**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**QUARTERLY REPORT UNDERSECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**FORQUARTER ENDED JUNE 30, 2004**

 

**COMMISSIONFILE NUMBER: 333-90273**

 

**FIDELITY D& D BANCORP, INC.**

 

| STATE OF INCORPORATION: |   | IRS EMPLOYER IDENTIFICATION NO: |
|-------------------------|--------|---------------------------------|
| **PENNSYLVANIA**        |   | **23-3017653**                  |

 

PRINCIPAL OFFICE:

**BLAKELY& DRINKER ST.**

**DUNMORE,PENNSYLVANIA 18512**

 

TELEPHONE:

**570-342-8281**

 

The Company (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months(or for such shorter period that the Company was required to file suchreports), and (2) has been subject to such filing requirements for the past 90days.

 

ý  YES   o NO

 

The Registrant is an accelerated filer (as defined in Exchange Act Rule12b-2)

 

o  YES  ý NO

 

The number of outstanding shares of Common Stock of Fidelity D & DBancorp, Inc. at July 30, 2004, the latest practicable date, was 1,831,789shares.

 

 

----

 

**FIDELITYD & D BANCORP, INC.**

 

Form 10-Q June 30, 2004

 

Index

 
| **Part I. Financial  information**        |                                                                                                                  |
|-------------------------------------------|-----------------------------------------------------------------------------------------------------------------------|
|                                      |                                                                                                                  |   |
| Item 1. Financial Statements (unaudited): |                                                                                                                  |
|                                      |                                                                                                                  |   |
|                                      | Consolidated Balance Sheets as of June 30, 2004 and  December 31, 2003                                      |   |
|                                      | Consolidated Statements of Income for the  three and six months ended June 30, 2004 and 2003                     |   |
|                                      | Consolidated Statements of Changes in  Shareholders’ Equity for the six months ended June 30, 2003 and 2004 |   |
|                                      | Consolidated Statements of Cash Flows for  the six months ended June 30, 2004 and 2003                           |   |
|                                      | Notes to Consolidated Financial Statements                                                                            |   |
|                                      |                                                                                                                  |   |
| Item 2.                                   | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                           |   |
|                                      |                                                                                                                  |   |
| Item 3.                                   | Quantitative and Qualitative Disclosure  about Market Risk                                                            |   |
|                                      |                                                                                                                  |   |
| Item 4.                                   | Controls and Procedures                                                                                               |   |
|                                      |                                                                                                                  |   |
| **Part  II.  Other Information**     |                                                                                                                  |
|                                      |                                                                                                                  |   |
| Item 1.                                   | Legal Proceedings                                                                                                     |   |
|                                      |                                                                                                                  |   |
| Item 2.                                   | Changes in Securities, Use of Proceeds and  Issuer Purchases of Equity Securities                                     |   |
|                                      |                                                                                                                  |   |
| Item 3.                                   | Defaults  upon Senior Securities                                                                                      |   |
|                                      |                                                                                                                  |   |
| Item 4.                                   | Submission of Matters to a Vote of Security  Holders                                                                  |   |
|                                      |                                                                                                                  |   |
| Item 5.                                   | Other Information                                                                                                     |   |
|                                      |                                                                                                                  |   |
| Item 6.                                   | Exhibits and Reports on Form 8-K                                                                                      |   |
|                                      |                                                                                                                  |   |
| Signatures                                |                                                                                                                  |   |
|                                      |                                                                                                                  |   |
| Exhibit  index                            |                                                                                                                  |   |

 

2

----

 

**FIDELITY D & D BANCORP, INC.**

ConsolidatedBalance Sheets

As of June 30, 2004 and December 31, 2003

 
|                                                                                                                                         |   | **June 30,  2004** |        | **December 31,  2003** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|-------------|-----------------------------|--------|
|                                                                                                                                         |   | **(unaudited)**         |        | **(audited)**               |   |
| **ASSETS**                                                                                                                                   |   |                    |        |                        |   |
| Cash and due from banks                                                                                                                      |   | $                       | 11,645,551  |                        | $      | 13,148,199 |   |
| Interest-bearing deposits with financial  institutions                                                                                       |   | 314,818                 |        | 6,083,402                   |   |
| Total cash and cash equivalents                                                                                                              |   | 11,960,369              |        | 19,231,601                  |   |
|                                                                                                                                         |   |                    |        |                        |   |
| Held-to-maturity securities                                                                                                                  |   | 3,460,588               |        | 4,712,142                   |   |
| Available-for-sale securities                                                                                                                |   | 122,955,437             |        | 139,695,232                 |   |
| Loans and leases, net (allowance for loan  losses of $5,876,178 in 2004 and $4,996,966 in 2003)                                              |   | 375,629,645             |        | 366,981,640                 |   |
| Loans available-for-sale (fair value  $1,295,494 in 2004; $20,500,507 in 2003)                                                               |   | 1,261,808               |        | 19,863,577                  |   |
| Accrued interest receivable                                                                                                                  |   | 1,871,888               |        | 1,807,081                   |   |
| Bank premises and equipment, net                                                                                                             |   | 11,619,584              |        | 12,091,937                  |   |
| Foreclosed assets held for sale                                                                                                              |   | 228,588                 |        | 467,166                     |   |
| Cash surrender value of bank owned life  insurance                                                                                           |   | 7,455,203               |        | 7,293,538                   |   |
| Other assets                                                                                                                                 |   | 4,177,734               |        | 3,071,552                   |   |
|                                                                                                                                         |   |                    |        |                        |   |
| **Total assets**                                                                                                                             |   | $                       | 540,620,844 |                        | $      | 575,215,466 |   |
|                                                                                                                                         |   |                    |        |                        |   |
| **LIABILITIES**                                                                                                                              |   |                    |        |                        |   |
| Deposits                                                                                                                                     |   |                    |        |                        |   |
| Non-interest-bearing                                                                                                                         |   | $                       | 65,967,823  |                        | $      | 64,398,658 |   |
| Certificates of deposit of $100,000 or more                                                                                                  |   | 102,447,800             |        | 112,857,420                 |   |
| Other interest-bearing deposits                                                                                                              |   | 208,888,297             |        | 224,186,468                 |   |
| Total deposits                                                                                                                               |   | 377,303,920             |        | 401,442,546                 |   |
|                                                                                                                                         |   |                    |        |                        |   |
| Accrued interest payable and other  liabilities                                                                                              |   | 3,186,580               |        | 3,208,009                   |   |
| Short-term borrowings                                                                                                                        |   | 45,190,349              |        | 54,756,978                  |   |
| Long-term debt                                                                                                                               |   | 71,500,427              |        | 71,876,034                  |   |
|                                                                                                                                         |   |                    |        |                        |   |
| **Total liabilities**                                                                                                                        |   | 497,181,276             |        | 531,283,567                 |   |
|                                                                                                                                         |   |                    |        |                        |   |
| **SHAREHOLDERS’  EQUITY**                                                                                                               |   |                    |        |                        |   |
| Preferred stock authorized 5,000,000 shares  with no par value; none issued                                                                  |   | —                  |        | —                      |   |
| Capital stock authorized 10,000,000 shares  with no par value; issued and outstanding 1,831,789 shares in 2004 and  1,828,270 shares in 2003 |   | 9,810,940               |        | 9,698,879                   |   |
| Treasury stock, at cost                                                                                                                      |   | —                  |        | (196,048                    | )      |
| Retained earnings                                                                                                                            |   | 35,384,149              |        | 34,641,976                  |   |
| Accumulated other comprehensive loss                                                                                                         |   | (1,755,521              | )           | (212,908                    | )      |
|                                                                                                                                         |   |                    |        |                        |   |
| **Total shareholders’  equity**                                                                                                         |   | 43,439,568              |        | 43,931,899                  |   |
|                                                                                                                                         |   |                    |        |                        |   |
| **Total liabilities  and shareholders’ equity**                                                                                         |   | $                       | 540,620,844 |                        | $      | 575,215,466 |   |

 

3

----

 

**FIDELITY D& D BANCORP, INC.**

ConsolidatedStatements of Income

(unaudited)

 
|                                                      |   | **Three  Months Ended** |      | **Six Months  Ended**   |   |
|-----------------------------------------------------------|--------|-------------------------|-----------|-------------------------|--------|
|                                                      |   | **June 30,  2004** |      | **June 30,  2003** |   | **June 30,  2004** |   | **June 30,  2003** |   |
| **Interest income**                                       |   |                    |      |                    |   |   |   |   |   |
| Interest and fees on loans:                               |   |                    |      |                    |   |   |   |   |   |
| Taxable                                                   |   | $                       | 5,461,234 |                    | $      | 5,695,878 |   | $ | 10,873,586 |   | $ | 11,617,961 |   |
| Nontaxable                                                |   | 74,428                  |      | 99,665                  |   | 158,516 |   | 205,337 |   |
| Leases                                                    |   | 42,926                  |      | 79,101                  |   | 92,346 |   | 170,835 |   |
| Interest-bearing deposits with financial  institutions    |   | 1,095                   |      | 2,464                   |   | 2,210 |   | 4,369 |   |
| Investment securities:                                    |   |                    |      |                    |   |   |   |   |   |
| US Government agencies                                    |   | 1,073,414               |      | 1,081,193               |   | 2,292,009 |   | 2,392,964 |   |
| States and political subdivisions  (nontaxable)           |   | 116,328                 |      | 113,116                 |   | 251,706 |   | 224,886 |   |
| Other securities                                          |   | 43,765                  |      | 59,209                  |   | 95,932 |   | 133,050 |   |
| Federal funds sold                                        |   | —                  |      | 16,210                  |   | 10,210 |   | 35,180 |   |
| **Total interest  income**                                |   | 6,813,190               |      | 7,146,836               |   | 13,776,515 |   | 14,784,582 |   |
| **Interest expense**                                      |   |                    |      |                    |   |   |   |   |   |
| Certificates of deposit of $100,000 or more               |   | 710,597                 |      | 1,319,105               |   | 1,601,268 |   | 2,607,286 |   |
| Other deposits                                            |   | 920,201                 |      | 1,367,259               |   | 1,970,850 |   | 2,829,695 |   |
| Securities sold under repurchase agreements               |   | 101,400                 |      | 127,495                 |   | 204,261 |   | 291,924 |   |
| Other short- and long-term borrowings and  other          |   | 989,827                 |      | 903,837                 |   | 1,976,026 |   | 1,794,570 |   |
| **Total interest  expense**                               |   | 2,722,025               |      | 3,717,696               |   | 5,752,405 |   | 7,523,475 |   |
| **Net interest income**                                   |   | 4,091,165               |      | 3,429,140               |   | 8,024,110 |   | 7,261,107 |   |
| Provision for loan losses                                 |   | 400,000                 |      | 460,000                 |   | 1,250,000 |   | 760,000 |   |
| **Net interest  income, after provision for loan losses** |   | 3,691,165               |      | 2,969,140               |   | 6,774,110 |   | 6,501,107 |   |
| **Other income:**                                         |   |                    |      |                    |   |   |   |   |   |
| Service charges on deposit accounts                       |   | 540,291                 |      | 436,256                 |   | 1,066,220 |   | 820,891 |   |
| Gain on sale of:                                          |   |                    |      |                    |   |   |   |   |   |
| Investment securities                                     |   | —                  |      | 132,277                 |   | 9,497 |   | 213,828 |   |
| Loans                                                     |   | 70,776                  |      | 356,305                 |   | 94,387 |   | 424,406 |   |
| Loss on leased assets                                     |   | (61,920                 | )         | (89,594                 | )      | (155,186 | ) | (89,594 | ) |
| Loss on foreclosed assets held for sale                   |   | (8,218                  | )         | (36,644                 | )      | (8,218 | ) | (40,172 | ) |
| Fees, other service charges and other  income             |   | 529,956                 |      | 461,998                 |   | 1,010,602 |   | 888,224 |   |
| **Total other income**                                    |   | 1,070,885               |      | 1,260,598               |   | 2,017,302 |   | 2,217,583 |   |
| **Other operating  expenses:**                            |   |                    |      |                    |   |   |   |   |   |
| Salaries and employee benefits                            |   | 1,703,504               |      | 1,567,548               |   | 3,448,020 |   | 3,228,177 |   |
| Premises and equipment                                    |   | 718,216                 |      | 682,206                 |   | 1,437,627 |   | 1,379,411 |   |
| Advertising                                               |   | 84,685                  |      | 68,238                  |   | 145,192 |   | 142,505 |   |
| Other                                                     |   | 1,032,303               |      | 696,128                 |   | 1,782,896 |   | 1,558,953 |   |
| **Total other  expenses**                                 |   | 3,538,708               |      | 3,014,120               |   | 6,813,735 |   | 6,309,046 |   |
| **Income before provision  for income taxes**             |   | 1,223,342               |      | 1,215,618               |   | 1,977,677 |   | 2,409,644 |   |
| Provision for income taxes                                |   | 302,449                 |      | 292,647                 |   | 431,877 |   | 599,373 |   |
| **Net income**                                            |   | $                       | 920,893   |                    | $      | 922,971 |   | $ | 1,545,800 |   | $ | 1,810,271 |   |
| Per share data:                                           |   |                    |      |                    |   |   |   |   |   |
| Net income - basic                                        |   | $                       | 0.50      |                    | $      | 0.50 |   | $ | 0.84 |   | $ | 0.99 |   |
| Net income - diluted                                      |   | $                       | 0.50      |                    | $      | 0.50 |   | $ | 0.84 |   | $ | 0.99 |   |
| Dividends                                                 |   | $                       | 0.22      |                    | $      | 0.22 |   | $ | 0.44 |   | $ | 0.44 |   |

 

4

----

 

