UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10 - Q
For the quarterly period ended September 30, 2015
or
For the transition period from to
Commission File Number 000-13396
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 period 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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes ¨ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.:
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes x No
The number of shares outstanding of the issuer’s common stock as of November 2, 2015
COMMON STOCK NO PAR VALUE PER SHARE: 14,407,148 SHARES
INDEX
PART I.
FINANCIAL INFORMATION
ITEM 1 – Financial Statements
Consolidated Balance Sheets – September 30, 2015 (unaudited) and December 31, 2014 (audited)
Consolidated Statements of Income – Three months ended September 30, 2015 and 2014 (unaudited)
Consolidated Statements of Income – Nine months ended September 30, 2015 and 2014 (unaudited)
Consolidated Statements of Comprehensive Income – Three and nine months ended September 30, 2015 and 2014 (unaudited)
Consolidated Statements of Cash Flows – Nine months ended September 30, 2015 and 2014 (unaudited)
Notes to Consolidated Financial Statements
ITEM 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations
ITEM 3 – Quantitative and Qualitative Disclosures about Market Risk
ITEM 4 – Controls and Procedures
ITEM 1 – Legal Proceedings
ITEM 1A – Risk Factors
ITEM 6 – Exhibits
Signatures
Forward-Looking Statements
This quarterly report on Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, with respect to our financial condition, liquidity, results of operations, future performance and our business. These forward-looking statements are intended to be covered by the safe harbor for “forward-looking statements” provided by the Private Securities Litigation Reform Act of 1995. Forward-looking statements are those that are not historical facts. Forward-looking statements include statements with respect to beliefs, plans, objectives, goals, expectations, anticipations, estimates and intentions that are subject to significant risks and uncertainties and are subject to change based on various factors (some of which are beyond our control). Forward-looking statements often include the words “believes,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions or future conditional verbs such as “may,” “will,” “should,” “would” and “could.” Such known and unknown risks, uncertainties and other factors that could cause the actual results to differ materially from the statements, include, but are not limited to, (i) changes in general business, industry or economic conditions or competition; (ii) changes in any applicable law, rule, regulation, policy, guideline or practice governing or affecting financial holding companies and their subsidiaries or with respect to tax or accounting principles or otherwise; (iii) adverse changes or conditions in capital and financial markets; (iv) changes in interest rates; (v) higher than expected costs or other difficulties related to integration of combined or merged businesses; (vi) the inability to realize expected cost savings or achieve other anticipated benefits in connection with business combinations and other acquisitions; (vii) changes in the quality or composition of our loan and investment portfolios; (viii) adequacy of loan loss reserves; (ix) increased competition; (x) loss of certain key officers; (xi) continued relationships with major customers; (xii) deposit attrition; (xiii) rapidly changing technology; (xiv) unanticipated regulatory or judicial proceedings and liabilities and other costs; (xv) changes in the cost of funds, demand for loan products or demand for financial services; (xvi) other economic, competitive, governmental or technological factors affecting our operations, markets, products, services and prices; and (xvii) our success at managing the foregoing items. Some of these and other factors are discussed in our annual and quarterly reports filed with the Securities and Exchange Commission (“SEC”). Such factors could have an adverse impact on our financial position and our results of operations.
The forward-looking statements contained herein are based upon management’s beliefs and assumptions. Any forward-looking statement made herein speaks only as of the date on which it is made. Factors or events that could cause our actual results to differ may emerge from time to time, and it is not possible for us to predict all of them. We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by law.
Part I Financial Information
Item 1. Financial Statements
CONSOLIDATED BALANCE SHEETS
Dollars in thousands, except share data
Cash and due from banks
Interest bearing deposits with other banks
Total cash and cash equivalents
Interest bearing time deposits with other banks
Securities available for sale
Trading securities
Loans held for sale
Loans
Less: unearned discount
Less: allowance for loan losses
Net loans
FHLB and other equity interests
Premises and equipment, net
Bank owned life insurance
Mortgage servicing rights
Goodwill
Core deposit intangible
Accrued interest receivable and other assets
Total Assets
Non-interest bearing deposits
Interest bearing deposits
Total deposits
FHLB and other long-term borrowings
Other short-term borrowings
Subordinated debentures
Accrued interest payable and other liabilities
Total liabilities
Common stock, $0 par value; authorized 50,000,000 shares; issued 14,473,482 shares
Additional paid in capital
Retained earnings
Treasury stock, at cost (67,001 shares at September 30, 2015 and 69,066 shares at December 31, 2014)
Accumulated other comprehensive income
Total shareholders’ equity
Total Liabilities and Shareholders’ Equity
See Notes to Consolidated Financial Statements
1
CONSOLIDATED STATEMENTS OF INCOME (unaudited)
Dollars in thousands, except per share data
INTEREST AND DIVIDEND INCOME:
Loans including fees
Securities:
Taxable
Tax-exempt
Dividends
Total interest and dividend income
INTEREST EXPENSE:
Deposits
Borrowed funds
Subordinated debentures (includes $95 and $96 accumulated other comprehensive income reclassification for change in fair value of interest rate swap agreements in 2015 and 2014, respectively)
Total interest expense
NET INTEREST INCOME
PROVISION FOR LOAN LOSSES
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES
NON-INTEREST INCOME:
Wealth and asset management fees
Service charges on deposit accounts
Other service charges and fees
Net realized gains on available-for-sale securities (includes $73 and $41 accumulated other comprehensive income reclassifications for net realized gains on available-for-sale securities in 2015 and 2014, respectively)
Net realized and unrealized losses on trading securities
Mortgage banking
Other
Total non-interest income
NON-INTEREST EXPENSES:
Salaries and benefits
Net occupancy expense
Amortization of core deposit intangible
Data processing
State and local taxes
Legal, professional, and examination fees
Advertising
FDIC insurance premiums
Total non-interest expenses
INCOME BEFORE INCOME TAXES
INCOME TAX EXPENSE (includes ($7) and ($20) income tax expense from reclassification items in 2015 and 2014, respectively)
NET INCOME
EARNINGS PER SHARE:
Basic
Diluted
DIVIDENDS PER SHARE:
Cash dividends per share
2
Subordinated debentures (includes $284 and $287 accumulated other comprehensive income reclassification for change in fair value of interest rate swap agreements in 2015 and 2014, respectively)
Net realized gains on available-for-sale securities (includes $564 and $245 accumulated other comprehensive income reclassifications for net realized gains on available-for-sale securities in 2015 and 2014, respectively)
Net realized and unrealized (losses) gains on trading securities
Merger costs
INCOME TAX EXPENSE (includes $98 and ($14) income tax expense from reclassification items in 2015 and 2014, respectively)
3
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (unaudited)
Dollars in thousands
Other comprehensive income, net of tax:
Net change in fair value of interest rate swap agreements designated as cash flow hedges:
Unrealized gain (loss) on interest rate swaps, net of tax of $44 and and ($20) for the three months ended September 30, 2015 and 2014, and $86 and $37 for the nine months ended September 30, 2015 and 2014
Reclassification adjustment for losses recognized in earnings, net of tax of ($33) and ($34) for the three months ended September 30, 2015 and 2014, and ($99) and ($100) for the nine months ended September 30, 2015 and 2014
Net change in unrealized gains on securities available for sale:
Unrealized gains on other-than-temporarily impaired securities available for sale:
Unrealized gains arising during the period, net of tax of $0 and ($26) for the three months ended September 30, 2015 and 2014, and ($90) and ($74) for the nine months ended September 30, 2015 and 2014
