News Column

LCNB CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

May 9, 2014

Forward Looking Statements Certain matters disclosed herein may be deemed to be forward-looking statements that involve risks and uncertainties. Forward looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact. Such statements are often characterized by the use of qualifying words and their derivatives such as "expects," "anticipates," "believes," "estimates," "plans," "projects," or other statements concerning opinions or judgments of LCNB and its management about future events. Factors that could influence the accuracy of such forward looking statements include, but are not limited to, regulatory policy changes, interest rate fluctuations, loan demand, loan delinquencies and losses, general economic conditions and other risks. Such forward-looking statements represent management's judgment as of the current date. Actual strategies and results in future time periods may differ materially from those currently expected. LCNB disclaims, however, any intent or obligation to update such forward-looking statements. LCNB intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.



Critical Accounting Policies

Allowance for Loan Losses. The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan losses when management believes that the collectability of the principal is unlikely. Subsequent recoveries, if any, are credited to the allowance. The allowance is an amount that management believes will be adequate to absorb inherent losses in the loan portfolio, based on evaluations of the collectability of loans and prior loan loss experience. The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrowers' ability to pay. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. The allowance consists of specific and general components. The specific component relates to loans that are classified as doubtful, substandard, or special mention. For such loans an allowance is established when the discounted cash flows or collateral value is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors, which include trends in underperforming loans, trends in the volume and terms of loans, economic trends and conditions, concentrations of credit, trends in the quality of loans, and borrower financial statement exceptions.



Based on its evaluations, management believes that the allowance for loan losses will be adequate to absorb estimated losses inherent in the current loan portfolio.

Acquired Credit Impaired Loans. LCNB accounts for acquisitions using the acquisition method of accounting, which requires that assets acquired and liabilities assumed be measured at their fair values at the acquisition date. Acquired loans are reviewed to determine if there is evidence of deterioration in credit quality since inception and if it is probable that LCNB will be unable to collect all amounts due under the contractual loan agreements. The analysis includes expected prepayments and estimated cash flows including principal and interest payments at the date of acquisition. The amount in excess of the estimated future cash flows is not accreted into earnings. The amount in excess of the estimated future cash flows over the book value of the loan is accreted into interest income over the remaining life of the loan (accretable yield). LCNB records these loans on the acquisition date at their net realizable value. Thus, an allowance for estimated future losses is not established on the acquisition date. Subsequent to the date of acquisition, expected future cash flows on loans acquired are updated and any losses or reductions in estimated cash flows which arise subsequent to the date of acquisition are reflected as a charge through the provision for loan losses. An increase in the expected cash flows adjusts the level of the accretable yield recognized on a prospective basis over the remaining life of the loan. Due to the number, size, and complexity of loans within the acquired loan portfolio, there is always a possibility of inherent undetected losses. 36



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LCNB CORP. AND SUBSIDIARIES



Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued)

