**FORM 10-Q**

 

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C.  20549**

 

**QUARTERLY REPORT UNDER SECTION 13OR 15(d)**

**OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the quarter ended****September 30, 2005**

** **

**Commission file number:  2-89573**

 

**TOWER BANCORP INC.**

(Exact name of registrant as specified in itscharter)

 
| **Commonwealth of Pennsylvania**                                                              | ** ** | **25-1445946**      |
|-----------------------------------------------------------------------------------------------|------------|---------------------|
| (State or other  jurisdiction of                                                              |       | (I.R.S. Employer    |
| incorporation or  organization)                                                               |       | Identification No.) |
|                                                                                          |       |                |
| **Center Square**                                                                             | ** ** | ** **          |
| **Greencastle, Pennsylvania**                                                                 | ** ** | **17225**           |
| (Address of principal  executive offices)                                                     |       | (Zip Code)          |
|                                                                                          |       |                |
| Registrant’s telephone number, including area code:    **(717) 597-2137** |

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes    ý        No    o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act)

 

Yes    o        No    ý

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).

 

Yes    o        No    ý

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

 

1,727,782shares of common stock outstanding at September 30, 2005

 

Page 1 of 34

 

 

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TOWER BANCORP, INC.

 

INDEX

 
| ** **                                                                                                            | **Page**  |
|-----------------------------------------------------------------------------------------------------------------------|-----------|
|                                                                                                                  |      |
| PART I - FINANCIAL INFORMATION                                                                                   |      |
|                                                                                                                  |      |
| Item 1 -  Financial Statements                                                                                        |      |
| Condensed  consolidated balance sheets – September 30, 2005 and December 31,  2004                     | 4         |
| Condensed  consolidated statements of income - three months ended September 30,  2005 and 2004                   | 5         |
| Condensed  consolidated statements of income - nine months ended September 30, 2005  and 2004                    | 6         |
| Condensed  consolidated statements of comprehensive income – nine months ended  September 30, 2005 and 2004 | 7         |
| Condensed  consolidated statements of cash flows – nine months ended September 30,  2005 and 2004           | 8         |
| Notes  to condensed consolidated financial statements                                                                 | 9  and 10 |
| Item 2 - Management’s discussion and analysis of  financial condition and results of operations                  | 11 - 22   |
| Item 3 - Quantitative and  qualitative disclosures about market risk                                                  | 23        |
| Item 4 - Controls and procedures                                                                                      | 23        |
|                                                                                                                  |      |
| PART II - OTHER INFORMATION                                                                                      | 24        |
|                                                                                                                  |      |
| Item 1 – Legal proceedings                                                                                       | 25        |
| Item 2 – Unregistered sales  of equity securities and use of proceeds                                            | 25        |
| Item 3 – Defaults upon  senior securities                                                                        | 25        |
| Item 4 – Submission of  matters to a vote of security holders                                                    | 25        |
| Item 5 – Other information                                                                                       | 26        |
| Item 6 – Index to Exhibits                                                                                       | 26        |
|                                                                                                                  |      |
| Signatures                                                                                                            | 28        |
|                                                                                                                  |      |
| Exhibits                                                                                                              | 28 - 34   |

 

Page 2 of 34

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PART I - FINANCIALINFORMATION

 

Page 3 of 34

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TOWER BANCORP, INC. AND ITS WHOLLY-OWNEDSUBSIDIARY

 

CONDENSEDCONSOLIDATED BALANCE SHEETS

 
| ** **                                                                         | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                         | ** ** | **(Unaudited)**              | ** ** | **(Audited)***              | ** ** |
| ** **                                                                         | ** ** | **(000 Omitted)**            | ** ** |
| ASSETS                                                                             |       |                         |       |                        |       |
| Cash and due  from banks                                                           |       | $                            | 11,336     |                        | $          | 10,045 |   |
| Federal funds  sold                                                                |       | 1,475                        |       | $                           | 0          |   |
| Interest bearing  balances with banks                                              |       | 3,057                        |       | 196                         |       |
| Investment  securities available for sale                                          |       | 85,593                       |       | 62,871                      |       |
| Restricted bank  stock                                                             |       | 2,484                        |       | 2,858                       |       |
| Loans                                                                              |       | 230,103                      |       | 229,469                     |       |
| Less: reserve  for possible loan losses                                            |       | (2,103                       | )          | (1,902                      | )          |
| Bank premises,  equipment, furniture and fixtures                                  |       | 4,117                        |       | 4,030                       |       |
| Accrued interest  receivable                                                       |       | 1,232                        |       | 904                         |       |
| Cash surrender  value of life insurance                                            |       | 7,296                        |       | 7,070                       |       |
| Other assets                                                                       |       | 2,498                        |       | 1,349                       |       |
| Total assets                                                                       |       | $                            | 347,088    |                        | $          | 316,890 |   |
|                                                                               |       |                         |       |                        |       |
| LIABILITIES AND CAPITAL                                                            |       |                         |       |                        |       |
| Deposits in  domestic offices:                                                     |       |                         |       |                        |       |
| Demand                                                                             |       | $                            | 27,251     |                        | $          | 23,944 |   |
| Savings                                                                            |       | 145,069                      |       | 122,625                     |       |
| Time                                                                               |       | 83,399                       |       | 83,721                      |       |
| Federal funds  purchased                                                           |       | 0                            |       | 225                         |       |
| Liabilities for  borrowed money                                                    |       | 37,293                       |       | 34,707                      |       |
| Accrued interest  payable                                                          |       | 327                          |       | 265                         |       |
| Other  liabilities                                                                 |       | 6,483                        |       | 7,332                       |       |
| Total  liabilities                                                                 |       | 299,822                      |       | 272,819                     |       |
|                                                                               |       |                         |       |                        |       |
| EQUITY CAPITAL                                                                     |       |                         |       |                        |       |
| Capital stock,  common, authorized 5,000,000 shares; 1,780,100 shares issued       |       | 2,225                        |       | 2,225                       |       |
| Additional  paid-in capital                                                        |       | 6,791                        |       | 6,782                       |       |
| Retained  earnings                                                                 |       | 30,594                       |       | 28,177                      |       |
| Accumulated  other comprehensive income                                            |       | 9,426                        |       | 8,801                       |       |
| Less: cost of  treasury stock; 2005– 52,318 shares; 2004 – 58,109 shares |       | (1,770                       | )          | (1,914                      | )          |
| Total equity  capital                                                              |       | 47,266                       |       | 44,071                      |       |
|                                                                               |       |                         |       |                        |       |
| Total  liabilities and capital                                                     |       | $                            | 347,088    |                        | $          | 316,890 |   |

 

----

* Condensed fromaudited financial statements.

 

The accompanying notes are an integral partof these

condensed financial statements.

 

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TOWER BANCORP, INC. AND ITS WHOLLY-OWNEDSUBSIDIARY

 

CONDENSEDCONSOLIDATED STATEMENTS OF INCOME

THREE MONTHS ENDED SEPTEMBER 30, 2005AND 2004

(UNAUDITED)

