================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ------------------ FORM 10-Q ------------------ |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2004 OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 ------------------ 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 ------------------ 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 checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). |_| The total number of shares of the registrant's Common Stock, $0.01 par value, outstanding on October 29, 2004 was 2,148,000. ================================================================================ PENSECO FINANCIAL SERVICES CORPORATION Page Part I -- FINANCIAL INFORMATION Item 1. Financial Statements - Consolidated Balance Sheets: September 30, 2004........................................ 3 December 31, 2003......................................... 3 Statements of Income: Three Months Ended September 30, 2004..................... 4 Three Months Ended September 30, 2003..................... 4 Nine Months Ended September 30, 2004...................... 5 Nine Months Ended September 30, 2003...................... 5 Statements of Cash Flows: Nine Months Ended September 30, 2004...................... 6 Nine Months Ended September 30, 2003...................... 6 Notes to Financial Statements................................ 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................................... 13 Item 3. Quantitative and Qualitative Disclosures About Market Risk..... 24 Item 4. Controls and Procedures........................................ 25 Part II -- OTHER INFORMATION Item 1. Legal Proceedings.............................................. 25 Item 2. Changes in Securities and Use of Proceeds...................... 25 Item 3. Defaults Upon Senior Securities................................ 25 Item 4. Submission of Matters to a Vote of Security Holders............ 25 Item 5. Other Information.............................................. 25 Item 6. Exhibits and Reports on Form 8-K............................... 25 Signatures............................................................. 26 Certifications......................................................... 27 PART I. FINANCIAL INFORMATION, Item 1 -- Financial Statements PENSECO FINANCIAL SERVICES CORPORATION CONSOLIDATED BALANCE SHEETS (unaudited) (in thousands of dollars) September 30, December 31, 2004 2003 ---------------- ---------------- ASSETS Cash and due from banks $ 10,409 $ 10,062 Interest bearing balances with banks 5,255 4,693 Federal funds sold 3,275 23,600 ---------------- ---------------- Cash and Cash Equivalents 18,939 38,355 Investment securities: Available-for-sale, at fair value 189,772 179,600 Held-to-maturity (fair value of $101,201 and $115,672, respectively) 98,637 113,525 ---------------- ---------------- Total Investment Securities 288,409 293,125 Loans, net of unearned income 263,980 240,382 Less: Allowance for loan losses 3,600 3,500 ---------------- ---------------- Loans, Net 60,380 236,882 Bank premises and equipment 9,404 9,935 Other real estate owned 44 121 Accrued interest receivable 3,437 3,298 Other assets 3,197 2,874 ---------------- ---------------- Total Assets $ 583,810 $ 584,590 ================ ================ LIABILITIES Deposits: Non-interest bearing $ 90,341 $ 79,726 Interest bearing 316,056 328,218 ---------------- ---------------- Total Deposits 406,397 407,944 Other borrowed funds: Repurchase agreements 25,904 19,454 Short-term borrowings 611 823 Long-term borrowings 86,875 93,523 Accrued interest payable 840 1,158 Other liabilities 1,183 881 ---------------- ---------------- Total Liabilities 521,810 523,783 ---------------- ---------------- STOCKHOLDERS' EQUITY Common stock ($ .01 par value, 15,000,000 shares authorized, 2,148,000 shares issued and outstanding) 21 21 Surplus 10,819 10,819 Retained earnings 50,321 48,131 Accumulated other comprehensive income 839 1,836 ---------------- ---------------- Total Stockholders' Equity 62,000 60,807 ---------------- ---------------- Total Liabilities and Stockholders' Equity $ 583,810 $ 584,590 ================ ================ PENSECO FINANCIAL SERVICES CORPORATION CONSOLIDATED STATEMENTS OF INCOME (unaudited) (in thousands of dollars) Three Months Ended Three Months Ended September 30, 2004 September 30, 2003 ---------------------- ---------------------- INTEREST INCOME Interest and fees on loans $ 3,468 $ 3,401 Interest and dividends on investments: U.S. Treasury securities and U.S. Agency obligations 1,976 2,141 States & political subdivisions 947 645 Other securities 21 33 Interest on Federal funds sold 14 147 Interest on balances with banks 16 28 ---------------------- ---------------------- Total Interest Income 6,442 6,395 ---------------------- ---------------------- INTEREST EXPENSE Interest on time deposits of $100,000 or more 164 202 Interest on other deposits 790 975 Interest on other borrowed funds 897 972 ---------------------- ---------------------- Total Interest Expense 1,851 2,149 ---------------------- ---------------------- Net Interest Income 4,591 4,246 Provision for loan losses 114 1 ---------------------- ---------------------- Net Interest Income After Provision for Loan Losses 4,477 4,245 ---------------------- ---------------------- OTHER INCOME Trust department income 372 345 Service charges on deposit accounts 271 283 Merchant transaction income 1,698 1,729 Other fee income 289 328 Other operating income 200 549 Realized gains (losses) on securities, net - - ---------------------- ---------------------- Total Other Income 2,830 3,234 ---------------------- ---------------------- OTHER EXPENSES Salaries and employee benefits 2,235 2,219 Expense of premises and fixed assets 556 607 Merchant transaction expenses 1,344 1,378 Other operating expenses 1,251 1,218 ---------------------- ---------------------- Total Other Expenses 5,386 5,422 ---------------------- ---------------------- Income before income taxes 1,921 2,057 Applicable income taxes 306 454 ---------------------- ---------------------- Net Income 1,615 1,603 Other comprehensive income, net of taxes: Unrealized securities gains (losses) 1,915 (610) ---------------------- ---------------------- Comprehensive Income $ 3,530 $ 993 ====================== ====================== Earnings per Common Share (Based on 2,148,000 shares outstanding) $ .75 $ .75 Cash Dividends Declared Per Common Share $ .30 $ .30 PENSECO FINANCIAL SERVICES CORPORATION CONSOLIDATED STATEMENTS OF INCOME (unaudited) (in thousands of dollars) Nine Months Ended Nine Months Ended September 30, 2004 September 30, 2003 ---------------------- ---------------------- INTEREST INCOME Interest and fees on loans $ 9,816 $ 11,443 Interest and dividends on investments: U.S. Treasury securities and U.S. Agency obligations 6,188 6,062 States & political subdivisions 2,675 1,927 Other securities 72 88 Interest on Federal funds sold 57 236 Interest on balances with banks 53 68 ---------------------- ---------------------- Total Interest Income 18,861 19,824 ---------------------- ---------------------- INTEREST EXPENSE Interest on time deposits of $100,000 or more 501 676 Interest on other deposits 2,453 3,286 Interest on other borrowed funds 2,737 2,199 ---------------------- ---------------------- Total Interest Expense 5,691 6,161 ---------------------- ---------------------- Net Interest Income 13,170 13,663 Provision for loan losses 135 456 ---------------------- ---------------------- Net Interest Income After Provision for Loan Losses 13,035 13,207 ---------------------- ---------------------- OTHER INCOME Trust department income 1,014 981 Service charges on deposit accounts 810 848 Merchant transaction income 4,097 4,141 Other fee income 848 923 Other operating income 481 1,432 Realized gains (losses) on securities, net - - ---------------------- ---------------------- Total Other Income 7,250 8,325 ---------------------- ---------------------- OTHER