Accounting for Intangibles. LCNB's intangible assets at March 31, 2014 are composed primarily of goodwill and core deposit intangibles related to the acquisitions of Sycamore during the fourth quarter 2007, First Capital during the first quarter 2013, and ENB during the first quarter 2014. It also includes mortgage servicing rights recorded from sales of mortgage loans to the Federal Home Loan Mortgage Corporation and mortgage servicing rights acquired through the merger with ENB. Goodwill is not subject to amortization, but is reviewed annually for impairment. The core deposit intangible for Sycamore was amortized on a straight line basis over six years. The core deposit intangible for First Capital is being amortized on a straight line basis over nine years and the core deposit intangible for ENB is being amortized on a straight line basis over eight years. Mortgage servicing rights are capitalized by allocating the total cost of loans between mortgage servicing rights and the loans based on their estimated fair values. Capitalized mortgage servicing rights are amortized to loan servicing income in proportion to and over the period of estimated servicing income, subject to periodic review for impairment. Results of Operations Net income for the three months ended March 31, 2014 was $1,323,000 (total basic and diluted earnings per common share of $0.14). This compares to net income of $1,728,000 (total basic and diluted earnings per common share of $0.23) for the same three month period in 2013. Results for 2014 were significantly affected by the completion of a merger with Eaton National Bank & Trust Co. ("ENB") on January 24, 2014 and the issuance of 1,642,857 new shares of voting common stock during the fourth quarter 2013. Results for 2013 were significantly affected by the completion of a merger with First Capital Bancshares, Inc. ("First Capital") and its subsidiary, Citizens National Bank of Chillicothe ("Citizens") on January 11, 2013. Net interest income for the three months ended March 31, 2014 was $1,385,000 greater than results for the comparative period in 2013 primarily due to the increased volume of average interest earning assets provided by the merger with ENB and by an increase in the net interest margin. The provision for loan losses for the first quarter 2014 was $68,000 less than for the same period in 2013. Net loan charge-offs for the first quarter 2014 and 2013 totaled $299,000 and $182,000, respectively. Other real estate owned (which includes property acquired through foreclosure or deed-in-lieu of foreclosure and also includes property deemed to be in-substance foreclosed) and other repossessed assets increased from $1,463,000 at December 31, 2013 to $1,799,000 at March 31, 2014 primarily due to a foreclosure and property obtained through the ENB acquisition. Non-interest income for the first quarter 2014 was $430,000 less than the comparable period in 2013 due to a combined $705,000 decrease in gains from sales of investment securities and mortgage loans, partially offset by increases in trust income and service charges and fees on deposit accounts. The decrease in gains from sales of investment securities and mortgage loans was due to lower sales volumes during the 2014 period. Non-interest expense for the first quarter 2014 was $1,581,000 more than the comparable period in 2013. Salaries and employee benefits, as well as a variety of other expense items, increased significantly due to the increased number of employees and offices resulting from the merger. Also contributing to the increase in non-interest expense were increases in other real estate owned expenses and merger-related expenses. Net Interest Income LCNB's primary source of earnings is net interest income, which is the difference between earnings from loans and other investments and interest paid on deposits and other liabilities. The following table presents, for the three months ended March 31, 2014 and 2013, average balances for interest-earning assets and interest-bearing liabilities, the income or expense related to each item, and the resulting average yields earned or rates paid. 37



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LCNB CORP. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Three Months Ended March 31, 2014 2013 Average Interest Average Average Interest Average Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ Balance Paid Rate Balance Paid Rate (Dollars in thousands) Loans (1) $ 647,535 7,696 4.82 % $ 536,518 6,580 4.97 % Federal funds sold - - - % 3,115 1 0.13 % Interest-bearing 13,892 8 0.23 % 13,166 7 0.22 % demand deposits Federal Reserve Bank 1,603 - - % 1,104 - - % stock Federal Home Loan 3,368 37 4.46 % 2,743 31 4.58 % Bank stock Investment securities: Taxable 199,723 891 1.81 % 188,749 834 1.79 % Non-taxable (2) 98,097 979 4.05 % 93,033 944 4.12 % Total earnings assets 964,218 9,611 4.04 % 838,428 8,397 4.06 % Non-earning assets 110,352 89,527 Allowance for loan (3,372 ) (3,349 ) losses Total assets $ 1,071,198$ 924,606 Interest-bearing $ 736,604 809 0.45 % $ 645,950 983 0.62 % deposits Short-term borrowings 10,814 3 0.11 % 11,623 3 0.10 % Long-term debt 11,821 103 3.53 % 13,396 112 3.39 % Total 759,239 915 0.49 % 670,969 1,098 0.66 % interest-bearing liabilities Demand deposits 185,447 153,026 Other liabilities 6,553 7,276 Capital 119,959 93,335 Total liabilities and $ 1,071,198$ 924,606 capital Net interest rate 3.55 % 3.40 % spread (3) Net interest income and net interest margin on a taxable-equivalent basis (4) 8,696 3.66 % 7,299 3.53 % Ratio of interest-earning assets to interest-bearing liabilities 127.00 % 124.96 %



(1) Includes nonaccrual loans, if any.