 
| ** **                                            | ** ** | **2005**          | ** ** | **2004**  | ** ** |
|-------------------------------------------------------|------------|-------------------|------------|-----------|------------|
| ** **                                            | ** ** | **(000 Omitted)** | ** ** |
| Interest Income                                       |       |              |       |      |       |
| Interest &  fees on loans                    |       | $                 | 3,605      |      | $          | 3,055 |   |
| Interest on  investment securities available for sale |       | 657               |       | 494       |       |
| Interest on  deposits with banks                      |       | 74                |       | 8         |       |
| Total  interest & dividend income            |       | 4,336             |       | 3,557     |       |
| Interest Expense                                      |       |              |       |      |       |
| Interest on  deposits                                 |       | 960               |       | 585       |       |
| Interest on  borrowed money                           |       | 449               |       | 465       |       |
| Total interest  expense                               |       | 1,409             |       | 1,050     |       |
|                                                  |       |              |       |      |       |
| Net interest  income                                  |       | 2,927             |       | 2,507     |       |
| Provision for loan losses                             |       | 60                |       | 90        |       |
|                                                  |       |              |       |      |       |
| Net interest income after provision for loan losses   |       | 2,867             |       | 2,417     |       |
|                                                  |       |              |       |      |       |
| Other Income                                          |       |              |       |      |       |
| Investment  service income                            |       | 71                |       | (6        | )          |
| Service charges  on deposit accounts                  |       | 305               |       | 276       |       |
| Other service  charges                                |       | 201               |       | 114       |       |
| Other operating  income                               |       | 80                |       | 113       |       |
| Investment  securities gains (losses)                 |       | 773               |       | 287       |       |
| Total other  income                                   |       | 1,430             |       | 784       |       |
|                                                  |       |              |       |      |       |
| Other Expense                                         |       |              |       |      |       |
| Salaries, wages  and other benefits                   |       | 1,140             |       | 986       |       |
| Occupancy and  equipment expense                      |       | 282               |       | 257       |       |
| Other operating  expenses                             |       | 870               |       | 755       |       |
| Total other  expenses                                 |       | 2,292             |       | 1,998     |       |
|                                                  |       |              |       |      |       |
| Income before  taxes                                  |       | 2,005             |       | 1,203     |       |
| Applicable income taxes                               |       | 553               |       | 309       |       |
| Net income                                            |       | $                 | 1,452      |      | $          | 894 |   |
|                                                  |       |              |       |      |       |
| Earnings per share:                                   |       |              |       |      |       |
| Basic Earnings per share                              |       | $                 | 0.84       |      | $          | 0.52 |   |
|                                                  |       |              |       |      |       |
| Weighted average shares outstanding                   |       | 1,728,274         |       | 1,724,023 |       |
|                                                  |       |              |       |      |       |
| Diluted Earnings per share                            |       | $                 | 0.82       |      | $          | 0.51 |   |
|                                                  |       |              |       |      |       |
| Weighted Average Shares Outstanding                   |       | 1,759,207         |       | 1,751,983 |       |

 

The accompanying notes are an integral partof these

condensed financial statements.

 

Page 5 of 34

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TOWER BANCORP, INC. AND ITS WHOLLY-OWNEDSUBSIDIARY

 

CONDENSEDCONSOLIDATED STATEMENTS OF INCOME

NINE MONTHS ENDED SEPTEMBER 30, 2005 AND2004

(UNAUDITED)

 
| ** **                                            | ** ** | **2005**           | ** ** | **2004**  | ** ** |
|-------------------------------------------------------|------------|--------------------|------------|-----------|------------|
| ** **                                            | ** ** | **(000 Ommitted)** | ** ** |
| Interest Income                                       |       |               |       |      |       |
| Interest &  fees on loans                    |       | $                  | 10,241     |      | $          | 8,913 |   |
| Interest on  investment securities available for sale |       | 1,676              |       | 1,544     |       |
| Interest on  deposits with banks                      |       | 139                |       | 32        |       |
| Total  interest & dividend income            |       | 12,056             |       | 10,489    |       |
| Interest Expense                                      |       |               |       |      |       |
| Interest on  deposits                                 |       | 2,418              |       | 1,680     |       |
| Interest on  borrowed money                           |       | 1,304              |       | 1,341     |       |
| Total interest  expense                               |       | 3,722              |       | 3,021     |       |
|                                                  |       |               |       |      |       |
| Net interest  income                                  |       | 8,334              |       | 7,468     |       |
|                                                  |       |               |       |      |       |
| Provision for loan losses                             |       | 210                |       | 270       |       |
|                                                  |       |               |       |      |       |
| Net interest income after provision for loan losses   |       | 8,124              |       | 7,198     |       |
|                                                  |       |               |       |      |       |
| Other Income                                          |       |               |       |      |       |
| Investment  service income                            |       | 178                |       | 34        |       |
| Service charges  on deposit accounts                  |       | 819                |       | 728       |       |
| Other service  charges                                |       | 481                |       | 324       |       |
| Other operating  income                               |       | 240                |       | 344       |       |
| Investment  securities gains (losses)                 |       | 1,574              |       | 1,432     |       |
| Total other  income                                   |       | 3,292              |       | 2,862     |       |
|                                                  |       |               |       |      |       |
| Other Expense                                         |       |               |       |      |       |
| Salaries, wages  and other benefits                   |       | 3,308              |       | 3,054     |       |
| Occupancy and  equipment expense                      |       | 840                |       | 759       |       |
| Other operating  expenses                             |       | 2,330              |       | 2,241     |       |
| Total other  expenses                                 |       | 6,478              |       | 6,054     |       |
|                                                  |       |               |       |      |       |
| Income before  taxes                                  |       | 4,938              |       | 4,006     |       |
| Applicable income taxes                               |       | 1,345              |       | 1,047     |       |
| Net income                                            |       | $                  | 3,593      |      | $          | 2,959 |   |
|                                                  |       |               |       |      |       |
| Earnings per share:                                   |       |               |       |      |       |
| Basic Earnings per share                              |       | $                  | 2.08       |      | $          | 1.71 |   |
|                                                  |       |               |       |      |       |
| Weighted average shares outstanding                   |       | 1,726,899          |       | 1,729,788 |       |
|                                                  |       |               |       |      |       |
| Diluted Earnings per share                            |       | $                  | 2.05       |      | $          | 1.68 |   |
|                                                  |       |               |       |      |       |
| Weighted Average Shares Outstanding                   |       | 1,758,483          |       | 1,758,053 |       |

 

The accompanying notes are an integral partof these

condensed financial statements.

 

Page 6  of 34

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TOWER BANCORP, INC. AND ITS WHOLLY-OWNEDSUBSIDIARY

 

CONDENSEDCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

NINE MONTHS ENDED SEPTEMBER 30, 2005 AND2004

(UNAUDITED)

 
| ** **                                                    | ** ** | **2005**          | ** ** | **2004** | ** ** |
|---------------------------------------------------------------|------------|-------------------|------------|----------|------------|
| ** **                                                    | ** ** | **(000 Omitted)** | ** ** |
|                                                          |       |              |       |     |       |
| Net income                                                    |       | $                 | 3,593      |     | $          | 2,959 |   |
|                                                          |       |              |       |     |       |
| Other  comprehensive income:                                  |       |              |       |     |       |
| Unrealized  holding gains (losses)                            |       | 2,521             |       | 2,523    |       |
|                                                          |       |              |       |     |       |
| Reclassification adjustment for gains realized in  net income |       | (1,574            | )          | (1,432   | )          |
|                                                          |       |              |       |     |       |
|                                                          |       | 947               |       | 1,091    |       |
|                                                          |       |              |       |     |       |
| Tax effect                                                    |       | (322              | )          | (371     | )          |
|                                                          |       |              |       |     |       |
| Other comprehensive income                                    |       | 625               |       | 720      |       |
|                                                          |       |              |       |     |       |
| Comprehensive income                                          |       | $                 | 4,218      |     | $          | 3,679 |   |

 

The accompanying notes are an integral partof these

condensed financial statements.