**FIDELITY D & D BANCORP, INC.**

Consolidated Statements of Changes in Shareholders’ Equity

For the six months endedJune 30, 2003 and 2004

 
|                                                                                                                       |   | **Capital  stock** |   | **Treasury  stock** |      | **Retained** |    | **Accumulated  other  comprehensive** |   |         |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|--------------------|--------|---------------------|-----------|--------------|---------|---------------------------------------|--------|--------------|--------|
|                                                                                                                       |   | **Shares**         |   | **Amount**          |      | **Shares**   |    | **Amount**                            |   | **earnings** |   | **income  (loss)** |   | **Total** |   |
| Balance, December 31, 2002 (audited)                                                                                  |   | 1,825,363          |   | $                   | 9,590,142 |         | (5,987  | )                                     | $      | (221,559     | )      | $ | 34,600,626 |   | $ | 1,265,224 |   | $ | 45,234,433 |   |
| Comprehensive income:                                                                                                      |   |               |   |                |      |         |    |                                  |   |         |   |   |   |   |   |
| Net income                                                                                                                 |   |               |   |                |      |         |    |                                  |   | 1,810,271    |   |   |   | 1,810,271 |   |
| Change in net unrealized holding gains (losses) on  available-for-sale securities, net net of reclassification adjustments |   |               |   |                |      |         |    |                                  |   |         |   | (470,250 | ) | (470,250 | ) |
| Comprehensive income                                                                                                       |   |               |   |                |      |         |    |                                  |   |         |   |   |   | 1,340,021 |   |
| Issuance of common stock through Employee Stock  Purchase Plan                                                             |   |               |   |                |      | 1,264        |    | 42,654                                |   |         |   |   |   | 42,654 |   |
| Dividends reinvested through Dividend Reinvestment  Plan                                                                   |   | 3,068              |   | 108,313             |      | 3,923        |    | 149,105                               |   |         |   |   |   | 257,418 |   |
| Stock options exercised                                                                                                    |   |               |   |                |      | 800          |    | 29,800                                |   |         |   |   |   | 29,800 |   |
| Purchase of treasury stock                                                                                                 |   |               |   |                |      | (12,720      | )       | (457,920                              | )      |         |   |   |   | (457,920 | ) |
| Dividends declared                                                                                                         |   |               |   |                |      |         |    |                                  |   | (802,176     | )      |   |   | (802,176 | ) |
| Balance, June 30, 2003 (unaudited)                                                                                    |   | 1,828,431          |   | $                   | 9,698,455 |         | (12,720 | )                                     | $      | (457,920     | )      | $ | 35,608,721 |   | $ | 794,974 |   | $ | 45,644,230 |   |
|                                                                                                                       |   |               |   |                |      |         |    |                                  |   |         |   |   |   |   |   |
| Balance, December 31, 2003 (audited)                                                                                  |   | 1,828,270          |   | $                   | 9,698,879 |         | (5,227  | )                                     | $      | (196,048     | )      | $ | 34,641,976 |   | $ | (212,908 | ) | $ | 43,931,899 |   |
| Comprehensive income:                                                                                                      |   |               |   |                |      |         |    |                                  |   |         |   |   |   |   |   |
| Net income                                                                                                                 |   |               |   |                |      |         |    |                                  |   | 1,545,800    |   |   |   | 1,545,800 |   |
| Change in net unrealized holding gains (losses) on  available-for-sale securities, net net of reclassification adjustments |   |               |   |                |      |         |    |                                  |   |         |   | (1,542,613 | ) | (1,542,613 | ) |
| Comprehensive income                                                                                                       |   |               |   |                |      |         |    |                                  |   |         |   |   |   | 3,187 |   |
| Reissued treasury stock through Employee Stock  Purchase Plan                                                              |   |               |   | (8,329              | )         | 1,635        |    | 61,370                                |   |         |   |   |   | 53,041 |   |
| Dividends reinvested through Dividend Reinvestment  Plan                                                                   |   | 3,519              |   | 120,390             |      | 3,592        |    | 134,678                               |   |         |   |   |   | 255,068 |   |
| Dividends declared                                                                                                         |   |               |   |                |      |         |    |                                  |   | (803,627     | )      |   |   | (803,627 | ) |
| Balance, June 30, 2004 (unaudited)                                                                                    |   | 1,831,789          |   | $                   | 9,810,940 |         | —  |                                  | $      | —       |   | $ | 35,384,149 |   | $ | (1,755,521 | ) | $ | 43,439,568 |   |

 

5

----

 

**FIDELITY D & D BANCORP, INC.**

Consolidated Statements of Cash Flows

(unaudited)

 
|                                                                               |   | **Six Months  Ended**   |       |
|------------------------------------------------------------------------------------|--------|-------------------------|------------|
|                                                                               |   | **June 30,  2004** |       | **June 30,  2003** |   |
| **Cash flows from  operating activities:**                                         |   |                    |       |   |   |
| Net income                                                                         |   | $                       | 1,545,800  |   | $ | 1,810,271 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |   |                    |       |   |   |
| Depreciation                                                                       |   | 615,541                 |       | 624,529 |   |
| Amortization of securities (net of  accretion)                                     |   | 315,524                 |       | 870,453 |   |
| Provision for loan losses                                                          |   | 1,250,000               |       | 760,000 |   |
| Deferred income tax                                                                |   | (128,406                | )          | (89,307 | ) |
| Write-down of foreclosed assets  held-for-sale                                     |   | 73,701                  |       | 444,403 |   |
| Increase in cash surrender value of life  insurance                                |   | (161,665                | )          | (111,473 | ) |
| Gain on sale of investment securities                                              |   | (9,497                  | )          | (213,828 | ) |
| Gain on sale of loans                                                              |   | (94,387                 | )          | (424,406 | ) |
| Loss on sale of foreclosed assets held-  for-sale                                  |   | 8,218                   |       | 40,172 |   |
| Loss on sale of leased assets                                                      |   | 155,186                 |       | 89,594 |   |
| Loss on disposal of equipment                                                      |   | 3,736                   |       | — |   |
| Amortization of loan servicing rights                                              |   | 56,319                  |       | 108,738 |   |
| Net increase in accrued interest receivable                                        |   | (64,807                 | )          | (24,055 | ) |
| Net (increase) decrease in other assets                                            |   | (273,465                | )          | 897,824 |   |
| Net decrease in accrued interest payable  and other liabilities                    |   | (21,429                 | )          | (158,571 | ) |
| Net cash provided by operating activities                                          |   | 3,270,369               |       | 4,624,344 |   |
| **Cash flows from  investing activities:**                                         |   |                    |       |   |   |
| Held-to-maturity securities:                                                       |   |                    |       |   |   |
| Proceeds from maturities, calls and  paydowns                                      |   | 1,243,638               |       | 3,906,383 |   |
| Available-for-sale securities:                                                     |   |                    |       |   |   |
| Proceeds from sales                                                                |   | 5,472,762               |       | 48,933,261 |   |
| Proceeds from maturities, calls and  paydowns                                      |   | 16,278,082              |       | 26,441,406 |   |
| Purchases                                                                          |   | (7,646,452              | )          | (75,259,314 | ) |
| Proceeds from sale of loans  available-for-sale                                    |   | 11,331,731              |       | 11,869,642 |   |
| Net increase in loans and leases                                                   |   | (3,342,844              | )          | (17,333,464 | ) |
| Purchase of life insurance policies                                                |   | —                  |       | (7,000,000 | ) |
| Proceeds from sale of leased assets                                                |   | 502,924                 |       | 894,072 |   |
| Acquisition of bank premises and equipment                                         |   | (146,924                | )          | (441,919 | ) |
| Proceeds from sale of credit card  receivables                                     |   | —                  |       | 2,977,526 |   |
| Proceeds from sale of foreclosed assets  held-for-sale                             |   | 341,862                 |       | 403,333 |   |
| Net cash provided by (used in) investing  activities                               |   | 24,034,779              |       | (4,609,074 | ) |
| **Cash flows from  financing activities:**                                         |   |                    |       |   |   |
| Net increase in noninterest-bearing  deposits                                      |   | 1,569,165               |       | 887,891 |   |
| Net (decrease) increase in certificates of  deposit of $100,000 or more            |   | (10,409,620             | )          | 20,474,943 |   |
| Net decrease in other interest-bearing  deposits                                   |   | (15,298,171             | )          | (2,553,398 | ) |
| Net decrease in short-term borrowings                                              |   | (9,566,629              | )          | (10,937,573 | ) |
| Purchase of treasury stock                                                         |   | —                  |       | (457,920 | ) |
| Repayment of long-term debt                                                        |   | (375,607                | )          | — |   |
| Dividends paid, net of dividend  reinvestment                                      |   | (548,559                | )          | (544,758 | ) |
| Proceeds from exercise of stock options                                            |   | —                  |       | 29,800 |   |
| Proceeds from employee stock purchase plan                                         |   | 53,041                  |       | 42,654 |   |
| Net cash (used in) provided by financing  activities                               |   | (34,576,380             | )          | 6,941,639 |   |
| Net (decrease) increase in cash and cash  equivalents                              |   | (7,271,232              | )          | 6,956,909 |   |
| Cash and cash equivalents, beginning                                               |   | 19,231,601              |       | 26,219,247 |   |
| Cash and cash equivalents, ending                                                  |   | $                       | 11,960,369 |   | $ | 33,176,156 |   |

 

6

----

 

**FIDELITY D& D BANCORP, INC.**

 

**Notes to ConsolidatedFinancial Statemen****ts**

**(unaudited)**

 

**1. Nature ofoperations and critical accounting policies**

 

# **Principles of consolidation**

 

The accompanying unaudited consolidated financial statements ofFidelity D&D Bancorp, Inc., and its wholly owned subsidiary, The FidelityDeposit and Discount Bank (the “Bank”), (collectively, the “Company”) have beenprepared in accordance with accounting principles generally accepted in theUnited States of America (“GAAP”) for interim financial information and withthe instructions to this Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of theinformation and footnote disclosures required by GAAP for complete financialstatements.  In the opinion ofmanagement, all normal recurring adjustments necessary for a fair presentationof the financial condition and results of operations for the periods have beenincluded.  All significant inter-companybalances and transactions have been eliminated in consolidation. Prior periodamounts are reclassified when necessary to conform to the current period’spresentation.

 

The preparation of financial statements in conformity with GAAPrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reported periods.  Actual results could differ from those estimates. For additionalinformation and disclosures required under GAAP, please refer to the Company’sAnnual Report on Form 10-K for the year ended December 31, 2003.

 

# **Nature of operations**

 

The Bank is a commercial bank chartered in the Commonwealth ofPennsylvania and a wholly owned subsidiary of the Company. Having commencedoperations in 1903, the Bank provides a full range of traditional bankingservices, trust services and alternative financial products from its mainoffice located in Dunmore and other branches throughout Lackawanna and Luzernecounties.

 

Management is responsible for the fairness, integrity and objectivityof the unaudited financial statements included in this report.  Management prepared the unaudited financialstatements in accordance with GAAP.  Inmeeting its responsibility for the financial statements, management depends onthe Company’s accounting systems and related internal controls.  These systems and controls are designed toprovide reasonable, but not absolute, assurance that the financial recordsaccurately reflect the transactions of the Company, the Company’s assets aresafeguarded and that financial statements present fairly the financialcondition and results of operations of the Company.

 

In the opinion of management, the consolidated balance sheets as ofJune 30, 2004 and December 31, 2003 and the related consolidatedstatements of income for each of the three and six month periods endedJune 30, 2004 and June 30, 2003 and changes in shareholders’ equityand cash flows for each of the six month periods ended June 30, 2004 andJune 30, 2003 present fairly the financial condition and results ofoperations of the Company.  All materialadjustments required for a fair presentation have been made.  These adjustments are of a normal recurringnature.  There have been no materialchanges in accounting principles, practices or in the method of application andthere have been no retroactive adjustments during these periods. The results ofoperations for interim periods are not necessarily indicative of the results ofoperations for the entire year.

 

This Quarterly Report on Form 10-Q should be read in conjunction withthe Company’s audited financial statements for the year ended December 31,2003 and the notes included therein, included within the Company’s AnnualReport filed on Form 10-K.

 

# **Critical accountingpolicies**

 

The presentation of financial statements in conformity with GAAPrequires management to make estimates and assumptions that affect many of thereported amounts and disclosures. Actual results could differ from theseestimates.

 

7

----

 

A material estimate that is particularly susceptible to significantchange is the determination of the allowance for loan losses.  Management believes that the allowance forloan losses, as of June 30, 2004, is adequate and reasonable.  Given the subjective nature of identifyingand valuing loan losses, it is likely that well-informed individuals could makematerially different assumptions, and could, therefore calculate a materiallydifferent allowance value.  Whilemanagement uses available information to recognize losses on loans, changes ineconomic conditions may necessitate revisions in the future.  In addition, various regulatory agencies, asan integral part of their examination process, periodically review theCompany’s allowance for loan losses. Such agencies may require the Company to recognize adjustments to theallowance based on their judgments of information available to them at the timeof their examination.

 

Another material estimate is the calculation of fair values of theCompany’s investment securities.  TheCompany receives estimated fair values of investment securities from anindependent valuation service.  Indeveloping these fair values, the valuation service uses estimates of cashflows based on historical performance of similar instruments in similarinterest rate environments.  Based onexperience, management is aware that estimated fair values of investmentsecurities tend to vary among valuation services.  Accordingly, when selling investment securities, managementtypically obtains price quotes from more than one source.  The majority of the Company’s investmentsecurities are classified as available-for-sale. Available-for-sale securitiesare carried at fair market value on the consolidated balance sheet, withunrealized gains and losses, net of income tax, reported as a separatecomponent of shareholders’ equity in accumulated other comprehensive income(loss).

 

The fair market value of residential mortgage loans, classified asavailable-for-sale (AFS), is obtained from the Federal National MortgageAssociation (Fannie Mae).  The fairvalue of Small Business Administration (SBA) loans, classified as AFS, isobtained from an outside pricing source. To determine the fair market value of student loans, classified as AFS,the Bank uses the pricing obtained from the most recent student loans sold fromits AFS portfolio.  The market to whichthe Bank sells mortgage and other loans is restricted and price quotes fromother sources are not typically obtained.

 

**2. Earnings per share**

 

Basic earnings per share (“EPS”) is computed by dividing net income bythe weighted-average number of common shares outstanding during theperiod.  Diluted EPS is computed bydividing net income by the weighted- average number of common sharesoutstanding plus the number of incremental shares that would be outstandingafter giving effect to the assumed exercise of stock options.

 

The following data illustrates the amounts used in computing EPS andthe effects on income and the weighted-average number of shares of potentiallydilutive common stock for the six months ended June 30, 2004 and 2003:

 
|                                       |   | **Income  numerator** |      | **Weighted-average  common shares  denominator** |      | **EPS** |   |
|--------------------------------------------|--------|-----------------------|-----------|--------------------------------------------------|-----------|---------|--------|
| June 30, 2004                         |   |                  |      |                                             |      |    |   |
| Basic EPS                                  |   | $                     | 1,545,800 |                                             | 1,826,886 |    | $      | 0.84 |   |
| Dilutive effect of potential common stock: |   |                  |      |                                             |      |    |   |
| Stock options:                             |   |                  |      |                                             |      |    |   |
| Exercise of outstanding options            |   |                  |      | 5,100                                            |      |    |   |
| Hypothetical share repurchase at $35.00    |   |                  |      | (4,517                                           | )         |    |   |
| Diluted EPS                                |   | $                     | 1,545,800 |                                             | 1,827,469 |    | $      | 0.84 |   |
|                                       |   |                  |      |                                             |      |    |   |
| June 30, 2003                         |   |                  |      |                                             |      |    |   |
| Basic EPS                                  |   | $                     | 1,810,271 |                                             | 1,822,438 |    | $      | 0.99 |   |
| Dilutive effect of potential common stock: |   |                  |      |                                             |      |    |   |
| Stock options:                             |   |                  |      |                                             |      |    |   |
| Exercise of outstanding options            |   |                  |      | 10,600                                           |      |    |   |
| Hypothetical share repurchase at $35.90    |   |                  |      | (9,785                                           | )         |    |   |
| Diluted EPS                                |   | $                     | 1,810,271 |                                             | 1,823,253 |    | $      | 0.99 |   |

 

8

----

 

**3. Stock plans**

 

As permitted by Accounting Principles Board (“APB”) Opinion No. 25,Accounting for Stock Issued to Employees, the Company uses the intrinsic valuemethod of accounting for stock compensation plans.  Under the intrinsic value method, compensation cost is measuredby the excess of the quoted market price of the stock, as of the grant date (orother measurement date) over the stock’s exercise price.  Since all options issued under the plans hadan exercise price equal to the quoted market value of the underlying commonstock on the date of grant, the stock is deemed to have no intrinsic value, andaccordingly, no compensation cost is recorded.

