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

May 9, 2014

Forward-Looking Statements The Private Securities Litigation Reform Act of 1995 contains safe harbor provisions regarding forward-looking statements. When used in this discussion, the words "believes," "anticipates," "contemplates," "expects," and similar expressions are intended to identify forward-looking statements. Such statements are 28

-------------------------------------------------------------------------------- subject to certain risks and uncertainties which could cause actual results to differ materially from those projected. Those risks and uncertainties are as follows: our ability to realize the anticipated benefits from our acquisition of North Penn Bancorp, Inc. possible future impairment of intangible assets our ability to effectively manage future growth loan losses in excess of our allowance risks inherent in commercial lending real estate collateral which is subject to declines in value potential other-than-temporary impairments higher deposit insurance premiums soundness of other financial institutions increased compliance burden under new financial reform legislation current market volatility potential liquidity risk availability of capital regional economic factors loss of senior officers comparatively low legal lending limits risks of new capital requirements limited market for the Company's stock restrictions on ability to pay dividends common stock may lose value competitive environment issuing additional shares may dilute ownership extensive and complex governmental regulation and associated cost interest rate risks



Norwood Financial Corp. undertakes no obligation to publicly release the results of any revisions to those forward-looking statements which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

Critical Accounting Policies

Note 2 to the Company's consolidated financial statements for the year ended December 31, 2013 (incorporated by reference in Item 8 of the Form 10-K) lists significant accounting policies used in the development and presentation of its financial statements. This discussion and analysis, the significant accounting policies, and other financial statement disclosures identify and address key variables and other qualitative and quantitative factors that are necessary for an understanding and evaluation of the Company and its results of operations. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of deferred tax assets, the fair value of financial instruments, the determination of goodwill impairment and the determination of other-than-temporary impairment on securities. Please refer to the discussion of the allowance for loan losses calculation under "Allowance for Loan Losses and Non-performing Assets" in the "Changes in Financial Condition" section. 29 --------------------------------------------------------------------------------



The Company uses the modified prospective transition method to account for stock based compensation. Under this method companies are required to record compensation expense, based on the fair value of options over the vesting period.

Deferred income taxes reflect temporary differences in the recognition of the revenue and expenses for tax reporting and financial statement purposes, principally because certain items are recognized in different periods for financial reporting and tax return purposes. Although realization is not assured, the Company believes that it is more likely than not that all deferred tax assets will be realized. Bonds, notes and debentures for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for premiums and discounts that are recognized in interest income using the interest method over the term of the security.



Management determines the appropriate classification of debt securities at the time of purchase and re-evaluates such designation as of each Consolidated Balance Sheet date.

Declines in the fair value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, the Company considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent of the Company to not sell the securities and it is more likely than not that it will not have to sell the securities before recovery of their cost basis. The Company believes that the unrealized loss on all other securities at March 31, 2014 and December 31, 2013 represent temporary impairment of the securities, related to changes in interest rates.



The Company, as a member of the Federal Home Loan Bank (FHLB) system, is required to maintain an investment in capital stock of its district FHLB according to a predetermined formula. This restricted stock has no quoted market value and is carried at cost.

Management evaluates the restricted stock for impairment. Management's determination of whether these investments are impaired is based on their assessment of the ultimate recoverability of their cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of their cost is influenced by criteria such as (1) the significance of the decline in net assets of the FHLB as compared to the capital stock amount for the FHLB and the length of time this situation has persisted, (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB, and (3) the impact of legislative and regulatory changes on institutions and, accordingly, on the customer base of the FHLB. Management considered that the FHLB's regulatory capital ratios have increased from the prior year, liquidity appears adequate, and the new shares of FHLB stock continue to change hands at the $100 par value. Management believes no impairment charge is necessary related to FHLB stock as of March 31, 2014. In connection with the acquisition of North Penn Bancorp, Inc. ("North Penn"), we recorded goodwill in the amount of $9.7 million, representing the excess of amounts paid over the fair value of net assets of the institutions acquired in purchase transactions, at its fair value at the date of acquisition. Goodwill is tested and deemed impaired when the carrying value of goodwill exceeds its implied fair value. The value of the goodwill can change in the future. We expect the value of the goodwill to decrease if there is a significant decrease in the franchise value of the Bank. If an impairment loss is determined in the future, we will reflect the loss as an expense for the period in which the impairment is determined, leading to a reduction of our net income for that period by the amount of the impairment loss. 30 --------------------------------------------------------------------------------