 

Page 7 of 34

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# TOWER BANCORP, INC. AND ITSWHOLLY-OWNED SUBSIDIARY

#  

CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS

Nine Months Ended September 30, 2005 and 2004

(UNAUDITED)

 
| ** **                                                                         | ** ** | **2005**           | ** ** | **2004**   | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------|------------|------------|------------|
| ** **                                                                         | ** ** | **(000  Omitted)** | ** ** | ** ** | ** ** |
| Cash flows from operating activities:                                              |       |               |       |       |       |
| Net income                                                                         |       | $                  | 3,593      |       | $          | 2,959 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |               |       |       |       |
| Depreciation and  amortization                                                     |       | 297                |       | 288        |       |
| Provision for  loan losses                                                         |       | 210                |       | 270        |       |
| (Gain) on sale  of investment securities                                           |       | (1,574             | )          | (1,432     | )          |
| (Increase) in  cash surrender value of life insurance                              |       | (226               | )          | (345       | )          |
| (Increase)Decrease  in other assets                                                |       | (820               | )          | 224        |       |
| (Increase)Decrease  in interest receivable                                         |       | (328               | )          | (9         | )          |
| Increase  (decrease) in interest payable                                           |       | 62                 |       | 33         |       |
| Increase  (decrease) in other liabilities                                          |       | (309               | )          | (155       | )          |
| Net cash  provided by operating activities                                         |       | 905                |       | 1,833      |       |
|                                                                               |       |               |       |       |       |
| Cash flows from investing activities:                                              |       |               |       |       |       |
| Loans (net)                                                                        |       | (643               | )          | (11,999    | )          |
| Purchases of  bank premises, equipment, furniture, and fixtures                    |       | (750               | )          | (1,272     | )          |
| Interest bearing  balances with banks                                              |       | (2,861             | )          | 380        |       |
| Purchases of  available for sale securities                                        |       | (24,921            | )          | (3,056     | )          |
| Maturities/sales  of available for sale securities                                 |       | 5,717              |       | 7,265      |       |
| Redemption  (purchase) of restricted bank stock                                    |       | (623               | )          | 132        |       |
| Net cash (used) by investing activities                                            |       | (24,081            | )          | (8,550     | )          |
|                                                                               |       |               |       |       |       |
| Cash flows from financing activities:                                              |       |               |       |       |       |
| Net increase in  deposits                                                          |       | 25,429             |       | 18,820     |       |
| Debt (net)                                                                         |       | 2,361              |       | (9,006     | )          |
| Cash dividends  paid                                                               |       | (2,001             | )          | (1,071     | )          |
| Purchase of  Treasury Stock                                                        |       | (189               | )          | (826       | )          |
| Proceeds from  sale of capital stock                                               |       | 342                |       | 242        |       |
| Net cash  provided by financing activities                                         |       | 25,942             |       | 8,159      |       |
|                                                                               |       |               |       |       |       |
| Net increase  (decrease) in cash and cash equivalents                              |       | 2,766              |       | 1,442      |       |
|                                                                               |       |               |       |       |       |
| Cash and cash  equivalents at beginning of year                                    |       | 10,045             |       | 8,929      |       |
|                                                                               |       |               |       |       |       |
| Cash and cash  equivalents at end of period                                        |       | $                  | 12,811     |       | $          | 10,371 |   |
|                                                                               |       |               |       |       |       |
| Cash and cash equivalents consists of:                                             |       |               |       |       |       |
| Cash and due  from banks                                                           |       | $                  | 11,336     |       | $          | 10,371 |   |
| Federal funds  sold                                                                |       | 1,475              |       | 0          |       |
| Total cash and  cash equivalents                                                   |       | $                  | 12,811     |       | $          | 10,371 |   |

 

The accompanying notes are an integral partof these

condensed financial statements.

 

Page 8 of 34

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NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2005

(UNAUDITED)

 

# Review of Interim Financial Statements

#  

The condensed consolidated financial statements asof and for the three and nine month periods ended September 30, 2005 and2004 have been reviewed by independent certified public accountants.  Their report on their review is attached as Exhibit 99to this 10-Q filing.

 

Note 1.                                                          Basis of Presentation

 

In the opinion of management, the accompanyingunaudited condensed consolidated financial statements contain all adjustments(consisting solely of normal recurring adjustments) necessary to present fairlyTower Bancorp, Inc.’s consolidated financial position as of September 30,2005 and the results of its operations for the three and nine month periodsended September 30, 2005 and 2004.

 

The results of operations for the three and nine monthperiods ended September 30, 2005 and 2004 are not necessarily indicativeof the results to be expected for the full year.

 

Note 2.                                                          Income Taxes

 

Income tax expense is less than the amountcalculated using the statutory tax rate primarily as a result of tax exemptincome earned from state and municipal securities and loans.

 

Note 3.                                                          Commitments

 

In the normal course of business, the bank makesvarious commitments and incurs certain contingent liabilities which are notreflected in the accompanying financial statements.  These commitments include various guaranteesand commitments to extend credit and the bank does not anticipate any losses asa result of these transactions.

 

Entry into a Material Definitive Agreement

 

On September 21, 2005, Tower Bancorp, Inc.(OTC BB: TOBC-OB)(“Tower”) parent company of The First National Bank ofGreencastle and FNB Financial Corporation (OTC BB: FNBBD-OB)(“FNB”) parentcompany of The First National Bank of McConnellsburg signed a definitiveagreement to combine their companies.

 

Pursuant to the terms of the agreement, FNBshareholders will be entitled to receive either 0.8663 shares of Tower commonstock or $ 39.00 for each share of FNB common stock.  Each shareholder of FNB will have the rightto receive shares of Tower common stock

 

Page 9 of 34

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for a portion of their shares and cash for theremaining portion of their shares. Shareholder election will be subject to allocation procedures, which areintended to ensure that a minimum 85% of the FNB common stock will be convertedinto shares of Tower common stock and up to 15% of the FNB common stock will bepaid in cash.  The total value of themerger is valued at $ 31.2 million.

 

The transaction is subject to shareholder approvalsby Tower and FNB shareholders and customary regulatory approvals.  The transaction is expected to close late inthe first quarter or early second quarter of 2006.

 

Note 4.                                                          Stock Option Plans

 

The Corporation applies APB Opinion 25 and relatedinterpretations in accounting for its stock option plans.  Accordingly, only compensation cost for theintrinsic value of options has been recognized. Had compensation cost for the Corporation’s stock option plans beendetermined based on the fair value at the grant dates for awards under the plansconsistent with the method prescribed by FASB Statement No. 123R, theCorporation’s net income and earnings per share would have been adjusted to thepro forma amounts indicated below:

 
| ** **                           | ** ** | ** **  | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
|--------------------------------------|------------|-------------|------------|------------------------------------------|------------|----------|------------|
| ** **                           | ** ** | ** **  | ** ** | **Nine Months Ended  September 30** | ** ** |
|                                 |       |        |       |                                     |       |     |       |
| Net income (000) omitted             |       | As reported |       | $                                        | 3,593      |     | $          | 2,959 |   |
|                                 |       | Pro forma   |       | 3,559                                    |       | 2,937    |       |
|                                 |       |        |       |                                     |       |     |       |
| Basic earnings per share             |       | As reported |       | 2.08                                     |       | 1.71     |       |
|                                 |       | Pro forma   |       | 2.06                                     |       | 1.70     |       |
|                                 |       |        |       |                                     |       |     |       |
| Earnings per share assuming dilution |       | As reported |       | 2.04                                     |       | 1.68     |       |
|                                 |       | Pro forma   |       | 2.02                                     |       | 1.67     |       |
|                                      |            |             |            |                                          |            |          |            |  |  |

 

Page 10 of 34

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ITEM2.

 

MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

 

September 30, 2005

 

The following is management’s discussion and analysis of thesignificant changes in the consolidated results of operations, capitalresources and liquidity presented in the accompanying unaudited consolidatedfinancial statements for the Company. This discussion should be read in conjunction with the precedingconsolidated financial statements and related footnotes, as well as the Company’sDecember 31, 2004 Annual Report on Form 10-K.  Current performance does not guarantee andmay not be indicative of similar performance in the future.

 

In addition to historical information, this quarterly report on Form 10-Qcontains forward-looking statements.  Theforward-looking statements contained in this report are subject to certainrisks, assumptions and uncertainties. Because of the possibility of change in the underlying assumptions,actual results could differ materially from those projected in theforward-looking statements.  Additionalfactors that might cause actual results to differ materially from thoseexpressed in the forward-looking statements include, but are not limited to:

 

•                  operating,legal and regulatory risks,

•                  economic,political and competitive forces affecting the Company’s services, and

•                  therisk that management’s analyses of these risks could be incorrect and/or thatthe strategies developed to address them could be unsuccessful.

 

The Company’s forward-looking statements are relevant only as of thedate on which the statements are made. By making forward-looking statements,the Company assumes no duty to update them to reflect new, changing orunanticipated events or circumstances. Readers should carefully review the riskfactors described in other periodic reports and public documents that theCompany files from time to time with the Securities and Exchange Commission.

