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ACNB > SEC Filings for ACNB > Form 10-Q on 4-Nov-2011All Recent SEC Filings

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Form 10-Q for ACNB CORP


4-Nov-2011

Quarterly Report


ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

INTRODUCTION AND FORWARD-LOOKING STATEMENTS

Introduction

The following is management's discussion and analysis of the significant changes in the financial condition, results of operations, capital resources, and liquidity presented in its accompanying consolidated financial statements for ACNB Corporation (the Corporation or ACNB), a financial holding company. Please read this discussion in conjunction with the consolidated financial statements and disclosures included herein. Current performance does not guarantee, assure or indicate similar performance in the future.

Forward-Looking Statements

In addition to historical information, this Form 10-Q contains forward-looking statements. Examples of forward-looking statements include, but are not limited to, (a) projections or statements regarding future earnings, expenses, net interest income, other income, earnings or loss per share, asset mix and quality, growth prospects, capital structure, and other financial terms,
(b) statements of plans and objectives of management or the Board of Directors, and (c) statements of assumptions, such as economic conditions in the Corporation's market areas. Such forward-looking statements can be identified by the use of forward-looking terminology such as "believes", "expects", "may", "intends", "will", "should", "anticipates", or the negative of any of the foregoing or other variations thereon or comparable terminology, or by discussion of strategy. Forward-looking statements are subject to certain risks and uncertainties such as local economic conditions, competitive factors, and regulatory limitations. Actual results may differ materially from those projected in the forward-looking statements. Such risks, uncertainties and other factors that could cause actual results and experience to differ from those projected include, but are not limited to, the following: the effects of the new laws and regulations, specifically the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act; ineffectiveness of the business strategy due to changes in current or future market conditions; the effects and expenses related to the charter conversion of our subsidiary bank from a federal to a state charter; the effects of economic deterioration on current customers, specifically the effect of the economy on loan customers' ability to repay loans; the effects of competition, and of changes in laws and regulations on competition, including industry consolidation and development of competing financial products and services; interest rate movements; the inability to achieve merger-related synergies; difficulties in integrating distinct business operations, including information technology difficulties; disruption from the transaction making it more difficult to maintain relationships with customers and employees, and challenges in establishing and maintaining operations in new markets; volatilities in the securities markets; and, deteriorating economic conditions. We caution readers not to place undue reliance on these forward-looking statements. They only reflect management's analysis as of this date. The Corporation does not revise or update these forward-looking statements to reflect events or changed circumstances. Please carefully review the risk factors described in other documents the Corporation files from time to time with the Securities and Exchange Commission, including the Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and any Current Reports on Form 8-K.

CRITICAL ACCOUNTING POLICIES

The accounting policies that the Corporation's management deems to be most important to the portrayal of its financial condition and results of operations, and that require management's most difficult, subjective or complex judgment, often result in the need to make estimates about the effect of such matters which are inherently uncertain. The following policies are deemed to be critical accounting policies by management:

The allowance for loan losses represents management's estimate of probable losses inherent in the loan portfolio. Management makes numerous assumptions, estimates and adjustments in determining an adequate allowance. The Corporation assesses the level of potential loss associated with its loan portfolio and provides for that exposure through an allowance for loan losses. The allowance is established through a provision for loan losses charged to earnings. The allowance is an estimate of the losses inherent in the loan portfolio as of the end of each reporting period. The Corporation assesses the adequacy of its allowance on a quarterly basis.


The specific methodologies applied on a consistent basis are discussed in greater detail under the caption, Allowance for Loan Losses, in a subsequent section of this Management's Discussion and Analysis of Financial Condition and Results of Operations.

The evaluation of securities for other-than-temporary impairment requires a significant amount of judgment. In estimating other-than-temporary impairment losses, management considers various factors including the length of time the fair value has been below cost, the financial condition of the issuer, and the Corporation's intent to sell, or requirement to sell, the securities before recovery of their value. Declines in fair value that are determined to be other than temporary are charged against earnings.