Changes in Financial Condition

General

Total assets as of March 31, 2014 were $703.2 million compared to $711.2 million as of December 31, 2013, a decrease of $8.0 million due to a $7.1 million reduction in loans outstanding.

Securities

The fair value of securities available for sale as of March 31, 2014 was $156.2 million compared to $158.1 million as of December 31, 2013. The Company purchased $10.9 million of securities principally using the proceeds from $15.2 million of sales, calls, maturities and principal reductions of securities.

The carrying value of the Company's securities portfolio (Available-for Sale and Held-to Maturity) consisted of the following:

March 31, 2014 December 31, 2013 (dollars in thousands) Amount % of portfolio



Amount % of portfolio

US Government agencies $ 27,092 17.3 % $ 33,413 21.1 % States and political subdivisions 62,758 40.1 59,204 37.4 Corporate obligations 3,700 2.4 3,711 2.3



Mortgage-backed securities-

government sponsored entities 62,445 39.9 61,650 39.0 Equity securities-financial services 345 0.2 328 0.2 Total $ 156,340 100.0 % $ 158,306 100.0 % The Company has securities in an unrealized loss position. In management's opinion, the unrealized losses reflect changes in interest rates subsequent to the acquisition of specific securities. The Company holds a small amount of equity securities in other financial institutions, the value of which has been impacted by the weakening conditions of the financial markets. Management believes that the unrealized losses on all holdings represent temporary impairment of the securities, as the Company has the intent and ability to hold these investments until maturity or market price recovery.



Loans

Loans receivable totaled $496.0 million at March 31, 2014 compared to $503.1 million as of December 31, 2013. The $7.1 million decrease recorded in the three month period ending March 31, 2014 was attributed to a $7.6 million decrease in commercial real estate loans and a $2.2 million decrease in residential mortgage loans. Commercial loans increased $1.9 million during the period while other loans increased $800,000. The allowance for loan losses totaled $5,727,000 as of March 31, 2014 and represented 1.15% of total loans, compared to $5,708,000, or 1.13% of total loans, at December 31, 2013, and $5,726,000, or 1.20% of total loans, as of March 31, 2013. The Company had net charge-offs for the three months ended March 31, 2014 of $401,000 compared to $576,000 in the comparable period in 2013. The Company's loan review process assesses the adequacy of the allowance for loan losses on a quarterly basis. The process includes an 31 -------------------------------------------------------------------------------- analysis of the risks inherent in the loan portfolio. It includes an analysis of impaired loans and a historical review of credit losses by loan type. Other factors considered include: concentration of credit in specific industries, economic and industry conditions, trends in delinquencies and loan classifications, large dollar exposures and loan growth. Management considers the allowance adequate at March 31, 2014 based on the Company's criteria. However, there can be no assurance that the allowance for loan losses will be adequate to cover significant losses, if any, that might be incurred in the future. As of March 31, 2014, non-performing loans totaled $9.5 million, or 1.92% of total loans compared to $9.5 million, or 1.90% of total loans at December 31, 2013. At March 31, 2014, non-performing assets totaled $10.9 million, or 1.55%, of total assets compared to $10.6 million, or 1.48%, of total assets at December 31, 2013. The increase reflects the transfer of four properties into foreclosed real estate owned with a carrying value of $383,000.



