UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10 - Q
For the quarterly period ended June 30, 2007
or
For the transition period from to
Commission File Number 0-13396
CNB FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
1 South Second Street
P.O. Box 42
Clearfield, Pennsylvania 16830
(Address of principal executive offices)
Registrant’s telephone number, including area code, (814) 765-9621
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes ¨ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). ¨ Yes x No
The number of shares outstanding of the issuer’s common stock as of August 7, 2007
COMMON STOCK: $0 PAR VALUE, 8,560,286 SHARES
INDEX
PART I.
FINANCIAL INFORMATION
SequentialPage Number
ITEM 1. – Financial Statements (unaudited)
PAGE 3.
PAGE 4.
PAGE 5.
PAGE 6.
PAGE 7.
PAGE 8.
ITEM 2 – Management’s Discussion and Analysis
PAGE 11.
ITEM 3 – Quantitative and Qualitative Disclosures
PAGE 20.
ITEM 4 – Controls and Procedures
PAGE 21.
PART II.
OTHER INFORMATION
PAGE 22.
PAGE 23.
2
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
(unaudited)
June 30,
ASSETS
Cash and due from banks
Interest bearing deposits with other banks
Federal funds sold
TOTAL CASH AND CASH EQUIVALENTS
Securities available for sale
Loans held for sale
Loans and leases
Less: unearned discount
Less: allowance for loan losses
NET LOANS
FHLB, and other equity interests
Premises and equipment, net
Bank owned life insurance
Accrued interest receivable and other assets
Mortgage servicing rights
Goodwill
Other intangible assets, net
TOTAL ASSETS
LIABILITIES
Deposits:
Non-interest bearing deposits
Interest bearing deposits
TOTAL DEPOSITS
Treasury, tax and loan borrowings
FHLB and other borrowings
Accrued interest and other liabilities
Subordinated debentures
TOTAL LIABILITIES
SHAREHOLDERS’ EQUITY
Common stock $0 par value Authorized 50,000,000 shares Issued 9,233,750 shares
Additional paid in capital
Retained earnings
Treasury stock, at cost
(676,619 shares for June 2007, and 369,546 shares for Dec 2006)
Accumulated other comprehensive income
TOTAL SHAREHOLDERS’ EQUITY
TOTAL LIABILITIES & SHAREHOLDERS’ EQUITY
3
CONSOLIDATED STATEMENTS OF INCOME (unaudited)
(Dollars in thousands, except per share data)
INTEREST AND DIVIDEND INCOME
Loans including fees
Deposits with banks
Securities:
Taxable
Tax-exempt
Dividends
TOTAL INTEREST AND DIVIDEND INCOME
INTEREST EXPENSE
Deposits
Borrowed funds
TOTAL INTEREST EXPENSE
Net interest income
Provision for loan losses
NET INTEREST INCOME AFTER PROVISION
OTHER INCOME
Trust & asset management fees
Service charges on deposit accounts
Other service charges and fees
Net security gains
Mortgage banking income
Bank owned life insurance earnings
Wealth management
Other
TOTAL OTHER INCOME
OTHER EXPENSES
Salaries & benefits
Net occupancy expense of premises
Amortization of intangibles
TOTAL OTHER EXPENSES
Income before income taxes
Applicable income taxes
NET INCOME
EARNINGS PER SHARE
Basic
Diluted
DIVIDENDS PER SHARE
Cash dividends per share
4
Wealth Management
Salaries & Benefits
EARNINGS PER SHARE, BASED ON WEIGHTED
AVERAGE SHARES OUTSTANDING
Net income, basic
Net income, diluted
5
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Consolidated Statements of Comprehensive Income (unaudited)
(dollars in thousands, except per share data)
Net Income
Other comprehensive income, net of tax
Unrealized gains/(losses)on securities:
Unrealized gains/(losses) arising during the period, net of tax of $434 and $337 for the three months ending June 30, 2007 and 2006 and $331 and $448 for the six months ending June 30, 2007 and 2006.
Reclassified adjustment for accumulated (gains) losses included in net income, net of tax of $8 and $0 for the three months ending June 30, 2007 and 2006 and $12 and $119 for the six months ending June 30, 2007 and 2006.
Other comprehensive income (loss)
Comprehensive income
6
CONSOLIDATED STATEMENTS OF CASHFLOWS (unaudited)
Consolidated Statements of Cash Flows (unaudited)
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operations:
Depreciation and amortization
Amortization, accretion and deferred loan fees
Deferred taxes
Security gains
Gain on sale of loans
Net (gains) losses on dispositions of acquired property
Proceeds from sale of loans
Origination of loans held for sale
Increase in bank owned life insurance
Stock-based compensation expense
Changes in:
Interest receivable and other assets
Interest payable and other liabilities
Net cash provided by operating activities
Cash flows from investing activities:
Proceeds from maturities, prepayments and calls of:
Proceeds from sales of securities available for sale
Purchase of securities available for sale
Loan origination and payments, net
Redemption (Purchase) of FHLB, FRB & Other Equity Interests
Net, purchase of premises and equipment
Proceeds from the sale of premises and equipment and foreclosed assets
Net cash used in investing activities
Cash flows from financing activities:
Net change in:
Checking, money market and savings accounts
Certificates of deposit
Proceeds from issuance of subordinated debenture
Repayments of subordinated debenture
Treasury stock purchased
Proceeds from sale of treasury stock
Proceeds from the exercise of stock options
Excess tax benefit from exercise of stock options
Cash dividends paid
Advances from long-term borrowings
Repayments of long-term borrowings
Net change in short-term borrowings
Net cash provided by financing activities
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents at beginning of year
Cash and cash equivalents at end of period
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest
Income Taxes
Supplemental non cash disclosures:
Transfers to other real estate owned
Grant of restricted stock awards from treasury stock
7
CNB FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
BASIS OF PRESENTATION
The accompanying consolidated financial statements have been prepared pursuant to rules and regulations of the Securities and Exchange Commission (SEC) and in compliance with accounting principles generally accepted in the United States of America. Because this report is based on an interim period, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted.
