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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-Q
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|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2009
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
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Commission file number 000-23777
PENSECO FINANCIAL SERVICES CORPORATION
Incorporated pursuant to the laws of Pennsylvania
------------------
Internal Revenue Service -- Employer Identification No. 23-2939222
150 North Washington Avenue, Scranton, Pennsylvania 18503-1848
(570) 346-7741
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Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes |X| No |_|
Indicate by check mark whether the registrant has submitted electronically and
posted on its corporate Web site, if any, every Interactive Data File required
to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section
232.405 of this chapter) during the preceding 12 months (or for such shorter
period that the registrant was required to submit and post such files).
Yes |_| No |_|
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of "large accelerated filer," "accelerated filer" and "smaller
reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer |_|
Accelerated filer |X|
Non-accelerated filer |_| (Do not check if a smaller reporting company)
Smaller reporting company |_|
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).
Yes |_| No |X|
The total number of shares of the registrant's Common Stock, $0.01 par value,
outstanding on October 31, 2009 was 3,276,079.
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PENSECO FINANCIAL SERVICES CORPORATION
Page
PART I -- FINANCIAL INFORMATION
Item 1. Unaudited Financial Statements - Consolidated
Balance Sheets:
September 30, 2009.................................... 3
December 31, 2008..................................... 3
Statements of Income:
Three Months Ended September 30, 2009................. 4
Three Months Ended September 30, 2008................. 4
Nine Months Ended September 30, 2009.................. 5
Nine Months Ended September 30, 2008.................. 5
Statements of Changes in Stockholders' Equity:
Three Months Ended September 30, 2009................. 6
Three Months Ended September 30, 2008................. 6
Nine Months Ended September 30, 2009.................. 7
Nine Months Ended September 30, 2008.................. 7
Statements of Cash Flows:
Nine Months Ended September 30, 2009.................. 8
Nine Months Ended September 30, 2008.................. 8
Notes to Unaudited Consolidated Financial Statements.... 9
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations................... 25
Item 3. Quantitative and Qualitative Disclosures About
Market Risk........................................... 43
Item 4. Controls and Procedures................................. 43
PART II -- OTHER INFORMATION
Item 1. Legal Proceedings....................................... 44
Item 1A. Risk Factors........................................... 44
Item 2. Unregistered Sales of Equity Securities and
Use of Proceeds....................................... 47
Item 3. Defaults Upon Senior Securities......................... 47
Item 4. Submission of Matters to a Vote of Security Holders..... 47
Item 5. Other Information....................................... 47
Item 6. Exhibits................................................ 47
Signatures......................................................... 47
2
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PART I. FINANCIAL INFORMATION, ITEM 1 -- FINANCIAL STATEMENTS
PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<Table>
<Caption>
September 30, December 31,
2009 2008
------------- ------------
ASSETS
Cash and due from banks $ 9,686 $ 7,246
Interest bearing balances with banks 2,244 2,109
Federal funds sold - -
------------- ------------
Cash and Cash Equivalents 11,930 9,355
Investment securities:
Available-for-sale, at fair value 149,366 94,996
Held-to-maturity (fair value of $54,375
and $64,678, respectively) 51,793 62,484
------------- ------------
Total Investment Securities 201,159 157,480
Loans, net of unearned income 597,564 441,148
Less: Allowance for loan losses 6,300 5,275
------------- ------------
Loans, Net 591,264 435,873
Bank premises and equipment 12,158 10,391
Other real estate owned 190 -
Accrued interest receivable 4,226 3,518
Goodwill 26,398 -
Cash surrender value of life insurance 14,253 7,684
Other assets 10,063 4,666
------------- ------------
Total Assets $871,641 $628,967
============= ============
LIABILITIES
Deposits:
Non-interest bearing $104,354 $ 72,456
Interest bearing 532,554 352,269
------------- ------------
Total Deposits 636,908 424,725
Other borrowed funds:
Repurchase agreements 25,104 29,155
Short-term borrowings 17,974 24,204
Long-term borrowings 65,872 72,720
Accrued interest payable 1,264 1,118
Other liabilities 7,296 3,403
------------- ------------
Total Liabilities 754,418 555,325
------------- ------------
STOCKHOLDERS' EQUITY
Common stock; $ .01 par value, 15,000,000
shares authorized, 3,276,079 shares issued
and outstanding at September 30, 2009 and
2,148,000 shares issued and outstanding at
December 31, 2008 33 21
Surplus 48,865 10,819
Retained earnings 67,495 64,745
Accumulated other comprehensive income 830 (1,943)
------------- ------------
Total Stockholders' Equity 117,223 73,642
------------- ------------
Total Liabilities and Stockholders' Equity $871,641 $628,967
============= ============
</Table>
(See accompanying Notes to Unaudited Consolidated Financial Statements)
3
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PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<Table>
<Caption>
Three Months Ended Three Months Ended
September 30, 2009 September 30, 2008
------------------ ------------------
INTEREST INCOME
Interest and fees on loans $ 8,718 $ 6,543
Interest and dividends on investments:
U.S. Treasury securities and U.S.
Agency obligations 800 1,047
States & political subdivisions 1,216 849
Other securities 8 68
Interest on Federal funds sold - 31
Interest on balances with banks 3 28
------------------ ------------------
Total Interest Income 10,745 8,566
------------------ ------------------
INTEREST EXPENSE
Interest on time deposits of $100,000 or more 507 336
Interest on other deposits 1,376 1,385
Interest on other borrowed funds 719 1,017
------------------ ------------------
Total Interest Expense 2,602 2,738
------------------ ------------------
Net Interest Income 8,143 5,828
Provision for loan losses 342 167
------------------ ------------------
Net Interest Income After Provision
for Loan Losses 7,801 5,661
------------------ ------------------
NON-INTEREST INCOME
Trust department income 369 386
Service charges on deposit accounts 546 403
Merchant transaction income 1,564 1,583
Brokerage income 93 136
Other fee income 398 347
Bank-owned life insurance income 132 78
Other operating income 14 30
VISA mandatory share redemption - -
Realized gains (losses) on securities, net 27 23
------------------ ------------------
Total Non-Interest Income 3,143 2,986
------------------ ------------------
NON-INTEREST EXPENSES
Salaries and employee benefits 3,224 2,481
Expense of premises and fixed assets 827 626
Merchant transaction expenses 1,061 1,182
Merger related costs - -
FDIC insurance assessments 127 17
Other operating expenses 1,798 1,520
------------------ ------------------
Total Non-Interest Expenses 7,037 5,826
------------------ ------------------
Income before income taxes 3,907 2,821
Applicable income taxes 812 579
------------------ ------------------
Net Income $ 3,095 $ 2,242
================== ==================
Weighted average shares outstanding 3,276,079 2,148,000
Earnings per Common Share 0.94 1.04
Cash Dividends Declared Per Common Share 0.42 0.42
</Table>
(See accompanying Notes to Unaudited Consolidated Financial Statements)
4
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PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<Table>
<Caption>
Nine Months Ended Nine Months Ended
September 30, September 30,
2009 2008
----------------- -----------------
INTEREST INCOME
Interest and fees on loans $ 23,729 $ 19,640
Interest and dividends on investments:
U.S. Treasury securities and U.S.
Agency obligations 2,550 3,052
States & political subdivisions 3,210 2,521
Other securities 30 211
Interest on Federal funds sold - 31
Interest on balances with banks 9 62
----------------- -----------------
Total Interest Income 29,528 25,517
----------------- -----------------
INTEREST EXPENSE
Interest on time deposits of $100,000 or more 1,267 1,142
Interest on other deposits 3,760 4,342
Interest on other borrowed funds 2,320 2,961
----------------- -----------------
Total Interest Expense 7,347 8,445
----------------- -----------------
Net Interest Income 22,181 17,072
Provision for loan losses 1,573 618
----------------- -----------------
Net Interest Income After Provision
for Loan Losses 20,608 16,454
----------------- -----------------
NON-INTEREST INCOME
Trust department income 1,054 1,133
Service charges on deposit accounts 1,366 1,062
Merchant transaction income 3,613 3,702
Brokerage income 289 487
Other fee income 1,016 964
Bank-owned life insurance income 343 236
Other operating income 302 148
VISA mandatory share redemption - 1,213
Realized gains (losses) on securities, net 341 23
----------------- -----------------
Total Non-Interest Income 8,324 8,968
----------------- -----------------
NON-INTEREST EXPENSES
Salaries and employee benefits 8,951 7,405
Expense of premises and fixed assets 2,435 2,061
Merchant transaction expenses 2,523 2,787
Merger related costs 1,550 -
FDIC insurance assessments 571 41
Other operating expenses 5,063 4,047
----------------- -----------------
Total Non-Interest Expenses 21,093 16,341
----------------- -----------------
Income before income taxes 7,839 9,081
Applicable income taxes 1,434 1,954
----------------- -----------------
Net Income $ 6,405 $ 7,127
================= =================
Weighted average shares outstanding 2,900,053 2,148,000
Earnings per Common Share $ 2.21 $ 3.32
Cash Dividends Declared Per Common Share $ 1.26 $ 1.24
</Table>
(See accompanying Notes to Unaudited Consolidated Financial Statements)
5
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PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
THREE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<Table>
<Caption>
Accumulated
Other Total
Common Retained Comprehensive Stockholders'
Stock Surplus Earnings Income Equity
---------- --------- ---------- -------------- -------------
Balance, June 30, 2008 $ 21 $10,819 $62,820 $(1,269) $ 72,391
Comprehensive income:
Net income - - 2,242 - 2,242
Other comprehensive income, net of tax
Unrealized losses on securities, net of
reclassification adjustment - - - (1,817) (1,817)
-------------- -------------
Other comprehensive income (1,817) (1,817)
-------------
Comprehensive income 425
Cash dividends declared ($0.42 per share) - - (902) - (902)
---------- --------- ---------- -------------- -------------
Balance, September 30, 2008 $ 21 $10,819 $64,160 $(3,086) $ 71,914
========== ========= ========== ============== =============
Balance, June 30, 2009 $ 33 $48,865 $65,777 $(1,462) $113,213
Comprehensive income:
Net income - - 3,095 - 3,095
Other comprehensive income, net of tax
Unrealized gains onsecurities, net of
reclassification adjustment - - - 2,292 2,292
-------------- -------------
Other comprehensive income 2,292 2,292
-------------
Comprehensive income 5,387
Cash dividends declared ($0.42 per share) - - (1,377) - (1,377)
---------- --------- ---------- -------------- -------------
Balance, September 30, 2009 $ 33 $48,865 $67,495 $ 830 $117,223
========== ========= ========== ============== =============
</Table>
6
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PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<Table>
<Caption>
Accumulated
Other Total
Common Retained Comprehensive Stockholders'
Stock Surplus Earnings Income Equity
---------- --------- ---------- -------------- -------------
Balance, December 31, 2007 $ 21 $10,819 $59,697 $ (822) $ 69,715
Comprehensive income:
Net income - - 7,127 - 7,127
Other comprehensive income, net of tax
Unrealized losses on securities, net of
reclassification adjustment - - - (2,709) (2,709)
Minimum pension liability adjustment - - - 445 445
-------------- -------------
Other comprehensive income (2,264) (2,264)
-------------
Comprehensive income 4,863
Cash dividends declared ($1.24 per share) - - (2,664) - (2,664)
---------- --------- ---------- -------------- -------------
Balance, September 30, 2008 $ 21 $10,819 $64,160 $(3,086) $ 71,914
========== ========= ========== ============== =============
Balance, December 31, 2008 $ 21 $10,819 $64,745 $(1,943) $ 73,642
Fair value of consideration exchanged in merger 12 38,046 - - 38,058
Comprehensive income:
Net income - - 6,405 - 6,405
Other comprehensive income, net of tax
Unrealized gains on securities, net of
reclassification adjustment - - - 2,773 2,773
-------------- -------------
Other comprehensive income 2,773 2,773
-------------
Comprehensive income 9,178
Cash dividends declared ($1.26 per share) - - (3,655) - (3,655)
---------- --------- ---------- -------------- -------------
Balance, September 30, 2009 $ 33 $48,865 $67,495 $ 830 $117,223
========== ========= ========== ============== =============
</Table>
(See accompanying Notes to Unaudited Consolidated Financial Statements)
7
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PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
<Table>
<Caption>
Nine Months Ended Nine Months Ended
September 30, 2009 September 30, 2008
------------------ ------------------
OPERATING ACTIVITIES
Net income $ 6,405 $ 7,127
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation 730 606
Provision for loan losses 1,573 618
Deferred income tax (benefit) provision (381) (9)
Amortization of securities, (net of accretion) 346 223
Gain on VISA mandatory share redemption - (1,213)
Net realized (gains) losses on securities (341) (23)
Loss (gain) on other real estate 52 (6)
Decrease (increase) in interest receivable 297 (48)
(Increase) decrease in cash surrender value of life
insurance (343) (237)
Decrease (increase) in other assets 2,012 (1,659)
Increase (decrease) income taxes payable 1,284 1,987
(Decrease) increase in interest payable (194) (408)
Increase (decrease) in other liabilities 77 633
------------------ ------------------
Net cash provided (used) by operating activities 11,517 7,591
------------------ ------------------
INVESTING ACTIVITIES
Purchase of investment securities available-for-sale (51,018) (48,841)
Proceeds from sales and maturities of investment
securities available-for-sale 29,561 24,544
Purchase of investment securities to be
held-to-maturity - -
Proceeds from repayments of investment securities
available-for-sale 3,252 6,494
Proceeds from repayments of investment securities
held-to-maturity 10,540 4,391
Net loans repaid (originated) 2,289 (28,981)
Proceeds from other real estate 480 28
Investment in premises and equipment (921) (458)
Net cash (paid) received in merger (12,645) -
------------------ ------------------
Net cash (used) provided by investing activities (18,462) (42,823)
------------------ ------------------
FINANCING ACTIVITIES
Net increase (decrease) in demand and savings
deposits 20,598 22,352
Net proceeds (payments) on time deposits 14,706 3,637
(Decrease) increase in repurchase agreements (4,051) 25,365
Net (decrease) increase in short-term borrowings (11,230) (12,629)
Increase in long-term borrowings 3,000 27,000
Repayments of long-term borrowings (9,848) (7,691)
Cash dividends paid (3,655) (2,664)
------------------ ------------------
Net cash provided (used) by financing activities 9,520 55,370
------------------ ------------------
Net increase (decrease) in cash and cash
equivalents 2,575 20,138
Cash and cash equivalents at January 1 9,355 11,644
------------------ ------------------
Cash and cash equivalents at September 30 $ 11,930 $ 31,782
================== ==================
</Table>
The Company paid interest and income taxes of $7,125 and $122 and $8,853 and
$2,080, for the nine months ended September 30, 2009 and 2008, respectively.
(See accompanying Notes to Unaudited Consolidated Financial Statements)
8
<Page>9
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE QUARTER ENDED SEPTEMBER 30, 2009
(UNAUDITED)
These Notes to Unaudited Consolidated Financial Statements reflect events
subsequent to December 31, 2008, the date of the most recent Report of
Independent Registered Public Accounting Firm, through the date of this
Quarterly Report on Form 10-Q. These Notes to Unaudited Consolidated Financial
Statements should be read in conjunction with Parts I and II of this Report and
the Company's Annual Report on Form 10-K for the year ended December 31, 2008,
which was filed with the Securities and Exchange Commission (SEC) on March 16,
2009.
FORWARD LOOKING INFORMATION
This Quarterly Report on Form 10-Q contains forward-looking statements that are
based on assumptions and may describe future plans, strategies and expectations
of Penseco Financial Services Corporation. These forward-looking statements are
generally identified by use of the words "believe," "expect," "intend,"
"anticipate," "estimate," "project" or similar expressions. Penseco Financial
Services Corporation's ability to predict results or the actual effect of future
plans or strategies is inherently uncertain. Factors which could have a material
adverse effect on the operations of Penseco Financial Services Corporation and
its subsidiary include, but are not limited to, changes in interest rates,
national and regional economic conditions, legislative and regulatory changes,
monetary and fiscal policies of the U.S. government, including policies of the
U.S. Treasury and the Federal Reserve Board, the quality and composition of the
loan or investment portfolios, demand for loan products, deposit flows,
competition, demand for financial services in Penseco Financial Services
Corporation's market area, changes in real estate market values in Penseco
Financial Services Corporation's market area, changes in relevant accounting
principles and guidelines and inability of third party service providers to
perform. Additional factors that may affect our results are discussed in Part
II, Item 1A to this Quarterly Report on Form 10-Q titled "Risk Factors".