 

The alternative fair value method of accounting for stock-basedcompensation provided under Statement of Financial Accounting Standards(“SFAS”) No. 123, Accounting forStock-Based Compensation, requires the use of option valuation models,such as the Black-Scholes option pricing model.  The Black-Scholes option pricing model was not developed for usein valuing stock options granted under employer stock option plans.  Rather, the Black-Scholes option pricingmodel was developed for use in estimating the fair market value of short-termoptions traded in organized exchanges. Options traded in organized exchanges have no vesting restrictions andare fully transferable.  In addition,option valuation models require the input of highly subjective assumptionsincluding the expected or implied volatility of the options underlyingstock.  Since the options granted underthe Company’s stock option plans have characteristics significantly differentfrom those of marketable options and because changes in the subjective inputassumptions can materially impact the estimated fair market value, inManagement’s opinion, the existing valuation models do no necessarily provide areliable single measure of the fair market value of its employee stock optionsat the time of grant.  In 2003 and forthe first six months of 2004, the Company did not grant stock options under anyof its stock plans.

 

**Item2.****                                         Management’s Discussion and Analysisof Results of Operations and Financial Condition**

 

The following is Management’s discussion and analysis of thesignificant changes in the consolidated financial condition of the Company asof June 30, 2004 and December 31, 2003 and the results of operationsfor the three and six months ended June 30, 2004 compared to the three andsix months ended June 30, 2003. Current performance may not be indicative of future results. This discussionshould be read in conjunction with the Company’s 2003 Annual Report filed onForm 10-K.

 

**Forward looking statements**

 

This Interim Report on Form 10-Q contains a number of forward-lookingstatements within the meaning of Section 27A of the Securities Act of1933, as amended, or the Securities Act, and Section 21E of the SecuritiesExchange Act of 1934, as amended, or the Exchange Act.  These statements may be identified by theuse of the words “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,”“may,” “outlook,” “plan,” “potential,” “predict,” “project,” “should,” “will,”“would” and similar terms and phrases, including references to assumptions.Forward looking statements include risks and uncertainties.

 

Forward-looking statements are based on various assumptions andanalyses made by us in light of Management’s experience and its perception ofhistorical trends, current conditions and expected future developments, as wellas other factors it believes are appropriate under the circumstances.  These statements are not guarantees offuture performance and are subject to risks, uncertainties and other factors(many of which are beyond our control) that could cause actual results todiffer materially from future results expressed or implied by suchforward-looking statements.  Thesefactors include, without limitation, the following:

 

•                  the timing andoccurrence or non-occurrence of events may be subject to circumstances beyondour control;

 

•                  there may beincreases in competitive pressure among financial institutions or fromnon-financial institutions;

 

•                  changes in theinterest rate environment may reduce interest margins;

 

•                  changes indeposit flows, loan demand or real estate values may adversely affect ourbusiness;

 

•                  changes inaccounting principles, policies or guidelines may cause our financial conditionto be perceived differently;

 

9

----

 

•                  general economicconditions, either nationally or locally in some or all areas in which we dobusiness, or conditions in the securities markets or the banking industry maybe less favorable than we currently anticipate;

 

•                  legislative orregulatory changes may adversely affect our business;

 

•                  technologicalchanges may be more difficult or expensive than we anticipate;

 

•                  success orconsummation of new business initiatives may be more difficult or expensivethan we anticipate; or

 

•                  acts of war orterrorism.

 

Management cautions readers not to place undue reliance onforward-looking statements, which reflect analyses only as of the date of thisreport.  We have no obligation to updateany forward-looking statements to reflect events or circumstances after thedate of this document.  Readers shouldreview the risk factors described in other documents that we file, from time totime, with the Securities and Exchange Commission, including Annual Reports toShareholders, Annual Reports filed on Form 10-K and other current reports filedon Form 8-K.

 

**General**

 

The Company’s results of operations depend primarily on its netinterest income, which is the difference between interest income oninterest-earning assets, which principally consists of loans and investmentsecurities, and interest expense on interest-bearing liabilities, whichconsists of deposits and borrowings. Net interest income is determined by the Company’s interest rate spread(i.e., the difference between the yields earned on its interest-earning assetsand the rates paid on its interest-bearing liabilities) and the relativeamounts of interest-earning assets and interest-bearing liabilities.  The interest rate spread is influenced bythe overall interest rate environment, the composition and characteristics ofinterest-earning assets and interest-bearing liabilities and by the competitionin our marketplace. The interest rate spread and the changes in the interestrate spread, from period-to-period, is also influenced by differences in thematurity and re-pricing characteristics of assets compared to the maturity andre-pricing characteristics of liabilities that fund them.

 

The Company’s profitability is also affected by the level of itsnon-interest income and expenses, provision for loan losses and provision forincome taxes.  Non-interest incomeconsists mostly of service charges on the Bank’s various deposit products andincome from loan and other banking fees. Non-interest expense consists of compensation and related employeebenefit expenses, occupancy, equipment, data processing, advertising,marketing, professional fees, insurance and other operating overhead.

 

The Company’s profitability is significantly affected by generaleconomic and competitive conditions, changes in market interest rates,government policies and actions of regulatory authorities.  The Company’s loan portfolio is concentratedin commercial and commercial real estate. The properties underlying the Company’s mortgages are concentrated innortheastern Pennsylvania.  Credit risk,which represents the possibility of the Company not recovering amounts due fromits borrowers, is significantly related to local economic conditions in theareas the properties are located as well as the Company’s underwritingstandards.  Economic conditions affectthe market value of the underlying collateral as well as the levels ofoccupancy of multi-family dwellings and levels of other income-producingproperties and establishments.

 

10

----

 

**COMPARISONOF RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDEDJUNE 30, 2004 AND JUNE 30, 2003**

 

**Overview**

 

Net income for the second quarter of 2004 of $921,000 was comparable to$923,000 for the same quarter in 2003. Diluted earnings per share for the three months ended June 30, 2004and 2003 amounted to $0.50.

 

The quarter-to-quarter comparison included an increase in net interestincome and a decrease in the provision for loans losses.  These items were offset by a decrease innon-interest income, an increase in non-interest expense and an increase in theprovision for income taxes.

 

Return on average assets and return on average equity were 0.67% and8.39%, respectively, for the three months ended June 30, 2004 compared to0.65% and 8.06%, respectively, for the same period in 2003.

 

*Net interest income*

 

Net interest income is the Company’s primary source of earnings and isinfluenced primarily by the amount, distribution and re-pricing characteristicsof its interest-earning assets and interest-bearing liabilities as well as therelative levels and movements of interest rates.

 

Net interest income increased $662,000, or 19%, to $4,091,000 in thesecond quarter of 2004, from $3,429,000 in the same period of 2003.  The increase was attributable to a 72 basispoint decrease in rates paid on average interest-bearing liabilities in conjunctionwith a $24,651,000 decrease in the average balances on which they arepaid.  The decrease in averageinterest-bearing liabilities was predominantly in the Bank’s certificate ofdeposits, which experienced a decline of $57,336,000 on average, from high costthirty-month product maturities and public fund certificate runoff, whencompared to the average balances for second quarter of 2003.  As a result, interest expense declined$996,000, or 27%, in the second quarter of 2004 compared to the same 2003quarter.  Compared to the second quarterof 2003, average interest-earning assets were $10,280,000 lower than the samequarter of 2004 due to called, matured and pay-downs of investmentsecurities.  In this low interest rateenvironment, the yield on interest-earning assets decreased 14 basis points to5.23% in the 2004 quarter, primarily due to lower rates on new loansoriginated.  The yield on investmentsecurities increased 19 basis points due to a decrease in amortization of bondpremium on the Bank’s portfolio of mortgage backed securities which representsthe highest concentration of investments within the portfolio.

 

The tax-equivalent yield on average interest-earning assets decreased12 basis points to 5.32% for the quarter ended June 30, 2004 compared tothe second quarter of 2003.  During thesecond quarter of 2004 the Bank’s tax equivalent margin and spread increased 58basis points and 60 basis points, respectively.  The increase in margin and spread is the result of the rates onthe Bank’s interest-bearing liabilities declining at a faster pace than theyields earned on interest-earning assets.

 

11

----

 

The following table sets forth, a comparison of average balance sheetamounts and their corresponding tax equivalent earnings and expenses andannualized tax-equivalent yield and rate for the periods indicated (dollars inthousands):

 
|                                          |   | **Three  months ended  June 30,** |    | **Six months  ended  June 30,** |   | **Year ended  December 31,** |   |
|-----------------------------------------------|--------|----------------------------------------|---------|--------------------------------------|--------|-----------------------------------|--------|
|                                          |   | **2004**                               |    | **2003**                             |   | **2004**                          |   | **2003** |   | **2003** |   |
| Average earning assets:                       |   |                                   |    |                                 |   |                              |   |   |   |   |   |
| Loans and leases                              |   | $                                      | 390,048 |                                 | $      | 385,383                           |   | $ | 391,358 |   | $ | 387,244 |   | $ | 387,099 |   |
| Investments                                   |   | 132,974                                |    | 142,019                              |   | 137,410                           |   | 145,565 |   | 144,759 |   |
| Federal funds sold                            |   | —                                 |    | 5,500                                |   | 2,204                             |   | 5,613 |   | 3,919 |   |
| Interest-bearing deposits                     |   | 534                                    |    | 933                                  |   | 626                               |   | 899 |   | 761 |   |
| Total                                         |   | $                                      | 523,556 |                                 | $      | 533,836                           |   | $ | 531,598 |   | $ | 539,321 |   | $ | 536,538 |   |
|                                          |   |                                   |    |                                 |   |                              |   |   |   |   |   |
| Average interest-bearing liabilities:         |   |                                   |    |                                 |   |                              |   |   |   |   |   |
| Other interest-bearing deposits               |   | $                                      | 109,680 |                                 | $      | 96,190                            |   | $ | 110,639 |   | $ | 96,252 |   | $ | 100,699 |   |
| Certificates of deposit                       |   | 206,010                                |    | 263,346                              |   | 216,863                           |   | 263,963 |   | 250,482 |   |
| Borrowed funds                                |   | 82,534                                 |    | 65,725                               |   | 78,821                            |   | 65,723 |   | 69,471 |   |
| Repurchase agreements                         |   | 40,045                                 |    | 37,660                               |   | 41,467                            |   | 42,441 |   | 41,355 |   |
| Total                                         |   | $                                      | 438,269 |                                 | $      | 462,920                           |   | $ | 447,790 |   | $ | 468,379 |   | $ | 462,007 |   |
|                                          |   |                                   |    |                                 |   |                              |   |   |   |   |   |
| Interest income:                              |   |                                   |    |                                 |   |                              |   |   |   |   |   |
| Loans and leases                              |   | $                                      | 5,618   |                                 | $      | 5,907                             |   | $ | 11,206 |   | $ | 12,074 |   | $ | 23,440 |   |
| Investments                                   |   | 1,303                                  |    | 1,311                                |   | 2,788                             |   | 2,856 |   | 5,443 |   |
| Federal funds sold                            |   | —                                 |    | 16                                   |   | 10                                |   | 35 |   | 46 |   |
| Interest-bearing deposits                     |   | 1                                      |    | 2                                    |   | 2                                 |   | 4 |   | 6 |   |
| Total                                         |   | $                                      | 6,922   |                                 | $      | 7,236                             |   | $ | 14,006 |   | $ | 14,969 |   | $ | 28,935 |   |
|                                          |   |                                   |    |                                 |   |                              |   |   |   |   |   |
| Interest expense:                             |   |                                   |    |                                 |   |                              |   |   |   |   |   |
| Other interest-bearing deposits               |   | $                                      | 179     |                                 | $      | 191                               |   | $ | 362 |   | $ | 385 |   | $ | 697 |   |
| Certificates of deposit                       |   | 1,452                                  |    | 2,496                                |   | 3,210                             |   | 5,051 |   | 9,334 |   |
| Borrowed funds                                |   | 990                                    |    | 904                                  |   | 1,976                             |   | 1,795 |   | 3,703 |   |
| Repurchase agreements                         |   | 101                                    |    | 127                                  |   | 204                               |   | 292 |   | 503 |   |
| Total                                         |   | $                                      | 2,722   |                                 | $      | 3,718                             |   | $ | 5,752 |   | $ | 7,523 |   | $ | 14,237 |   |
|                                          |   |                                   |    |                                 |   |                              |   |   |   |   |   |
| Net Interest Income                           |   | $                                      | 4,200   |                                 | $      | 3,518                             |   | $ | 8,254 |   | $ | 7,446 |   | $ | 14,698 |   |
|                                          |   |                                   |    |                                 |   |                              |   |   |   |   |   |
| Yield on average earning assets               |   | 5.32                                   | %       | 5.44                                 | %      | 5.30                              | %      | 5.60 | % | 5.39 | % |
| Cost of average interest-bearing  liabilities |   | 2.50                                   | %       | 3.22                                 | %      | 2.58                              | %      | 3.24 | % | 3.08 | % |
|                                          |   |                                   |    |                                 |   |                              |   |   |   |   |   |
| Net interest spread                           |   | 2.82                                   | %       | 2.22                                 | %      | 2.72                              | %      | 2.36 | % | 2.31 | % |
|                                          |   |                                   |    |                                 |   |                              |   |   |   |   |   |
| Net interest margin                           |   | 3.23                                   | %       | 2.65                                 | %      | 3.12                              | %      | 2.78 | % | 2.74 | % |

 

In the table above, interest income was adjusted to a tax-equivalentbasis to recognize the income from the various tax-exempt assets as if theinterest was fully taxable.  Thistreatment allows a uniform comparison among the yields on interest-earningassets.  The calculations were computedon a fully tax-equivalent basis using the corporate federal tax rate of34%.  Net interest spread represents thedifference between the yield on interest-earning assets and the rate oninterest-bearing liabilities.  Netinterest margin represents the ratio of net interest income to total averageinterest-earning assets. 

 

12

----

 

*Provision for loanlosses*

 

The provision for loan losses represents the necessary amount chargedto operations with the purpose to increase the allowance for loan losses to alevel that represents Management’s best estimate of known and inherent lossesin the Bank’s loan portfolio.  Loans andleases determined to be uncollectible are charged-off against the allowance forloan losses.

 

The required amount of the provision for loan losses, based upon theadequate level of the allowance for loan losses, is subject to ongoing analysisof the loan portfolio. The Bank maintains a Special Asset Committee which meetsperiodically to review problem loans and leases. The committee is comprised ofBank management, including the credit administration officer, loan workoutofficer and collection personnel. The committee reports quarterly to the CreditAdministration Committee of the Board of Directors.

