cash and interest-bearing deposits with an original maturity of generally three months or less.
SECURITIES
The Company divides its securities portfolio into three segments: (a) held to maturity; (b) available for sale; and (c) trading. At the time of purchase, the Company makes a determination on whether or not it will hold the investments to maturity, based upon an evaluation of the probability of the occurrence of future events. Securities classified as held to maturity are accounted for at amortized cost adjusted for amortization of premiums and accretion of discounts using a method which approximates a level yield, based on the Company's intent and ability to hold the securities until maturity. Trading securities are accounted for at quoted market prices with changes in market values thereof being recorded as gain or loss in the statement of operations. All other securities, including investment securities which the Company believes may be involved in interest rate risk, liquidity, or other asset-liability management decisions which might reasonably result in such securities not being held until maturity, are included in the available for sale category and are accounted for at fair value with unrealized gains or losses, net of taxes, being reflected as adjustments to accumulated other comprehensive income. If investment securities are sold, any gain or loss is determined by specific identification and reflected in the operating results for the period in which the sale occurs.
OTHER THAN TEMPORARY IMPAIRMENT OF INVESTMENT SECURITIES
Securities are evaluated periodically to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term "other than temporary" is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support realizable value equal to or greater than carrying value of the investment. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at a level that represents management's best estimate of known and inherent losses, which are probable and reasonably determinable based upon an evaluation of the loan portfolio. Homogeneous portfolios of loans, which include residential mortgage, home equity and other consumer loans, are evaluated as a group. Commercial business loans greater than $100,000, commercial mortgage and construction loans are evaluated individually. Specific portions of the allowance are developed by analyzing individual loans for adequacy of collateral, cash flow and other risks unique to that particular loan. General portions of the allowance are developed by grading individual loans in the commercial and construction portfolios and applying loss factors by grade. The general portion of the allowance also includes loss factors applied to the homogeneous portfolios as a group. The loss factors applied to graded loans were developed based on the Company's loss history for loans with similar attributes, local and national economic conditions as well as input from the Company's primary banking regulators. Loss factors are applied to homogeneous loans based upon prior loss experience of the portfolio, local and national economic conditions, delinquency trends and the volume of non-performing loans. Although management believes it has used the best information available to it in making such determinations, and that the present allowance for loan losses is adequate, future adjustments to the allowance may be necessary, and net income may be adversely affected if circumstances differ substantially from the assumptions used in determining the level of the allowance. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for losses on loans. Such agencies may require the Bank to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. The allowance is increased by the provision for loan losses, which is charged to operations. Loan losses, other than those incurred on loans held for sale, are charged directly against the allowance and recoveries on previously charged-off loans are added to the allowance.
For purposes of applying the measurement criteria for impaired loans, the Company excludes large groups of smaller balance homogeneous loans, primarily consisting of residential real estate loans and consumer loans as well as commercial business loans with balances of less than $100,000. For applicable loans, the Company evaluates the need for impairment recognition when a loan becomes non-accrual or earlier if, based on management's assessment of the relevant facts and circumstances, it is probable that the Company will be unable to collect all proceeds under the contractual terms of the loan agreement. At and during the years ended June 30, 2004, 2003 and 2002, the recorded investment in impaired loans was not significant. The Company's policy for the recognition of interest income on impaired loans is the same as for non-accrual loans. A portion of an impaired loan is charged off when the Company determines that foreclosure is probable and the fair value of the collateral is less than the recorded investment of the impaired loan.
LOANS, LOAN ORIGINATION FEES AND UNCOLLECTED INTEREST
Loans (other than loans held for sale) are recorded at cost net of unearned discounts, deferred fees and allowances. Discounts and premiums on purchased loans are amortized using the interest method over the remaining contractual life of the portfolio, adjusted for actual prepayments. Loan origination fees and certain direct origination costs are deferred and amortized over the life of the related loans as an adjustment of the yield on the loans using a level yield method of accounting.
Uncollected interest receivable on loans is accrued to income as earned. Non-accrual loans are loans on which the accrual of interest has ceased because the collection of principal or interest payments is determined to be doubtful by management. It is the policy of the Company to discontinue the accrual of interest when principal or interest payments are delinquent 90 days or more (unless the loan principal and interest are determined by management to be fully secured and in the process of collection), or earlier, if the financial condition of the borrower raises significant concern with regard to the ability of the borrower to service the debt in accordance with the current loan terms. The Company uses the contractual due date in determining the delinquent status of a loan. Interest income on such loans is not accrued until the financial condition and payment record of the borrower once again demonstrate the ability to service the debt.
LOANS HELD FOR SALE
The Company originates certain loans that are designated as held for sale at the time of their origination. These loans are immediately sold with servicing released and the company does not retain any interest or obligation after the loans are sold. These loans consist primarily of fixed-rate, single-family residential mortgage loans which meet the underwriting characteristics of certain government-sponsored enterprises (conforming loans). Loans held for sale are carried at the lower of aggregate cost or fair value, with any resulting loss included in non-interest income for the period. Realized gains or losses are included in non-interest income for the period. The Company recognizes servicing fee income when payments are received.
REAL ESTATE OWNED ("REO")
Real estate acquired through foreclosure or by deed in lieu of foreclosure is classified as REO. REO is carried at the lower of cost (lesser of carrying value of the loan or fair value of the property at date of acquisition) or fair value less selling expenses. Costs relating to the development or improvement of the property are capitalized; holding costs are charged to expense.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost, less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which range from 15 to 30 years for property and 3 to 7 years for equipment. When assets are retired or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts. The cost of maintenance and repairs is charged to expense as incurred and renewals and betterments are capitalized.