The following table sets forth information regarding non-performing loans and foreclosed real estate at the dates indicated:

(dollars in thousands) March 31, 2014 December 31, 2013 Loans accounted for on a non-accrual basis: Commercial and all other $ - $ - Real Estate 9,532 9,547 Total non-accrual loans * 9,532 9,547 Accruing loans which are contractually past due 90 days or more - - Total non-performing loans 9,532 9,547 Foreclosed real estate 1,364 1,009 Total non-performing assets $ 10,896 $ 10,556 Allowance for loans losses $ 5,727 $ 5,708 Coverage of non-performing loans 0.60 x 0.60 x Non-performing loans to total loans 1.92 % 1.90 % Non-performing loans to total assets 1.36 % 1.34 % Non-performing assets to total assets 1.55 %



1.48 %

*Includes non-accrual TDRs of $6.2 million as of March 31, 2014 and December 31, 2013. The Company also had $3.0 million of accruing TDRs on those dates.

Deposits

During the period, total deposits decreased $1.1 million due primarily to a $3.7 million decrease in certificates of deposit over $100,000 as municipalities utilized funds to meet cash flow needs. All other deposit products increased $2.6 million, net.



The following table sets forth deposit balances as of the dates indicated:

(dollars in thousands) March 31, 2014 December 31, 2013 Non-interest bearing demand $ 93,400 $ 92,684 Interest bearing demand 46,059 45,444 Money market deposit accounts 120,907 122,423 Savings 71,356 69,202 Time deposits $100,000 132,382 131,793 Time deposits >$100,000 75,972 79,636 Total $ 540,076 $ 541,182 32

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Borrowings

Short-term borrowings as of March 31, 2014 totaled $40.4 million compared to $49.9 million as of December 31, 2013. Short-term borrowings, which consisted of securities sold under agreements to repurchase and overnight borrowings from the FHLB, decreased $9.5 million principally due to the seasonality of municipal cash management accounts and a reduced level of overnight borrowings due to loan payoffs.



Other borrowings consisted of the following:

(dollars in thousands) March 31, 2014 December 31, 2013 Notes with the FHLB: Fixed rate note due July 2015 at 4.34% $ 7,254 $ 7,301 Convertible note due January 2017 at 4.71% 10,000



10,000

Amortizing fixed rate borrowing due January, 2018 at 0.91% 2,312 2,460 Amortizing fixed rate borrowing due December, 2018 at 1.425% 3,807 4,000 $ 23,373 $ 23,761 The convertible notes contain an option which allows the FHLB, at quarterly intervals to change the note to an adjustable-rate advance at three month LIBOR plus 19 to 22 basis points. If the notes are converted, the option allows the Bank to put the funds back to the FHLB at no charge. The fixed rate borrowing due July 2015 includes a $254,000 fair value adjustment recorded at the time of the North Penn acquisition.



Off-Balance Sheet Arrangements

The Bank is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The Bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Commitments to grant loans totaled $24.7 million as of March 31, 2014 compared to $22.8 million as of December 31, 2013. A summary of the contractual amount of the Company's financial instrument commitments is as follows: March 31, 2014December 31, 2013 (in thousands)



Unfunded availability under loan commitments $ 24,728 $

22,845

Unfunded commitments under lines of credit 46,360 42,575 Standby letters of credit 5,700 5,701 $ 76,788 $ 71,121 33

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Stockholders' Equity and Capital Ratios

As of March 31, 2014, stockholders' equity totaled $94.2 million, compared to $91.9 million as of December 31, 2013. The net change in stockholders' equity included $2.0 million of net income that was partially offset by $1.1 million of dividends declared, a $179,000 reduction due to an increase in Treasury Stock, and a $40,000 increase due to the exercise and vesting of stock options. In addition, total equity increased $1.6 million due to an increase in the fair value of securities in the available for sale portfolio, net of tax. This increase in fair value is the result of a change in interest rates and spreads, which may impact the value of the securities. Because of interest rate volatility, the Company's accumulated other comprehensive income could materially fluctuate for each interim and year-end period.