 

Management continuously reviews the risks inherent in the loan andlease portfolio. Specific factors used to evaluate the adequacy of the loanloss provision during the formal process include:

 

•                  Specific loansthat could have loss potential

•                  Levels of andtrends in delinquencies and non-accrual loans

•                  Levels of andtrends in charge-offs and recoveries

•                  Trends in volumeand terms of loans

•                  Changes in riskselection and underwriting standards

•                  Changes inlending policies, procedures and practices

•                  Experience,ability and depth of lending personnel

•                  National andlocal economic trends and conditions

•                  Changes incredit concentrations

 

The provision for loan losses decreased to $400,000, for the threemonths ended June 30, 2004, compared to $460,000 for the three monthsended June 30, 2003.  Thoughnon-performing loans increased $2,544,000, from December 31, 2003,management believes the current balance in the allowance for loan losses, duemostly to the provision recorded during the latter part of 2003 and the firstquarter of 2004, is adequate.  For moredetailed information, refer to the sections titled “Allowance for Loan Loss”and “Non-performing Assets” under the Comparison of Financial Condition atJune 30, 2004 and December 31, 2003.

 

*Other income*

 

Non-interest income consists of service charges or fees collected onthe Bank’s various deposit and loan products, net mortgage servicing revenue,fees from trust, asset management and other financial services, the increase incash surrender value of bank owned life insurance and the realized gains andlosses from the sales of investment securities, loans, leased assets andforeclosed assets held for sale.

 

Other income was $190,000, or 15%, lower for the three months endedJune 30, 2004 compared to the same period in 2003.  During 2004, the Bank’s sale of residentialmortgages, into the secondary market, declined significantly compared to2003.  The surge in sales in 2003 wasthe result of the mortgage refinance activity that was spurred by therelatively low interest rate environment.  As a result of lower sales activity, income from the sales of loansdeclined from $356,000 for the three months ended June 30, 2003 to $71,000for the three months ended June 30, 2004. In addition, the Bank recorded gains of investment securities of$132,000 in 2003 which did not recur in 2004. Partially offsetting the decline in income recognized from the sales ofloans and securities, the Bank experienced growth in service charges on depositaccounts and other fees and charges, including an increase in the cashsurrender value of bank owned life insurance.

 

*Other expenses*

 

Other expenses were $525,000 or 17% more for the three months endedJune 30, 2004 compared to the same period in 2003.  The increase was largely due to a $136,000increase in compensation and benefits expense, a $36,000 increase in premisesand equipment expenses, a $16,000 increase in advertising and approximately$336,000 more in other operating expenses. The increase in compensation and benefits was due to the hiring ofadditional experienced staff in key positions in 2004, increased incentivecompensation and the related payroll taxes and the increased cost of various

 

13

----

 

employee benefits.  The increasein premises and equipment was due to increased expenses related to equipmentrepairs and rentals.   The increase inthe other operating expenses was primarily the result of an initial recognitionof an estimated $278,000 obligation related to the retirement benefit innegotiations with the Company’s former chairman and president.  The retirement benefit represents a presentvalue obligation for certain benefits, to be paid periodically in the future,that include payments, reduced by appropriate taxes, and estimated medicalinsurance premiums as well as the transfer of a company owned vehicle.  Based upon the subjective nature of themedical insurance premium portion of the accrual, as it relates to futurepremium costs, and the uncertainty of the future benefit period to be covered,the Company may find it necessary to increase or decrease the accrual.

 

*Income tax provision*

 

The difference between the expected provision and actual provision forincome taxes is primarily due to tax-free income and use of low-income housingtax credits.

 

For the three months ended June 30, 2004, the Company recorded atax provision of $302,000 compared to $293,000 for the three months endedJune 30, 2003.  For the respectiveperiod, the effective tax rates were 24.7% and 24.1%.  The effective tax rate for the periods differ due to the percentageof pre-tax earnings represented by tax-free income from the Bank’s portfolio ofmunicipal securities, a portion of dividends received from its investment inequity securities, tax-free commercial mortgages and leases and the increase inthe cash surrender value of the bank owned life insurance.

 

**COMPARISONOF RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDEDJUNE 30, 2004 AND JUNE 30, 2003**

 

**Overview**

 

Net income for the first six months of 2004 declined 15% to $1,546,000from $1,810,000 for the first six months of 2003.  Diluted earnings per share decreased to $0.84 in the first halfof 2004 from $0.99 in the first half of 2003.

 

The decrease in net earnings recorded for the six months endedJune 30, 2004 was the result of an increase in the provision for loanlosses, an increase in non-interest expense and a decrease in non-interestincome.  These items were partiallyoffset by an increase in net interest income.

 

Return on average assets and return on average equity were 0.55% and7.01%, respectively, for the six months ended June 30, 2004 compared to0.64% and 7.99%, respectively, for the same period in 2003.

 

*Net interest income*

 

Net interest income increased $763,000, or 11%, to $8,024,000 for thesix months ended June 30, 2004, from $7,261,000 for the same period in2003.  The increase was primarily due toa combined 66 basis point decline in rates paid on interest-bearing liabilitiesand a $20,589,000 decrease in average interest-bearing liabilities.  The average balances in the Bank’scertificates of deposit declined $47,100,000 from the average for the sixmonths of 2003, primarily from high cost thirty-month product maturities andpublic fund certificate runoff.  As aresult, interest expense declined $1,771,000, or 24%, in the first half of 2004compared to the same 2003 period. Average interest-earning assets decreased $7,723,000 during the sixmonths ended June 30, 2004 compared to the same period in 2003.  The low interest rate environment that hadbeen prevalent for the first half of 2004 caused yields on interest-earningassets to decline to 5.21%, from 5.53% for the six months ended June 30,2003.  Lower rates on loan originationsresulted in a 53 basis point decline in the yield on the loan portfolio.

 

The tax-equivalent yield on average interest-earning assets decreased30 basis points to 5.30% for the first half of 2004, compared to 5.60% for thesame period in 2003.   During the firsthalf of 2004 the Bank’s tax equivalent margin and spread increased 34 basispoints and 36 basis points, respectively. The increase in margin and spread is the result of the Bank’s rates oninterest-bearing liabilities declining at a faster pace than the yields earnedon interest-earning assets.

 

The ratio of average interest-earning assets to averageinterest-bearing liabilities increased from 115.14% for the six months endedJune 30, 2003 to 118.72% for the six months ended June 30, 2004.

 

14

----

 

*Provision for loanlosses*

 

The provision for loan losses for the first six months of 2004 was$1,250,000 or $490,000 more than the provision recorded during the six monthsended June 30, 2003.  The increasewas due to an increase in non-performing loans of approximately $2,544,000since December 31, 2003.  Most ofthe provision for loan losses was recorded during the first quarter of 2004,when non-performing loans increased $4,398,000.   The increase in non-performing loans was due primarily to asingle commercial relationship consisting of two loans of $4,825,000 in theaggregate.  These two loans migrated tonon-performing status during the first quarter of 2004.  For more detailed information, refer to thesections titled “Allowance for Loan Loss” and “Non-performing Assets” under theComparison of Financial Condition at June 30, 2004 and December 31,2003.

 

*Other income*

 

For the first six months of 2004, other income was $200,000, or 9%,lower compared to the same period in 2003. Other income was lower, in 2004, due primarily to increased lossesrecorded from the sales of leased assets and less net gains recorded from thesales of investment securities.  Salesof mortgage loans into the secondary market declined $330,000 due to theaforementioned decline in loan refinance activity.  Partially offsetting these items was growth in service charges ondeposit accounts and other fees and charges, including an increase in the cashsurrender value of bank owned life insurance.

 

*Other expenses*

 

For the first six months of 2004, other expenses increased $505,000, or8%, to $6,814,000 from the $6,309,000 recorded during the first six months of2003.  The primary cause of the increasewas a $220,000 increase in salary and benefits expense, a $58,000 increase inpremises and equipment expenses and an increase of $224,000 other operatingexpenses.  The increase in salaries andbenefits was due to added staff in key positions in 2004, increased incentivecompensation and the related payroll taxes and the escalating costs of theBank’s various benefit programs.  Theincrease in premises and equipment was largely due to increased equipmentrepairs and rentals, partially offset by decreases in the expenses to maintainthe buildings and grounds.  The increasein other operating expenses was primarily the result of recognition of theestimated $278,000 obligation related to the retirement benefit afforded to theCompany’s former chairman and president as described under the caption “Otherexpenses” in the Comparison of Results of Operations for the three months endedJune 30, 2004 and June 30, 2003, above.

 

*Income tax provision*

 

For the six month periods ended June 30, 2004 and 2003, theCompany recorded tax provisions of $432,000 and $599,000, respectively,representing effective tax rates of 21.8% and 24.9%, for each of theperiods.  The effective tax rate for theperiods differ due to the percentage of pre-tax earnings represented bytax-free income from the Bank’s portfolio of municipal securities, a portion ofdividends received from its investment in equity securities, tax-freecommercial mortgages and leases and the increase in the cash surrender value ofthe bank owned life insurance.

 

**COMPARISONOF FINANCIAL CONDITION AT JUNE 30, 2004 AND DECEMBER 31, 2003**

 

**Overview**

 

Consolidated assets decreased $34,595,000, or 6%, during the six monthsended June 30, 2004 to $540,621,000. The asset decline resulted from a decrease in deposits of $24,139,000and a decline in total borrowings of $9,942,000.  Cash and cash equivalents, investments and loans decreased$7,271,000, $17,991,000 and $9,954,000, respectively, since December 31,2003.   Shareholders’ equity decreased$492,000 from $43,932,000, at December 31, 2003, to $43,440,000, atJune 30, 2004.  The decrease inshareholders’ equity was attributable to a $1,543,000 net unrealized holdingloss on available-for-sale securities, recorded within other comprehensiveloss, partially offset by earnings net of dividends paid and an increase incommon stock.  Common stock, net oftreasury shares, grew from shares issued under the employee stock purchase anddividend re-investment plans.

 

A comparison of selected balance sheet information as of June 30,2004 and December 31, 2003 follows:

 

15

----

 

*Investmentsecurities*

 

The Bank’s investment policy is designed to complement its lendingactivities, generate a favorable return without incurring undue interest rateand credit risk, manage interest rate sensitivity, provide monthly cash flowand manage liquidity at acceptable levels. In establishing investment strategies, the Bank considers its businessand growth or restructuring plans, the economic environment, the interest ratesensitivity position, the types of securities held, permissible purchases,credit quality, maturity, call or average-life intervals and investmentconcentrations.

 

At the time of purchase, the Bank classifies investment securities intoone of three categories: trading, available-for-sale (AFS) or held to maturity(HTM).  To date, the Bank has notpurchased any securities for trading purposes. Management classifies mostsecurities as AFS even though it has no immediate intent to sell them.  The AFS designation affords Management theflexibility to sell securities and adjust the balance sheet in response tocapital levels, liquidity needs and/or changes in market conditions.  Securities AFS are carried at fair marketvalue in the consolidated balance sheet with an adjustment to stockholders’equity, net of tax, which is presented under the caption “Accumulated othercomprehensive income (loss)”. Securities designated as HTM are carried at amortized cost.

 

At June 30, 2004, the carrying value of investment securitiestotaled $126,416,000 or 23% of total assets. The portfolio is comprised of HTM and AFS securities with carryingvalues of $3,461,000 and $122,955,000, respectively.  Approximately 56% of the investment portfolio was comprised ofmortgage-backed securities that amortize and provide monthly cash flow.  Agency bonds and municipal bonds comprised28% and 9% of the investment portfolio, respectively.

 

At June 30, 2004, the AFS portfolio had an estimated pre-taxmarket decline of $2,661,000 and an after-tax equity adjustment of$1,756,000.  This represents anafter-tax depreciation of $1,543,000 in the estimated fair value fromDecember 31, 2003.  The declineoccurred due to the composition of the Bank’s investment portfolio whichincludes securities with yields less than what can be readily obtained fromsimilar securities in the investment markets.

 

The amortized cost and fair value of investment securities HTM and AFSat June 30, 2004 consisted of the following (dollars in thousands):

 
|                                              |   | **Amortized  cost** |    | **Gross  unrealized  gains** |   | **Gross  unrealized  losses** |   | **Fair  value** |   |
|---------------------------------------------------|--------|---------------------|---------|------------------------------|--------|-------------------------------|--------|-----------------|--------|
|                                              |   |                |    |                         |   |                          |   |            |   |
| Held-to-maturity securities:                      |   |                |    |                         |   |                          |   |            |   |
|                                              |   |                |    |                         |   |                          |   |            |   |
| Mortgage-backed securities                        |   | $                   | 3,461   |                         | $      | 119                           |   | $               | — |   | $ | 3,580 |   |
|                                              |   |                |    |                         |   |                          |   |            |   |
| Available-for-sale securities:                    |   |                |    |                         |   |                          |   |            |   |
| U.S. government agencies and corporations         |   | $                   | 37,026  |                         | $      | —                        |   | $               | 1,330  |   | $ | 35,696 |   |
| Obligations of states and municipal  subdivisions |   | 11,253              |    | 40                           |   | 277                           |   | 11,016          |   |
| Corporate bonds                                   |   | 3,992               |    | 26                           |   | —                        |   | 4,018           |   |
| Mortgage-backed securities                        |   | 68,324              |    | 104                          |   | 1,391                         |   | 67,037          |   |
|                                              |   |                |    |                         |   |                          |   |            |   |
| Sub total                                         |   | 120,595             |    | 170                          |   | 2,998                         |   | 117,767         |   |
|                                              |   |                |    |                         |   |                          |   |            |   |
| Equity securities:                                |   |                |    |                         |   |                          |   |            |   |
| Restricted (regulatory equity)                    |   | 4,742               |    | —                       |   | —                        |   | 4,742           |   |
| Other                                             |   | 279                 |    | 167                          |   | —                        |   | 446             |   |
|                                              |   |                |    |                         |   |                          |   |            |   |
| Total available-for-sale                          |   | $                   | 125,616 |                         | $      | 337                           |   | $               | 2,998  |   | $ | 122,955 |   |
|                                              |   |                |    |                         |   |                          |   |            |   |
| Total securities                                  |   | $                   | 129,077 |                         | $      | 456                           |   | $               | 2,998  |   | $ | 126,535 |   |
|                                                   |        |                     |         |                              |        |                               |        |                 |        |  |  |  |  |  |

 

16

----

 

The amortized cost and fair value of investmentsheld-to-maturity and available-for-sale by contractual maturity atJune 30, 2004 are as follows (dollars in thousands):

 
|                           |   | **Amortized  cost** |    | **Market  value** |   |
|--------------------------------|--------|---------------------|---------|-------------------|--------|
| Held-to-maturity securities:   |   |                |    |              |   |
| Due after ten years            |   | $                   | 3,461   |              | $      | 3,580 |   |
|                           |   |                |    |              |   |
| Available-for-sale securities: |   |                |    |              |   |
| One year or less               |   | $                   | 200     |              | $      | 202 |   |
| One through five years         |   | 3,432               |    | 3,369             |   |
| Five through ten years         |   | 22,539              |    | 21,869            |   |
| Over ten years                 |   | 26,100              |    | 25,290            |   |
| Total agency and muncipal      |   | 52,271              |    | 50,730            |   |
|                           |   |                |    |              |   |
| Mortgage-backed securities     |   | 68,324              |    | 67,037            |   |
| Equity securities              |   | 5,021               |    | 5,188             |   |
| Total available-for-sale       |   | $                   | 125,616 |              | $      | 122,955 |   |
|                           |   |                |    |              |   |
| Total securities               |   | $                   | 129,077 |              | $      | 126,535 |   |

 

Expected maturities willdiffer from contractual maturities because borrowers may have the right to callor repay obligations with or without call or prepayment penalty.  Federal agency and municipal securities areincluded based upon their original stated maturity.  Mortgage-backed securities, which are based on weighted-averagelives and subject to monthly principal pay-downs, are listed in total.  Equity securities, which have no statedmaturity and are listed in total, include stock of the Federal Home Loan Bankwhich is carried at cost.