DERIVATIVE FINANCIAL INSTRUMENTS
The Company may utilize certain derivative instruments as a tool in its asset/liability management. At June 30, 2004, the Company was positively gapped whereby its' interest-earning assets were re-pricing at a quicker rate than its' interest-bearing liabilities. To partially offset the negative impact of the current low market interest rate environment, the Company entered into three separate interest rate swaps aggregating $41 million notional amount to hedge certain of its' higher rate FHLBP Advances. The swap had the effect of converting the higher fixed rate Advances to lower adjustable rate borrowings, which positively impacts the Company's net interest margin in the current interest rate environment. As the terms of the Swap match that of the FHLBP Advances, the Swap is deemed a perfect hedge in accordance with SFAS No. 133 and changes in the fair market value of the Swap will increase (decrease) a Swap asset or liability with a corresponding offset to the FHLBP Advances. The interest differential paid or received is reflected as an increase (decrease) to the interest expense on the FHLBP Advances. Further, since the Company is positively gapped; if the balance sheet were to remain static, future increases should have similar impacts to the earnings and costs of the interest-earning assets and interest-bearing liabilities. Additionally, in August 2003, the Bank purchased a $30 million notional amount 3.50% Three Month LIBOR interest rate cap while simultaneously selling a $30 million notional amount 6.00% Three Month LIBOR interest rate cap ("Interest Rate Corridor"). The Company paid a net premium, which entitles it to receive the difference between Three Month LIBOR from 3.50% to 6.00% times the $30 million notional amount. The Interest Rate Corridor is being used to hedge the cash flows of $10.3 million in floating rate Trust Preferred Securities as well as the cash flows of certain borrowings, which could negatively impact earnings in a rising interest rate environment.
DEFERRED INCOME TAXES
The Company accounts for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for operating losses and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
EARNINGS PER SHARE
The dilutive effect of stock options is excluded from basic earnings per share, but included in the computation of diluted earnings per share. Earnings per share and weighted average shares outstanding have been adjusted to reflect the effects of the 5% stock dividends paid in September 2003, 2002, and 2001. The following table sets forth the computation of basic and diluted earnings per share (Dollars in thousands, except per share data):
YEAR ENDED JUNE 30, ------------------------ 2004 2003 2002 ------ ------ ------ Numerator: Net income $6,310 $5,262 $5,575 ------ ------ ------ Denominator: Denominator for basic earnings per share-weighted average shares 4,841 4,771 4,774 Effect of dilutive securities: Employee stock options 176 170 21 ------ ------ ------ Denominator for diluted earnings per share-adjusted weighted average shares and assumed exercise 5,017 4,941 4,805 ====== ====== ====== Basic earnings per share $ 1.30 $ 1.10 $ 1.17 ====== ====== ====== Diluted earnings per share $ 1.26 $ 1.06 $ 1.16 ====== ====== ======
GOODWILL AND OTHER INTANGIBLES
Goodwill represents the excess of the purchase price over the fair value of net assets acquired in accordance with the purchase method of accounting. Other intangibles represent primarily the net present value of the future economic benefits to be derived from the purchase of core deposits ("core deposit intangible"), which are being amortized on an accelerated basis over their estimated useful lives of approximately eight years. Effective July 1, 2001, the Company adopted certain provisions of Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets," as required for goodwill and intangible assets resulting from business combinations consummated after June 30, 2001. For all business combinations completed after June 30, 2001, such as the acquisition of the Coatesville Branch from PNC National Bank (see note 2), goodwill is deemed to have an indefinite life and is therefore not amortized, but is subject to annual impairment tests.
The Company adopted the remaining provisions of SFAS No. 142 on April 1, 2002. Under these rules, all goodwill and intangible assets deemed to have indefinite lives are no longer amortized, but are subject to annual impairment tests in accordance with the provisions of SFAS No. 142. Other intangible assets continue to be amortized over their estimated useful lives.
NOTE 2 - ACQUISITIONS
Effective March 31, 2004, in order to further enhance its existing branch network, First Financial Bank acquired the Coatesville, Chester County, Pennsylvania branch of PNC National Bank. As a result of the acquisition, First Financial Bank assumed approximately $19.6 million of deposit liabilities and acquired $4.0 million in consumer and commercial loans and buildings of $550,000. Additionally, the Company recorded an approximate $400,000 Core Deposit Intangible and $1.2 million in goodwill. The acquisition was accounted for using the purchase method of accounting. The following table details the assets acquired and liabilities assumed as a result of the branch acquisition (Dollars in thousands):
ASSETS ACQUIRED: Cash on hand $ 13,536 Loans 3,955 Premise and equipment 550 Goodwill 1,171 Core deposit intangible 395 ------------ Total assets acquired $ 19,607 ============
Deposits $ 19,607 ------------ Total liabilities assumed $ 19,607 ============
NOTE 3 - INVESTMENT SECURITIES
The following table summarizes the estimated fair value of securities with gross unrealized losses at June 30, 2004, segregated between securities that have been in a continuous unrealized loss position for less than twelve months and those that have been in a continuous unrealized loss position for twelve months or longer (Dollars in thousands).
Management does not believe any individual unrealized loss as of June 30, 2004 represents an other-than-temporary impairment. The temporary impairment is directly related to changes in market interest rates. In general, as interest rates rise, the fair value of fixed-rate securities will decrease and, as interest rates fall, the fair value of fixed-rate securities will increase. The severity of the impairment as a percent of the total investment position is nominal and the duration of the impairment to date is short. The impairments are deemed temporary based on the direct relationship of the decline in fair value to movements in interest rates, as well as the relatively short duration of the investments and their high credit quality.