EXPENSES Salaries and employee benefits 6,792 6,619 Expense of premises and fixed assets 1,837 1,929 Merchant transaction expenses 3,281 3,437 Other operating expenses 3,618 3,546 ---------------------- ---------------------- Total Other Expenses 15,528 15,531 ---------------------- ---------------------- Income before income taxes 4,757 6,001 Applicable income taxes 634 1,254 ---------------------- ---------------------- Net Income 4,123 4,747 Other comprehensive income, net of taxes: Unrealized securities (losses) gains (997) (828) ---------------------- ---------------------- Comprehensive Income $ 3,126 $ 3,919 ====================== ====================== Earnings per Common Share (Based on 2,148,000 shares outstanding) $ 1.92 $ 2.21 Cash Dividends Declared Per Common Share $ .90 $ .90 PENSECO FINANCIAL SERVICES CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (in thousands of dollars) Nine Months Ended Nine Months Ended September 30, 2004 September 30, 2003 --------------------- --------------------- OPERATING ACTIVITIES Net Income $ 4,123 $ 4,747 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 624 891 Provision for loan losses 114 456 Deferred income tax provision (benefit) 60 20 Amortization of securities, (net of accretion) 1,191 694 Net realized losses (gains) on securities - - Loss (gain) on other real estate - 13 (Increase) decrease in interest receivable (139) 325 (Increase) decrease in other assets (323) 297 Increase (decrease) in income taxes payable 183 55 (Decrease) increase in interest payable (318) (324) Increase (decrease) in other liabilities 573 160 --------------------- --------------------- Net cash provided by operating activities 6,088 7,334 --------------------- --------------------- INVESTING ACTIVITIES Purchase of investment securities available-for-sale (49,543) (37,383) Proceeds from investment securities available-for-sale 23,015 17,756 Purchase of investment securities to be held-to-maturity - (103,031) Proceeds from repayments of investment securities available-for-sale 14,108 4,386 Proceeds from repayments of investment securities held-to-maturity 14,434 16,069 Net loans (originated) repaid (23,656) 46,865 Proceeds from other real estate 121 143 Investment in premises and equipment (93) (1,064) --------------------- --------------------- Net cash (used) provided by investing activities (21,614) (56,259) --------------------- --------------------- FINANCING ACTIVITIES Net increase (decrease) in demand and savings deposits 11,181 8,729 Net (payments) proceeds on time deposits (12,728) (10,926) Increase (decrease) in federal funds purchased - - Increase (decrease) in repurchase agreements 6,450 5,775 Net (decrease) increase in short-term borrowings (212) (662) Proceeds from long-term borrowings - 100,000 Repayments of long-term borrowings (6,648) (4,299) Cash dividends paid (1,933) (1,933) --------------------- --------------------- Net cash (used) provided by financing activities (3,890) 96,684 --------------------- --------------------- Net (decrease) increase in cash and cash equivalents (19,416) 47,759 Cash and cash equivalents at January 1 38,355 54,619 --------------------- --------------------- Cash and cash equivalents at September 30 $ 18,939 $ 102,378 ===================== ===================== The Company paid interest and income taxes of $6,009 and $432 and $6,485 and $1,518, for the nine month periods ended September 30, 2004 and 2003, respectively. Notes to CONSOLIDATED Financial Statements For the Quarter Ended September 30, 2004 (unaudited) These Notes to Financial Statements reflect events subsequent to December 31, 2003, the date of the most recent Report of Independent Auditors, through the date of this Quarterly Report on Form 10-Q for the quarter ended September 30, 2004. These Notes to Financial Statements should be read in conjunction with Financial Information and Other Information required to be furnished as part of this Report, in particular, (1) Management's Discussion and Analysis of Financial Condition and Results of Operations for the three months ended September 30, 2004 and September 30, 2003 and for the nine months ended September 30, 2004 and September 30, 2003, with respect to the Company's net interest income, capital requirements and liquidity, (2) Part II, Item 6, Exhibits and Reports on Form 8-K and (3) the Company's Annual Report - Form 10-K for the year ended December 31, 2003, incorporated herein by reference. NOTE 1 -- Principles of Consolidation Penseco Financial Services Corporation (Company) 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 and with general practices within the banking industry. NOTE 2 -- Basis of Presentation The unaudited consolidated financial statements have been prepared in accordance with 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. For further information, refer to the consolidated financial statements and accompanying notes included in the Company's Annual Report - Form 10-K for the year ended December 31, 2003. 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 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. The amortized cost and fair value of investment securities at September 30, 2004 and December 31, 2003 are as follows: Available-for-Sale Gross Gross Amortized Unrealized Unrealized Fair September 30, 2004 Cost Gains Losses Value - -------------------------------------------------------------------------------- U.S. Treasury securities $ 4,999 $ 101 $ - $ 5,100 U.S. Agency securities 70,953 485 160 71,278 Mortgage-backed securities 57,635 51 86 57,600 States & political subdivisions 48,751 792 229 49,314 - -------------------------------------------------------------------------------- Total Debt Securities 182,338 1,429 475 183,292 Equity securities 6,163 317 - 6,480 - -------------------------------------------------------------------------------- Total Available-for-Sale $ 188,501 $ 1,746 $ 475 $ 189,772 =============================================================================== Available-for-Sale Gross Gross Amortized Unrealized Unrealized Fair December 31, 2003 Cost Gains Losses Value - -------------------------------------------------------------------------------- U.S. Treasury securities $ 15,008 $ 379 $ - $ 15,387 U.S. Agency securities 63,568 1,435 - 65,003 Mortgage-backed securities 71,975 147 107 72,015 States & political subdivisions 20,158 683 - 20,841 - -------------------------------------------------------------------------------- Total Debt Securities 170,709 2,644 107 173,246 Equity securities 6,109 245 - 6,354 - -------------------------------------------------------------------------------- Total Available-for-Sale $ 176,818 $ 2,889 $ 107 $ 179,600 ================================================================================ Held-to-Maturity Gross Gross Amortized Unrealized Unrealized Fair September 30, 2004 Cost Gains Losses Value - -------------------------------------------------------------------------------- Mortgage-backed securities $ 69,388 $ 8 $ 267 $ 69,129 States & political subdivisions 29,249 2,823 - 32,072 - -------------------------------------------------------------------------------- Total Held-to-Maturity $ 98,637 $ 2,831 $ 267 $ 101,201 ================================================================================ Held-to-Maturity Gross Gross Amortized Unrealized Unrealized Fair December 31, 2003 Cost Gains Losses Value - -------------------------------------------------------------------------------- Mortgage-backed securities $ 84,138 $ 8 $ 580 $ 83,566 States & political subdivisions 29,387 2,719 - 32,106 - -------------------------------------------------------------------------------- Total Held-to-Maturity $ 113,525 $ 2,727 $ 580 $ 115,672 ================================================================================ The amortized cost and fair value of debt securities at September 30, 2004 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. September 30, 2004 