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PENNS WOODS BANCORP INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operation

May 12, 2014

EARNINGS SUMMARY

Comparison of the Three Months Ended March 31, 2014 and 2013

Summary Results

Net income for the three months ended March 31, 2014 was $3,469,000 compared to $3,684,000 for the same period of 2013 as after-tax securities gains decreased $621,000 (from a gain of $986,000 to a gain of $393,000). In addition, a gain of $174,000 on death benefits related to bank owned life insurance was recorded during the first quarter of 2014. Basic and diluted earnings per share for the three months ended March 31, 2014 and 2013 were $0.72 and $0.96, respectively. Return on average assets and return on average equity were 1.15% and 10.58% for the three months ended March 31, 2014 compared to 1.72% and 15.51% for the corresponding period of 2013. Net income from core operations ("operating earnings") increased to $3,036,000 for the three months ended March 31, 2014 compared to $3,033,000 for the same period of 2013. Operating earnings per share for the three months ended March 31, 2014 were $0.63 basic and dilutive compared to $0.79 basic and dilutive for the three months ended March 31, 2013. Management uses the non-GAAP measure of net income from core operations, or operating earnings, in its analysis of the Company's performance. This measure, as used by the Company, adjusts net income by excluding significant gains or losses that are unusual in nature. Because certain of these items and their impact on the Company's performance are difficult to predict, management believes the presentation of financial measures excluding the impact of such items provides useful supplemental information in evaluating the operating results of the Company's core businesses. For purposes of this Quarterly Report on Form 10-Q, net income from core operations, or operating earnings, means net income adjusted to exclude after-tax net securities gains or losses and bank-owned life insurance gains on death benefit. These disclosures should not be viewed as a substitute for net income determined in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies. Reconciliation of GAAP and Non-GAAP Financial Measures Three Months Ended (Dollars in Thousands, Except Per Share Data) March 31, 2014 2013 GAAP net income $ 3,469$ 3,684 Less: net securities and bank-owned life insurance gains, net of tax 433 651 Non-GAAP operating earnings $ 3,036$ 3,033 Three Months Ended March 31, 2014 2013 Return on average assets (ROA) 1.15 % 1.72 %



Less: net securities and bank-owned life insurance gains, net of tax

0.14 % 0.31 % Non-GAAP operating ROA 1.01 % 1.41 % Three Months Ended March 31, 2014 2013 Return on average equity (ROE) 10.58 % 15.51 %



Less: net securities and bank-owned life insurance gains, net of tax

1.32 % 2.74 % Non-GAAP operating ROE 9.26 % 12.77 % Three Months Ended March 31, 2014 2013 Basic earnings per share (EPS) $ 0.72$ 0.96 Less: net securities and bank-owned life insurance gains, net of tax 0.09 0.17 Non-GAAP basic operating EPS $ 0.63$ 0.79 28



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Table of Contents Three Months Ended March 31, 2014 2013 Dilutive EPS $ 0.72$ 0.96 Less: net securities and bank-owned life insurance gains, net of tax 0.09 0.17 Non-GAAP dilutive operating EPS $ 0.63$ 0.79 Interest and Dividend Income Interest and dividend income for the three months ended March 31, 2014 increased to $11,329,000 compared to $9,540,000 for the same period of 2013. The increase was due to loan portfolio income increasing as the impact of portfolio growth, due primarily due to the acquisition of Luzerne Bank, offset a reduction in yield of 81 basis points ("bp") due to the competitive landscape and the continued low rate environment that is impacting new loan rates as well as the variable rate segment of the loan portfolio. The loan portfolio income increase was partially offset by a decrease in investment portfolio interest due to a decline in the average taxable equivalent yield of 38 bp as the duration in the investment portfolio continues to be shortened in order to reduce interest rate and market risk in the future. This is being undertaken primarily through the sale of long-term municipal bonds that have a maturity date of 2025 or later and securities with a call date within the next five years. To offset the revenue impact of the declining asset yields, a focus has been placed on increasing earning assets by adding quality short and intermediate term loans such as home equity loans, even though these new earning assets are a lower yields than legacy assets.