Unrealized gains on other securities available for sale:
Unrealized gains arising during the period, net of tax of $(2,059) and ($552) for the three months ended September 30, 2015 and 2014, and ($1,221) and ($4,441) for the nine months ended September 30, 2015 and 2014
Reclassification adjustment for realized gains included in net income, net of tax of $26 and $14 for the three months ended September 30, 2015 and 2014, and $197 and $85 for the nine months ended September 30, 2015 and 2014
Other comprehensive income
COMPREHENSIVE INCOME
4
CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income
Adjustments to reconcile net income to net cash provided by operations:
Provision for loan losses
Depreciation and amortization of premises and equipment, core deposit intangible, and mortgage servicing rights
Amortization and accretion of securities premiums and discounts, deferred loan fees and costs, net yield and credit mark on acquired loans, and unearned income
Net realized gains on sales of available-for-sale securities
Net realized and unrealized losses (gains) on trading securities
Proceeds from sale of trading securities
Purchase of trading securities
Gain on sale of loans
Net losses on dispositions of premises and equipment and foreclosed assets
Proceeds from sale of loans
Origination of loans held for sale
Income on bank owned life insurance
Stock-based compensation expense
Contribution of treasury stock
Changes in:
NET CASH PROVIDED BY OPERATING ACTIVITIES
CASH FLOWS FROM INVESTING ACTIVITIES:
Net decrease in interest bearing time deposits with other banks
Proceeds from maturities, prepayments and calls of available-for-sale securities
Proceeds from sales of available-for-sale securities
Purchase of available-for-sale securities
Loan origination and payments, net
Purchase of FHLB and other equity interests
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
Purchase of treasury stock
Cash dividends paid
Repayment of long-term borrowings
Proceeds from long-term borrowings
Net change in short-term borrowings
NET CASH PROVIDED BY FINANCING ACTIVITIES
NET DECREASE IN CASH AND CASH EQUIVALENTS
CASH AND CASH EQUIVALENTS, Beginning
CASH AND CASH EQUIVALENTS, Ending
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest
Income taxes
SUPPLEMENTAL NONCASH DISCLOSURES:
Transfers to other real estate owned
Grant of restricted stock awards from treasury stock
5
NOTES TO CONSOLIDATED FINANCIALSTATEMENTS
(UNAUDITED)
The accompanying consolidated financial statements have been prepared pursuant to rules and regulations of the SEC and in compliance with accounting principles generally accepted in the United States of America (“GAAP”). Because this report is based on an interim period, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted.
In the opinion of management of the registrant, the accompanying consolidated financial statements as of September 30, 2015 and for the three and nine month periods ended September 30, 2015 and 2014 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 presented. The financial performance reported for CNB Financial Corporation (the “Corporation”) for the three and nine month periods ended September 30, 2015 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 on Form 10-K for the period ended December 31, 2014 (the “2014 Form 10-K”). All dollar amounts are stated in thousands, except share and per share data and other amounts as indicated. Certain prior period amounts have been reclassified to conform to the current period presentation.
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 aggregate grants of up to 500,000 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 date. For independent directors, the vesting schedule is one-third of the granted options or restricted stock per year beginning one year after the grant date, with 100% vested on the third anniversary of the grant date.
At September 30, 2015, there was no unrecognized compensation cost related to nonvested stock options granted under this plan and no stock options were granted during the three and nine month periods ended September 30, 2015 and 2014.
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. Nonvested restricted stock awards are recorded as a reduction of additional paid-in-capital in shareholders’ equity until earned. Compensation expense resulting from these restricted stock awards was $169 and $474 for the three and nine months ended September 30, 2015, and $118 and $445 for the three and nine months ended September 30, 2014. As of September 30, 2015, there was $1,148 of total unrecognized compensation cost related to unvested restricted stock awards.
A summary of changes in nonvested restricted stock awards for the three months ended September 30, 2015 follows:
Per Share
Weighted Average
Nonvested at beginning of period
Granted
Vested
Nonvested at end of period
6
A summary of changes in nonvested restricted stock awards for the nine months ended September 30, 2015 follows:
Fair Value Measurement
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. A fair value hierarchy has also been established which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The following three levels of inputs are used to measure fair value:
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
The fair values of most trading securities and securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs).
The Corporation’s structured pooled trust preferred security is priced using Level 3 inputs. The decline in the level of observable inputs and market activity in this class of investments by the measurement date has been significant and resulted in unreliable external pricing. Broker pricing and bid/ask spreads, when available, vary widely, and the once-active market has become comparatively inactive. The Corporation engaged a third party consultant who has developed a model for pricing this security. Information such as historical and current performance of the underlying collateral, deferral and default rates, collateral coverage ratios, break in yield calculations, cash flow projections, liquidity and credit premiums required by a market participant, and financial trend analysis with respect to the individual issuing financial institutions and insurance companies are utilized in determining the security valuation. Due to the current market conditions as well as the limited trading activity of these types of securities, the market value of the Corporation’s structured pooled trust preferred security is highly sensitive to assumption changes and market volatility.
The Corporation’s derivative instrument is an interest rate swap that is similar to those that trade in liquid markets. As such, significant fair value inputs can generally be verified and do not typically involve significant management judgments (Level 2 inputs).
7
Assets and liabilities measured at fair value on a recurring basis are as follows at September 30, 2015 and December 31, 2014:
Description
Assets:
Securities Available For Sale:
U.S. Government sponsored entities
States and political subdivisions
Residential and multi-family mortgage
Corporate notes and bonds
Pooled trust preferred
Pooled SBA
Other securities
Total Securities Available For Sale
Trading Securities:
Corporate equity securities
Mutual funds
Total Trading Securities
Liabilities,
Interest rate swaps
8
The table below presents a reconciliation of the fair value of securities available for sale measured on a recurring basis using significant unobservable inputs (Level 3) for the three months ended September 30, 2015 and September 30, 2014:
Balance, July 1
Total gains or (losses):
Included in other comprehensive income (unrealized)
Balance, September 30
The table below presents a reconciliation of the fair value of securities available for sale measured on a recurring basis using significant unobservable inputs (Level 3) for the nine months ended September 30, 2015 and September 30, 2014:
Balance, January 1
The following table presents quantitative information about Level 3 fair value measurements at September 30, 2015:
Fairvalue
ValuationTechnique
Unobservable
Inputs
Input
Utilized
Discounted
cash flow
Yield
Prepayment speed
9%
2.0% constant prepayment rate in 2015 and thereafter
The following table presents quantitative information about Level 3 fair value measurements at December 31, 2014:
11%
At September 30, 2015 and December 31, 2014, the significant unobservable inputs used in the fair value measurement of the Corporation’s pooled trust preferred security are collateral default rate, yield, and prepayment speed. Significant increases in specific-issuer default assumptions or decreases in specific-issuer recovery assumptions would result in a significantly lower fair value measurement. Conversely, decreases in specific-issuer default assumptions or increases in specific-issuer recovery assumptions would result in a higher fair value measurement.