In the opinion of Management of the registrant, the accompanying consolidated financial statements as of June 30, 2007 and for the quarters and six months ended June 30, 2007 and 2006 include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the financial condition and the results of operations for the periods. The financial performance reported for CNB Financial Corporation (the Corporation) for the three and six month periods ended June 30, 2007 is not necessarily indicative of the results to be expected for the full year. This information should be read in conjunction with the Corporation’s Annual Report to shareholders and Form 10-K for the period ended December 31, 2006.
STOCK COMPENSATION
The Corporation has a stock incentive plan for key employees and independent directors. The Stock incentive plan, which is administered by a committee of the Board of Directors, provides for up to 625,000 shares of common stock in the form of nonqualified options or restricted stock. For key employees, the plan vesting is one-fourth of the granted options or restricted stock per year beginning one year after the grant date with 100% vested on the fourth anniversary of the grant. For independent directors, the vesting schedule is one-third of the granted options per year beginning one year after the grant date with 100% vested on the third anniversary of the grant.
Stock Options
A summary of the activity for stock options is as follows:
Weighted
Average
Exercise
Price
Options outstanding, beginning of period
Forfeited
Exercised
Granted
Options outstanding, end of period
Options exercisable, end of period
No stock options were granted during the three or six month periods ended June 30, 2007 or 2006.
The aggregate intrinsic value of all options outstanding at June 30, 2007 was $529,868. The aggregate intrinsic value of all options that were exercisable at June 30, 2007 was $529,868.
There was no compensation expense related to stock options for the three or six months ended June 30, 2007. Compensation expense related to stock options for the six months ended June 30, 2006 resulted in a reduction of income before taxes of $18,000 and a reduction
8
in net income of $12,000. Due to the insignificance of the amount, there was no measurable effect on basic and diluted earnings per share. There is no remaining unrecognized compensation cost related to unvested stock options granted as of June 30, 2007.
Restricted Stock Awards
Periodically the Executive Compensation and Personnel Committee of the Board of Directors grants restricted stock awards to certain key employees and independent directors of the Corporation. Compensation expense for the restricted stock awards is recognized over the requisite service period noted above based on the fair value of the shares at the date of grant. Unearned restricted stock awards are recorded as a reduction of shareholders equity until earned. Compensation expense resulting from these restricted stock awards was approximately $25,000 and $44,000 for the three and six months ended June 30, 2007 and $11,000 and $16,000 for the three and six months ended June 30, 2006. As of June 30, 2007, there was $287,900 of total unrecognized compensation cost related to unvested restricted stock awards. At June 30, 2007, there are 23,440 unvested shares at a weighted average grant date fair value of $14.11.
Basic earnings per share is computed by dividing net income by the weighted average number of shares outstanding during the period. Restricted stock awards are considered outstanding as they become earned. Diluted earnings per share is computed using the weighted average number of shares determined for the basic computation plus the dilutive effect of potential common shares issuable under stock compensation plans. For the three and six month periods ended June 30, 2007 and 2006, 110,500 shares under option were excluded from the diluted earnings per share calculations as they were anti-dilutive.
The computation of basic and diluted EPS is shown below (in thousands except per share data):
Basic earnings per share computation:
Gross weighted average shares outstanding
Less: Average unearned restricted stock
Net weighted average shares outstanding
Basic earnings per share:
Diluted earnings per share computation:
Weighted average shares outstanding for basic earnings per share
Add: Dilutive effects of assumed exercises of stock options
Weighted average shares and potentially dilutive shares
Diluted earnings per share
9
RECENT ACCOUNTING PRONOUNCEMENTS
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (FIN 48), which prescribes a recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The adoption of FIN 48 did not have a material effect on the consolidated financial statements.
The Corporation and its subsidiaries are subject to U.S. federal income tax. The Corporation is no longer subject to examination by taxing authorities for years before 2002. The Corporation does not expect the total amount of unrecognized tax benefits to significantly increase in the next twelve months.
The Corporation recognizes interest related to income tax matters as interest expense and penalties related to income tax matters as other expense. The corporation did not have any amounts accrued for interest and penalties at January 1, 2007.