Securities that have been impaired greater than twelve months include primarily trust preferred corporate debt and preferred stock. The decline in the market value of these securities was deemed temporary due to positive factors supporting the recoverability of these investments. Positive factors considered include credit ratings, timely interest payments, dividend payments, and the financial health of the issuer.
Investment securities are summarized (Dollars in thousands) as follows:
The amortized cost and estimated fair value of investment securities at June 30, 2004 by contractual maturity, are shown below (Dollars in thousands).
Expected maturities may differ from contractual maturities because borrowers generally have the right to call or prepay obligations without prepayment penalties. The weighted average yield, based on amortized cost, is presented on a taxable equivalent basis using the Federal marginal rate of 34% adjusted for the 20% interest expense disallowance (27.2%). Proceeds from sales and calls of investment securities available for sale during fiscal 2004, 2003, and 2002, were $97.3 million, $125.6 million and $77.6 million, respectively. Gross gains of $1.1 million, $865 thousand and $454 thousand, in fiscal 2004, 2003 and 2002, respectively, and gross losses, including impairment losses, of $68 thousand, $383 thousand, and $1.1 million, in fiscal 2004, 2003, and 2002, respectively, were realized on those sales. Accrued interest receivable on investments amounted to $1.2 million and $908 thousand at June 30, 2004 and 2003, respectively. At June 30, 2004, $41.8 million of investment securities were pledged as collateral for Municipal savings deposits with the Bank, for securities sold under agreements to repurchase, and for the Bank's treasury, tax and loan account with the Federal Reserve.
Included in investment securities available for sale at June 30, 2004 are three non-rated Pennsylvania Municipal Authority Bonds that have been classified as substandard. These bonds were originally purchased during the period from June 1998 through June 2000. The aggregate book value of the bonds; after write-downs of $955 thousand, is $5.6 million. Two of the three bonds with an aggregate book value of $4.9 million are zero coupon bonds with maturities extending up to 2034. Both bonds are secured by the revenue streams of commercial office buildings, which are leased to various agencies of the Commonwealth of Pennsylvania under long-term lease arrangements with renewal options.
The third bond was issued by the Housing Authority of Chester County and has a book balance of $720 thousand and bears interest at rates between 5.60% and 6% and matures in June 2019. This bond involves low-income scattered housing in Chester County under a program of the Office of Housing and Urban Development ("HUD"). HUD has committed to provide additional funds to build additional houses, which would be donated to this bond issues. The retirement of the bond issue is dependent upon proceeds from either the rental or sale of the existing and additional houses. This bond is on non-accrual at June 30, 2004
These classified investments are closely monitored and fairly stated at June 30, 2004 based on available information. There can be no assurance that further subsequent adverse or positive developments may occur and thus could result in further adjustments to the carrying value of these investments.
Debt securities included in available for sale securities at June 30, 2004 and 2003 primarily consist of long term Corporate Debt obligations with investment grade ratings and most of these obligations are floating rates tied to movements in the Treasury markets.
NOTE 4 - LOANS RECEIVABLE
Loans receivable, (Dollars in thousands) are summarized as follows:
AT JUNE 30, -------------------- 2004 2003 --------- --------- First mortgage loans: Residential $ 74,004 $ 101,997 Construction - residential 18,745 22,877 Land acquisition and development 13,928 17,964 Commercial 140,721 122,207 Construction-commercial 16,187 16,232 Commercial business 49,142 43,059 Consumer 114,787 88,918 --------- --------- Total loans 427,514 413,254
Less: Undisbursed loan proceeds Construction - residential (16,223) (22,359) Construction - commercial (9,326) (3,585) Deferred loan fees (508) (933) Allowance for loan losses (6,331) (5,415) --------- --------- Net loans $ 395,126 $ 380,962 ========= =========
Accrued interest receivable on loans amounted to $1.5 million at both June 30, 2004 and 2003. At June 30, 2004, 2003, and 2002, the Company serviced loans for others totaling $9.9 million, $18.0 million and $23.7 million, respectively.
The aggregate amount of loans by the Company to its directors and executive officers was $255 thousand and $3.0 million at June 30, 2004 and 2003, respectively. These loans were made in the ordinary course of business at substantially the same terms and conditions as those with other borrowers. An analysis of the activity of these loans, in millions, follows:
Balance at July 1, 2003 $3.0 New loans .2 Repayments (2.9) ------------ Balance at June 30, 2004 $ 0.3 ============
The total amount of non-performing loans was $4.2 million, $4.2 million, and $944 thousand, at June 30, 2004, 2003 and 2002, respectively. If these non-performing loans had been current in accordance with their original terms and had been outstanding throughout the period, the gross interest income for fiscal 2004, 2003, and 2002 that would have been recorded for these loans was $734 thousand, $451 thousand, and $195 thousand, respectively. Interest income on these non-performing loans included in income for fiscal 2004, 2003, and 2002 amounted to $107 thousand, $353 thousand, and $114 thousand, respectively. The total balance of impaired loans at June 30, 2004 and 2003 were $4.0 million and $3.2 million, respectively. The allowance for loan losses on impaired loans at June 30, 2004 was $1.3 million as compared to $644 thousand at June 30, 2003.