 

CRITICAL ACCOUNTING POLICIES

 

Disclosure of the Company’s significant accounting policies is includedin Note 1 to the consolidated financial statements of the Company’s AnnualReport on Form 10-K for the year ended December 31, 2004. Some ofthese policies are particularly sensitive, requiring significant judgments,estimates and assumptions to be made by management. Additional information iscontained on pages 18 and 19 of this report for the provision andallowance for loan losses.

 

Page 11 of 34

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OVERVIEW

 

Net income for the nine months ended September 30, 2005 and 2004was $3,593,000 and $2,959,000, respectively.  The increase of $634,000, or 21.4%, isattributable to the Company’s core banking business, where net interest incomeincreased 11.6%, other income increased 15.0% and the provision for loan lossesdecreased 22.2%.  On a basic and dilutedper share basis, net income for the nine months ended September 30, 2005was $2.08 and $2.04, respectively, as compared with $1.71 and $1.68 for thenine months ended September 30, 2004.  Net income as a percentage of average assetson an annualized basis, also known as return on average assets, increased to1.46% for the first nine months of 2005 from 1.31% for the first nine months of2004 as a result of increased net income.  Net income as a percentage of total averagestockholders’ equity on an annualized basis, also known as return on averageequity, was 10.54% and 9.48% for the first nine months of 2005 and 2004, respectively. The increase in this ratio is alsoattributable to an increased level of net income.

 

During the first nine months of 2005, the Company’s assets grew$30,198,000, or 9.5%, to $347,088,000 as of September 30, 2005 from $316,890,000as of December 31, 2004. This increase is primarily attributable to growthin security investments, which increased to $85,593,000 as of September 30,2005 from $62,871,000 as of December 31, 2004. Total deposits increased by$25,429,000, or 11.0%, during the first nine months of 2005 to $255,719,000 asof September 30, 2005 from $230,290,000 as of December 31, 2004. Thiscompares to an increase of $18,820,000, or 9.1%, to $225,785,000 at September 30,2004 from $206,965,000 as of December 31, 2003. The growth in totaldeposits during the first nine months of 2005 was more than the growth indeposits during the same period in 2004 due primarily to one new money market accountfor an estate, in the amount of $11,300,000 opened in 2005.  That account is expected to close sometime inthe first quarter of 2006.  As a resultof competition in the market, and, to a certain degree, customers’ continueduncertainty as to how to best invest their monies, deposit growth may notcontinue to grow at the current rates. Since deposit growth was more thansufficient to fund the increased loan demand, investment securities werepurchased.

 

RESULTS OF OPERATIONS

 

Net Interest Income

 

For the three months ended September 30, 2005, total interestincome increased by $779,000, or 21.9%, to $4,336,000 as compared with $3,557,000for the three months ended September 30, 2004. This increase is primarilydue to investment security growth and increases in the one year Treasury rateand the prime rate.

 

Total interest expense increased by $359,000, or 34.2%, to $1,409,000for the three months ended September 30, 2005 from $1,050,000 for thethree months ended September 30, 2004. This increase is not onlyattributable to the increased deposit balances and the increased costsassociated with attracting deposits at a time when short-term interest ratesare rising, but is also impacted by the higher costs associated withborrowings.

 

Net interest income increased by $420,000, or 16.8%, to $2,927,000 forthe three months ended September 30, 2005 from $2,507,000 for the threemonths ended September 30, 2004.

 

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For the nine months ended September 30, 2005, total interestincome increased by $1,567,000, or 14.9%, to $12,056,000, compared with $10,489,000for the nine months ended September 30, 2004. This increase is the resultof an 8.3% increase in average interest-earning assets, which grew to$307,180,000 for the first nine months of 2005, from $283,549,000 for the firstnine months of 2004. The growth in average interest earning assets wasattributable to increased loan volume and investment securities, which werefunded from the cash flow generated from the reduction of overnight borrowingsand deposit growth. Management targeted efforts to attract mortgage and smallcommercial loans.  Management believesthat our experience in making mortgage and small commercial loans positions thecompany well to meet the financing demands of individuals and smallbusinesses.  Further impacting interestincome were six 25-basis point increases in the prime rate and increases in theone year Treasury during the first nine months of 2005 that resulted in higheryields on interest earning assets.

 

Total interest expense increased by $701,000, or 23.2%, to $3,722,000for the nine months ended September 30 2005, from $3,021,000 for the ninemonths ended September 30, 2004. This increase is attributable to thegrowth in average interest bearing liabilities, which increased to $253,649,000for the first nine months of 2005 from $236,878,000 for the first nine monthsof 2004. Increases in rates were needed to attract deposits, particularly moneymarket accounts, which increased 96 basis points to 1.85%.  The interest expense for money marketaccounts increased $363,000 to $632,000 for the nine months ended September 30,2005, from $269,000 for the nine months ended September 2004.

 

Net interest income increased by $866,000, or 11.6%, to $8,334,000 forthe nine months ended September 30, 2005 from $7,468,000 for the nine monthsended September 30, 2004. This increase is attributable to the repricingof mortgage and to a lesser extent commercial loans tied to the one yeartreasury and prime rates plus the increased earning assets funded by depositgrowth.

 

The net interest rate spread was 3.5% for the nine months ending September 30,2005, and the net interest margin was 3.8%. Due to a large investment portfolio at the holding company level, theseratios are lower than the Bank’s separate performance of 4.0% net interest spreadand 4.2% net interest margin for the same period.

 

Provision for Loan Losses

 

The provision for loan losses was $60,000 for the three months ended September 30,2005 compared with $90,000 for the three months ended September 30, 2004,a decrease of 33.3%.  The decrease in theprovision is attributable to the consistency in the high quality of the loanportfolio.

 

For the nine months ended September 30, 2005, the provision forloan losses was $210,000, a decrease of $60,000, or 22.2%, compared with $270,000for the nine months ended September 30, 2004. The decrease in theprovision is attributable to the consistency in the high quality of the loanportfolio.

 

The allowance for loans losses represented 0.91% of total loans at September 30,2005, compared with 0.83% as of December 31, 2004 and 0.81% as of September 30,2004. Management performs ongoing assessments of the loan loss reserve inrelation to loan portfolio growth, credit exposure to individual borrowers,overall trends in the loan portfolio and other relevant factors. Based uponthese factors, management believes that as of

 

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September 30, 2005, the reserve is reasonable and sufficient tosupport the increased loan growth in light of the strong asset quality assupported by the ratios reflected in Table 2 on page 19.

 

Other Income

 

For the three months ended September 30, 2005, other income was$1,430,000, an increase of $646,000, or 82.4%, compared with other income of $784,000for the three months ended September 30, 2004. The increase was primarilydue to an increase of $486,000 in gains from the sale of investment securities,which are $773,000 for the three months ended September 30, 2005 and$287,000 for the three months ended September 30, 2004.  Other income was positively impacted byincreases of $77,000 in investment services, which was new offering as of October 2004,$35,000 in NSF fees, $31,000 in mortgage banking activities, which was a newoffering as of June 2005, $23,000 in ATM fees and $16,000 in safe depositbox fees.

 

Other income for the nine months ended September 30, 2005increased $430,000, or 15.0%, to $3,292,000 from $2,862,000 for the first ninemonths ended September 30, 2004. This increase was primarily due to a $142,000increase in gains from the sale of investment securities and a $144,000increase in investment services.  Otherincome was positively impacted by increases of $87,000 in NSF fees, $59,000 inATM fees due to an increased surcharge fee as of July 2004, $31,000 inmortgage banking activities, $17,000 in safe deposit box fees and $16,000 inother service charges due to increased activity.

 

Other Expenses

 

Other expenses, which include salary, occupancy equipment, and allother expenses incidental to the operation of the Company, increased to$2,292,000 for the three months ended September 30, 2005 from $1,998,000for the three months ended September 30, 2004.  The $294,000, or 14.7% increase was primarilydue to increases in salary and benefits and accounting/consulting fees relatedto SOX 404 compliance.

 

Salaries and employee benefit expenses, which make up the largestcomponent of other expenses, increased $154,000, or 15.6%, to $1,140,000 forthe three months ended September 30, 2005 from $986,000 for the threemonths ended September 30, 2004. The increase is primarily attributable toincreased salary expenses of $109,000 and the associated benefit costs.

