EXHIBIT 13
EXCERPTS FROM THE 2003 ANNUAL REPORT TO SHAREHOLDERS
19
.
.
.
Selected Financial Data
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
SUMMARY OF OPERATIONS
(in thousands)
Total interest income $ 19,964 $ 20,674 $ 22,602 $ 21,904 $ 20,314
Total interest expense 6,898 8,907 10,871 11,064 9,534
---------- ---------- ---------- ---------- ----------
Net interest income 13,066 11,767 11,731 10,840 10,780
Provision for loan losses 553 515 143 119 225
Noninterest income 4,380 3,534 2,496 2,164 2,110
Noninterest expense 12,290 11,008 10,298 9,124 8,927
---------- ---------- ---------- ---------- ----------
Income before income taxes 4,603 3,778 3,786 3,761 3,738
Provision for income taxes 1,171 677 932 1,054 1,074
---------- ---------- ---------- ---------- ----------
Net income $ 3,432 $ 3,101 $ 2,854 $ 2,707 $ 2,664
---------- ---------- ---------- ---------- ----------
RATIOS
(in percentages)
Return on average shareholders' equity 10.3% 10.1% 10.0% 10.3% 10.2%
Return on average assets 0.96 0.91 0.91 0.94 0.95
Tier I risk-based capital 11.1 11.3 10.9 11.3 11.2
Total risk-based capital 11.7 11.9 11.6 12.1 12.1
Average shareholders' equity to average assets 9.3 9.0 9.1 9.1 9.3
PER COMMON SHARE
(adjusted for stock dividends)
Net income, basic $ 1.21 $ 1.10 $ 1.01 $ 0.97 $ 0.94
Net income, diluted $ 1.20 $ 1.09 $ 1.01 $ 0.97 $ 0.94
Cash dividends paid $ 0.47 $ 0.45 $ 0.43 $ 0.39 $ 0.34
Stock dividend paid 5% 5% 5% 5% 5%
Book value $ 11.91 $ 11.38 $ 10.38 $ 9.70 $ 9.16
Cash dividend payout ratio 38.7% 40.7% 42.1% 40.7% 38.0%
Weighted average shares outstanding 2,833,242 2,828,029 2,825,804 2,799,946 2,825,675
SUMMARY OF FINANCIAL CONDITION AT YEAR-END
(in thousands)
Securities, available-for-sale $ 62,738 $ 68,863 $ 37,436 $ 37,335 $ 43,031
Securities, held-to-maturity 9,355 9,357 9,358 9,360 9,361
Loans held for sale 2,157 4,586 12,349 0 0
Loans 260,206 233,960 225,785 217,926 207,318
Assets 372,547 349,897 330,455 295,092 291,156
Deposits 304,282 292,627 276,945 247,414 238,458
Borrowings 31,234 23,253 19,573 19,034 25,999
Equity 33,789 32,223 29,368 27,391 25,372
OTHER DATA
Number of bank offices 11 11 10 8 8
Number of employees (full-time equivalent) 143 163 152 136 131
Trust and investment services
(in thousands)
Assets under management (market value) $ 92,312 $ 80,780 $ 78,203 $ 79,850 $ 76,838
Fee income 848 758 678 670 542
---------- ---------- ---------- ---------- ----------
[LOGO 9]
20
Consolidated Statements of Financial Condition
DECEMBER 31,
(dollars in thousands, except per share data) 2003 2002
- --------------------------------------------- ---- ----
ASSETS
Interest bearing deposits with banks $ 108 $ 242
Cash and due from banks 12,300 10,878
Total cash and cash equivalents 12,408 11,120
Securities, available-for-sale 62,738 68,863
Securities, held-to-maturity (fair value $10,223 for 2003 and $9,539 for 2002) 9,355 9,357
Restricted investment in bank stock, at cost 1,976 1,503
Loans held for sale 2,157 4,586
Loans (net of deferred fees of $610 in 2003 and $645 in 2002) 260,206 233,960
Less-allowance for loan losses (1,694) (1,515)
------------- -------------
Net loans 258,512 232,445
Premises and equipment 9,358 9,335
Other assets 16,043 12,688
------------- -------------
Total assets $ 372,547 $ 349,897
============= =============
LIABILITIES
Deposits
Noninterest bearing $ 33,188 $ 30,120
Interest bearing 271,094 262,507
------------- -------------
Total deposits 304,282 292,627
Short-term borrowings 6,795 7,089
Long-term debt 24,439 16,164
Other liabilities 3,242 1,794
------------- -------------
Total liabilities 338,758 317,674
SHAREHOLDERS' EQUITY
Preferred stock, par value $2.50 per share;
1,000,000 shares authorized; 0 shares issued and outstanding 0 0
Common stock, par value $2.50 per share;
10,000,000 shares authorized; 2,837,634 shares issued
and outstanding for 2003 and 2,697,035 for 2002 7,094 6,743
Additional paid-in capital 17,451 15,549
Retained earnings 8,498 8,551
Accumulated other comprehensive income 746 1,380
------------- -------------
Total shareholders' equity 33,789 32,223
------------- -------------
Total liabilities and shareholders' equity $ 372,547 $ 349,897
------------- -------------
See accompanying notes.
[LOGO 10]
21
Consolidated Statements of Income
YEARS ENDED DECEMBER 31,
(dollars in thousands, except per share data) 2003 2002 2001
- --------------------------------------------- ---- ---- ----
INTEREST INCOME
Loans, including fees $16,920 $17,231 $19,013
Investment securities
Taxable 2,506 2,655 2,348
Tax-exempt 439 522 546
Dividends 35 37 120
Other 64 229 575
------- ------- -------
Total interest income 19,964 20,674 22,602
INTEREST EXPENSE
Deposits 5,821 7,698 9,704
Federal funds purchased and other short-term borrowings 19 10 7
Long-term debt 1,058 1,199 1,160
------- ------- -------
Total interest expense 6,898 8,907 10,871
------- ------- -------
Net interest income 13,066 11,767 11,731
PROVISION FOR LOAN LOSSES 553 515 143
------- ------- -------
Net interest income after provision for loan losses 12,513 11,252 11,588
NONINTEREST INCOME
Trust and investment services fees 848 758 678
Service charges on deposit accounts 1,155 792 705
Mutual fund, annuity and insurance sales 685 272 193
Income from bank owned life insurance 318 325 294
Other income 401 436 467
Gain on sales of securities 266 179 0
Gain on sales of mortgages, net of unrealized losses 707 772 159
------- ------- -------
Total noninterest income 4,380 3,534 2,496
NONINTEREST EXPENSE
Personnel 6,558 6,005 5,281
Occupancy of premises, net 996 808 832
Furniture and equipment 1,151 1,072 1,083
Postage, stationery and supplies 427 410 395
Professional and legal 471 226 306
Marketing and advertising 371 432 414
Foreclosed real estate, net 49 71 239
Other 2,267 1,984 1,748
------- ------- -------
Total noninterest expense 12,290 11,008 10,298
------- ------- -------
Income before income taxes 4,603 3,778 3,786
PROVISION FOR INCOME TAXES 1,171 677 932
------- ------- -------
Net income $ 3,432 $ 3,101 $ 2,854
------- ------- -------
Net income per share, basic $ 1.21 $ 1.10 $ 1.01
Net income per share, diluted $ 1.20 $ 1.09 $ 1.01
See accompanying notes.
[LOGO 11]
22
Consolidated Statements of Cash Flows
YEARS ENDED DECEMBER 31,
(dollars in thousands) 2003 2002 2001
- ---------------------- ---- ---- ----
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 3,432 $ 3,101 $ 2,854
Adjustments to reconcile net income to cash provided by operations:
Depreciation 986 958 945
Provision for loan losses 553 515 143
Provision for losses on foreclosed real estate 55 30 62
Deferred federal income tax benefit (expense) 119 (614) (8)
Amortization of investment in real estate partnership 203 777 0
Increase in cash surrender value of life insurance investment (318) (325) (294)
Originations of held for sale mortgages (65,339) (54,488) (21,510)
Proceeds from sales of held for sale mortgages 68,475 63,023 9,320
Gain on sales of held for sale mortgages (707) (772) (218)
Unrealized loss on held for sale mortgages 0 0 59
Gain on sales of securities (266) (179) 0
Gain on sales of foreclosed real estate (126) (58) (89)
Decrease (increase) in accrued interest receivable 165 (116) 176
Decrease (increase) in other assets 392 (552) (183)
Decrease in accrued interest payable (114) (163) (101)
Increase in other liabilities 160 200 322
Other, net 621 684 194
--------- --------- ---------
Net cash provided by (used in) operating activities 8,291 12,021 (8,328)
CASH FLOWS FROM INVESTING ACTIVITIES
Securities, available-for-sale
Purchases (31,300) (68,284) (14,606)
Maturities and calls 22,660 23,704 14,944
Sales 13,542 14,311 0
Net (increase) decrease in restricted investment in bank stock (473) (577) 2,311
Net increase in loans made to customers (28,220) (9,615) (9,285)
Purchases of premises and equipment (1,017) (899) (746)
Investment in real estate partnership (1,243) (2,982) 0
Investment in life insurance (7) (306) 0
Purchase of assets of insurance agency (25) (125) 0
Proceeds from sales of foreclosed real estate 776 674 2,765
--------- --------- ---------
Net cash used in investing activities (25,307) (44,099) (4,617)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in demand and savings deposits 12,964 20,671 11,675
Net (decrease) increase in time deposits (1,309) (4,989) 17,856
Net (decrease) increase in short-term borrowings (294) 7,089 0
Proceeds from issuance of long-term debt 10,000 0 2,000
Repayment of long-term debt (1,725) (3,409) (2,110)
Dividends paid (1,327) (1,262) (1,201)
Issuance of common stock 0 67 27
Cash paid in lieu of fractional shares (5) (4) (4)
--------- --------- ---------
Net cash provided by financing activities 18,304 18,163 28,243
--------- --------- ---------
Net increase (decrease) in cash and cash equivalents 1,288 (13,915) 15,298
Cash and cash equivalents at beginning of year 11,120 25,035 9,737
--------- --------- ---------
Cash and cash equivalents at end of year $ 12,408 $ 11,120 $ 25,035
--------- --------- ---------
SUPPLEMENTAL DISCLOSURES
Interest paid on deposits and borrowed funds $ 7,012 $ 9,070 $ 10,952
Income taxes paid $ 650 $ 725 $ 1,099
See accompanying notes.
[LOGO 12]
23
Consolidated Statements of Changes in Shareholders' Equity
ACCUMULATED
ADDITIONAL OTHER
COMMON PAID-IN RETAINED COMPREHENSIVE TREASURY
(dollars in thousands, except per share data) STOCK CAPITAL EARNINGS INCOME STOCK TOTAL
- --------------------------------------------- ----- ------- -------- ------ ----- -----
Balance, December 31, 2000 $6,137 $12,447 $ 8,844 $ 126 $ (163) $ 27,391
Comprehensive income
Net income 2,854 2,854
Other comprehensive income, net of tax:
Unrealized gains on securities 301 301
----------
Total comprehensive income 3,155
Cash dividends ($.43 per share) (1,201) (1,201)
5% stock dividend - 121,738 shares at fair value 268 1,535 (1,970) 163 (4)
Issuance of common stock under stock option plan 6 22 (1) 27
------ ------- -------- -------------- -------- ----------
Balance, December 31, 2001 6,411 14,004 8,526 427 0 29,368
Comprehensive income
Net income 3,101 3,101
Other comprehensive income, net of tax:
Unrealized gains on securities
net of reclassification adjustment for gains included
in net income 953 953
----------
Total comprehensive income 4,054
Cash dividends ($.45 per share) (1,262) (1,262)
5% stock dividend - 127,927 shares at fair value 320 1,490 (1,814) (4)
Issuance of common stock under dividend reinvestment plan 6 33 39
Issuance of common stock under stock option plan 6 22 28
------ ------- -------- -------------- -------- ----------
Balance, December 31, 2002 6,743 15,549 8,551 1,380 0 32,223
Comprehensive income
Net income 3,432 3,432
Other comprehensive income, net of tax:
Unrealized losses on securities
net of reclassification adjustment for gains included
in net income (634) (634)
----------
Total comprehensive income 2,798
Cash dividends ($.47 per share) (1,327) (1,327)
5% stock dividend - 134,564 shares at fair value 336 1,817 (2,158) (5)
Issuance of common stock for insurance agency purchase 15 85 100
------ ------- -------- -------------- -------- ----------
Balance, December 31, 2003 $7,094 $17,451 $ 8,498 $ 746 $ 0 $ 33,789
------ ------- -------- -------------- -------- ----------
See accompanying notes.
[LOGO 13]
24
Notes to Consolidated Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
NATURE OF OPERATIONS AND BASIS OF PRESENTATION
Codorus Valley Bancorp, Inc. (Corporation or Codorus Valley) is a one-bank
holding company headquartered in York, Pennsylvania that provides a full range
of banking services through its subsidiary, PeoplesBank, A Codorus Valley
Company (PeoplesBank). PeoplesBank operates two wholly owned subsidiaries, SYC
Insurance Services, Inc. that sells nondeposit investment products and SYC
Settlement Services, Inc., which provides real estate settlement services.
PeoplesBank operates under a state charter subject to regulation by the
Pennsylvania Department of Banking and by the Federal Deposit Insurance
Corporation.
The consolidated financial statements include the accounts of Codorus Valley and
its wholly owned bank subsidiary, PeoplesBank, and its wholly owned nonbank
subsidiary, SYC Realty Company, Inc. All significant intercompany account
balances and transactions have been eliminated in consolidation. The accounting
and reporting policies of Codorus Valley and subsidiaries conform to accounting
principles generally accepted in the United States of America and have been
followed on a consistent basis.
INVESTMENT SECURITIES
The classification of securities is determined at the time of acquisition and is
reevaluated at each reporting date. Securities classified as available-for-sale
are debt securities that the Corporation intends to hold for an indefinite
period of time, but not necessarily to maturity. Any decision to sell a security
classified as available-for-sale would be based on various factors, including
significant movements in interest rates, changes in maturity mix of assets and
liabilities, liquidity needs, regulatory considerations and other factors.
Securities available-for-sale are carried at fair value, with unrealized gains
and losses, net of taxes, reported as a component of accumulated other
comprehensive income in shareholders' equity. Premiums and discounts are
recognized in interest income using the interest method over the estimated life
of the securities. Realized gains and losses from the sale of available-for-sale
securities are computed on the basis of specific identification of the adjusted
cost of each security and are shown net as a separate line item in the statement
of income.
Securities classified as held-to-maturity are those debt securities that the
Corporation has both the intent and ability to hold to maturity regardless of
changes in market conditions, liquidity needs or general economic conditions.
These securities are carried at cost adjusted for amortization of premium and
accretion of discount, computed by the interest method over the estimated life
of the securities.
Declines in the fair value of available-for-sale and held-to-maturity securities
below cost that are deemed to be other than temporary are reflected in earnings
as realized losses. In estimating other than temporary impairment losses,
management considers independent price quotations, projected target prices of
investment analysts within the short term and the financial condition of the
issuer.
RESTRICTED STOCK
Federal law requires a member institution of the Federal Home Loan Bank to hold
stock of its district FHLB according to a predetermined formula. The stock is
carried at cost.
LOANS HELD FOR SALE
Loans held for sale are reported at the lower of cost or fair value, as
determined in the aggregate. The amount, by which cost exceeds fair value, if
any, is accounted for as a valuation allowance and is charged to expense in the
period of the change.
MORTGAGE SERVICING RIGHTS
An asset is recognized for mortgage servicing rights acquired through purchase
or origination. Amounts capitalized are amortized in proportion to, and over the
period of, estimated net servicing income. If mortgage loans are sold or
securitized with servicing retained, the total cost of the mortgage loans is
allocated to loans and the servicing rights based on their relative fair values.
Loans serviced for others were $3,798,000 at December 31, 2003, $7,611,000 at
December 31, 2002, and $12,005,000 at December 31, 2001. Related servicing
rights were $26,000 at December 31, 2003, $52,000 at December 31, 2002, and
$83,000 at December 31, 2001.
LOANS
Loans receivable that management has the intent and ability to hold for the
foreseeable future or until maturity or payoff are stated at their outstanding
unpaid principal balances, net of any deferred fees and costs. Interest income
is accrued on the unpaid principal balance. Loan origination fees and costs are
generally deferred and recognized as adjustments of interest rate yields, by
being amortized to interest income over the terms of the related loans.
Determination of loans past due status is based on contractual terms. When
circumstances indicate that collection of a loan is doubtful, the accrual of
interest income is discontinued, and unpaid interest previously credited to
income is reversed and charged against current income. Loans are returned to
accrual status when management determines that circumstances have improved to
the extent that both principal and interest are deemed collectible.
[LOGO 14]
25
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONT'D)
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is established as losses are estimated to have
occurred through a provision for loan losses charged to earnings. Loan losses
are charged against the allowance when management believes the uncollectibility
of a loan balance is confirmed. Subsequent recoveries, if any, are credited to
the allowance.
The allowance for loan losses is maintained at a level considered adequate to
provide for losses that can be reasonably anticipated. Management's periodic
evaluation of the adequacy of the allowance is based on current economic
conditions, prior loss experience, adequacy of collateral, risk characteristics
of the loan portfolio and other relevant factors. This evaluation is inherently
subjective, as it requires estimates that are susceptible to significant
revision as more information becomes available.