Available-for-Sale Held-to-Maturity - -------------------------------------------------------------------------------------- Amortized Fair Amortized Fair Cost Value Cost Value - -------------------------------------------------------------------------------------- Due in one year or less: U.S. Treasury securities $ 4,999 $ 5,100 $ - $ - U.S. Agency securities 15,015 15,457 - - After one year through five years: U.S. Agency securities 55,938 55,821 - - After ten years: States & political subdivisions 48,751 49,314 29,249 32,072 - -------------------------------------------------------------------------------------- Subtotal 124,703 125,692 29,249 32,072 Mortgage-backed securities 57,635 57,600 69,388 69,129 - -------------------------------------------------------------------------------------- Total Debt Securities $ 182,338 $ 183,292 $ 98,637 $ 101,201 ====================================================================================== 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, 2004 are as follows: Less than twelve months Twelve months or more Totals ------------------------------ ------------------------------ ------------------------------ Fair Unrealized Fair Unrealized Fair Unrealized Value Losses Value Losses Value Losses ------------- ------------- ------------- ------------- ------------- ------------- U.S. Agency securities $ 40,665 $ 160 $ - $ - $ 40,665 $ 160 Mortgage-backed securities 39,086 86 68,807 267 107,893 353 States & political subdivisions 17,517 229 - - 17,517 229 ------------- ------------- ------------- ------------- ------------- ------------- Total $ 97,268 $ 475 $ 68,807 $ 267 $ 166,075 $ 742 ============= ============= ============= ============= ============= ============= The above table includes forty-nine (49) securities that have unrealized losses for less than twelve months and one (1) mortgaged-backed security that has been in an unrealized loss position for twelve or more months. The unrealized losses in each case are related to interest rate fluctuations. Because the decline in market value is attributable to changes in interest rates and not credit quality and because the Company has the ability and intent to hold these investments until a market price recovery, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at September 30, 2004. NOTE 5 -- Loan Portfolio Details regarding the Company's loan portfolio: September 30, December 31, As Of: 2004 2003 - -------------------------------------------------------------------------------- Real estate - construction and land development $ 5,737 $ 3,078 Real estate mortgages 187,217 172,964 Commercial 37,137 30,056 Credit card and related plans 2,451 2,403 Installment 25,459 25,855 Obligations of states & political subdivisions 5,979 6,026 - -------------------------------------------------------------------------------- Loans, net of unearned income 263,980 240,382 Less: Allowance for loan losses 3,600 3,500 - -------------------------------------------------------------------------------- Loans, net $ 260,380 $ 236,882 - -------------------------------------------------------------------------------- NOTE 6 -- Loan Servicing The Company generally retains the right to service mortgage loans sold to others. The cost allocated to the mortgage servicing rights retained has been recognized as a separate asset and is being 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 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. NOTE 7 -- Long-Term Debt During the quarter ended March 31, 2003, the Bank borrowed $100,000 from the Federal Home Loan Bank, in four loans with various maturity dates, to finance the purchase of a mortgaged-backed security. The loans are secured by a general collateral pledge of the Company. A summary of the long-term debt at September 30, 2004 is as follows: Note payable, due in monthly installments of $161, including principal and interest at a fixed rate of 2.73%, maturing March, 2008. $ 6,427 Note payable, due in monthly installments of $253, including principal and interest at a fixed rate of 3.22%, maturing March, 2010. 15,281 Note payable, due in monthly installments of $430, including principal and interest at a fixed rate of 3.74%, maturing March, 2013. 37,528 Note payable, due in monthly installments of $186, including principal and interest at a fixed rate of 4.69%, maturing March, 2023. 27,639 -------- Total long-term debt $ 86,875 ======== The Company has agreed to maintain sufficient qualifying collateral to fully secure the above borrowings. Aggregate maturities of long-term debt at September 30, 2004 are as follows: September 30, Principal ------------- --------- 2005 $ 9,139 2006 9,464 2007 9,801 2008 9,181 2009 8,533 Thereafter 40,757 --------- $ 86,875 ========= NOTE 8 -- Employee Benefit Plans The components of the net periodic benefit costs are as follows: Pension Benefits Other Benefits ------------------ ----------------- Nine months ended September 30, 2004 2003 2004 2003 - ----------------------------------------------------------------------------- Service cost $ 297 $ 289 $ 1 $ 1 Interest cost 493 476 4 4 Expected return on plan assets (525) (468) - - Amortization of prior service cost - - 2 2 Amortization of net (gain) loss 93 131 - - - ----------------------------------------------------------------------------- Net periodic pension cost $ 358 $ 428 $ 7 $ 7 - ----------------------------------------------------------------------------- Contributions The Company previously disclosed in its financial statements for the year ended December 31, 2003, that it expected to contribute $318 to its pension plan and $12 to its postretirement plan in 2004. As of September 30, 2004, $190 has been contributed to the pension plan. The Company presently anticipates contributing $381 to fund its pension plan in 2004. The postretirement plan estimate has not changed since December 31, 2003. NOTE 9 -- Regulatory Matters The Company and the Bank are subject to various regulatory capital requirements administered by the 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 judgements 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 below) 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. The Bank's actual capital amounts and ratios are substantially identical to the Company's. Management believes, as of September 30, 2004, that the Company and the Bank meet all capital adequacy requirements to which they are subject. As of September 30, 2004, 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. 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. Accordingly, at September 30, 2004, the balances in the Capital Stock and Surplus accounts totalling $10,840 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 the 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. Actual Regulatory Requirements - ---------------------------------------------- -------------------------------------------- For Capital To Be Adequacy Purposes "Well Capitalized" As of September 30, 2004 Amount Ratio Amount Ratio Amount Ratio - ---------------------------------------------------------------------------------------------- Total Capital (to Risk Weighted Assets) $ 64,269 19.95% > $ 25,774 > 8.0% > $ 32,217 > 10.0% - - - - Tier 1 Capital (to Risk Weighted Assets) $ 60,669 18.83% > $ 12,887 > 4.0% > $ 19,330 > 6.0% - - - - Tier 1 Capital (to Average Assets) $ 60,669 10.39% > $ * > * > $ 29,185 > 5.0% - - - - *3.0% ($17,511), 4.0% ($23,348) or 5.0% ($29,185) depending on the bank's CAMELS Rating and other regulatory risk factors. Actual Regulatory Requirements - ---------------------------------------------- -------------------------------------------- For Capital To Be Adequacy Purposes "Well Capitalized" As of December 31, 2003 Amount Ratio Amount Ratio Amount Ratio - ---------------------------------------------------------------------------------------------- Total Capital (to Risk Weighted Assets) $ 61,824 21.99% > $ 22,490 > 8.0% > $ 28,112 > 10.0% - - - - Tier I Capital (to Risk Weighted Assets) $ 58,324 20.75% > $ 11,245 > 4.0% > $ 16,867 > 6.0% - - - - Tier I Capital (to Average Assets) $ 58,324 10.21% > * > * > $ 28,556 > 5.0% - - - - * 3.0% ($17,134), 4.0% ($22,845) or 5.0% ($28,556) depending on the bank's CAMELS Rating and other regulatory risk factors. 