Interest and dividend income composition for the three months ended March 31, 2014 and 2013 was as follows:

Three Months Ended March 31, 2014 March 31, 2013 Change (In Thousands) Amount % Total Amount % Total Amount % Loans including fees $ 8,813 77.79 % $ 6,768 70.94 % $ 2,045 30.22 % Investment securities: Taxable 1,458 12.87 1,443 15.13 15 1.04 Tax-exempt 931 8.22 1,267 13.28 (336 ) (26.52 ) Dividend and other interest income 127 1.12 62 0.65 65 104.84 Total interest and dividend income $ 11,329 100.00 % $ 9,540 100.00 % $ 1,789 18.75 % Interest Expense Interest expense for the three months ended March 31, 2014 decreased $93,000 to $1,242,000 compared to $1,335,000 for the same period of 2013. The decrease associated with deposits is primarily the result of a reduction of 32 and 12 bps in the rate paid on time deposits and money markets, respectively, and a continued shift from higher cost time deposits to core deposits, with emphasis on money market and NOW accounts. Factors that led to the rate decreases include, but are not limited to, Federal Open Market Committee ("FOMC") actions to maintain low interest rates, campaigns conducted by the Company to focus on core deposit (non-time deposit) growth as the building block to solid customer relationships, and the acquisition of Luzerne Bank. In addition, during the past two years the time deposit portfolio has been shortened in order to increase repricing frequency. The time deposit portfolio is now slowly being lengthened to build protection when interest rates begin to increase. In addition, the Marcellus Shale natural gas exploration in north central Pennsylvania is creating opportunities to gather new and build upon existing deposit relationships. Borrowing interest expense decreased as FHLB long-term borrowings have matured and have been replaced at rates less than 1% with maturities ranging from four to five years.



Interest expense composition for the three months ended March 31, 2014 and 2013 was as follows:

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Table of Contents Three Months Ended March 31, 2014 March 31, 2013 Change (In Thousands) Amount % Total Amount % Total Amount % Deposits $ 758 61.03 % $ 791 59.25 % $ (33 ) (4.17 ) % Short-term borrowings 15 1.21 25 1.87 (10 ) (40.00 ) Long-term borrowings 469 37.76 519 38.88 (50 ) (9.63 ) Total interest expense $ 1,242 100.00 % $ 1,335 100.00 % $ (93 ) (6.97 ) % Net Interest Margin The net interest margin ("NIM") for the three months ended March 31, 2014 was 3.96% compared to 4.46% for the corresponding period of 2013. The NIM declined as a 26 bp decline in the rate paid on interest bearing liabilities was countered by a 70 bp decline in the yield on interest earning assets. The decrease in earning asset yield is due to the impact of the current low rate environment on the loan and investment portfolios. In addition, the duration of the investment portfolio has been shortened by utilizing variable rate and intermediate term corporate bonds to offset the relatively longer duration of the municipal bonds within the portfolio. This shortening of the investment portfolio limits current earnings due to the low rates on the short end of the interest rate curve, but it also limits interest rate risk and will provide cash flow over the next few years as we anticipate a period of increasing rates.



The

decrease in the cost of interest bearing liabilities from 0.85% to 0.59% was driven by a reduction in the rate paid on time deposits of 32 bp. The reduction in the rate paid on time deposits was the result of shortening the time deposit portfolio, which has resulted in an increasing repricing frequency during this period of low rates. In addition, a focus on increasing core deposits has resulted in significant growth in lower cost core deposits. The duration of the time deposit portfolio has slowly started to be lengthened due to the apparent bottoming or near bottoming of deposit rates. The average rate on long-term borrowings declined due to the maturity of FHLB borrowings during 2013.



The following is a schedule of average balances and associated yields for the three months ended March 31, 2014 and 2013:

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Table of Contents AVERAGE BALANCES AND INTEREST RATES Three Months Ended March 31, 2014 Three Months Ended March 31, 2013 (In Thousands) Average Balance Interest Average Rate Average Balance Interest Average Rate Assets: Tax-exempt loans $ 27,190 $ 306 4.57 % $ 21,757 $ 249 4.64 % All other loans 770,656 8,611 4.53 % 495,789 6,604 5.40 % Total loans 797,846 8,917 4.53 % 517,546 6,853 5.34 % Fed funds sold 562 - - % - - - % Taxable securities 176,725 1,577 3.57 % 161,529 1,504 3.72 % Tax-exempt securities 97,131 1,411 5.81 % 127,474 1,920 6.02 % Total securities 273,856 2,988 4.36 % 289,003 3,424 4.74 % Interest-bearing deposits 16,043 8 0.20 % 3,683 1 0.11 % Total interest-earning assets 1,088,307 11,913 4.42 % 810,232 10,278 5.12 % Other assets 116,465 48,485 Total assets $ 1,204,772 $ 858,717 Liabilities and shareholders' equity: Savings $ 139,756 32 0.09 % $ 84,545 24 0.12 % Super Now deposits 176,806 157 0.36 % 137,315 174 0.51 % Money market deposits 206,812 133 0.26 % 144,366 135 0.38 % Time deposits 232,182 436 0.76 % 171,733 458 1.08 % Total interest-bearing deposits 755,556 758 0.41 % 537,959 791 0.60 % Short-term borrowings 20,101 15 0.30 % 21,370 25 0.47 % Long-term borrowings 71,202 469 2.63 % 75,889 519 2.74 % Total borrowings 91,303 484 2.12 % 97,259 544 2.24 % Total interest-bearing liabilities 846,859 1,242 0.59 % 635,218 1,335 0.85 % Demand deposits 212,152 116,021 Other liabilities 14,608 12,457 Shareholders' equity 131,153 95,021 Total liabilities and shareholders' equity $ 1,204,772 $ 858,717 Interest rate spread 3.83 % 4.27 % Net interest income/margin $ 10,671 3.96 % $ 8,943 4.46 % 1. Information on this table has been calculated using average daily balance sheets to obtain average balances. 2. Non-accrual loans have been included with loans for the purpose of analyzing net interest earnings. 3. Income and rates on a fully taxable equivalent basis include an adjustment for the difference between annual income from tax-exempt obligations and the taxable equivalent of such income at the standard 34% tax rate. The following table presents the adjustment to convert net interest income to net interest income on a fully taxable equivalent basis for the three months ended March 31, 2014 and 2013. 31



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Table of Contents Three Months Ended March 31, (In Thousands) 2014 2013 Total interest income $ 11,329$ 9,540 Total interest expense 1,242 1,335 Net interest income 10,087 8,205 Tax equivalent adjustment 584 738 Net interest income (fully taxable equivalent) $ 10,671



$ 8,943

The following table sets forth the respective impact that both volume and rate changes have had on net interest income on a fully taxable equivalent basis for the three months ended March 31, 2014 and 2013: Three Months Ended March 31, 2014 vs. 2013 Increase (Decrease) Due to (In Thousands) Volume Rate Net Interest income: Tax-exempt loans $ 61$ (4 )$ 57 All other loans 3,204 (1,197 ) 2,007 Fed funds sold - - - Taxable investment securities 138 (65 ) 73 Tax-exempt investment securities (443 ) (66 ) (509 ) Interest bearing deposits 7 - 7 Total interest-earning assets 2,967 (1,332 ) 1,635 Interest expense: Savings deposits 14 (6 ) 8 Super Now deposits 43 (60 ) (17 ) Money market deposits 96 (98 ) (2 ) Time deposits 136 (158 ) (22 ) Short-term borrowings (1 ) (9 ) (10 ) Long-term borrowings (31 ) (19 ) (50 )



Total interest-bearing liabilities 257 (350 ) (93 ) Change in net interest income $ 2,710$ (982 )$ 1,728

Provision for Loan Losses

The provision for loan losses is based upon management's quarterly review of the loan portfolio. The purpose of the review is to assess loan quality, identify impaired loans, analyze delinquencies, ascertain loan growth, evaluate potential charge-offs and recoveries, and assess general economic conditions in the markets served. An external independent loan review is also performed annually for the Bank. Management remains committed to an aggressive program of problem loan identification and resolution. The allowance for loan losses is determined by applying loss factors to outstanding loans by type, excluding loans for which a specific allowance has been determined. Loss factors are based on management's consideration of the nature of the portfolio segments, changes in mix and volume of the loan portfolio, and historical loan loss experience. In addition, management considers industry standards and trends with respect to non-performing loans and its knowledge and experience with specific lending segments. Although management believes it uses the best information available to make such determinations and that the allowance for loan losses is adequate at March 31, 2014, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making the initial determinations. A downturn in the local economy, increased unemployment, and delays in receiving financial information from borrowers could result in increased levels of nonperforming assets, charge-offs, loan loss provisions, and reductions in income. Additionally, as an integral part of the examination process, bank regulatory agencies periodically review the Bank's loan loss allowance. The banking agencies could require the recognition of additions to the loan loss allowance based on their judgment of information available to them at the time of their examination. 32



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Table of Contents

When determining the appropriate allowance level, management has attributed the allowance for loan losses to various portfolio segments; however, the allowance is available for the entire portfolio as needed. The allowance for loan losses decreased from $10,144,000 at December 31, 2013 to $8,520,000 at March 31, 2014. The decrease in the allowance for loan losses was driven by net charge-offs during the three months ended March 31, 2014 of $2,134,000. The majority of the loans charged-off had a specific allowance within the allowance for losses. At March 31, 2014 and December 31, 2013, the allowance for loan losses to total loans was 1.04% and 1.24%, respectively.