 

Occupancy and equipment expenses increased $25,000, or 9.7%, to $282,000for the three months ended September 30, 2005 from $257,000 for the threemonths ended September 30, 2004. The increase is primarily due to the rentexpense associated with a lease agreement entered into in June 2005 for anew office located on Eastern Boulevard, Hagerstown and to overall growth ofthe Company.

 

Other operating expenses during the three months ended September 30,2005 increased $115,000 or 15.2% to $870,000 from $755,000 during the threemonths ended September 30, 2004. The increase is primarily due to an increase of $123,000 in legal feesassociated with corporate matters and an increase of $77,000 in accounting feesfor SOX 404 compliance.

 

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For the nine months ended September 30, 2005, total other expensesincreased $424,000, or 7.0%, to $6,478,000 from $6,054,000 for the nine monthsended September 30, 2004. The increase is the result of the Company’sgrowth, increases in legal and accounting fees, SOX 404 compliance costs, andexpenses for a new office.

 

Salary expenses and related employee benefits were $3,308,000 for the ninemonths ended September 30, 2005, an increase of $254,000, or 8.3%, comparedwith $3,054,000 for the nine months ended September 30, 2004. The increaseis primarily attributable to increased salary expenses of $169,000, or 7.7%,and the associated benefit costs.

 

Occupancy and equipment expenses for the nine months ended September 30,2005 increased to $840,000 from $759,000 for the nine months ended September 30,2004. The increase of $81,000, or 10.7%, is primarily due to an increase of$40,000 rent expense associated with a new office on Eastern Boulevard,Hagerstown.  Occupancy and equipmentexpenses were also negatively impacted by increases of $8,000 in real estatetaxes and $5,000 in building depreciation costs.

 

Other operating expenses increased $89,000, or 4.0%, to $2,330,000 forthe nine months ended September 30, 2005 from $2,241,000 for the ninemonths ended September 30, 2004. This increase was primarily the result ofaccounting fees increasing $126,000 due to SOX 404 compliance, legal feesincreasing $82,000 and a $48,000 increase of donation expense.  Other expenses increasing were $9,000insurance expense, $8,000 dues and subscription expenses and $8,000 PA sharestax expense.  Offsetting the increasedexpenses were a $30,000 decrease in check losses and an $8,000 decrease ofpostage expense.

 

Income Taxes

 

Income tax expense was $553,000 for the three months ended September 30,2005, an increase of $244,000, or 79.0%, compared with $309,000 for the threemonths ended September 30, 2004. The increased tax expense is due toachieving a higher level of net income.

 

For the nine months ended September 30, 2005, the tax provisionwas $1,345,000 compared with $1,047,000 for the nine months ended September 30,2004. This increase of $298,000, or 28.5%, is the result of achieving a higherlevel of pre-tax net income coupled with a lower amount of tax-exempt income.  The effective tax rate was 27.2% for 2005 and26.1% for 2004.

 

Net Income

 

Net income for the three months ended September 30, 2005 was$1,452,000, an increase of $558,000, or 62.4%, compared with $894,000 for thethree months ended September 30, 2004. The increase in net income is theresult of increases of $420,000 in net interest income, $646,000 in otherincome, and a decrease of $30,000 in the provision for loan losses, offset byincreases of $294,000 in other expenses and $244,000 in taxes. Basic anddiluted earnings per share for the three months ended September 30, 2005were $0.84 and $0.82 as compared with $0.52 and $0.51 for the three monthsended September 30, 2004.

 

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Net income for the nine months ended September 30, 2005 was$3,593,000, an increase of $634,000, or 21.4%, compared with $2,959,000 for thenine months ended September 30, 2004.  The increase in net income is the result ofincreases of $866,000 in net interest income, a decrease of $60,000 in theprovision for loan losses, and an increase of $430,000 in other income, offsetby increases of $424,000 in other expenses and $298,000 in taxes.  Factors contributing to the increased level ofnet income include increased interest income from the impact of rate increasesand increased interest income from investment security growth, as well as theBank’s efforts to manage its cost of funds.  Increased other income, derived frominvestment service fees, gains on sale of investments and increased customerservice fees further enhanced net income.  Basic and diluted earnings per share for thenine months ended September 30, 2005 were $2.08 and $2.04 compared with$1.71 and $1.68 for the nine months ended September 30, 2004.

 

FINANCIAL CONDITION

 

Securities

 

The Company’s securities portfolio is comprised of securities that notonly provide interest and dividend income, including tax-exempt income, butalso provide a source of liquidity, diversify the earning assets portfolio,allow for the management of risk and tax liability, and provide collateral forrepurchase agreements and public fund deposits. Policies are in place toaddress various aspects of managing the portfolio, including but not limitedto, concentrations, liquidity, credit quality, interest rate sensitivity andregulatory guidelines.

 

Although the Company generally intends to hold its investmentsecurities to maturity, a significant portion of the securities portfolio isclassified as available for sale, with new purchases generally categorized assuch. Securities in the available for sale category are accounted for at fairvalue with unrealized appreciation or depreciation, net of tax, reported as aseparate component of stockholders’ equity. Securities in the held to maturitycategory are accounted for at amortized cost. All securities held as of September 30,2005 are classified as available for sale. The Company holds no tradingsecurities in its portfolio.  Thesecurities portfolio includes equities owned by the holding company, most ofwhich are investments in banks, bank holding companies and financialinstitutions.  Equity investments areaccounted for at fair market value.  Theremaining securities, primarily debt instruments, are owned by the bank.

 

The consolidated securities portfolio at September 30, 2005 was$85,593,000, compared to $62,871,000 at December 31, 2004, an increase of$22,722,000, or 36.1%.  The increase isdue primarily to the purchase of $ 15,000,000 short-term bank ownedinvestments funded by a large money market deposit account open in June 2005for an estate.

 

Bank Owned Securities

 

The bank owned securities portfolio at September 30, 2005 was$48,638,000, compared to $29,888,000 at December 31, 2004, an increase of$18,750,000, or 62.7%. The increase is attributable to June 2005 purchasesof $15,000,000 available for sale securities maturing within nine to twelvemonths and July 2005 purchases of $5,000,000 available for sale securitiesmaturing in late 2008 and 2009.

 

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The carrying value of the available for sale portion of the portfolioat September 30, 2005 includes an unrealized gain of $1,084,000 (reflectedas accumulated other comprehensive income of $715,000 in stockholders’ equity,net of a deferred income tax liability of $369,000). This compares with anunrealized gain at December 31, 2004 of $1,122,000 (reflected asaccumulated other comprehensive income of $741,000 in stockholders’ equity, netof a deferred income tax liability of $381,000).

 

Holding Company Owned Securities

 

The holding company securities portfolio at September 30, 2005 was$36,955,000, compared to $32,983,000 at December 31, 2004, an increase of$3,972,000, or 12.0%.  The increase isattributable to the purchase of $4,903,000 equity securities plus $986,000increase of unrealized gains less the sale of $1,917,000 equitysecurities.  Gain on sale of equitysecurities was $1,606,000.

 

The carrying value of the available for sale portion of the portfolioat September 30, 2005 includes an unrealized gain of $13,198,000 (reflectedas accumulated other comprehensive income of $8,711,000 in stockholders’equity, net of a deferred income tax liability of $4,487,000). This compareswith an unrealized gain at December 31, 2004 of $12,212,000 (reflected asaccumulated other comprehensive income of $8,060,000 in stockholders’ equity,net of a deferred income tax liability of $4,152,000).

 

Loans

 

The loan portfolio comprises the major component of the Company’searning assets and generally is the highest yielding asset category. Grossloans receivable, net of unearned fees and origination costs, increased$634,000, or 0.3%, to $230,103,000 at September 30, 2005 from $229,469,000at December 31, 2004. Gross loans represented 90.0% of total deposits at September 30,2005 as compared with 99.6% at December 31, 2004, since deposit growth hasoutpaced loan growth.  Loan growth thusfar in 2005 was modest in mortgage loans, commercial loans and lines ofcredit.  Tax free loans at September 30,2005 were $815,000, compared to $4,924,000 at December 31, 2004, adecrease of $4,109,000 or 83.4%.  Thebank, in June 2005, began selling mortgage loans to Federal Home Loan Bankof Pittsburgh in order to offer long term fixed rate mortgages while managinglong term interest rate risk.  At September 30,2005 the bank had sold $6,194,000 mortgage loans to the Federal Home Loan Bankof Pittsburgh.