Accounting Standard Codification (ASC) Topic 350, Intangibles - Goodwill and Other, requires that goodwill is not amortized to expense, but rather that it be tested for impairment at least annually. Impairment write-downs are charged to results of operations in the period in which the impairment is determined. The Corporation did not identify any impairment of its recorded goodwill from its most recent testing, which was performed as of December 31, 2010. If certain events occur which might indicate goodwill has been impaired, the goodwill is tested for impairment when such events occur. The Corporation has not identified any such events and, accordingly, has not tested goodwill for impairment during the nine months ended September 30, 2011. Other acquired intangible assets with finite lives, such as customer lists, are required to be amortized over the estimated lives. These intangibles are generally amortized using the straight line method over estimated useful lives of ten years.

RESULTS OF OPERATIONS

Quarter ended September 30, 2011, compared to quarter ended September 30, 2010

Executive Summary

Net income for the three months ended September 30, 2011, was $2,180,000 compared to $2,304,000 for the same quarter in 2010, a decrease of $124,000 or 5%. Earnings per share was $0.37 in 2011 and $0.39 in 2010. Net interest income decreased $154,000 or 2%. Provision for loan losses decreased $200,000 or 14%; other income decreased $34,000 or 1%; and, other expenses increased $200,000 or 3%.

Net Interest Income

Net interest income totaled $8,558,000 for the quarter ended September 30, 2011, compared to $8,712,000 for the same period in 2010, a decrease of $154,000 or 2%. Net interest income decreased due to a decrease in interest income to a greater degree than the decrease in interest expense, both resulting from reductions in market rates associated with the continued low rates maintained by the Federal Reserve Bank. Interest income decreased $679,000 or 6% due to declines in the Federal Funds Target Rate and other market driver rates. These driver rates are indexed to a portion of the loan portfolio in that a decrease in the driver rates decreases the yield on the loans at subsequent interest rate reset dates. In this manner, interest income will continue to decrease as new loans replace paydowns on existing loans and variable rate loans reset to new lower rates. In addition, interest income was lower as a result of investment securities paydowns that were reinvested at much lower market rates resulting from Federal Reserve Bank buying activities or were left in short-term, low-rate money market type accounts (depending on the interest rate risk and liquidity tolerances set according to the mix of deposit funding sources). Likewise, alternative funding sources, such as the Federal Home Loan Bank (FHLB), and other market driver rates are factors in rates the Corporation and the local market pay for deposits. However, during the third quarter of 2011, several of the core deposit rates continued at practical floors after the Federal Open Market Committee decreased the Federal Funds Target Rate by 400 basis points during 2008 and maintained it at 0% to 0.25% since that time. Interest expense decreased $525,000 or 22%. For more information about interest rate risk, please refer to Item 7A - Quantitative and Qualitative Disclosures about Market Risk in the Annual Report on Form 10-K dated December 31, 2010, and filed with the SEC on March 11, 2011. Over the longer term, the Corporation continues its strategic direction to increase asset yield and interest income by means of loan growth and rebalancing the composition of earning assets.

The net interest spread for the third quarter of 2011 was 3.46% compared to 3.68% during the same period in 2010. Also comparing the third quarter of 2011 to 2010, the yield on interest earning assets decreased by 0.49% and the cost of interest bearing liabilities decreased by 0.27%. The net interest margin was 3.62% for the third quarter of 2011 and 3.85% for the third quarter of 2010.


The net interest margin decline was mainly a result of the rate of decline in the yield on assets decreasing to a greater degree than the decline in funding rates due to low rates on deposits as described above.

Average earning assets were $940,961,000 during the third quarter of 2011, an increase of $38,259,000 from the average for the third quarter of 2010. Average interest bearing liabilities were $784,260,000 in the third quarter of 2011, an increase of $7,929,000 from the same quarter in 2010.

Provision for Loan Losses

The provision for loan losses was $1,200,000 in the third quarter of 2011 compared to $1,400,000 in the third quarter of 2010, a decrease of $200,000 or 14%. The decrease was a result of analysis of the adequacy of the allowance for loan losses. Each quarter, the Corporation measures risk in the loan portfolio compared with the balance in the allowance for loan losses and the current evaluation factors. For more information, please refer to Allowance for Loan Losses in the subsequent Financial Condition section. ACNB charges confirmed loan losses to the allowance and credits the allowance for recoveries of previous loan charge-offs. For the third quarter of 2011, the Corporation had net charge-offs of $488,000, as compared to net charge-offs of $466,000 for the third quarter of 2010.