These risks and uncertainties should be considered in evaluating forward-looking
statements and undue reliance should not be placed on such statements. Except as
required by applicable law or regulation, Penseco Financial Services Corporation
does not undertake, and specifically disclaims any obligation, to release
publicly the result of any revisions that may be made to any forward-looking
statements to reflect events or circumstances after the date of the statements
or to reflect the occurrence of anticipated or unanticipated events.
Unless the context indicates otherwise, all references in this Quarterly Report
to "Company," "we," "us" and "our" refer to Penseco Financial Services
Corporation and its subsidiary.
NOTE 1 -- PRINCIPLES OF CONSOLIDATION
Penseco Financial Services Corporation is a financial holding company
incorporated under the laws of Pennsylvania. It is the parent company of Penn
Security Bank and Trust Company (Bank), a Pennsylvania state chartered bank.
Intercompany transactions have been eliminated in preparing the consolidated
financial statements.
The accounting policies of the Company conform with accounting principles
generally accepted in the United States of America (GAAP) and with general
practices within the banking industry.
NOTE 2 -- BASIS OF PRESENTATION
The unaudited consolidated financial statements have been prepared in accordance
with the instructions to SEC Form 10-Q and generally accepted accounting
principles for interim financial information. In the opinion of management, all
adjustments that are of a normal recurring nature and are considered necessary
for a fair presentation have been included. They are not, however, necessarily
indicative of the results of consolidated operations for a full year or any
other period.
All information is presented in thousands of dollars, except per share amounts.
For further information, refer to the consolidated financial statements and
accompanying notes included in the Company's Annual Report on Form 10-K for the
year ended December 31, 2008.
The Company has evaluated subsequent events for recognition and/or disclosure
through November 2, 2009, the date the consolidated financial statements
included in this Quarterly Report on Form 10-Q were issued.
9
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NOTE 3 -- 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 reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change
relate to the determination of the allowance for losses on loans and the
valuation of real estate acquired in connection with foreclosures or in
satisfaction of loans. In connection with the determination of the allowances
for losses on loans and foreclosed real estate, management obtains independent
appraisals for significant properties.
NOTE 4 -- INVESTMENT SECURITIES
Investments in securities are classified in two categories and accounted for as
follows:
Securities Held-to-Maturity Bonds, notes, debentures and mortgage-backed
- ---------------------------
securities for which the Company has the positive intent and ability to hold to
maturity are reported at cost, adjusted for amortization of premiums and
accretion of discounts computed on the straight-line basis, which approximates
the interest method, over the remaining period to maturity.
Securities Available-for-Sale Bonds, notes, debentures, mortgage-backed
- -----------------------------
securities and certain equity securities not classified as securities to be
held-to-maturity are carried at fair value with unrealized gains and losses, net
of tax, reported as a net amount in a separate component of stockholders' equity
until realized.
The amortization of premiums on mortgage-backed securities is done based on
management's estimate of the lives of the securities, adjusted, when necessary,
for advanced prepayments in excess of those estimates.
Realized gains and losses on the sale of securities available-for-sale are
determined using the specific identification method and are reported as a
separate component of other income in the Statements of Income. Unrealized gains
and losses are included as a separate item in computing comprehensive income.
The amortized cost and fair value of investment securities at September 30, 2009
and December 31, 2008 are as follows:
<Table>
<Caption>
AVAILABLE-FOR-SALE
Gross Gross
Amortized Unrealized Unrealized Fair
September 30, 2009 Cost Gains Losses Value
- ------------------------------------------------------------------------------------------------
U.S. Agency securities $ 45,495 $ 771 $ 3 $46,263
Mortgage-backed securities 17,635 635 - 18,270
States & political subdivisions 74,126 3,145 257 77,014
- ------------------------------------------------------------------------------------------------
Total Debt Securities 137,256 4,551 260 141,547
Equity securities 7,567 955 703 7,819
- ------------------------------------------------------------------------------------------------
Total Available-for-Sale $144,823 $5,506 $ 963 $149,366
- ------------------------------------------------------------------------------------------------
</Table>
<Table>
<Caption>
AVAILABLE-FOR-SALE
Gross Gross
Amortized Unrealized Unrealized Fair
December 31, 2008 Cost Gains Losses Value
- ------------------------------------------------------------------------------------------------
U.S. Agency securities $25,221 $ 919 $ - $26,140
Mortgage-backed securities 20,873 392 16 21,249
States & political subdivisions 41,726 514 1,460 40,780
- ------------------------------------------------------------------------------------------------
Total Debt Securities 87,820 1,825 1,476 88,169
Equity securities 6,835 623 631 6,827
- ------------------------------------------------------------------------------------------------
Total Available-for-Sale $94,655 $2,448 $2,107 $94,996
- ------------------------------------------------------------------------------------------------
</Table>
10
<Page>11
HELD-TO-MATURITY
<Table>
<Caption>
Gross Gross
Amortized Unrealized Unrealized Fair
September 30, 2009 Cost Gains Losses Value
- ------------------------------------------------------------------------------------------------
Mortgage-backed securities $25,365 $1,393 $ - $26,758
States & political subdivisions 26,428 1,189 - 27,617
- ------------------------------------------------------------------------------------------------
Total Held-to-Maturity $51,793 $2,582 $ - $54,375
- ------------------------------------------------------------------------------------------------
</Table>
<Table>
<Caption>
HELD-TO-MATURITY
Gross Gross
Amortized Unrealized Unrealized Fair
December 31, 2008 Cost Gains Losses Value
- ------------------------------------------------------------------------------------------------
Mortgage-backed securities $33,254 $ 661 $ 2 $33,913
States & political subdivisions 29,230 1,558 23 30,765
- ------------------------------------------------------------------------------------------------
Total Held-to-Maturity $62,484 $2,219 $ 25 $64,678
- ------------------------------------------------------------------------------------------------
</Table>
Equity securities at September 30, 2009 and December 31, 2008 consisted
primarily of other financial institutions' stock and Federal Home Loan Bank of
Pittsburgh (FHLB) stock, which is a required investment in order for the Company
to participate in a FHLB available line of credit program. The FHLB stock is
stated at par value as it is restricted to purchases and sales with the FHLB.
The FHLB indefinitely suspended its stock repurchase and dividend payments
during December 2008. Based on current financial information available,
management does not believe the FHLB stock value is impaired as of September 30,
2009.
The amortized cost and fair value of debt securities at September 30, 2009 by
contractual maturity are shown below. Expected maturities may differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties.
<Table>
<Caption>
September 30, 2009 Available-for-Sale Held-to-Maturity
- --------------------------------------------------------------------------------------
Amortized Fair Amortized Fair
Cost Value Cost Value
- --------------------------------------------------------------------------------------
Due in one year or less:
U.S. Agency securities $ 8,169 $ 8,283 $ - $ -
States & political subdivisions 45 45 - -
After one year through five years:
U.S. Agency securities 34,811 35,459 - -
States & political subdivisions 320 334 - -
After five year through ten years:
U.S. Agency securities 2,515 2,521 - -
States & political subdivisions 1,468 1,591 5,249 5,488
After ten years:
States & political subdivisions 72,293 75,044 21,179 22,129
- --------------------------------------------------------------------------------------
Subtotal 119,621 123,277 26,428 27,617
Mortgage-backed securities 17,635 18,270 25,365 26,758
- --------------------------------------------------------------------------------------
Total Debt Securities $137,256 $141,547 $51,793 $54,375
- --------------------------------------------------------------------------------------
</Table>
11
<Page>12
The gross fair value and unrealized losses of the Company's investments
aggregated by investment category and length of time that individual securities
have been in a continuous unrealized loss position, at September 30, 2009 and
December 31, 2008, are as follows:
<Table>
<Caption>
Less than twelve months Twelve months or more Totals
----------------------- ----------------------- -----------------------
Fair Unrealized Fair Unrealized Fair Unrealized
September 30, 2009 Value Losses Value Losses Value Losses
- ---------------------------------------------------------------------------------------------------------------------------
U.S. Agency securities $2,068 $ 3 $ - $ - $2,068 $ 3
States & political subdivisions - - 5,211 257 5,211 257
Equities - - 246 703 246 703
- ---------------------------------------------------------------------------------------------------------------------------
Total $2,068 $ 3 $5,457 $ 960 $7,525 $ 963
- ---------------------------------------------------------------------------------------------------------------------------
</Table>
<Table>
<Caption>
Less than twelve months Twelve months or more Totals
----------------------- ----------------------- -----------------------
Fair Unrealized Fair Unrealized Fair Unrealized
December 31, 2008 Value Losses Value Losses Value Losses
- ---------------------------------------------------------------------------------------------------------------------------
Mortgage-backed securities $ - $ - $5,351 $ 18 $ 5,351 $ 18
States & political subdivisions 21,569 1,247 1,409 236 22,978 1,483
Equities 37 15 395 616 432 631
- ---------------------------------------------------------------------------------------------------------------------------
Total $21,606 $1,262 $7,155 $ 870 $28,761 $2,132
- ---------------------------------------------------------------------------------------------------------------------------
</Table>
The table at September 30, 2009 includes one (1) security that has an unrealized
loss for less than twelve months and eighteen (18) securities that have been in
an unrealized loss position for twelve or more months. The table at December 31,
2008 includes forty-two (42) securities that have unrealized losses for less
than twelve months and twenty (20) securities that have been in an unrealized
loss position for twelve or more months. The Company has analyzed its investment
portfolio and determined that the market value fluctuation in these securities
is consistent with the broader market and not a cause for recognition of a
current loss.
U.S. AGENCY SECURITIES
The unrealized losses on the Company's investments in U.S. Agency securities
were caused by interest rate fluctuations. The contractual terms of these
investments do not permit the issuer to settle the securities at a price less
than the par value of the investment. Because the Company does not intend to
sell the investments and it is not more likely than not that the Company will be
required to sell the investments before recovery of their amortized cost bases,
which may be maturity, the Company does not consider those investments to be
other-than-temporarily impaired at September 30, 2009.
MORTGAGE-BACKED SECURITIES
The unrealized losses on the Company's investments in mortgage-backed securities
were caused by interest rate fluctuations. The contractual cash flows of these
investments are guaranteed by an agency of the U.S. government. Accordingly, it
is expected that these securities would not be settled at a price less than the
amortized cost of the Company's investment. Because the decline in market value
is attributable to changes in interest rates and not credit quality, and because
the Company does not intend to sell the investments and it is not more likely
than not that the Company will be required to sell the investments before
recovery of their amortized cost bases, which may be maturity, the Company does
not consider those investments to be other-than-temporarily impaired at
September 30, 2009.
STATES AND POLITICAL SUBDIVISIONS
The unrealized losses on the Company's investments in states and political
subdivisions were caused by interest rate fluctuations. The contractual terms of
these investments do not permit the issuer to settle the securities at a price
less than the par value of the investment. Because the Company does not intend
to sell the investments and it is not more likely than not that the Company will
be required to sell the investments before recovery of their amortized cost
12
<Page>13
bases, which may be maturity, the Company does not consider those investments to
be other-than-temporarily impaired at September 30, 2009.
MARKETABLE EQUITY SECURITIES
The unrealized losses on the Company's investments in marketable equity
securities were caused primarily by interest rate fluctuations and other market
conditions. The Company's investments in marketable equity securities consist
primarily of investments in common stock of companies in the financial services
industry. The Company has analyzed its equity portfolio and determined that the
market value fluctuation in these equity securities is consistent with the
broader market and not a cause for recognition of a current loss. Because the
Company does not intend to sell the investments and it is not more likely than
not that the Company will be required to sell the investments before recovery of
their cost bases, the Company does not consider those investments to be
other-than-temporarily impaired at September 30, 2009.
NOTE 5 -- LOAN PORTFOLIO
Details regarding the Company's loan portfolio on September 30, 2009 and
December 31, 2008 are as follows:
<Table>
<Caption>
September 30, December 31,
As of: 2009 2008
- ---------------------------------------------------------------------------------------
Real estate - construction and land development $ 31,761 $ 21,949
Real estate mortgages 466,617 355,528
Commercial 27,095 27,793
Credit card and related plans 3,272 3,272
Installment and other 61,656 28,135
Obligations of states & political subdivisions 7,163 4,471
- ---------------------------------------------------------------------------------------
Loans, net of unearned income 597,564 441,148
Less: Allowance for loan losses 6,300 5,275
- ---------------------------------------------------------------------------------------
Loans, net $591,264 $435,873
- ---------------------------------------------------------------------------------------
</Table>
The Company does not engage in any sub-prime or Alt-A credit lending. Therefore,
the Company is not subject to any credit risks associated with such loans. The
Company's loan portfolio consists primarily of residential and commercial
mortgage loans secured by properties located in Northeastern Pennsylvania and
subject to conservative underwriting standards.
NOTE 6 -- LOAN SERVICING
The Company generally retains the right to service mortgage loans sold to third
parties. The cost allocated to the mortgage servicing rights retained has been
recognized as a separate asset and is amortized in proportion to and over the
period of estimated net servicing income.
Mortgage servicing rights are evaluated for impairment based on the fair value
of those rights. Fair values are estimated using discounted cash flows based on
current market rates of interest and expected future prepayment rates. For
purposes of measuring impairment, the rights must be stratified by one or more
predominant risk characteristics of the underlying loans. The Company stratifies
its capitalized mortgage servicing rights based on the product type, interest
rate and term of the underlying loans. The amount of impairment recognized is
the amount, if any, by which the amortized cost of the rights for each stratum
exceed the fair value.
NOTE 7 -- GOODWILL
Goodwill represents the excess of the purchase price over the underlying fair
value of merged entities. Goodwill is assessed for impairment at least annually
and as triggering events occur. In making this assessment, management considers
a number of factors including, but not limited to, operating results, business
plans, economic projections, anticipated future cash flows, and current market
data. There are inherent uncertainties related to these factors and management's
judgment in applying them to the analysis of goodwill impairment. Changes in
economic and operating conditions, as well as other factors, could result in
goodwill impairment in future periods.
13
<Page>14
NOTE 8 -- OTHER INTANGIBLE ASSETS
Intangible assets include premiums from purchases of core deposit relationships
acquired in the Merger (as defined in Note 12). The core deposit intangible is
being amortized over ten years on a sum-of-the-years-digits basis. Amortization
expense for the next five years is expected to be as follows:
September 30,
-------------
2010 $ 231
2011 207
2012 182
2013 158
2014 134
NOTE 9 -- LONG-TERM DEBT
A summary of the Company's long-term debt at September 30, 2009 is as follows:
<Table>
<Caption>
Monthly Installment Fixed Rate Maturity Date Balance
- ---------------------------------------------------------------------------------
Amortizing loans
$ 253 3.22% 03/15/10 $ 1,504
29 1.84% 08/28/12 973
90 3.10% 02/28/13 3,500
430 3.74% 03/13/13 16,906
18 2.66% 08/28/14 984
67 3.44% 03/02/15 3,972
13 3.48% 03/31/15 806
10 3.83% 04/02/18 880
186 4.69% 03/13/23 22,347
- ---------------------------------------------------------------------------------
Total amortizing 51,872
- ---------------------------------------------------------------------------------
Non-amortizing loans
2.61% 03/01/10 1,000
1.71% 03/02/10 1,000
2.61% 08/30/10 1,000
2.88% 02/28/11 2,000
3.27% 02/29/12 2,000
3.49% 02/28/13 7,000
- ---------------------------------------------------------------------------------
Total non-amortizing 14,000
- ---------------------------------------------------------------------------------
Total long-term debt $65,872
- ---------------------------------------------------------------------------------
</Table>
The loans are secured by a general collateral pledge of the Company.
The Company has agreed to maintain sufficient qualifying collateral to fully
secure the above borrowings.
Aggregate maturities of long-term debt at September 30, 2009 are as follows:
September 30, Principal
------------- ---------
2010 $ 12,733
2011 10,536
2012 10,827
2013 12,724
2014 2,577
Thereafter 16,475
---------
$ 65,872
=========
14
<Page>15
NOTE 10 -- EMPLOYEE BENEFIT PLANS
The Company provides a defined benefit pension plan, currently under
curtailment, and a post-retirement benefit plan for eligible employees.