The activity in the allowance for loan losses (Dollars in thousands) was as follows:
YEAR ENDED JUNE 30, ------------------------------ 2004 2003 2002 -------- -------- -------- Balance, beginning of period $ 5,415 $ 4,588 $ 4,264 Provision for loan losses 971 879 547 Acquired with branch acquisition 45 -- -- Loans charged off (131) (76) (229) Recoveries 31 24 6 ------- ------- ------- Balance, end of period $ 6,331 $ 5,415 $ 4,588 ======= ======= =======
NOTE 5 - PROPERTY AND EQUIPMENT
Property and equipment by major classification are summarized (Dollars in thousands) as follows:
2004 2003 --------- --------- Land $ 1,569 $ 1,521 Buildings and improvements 12,678 11,653 Furniture, fixtures and equipment 5,580 5,004 -------- -------- Total 19,827 18,178 Less accumulated depreciation (6,818) (5,829) -------- -------- Net $ 13,009 $ 12,349 ======== ========
NOTE 6 - DEPOSITS
Deposits (Dollars in thousands) consist of the following major classifications:
At June 30, 2004 and 2003, municipal deposits totaled $11.6 million and $31.0 million, respectively, which are collateralized with pledged investments.
A summary of certificates by contractual maturity (Dollars in thousands) at June 30, 2004 is as follows:
YEARS ENDING JUNE 30, AMOUNT ------------------------------------- ---------- 2005 $ 61,723 2006 15,742 2007 11,261 2008 4,635 2009 11,228 2010 and thereafter 2,778 ----------- $107,367 ==========
Interest expense on deposits (Dollars in thousands) is comprised of the following:
YEAR ENDED JUNE 30, ------------------------------------- 2004 2003 2002 ------- ------- -------- NOW checking accounts $ 153 $ 304 $ 433 Money market deposit accounts 1,630 1,390 1,430 Savings accounts 75 202 320 Certificates less than $100,000 2,413 4,008 5,347 Certificates $100,000 & greater 1,029 2,069 3,652 ------- ------- -------- $ 5,300 $ 7,973 $ 11,182 ======= ======= ========
NOTE 7 - ADVANCES FROM FEDERAL HOME LOAN BANK OF PITTSBURGH ("FHLBP")
Under the terms of its collateral agreement with the FHLBP, the Company maintains otherwise unencumbered qualifying assets (principally 1-4 family residential mortgage loans and U.S. Government and Agency notes and bonds) in the amount of at least as much as its advances from the FHLBP. The Company's FHLBP stock is also pledged to secure these advances. At June 30, 2004 and 2003, such advances (Dollars in thousands) mature as follows:
Included in the table above at June 30, 2004 are $81.0 million of convertible advances whereby the FHLBP (Federal Home Loan Bank of Pittsburgh) has the option at a predetermined time to convert the fixed interest rate to an adjustable rate tied to LIBOR (London Inter Bank Offering Rate). The Bank has the option to prepay these advances if the FHLBP converts the interest rate. These advances are included in the year of their stated maturity.
The Company has a line of credit of $10 million with the FHLBP. The Company, from time to time, will use the line of credit to meet liquidity needs. At June 30, 2004 and 2003, there were no balances outstanding on the line of credit.
NOTE 8 - TRUST PREFERRED SECURITIES
On March 26, 2002, the Company issued $10.3 million of Junior Subordinated Debentures to Chester Valley Statutory Trust, a Pennsylvania Business Trust, in which the Company owns all of the common equity. The Trust then issued $10.0 million of Trust Preferred Securities, which pay interest quarterly at three-month Libor plus 3.60% to investors, which are secured by the Junior Subordinated Debentures and the guarantee of the Company. The Junior Subordinated Debentures are treated as debt of the Company but they qualify as Tier I capital, subject to certain limitations under the risk-based capital guidelines of the Federal Reserve. The Trust Preferred Securities are callable by the Company on March 26, 2007, or at any time in the event the deduction of related interest for federal income taxes is prohibited, the treatment as Tier I capital is no longer permitted or under certain other circumstances. The Trust Preferred Securities must be redeemed by the Company; upon their maturity, in 2032.
NOTE 9 -INCOME TAXES
The provision (and benefit) for income taxes is summarized as follows (Dollars in thousands):
AT JUNE 30, ------------------------------ 2004 2003 2002 -------- -------- -------- Current: Federal $ 2,016 $ 1,923 $ 1,471 State 82 68 97 Deferred - Federal (83) (364) (213) -------- -------- -------- Total $ 2,015 $ 1,627 $ 1,355 ======== ======== ========
In addition to amounts applicable to income before taxes, the following income tax expense (benefit) amounts were recorded in shareholder's equity (Dollars in thousands):
AT JUNE 30, ------------------------------ 2004 2003 2002 -------- -------- -------- Compensation expense for tax purposes in excess of amounts recognized for financial statement purposes (173) $ (137) $ (27) Other comprehensive results (1,516) 802 465 -------- -------- -------- Total income tax expense (benefit) (1,689) $ 665 $ 438 ======== ======== ========
The provision for income taxes differs from the statutory rate due to the following (Dollars in thousands):
AT JUNE 30, ------------------------------ 2004 2003 2002 -------- -------- -------- Federal income taxes at statutory rate $ 2,830 $ 2,342 $ 2,356 Tax exempt interest and dividends, net (619) (578) (796) State taxes, net of federal benefit 54 45 64 Increase in cash value of BOLI (85) (56) -- Low income housing tax credits (139) (139) (270) Other, net (26) 13 1 -------- -------- -------- $ 2,015 $ 1,627 $ 1,355 ======== ======== ========
The deferred tax assets and liabilities at June 30, 2004 and 2003 consisted of the following (Dollars in thousands): AT JUNE 30, --------------------- 2004 2003 --------------------- Deferred tax assets: Tax credit carry-forward $ -- $ 221 Allowance for loan losses 2,153 1,841 Deferred compensation 138 59 Uncollected interest 150 78 Net unrealized loss on securities available for sale 1,106 -- Investment in joint ventures 87 49 Write-down investment securities -- 130 Other 38 31 ------ ------ Gross deferred tax assets 3,672 2,409 ------ ------
Deferred tax liabilities: Tax bad debt reserves -- 27 Loan discount 46 60 Net unrealized gain on securities available for sale -- 410 Goodwill amortization 7 -- Depreciation 286 178 ------ ------ Gross deferred tax liabilities 339 675 ------ ------ Net deferred tax assets $3,333 $1,734 ====== ======
The realization of deferred tax assets is dependent upon a variety of factors, including the generation of future taxable income, the existence of taxes paid and recoverable, the reversal of deferred tax liabilities and tax planning strategies. Based upon these and other factors, management believes it is more likely than not that the Company will realize the benefits of these deferred tax assets.