The allowance consists of specific, general and unallocated components. The
specific component relates to loans that are classified as doubtful, substandard
or special mention. For such loans that are also classified as impaired, an
allowance is established when the discounted cash flows (or collateral value or
observable market price) of the impaired loan is lower that the carrying value
of that loan. The general component covers non-classified loans and is based on
historical loss experience adjusted for qualitative factors. An unallocated
component is maintained to cover uncertainties that could affect management's
estimate of probable losses. The unallocated component of the allowance reflects
the margin of imprecision inherent in the underlying assumptions used in the
methodologies for estimating specific general losses in the portfolio.
A loan is considered impaired when, based on current information and events, it
is probable that PeoplesBank will be unable to collect all amounts due according
to contractual terms of the loan agreement. An insignificant delay or shortfall
in the amount of payments would not cause a loan to be rendered impaired.
Impairment is measured on an individual loan basis for business loans by either
the present value of expected future cash flows discounted at the loan's
effective interest rate, the loan's observable market price or the fair value of
the collateral if the loan is collateral dependent. Large groups of smaller
balance homogeneous loans are collectively evaluated for impairment using loss
factors derived in part from historical charge-offs. Income on impaired loans is
recognized under the same policy as disclosed under Loans.
TRANSFERS OF FINANCIAL ASSETS
Transfers of financial assets are accounted for as sales, when control over the
assets has been surrendered. Control over transferred assets is deemed to be
surrendered when (1) the assets have been isolated from the Corporation, (2) the
transferee obtains the right (free of conditions that constrain it from taking
advantage of that right) to pledge or exchange the transferred assets, and (3)
the Corporation does not maintain effective control over the transferred assets
through an agreement to repurchase them before their maturity.
PREMISES AND EQUIPMENT
Premises and equipment are carried at cost less accumulated depreciation.
Depreciation expense is calculated principally on the straight-line method over
the assets estimated useful lives. Estimated useful lives are ten to forty years
for buildings and improvements, five to ten years for furniture and equipment
and three to five years for computer equipment and software. Maintenance and
repairs are charged to expense as incurred. The cost of significant improvements
to existing assets is capitalized. When facilities are retired or otherwise
disposed of, the cost is removed from the asset accounts and any gain or loss is
reflected in the statement of income.
FORECLOSED REAL ESTATE
Foreclosed real estate, included in other assets, is comprised of property
acquired through a foreclosure proceeding, acceptance of a deed-in-lieu of
foreclosure, or insubstance foreclosures. Foreclosed real estate is initially
recorded at fair value at the date of foreclosure, establishing a new cost
basis. Appraisals are generally used to determine fair value. After foreclosure,
management reviews valuations quarterly and the asset is carried at the lower of
cost or fair value minus estimated costs to sell. Costs related to the
improvement of foreclosed real estate are generally capitalized until the real
estate reaches a saleable condition. Revenue and expense from operations and
changes in the valuation allowance are included in expense. When a foreclosed
real estate asset is ultimately sold, any gain or loss on the sale is included
in the income statement as a component of foreclosed real estate expense.
INVESTMENTS IN REAL ESTATE PARTNERSHIPS
In March 2003, PeoplesBank acquired a 73.47 percent limited partner interest in
a real estate joint venture to develop, construct, own and operate a 60-unit
affordable housing complex for rental to families, to be known as Village Court,
located in Dover Township, York County, Pennsylvania. Management expects this
project to be completed in the latter half of 2004 based on a projection
provided by Creating Affordable Housing, Inc., the general partner. At December
31, 2003, an investment balance of $2,770,000 was included
[LOGO 15]
26
Notes to Consolidated Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONT'D)
in other assets and an investment payable of $1,527,000 was included in other
liabilities. Additionally, PeoplesBank is a 99.99 percent limited partner in a
real estate joint venture that rehabilitated and now operates seven buildings in
the City of York (Pennsylvania) as part of a revitalization initiative. An
affiliate of the YMCA of York holds the remaining partnership interest. The
buildings provide low-income housing to qualified families and to a lesser
degree, space for commercial purposes. The investment balance, recorded in other
assets, was $2,002,000 at December 31, 2003, compared to $2,205,000 at December
31, 2002.
Investment and related tax credits are accounted for under the effective yield
method of accounting whereby tax credits are recognized as they are allocated
and the cost of the investment is amortized to provide a constant yield over the
period that tax credits are allocated.
BANK OWNED LIFE INSURANCE
PeoplesBank invests in bank owned life insurance (BOLI) as a source of funding
for employee benefit expenses. BOLI involves the purchasing of life insurance by
PeoplesBank on a chosen group of employees and directors. PeoplesBank is the
owner and beneficiary of the policies. This life insurance investment is carried
at the cash surrender value of the underlying policies and is included in other
assets in the amount of $7,051,000 at December 31, 2003, compared to $6,726,000
at December 31, 2002. Income from the increase in cash surrender value of the
policies is a separate line item within the noninterest income section of the
income statement.
TRUST AND INVESTMENT SERVICES ASSETS
Assets held by PeoplesBank in a fiduciary or agency capacity for its customers
are not included in the consolidated statements of financial condition since
these items are not assets of PeoplesBank.
ADVERTISING
Advertising costs are charged to expense when incurred.
INCOME TAXES
Deferred income taxes are provided on the liability method whereby deferred tax
assets are recognized for deductible temporary differences and deferred tax
liabilities are recognized for taxable temporary differences. Temporary
differences are the differences between the reported amounts of assets and
liabilities and their tax bases. Deferred tax assets are reduced by a valuation
allowance, when in the opinion of management, it is more likely than not that
some portion or all the deferred tax assets will not be realized. Deferred tax
assets and liabilities are adjusted through the provision for income taxes for
the effects of changes in tax laws and rates on the effective date.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts reported in the financial statements and accompanying notes.
Actual results could differ from those estimates. Material estimates that are
particularly susceptible to significant change in the near term relate to the
determination of the allowance for loan losses.
PER SHARE DATA
Basic earnings per share represent income available to common shareholders
divided by the weighted average number of common shares outstanding during the
period. The weighted average number of shares of common stock outstanding,
adjusted for stock dividends, was 2,833,242 for 2003, 2,828,029 for 2002 and
2,825,804 for 2001. Diluted earnings per share reflect additional common shares
that would have been outstanding if dilutive potential common shares had been
issued as well as any adjustments to income that would result from the presumed
issuance. Potential common shares that may be issued by the Corporation relate
solely to outstanding stock options, and are determined using the treasury stock
method. The weighted average number of dilutive shares was 32,283 for 2003,
12,183 for 2002 and 9,608 for 2001. Anti-dilutive options excluded from the
computation of earnings per share were 35,742 for 2003, 94,031 for 2002, and
123,786 for 2001. All per share amounts have been adjusted for stock dividends.
STOCK-BASED COMPENSATION
Stock options issued under shareholder approved employee and director stock
option plans are accounted for under Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" (APB 25). Stock options are granted
at exercise prices not less than the fair value of the common stock on the date
of grant. Under APB 25, no compensation expense is recognized related
[LOGO 16]
27
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONT'D)
to these plans. The pro forma impact on net income and earnings per share that
would occur if compensation expense were recognized based on the estimated fair
value of the options on the date of the grant is as follows:
YEARS ENDED DECEMBER 31,
(dollars in thousands, except per share data) 2003 2002 2001
- --------------------------------------------- ---- ---- ----
Reported net income $3,432 $3,101 $2,854
Deduct total stock-based employee compensation expense
determined under fair value based method for all awards,
net of related tax effects 22 160 115
Pro forma net income $3,410 $2,941 $2,739
Reported basic earnings per share $ 1.21 $ 1.10 $ 1.01
Reported diluted earnings per share $ 1.20 $ 1.09 $ 1.01
Pro forma basic earnings per share $ 1.20 $ 1.04 $ 0.97
Pro forma diluted earnings per share $ 1.19 $ 1.04 $ 0.97
------ ------ ------
The grant-date fair value of options granted, adjusted for stock dividends, was
$6.29 for 2002 and $6.14 for 2001. There were no options granted in 2003. The
2002 and 2001 values were calculated using the Black-Scholes option valuation
model. The following significant assumptions were used:
2002 2001
---- ----
Expected life (in years) 5.25 6.21
Risk free interest rate 4.52% 4.88%
Expected volatility 56.9% 59.1%
Expected dividend yield 3.2% 3.2%
--- ---
CASH FLOW INFORMATION
For purposes of the statements of cash flows, the Corporation considers interest
bearing deposits with banks, cash and due from banks, and federal funds sold to
be cash and cash equivalents.
Noncash items for the year ended December 31, 2003, included a real estate
partnership investment commitment for $1,527,000 and the transfer of loans to
foreclosed real estate for $1,569,000. Noncash items for the year ended December
31, 2002, consisted of the transfer of loans to foreclosed real estate for
$356,000. Noncash items for the year ended December 31, 2001, included a real
estate partnership investment commitment for $2,982,000, an asset acquired under
a capital lease for $672,000, and the transfer of loans to foreclosed real
estate for $1,346,000.
OFF-BALANCE SHEET FINANCIAL INSTRUMENTS
In the ordinary course of business, the Corporation has entered into off-balance
sheet financial instruments consisting of commitments to extend credit and
standby letters of credit. These financial instruments are recorded on the
balance sheet when they become payable by the borrower to the Corporation.
COMPREHENSIVE INCOME
Accounting principles generally require that recognized revenue, expenses, gains
and losses be included in net income. Although certain changes in assets and
liabilities, such as unrealized gains and losses on available-for-sale
securities, are reported as a separate component of the equity section of the
balance sheet, such items, along with net income, are components of
comprehensive income. The components of other comprehensive income and related
tax effects are presented in the following table:
YEARS ENDED DECEMBER 31,
(dollars in thousands) 2003 2002 2001
- ---------------------- ---- ---- ----
Unrealized holding (losses) gains arising during the year $(695) $1,621 $ 458
Reclassification adjustment for gains included in income (266) (179) 0
----- ------ -----
Net unrealized (losses) gains (961) 1,442 458
Tax effect 327 (489) (157)
----- ------ -----
Net of tax amount $(634) $ 953 $ 301
----- ------ -----
[LOGO 17]
28
Notes to Consolidated Financial Statements
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONT'D)
SEGMENT REPORTING
Management has determined that it operates in only one segment, community
banking. The Corporation's non-banking activities are insignificant to the
consolidated financial statements.
TREASURY STOCK
The acquisition of treasury stock is recorded under the cost method. The
subsequent disposition or sale of the treasury stock is recorded using the
average cost method.
RECLASSIFICATIONS
Certain amounts in the 2002 and 2001 financial statements have been reclassified
to conform to the 2003 presentation format. These reclassifications had no
impact on the Corporation's net income.
RECENTLY ISSUED FASB STATEMENTS
In May 2003, the Financial Accounting Standards Board issued Statement No. 150
(Statement), "Accounting for Certain Financial Instruments with Characteristics
of Both Liabilities and Equity." This Statement requires that an issuer classify
a financial instrument that is within its scope as a liability. Many of these
instruments were previously classified as equity. This Statement was effective
for financial instruments entered into or modified after May 31, 2003 and
otherwise was effective beginning July 1, 2003. The adoption of this Statement
did not have any impact on the Corporation's financial condition or results of
operations.
In April 2003, the Financial Accounting Standards Board (Board) issued Statement
No. 149 (Statement), "Amendment of Statement No. 133, Accounting for Derivative
Instruments and Hedging Activities." This Statement clarifies the definition of
a derivative and incorporates certain decisions made by the Board as part of the
Derivatives Implementation Group process. The Statement was effective for
contracts entered into or modified, and for hedging relationships designated
after June 30, 2003 and should be applied prospectively. The provisions of the
Statement that relate to implementation issues addressed by the Derivatives
Implementation Group that have been effective should continue to be applied in
accordance with their respective dates. Adoption of this Statement did not have
any impact on the Corporation's financial condition or results of operations.
In January 2003, the Financial Accounting Standards Board (FASB) issued FASB
Interpretation No. 46 (FIN 46), "Consolidation of Variable Interest Entities, an
Interpretation of ARB No. 51." FIN 46 was revised in December 2003. This
interpretation provides new guidance for the consolidation of variable interest
entities (VIEs) and requires such entities to be consolidated by their primary
beneficiaries if the entities do not effectively disperse risk among parties
involved. The interpretation also adds disclosure requirements for investors
that are involved with unconsolidated VIEs. The disclosure requirements apply to
all financial statements issued after December 31, 2003. The consolidation
requirements apply to companies that have interests in special-purpose entities
for periods ending after December 15, 2003. Consolidation of other types of VIEs
is required in financial statements for periods ending after March 15, 2004. The
adoption of FIN 46 did not have and is not expected to have a significant impact
on the Corporation's financial condition or results of operations.
In November 2002, the Financial Accounting Standards Board (FASB) issued FASB
Interpretation No. 45 (FIN 45), "Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others." FIN 45 expands the disclosures to be made by a guarantor in its
financial statements about its obligations under certain guarantees and requires
the guarantor to recognize a liability for the fair value of an obligation
assumed under certain specified guarantees. Under FIN 45, the Corporation does
not issue any guarantees that would require liability recognition or disclosure,
other than its standby letters of credit, as discussed in Note 15. Adoption of
FIN 45 did not have a significant impact on the Corporation's financial
condition or results of operations.
NOTE 2 - RESTRICTIONS ON CASH AND DUE FROM BANKS
Cash balances reserved to meet regulatory requirements of the Federal Reserve
Bank and balances maintained at other banks for compensating balance
requirements averaged approximately $3,925,000 for 2003 and $4,198,000 for 2002.
[LOGO 18]
29
NOTE 3 - SECURITIES AVAILABLE-FOR-SALE AND HELD-TO-MATURITY
A summary of available-for-sale and held-to-maturity securities at December 31,
follows:
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
(dollars in thousands) COST GAINS LOSSES VALUE
- ---------------------- ---- ----- ------ -----
2003
Available-for-sale
Debt securities
U.S. agencies $45,355 $ 556 $ (152) $ 45,759
States and municipals 8,617 656 0 9,273
Mortgage-backed securities 7,636 103 (33) 7,706
------- -------- -------- --------
Total available-for-sale $61,608 $ 1,315 $ (185) $ 62,738
------- -------- -------- --------
Held-to-maturity:
Debt securities-corporate trust preferreds $ 9,355 $ 916 $ (48) $ 10,223
------- -------- -------- --------
Total held-to-maturity $ 9,355 $ 916 $ (48) $ 10,223
------- -------- -------- --------
2002
Available-for-sale
Debt securities
U.S. treasuries $ 1,004 $ 16 $ 0 $ 1,020
U.S. agencies 35,087 1,015 0 36,102
States and municipals 10,474 679 0 11,153
Mortgage-backed securities 20,207 381 0 20,588
------- -------- -------- --------
Total available-for-sale $66,772 $ 2,091 $ 0 $ 68,863
------- -------- -------- --------
Held-to-maturity
Debt securities-corporate trust preferreds $ 9,357 $ 445 $ (263) $ 9,539
------- -------- -------- --------
Total held-to-maturity $ 9,357 $ 445 $ (263) $ 9,539
------- -------- -------- --------
The amortized cost and estimated fair value of debt securities at December 31,
2003, by contractual maturity, are shown below. Actual maturities may differ
from contractual maturities if call options on selected debt issues are
exercised in the future. Mortgage-backed securities are included in the maturity
categories based on average expected life.
DECEMBER 31, 2003
AMORTIZED FAIR
(dollars in thousands) COST VALUE
- ---------------------- ---- -----
Available-for-sale
Due in one year or less $ 7,115 $ 7,225
Due after one year through five years 46,983 47,486
Due after five years through ten years 6,216 6,632
Due after ten years 1,294 1,395
------- -------
Total debt securities, available-for-sale $61,608 $62,738
------- -------
Held-to-maturity
Due after ten years $ 9,355 $10,223
------- -------
Gross gains realized from the sale of available-for-sale securities were
$266,000, $179,000 and $0, for 2003, 2002 and 2001, respectively. Securities
with a carrying value of $18,226,000 and $21,057,000 on December 31, 2003 and
2002, respectively, were pledged to secure certain public and trust deposits.
30 [LOGO 19]
Notes to Consolidated Financial Statements
NOTE 3 - SECURITIES AVAILABLE-FOR-SALE AND HELD-TO-MATURITY (CONT'D)
The following table shows investments' gross unrealized losses and fair value,
aggregated by investment category and length of time that individual securities
have been in a continuous unrealized loss position, at December 31, 2003.
LENGTH OF TIME IN UNREALIZED LOSS POSITION
------------------------------------------
LESS THAN 12 MONTHS 12 MONTHS OR MORE TOTAL
FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED
(dollars in thousands) VALUE LOSSES VALUE LOSSES VALUE LOSSES
- ---------------------- ----- ------ ----- ------ ----- ------
Available-for-sale
U. S. agencies $14,998 $ 152 $ 0 $ 0 $ 14,998 $ 152
Mortgage-backed securities 929 33 0 0 929 33
------- ------- ------ -------- -------- -------
Total temporarily impaired debt
securities, available-for-sale $15,927 $ 185 $ 0 $ 0 $ 15,927 $ 185
------- ------- ------ -------- -------- -------
Held-to-maturity
Debt securities-corporate trust preferred $ 0 $ 0 $ 467 $ 48 $ 467 $ 48
Total temporarily impaired debt
------- ------- ------ -------- -------- -------
securities, held-to-maturity $ 0 $ 0 $ 467 $ 48 $ 467 $ 48
------- ------- ------ -------- -------- -------
The $185,000 unrealized loss (less than 12 months) within the available-for-sale
category was attributable to thirteen different securities. Management believes
that the unrealized loss was the result of fluctuations in market interest rates
subsequent to acquisition. Management has the ability to hold these investments
until the earlier of maturity or a market price recovery. The $48,000 unrealized
loss (12 months or more) in the held-to-maturity category was attributable to a
single trust preferred security, rated investment grade and guaranteed by Royal
Bank of Canada.