 

*Loans available -for- sale (AFS)*

 

Upon origination, certain residential mortgages, the guaranteedportions of Small Business Administration loans and student loans areclassified as AFS.  Should market ratesincrease, fixed-rate loans and loans not immediately scheduled to re-pricewould no longer produce yields consistent with the current market.  In a declining interest rate environment,the Bank would be exposed to prepayment risk and, as rates on adjustable rateloans decrease interest income would be negatively affected.  To better manage interest rate risk, loans thatmeet these conditions may be classified as AFS.  Consideration is also given to the current liquidity position andexpected future liquidity needs.  LoansAFS are carried at the lower of cost or estimated fair value in theaggregate.  Net unrealized losses arerecognized through a valuation allowance by charges to income.  Unrealized gains are recognized to theextent of previous write-downs.

 

At June 30, 2004, loans AFS totaled $1,262,000, compared to$19,864,000, at December 31, 2003 or a decrease of $18,602,000.  During the second quarter, the Banktransferred higher yielding mortgage loans with relatively shorter lives withaggregate principal balances of $11,246,000 and aggregate market values of$11,446,000 from the AFS to its loan portfolio.  The loans were transferred at the lower of cost or market andtherefore, no gain or loss was recognized. The Bank has both the ability and intent to hold these loans untilmaturity and they will continue to provide the Bank with yields in excess ofcurrent market rates.  In addition, bytransferring the loans from the AFS to the loan portfolio, the Bank will nolonger be required to apply lower-of-cost-or market treatment to the principalbalance.  In an increasing interest rateenvironment, the loans AFS could attain market values significantly below theirprincipal balances and, as a result, could create a significant drag on currentearnings.  During 2004, loans totaling$11,701,000 have been sold into the secondary market and gains of approximately$94,000 have been recognized.

 

*Loans*

 

The Bank originates commercial and commercial real estate loans,residential, consumer, home equity and construction loans.  The relative volume of originations isdependent upon customer demand, current interest rates and the perception andduration of future interest levels.  TheBank continues to focus its efforts on the expansion of variable-rateportfolios of commercial lending as well as originations of fixed-rateresidential, including multi-family and consumer loans.  The broad spectrum of products providesdiversification which helps manage, to an extent, interest rate risk and creditconcentration risk.  Credit risk isfurther managed through underwriting policies and procedures and loanmonitoring practices.  Interest raterisk is managed using various asset/liability modeling techniques andanalyses.  The

 

17

----

 

interest rates on most commercial loans are adjustable with resetintervals of five years or less. Whenever practical, the Bank originatesvariable rate loans.

 

The majority of our loan portfolio is collateralized, at least in part,by real estate in the greater Lackawanna and Luzerne counties ofPennsylvania.  Commercial lendingactivities generally involve a greater degree of credit risk than residentiallending because they typically have larger balances and are more affected byadverse conditions in the economy. Because payments on loans secured by commercial and commercial realestate often depend upon the successful operation and management of theproperties and the businesses which operate from within them, repayment of suchloans may be affected by factors outside the borrower’s control.  Such factors may include adverse conditionsin the real estate market, the economy, the industry or changes in governmentregulations.  As such, commercial loansrequire more ongoing evaluation and monitoring that is occurring with theBank’s credit administration and outsourced loan review functions.

 

Loans, net of unearned income increased from $371,979,000 atDecember 31, 2003, to $381,506,000 at June 30, 2004. During thesecond quarter, the Bank transferred residential mortgage loans with aggregateprincipal balances of $11,246,000 from the AFS to the loan portfolio.  See “Loans-available-for sale”, above forfurther discussion on these loans.

 

The following table sets forth the composition of the loan portfolio atJune 30, 2004 and December 31, 2003:

 
|                                  |   | **June 30,  2004** |        | **December 31,  2003** |   |
|---------------------------------------|--------|-------------------------|-------------|-----------------------------|--------|
| Residential real estate               |   | $                       | 101,809,741 |                        | $      | 90,779,488 |   |
| Commercial and commercial real estate |   | 221,538,503             |        | 221,275,922                 |   |
| Consumer and home equity              |   | 47,630,643              |        | 49,216,897                  |   |
| Real estate construction              |   | 7,378,988               |        | 7,267,616                   |   |
| Direct financing leases               |   | 3,277,593               |        | 3,685,802                   |   |
| Gross loans                           |   | 381,635,468             |        | 372,225,725                 |   |
| Less:                                 |   |                    |        |                        |   |
| Unearned discount                     |   | 129,645                 |        | 247,119                     |   |
| Allowance for loan losses             |   | 5,876,178               |        | 4,996,966                   |   |
| Net loans                             |   | $                       | 375,629,645 |                        | $      | 366,981,640 |   |
|                                  |   |                    |        |                        |   |
| Loans available-for-sale              |   | $                       | 1,261,808   |                        | $      | 19,863,577 |   |

 

*Allowance for loanlosses*

 

Management continually evaluates the credit quality of the Bank’s loanportfolio and performs a formal review of the allowance for loan loss adequacy,on a quarterly basis.  The allowance forloan loss reflects management’s best estimate of losses, both known andinherent, in the existing loan portfolio. Management’s judgment is based on theevaluation of individual loans, past experience, the assessment of currenteconomic conditions, and other relevant factors. The provision for loan lossesrepresents the amount necessary to maintain an appropriate allowance. Loanlosses are charged directly against the allowance for loan losses when loansare deemed to be uncollectible. Recoveries on previously charged-off loans areadded to the allowance when received.

 

Management applies two primary components during the loan reviewprocess to determine proper allowance levels. The two levels are specific loanloss allocation for loans that are deemed impaired and a general loan lossallocation for those loans not specifically allocated.  The methodology to analyze the adequacy ofthe allowance for loan losses is as follows:

 

•                  Identificationof specific problem loans by loan category by credit administration;

•                  Calculation ofspecific allowances required based on collateral and other persuasive evidence;

•                  Identificationof loans collateralized by cash and marketable securities;

•                  Determination ofremaining homogenous pools by loan category and eliminating loanscollateralized by cash, marketable securities and loans with specificallocations;

•                  Application ofhistorical loss percentages (three year average) to pools to determine theallowance allocation; and

 

18

----

 

•                  Application of aqualitative factor adjustment percentage to historical losses for trends orchanges in the loan portfolio.

 

Allocation of the allowance for loan losses for different categories ofloans is based on the methodology used by the Bank, as explained above. Thechanges in the allocations from period to period are based upon reviews of theloan and lease portfolios.

 

Net charge-offs for the six months ended June 30, 2004 were$371,000, compared to $878,000, for the same period in 2003.  Commercial and real estate mortgage netcharge-offs decreased $99,000 and $63,000, respectively, for the six monthsended June 30, 2004 compared to the same period in 2003.  Consumer loans experienced an $83,000 netcharge-off during the first half of 2004 compared to a net charge-off of$401,000 in the first half of 2003. Supplementing our existing loan work-out officer with a seasoned creditadministration officer and collections manager has enabled us to aggressivelymanage and timely pursue the recovery of previously written-off loans.  Recovery of previous loan write-offsincreased $200,000 during the first half of 2004, compared to the same periodin 2003.

 

Management believes that the current balance in the allowance for loanslosses of $5,876,000 is sufficient to withstand the identified potential creditquality issues that may arise that are inherent to the loan portfolio.  Currently, Management is unaware of anypotential problem loans that have not been reviewed.  Potential problem loans are those where there is knowninformation that leads Management to believe repayment of principal and/orinterest is in jeopardy and the loans are neither non-accrual status nor pastdue 90 days or more.  However, therecould be instances which become identified over the year that may requireadditional charge-offs and/or increases to the allowance.  The ratio of allowance for loan losses tototal loans was 1.54% at June 30, 2004 compared to 1.28% atDecember 31, 2003.

 

The following table sets forth the activity in the allowance for loanlosses and certain key ratios for the period indicated:

 
|                            |   | **As of and  for the  six months ended  June 30, 2004** |        | **As of and  for the  year ended  December 31, 2003** |   | **As of and  for the  six months ended  June 30, 2003** |   |
|---------------------------------|--------|--------------------------------------------------------------|-------------|------------------------------------------------------------|--------|--------------------------------------------------------------|--------|
|                            |   |                                                         |        |                                                       |   |                                                         |   |
| Balance at beginning of period  |   | $                                                            | 4,996,966   |                                                       | $      | 3,899,753                                                    |   | $ | 3,899,753 |   |
|                            |   |                                                         |        |                                                       |   |                                                         |   |
| Provision charged to operations |   | 1,250,000                                                    |        | 3,715,000                                                  |   | 760,000                                                      |   |
|                            |   |                                                         |        |                                                       |   |                                                         |   |
| Charge-offs:                    |   |                                                         |        |                                                       |   |                                                         |   |
| Commercial                      |   | 319,370                                                      |        | 1,334,144                                                  |   | 317,352                                                      |   |
| Real estate                     |   | 122,943                                                      |        | 502,846                                                    |   | 186,182                                                      |   |
| Consumer                        |   | 201,025                                                      |        | 1,166,831                                                  |   | 439,598                                                      |   |
| Lease financing                 |   | 44,519                                                       |        | 92,264                                                     |   | 51,539                                                       |   |
| Total                           |   | 687,857                                                      |        | 3,096,085                                                  |   | 994,671                                                      |   |
|                            |   |                                                         |        |                                                       |   |                                                         |   |
| Recoveries:                     |   |                                                         |        |                                                       |   |                                                         |   |
| Commercial                      |   | 171,184                                                      |        | 204,137                                                    |   | 70,190                                                       |   |
| Real estate                     |   | 8,010                                                        |        | 34,168                                                     |   | 8,086                                                        |   |
| Consumer                        |   | 118,051                                                      |        | 229,879                                                    |   | 38,767                                                       |   |
| Lease financing                 |   | 19,824                                                       |        | 10,114                                                     |   | —                                                       |   |
| Total                           |   | 317,069                                                      |        | 478,298                                                    |   | 117,043                                                      |   |
|                            |   |                                                         |        |                                                       |   |                                                         |   |
| Net charge-offs                 |   | 370,788                                                      |        | 2,617,787                                                  |   | 877,628                                                      |   |
|                            |   |                                                         |        |                                                       |   |                                                         |   |
| Balance at end of period        |   | $                                                            | 5,876,178   |                                                       | $      | 4,996,966                                                    |   | $ | 3,782,125 |   |
|                            |   |                                                         |        |                                                       |   |                                                         |   |
| Total loans, end of period      |   | $                                                            | 382,767,632 |                                                       | $      | 391,842,183                                                  |   | $ | 387,167,312 |   |

 

19

----

 
|                                                                      |   | **As of and  for the  six months ended  June 30, 2004** |       | **As of and  for the  year ended  December 31, 2003** |   | **As of and  for the  six months ended  June 30, 2003** |   |
|---------------------------------------------------------------------------|--------|--------------------------------------------------------------|------------|------------------------------------------------------------|--------|--------------------------------------------------------------|--------|
| Net charge-offs to:                                                       |   |                                                         |       |                                                       |   |                                                         |   |
| Loans, end of period                                                      |   | 0.10                                                         | %          | 0.67                                                       | %      | 0.23                                                         | %      |
| Allowance for loan losses                                                 |   | 6.31                                                         | %          | 52.39                                                      | %      | 23.20                                                        | %      |
| Provisions for loan losses                                                |   | 29.66                                                        | %          | 70.47                                                      | %      | 115.48                                                       | %      |
|                                                                      |   |                                                         |       |                                                       |   |                                                         |   |
| Allowance for loan losses to:                                             |   |                                                         |       |                                                       |   |                                                         |   |
| Total loans                                                               |   | 1.54                                                         | %          | 1.28                                                       | %      | 0.98                                                         | %      |
| Non-accrual loans                                                         |   | 56.93                                                        | %          | 68.24                                                      | %      | 77.66                                                        | %      |
| Non-performing loans                                                      |   | 54.28                                                        | %          | 60.34                                                      | %      | 47.43                                                        | %      |
| Net charge-offs                                                           |   | 15.85                                                        | x          | 1.91                                                       | x      | 4.31                                                         | x      |
|                                                                      |   |                                                         |       |                                                       |   |                                                         |   |
| Loans 30-89 days past due and still  accruing                             |   | $                                                            | 3,964,766  |                                                       | $      | 3,974,821                                                    |   | $ | 6,366,530 |   |
| Loans 90 days past due and accruing                                       |   | $                                                            | 502,686    |                                                       | $      | 957,971                                                      |   | $ | 3,103,903 |   |
| Non-accrual loans                                                         |   | $                                                            | 10,322,405 |                                                       | $      | 7,323,014                                                    |   | $ | 4,870,361 |   |
| Allowance for loan losses to loans 90 days  or more past due and accruing |   | 11.69                                                        | x          | 5.22                                                       | x      | 1.22                                                         | x      |

 

*Non-performingassets*

 

The Bank defines non-performing assets as accruing loans past due 90days or more, non-accrual loans, restructured loans, other real estate ownedand repossessed assets.  The Bank didnot have restructured loans at June 30, 2004 or December 31,2003.  As of June 30, 2004,non-performing assets represented 2.04% of total assets compared to 1.52% atDecember 31, 2003.

 

The non-accrual loan balance increased $2,999,000, to $10,322,000during the first six months of 2004. Loans classified as non-accrual of $6,100,000 were added during thefirst six months of 2004 of which $233,000 was subsequently collected.  The increase was primarily in commercialloans caused mostly by a single relationship with two loans totaling$4,825,000.  These two loans have beensubsequently assumed by a new operating entity but will remain on non-accrualstatus until a repayment history is developed. This increase was partially offset by total payoffs or pay downs of$1,446,000, charge offs of $456,000 and $1,140,000 of loans that have migratedto performing status.

 

Foreclosed assets held for sale includes other real estate owned (OREO)and repossessed assets.  The $216,000OREO balance is represented by three properties that were foreclosed upon andtransferred from loans.  All of theproperties are currently listed for sale with a realtor.  Repossessed assets represent indirect autoloans, the payments of which have become delinquent and the vehiclesrepossessed.

 

Non-performing loans increased $2,544,000 since December 31, 2003.The increase was primarily in commercial loans as described above.  The ratio of non-performing loans to end ofperiod total loans increased 73 basis points, during the six month period. Forthe same period in 2003, the ratio of non-performing loans to total loans was2.08%, compared to 2.87% in 2004, or an increase of 79 basis points.