The Small Business Job Protection Act of 1996 ("Act"), enacted on August 20,1996, provides for the repeal of the tax bad debt deduction computed under the percentage of taxable income method. The repeal of the use of this method is effective for tax years beginning after December 31, 1995. Prior to the change in law, the Bank had qualified under the provisions of the Code, which permitted it to deduct from taxable income an allowance for bad debts based on 8% of taxable income.
Upon repeal, the Bank is required to recapture into income, over a six-year period, the portion of its tax bad debt reserves that exceed its base year reserves (i.e., tax reserves for tax years beginning before 1988). The base year tax reserves, which may be subject to recapture if the Bank ceases to qualify as a bank for federal income tax purposes, are restricted with respect to certain distributions. The Bank's total tax bad debt reserves at June 30, 2004, are approximately $2.6 million of which $2.6 million represents the base year amount and $0 is subject to recapture. The Company has previously recorded a deferred tax liability for the excess base year reserves to be recaptured; therefore, this recapture will not impact the statement of operations.
NOTE 10 - COMMITMENTS AND CONTINGENCIES
Financial instruments with off-balance-sheet risk: - --------------------------------------------------
In the normal course of business, the Company is a party to financial instruments with off-balance-sheet risk, which meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. Commitments to originate loans amounted to $10.0 million as of June 30, 2004, which represent fixed-rate loans with interest rates ranging 6.00% to 6.75%. At June 30, 2004, the Company had undisbursed loans in process for construction loans of $25.5 million and $83.2 million in undisbursed lines of credit. In addition, at such date the Company has issued $1.1 million in commercial letters of credit fully secured by deposit accounts or real estate.
Concentration of credit risk: - -----------------------------
The Company is principally a local lender and therefore has a significant concentration of residential and commercial real estate loans as well as consumer and commercial business loans to borrowers who reside in and/or which are collateralized by real estate located primarily in Chester County, Pennsylvania. The ability of such customers to honor these obligations is dependent, in varying degrees, on the overall economic performance of this diversified area.
Other commitments and contingencies: - ------------------------------------
The Bank and PCIS have entered into operating leases for several of their branch and office facilities. The minimum annual rental payments under these leases at June 30, 2004, (Dollars in thousands) are as follows:
MINIMUM LEASE YEAR PAYMENTS ------------------------ ------------------ 2005 $ 790 2006 675 2007 522 2008 468 2009 445 2010 and thereafter 1,912
Rent expense under these leases for each of the years ended June 30, 2004, 2003, and 2002, was $893 thousand, $737 thousand, and $639 thousand, respectively.
The Company, the Bank and two employees (together "the parties") have been sued in the Court of Common Pleas in Philadelphia, County by a former employee to recover damages for breach of contract and other matters. The Company adamantly denies any wrongdoing and intends to aggressively defend its actions. The matter has been referred to the Company's insurance carrier, who has engaged counsel to defend its actions. The policy carries a $100,000 deductible, which includes cost of defense. The $100,000 was expensed as of June 30, 2003. The Company believes it will be successful in its defense; however, in the event the parties are unsuccessful in their defense, the Company does not believe the lawsuit would have a material adverse effect on the financial condition of the Company as insurance coverage was and is in place.
The Company is involved in other routine, non-material legal proceedings occurring in the ordinary course of business which management believes will not have a material adverse effect on the financial condition or operations of the Company.
NOTE 11 - AFFILIATED TRANSACTIONS
Two directors of the Company are a principal and a partner in law firms which the Company retained during fiscal years 2004, 2003, and 2002, and which the Company intends to retain during fiscal year 2005. The amount of legal fees paid to the law firms did not exceed 5% of those firms' gross revenues for any such year.
A director of the Company is a director and president of a mortgage-banking firm from which the Company purchased single-family residential mortgage loans during fiscal year 2000, and the Company may resume the business relationship during fiscal year 2005.
NOTE 12 - STOCKHOLDERS' EQUITY
At the time of its conversion from a state-chartered mutual association to a state-chartered capital stock association, the Bank established a liquidation account in an amount equal to $4.8 million at September 30, 1986. The liquidation account is maintained for the benefit of eligible savings account holders who have maintained their savings account in the Bank after conversion. In the unlikely event of a complete liquidation, each eligible savings account holder will be entitled to receive a liquidation distribution from the liquidation account, in the amount of the then current adjusted sub-account balance for savings accounts held, before any liquidation distribution may be made with respect to capital stock.
Except for the repurchase of stock and payment of dividends by the Bank, the existence of the liquidation account does not restrict the use or application of such net worth. The Company may not declare or pay a cash dividend on, or repurchase, any of its common stock if the effect thereof would cause the net worth of the Bank to be reduced below the amount required for the liquidation account.
In September 2003, 2002 and 2001, the Company paid 5% common stock dividends in the amounts of 228,000 shares, 216,000 shares and 206,000 shares, respectively, from authorized but unissued common stock with fractional shares being paid in the form of cash.