Other Income

Total other income was $2,882,000 for the three months ended September 30, 2011, down $34,000, or 1%, from the third quarter of 2010. Fees from deposit accounts increased by $3,000, or less than 1%, due to varying volume. Further, certain government regulations effective in 2010 limited service charge increases and make future revenue levels uncertain. Revenue from ATM and debit card transactions increased 11% to $319,000 due to higher volume. The increase resulted from consumer desire to use more electronic delivery channels; however, new government regulations could result in price controls on this activity in future periods, the effect of which cannot be currently quantified. Income from fiduciary activities, which include both institutional and personal trust management services, totaled $323,000 for the three months ended September 30, 2011, as compared to $350,000 during the third quarter of 2010, an 8% decrease as a result of lower average asset market values under management. Earnings on bank-owned life insurance decreased by $8,000, or 3%, as a result of variations in crediting rates. The Corporation's wholly-owned subsidiary, Russell Insurance Group, Inc. (RIG), saw revenue increase by $49,000 or 4%. The increase was due to timing on renewals, as revenue in the longer term is down in a "soft" insurance market and from the effects of the prolonged economic recession on business clients. Other income in the quarter ended September 30, 2011, was lower due to decreased fees related to sales of residential mortgages in 2011.

Impairment Testing

RIG has certain long-lived assets, including purchased intangible assets subject to amortization such as insurance books of business and associated goodwill assets, which are reviewed for impairment annually or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. Goodwill, that has an indefinite useful life, is evaluated for impairment annually and is evaluated for impairment more frequently if events and circumstances indicate that the asset might be impaired. That annual assessment date is December 31. An impairment loss is recognized to the extent that the carrying amount exceeds the asset's fair value. The goodwill impairment analysis is a two-step test. The first step, used to identify potential impairment, involves comparing each reporting unit's estimated fair value to its carrying value, including goodwill. If the estimated fair value of a reporting unit exceeds its carrying value, goodwill is considered not to be impaired. If the carrying value exceeds estimated fair value, there is an indication of potential impairment and the second step is performed to measure the amount of impairment. If required, the second step involves calculating an implied fair value of goodwill for the reporting unit for which the first step indicated potential impairment.


The implied fair value of goodwill is determined in a manner similar to the amount of goodwill calculated in a business combination, by measuring the excess of the estimated fair value of the reporting unit to a group of likely buyers whose cash flow estimates could differ from those of the reporting entity, as determined in the first step, over the aggregate estimated fair values of the individual assets, liabilities and identifiable intangibles as if the reporting unit was being acquired in a business combination. If the implied fair value of goodwill exceeds the carrying value of goodwill assigned to the reporting unit, there is no impairment. If the carrying value of goodwill assigned to a reporting unit exceeds the implied fair value of the goodwill, an impairment charge is recorded for the excess. Subsequent reversal of goodwill impairment losses is not permitted. ACNB performs an annual evaluation to determine if there is goodwill impairment. For the year ended December 31, 2010, compared to 2009, commissions from insurance sales decreased 10% and, as some agency expenses are fixed, RIG's stand-alone net income decreased by 39% in 2010 compared to 2009. Since the testing for potential impairment involves methods that include current and projected income amounts, the fair value declined at December 31, 2010, as compared to previous years' impairment testing results.

The results of the annual evaluations determined that there was no impairment of goodwill, including the testing at December 31, 2010. However, future declines in RIG's net income or changes in external market factors, including cash flow estimates of likely buyers that are assumed in impairment testing, may require an impairment charge to goodwill. A liability incurred for contingent consideration owed on previous purchases of additional insurance books of business could also unfavorably impact the fair value of RIG. Although it is probable that some liability for further contingent consideration will be incurred, it is considered remote that the maximum aggregate liability of $1,800,000 will be incurred on the measurement dates. The amount of the ultimate liability is not reasonably estimable at September 30, 2011, because of the uncertainties in retaining books of business in the current economic cycle. Should it be determined in a future period that the goodwill has been impaired, then a charge to earnings will be recorded in the period such determination is made.