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 and it's subsidiary, Penn Security Bank and Trust Company, for the three months ended September 30, 2004 and September 30, 2003 and for the nine months ended September 30, 2004 and September 30, 2003. Throughout this review, the subsidiary of Penseco Financial Services Corporation, Penn Security Bank and Trust Company, is referred to as the "Company". All intercompany accounts and transactions have been eliminated in preparing the consolidated financial statements. All information is presented in thousands of dollars, except as indicated. 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 judgement, 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 judgements 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 quoted market prices. 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. 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. Executive Summary Net income for the three months ended September 30, 2004 remained basically unchanged at $1,615 or $.75 per share compared with $1,603 or $.75 per share for the three months ended September 30, 2003. Net interest income, before provision for loan losses, increased $345 or 8.1% to $4,591 for the three months ended September 30, 2004 compared to $4,246 for the same period of 2003. The growth partially came from increases in the investment securities portfolio along with increased loans, and lower interest expense on time deposits and long-term borrowings. The provision for loan losses increased $113 from the year ago period due to growth in the Company's loan portfolio based upon the analysis methodology of valuating the reserve for bad debts and as an act of prudence by management. Other income decreased $404 or 12.5% mostly due to a reduction of $367 in gains on the sale of mortgage loans to the secondary market which peaked during the third quarter of 2003. Also, the Company experienced reduced fee income of $25 from income on sold mortgages serviced for others. Other expenses decreased slightly by $36 to $5,386 compared to $5,422 from the year ago period. Applicable income taxes decreased $148 mainly due to increased tax-free income. For the nine months ended September 30, 2004, net income decreased $624 or 13.1% to $4,123 or $1.92 per share compared with the 2003 year to date period of $4,747 or $2.21 per share. Net interest income before provision for loan losses decreased $493 or 3.6% to $13,170 for the nine months ended September 30, 2004 from $13,663 for the same period of 2003. Provision for loan losses decreased to $135 in 2004 from $456 for the same period of 2003. Net interest income after provision for loan losses decreased $172 or 1.3% to $13,035 from $13,207 for the nine months ended September 30, 2003. Other income decreased $1,075 or 12.9% of which $1,036 is attributed to a reduction in gains on the sale of mortgage loans to the secondary market which peaked during the third quarter of 2003. Other expenses were relatively unchanged at $15,528 compared to $15,531 from the year ago period. Applicable income taxes decreased $620 mainly from increased tax-free income along with lower net income. 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. 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 after provision for loan losses increased $232 or 5.5% to $4,477 for the three months ended September 30, 2004 compared to $4,245 for the three months ended September 30, 2003. Earning assets increased 19 basis points, largely due to the increases in investments and loans, along with lower interest expense on time deposits and long-term borrowings. Offsetting this increase was an increase in the provision for loan losses from $1 in 2003 to $114 in 2004. The net interest margin represents the Company's net yield on its earning assets and is calculated as net interest income divided by average earning assets. In the three months ended September 30, 2004, net interest margin was 3.28% increasing 35 basis points from 2.93% in the same period of 2003. Total average earning assets and average interest bearing funds decreased in the three months ended September 30, 2004 as compared to 2003. Average earning assets decreased $19.3 million or 3.3%, from $579.7 million in 2003 to $560.4 million in 2004 and average interest bearing funds decreased $22.9 million, or 5.0%, from $459.4 million to $436.5 million for the same period, mainly due to a reduction of time deposits from September 2003. As a percentage of average assets, earning assets increased to 96.3% for the three months ended September 30, 2004 from 96.0% for the year ago period. Changes in the mix of both earning assets and funding sources also impacted net interest income in the three months ended September 30, 2004 and 2003. Average loans as a percentage of average earning assets increased from 42.8% in 2003 to 46.0% in 2004, due largely to the increase in commercial and real estate loans. Average investments increased $37.6 million from 44.1% to 52.3% of average assets but at lower yields than 2003. Average short-term investments, federal funds sold and interest bearing balances with banks, decreased $66.6 million to $9.3 from $75.9 and also decreased as a percentage of average earning assets from 13.1% in 2003 to 1.7% in 2004 as the Company invested in tax-free securities. Average time deposits decreased $19.0 million or 13.7% from 30.1% of interest bearing liabilities in 2003 to 27.4% in 2004. Average long-term borrowings decreased $8.9. 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 25 basis points from 4.93% in the three months ended September 30, 2003 to 4.68% for 2004. Also, average loan yields decreased 10 basis points, from 5.48% in the three months ended September 30, 2003 to 5.38% in 2004. The average time deposit costs decreased 28 basis points from 2.56% in 2003 to 2.28% in 2004; however money market accounts increased 4 basis points from .74% in 2003 to .78% in 2004. The most significant change in net interest income has been from increases in our loan portfolio along with increased tax-free income from the investment portfolio. In 2003, the Company purchased a FHLMC (Freddie Mac) pool of new twenty year residential mortgages, with a 5 1/2% coupon and a face value of $100 million. The Company financed the purchase by borrowing $100 million from the Federal Home Loan Bank with maturities ranging from 5 to 20 years. The interest spread will vary depending on various interest rate scenarios which affect prepayment speeds. 