NOTE 13 - REGULATORY CAPITAL
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. As a result of the Holding Company's designation as a bank holding company, it will also become subject to regulatory capital requirements. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's and the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off balance sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). At June 30, 2004 and 2003 the Bank was in compliance with all such requirements and is deemed a "well-capitalized" institution for regulatory purposes. There are no conditions or events since June 30, 2003 that management believes have changed the institution's category.
The Company's and the Bank's actual capital amounts and ratios for June 30, 2004 and June 30, 2003, as calculated under FDIC regulations are presented in the table as follows (Dollars in thousands).
NOTE 14 - FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company is required to disclose estimated fair values for its financial instruments.
Limitations - -----------
Estimates of fair value are made at a specific point in time, based upon, where available, relevant market prices and information about the financial instrument. Such estimates do not include any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. For a substantial portion of the Company's financial instruments, no quoted market exists. Therefore, estimates of fair value are necessarily based on a number of significant assumptions (many of which involve events outside the control of management). Such assumptions include assessments of current economic conditions, perceived risks associated with these financial instruments and their counterparts, future expected loss experience and other factors. Given the uncertainties surrounding these assumptions, the reported fair values represent estimates only, and therefore cannot be compared to the historical accounting model. Use of different assumptions or methodologies are likely to result in significantly different fair value estimates.
The estimated fair values presented neither include nor give effect to the values associated with the Company's banking, or other businesses, existing customer relationships, extensive branch banking network, property, equipment, goodwill or certain tax implications related to the realization of unrealized gains or losses. Also, the fair values of non-interest-bearing demand deposits, savings and NOW accounts and money market deposit accounts are equal to the carrying amount because these deposits have no stated maturity. This approach to estimating fair value excludes the significant benefit that results from the low-cost funding provided by such deposit liabilities, as compared to alternative sources of funding. As a consequence, the fair value of individual assets and liabilities may not be reflective of the fair value of a financial services organization that is a going concern.
The following methods and assumptions were used to estimate the fair value of each major classification of financial instrument at June 30, 2004 and 2003:
Cash and cash equivalents: - -------------------------
Current carrying amounts approximate estimated fair value.
Trading account securities, securities held to maturity and securities available - -------------------------------------------------------------------------------- for sale: - --------
Current quoted market prices were used to determine fair value.
Loans: - -----
Fair values were estimated for portfolios of loans with similar financial characteristics. Loans were segregated by type, and each loan category was further segmented by fixed- and adjustable-rate interest terms. The estimated fair value of the segregated portfolios was calculated by discounting cash flows through the estimated maturity and prepayment speeds while using estimated market discount rates that reflected credit and interest risk inherent in the loans. The estimate of the maturities and prepayment speeds was based on the Company's historical experience.
Deposits: - --------
The fair value of deposits with no stated maturity, such as non-interest-bearing deposits, savings, NOW and money market accounts, as well as repurchase agreements, is equal to the amount payable on demand. The fair value of certificates of deposit was estimated by discounting the contractual cash flows using current market rates offered in the Company's market area for deposits with comparable terms and maturities.
Borrowed Funds: - --------------
The fair value of borrowings was estimated using rates currently available to the Company for debt with similar terms and remaining maturities.
Off-Balance Sheet Instruments: - -----------------------------
The fair value of off-balance sheet instruments, including commitments to extend credit and stand-by letters of credit, is estimated using the fees currently charged to enter into similar agreements with comparable remaining terms and reflects the present creditworthiness of the counterparties.
The Company may utilize certain derivative instruments as a tool in its asset/liability management. To partially offset the negative impact of the current low market interest rate environment, the Company entered into three separate interest rate swaps aggregating $41 million notional amount to hedge certain of its' higher rate FHLBP Advances. The swaps had the effect of converting the higher fixed rate Advances to lower adjustable rate borrowings, which positively impacts the Company's net interest margin in the current interest rate environment. As the terms of the Swap match that of the FHLBP Advances, the Swap is deemed a perfect hedge in accordance with SFAS No. 133 and changes in the fair market value of the Swap will increase (decrease) a Swap asset or liability with a corresponding offset to the FHLBP Advances. The interest differential paid or received is reflected as an increase (decrease) to the interest expense on the FHLBP Advances. Further, since the Company is positively gapped; if the balance sheet were to remain static, future increases should have similar impacts to the earnings and costs of the interest-earning assets and interest-bearing liabilities. Additionally, in August 2003, the Bank purchased a $30 million notional amount 3.50% Three Month LIBOR interest rate cap while simultaneously selling a $30 million notional amount 6.00% Three Month LIBOR interest rate cap ("Interest Rate Corridor"). The Company paid a net premium, which entitles it to receive the difference between Three Month LIBOR from 3.50% to 6.00% times the $30 million notional amount. The Interest Rate Corridor is being used to hedge the cash flows of $10.3 million in floating rate Trust Preferred Securities as well as the cash flows of certain borrowings, which could negatively impact earnings in a rising interest rate environment.
The carrying amounts and estimated fair values of the Company's financial instruments were as follows (Dollars in thousands):
The estimated fair value of the Company's off-balance sheet financial instruments is as follows (Dollars in thousands):
NOTE 15 - EMPLOYEE BENEFITS
Stock Compensation Program - --------------------------
The Company has two stock option plans (collectively, the "Plans") -- the 1993 Plan and the 1997 Plan. At June 30, 2004, an aggregate of 0 and 134,082, respectively, options were available for grant under the 1993 Plan and the 1997 Plans, respectively. As of June 30, 2004, there were 297,621 and 615,313 options granted under the 1993 and 1997 Plans, respectively. Under the Plans, the option price per share for options granted may not be less than the fair market value of the common stock on the date of grant. Options may be granted under the 1993 Plan and the 1997 Plan during the ten-year periods ending August 2003 and August 2007, respectively, and options granted under the Plans are exercisable up to ten years from the date of grant. Rights to exercise options under the Plans may be limited by imposition of vesting schedules at the time the options are granted.