9
Assets and liabilities measured at fair value on a non-recurring basis are as follows at September 30, 2015 and December 31, 2014:
Impaired loans:
Commercial mortgages
Commercial, industrial, and agricultural
Impaired loans, which, if collateral dependent, are measured for impairment using the fair value of collateral, had a recorded investment of $7,004 with a valuation allowance of $1,754 as of September 30, 2015, resulting in an additional provision for loan losses of ($361) and ($298) for the corresponding three and nine month period ended September 30, 2015. Impaired loans had a recorded investment of $7,423 with a valuation allowance of $2,250 as of December 31, 2014. Additional provision for loan losses were incurred of ($69) and $51 for the three and nine months ended September 30, 2014.
The estimated fair values of impaired collateral dependent loans such as commercial or residential mortgages are determined primarily by using third-party appraisals. When a collateral dependent loan, such as a commercial or residential mortgage loan, becomes impaired, a decision is made regarding whether an updated certified appraisal of the real estate is necessary. This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio based on the original appraisal, and the condition of the property. Appraised values are discounted to arrive at the estimated selling price of the collateral and a further reduction for estimated costs to sell the property is applied, which results in an amount that is considered to be the estimated fair value. If a loan becomes impaired and management determines an updated appraisal is not necessary, an appropriate adjustment factor is applied based on experience with current valuations of similar collateral in determining the loan’s estimated fair value and resulting allowance for loan losses. Third-party appraisals are not customarily obtained in respect of unimpaired loans, unless in management’s view changes in circumstances warrant obtaining an updated appraisal.
The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at September 30, 2015:
Impaired loans – commercial
mortgages
Impaired loans – commercial,
industrial, and agricultural
10
The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at December 31, 2014:
Fair Value of Financial Instruments
The following table presents the carrying amount and fair value of financial instruments at September 30, 2015:
ASSETS
Cash and cash equivalents
Accrued interest receivable
LIABILITIES
FHLB and other borrowings
Accrued interest payable
The following table presents the carrying amount and fair value of financial instruments at December 31, 2014:
11
The methods and assumptions, not otherwise presented, used to estimate fair values are described as follows:
Cash and cash equivalents: The carrying amounts of cash and cash equivalents approximate fair values and are classified as Level 1.
Interest bearing time deposits with other banks: The fair value of interest bearing time deposits with other banks is estimated using a discounted cash flow calculation that applies interest rates currently being offered to a schedule of aggregated expected monthly maturities, resulting in a Level 2 classification.
Loans held for sale: The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification.
Loans: For variable rate loans that re-price frequently and with no significant change in credit risk, fair values are based on carrying values, resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality, resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.
FHLB and other equity interests: It is not practical to determine the fair value of Federal Home Loan Bank (“FHLB”) stock and other equity interests due to restrictions placed on the transferability of these instruments.
Accrued interest receivable: The carrying amount of accrued interest receivable approximates fair value. The Level classification of accrued interest receivable is matched to the corresponding Level of the asset with which it is associated.
Deposits: The fair values disclosed for demand deposits are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount), resulting in a Level 1 classification. Fair values for time deposits are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits, resulting in a Level 2 classification.
FHLB and other borrowings: The fair values of the Corporation’s FHLB and other borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements, resulting in a Level 2 classification.
Subordinated debentures: The fair value of the Corporation’s subordinated debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of arrangements, resulting in a Level 2 classification.
Accrued interest payable: The carrying amount of accrued interest payable approximates fair value resulting in a classification that is consistent with the liability with which it is associated.
While estimates of fair value are based on management’s judgment of the most appropriate factors as of the balance sheet date, there is no assurance that the estimated fair values would have been realized if the assets had been disposed of or the liabilities settled at that date, since market values may differ depending on various circumstances. The estimated fair values would also not apply to subsequent dates.
In addition, other assets and liabilities that are not financial instruments, such as premises and equipment, are not included in the disclosures. Also, non-financial assets such as, among other things, the estimated earning power of core deposits, the earnings potential of trust accounts, the trained workforce, and customer goodwill, which typically are not recognized on the balance sheet, may have value but are not included in the fair value disclosures.
12
Securities available for sale at September 30, 2015 and December 31, 2014 are as follows:
U.S. Gov’t sponsored entities
State & political subdivisions
Residential & multi-family mortgage
Corporate notes & bonds
Total
At September 30, 2015 and December 31, 2014, there were no holdings of securities of any one issuer, other than the U.S. Government sponsored entities, in an amount greater than 10% of shareholders’ equity. The Corporation’s residential and multi-family mortgage securities are issued by government sponsored entities.
Trading securities at September 30, 2015 and December 31, 2014 are as follows:
Securities with unrealized losses at September 30, 2015 and December 31, 2014, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, are as follows (in thousands):
September 30, 2015
Description of Securities
13
December 31, 2014
The Corporation evaluates securities for other-than-temporary impairment on a quarterly basis, or more frequently when economic or market conditions warrant such an evaluation.
A roll-forward of the other-than-temporary impairment amount related to credit losses for the three and nine months ended September 30, 2015 and 2014 is as follows:
Balance of credit losses on debt securities for which a portion of other-than-temporary impairment was recognized in earnings, beginning of period
Additional credit loss for which other-than-temporary impairment was not previously recognized
Additional credit loss for which other-than-temporary impairment was previously recognized
Balance of credit losses on debt securities for which a portion of other-than-temporary impairment was recognized in earnings, end of period
Due to the insignificance of the adjusted amortized cost balance, no further disclosures are required with respect to the Corporation’s structured pooled trust preferred securities.
For the securities that comprise corporate notes and bonds and the securities that are issued by state and political subdivisions, management monitors publicly available financial information, such as filings with the Securities and Exchange Commission, in order to evaluate the securities for other-than-temporary impairment. For financial institution issuers, management monitors information from quarterly “call” report filings that are used to generate Uniform Bank Performance Reports. All other securities that were in an unrealized loss position at the balance sheet date were reviewed by management, and issuer-specific documents were reviewed, as appropriate given the following considerations. When reviewing securities for other-than-temporary impairment, management considers the financial condition and near-term prospects of the issuer and whether downgrades by bond rating agencies have occurred. Management also considers the length of time and extent to which fair value has been less than cost, and whether management does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery.
