## COMPARISON OF OPERATING RESULTS FOR THE YEARS ENDED DECEMBER 31, 2012 AND DECEMBER 31, 2011 

SUMMARY OF PERFORMANCE. Net earnings for 2012 increased $1.9 million, or 42.0%, to $6.4 million as compared to 2011. The improvement in net earnings was primarily the result of a $3.1 million increase in non-interest income. The increase in non-interest income was primarily the result of a $2.9 million increase in gains on sales of loans as low mortgage rates increased our origination and sale volumes of one-to-four family residential real estate loans. Also contributing to our improved earnings was a $215,000 increase in net interest income, a $100,000 decrease in our provision for loan losses and an increase of $309,000 in net gains on investment securities. Partially offsetting those improvements were increases of $550,000 in non-interest expense and $1.3 million in income tax expense. 

Net interest income for 2012 increased $215,000 to $18.1 million, or 1.2% higher than 2011. Our net interest margin, on a tax equivalent basis, decreased from 3.77% during 2011 to 3.47% in 2012. Net interest margin declined as deposit growth outpaced loan demand, resulting in higher levels of investment securities and cash and cash equivalents, which typically earn lower yields than loans. The lower net interest margin was partially offset by an increase in average interest-earning assets from $510.6 million during 2011 to $562.5 million during 2012. Average interest-earning asset balances increased primarily as a result of the acquisition of The Wellsville Bank. It is unlikely that we will be able to increase our net interest margin from current levels in the near term and may continue to see a decline as we currently expect to reinvest our future cash flows into lower yielding investments and may not be able to renew our current loans at the same rates. 

We distributed a 5% stock dividend for the twelfth consecutive year in December 2012. All per share and average share data in this section reflect the 2012 and 2011 stock dividends. 

INTEREST INCOME. Interest income for 2012 decreased $534,000 to $22.1 million, a decrease of 2.4% as compared to 2011. Interest income on loans decreased $718,000, or 4.1%, to $16.7 million for 2012, due to lower tax equivalent yields earned on loans. Our average tax equivalent yield on loans decreased to 5.37% in 2012 from 5.61% in 2011. Partially offsetting the lower yields was an increase in average balances, which increased from $313.9 million in 2011 to $315.2 million in 2012. Interest income on investment securities increased $184,000, or 3.6%, to $5.3 million for 2012, as compared to 2011. The increase in interest income on investment securities was due to higher average balances of investment securities, which increased from $193.4 million during 2011 to $235.4 million during 2012 resulting in part from our purchases of additional investment securities with excess liquidity and in part from our acquisition of The Wellsville Bank. Partially offsetting the effects of this increase in average balances was a decline in the tax equivalent yield on our investment portfolio from 3.27% during 2011 to 2.76% during 2012. The yield on our investment securities declined as the current interest rate environment resulted in the purchase of lower yielding investment securities with funds from the maturities, prepayments and sales of higher yielding investment securities. 

INTEREST EXPENSE. Interest expense during 2012 decreased $749,000, or 16.1%, to $3.9 million as compared to 2011. Interest expense on interest-bearing deposits decreased $611,000, or 22.1%, to $2.1 million as a result of lower rates on our certificates of deposit, money market, NOW and savings accounts. Our total cost of deposits declined from 0.72% during 2011 to 0.50% during 2012 as we were able to reprice our deposits lower in the current low rate environment. Our average deposit balances increased from $385.7 million to $426.5 million over the same periods due both to organic growth and our acquisition of The Wellsville Bank. For 2012, interest expense on borrowings decreased $138,000, or 7.3%, to $1.8 million due to lower outstanding balances on our borrowings. Our average outstanding borrowings declined from $68.9 million in 2011 to $59.3 million in the same period of 2012 as we repaid our lower rate, short-term borrowings with excess liquidity, which increased our average cost of borrowings from 2.76% in 2011 to 2.97% in 2012. 

NET INTEREST INCOME. Net interest income represents the difference between income derived from interest- earning assets and the expense incurred on interest-bearing liabilities. Net interest income is affected by both the difference between the rates of interest earned on interest-earnings assets and the rates paid on interest-bearing liabilities (“interest rate spread”) as well as the relative amounts of interest-earning assets and interest-bearing liabilities. 