The following table is a summary of option transactions since June 30, 2001. These options and option prices for the years 2004, 2003, and 2002 have been adjusted to reflect the stock dividends.
At June 30, 2004, the range of exercise prices was $6.92 to $23.33 and the weighted average remaining contractual life of the outstanding options is 7.2 years. The Black-Scholes option-pricing model was used to determine the grant-date fair value of options. Significant assumptions used in the model included a weighted average risk free rate of return of 3.52% in 2004, 3.25% in 2003, and 5.09% in 2002; expected option life of 6 years for 2004, 2003, and 2002 ; expected stock price volatility of 32.83% for 2004, 34.33% for 2003, and 32.37% for 2002, and expected dividends of 1.96%, 2.55%, and 2.59%, for 2004, 2003, and 2002, respectively.
Employee Stock Ownership Plan (ESOP) - ------------------------------------
The Bank maintains an ESOP for all employees of the Bank with at least one year of credited service. Benefits become 20% vested after three years of service, increasing to 100% after seven years. Forfeitures are reallocated amongst remaining participating employees. Vested benefits are generally payable upon retirement, disability or separation from service.
The ESOP is subject to the requirements of the Employee Retirement Income Security Act of 1974, as amended, and the regulations of the Internal Revenue Service and the Department of Labor.
The ESOP has been funded by contributions from the Bank, and benefits to participants are normally paid in cash or whole shares of common stock.
The ESOP plan was established in October 1987. Contributions to the ESOP and forfeited shares were allocated among members on the basis of compensation. Dividends received on the ESOP shares are allocated to participants based on the number of shares held by each participant. A total of 16,755; 9,197 and 13,466 shares were allocated in fiscal 2004, 2003 and 2002, respectively. The shares of stock allocated by the ESOP during the three years ended June 30, 2004 were purchased by the plan from Company contributions and dividends received on the ESOP shares.
Contributions by the Bank to the ESOP in fiscal 2004, 2003 and 2002 amounted to $25 thousand, $24 thousand and $50 thousand, respectively, and are included in the accompanying consolidated statements of operations in salaries and employee benefits. The ESOP loans matured and were paid in April 1999.
Pension Plan - ------------
The Bank has a noncontributory defined benefit pension plan, which is fully funded through a multi-employer investment trust covering qualified salaried employees. Costs recognized for the years ended June 30, 2004, 2003, and 2002, totaled $378 thousand, $260 thousand, and $209 thousand, respectively. Information relative to the financial status of the Bank's portion of the Plan is not currently available.
NOTE 16 - SEGMENT REPORTING
The Company has two reportable segments: the Bank and PCIS. The Bank operates a branch bank network with twelve full-service banking offices and provides deposits and loan services to customers. Additionally, the Bank offers trust services at its Downingtown headquarters. PCIS operates a full service investment advisory and securities brokerage firm through two offices. Both segments operate primarily in southeastern Pennsylvania.
The Company evaluates performance based on profit or loss from operations after income taxes not including nonrecurring gains and losses. There are no material intersegment sales or transfers. The Company's reportable segments have traditionally been two independent financial services institutions. The two segments are managed separately. All senior officers from PCIS prior to the acquisition have been retained to manage the segment.
The following table highlights income statement and balance sheet information for each of the segments at or for the years ended June 30, 2004, 2003, and 2002 (Dollars in thousands):
FOR THE YEAR ENDED JUNE 30, 2004: BANK PCIS TOTAL ------------------------------------------------------------------ Net interest income $ 19,142 $ 8 $ 19,150 Other income 5,353 3,733 9,086 Total Net income 5,927 383 6,310 Total assets 640,493 1,615 642,108 Total interest-bearing deposits 14,028 1,324 15,352 Total trading securities -- 8 8
FOR THE YEAR ENDED JUNE 30, 2003: BANK PCIS TOTAL ------------------------------------------------------------------ Net interest income $ 17,810 $ 13 $ 17,823 Other income 4,223 3,351 7,574 Total Net income 4,949 313 5,262 Total assets 582,665 1,863 584,528 Total interest-bearing deposits 8,047 1,391 9,438 Total trading securities -- 10 10
FOR THE YEAR ENDED JUNE 30, 2002: BANK PCIS TOTAL ------------------------------------------------------------------ Net interest income $ 18,073 $ 33 $ 18,106 Other income 1,826 3,522 5,348 Total Net income 5,214 361 5,575 Total assets 564,368 1,664 566,032 Total interest-bearing deposits 27,862 1,301 29,163 Total trading securities -- 16 16
NOTE 17 - SUMMARIZED QUARTERLY FINANCIAL DATA FOR FISCAL 2004 AND 2003 (UNAUDITED) (Dollars in thousands except per share data)
(1) Earnings per share have been restated to reflect the effects of the 5% stock dividends paid in September 2003 and 2002.