As of September 30, 2015 and December 31, 2014, management concluded that the securities described in the previous paragraph were not other-than-temporarily impaired for the following reasons:
There is no indication of any significant deterioration of the creditworthiness of the institutions that issued the securities.
All contractual interest payments on the securities have been received as scheduled, and no information has come to management’s attention through the processes previously described which would lead to a conclusion that future contractual payments will not be timely received.
The Corporation does not intend to sell and it is not more likely than not that it will be required to sell the securities in an unrealized loss position before recovery of its amortized cost basis.
14
Information pertaining to the sale of available for sale securities is as follows:
Three months ended September 30, 2015
Nine months ended September 30, 2015
Three months ended September 30, 2014
Nine months ended September 30, 2014
The following is a schedule of the contractual maturity of securities available for sale, excluding equity securities, at September 30, 2015:
1 year or less
1 year – 5 years
5 years – 10 years
After 10 years
Total debt securities
Mortgage and asset backed securities and pooled SBA securities are not due at a single date; periodic payments are received based on the payment patterns of the underlying collateral.
On September 30, 2015 and December 31, 2014, securities carried at $344,036 and $325,799, respectively, were pledged to secure public deposits and for other purposes as provided by law.
Total net loans at September 30, 2015 and December 31, 2014 are summarized as follows:
Residential real estate
Consumer
Credit cards
Overdrafts
allowance for loan losses
Loans, net
At September 30, 2015 and December 31, 2014, net unamortized loan fees and costs of $(160) and $483, respectively, have been included in the carrying value of loans.
The Corporation’s outstanding loans and related unfunded commitments are primarily concentrated within Central and Western Pennsylvania and Central Ohio. The Bank attempts to limit concentrations within specific industries by utilizing dollar limitations to single industries or customers, and by entering into participation agreements with third parties. Collateral requirements are established based on management’s assessment of the customer. The Corporation maintains lending policies to control the quality of the loan portfolio. These policies delegate the authority to extend loans under specific guidelines and underwriting standards. These policies are prepared by the Corporation’s management and reviewed and ratified annually by the Corporation’s Board of Directors.
15
All relevant documentation, such as the loan application, financial statements and tax returns, required under the lending policies is summarized and provided to management in connection with the loan approval process. Such documentation is subsequently electronically archived in the Corporation’s document management system. Pursuant to the Corporation’s lending policies, management considers a variety of factors when determining whether to extend credit to a customer, including loan-to-value ratios, FICO scores, quality of the borrower’s financial statements, and the ability to obtain personal guarantees.
Commercial, industrial, and agricultural loans comprised 30% and 32% of the Corporation’s total loan portfolio at September 30, 2015 and December 31, 2014, respectively. Commercial mortgage loans comprised 28% and 26% of the Corporation’s total loan portfolio at September 30, 2015 and December 31, 2014, respectively. Management assigns a risk rating to all commercial loans in excess of $250,000. The loan-to-value policy guidelines for commercial, industrial, and agricultural loans are generally a maximum of 80% of the value of business equipment, a maximum of 75% of the value of accounts receivable, and a maximum of 60% of the value of business inventory. The loan-to-value policy guideline for commercial mortgage loans is generally a maximum of 85% of the appraised value of the real estate.
Residential real estate loans comprised 37% and 37% of the Corporation’s total loan portfolio at September 30, 2015 and December 31, 2014, respectively. The loan-to-value policy guidelines for residential real estate loans vary depending on the collateral position and the specific type of loan. Higher loan-to-value terms may be approved with the appropriate private mortgage insurance coverage. The Corporation also originates and prices loans for sale into the secondary market through Freddie Mac. Loans originated for sale into the secondary market are classified as loans held for sale and are excluded from residential real estate loans reported above. The rationale for these sales is to mitigate interest rate risk associated with holding lower rate, long-term residential mortgages in the loan portfolio and to generate fee revenue from sales and servicing the loan. The Corporation also offers a variety of unsecured and secured consumer loan and credit card products which represent less than 10% of the total loan portfolio at both September 30, 2015 and December 31, 2014. Terms and collateral requirements vary depending on the size and nature of the loan.
CNB has not underwritten any hybrid loans, payment option loans, or low documentation/no documentation loans. Variable rate loans are generally underwritten at the fully indexed rate. Loan underwriting policies and procedures have not changed materially between any periods presented.
Transactions in the allowance for loan losses for the three months ended September 30, 2015 were as follows:
Allowance for loan losses, July 1, 2015
Charge-offs
Recoveries
Provision (benefit) for loan losses
Allowance for loan losses, September 30, 2015
Transactions in the allowance for loan losses for the nine months ended September 30, 2015 were as follows:
Allowance for loan losses, January 1, 2015
16
Transactions in the allowance for loan losses for the three months ended September 30, 2014 were as follows:
Allowance for loan losses, July 1, 2014
Allowance for loan losses, September 30, 2014
Transactions in the allowance for loan losses for the nine months ended September 30, 2014 were as follows:
Allowance for loan losses, January 1, 2014
The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and is based on the Corporation’s impairment method as of September 30, 2015 and December 31, 2014. The recorded investment in loans excludes accrued interest and unearned discounts due to their insignificance.
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment
Collectively evaluated for impairment
Acquired with deteriorated credit quality
Modified in a troubled debt restructuring
Total ending allowance balance
Loans:
Total ending loans balance
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The following tables present information related to loans individually evaluated for impairment, including loans modified in troubled debt restructurings, by portfolio segment as of September 30, 2015 and December 31, 2014 and for the three and nine months ended September 30, 2015 and 2014:
With an allowance recorded:
Commercial mortgage
With no related allowance recorded:
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The following table presents the recorded investment in nonaccrual loans and loans past due over 90 days still accruing interest by class of loans as of September 30, 2015 and December 31, 2014:
Nonaccrual loans and loans past due over 90 days still on accrual include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.
Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time (generally six months) and the ultimate collectability of the total contractual principal and interest is no longer in doubt.
The following table presents the aging of the recorded investment in past due loans as of September 30, 2015 and December 31, 2014 by class of loans.
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Troubled Debt Restructurings
The terms of certain loans have been modified as troubled debt restructurings. The modification of the terms of such loans included either or both of the following: a reduction of the stated interest rate of the loan or an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk.
The following table presents the number of loans, loan balances, and specific reserves for loans that have been restructured in a troubled debt restructuring as of September 30, 2015 and December 31, 2014.
There were no loans modified as troubled debt restructurings during the three or nine months ended September 30, 2015 and September 30, 2014.