In September 2006, the FASB issued FAS No. 157, Fair Value Measurements. This statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. This statement establishes a fair value hierarchy about the assumptions used to measure fair value and clarifies assumptions about risk and the effect of a restriction on the sale or use of an asset. The standard is effective for fiscal years beginning after November 15, 2007. The Corporation has not completed its evaluation of the impact of the adoption of this standard.
In February 2007, the FASB issued FAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115, which provides all entities with an option to report selected financial assets and liabilities at fair value. The objective of FAS No. 159 is to improve financial reporting by providing entities with the opportunity to mitigate volatility in earnings caused by measuring related assets and liabilities differently without having to apply the complex provisions of hedge accounting. FAS No. 159 is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007 provided the entity also elects to apply the provisions of FAS No. 157,Fair Value Measurements. The Corporation has not completed its evaluation of the impact of the adoption of this standard.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified for comparative purposes.
10
ITEM 2
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following discussion and analysis of the consolidated financial statements of CNB Financial Corporation (the “Corporation”) is presented to provide insight into management’s assessment of financial results. The Corporation’s subsidiary CNB Bank (the “Bank”) provides financial services to individuals and businesses within the Bank’s market area which is primarily made up of the west central Pennsylvania counties of Cambria, Clearfield, Centre, Elk, Jefferson, McKean and Warren. During 2005 the Bank entered the northwestern Pennsylvania county of Erie and began doing business as ERIEBANK. The Bank is subject to regulation, supervision and examination by the Pennsylvania State Department of Banking as well as the Federal Deposit Insurance Corporation. The financial condition and results of operations are not intended to be indicative of future performance. One of the Corporation’s subsidiaries, CNB Securities Corporation, is incorporated in Delaware and currently maintains investments in debt and equity securities. County Reinsurance Company, also a subsidiary, is a Corporation of Arizona, and provides credit life and disability for customers of CNB Bank. CNB Insurance Agency, incorporated in Pennsylvania, provides for the sale of nonproprietary annuities and other insurance products. Finally, Holiday Financial Services Corporation was formed in the fourth quarter of 2005 to facilitate the Corporation’s entry into the consumer discount loan and finance business. Management’s discussion and analysis should be read in conjunction with the consolidated financial statements and related notes.
Risk identification and management are essential elements for the successful management of the Corporation. In the normal course of business, the Corporation is subject to various types of risk, including interest rate, credit, and liquidity risk. These risks are controlled through policies and procedures established throughout the Corporation.
Interest rate risk is the sensitivity of net interest income and the market value of financial instruments to the direction and frequency of changes in interest rates. Interest rate risk results from various repricing frequencies and the maturity structure of the financial instruments owned by the Corporation. The Corporation uses its asset/liability management policy and systems to control, monitor and manage interest rate risk.
Credit risk represents the possibility that a customer may not perform in accordance to contractual terms. Credit risk results from loans with customers and the purchase of securities. The Corporation’s primary credit risk is in the loan portfolio. The Corporation manages credit risk by following an established credit policy and through a disciplined evaluation of the adequacy of the allowance for loan losses. Also, the investment policy limits the amount of credit risk that may be taken in the securities portfolio.
Liquidity risk represents the inability to generate or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and obligations to depositors. The Corporation has established guidelines within its asset liability management policy to manage liquidity risk. These guidelines include contingent funding alternatives.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents remained relatively constant decreasing only $322,000 since December 31, 2006. Management believes the liquidity needs of the Corporation are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources, and the portion of the investment and loan portfolios that mature within one year. These sources of funds will enable the Corporation to meet cash obligations and off-balance sheet commitments as they come due.
SECURITIES
Securities increased $9.8 million or 6.2% since December 31, 2006. The increase is primarily the result of purchases of structured collateralized mortgage obligations and U.S. Government Agency Securities.
The Corporation generally buys into the market over time and does not attempt to “time” its transactions. In doing this, the highs and lows of the market are averaged into the portfolio and minimize the overall effect of different rate environments. Management monitors the earnings performance and the effectiveness of the liquidity of the securities portfolio on a regular basis through Asset / Liability Committee (“ALCO’) meetings. The ALCO also reviews and manages interest rate risk for the Corporation. Through active balance sheet management and analysis of the securities portfolio, the Corporation maintains sufficient liquidity to satisfy depositor requirements and various credit needs of its customers.
11
LOANS
The Corporation’s lending is primarily focused on the west central Pennsylvania market and consists principally of commercial lending primarily to locally owned small businesses and retail lending which includes single-family residential mortgages and other consumer lending. At June 30, 2007, the Corporation had $571.7 million in loans outstanding, net of unearned discount, an increase of $24.7 million (or 4.5%) since December 31, 2006. The increase was primarily the result of demand for our commercial loan products including commercial mortgages. The Corporation views commercial lending as its competitive advantage and continues to focus on this area by hiring and retaining experienced loan officers and supporting them with quality credit analysis. In addition, the Corporation ran a successful home equity loan promotion during the fist six months of 2007 which was the primary reason for the growth in residential mortgages of $9.8 million or 6.1%.
The Corporation expects increasing loan demand throughout the remainder of 2007 with the growth of our ERIEBANK division as well as improved demand in our traditional markets.