 

Credit Risk and Loan Quality

 

The Company continues to be prudent in its efforts to minimize creditrisk. The Bank’s written lending policy requires underwriting, loandocumentation and credit analysis standards to be met prior to the approval andfunding of any loan. In accordance with that policy, the loan review processmonitors the loan portfolio on an ongoing basis. The Credit Administration areaand the accounting department then prepares an analysis of the allowance forloan losses which is then submitted to the Board of Directors for itsassessment as to the adequacy of the allowance. The allowance for loan lossesis an accumulation of expenses that has been charged against past and presentearnings in anticipation of potential losses in the loan portfolio.

 

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The allowance for loan losses at September 30, 2005 and December 31,2004 was $2,103,000 and $1,902,000, respectively, compared to $1,836,000 at September 30,2004. The increase in the allowance is attributable to the modest growth of theloan portfolio and the shift in the loan mix, where there has been continuedgrowth in commercial loans, which generally carry a higher level of creditrisk.  The allowance decreased during thenine months ended September 30, 2004 due to a commercial loan charge offof $ 233,000 in June 2004.  At September 30,2005, the allowance for loan losses represented 0.91% of the gross loanportfolio, compared with 0.83% at December 31, 2004. This compares to0.81% at September 30, 2004. At September 30, 2005, in considerationof the strong asset quality, management believes the allowance for loan lossreserve to be reasonable and adequate to support the loan growth and to addressany potential losses.

 

Table 1 -“Analysis of Allowance for Loan Loss” -details the activitywhich occurred in the allowance over the first nine months of 2005 and 2004.

 

**Table 1 -Analysis of Allowancefor Loan Loss (1)**

 
| **(in thousands)**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|
|                                               |       |     |       |     |       |
| Balance, January 1                            |       | $        | 1,902      |     | $          | 1,863 |   |
| Provision charged to operating expense             |       | 210      |       | 270      |       |
| Charge-offs:                                       |       |     |       |     |       |
| Commercial                                         |       | 0        |       | (266     | )          |
| Real Estate                                        |       | 0        |       | 0        |       |
| Consumer                                           |       | (53      | )          | (82      | )          |
| Total  charge-offs                                 |       | (53      | )          | (348     | )          |
|                                               |       |     |       |     |       |
| Recoveries:                                        |       |     |       |     |       |
| Commercial                                         |       | 22       |       | 35       |       |
| Real Estate                                        |       | 0        |       | 0        |       |
| Consumer                                           |       | 22       |       | 16       |       |
| Total Recoveries                                   |       | 44       |       | 51       |       |
|                                               |       |     |       |     |       |
| Net charge-offs                                    |       | (9       | )          | (297     | )          |
| Balance, September 30                         |       | $        | 2,103      |     | $          | 1,836 |   |
|                                               |       |     |       |     |       |
| Net charge-offs or recoveries to Average net loans |       | 0.00     | %          | 0.14     | %          |

 

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(1) Bank’s loan portfolio is entirely domestic

 

The Bank’s lending policy is executed through the assignment of tieredloan limit authorities to individual officers of the Bank, the Officer’s Loan Committeeand the Board of Directors. Although the Bank maintains sound credit policies,certain loans may deteriorate for a variety of reasons. The Bank’s policy is toplace all loans on a non-accrual status upon becoming 90 days delinquent intheir payments, unless there is a documented and reasonable expectation of thecollection of the delinquent amount. Loans are reviewed monthly as to theirstatus, and on a quarterly basis presented to the Board of Directors.Management is not aware of any material potential loan problems that have notbeen disclosed in this report.

 

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Table 2 -“Asset Quality Ratios” -summarizes pertinent asset qualityratios at September 30, 2005 and December 31, 2004.

 

**Table 2 -Asset Quality Ratios**

 
| ** **                            | ** ** | **9/30/05** | ** ** | **12/31/04** | ** ** |
|---------------------------------------|------------|-------------|------------|--------------|------------|
| Non-accrual loans/Total loans         |       | 0.00        | %          | 0.00         | %          |
| Non-performing assets (1)/Total loans |       | 0.14        | %          | 0.01         | %          |
| Net charge offs/Average loans         |       | 0.00        | %          | 0.14         | %          |
| Allowance/Total loans                 |       | 0.91        | %          | 0.83         | %          |
| Allowance/Non-accrual loans           |       | N/A         |       | N/A          |       |
| Allowance/Non-performing loans (1)    |       | 661.32      | %          | 8,645.45     | %          |

 

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(1) -Includes non-accrual loans

 

At September 30, 2005, the Company had other real estate owned(not used in operations) in the amount of $ 1,349,728, which was up from the$ 982,636 owned at December 31, 2004.  At September 30, 2005 and December 31,2004, the Company had non-accrual loans in the amount of $ 0.0 and$ 9,000, respectively.

 

Loan concentrations are considered to exist when the total amount ofloans to any one or a multiple number of borrowers engaged in similaractivities or having similar characteristics exceeds 10% of loans outstandingin any one category.  The Companymaintains a diversified loan portfolio, granting agribusiness, commercial, andresidential loans to customers.  Themajority of the Bank’s lending is made within its primary market area, whichincludes southern Franklin County, Pennsylvania and northern Washington County,Maryland.

 

Bank Owned Life Insurance

 

The Company has Bank Owned Life Insurance (“BOLI”) for certainofficers, whereby the Bank is the owner and beneficiary of the policies. TheBank’s deposits and proceeds from the sale of investment securities funded theBOLI. Earnings from the BOLI are recognized as other income. The BOLI generatesincome from the appreciation of the cash surrender values of the pool ofinsurance, and its tax advantage to the Company. This income is used to “fund”a portion of current and future employee benefit costs and a NonqualifiedSupplemental Executive Retirement Plan for the Company’s Chief ExecutiveOfficer.

 

The Company had $6,071,000, $5,851,000 and $5,905,000 in BOLI as of September 30,2005, September 30, 2004 and December 31, 2004. Although the BOLI isan asset that may be liquidated, it is the Company’s intention to hold thispool of insurance because it provides tax-exempt income that lowers the Company’stax liability, while enhancing its overall capital position.  The Company also expects to collect futureproceeds as the beneficiary of the policies.

 

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Deposits

 

Deposits are the majorsource of the Company’s funds for lending and investment purposes. Totaldeposits at September 30, 2005 were $255,719,000, an increase of$25,429,000, or 11.0%, from total deposits of $230,290,000 at December 31,2004. The increase in deposits included a money market account opened in June 2005for an estate with an $11,300,000 balance on September 30, 2005.  The account is expected to close during thefirst quarter of 2006.  In addition,savings and interest bearing demand deposit accounts increased $11,144,000 fromDecember 31, 2004 to September 30, 2005.  During the same nine months non-interestdemand deposits increased $3,307,000 as a result of introducing free checkingin 2005.  From December 2005 to March 2006approximately $11,500,000 in a special 14-month time deposit product willmature.  Management has reviewed optionsto manage the funding of the bank and respond to the maturing timedeposits.  The cost of deposits hasincreased due to the increased costs associated with attracting deposits at atime when short term interest rates are rising. Higher rates impacted the cost of interest bearing deposits, which increasedto 1.49% as of September 30, 2005 from 1.17% as of December 31, 2004and 1.15% as of September 30, 2004.

 

Short-Term Borrowings

 

Short term borrowings at September 30, 2005 were $7,293,000,compared to $4,931,000 at December 31, 2004, an increase of $2,362,000, or47.9%.  Federal funds purchased, TreasuryTax and Loan demand note, lines of credits with banks and overnight borrowingswith the Federal Home Loan Bank of Pittsburgh are considered to be short termborrowings.  Short term borrowingsfluctuate daily to meet the liquidity needs of the Company.  The Company had short term sources of availableborrowings in the amount of a $25,000,000 overnight line from the Federal HomeLoan Bank of Pittsburgh and $10,100,000 from area banks.  As of August 31, 2005, the maximumborrowing capacity with the Federal Home Loan Bank of Pittsburgh isapproximately $166,791,000, of which the $25,000,000 overnight line is part.