 

20

----

 

The following table sets forth non-performing assets data as of theperiod indicated:

 
|                                                                               |   | **June 30,  2004** |        | **December 31,  2003** |   | **June 30,  2003** |   |
|------------------------------------------------------------------------------------|--------|-------------------------|-------------|-----------------------------|--------|-------------------------|--------|
|                                                                               |   |                    |        |                        |   |                    |   |
| Loans past due 90 days or more and accruing                                        |   | $                       | 502,686     |                        | $      | 957,971                 |   | $ | 3,103,903 |   |
| Non-accrual loans                                                                  |   | 10,322,405              |        | 7,323,014                   |   | 4,870,361               |   |
| Total non-performing loans                                                         |   | 10,825,091              |        | 8,280,985                   |   | 7,974,264               |   |
|                                                                               |   |                    |        |                        |   |                    |   |
| Restructured loans                                                                 |   | —                  |        | —                      |   | 1,351,461               |   |
| Other real estate owned                                                            |   | 216,254                 |        | 394,246                     |   | 145,892                 |   |
| Repossessed assets                                                                 |   | 12,334                  |        | 72,920                      |   | 110,013                 |   |
| Total non-performing assets                                                        |   | $                       | 11,053,679  |                        | $      | 8,748,151               |   | $ | 9,581,630 |   |
|                                                                               |   |                    |        |                        |   |                    |   |
| Net loans including AFS                                                            |   | $                       | 376,891,453 |                        | $      | 386,845,217             |   | $ | 383,385,187 |   |
| Total assets                                                                       |   | $                       | 540,620,844 |                        | $      | 575,215,466             |   | $ | 585,780,767 |   |
| Non-accrual loans to net loans                                                     |   | 2.74                    | %           | 1.89                        | %      | 1.27                    | %      |
| Non-performing assets to net loans,  foreclosed real estate and repossessed assets |   | 2.93                    | %           | 2.26                        | %      | 2.50                    | %      |
| Non-performing assets to total assets                                              |   | 2.04                    | %           | 1.52                        | %      | 1.64                    | %      |
| Non-performing loans to net loans                                                  |   | 2.87                    | %           | 2.14                        | %      | 2.08                    | %      |

 

*Other assets*

 

The $1,106,000 increase in other assets from $3,072,000, atDecember 31, 2003, to $4,178,000, at June 30, 2004, was primarily dueto an increase in the deferred tax asset of $923,000, $737,000 of whichresulted from the change in the estimated fair value of investment securitiesAFS.  The balance of the increase inother assets is from normal recurring operations.

 

*Deposits*

 

The Bank is a community-based commercial financial institution andoffers a variety of deposit accounts with a range of interest rates andterms.  Deposit products includepassbook and statement savings accounts, NOW, money market, demand deposit andcertificates of deposit accounts.  Theflow of deposits is influenced significantly by general economic conditions,changes in prevailing interest rates, pricing and competition.  Most of the Bank’s deposits are obtainedfrom the communities surrounding the 12 branch offices.  We attempt to attract and retain depositcustomers via sales and marketing efforts with new products, quality service,competitive rates and long-standing customer relationships.

 

To determine the levels of deposit rates, consideration is given to localcompetition, market yields and the rates charged for alternative sources offunding such as borrowings.  Although wehave experienced a continued intense competition for deposits, we have notincreased rates significantly as we only consider cost effective strategies ina relatively low interest rate environment.

 

21

----

 

The following table represents the components of deposits as ofJune 30, 2004 and December 31, 2003:

 
|                                |   | **June 30,  2004** |        | **December 31,  2003** |   | **Dollar  change** |   | **Percent  change** |        |
|-------------------------------------|--------|-------------------------|-------------|-----------------------------|--------|--------------------|--------|---------------------|-------------|
| **Non-interest-bearing deposits**   |   |                    |        |                        |   |               |   |                |        |
| Personal                            |   | $                       | 27,628,120  |                        | $      | 26,206,156         |   | $                   | 1,421,964   |   | 5.43 | % |
| Non-personal                        |   | 28,342,822              |        | 29,561,169                  |   | (1,218,347         | )      | -4.12               | %           |
| Public fund                         |   | 4,103,206               |        | 3,635,074                   |   | 468,132            |   | 12.88               | %           |
| Bank checks                         |   | 5,893,675               |        | 4,996,259                   |   | 897,416            |   | 17.96               | %           |
| Total                               |   | $                       | 65,967,823  |                        | $      | 64,398,658         |   | $                   | 1,569,165   |   | 2.44 | % |
|                                |   |                    |        |                        |   |               |   |                |        |
| **Time deposits**                   |   |                    |        |                        |   |               |   |                |        |
| **of $100,000 or greater**          |   |                    |        |                        |   |               |   |                |        |
| Personal                            |   | $                       | 67,266,143  |                        | $      | 78,560,841         |   | $                   | (11,294,698 | ) | -14.38 | % |
| Non-personal                        |   | 17,749,264              |        | 16,057,391                  |   | 1,691,873          |   | 10.54               | %           |
| Public fund                         |   | 11,855,135              |        | 12,412,714                  |   | (557,579           | )      | -4.49               | %           |
| IRA’s                          |   | 5,577,258               |        | 5,826,474                   |   | (249,216           | )      | -4.28               | %           |
| Total                               |   | $                       | 102,447,800 |                        | $      | 112,857,420        |   | $                   | (10,409,620 | ) | -9.22 | % |
|                                |   |                    |        |                        |   |               |   |                |        |
| **Other interest-bearing deposits** |   |                    |        |                        |   |               |   |                |        |
| Time deposits less than $100,000:   |   |                    |        |                        |   |               |   |                |        |
| Personal                            |   | $                       | 75,067,552  |                        | $      | 83,057,733         |   | $                   | (7,990,181  | ) | -9.62 | % |
| Non-personal                        |   | 4,511,876               |        | 5,387,417                   |   | (875,541           | )      | -16.25              | %           |
| Public fund                         |   | 643,082                 |        | 597,772                     |   | 45,310             |   | 7.58                | %           |
| IRA’s                          |   | 19,108,245              |        | 19,694,374                  |   | (586,129           | )      | -2.98               | %           |
| sub total                           |   | 99,330,755              |        | 108,737,296                 |   | (9,406,541         | )      | -8.65               | %           |
| NOW accounts                        |   | 37,824,241              |        | 44,290,199                  |   | (6,465,958         | )      | -14.60              | %           |
| Money market deposits               |   | 28,098,009              |        | 28,284,225                  |   | (186,216           | )      | -0.66               | %           |
| Savings and clubs                   |   | 43,635,292              |        | 42,874,748                  |   | 760,544            |   | 1.77                | %           |
| Total                               |   | $                       | 208,888,297 |                        | $      | 224,186,468        |   | $                   | (15,298,171 | ) | -6.82 | % |
|                                |   |                    |        |                        |   |               |   |                |        |
| **Total deposits**                  |   |                    |        |                        |   |               |   |                |        |
| Noninterest-bearing deposits        |   | $                       | 65,967,823  |                        | $      | 64,398,658         |   | $                   | 1,569,165   |   | 2.44 | % |
| Interest-bearing deposits           |   | 311,336,097             |        | 337,043,888                 |   | (25,707,791        | )      | -7.63               | %           |
| Total                               |   | $                       | 377,303,920 |                        | $      | 401,442,546        |   | $                   | (24,138,626 | ) | -6.01 | % |
|                                |   |                    |        |                        |   |               |   |                |        |
| **Public funds**                    |   |                    |        |                        |   |               |   |                |        |
| Noninterest-bearing                 |   | $                       | 4,103,206   |                        | $      | 3,635,074          |   | $                   | 468,132     |   | 12.88 | % |
| Certificates of deposit             |   | 12,498,217              |        | 13,010,486                  |   | (512,269           | )      | -3.94               | %           |
| NOW accounts                        |   | 8,577,974               |        | 9,850,661                   |   | (1,272,687         | )      | -12.92              | %           |
| Money market deposits               |   | 3,763,693               |        | 8,029,671                   |   | (4,265,978         | )      | -53.13              | %           |
| Savings and clubs                   |   | 1,519,879               |        | 3,278,114                   |   | (1,758,235         | )      | -53.64              | %           |
| Total                               |   | $                       | 30,462,969  |                        | $      | 37,804,006         |   | $                   | (7,341,037  | ) | -19.42 | % |
|                                |   |                    |        |                        |   |               |   |                |        |
| **Internet deposits**               |   |                    |        |                        |   |               |   |                |        |
| Noninterest-bearing                 |   | $                       | —      |                        | $      | 27,505             |   | $                   | (27,505     | ) | -100.00 | % |
| Interest-bearing                    |   | 4,300,905               |        | 4,915,604                   |   | (614,699           | )      | -12.51              | %           |
| Total                               |   | $                       | 4,300,905   |                        | $      | 4,943,109          |   | $                   | (642,204    | ) | -12.99 | % |
|                                |   |                    |        |                        |   |               |   |                |        |
| Total assets                        |   | $                       | 540,620,844 |                        | $      | 575,215,466        |   |                |        |   |   |
| Total deposits to total assets      |   | 69.79                   | %           | 69.79                       | %      |               |   |                |        |
| Internet deposits to total deposits |   | 1.14                    | %           | 1.23                        | %      |               |   |                |        |
| Public funds to total deposits      |   | 8.07                    | %           | 9.42                        | %      |               |   |                |        |
| Public funds to total assets        |   | 5.63                    | %           | 6.57                        | %      |               |   |                |        |

 

Total deposits decreased $24,139,000 or 6% during the first six monthsof 2004 to $377,304,000.  Total averagedeposits decreased $18,720,000 or 5% from $412,068,000, at December 31,2003 to $393,348,000 at June 30, 2004.

 

22

----

 

Non-interest bearing demand deposits (DDA’s) are an important source offunds for the Bank as they lower the overall deposit costs.  The average balance of these accountsincreased $4,941,000 or approximately 8%. To remain competitive in the markets in which we operate, rates on mostinterest-bearing deposit products were increased modestly in 2004.  However, management expects approximately34% of the certificate of deposit portfolio to re-price to lower market ratesover the next year.  Specifically, over$20,000,000 that remains in the thirty-month time deposit product, if retained,will re-price in the next 12 months.

 

During the first six months of 2004, the Bank’s deposit mix, thoughconcentrated in time deposits, experienced a decline in most depositcategories.  Core deposits, whichexcludes time deposits of $100,000 or greater, decreased $13,729,000 or 5%during the first six months of 2004, to $274,856,000.  The Bank experienced a reduction in its transactional depositproducts which includes both DDA’s and NOW accounts.  Checking accounts which includes transactional accounts, less“bank checks”, decreased $5,794,000 or 6%, while savings and club accountsincreased $761,000 or 2%.  Money marketaccounts decreased minimally throughout 2004.

 

Time deposits of $100,000 or greater decreased $10,410,000, or 9%, from$112,857,000 million at December 31, 2003 to $102,448,000 at June 30,2004.  This high-costing time depositreduction occurred mostly from the run-off of thirty-month personal certificateof deposit accounts.  The time depositrun-off is suspected to have gone to other institutions offering promotionalshort-term, above market rate products, in which management believes a portionmay be recaptured later in 2004.  Totaltime deposits, at June 30, 2004, were $201,779,000 or 53% of totaldeposits compared to $221,595,000 million or 55% at December 31, 2003.  Approximately $67,816,000, or 34%, of totaltime deposits or 18% of total deposits are scheduled to mature in 2004.  These maturing time deposits provide anopportunity for the Bank to service these customers and retain these depositsat potentially lower rates.  The tieredmoney market deposit account along with the twenty-four and thirty-six monthSmart certificate of deposit accounts, which provides the customer the abilityto step up to a potentially higher rate at the one year anniversary, weresuccessful products that have captured part of these maturing deposits and

 

Public funds have been a somewhat stable source of deposits and nowrepresent $30,463,000 or 8% of total deposits at June 30, 2004 compared to$37,804,000 or 9% at December 31, 2003. The Bank is able to maintain public funds due to long establishedrelationships and competitive product pricing. However, Management recognizesthat public fund deposits are sensitive to the operating demands and businesscycles of the various public entities as well as the forever-changing politicallandscape.  As such, the Bank couldcontinue to experience shifts and outflows of these balances throughout theyear.

 

The Bank has begun implementation strategies with increased emphasis onexpansion of commercial and consumer relationships, with a goal to increaselower costing core deposits, curtail deposit outflows, retain maturing timedeposits and grow the deposit base to a higher level.  To maintain and grow the Bank’s asset size will be largelydependent upon deposit retention and new customer relationships.

 

*Borrowings*

 

Borrowings totaled $116,691,000 at June 30, 2004 compared to$126,633,000 at December 31, 2003.

 

Borrowings are used as a complement to deposit generation as analternative funding source.  The Bankwill Borrow from the Federal Home Loan Bank for asset growth and liquidityneeds.  Included in borrowings isshort-term customer repurchase (repos) agreements of $38,360,000 and$39,363,000, at June 30, 2004 and December 31, 2003, respectively.Repos are non-insured interest-bearing liabilities that have a securityinterest in qualified investment securities of the Bank.  Repos offered are either fixed-term or adaily-sweep product of the Bank.  Thebalance in customer repurchase agreements fluctuates daily because thedaily-sweep product is dependent on the level of available funds in depositoraccounts.  Borrowings also included$71,500,000 and $71,876,000 in long-term advances from the Federal Home LoanBank, at June 30, 2004 and December 31, 2003, respectively.

 

The combined short- and long-term weighted-average interest rate onborrowings was 3.77% and 3.39% at June 30, 2004 and December 31,2003, respectively.

 

23

----

 

*Accrued interestpayable and other liabilities*

 

Accrued expenses and other liabilities decreased $21,000 during thefirst six months of 2004 and represents fluctuations that would be considerednormal recurring operating transactions. Accrued interest payable decreased $167,000 while other liabilities andaccrued expenses increased $146,000.

 

**Item3.****                                         Quantitative and QualitativeDisclosure about Market Risk**

 

*Management ofinterest rate risk and market risk analysis*

 

The Company is subject to the interest rate risks inherent in ourlending, investing and financing activities. Fluctuations of interest rates will impact interest income and interestexpense along with affecting market values of all interest-earning assets andinterest-bearing liabilities, except for those assets or liabilities with ashort term remaining to maturity. Interest rate risk management is an integral part of the asset/liabilitymanagement process.  The Company hasinstituted certain procedures and policy guidelines to manage the interest raterisk position. Those internal policies enable the Company to react to changesin market rates to protect net interest income from significantfluctuations.  The primary objective inmanaging interest rate risk is to minimize the adverse impact of changes ininterest rates on net interest income along with creating an asset/liabilitystructure that maximizes earnings.

 

*Asset/LiabilityManagement*: One major objective of the Company whenmanaging the rate sensitivity of its assets and liabilities is to stabilize netinterest income.  The management of andauthority to assume interest rate risk is the responsibility of the Company’sAsset/Liability Committee (ALCO), which is comprised of senior management andBoard members.  ALCO meets quarterly tomonitor the ratio of interest sensitive assets to interest sensitiveliabilities.  The process to reviewinterest rate risk management is a regular part of management of theCompany.  Consistent policies andpractices of measuring and reporting interest rate risk exposure, particularlyregarding the treatment of non-contractual assets and liabilities, are ineffect.  In addition, there is an annualprocess to review the interest rate risk policy with the Board of Directorswhich includes limits on the impact to earnings from shifts in interest rates.