A comparison of the Company's regulatory capital ratios is as follows:

March 31, 2014 December 31, 2013 Tier 1 Capital (To average assets) 12.19 % 12.09 % Tier 1 Capital (To risk-weighted assets) 16.86 % 16.53 % Total Capital (To risk-weighted assets) 18.00 % 17.66 % The minimum capital requirements imposed by the FDIC on the Bank for leverage, Tier 1 and Total Capital are 4%, 4% and 8%, respectively. The Company has similar capital requirements imposed by the Board of Governors of the Federal Reserve System (FRB). The Bank is also subject to more stringent Pennsylvania Department of Banking and Securities (PDB&S) guidelines. The Bank's capital ratios do not differ significantly from the Company's ratios. Although not adopted in regulation form, the PDB&S utilizes capital standards requiring a minimum of 6.5% leverage capital and 10% total capital. The Company and the Bank were in compliance with FRB, FDIC and PDB&S capital requirements as of March 31, 2014 and December 31, 2013. Liquidity As of March 31, 2014, the Company had cash and cash equivalents of $8.7 million in the form of cash, due from banks and short-term deposits with other institutions. In addition, the Company had total securities available for sale of $156.2 million which could be used for liquidity needs. This totals $164.9 million of liquidity and represents 23.4% of total assets compared to $166.0 million and 23.3% of total assets as of December 31, 2013. The Company also monitors other liquidity measures, all of which were within the Company's policy guidelines as of March 31, 2014 and December 31, 2013. Based upon these measures, the Company believes its liquidity is adequate.



Capital Resources

The Company has a line of credit commitment available from the Federal Home Loan Bank (FHLB) of Pittsburgh for borrowings of up to $20,000,000 which expires in December 2016. Borrowings under this line were $5.9 million and $13.4 million at March 31, 2014 and December 31, 2013, respectively. 34 -------------------------------------------------------------------------------- The Company has a line of credit commitment from Atlantic Central Bankers Bank for $7,000,000 which expires June 30, 2014. There were no borrowings under this line as of March 31, 2014 and December 31, 2013.



The Company has a line of credit commitment available which has no stated expiration date from PNC Bank for $16,000,000. There were no borrowings under this line as of March 31, 2014 and December 31, 2013.

The Bank's maximum borrowing capacity with the Federal Home Loan Bank was approximately $287,228,000 as of March 31, 2014, of which $29,300,000 and $37,200,000 was outstanding at March 31, 2014 and December 31, 2013 respectively. Advances from the Federal Home Loan Bank are secured by qualifying assets of the Bank.

Non-GAAP Financial Measures This report contains or references fully taxable-equivalent (fte) interest income and net interest income, which are non-GAAP financial measures. Interest income (fte) and net interest income (fte) are derived from GAAP interest income and net interest income using an assumed tax rate of 34%. We believe the presentation of interest income (fte) and net interest income (fte) ensures comparability of interest income and net interest income arising from both taxable and tax-exempt sources and is consistent with industry practice. Net interest income (fte) is reconciled to GAAP net interest income on page 36. Although the Company believes that these non-GAAP financial measures enhance investors' understanding of our business and performance, these non-GAAP financial measures should not be considered an alternative to GAAP measures. 35

-------------------------------------------------------------------------------- Results of Operations NORWOOD FINANCIAL CORP. Consolidated Average Balance Sheets with Resultant Interest and Rates (Tax-Equivalent Basis, dollars in thousands) Three Months Ended March 31, 2014 2013 Average Average Average Average Balance Interest Rate Balance Interest Rate (2) (1) (3) (2) (1) (3) Assets Interest-earning assets: Interest bearing deposits with banks $ 854$ 1 0.47 % $ 3,983$ 3 0.30 % Securities held-to-maturity 175 3 6.86 173 3 6.94 Securities available for sale: Taxable 99,840 488 1.96 89,946 400 1.78 Tax-exempt (1) 59,990 753 5.02 54,973 706 5.14 Total securities available for sale (1) 159,830 1,241 3.11 144,919 1,106 3.05 Loans receivable (1) (4) (5) 500,182 6,040 4.83