Other Expenses

The largest component of other expenses is salaries and employee benefits, which increased by $17,000, or less than 1%, when comparing the third quarter of 2011 to the same quarter a year ago. Overall, the net increase in salaries and employee benefits was the result of:

Increases from normal promotion and production-based incentive/bonus compensation to employees,

An increase in the number of full-time equivalent employees,

Increased payroll taxes including higher unemployment tax assessments, and

Increased employee usage of medical insurance, 401(k) plan benefits, and unused paid time off accumulation; all of which were partially offset by

Decreased defined benefit pension expense resulting from a strong funded position in 2011. The Corporation reduced the benefit formula for the defined benefit pension plan effective January 1, 2010, in order to manage total benefit costs. The Corporation's overall investment strategy is to achieve a mix of investments to meet the long-term rate of return assumption and near-term pension obligations with a diversification of asset types, fund strategies, and fund managers. The mix of investments is adjusted periodically by retaining an advisory firm to recommend appropriate allocations after reviewing the Corporation's risk tolerance on contribution levels, funded status, plan expense, as well as any applicable regulatory requirements. However, the determination of upcoming benefit expense is also dependent on the fair value of assets and the discount rate on the year-end measurement date; specifically, with low discount rates and fair value volatility, the expense can be negatively impacted by conditions on that particular measurement date.

Net occupancy expense decreased $15,000, or 3%, in part due to lower specific repair work. A new office in Spring Grove, Pennsylvania, opened in August 2011, not significantly impacting the quarter's expenses. Equipment expense increased by $48,000, or 8%, as a result of equipment and software upgrades in order to keep electronic delivery channels reliable and secure.


Professional services expense totaled $267,000 during the third quarter of 2011, as compared to $247,000 for the same period in 2010, an increase of $20,000 or 8%. The increase was due to higher loan collection legal costs.

Marketing expense increased by $51,000, or 71%, in the third quarter of 2011. Higher marketing expense reflects higher current spending to promote the new Spring Grove office, as well as certain in-market consumer loans. In addition, the Corporation continued to advertise its products and services and to promote its brand via marketing and advertising initiatives.

FDIC expense for the third quarter of 2011 was $200,000, a decrease of $100,000 from the third quarter of 2010. The decrease was due in part to improved risk ratings and a revised computation method. Over the last several years, much higher expense was required of all FDIC-insured banks to restore the deposit insurance fund due to the cost of protecting depositors' accounts at failed banks during the severe recession. At the end of the third quarter of 2009, the FDIC announced a plan in which most banks prepaid an estimated three years of regular quarterly premiums at year-end 2009, as opposed to a special assessment similar to which was levied on all insured banks in the second quarter of 2009. The prepaid assessments did not immediately affect ACNB earnings. ACNB recorded its prepaid assessments as a prepaid expense (an asset) as of December 30, 2009, in the amount of $3,956,000, the date the payment was made. For the quarter ended December 31, 2009, and each quarter thereafter, each institution records an expense for its regular quarterly assessment and an offsetting credit to the prepaid expense until the asset is exhausted. Once the asset is exhausted, the institution will record an accrued expense payable each quarter for the assessment payment, which would be made to the FDIC at the end of the following quarter. Even though an estimated premium is prepaid under this plan, the actual expense will vary based on several factors and risk ratings.

Other tax expenses increased by $28,000, or 15%, due to a sales tax refund in the third quarter of 2010. Supplies and postage increased by $3,000, or 2%, due to timing on larger supply orders. Other operating expenses increased by $179,000, or 23%, in the third quarter of 2011, as compared to the third quarter of 2010. Primarily responsible for the increase were write-downs and other expenses on foreclosed assets held for resale.

Income Tax Expense

The Corporation recognized income taxes of $562,000, or 20.5% of pretax income, during the third quarter of 2011, as compared to $626,000, or 21.4% of pretax income, during the same period in 2010. The variances from the federal statutory rate of 34% in both periods are generally due to tax-exempt income and investments in low-income housing partnerships (which qualify for federal tax credits). The income tax provision during the third quarters ended September 30, 2011 and 2010, included low-income housing tax credits of $139,000 and $145,000, respectively.

Nine months ended September 30, 2011, compared to nine months ended September 30, 2010

Executive Summary

Net income for the nine months ended September 30, 2011, was $6,746,000 compared to $6,791,000 for the same period in 2010, a decrease of $45,000 or 1%. Earnings per share was $1.14 in 2011 and $1.15 in 2010. Net interest income decreased $774,000 or 3%; provision for loan losses decreased $1,000,000 or 22%; other income decreased $98,000 or 1%; and, other expenses increased $110,000 or less than 1%.