NOTE 4 - LOANS
The composition of the loan portfolio at December 31, is as follows:
(dollars in thousands) 2003 2002
- ---------------------- ---- ----
Commercial, industrial and agricultural $163,676 $161,425
Real estate - construction and land development 28,147 20,596
-------- --------
Total commercial related loans 191,823 182,021
Real estate - residential mortgages 25,134 24,803
Installment 43,249 27,136
-------- --------
Total consumer related loans 68,383 51,939
-------- --------
Total loans $260,206 $233,960
-------- --------
Concentrations of credit risk arise when a number of customers are engaged in
similar business activities in the same geographic region or have similar
economic features that could cause their ability to meet contractual obligations
to be similarly affected by changes in economic conditions. Most of the
Corporation's business is with customers in York County, Pennsylvania and
northern Maryland. Although this may pose a concentration risk geographically,
we believe the diverse local economy and detailed knowledge about the customer
base minimizes this risk. At year-end 2003 and 2002, the total loan portfolio
included two industry concentrations that exceeded 10 percent. The commercial
real estate leasing industry accounted for 11.8 and 15.7 percent, respectively
of the total loan portfolio, and the agricultural industry accounted for 10.3
and 8.5 percent, respectively of the total loan portfolio. Loans to borrowers
within these industries are usually collateralized by real estate.
Loans to directors, executive officers, principal shareholders, and any
associates of such persons amounted to $3,434,000 at December 31, 2003, and
$3,453,000 at December 31, 2002. During 2003, total loan additions amounted to
$2,875,000 and total payments collected amounted to $2,894,000. Related party
loans are made on substantially the same terms, including interest rates and
collateral, as those prevailing at the time for comparable transactions with
unrelated persons and do not involve more than normal risk of collection. As of
year-end 2003, all loans to this group were current and performing in accordance
with contractual terms.
[LOGO 20]
31
NOTE 5 - IMPAIRED, NONACCRUAL AND PAST DUE LOANS
Information regarding impaired commercial loans at December 31, was as follows:
(dollars in thousands) 2003 2002 2001
- ---------------------- ---- ---- ----
Impaired loans $4,006 $6,445 $2,199
Amount of impaired loans that have a related allowance 1,064 1,359 2,199
Allowance for impaired loans 611 444 734
Average investment in impaired loans 5,352 5,869 2,650
Interest income recognized on impaired commercial loans 266 152 115
------ ------ ------
Impairment related to the above loans was measured based on fair values of
collateral. As of December 31, 2003 and 2002, the loan portfolio included total
nonaccrual loans of $516,000 and $5,051,000, respectively. Interest that would
have been included in income had those loans been accruing at their contractual
rates in 2003 was $34,000, compared with $36,000 that was recognized in income.
Loans contractually past due 90 days or more as to principal or interest, but
still accruing interest totaled $49,000 at December 31, 2003 and $453,000 at
December 31, 2002.
NOTE 6 - ANALYSIS OF ALLOWANCE FOR LOAN LOSSES
Changes in the allowance for loan losses for each of the three years ended
December 31, were as follows:
(dollars in thousands) 2003 2002 2001
- ---------------------- ---- ---- ----
Balance at beginning of year $1,515 $1,898 $1,967
Provision charged to operating expense 553 515 143
Loans charged off (770) (1,185) (232)
Recoveries 396 287 20
------ ------ ------
Balance at end of year $1,694 $1,515 $1,898
------ ------ ------
[LOGO 21]
32
Notes to Consolidated Financial Statements
NOTE 7 - PREMISES AND EQUIPMENT
A summary of premises and equipment at December 31, was as follows:
(dollars in thousands) 2003 2002
- ---------------------- ---- ----
Land $ 1,149 $ 1,149
Buildings and improvements 8,746 8,481
Capitalized leased premises 672 672
Equipment 6,855 6,156
------- -------
17,422 16,458
Less-accumulated depreciation (8,064) (7,123)
------- -------
Net premises and equipment $ 9,358 $ 9,335
------- -------
PeoplesBank leases certain banking branches under capital and noncancellable
operating leases, which expire on various dates through 2016. The terms include
various renewal options and provide for rental increases based upon
predetermined factors. Total lease expenses under operating leases amounted to
$70,000 in 2003, $38,000 in 2002 and $22,000 in 2001. At December 31, 2003,
future minimum lease payments for these leases and a capital lease are payable
as follows:
CAPITAL OPERATING
(dollars in thousands) LEASE LEASES
- ---------------------- ----- ------
2004 $ 88 $ 66
2005 88 67
2006 94 67
2007 95 68
2008 95 70
Thereafter 701 225
---------- ------
Total future minimum lease payments 1,161 $ 563
Less-interest (524)
----------
Present value of minimum lease payments $ 637
----------
NOTE 8 - DEPOSITS
The composition of deposits at December 31, was as follows:
(dollars in thousands) 2003 2002
- ---------------------- ---- ----
Noninterest bearing demand $ 33,188 $ 30,120
NOW 40,552 34,851
Money market 75,529 73,938
Savings 15,627 13,023
Time CDs less than $100,000 113,014 114,808
Time CDs $100,000 or more 26,372 25,887
-------- --------
Total deposits $304,282 $292,627
-------- --------
Scheduled maturities of time deposits as of December 31, were as follows:
(dollars in thousands) 2003
- ---------------------- ----
2004 $ 75,043
2005 30,804
2006 18,350
2007 11,016
2008 4,173
--------
Total time deposits $139,386
--------
[LOGO 22]
33
NOTE 9 - SHORT-TERM BORROWINGS AND LONG-TERM DEBT
The schedule below provides a summary of short-term borrowings that consist of
federal funds purchased and other borrowings. Federal funds purchased from
correspondent banks usually mature in one business day. Other short-term
borrowings consist of credit available through Federal Home Loan Bank of
Pittsburgh (FHLBP). Based on the most recent analysis, total credit available
from the FHLBP, for both short and long-term credit needs, is approximately $95
million. As of December 31, 2003, total unused credit with the FHLBP was
approximately $66 million. Obligations to the FHLBP are secured by FHLB stock
and qualifying collateral, principally the unpledged portion of PeoplesBank's
investment securities portfolio and qualifying mortgage loan receivables. The
interest rate for short-term borrowings reprices daily based on the federal
funds rate or the open repo market depending on the borrowing program.
A summary of aggregate short-term borrowings on December 31, is as follows:
(dollars in thousands) 2003 2002 2001
- ---------------------- ---- ---- ----
Amount outstanding at end of year $6,795 $7,089 $ 0
Weighted average interest rate at end of year 1.03% 1.31% 0.00%
Maximum amount outstanding at any month-end $6,795 $7,089 $3,000
Daily average amount outstanding $1,473 $ 591 $ 101
Approximate weighted average interest rate for the year 1.29% 1.69% 6.93%
------ ------ ------
A summary of long-term debt at December 31, is as follows:
(dollars in thousands) 2003 2002
- ---------------------- ---- ----
PeoplesBank obligations to FHLBP
Due 2004, 5.12% $ 0 $ 1,025
Due 2005, 5.36%, convertible quarterly after
December 2002 6,000 6,000
Due 2007, 4.69%, amortizing 1,256 1,636
Due 2009, 3.47%, convertible quarterly after
December 2006 5,000 0
Due 2013, 3.46%, amortizing 4,753 0
Due 2014, 6.43%, convertible quarterly after
July 2009 5,000 5,000
Codorus Valley Bancorp, Inc. obligation
Due 2009, 7.35%, amortizing 1,793 1,848
------- -------
23,802 15,509
Capital lease obligation 637 655
------- -------
Total long-term debt $24,439 $16,164
------- -------
PeoplesBank's obligations to FHLBP are fixed rate and fixed/floating
(convertible) rate instruments. The FHLBP has an option on the convertible
borrowings to convert the rate to a floating rate after the expiration of a
specified period. The floating rate is based on the LIBOR index plus a spread.
If the FHLBP elects to exercise its conversion option, PeoplesBank can repay the
converted loan without a prepayment penalty. The obligation of Codorus Valley is
secured by a mortgage on the Codorus Valley Corporate Center office building at
105 Leader Heights Road, York, Pennsylvania. In February 2004, this obligation
was refinanced without interest penalty. The new obligation is for approximately
the same amount, matures in 2011 and has a floating rate based on the 1-month
LIBOR index plus 150 basis points. Total maturities of total long-term debt over
the next five years are as follows: $916,000 in 2004, $6,956,000 in 2005,
$1,007,000 in 2006, $594,000 in 2007 and $621,000 in 2008.
[LOGO 23]
34
Notes to Consolidated Financial Statements
NOTE 10 - SHAREHOLDERS' EQUITY
On April 8, 2003, the board of directors declared a 5 percent common stock
dividend payable on or before June 5, 2003, to shareholders of record on April
22, 2003. On April 9, 2002, the board of directors declared a 5 percent common
stock dividend payable on or before June 6, 2002, to shareholders of record on
April 23, 2002. On April 10, 2001, the board of directors declared a 5 percent
common stock dividend payable on or before June 7, 2001, to shareholders of
record on April 24, 2001.
Codorus Valley maintains a Dividend Reinvestment and Stock Purchase Plan (Plan).
Shareholders of common stock may participate in the Plan, which allows
additional shares of common stock to be purchased with reinvested dividends at
prevailing market prices. To the extent that shares are not available in the
open market, 159,942 shares of common stock are reserved and available for
issuance at December 31, 2003. Under the Plan, no shares were issued in 2003,
2,642 shares were issued in 2002 and no shares were issued in 2001. Open market
purchases are usually made by an independent purchasing agent retained to act as
agent for Plan participants, and the purchase price to participants will be the
actual price paid, excluding brokerage commissions and other expenses which will
be paid by the Corporation. The Plan also permits participants to make
additional voluntary cash payments toward the purchase of shares of the
Corporation's common stock.
NOTE 11 - REGULATORY MATTERS
The Corporation is subject to restrictions on the payment of dividends to its
shareholders pursuant to the Pennsylvania Business Corporation Law of 1988, as
amended (BCL). The BCL prohibits dividend payments if such payment would render
the Corporation insolvent or result in negative net worth. Federal and state
banking regulations place certain restrictions on dividends paid and loans or
advances made by PeoplesBank to the Corporation. The total amount of dividends,
which may be paid at any date, is generally limited to the retained earnings of
PeoplesBank, and loans or advances are limited to 10 percent of PeoplesBank's
capital stock and surplus on a secured basis. In addition, dividends paid by
PeoplesBank to the Corporation would be prohibited if the effect thereof would
cause the Bank's capital to be reduced below applicable minimum capital
requirements.
The Corporation and PeoplesBank are subject to various regulatory capital
requirements. Failure to meet minimum capital requirements can result in certain
mandatory and possible additional discretionary actions by regulators that, if
imposed, could have a material effect on the Corporation's financial statements.
Under capital adequacy guidelines and the regulatory framework for prompt
corrective action, the Corporation and PeoplesBank must meet specific capital
guidelines that involve quantitative measures of assets, liabilities, and
certain off-balance sheet items as calculated under regulatory accounting
practices. The capital amounts and classification are also subject to
qualitative judgements by the regulators.
Quantitative measures established by regulators to ensure capital adequacy
require the Corporation and PeoplesBank to maintain minimum ratios, as set forth
below, to total and tier 1 capital as a percentage of risk-weighted assets, and
of tier 1 capital to average assets (leverage ratio). Management believes that
the Corporation and PeoplesBank were well capitalized on December 31, 2003,
based on FDIC capital guidelines.
The FDIC's minimum quantitative standards for a well capitalized institution are
as follows: tier 1 risk-based capital ratio, 6 percent; total risk-based capital
ratio, 10 percent; and leverage ratio, 5 percent. The FDIC's minimum
quantitative standards for an adequately capitalized institution are as follows:
tier 1 risk-based capital ratio, 4 percent; total risk-based capital ratio, 8
percent; and leverage ratio, 4 percent. At the state level, the Pennsylvania
Department of Banking uses a leverage ratio guideline of 6 percent. The
following table shows the Corporation and PeoplesBank's actual and required
ratios and capital amounts on December 31, 2003 and 2002.
[LOGO 24]
35
NOTE 11 - REGULATORY MATTERS (CONT'D)
MINIMUM FOR WELL CAPITALIZED
CODORUS VALLEY BANCORP, INC. ACTUAL CAPITAL ADEQUACY MINIMUM*
(dollars in thousands) AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
- ---------------------- ------ ----- ------ ----- ------ -----
December 31, 2003
Capital ratios
Tier 1 risk-based $ 32,702 11.13% > or = $ 11,751 > or = 4.0% N/A N/A
Total risk-based 34,396 11.71 > or = 23,502 > or = 8.0 N/A N/A
Leverage 32,702 9.15 > or = 14,292 > or = 4.0 N/A N/A
December 31, 2002
Capital ratios
Tier 1 risk-based $ 30,475 11.32% > or = $ 10,770 > or = 4.0% n/a n/a
Total risk-based 31,990 11.88 > or = 21,539 > or = 8.0 n/a n/a
Leverage 30,475 8.93 > or = 13,650 > or = 4.0 n/a n/a
MINIMUM FOR WELL CAPITALIZED
PEOPLESBANK ACTUAL CAPITAL ADEQUACY MINIMUM*
(dollars in thousands) AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
- ---------------------- ------ ----- ------ ----- ------ -----
December 31, 2003
Capital ratios
Tier 1 risk-based $ 28,048 9.75% > or = $11,504 > or = 4.0% > or = $17,256 > or = 6.0%
Total risk-based 29,742 10.34 > or = 23,008 > or = 8.0 > or = $28,760 > or =10.0
Leverage 28,048 7.99 > or = 14,043 > or = 4.0 > or = 17,554 > or = 5.0
December 31, 2002
Capital ratios
Tier 1 risk-based $ 25,946 9.86% > or = $10,521 > or = 4.0% > or = $15,782 > or = 6.0%
Total risk-based 27,461 10.44 > or = 21,042 > or = 8.0 > or = 26,303 > or =10.0
Leverage 25,946 7.75 > or = 13,390 > or = 4.0 > or = 16,738 > or = 5.0
* To be well capitalized under prompt correction action provisions.
NOTE 12 - BENEFIT PLANS
DEFINED CONTRIBUTION PLAN
The Corporation maintains a 401(k) savings and investment plan covering
substantially all employees. Under the plan, employees can contribute a
percentage of their gross salary. In 2003, 2002, and 2001, the Corporation
matched 50 percent of the first 6 percent of an employee's contribution. The
Corporation's expense for the 401(k) savings and investment plan was $103,000
for 2003, $92,000 for 2002, and $77,000 for 2001.
SUPPLEMENTAL BENEFIT PLANS
PeoplesBank maintains supplemental retirement plans for selected executives and
supplemental life insurance for executive officers and directors. The
supplemental life insurance plans replaced other insurance coverage. The expense
associated with these plans was approximately $147,000 for 2003, $130,000 for
2002, and $118,000 for 2001. The accrued liability was $629,000 at December 31,
2003, and $482,000 at December 31, 2002. Investment in bank owned life insurance
policies was used to finance the supplemental benefit plans, and provide a
tax-exempt return to PeoplesBank.
EMPLOYEE STOCK BONUS PLAN
In 2001, the Corporation implemented an Employee Stock Bonus Plan, administered
by nonemployee members of the Corporation's board of directors, under which the
Corporation may issue shares of its common stock to employees as performance
based compensation. As of December 31, 2003, 10,796 shares of common stock were
reserved for possible issuance under this plan, subject to future adjustment in
the event of specified changes in the Corporation's capital structure. Under the
Employee Stock Bonus Plan, 66 shares of stock were issued during 2003 and 152
shares of stock were issued during 2002.
[LOGO 25]
36
Notes to Consolidated Financial Statements
NOTE 13 - STOCK OPTION PLANS
The Corporation maintains three stock option plans as follows: a 2000 Stock
Incentive Plan (2000 Plan), a 1998 Independent Directors Stock Option Plan (1998
Plan) and a 1996 Stock Incentive Plan (1996 Plan). All options available for
grant under the 1998 and 1996 Plans have been granted.
Shares reserved and available for issuance were 115,763 for the 2000 Plan,
122,997 for the 1998 Plan, and 92,012 for the 1996 Plan at December 31, 2003.
Shares reserved for future issuance under each plan are subject to adjustment in
the event of specified changes in the Corporation's capital structure. Options
awarded under these plans to date have been granted with an exercise price equal
to the fair value of the stock on the grant date, a vesting period of six months
and an expiration period of ten years.
The 2000 Plan also allows for the granting of stock appreciation rights and
restricted stock, none of which have been granted to date at December 31, 2003.