478,170 6,231 5.21

Total interest earning assets 661,041 7,285 4.41 627,245 7,343 4.68 Non-interest earning assets: Cash and due from banks 7,638



8,835

Allowance for loan losses (5,886 ) (5,580 ) Other assets 42,204 44,199 Total non-interest earning assets 43,956 47,454 Total Assets $ 704,997$ 674,699 Liabilities and Stockholders' Equity Interest bearing liabilities: Interest bearing demand and money market $ 168,265$ 79 0.19 $ 167,514$ 111 0.27 Savings 69,963 9 0.05 69,178 17 0.10 Time 210,543 547 1.04 210,035 626 1.19 Total interest bearing deposits 448,771 635 0.57 446,727 754 0.68 Short-term borrowings 41,929 22 0.21 22,137 12 0.22 Other borrowings 23,575 166 2.82 24,734 190 3.07 Total interest bearing liabilities 514,275 823 0.64 493,598 956 0.77 Non-interest bearing liabilities: Demand deposits 92,593 83,618 Other liabilities 3,995 4,073 Total non-interest bearing liabilities 96,588 87,691 Stockholders' equity 94,134 93,410 Total Liabilities and Stockholders' Equity $ 704,997$ 674,699 Net interest income (tax equivalent basis) 6,462 3.77 % 6,387 3.91 % Tax-equivalent basis adjustment (317 ) (286 ) Net interest income $ 6,145$ 6,101 Net interest margin (tax equivalent basis) 3.91 % 4.07 %



(1) Interest and yields are presented on a tax-equivalent basis using a marginal

tax rate of 34%. (2) Average balances have been calculated based on daily balances. (3) Annualized



(4) Loan balances include non-accrual loans and are net of unearned income.

(5) Loan yields include the effect of amortization of deferred fees, net of costs. 36

-------------------------------------------------------------------------------- Rate/Volume Analysis. The following table shows the fully taxable equivalent effect of changes in volumes and rates on interest income and interest expense. Increase/(Decrease) Three months ended March 31, 2014 Compared to Three months ended March 31, 2013 Variance due to Volume Rate Net (dollars in thousands) Interest earning assets: Interest bearing deposits with banks $ (9 ) $ 7 $ (2 ) Securities held to maturity - - - Securities available for sale: Taxable 46 42 88 Tax-exempt securities 140 (93 ) 47 Total securities 186 (51 ) 135 Loans receivable 1,336 (1,527 ) (191 ) Total interest earning assets 1,513 (1,571 ) (58 ) Interest bearing liabilities: Interest-bearing demand and money market 3 (35 ) (32 ) Savings 1 (9 ) (8 ) Time 10 (89 ) (79 ) Total interest bearing deposits 14 (133 ) (119 ) Short-term borrowings 13 (3 ) 10 Other borrowings (9 ) (15 ) (24 ) Total interest bearing liabilities 18 (151 ) (133 ) Net interest income (tax-equivalent basis) $ 1,495



$ (1,420 )$ 75

Changes in net interest income that could not be specifically identified as either a rate or volume change were allocated proportionately to changes in volume and changes in rate.

37

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Comparison of Operating Results for The Three Months Ended March 31, 2014 to March 31, 2013

General For the three months ended March 31, 2014, net income totaled $1,964,000 compared to $2,308,000 earned in the similar period in 2013. The decrease in net income for the three months ended March 31, 2014 was due primarily to $770,000 of proceeds from a bank-owned life insurance policy that was recorded in the first quarter of 2013, some of which was offset by higher core earnings and a reduced provision for loan losses in the current year. Earnings per share for the current period were $.54 for basic and fully diluted compared to $.64 per share basic and $.63 fully diluted for the three months ended March 31, 2013. The resulting annualized return on average assets and annualized return on average equity for the three months ended March 31, 2014 were 1.13% and 8.46%, respectively, compared to 1.39% and 10.02%, respectively, for the similar period in 2013.