A loan is considered to be in payment default once it is 90 days contractually past due under the modified terms. All loans modified in troubled debt restructurings are performing in accordance with their modified terms as of September 30, 2015 and December 31, 2014 and no principal balances were forgiven in connection with the loan restructurings.
In order to determine whether a borrower is experiencing financial difficulty, the Corporation performs an evaluation using its internal underwriting policies of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without a loan modification. The Corporation has no further loan commitments to customers whose loans are classified as a troubled debt restructuring.
Generally, non-performing troubled debt restructurings are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time (generally six months) and the ultimate collectability of the total contractual principal and interest is no longer in doubt.
Credit Quality Indicators
The Corporation classifies commercial, industrial, and agricultural loans and commercial mortgage loans into risk categories based on relevant information about the ability of borrowers to service their debt, such as current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. Loans with outstanding balances greater than $1 million are analyzed at least semiannually and loans with outstanding balances of less than $1 million are analyzed at least annually.
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The Corporation uses the following definitions for risk ratings:
Special Mention: Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Corporation’s credit position at some future date.
Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Corporation will sustain some loss if the deficiencies are not corrected.
Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Loans not rated as special mention, substandard, or doubtful are considered to be pass rated loans. All loans included in the following tables have been assigned a risk rating within 12 months of the balance sheet date.
The Corporation considers the performance of the loan portfolio and its impact on the allowance for loan losses. For residential real estate, consumer, and credit card loan classes, the Corporation also evaluates credit quality based on the aging status of the loan, which was previously presented, and by payment activity. The following table presents the recorded investment in residential, consumer, and credit card loans based on payment activity as of September 30, 2015 and December 31, 2014:
Performing
Non-performing
The Corporation’s portfolio of residential real estate and consumer loans maintained within Holiday Financial Services Corporation (“Holiday”) is considered to be subprime. Holiday is a subsidiary that offers small balance unsecured and secured loans, primarily collateralized by automobiles and equipment, to borrowers with higher risk characteristics than are typical in the Bank’s consumer loan portfolio.
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Holiday’s loan portfolio is summarized as follows at September 30, 2015 and December 31, 2014:
6. DEPOSITS
Total deposits at September 30, 2015 and December 31, 2014 are summarized as follows (in thousands):
Checking, non-interest bearing
Checking, interest bearing
Savings accounts
7. EARNINGS PER SHARE
Basic earnings per share is computed by dividing net income by the weighted average number of shares outstanding during the applicable period, excluding outstanding participating securities. 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 certain stock compensation plans. For the three and nine months ended September 30, 2015, there were no outstanding stock options to include in the diluted earnings per share calculation.
Unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and are excluded in the computation of earnings per share pursuant to the two-class method. The Corporation has determined that its outstanding unvested stock awards are participating securities.
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The computation of basic and diluted earnings per share is shown below (in thousands except per share data):
Basic earnings per common share computation:
Net income per consolidated statements of income
Net earnings allocated to participating securities
Net earnings allocated to common stock
Distributed earnings allocated to common stock
Undistributed earnings allocated to common stock
Weighted average common shares outstanding, including shares considered participating securities
Less: Average participating securities
Weighted average shares
Basic earnings per common share
Diluted earnings per common share computation:
Weighted average common shares outstanding for basic earnings per common share
Add: Dilutive effects of assumed exercises of stock options
Weighted average shares and dilutive potential common shares
Diluted earnings per common share
On May 3, 2011, the Corporation executed an interest rate swap agreement with a 5 year term and an effective date of September 15, 2013 in order to hedge cash flows associated with $10 million of a subordinated note that was issued by the Corporation during 2007 and elected cash flow hedge accounting for the agreement. The Corporation’s objective in using this derivative is to add stability to interest expense and to manage its exposure to interest rate risk. The interest rate swap involves the receipt of variable-rate amounts in exchange for fixed-rate payments from September 15, 2013 to September 15, 2018 without exchange of the underlying notional amount. At September 30, 2015, the variable rate on the subordinated debt was 1.84% (LIBOR plus 155 basis points) and the Corporation was paying 5.57% (4.02% fixed rate plus 155 basis points).
As of September 30, 2015 and December 31, 2014, no derivatives were designated as fair value hedges or hedges of net investments in foreign operations. Additionally, the Corporation does not use derivatives for trading or speculative purposes and currently does not have any derivatives that are not designated as hedges.
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The following tables provide information about the amounts and locations of activity related to the interest rate swaps designated as cash flow hedges within the Corporation’s consolidated balance sheet and statement of income as of September 30, 2015 and December 31, 2014 and for the three and nine months ended September 30, 2015 and 2014:
Interest rate contracts
other liabilities
For the Three Months
Ended September 30, 2015
For the Nine Months
Ended September 30, 2014
Amounts reported in accumulated other comprehensive loss related to the interest rate swap will be reclassified to interest expense as interest payments are made on the subordinated debentures. Such amounts reclassified from accumulated other comprehensive loss to interest expense in the next twelve months are expected to be $381. As of September 30, 2015 and December 31, 2014, a cash collateral balance in the amount of $1,400 was maintained with a counterparty to the interest rate swaps. These balances are included in interest bearing deposits with other banks on the consolidated balance sheet.
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In January 2014, the FASB issued Accounting Standards Update 2014-04, “Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40)” (ASU 2014-04). The amendments in ASU 2014-04 clarify the circumstances under which an in substance repossession or foreclosure occurs and when a creditor is considered to have received physical possession of a residential real estate property collateralizing a residential real estate loan. The amendments in ASU 2014-04 also require interim and annual disclosure of the amount of foreclosed residential real estate property held by the creditor and the recorded investment in loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. ASU 2014-04 is effective for reporting periods beginning after December 15, 2014. The effect of adopting ASU 2014-04 did not have a material effect on the Corporation’s financial statements.
In June 2014, the FASB issued ASU 2014-11 “Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures”. The amendments in ASU 2014-11 change the accounting for repurchase-to-maturity transactions and linked repurchase financings to secured borrowing accounting, which is consistent with the accounting for other repurchase agreements. The amendments also require two new disclosures. The first disclosure requires an entity to disclose information on transfers accounted for as sales in transactions that are economically similar to repurchase agreements. The second disclosure provides increased transparency about the types of collateral pledged in repurchase agreements and similar transactions accounted for as secured borrowings. 2014-11 is effective for reporting periods beginning after December 15, 2014. The effect of adopting ASU 2014-11 did not have a material effect on the Corporation’s financial statements.
In June 2014, the FASB issued ASU 2014-12 “Compensation – Stock Compensation (Topic 718)”. ASU 2014-12 clarifies that entities should treat performance targets that can be met after the requisite service period of a share-based payment award as performance conditions that affect vesting. Therefore, an entity would not record compensation expense (measured as of the grant date without taking into account the effect of the performance target) related to an award for which transfer to the employee is contingent on the entity’s satisfaction of a performance target until it becomes probable that the performance target will be met. No new disclosures are required under ASU 2014-12. The guidance is effective for reporting periods beginning after December 15, 2015. The effect of adopting ASU 2014-12 is not expected to have a material effect on the Corporation’s financial statements.