Net Interest Income

Net interest income totaled $25,716,000 for the nine months ended September 30, 2011, compared to $26,490,000 for the same period in 2010, a decrease of $774,000 or 3%. Net interest income decreased due to a decrease in interest income to a greater degree than the decrease in interest expense, both resulting from continued low rates maintained by the Federal Reserve Bank. Interest income decreased $2,526,000, or 8%, due to declines in the Federal Funds Target Rate and other market driver rates. These driver rates are indexed to a portion of the loan portfolio in that a decrease in the driver rates decreases the yield on the loans at subsequent interest rate reset dates. In this manner, interest income will continue to decrease as new loans replace paydowns on existing loans and variable rate loans reset to new lower rates. In addition, interest income was lower as a result of investment securities paydowns that were reinvested at much lower market rates resulting from Federal Reserve Bank buying activities, or were left in short-term, low-rate money market type accounts (depending on the interest rate risk and liquidity tolerances set according to the mix of deposit funding sources). Finally, interest income was lower in 2011 compared to 2010 due to a $605,000 (included in the $2,526,000 decrease above) interest recovery in 2010 on full payoff of a loan that was in nonaccrual status in prior years.


Likewise, alternative funding sources, such as the FHLB, and other market driver rates are factors in rates the Corporation and the local market pay for deposits. However, during 2011, several of the core deposit rates continued at practical floors after the Federal Open Market Committee decreased the Federal Funds Target Rate by 400 basis points during 2008 and maintained it at 0% to 0.25% since that time. Interest expense decreased $1,752,000 or 24%. For more information about interest rate risk, please refer to Item 7A - Quantitative and Qualitative Disclosures about Market Risk in the Annual Report on Form 10-K dated December 31, 2010, and filed with the SEC on March 11, 2011.

The net interest spread for the first nine months of 2011 was 3.63% compared to 3.83% (3.74% without the one-time interest recovery) during the same period in 2010. Without the one-time interest recovery, the yield on interest earning assets decreased by 0.40%, primarily due to rates resetting and new loan origination at lower rates, and the cost of interest bearing liabilities decreased by 0.30%. The net interest margin was 3.78% for the first nine months of 2011 and was 3.99% (3.90% without the one-time interest recovery) for the first nine months of 2010.

Average earning assets were $912,299,000 during the first nine months of 2011, an increase of $20,097,000 from the average for the first nine months of 2010. Average interest bearing liabilities were $772,518,000 in the first nine months of 2011, a decrease of $1,231,000 from the same nine months in 2010. However, average non-interest bearing demand deposits increased by $11,986,000 Access to funding in the local market that preferred dealing with a stable local institution was the primary reason for the increase in earning assets and local funding sources between the two periods.

Provision for Loan Losses

The provision for loan losses was $3,610,000 in the first nine months of 2011, as compared to $4,610,000 in the first nine months of 2010. The decrease was a result of measured risk in the loan portfolio compared with the balance in the allowance for loan losses. ACNB adjusts the provision for loan losses as necessary to maintain the allowance at a level deemed necessary to meet the risk characteristics of the loan portfolio. For more information, please refer to Allowance for Loan Losses in the subsequent Financial Condition section. For the first nine months of 2011, the Corporation had net charge-offs of $3,450,000, as compared to net charge-offs of $1,312,000 for the first nine months of 2010.

Other Income

Total other income was $8,846,000 for the nine months ended September 30, 2011, down $98,000, or 1%, from the first nine months of 2010. Fees from deposit accounts were $1,787,000, an increase of $19,000, or 1%, due to increased volume. However, certain government regulations effective in 2010 limited service charge increases and make future revenue levels uncertain. ATM and debit card revenue increased by $86,000, or 10%, as customers increasingly prefer electronic transactions; this revenue source is likewise subject to new government regulation with the impact uncertain. Income from fiduciary activities, which include both institutional and personal trust management services, totaled $1,025,000 for the nine months ended September 30, 2011, as compared to $953,000 during the first nine months of 2010, an 8% increase as a result of higher average assets under management. Earnings on bank-owned life insurance decreased by $27,000, or 4%, on lower rates. A $78,000 gain on life insurance resulted from an insurance death claim for a Director in 2010. The Corporation's insurance subsidiary, Russell Insurance Group, Inc. (RIG), experienced a revenue decrease of $41,000 or 1%. Revenue during the nine-month period was constrained by generally lower commissions in a "soft" insurance market and the effects of the prolonged economic recession on business clients. . . .

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