The components of the net periodic benefit cost are as follows:
<Table>
<Caption>
Pension Benefits Other Benefits
-----------------------------------------
Nine months ended September 30, 2009 2008 2009 2008
- -----------------------------------------------------------------------------------------------------
Service cost $ - $ 303 $ 4 $ 4
Interest cost 526 612 14 14
Expected return on plan assets (614) (765) - -
Amortization of prior service cost - - 5 5
Amortization of net loss (gain) 145 105 - -
- -----------------------------------------------------------------------------------------------------
Net periodic pension cost $ 57 $ 255 $ 23 $ 23
- -----------------------------------------------------------------------------------------------------
</Table>
Effective June 22, 2008 the Company curtailed its defined benefit pension plan.
The Company previously disclosed in its financial statements for the year ended
December 31, 2008 that it did not expect to contribute to its pension plan but
expected to contribute $18 to its post-retirement plan during 2009. The
actuarial calculations of required contributions for 2009 were revised to $468
and $32, respectively, as to its pension and post-retirement plans. As of
October 15, 2009, $0 has been contributed to the pension plan for 2009, due to
the use of a portion of the Funding Standard Carryover Balance to satisfy the
installments required to date, and $16 was contributed to the post retirement
plan. Readers should refer to the Company's Annual Report on Form 10-K for 2008
for further details on the Company's defined benefit pension plan. The
actuarially computed information on the plan curtailment, as to the pension
obligation and funded status, was disclosed in the Company's Quarterly Report on
Form 10-Q for the quarter ended June 30, 2008, as filed with the SEC on August
7, 2008.
Effective July 1, 2008, the Company began to sponsor a new 401(k) profit sharing
plan for all eligible employees. The Company's profit sharing expense for the
nine months ended September 30, 2009 was $335.
Under the 2008 Long-Term Incentive Plan the Company granted restricted stock
awards, valued at $75 during the nine months ended September 30, 2009.
NOTE 11 -- REGULATORY MATTERS
The Company and the Bank are subject to various regulatory capital requirements
administered by Federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory--and possibly additional
discretionary--actions by regulators that, if undertaken, could have a direct
material effect on the Company and the Bank's Consolidated Financial Statements.
Under capital adequacy guidelines and the regulatory framework for prompt
corrective action, the Company and the Bank must meet specific capital
guidelines that involve quantitative measures of their assets, liabilities, and
certain off-balance sheet items as calculated under regulatory accounting
practices. The Company and the Bank's capital amounts and classifications are
also subject to qualitative judgments by the regulators about components, risk
weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Company and the Bank to maintain minimum amounts and ratios (set
forth in the Capital Adequacy table on the following page) of Tier I and Total
Capital to risk-weighted assets and of Tier I Capital to average assets
(Leverage ratio). The table also presents the Company's actual capital amounts
and ratios. Management believes, as of September 30, 2009, that the Company and
the Bank meet all capital adequacy requirements to which they are subject.
As of September 30, 2009, the most recent notification from the Federal Deposit
Insurance Corporation (FDIC) categorized the Company as "well capitalized" under
the regulatory framework for prompt corrective action. To be categorized as
"well capitalized", the Company must maintain minimum Tier I Capital, Total
Capital and Leverage ratios as set forth in the Capital Adequacy table. There
are no conditions or events since that notification that management believes
have changed the Company's categorization by the FDIC.
15
<Page>16
The Company and Bank are also subject to minimum capital levels, which could
limit the payment of dividends, although the Company and Bank currently have
capital levels which are in excess of minimum capital level ratios required.
The Pennsylvania Banking Code restricts capital funds available for payment of
dividends to the retained earnings of the Bank. The balances in the capital
stock and surplus accounts are unavailable for dividends.
In addition, the Bank is subject to restrictions imposed by Federal law on
certain transactions with the Company's affiliates. These transactions include
extensions of credit, purchases of or investments in stock issued by an
affiliate, purchases of assets subject to certain exceptions, acceptance of
securities issued by an affiliate as collateral for loans, and the issuance of
guarantees, acceptances, and letters of credit on behalf of affiliates. These
restrictions prevent the Company's affiliates from borrowing from the Bank
unless the loans are secured by obligations of designated amounts. Further, the
aggregate of such transactions by the Bank with a single affiliate is limited in
amount to 10 percent of the Bank's Capital Stock and Surplus, and the aggregate
of such transactions with all affiliates is limited to 20 percent of the Bank's
Capital Stock and Surplus. The Federal Reserve System has interpreted "Capital
Stock and Surplus" to include undivided profits.
<Table>
<Caption>
ACTUAL REGULATORY REQUIREMENTS
- ---------------------------------------------------------------- --------------------------------------
For Capital To Be
Adequacy Purposes "Well Capitalized"
----------------- ------------------
As of September 30, 2009 Amount Ratio Amount Ratio Amount Ratio
- -----------------------------------------------------------------------------------------------------------
Total Capital (to Risk Weighted Assets)
PFSC (Company) $94,294 16.88% > $44,678 > 8.0% > $55,847 > 10.0%
- - - -
PSB (Bank) $90,888 16.29% > $44,646 > 8.0% > $55,807 > 10.0%
- - - -
Tier 1 Capital (to Risk Weighted Assets)
PFSC (Company) $87,994 15.76% > $22,339 > 4.0% > $33,508 > 6.0%
- - - -
PSB (Bank) $84,588 15.16% > $22,323 > 4.0% > $33,484 > 6.0%
- - - -
Tier 1 Capital (to Average Assets)
PFSC (Company) $87,994 11.69% > * > * > $37,621 > 5.0%
- - - -
PSB (Bank) $84,588 11.30% > * > * > $37,436 > 5.0%
- - - -
</Table>
PFSC - *3.0% ($22,573), 4.0% ($30,097) or 5.0% ($37,621) depending on the bank's
CAMELS Rating and other regulatory risk factors.
PSB - *3.0% ($22,462), 4.0% ($29,949) or 5.0% ($37,436) depending on the bank's
CAMELS Rating and other regulatory risk factors.
<Table>
<Caption>
ACTUAL REGULATORY REQUIREMENTS
- ---------------------------------------------------------------- --------------------------------------
For Capital To Be
Adequacy Purposes "Well Capitalized"
----------------- ------------------
As of December 31, 2009 Amount Ratio Amount Ratio Amount Ratio
- -----------------------------------------------------------------------------------------------------------
Total Capital (to Risk Weighted Assets)
PFSC (Company) $80,630 19.81% > $32,570 > 8.0% > $40,712 > 10.0%
- - - -
PSB (Bank) $77,275 19.03% > $32,486 > 8.0% > $40,607 > 10.0%
- - - -
Tier 1 Capital (to Risk Weighted Assets)
PFSC (Company) $75,544 18.56% > $16,285 > 4.0% > $24,427 > 6.0%
- - - -
PSB (Bank) $72,197 17.78% > $16,243 > 4.0% > $24,364 > 6.0%
- - - -
Tier 1 Capital (to Average Assets)
PFSC (Company) $75,544 12.26% > * > * > $30,813 > 5.0%
- - - -
PSB (Bank) $72,197 11.73% > * > * > $30,765 > 5.0%
- - - -
</Table>
PFSC - *3.0% ($18,488), 4.0% ($24,651) or 5.0% ($30,813) depending on the bank's
CAMELS Rating and other regulatory risk factors.
PSB - *3.0% ($18,459), 4.0% ($24,612) or 5.0% ($30,765) depending on the bank's
CAMELS Rating and other regulatory risk factors.
16
<Page>17
NOTE 12 -- MERGER
An Agreement and Plan of Merger (the Agreement) by and between the Company, the
Bank and Old Forge Bank, was entered into on December 5, 2008. The Agreement
provided for, among other things, the Company to acquire 100% of the outstanding
common shares of Old Forge Bank through a two-step merger transaction (the
Merger). The Company consummated the acquisition of Old Forge Bank on April 1,
2009. Old Forge Bank was merged with and into the Bank. Following the Merger,
the Bank continues to operate as a banking subsidiary of the Company.
Shareholders of Old Forge Bank were entitled to receive the merger consideration
in either cash or shares of Company common stock, or any combination thereof,
subject to certain limitations and allocation procedures set forth in the
Agreement. The per share amount was calculated from the cash consideration and
the value of the stock consideration based on the Company's closing price of the
Company's common stock over a fixed period of time, as provided for in the
Agreement.
Old Forge Bank was an independent $215 million community bank, operating from
three locations in Lackawanna and Luzerne Counties of Pennsylvania. As a result
of the Merger, the Company is now an $872 million financial institution serving
Northeastern Pennsylvania from 12 locations. Management of the Company believes
that the combined entity is in a more favorable position to compete with local
and regional banks in the marketplace.
There was approximately $26.4 million of goodwill created in the Merger, largely
based on the Company's evaluation of the business growth opportunities inherent
in the Old Forge Bank customer base, as well as operating synergies and economy
of scale resulting from the Merger. None of the goodwill is expected to be
deductible for income tax purposes.
The following table summarizes the consideration paid for Old Forge Bank and the
identifiable assets acquired and liabilities assumed at acquisition date.
April 1, 2009
-------------
Consideration
- -------------
Cash $ 17,405
Common Stock issued - 1,128,079 shares
of the Company, net of issuance costs of $184 38,058
---------
Fair value of consideration transferred $ 55,463
=========
The fair value of the 1,128,079 common shares of the Company issued as part of
the consideration paid to former Old Forge Bank shareholders was $38,058,
determined by use of the weighted average price of Company shares traded on
March 31, 2009 ($33.90 per share). The Company believes that the weighted
average price of the Company stock traded on March 31, 2009 is the best
indication of value since the Company's common stock is not a heavily traded
security.
Acquisition-related costs recorded in the income
statement of the acquirer for the nine months
ended September 30, 2009. $ 1,550
Acquisition-related costs recorded as an offset to
surplus of the acquirer as of September 30, 2009. $ 184
17
<Page>18
Recognized amounts of identifiable assets acquired and liabilities assumed
on April 1, 2009 are:
Cash $ 4,760
Investments 32,095
Loans 159,949
Property and equipment 1,576
Core Deposit Intangible 2,027
All other assets 12,193
-----------
Identifiable Assets 212,600
-----------
Deposits 177,018
Borrowings 5,000
All other liabilities 1,517
------------
Identifiable Liabilities 183,535
------------
Identifiable net assets 29,065
Goodwill 26,398
-----------
Total consideration transferred $ 55,463
============
The fair value of the financial assets acquired included loans receivable with a
gross amortized cost basis of $166,348 at April 1, 2009. The table below
illustrates the fair value adjustments made to the amortized cost basis in order
to present the fair value of the loans acquired.
Gross amortized costs basis at April 1, 2009 $166,348
Market rate adjustment 640
Credit fair value adjustment in pools of homogeneous loans (5,648)
Credit fair value adjustment on distressed loans (1,391)
----------
Fair value of purchased loans at April 1, 2009 159,949
==========
18
<Page>19
PRO FORMA BALANCE SHEET
As of December 31, 2008
<Table>
<Caption>
Penseco
Financial Services Old Forge
Corporation Bank Pro Forma
($ = 000's) 12/31/2008 12/31/2008 Eliminations Marks/Costs Adjustments 12/31/2008
- --------------------------------------------------------- ---------- ------------ ----------- ----------- ----------
ASSETS
Cash and Equivalents $ 9,355 $ 4,275 $ 13,630
Securities 157,480 40,033 197,513
Gross Loans 441,148 169,789 (7,828)(d) 603,109
Loan Loss Reserves (5,275) (1,429) 1,429(a) (5,275)
Goodwill - - 26,398(j) 26,398
Other Intangibles 41 150 (150)(b) 2,027(k) 2,068
Buildings and Furniture, Fixtures
& Equipment 10,391 1,701 (132)(e) 11,960
Other Assets 15,827 8,743 1,853(f) (17,405)(i) 9,018
----------------- ---------- ----------
Total Assets $628,967 $223,262 $858,421
================= ========== ==========
LIABILITIES
Deposits $424,725 $180,458 929(g) 606,112
Borrowings 126,079 7,500 133,579
Other Liabilities 4,521 1,825 684(h) 7,030
----------------- ---------- ----------
Total Liabilities 555,325 189,783 746,721
STOCKHOLDERS' EQUITY
Common Equity 73,642 33,479 (33,479)(c) 38,058(l) 111,700
----------------- ---------- ----------
Total Equity 73,642 33,479 111,700
----------------- ---------- ----------
TOTAL LIABILITIES & EQUITY $628,967 $223,262 $858,421
================= ========== ==========
</Table>
Footnotes:
- -------------------------------------------------------------------------------
(a) Elimination of loan loss reserve
(b) Elimination of Old Forge Bank's intangible assets
(c) Elimination of Old Forge Bank's common equity
(d) Fair value adjustment for loans
(e) Buildings and Furniture, Fixtures & Equipment fair value adjustment
(f) Deferred tax adjustments related to fair value adjustment
(g) Fair value adjustment for certificates of deposits
(h) Fair value adjustment for unrecorded contingent liability
(i) Escrowed purchase price related to cash component
(j) Goodwill created in the transaction
(k) Fair value adjustment for core deposit intangible
(l) Purchase price related to the equity interest transferred
19
<Page>20
PRO FORMA INCOME STATEMENT
For the Three Months Ended September 30, 2008
<Table>
<Caption>
Penseco
Financial Services Old Forge
Corporation Bank Pro Forma
($ = 000's) 9/30/2008 9/30/2008 Adjustments 9/30/2008
- -------------------------------------------------------------------- --------- ----------- ---------
INTEREST INCOME
Interest and fees on loans $6,543 $2,523 $ 184 (a) $9,250
Interest and dividends on investments 1,964 447 (30) (b) 2,381
Interest on Federal funds sold 31 1 32
Interest on balances with banks 28 1 29
- ----------------------------------------------------------------------------------------------------------------------
Total Interest Income 8,566 2,972 154 11,692
- ----------------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Interest on deposits 1,721 1,037 (92) (c) 2,666
Interest on borrowed funds 1,017 15 1,032
- ----------------------------------------------------------------------------------------------------------------------
Total Interest Expense 2,738 1,052 (92) 3,698
- ----------------------------------------------------------------------------------------------------------------------
Net Interest Income 5,828 1,920 246 7,994
Provision for loan losses 167 75 242
- ----------------------------------------------------------------------------------------------------------------------
Net Interest Income After Provision
for Loan Losses 5,661 1,845 246 7,752
- ----------------------------------------------------------------------------------------------------------------------
NON-INTEREST INCOME
Service Charges on Deposits 403 90 493
Other Non-Interest Income 2,560 92 2,652
Realized gains (losses) on securities 23 (4) 19
- ----------------------------------------------------------------------------------------------------------------------
Total Non-Interest Income 2,986 178 3,164
- ----------------------------------------------------------------------------------------------------------------------
NON-INTEREST EXPENSES
Salaries and employee benefits 2,481 685 3,166
Expense of premises and equipment 626 133 759
Other Non-Interest Expense 2,719 414 61 (d) 3,194
- ----------------------------------------------------------------------------------------------------------------------
Total Non-Interest Expenses 5,826 1,232 61 7,119
- ----------------------------------------------------------------------------------------------------------------------
Income before income taxes 2,821 791 185 3,797
Applicable income taxes 579 154 63 796
- ----------------------------------------------------------------------------------------------------------------------
NET INCOME $2,242 (f) $ 637 (f) $ 122 $3,001
======================================================================================================================
Earnings Per Common Share $ 1.04 $ 1.14 (e) $ 0.92
</Table>
FOOTNOTES:
- -------------------------------------------------------------------------------
(a) Amortization of loan fair value adjustment
(b) Opportunity cost of cash paid to Old Forge shareholders at 0.70% rate
(c) Amortization of certificate of deposit fair value adjustment
(d) Amortization of core deposit intangible over a 10 year period using the
sum of the years digits method
(e) Pro Forma EPS based on Pro Forma shares outstanding of 3,276,079
(f) Excludes merger related costs of $1,550,000 and $451,000 and related tax
effect incurred by Penseco and Old Forge Bank, respectively
20
<Page>21
PRO FORMA INCOME STATEMENT
For the Nine Months Ended September 30, 2009
<Table>
<Caption>
Penseco
Financial Services Old Forge
Corporation Bank Pro Forma
($ = 000's) 9/30/2009 9/30/2009 Adjustments 9/30/2009
- -------------------------------------------------------------------- --------- ----------- ---------
INTEREST INCOME
Interest and fees on loans $23,729 $2,524 $184 (a) $26,437
Interest and dividends on investments 5,790 377 (30) (b) 6,137
Interest on Federal funds sold - 1 1
Interest on balances with banks 9 - 9
- ----------------------------------------------------------------------------------------------------------------------
Total Interest Income 29,528 2,902 154 32,584
- ----------------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Interest on deposits 5,027 897 (70) (c) 5,854
Interest on borrowed funds 2,320 9 2,329
- ----------------------------------------------------------------------------------------------------------------------
Total Interest Expense 7,347 906 (70) 8,183
- ----------------------------------------------------------------------------------------------------------------------
Net Interest Income 22,181 1,996 224 24,401
Provision for loan losses 1,573 75 1,648
- ----------------------------------------------------------------------------------------------------------------------
Net Interest Income After Provision
for Loan Losses 20,608 1,921 224 22,753
- ----------------------------------------------------------------------------------------------------------------------
NON-INTEREST INCOME
Service Charges on Deposits 1,366 80 1,446
Other Non-Interest Income 6,617 97 6,714
Realized gains (losses) on securities 341 - 341
- ----------------------------------------------------------------------------------------------------------------------
Total Non-Interest Income 8,324 177 8,501