ITEM 2
MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION
AND RESULTS OFOPERATIONS
The following discussion and analysis of the consolidated financial statements of 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 primarily within its primary market area of the Pennsylvania counties of Blair, Cambria, Cameron, Centre, Clearfield, Crawford, Elk, Indiana, Jefferson, and McKean. As ERIEBANK, a division of CNB Bank, the Bank operates in the Pennsylvania counties of Crawford, Erie, and Warren, and the Ohio county of Ashtabula. As FCBank, a division of CNB Bank, the Bank operates in the Ohio counties of Crawford, Richland, Ashland, Wayne, Marion, Morrow, Knox, Holmes, Delaware, and Franklin.
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 of the Corporation and its consolidated subsidiaries are not necessarily indicative of future performance. CNB Securities Corporation is incorporated in Delaware and currently maintains investments in debt and equity securities. County Reinsurance Company is an Arizona corporation and provides credit life and disability insurance for customers of CNB Bank. CNB Insurance Agency, incorporated in Pennsylvania, provides for the sale of nonproprietary annuities and other insurance products. Holiday Financial Services Corporation (“Holiday”), incorporated in Pennsylvania, offers small balance unsecured loans and secured loans, primarily collateralized by automobiles and equipment, to borrowers with higher risk characteristics.
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When we use the terms “we”, “us” and “our”, we mean CNB Financial Corporation and its subsidiaries. Management’s discussion and analysis should be read in conjunction with the Corporation’s consolidated financial statements and related notes.
The following discussion should be read in conjunction with the Corporation’s Consolidated Financial Statements and Notes thereto, for the year ended December 31, 2014, included in its 2014 Form 10-K, and in conjunction with the Consolidated Financial Statements and Notes thereto included in Item 1 of this report. Operating results for the three and nine months ended September 30, 2015 are not necessarily indicative of the results for the full year ending December 31, 2015, or any future period.
GENERAL OVERVIEW
Management uses return on average equity, earnings per share, asset quality, and other metrics to measure the performance of the Corporation. The interest rate environment will continue to play an important role in the future earnings of the Corporation. During the past several years, in order to address the historically low interest rates that are primarily tied to short-term rates, such as the Prime Rate, the Corporation has taken a variety of measures including instituting rate floors on our commercial lines of credit and home equity lines.
Non-interest costs are expected to increase with the growth of the Corporation; however, management’s growth strategies are expected to also result in an increase in earning assets as well as enhanced non-interest income which is expected to more than offset increases in non-interest expenses in 2015 and beyond. While past results are not an indication of future earnings, management believes the Corporation is well-positioned to sustain earnings during 2015.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents totaled $27.4 million at September 30, 2015 compared to $27.9 million at December 31, 2014. Cash and cash equivalents fluctuate based on the timing and amount of liquidity events that occur in the normal course of business.
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, FHLB financing, and the portions of the securities and loan portfolios that mature within one year. The Corporation expects that these sources of funds will enable it to meet cash obligations and off-balance sheet commitments as they come due.
SECURITIES
Securities available for sale and trading securities decreased by $98.4 million, or 14.3% since December 31, 2014, and associated cash proceeds were used primarily to fund loan growth. The footnotes to the consolidated financial statements provide more detail concerning the composition of the Corporation’s securities portfolio, the process for evaluating securities for other-than-temporary impairment, and for valuation of structured pooled trust preferred 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 the overall effect of different rate environments is minimized. The Corporation monitors the earnings performance and the effectiveness of the liquidity of the securities portfolio on a regular basis through meetings of the Asset/Liability Committee of the Corporation’s Board of Directors (“ALCO”). The ALCO also reviews and manages interest rate risk for the Corporation. Through active balance sheet management and analysis of the securities portfolio, a sufficient level of liquidity is maintained to satisfy depositor requirements and various credit needs of our customers.
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LOANS
The Corporation experienced an increase in loans, net of unearned discount, of $160.8 million, or 11.9%, during the first nine months of 2015. Lending efforts consist principally of commercial and retail lending, which includes single family residential mortgages and other consumer loans. 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. Although loan balances increased only slightly in the first quarter, the increase in loan demand was more significant in the second and third quarters and the Corporation expects solid loan growth throughout the remainder of 2015 across all of its market areas.
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.
The table below shows activity within the allowance account for the specified periods (in thousands):
Balance at beginning of period
Charge-offs:
Recoveries:
Overdraft deposit accounts
Net charge-offs
Balance at end of period
Loans, net of unearned
Allowance to net loans
Net charge-offs to average loans (annualized)
Nonperforming assets
Nonperforming % of total assets
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The adequacy of the allowance for loan losses is subject to a formal analysis by the Credit Administrator of the Corporation. 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 classified loans that is given a specific reserve. The remaining loans are pooled, by category, into these segments:
Reviewed
Homogeneous
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 the following six qualitative factors:
levels of and trends in delinquencies, non-accrual loans, and classified loans;
trends in volume and terms of loans;
effects of any changes in lending policies and procedures;
experience and ability of management;
national and local economic trends and conditions; and
concentrations of credit.
The methodology described above was created using the experience of the Corporation’s Credit Administrator, guidance from the regulatory agencies, expertise of a third-party loan review provider, and discussions with peers. The resulting factors are applied to the pool balances in order to estimate the probable risk of loss within each pool. 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 considers numerous historical and other factors to analyze the adequacy of the allowance and current period charges against the provision for loan losses. Management uses the analysis to compare and plot the actual level of the allowance against the aggregate amount of loans adversely classified in order to compute the estimated probable losses associated with those loans. Management then determines the current adequacy of the allowance and evaluates 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 to be a competitive advantage and continues to focus on this area as part of its strategic growth initiatives. However, management recognizes and considers the fact that risk is more pronounced in these types of credits and is, to a greater degree than with other loans, driven by the economic environment in which the debtor’s business operates.
During the nine months ended September 30, 2015, CNB recorded a provision for loan losses of $1.9 million, as compared to a provision for loan losses of $3.6 million for the nine months ended September 30, 2014. The decrease in the provision for loan losses in the first nine months of 2015 compared to the first nine months of 2014 primarily reflects lower historical loss rates in all portfolio segments over the period of analysis. In addition, the lower historical loss rates are resulting in a significantly lower allowance to net loans ratio, as noted in the table on the previous page.
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Management believes that the allowance for loan losses is reasonable and adequate to absorb probable incurred losses in the Corporation’s portfolio at September 30, 2015.
FUNDING SOURCES
The Corporation considers deposits, short-term borrowings, and term debt when evaluating funding sources. Deposits were $1.847 billion at both September 30, 2015 and December 31, 2014.