A summary of stock options from all Plans, adjusted for stock dividends, is
presented in the following table:
YEARS ENDED DECEMBER 31,
2003 2002 2001
-----------------------------------------------------------------------------
WEIGHTED WEIGHTED WEIGHTED
AVG. EXERCISE AVG. EXERCISE AVG. EXERCISE
OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE
------- ----- ------- ----- ------- -----
Outstanding at beginning of year 201,337 $14.15 191,052 $14.07 170,824 $ 14.29
Granted - - 12,600 14.76 34,179 13.34
Exercised - - 2,315 10.37 2,315 10.37
Forfeited - - - - 11,636 15.90
------- ------ ------- ------ ------- -------
Outstanding at end of year 201,337 $14.15 201,337 $14.15 191,052 $ 14.07
------- ------ ------- ------ ------- -------
Information regarding options outstanding as of December 31, 2003, is presented
in the following table:
WEIGHTED AVG.
REMAINING
OPTIONS WEIGHTED AVG. CONTRACTUAL OPTIONS WEIGHTED AVG.
OUTSTANDING EXERCISE PRICE LIFE EXERCISABLE EXERCISE PRICE
----------- -------------- ---- ----------- --------------
Options with exercise prices
ranging from $8.50 to $11.50 30,772 $10.26 4.5 YEARS 30,772 $10.26
Options with exercise prices
ranging from $11.51 to $14.50 84,152 13.79 5.7 YEARS 71,686 13.82
Options with exercise prices
ranging from $14.51 to $17.50 86,413 15.89 5.4 YEARS 81,308 15.93
------- ------ --- ------- ------
Total options outstanding with exercise
prices ranging from $8.50 to $17.50 201,337 $14.15 5.4 YEARS 183,766 $14.16
------- ------ --- ------- ------
[LOGO 26]
37
NOTE 14 - INCOME TAXES
Significant components of the Corporation's deferred tax assets and liabilities
at December 31, are as follows:
(dollars in thousands) 2003 2002
- ---------------------- ---- ----
Deferred tax assets
Allowance for loan losses $ 411 $ 351
Deferred compensation 214 164
Partnership investment amortization 328 259
Tax credit carryforward 285 428
------ --------
Total deferred tax assets 1,238 1,202
------ --------
Deferred tax liabilities
Deferred loan fees 120 82
Depreciation 330 259
Net unrealized gains on available-for-sale securities 384 711
Other, net 153 107
------ --------
Total deferred tax liabilities 987 1,159
------ --------
Net deferred tax asset $ 251 $ 43
------ --------
Analysis of federal income taxes reflected in the income statements is as
follows:
(dollars in thousands) 2003 2002 2001
- ---------------------- ---- ---- ----
Current tax provision $1,052 $1,291 $940
Deferred tax benefit (provision) 119 (614) (8)
------ ------ ----
Total tax provision $1,171 $ 677 $932
------ ------ ----
The reasons for the difference between the provision for income taxes and the
amount computed by applying the statutory federal income tax rate to income
before income taxes are as follows:
(dollars in thousands) 2003 2002 2001
- ---------------------- ---- ---- ----
Income before income taxes $4,603 $3,778 $3,786
------ ------ ------
Computed tax at 34% $1,565 $1,285 $1,287
Increase (reduction) in taxes resulting from:
Tax-exempt interest income (157) (182) (190)
Interest expense disallowance 13 20 27
Tax-exempt income from bank owned life insurance (108) (110) (100)
Tax credits (155) (372) (99)
Other, net 13 36 7
------ ------ ------
Provision for income taxes $1,171 $ 677 $ 932
------ ------ ------
The provision for income taxes includes $90,000, $61,000 and $0 of applicable
income tax expense related to net investment security gains in 2003, 2002 and
2001, respectively. Based on current tax law, tax credits can be carried back
one year and carried forward twenty years.
[LOGO 27]
38
Notes to Consolidated Financial Statements
NOTE 15 - COMMITMENTS TO EXTEND CREDIT
In the normal course of business, the Corporation is a party to various
financial transactions that are not funded as of the balance sheet date.
Off-balance sheet financial instruments, which enable bank customers to meet
their financing needs, are comprised mainly of commitments to extend credit and
standby letters of credit. Standby letters of credit written are conditional
commitments issued by PeoplesBank to guarantee the performance of a customer to
a third party. The credit and market risk involved in issuing letters of credit
is essentially the same as that involved in extending other loan commitments. To
manage these risks the Corporation uses the same credit policies in making
commitments and conditional obligations as it does for on-balance sheet
instruments and requires collateral to support these letters of credit as deemed
necessary. Management believes that the proceeds obtained through a liquidation
of such collateral would be sufficient to cover the maximum potential amount of
future payments required under the corresponding guarantees. The current amount
of the liability as of December 31, 2003, for guarantees under standby letters
of credit issued is not material. Normally, commitments to extend credit and
letters of credit have fixed expiration dates or termination clauses, have
specific rates and are for specific purposes. Many of the commitments are
expected to expire without being extended; therefore, total commitment amounts
do not necessarily represent future cash requirements.
The following is a summary of outstanding commitments:
DECEMBER 31,
(dollars in thousands) 2003 2002
- ---------------------- ---- ----
Commitments to grant loans
Fixed rate $ 7,929 $15,180
Variable rate 8,458 4,840
Unfunded commitments of existing loans
Fixed rate $ 8,685 $14,316
Variable rate 35,800 28,681
Standby letters of credit $ 3,496 $ 2,454
------- -------
NOTE 16 - CONTINGENT LIABILITIES
On March 19, 2003, a former bank client filed a counterclaim against PeoplesBank
in the Court of Common Pleas of Dauphin County, Pennsylvania, alleging, among
other things, that PeoplesBank: breached an implied-in-fact agreement to the
claimants related to loans made to the claimants; intentionally interfered with
the claimants' existing contracts and prospective business relations; and made
certain misrepresentations to the claimants. The claimants allege to have
incurred unliquidated losses and other damages in excess of $3.9 million and
exemplary damages in excess of $35,000. The counterclaim was filed in response
to the complaint filed by PeoplesBank whereby PeoplesBank alleges that the
claimants defaulted on a promissory note resulting in damages to PeoplesBank in
excess of $1.2 million. Management believes there are substantial defenses to
this lawsuit and intends to defend it vigorously. The impact of the final
disposition of this lawsuit cannot be assessed at this time. Counsel believes
that the claim may qualify as a "covered claim" under PeoplesBank's lender
liability insurance policy, which provides coverage for losses in excess of
$100,000, and which should cover the defense and indemnification of PeoplesBank
for the claim. The factual discovery process has not been completed. Although
PeoplesBank expects to incur costs in defending these claims, based on the
results of its investigation thus far and preliminary discussions with its
lawyers, PeoplesBank currently does not believe the ultimate resolution of the
claims will have a material impact on its financial condition or results of
operations.
Also during the first quarter of 2003, PeoplesBank became aware of a civil
forfeiture action brought about by the United States Attorney's Office. The
forfeiture action involves real estate supporting a loan that PeoplesBank made
to a customer who was allegedly involved with criminal activity. PeoplesBank is
actively protecting its mortgage interest in the real estate from forfeiture
through available defenses including the "innocent owner defense."
NOTE 17 - FAIR VALUE OF FINANCIAL INSTRUMENTS
FASB Statement No. 107, "Disclosures About Fair Value of Financial Instruments,"
requires disclosure of fair value information about financial instruments,
whether or not recognized on the balance sheet, for which it is practicable to
estimate that value. In cases where quoted market prices are not available, fair
values are based on estimates using present value of expected future cash flows
or other valuation techniques. Those techniques are significantly affected by
the assumptions used, including the discount rate and estimates
[LOGO 28]
39
NOTE 17 - FAIR VALUE OF FINANCIAL INSTRUMENTS (CONT'D)
of future cash flows. In that regard, derived fair value estimates cannot be
substantiated by comparison to independent markets and, in many cases, could not
be realized in immediate settlement of the instrument. Statement No. 107
excludes certain financial instruments and all nonfinancial instruments from its
disclosure requirements. Accordingly, the aggregate fair value amounts presented
do not represent the underlying value of the Corporation.
The Corporation used the methods and assumptions below in estimating its fair
value disclosures for financial instruments.
Cash and equivalents--The carrying amounts reported in the balance sheet for
cash and equivalents approximate their fair value at the reporting date.
Investment securities--Fair values for investment securities are based on quoted
market prices, where available. When quoted market prices are not available,
fair values are based on quoted market prices of comparable instruments.
Loans receivable--For variable-rate and adjustable-rate loans that reprice
frequently and show no significant change in credit risk; fair values were based
on carrying values. For fixed-rate loans, fair values were estimated using
discounted cash flow analysis using interest rates currently being offered for
loans with similar terms to borrowers of similar credit quality.
Mortgage servicing rights--The fair value of mortgage servicing rights is based
on observable market prices available or the present value of expected future
cash flows when not available.
Accrued interest receivable and payable--The carrying amounts of accrued
interest receivable and payable approximate their fair values.
Demand and savings deposits--The carrying amounts of demand and savings deposits
approximate their fair values.
Time deposits--The carrying value of time certificates of deposit (CDs) less
than $100,000 with an original term of six months or less and variable rate CDs
of less than $100,000 is assumed to approximate market value. The fair value of
all other CDs is estimated by discounting the future cash flows, using rates
offered for deposits of similar remaining maturities at the reporting date.
Short-term borrowings--The carrying amount of short-term borrowings approximates
the fair value.
Long-term debt--The fair value of long-term debt is estimated by discounting the
future cash flows, using rates available for debt of similar remaining
maturities at the reporting date.
Off-balance sheet instruments--The fair value of off-balance sheet instruments,
such as commitments to extend credit and standby letters of credit, are based on
fees currently charged to enter into similar agreements. These amounts were not
considered material at December 31, 2003 and 2002.
An analysis of financial instruments is as follows:
DECEMBER 31, 2003 DECEMBER 31, 2002
CARRYING FAIR CARRYING FAIR
(dollars in thousands) AMOUNT VALUE AMOUNT VALUE
- ---------------------- ------ ----- ------ -----
Financial assets
Cash and equivalents $ 12,408 $ 12,408 $ 11,120 $ 11,120
Securities, available-for-sale 62,738 62,738 68,863 68,863
Securities, held-to-maturity 9,355 10,223 9,357 9,539
Restricted investment in bank stock 1,976 1,976 1,503 1,503
Loans, held for sale 2,157 2,183 4,586 4,649
Loans, net of allowance 258,512 263,468 232,445 235,993
Mortgage servicing rights 26 26 52 52
Accrued interest receivable 1,556 1,556 1,721 1,721
Financial liabilities
Demand and savings deposits $164,896 $164,896 $151,932 $151,932
Time deposits 139,386 142,943 140,695 145,272
Short-term borrowings 6,795 6,795 7,089 7,089
Long-term debt 24,439 25,466 16,164 17,663
Accrued interest payable 340 340 454 454
Off-balance sheet instruments 0 0 0 0
-------- -------- -------- -------
[LOGO 29]
40
Notes to Consolidated Financial Statements
NOTE 18 - CONDENSED FINANCIAL INFORMATION-PARENT COMPANY ONLY
CONDENSED STATEMENTS OF FINANCIAL CONDITION
DECEMBER 31,
(dollars in thousands) 2003 2002
- ---------------------- ---- ----
ASSETS
Cash and due from banks $ 242 $ 181
Securities, held-to-maturity 3,777 3,776
Investment in subsidiaries 29,137 27,697
Premises and equipment 4,305 4,389
Other assets 173 146
------- -------
Total assets $37,634 $36,189
------- -------
LIABILITIES
Long-term debt $ 1,793 $ 1,848
Long-term debt with subsidiary, PeoplesBank 2,032 2,092
Other liabilities 20 26
------- -------
Total liabilities 3,845 3,966
SHAREHOLDERS' EQUITY 33,789 32,223
------- -------
Total liabilities and shareholders' equity $37,634 $36,189
------- -------
CONDENSED STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31,
(dollars in thousands) 2003 2002 2001
- ---------------------- ---- ---- ----
INCOME
Interest from investment securities $ 347 $ 371 $ 394
Dividends from subsidiary, PeoplesBank 1,453 1,263 1,301
Rental income 433 456 445
Other 0 24 0
------ ------ ------
Total income 2,233 2,114 2,140
EXPENSE
Interest expense on long-term debt 301 312 319
Other 623 595 656
------ ------ ------
Total expense 924 907 975
------ ------ ------
Income before applicable income tax benefit and
undistributed earnings of subsidiaries 1,309 1,207 1,165
APPLICABLE INCOME TAX BENEFIT 49 22 46
------ ------ ------
Income before undistributed earnings of subsidiaries 1,358 1,229 1,211
Undistributed earnings of subsidiaries 2,074 1,872 1,643
------ ------ ------
Net income $3,432 $3,101 $2,854
------ ------ ------
[LOGO 30]
41
NOTE 18 - CONDENSED FINANCIAL INFORMATION-PARENT COMPANY ONLY (CONT'D)
CONDENSED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31,
(dollars in thousands) 2003 2002 2001
- ---------------------- ---- ---- ----
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 3,432 $ 3,101 $ 2,854
Adjustments to reconcile net income to net cash
provided by operations:
Depreciation 173 171 172
Undistributed earnings of subsidiaries (2,074) (1,872) (1,643)
Gain on sale of premises and equipment and securities 0 (24) 0
Other, net 66 25 (45)
------- ------- -------
Net cash provided by operating activities 1,597 1,401 1,338
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sales of securities, available-for-sale 0 40 0
Purchase of securities, available-for-sale 0 0 (1)
Purchases of premises and equipment (89) (75) (52)
Proceeds from sales of premises and equipment 0 40 0
------- ------- -------
Net cash provided by (used in) investing activities (89) 5 (53)
CASH FLOWS FROM FINANCING ACTIVITIES
Repayments of long-term debt (115) (108) (100)
Dividends paid (1,327) (1,262) (1,201)
Issuance of common stock 0 67 27
Cash paid in lieu of fractional shares (5) (4) (4)
------- ------- -------
Net cash used in financing activities (1,447) (1,307) (1,278)
------- ------- -------
Net increase in cash and cash equivalents 61 99 7
Cash and cash equivalents at beginning of year 181 82 75
------- ------- -------
Cash and cash equivalents at end of year $ 242 $ 181 $ 82
------- ------- -------
[LOGO 31]
42
Report of Independent Auditors
[BEARD MILLER COMPANY LLP LOGO]
The Shareholders and Board of Directors
Codorus Valley Bancorp, Inc.
York, Pennsylvania
We have audited the accompanying consolidated statements of financial
condition of Codorus Valley Bancorp, Inc. and subsidiaries as of December 31,
2003 and 2002, and the related consolidated statements of income, changes in
shareholders' equity, and cash flows for each of the three years in the period
ended December 31, 2003. These financial statements are the responsibility of
the Corporation's management. Our responsibility is to express an opinion on
these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Codorus
Valley Bancorp, Inc. as of December 31, 2003 and 2002, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2003, in conformity with accounting principles generally accepted
in the United States of America.
Beard Miller Company LLP.
Harrisburg, Pennsylvania
January 9, 2004
[LOGO 32]
43
MANAGEMENT'S DISCUSSION OF CONSOLIDATED FINANCIAL CONDITION & RESULTS OF
OPERATIONS
Management's discussion and analysis of the significant changes in the results
of operations, capital resources and liquidity presented in the accompanying
consolidated financial statements for Codorus Valley Bancorp, Inc. (Codorus
Valley or Corporation), a bank holding company, and its wholly owned
subsidiary, PeoplesBank, A Codorus Valley Company (PeoplesBank), are provided
below. Codorus Valley's consolidated financial condition and results of
operations consist almost entirely of PeoplesBank's financial condition and
results of operations. Current performance does not guarantee and may not be
indicative of similar performance in the future.
FORWARD-LOOKING STATEMENTS
Management of the Corporation has made forward-looking statements in this Annual
Report. These forward-looking statements may be subject to risks and
uncertainties. Forward-looking statements include information concerning
possible or assumed future results of operations of the Corporation and its
subsidiaries. When words such as "believes," "expects," "anticipates" or similar
expressions occur in this Annual Report, management is making forward-looking
statements.
Shareholders should note that many factors, some of which are discussed
elsewhere in this report and in the documents that management incorporates by
reference, could affect the future financial results of the Corporation and its
subsidiaries, both individually and collectively, and could cause those results
to differ materially from those expressed in the forward-looking statements
contained or incorporated by reference in this Annual Report. These factors
include the following:
- operating, legal and regulatory risks;
- economic, political and competitive forces affecting banking,
securities, asset management and credit services businesses; and
- the risk that management's analyses of these risks and forces could be
incorrect and/or that the strategies developed to address them could
be unsuccessful.
The Corporation undertakes no obligation to publicly revise or update these
forward-looking statements to reflect events or circumstances that arise after
the date of this report. Readers should carefully review the risk factors
described in other documents that Codorus Valley files periodically with the
Securities and Exchange Commission.
CRITICAL ACCOUNTING ESTIMATES
Disclosure of Codorus Valley's significant accounting policies is included in
Note 1 to the consolidated financial statements of this Annual Report. Some of
these policies are particularly sensitive, requiring that significant judgments,
estimates and assumptions be made by management. Additional information is
contained in Management's Discussion and Analysis for the most sensitive of
these issues, including the provision and allowance for loan losses, located on
pages 38 and 44 of this Annual Report.
Significant estimates are made by management in determining the allowance for
loan losses. Management considers a variety of factors in establishing this
estimate such as current economic conditions, diversification of the loan
portfolio, delinquency statistics, results of internal loan reviews, financial
and managerial strength of borrowers, adequacy of collateral, if collateral
dependent, or present value of future cash flows and other relevant factors.