Total loans, net of unearned discount, at June 30, 2007 and December 31, 2006 are summarized as follows:
2007
Commercial, Financial and Agricultural
Residential Mortgage
Commercial Mortgage
Installment
Lease Receivables
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is established by provisions for losses in the loan portfolio as well as overdrafts in deposit accounts. These provisions are charged against current income. Loans and overdrafts deemed not collectible are charged-off against the allowance while any subsequent collections are recorded as recoveries and increase the allowance.
12
The table below shows activity within the allowance account:
Balance at beginning of Period
Charge-offs:
Commercial and financial
Commercial mortgages
Residential mortgages
Lease receivables
Overdrafts
Recoveries:
Net charge-off’s:
Balance at end-of-period
Loans, net of unearned
Allowance to net loans
Net charge-offs to average loans
Non performing assets
Non performing % of total assets
The adequacy of the allowance for loan and lease losses is subject to a formal analysis by the credit administrator of the Bank. As part of the formal analysis, delinquencies and losses are monitored monthly. The loan portfolio is divided into several categories in order to better analyze the entire pool. First is a selection of criticized loans that is given a specific reserve. The remaining loans are pooled, by category, into these segments:
Reviewed
Homogeneous
Residential real estate
Credit cards
The reviewed loan pools are further segregated into four categories: special mention, substandard, doubtful and unclassified. Historical loss factors are calculated for each pool excluding overdrafts based on the previous eight quarters of experience. The homogeneous pools are evaluated by analyzing the historical loss factors from the most previous quarter end and the two most recent year ends. The historical loss factors for both the reviewed and homogeneous pools are adjusted based on these six qualitative factors:
Levels of and trends in delinquencies and non-accruals
Trends in volume and terms of loans
Effects of any changes in lending policies and procedures
Experience, ability and depth of management
National and local economic trends and conditions
Concentrations of credit
The methodology described above was created using the experience of our credit administrator, guidance from the regulatory agencies, expertise of our loan review partner, and discussions with our peers. The resulting factors are applied to the pool balances in order to estimate the inherent risk of loss within each pool.
As noted in the above table, both the level of nonperforming assets and percentage of net charge-offs has improved since December 31, 2006. However, over the same time period, the coverage percentage of the allowance
13
to net loans has remained constant at 1.11%. This consistency was deemed necessary based on the evaluation described herein and included consideration of the growth of our consumer finance and discount loan subsidiary, Holiday Financial Services Corporation (HFSC). During 2007, the Corporation has continued to grow HFSC’s portfolio of consumer finance and discount loans with different risk characteristics than its consumer loan portfolio in its banking subsidiary. Although this loan portfolio is not currently significant in terms of the overall loan portfolio, it was nevertheless considered in our analysis resulting in increases in our provision, thus affecting the allowance coverage of net loans during the six months ended June 30, 2007. In addition, our analysis considered the effects on our customers of the rising cost of doing business as a result of general increases in production costs including fuel prices.
Prudent business practices dictate that the level of the allowance, as well as corresponding charges to the provision for loan losses, should be commensurate with identified areas of risk within the loan portfolio and the attendant risks inherent therein. The quality of the credit risk management function and the overall administration of this vital segment of the Corporation’s assets are critical to the ongoing success of the Corporation.
The previously mentioned analysis considered numerous historical and other factors to analyze the adequacy of the allowance and current period charges against the provision for loan losses. Management paid special attention to a section of the analysis that compared and plotted the actual level of the allowance against the aggregate amount of loans adversely classified in order to compute the estimated potential losses associated with those loans. By noting the “spread” at the present time, as well as prior periods, management can determine the current adequacy of the allowance as well as evaluate trends that may be developing. The volume and composition of the Corporation’s loan portfolio continue to reflect growth in commercial credits including commercial real estate loans. As mentioned in the Loans section of this analysis, management considers commercial lending a competitive advantage and continues to focus on this area as part of its strategic growth initiatives. However, management must also consider the fact that the inherent risk is more pronounced in these types of credits and is also driven by the economic environment of its market areas.
During the six month period ended June 30, 2007 the Corporation decreased its provision for loan losses as compared to the six month period ended June 30, 2006. This decrease was primarily due to a decline in our level of non performing loans and net charge-offs as compared to the prior period. Management believes that both its current period provision and allowance coverage of net loans are reasonable and adequate.
FUNDING SOURCES
The Corporation considers deposits, short-term borrowings, and term debt when evaluating funding sources. Traditional deposits continue to be the main source of funds in the Corporation increasing $16.6 million from $631.3 million at December 31, 2006 to $647.9 million at June 30, 2007. The increase in deposits was primarily the result of growth in our interest bearing and non interest bearing demand deposits.
Periodically, the Corporation utilizes term borrowings from the Federal Home Loan Bank (FHLB) and other lenders to meet funding needs not accommodated by deposit growth. During the second quarter, the Corporation obtained $10.0 million in funding from the FHLB in a 10-year note at 4.60%. The borrowing has a fixed rate for the first twenty four months after which the FHLB has the option to convert the borrowing to float on the 3-month LIBOR plus 0.16%. The proceeds of the note were used to fund loan growth that occurred during the quarter. Management plans to maintain access to short and long-term borrowings as an available funding source when deemed appropriate.