NOTE 18 - PARENT COMPANY FINANCIAL INFORMATION (in thousands)
Financial information of Chester Valley Bancorp Inc. (parent company only) follows:
STATEMENTS OF FINANCIAL CONDITION JUNE 30, --------------------- 2004 2003 -------- -------- ASSETS On deposit with subsidiaries $ 1,162 $ 454 Securities available for sale 688 1,236 Investment in subsidiaries 60,667 57,741 Other assets 141 466 -------- -------- TOTAL ASSETS $ 62,658 $ 59,897 ======== ========
LIABILITIES Other liabilities $ 91 $ 16 Subordinated debentures 10,310 10,310 -------- -------- TOTAL LIABILITIES 10,401 10,326
STOCKHOLDERS' EQUITY 52,257 49,571 -------- -------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 62,658 $ 59,897 ======== ========
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
ITEM 9a.
ITEM 9a. CONTROLS AND PROCEDURES
Our management evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and regulations and are operating in an effective manner.
No change in our internal control over financial reporting (as defined in Rules 13a-15(f) or 15(d)-15(f) under the Securities Exchange Act of 1934) occurred during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART III --------
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required herein is incorporated by reference from pages 4 to 8 of the Company's Definitive Proxy Statement for the Annual meeting of Stockholders to be held on October 25, 2004, which was filed with the SEC on September 10, 2004 ("Definitive Proxy Statement").
The Company has adopted a code of ethics policy, which applies to its' principal executive officer, principal financial officer, principal accounting officer, as well as its' directors and employees generally. The Company will provide a copy of its' code of ethics to any person, free of charge, upon request. Any requests for a copy should be made to our shareholder relations administrator, Chester Valley Bancorp, 100 E. Lancaster Avenue, Downingtown, Pa 19335.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required herein is incorporated by reference on pages 9 to 14 of the Company's Definitive Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required herein is incorporated by reference from pages 2 to 3 of the Company's Definitive Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required herein is incorporated by reference to page 15 through page 18 of the Definitive Proxy Statement.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANTS FEES AND SERVICES
The information required herein is incorporated by reference to page 18 of the Definitive Proxy Statement.
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report:
(1) The following consolidated financial statements and report of Independent Auditors of Chester Valley Bancorp Inc. and Subsidiaries are included in Item 8 of this Annual Report on Form 10-K:
(a) Consolidated Statements of Financial Condition at June 30, 2004 and 2003. (b) Consolidated Statements of Operations for the Years Ended June 30, 2004, 2003, and 2002. (c) Consolidated Statements of Stockholders' Equity and Comprehensive Income for the Years Ended June 30, 2004, 2003, and 2002. (d) Consolidated Statements of Cash Flows for the Years Ended June 30, 2004, 2003 and 2002. (e) Notes to Consolidated Financial Statements. (f) Report of Independent Auditors.
(2) Financial statement schedules for which provision is made in the applicable accounting regulations of the SEC are omitted because of the absence of the conditions under which they are required or because the required information is set forth in the Consolidated Financial Statements or Notes thereto.
(b) The following reports on Form 8-K have been filed in the last quarter of this report:
(1) Current report on Form 8-K with respect to Items 12 and 7 filed on April 3, 2004. (2) Current report on Form 8-K with respect to Items 5 and 7 filed on May 27, 2004. (3) Current report on Form 8-K with respect to items 7 and 9 filed on June 17, 2004.
(c) The following exhibits are filed as a part of this Form 10-K.
INDEX TO EXHIBITS
Number Description of Documents - ------ ------------------------
3a Restated Articles of Incorporation** 3b Bylaws, as amended (filed herewith) 4 Specimen Stock Certificate* 10a Key Employee Stock Compensation Program, as amended** 10b Employee Stock Ownership Plan** 10c Employment Agreement By and Between the Holding Company, the Bank and Donna M. Coughey***** 10d Employment Agreement By and Between the Holding Company, the Bank and Colin N. Maropis** 10e Amendment No. 1 to the Employment Agreement By and Between the Holding Company, the Bank and Colin N. Maropis *** 10f Change in Control Agreement By and Between the Holding Company, the Bank and Joseph T. Crowley****** 10g Change in Control Agreement By and Between the Holding Company, the Bank and Michael Sexton****** 10h Form of Change in Control Agreement By and Between the Holding Company, the Bank and G. Richard Bertolet, Christopher Breslin, Matthew Kelly, Margaret Leimkuhler and Thomas Varley****** 10i 1997 Stock Option Plan as amended **** 10j 1993 Stock Option Plan as amended ****
11 Statement re: computation of per share earnings - reference is made to Item 8 hereof 21 Subsidiaries of the Registrant - Reference is made to Item, 1, Business - Subsidiaries," for the required information 23 Consent of Registered Independent Public Accounting Firm (filed herewith) 31.1 Certification of the Chief Executive Officer pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 dated September 10, 2004 (filed herewith) 31.2 Certification of the Chief Financial Officer pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 dated September 10, 2004 (filed herewith) 32.1 Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 dated September 10, 2004 (filed herewith) 32.2 Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 dated September 10, 2004 (filed herewith) (*) Incorporated herein by reference from the Company's Registration Statement on Form S-4 (33-30433) dated August 10, 1989 (**) Incorporated herein by reference from the Company's Annual Report on Form 10-KSB for the year ended June 30, 1990 (***) Incorporated herein by reference from the Company's Annual Report on Form 10-KSB for the year ended June 30, 1992 (****) Incorporated herein by reference from the Company's Annual Report on Form 10-KSB for the year ended June 30, 1997 (*****) Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended June 30, 2001. (******) Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended June 30, 2003. (d) Not Applicable
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this amended report to be signed on its behalf by the undersigned, thereunto duly authorized.
CHESTER VALLEY BANCORP INC.
Dated: September 10, 2004 By: /s/ Donna M. Coughey ---------------------------------------- Donna M. Coughey Director, President and Chief Executive Officer
Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed by the following persons in the capacities and on the dates indicated.