The following table sets forth changes in net income:

(dollars in thousands) Three months ended March 31, 2014 to March 31, 2013 Net income three months ended March 31, 2013 $ 2,308 Change due to: Net interest income 44 Provision for loan losses 380 Gain on sales of loans and securities (15 ) Earnings and proceeds on bank-owned life insurance (757 ) Other income (52 ) Salaries and employee benefits



46

Occupancy, furniture and equipment (49 ) Foreclosed real estate owned 126 All other expenses 46 Income tax expense (113 ) Net income three months ended March 31, 2014 $ 1,964 Net Interest Income Net interest income on a fully taxable equivalent basis (fte) for the three months ended March 31, 2014 totaled $6,462,000 which was $75,000 higher than the comparable period in 2013. The increase in net interest income largely reflects the improved mix and growth of the balance sheet which offset the reduced earnings on loans and investments due to repricing in the current low interest rate environment. The fte net interest spread and net interest margin were 3.77% and 3.91%, respectively, for the three months ended March 31, 2014 compared to 3.91% and 4.07%, respectively, for the similar period in 2013. Interest income (fte) totaled $7,285,000 with a yield on average earning assets of 4.41% compared to $7,343,000 and 4.68% for the 2013 period. Average loans increased $22.0 million over the comparable period of last year but resulted in a 38 basis point reduction in the yield earned, resulting in a $191,000 reduction in fte loan income. Reduced yields on tax-free securities were offset by higher yields on taxable securities and increased balances, resulting in a $135,000 increase in earnings on securities. Average earning assets totaled $661.0 million for the three months ended March 31, 2014, an increase of $33.8 million over the average for the similar period in 2013. This increase in average earning assets helped offset the decline in asset yields. 38 -------------------------------------------------------------------------------- Interest expense for the three months ended March 31, 2014 totaled $823,000 at an average cost of 0.64% compared to $956,000 and 0.77% for the similar period in 2013. As a result of the continued low interest rate environment, the Company further reduced rates paid on its money market and savings accounts. The cost of time deposits, which is the most significant component of funding, declined to 1.04% from 1.19% for the similar period in the prior year. As time deposits matured, they repriced at the current lower rates resulting in the decrease.



Provision for Loan Losses

The Company's provision for loan losses for the three months ended March 31, 2014 was $420,000 compared to $800,000 for the three months ended March 31, 2013. The Company makes provisions for loan losses in an amount necessary to maintain the allowance for loan losses at an acceptable level. Net charge-offs were $401,000 for the quarter ended March 31, 2014 compared to $576,000 for the similar period in 2013. Other Income Other income totaled $1,053,000 for the three months ended March 31, 2014 compared to $1,877,000 for the similar period in 2013. Earnings and proceeds from bank-owned life insurance policies decreased due to a non-recurring gain of $770,000 recognized in the first quarter of 2013. Net gains from the sale of loans and securities decreased $15,000 compared to the same period of 2013 due to reduced activity. All other items of other income decreased $52,000, net, compared to the first quarter of last year.



Other Expense

Other expense for the three months ended March 31, 2014 totaled $4,132,000 or $169,000 lower than the same period of 2013. Costs associated with foreclosed real estate properties decreased $126,000 while all other operating expenses decreased $43,000, net. Income Tax Expense Income tax expense totaled $682,000 for an effective tax rate of 25.8% for the period ending March 31, 2014 compared to $569,000 for an effective tax rate of 19.8% for the similar period in 2013. The 2013 period included a non-recurring tax-free gain. 39



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Source: Edgar Glimpses