On April 5, 2007, CNB Capital Trust II, a trust formed by the Corporation, issued $10.0 million in trust-preferred securities in a pooled offering. The interest rate is determined quarterly and floats based on the 3-month LIBOR plus 1.55%. The Corporation issued subordinated debentures to the trust in exchange for the proceeds of the offering. These debentures represent the sole asset of the trust and must be redeemed no later than 2037. The Corporation used the proceeds to fund loan growth as well as repurchase shares of its own stock as discussed below in the Shareholders’ Equity section of this analysis. An additional $10.0 million in trust-preferred securities was issued on June 25, 2007 by CNB Capital Trust III. The terms and structure of the transaction were exactly the same as the April 5th issuance, however, the proceeds were used to liquidate similar trust-preferred securities issued in 2002 which floated on the 3-month LIBOR plus 3.45%.
The Corporation’s capital continues to provide a base for profitable growth. Total shareholders’ equity was $68.4 million at June 30, 2007 compared to $72.3 million at December 31, 2006, a decrease of $3.9 million. The
14
reason for the decrease in equity was a increase in treasury stock of $4.7 million in the first six months of 2007. During the first two quarters of 2007, the Corporation continued to repurchase shares of its own stock under a publicly announced plan resulting in an increase in treasury shares of 307,073 since December 31, 2006. The majority of the increase was the result of a private purchase of 304,220 shares from another financial institution which occurred in the second quarter of 2007.
In the first six months of 2007, the Corporation earned $4.3 million and declared dividends of $2.7 million, a dividend payout ratio of 61.8% of net income.
The Corporation has also complied with the standards of capital adequacy mandated by the banking regulators. Bank regulators have established “risk-based” capital requirements designed to measure capital adequacy. Risk-based capital ratios reflect the relative risks of various assets banks hold in their portfolios. A weight category of 0% (lowest risk assets), 20%, 50%, or 100% (highest risk assets), is assigned to each asset on the balance sheet. The Corporation’s total risk-based capital ratio of 13.38% at June 30, 2007 is above the well-capitalized standard of 10%. The Corporation’s Tier 1 capital ratio of 12.29% is above the well-capitalized minimum of 6%. The leverage ratio at June 30, 2007 was 9.81%, also above the well-capitalized standard of 5%. The Corporation is well capitalized as measured by the federal regulatory agencies. The ratios provide quantitative data demonstrating the strength and future opportunities for use of the Corporation’s capital base. Management continues to evaluate risk-based capital ratios and the capital position of the Corporation as part of its strategic decision making process.
LIQUIDITY AND INTEREST RATE SENSITIVITY
Liquidity measures an organizations’ ability to meet cash obligations as they come due. The Consolidated Statement of Cash Flows presented on page 6 of the accompanying unaudited financial statements provides analysis of the Corporation’s cash and cash equivalents. Additionally, management considers that portion of the loan and investment portfolio that matures within one year as part of the Corporation’s liquid assets. The Corporation’s liquidity is monitored by the ALCO Committee, which establishes and monitors ranges of acceptable liquidity. Management feels the Corporation’s current liquidity and interest rate position is acceptable.
OFF BALANCE SHEET ACTIVITIES
Some financial instruments, such as loan commitments, credit lines, letters of credit and overdraft protection, are issued to meet customer financing needs. The contractual amount of financial instruments with off-balance sheet risk was as follows at June 30, 2007:
Commitments to extend credit
Standby letters of credit
15
CONSOLIDATED YIELD COMPARISONS
(In thousands)
CNB Financial Corporation
Average Balances and Net Interest Margin
Assets
Interest-bearing deposits with banks
Federal funds sold and securities purchased under agreements to resell
Taxable (1)
Tax-Exempt (1,2)
Equity Securities (1,2)
Total Securities
Loans
Commercial (2)
Mortgage (2)
Leasing
Total Loans (3)
Total earning assets
Non Interest Bearing Assets
Cash & Due From Banks
Premises & Equipment
Other Assets
Allowance for Loan Losses
Total Non Interest Earning Assets
Total Assets
Liabilities and Shareholders’ Equity
Interest-Bearing Deposits
Demand-interest-bearing
Savings
Time
Total interest-bearing deposits
Short-term borrowings
Long-term borrowings
Total interest-bearing liabilities
Demand-non-interest-bearing
Other liabilities
Total Liabilities
Shareholders’ Equity
Total Liabilities and Shareholders’ Equity
Interest Income/Earning Assets
Interest Expense/Interest Bearing Liabilities
Net Interest Spread
Interest Income/Interest Earning Assets
Interest Expense/Interest Earning Assets
Net Interest Margin
16
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 2007 AND 2006
The Corporation had net income of $2.4 million for the second quarter of 2007 compared to $2.3 million for the same period of 2006. The earnings per diluted share increased from $0.26 in the second quarter of 2006 to $0.27 for the second quarter of 2007.