Estimates related to the value of collateral also have a significant impact on
whether or not management continues to accrue income on delinquent loans and on
the amounts at which foreclosed real estate is recorded on the statement of
financial condition. As described in Note 16--Contingent Liabilities, property
collateralizing a loan on PeoplesBank's balance sheet is subject to litigation.
In establishing the loan loss allowance, management presumed that the rights to
the property would be protected. If, however, PeoplesBank's property rights are
not successfully protected the allowance for loan losses will need to be
increased through provision expense to cover the loss.
As permitted by SFAS No. 123, the Corporation accounts for stock-based
compensation in accordance with Accounting Principles Board Opinion (APB) No.
25. Under APB No. 25, no compensation expense is recognized in the income
statement related to any options granted under the Corporation's stock option
plans. The pro forma impact of net income and earnings per share that would
occur if compensation expense was recognized, based on the estimated fair value
of the options on the date of the grant, is disclosed in Note 1 to the
consolidated financial statements. The Corporation has no current plans to
change its method of accounting for stock-based compensation.
Management discussed the development and selection of critical accounting
estimates and related Management Discussion and Analysis disclosure with the
Audit Committee. There were no material changes made to the critical accounting
estimates during the periods presented within this report.
Overview
THE UNITED STATES ECONOMY
United States economic activity improved in the second half of 2003, stimulated
by an end to major combat in Iraq, an increase in corporate profits and stock
prices and federal tax cuts. The unusually low level of market interest rates
was another important contributing factor. On June 25, 2003, the Federal Reserve
Board (Fed) lowered the federal funds rate one-quarter percent to 1 percent, its
only interest rate change in 2003. The national prime rate moved in lock step
and ended the year at 4 percent. Both benchmark interest rates were at 45-year
lows. After three consecutive years of stock market losses the Dow Jones
Industrial Average closed at 10,454, up 25.3 percent for the year and the S&P
500 closed at 1,112, up 26.4 percent for the year. Many economists believe that
the financial underpinnings for long-term economic growth are in place and
therefore, are generally optimistic about 2004. The only missing ingredient for
[LOGO 33]
44
Management's Discussion of Consolidated Financial Condition & Results of
Operations
a full-blown economic recovery is job growth. At year-end 2003 the unemployment
rate was 5.7 percent, well above a 4 percent "natural" rate of unemployment as
defined by the Fed.
Comparatively, on November 6, 2002, the Fed lowered the federal funds rate
one-half percent to 1.25 percent, its only interest rate change for 2002. The
national prime rate moved in lock step and ended the year at 4.25 percent. The
year 2002 ended with consumer confidence declining due to rising unemployment
and a discouraging job outlook. Other factors constraining economic growth
throughout the year included: the third of three consecutive years of stock
market losses, an occurrence not seen in the past 60 years; high profile
accounting scandals and bankruptcies; lackluster corporate earnings reports; and
anxiety over terrorism and possible military conflict around the world.
THE FINANCIAL SERVICES INDUSTRY
For the first nine months of 2003, FDIC insured institutions in the aggregate
earned 12 percent more than in the same period of 2002, based on the most
current available information from the FDIC. In short, it appears that the
financial services industry is poised for a record earnings year. The increase
in earnings was due primarily to increases in noninterest income (gains from the
sale of mortgages) and gains from the sale of securities, and a decrease in the
provision for loan losses. Net interest income increased only 1.2 percent as
yields declined faster than funding costs placing pressure on net interest
margins. Asset quality continued to improve as both noncurrent loans and
charge-offs declined, and risk-based regulatory capital ratios continued to
strengthen. Commercial banks, an FDIC reporting subset that totaled 4,166 in
number, achieved a return on assets of 1.31 percent and a return on equity of
13.91 percent for the first nine months of 2003 annualized.
For the fourth consecutive year, bank stocks represented on the Nasdaq Bank
Stock Index outperformed the benchmark S&P 500 Index. The Nasdaq Bank stock
index increased 30 percent for 2003, 5 percent for 2002, 13 percent for 2001 and
19 percent for 2000. Comparatively, the S&P 500 Index increased 26 percent for
2003 and decreased 23 percent for 2002, 13 percent for 2001 and 9 percent for
2000.
Management believes that the financial services industry will continue to
consolidate as a strategy to increase profits and market share. With an emphasis
on strengthening customer relationships and finding new ways to generate fee
income, it is likely that the industry will increase the diversity of financial
products and services. Management believes that industry consolidation and
product diversification may enhance its competitive position as a community
bank.
BUSINESS STRATEGIES
Throughout 2003, management and the board of directors (board) continued to
implement a series of initiatives, as guided by the Corporation's long-range
strategic plan. One such initiative was to engage a consulting firm to conduct a
company wide performance evaluation, to include staffing and work processes.
Acting upon the consultant's recommendations, management realigned staffing to
move toward industry standards and improved operating efficiency. These
benefits, on an annualized basis, far exceeded the one time consultant's fee.
The Corporation relies heavily on technological innovation to provide quality
products and services to its customers, contain costs and remain competitive.
Two projects serve as examples. PeoplesBank began implementing a document
imaging system, which scans and stores documents on an electronic medium, to
increase operational efficiency. Document imaging eliminates the need to
maintain bulky physical files for many paper documents and provides a means for
authorized employees to quickly access information. Document imaging will be
phased in for selected divisions of the Bank throughout 2004. PeoplesBank is
also in the process of redesigning its website to provide more information and
useful features in a user friendly format. The change is in response to a
growing customer base that prefers the convenience of using electronic delivery
channels to satisfy some of their financial needs. Management plans to introduce
the new website in the second quarter of 2004.
Management relocated Market Street Financial Services, an insurance agency
acquired in September 2002, to the Codorus Valley Corporate Center, the
Corporation's headquarters to better integrate its wealth management marketing
efforts with business banking and consumer banking. Looking ahead, management
plans to implement strategies to grow business banking, increase fee income and
contain operating expense.
FINANCIAL HIGHLIGHTS
The Corporation earned $3,432,000 or $1.20 per diluted share for 2003, compared
to $3,101,000 or $1.09 per diluted share for 2002, and $2,854,000 or $1.01 per
diluted share for 2001. All per share amounts were adjusted for stock dividends.
The $331,000 or 11 percent increase in current period net income was caused
primarily by increases in net interest income and noninterest income, which more
than offset increases in noninterest expense and federal income tax. Current
period net interest income increased $1,299,000 or 11 percent over 2002 due
primarily to lower funding costs (rate driven). Noninterest income, which
included gains from the sale of mortgages and investment securities, increased
$846,000 or 24 percent over 2002 due primarily to income from mutual funds,
annuity and insurance sales, and service charges on deposit accounts.
Noninterest expense increased $1,282,000 or 12 percent over 2002 due primarily
to expansion resulting from the acquisition of an insurance agency in September
2002 and the addition of a full service financial center in December 2002.
Current period federal income tax increased $494,000 over 2002 due to an
increase in pretax earnings and a decrease in tax credits. A summary of
quarterly earnings for 2003 and 2002 is presented in Table 13--Summary of
Quarterly Financial Data.
Net income for 2002 was $3,101,000, an increase of $247,000 or 9 percent above
2001. The increase was due to an increase in
[LOGO 34]
45
noninterest income and a decrease in federal income tax, which more than offset
increases in noninterest expense and loan loss provision. The 42 percent
increase in noninterest income was due primarily to gains from the sale of
residential mortgages and investment securities. The 27 percent decrease in
federal income tax was due to tax credits received by PeoplesBank from an
investment in a real estate partnership that provides low-income housing. The 7
percent increase in noninterest expense was caused primarily by operating
expenses attributable to corporate expansion in 2002 and 2001 and normal
business growth. The 260 percent increase in the loan loss provision was the
result of a higher level of charge-offs stemming primarily from a loss on
equipment financing contracts. Management believed that the loss on these
contracts was caused in part by external fraud and sought legal redress along
with other defrauded financial institutions. In December 2003, a negotiated
settlement was finalized and PeoplesBank recovered $350,000.
Annual cash dividends per share, as adjusted, were $.47 for 2003, compared to
$.45 for 2002. Additionally, a 5 percent stock dividend was paid in 2003 and
2002. Book value per share, as adjusted, was $11.91 for year-end 2003, compared
to $11.38 for year-end 2002.
Net income as a percentage of average shareholders' equity (return on equity or
ROE), was 10.3 percent for 2003, compared to 10.1 percent for 2002. Net income
as a percentage of average total assets (return on assets or ROA), was .96
percent for 2003, compared to .91 percent for 2002.
At December 31, 2003, nonperforming assets as a percentage of total loans and
net foreclosed real estate were approximately .72 percent, compared to 2.55
percent for year-end 2002. Information regarding nonperforming assets is
provided in the Risk Management section of this report, including Table
8--Nonperforming Assets. The allowance for loan losses as a percentage of total
loans was .65 percent for year-end 2003 and 2002. Information regarding the
allowance is provided in the Risk Management section of this report, including
Tables 9 and 10. Based on a recent evaluation of probable loan losses and the
current loan portfolio, management believes that the allowance is adequate to
support losses inherent in the portfolio at December 31, 2003.
Throughout 2003, the Corporation maintained a capital level well above minimum
regulatory quantitative requirements. Currently, there are three federal
regulatory definitions of capital that take the form of minimum ratios. Table
7--Capital Ratios, shows that the Corporation and PeoplesBank were well
capitalized on December 31, 2003.
A more detailed analysis of the factors and trends affecting corporate earnings
follows.
Income Statement Analysis
NET INTEREST INCOME
The Corporation's principal source of revenue is net interest income, the
difference between interest income earned on loans and investment securities,
and interest expense incurred on deposits and borrowed funds. The fluctuation in
net interest income from year to year is caused by changes in interest rates,
volumes and the composition or mix of interest rate sensitive assets and
liabilities.
For analytical purposes, Table 1--Net Interest Income, Table 2--Rate/Volume
Analysis of Changes in Net Interest Income and Table 3--Average Balances and
Interest Rates, are presented on a tax equivalent basis to make it easier to
compare taxable and tax-exempt assets. Income from tax-exempt assets, primarily
loans to or securities issued by state and local governments, is increased by an
amount equivalent to the federal income taxes which would have been incurred if
the income was taxable at the statutory rate of 34 percent. Unless otherwise
noted, the
TABLE 1 - NET INTEREST INCOME (TAX EQUIVALENT BASIS)
(dollars in thousands) 2003 2002 2001 2000 1999 5 YR CGR*
- ---------------------- ---- ---- ---- ---- ---- ---------
Total interest income $ 19,964 $ 20,674 $ 22,602 $ 21,904 $ 20,314 0.0%
Tax equivalent adjustment 238 277 288 249 192 n/a
-------- -------- -------- -------- -------- ----
Adjusted total interest income 20,202 20,951 22,890 22,153 20,506 0.1%
Total interest expense 6,898 8,907 10,871 11,064 9,534 -5.7%
-------- -------- -------- -------- -------- ----
Net interest income $ 13,304 $ 12,044 $ 12,019 $ 11,089 $ 10,972 4.1%
Average earning assets $322,391 $310,431 $286,777 $264,174 $253,800 6.3%
Average interest bearing liabilities $290,405 $281,062 $257,262 $237,537 $228,163 6.5%
Yield on earning assets 6.27% 6.75% 7.98% 8.39% 8.08%
Rate on interest bearing liabilities 2.38% 3.17% 4.23% 4.66% 4.18%
-------- -------- -------- -------- -------- ----
Interest rate spread 3.89% 3.58% 3.75% 3.73% 3.90%
Net yield on average earning assets 4.13% 3.88% 4.19% 4.20% 4.32%
-------- -------- -------- -------- -------- ----
* Compound growth rate (CGR) is the average annual growth over the five-year
period which began in 1998.
[LOGO 35]
46
Management's Discussion of Consolidated Financial Condition & Results of
Operations
TABLE 2 - RATE/VOLUME ANALYSIS OF CHANGES IN NET INTEREST INCOME (TAX EQUIVALENT
BASIS)
YEAR ENDED 2003 COMPARED TO 2002
DECEMBER 31, INCREASE CHANGE DUE TO
(dollars in thousands) 2003 2002 (DECREASE) VOLUME RATE
- ---------------------- ---- ---- ---------- ------ ----
Interest Income
Interest bearing deposits with banks $ 2 $ 5 $ (3) $ (2) $ (1)
Federal funds sold 62 224 (162) (131) (31)
Securities, taxable 2,541 2,693 (152) 404 (556)
Securities, tax-exempt 665 791 (126) (120) (6)
Loans, taxable 16,897 17,216 (319) 949 (1,268)
Loans, tax-exempt 35 22 13 27 (14)
------- ------- -------- ------- --------
Total interest income 20,202 20,951 (749) 1,127 (1,876)
Interest Expense
Deposits
Interest bearing demand 822 1,201 (379) 147 (526)
Savings 84 131 (47) 7 (54)
Time deposits under $100,000 4,034 5,154 (1,120) (60) (1,060)
Time deposits $100,000 and above 881 1,212 (331) (121) (210)
Short-term borrowings 19 10 9 15 (6)
Long-term debt 1,058 1,199 (141) (35) (106)
------- ------- -------- ------- --------
Total interest expense 6,898 8,907 (2,009) (47) (1,962)
------- ------- -------- ------- --------
Net interest income $13,304 $12,044 $ 1,260 $ 1,174 $ 86
------- ------- -------- ------- --------
YEAR ENDED 2002 COMPARED TO 2001
DECEMBER 31, INCREASE CHANGE DUE TO
(dollars in thousands) 2002 2001 (DECREASE) VOLUME RATE
- ---------------------- ---- ---- ---------- ------ ----
Interest Income
Interest bearing deposits with banks $ 5 $ 13 $ (8) $ 0 $ (8)
Federal funds sold 224 562 (338) (108) (230)
Securities, taxable 2,693 2,468 225 1,211 (986)
Securities, tax-exempt 791 827 (36) (30) (6)
Loans, taxable 17,216 18,999 (1,783) 739 (2,522)
Loans, tax-exempt 22 21 1 13 (12)
------- ------- -------- ------- -------
Total interest income 20,951 22,890 (1,939) 1,825 (3,764)
Interest Expense
Deposits
Interest bearing demand 1,201 1,801 (600) 420 (1,020)
Savings 131 219 (88) (11) (77)
Time deposits under $100,000 5,154 6,222 (1,068) 95 (1,163)
Time deposits $100,000 and above 1,212 1,462 (250) 137 (387)
Short-term borrowings 10 7 3 34 (31)
Long-term debt 1,199 1,160 39 23 16
------- ------- -------- ------- -------
Total interest expense 8,907 10,871 (1,964) 698 (2,662)
------- ------- -------- ------- -------
Net interest income $12,044 $12,019 $ 25 $ 1,127 $(1,102)
------- ------- -------- ------- -------
Changes which are due to both volume and rate are allocated in proportion to
their relationship to the amount of change attributed directly to volume or
rate. Taxable loans include loan fees of $1,082,000 in 2003, $955,000 in 2002,
and $639,000 in 2001.
[LOGO 36]
47
discussion that follows is based on interest income and interest expense as
reported in the consolidated statements of income.
Net interest income for 2003 was $13,066,000, an increase of $1,299,000 or 11
percent above 2002. Net interest income increased primarily as a result of lower
funding costs, which were rate driven. Earning assets averaged $322 million and
yielded 6.27 percent (tax equivalent basis) for 2003 compared to $310 million
and 6.75 percent, respectively, for 2002. The increase in average earning assets
occurred primarily in consumer loans, investment securities and business loans.