- ----------------------------------------------------------------------------------------------------------------------
NON-INTEREST EXPENSES
Salaries and employee benefits 8,951 696 9,647
Expense of premises and equipment 2,435 146 2,581
Other Non-Interest Expense 8,157 428 61 (d) 8,646
- ----------------------------------------------------------------------------------------------------------------------
Total Non-Interest Expenses 19,543 1,270 61 20,874
- ----------------------------------------------------------------------------------------------------------------------
Income before income taxes 9,389 828 163 10,380
Applicable income taxes 1,822 315 55 2,192
- ----------------------------------------------------------------------------------------------------------------------
NET INCOME $ 7,567 (f) $ 513 (f) $108 $ 8,188
======================================================================================================================
Earnings Per Common Share $ 3.52 $ 0.92 (e) $ 2.50
</Table>
FOOTNOTES:
- -------------------------------------------------------------------------------
(a) Amortization of loan fair value adjustment
(b) Opportunity cost of cash paid to Old Forge shareholders at 0.70% rate
(c) Amortization of certificate of deposit fair value adjustment
(d) Amortization of core deposit intangible over a 10 year period using the
sum of the years digits method
(e) Pro Forma EPS based on weighted average shares outstanding of 3,276,079
(f) Excludes merger related costs of $1,550,000 and $451,000 and related tax
effect incurred by Penseco and Old Forge Bank, respectively
21
<Page>22
PRO FORMA INCOME STATEMENT
For the Nine Months Ended September 30, 2008
<Table>
<Caption>
Penseco
Financial Services Old Forge
Corporation Bank Pro Forma
($ = 000's) 9/30/2008 9/30/2008 Adjustments 9/30/2008
- -------------------------------------------------------------------- --------- ----------- ---------
INTEREST INCOME
Interest and fees on loans $19,640 $7,617 $ 551 (a) $27,808
Interest and dividends on investments 5,784 1,337 (91) (b) 7,030
Interest on Federal funds sold 31 32 63
Interest on balances with banks 62 5 67
- ----------------------------------------------------------------------------------------------------------------------
Total Interest Income 25,517 8,991 460 34,968
- ----------------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Interest on deposits 5,484 3,302 (305) (c) 8,481
Interest on borrowed funds 2,961 43 3,004
- ----------------------------------------------------------------------------------------------------------------------
Total Interest Expense 8,445 3,345 (305) 11,485
- ----------------------------------------------------------------------------------------------------------------------
Net Interest Income 17,072 5,646 765 23,483
Provision for loan losses 618 225 843
- ----------------------------------------------------------------------------------------------------------------------
Net Interest Income After Provision
for Loan Losses 16,454 5,421 765 22,640
- ----------------------------------------------------------------------------------------------------------------------
NON-INTEREST INCOME
Service Charges on Deposits 1,062 285 1,347
Other Non-Interest Income 7,883 277 8,160
Realized gains (losses) on securities 23 14 37
- ----------------------------------------------------------------------------------------------------------------------
Total Non-Interest Income 8,968 576 9,544
- ----------------------------------------------------------------------------------------------------------------------
NON-INTEREST EXPENSES
Salaries and employee benefits 7,405 2,130 9,535
Expense of premises and equipment 2,061 404 2,465
Other Non-Interest Expense 6,875 1,197 182 (d) 8,254
- ----------------------------------------------------------------------------------------------------------------------
Total Non-Interest Expenses 16,341 3,731 182 20,254
- ----------------------------------------------------------------------------------------------------------------------
Income before income taxes 9,081 2,266 583 11,930
Applicable income taxes 1,954 443 198 2,595
- ----------------------------------------------------------------------------------------------------------------------
NET INCOME $ 7,127 (f) $ 1,823 (f) $ 385 $ 9,335
======================================================================================================================
Earnings Per Common Share $ 3.32 $ 3.26 (e) $ 2.85
</Table>
FOOTNOTES:
- -------------------------------------------------------------------------------
(a) Amortization of loan fair value adjustment
(b) Opportunity cost of cash paid to Old Forge shareholders at 0.70% rate
(c) Amortization of certificate of deposit fair value adjustment
(d) Amortization of core deposit intangible over a 10 year period using the
sum of the years digits method
(e) Pro Forma EPS based on Pro Forma shares outstanding of 3,276,079
(f) Excludes merger related costs of $1,550,000 and $451,000 and related tax
effect incurred by Penseco and Old Forge Bank, respectively
22
<Page>23
NOTE 13 - FAIR VALUE MEASUREMENTS
The following table sets forth the Company's financial assets that were
accounted for at fair value and are classified in their entirety based on the
lowest level of input that is significant to the fair value measurement.
Level I - Quoted prices (unadjusted) in active markets for identical assets or
liabilities that the Company has the ability to access at the measurement date.
Level II- Observable inputs other than Level 1 prices, such as quoted prices for
similar assets or liabilities in active markets; quoted prices in markets that
are not active for identical or similar assets or liabilities; or other inputs
that are observable or can be corroborated by observable market data for
substantially the full term of the assets or liabilities.
Level III- Unobservable inputs that are supported by little or no market
activity and significant to the fair value of the assets or liabilities that are
developed using the reporting entities' estimates and assumptions, which reflect
those that market participants would use.
ASSETS AND LIABILITIES MEASURED AT FAIR VALUE ON A RECURRING BASIS
A description of the valuation methodologies used for financial instruments
measured at fair value on a recurring basis, as well as the classification of
the instruments pursuant to the valuation hierarchy, are as follows:
Securities Available for Sale
Securities classified as available for sale are reported using Level I, Level II
and Level III inputs. Level I instruments generally include equity securities
valued in accordance with quoted market prices in active markets. Level II
instruments include U.S. government agency obligations, state and municipal
bonds, mortgage-backed securities and corporate bonds. For these securities, the
Company obtains fair value measurements from an independent pricing service. The
fair value measurements consider observable data that may include dealer quotes,
market spreads, cash flows, the U.S. Treasury yield curve, live trading levels,
trade execution data, market consensus prepayment speeds, credit information and
the bond's terms and conditions, among other things. Level III instruments
include certain non-public equity securities and real estate sold under
contract. See Note 4 - Investment Securities for additional information.
Assets and liabilities measured at fair value on a recurring basis are
summarized below.
<Table>
<Caption>
September 30, 2009
----------------------------------------------------
Level I Level II Level III Total
---------- ---------- ----------- ----------
Assets:
Securities available-for-sale $ 7,769 $141,547 $ 50 $149,366
Other real estate owned $ - $ 65 $ 125 $ 190
</Table>
Level III classifications increased by $125 due to the addition of $129 in real
estate sold under contract resulting from the Merger, less payments of $4
received during the nine months ended September 30, 2009.
ASSETS MEASURED AT FAIR VALUE ON A NONRECURRING BASIS
A description of the valuation methodologies and classification levels used for
financial instruments measured at fair value on a nonrecurring basis are listed
below. These listed instruments are subject to fair value adjustments
(impairment) as they are valued at the lower of cost or market.
Goodwill and Other Identifiable Intangibles
The Company employs general industry practices in evaluating the fair value of
its goodwill and other identifiable intangibles. The Company calculates the fair
value, with the assistance of a third party specialist, using a combination of
the following valuation methods: dividend discount analysis under the income
approach, which calculates the present value of all excess cash flows plus the
present value of a terminal value and market multiples (pricing ratios) under
the market approach. In 2010, management will perform its initial review of
goodwill and other identifiable intangibles.
23
<Page>24
Certain assets measured at fair value on a non-recurring basis are presented
below:
<Table>
<Caption>
Fair Value Measurement Using
-------------------------------------------------------------
Quoted Prices
in Active Significant
Markets for Other Significant Balance
Identical Observable Unobservable September
Assets/Liabilities Inputs Inputs 30, 2009
----------------- ------------ ------------- -------------
Level I Level II Level III Total
----------------- ------------ ------------- -------------
ASSETS
Core Deposit Intangible $ - $ - $ 1,843 $ 1,843
Goodwill - - 26,398 26,398
----------------- ------------ ------------- -------------
Total Assets $ - $ - $28,241 $28,241
----------------- ------------ ------------- -------------
</Table>
DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
General Accepted Accounting Principals (GAAP) requires disclosure of the
estimated fair value of an entity's assets and liabilities considered to be
financial instruments. For the Company, as for most financial institutions, the
majority of its assets and liabilities are considered financial instruments.
However, many such instruments lack an available trading market, as
characterized by a willing buyer and seller engaging in an exchange transaction.
Also, it is the Company's general practice and intent to hold its financial
instruments to maturity and not to engage in trading or sales activities, except
for certain loans and investments. Therefore, the Company had to use significant
estimates and present value calculations to prepare this disclosure.
Changes in the assumptions or methodologies used to estimate fair values may
materially affect the estimated amounts. Also, management is concerned that
there may not be reasonable comparability between institutions due to the wide
range of permitted assumptions and methodologies in the absence of active
markets. This lack of uniformity gives rise to a high degree of subjectivity in
estimating financial instrument fair values.
Estimated fair values have been determined by the Company using the best
available data and an estimation methodology suitable for each category of
financial instruments. The estimation methodologies used at September 30, 2009
and December 31, 2008 are outlined below. The methodologies for estimating the
fair value of financial assets and financial liabilities that are measured at
fair value on a recurring or non-recurring basis are discussed in the fair value
measurements section above. The estimated fair value approximates carrying value
for cash and cash equivalents, accrued interest and the cash surrender value of
life insurance policies. The methodologies for other financial assets and
financial liabilities are discussed below:
Short-term financial instruments
The carrying value of short-term financial instruments including cash and due
from banks, federal funds sold, interest-bearing deposits in banks and other
short-term investments and borrowings, approximates the fair value of these
instruments. These financial instruments generally expose the Company to limited
credit risk and have no stated maturities or have short-term maturities with
interest rates that approximate market rates.
Investment securities held to maturity
The estimated fair values of investment securities held to maturity are based on
quoted market prices, provided by independent third parties that specialize in
those investment sectors. If quoted market prices are not available, estimated
fair values are based on quoted market prices of comparable instruments.
Loans
The loan portfolio, net of unearned income, has been valued by a third party
specialist using quoted market prices, if available. When market prices were not
available, a credit risk based present value discounted cash flow analysis was
utilized. The primary assumptions utilized in this analysis are the discount
rate based on the libor curve, adjusted for credit risk, and prepayment
estimates based on factors such as refinancing incentives, age of the loan and
seasonality. These assumptions were applied by loan category and different
spreads were applied based upon prevailing market rates by category.
24
<Page>25
Deposits
The estimated fair values of demand deposits (i.e., interest and non-interest
bearing checking accounts, savings and money market accounts) are, by
definition, equal to the amount payable on demand at the reporting date (i.e.,
their carrying amounts). The fair value for certificates of deposit was
calculated by an independent third party by discounting contractual cash flows
using current market rates for instruments with similar maturities, using a
credit based risk model. The carrying amount of accrued interest receivable and
payable approximates fair value.
Long-term borrowings
The amounts assigned to long-term borrowings was based on quoted market prices,
when available, or were based on discounted cash flow calculations using
prevailing market interest rates for debt of similar terms.
The carrying and fair values of certain financial instruments were as follows.
<Table>
<Caption>
September 30, 2009 December 31, 2008
------------------------ ------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
------------ ---------- ------------ ----------
Cash and cash equivalents $ 11,930 $ 11,930 $ 9,355 $ 9,355
Investment securities available- for-sale 149,366 149,366 94,996 94,996
Investment securities held-to-maturity 51,793 54,375 62,484 64,678
Loans, net 591,264 601,518 435,873 441,369
Cash surrender value of life insurance 14,253 14,253 7,684 7,684
Time deposits 213,470 216,375 109,576 110,661
Long-term borrowings 65,872 68,495 72,720 75,415
</Table>
PART 1. FINANCIAL INFORMATION, ITEM 2 --
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following commentary provides an overview of the financial condition and
significant changes in the results of operations of Penseco Financial Services
Corporation (the "Company") and its subsidiary, Penn Security Bank and Trust
Company (the "Bank"), at September 30, 2009 and for the three and nine month
periods ended September 30, 2009 and September 30, 2008. All information is
presented in thousands of dollars, except as indicated. The Company consummated
the acquisition of Old Forge Bank on April 1, 2009 (the Merger). Therefore, the
operating results for Old Forge Bank for the three month period ended March 31,
2009 is not included herein. See page 21 for the presentation of the pro forma
results of the Company for the nine months ended September 30, 2009.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Provision (allowance) for possible loan losses - The provision for loan losses
is based on past loan loss experience, management's evaluation of the potential
loss in the current loan portfolio under current economic conditions and such
other factors as, in management's best judgment, deserve current recognition in
estimating loan losses. The annual provision for loan losses charged to
operating expense is that amount which is sufficient to bring the balance of the
allowance for possible loan losses to an adequate level to absorb anticipated
losses.
Actuarial assumptions associated with pension, post-retirement and other
employee benefit plans - These assumptions include discount rate, rate of future
compensation increases and expected return on plan assets.
Provision for income taxes - Management believes that the assumptions and
judgments used to record tax related assets or liabilities have been
appropriate.
Fair value of certain investment securities - Fair value of investment
securities are based on the most observable input available.
25
<Page>26
Premium amortization - The amortization of premiums on mortgage-backed
securities is done based on management's estimate of the lives of the
securities, adjusted, when necessary, for advanced prepayments in excess of
those estimates.
Loans purchased - Loans purchased as a result of the Merger were recorded at the
acquisition date fair value. Management made three different types of fair value
adjustments in order to record the loans at fair value. An interest rate fair
value adjustment was made comparing current weighted average rates of the
acquired loans to stated market rates of similar loan types. A general credit
fair value adjustment was made on similar loan types based on historical loss
projections plus a discount for the weak economic environment. A specific credit
fair value adjustment was made to loans identified by management as being
problematic. The specific loans have been discounted by management based on
collateral values and expected cash flows. The interest rate and general credit
fair value adjustments are being accreted over an eight year period based on a
sum-of-the-years-digits basis. The specific credit fair value adjustment is
reduced only when cash flows are received.
Loan servicing rights - Mortgage servicing rights are evaluated for impairment
based on the fair value of those rights. Fair values are estimated using
discounted cash flows based on current market rates of interest and current
expected future prepayment rates. For purposes of measuring impairment, the
rights must be stratified by one or more predominant risk characteristics of the
underlying loans. The Company stratifies its capitalized mortgage servicing
rights based on the product type, interest rate and term of the underlying
loans. The amount of impairment recognized is the amount, if any, by which the
amortized cost of the rights for each stratum exceed the fair value.
Time Deposits - Time Deposits acquired through the Merger have been recorded at
their acquisition date fair value. The fair value of time deposits represents
the present value of the time deposits expected contractual payments discounted
by market rates for similar deposits. The fair value adjustment is amortized
monthly based a level yield methodology.
Core Deposit Intangible - The fair value assigned to the core deposit intangible
asset represents the future economic benefit of the potential cost savings from
acquiring core deposits in the Merger compared to the cost of obtaining
alternative funding such as brokered deposits from market sources. Management
utilized an income approach to present value the expected after tax cash flow
benefits of the acquired core deposits.