(2) Income from tax-exempt securities is included in interest income on a

taxable-equivalent basis. Interest income has been divided by a factor

comprised of the complement of the incremental tax rate of 34%.

(3) The net interest spread is the difference between the average rate on total

interest-earning assets and interest-bearing liabilities.

(4) The net interest margin is the taxable-equivalent net interest income

divided by average interest-earning assets.

The following table presents the changes in taxable-equivalent basis interest income and expense for each major category of interest-earning assets and interest-bearing liabilities and the amount of change attributable to volume and rate changes for the three months ended March 31, 2014 as compared to the same period in 2013. Changes not solely attributable to rate or volume have been allocated to volume and rate changes in proportion to the relationship of absolute dollar amounts of the changes in each. 38



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LCNB CORP. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Three Months Ended March 31, 2014 vs. 2013 Increase (decrease) due to: Volume Rate Total (In thousands) Interest-earning Assets: Loans $ 1,325 (209 ) 1,116 Federal funds sold (1 ) - (1 ) Interest-bearing demand deposits - 1 1 Federal Reserve Bank stock - - - Federal Home Loan Bank stock 7 (1 ) 6 Investment securities: Taxable 49 8 57 Non-taxable 51 (16 ) 35 Total interest income 1,431 (217 ) 1,214 Interest-bearing Liabilities: Deposits 125 (299 ) (174 ) Short-term borrowings - - - Long-term debt (14 ) 5 (9 ) Total interest expense 111 (294 ) (183 ) Net interest income $ 1,320 77 1,397 Net interest income on a fully tax-equivalent basis for the three months ended March 31, 2014 totaled $8,696,000, an increase of $1,397,000 over the comparable period in 2013. Total interest income increased $1,214,000 and total interest expense decreased $183,000.



The increase in total interest income was primarily due to a $125.8 million increase in average total earning assets, slightly offset by a 2 basis point (a basis point equals 0.01%) decrease in the average rate earned on earning assets.

The increase in average interest earning assets was primarily due to interest-earning assets acquired through the merger with ENB. The decrease in the average rate earned reflects a general decrease in market rates.

The decrease in total interest expense was primarily due to a 17 basis point decrease in the average rate paid on interest-bearing liabilities, partially offset by an $88.3 million increase in average interest-bearing liabilities. The increase in average interest-bearing liabilities was primarily due to an $90.7 million increase in average interest-bearing deposits primarily due to the merger. The decrease in the average rate paid on interest-bearing liabilities also reflects a general decrease in market rates. Provision and Allowance For Loan Losses The total provision for loan losses is determined based upon management's evaluation as to the amount needed to maintain the allowance for loan losses at a level considered appropriate in relation to the risk of losses inherent in the portfolio. In addition to historic charge-off percentages, factors taken into consideration to determine the adequacy of the allowance for loan losses include the nature, volume, and consistency of the loan portfolio, overall portfolio quality, a review of specific problem loans, and current economic conditions that may affect borrowers' ability to pay. The provision for loan losses for the three months ended March 31, 2014 and 2013 was $81,000 and $149,000, respectively. The decrease in the provision reflects stabilization in the credit quality of the loan portfolio in part due to relatively stable regional market conditions. The fair value of loans acquired through the merger with ENB was estimated by discounting at current rates the cash flows expected to be received on ENB's loan portfolio. Since the estimation of cash flows recognized the probability that LCNB would not be able to collect all contractually required principal and interest payments, ENB's allowance for loan losses was not carried forward. 39



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LCNB CORP. AND SUBSIDIARIES



Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued)