In spite of an increase in the volume of assets, interest income was adversely
impacted by low market interest rates, which lowered yields. Interest income on
other earning assets, principally federal funds sold, decreased due to a
decrease in volume as funds were deployed to loans and investments. Interest
bearing liabilities averaged $290 million at an average rate of 2.38 percent for
2003 compared to $281 million and 3.17 percent, respectively, for 2002. The
increase in the volume of interest bearing liabilities occurred primarily in
demand deposits. For 2003, average time deposits decreased by 3 percent as rates
were managed to lower funding
TABLE 3 - AVERAGE BALANCES AND INTEREST RATES (TAX EQUIVALENT BASIS)
2003 2002 2001
------------------------ ------------------------- -------------------------
AVERAGE AVERAGE AVERAGE
(dollars in thousands) BALANCE INTEREST RATE BALANCE INTEREST RATE BALANCE INTEREST RATE
- ---------------------- ------- -------- ---- ------- -------- ---- ------- -------- ----
Assets
Interest bearing deposits with banks $ 158 $ 2 1.27% $ 231 $ 5 2.16% $ 239 $ 13 5.44%
Federal funds sold 5,552 62 1.12 13,336 224 1.68 16,513 562 3.40
Investment securities
Taxable 64,723 2,541 3.93 56,277 2,693 4.79 37,748 2,468 6.54
Tax-exempt 9,160 665 7.26 10,803 791 7.32 11,204 827 7.38
-------- -------- ----- -------- --------- ----- -------- ------- -----
Total investment securities 73,883 3,206 4.34 67,080 3,484 5.19 48,952 3,295 6.73
Loans
Taxable (1) 242,123 16,897 6.98 229,479 17,216 7.50 220,885 18,999 8.60
Tax-exempt 675 35 5.19 305 22 7.21 188 21 11.17
-------- -------- ----- -------- --------- ----- -------- ------- -----
Total loans 242,798 16,932 6.97 229,784 17,238 7.50 221,073 19,020 8.60
-------- -------- ----- -------- --------- ----- -------- ------- -----
Total earning assets 322,391 20,202 6.27 310,431 20,951 6.75 286,777 22,890 7.98
Other assets (2) 36,323 31,972 25,773
-------- -------- ----- -------- --------- ----- -------- ------- -----
Total assets $358,714 $342,403 $312,550
-------- -------- ----- -------- --------- ----- -------- ------- -----
Liabilities and Shareholders' Equity
Interest bearing deposits
Interest bearing demand $115,152 $ 822 0.71% $102,581 $ 1,201 1.17% $ 83,172 $ 1,801 2.17%
Savings 14,329 84 0.59 13,615 131 0.96 14,348 219 1.53
Time deposits under $100,000 114,418 4,034 3.53 115,773 5,154 4.45 114,026 6,222 5.46
Time deposits $100,000 and above 26,335 881 3.35 29,243 1,212 4.14 26,737 1,462 5.47
-------- -------- ----- -------- --------- ----- -------- ------- -----
Total interest bearing deposits 270,234 5,821 2.15 261,212 7,698 2.95 238,283 9,704 4.07
Short-term borrowings 1,473 19 1.29 591 10 1.69 101 7 6.93
Long-term debt 18,698 1,058 5.66 19,259 1,199 6.23 18,878 1,160 6.14
-------- -------- ----- -------- --------- ----- -------- ------- -----
Total interest bearing liabilities 290,405 6,898 2.38 281,062 8,907 3.17 257,262 10,871 4.23
Noninterest bearing deposits 31,893 27,690 25,165
Other liabilities 3,200 2,895 1,569
Shareholders' equity 33,216 30,756 28,554
-------- -------- ----- -------- --------- ----- -------- ------- -----
Total liabilities and
shareholders' equity $358,714 $342,403 $312,550
-------- -------- ----- -------- --------- ----- -------- ------- -----
Net interest income $ 13,304 $ 12,044 $12,019
-------- -------- ----- -------- --------- ----- -------- ------- -----
Interest rate spread 3.89% 3.58% 3.75%
-------- -------- ----- -------- --------- ----- -------- ------- -----
Net yield on earning assets 4.13% 3.88% 4.19%
-------- -------- ----- -------- --------- ----- -------- ------- -----
(1) Includes loan fees of $1,082,000 in 2003, $955,000 in 2002 and $639,000 in
2001.
(2) Includes average nonaccrual loans of $4,235,000 in 2003, $3,825,000 in
2002, and $1,759,000 in 2001.
[LOGO 37]
48
Management's Discussion of Consolidated Financial Condition & Results of
Operations
costs. The net yield on earning assets, on a tax equivalent basis, was 4.13
percent for 2003, compared to 3.88 percent for 2002. Looking ahead, management
believes that PeoplesBank's asset-sensitive balance sheet is positioned to
benefit from economic growth and rising market interest rates.
Comparatively, net interest income was $11,767,000 for 2002; an increase of
$36,000 or .3 percent above the $11,731,000 earned in 2001. In spite of a $23.7
million or 8 percent increase in average earning assets, net interest income was
flat for 2002 due to abnormally low market interest rates, a reflection of the
Fed's accommodative monetary policy to stimulate a sluggish national economy.
For 2002, low market interest rates lowered yields on earning assets to a
greater degree than they lowered funding costs on interest bearing liabilities.
Interest income from loans for 2002 was also constrained by an increase in
nonperforming loans. Earning assets averaged $310 million and yielded 6.75
percent (tax equivalent basis) for 2002 compared to $287 million and 7.98
percent, respectively, for 2001. Asset growth occurred primarily in investment
securities and business loans. For the second consecutive year, deposits
experienced strong growth as investors sought safe haven from widespread price
declines in securities markets. Interest bearing liabilities averaged $281
million at an average rate of 3.17 percent for 2002 compared to $257 million and
4.23 percent, respectively, for 2001. Funding was provided primarily by growth
in interest bearing demand deposits. The same factors that constrained net
interest income also constrained the net yield on average earning assets, which
was 3.88 percent for 2002 compared to 4.19 percent for 2001.
PROVISION FOR LOAN LOSSES
The provision for probable loan losses is an estimated expense charged to
earnings to address losses attributable to uncollectible loans. The provision
reflects management's judgement of an appropriate level for the allowance for
loan losses. The Risk Management section, including Tables 8, 9, and 10, of this
report, provides detailed information about the allowance, provision and credit
risk. For 2003, the provision expense for probable loan loss was $553,000,
compared to $515,000 for 2002 and $143,000 for 2001. The level of expense for
2003 and 2002 reflected an increase in loan charge-offs, net of recoveries, due
largely to a group of equipment financing contracts acquired from a third party
broker. Management believed that the loss on these contracts was caused in part
by external fraud and sought legal redress along with other defrauded financial
institutions. In December 2003, a negotiated settlement was finalized and
PeoplesBank recovered $350,000. At December 31, 2003, six equipment leasing
contracts, which totaled $361,000, remained in PeoplesBank's portfolio and were
performing.
Other factors that impacted the provision for 2002 included an increase in the
nonperforming loan portfolio and continued concern over the sluggish national
and local economies. The level of expense for 2001 was responsive to loan growth
and a national and local economic slowdown.
NONINTEREST INCOME
Total noninterest income for 2003 was $4,380,000, an increase of $846,000 or 24
percent above 2002. The increase was caused primarily by increases in income
from mutual fund, annuity and insurance sales, and service charges on deposit
accounts. The $413,000 or 152 percent increase in mutual fund, annuity and
insurance commissions was attributable to an insurance agency acquired by
PeoplesBank in September 2002. The $363,000 or 46 percent increase in service
charges on deposit accounts was attributable to an increase in insufficient
funds fees. Insufficient funds fees increased primarily as a result of a
discretionary overdraft service, implemented by PeoplesBank in June 2003.
Current period gains from the sale of mortgages decreased $65,000 or 8 percent
below 2002. During the third quarter of 2003, long-term market interest rates
began to rise, curtailing mortgage refinancings and lowering expectations for
gains in future periods. Low market interest rates during the first half of 2003
improved securities prices and enabled management to realize an $87,000 increase
in gains from the sale of investment securities.
Total noninterest income for 2002 was $3,534,000, an increase of $1,038,000 or
42 percent above 2001. The increase was caused primarily by increases in gains
from the sale of residential mortgages and investment securities. Gains from the
sale of mortgages were up $613,000 or 386 percent. The increase reflected a full
year of operation for the mortgage banking division and low market interest
rates, which fueled a mortgage refinance boom. Gains from the sale of securities
were $179,000 for 2002. Comparatively, no gains were realized from the sale of
securities in 2001. The $79,000 or 41 percent increase in mutual fund, annuity
and insurance commissions for 2002 was due in part to an insurance agency
acquired by PeoplesBank in September 2002.
NONINTEREST EXPENSE
Total noninterest expense for 2003 was $12,290,000, an increase of $1,282,000 or
12% above 2002. The increase was the result of corporate expansion and increases
in professional and legal fees and other expenses. With regard to expansion, the
current year absorbed a full year's impact of personnel, occupancy and other
expenses associated with the acquisition of an insurance agency in September
2002 and the addition of a financial center in December 2002. Current year
professional and legal expense, principally consulting fees, increased $245,000
or 108 percent above 2002. During 2003, management engaged a consulting firm to
conduct a company wide performance evaluation, to include staffing and work
processes. Acting upon the consultant's recommendations, management realigned
staffing to move toward industry standards and improved operating efficiency.
These benefits, on an annualized basis, far exceeded the one time consultant's
fee, which was approximately $275,000. Other expense for 2003 increased $283,000
or 14 percent above 2002 due primarily to expansion and normal business growth.
An increase in ATM and point-of-sale processing expenses, driven by an increase
in transaction volume, also contributed to the increase in other expense.
[LOGO 38]
49
Total noninterest expense for 2002 was $11,008,000, an increase of $710,000 or 7
percent above 2001. The increase was caused primarily by increases in personnel
and other expense. Personnel increased $724,000 or 14 percent due primarily to
planned corporate expansion. Year 2002 included the full year cost of prior year
initiatives, including the addition of two financial centers, a mortgage banking
operation and a centralized telephone call center. Other expense increased
$236,000 or 14 percent due to: a $35,000 loss on a fraudulent check, increases
in selected expenses such as memberships and subscriptions, appraisals, loan
expenses, employee training, seminars and business meetings, insurance, and
normal business growth. For 2002, foreclosed real estate expense decreased
$168,000 or 70 percent. The prior year reflected a higher level of carrying
costs and loss provisions attributable to a larger portfolio of acquired
properties. Professional and legal expense for 2002 decreased $80,000 or 26
percent. The prior year reflected a higher level of expense caused by increased
information technology consulting and services, legal advice for arbitration
pertaining to a defective roof and HVAC system at the Corporation's headquarters
and consulting advice relative to future growth strategies.
INCOME TAXES
The provision for federal income tax was $1,171,000 for 2003, compared to
$677,000 for 2002. The $494,000 or 73 percent increase in tax reflects an
increase in pretax income and a $217,000 decrease in federal tax credits. Tax
credits were maximized in 2002 due to the inclusion of low-income housing tax
credits and historical rehabilitation tax credits from PeoplesBank's investment
in a low-income housing project. Historical rehabilitation tax credits are
available only in the year the rehabilitation construction is complete. Details
about this real estate partnership are provided under the Other Assets
subheading within the Balance Sheet Review section of this report.
Comparatively, the provision for 2002 decreased $255,000 or 27 percent below
2001 due to the recognition of tax credits from the investment in low-income
housing.
Balance Sheet Review
INVESTMENT SECURITIES
The investment securities portfolio is an interest earning asset, second in size
to the loan portfolio. Investment securities serve as an important source of
revenue, a primary source of liquidity, and as collateral for public and trust
deposits.
On December 31, 2003, securities available-for-sale were $62.7 million
reflecting a $6 million decrease below December 31, 2002, as funds were deployed
to higher yielding loan portfolios. Decisions to purchase or sell securities are
based on an assessment of current economic and financial conditions, including
the interest rate environment, liquidity and income requirements. Securities
available-for-sale are limited to high quality debt instruments as shown in Note
3 -- Securities Available-for-Sale and Held-to-Maturity. Note 3 shows that
unrealized gains far exceed unrealized losses due to low market interest rates
for year-end 2003 and 2002. Table 4 -- Analysis of Investment Securities shows
that the available-for-sale portfolio yielded 3.63 percent with an average
maturity of 2.9 years on December 31, 2003, compared to 4.59 percent and 3.1
years, respectively, on December 31, 2002. The decrease in yield during the
current period was a result of low market interest rates.
On December 31, 2003, securities held-to-maturity were $9.4 million,
approximately the same level as year-end 2002. The held-to-maturity portfolio
consisted of fixed rate, long-term preferred stock (trust preferreds) issued by
commercial bank holding companies. These trust preferreds are substantially
junior subordinated debt, pay interest semi-annually, are callable, and mature
in years 2026-2028. Table 4 shows the portfolio as having a weighted average
yield of 8.43 percent and a weighted average remaining maturity of 23 years as
of December 31, 2003. Approximately $5.6 million, held by PeoplesBank, are rated
investment grade by a national rating service. The remaining $3.8 million, held
by the Corporation, are either not rated or rated below investment grade.
Generally, investment was limited to $500,000 per issuer based on an analysis of
the issuer's financial and strategic history. The trust preferred portfolio,
part of a leverage growth strategy in a prior period, was financed primarily by
borrowing from the Federal Home Loan Bank of Pittsburgh and a local financial
institution.
LOANS
On December 31, 2003, total loans were $260 million, an increase of
approximately $26 million or 11 percent above year end 2002. Table 5 -- Loan
Portfolio Composition presents the composition of total loans on a comparative
basis for five yearend periods. The table reflects the Corporation's emphasis on
commercial lending. At year-end 2003, commercial loans increased approximately
$10 million or 5 percent above year-end 2002. Consumer loans, principally
installment loans, increased $16 million or 32 percent above the prior year-end
in response to an aggressive marketing promotion. During 2003, PeoplesBank's
mortgage banking staff focused on originating and selling residential mortgages
without retaining servicing rights. These loans are classified on the balance
sheet as loans held for sale. On December 31, 2003, loans held for sale were
$2.2 million compared to $4.6 million for year-end 2002.
Table 6 -- Selected Loan Maturities and Interest Rate Sensitivity shows that, at
December 31, 2003, the commercial loan portfolio was divided almost evenly
between $95 million in fixed rate loans and $96 million in floating or
adjustable rate loans. The 50/50 mix was the same on December 31, 2002. Floating
rate loans reprice periodically with changes in either the US Prime rate or
LIBOR as reported in the Wall Street Journal, or PeoplesBank's base rate.
Adjustable rate loans reprice at annual intervals based on the US treasury yield
curve. Additional loan information can be found in Note 4 -- Loans, and within
the Risk Management section of this report.
[LOGO 39]
50
Management's Discussion of Consolidated Financial Condition & Results of
Operations
TABLE 4 - ANALYSIS OF INVESTMENT SECURITIES (AMORTIZED COST BASIS)
CORPORATE WEIGHTED
U.S. U.S. STATE & TRUST AVERAGE
(dollars in thousands) TREASURIES AGENCIES (1) MUNICIPALS PREFERREDS TOTAL YIELD (2)
- ---------------------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 2003
Available-for-sale
Maturity
Within one year $ 6,865 $ 250 $ 7,115 3.47%
One to five years 45,124 1,859 46,983 3.11
Five to ten years 1,002 5,214 6,216 6.74
Over ten years 1,294 1,294 7.76
- ---------------------------------------------------------------------------------------------------------------------------------
Total $ 0 $52,991 $8,617 $ 0 $61,608 3.63%
- ---------------------------------------------------------------------------------------------------------------------------------
Average maturity 2.9 YEARS
Held-to-maturity
Maturity
Over ten years $ 0 $ 0 $ 0 $ 9,355 $ 9,355 8.43%
- ---------------------------------------------------------------------------------------------------------------------------------
Total $ 0 $ 0 $ 0 $ 9,355 $ 9,355 8.43%
- ---------------------------------------------------------------------------------------------------------------------------------
Average maturity 23.2 YEARS
DECEMBER 31, 2002
Available-for-sale
Maturity
Within one year $ 1,004 $ 7,461 $ 8,465 4.50%
One to five years 47,833 3,279 51,112 4.20
Five to ten years 5,601 5,601 7.25
Over ten years 1,594 1,594 7.98
- ---------------------------------------------------------------------------------------------------------------------------------
Total $ 1,004 $55,294 $10,474 $ 0 $66,772 4.59%
- ---------------------------------------------------------------------------------------------------------------------------------
Average maturity 3.1 years
Held-to-maturity
Maturity
Over ten years $ 0 $ 0 $ 0 $ 9,357 $ 9,357 8.43%
- ---------------------------------------------------------------------------------------------------------------------------------
Total $ 0 $ 0 $ 0 $ 9,357 $ 9,357 8.43%
- ---------------------------------------------------------------------------------------------------------------------------------
Average maturity 24.2 years
DECEMBER 31, 2001
Available-for-sale
Maturity
Within one year $10,235 $10,235 5.68%
One to five years 15,667 2,676 18,343 5.60
Five to ten years 4,756 4,756 6.92
Over ten years 3,439 3,439 7.89
- ---------------------------------------------------------------------------------------------------------------------------------
Total $ 0 $25,902 $10,871 $ 0 $36,773 6.01%
- ---------------------------------------------------------------------------------------------------------------------------------
Average maturity 3.5 years
Held-to-maturity
Maturity
Over ten years $ 0 $ 0 $ 0 $ 9,358 $ 9,358 8.44%
- ---------------------------------------------------------------------------------------------------------------------------------
Total $ 0 $ 0 $ 0 $ 9,358 $ 9,358 8.44%
- ---------------------------------------------------------------------------------------------------------------------------------
Average maturity 25.2 years
(1) U.S. agency mortgage-backed instruments are included in the maturity
categories based on average expected life.
(2) Yields on tax-exempt obligations were computed on a tax equivalent basis
using a 34% tax rate.
[LOGO 40]
51
OTHER ASSETS
Included in other assets on December 31, 2003, is PeoplesBank's $4.8 million
investment in two unrelated joint ventures whose purpose is to provide low cost
housing to qualified families. PeoplesBank's role in these partnerships is
solely as an investor, whose return is in the form of federal tax credits, which
will be realized over a ten-year period. PeoplesBank holds a 99.99 percent
interest and a remaining $2 million investment in the first joint venture, which
was operational in 2001. In the second joint venture PeoplesBank holds a 73.47
percent interest representing a $2.8 million investment. The second joint
venture involves the construction and lease of 60 new townhouses. Rain delays
have hampered construction efforts thus far and have delayed completion of this
project. Management anticipates that this venture will be complete and fully
operational in the latter half of 2004 based on a projection provided by the
general partner.
Funding
DEPOSITS
Deposits are a principal source of funding for earning assets. On December 31,
2003, total deposits were $304 million, reflecting an $11.7 million or 4 percent
increase above year-end 2002. The increase occurred in core deposits such as
demand, money market and savings accounts. Relatively low certificate of deposit
rates, heavily influenced by low market interest rates, and an improving stock
market likely influenced customers to favor highly liquid core deposit accounts.
Other factors that contributed to the increase in deposits included the addition
of a financial center in December 2002 and normal business growth. The average
rate paid on interest bearing deposits was 2.15 percent for 2003 compared to
2.95 percent for 2002. The reduction in the rate for 2003 reflected unusually
low market interest rates for the second consecutive year. A comparative
breakdown of deposits is located in Note 8 -- Deposits.