Periodically, the Corporation utilizes term borrowings from the FHLB and other lenders to meet funding needs. Management plans to maintain access to short-term and long-term borrowings as an available funding source.
SHAREHOLDERS’ EQUITY AND CAPITAL RATIOS AND METRICS
The Corporation’s capital continued to provide a base for profitable growth through September 30, 2015. Total shareholders’ equity was $199.9 million at September 30, 2015 and $188.5 million at December 31, 2014. In the first nine months of 2015, the Corporation earned $16.7 million and declared dividends of $7.1 million, resulting in a dividend payout ratio of 42.8% of net income.
The Corporation is required to comply with standards of capital adequacy mandated by banking regulators. On January 1, 2015, rules to implement Basel III capital requirements became effective for community banks. The September 30, 2015 regulatory capital ratios were prepared under the Basel III capital requirements. Prior year ratios were prepared under Basel I requirements. The Corporation exceeded all of its regulatory capital requirements under the applicable guidelines for the respective periods.
The Corporation’s capital ratios, book value per share and tangible book value per share as of September 30, 2015 and December 31, 2014 are as follows:
Total risk-based capital ratio
Tier 1 capital ratio
Tier 1 common equity ratio
Leverage ratio
Tangible common equity/tangible assets (1)
Book value per share
Tangible book value per share (1)
Shareholders’ equity
Less goodwill
Less core deposit intangible
Tangible common equity
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Total assets
Tangible assets
Ending shares outstanding
Tangible book value per share
Tangible common equity/tangible assets
The decreases in the Total and Tier I risk-based capital ratios relate to changes in the composition of the Corporation’s balance sheet. Strong loan growth through the first three quarters of 2015 has been partially funded by the liquidation of investment securities. This has resulted in a higher risk-weighted balance sheet, as loans are typically higher risk-weighted than investment securities. This has also resulted in a more profitable asset mix, as the loans added have higher yields than the investment securities they replaced. As of September 30, 2015, the Corporation meets all well-capitalized regulatory requirements to which it is subject.
LIQUIDITY
Liquidity measures an organization’s ability to meet cash obligations as they come due. The consolidated statement of cash flows 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 to be part of the Corporation’s liquid assets. The Corporation’s liquidity is monitored by both management and the ALCO, which establishes and monitors ranges of acceptable liquidity. Management believes the Corporation’s current liquidity 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. These are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are met, and usually have expiration dates. Commitments may expire without being used. Off balance sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies are used to make such commitments as are used for loans, including obtaining collateral at exercise of the commitment. The contractual amount of financial instruments with off balance sheet risk was as follows at September 30, 2015 and December 31, 2014:
Commitments to make loans
Unused lines of credit
Standby letters of credit
Commitments to make loans are generally made for periods of 60 days or less. The fixed rate loan commitments have interest rates ranging from 1.19% to 18.00% and maturities ranging from 3 months to 20 years at September 30, 2015 and interest rates ranging from 1.69% to 18.00% and maturities ranging from 3 months to 20 years at December 31, 2014.
RESULTS OF OPERATIONS
Three Months Ended September 30, 2015 and 2014
OVERVIEW OF THE INCOME STATEMENT
The Corporation had net income of $5.5 million in the third quarter of 2015 and 2014. The earnings per diluted share were $0.38 in the third quarter of 2015 and $0.39 in the third quarter of 2014. The annualized return on assets and return on equity for the third quarter of 2015 are 0.98% and 11.08% compared to 1.02% and 12.10% for the third quarter of 2014.
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INTEREST INCOME AND EXPENSE
Net interest margin on a fully tax equivalent basis was 3.75% for the three months ended September 30, 2015, compared to 3.76% for the three months ended September 30, 2014. Net accretion included in loan interest income in the third quarter of 2015 was $524 thousand, which resulted in an increase in the net interest margin of 10 basis points. Net accretion included in loan interest income in the third quarter of 2014 was $500 thousand, which resulted in an increase to the net interest margin of 9 basis points.
Total interest and dividend income was $22.2 million for the three months ended September 30, 2015, an increase of $705 thousand, or 3.3%, compared to the three months ended September 30, 2014. During the three months ended September 30, 2015, total interest expense increased by $107 thousand, or 3.5%, compared to the three months ended September 30, 2014.
The Corporation recorded a provision for loan losses of $463 thousand in the third quarter of 2015 compared to $1.0 million in the third quarter of 2014. The decrease in the provision for loan losses in the third quarter of 2015 compared to the third quarter of 2014 primarily reflects lower historical loss rates in the commercial and industrial and commercial real estate segments over the period of analysis.
Management believes the provision for loan losses was appropriate and the allowance for loan losses is adequate to absorb probable incurred losses in our portfolio as of September 30, 2015.
NON-INTEREST INCOME
Non-interest income was $3.4 million for the three months ended September 30, 2015, compared to $3.5 million for the three months ended September 30, 2014.
Net realized and unrealized losses on trading securities was $260 thousand for the three months ended September 30, 2015, compared to $59 thousand for the three months ended September 30, 2014, resulting primarily from fluctuations in the market during the third quarter of 2015.
NON-INTEREST EXPENSES
Total non-interest expenses increased $1.3 million, or 9.7%, to $14.4 million during the three months ended September 30, 2015 compared to the three months ended September 30, 2014. Salaries and benefits expenses increased $1.0 million, or 15.4%, to $7.6 million during the three months ended September 30, 2015 compared to the three months ended September 30, 2014 due to an increase in average full-time equivalent employees as well as routine merit increases and increases in certain employee benefit expenses, such as health insurance premiums, which continue to increase in line with market conditions. During the three months ended September 30, 2015, CNB hired 10 additional full-time equivalent staff to facilitate the Corporation’s continued growth.
INCOME TAX EXPENSE
Income tax expense was $2.0 million in the third quarter of 2015 and $2.2 million in the third quarter of 2014, resulting in effective tax rates of 27.0% and 28.4% for the periods, respectively. The effective rates 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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CONSOLIDATED YIELD COMPARISONS
AVERAGE BALANCES AND NET INTEREST MARGIN FOR THE NINE MONTHS ENDED
ASSETS:
Taxable (1)
Tax-Exempt (1,2)
Equity Securities (1,2)
Total securities
Commercial (2)
Mortgage (2)
Total loans (3)
Total earning assets
Non interest-bearing assets:
Premises and equipment
Other assets
Allowance for loan losses
Total non interest-bearing assets
TOTAL ASSETS
LIABILITIES AND SHAREHOLDERS’ EQUITY:
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 AND SHAREHOLDERS’ EQUITY
Interest income/Earning assets
Interest expense/Interest-bearing liabilities
Net interest spread
Interest expense/Earning assets
Net interest margin
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Nine Months Ended September 30, 2015 and 2014
The Corporation had net income of $16.7 million for the nine months ended September 30, 2015, compared to $16.3 million for the same period of 2014. The earnings per diluted share were $1.16 for the nine months ended September 30, 2015 and $1.13 for the nine months ended September 30, 2014. The return on average assets and return on average equity for the nine months ended September 30, 2015 are 1.00% and 11.34%, respectively, compared to 1.01% and 12.22%, respectively, for the same period of 2014.