 

*Interest Rate RiskMeasurement:* Interest rate risk is monitored throughthe use of three complementary measures: static gap analysis, earnings at risk simulation and economic value atrisk simulation.  While each of theinterest rate risk measurements has limitations, taken together they representa reasonably comprehensive view of the magnitude of interest rate risk in theCompany and the distribution of risk along the yield curve, the level of riskthrough time and the amount of exposure to changes in certain interest raterelationships.

 

*Static Gap:*The ratio between assets and liabilities repricing in specific time intervalsis referred to as an interest rate sensitivity gap.  Interest rate sensitivity gaps can be managed to take advantageof the slope of the yield curve as well as forecasted changes in the level ofinterest rate changes.

 

To manage this interest rate sensitivity position, an asset/liabilitymodel called ‘cumulative gap analysis’ is used to monitor the difference in thevolume of the Company’s interest sensitive assets and liabilities that matureor reprice within given periods.  Apositive gap (asset sensitive) indicates that more assets reprice during agiven period compared to liabilities, while a negative gap (liabilitysensitive) has the opposite effect.  TheCompany employs computerized net interest income simulation modeling to assistin quantifying interest rate risk exposure. This process measures and quantifies the impact on net interest incomethrough varying interest rate changes and balance sheet compositions.  The use of this model assists the ALCO togauge the effects of the interest rate changes on interest sensitive assets andliabilities in order to determine what impact these rate changes will have uponthe net interest spread.

 

At June 30, 2004, the Company maintained a one-year cumulativepositive gap of $38,054 or 7.04% of total assets.  The effect of this gap position provided a positive mismatch ofassets and liabilities, which may expose the Bank to an increased interest raterisk position during a period of declining interest rates.  Conversely, in an increasing interest rateenvironment, net income could be positively affected because more assets willreprice during a one-year period.

 

24

----

 
|                                      |   | **Interest  sensitivity gap at June 30, 2004** |    |
|-------------------------------------------|--------|-----------------------------------------------------|---------|
|                                      |   | **3 months  or less**                               |    | **3 through  12 months** |   | **1 through  3 years** |   | **Over  3 years** |   | **Total** |   |
|                                      |   | **(dollars  in thousands)**                         |    |
|                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                 |   | $                                                   | 427     |   | $ | — |   | $ | — |   | $ | 11,533 |   | $ | 11,960 |   |
| Investment securities                     |   | 3,802                                               |    | 12,626 |   | 32,403 |   | 77,585 |   | 126,416 |   |
| Loans                                     |   | 121,412                                             |    | 97,266 |   | 81,297 |   | 76,916 |   | 376,891 |   |
| Fixed and other assets                    |   | —                                              |    | 7,455 |   | — |   | 17,899 |   | 25,354 |   |
| Total assets                              |   | $                                                   | 125,641 |   | $ | 117,347 |   | $ | 113,700 |   | $ | 183,933 |   | $ | 540,621 |   |
| Total cumulative assets                   |   | $                                                   | 125,641 |   | $ | 242,988 |   | $ | 356,688 |   | $ | 540,621 |   |   |   |
|                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Non interest-bearing transaction deposits |   | $                                                   | —  |   | $ | 6,596 |   | $ | 18,141 |   | $ | 41,231 |   | $ | 65,968 |   |
| Interest-bearing transaction deposits     |   | 5,620                                               |    | 51,969 |   | 41,786 |   | 10,182 |   | 109,557 |   |
| Time deposits                             |   | 31,281                                              |    | 64,755 |   | 93,330 |   | 12,413 |   | 201,779 |   |
| Repurchase agreements                     |   | 28,188                                              |    | 3,887 |   | 6,285 |   | — |   | 38,360 |   |
| Short-term borrowings                     |   | 6,830                                               |    | — |   | — |   | — |   | 6,830 |   |
| Long-term debt                            |   | 202                                                 |    | 5,606 |   | 1,616 |   | 64,076 |   | 71,500 |   |
| Other liabilities                         |   | —                                              |    | — |   | — |   | 3,187 |   | 3,187 |   |
| Total liabilities                         |   | $                                                   | 72,121  |   | $ | 132,813 |   | $ | 161,158 |   | $ | 131,089 |   | $ | 497,181 |   |
| Total cumulative liabilities              |   | $                                                   | 72,121  |   | $ | 204,934 |   | $ | 366,092 |   | $ | 497,181 |   |   |   |
|                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Interest sensitivity gap                  |   | $                                                   | 53,520  |   | $ | (15,466 | ) | $ | (47,458 | ) | $ | 52,844 |   |   |   |
|                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Cumulative gap                            |   | $                                                   | 53,520  |   | $ | 38,054 |   | $ | (9,404 | ) | $ | 43,440 |   |   |   |
|                                      |   |                                                |    |   |   |   |   |   |   |   |   |
| Cumulative gap to total assets            |   | 9.90                                                | %       | 7.04 | % | (1.74 | )% | 8.04 | % |   |   |

 

Investments and loans are included inthe earlier of the period in which interest rates were next scheduled to adjustor the period in which they are due.  Inaddition, loans were included in the periods in which they are scheduled to berepaid based on scheduled amortization. For amortizing loans and mortgage-backed securities, annual prepaymentrates are assumed reflecting historical experience as well as management’sknowledge of and experience with loan products.

 

The Bank’s demand and savings accounts weregenerally subject to immediate withdrawal. However, management considers a certain amount of such accounts to becore accounts having significantly longer effective maturities based on theretention experiences of such deposits in changing interest rateenvironments.  The effective maturitiespresented are the recommended maturity distribution limits for non-maturingdeposits based on historical deposit studies.

 

Certain shortcomings are inherent in themethod of analysis presented in the above table.  Although certain assets and liabilities may have similarmaturities or periods of repricing, they may react in different degrees tochanges in market interest rates.  Theinterest rates on certain types of assets and liabilities may fluctuate inadvance of changes in market interest rates, while interest rates on othertypes of assets and liabilities may lag behind changes in market interestrates.  Certain assets, such asadjustable-rate mortgages, have features which restrict changes in interestrates on a short-term basis and over the life of the asset.  In the event of a change in interest rates,prepayment and early withdrawal levels may deviate significantly from thoseassumed in calculating the table.  Theability of many borrowers to service their adjustable-rate debt may decrease inthe event of an interest rate increase.

 

*Earnings at Risk andEconomic Value at Risk Simulations:* The Companyrecognizes that more sophisticated tools exist for measuring the interest raterisk in the balance sheet beyond static gap analysis.  Although it will continue to measure its static gap position, theCompany utilizes additional modeling for identifying and measuring the interestrate risk in the overall balance sheet. The ALCO is responsible for focusing on “earnings at risk” and “economicvalue at risk”, and how both relate to the risk-based capital position whenanalyzing the interest rate risk.

 

*Earnings at Risk:*Earnings at risk simulation measure the change in net interest income and netincome should interest rates rise and fall. The simulation recognizes that not all assets and liabilities reprice ona one-for-one basis with market rates (e.g., savings rate).  The ALCO looks at “earnings at risk” todetermine income changes from a base case scenario under an increase anddecrease of 200 basis points in interest rates simulation model.

 

*Economic Value atRisk:* Earnings at risk simulation measure theshort-term risk in the balance sheet. Economic value (or portfolio equity) at risk measures the long-term riskby finding the net present value of the future cash flows from the Company’sexisting assets and liabilities.  TheALCO examines this ratio quarterly utilizing an increase and decrease of 200basis points in interest rates simulation model. The ALCO recognizes that, insome instances, this ratio may contradict the “earnings at risk” ratio.

 

25

----

 

The following table illustrates the simulated impact of 200 basispoints upward or downward movement in interest rates on net interest income,net income, and the change in economic value (portfolio equity).  This analysis assumed that interest-earningasset and interest-bearing liability levels at June 30, 2004 remainedconstant.  The impact of the rate movementswas developed by simulating the effect of rates changing over a twelve-month periodfrom the June 30, 2004 levels:

 
|                                                  |   | **Rates +200** |   | **Rates -200** |   |
|-------------------------------------------------------|--------|----------------|--------|----------------|--------|
|                                                  |   |           |   |           |   |
| Earnings at risk:                                     |   |           |   |           |   |
| Percent change in:                                    |   |           |   |           |   |
| Net interest income                                   |   | 9.1            | %      | (21.4          | )%     |
| Net income                                            |   | 25.1           |   | (58.3          | )      |
|                                                  |   |           |   |           |   |
| Economic value at risk:                               |   |           |   |           |   |
| Percent change in:                                    |   |           |   |           |   |
| Economic value of equity                              |   | (21.6          | )      | (16.9          | )      |
| Economic value of equity as a percent of  book assets |   | (2.1           | )      | (1.7           | )      |

 

Economic value has the most meaning when viewed within the context ofrisk-based capital.  Therefore, theeconomic value may change beyond the Company’s policy guideline for a shortperiod of time as long as the risk-based capital ratio, after adjusting for theexcess equity exposure, is greater than 10%.

 

The table below summarizes estimated changes in net interest incomeover a twelve-month period beginning July 1, 2004, under alternateinterest rate scenarios using the income simulation model described above:

 
| **Change in interest rates** |   | **Net  interest  income**   |   | **Dollar  variance** |   | **Percent  change** |   |
|------------------------------|--------|-----------------------------|--------|----------------------|--------|---------------------|--------|
|                         |   | **(dollars  in thousands)** |   |                 |   |
|                         |   |                        |   |                 |   |                |   |
| +200 basis points            |   | $                           | 18,978 |                 | $      | 1,576               |   | 9.1 | % |
| +100 basis points            |   | 18,168                      |   | 766                  |   | 4.4                 | %      |
| Flat rate                    |   | 17,402                      |   | —               |   | —              |   |
| -100 basis points            |   | 15,909                      |   | (1,493               | )      | (8.6                | )%     |
| -200 basis points            |   | 13,686                      |   | (3,716               | )      | (21.4               | )%     |
|                              |        |                             |        |                      |        |                     |        |  |  |

 

Simulation models require assumptions about certain categories ofassets and liabilities. The models schedule existing assets andliabilities by their contractual maturity, estimated likely call date, orearliest repricing opportunity. Mortgage-backed securities and amortizing loansare scheduled based on their anticipated cash flow including estimatedprepayments. For investment securities, we use a third party service to providecash flow estimates in the various rate environments. Savings accounts,including passbook, statement savings, money market, and interest checkingaccounts, do not have a stated maturity or repricing term and can be withdrawnor reprice at any time. This may impact the margin if more expensivealternative sources of deposits are required to fund loans or deposit runoff.  Management projects the repricingcharacteristics of these accounts based on historical performance andassumptions that it believes reflect their rate sensitivity. The consultingmodel reinvests all maturities, repayments and prepayments for each type ofasset or liability into the same product for a new like term then appliesgrowth or run-off estimates provided by management. As a result, the mix ofinterest-earning assets and interest bearing-liabilities is not held constant.

 

*Liquidity*

 

Liquidity management ensures that adequatefunds will be available to meet customers’ needs for borrowings, depositwithdrawals and maturities and normal operating expenses of the Bank.  Current sources of liquidity are cash andcash equivalents, asset maturities and pay downs within one year, loans andinvestments available-for-sale, growth of core deposits, growth of repurchaseagreements, increase of other borrowed funds from correspondent banks andissuance of capital stock.  Inaddition, the Bank’s other sources of liquidity are borrowings from the FederalReserve Discount Window and Federal Home Loan Bank advances.  Although regularly scheduled investment and loan payments aredependable sources of daily funds, the sale of loans and investment securities

 

26

----

 

available-for-sale, deposit activity, andinvestment and loan prepayments are significantly influenced by generaleconomic conditions and the level of interest rates.

 

At June 30, 2004, the Companymaintained $12.0 million in cash and cash equivalents.  In addition, the Company had $1.3 million ofloans available-for-sale and $123.0 million in investmentsavailable-for-sale.  This combined totalof $136.3 million represented 25% of total assets at June 30, 2004.  Management believes that the present levelof liquidity adequate for current operations.

 

*Capital*

 

The Company is subject to various regulatory capital requirementsadministered by the federal banking agencies. Failure to meet minimum capitalrequirements can initiate certain mandatory and possible additionaldiscretionary actions by regulators that, if undertaken, could have a directmaterial effect on the Company’s financial statements. Under capital adequacyguidelines and the regulatory framework for prompt corrective action, theCompany must meet specific capital guidelines that involve quantitativemeasures of the Company’s assets, liabilities, and certain off-balance-sheetitems as calculated under regulatory accounting practices. The Company’scapital amounts and classification are also subject to qualitative judgments bythe regulators about components, risk weightings, and other factors.

 

Capital is fundamental to support our continued growth. In addition,the Company and Bank are subject to various regulatory capital requirements.Regulatory capital is defined in terms of Tier 1 capital (shareholders’ equityplus the allowable portion of the minority interest in equity of subsidiaries,minus unrealized gains or plus unrealized losses on available for salesecurities, and minus certain intangible assets), Tier 2 capital (whichincludes the allowable portion of the allowance for loan losses, minorityinterest in equity of subsidiaries and subordinated debt), and total capital(Tier 1 plus Tier 2). Risk-based capital ratios are expressed as percentages ofrisk-weighted assets. Risk-weighted assets are determined by assigning variousweights to all assets and off-balance sheet financial instruments, such asletters of credit and loan commitments, based on associated risk. Regulatorshave also adopted minimum Tier 1 leverage ratio standards, which measure theratio of Tier 1 capital to total average quarterly assets.