INTEREST INCOME AND EXPENSE
Net interest income totaled $7.6 million in the second quarter, an increase of $385,000 (or 5.4%) over the second quarter of 2006. Total interest and dividend income increased by $1.1 million (or 8.6%) as compared to the second quarter of 2006 while total interest expense increased $673 thousand (or 13.1%) as compared to the second quarter of 2006. The primary reason for the growth in net interest income stems from an improved level of average earning assets and increasing yields as discussed more fully in the section of this analysis which covers the six month periods.
PROVISION FOR LOAN LOSSES
The Corporation recorded a provision for loan losses of $442,000 in the second quarter of 2007 compared to $390,000 in the second quarter of 2006. As discussed in the allowance for loan loss section of this analysis, Management believes the charges to the provision are reasonable to provide allowance coverage that is adequate to absorb probable incurred losses in our portfolio as of June 30, 2007.
Other income increased $208 thousand (or 10.8%) in the second quarter of 2007 as compared to the same period in 2006. The increase is primarily the result of increases in “other service charges and fees” and the “other” line item which increased by $77,000 and $61,000, respectively, as compared to the second quarter of 2006. The increase in “other service charges and fees” is not specific to any one income line item but reflects the growth of transactions in the Corporation’s banking franchise as well as Holiday Financial Services Corporation.
The majority of the increase in the “other” category has been from increased transactions on our Visa Check Card product which was enhanced in February of 2006 with a new points program that allows customers to earn points for each dollar charged to the card.
NON-INTEREST EXPENSE
Non-interest expense increased by 9.2 % to $6.0 million in the second quarter of 2007 compared to $5.5 million in the second quarter of 2006. The majority (approximately 80%) of the increase was a result of the Corporation’s increasing costs for salaries and wages, benefits and occupancy related costs. Like many growing entities, the Corporation is faced with increasing employee related costs in order to support its growth.
As mentioned in the future outlook section of this analysis, the Corporation is continuing the process of expanding its ERIEBANK division and will continue to grow its consumer finance venture, Holiday Financial Services Corporation. During 2007, we have begun building ERIEBANK branches and have opened three additional offices of Holiday Financial Services Corporation. The Corporation realizes that expenses related to these new ventures may outpace related revenues in the near term but believes the long-term growth potential is more than worth the near term cost. As such, the Corporation will strive to manage expenses while recognizing some, such as increasing costs for salaries, occupancy, outside services and technology, are the result of continued growth.
FEDERAL INCOME TAX EXPENSE
Federal income tax expense was $858 thousand in the second quarter of 2007 as compared to $869 thousand in the second quarter of 2006 resulting in an effective tax rate of 26.5% and 27.1%, respectively. The effective tax rate for the periods differed from the federal statutory rate of 35.0% principally as a result of tax exempt income from securities and loans as well as earnings from bank owned life insurance.
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SIX MONTHS ENDED JUNE 30, 2007 AND 2006
The Corporation had net income of $4.3 million for the six months of 2007 compared to $4.8 million for the same period of 2006. The earnings per diluted share decreased from $0.53 in the first six months of 2006 to $0.49 for the first six months of 2007. The return on assets and the return on equity for the six months of 2007 are 1.10% and 11.95% as compared to 1.24% and 13.55% for the first six months of 2006.
Net interest income totaled $14.6 million in the first six months, an increase of $613,000 (or 4.4%) over the first six months of 2006. Total interest and dividend income increased by $2.2 million (or 9.1%) as compared to the first six months of 2006 while total interest expense increased $1.5 million (or 15.8%) as compared to the first six months of 2006. Although high rates on the short end of the yield curve have increased the Corporation’s cost of funding we have seen greater positive increases in interest income from loans and investments due to our increased level of average earning assets and improved overall yield as noted in the Consolidated Yield Comparison on page 16 of this analysis. As noted in the table on page 16, the Corporation’s average earning assets have grown by $27.7 million since June 30, 2006 while the yield has increased by 30 basis point from 6.93% to 7.23%.
The Corporation recorded a provision for loan losses of $568,000 in the first six months of 2007 compared to $755,000 in the first six months of 2006. As discussed in more detail in the Allowance for Loan Losses section of this analysis, management believes the charges to the provision in the current year are necessary to provide adequate coverage of its current loan balances based on its most recent analysis.
Other income remained relatively flat decreasing 40,000 (or 0.9%) in the first six months of 2007 as compared to the same period in 2006. However, the prior year was more positively affected by net security gains. During the first six months of 2006, the Corporation recorded a security gain when the issuer of a financial institution equity security held in the Corporation’s available-for-sale portfolio was acquired by another financial institution. As a result of the acquisition, the Corporation received 1.994 shares of the acquiring entity’s stock in exchange for each share of the equity security that it held. Following current accounting guidance in FAS No. 153, Exchanges of Nonmonetary Assets, the Corporation recorded a $341,000 realized gain as a result of the difference between its basis in the equity security it held and the fair market value of the shares it received at the date of the exchange. Net security gains in the current year only amounted to $35,000.
Excluding security gains, total other income increased by $266,000 (or 7.1%) in the six months of 2007 as compared to the same period in 2006. The reason for the increase is primarily due to “other service charges and fees” and the “other” line item which increased by $110,000 and $171,000, respectively. Factors’ leading to increased income in these lines was previously discussed in the three month section of this analysis.