The

ratio was impacted by the growth in the loan portfolio due to the acquisition of Luzerne Bank and the related purchase accounting adjustments.

The provision for loan losses totaled $485,000 and $500,000 for the three months ended March 31, 2014 and 2013. The amount of the provision for loan losses was the result of several factors, including but not limited to, a ratio of nonperforming loans to total loans of 1.29% at March 31, 2014 and a ratio of the allowance for loan losses to nonperforming loans of 80.27% at March 31, 2014. Nonperforming loans increased to $10,614,000 at March 31, 2014 from $9,059,000 at March 31, 2013 due primarily to one commercial real estate backed loan becoming non-performing. Internal loan review and analysis coupled with the ratios noted previously dictated that the provision for loan losses was at a level of $485,000 for the three months ended March 31, 2014. The amount of the provision for loan losses for the period ended March 31, 2014 did not equate to the change in nonperforming loans as of March 31, 2014 because the majority of the non-performing loans are centered on several loans that are either in a secured position and have sureties with a strong underlying financial position or have a specific allocation for any impairment recorded within the allowance for loan losses.



The following is a table showing total nonperforming loans as of:

Total Nonperforming Loans (In Thousands) 90 Days Past Due Non-accrual Total March 31, 2014 $ 153$ 10,461$ 10,614 December 31, 2013 604 9,074 9,678 September 30, 2013 231 5,833 6,064 June 30, 2013 8 6,507 6,515 March 31, 2013 37 9,022 9,059 Non-interest Income Total non-interest income for the three months ended March 31, 2014 compared to the same period in 2013 increased $478,000 to $3,211,000. Excluding net securities gains/losses, non-interest income for the three months ended March 31, 2014 increased $1,071,000 compared to the 2013 period due in part to the acquisition of Luzerne Bank. The increase in service charges was driven by the acquisition of Luzerne Bank. Bank owned life insurance income increased primarily due to a gain on death benefits. Insurance commissions and brokerage commissions increased due in part to the acquisition of Luzerne Bank and a shift in product mix. Other income was impacted by the acquisition of Luzerne Bank as it increased as debit and credit card related income continues to build as debit cards continue to gain in popularity, while an increasing number of merchants utilize our merchant card services.



Non-interest income composition for the three months ended March 31, 2014 and 2013 was as follows:

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Table of Contents Three Months Ended March 31, 2014 March 31, 2013 Change (In Thousands) Amount % Total Amount % Total Amount % Service charges $ 595 18.53 % $ 442 16.17 % $ 153 34.62 % Securities gains, net 393 12.24 986 36.08 (593 ) (60.14 ) Bank-owned life insurance 370 11.52 138 5.05 232 168.12 Gain on sale of loans 290 9.03 351 12.84 (61 ) (17.38 ) Insurance commissions 420 13.08 264 9.66 156 59.09 Brokerage commissions 271 8.44 248 9.07 23 9.27 Other 872 27.16 304 11.11



568 186.84 Total non-interest income $ 3,211 100.00 % $ 2,733 100.00 % $ 478 17.49 %

Non-interest Expense Total non-interest expense increased $2,792,000 for the three months ended March 31, 2014 compared to the same period of 2013 due primarily to the acquisition of Luzerne Bank. The increase in salaries and employee benefits was attributable to increases in salaries and health insurance coupled with the acquisition of Luzerne Bank. Occupancy and furniture and equipment expenses increased due to the additional branches of Luzerne Bank and significant upgrades to the core operating system, a new teller system, and various enhancements to other ancillary systems. Other expenses increased primarily due to increased fees related to providing debit card services and other expenses related to the acquisition of Luzerne Bank.



Non-interest expense composition for the three months ended March 31, 2014 and 2013 was as follows:


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Source: Edgar Glimpses


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