On December 31, 2003, total certificates of deposit were $139 million, scheduled
to mature in the following years: $75 million in 2004, $31 million in 2005, $18
million in 2006, $11 million in 2007 and $4 million in 2008. At 2003 year-end,
the balance of certificates $100,000 and above was $26 million. Of this total:
$7 million mature within three months; $2 million mature after three months but
within six months; $7 million mature after six months but within twelve months;
and the remaining $10 million mature beyond twelve months.
SHORT-TERM BORROWINGS AND LONG-TERM DEBT
To meet day-to-day funding needs, PeoplesBank may borrow from larger
correspondent banks in the form of federal funds
TABLE 5 - LOAN PORTFOLIO COMPOSITION
DECEMBER 31,
(dollars in thousands) 2003 % 2002 % 2001 % 2000 % 1999 %
- -----------------------------------------------------------------------------------------------------------------------------------
Commercial, industrial and
agricultural $163,676 62.9 $161,425 69.0 $152,112 67.3 $140,388 64.4 $131,395 63.4
Real estate - construction and
land development 28,147 10.8 20,596 8.8 21,889 9.7 19,365 8.9 21,956 10.6
- -----------------------------------------------------------------------------------------------------------------------------------
Total commercial related loans 191,823 73.7 182,021 77.8 174,001 77.0 159,753 73.3 153,351 74.0
Real estate-residential mortgages 25,134 9.7 24,803 10.6 24,799 11.0 30,831 14.2 29,815 14.4
Installment 43,249 16.6 27,136 11.6 26,985 12.0 27,342 12.5 24,152 11.6
- -----------------------------------------------------------------------------------------------------------------------------------
Total consumer related loans 68,383 26.3 51,939 22.2 51,784 23.0 58,173 26.7 53,967 26.0
- -----------------------------------------------------------------------------------------------------------------------------------
Total loans $260,206 100.0 $233,960 100.0 $225,785 100.0 $217,926 100.0 $207,318 100.0
- -----------------------------------------------------------------------------------------------------------------------------------
TABLE 6 - SELECTED LOAN MATURITIES AND INTEREST RATE SENSITIVITY
DECEMBER 31, 2003
YEARS TO MATURITY
(dollars in thousands) 1 OR LESS 1 TO 5 OVER 5 TOTAL
- -------------------------------------------------------------------------------------------------------
Commercial, industrial and agricultural $19,062 $37,358 $107,256 $163,676
Real estate-construction and land
development 14,166 10,130 3,851 28,147
- -------------------------------------------------------------------------------------------------------
Total commercial related $33,228 $47,488 $111,107 $191,823
Fixed interest rates $ 5,370 $18,011 $ 71,968 $ 95,349
Floating or adjustable interest rates 27,858 29,477 39,139 96,474
- -------------------------------------------------------------------------------------------------------
Total commercial related $33,228 $47,488 $111,107 $191,823
- -------------------------------------------------------------------------------------------------------
[LOGO 41]
52
Management's Discussion of Consolidated Financial Condition & Results of
Operations
purchased. It also uses credit available at the Federal Home Loan Bank of
Pittsburgh (FHLBP). Interest rates are established daily based on prevailing
market conditions for overnight funds. On December 31, 2003 and 2002,
PeoplesBank had $7 million in outstanding short-term borrowings.
Long-term debt is a primary funding source for asset growth. On December 31,
2003, long-term debt was $24.4 million, which was $8 million above year-end
2002. During 2003, PeoplesBank borrowed $5 million on two occasions, for a total
of $10 million, from the FHLBP. The first loan was a 10-year amortizing loan
with a fixed interest rate of 3.46 percent. The second loan was a 6-year balloon
with a convertible interest rate. For the first three years the interest rate is
fixed at 3.47 percent. This rate will prevail for the remaining three years
unless the FHLBP elects to convert it to a floating rate, which will be based on
a spread to the 3-month LIBOR. A listing of outstanding long-term debt
instruments is provided in Note 9 -- Short-term Borrowings and Long-term Debt.
Generally, funds for the payment of long-term debt come from operations and
refinancings.
PeoplesBank's maximum borrowing capacity, as established quarterly by the FHLBP,
was approximately $95 million as of September 30, 2003, the most recent
available date. On December 31, 2003, PeoplesBank had approximately $29 million
outstanding on its account with the FHLBP at an average rate of 3.85 percent.
SHAREHOLDERS' EQUITY AND CAPITAL ADEQUACY
Shareholders' equity, or capital, is a source of funds, which enables the
Corporation to maintain asset growth and absorb losses. Total shareholders'
equity was $33.8 million on December 31, 2003, compared to $32.2 million for
year-end 2002. The increase in equity was primarily attributable to an increase
in retained earnings from profitable operations.
The Corporation and PeoplesBank are subject to various regulatory capital
requirements administered by banking regulators that involve quantitative
guidelines and qualitative judgements. Quantitative measures established by
regulators pertain to minimum capital ratios, as set forth in Table 7 -- Capital
Ratios. Table 7 provides a comparison of the Corporation's and PeoplesBank's
risk-based capital ratios and leverage ratios to the minimum regulatory
requirement for the periods indicated.
The Corporation typically pays cash dividends on a quarterly basis. The board of
directors determines the dividend rate after considering the Corporation's
capital requirements, current and projected net income, and other factors.
Annual cash dividends on a per common share basis, were $.47 for 2003 and $.45
for 2002. All per share amounts were adjusted for stock dividends.
Periodically, the Corporation pays stock dividends as another means of enhancing
long-term shareholder value. In June of 2003 and 2002, the Corporation paid a 5
percent stock dividend. Payment of the stock dividend in 2003 resulted in the
issuance of 134,564 additional common shares. Payment of the stock dividend in
2002 and 2001 resulted in the issuance of 127,927 and 121,738, respectively,
additional common shares. The weighted average number of shares of common stock
outstanding, restated for the stock dividend, was 2,833,242 for 2003, 2,828,029
for 2002, and 2,825,804 for 2001.
As previously disclosed in this report, the Corporation maintains various
employee, director and shareholder benefit plans that could result in the
issuance of its common stock. Information about these plans can be found in Note
10 -- Shareholders' Equity, Note 12 -- Benefit Plans, and Note 13 -- Stock
Option Plans of the consolidated financial statements.
Capital investments made in earlier periods, as described in previous SEC
filings, and future investments will impact current and future earnings and
capital growth. Possible future investments may be made to expand the
Corporation's banking franchise and its technological capabilities and to create
or acquire financial services companies. Management and the board believe that
capital investment, guided by a long range strategic plan, is necessary to
develop an infrastructure to grow market share and net income over the long-term
and is an important strategy for enhancing long-term shareholder value.
Risk Management
The Corporation's Risk Management Committee meets at least quarterly and
includes members of senior management and an independent director. The objective
of the Committee is to identify and manage risk inherent in the operations of
the Corporation and its affiliates. The Committee's risk review is broad in
scope and includes the following risks: credit, interest rate, liquidity, price,
transaction, compliance, strategic and reputation. One of its primary
responsibilities is to develop and implement formal risk management policies and
procedures, and monitor compliance.
CREDIT RISK MANAGEMENT
The Corporation emphasizes the management of credit risk. To support this
objective a sound lending policy framework has been established. Within this
framework are six basic policies that guide the lending process and minimize
risk. First, the Corporation follows detailed written lending policies and
procedures. Second, loan approval authority is granted commensurate with dollar
amount, loan type, level of risk, and loan officer experience. Third, loan
review committees function at both the senior lending officer level and the
board level to review and authorize loans that exceed preestablished dollar
thresholds and/or meet other criteria. Fourth, the Corporation directly lends
mainly within its primary geographical market area, York County, Pennsylvania
and northern Maryland. Although this may pose a geographical concentration risk,
the diverse local economy and employee knowledge of customers minimizes this
risk. Fifth, the loan portfolio is diversified to prevent dependency upon a
single customer or small group of related customers. And sixth, the Corporation
does not lend to
[LOGO 42]
53
foreign countries or persons residing therein.
In addition to a comprehensive lending policy, numerous internal reviews of the
loan and foreclosed real estate portfolios occur throughout the year. In
addition to internal controls, loan portfolios are reviewed by independent
auditors in connection with their annual financial statement audit, and are
examined periodically by bank regulators.
One component of the internal credit risk review is the identification and
management of industry concentrations. At year-end 2003, the total loan
portfolio included two industry concentrations that exceeded 10 percent. The
commercial real estate leasing industry accounted for 11.8 percent and the
agricultural industry accounted for 10.3 percent. Comparatively, these
industries were 15.7 percent and 8.5 percent, respectively, for year-end 2002.
Loans to borrowers within these industries are usually collateralized by real
estate.
NONPERFORMING ASSETS
Table 8 -- Nonperforming Assets, shows asset categories posing the greatest risk
of loss. Management generally places a loan on nonaccrual status and ceases
accruing interest income when loan payment performance is unsatisfactory and the
loan is past due 90 days or more. Loans past due 90 days or more and still
accruing interest, are contractually past due, but well collateralized and in
the process of collection. The final category, foreclosed real estate is
acquired to satisfy debts owed to PeoplesBank. Table 8 also provides a summary
of nonperforming assets and related ratios. The paragraphs below explain the
changes within each classification on that table for December 31, 2003, compared
to December 31, 2002.
For all reporting periods, nonaccrual loans were principally comprised of
collateral dependent commercial loans. Accordingly, the Corporation recognizes
interest income on a cash basis for these loans. On December 31, 2003, the
nonaccrual loan portfolio was $516,000, significantly below the $5,051,000
reported on December 31, 2002. The decrease was primarily attributable to the
payoff of a $2,635,000 impaired business loan. The payoff resulted in the full
recovery of principal and interest due on the loan. Additionally, a $1,230,000
business loan was reclassified from nonaccrual loans to foreclosed real estate.
Details about the reclassification are provided in the foreclosed real estate
section below. No loan loss allowance was established for either loan because
they were adequately collateralized in management's judgment. On December 31,
2003, nonaccrual loans were comprised of fourteen unrelated accounts ranging in
size from $3,000 to $141,000. Accounts within the nonaccrual loan portfolio vary
by industry and are generally collateralized with real estate assets. Management
and the board of directors evaluate the allowance for loan losses quarterly.
Efforts to modify contractual terms for individual accounts, based on prevailing
market conditions, or liquidate collateral assets, are proceeding as quickly as
potential buyers can be located and legal constraints permit.
Accruing loans that are contractually past due 90 days or more as to principal
or interest totaled $49,000 on December 31, 2003, compared to $453,000 on
December 31, 2002. Generally, loans in the past due category are adequately
collateralized and in the process of collection.
Foreclosed real estate, net of allowance, was $1,326,000 on December 31, 2003,
compared to $465,000 on December 31,
TABLE 7 - CAPITAL RATIOS
FEDERAL FEDERAL CAPITAL*
DECEMBER 31, MINIMUM WELL AT DECEMBER 31,
(dollars in thousands) 2003 2002 REQUIRED CAPITALIZED 2003 2002
- ------------------------------------------------------------------------------------------------------------------------------------
Tier 1 risk-based capital 4.00% 6.00%
(as a percentage of risk weighted assets)
Codorus Valley Bancorp, Inc. consolidated 11.13% 11.32% $32,702 $30,475
PeoplesBank 9.75 9.86 28,048 25,946
Total risk-based capital 8.00% 10.00%
(as a percentage of risk weighted assets)
Codorus Valley Bancorp, Inc. consolidated 11.71% 11.88% $34,396 $31,990
PeoplesBank 10.34 10.44 29,742 27,461
Leverage 4.00% 5.00%
(Tier 1 capital as a percentage of average total assets)
Codorus Valley Bancorp, Inc. consolidated 9.15% 8.93% $32,702 $30,475
PeoplesBank 7.99 7.75 28,048 25,946
* Net unrealized gains and losses on securities available-for-sale, net of
taxes, are disregarded for capital ratio computation purposes in accordance with
federal regulatory banking guidelines.
[LOGO 43]
54
Management's Discussion of Consolidated Financial Condition & Results of
Operations
2002. The increase was attributable to the reclassification of a $1,230,000
nonaccrual business loan. The reclassification was based on an in-substance
foreclosure presumption since PeoplesBank controls the real estate collateral,
pending the outcome of an ongoing lawsuit with the borrowers. During March 2003,
the borrowers of the $1,230,000 loan filed a counterclaim against PeoplesBank
described in Note 16 -- Contingent Liabilities of the consolidated financial
statements. On December 31, 2003, a loss allowance for foreclosed real estate
assets was unnecessary in management's judgment because the fair value supported
by independent appraisal, less selling expenses, exceeded carrying value.
The provision expense for foreclosed real estate, due to declines in the fair
value of individual assets, was $55,000 for 2003, compared to $30,000 for 2002,
and $62,000 for 2001. Efforts to liquidate foreclosed real estate are proceeding
as quickly as potential buyers can be located.
On December 31, 2003, there were approximately $3.9 million in potential problem
loans identified by management. Potential problem loans consist of loans for
which management has serious doubts as to the ability of the borrower to comply
with present repayment terms, and which were not disclosed in Table 8. A loss
allowance was established for those potential problem loans that in management's
judgment were inadequately collateralized. Comparatively, management was
monitoring approximately $1.3 million in potential problem loans on December 31,
2002.
Forfeiture Action Related To Mortgaged Property
On March 26, 2003, the United States Attorney's Office began a property (in rem)
civil forfeiture action, by Complaint in the United States District Court for
the Middle District of Pennsylvania, titled United States of America v.
Approximately 83 Acres of Real Estate Located in Fairview Township, York County,
Pennsylvania, titled in the name of CCA Associates, Inc. The real property,
which is the subject of the forfeiture action, serves as the sole collateral for
a loan by PeoplesBank to CCA Associates, Inc. (CCA), the owner or reputed owner
of this property. The loan to CCA, which was guaranteed by a third party, has a
current principal balance of $1,500,000 plus accrued interest and other fees and
costs. The third party guarantor recently pled guilty and is awaiting sentencing
by the federal government for his involvement in criminal activity. PeoplesBank
intends to protect its mortgage interest in the real estate from forfeiture
through available defenses including the "innocent owner defense." As of the
date this report was filed, the loan was current and classified as a performing
asset. Management believes that the primary debt obligation to PeoplesBank will
be satisfied once the property is liquidated and the proceeds from the sale
distributed. Therefore, management does not believe that the forfeiture action
will have a material adverse impact on the Corporation.
ALLOWANCE FOR LOAN LOSSES
Although the Corporation maintains sound credit policies, certain loans
deteriorate and must be charged off as losses. The allowance for loan losses is
maintained to absorb losses inherent in the portfolio at December 31, 2003. The
allowance is increased by provisions charged to expense and is reduced by loan
charge-offs, net of recoveries. In analyzing the adequacy of the allowance,
management considers the results of internal and external credit reviews, past
loss experience, changes in the size
TABLE 8 - NONPERFORMING ASSETS
DECEMBER 31,
(dollars in thousands) 2003 2002 2001 2000 1999
- -------------------------------------------------------------------------------------------------------------------------------
Nonaccrual loans $ 516 $5,051 $1,411 $2,006 $1,892
Accruing loans that are contractually past due
90 days or more as to principal or interest 49 453 164 346 13
Foreclosed real estate, net of reserve 1,326 465 692 2,390 1,385
- -------------------------------------------------------------------------------------------------------------------------------
Total nonperforming assets $1,891 $5,969 $2,267 $4,742 $3,290
- -------------------------------------------------------------------------------------------------------------------------------
Ratios
Nonaccrual loans as a % of total year-end loans 0.20% 2.16% 0.62% 0.92% 0.91%
Nonperforming assets as a % of total year-end
loans and net foreclosed real estate 0.72% 2.55% 1.00% 2.15% 1.58%
Nonperforming assets as a % of total year-end
stockholders' equity 5.60% 18.52% 7.72% 17.31% 12.97%
Allowance for loan losses as a multiple of
nonaccrual loans 3.3x .3x 1.3x 1.0x 1.1x
- -------------------------------------------------------------------------------------------------------------------------------
[LOGO 44]
55
and composition of the loan portfolio, adequacy of collateral, general economic
conditions and the local business outlook. Determining the level of the
allowance for probable loan losses at any given period is difficult,
particularly during deteriorating or uncertain economic periods. Management must
make estimates using assumptions and information which are often subjective and
fluid. Table 9 -- Analysis of Allowance for Loan Losses presents an analysis of
the activity in the allowance for loan losses over a five-year period. Table 10
- -- Allocation of the Allowance for Loan Losses presents an allocation of the
allowance for loan losses by major loan category. The unallocated component of
the allowance for loan losses represents probable losses inherent in the
portfolio that are not fully captured in the allocated allowance analyses, such
as: industry concentrations, imprecision in the loan risk evaluation process and
current economic factors.
The allowance was $1,694,000 or .65 percent of total loans on December 31,
2003, compared to $1,515,000 and .65 percent, respectively, on December 31,
2002. The provision expense for 2003 was $553,000, compared to $515,000 for
2002. The provision expense for both years reflected an increase in loan
charge-offs, net of recoveries, compared to prior periods due largely to a group
of equipment financing contracts acquired from a third party broker. Total
charge-offs relating to the equipment financing contracts amounted to $491,000
for 2003 and $864,000 for 2002. Management believed that the loss on these
contracts was caused in part by external fraud and sought legal redress along
with other defrauded financial institutions. In December 2003, a negotiated
settlement was finalized and PeoplesBank recovered $350,000. As of December 31,
2003, six equipment leasing contracts, which totaled $361,000, remained in
PeoplesBank's portfolio and were performing. Based on a recent evaluation of
probable loan losses in the current portfolio, management believes that the
allowance is adequate to support losses inherent in the loan portfolio on
December 31, 2003.