Non-interest expense increased by 12.1% to $12.3 million in the first six months of 2007 compared to $11.0 million in the first six months of 2006. The majority (approximately 76%) of the increase was a result of the Corporation’s increasing costs for salaries and benefits as well as occupancy related costs. Like many growing entities, the Corporation is faced with increasing employee and occupancy related costs to support its growth. As such, the Corporation will strive to manage expenses while recognizing some, such as increasing costs for salaries, occupancy, outside services and technology, are the result of continued growth. As mentioned in the Future Outlook section of this analysis, the Corporation is continuing the process of expanding its banking franchise into the Erie, Pennsylvania market and has opened three new offices of its consumer finance subsidiary, Holiday Financial Services Corporation, in the first six months of 2007. The Corporation realizes that expenses related to these new ventures may outpace related revenues in the near term but believes the long-term growth potential is more than worth the near term cost.
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Federal income tax expense was $1.5 million in the first six months of 2007 as compared to $1.6 million in the first six months of 2006 resulting in an effective tax rate of 26.1% and 25.3%, respectively. The effective tax rate for the periods differed from the federal statutory rate of 35.0% principally as a result of tax exempt income from securities and loans as well as earnings from bank owned life insurance.
FUTURE OUTLOOK
During 2005, the Bank established a loan production office in Erie, Pennsylvania in order to begin offering commercial loan service to businesses located within Erie and Erie County. During the third quarter of 2006, management opened its first full service branch in Erie at a temporary location. During 2007 and 2008, we plan to build three full service branches in Erie. Management believes that our ERIEBANK division, along with our traditional CNB Bank market areas, should provide the Bank with sustained loan growth during the remainder of 2007.
In the fourth quarter of 2005, the Corporation formed a new subsidiary and entered the consumer discount loan and finance business as Holiday Financial Services Corporation. In 2006 we opened three new offices in the communities of Hollidaysburg, Northern Cambria and Clearfield, Pennsylvania. Three additional offices in the communities of Bellefonte, Ridgway and Bradford, Pennsylvania have been opened in 2007 bringing our total to seven. Although the consumer discount loan business is relatively new to the Corporation, management is making the necessary investments in experienced personnel and technology which we believe will facilitate the growth of Holiday Financial Services into a successful and profitable subsidiary of the Corporation in future years.
While non-interest costs are expected to increase with the growth of the Corporation’s banking and consumer discount loan franchises, these new ventures should provide growth in earning assets as well as enhanced non-interest income to more than offset these costs in 2008 and beyond. As such, the Corporation is making the necessary investments in 2007 knowing that earnings will be reduced in the near term due to costs increasing faster than related revenues.
The interest rate environment will continue to play an important rule in the future earnings of the Corporation. Our net interest margin remained strong in the six months of 2007 even with the sustained yield curve inversion which negatively affected the earnings of many financial institutions. Management will closely monitor our net interest margin throughout 2007, as well as continue to apply a disciplined approach to managing our balance sheet, as the majority of the earnings of the Corporation continue to be derived from interest income. Non-interest income should be enhanced in several areas including improved service charge and fee income as we enter new markets and grow transaction accounts.
Management concentrates on return on average equity and earnings per share evaluations, plus other methods to measure and direct the performance of the Corporation. While past results are not an indication of future earnings, we feel the Corporation is positioned to enhance performance of normal operations through the remainder of 2007.
CRITICAL ACCOUNTING POLICIES
The accounting and reporting policies of CNB Financial Corporation are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the financial services industry. Accounting and reporting practices for the allowance for loan losses and fair value of securities are deemed critical since they involve the use of estimates and require significant management judgments. Application of assumptions different than those used by management could result in material changes in CNB Financial Corporation’s financial position or results of operations. Note 1 ( Summary of Significant Accounting Policies), Note 3 (Securities), and Note 5 (Allowance for Loan and Lease Losses), of the 2006 Annual Report and 10-K, provide detail with regard to the Corporation’s accounting for the allowance for loan losses and fair value of securities. There have been no significant changes in the application of accounting policies since December 31, 2006.
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“SAFE HARBOR” STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Certain statements contained in the report that are not historical facts are forward looking statements that are subject to certain risks and uncertainties. When used herein, the terms “anticipates,” “plans,” “expects,” “believes,” “estimate,” “projected,” “forecast,” “should,” or “gravitate to” and similar expressions as they relate to CNB Financial Corporation or its management are intended to identify such forward looking statements. CNB Financial Corporation’s actual results, performance or achievements may materially differ from those expressed or implied in the forward-looking statements. Risks and uncertainties that could cause or contribute to such material differences include, but are not limited to, general economic conditions, interest rate environment, competitive conditions in the financial services industry, changes in law, governmental policies and regulations, and rapidly changing technology affecting financial services.