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, 2004 and September 30, 2003. - ---------------------------------------------------------------------------------------------------------- September 30, 2004 September 30, 2003 ASSETS Average Revenue/ Yield/ Average Revenue/ Yield/ Balance Expense Rate Balance Expense Rate - ---------------------------------------------------------------------------------------------------------- Investment Securities Available-for-sale: U.S. Treasury securities $ 5,200 $ 86 6.62% $ 31,034 $ 326 4.20% U.S. Agency obligations 134,351 1,094 3.26% 72,719 871 4.79% States & political subdivisions 47,062 538 6.93% 20,994 265 7.65% Federal Home Loan Bank stock 5,894 19 1.29% 6,113 31 2.03% Other 567 2 1.41% 448 2 1.79% Held-to-maturity: U.S. Agency obligations 70,867 796 4.49% 94,711 944 3.99% States & political subdivisions 29,248 409 8.47% 29,540 380 7.79% Loans, net of unearned income: Real estate mortgages 187,013 2,571 5.50% 183,014 2,554 5.58% Commercial 37,090 465 5.01% 30,660 394 5.14% Consumer and other 33,826 432 5.11% 34,607 453 5.24% Federal funds sold 3,519 14 1.59% 62,615 147 0.94% Interest on balances with banks 5,787 16 1.11% 13,236 28 0.85% - ---------------------------------------------------------------------------------------------------------- Total Earning Assets/Total Interest Income 560,424 $ 6,442 4.60% 579,691 $ 6,395 4.41% - ---------------------------------------------------------------------------------------------------------- Cash and due from banks 8,816 9,053 Bank premises and equipment 9,502 10,214 Accrued interest receivable 3,391 3,014 Other assets 3,309 5,324 Less: Allowance for loan losses 3,498 3,504 - ---------------------------------------------------------------------------------------------------------- Total Assets $ 581,944 $ 603,792 - ---------------------------------------------------------------------------------------------------------- LIABILITIES AND STOCKHOLDERS' EQUITY Deposits: Demand-Interest bearing $ 32,484 $ 26 0.32% $ 29,581 $ 24 0.32% Savings 82,997 73 0.35% 77,896 97 0.50% Money markets 89,365 174 0.78% 92,805 172 0.74% Time - Over $100 27,886 164 2.35% 32,605 202 2.48% Time - Other 91,478 517 2.26% 105,774 682 2.58% Federal funds purchased - - - - - - Repurchase agreements 23,876 44 0.74% 23,518 43 0.73% Short-term borrowings 525 2 1.52% 444 1 0.90% Long-term borrowings 87,851 851 3.87% 96,754 928 3.84% - ---------------------------------------------------------------------------------------------------------- Total Interest Bearing Liabilities/ Total Interest Expense 436,462 $ 1,851 1.70% 459,377 $ 2,149 1.87% - ---------------------------------------------------------------------------------------------------------- Demand - Non-interest bearing 85,225 80,405 All other liabilities 349 2,739 Stockholders' equity 59,908 61,271 - ---------------------------------------------------------------------------------------------------------- Total Liabilities and Stockholders' Equity $ 581,944 $ 603,792 - ---------------------------------------------------------------------------------------------------------- Interest Spread 2.90% 2.54% - ---------------------------------------------------------------------------------------------------------- Net Interest Income $ 4,591 $ 4,246 - ---------------------------------------------------------------------------------------------------------- FINANCIAL RATIOS Net interest margin 3.28% 2.93% Return on average assets 1.11% 1.06% Return on average equity 10.78% 10.46% Average equity to average assets 10.29% 10.15% Dividend payout ratio 38.87% 40.13% - ---------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses decreased $172 or 1.3% to $13,035 for the nine months ended September 30, 2004 compared to $13,207 for the nine months ended September 30, 2003. Earning assets repriced downward 42 basis points, largely due to the reduction in our average loan portfolio for the nine months of 2004 versus 2003, due to the refinancing of residential portfolio mortgage loans with lower fixed-rate obligations, which then were sold to the secondary market and peaked during the third quarter of 2003. Offsetting this decrease was increased securities portfolio income and a reduction in the provision for loan losses from $456 in 2003 to $135 in 2004. The net interest margin represents the Company's net yield on its earning assets and is calculated as net interest income divided by average earning assets. In the nine months of 2004, net interest margin was 3.12% decreasing 25 basis points from 3.37% in the same period of 2003. Total average earning assets and average interest bearing funds increased in the nine months ended September 30, 2004 as compared to 2003. Average earning assets increased $21.7 million or 4.0%, from $540.9 million in 2003 to $562.6 million in 2004 and average interest bearing funds increased $13.4 million, or 3.2%, from $425.1 million to $438.5 million for the same period. As a percentage of average assets, earning assets increased to 96.4% for the nine months ended September 30 of 2004 from 95.9% for the year ago period. Changes in the mix of both earning assets and funding sources also impacted net interest income in the nine months ended September 30, 2004 and 2003. Average loans as a percentage of average earning assets decreased from 49.8% in 2003 to 44.6% in 2004, due in part to the sale of all new and refinanced fixed rate mortgages in the secondary market, which peaked during the third quarter of 2003; also, the increase in total assets caused by the leveraged transaction noted below during 2003; average investments increased $66.9 million from 42.5% to 52.8%. Average short-term investments, federal funds sold and interest bearing balances with banks decreased $26.4 million to $15.0 from $41.4 and also decreased as a percentage of average earning assets from 7.7% in 2003 to 2.7% in 2004 as the Company invested in tax-free securities. Average time deposits decreased $17.2 million or 12.2% from 33.1% of interest bearing liabilities in 2003 to 28.2% in 2004. However, average short-term borrowings, long-term borrowings and repurchase agreements increased $20.5 from 21.7% in 2003 to 25.7% in 2004, as a percentage of funding sources, principally related to the leveraged transaction described below. 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 63 basis points from 5.26% for the nine months ended September 30, 2003 to 4.63% for 2004. Also, average loan yields decreased 44 basis points, from 5.66% for the nine months ended September 30, 2003 to 5.22% in 2004. The average time deposit costs decreased 47 basis points from 2.75% in 2003 to 2.28% in 2004, along with money market accounts decreasing 15 basis points from ..88% in 2003 to .73% in 2004. These reductions are offset by the interest on new fixed-rate, long-term borrowings. The most significant change in net interest income has been the reduction in our loan portfolio during 2003 due to the refinancing of higher rate, long-term, fixed-rate real estate loans, which were sold to the secondary market. A gain on the sale of mortgage loans partially offset the decline in net interest income, during 2003. During 2004 net loans increased to $260 from $237, an increase of $23 or 9.7% In 2003, the Company purchased a FHLMC (Freddie Mac) pool of new twenty year residential mortgages, with a 5 1/2% coupon and a face value of $100 million. The Company financed the purchase by borrowing $100 million from the Federal Home Loan Bank with maturities ranging from 5 to 20 years. The interest spread will vary depending on various interest rate scenarios which affect prepayment speeds. 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, 2004 and September 30, 2003. - ---------------------------------------------------------------------------------------------------------- September 30, 2004 September 30, 2003 ASSETS Average Revenue/ Yield/ Average Revenue/ Yield/ Balance Expense Rate Balance Expense Rate - ---------------------------------------------------------------------------------------------------------- Investment Securities Available-for-sale: U.S. Treasury securities $ 6,575 $ 285 5.78% $ 32,900 $ 1,013 4.11% U.S. Agency obligations 135,161 3,322 3.28% 70,231 2,650 5.03% States & political subdivisions 43,127 1,470 6.89% 20,358 705 7.00% Federal Home Loan Bank stock 5,714 62 1.45% 4,550 80 2.34% Other 537 10 2.48% 414 8 2.58% Held-to-maturity: U.S. Agency obligations 76,519 2,581 4.50% 71,674 2,399 4.46% States & political subdivisions 29,294 1,205 8.31% 29,840 1,222 8.27% Loans, net of unearned income: Real estate mortgages 181,477 7,228 5.31% 200,403 8,832 5.88% Commercial 35,041 1,274 4.85% 31,367 1,150 4.89% Consumer and other 34,214 1,314 5.12% 37,803 1,461 5.15% Federal funds sold 7,161 57 1.06% 31,812 236 0.99% Interest on balances with banks 7,790 53 0.91% 9,550 68 0.95% - ---------------------------------------------------------------------------------------------------------- Total Earning Assets/Total Interest Income 562,610 $ 18,861 4.47% 540,902 $ 19,824 4.89% - ---------------------------------------------------------------------------------------------------------- Cash