LIQUIDITY
Maintaining adequate liquidity provides the Corporation with the ability to meet
financial obligations to depositors, loan customers, employees, and shareholders
on a timely and cost effective basis in the normal course of business.
Additionally, it provides funds for growth and business opportunities as they
arise. Liquidity is generated from transactions relating to both the
Corporation's assets and liabilities. The primary sources of asset liquidity are
scheduled investment security maturities and cash inflows, funds received from
customer loan payments, and asset sales. The primary sources of liability
liquidity are deposit growth, short-term borrowing and long-term debt. Retained
earnings from profitable operations are another source of liquidity. The
Consolidated Statements of Cash Flows present the changes in cash from
operating, investing and financing activities. For 2003, management believes
that liquidity was adequate based on its availability from many sources,
including the potential liquidation of a $63 million portfolio of
available-for-sale securities valued at December 31, 2003 and unused credit with
the FHLBP of approximately $66 million. The Corporation's loan-to-deposit ratio
was 86 percent for year-end 2003, compared to 80 percent for year-end 2002.
TABLE 9 - ANALYSIS OF ALLOWANCE FOR LOAN LOSSES
(dollars in thousands) 2003 2002 2001 2000 1999
- ----------------------------------------------------------------------------------------------------------------------------
Balance - beginning of year $1,515 $1,898 $1,967 $2,023 $1,865
Provision charged to operating expense 553 515 143 119 225
Loans charged off
Commercial 684 1,100 121 191 23
Real estate-mortgage 0 7 0 15 0
Consumer 86 78 111 32 63
- ----------------------------------------------------------------------------------------------------------------------------
Total loans charged off 770 1,185 232 238 86
Recoveries
Commercial 370 274 9 27 12
Real estate-mortgage 0 0 0 0 0
Consumer 26 13 11 36 7
- ----------------------------------------------------------------------------------------------------------------------------
Total recoveries 396 287 20 63 19
- ----------------------------------------------------------------------------------------------------------------------------
Net charge-offs 374 898 212 175 67
- ----------------------------------------------------------------------------------------------------------------------------
Balance - end of year $1,694 $1,515 $1,898 $1,967 $2,023
- ----------------------------------------------------------------------------------------------------------------------------
Ratios
Net charge-offs to average total loans 0.15% 0.39% 0.10% 0.08% 0.03%
Allowance for loan losses to total
loans at year-end 0.65% 0.65 0.84 0.90 0.98
Allowance for loan losses to nonaccrual
loans and loans past due 90 days or more 299.8% 27.5 120.5 83.6 106.2
- ----------------------------------------------------------------------------------------------------------------------------
[LOGO 45]
56
Management's Discussion of Consolidated Financial Condition & Results of
Operations
Off-Balance Sheet Arrangements
The Corporation's financial statements do not reflect various commitments that
are made in the normal course of business, which may involve some liquidity
risk. These commitments consist mainly of unfunded loans and letters of credit
made under the same standards as on-balance sheet instruments. Financial
instruments with off-balance sheet risk are disclosed in Note 15 of this report
and total $64 million at December 31, 2003, compared to $65 million at December
31, 2002. Normally these commitments have fixed expiration dates or termination
clauses and are for specific purposes. Accordingly, many of the commitments are
expected to expire without being drawn upon and therefore, generally do not
present significant liquidity risk to the Corporation or PeoplesBank.
Contractual Obligations
Table 11 -- Contractual Obligations, shows the amount and timing of payments
that are due under long-term contractual obligations.
MARKET RISK MANAGEMENT
In the normal course of conducting business, the Corporation is exposed to
market risk, principally interest rate risk, through the operations of its
banking subsidiary, PeoplesBank. Interest rate risk arises from market driven
fluctuations in interest rates that may affect cash flows, income, expense and
the values of financial instruments. PeoplesBank is particularly vulnerable to
changes in the short-term US Prime interest rate (prime rate) and LIBOR. An
Asset-Liability Committee (committee) comprised of members of senior management
manages interest rate risk.
TABLE 10 - ALLOCATION OF ALLOWANCE FOR LOAN LOSSES
DECEMBER 31,
2003 2002 2001 2000 1999
----------------- ------------------ ----------------- ------------------ ----------------
% TOTAL % TOTAL % TOTAL % TOTAL % TOTAL
(dollars in thousands) AMOUNT LOANS AMOUNT LOANS AMOUNT LOANS AMOUNT LOANS AMOUNT LOANS
------ ------- ------ ------- ------ ------- ------ ------- ------ -------
Commercial, industrial
and agricultural $1,105 62.9 $ 906 69.0 $1,188 67.3 $1,064 64.4 $ 972 63.4
Real estate-construction
and land development 80 10.8 61 8.8 55 9.7 357 8.9 196 10.6
------ ----- ------ ----- ------ ----- ------ ----- ------ -----
Total commercial
related loans 1,185 73.7 967 77.8 1,243 77.0 1,421 73.3 1,168 74.0
Real estate-residential
mortgages 15 9.7 16 10.6 15 11.0 100 14.2 155 14.4
Installment 115 16.6 70 11.6 69 12.0 71 12.5 50 11.6
------ ----- ------ ----- ------ ----- ------ ----- ------ -----
Total consumer
related loans 130 26.3 86 22.2 84 23.0 171 26.7 205 26.0
Unallocated 379 N/A 462 n/a 571 n/a 375 n/a 650 n/a
------ ----- ------ ----- ------ ----- ------ ----- ------ -----
Total $1,694 100.0 $1,515 100.0 $1,898 100.0 $1,967 100.0 $2,023 100.0
------ ----- ------ ----- ------ ----- ------ ----- ------ -----
Note: The specific allocation for any particular loan category may be
reallocated in the future as risk perceptions change. Furthermore, the portion
allocated to each loan category is not the total amount available for future
losses that might occur within such categories since the total allowance is a
general allowance applicable to the entire loan portfolio.
TABLE 11 - CONTRACTUAL OBLIGATIONS
LESS THAN 1-3 3-5 MORE THAN
(dollars in thousands) TOTAL 1 YEAR YEARS YEARS 5 YEARS
- --------------------------------------------------------------------------------------------------------
Long-term debt $ 23,802 $ 896 $ 7,910 $ 1,141 $13,855
Capital lease obligations 637 20 53 74 490
Operating leases 563 66 134 138 225
Time deposits 139,386 75,043 49,154 15,189 0
- --------------------------------------------------------------------------------------------------------
Total $164,388 $76,025 $57,251 $16,542 $14,570
- --------------------------------------------------------------------------------------------------------
[LOGO 46]
57
The committee's objective is to maximize net interest income within acceptable
levels of liquidity and interest rate risk and within capital adequacy
constraints. PeoplesBank is not subject to foreign currency or commodity price
risk, nor does it own any trading assets.
The committee manages interest rate risk primarily through sensitivity analysis.
Asset-liability management simulation software (ALM model) is used to model and
measure the potential loss in future net income based on hypothetical changes in
interest rates. Interest rate forecasts are supplied by a national forecasting
service and integrated with the ALM model. The Corporation's policy limit for
the maximum negative impact on net income is 10 percent over a twelve-month
period. This policy limit is tested periodically by measuring the change in net
income from a baseline scenario where interest rates are held constant, to a
high rate scenario (gradual 200 basis point increase in prime and fed funds
rates), a low rate scenario (gradual 200 basis point decrease in prime and fed
funds rates) and a most likely scenario (defined by a forecasting service) over
the future twelve month period. Important ALM modeling assumptions include: the
use of contractual cash flows; varying levels of prepayments for loans and
mortgage-backed securities; stability of noninterest income and expense;
reinvestment of repriceable cash flows in the same type of asset or liability;
and constant product rate spreads, determined at the balance sheet date, over
the twelve-month measurement period. The ALM model also includes significant
balance sheet characteristics such as rate caps and floors.
The Corporation performed a simulation on its balance sheet for December 31,
2003 and 2002. The results of that point-in-time analysis are shown in Table 12
- -- Interest Rate Sensitivity. On both dates the Corporation's balance sheet was
asset sensitive in response to abnormally low market interest rates engineered
by the Federal Reserve Bank to stimulate domestic economic growth. Asset
sensitivity means that loan and investment assets will reprice to a greater and
faster degree than the deposits and debt that fund them. Therefore, if market
interest rates increase, earnings will increase. Conversely, if market interest
rates decrease, earnings will decrease. Generally, the financial services
industry has experienced increased liquidity, as deposit customers sought safe
haven from capital markets, loan customers refinanced, bond issuers called bonds
and mortgage-backed securities prepaid faster than scheduled. On December 31,
2003 and 2002, the hypothetical 200 basis point reduction in market interest
rates (low rate scenario) portrays a decline in net income of 10.6 percent and
10.8 percent, respectively, slightly exceeding management's 10 percent policy
guideline. Management believes that the Corporation's balance sheet is
positioned to benefit from an economic recovery and rising market interest
rates.
Measurement of interest rate risk requires many assumptions. These assumptions
are inherently uncertain and, as a result, the model cannot precisely estimate
net interest income or precisely predict the impact of higher or lower rates on
net income. Actual results may differ from simulated results due to many factors
TABLE 12 - INTEREST RATE SENSITIVITY
CHANGE IN INTEREST FORECASTED CHANGE IN
RATES (BASIS POINTS) INTEREST RATE NET INCOME
OVER 12 MOS SCENARIO $000's %
- -------------------------------------------------------------------
AT DECEMBER 31, 2003
+200 HIGH 241 5.8
0 FLAT (BASELINE) 0 0.0
-200 LOW (438) (10.6)
+88 MOST LIKELY 17 0.4
AT DECEMBER 31, 2002
+200 High 217 6.0
0 Flat (baseline) 0 0.0
-200 Low (393) (10.8)
+118 Most likely 94 2.6
- -------------------------------------------------------------------
[LOGO 47]
58
Management's Discussion of Consolidated Financial Condition & Results of
Operations
including: timing of cashflows, magnitude and frequency of interest rate
changes, customer behavior, changes in market conditions, and management
strategies.
IMPACT OF INFLATION AND CHANGING PRICES
The majority of assets and liabilities of a financial institution are monetary
in nature and therefore differ greatly from most commercial and industrial
companies that have significant investments in fixed assets or inventories.
However, inflation may impact the growth of total assets in the banking industry
and the resulting need to increase equity capital at higher than normal rates in
order to maintain an appropriate equity-to-assets ratio. Inflation may also
significantly affect noninterest expenses, which tend to rise during periods of
general inflation. The level of inflation can be measured by the change in the
Consumer Price Index (CPI) for all urban consumers (December vs. December). The
change in the CPI for 2003 was 1.9 percent, compared to 2.4 percent for 2002,
and 1.6 percent for 2001.
Management believes that the most significant impact on financial results is the
Corporation's ability to react to changes in market interest rates. As discussed
previously, management strives to structure the balance sheet to increase net
interest income by managing interest rate sensitive assets and liabilities to
reprice in response to changes in market interest rates. Additionally,
management is focused on increasing fee income, an income component less
sensitive to changes in market interest rates.
OTHER RISKS
More grand acts of terrorism in the United States of America, or in other
countries, could erode consumer and business confidence and disrupt commerce,
resulting in a prolonged economic recession. A prolonged economic recession
could have a material adverse effect on liquidity, capital resources or results
of operations of Codorus Valley.
Periodically, federal and state legislation is proposed that could result in
additional regulation of, or restrictions on, the business of Codorus Valley and
its subsidiaries. Management is not aware of any current specific
recommendations by regulatory authorities or proposed legislation, which, if
they were implemented, would have a material adverse effect upon the liquidity,
capital resources, or results of operations. Although the general cost of
compliance with numerous and multiple federal and state laws and regulations
does have, and in the future may have, a negative impact on Codorus Valley's
results of operations.
TABLE 13 - SUMMARY OF QUARTERLY FINANCIAL DATA
2003 2002
----------------------------------------------------------------------------------------
(dollars in thousands, FOURTH THIRD SECOND FIRST FOURTH THIRD SECOND FIRST
except per share data) QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER
- ---------------------------------------------------------------------------------------------------------------------------------
Interest income $ 4,893 $5,284 $ 4,914 $4,873 $5,179 $5,227 $5,110 $5,158
Interest expense 1,661 1,702 1,752 1,783 2,009 2,140 2,342 2,416
- ---------------------------------------------------------------------------------------------------------------------------------
Net interest income 3,232 3,582 3,162 3,090 3,170 3,087 2,768 2,742
Provision for loan losses 75 254 187 37 445 0 50 20
Noninterest income 891 962 787 767 733 630 611 609
Noninterest expense 3,148 2,891 3,178 3,073 2,977 2,717 2,627 2,687
- ---------------------------------------------------------------------------------------------------------------------------------
Net operating income 900 1,399 584 747 481 1,000 702 644
Gains from sales of securities 0 0 99 167 0 107 0 72
Gains, other 70 155 245 237 312 136 82 242
- ---------------------------------------------------------------------------------------------------------------------------------
Pretax income 970 1,554 928 1,151 793 1,243 784 958
Provision for income taxes 235 431 215 290 110 271 125 171
- ---------------------------------------------------------------------------------------------------------------------------------
Net income $ 735 $1,123 $ 713 $ 861 $ 683 $ 972 $ 659 $ 787
- ---------------------------------------------------------------------------------------------------------------------------------
Net income per share, basic $ 0.26 $ 0.40 $ 0.25 $ 0.30 $ 0.24 $ 0.34 $ 0.23 $ 0.29
Net income per share, diluted $ 0.25 $ 0.39 $ 0.25 $ 0.31 $ 0.24 $ 0.34 $ 0.23 $ 0.28
- ---------------------------------------------------------------------------------------------------------------------------------
Note: Net income per share was adjusted for stock dividends.
[LOGO 48]
59
Corporate Information
Corporate Profile
Codorus Valley Bancorp, Inc. is a Pennsylvania business incorporated in 1986,
which became a bank holding company on March 2, 1987, under the Bank Holding
Company Act of 1956. PeoplesBank, A Codorus Valley Company, is its wholly owned
banking subsidiary and SYC Realty Co., Inc. is its wholly owned nonbank
subsidiary. Organized in 1934, PeoplesBank offers a full range of business and
consumer banking services through eleven financial centers throughout York
County, Pennsylvania. It also offers wealth management and real estate services.
The deposits of PeoplesBank are fully insured by the Federal Deposit Insurance
Corporation (FDIC) to the maximum extent provided by law. In 1998, PeoplesBank
created SYC Settlement Services, Inc., as a wholly owned subsidiary, to provide
real estate settlement services. In 1999, PeoplesBank created SYC Insurance
Services, Inc., as a wholly owned subsidiary, to sell nondeposit investment
products.
Headquarters
Codorus Valley Bancorp, Inc. is headquartered at the Codorus Valley Corporate
Center, 105 Leader Heights Road, York, PA 17403.
Stock, Dividend and Broker Information
Outstanding common stock of Codorus Valley Bancorp, Inc. is quoted under the
symbol CVLY on the Nasdaq National Market System. At December 31, 2003, there
were approximately 964 shareholders of record.
Prices presented below are based on the close price as quoted on the Nasdaq
National Market System. Cash dividends paid for the most recent eight quarters
are also provided in the table below. Cash dividends per share (rounded) and
market prices are adjusted for stock dividends.
2003 2002
--------------------------------------- ---------------------------------------
DIVIDENDS DIVIDENDS
QUARTER HIGH LOW PER SHARE HIGH LOW PER SHARE
- ----------------------------------------------------------------------------------------------------------
First $15.57 $13.90 $0.114 $14.24 $12.25 $0.109
Second 16.49 14.95 $0.114 15.24 12.38 0.109
Third 18.00 15.53 $0.120 16.00 14.36 0.114
Fourth 21.10 17.81 $0.120 15.48 13.43 0.114
For further information, we refer you to the following market makers in our
common stock:
Boenning & Scattergood, Inc. Ferris, Baker Watts, Inc.
800-842-8928 410-468-2749
Notice of Annual Meeting
The Annual Meeting of Shareholders will be held on Tuesday, May 18, 2004 at 9:00
a.m. Eastern Time, at the Codorus Valley Corporate Center, 105 Leader Heights
Road, York, PA 17403.
Transfer Agent
Wells Fargo Bank, N.A., P.O. Box 64854, St. Paul, MN 55164-0854
800-468-9716
Dividend Reinvestment and Stock Purchase Plan
Information regarding the Corporation's Dividend Reinvestment and Stock Purchase
Plan may be obtained by calling 800-468-9716 or by writing to: Wells Fargo Bank,
N.A., P.O. Box 64854, St. Paul, MN 55164-0854
Form 10-K Request
The form 10-K Report filed with the Securities and Exchange Commission (SEC) may
be obtained, without charge, as follows:
Via the Internet: www.peoplesbanknet.com, select Codorus Valley Bancorp, Inc.,
then select the Securities and Exchange Commission link, or visit the SEC
website at www.sec.gov/edgarhp.htm
Via written request to: Chief Financial Officer, Codorus Valley Bancorp, Inc.,
P.O. Box 2887, York, PA 17405-2887.
[LOGO 49]
60