ITEM 3
QUANTITATIVE & QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates, and equity prices. As a financial institution, the Corporation is primarily sensitive to the interest rate risk component. Changes in interest rates will affect the levels of income and expense recorded on a large portion of the Bank’s assets and liabilities. Additionally, such fluctuations in interest rates will impact the market value of all interest sensitive assets. The Asset/Liability Committee (ALCO) is responsible for reviewing the interest rate sensitivity position and establishing policies to control exposure to interest rate fluctuations. The primary goal established by this policy is to increase total income within acceptable risk limits.
The corporation monitors interest rate risk through the use of two models: earnings simulation and static gap. Each model standing alone has limitations, however taken together they represent a reasonable view of the Corporation’s interest rate risk position. The following discussion provides a summary of our analysis at June 30, 2007.
STATIC GAP: Gap analysis is intended to provide an approximation of projected repricing of assets and liabilities at a point in time on the basis of stated maturities, prepayments, and scheduled interest rate adjustments within selected time intervals. A gap is defined as the difference between the principal amount of assets and liabilities which reprice within those time intervals. The cumulative one year gap at June 30, 2007 was (2.07)% of total earning assets compared to policy guidelines of plus or minus 15.0%.
Fixed rate securities, loans and CDs are included in the gap repricing based on time remaining until maturity. Mortgage prepayments are included in the time frame in which they are expected to be received.
Certain shortcomings are inherent in the method of analysis presented in Static Gap. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may not react correspondingly to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate with changes in market interest rates, while interest rates on other types of assets may lag behind changes in market rates. Additionally, certain assets, such as adjustable-rate loans, have features, like annual and lifetime rate caps, which restrict changes in interest rates both on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate from those assumed in the table. Finally, the ability of certain borrowers to make scheduled payments on their adjustable-rate loans may decrease in the event of an interest rate increase.
EARNINGS SIMULATION: This model forecasts the projected change in net income resulting from an increase or decrease in the level of interest rates. The model assumes a one time shock of plus or minus 200 basis points or 2%.
The model makes various assumptions about cash flows and reinvestments of these cash flows in the different rate environments. Generally, repayments, maturities and calls are assumed to be reinvested in like instruments and no significant change in the balance sheet mix is assumed. Actual results could differ significantly from these estimates which would produce significant differences in the calculated projected change in income. The limits stated above do not necessarily represent measures that would be taken by management in order to stabilize income results. The instruments on the balance sheet do react at different speeds to various changes in interest rates as discussed under Static Gap. In addition, there are strategies available to management that minimize the decline in income caused by a rapid rise in interest rates.
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The following table summarizes the information from the interest rate risk measures reflecting rate sensitive assets to rate sensitive liabilities at June 30, 2007 and December 31, 2006:
Static 1-Yr. Cumulative Gap
Earnings Simulation
-200 bps vs. Stable Rate
+200 bps vs. Stable Rate
The interest rate sensitivity position at June 30, 2007 was liability sensitive in the short-term which is consistent with December 31, 2006. Management measures the potential impact of significant changes in interest rates on both earnings and equity. By the use of computer generated models, the potential impact of these changes has been determined to be acceptable with modest affects on net income and equity given and interest rate shock of an increase or decrease in rates of 2.0%. We continue to monitor the interest rate sensitivity through the ALCO and use the data to make strategic decisions.
ITEM 4
CONTROLS AND PROCEDURES
As of the end of the period covered by this quarterly report, an evaluation was carried out under the supervision and with the participation of the Corporation’s management, including our Chief Executive Officer and Principal Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on their evaluation, our Chief Executive Officer and Principal Financial Officer have concluded that the Corporation’s disclosure controls and procedures are, to the best of their knowledge, effective to ensure that information required to be disclosed by the Corporation in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. Subsequent to the date of their evaluation, our Chief Executive Officer and Principal Financial Officer have concluded that there were no significant changes in the Corporation’s internal controls or in other factors that could significantly affect its internal controls, including any corrective actions with regard to significant deficiencies and material weaknesses.
PART II OTHER INFORMATION
ISSUER PURCHASES OF EQUITY SECURITIES
Period
Total Number
of Shares (or
Units)
Purchased
Price Paid
per Share
(or Unit)
Total Number of
Shares (or Units)
Purchased as Part
of Publicly
Announced Plans
or Programs
Maximum Number (or
Approximate Dollar
Value) of Shares (or
Units) that May Yet Be
Purchased Under the
Plans or Programs
4/1/07 to 4/30/07
5/1/07 to 5/31/07
6/1/07 to 6/30/07
Total
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Purchases not made in conjunction with the Publicly Announced Plan were made to facilitate employee benefit plans in the form of a 401(k).
Results of shareholder voting on these individuals were a follows:
Dennis L. Merrey
William R. Owens
Deborah Dick Pontzer
Charles H. Reams
For
Against or Withheld
The following directors’ terms of office as director continued after the meeting:
Joseph B. Bower, Jr., Robert E. Brown, William F. Falger, James J. Leitzinger, Michael F. Lezzer, Robert W. Montler, Jeffrey S. Powell, James B. Ryan, and Peter F. Smith.
Results of ratification of appointment of Crowe Chizek and Company LLC as independent auditors was as follows:
The total shares voted at the annual meeting were 6,810,541.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
(Registrant)
/s/ William F. Falger
/s/ Charles R. Guarino
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