 

Quantitative measures, established by regulation to ensure capitaladequacy, require the Company to maintain minimum amounts and ratios (set forthin the following table as defined in the regulations) of total and Tier Icapital to risk-weighted assets, and of Tier I capital to average assets.  Capital is evaluated in relation to totalassets and the risk associated with those assets.  As of June 30, 2004, the Company meets all capital adequacyrequirements to which it is subject. Both the Company’s and the Bank’s actual capital amounts and ratios arepresented.

 
|                      |   | **Actual** |       | **For  capital  adequacy purposes** |   | **To be well  capitalized  under prompt corrective  action provisions** |   |
|---------------------------|--------|------------|------------|-------------------------------------|--------|-------------------------------------------------------------------------|--------|
|                      |   | **Amount** |       | **Ratio**                           |   | **Amount**                                                              |   | **Ratio** |   | **Amount** |   | **Ratio** |   |
|                      |   |       |       |                                |   |                                                                    |   |   |   |   |   |   |   |
| Total capital             |   |       |       |                                |   |                                                                    |   |   |   |   |   |   |   |
| (to risk-weighted assets) |   |       |       |                                |   |                                                                    |   |   |   |   |   |   |   |
| Consolidated              |   | $          | 49,841,204 |                                | 13.56  | %                                                                       | $      | 29,402,386 |   | 8.00 | % | N/A |   | N/A |   |
| Bank                      |   | $          | 49,511,271 |                                | 13.49  | %                                                                       | $      | 29,369,597 |   | 8.00 | % | $ | 36,711,996 |   | 10.00 | % |
| Tier 1 capital            |   |       |       |                                |   |                                                                    |   |   |   |   |   |   |   |
| (to risk-weighted assets) |   |       |       |                                |   |                                                                    |   |   |   |   |   |   |   |
| Consolidated              |   | $          | 45,155,912 |                                | 12.29  | %                                                                       | $      | 14,701,193 |   | 4.00 | % | N/A |   | N/A |   |
| Bank                      |   | $          | 44,896,307 |                                | 12.23  | %                                                                       | $      | 14,684,799 |   | 4.00 | % | $ | 22,027,198 |   | 6.00 | % |
| Tier 1 Capital            |   |       |       |                                |   |                                                                    |   |   |   |   |   |   |   |
| (to average assets)       |   |       |       |                                |   |                                                                    |   |   |   |   |   |   |   |
| Consolidated              |   | $          | 45,155,912 |                                | 8.19   | %                                                                       | $      | 22,065,349 |   | 4.00 | % | N/A |   | N/A |   |
| Bank                      |   | $          | 44,896,307 |                                | 8.14   | %                                                                       | $      | 22,051,255 |   | 4.00 | % | $ | 27,564,069 |   | 5.00 | % |

 

27

----

 

**Item4.****                                         Controls and Procedures**

 

The Company maintains controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Based upon their evaluation of those controls and procedures as of the end of the period covered by this report, the Chief Operating and Chief Financial Officers of the Company concluded that the Company’s disclosure controls and procedures were adequate.

 

**PART II. Other Information**

 

**Item1.****                                         Legal Proceedings**

 

The nature of the Company’sbusiness generates some litigation involving matters arising in the ordinarycourse of business. However, in the opinion of the Company, after consulting with legal counsel, nolegal proceedings are pending, which, if determined adversely to the Company orthe Bank, would have a material effect on the Company’s undivided profits orfinancial condition.  No legalproceedings are pending other than ordinary routine litigation incidental tothe business of the Company and the Bank. In addition, to management’s knowledge, no governmental authorities haveinitiated or contemplated any material legal actions against the Company or theBank its properties.

 

**Item  2.****                                      Changes in Securities, Use ofProceeds and Issuer Purchases of Equity Securities**

 

None

 

**Item 3.****                                         Defaultupon Senior Securities**

 

None

 

**Item4.****                                         Submissionof Matters to a Vote by Security Holders**

 

At the annual meeting of shareholders held on May 4, 2004, the judgesof election made the report concerning the results of balloting.  Holders of 1,419,390 shares of common stock,representing 77.6% of the total number of shares outstanding, were representedin person or by proxy at the 2004 annual meeting of shareholders.  The following votes were cast:

 

Election of Class C Directors to serve for a three-year term:

 
|               |   | **For**   |   | **Withhold  Authority** |   | **Abstain** |   |
|--------------------|--------|-----------|--------|-------------------------|--------|-------------|--------|
| Brian J. Cali      |   | 1,379,461 |   | 39,929                  |   | -0-         |   |
| Patrick J. Dempsey |   | 1,386,560 |   | 32,830                  |   | -0-         |   |

 

Ratification of independent certified public accountants:

 
|                 |   | **For**   |   | **Against** |   | **Abstain** |   |
|----------------------|--------|-----------|--------|-------------|--------|-------------|--------|
| Parente Randolph, PC |   | 1,397,937 |   | 11,437      |   | 10,016      |   |

 

**Item 5.****                                         OtherInformation**

 

None

 

28

----

 

**Item6.****                                         Exhibits and Reports on Form 8-K**

 

a)              Exhibits

 
| ***3(i)***  |   | ***Amended and  Restated Articles of Incorporation of Registrant.***Incorporated  by reference to Exhibit 3(i) to Registrant’s Registration Statement No.  333-90273 on Form S-4, filed with the SEC on November 3, 1999 and as  amended on April 6, 2000.                                                                                |
|-------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| ***3(ii)*** |   | ***Bylaws of  Registrant.***Incorporated by reference to Exhibit  3(ii) to Registrant’s Registration Statement No. 333-90273 on Form S-4, filed  with the SEC on November 3, 1999 and as amended on April 6, 2000.                                                                                                                        |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| ***10.1***  |   | ***1998 Independent  Directors Stock Option Plan of The Fidelity Deposit and Discount Bank, as  assumed by Registrant.***Incorporated by reference  to Exhibit 10.1 to Registrant’s Registration Statement No. 333-90273 on Form  S-4, filed with the SEC on November 3, 1999 and as amended on  April 6, 2000.                           |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| ***10.2***  |   | ***1998 Stock  Incentive Plan of The Fidelity Deposit and Discount Bank, as assumed by  Registrant.***Incorporated by reference to Exhibit  10.2 of Registrant’s Registration Statement No. 333-90273 on Form S-4, filed  with the SEC on November 3, 1999 and as amended on April 6, 2000.                                               |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| ***10.3***  |   | ***Form of Deferred Compensation  Plan of The Fidelity Deposit and Discount Bank.***Incorporated  by reference to Exhibit 10.3 to Registrant’s Registration Statement  No.333-45668 on Form S-1, filed with the SEC on September 12, 2000 and  as amended on October 11, 2000.                                                            |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| ***10.4***  |   | ***Registrant’s 2000  Dividend Reinvestment Plan.***Incorporated by  reference to Exhibit 4 to Registrant’s Registration Statement No. 333-45668  on Form S-1, filed with the SEC on September 12, 2000 and as amended by  Pre-Effective Amendment No. 1 on October 11, 2000 and by Post-Effective  Amendment No. 1 on May 30, 2001. |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| ***10.5***  |   | ***Registrant’s 2000  Independent Directors Stock Option Plan.***Incorporated  by reference to Exhibit 4.3 to Registrant’s Registration Statement No.  333-64356 on Form S-8 filed with the SEC on July 2, 2001.                                                                                                                          |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| ***10.6***  |   | ***Registrant’s 2000  Stock Incentive Plan***. Incorporated by reference  to Exhibit 4.4 to Registrant’s Registration Statement No. 333-64356 on Form  S-8 filed with the SEC on July 2, 2001.                                                                                                                                            |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| ***10.7***  |   | ***Registrant’s 2002 Employee Stock Purchase Plan.***Incorporated by reference to  Exhibit 4.5 to Registrant’s Registration Statement No. 333-113339 on Form S-8  filed with the SEC on March 5, 2004 and Appendix A to Registrant’s  Definitive Proxy Statement filed with the SEC on March 28, 2002.                          |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| ***10.***8  |   | ***Employment  Agreement between Registrant, The Fidelity Deposit and Discount Bank and  Steven C. Ackmann, dated June 21, 2004.***Incorporated  by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed  with the SEC on June 24, 2004.                                                                            |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| ***10.9***  |   | ***Complete  Settlement Agreement and General Release between Michael F. Marranca,  Registrant and The Fidelity Deposit and Discount Bank, dated July30, 2004.*** Incorporated by reference to Exhibit 99.1  to Registrant’s Current Report on Form 8-K filed with the SEC on  August 10, 2004.                                           |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| ***11***    |   | ***Statement  regarding computation of earnings per share.***Included  herein in Note 2 “Earnings per Share”, contained within the Notes to  Consolidated Financial Statements, and incorporated herein by reference.                                                                                                                          |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| ***31.1***  |   | ***Rule 13a-14(a)  Certification of Principal Executive Officer, filed herewith.***                                                                                                                                                                                                                                                                      |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| ***31.2***  |   | ***Rule 13a-14(a)  Certification of Principal Financial Officer, filed herewith.***                                                                                                                                                                                                                                                                      |
|        |   |                                                                                                                                                                                                                                                                                                                                                     |
| ***32.1***  |   | ***Certification of  Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed  herewith.***                                                                                                                                                                |

 

29

----

 
| ***32.2*** |   | ***Certification of  Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed  herewith.*** |
|------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

b)             Current Reports on Form 8-K filed by theRegistrant during the quarter ended June 30, 2004:

 

On June 22, 2004, Fidelity D&D Bancorp, Inc. announced thehiring of Steven C. Ackmann as President and Chief Executive Officer of itswholly owned subsidiary, The Fidelity Deposit and Discount Bank.  An employment agreement was included withthe Form 8-K filing of June 24, 2004, by exhibit thereto.

 

30

----

 

**FIDELITYD&D BANCORP, INC.**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Company has caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
|                       | **FIDELITY D&D BANCORP, INC.**                       |
|----------------------------|----------------------------------------------------------|
|                       |                                                     |
|                       |                                                     |
| Date: August 13, 2004 | /s/ Daniel J. Santaniello                                |   |
|                       |   Daniel J. Santaniello,                       |
|                       | Vice President and Chief Operating Officer               |
|                       |                                                     |
|                       |                                                     |
| Date: August 13, 2004 | /s/ Salvatore R. DeFrancesco, Jr.                        |   |
|                       |  Salvatore R. DeFrancesco, Jr.,                     |
|                       |    Treasurer and Chief  Financial Officer |
|                            |                                                          |  |  |

 

31

----

 

**FIDELITYD&D BANCORP, INC.**

 

Exhibit Index

 
|        |   |                                                                                                                                                                                                                                                                                                                                                       | **Page** |    |
|-------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|---------|
|        |   |                                                                                                                                                                                                                                                                                                                                                       |     |    |
| ***3(i)***  |   | ***Amended and  Restated Articles of Incorporation of Registrant.***  Incorporated by reference to Exhibit 3(i) to Registrant’s Registration  Statement No. 333-90273 on Form S-4, filed with the SEC on November 3,  1999 and as amended on April 6, 2000.                                                                                 |     | ******* |
|        |   |                                                                                                                                                                                                                                                                                                                                                       |     |    |
| ***3(ii)*** |   | ***Bylaws of  Registrant***. Incorporated by reference to Exhibit  3 (ii) to Registrant’s Registration Statement No. 333-90273 on Form S-4,  filed with the SEC on November 3, 1999 and as amended on April 6,  2000.                                                                                                                       |     | ******* |
|        |   |                                                                                                                                                                                                                                                                                                                                                       |     |    |
| ***10.1***  |   | ***1998 Independent  Directors Stock Option Plan of The Fidelity Deposit and Discount Bank, as  assumed by Registrant.*** Incorporated by reference  to Exhibit 10.1 to Registrant’s Registration Statement No. 333-90273 on Form  S-4, filed with the SEC on November 3, 1999 and as amended on  April 6, 2000.                            |     | ******* |
|        |   |                                                                                                                                                                                                                                                                                                                                                       |     |    |
| ***10.2***  |   | ***1998 Stock  Incentive Plan of The Fidelity Deposit and Discount Bank, as assumed by  Registrant.***Incorporated by reference to Exhibit  10.2 of Registrant’s Registration Statement No. 333-90273 on Form S-4, filed  with the SEC on Nov. 3, 1999 and as amended on April 6, 2000.                                                          |     | ******* |
|        |   |                                                                                                                                                                                                                                                                                                                                                       |     |    |
| ***10.3***  |   | ***Form of Deferred  Compensation Plan of The Fidelity Deposit and Discount Bank.***Incorporated  by reference to Exhibit 10.3 to Registrant’s Registration Statement No.  333-45668 on Form S-1, filed with the SEC on September 12, 2000 and as  amended on October 11, 2000.                                                             |     | ******* |
|        |   |                                                                                                                                                                                                                                                                                                                                                       |     |    |
| ***10.4***  |   | ***Registrant’s 2000  Dividend Reinvestment Plan****.*Incorporated by  reference to Exhibit 4 to Registrant’s Registration Statement No. 333-45668  on Form S-1, filed with the SEC on September 12, 2000 and as amended by  Pre-Effective Amendment No. 1 on October 11, 2000 and by Post-Effective  Amendment No. 1 on May 30, 2001. |     | ******* |
|        |   |                                                                                                                                                                                                                                                                                                                                                       |     |    |
| ***10.5***  |   | ***Registrant’s 2000  Independent Directors Stock Option Plan.***Incorporated  by reference to Exhibit 4.3 to Registrant’s Registration Statement No.  333-64356 on Form S-8 filed with the SEC  on July 2, 2001.                                                                                                                      |     | ******* |
|        |   |                                                                                                                                                                                                                                                                                                                                                       |     |    |
| ***10.6***  |   | ***Registrant’s 2000  Stock Incentive Plan.***Incorporated by reference  to Exhibit 4.4 to Registrant’s Registration Statement No. 333-64356 on Form  S-8 filed with the SEC on July 2, 2001.                                                                                                                                               |     | ******* |

 

32

----

 
| ***10.7*** |   | ***Registrants’s2002  Employee Stock Purchase Plan.***Incorporated by  reference to Exhibit 4.5 to Registrant’s Registration Statement No.  333-113339 on Form S-8 filed with the SEC on March 5, 2004.                                                                                         |     | *      |
|------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|--------|
|       |   |                                                                                                                                                                                                                                                                                                           |     |   |
| ***10.8*** |   | ***Employment  Agreement between Registrant, The Fidelity Deposit and Discount Bank and  Steven C. Ackmann, dated June 21, 2004****.*Incorporated  by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed  with the SEC on June 24, 2004*.*                              |     | *      |
|       |   |                                                                                                                                                                                                                                                                                                           |     |   |
| ***10.9*** |   | ***Complete  Settlement Agreement and General Release between Michael F. Marranca, Registrant  and The Fidelity Deposit and Discount Bank, dated July 30, 2004.***Incorporated  by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed  with the SEC on August 10, 2004. |     | *      |
|       |   |                                                                                                                                                                                                                                                                                                           |     |   |
| ***11***   |   | ***Statement  regarding computation of earnings per share***.  Included herein.                                                                                                                                                                                                                                | ***8***  |   |
|       |   |                                                                                                                                                                                                                                                                                                           |     |   |
| ***14***   |   | ***Code of Ethics.***Incorporated  by reference to Exhibit 14 to Registrant’s 2003 Annual Report filed on form  10K filed with the SEC on March 29, 2004*.*                                                                                                                                          |     | *      |
|       |   |                                                                                                                                                                                                                                                                                                           |     |   |
| ***31.1*** |   | ***Rule 13a-14(a)  Certification of Principal Executive Officer.***                                                                                                                                                                                                                                            | ***34*** |   |
|       |   |                                                                                                                                                                                                                                                                                                           |     |   |
| ***31.2*** |   | ***Rule 13a-14(a)  Certification of Principal Financial Officer.***                                                                                                                                                                                                                                            | ***35*** |   |
|       |   |                                                                                                                                                                                                                                                                                                           |     |   |
| ***32.1*** |   | ***Certification of  Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.***                                                                                                                                       | ***36*** |   |
|       |   |                                                                                                                                                                                                                                                                                                           |     |   |
| ***32.2*** |   | ***Certification of  Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.***                                                                                                                                       | ***37*** |   |

 

----

*******-Incorporated by Reference

 

33

----