 

Long-Term Debt and Borrowing Capacity

 

There were $30 million outstanding in fixed rate term loans with theFederal Home Loan Bank of Pittsburgh at September 30, 2005, the sameamount borrowed at December 31, 2004 and September 30, 2004.  The $30 million borrowing is comprised of thefollowing fixed rate borrowings (in thousands):

 
| **Maturity**            | ** ** | **Loan Type** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
|-------------------------|------------|---------------|------------|------------|------------|----------|------------|
| September 15, 2008 |       | Convertible   |       | $          | 5,000      |     | 5.40       | % |
| November 20, 2008  |       | Convertible   |       | 5,000      |       | 4.63     | %          |
| November 24, 2008  |       | Convertible   |       | 5,000      |       | 5.01     | %          |
| April 6, 2011      |       | Convertible   |       | 5,000      |       | 5.25     | %          |
| November 27, 2012  |       | Convertible   |       | 5,000      |       | 3.99     | %          |
| May 7, 2018        |       | Convertible   |       | 5,000      |       | 4.13     | %          |
|                    |       | Total         |       | $          | 30,000     |     | 4.74       | % |

 

The Bank has a total maximum borrowing capacity for both short andlong-term borrowings of approximately $166,791,000 with the Federal Home LoanBank of Pittsburgh, out of which $30 million represents fixed rate term loans,that were outstanding at September 30, 2005, and resulted in an unusedborrowing capacity of $136,791,000.

 

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Asset/Liability Management

 

Themanagement of interest rate risk involves measuring and analyzing the maturityand repricing of interest-earning assets and interest bearing liabilities atspecific points in time. The imbalance between interest-earning assets andinterest bearing liabilities is commonly referred to as the interest rate gap.The interest rate gap is one measure of the risk inherent in the existingbalance sheet as it relates to potential changes in net interest income.Maintaining an appropriate balance between interest-earning assets and interestbearing liabilities is a means of monitoring and possibly avoiding materialfluctuations in the net interest margin during periods of changing interestrates.

 

The Company’s overall sensitivity to interest rate risk is low due toits non-complex balance sheet. The Company manages its balance sheet with theintent of stabilizing net interest income and net economic value under a broadrange of interest rate environments. The Company has the ability to effectvarious strategies to manage interest rate risk, which include, but are notlimited to, selling newly originated residential mortgage loans, controllingthe volume mix of fixed/variable rate commercial loans, mortgage loans andsecurities, increasing/ decreasing deposits via interest rate changes,borrowing from the Federal Home Loan Bank of Pittsburgh, and buying/sellingsecurities. Adjustments to the mix of assets and liabilities are madeperiodically in an effort to give the Company dependable and steady growth innet interest income, while at the same time, managing the related risks.

 

Liquidity

 

Liquidity represents the Company’s ability to efficiently manage cashflows at reasonable rates to support possible commitments to borrowers or thedemands of depositors. Liquidity is essential to compensate for fluctuations inthe balance sheet and provide funds for growth and normal operatingexpenditures. Liquidity needs may be met by converting assets into cash orobtaining sources of additional funding.

 

Liquidity from asset categories is provided through cash, amounts duefrom banks, interest-bearing deposits with banks and federal funds sold, whichwere $15,868,000 at September 30, 2005, compared to $10,241,000 at December 31,2004. Additional asset liquidity sources include principal and interestpayments from securities in the Company’s investment portfolio and cash flowfrom its amortizing loan portfolio. Longer-term liquidity needs may be met byselling securities available for sale, selling loans or raising additionalcapital. At September 30, 2005, there were $69,416,000 in liquidsecurities as compared to $45,991,000 at December 31, 2004. Liquidsecurities increased by $23,425,000 since year end due to purchases exceedingsales, calls and maturity of investment securities, primarily the$ 15,000,000 in short term investments purchased in June 2005.

 

Liability liquidity sources include attracting deposits at competitiverates. Deposits at September 30, 2005 were $255,719,000, compared to$230,290,000 at December 31, 2004. In addition, the Company has borrowingcapacity and lines of credit with the Federal Home Loan Bank of Pittsburgh,Atlantic Central Bankers Bank and several local banks.

 

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The Company’s financial statements do not reflect various off-balancesheet commitments that are made in the normal course of business, which mayinvolve some liquidity risk. Off-balance sheet arrangements are discussed indetail below.

 

Management is of the opinion that its liquidity position, at September 30,2005, is adequate to respond to fluctuations “on” and “off” the balance sheet.In addition, management knows of no trends, demands, commitments, events oruncertainties that may result in, or that are reasonably likely to result inthe Company’s inability to meet anticipated or unexpected liquidity needs.

 

Off-Balance Sheet Arrangements

 

The Company’s financial statements do not reflect various off-balancesheet arrangements that are made in the normal course of business. Thesecommitments consist mainly of loans approved but not yet funded, unused linesof credit and letters of credit made in accordance with the same standards ason-balance sheet instruments. Unused commitments at September 30, 2005were $73,553,000, which consisted of $72,195,000 in unfunded commitments toexisting loans and unfunded new loans and $1,358,000 in letters of credit.Because these instruments have fixed maturity dates, and because many of themwill expire without being drawn upon, they do not generally present asignificant liquidity risk to the Company. Management believes that any amountsactually drawn upon can be funded in the normal course of operations. TheCompany has no investment in or financial relationship with any unconsolidatedentities that are reasonably likely to have a material effect on liquidity orthe availability of capital resources.

 

Capital

 

The following table presents the risk-based and leverage capitalamounts and ratios at September 30, 2005 for the Company and the Bank.

 

**Table 3 - Capital Ratios**

 
| ** **                                      | ** ** | **Actual**                 | ** ** | **Minimum for  Capital Adequacy  Purposes** | ** ** | **To be Well  Capitalized under  Prompt Corrective  Action Provisions** | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|---------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                                      | ** ** | **Amount**                 | ** ** | **Ratio**                                   | ** ** | **Amount**                                                              | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| ** **                                      | ** ** | **(Dollars in Thousands)** | ** ** |
| Total risk based  capital/risk weighted assets: |       |                       |       |                                        |       |                                                                    |       |   |   |   |   |   |   |
| Company                                         |       | $                          | 45,881     |                                        | 20.5       | %                                                                       | >17,901 |   | >8.0 | % | N/A |   | N/A |   |
|                                            |       |                       |       |                                        |       |                                                                    |       |   |   |   |   |   |   |
| Bank                                            |       | 26,087                     |       | 13.3                                        | %          | >15,655                                                              |       | >8.0 | % | >19,569 |   | >10.0 | % |
|                                            |       |                       |       |                                        |       |                                                                    |       |   |   |   |   |   |   |
| Tier 1 capital/risk weighted assets:            |       |                       |       |                                        |       |                                                                    |       |   |   |   |   |   |   |
| Company                                         |       | 37,840                     |       | 16.9                                        | %          | >8,949                                                               |       | >4.0 | % | N/A |   | N/A |   |
|                                            |       |                       |       |                                        |       |                                                                    |       |   |   |   |   |   |   |
| Bank                                            |       | 23,985                     |       | 12.3                                        | %          | >7,828                                                               |       | >4.0 | % | 11,741 |   | >6.0 | % |
|                                            |       |                       |       |                                        |       |                                                                    |       |   |   |   |   |   |   |
| Tier 1 capital/average assets                   |       |                       |       |                                        |       |                                                                    |       |   |   |   |   |   |   |
| Company                                         |       | 37,840                     |       | 11.0                                        | %          | >13,815                                                              |       | >4.0 | % | N/A |   | N/A |   |
|                                            |       |                       |       |                                        |       |                                                                    |       |   |   |   |   |   |   |
| Bank                                            |       | 23,985                     |       | 7.7                                         | %          | >12,484                                                              |       | >4.0 | % | >15,605 |   | >5.0 | % |
|                                                 |            |                            |            |                                             |            |                                                                         |            |  |  |  |  |  |  |  |

 

Page 22 of 34

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These capital ratios continue to remain at levels which are consideredto be “well-capitalized” as defined by regulatory guidelines.