The Corporation’s net interest margin on a fully tax equivalent basis was 3.74% for the nine months ended September 30, 2015, compared to 3.78% for the nine months ended September 30, 2014. Net accretion included in loan interest income in the nine months ended September 30, 2015 was $1.9 million, resulting in an increase in the net interest margin of 12 basis points and was $1.7 million for the nine months ended September 30, 2014, which resulted in an increase to the net interest margin of 11 basis points. During the first nine months of 2015, the Corporation experienced net interest margin compression as a result of loans repricing and new loans with market yields significantly below historical averages, which is consistent with the trends across the financial services industry in this historically low interest rate environment.
Total interest and dividend income was $65.2 million for the nine months ended September 30, 2015, an increase of $797 thousand, or 1.2%, as compared to the nine months ended September 30, 2014. The Corporation’s total earning assets have grown and the asset mix has also shifted to a higher percentage of loans and less investments, which has resulted in higher levels of interest income. During the nine months ended September 30, 2015, total interest expense increased by $181 thousand, or 2.0%, compared to the nine months ended September 30, 2014.
The Corporation recorded a provision for loan losses of $1.9 million during the nine months ended September 30, 2015 compared to $3.6 million during the nine months ended September 30, 2014. Net charge-offs for the nine months ended September 30, 2015 were $2.0 million, compared to net charge-offs of $1.9 million during the nine months ended September 30, 2014. The decrease in the provision for loan losses in the first nine months of 2015 compared to the first nine months of 2014 primarily reflects lower historical loss rates in the commercial & industrial and commercial real estate segments over the period of analysis.
Total non-interest income was $10.7 million for the nine months ended September 30, 2015, compared to $10.2 million for the nine months ended September 30, 2014. Non-interest income as a percentage of average assets increased from 0.63% during the first nine months of 2014 to 0.64% during the first nine months of 2015. This increase is due primarily to higher bank owned life insurance income and higher interchange fees from debit and credit card transactions in the first nine months of 2015 as compared to the first nine months of 2014.
Total non-interest expenses increased $2.6 million, or 6.7% to $41.6 million during the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014.
Salaries and benefits expenses increased $1.9 million, or 9.4%, to $21.7 million during the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014 due to an increase in average full-time equivalent employees as well as routine merit increases and increases in certain employee benefit expenses, such as health insurance premiums, which continue to increase in line with market conditions. During the first nine months of 2015, the Corporation hired 30 additional full-time equivalent staff to facilitate the Corporation’s continued growth.
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Income tax expense was $6.2 million for the nine months ended September 30, 2015 as compared to $6.5 million for the nine months ended September 30, 2014, resulting in effective tax rates of 27.1% and 28.4% for the periods, respectively. The effective rates for the periods differed from the federal statutory rate of 35.0% principally as a result of tax exempt income from securities and loans, earnings from bank owned life insurance, and nondeductible merger costs.
CRITICAL ACCOUNTING POLICIES
The Corporation’s accounting and reporting policies are in accordance with GAAP 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. In addition, the fair value of assets acquired and liabilities assumed in connection with business combinations, including the associated goodwill that was recorded, required the use of material estimates. Application of assumptions different than those used by management could result in material changes in the Corporation’s financial position or results of operations. Note 1 (Summary of Significant Accounting Policies), Note 2 (Business Combination), Note 4 (Securities), and Note 5 (Loans) of the Corporation’s 2014 Form 10-K provide detail with regard to the Corporation’s accounting for the allowance for loan losses, the fair value of securities, business combinations and loans. There have been no significant changes in the application of accounting policies since December 31, 2014.
ITEM 3
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As a financial institution, the Corporation’s primary source of market risk is interest rate risk, which is the exposure to fluctuations in the Corporation’s future earnings resulting from changes in interest rates. This exposure is correlated to the repricing characteristics of the Corporation’s portfolio of assets and liabilities. Each asset or liability reprices either at maturity or during the life of the instrument.
The principal purpose of asset/liability management is to maximize current and future net interest income within acceptable levels of interest rate risk while satisfying liquidity and capital requirements. Net interest income is enhanced by increasing the net interest margin and by the growth in earning assets. As a result, the primary goal of interest rate risk management is to maintain a balance between risk and reward such that net interest income is maximized while risk is maintained at an acceptable level.
The Corporation uses an asset-liability management model to measure the effect of interest rate changes on its net interest income. The Corporation’s management also reviews asset-liability maturity gap and repricing analyses regularly. The Corporation does not always attempt to achieve a precise match between interest sensitive assets and liabilities because it believes that an actively managed amount of interest rate risk is inherent and appropriate in the management of the Corporation’s profitability.
Asset-liability modeling techniques and simulation involve assumptions and estimates that inherently cannot be measured with precision. Key assumptions in these analyses include maturity and repricing characteristics of assets and liabilities, prepayments on amortizing assets, non-maturing deposit sensitivity, and loan and deposit pricing. These assumptions are inherently uncertain due to the timing, magnitude, and frequency of rate changes and changes in market conditions and management strategies, among other factors. However, the analyses are useful in quantifying risk and provide a relative gauge of the Corporation’s interest rate risk position over time.
Management reviews interest rate risk on a quarterly basis and reports to the ALCO. This review includes earnings shock scenarios whereby interest rates are immediately increased and decreased by 100, 300, and 400 basis points. These scenarios,
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detailed in the table below, indicate that there would not be a significant variance in net interest income over a one-year period due to interest rate changes; however, actual results could vary significantly. All interest rate risk levels according to the model were within the tolerance limits of ALCO approved policy of +/- 25%. In addition, the table does not take into consideration changes that management would make to realign its assets and liabilities in the event of an unexpected change in the interest rate environment. Due to the historically low interest rate environment, the -300 and -400 scenarios have been excluded from the table.
Change in
Basis Points
% Change in Net
Interest Income
400
300
100
(100)
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 the Chief Executive Officer and Principal Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934) (“Exchange Act”). Based on their evaluation, our Chief Executive Officer and Principal Financial Officer have concluded that the Corporation’s disclosure controls and procedures were effective as of the end of the period covered by this quarterly report 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 SEC rules and forms. There were no changes in the Corporation’s internal control over financial reporting that occurred during the period covered by this quarterly report that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.
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PART II OTHER INFORMATION
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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/ Joseph B. Bower, Jr.
/s/ Brian W. Wingard
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EXHIBIT INDEX
38