and due from banks 8,576 8,473 Bank premises and equipment 9,683 9,965 Accrued interest receivable 3,172 3,177 Other assets 3,165 4,902 Less: Allowance for loan losses 3,498 3,383 - ---------------------------------------------------------------------------------------------------------- Total Assets $ 583,708 $ 564,036 - ---------------------------------------------------------------------------------------------------------- LIABILITIES AND STOCKHOLDERS' EQUITY Deposits: Demand-Interest bearing $ 31,312 $ 76 0.32% $ 28,298 $ 109 0.51% Savings 81,928 274 0.45% 76,124 372 0.65% Money markets 89,071 490 0.73% 87,784 579 0.88% Time - Over $100 28,936 501 2.31% 33,150 676 2.72% Time - Other 94,605 1,613 2.27% 107,523 2,226 2.76% Federal funds purchased - - - - - - Repurchase agreements 22,144 121 0.73% 21,031 134 0.85% Short-term borrowings 476 4 1.12% 820 10 1.63% Long-term borrowings 90,072 2,612 3.87% 70,348 2,055 3.89% - ---------------------------------------------------------------------------------------------------------- Total Interest Bearing Liabilities/ Total Interest Expense 438,544 $ 5,691 1.73% 425,078 $ 6,161 1.93% - ---------------------------------------------------------------------------------------------------------- Demand - Non-interest bearing 82,517 75,829 All other liabilities 1,580 2,849 Stockholders' equity 61,067 60,280 - ---------------------------------------------------------------------------------------------------------- Total Liabilities and Stockholders' Equity $ 583,708 $ 564,036 - ---------------------------------------------------------------------------------------------------------- Interest Spread 2.74% 2.96% - ---------------------------------------------------------------------------------------------------------- Net Interest Income $ 13,170 $ 13,663 - ---------------------------------------------------------------------------------------------------------- FINANCIAL RATIOS Net interest margin 3.12% 3.37% Return on average assets 0.94% 1.12% Return on average equity 9.00% 10.50% Average equity to average assets 10.46% 10.69% Dividend payout ratio 46.88% 40.68% - ---------------------------------------------------------------------------------------------------------- Investments The Company's investment portfolio consists primarily of two functions: One to provide liquidity and two 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. 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 determined based on management's estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates. 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. During 2003, the Company experienced accelerated pre-payments of its fixed-rate mortgage-backed securities portfolio, due to the historically low-rate interest environment. Additionally, amortization of the bond premium was also accelerated relative to the increased pre-payments of principal on the mortgage-backed securities, which impacted earnings on a negative basis. The proceeds of the pre-payments have been reinvested in long-term municipal securities at tax equivalent yields higher than the Company was receiving on the mortgage-backed securities. 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 the economy shows strength and improves, migration of some deposits may return to the equity markets as consumers become more prone to 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 the 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. Accordingly, there can be no assurance that existing levels of the allowance will ultimately prove adequate to cover actual loan losses. 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. For the three months ended September 30, 2004, the provision for loan losses increased to $114 from $1 in the three months ended September 30, 2003. Loans charged off totaled $15 and recoveries were $1 for the three months ended September 30, 2004. In the same period of 2003, loans charged off were $29 and recoveries were $28. In the nine months ended September 30, 2004, the provision for loan losses was $135, a decrease from $456 in the nine months ended September 30, 2003. Loans charged-off totaled $43 and recoveries of $8 for the nine months ended September 30, 2004. In the same period of 2003 loans charged off were $334, offset by recoveries of $31. At September 30, 2004 the allowance for loan losses was set at $3,600 or 1.36% of loans based upon the bank's analysis methodology as an act of prudence by management. Other Income The following table sets forth information by category of other income for the Company for three months ended September 30, 2004 and September 30, 2003, respectively: September 30, September 30, Three Months Ended: 2004 2003 - ------------------------------------------------------------------------ Trust department income $ 372 $ 345 Service charges on deposit accounts 271 283 Merchant transaction income 1,698 1,729 Other fee income 289 328 Other operating income 200 549 Realized gains (losses) on securities, net - - - ------------------------------------------------------------------------ Total Other Income $ 2,830 $ 3,234 - ------------------------------------------------------------------------ Other income decreased $404 or 12.5% to $2,830 for the three months ended September 30, 2004 compared with $3,234 for the similar period of 2003. Trust income increased $27 or 7.8% largely due to new business. Other fee income decreased $39 or 11.9% mainly from reduced income from mortgage loans serviced for others. Other operating income decreased $349 or 63.6%, primarily due to a reduction in gains on the sale of loans in the secondary market of $367, which peaked during the third quarter of 2003, offset by increased brokerage income of $22 largely due to new business. The following table sets forth information by category of other income for the Company for nine months ended September 30, 2004 and September 30, 2003, respectively: September 30, September 30, Nine Months Ended: 2004 2003 - ------------------------------------------------------------------------ Trust department income $ 1,014 $ 981 Service charges on deposit accounts 810 848 Merchant transaction income 4,097 4,141 Other fee income 848 923 Other operating income 481 1,432 Realized gains (losses) on securities, net - - - ------------------------------------------------------------------------ Total Other Income $ 7,250 $ 8,325 - ------------------------------------------------------------------------ Other income decreased $1,075 or 12.9% to $7,250 for the nine months ended September 30, 2004 from $8,325 for the same period of 2003. Trust income increased $33 or 3.4%. Other fee income decreased $75 or 8.8% mainly due to reduced cardholder discounts and income from sold mortgages serviced for others. Other operating income decreased $951 or 66.4%, primarily due to a reduction in gains on the sale of loans in the secondary market of $1,036, which peaked during the third quarter of 2003, offset by increased brokerage income of $83 or 26.1% largely due to new business. Other Expenses The following table sets forth information by category of other expenses for the Company for the three months ended September 30, 2004 and September 30, 2003, respectively: September 30, September 30, Three Months Ended: 2004 2003 - ------------------------------------------------------------------------ Salaries and employee benefits $ 2,235 $ 2,219 Expense of premises and fixed assets 556 607 Merchant transaction expenses 1,344 1,378 Other operating expenses 1,251 1,218 - ------------------------------------------------------------------------ Total Other Expenses $ 5,386 $ 5,422 - ------------------------------------------------------------------------ Total other expenses decreased $36 to $5,386 in the three months ended September 30, 2004 compared with $5,422 for the same period of 2003. Applicable income taxes decreased $148 due to increased tax-free income. The following table sets