 

Banking laws and regulations limit the amount of cash dividends thatmay be paid without prior approval from the Company’s regulatory agencies. Inabidance with such requirements, on September 14, 2005, the Board ofDirectors authorized and declared a quarterly cash dividend in the amount of$0.24 per share, payable on October 24, 2005 to all shareholders of recordas of October 7, 2005. The payment of this quarterly cash dividenddecreased retained earnings by $415,000.

 

**ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

There have been no material changes to the quantitative and qualitativedisclosures made in Tower Bancorp’s annual report on Form 10-K for theyear ended December 31, 2004.

 

**ITEM 4 - CONTROLS AND PROCEDURES**

 

**CONTROLS AND PROCEDURES**

 

The Corporation’s Chief Executive Officer and ChiefFinancial Officer have evaluated the effectiveness of the Corporation’sdisclosure controls and procedures (as such term is defined in the Rules 13a-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”))as of September 30,2005.  Based on such evaluation, suchofficers have concluded that, as of September 30, 2005, the Corporation’sdisclosure controls and procedures are effective in alerting them on a timelybasis to material information relating to the Corporation (including itsconsolidated subsidiary) required to be included in the Corporation’s periodicfilings under the Exchange Act.

 

**CHANGES IN INTERNAL CONTROLS**

 

There have not been any changes in the Corporation’sinternal control over financial reporting or in other factors that materiallyaffected or are reasonably likely to materially affect such control during thethird quarter of 2005.

 

Page 23 of 34

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PART II – OTHER INFORMATION

 

Page 24 of 34

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PART II – OTHER INFORMATION

 

Item1 – Legal Proceedings

 

The nature of the Company’s business generates somelitigation involving matters arising in the ordinary course of business.  However, in the opinion of the Company, afterconsulting with legal counsel, no legal proceedings are pending, which wouldhave a material effect.  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.

 

Item2 – Unregistered Sales of Equity Securities and the Use of Proceeds

 

ISSUER PURCHASES OF EQUITY SECURITIES

 
| ** **          | ** ** | **(a)**                                | ** ** | **(b)**                            | ** ** | **(c)**                                                                       | ** ** | **(d)**                                                                     | ** ** |
|---------------------|------------|----------------------------------------|------------|------------------------------------|------------|-------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| **Period**          | ** ** | **Total Number  of shares  purchased** | ** ** | **Average price  paid per  share** | ** ** | **Total number  of shares  purchased as  part of  publicly  announced  plan** | ** ** | **Maximum  number of  shares  that may yet  be purchased  under the  plan** | ** ** |
| July 2005      |       | None                                   |       | N/A                                |       | None                                                                          |       | 11,585                                                                      |       |
|                |       |                                   |       |                               |       |                                                                          |       |                                                                        |       |
| August 2005    |       | None                                   |       | N/A                                |       | None                                                                          |       | 11,585                                                                      |       |
|                |       |                                   |       |                               |       |                                                                          |       |                                                                        |       |
| September 2005 |       | 1,000                                  |       | 43.50                              |       | 1,000                                                                         |       | 10,585                                                                      |       |
|                |       |                                   |       |                               |       |                                                                          |       |                                                                        |       |
| Total               |       | 4,192                                  |       | 45.14                              |       | 4,192                                                                         |       | 10,585                                                                      |       |

 

Item3 - Defaults Upon Senior Securities

 

Not applicable

 

Item4 - Submission of Matters to a Vote of Security Holders

 

Not applicable.

 

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Item5 - Other Information

 

Not applicable

 

Item6 – Index to Exhibits

 
| **Exhibit** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                      |
|-------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                                                            |
| 2.1         |       | Agreement  and Plan of Merger, dated as of September 21, 2005, by and between Tower  Bancorp, Inc. and FNB Financial Corporation (incorporated by reference  to Exhibit 2.1 of Tower Bancorp, Inc.’s Form 8-K filed on  September 22, 2005). |
|        |       |                                                                                                                                                                                                                                                                            |
| 3.1         |       | Articles of Incorporation  of Tower Bancorp, Inc.                                                                                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                                            |
| 3.2         |       | Bylaws of Tower  Bancorp, Inc.                                                                                                                                                                                                                                             |
|        |       |                                                                                                                                                                                                                                                                            |
| 10.1        |       | Change  of Control Agreement of Jeffrey B. Shank dated as of September *25,*2002 (incorporated by referenced to  Exhibit 99.4 of Tower Bancorp, Inc.’s Form 10-Q for the  quarter ended September 30, 2002).                                      |
|        |       |                                                                                                                                                                                                                                                                            |
| 10.2        |       | Change  of Control Agreement of Franklin T. Klink, III dated as of  November 26, 2001 (incorporated by reference to Exhibit 10.1 of  Tower Bancorp, Inc.’s Form 10-K for the year ended  December 31, 2001).                                 |
|        |       |                                                                                                                                                                                                                                                                            |
| 10.3        |       | Change  of Control Agreement of Donald G. Kunkle dated as of January *4,*2002 (incorporated by reference to  Exhibit 10.2 of Tower Bancorp, Inc.’s Form 10-K for the year  ended December 31, 2001).                                              |
|        |       |                                                                                                                                                                                                                                                                            |
| 10.4        |       | Change  of Control Agreement of John H. McDowell, Sr. dated as of  December 23, 1998 (incorporated by reference to Exhibit 10.2 of  Tower Bancorp, Inc.’s Form 10-K for the year ended  December 31, 1998).                                  |
|        |       |                                                                                                                                                                                                                                                                            |
| 10.5        |       | Tower  Bancorp, Inc.’s 1995 Non-Qualified Stock Option Plan (incorporated by  reference to Exhibit 99.1 to Tower Bancorp, Inc.’s Registration  Statement on Form S-8 (File No. 333-4066 1)).                                                 |

 

Page 26 of 34

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| **Exhibit** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                 |
|-------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                                       |
| 10.6        |       | Tower  Bancorp, Inc. Stock Option Plan for Outside Directors (incorporated by  reference to Exhibit 99.2 to Tower Bancorp, Inc.’s Registration  Statement on Form S-8 (File No. 333-40661)).                                 |
|        |       |                                                                                                                                                                                                                                                       |
| 10.7        |       | Supplemental  Executive Retirement Agreement of Jeffrey B. Shank dated as of  September *25,*2002  (incorporated by reference to Exhibit 99.3 of Tower Bancorp, Inc.’s  Form 10-Q for the quarter ended September 30, 2002). |
|        |       |                                                                                                                                                                                                                                                       |
| 31.1        |       | Certification of Chief Executive Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                  |
|        |       |                                                                                                                                                                                                                                                       |
| 31.2        |       | Certification of Chief Financial Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                  |
|        |       |                                                                                                                                                                                                                                                       |
| 32.1        |       | Certification of Chief Executive Officer pursuant to 18 U.S.C.  Section 1350                                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                       |
| 32.2        |       | Certification of Chief Financial Officer pursuant to 18 U.S.C.  Section 1350                                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                       |
| 99          |       | Report of Independent Accountants on Interim Financial Statements                                                                                                                                                                                          |

 

Page 27 of 34

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SIGNATURES

 

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
|   | TOWER BANCORP, INC.            |
|--------|--------------------------------|
|   | (REGISTRANT)                   |
|   |                           |
|   |                           |
|   | /s/ Jeff B. Shank              |   |
|   | Jeff B. Shank, President, CEO  |
|   | (Principal Executive  Officer) |
| Date:  | November 14, 2005         |   |   |
|   |                           |
|   |                           |
|   | /s/Franklin T. Klink, III |   |
|   | Franklin T. Klink, III,   |
|   | Treasurer                      |
|   | (Principal Financial Officer)  |
| Date:  | November 14, 2005         |   |   |
|        |                                |  |  |  |  |

 

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