MERGER AND ACQUISITIONS
On April 1, 2009, the Company completed the Merger with Old Forge Bank in a cash
and stock transaction valued at approximately $55.5 million. The Merger is
accounted for using the acquisition method of accounting and, accordingly, the
assets and liabilities of Old Forge Bank have been recorded at their respective
fair values on the date the Merger was completed. The Merger was effected by the
issuance of 1,128,079 shares of Company common stock to Old Forge Bank. Each
share of Old Forge Bank common stock was exchanged for 2.9012 shares of Company
common stock, with any fractional shares as a result of the exchange, paid to
Old Forge Bank shareholders in cash based on $35.255 per share of Company stock.
NON-GAAP FINANCIAL MEASURES
Certain financial measures contained in this Form 10-Q with respect to the three
months and nine months ended September 30, 2009 exclude the decrease of the
liability accrual related to VISA's covered litigation provision as well as the
gain from the mandatory redemption of a portion of the Company's class B shares
in VISA, both of which occurred in 2008. Also, as to the three months and nine
months ended September 30, 2009, these financial measures exclude Merger related
costs related to the acquisition of Old Forge Bank on April 1, 2009. Financial
measures which exclude the above referenced items have not been determined in
accordance with generally accepted accounting principles ("GAAP") and are
therefore non-GAAP financial measures. Management of the Company believes that
investors' understanding of the Company's performance is enhanced by disclosing
these non-GAAP financial measures as a reasonable basis for comparison of the
Company's ongoing results of operations. These non-GAAP measures should not be
considered a substitute for GAAP-basis measures and results. Our non-
26
<Page>27
GAAP measures may not be comparable to non-GAAP measures of other companies. The
attached Non-GAAP Reconciliation Schedule provides a reconciliation of these
non-GAAP financial measures to the most closely analogous measure determined in
accordance with GAAP.
In March 2008, VISA, Inc. (VISA) completed its initial public offering. The Bank
and certain other VISA member banks are shareholders in VISA. Following the
initial public offering, the Company received $1.2 million in proceeds from the
offering, as a mandatory partial redemption of 28,351 shares, reducing the
Company's holdings from 73,333 to 44,982 shares of Class B common stock. Using
proceeds from this offering, VISA established a $3.0 billion escrow account to
cover the resolution of pending litigation and related claims. The partial
redemption proceeds of $1.2 million are reflected in other non-interest income
in the first quarter of 2008.
The remaining unredeemed shares of VISA Class B common stock are restricted and
may not be transferred until the later of (1) three years from the date of the
initial public offering or (2) the period of time necessary to resolve the
covered litigation. The current conversion ratio of 0.5824 was established for
the conversion rate of Class B shares into Class A shares. If the funds in the
escrow account are insufficient to settle all the covered litigation, VISA may
sell additional Class A shares, use the proceeds to settle litigation, and
further reduce the conversion ratio. If funds remain in the escrow account after
all litigation is settled, the Class B conversion ratio will be increased to
reflect that surplus. As of September 30, 2009, the value of the Class A shares
was $69.11 per share. The value of unredeemed Class A equivalent shares owned by
the Company was $1.8 million as of September 30, 2009, and has not yet been
reflected in the accompanying financial statements.
In connection with VISA's establishment of the litigation escrow account, the
Company reversed $497 reserve in the first quarter of 2008, reflected as a
reduction of other non-interest expense. This reserve was created in the fourth
quarter of 2007, pending completion of the VISA, Inc. initial public offering as
a charge to other non-interest expense.
Merger costs of $0 and $1,550 in the three months and nine months ended
September 30, 2009, respectively, related to the acquisition of Old Forge Bank
consist primarily of investment banking costs, system conversion costs,
valuation services, legal and accounting fees and severance payments.
NON-GAAP RECONCILIATION SCHEDULE
PENSECO FINANCIAL SERVICES CORPORATION
(UNAUDITED)
(IN THOUSANDS)
The following tables present the reconciliation of non-GAAP financial measures
to reported GAAP financial measures.
<Table>
<Caption>
Three Months Ended
September 30,
2009 2008 Change
----------- ---------- -----------
Net interest income after provision for loan losses $ 7,801 $ 5,661 $ 2,140
Non-interest income 3,143 2,986 157
Non-interest expense (7,037) (5,826) (1,211)
Income tax benefit (provision) (812) (579) (233)
----------- ---------- -----------
Net income 3,095 2,242 853
ADJUSTMENTS
- -----------
Non-interest income
Gain on mandatory redemption of VISA, Inc.
class B common stock - - -
Non-interest expense
Merger related costs - - -
Covered litigation provision - - -
----------- ---------- -----------
Total Adjustments pre-tax - - -
Income tax provision (benefit) - - -
----------- ---------- -----------
After tax adjustments to GAAP - - -
----------- ---------- -----------
Adjusted net income $ 3,095 $ 2,242 $ 853
=========== ========== ===========
27
<Page>28
Return on Average Assets 1.44% 1.41%
Return on Average Equity 10.82% 12.24%
Dividend Payout Ratio 44.68% 40.38%
</Table>
Return on average equity (ROE) and return on average assets (ROA) for the three
months ended September 30, 2009 was 10.82% and 1.44%, respectively. ROE was
12.24% and ROA was 1.41% for the same period last year. The dividend payout
ratio was 44.68% and was 40.38% for the same period last year.
NON-GAAP RECONCILIATION SCHEDULE
PENSECO FINANCIAL SERVICES CORPORATION
(UNAUDITED)
(IN THOUSANDS)
The following tables present the reconciliation of non-GAAP financial measures
to reported GAAP financial measures.
<Table>
<Caption>
Nine Months Ended
September 30,
2009 2008 Change
----------- ---------- -----------
Net interest income after provision for loan losses $20,608 $16,454 $ 4,154
Non-interest income 8,324 8,968 (644)
Non-interest expense (21,093) (16,341) (4,752)
Income tax benefit (provision) (1,434) (1,954) 520
----------- ---------- -----------
Net income 6,405 7,127 (722)
ADJUSTMENTS
- -----------
Non-interest income
Gain on mandatory redemption of VISA, Inc.
class B common stock - (1,213) 1,213
Non-interest expense
Merger related costs 1,550 - 1,550
Covered litigation provision - (497) 497
----------- ---------- -----------
Total Adjustments pre-tax 1,550 (1,710) 3,260
Income tax provision (benefit) 527 (581) 1,108
----------- ---------- -----------
After tax adjustments to GAAP 1,023 (1,129) 2,152
----------- ---------- -----------
Adjusted net income $7,428 $5,998 $1,430
=========== ========== ===========
Return on Average Assets 1.27% 1.30%
Return on Average Equity 9.78% 11.05%
Dividend Payout Ratio 49.22% 44.44%
</Table>
Return on average equity (ROE) and return on average assets (ROA) for the nine
months ended September 30, 2009 was 8.43% (9.78% excluding the Merger costs) and
1.09% (1.27% excluding the Merger costs), respectively. ROE was 13.14% (11.05%
excluding the VISA IPO impact) and ROA was 1.55% (1.30% excluding the VISA IPO
impact) for the same period last year. The dividend payout ratio was 57.01%
(49.22% excluding the Merger costs) and was 37.35% (44.44% excluding the VISA
IPO impact) for the same period last year.
EXECUTIVE SUMMARY
Penseco Financial Services Corporation reported an increase in net income of
$853 or 38.0% for the three months ended September 30, 2009 to $3,095 or $.94
per share compared with $2,242 or $1.04 per share from the year ago period. The
increase in net income was primarily attributed to the Merger, which was
completed on April 1, 2009. Net interest income increased $2,315 or 39.7%
largely due to an increased loan portfolio of $155.4 million from Old Forge
Bank. Core net income increased $853 or 38.0% due to higher earning assets
related to the Merger. Non-
28
<Page>29
interest income increased $157 or 5.3% primarily as a result of higher service
charges on deposit accounts and higher operating income. Offsetting this
increase was higher total non-interest expenses of $1,211 or 20.8% mainly from
higher salary and benefits expenses, operating expenses and FDIC insurance
assessments. Return on average assets and return on average equity was 1.44% and
10.82% respectively, for the three months ending September 30, 2009, versus
1.41% and 12.24% respectively, for the same period last year.
The Company reported a decrease in net income of $722 for the nine months ended
September 30, 2009 to $6,405 or $2.21 per weighted average share compared with
$7,127 or $3.32 per share from the year ago period. The decrease in net income
was primarily attributed to $1,550 of costs associated with the Merger, in
addition to a $530 increase in FDIC insurance costs, along with the first
quarter 2008 one time positive impact of $1,710 related to Visa International's
Initial Public Offering. Net interest income, after provision for loan losses,
increased $4,154 or 25.2% during the 2009 period, largely due to increased
interest and fees on loans and reduced interest expense from lower deposit
costs. Core net income increased $1,430 or 23.8% due to increases in earning
assets. The Company increased the provision for potential loan loss expense by
$955 to $1,573 in the first nine months of 2009 compared to $618 for the first
nine months of 2008, due to the softness in the economy.
Net income from accretion and amortization of acquisition date fair value
adjustments included in the financial results during the periods indicated.
<Table>
<Caption>
Three Months Ended Nine Months Ended
September 30, 2009 September 30, 2009
------------------ ------------------
Homogeneous loan pools $ 183 $ 367
Time deposits 92 235
Core deposit intangible expense (61) (122)
------------------ ------------------
Net income from acquisition fair value adjustment $ 214 $ 480
------------------ ------------------
</Table>
Accretion of the loan pools credit fair value adjustment and market rate fair
value adjustment is calculated on a sum-of-the-year-digits basis over an eight
year period. The fair value market rate adjustment of the time deposits is
amortized monthly based on a level yield methodology. The core deposit
intangible is being amortized over ten years on a sum-of-the-years-digits basis.
NET INTEREST INCOME AND NET INTEREST MARGIN
Net interest income, the largest contributor to the Company's earnings, is
defined as the difference between interest income on assets and the cost of
funds supporting those assets. Average earning assets are composed primarily of
loans and investments while deposits, short-term and long-term borrowings
represent interest-bearing liabilities. Variations in the volume and mix of
these assets and liabilities, as well as changes in the yields earned and rates
paid, are determinants of changes in net interest income.
Net interest income before provision for loan losses increased $2,315 or 39.7%
to $8,143 for the three months ended September 30, 2009 compared to $5,828 for
the three months ended September 30, 2008. The average yield on interest earning
assets decreased 19 basis points.
The net interest margin represents the Company's net yield on its average
interest earning assets and is calculated as net interest income divided by
average interest earning assets. In the three months ended September 30, 2009,
net interest margin increased 28 basis points to 4.13% from 3.85% in the same
period of 2008.
Total average interest earning assets and average interest bearing funds
increased during the three months ended September 30, 2009 as compared to 2008.
Average interest earning assets increased $184.0 million or 30.4%, from $605.1
million in 2008 to $789.1 million in 2009 and average interest bearing funds
increased $151.4 million, or 31.4%, from $482.9 million to $634.3 million for
the same period. Average long-term borrowings decreased a net of $10.0 million
or 13.1% during the three months ended September 30, 2009 from year ago levels.
Average earning assets, including Bank-Owned Life Insurance (BOLI), decreased to
93.2% for the three months ended September 30, 2009 from 96.5% for the year ago
period.
Changes in the mix of both interest earning assets and funding sources also
impacted net interest income in the three months ended September 30, 2009 and
2008. Average loans as a percentage of average interest earning assets
29
<Page>30
increased from 70.6% in 2008 to 74.9% in 2009. Average investments increased
$28.6 million but decreased to 24.5% from 27.2% as a percentage of interest
earning assets. Interest bearing balances with banks decreased $2.1 million to
$4.5 million from $6.6 million. Average time deposits increased $107.1 million
to $215.1 million from $108.0 million; average long-term borrowings decreased
$10.0 million, and repurchase agreements decreased $16.9 million or 40.6% to
$24.7 million compared to $41.6 million for the year ago period.
Shifts in the interest rate environment and competitive factors affected the
rates paid for funds as well as the yields earned on assets. The investment
securities tax equivalent yield decreased 35 basis points from 5.83% for the
three months ended September 30, 2008 to 5.48% for the three months ended
September 30, 2009. Average loan yields decreased 23 basis points, from 6.13%
for the three months ended September 30, 2008 to 5.90% for the three months
ended September 30, 2009.
The average time deposit costs decreased 118 basis points from 3.60% for the
three months ended September 30, 2008 to 2.42% for the three months ended
September 30, 2009. In addition, the average cost of money market accounts
decreased 80 basis points from 1.83% for the three months ended September 30,
2008 to 1.03% for the three months ended September 30, 2009.
30
<Page>31
DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY/INTEREST RATES AND
INTEREST DIFFERENTIAL
The table below presents average balances, interest income on a fully taxable
equivalent basis and interest expense, as well as average rates earned and paid
on the Company's major asset and liability items for the three months ended
September 30, 2009 and September 30, 2008.
<Table>
<Caption>
- ------------------------------------------------------------------------------------------------------------------
SEPTEMBER 30, 2009 SEPTEMBER 30, 2008
ASSETS AVERAGE REVENUE/ YIELD/ AVERAGE REVENUE/ YIELD/
BALANCE EXPENSE RATE BALANCE EXPENSE RATE
- -------------------------------------------------------------------------------------------------------------------
Investment Securities
Available-for-sale:
U.S. Agency obligations $ 58,751 $ 487 3.32% $ 52,730 $ 634 4.81%
States & political subdivisions 73,418 854 7.05% 40,688 457 6.81%
Federal Home Loan Bank stock 6,402 - - 4,771 41 3.44%
Other 1,310 8 2.44% 2,612 27 4.13%
Held-to-maturity:
U.S. Agency obligations 26,477 313 4.73% 34,820 413 4.74%
States & political subdivisions 27,162 362 8.08% 29,234 392 8.13%
Loans, net of unearned income:
Real estate mortgages 327,289 4,542 5.55% 274,047 4,130 6.03%
Commercial real estate 167,031 2,206 5.28% 94,135 1,456 6.19%
Commercial 24,609 392 6.37% 23,844 380 6.37%
Consumer and other 72,178 1,578 8.75% 34,861 577 6.62%
Federal funds sold - - - 6,685 31 1.85%
Interest on balances with banks 4,467 3 0.27% 6,627 28 1.69%
- -------------------------------------------------------------------------------------------------------------------
Total Interest Earning Assets/
Total Interest Income 789,094 $10,745 5.76% 605,054 $ 8,566 5.95%
- -------------------------------------------------------------------------------------------------------------------
Cash and due from banks 10,320 10,137
Bank premises and equipment 12,231 9,154
Accrued interest receivable 4,003 3,455
Goodwill 26,398 -
Cash surrender value of life insurance 14,171 7,554
Other assets 11,448 4,559
Less: Allowance for loan losses 6,011 5,119
- -------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $861,654 $634,794
- -------------------------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Demand-Interest bearing $ 67,497 93 0.55% $ 56,199 $ 97 0.69%
Savings 110,555 108 0.39% 76,338 92 0.48%
Money markets 146,933 379 1.03% 122,837 561 1.83%
Time - Over $100 79,674 507 2.55% 37,347 336 3.60%
Time - Other 135,441 796 2.35% 70,624 635 3.60%
Federal funds purchased 2,723 3 0.44% - - -
Repurchase agreements 24,687 73 1.18% 41,624 274 2.63%
Short-term borrowings 174 1 2.30% 1,333 8 2.40%
Long-term borrowings 66,622 642 3.85% 76,553 735 3.84%
- -------------------------------------------------------------------------------------------------------------------
Total Interest BearingLiabilities/
Total Interest Expense 634,306 $ 2,602 1.64% 482,855 $ 2,738 2.27%
- -------------------------------------------------------------------------------------------------------------------
Demand - Non-interest bearing 104,370 75,069
All other liabilities 8,511 3,616
Stockholders' equity 114,467 73,254
- -------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY $861,654 $634,794
- -------------------------------------------------------------------------------------------------------------------
Interest Spread 4.12% 3.68%
- -------------------------------------------------------------------------------------------------------------------
Net Interest Income $ 8,143 $ 5,828
- -------------------------------------------------------------------------------------------------------------------
FINANCIAL RATIOS
Net interest margin 4.13% 3.85%
Return on average assets 1.44% 1.41%
Return on average equity 10.82% 12.24%
Average equity to average assets 13.28% 11.54%
Dividend payout ratio 44.68% 40.38%
- -------------------------------------------------------------------------------------------------------------------
</Table>
31
<Page>32
Net interest income before provision for loan losses increased $5,109 or 29.9%
to $22,181 for the nine months ended September 30, 2009, compared to $17,072 for
the nine months ended September 30, 2008. The average yield on interest earning
assets decreased 37 basis points, largely from the Federal Reserve Bank lowering
its target for the federal funds rate to 25 basis points from the fall of 2008.