forth information by category of other expenses for the Company for the nine months ended September 30, 2004 and September 30, 2003, respectively: September 30, September 30, Nine Months Ended: 2004 2003 - ------------------------------------------------------------------------ Salaries and employee benefits $ 6,792 $ 6,619 Expense of premises and fixed assets 1,837 1,929 Merchant transaction expenses 3,281 3,437 Other operating expenses 3,618 3,546 - ------------------------------------------------------------------------ Total Other Expenses $ 15,528 $ 15,531 - ------------------------------------------------------------------------ Total other expenses decreased $3 to $15,528 during the nine months ended September 30, 2004 compared with $15,531 for the same period of 2003. Salaries and employment benefits expense increased $173 or 2.6%, mainly from increases in salaries of $100, employee hospitalization of $35 and employee education costs of $25, offset by decreased merchant transaction expense of $156 or 4.5%. Applicable income taxes decreased $620 mainly due to increased tax-free income along with lower net income. Loan Portfolio Details regarding the Company's loan portfolio: September 30, December 31, As Of: 2004 2003 - -------------------------------------------------------------------------------- Real estate - construction and land development $ 5,737 $ 3,078 Real estate mortgages 187,217 172,964 Commercial 37,137 30,056 Credit card and related plans 2,451 2,403 Installment 25,459 25,855 Obligations of states & political subdivisions 5,979 6,026 - -------------------------------------------------------------------------------- Loans, net of unearned income 263,980 240,382 Less: Allowance for loan losses 3,600 3,500 - -------------------------------------------------------------------------------- Loans, net $ 260,380 $ 236,882 - -------------------------------------------------------------------------------- Loan Quality The comprehensive lending policy established by the Board of Directors guides the lending activities of the Company. 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. 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 is adequate. 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 Non-performing assets consist of non-accrual loans, loans past due 90 days or more and still accruing interest and other real estate owned. The following table sets forth information regarding non-performing assets as of the dates indicated: September 30, December 31, September 30, As Of: 2004 2003 2003 - ---------------------------------------------------------------------------------------------- Non-accrual loans $ 2,253 $ 1,533 $ 2,192 Loans past due 90 days or more and accruing: Guaranteed student loans 245 169 227 Credit card and home equity loans 2 3 24 - ---------------------------------------------------------------------------------------------- Total non-performing loans 2,500 1,705 2,443 Other real estate owned 44 121 278 - ---------------------------------------------------------------------------------------------- Total non-performing assets $ 2,544 $ 1,826 $ 2,721 - ---------------------------------------------------------------------------------------------- Loans are generally placed on a non-accrual status when principal or interest is past due 90 days or 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 principal is probable. Loans on which the accrual of interest has been discontinued or reduced amounted to $2,253 and $2,192 at September 30, 2004 and September 30, 2003, respectively. If interest on those loans had been accrued, such income would have been $265 and $195 for the nine months ended September 30, 2004 and September 30, 2003, respectively. Interest income on those loans, which is recorded only when received, amounted to $27 and $34 for September 30, 2004 and September 30, 2003, respectively. There are no commitments to lend additional funds to individuals whose loans are in non-accrual status. The management 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 quality, and current economic conditions that may affect the borrower's ability to pay. As of September 30, 2004 there are no significant loans as to which management has serious doubt about their collectibility other than what is included above. At September 30, 2004 and December 31, 2003, the Company did not have any loans specifically classified as impaired. 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. Loan Loss Experience The following tables present the Company's loan loss experience during the periods indicated: September 30, September 30, Three Months Ended: 2004 2003 - -------------------------------------------------------------------------- Balance at beginning of period $ 3,500 $ 3,500 Charge-offs: Real estate mortgages - - Commercial and all others - 13 Credit card and related plans 10 15 Installment loans 5 1 - -------------------------------------------------------------------------- Total charge-offs 15 29 - -------------------------------------------------------------------------- Recoveries: Real estate mortgages - 24 Commercial and all others - - Credit card and related plans - - Installment loans 1 4 - -------------------------------------------------------------------------- Total recoveries 1 28 - -------------------------------------------------------------------------- Net charge-offs (recoveries) 14 1 - -------------------------------------------------------------------------- Provision charged to operations 114 1 - -------------------------------------------------------------------------- Balance at End of Period $ 3,600 $ 3,500 - -------------------------------------------------------------------------- Ratio of net charge-offs (recoveries) to average loans outstanding 0.005% 0.001% - -------------------------------------------------------------------------- September 30, September 30, Nine Months Ended: 2004 2003 - -------------------------------------------------------------------------- Balance at beginning of period $ 3,500 $ 3,347 Charge-offs: Real estate mortgages - 6 Commercial and all others 12 289 Credit card and related plans 23 35 Installment loans 8 4 - -------------------------------------------------------------------------- Total charge-offs 43 334 - -------------------------------------------------------------------------- Recoveries: Real estate mortgages 3 24 Commercial and all others - - Credit card and related plans 2 2 Installment loans 3 5 - -------------------------------------------------------------------------- Total recoveries 8 31 - -------------------------------------------------------------------------- Net charge-offs (recoveries) 35 303 - -------------------------------------------------------------------------- Provision charged to operations 135 456 - -------------------------------------------------------------------------- Balance at End of Period $ 3,600 $ 3,500 - -------------------------------------------------------------------------- Ratio of net charge-offs (recoveries) to average loans outstanding 0.014% 0.112% - -------------------------------------------------------------------------- Due to the continuing economic uncertainties, management believes the allowance for loan losses is considered adequate based on its methodology. The allowance for loan losses, as a percentage of total loans, stands at 1.36% at September 30, 2004 and 1.45% at September 30, 2003. The allowance for loan losses is allocated as follows: As Of: September 30, 2004 December 31, 2003 September 30, 2003 - ----------------------------------------------------------------------------------------------- Amount %* Amount %* Amount %* - ----------------------------------------------------------------------------------------------- Real estate mortgages $ 1,100 73% $ 1,100 73% $ 1,400 73% Commercial and all others 2,070 16% 1,970 15% 1,575 15% Credit card and related plans 180 1% 180 1% 175 1% Personal installment loans 250 10% 250 11% 350 11% - ----------------------------------------------------------------------------------------------- Total $ 3,600 100% $ 3,500 100% $ 3,500 100% - ----------------------------------------------------------------------------------------------- * 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. Treasury and 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. The Company is not a party to any commitments, guarantees or obligations that could materially affect its liquidity. The Company offers collateralized repurchase agreements that 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. The Company continues to have $180,530 of available borrowing capacity with the FHLB. 