Non-Interest Income Total non-interest income for the first quarter 2014 was $430,000 less than for the first quarter 2013 primarily due to a $591,000 decrease in net gains on sales of investment securities and a $114,000 decrease in net gains from sales of mortgage loans. The decreases reflect declines in the volume of investment securities and loans sold. These decreases were partially offset by a $143,000 increase in service charges and fees on deposit accounts and an $80,000 increase in trust income. Service charges and fees on deposit accounts increased primarily due to a greater number of deposit accounts resulting from the merger with ENB. Trust income increased primarily due to an increase in the fair value of trust assets and brokerage accounts managed along with fee adjustments that became effective July 1, 2013. Non-Interest Expense Non-interest expense for the first quarter 2014 was $1,581,000 greater than for the first quarter 2013 primarily due to a $624,000 increase in salaries and employee benefits, a $145,000 increase in net occupancy expense, and a $237,000 increase in merger-related expenses, and a $536,000 increase in other non-interest expense. The increase in salaries and employee benefits reflects the additional staff needed to operate the five offices LCNB acquired as a result of the merger with ENB. Net occupancy expense increased due to increased costs for the additional offices and to greater snow removal costs required for the 2014 period. Included in the other non-interest expense increase was a $247,000 increase in other real estate owned expenses, reflecting the absence of a $245,000 net gain recognized on the sale of property during the first quarter 2013. Income Taxes LCNB's effective tax rates for the three months ended March 31, 2014 and 2013 were 21.6% and 23.0%, respectively. The difference between the statutory rate of 34.0% and the effective tax rate is primarily due to tax-exempt interest income from municipal securities and tax-exempt earnings from bank owned life insurance. Financial Condition The carrying values of loans, securities available-for-sale, premises and equipment, and deposits were greatly influenced by the merger. See Note 2 - Acquisition to the Financial Statements for a description of the merger and a summary of the fair values of ENB's assets and liabilities added to LCNB's consolidated balance sheet.



Liquidity

LCNB depends on dividends from its subsidiaries for the majority of its liquid assets, including the cash needed to pay dividends to its shareholders.

National banking law limits the amount of dividends the Bank may pay to the sum of retained net income for the current year plus retained net income for the previous two years. Prior approval from the Office of the Comptroller of the Currency, the Bank's primary regulator, is necessary for the Bank to pay dividends in excess of this amount. In addition, dividend payments may not reduce capital levels below minimum regulatory guidelines. Management believes the Bank will be able to pay anticipated dividends to LCNB Corp. without needing to request approval. The Bank is not aware of any reasons why it would not receive such approval. Liquidity is the ability to have funds available at all times to meet the commitments of LCNB. Asset liquidity is provided by cash and assets which are readily marketable or pledgeable or which will mature in the near future. Liquid assets include cash and cash equivalents and securities available for sale.



At

March 31, 2014, LCNB's liquid assets amounted to $343.5 million or 30.3% of total assets. This compares to liquid assets totaling $272.9 million or 29.3% of total assets at December 31, 2013.

Liquidity is also provided by access to core funding sources, primarily core depositors in LCNB's market area. Approximately 82.7% of total deposits at March 31, 2014 were "core" deposits, compared to 83.9% of deposits at December 31, 2013. Core deposits, for this purpose, are defined as total deposits less public funds and certificates of deposit greater than $100,000. The percentage of core deposits to total deposits decreased because of the growth in public fund deposits discussed above in relation to total growth in deposits. Secondary sources of liquidity include LCNB's ability to sell loan participations, borrow funds from the Federal Home Loan Bank, purchase federal funds, issue repurchase agreements, or use a line of credit established with another bank. Management closely monitors the level of liquid assets available to meet ongoing funding needs. It is management's intent to maintain adequate liquidity so that sufficient funds are readily available at a reasonable cost. LCNB experienced no liquidity or operational problems as a result of the current liquidity levels. 40



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Table of Contents LCNB CORP. AND SUBSIDIARIES


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