The net interest margin represents the Company's net yield on its average
interest earning assets and is calculated as net interest income divided by
average interest earning assets. For the nine months ended September 30, 2009,
net interest margin was 4.09%, an increase of 20 basis points from 3.89% in the
same period of 2008.
Total average interest earning assets and average interest bearing funds
increased for the nine months ended September 30, 2009 as compared to the nine
months ended September 30, 2008. Average interest earning assets increased
$138.4 million or 23.7%, from $584.4 million in 2008 to $722.8 million in 2009
and average interest bearing funds increased $115.0 million, or 24.7%, from
$465.0 million to $580.0 million for the same period. As a percentage of average
assets, average earning assets, including BOLI, decreased to 94.1% for the nine
months ended September 30, 2009 from 96.4% for the year ago period.
Changes in the mix of both interest earning assets and funding sources also
impacted net interest income in the nine months ended September 30, 2009 and
2008. Average loans as a percentage of average interest earning assets increased
from 71.2% in 2008 to 74.6% in 2009, due in part to the Merger. Average
investments increased $17.7 million year over year and decreased as a percentage
of average interest earning assets to 24.8% at September 30, 2009 from 27.7% at
September 30, 2008. Average short-term investments, federal funds sold and
interest bearing balances with banks, decreased as a percentage of average
assets to 0.5% at September 30, 2009 from 1.1% at September 30, 2008. Average
time deposits increased $68.1 million or 63.1% from 23.2% of interest bearing
liabilities in 2008 to 30.3% in 2009. During the nine months ended September 30,
2009, average federal funds purchased increased $3.5 million; average repurchase
agreements decreased $8.0 million; average short-term borrowings increased $1.9
million and average long-term borrowings decreased $4.1 million.
Shifts in the interest rate environment and competitive factors affected the
rates paid for funds as well as the yields earned on assets. The investment
securities tax equivalent yield decreased 30 basis points from 5.83% for the
nine months ended September 30, 2008 to 5.53% for the nine months ended
September 30, 2009. Also, average loan yields decreased 43 basis points, from
6.30% for the nine months ended September 30, 2008 to 5.87% for the same period
of 2008.
The average time deposit costs decreased 135 basis points from 3.89% for the
nine months ended September 30, 2008 to 2.54% for the nine months ended
September 30, 2009, along with the average cost of money market accounts
decreasing 94 basis points from 2.01% for the nine months ended September 30,
2008 to 1.07% for the nine months ended September 30, 2009.
32
<Page>33
DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY/INTEREST RATES AND
INTEREST DIFFERENTIAL
The table below presents average balances, interest income on a fully taxable
equivalent basis and interest expense, as well as average rates earned and paid
on the Company's major asset and liability items for the nine months ended
September 30, 2009 and September 30, 2008.
<Table>
<Caption>
- ------------------------------------------------------------------------------------------------------------------
SEPTEMBER 30, 2009 SEPTEMBER 30, 2008
ASSETS AVERAGE REVENUE/ YIELD/ AVERAGE REVENUE/ YIELD/
BALANCE EXPENSE RATE BALANCE EXPENSE RATE
- -------------------------------------------------------------------------------------------------------------------
Investment Securities
Available-for-sale:
U.S. Agency obligations $ 56,958 $ 1,502 3.52% $ 47,809 $ 1,774 4.95%
States & political subdivisions 57,611 2,083 7.30% 40,799 1,353 6.70%
Federal Home Loan Bank stock 6,100 - - 4,796 135 3.75%
Other 1,353 30 2.96% 2,795 76 3.63%
Held-to-maturity:
U.S. Agency obligations 29,429 1,048 4.75% 36,454 1,278 4.67%
States & political subdivisions 28,150 1,127 8.09% 29,237 1,168 8.07%
Loans, net of unearned income:
Real estate mortgages 313,986 13,312 5.65% 267,788 12,265 6.11%
Commercial real estate 141,636 5,714 5.38% 88,392 4,265 6.43%
Commercial 25,227 1,090 5.76% 23,978 1,237 6.88%
Consumer and other 58,580 3,613 8.22% 35,812 1,873 6.97%
Federal funds sold - - - 2,228 31 1.86%
Interest on balances with banks 3,805 9 0.32% 4,337 62 1.91%
- -------------------------------------------------------------------------------------------------------------------
Total Interest Earning Assets/
Total Interest Income 722,835 $29,528 5.75% 584,425 $25,517 6.12%
- -------------------------------------------------------------------------------------------------------------------
Cash and due from banks 9,907 10,078
Bank premises and equipment 11,700 9,183
Accrued interest receivable 3,741 3,363
Goodwill 17,598 -
Cash surrender value of life insurance 11,979 7,475
Other assets 8,948 4,667
Less: Allowance for loan losses 5,890 4,919
- -------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $780,818 $614,272
- -------------------------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Demand-Interest bearing $ 62,582 $ 281 0.60% $ 54,349 $ 314 0.77%
Savings 98,928 299 0.40% 76,741 329 0.57%
Money markets 135,743 1,092 1.07% 112,516 1,696 2.01%
Time - Over $100 62,721 1,267 2.69% 38,042 1,142 4.00%
Time - Other 113,286 2,088 2.46% 69,872 2,003 3.82%
Federal funds purchased 3,521 20 0.76% - - -
Repurchase agreements 26,328 277 1.40% 34,256 681 2.65%
Short-term borrowings 8,066 35 0.58% 6,224 158 3.38%
Long-term borrowings 68,864 1,988 3.85% 73,003 2,122 3.88%
- -------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities/
Total Interest Expense 580,039 $ 7,347 1.69% 465,003 $ 8,445 2.42%
- -------------------------------------------------------------------------------------------------------------------
Demand - Non-interest bearing 92,662 72,213
All other liabilities 6,838 4,714
Stockholders' equity 101,279 72,342
- -------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY $780,818 $614,272
- -------------------------------------------------------------------------------------------------------------------
Interest Spread 4.06% 3.70%
- -------------------------------------------------------------------------------------------------------------------
Net Interest Income $22,181 $17,072
- -------------------------------------------------------------------------------------------------------------------
FINANCIAL RATIOS
Net interest margin 4.09% 3.89%
Return on average assets 1.09% 1.55%
Return on average equity 8.43% 13.14%
Average equity to average assets 12.97% 11.78%
Dividend payout ratio 57.01% 37.35%
- -------------------------------------------------------------------------------------------------------------------
</Table>
33
<Page>34
INVESTMENTS
The Company's investment portfolio has primarily two functions: To provide
liquidity and to contribute to earnings. To provide liquidity the Company may
invest in short-term securities such as Federal funds sold, interest bearing
deposits with banks, U.S. Treasury securities and U.S. Agency securities all
with maturities of one year or less. These funds are invested short-term to
ensure the availability of funds to meet customer demand for credit needs. The
Company enhances interest income by securing long-term investments within its
investment portfolio, by means of U.S. Treasury securities, U.S. Agency
securities, municipal securities and mortgage-backed securities, generally with
maturities greater than one year. The Company's mortgage-backed securities
portfolio does not contain any sub-prime or Alt-A credits.
Investments in securities are classified in two categories and accounted for as
follows:
Securities Held-to-Maturity Bonds, notes, debentures and mortgage-backed
- ---------------------------
securities for which the Company has the positive intent and ability to hold to
maturity are reported at cost, adjusted for amortization of premiums and
accretion of discounts computed on the straight-line basis, which approximates
the interest method, over the remaining period to maturity.
Securities Available-for-Sale Bonds, notes, debentures, mortgage-backed
- -----------------------------
securities and certain equity securities not classified as securities to be held
to maturity are carried at fair value with unrealized holding gains and losses,
net of tax, reported as a net amount in a separate component of stockholders'
equity until realized.
The amortization of premiums on mortgage-backed securities is done based on
management's estimate of the lives of the securities, adjusted, when necessary,
for advanced prepayments in excess of those estimates.
Realized gains and losses on the sale of securities available-for-sale are
determined using the specific identification method and are reported as a
separate component of other income in the Statements of Income. Unrealized gains
and losses are included as a separate item in computing comprehensive income.
DEPOSITS
The Company is largely dependent on its core deposit base to fund operations.
Management has competitively priced its deposit products in checking, savings,
money market and time deposits to provide a stable source of funding.
As general interest rates in the economy change, there is migration of some
deposits among investment options as customers seek increased yields.
Historically, such changes in the Company's deposit base have been minimal.
PROVISION FOR LOAN LOSSES
The provision for loan losses represents management's determination of the
amount necessary to bring the allowance for loan losses to a level that
management considers adequate to reflect the risk of future losses inherent in
the Company's loan portfolio. The process of determining the adequacy of the
allowance is necessarily judgmental and subject to changes in external
conditions. The allowance for loan losses reflects management's judgment as to
the level considered appropriate to absorb such losses based upon a review of
many factors, including historical loss experience, adverse situations that may
affect a borrower's ability to repay (including the timing of future payments),
economic conditions and trends, loan portfolio volume and mix, loan performance
trends, the value and adequacy of collateral, and the Company's internal credit
review process. The quarterly provision for loan losses charged to operating
expense is that amount which is sufficient to bring the balance of the allowance
for possible loan losses to an adequate level to absorb anticipated losses.
Based on this ongoing evaluation, management determines the provision necessary
to maintain an appropriate allowance.
Although management uses available information to establish the appropriate
level of the allowance for loan losses, future additions or reductions to the
allowance may be necessary based on estimates that are susceptible to change as
a result of changes in economic conditions and other factors. As a result, our
allowance for loan losses may not be sufficient to cover actual loan losses, and
future provisions for loan losses could materially adversely affect the
Company's operating results. In addition, various regulatory agencies, as an
integral part of their examination process, periodically review the Company's
allowance for loan losses. Such agencies may require the Company to
34
<Page>35
recognize adjustments to the allowance based on their judgments about
information available to them at the time of their examination.
The provision for loan losses increased $175 from $167 for the three months
ended September 30, 2008 to $342 for the three months ended September 30, 2009,
mainly due to the management's more conservative valuation of the loan portfolio
for loan losses in response to recent economic conditions. Loans charged off
totaled $96 and recoveries were $4 for the three months ended September 30,
2009. In the same period of 2008, loans charged off totaled $82 and recoveries
were $15. For the nine months ended September 30, 2009, the provision for loan
losses was $1,573, an increase from $618 in the first nine months of 2008. Loans
charged-off totaled $555 and recoveries were $7 for the nine months ended
September 30, 2009. In the same period of 2008, loans charged off totaled $109
and recoveries were $31. At September 30, 2009 the allowance for loan losses was
$6,300, or 1.05% of gross loans compared to $5,240 or 1.21% of gross loans at
September 30, 2008.
NON-INTEREST INCOME
The following table sets forth information by category of non-interest income
for the Company for the three months ended September 30, 2009 and September 30,
2008, respectively:
<Table>
<Caption>
September 30, September 30,
Three Months Ended: 2009 2008
- ------------------------------------------------------------------------------------
Trust department income $ 369 $ 386
Service charges on deposit accounts 546 403
Merchant transaction income 1,564 1,583
Brokerage income 93 136
Other fee income 398 347
Bank-owned life insurance income 132 78
Other operating income 14 30
VISA mandatory share redemption - -
Realized gains (losses) on securities, net 27 23
- -----------------------------------------------------------------------------------
Total Non-Interest Income $3,143 $2,986
===================================================================================
</Table>
Total non-interest income increased $157 or 5.3% to $3,143 for the three months
ended September 30, 2009, compared with $2,986 for the same period in 2008.
Service charges on deposit accounts increased $143 or 35.5% primarily due to the
increased number of accounts resulting from the Merger and increased service
charge activity. Brokerage fee income decreased $43 or 31.6% mostly due to the
decline in the overall market. Bank-owned life insurance income increased $54 or
69.2% due to the Merger. Other operating income decreased $16 largely due to a
gain on the sale of an other real estate owned property during 2008.
The following table sets forth information by category of non-interest income
for the Company for nine months ended September 30, 2009 and September 30, 2008,
respectively:
<Table>
<Caption>
September 30, September 30,
Nine Months Ended: 2009 2008
- ------------------------------------------------------------------------------------
Trust department income $1,054 $1,133
Service charges on deposit accounts 1,366 1,062
Merchant transaction income 3,613 3,702
Brokerage income 289 487
Other fee income 1,016 964
Bank-owned life insurance income 343 236
Other operating income 302 148
VISA mandatory share redemption - 1,213
Realized gains (losses) on securities, net 341 23
- ------------------------------------------------------------------------------------
Total Non-Interest Income $8,324 $8,968
===================================================================================
</Table>
Total non-interest income decreased $644 or 7.2% to $8,324 during the first nine
months of 2009 from $8,968 for the same period of 2008. The decrease in
non-interest income was primarily attributed to a one time gain of $1,213
35
<Page>36
related to the VISA IPO during first quarter of 2008. Service charges on deposit
accounts increased $304 or 28.6% primarily due to the increased number of
accounts resulting from the Merger and increased service charge activity.
Merchant transaction income decreased $89 or 2.4%, mainly due to lower
transaction volume from continued softness in the economy. Brokerage fee income
decreased $198 or 40.7% mostly due to the decline in the overall market.
Bank-owned life insurance income increased $107 or 45.3% due to the Merger.
Other operating income increased $154 or 104.1% largely due to gains on the sale
of low yielding long-term fixed rate real estate loans. The majority of the Old
Forge Bank securities portfolio was sold during the second quarter of 2009
netting gains of $302, with the proceeds reinvested into higher quality
securities.
NON-INTEREST EXPENSES
The following table sets forth information by category of non-interest expenses
for the Company for the three months ended September 30, 2009 and September 30,
2008, respectively:
<Table>
<Caption>
September 30, September 30,
Three Months Ended: 2009 2008
- ------------------------------------------------------------------------------------
Salaries and employee benefits $3,224 $2,481
Expense of premises and fixed assets 827 626
Merchant transaction expenses 1,061 1,182
Merger related costs - -
FDIC insurance assessments 127 17
Other operating expenses 1,798 1,520
- ------------------------------------------------------------------------------------
Total Non-Interest Expenses $7,037 $5,826
===================================================================================
</Table>
Total non-interest expenses increased $1,211 or 20.8% to $7,037 for the three
months ended September 30, 2009 compared with $5,826 for the same period of
2008. Salaries and employee benefits expense increased $743 or 29.9% due to
additional staff from the Merger. Expense of premises and fixed assets increased
$201 or 32.1%. Merchant transaction expenses decreased $121 or 10.2% due to
lower transaction volume from the softness in the economy. FDIC insurance
assessments increased $110 or 647.1%. Other operating expenses increased $278 or
18.3% partly from increased shares tax of $96, increased professional services
and increased general operating expenses.
The following table sets forth information by category of non-interest expenses
for the Company for the nine months ended September 30, 2009 and September 30,
2008, respectively:
<Table>
<Caption>
September 30, September 30,
Nine Months Ended: 2009 2008
- ------------------------------------------------------------------------------------
Salaries and employee benefits $ 8,951 $ 7,405
Expense of premises and fixed assets 2,435 2,061
Merchant transaction expenses 2,523 2,787
Merger related costs 1,550 -
FDIC insurance assessments 571 41
Other operating expenses 5,063 4,047
- ------------------------------------------------------------------------------------
Total Non-Interest Expenses $21,093 $16,341
===================================================================================
</Table>
Total non-interest expenses increased $4,752 or 29.1% to $21,093 during the
first nine months of 2009 compared with $16,341 for the same period of 2008.
Salaries and employee benefits expense increased $1,546 or 20.9% mainly due to
increased salaries resulting from additional employees as a result of the
Merger. Premises and fixed assets expense increased $374 or 18.1% due to
additional depreciation and increased occupancy expense in part due to the
Merger. Merchant transaction expenses decreased $264 or 9.5% due to lower
transaction volume. Merger related costs of $1,550 consist of computer and
equipment upgrades of $606, investment banking, valuation services, legal and
accounting fees of $429, severance payments of $450 and stay bonuses of $65.