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. 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. The Bank has issued standby letters of credit for the account of a related party in the amount of $6,853. 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 common stock. Management has no plans to offer additional common stock at this time. The Company's total risk-based capital ratio was 19.95% at September 30, 2004. The Company's risk-based capital ratio is more than the 10.00% ratio that Federal regulators use as the "well capitalized" threshold. 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% limit, which determines whether a company is "adequately capitalized". Under these rules, the Company could significantly increase its assets and still comply with these capital requirements without the necessity of increasing its equity capital. Sarbanes-Oxley Act of 2002 The Sarbanes-Oxley Act, enacted in July of 2002, continues to impact the Company. A recalculation of our public float as of June 30, 2003 and 2004 determined that the Company is not subject to the accelerated filing deadlines of the Securities and Exchange Commission (SEC) which reduced the number of days accelerated filers have to issue the 2004 Annual Report (Form 10-K) from 75 to 60 days. Similarly, for accelerated filers, the quarterly reports for 2004 have to be filed within 40 days of the end of each quarter from 45 days in prior years. In 2005, accelerated filers will lose another 5 days and quarterly reports will need to be filed within 35 days of the end of each quarter. Although not subject to the accelerated filing dates we do intend to file our quarterly reports this year within 40 days of the end of each quarter. Section 404 of the Act requires that, for the Company, commencing with the Annual Report for year 2005, which must be filed with the SEC by March 1, 2006, and for each year thereafter, the report must include an internal control report that contains management's assertions regarding the effectiveness of the Company's internal control structure and procedures over financial reporting. The Company's auditors must also provide an opinion about whether management's assessment of the effectiveness of its internal control over financial reporting is fairly stated in all material respects. This provision will require management to document each type of transaction that occurs in the Company, the risks involved in the transaction, the internal controls established to mitigate such risks, information and communication of the results and finally a monitoring of the controls. Affecting all of this is the control environment within the Company. All of this must be accomplished by December 31, 2005, and due to this, management is already spending an enormous amount of time documenting the internal control processes within the Company. PART 1. FINANCIAL INFORMATION, Item 3 -- QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk is the risk of loss from adverse changes in market prices and rates. The Company's market risk arises principally from interest rate risk inherent in its lending, deposit and borrowing activities. Management actively monitors and manages its interest rate risk exposure. Although the Company manages other risks, such as credit quality and liquidity risk in the normal course of business, management considers interest rate risk to be its most significant market risk and the risk that could potentially have the largest material effect on the Company's financial condition and results of operations. Other types of market risks such as foreign currency exchange risk and commodity price risk do not arise in the normal course of community banking activities. Achieving consistent growth in net interest income is the primary goal of the Company's asset/liability function. The Company attempts to control the mix and maturities of assets and liabilities to achieve consistent growth in net interest income despite changes in market interest rates. The Company seeks to accomplish this goal while maintaining adequate liquidity and capital. A continuation of historically low interest rates will most likely affect negatively the Company's net interest income. The Company continues to evaluate its mix of assets and liabilities in response to the changing economy. PART 1. FINANCIAL INFORMATION, Item 4 -- CONTROLS AND PROCEDURES Based on the evaluations by the Company's principal executive officer, Otto P. Robinson, Jr., President and the Company's principal financial officer, Patrick Scanlon, Controller, of the Company's Disclosure Controls and Procedures as of September 30, 2004, they have concluded that the Company's disclosure controls are effective, reasonably ensure that material information relating to the Company and its consolidated subsidiaries is made known to them by others within those entities, particularly during the period in which this report is being prepared, and identify significant deficiencies or material weaknesses in internal controls which could adversely affect the Company's ability to record, process, summarize and report financial data. Based on information available to them, they are not aware of significant deficiencies or material weaknesses in the Company's internal control system. Based on information available to them, they are not aware of any changes made in internal controls or in other factors during the reporting period that could materially affect or is reasonably likely to materially affect the Company's internal controls over financial reporting. Based on information available to them, they are not aware of any fraud that involves management or other employees of the Company. Despite these and other controls and procedures, the Company's two hundred or so employees process over 10 million financial transactions every year. The Company's computer systems consist of some 17 million lines of code used in the processing of this financial information. Financial accounting rules encompass thousands of pages of instructions and contain many confusing and "gray" areas. From time to time honest errors in the entry, processing, or reporting of this information are discovered or a dishonest or disloyal employee surfaces. Fortunately, in the past any such errors or discoveries have not been material and therefore we have never had to restate the Company's financial results. The probability is that we won't in the future, but the possibility does exist and the certifications marked as exhibits 31 and 32 are made subject to these contingencies. PART II. OTHER INFORMATION Item 1 -- Legal Proceedings None. Item 2 -- Changes in 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 and Reports on Form 8-K a. Exhibits 31 Certifications required under Section 302 of the Sarbanes-Oxley Act of 2002 32 Certifications required under Section 906 of the Sarbanes-Oxley Act of 2002 b. Reports on Form 8-K An 8-K was filed on August 18, 2004, reporting the impending retirement of the Company's President Otto P. Robinson, Jr. 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/ RICHARD E. GRIMM ------------------------------ Richard E. Grimm Executive Vice-President Dated: October 29, 2004 By /s/ PATRICK SCANLON ------------------------------ Patrick Scanlon Controller Dated: October 29, 2004