FDIC insurance assessments increased $530 or 1,292.7% due to a one time FDIC
special assessment cost of $385 and increases in quarterly assessments. Other
operating expenses increased $1,016 or 25.1% due to the reversal in the first
quarter
36
<Page>37
of 2008 of the $497 VISA litigation accrual recorded by the Company in
the fourth quarter of 2007, offset by an increase in advertising expenses,
professional services and increased general operating expenses.
INCOME TAXES
Applicable income taxes increased $233 for the three months ended September 30,
2009 due to overall higher income. Also, applicable income taxes decreased $520
or 26.6% during the first nine months of 2009 primarily due to the $1,550 of
costs associated with the Merger, a higher provision for loan losses in 2009 and
a one time gain on the VISA IPO during the nine months ended September 30, 2008.
LOAN PORTFOLIO
Details regarding the Company's loan portfolio on September 30, 2009 and
December 31, 2008 are as follows:
<Table>
<Caption>
September 30, September 30,
As of: 2009 2008
- ------------------------------------------------------------------------------------
Real estate - construction and land development $ 31,761 $ 21,949
Real estate mortgages 466,617 355,528
Commercial 27,095 27,793
Credit card and related plans 3,272 3,272
Installment and other 61,656 28,135
Obligations of states & political subdivisions 7,163 4,471
- ------------------------------------------------------------------------------------
Loans, net of unearned income 597,564 441,148
Less: Allowance for loan losses 6,300 5,275
- ------------------------------------------------------------------------------------
Loans, net $591,264 $435,873
===================================================================================
</Table>
The Company does not engage in any sub-prime or Alt-A credit lending. Therefore,
the Company is not subject to any credit risks associated with such loans. The
Company's loan portfolio primarily consists of residential and commercial
mortgage loans, secured by properties located in Northeastern Pennsylvania and
subject to conservative underwriting standards.
The following table presents the components of the allowance for credit losses
as of September 30, 2009 and December 31, 2008:
<Table>
<Caption>
September 30, December 31,
2009 2008
--------------------------------
Allowance for loan losses $ 6,300 $ 5,275
Credit fair value adjustment on
purchased loans 6,358 -
--------------------------------
Allowance for credit losses $12,658 $ 5,275
================================
</Table>
The allowance for loan loss as a percentage of loans was 1.05% at September 30,
2009, compared to 1.20% at December 31, 2008. The decrease is a result of
eliminating the allowance for loan loss and incorporating a credit fair value
adjustment on purchased loans. As a result, the allowance for credit losses,
which included the allowance for loan loss and the credit fair value adjustment
on loans purchased, provides an allowance for credit loss as a percentage of
period end loans of 2.10% at September 30, 2009. The evaluation of credit fair
value adjustment on purchased loans was made in accordance accounting standards
as described below.
The increase in mortgage loans of $120.9 million between December 31, 2008 and
September 30, 2009 is predominately due to mortgage loans acquired in the
Merger. The mortgage loan portfolio continues to be the largest component of the
loan portfolio, representing 83.4% and 85.6% of total loans at September 30,
2009 and December 31, 2008, respectively. However, due to deteriorating economic
conditions and continued recessionary conditions resulting in lower levels of
loan demand, we expect that loan growth may be slower than historically
expected.
The increase in installment and other loans between December 31, 2008 and
September 30, 2009 is primarily due to the purchase of the indirect loan
portfolio of Old Forge Bank.
37
<Page>38
LOAN QUALITY
The lending activities of the Company are guided by the comprehensive lending
policy established by the Board of Directors. Loans must meet criteria which
include consideration of the character, capacity and capital of the borrower,
collateral provided for the loan, and prevailing economic conditions. Due to the
consistent application of conservative underwriting standards, the Company's
loan quality has remained strong during the current general economic downturn.
The Company has not engaged in any sub-prime credit lending and is therefore,
not subject to the credit risks associated with such loans.
Regardless of credit standards, there is risk of loss inherent in every loan
portfolio. The allowance for loan losses is an amount that management believes
will be adequate to absorb possible losses on existing loans that may become
uncollectible, based on evaluations of the collectibility of the loans. The
evaluations take into consideration such factors as change in the nature and
volume of the loan portfolio, overall portfolio quality, review of specific
problem loans, industry experience, collateral value and current economic
conditions that may affect the borrower's ability to pay. Management believes
that the allowance for loan losses was adequate as of September 30, 2009. While
management uses available information to recognize losses on loans, future
additions to the allowance may be necessary based on changes in economic
conditions. In addition, various regulatory agencies, as an integral part of
their examination process, periodically review the Company's allowance for loan
losses. Such agencies may require the Company to recognize additions to the
allowance based on their judgment of information available to them at the time
of their examination.
The allowance for loan losses is increased by periodic charges against earnings
as a provision for loan losses, and decreased periodically by charge-offs of
loans (or parts of loans) management has determined to be uncollectible, net of
actual recoveries on loans previously charged-off.
NON-PERFORMING ASSETS
The following table sets forth information regarding non-accrual loans and loans
past due 90 days or more and still accruing interest:
<Table>
<Caption>
September 30, December 31, September 30,
As of: 2009 2008 2008
- -----------------------------------------------------------------------------------------------
Non-accrual loans $ 3,111 $ 1,454 $ 1,352
Other real estate owned 65 - -
- -----------------------------------------------------------------------------------------------
Total non-performing assets $ 3,176 $ 1,454 $ 1,352
===============================================================================================
Loans past due 90 days or more and accruing:
Secured by real estate 1,509 810 924
Guaranteed student loans 283 203 200
Credit card loans 19 17 29
Commercial 7 119 -
Other loans to individuals for
household, family, and other
personal expenditures 13 4 -
- -----------------------------------------------------------------------------------------------
Total loans past due 90 days or more
and accruing $ 1,831 $ 1,153 $ 1,153
===============================================================================================
</Table>
<Table>
<Caption>
September 30, December 31, September 30,
As of: 2009 2008 2008
- -----------------------------------------------------------------------------------------------
Allowance for loan losses $ 6,300 $ 5,275 $ 5,240
Credit fair value adjustment on loans purchased 6,358 - -
- -----------------------------------------------------------------------------------------------
Allowance for credit losses $ 12,658 $ 5,275 $ 5,240
===============================================================================================
Non-performing assets to total assets 0.36% 0.23% 0.21%
Non-performing loans to period end loans 0.52% 0.33% 0.31%
Allowance for loan losses to period
end loans 1.05% 1.20% 1.21%
Allowance for credit losses to period
end loans 2.10% 1.20% 1.21%
Allowance for loan losses to non-performing
loans 202.51% 362.79% 387.57%
Allowance for credit losses to non-performing
loans 406.88% 362.79% 387.57%
</Table>
38
<Page>39
Non-accrual loans increased $1,759 to $3,111 at September 30, 2009 from $1,352
at September 30, 2008 due to the continued deterioration in the economy.
Management is actively monitoring these accounts. Also, non-accrual loans have
increased $1,657 from $1,454 at December 31, 2008.
Loans are generally placed on a non-accrual status when principal or interest is
past due 90 days and when payment in full is not anticipated. When a loan is
placed on non-accrual status, all interest previously accrued but not collected
is charged against current income. Loans are returned to accrual status when
past due interest is collected and the collection of future principal and
interest is probable.
Loans on which the accrual of interest has been discontinued or reduced amounted
to $3,111 at September 30, 2009, up from $1,454 at December 31, 2008 and $1,352
at September 30, 2008. If interest on those loans had been accrued, such income
would have been $394 and $186 for the nine months ended September 30, 2009 and
September 30, 2008, respectively. Interest income on those loans, which is
recorded only when received, amounted to $35 and $16 at September 30, 2009 and
September 30, 2008, respectively. There were no commitments to lend additional
funds to individuals whose loans are in non-accrual status.
Management's process for evaluating the adequacy of the allowance for loan
losses includes reviewing each month's loan committee reports which list all
loans that do not meet certain internally developed criteria as to collateral
adequacy, payment performance, economic conditions and overall credit risk.
These reports also address the current status and actions in process on each
listed loan. From this information, adjustments are made to the allowance for
loan losses. Such adjustments include both specific loss allocation amounts and
general provisions by loan category based on present and past collection
experience, nature and volume of the loan portfolio, overall portfolio quality,
and current economic conditions that may affect the borrower's ability to pay.
During the second quarter of 2008, the Company was notified that The Education
Resources Institute, Inc. (TERI), a guarantor of a portion of our student loan
portfolio, had filed for reorganization under Chapter 11 of the Federal
Bankruptcy Act. At September 30, 2009, the Company had $8.1 million of TERI
loans out of a total student loan portfolio of $19.0 million. The Company does
not anticipate that TERI's bankruptcy filing will significantly impact the
Company's financial statements. These loans are placed on non-accrual status
when they become more than 90 days past due. At September 30, 2009 there was
$147 thousand in such loans placed on non-accrual status.
Most of the Company's lending activity is with customers located in the
Company's geographic market area and repayment thereof is affected by economic
conditions in this market area.
39
<Page>40
LOAN LOSS EXPERIENCE
The following tables present the Company's loan loss experience during the
periods indicated:
<Table>
<Caption>
September30, September 30,
Three Months Ended: 2009 2008
- -----------------------------------------------------------------------------
Balance at beginning of period $ 6,050 $ 5,140
Charge-offs:
Real estate mortgages 41 -
Commercial and all others - -
Credit card and related plans 8 2
Installment loans 47 80
- -----------------------------------------------------------------------------
Total charge-offs 96 82
- -----------------------------------------------------------------------------
Recoveries:
Real estate mortgages - -
Commercial and all others - 1
Credit card and related plans - 14
Installment loans 4 -
- -----------------------------------------------------------------------------
Total recoveries 4 15
- -----------------------------------------------------------------------------
Net charge-offs (recoveries) 92 67
- -----------------------------------------------------------------------------
Provision charged to operations 342 167
- -----------------------------------------------------------------------------
Balance at End of Period $ 6,300 $ 5,240
=============================================================================
Ratio of net charge-offs (recoveries)
to average loans outstanding 0.016% 0.016%
=============================================================================
</Table>
<Table>
<Caption>
September30, September 30,
Nine Months Ended: 2009 2008
- -----------------------------------------------------------------------------
Balance at beginning of period $ 5,275 $ 4,700
Charge-offs:
Real estate mortgages 349 -
Commercial and all others - -
Credit card and related plans 45 16
Installment loans 161 93
- -----------------------------------------------------------------------------
Total charge-offs 555 109
- -----------------------------------------------------------------------------
Recoveries:
Real estate mortgages - -
Commercial and all others - 14
Credit card and related plans 1 17
Installment loans 6 -
- -----------------------------------------------------------------------------
Total recoveries 7 31
- -----------------------------------------------------------------------------
Net charge-offs (recoveries) 548 78
- -----------------------------------------------------------------------------
Provision charged to operations 1,573 618
- -----------------------------------------------------------------------------
Balance at End of Period $ 6,300 $ 5,240
=============================================================================
Ratio of net charge-offs (recoveries)
to average loans outstanding 0.102% 0.019%
=============================================================================
</Table>
Management's process for evaluating the adequacy of the allowance for loan
losses includes reviewing each month's loan committee reports which list all
loans that do not meet certain internally developed criteria as to collateral
adequacy, payment performance, economic conditions and overall credit risk.
These reports also address the current status and actions in process on each
listed loan. From this information, adjustments are made to the allowance for
loan losses. Such adjustments include both specific loss allocation amounts and
general provisions by loan category based on present and past collection
experience, nature and volume of the loan portfolio, overall portfolio quality,
and current economic conditions that may affect the borrower's ability to pay.
40
<Page>41
The allowance for loan loss as a percentage of loans was 1.05% at September 30,
2009, compared to 1.20% at December 31, 2008. The decrease is a result of
eliminating the allowance for loan loss and incorporating a credit fair value
adjustment on purchased loans. As a result, the allowance for credit losses,
which included the allowance for loan loss and the credit fair value adjustment
on loans purchased, provides an allowance for credit loss as a percentage of
period end loans of 2.10% at September 30, 2009. The evaluation of credit fair
value adjustment on purchased loans was made in accordance accounting standards
as described below.
An adjustment was made to reflect the elimination of Old Forge Bank's allowance
for loan loss required by applying purchase accounting. As a result, the
purchased loan portfolio was evaluated based on risk characteristics and other
credit and market data by loan type to determine a credit risk component to the
fair value of loans purchased. The purchased loan balance was reduced by the
aggregate amount of the credit component in determining the fair market value of
loans purchased. The credit component does not account for purchased loans that
are deemed to be impaired. We evaluated the purchased loan portfolio and
identified seven (7) loans that were deemed to be impaired. Accordingly, these
loans were written down at the date of the Merger to the amount of cash flows
that are expected to be collected on each of these loans.
Determining the level of the allowance for probable loan loss at any given point
in time is difficult, particularly during uncertain economic periods. We must
make estimates using assumptions and information that is often subjective and
changing rapidly. The review of the loan portfolio is a continuing process in
light of a changing economy and the dynamics of the banking and regulatory
environment. In management's opinion, the allowance for loan loss was adequate
to meet probable incurred loan losses at September 30, 2009. There can be no
assurance, however, that we will not sustain loan losses in future periods that
could be greater than the size of the allowance at September 30, 2009.
Management believes that the allowance for loan loss is appropriate based on
applicable accounting standards.
The allowance for loan losses at September 30, 2009 was $6,300 or 1.05% of total
loans compared to $5,240 or 1.21% of total loans at September 30, 2008.
Management believes the loan loss reserve is adequate. The reserve for credit
losses, which includes the loan loss reserve plus a credit discount for loans
acquired in the Old Forge Bank merger, equaled 2.10% of total loans at September
30, 2009.
The allowance for loan losses is allocated as follows:
<Table>
<Caption>
As of: September 30, December 31, September 30,
2009 2008 2008
- ----------------------------------------------------------------------------------------------
Amount % * Amount % * Amount % *
- ----------------------------------------------------------------------------------------------
Real estate mortgages $1,200 83% $1,200 86% $1,200 86%
Commercial and all others 4,200 4% 3,275 6% 3,340 6%
Credit card and related plans 350 1% 300 1% 300 1%
Personal installment loans 550 12% 500 7% 300 7%
- ----------------------------------------------------------------------------------------------
Total $6,300 100% $5,275 100% $5,140 100%
==============================================================================================
</Table>
* Percent of loans in each category to total loans
LIQUIDITY
The objective of liquidity management is to maintain a balance between sources
and uses of funds in such a way that the cash requirements of customers for
loans and deposit withdrawals are met in the most economical manner. Management
monitors its liquidity position continuously in relation to trends of loans and
deposits for short-term as well as long-term requirements. Liquid assets are
monitored on a daily basis to assure maximum utilization. Management also
manages its liquidity requirements by maintaining an adequate level of readily
marketable assets and access to short-term funding sources. Management does not
foresee any adverse trends in liquidity.
The Company remains in a highly liquid condition both in the short and long
term. Sources of liquidity include the Company's U.S. Agency bond portfolios,
additional deposits, earnings, overnight loans to and from other companies
(Federal Funds) and lines of credit at the Federal Reserve Bank and the Federal
Home Loan Bank (FHLB). The Company is not a party to any commitments, guarantees
or obligations that could materially affect its liquidity.
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<Page>42
The Company offers collateralized repurchase agreements, which have a one day
maturity, as an alternative deposit option for its customers. The Company also
has long-term debt outstanding to the FHLB, which was used to purchase a Freddie
Mac pool of residential mortgages, as described earlier in this report. At
September 30, 2009 the Company had $228,722 of available borrowing capacity with
the FHLB and a Borrower-In-Custody (BIC) line of credit of $12,977 with the
Federal Reserve Bank of Philadelphia.
The Company is a separate legal entity from the Bank and must provide for its
own liquidity. In addition to its operating expenses, the Company is responsible
for paying any dividends declared to its shareholders. The Company's primary
source of income is dividends received from the Bank. The amount of dividends
that the Bank may declare and pay to the Company is generally restricted under
Pennsylvania law to the retained earnings of the Bank. At September 30, 2009,
the Company had liquid assets of $3.5 million.
COMMITMENTS AND CONTINGENT LIABILITIES
In the normal course of business, there are outstanding commitments and
contingent liabilities, created under prevailing terms and collateral
requirements such as commitments to extend credit, financial guarantees and
letters of credit, which are not reflected in the accompanying Financial
Statements. The Company does not anticipate any losses as a result of these
transactions. These instruments involve, to varying degrees, elements of credit
and interest rate risk in excess of the amount recognized in the Balance Sheets.
The contract or notional amounts of those instruments reflect the extent of
involvement the Company has in particular classes of financial instruments.
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition established in the contract. Commitments
generally have expiration dates of one year or less or other termination clauses
and may require payment of a fee. Since many of the commitments are expected to
expire without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements.
Standby letters of credit are conditional commitments issued to guarantee the
performance of a customer to a third party. The credit risk involved in issuing
letters of credit is essentially the same as that involved in extending loan
facilities to customers.
At September 30, 2009 the Bank has entered into contracts for the renovation of
various branches, in the aggregate amount of $1,932, approximately $175 of which
had been disbursed as of September 30, 2009.
RELATED PARTIES
The Company does not have any material transactions involving related persons or
entities, other than traditional banking transactions, which are made on the
same terms and conditions as those prevailing at the time for comparable
transactions with unrelated parties. At September 30, 2009, the Bank has issued
standby letters of credit for the accounts of related parties in the amount of
$8,007.
CAPITAL RESOURCES
A strong capital position is important to the continued profitability of the
Company and promotes depositor and investor confidence. The Company's capital
provides a basis for future growth and expansion and also provides additional
protection against unexpected losses.
Additional sources of capital would come from retained earnings from the
operations of the Company and from the sale of additional shares of common
stock. Management has no plans to offer additional shares of common stock at
this time.
The Company's total risk-based capital ratio was 16.88% at September 30, 2009.
The Company's risk-based capital ratio is more than the 10.00% ratio that
Federal regulators use as the "well capitalized" threshold under the Federal
prompt corrective action regulations. This is the current criteria which the
FDIC uses in determining the lowest insurance rate for deposit insurance. The
Company's risk-based capital ratio is more than double the 8.00% minimum
threshold, which determines whether a company is "adequately capitalized".
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<Page>43
PART 1. FINANCIAL INFORMATION, ITEM 3 --
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company currently does not enter into derivative financial instruments,
which include futures, forwards, interest rate swaps, option contracts and other
financial instruments with similar characteristics. However, the Company is
party to traditional financial instruments with off-balance sheet risk in the
normal course of business to meet the financing needs of its customers. These
financial instruments include commitments to extend credit, financial guarantees
and letters of credit. These traditional instruments involve to varying degrees,
elements of credit and interest rate risk in excess of the amount recognized in
the Consolidated Balance Sheets.
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition established in the contract. Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee. Standby letters of credit are conditional commitments
issued to guarantee the performance of a customer to a third party up to a
stipulated amount and with specified terms and conditions.
Commitments to extend credit and standby letters of credit are not recorded as
an asset or liability by the Company until the instrument is exercised.
The Company's exposure to market risk is reviewed on a regular basis by its
Asset/Liability Committee. Interest rate risk is the potential of economic
losses due to future interest rate changes. These economic losses can be
reflected as a loss of future net interest income and/or a loss of current fair
market values. The objective is to measure the effect on net interest income and
to adjust the balance sheet to minimize the inherent risk while at the same time
maximizing income. Management realizes certain risks are inherent and that the
goal is to identify and minimize the risks. Tools used by management include the
standard GAP report and an interest rate shock simulation report. The Company
has no market risk sensitive instruments held for trading purposes. It appears
the Company's market risk is reasonable at this time.
For a discussion of the Company's asset and liability management policies, as
well as the potential impact of interest rate changes upon the market value of
the Company's financial instruments, see Item 7A in the Company's Annual Report
on Form 10-K for the year ended December 31, 2008. Management, as part of its
regular practices, performs periodic reviews of the impact of interest rate
changes upon net interest income and market value of the Company's portfolio
equity. Based on, among other factors, such reviews, management believes that
there have been no material changes in the market risk of the Company's asset
and liability position since December 31, 2008.
PART 1. FINANCIAL INFORMATION, ITEM 4 --
CONTROLS AND PROCEDURES
Under the supervision and with the participation of our management, including
our Chief Executive Officer and Controller, we conducted an evaluation of our
disclosure controls and procedures, as such term is defined under Rule 13a-15(e)
under the Securities Exchange Act of 1934. Based upon this evaluation, our Chief
Executive Officer and our Controller (our Principal Financial Officer) concluded
that our disclosure controls and procedures were effective as of the end of the
period covered by this quarterly report.
The Company continually assesses the adequacy of its internal control over
financial reporting and enhances its controls in response to internal control
assessments, and internal and external audit and regulatory recommendations.
Management maintains a comprehensive system of controls intended to ensure that
transactions are executed in accordance with management's authorization, assets
are safeguarded, and financial records are reliable. Management also takes steps
to see that information and communication flows are effective and to monitor
performance, including performance of internal control procedures.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate due to changes in conditions, or that the degree of compliance with
the policies or procedures may deteriorate.
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<Page>44
There have been no substantive changes in the internal control over financial
reporting during the quarter ended September 30, 2009 that have materially
affected, or are reasonably likely to materially affect, the Company's internal
control over financial reporting.
PART II. OTHER INFORMATION
ITEM 1 -- LEGAL PROCEEDINGS
None.
ITEM 1A -- RISK FACTORS
In addition to the other information set forth in this report, you should
carefully consider the factors discussed below, which could materially affect
our business, financial condition or future results. The risks described below
are not the only risks that the Company faces. Additional risks and
uncertainties not currently known to us or that we currently deem to be
immaterial also may materially adversely affect our business, financial
condition and/or operating results.
RISKS RELATED TO OUR BUSINESS
CREDIT RISK
CHANGES IN THE CREDIT QUALITY OF OUR LOAN PORTFOLIO MAY IMPACT THE LEVEL OF OUR
ALLOWANCE FOR LOAN LOSSES.
We make various judgments about the collectibility of our loans, including the
creditworthiness of our borrowers and the value of the real estate and other
assets serving as collateral for our loans. In determining the amount of the
allowance for loan losses, we review our loans and our loan loss and delinquency
experience, and we evaluate economic conditions. If our judgments are incorrect,
our allowance for loan losses may not be sufficient to cover future losses,
which will result in additions to our allowance through increased provisions for
loan losses. In addition, bank regulators periodically review our allowance for
loan losses and may require us to increase our provision for loan losses or
recognize further loan charge-offs. Increased provisions for loan losses would
increase our expenses and reduce our profits.
Nonetheless, to the best of management's knowledge, there are also no particular
risk elements in the local economy that put a group or category of loans at
increased risk. The Company does not engage in any sub-prime or Alt-A credit
lending. Therefore, the Company is not subject to any credit risks associated
with such loans.
Also, the Company is not dependent upon a single customer, or a few customers,
the loss of one or more of which would have a material adverse effect on its
operations. The operations and earnings of the Corporation are also not
materially affected by seasonal changes.
MARKET RISK
CHANGES IN INTEREST RATES COULD AFFECT OUR INVESTMENT VALUES AND NET INTEREST
INCOME WHICH COULD HURT OUR PROFITS.
At September 30, 2009, the Company owned approximately $149.4 million of
marketable securities available for sale. These securities are carried at fair
value on the consolidated balance sheets. Unrealized gains or losses on these
securities, that is, the difference between the fair value and the amortized
cost of these securities, are reflected in stockholders' equity, net of deferred
taxes. As of September 30, 2009, the Company's available for sale marketable
securities portfolio had a net unrealized gain, net of taxes, of $3.0 million.
The fair value of the Company's available for sale marketable securities is
subject to interest rate change, which would not affect recorded earnings, but
would increase or decrease comprehensive income and stockholders' equity.
The principal component of the Company's earnings is net interest income, which
is the difference between interest and fees earned on interest-earning assets
and interest paid on deposits and other borrowings. The most significant impact
on net interest income between periods is derived from the interaction of
changes in the volume of and rates earned or paid on interest-earning assets and
interest-bearing liabilities. The volume of earning dollars in loans and
investments, compared to the volume of interest-bearing liabilities represented
by deposits and borrowings,
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<Page>45
combined with the spread, produces the changes in net interest income between
periods.
The Company continually monitors the relationship of its interest rate sensitive
assets and liabilities through its Asset/Liability Committee.
STRONG COMPETITION WITHIN OUR MARKET COULD HURT OUR PROFITS AND INHIBIT GROWTH.
The Bank operates in a competitive environment in which it must share its market
with many local independent banks as well as several banks which are affiliates
or branches of very large regional holding companies. The Bank encounters
competition from diversified financial institutions, ranging in size from small
banks to the nationwide banks operating in its region. The competition includes
commercial banks, savings and loan associations, credit unions, other lending
institutions and mortgage originators.
The principal competitive factors among the Company's competitors can be grouped
into two categories: pricing and services. In the Company's primary service
area, interest rates on deposits, especially time deposits, and interest rates
and fees charged to customers on loans are very competitive. From a service
perspective, the Bank competes in areas such as convenience of location, types
of services, service costs and banking hours. Our profitability depends on our
continued ability to compete successfully in our market area.
COMPLIANCE RISK
WE OPERATE IN A HIGHLY REGULATED ENVIRONMENT AND MAY BE ADVERSELY AFFECTED BY
CHANGES IN LAWS AND REGULATIONS.
The Company is registered as a financial holding company under the Bank Holding
Company Act of 1956, as amended, and, as such, is subject to supervision and
regulation by the Board of Governors of the Federal Reserve System ("FRB"). The
Company is required to file annual and quarterly reports of its operations with
the FRB.
As a financial holding company, the Company is permitted to engage in
banking-related activities as authorized by the FRB, directly or through
subsidiaries or by acquiring companies already established in such activities
subject to the FRB regulations relating to those activities.
Our banking subsidiary, Penn Security Bank and Trust Company, as a Pennsylvania
state-chartered financial institution, is subject to supervision, regulation and
examination by the Commonwealth of Pennsylvania Department of Banking and by the
Federal Deposit Insurance Corporation (the "FDIC"), which insures the Bank's
deposits to the maximum extent permitted by law.
Any change in such regulation and oversight, whether in the form of regulatory
policy, regulations, legislation or supervisory actions, may have a material
impact on our operations.
OPERATIONAL RISK
A CONTINUATION OF RECENT TURMOIL IN THE FINANCIAL MARKETS COULD HAVE AN ADVERSE
EFFECT ON THE FINANCIAL POSITION OR RESULTS OF OPERATIONS.
In recent periods, United States and global markets, as well as general economic
conditions, have been disrupted and volatile. Concerns regarding the financial
strength of financial institutions have led to distress in credit markets and
issues relating to liquidity among financial institutions. Some financial
institutions around the world have failed; others have been forced to seek
acquisition partners. The United States and other governments have taken steps
to try to stabilize the financial system, including investing in financial
institutions. The Company has not applied for and is not participating in any
government sponsored Capital Purchase Programs. Our company's financial
condition and results of operations could be adversely affected by (1) continued
disruption and volatility in financial markets, (2) continued capital and
liquidity concerns regarding financial institutions generally and our
counterparties specifically, including the Federal Home Loan Bank, (3)
limitations resulting from governmental action in an effort to stabilize or
provide additional regulation of the financial system, or (4) recessionary
conditions that are deeper or last longer than currently anticipated. Further,
there can be no assurance that action by federal and state legislatures, and
governmental agencies and regulators, including the enacted legislation
authorizing the U.S. government to invest in financial institutions, or changes
in tax policy, will help stabilize the U.S. financial system and any such
45
<Page>46
action, including changes to existing legislation or policy, could have an
adverse effect on the financial conditions or results of operations of the
Company.
SPECIAL FDIC ASSESSMENTS WILL HURT OUR EARNINGS.
Beginning in late 2008, the economic environment caused higher levels of bank
failures, which dramatically increased FDIC resolution costs and led to a
significant reduction in the Deposit Insurance Fund. As a result, the FDIC has
significantly increased the initial based assessment rates paid by financial
institutions for deposit insurance. The base assessment rate was increased by
seven basis points (7 cents for every $100 of deposits) for the first quarter of
2009. Effective April 1, 2009, initial base assessment rates were changed to
range from 12 basis points to 45 basis points across all risk categories with
possible adjustments to these rates based on certain specified factors. These
increases in the base assessment rate have increased our deposit insurance costs
and will negatively impact our earnings. In addition, in May 2009, the FDIC
imposed a special assessment on all insured institutions due recent bank and
savings association failures. The emergency assessment amounts to 5 basis points
on each institution's assets minus Tier 1 capital as of June 30, 2009, subject
to a maximum equal to 10 basis points times the institution's assessment base.
The assessment was payable on September 30, 2009. Our special assessment was
$385. The special assessment has negatively impacted our earnings. In addition,
the FDIC may impose additional emergency special assessments in the future, of
up to 5 basis points per quarter on each institution's assets minus Tier 1
capital if necessary to maintain public confidence in federal deposit insurance
or as a result of deterioration in the deposit insurance fund reserve ratio due
to institution failures. Any additional emergency special assessment imposed by
the FDIC will further hurt our earnings. Most recently, the FDIC has proposed to
require insured institutions to prepay estimated deposit insurance assessments
for the remainder of 2009 through 2012. If adopted, the prepayments would be in
lieu of additional special assessments. Based on the proposal, the bank's
prepayments on December 30, 2009 would approximate $3 million.
THE COMPANY NEEDS TO CONTINUALLY ATTRACT AND RETAIN QUALIFIED PERSONNEL FOR ITS
OPERATIONS.
High quality customer service, as well as efficient and profitable operations,
is dependent on the Company's ability to attract and retain qualified
individuals for key positions within the organization. The Company has
successfully recruited several individuals for management positions in recent
years. As of September 30, 2009, the Company employed 222 full-time equivalent
employees. The employees of the Company are not represented by any collective
bargaining group. Management of the Company considers relations with its
employees to be good.
OUR OPERATIONS COULD BE AFFECTED IF WE DO NOT HAVE ACCESS TO MODERN AND RELIABLE
TECHNOLOGY.
The Company operates in a highly-automated environment, wherein almost all
transactions are processed by computer software to produce results. To remain
competitive, the Company must continually evaluate the adequacy of its data
processing capabilities and make revisions as needed.
The Company regularly tests its ability to restore data capabilities in the
event of a natural disaster, sustained power failure or other inability to
utilize its primary systems.
LIQUIDITY RISK
INCREASED NEEDS FOR DISBURSEMENT OF FUNDS ON LOANS AND DEPOSITS CAN AFFECT OUR
LIQUIDITY.
The objective of liquidity management is to maintain a balance between sources
and uses of funds in such a way that the cash requirements of customers for
loans and deposit withdrawals are met in the most economical manner. Management
monitors its liquidity position continuously in relation to trends of loans and
deposits for short-term as well as long-term requirements. Liquid assets are
monitored on a daily basis to assure maximum utilization. Management also
manages its liquidity requirements by maintaining an adequate level of readily
marketable assets and access to short-term funding sources. Management does not
foresee any adverse trends in liquidity.
OUR FUTURE PENSION PLAN COSTS AND CONTRIBUTIONS COULD BE UNFAVORABLY IMPACTED BY
THE FACTORS THAT ARE USED IN THE ACTUARIAL CALCULATIONS.
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Our costs for the non-contributory defined benefit pension plans are dependent
upon a number of factors, such as the rates of return on plan assets, discount
rates, the level of interest rates used to measure the required minimum funding
levels of the plans, future government regulation and our required or voluntary
contributions made to the plans. Without sustained growth in the pension
investments over time to increase the value of our plan assets and depending
upon the other factors impacting our costs as listed above, we could be required
to fund our plans with higher amounts of cash than are anticipated by our
actuaries. Such increased funding obligations could have a material impact on
our liquidity by reducing our cash flows.
ITEM 2 -- UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3 -- DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4 -- SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5 -- OTHER INFORMATION
None.
ITEM 6 -- EXHIBITS
31 Rule 13a-14(a) / 15-d-4(a) Certifications
32 Section 1350 Certifications
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
PENSECO FINANCIAL SERVICES CORPORATION
By /s/ CRAIG W. BEST
------------------------------
Craig W. Best
President and CEO
(Principal Executive Officer)
Dated: November 5, 2009
By /s/ PATRICK SCANLON
------------------------------
Patrick Scanlon
Senior Vice President, Finance Division Head
(Principal Financial Officer)
Dated: November 5, 2009
47