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DNBF > SEC Filings for DNBF > Form 10-K on 20-Mar-2013All Recent SEC Filings

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Annual Report

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

I. Introductory Overview

DNB Financial Corporation ("DNB") is a bank holding company whose bank subsidiary, DNB First, National Association (the "Bank") is a nationally chartered commercial bank with trust powers, and a member of the FDIC. DNB provides a broad range of banking services to individual and corporate customers through its thirteen community offices located throughout Chester and Delaware Counties, Pennsylvania. DNB is a community banking organization that focuses its lending and other services on businesses and consumers in the local market area. DNB funds all these activities with retail and business deposits and borrowings. Through its Wealth Management division, the Bank provides wealth management and trust services to individuals, businesses and non-profit organizations. The Bank and its subsidiary, DNB Investments and Insurance, make available certain non-depository products and services, such as securities brokerage, mutual funds, life insurance and annuities.

DNB earns revenues and generates cash flows by lending funds to commercial and consumer customers in its marketplace. DNB generates its largest source of interest income through its lending function. A secondary source of interest income is DNB's investment portfolio, which provides liquidity and cash flows for future lending needs.

In addition to interest earned on loans and investments, DNB earns revenues from fees it charges customers for non-lending services. These services include wealth management and trust services; brokerage and investment services; cash management services; banking and ATM services; as well as safekeeping and other depository services.

To ensure we remain well positioned to meet the growing needs of our customers and communities and to meet the challenges of the 21st century, we've worked to build awareness of our full-service capabilities and ability to meet the needs of a wide range of customers. This served to not only retain our existing, customer base, but to position ourselves as an attractive financial institution on which younger individuals and families can build their dreams. To that end, DNB continues to make appropriate investments in all areas of our business, including people, technology, facilities and marketing.

Highlights of DNB's results for the year-end December 31, 2012 include:

Increased earnings - Net income increased $337,000 or 6.9% year over year. Net income was $5.2 million or $1.79 per diluted share in 2012, compared to $4.9 million or $1.53 per diluted share in 2011.

Improvement of net interest margin - DNB's net interest margin, on a tax-equivalent basis, improved 6 basis points from 3.72% in 2011 to 3.78% in 2012. The most significant factor in this improvement was the reduction in the cost of interest bearing liabilities, which declined from 0.93% in 2011 to 0.78% in 2012.

DNB continued to focus on growing fee-based income - Our Wealth Management area experienced a 31.6% increase over 2011, exceeding $1.0 million for the first time compared to $785,000 in 2011. Fees for deposit and cash management services also increased $216,000 or 18.9% over 2011.

Strengthened capital position - Shareholder's equity increased $5.7 million to $56.7 million at December 31, 2012 compared to December 31, 2011, reflecting our solid earnings growth. DNB's Tier 1 leverage ratio and Tier 1 risk-based capital ratio were 10.50% and 14.60%, exceeding regulatory definitions for a well capitalized institution.

The global and U.S. economies have experienced significantly reduced business activity as a result of disruptions in the financial system during the past four years. Dramatic declines in the housing market, with falling home prices and increasing foreclosures and unemployment, have resulted in significant write-

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downs of asset values by financial institutions, including government-sponsored entities and major commercial and investment banks. As a result of the recession, retail customers may delay borrowing from DNB as unemployment remains high and availability to borrow against equity in primary residences diminishes. As the U.S. economy moves through a period of recession, delinquencies will rise as the value of homes decline and DNB's borrowers experience financial difficulty due to corporate downsizing, reduced sales, or other negative events which may impact their ability to meet their contractual loan payments. As a result of these negative trends in the economy and their impact on our borrowers' ability to repay their loans, DNB made a $1.5 million provision in 2012 in response to DNB's increased level of non-performing loans which increased $2.8 million during the year to $10.4 million at December 31, 2012.

In addition, DNB's net interest margin has been impacted by these changes in the economy. Management has been aggressive in managing DNB's cost of funds during the year by implementing carefully planned pricing strategies, designed to offset the decline in rates on earning assets, while matching liquidity needs. Our composite cost of funds for 2012 dropped 15 basis points to 0.78%, from 0.93% in 2011. DNB's net interest margin increased to 3.78% in 2012 from 3.72% in 2011.

Earnings. For the year ended December 31, 2012, DNB reported net income of $5.2 million, an increase of $337,000 from the $4.9 million reported for the year ended December 31, 2011, or $1.79 per share versus $1.53 per share, respectively, on a fully diluted basis. DNB's earnings were favorably impacted by a higher net interest margin and a higher level of non-interest income. Although DNB reported an increase in earnings in 2012 over 2011, our operations and earnings are subject to the same negative economic conditions challenging all commercial banking institutions.

Asset Quality. Non-performing assets were $11.7 million at December 31, 2012 compared to $11.6 million at December 31, 2011. Non-performing assets as of December 31, 2012 were comprised of $9.6 million of non-accrual loans and leases, $869,000 of loans and leases delinquent over ninety days and still accruing, as well as $1.1 million of Other Real Estate Owned ("OREO") and $126,000 in other repossessed property. As of December 31, 2012, the non-performing loans to total loans ratio increased to 2.63% compared to 1.89% at December 31, 2011. The non-performing assets to total assets ratio decreased to 1.82% at December 31, 2012, compared to 1.91% at December 31, 2011. The allowance for credit losses was $6.8 million at December 31, 2012, compared to $6.2 million at December 31, 2011. The allowance to total loans was 1.72% at December 31, 2012 compared to 1.53% at December 31, 2011. DNB's delinquency ratio (the total of all delinquent loans and leases plus loans greater than 90 days and still accruing, divided by total loans and leases) was 2.36% at December 31, 2012, up from 2.19% at December 31, 2011. The increase in delinquencies during 2012 occurred primarily in the commercial loan portfolio.

II. Overview of Financial Condition - Major Changes and Trends

At December 31, 2012, DNB had consolidated assets of $639.6 million and a Tier I/Leverage Capital Ratio of 10.50%. Loans and leases comprise 64.5% of earning assets, while investments and overnight funds constitute the remainder. During 2012, assets increased $32.5 million to $639.6 million at December 31, 2012, compared to $607.1 million at December 31, 2011. During the same period, investment securities increased $57.4 million to $201.3 million, while the loan and lease portfolio decreased $7.2 million, or 1.78%, to $396.5 million. Deposits increased $32.9 million to $530.4 million at December 31, 2012. DNB's liabilities are comprised of a high level of core deposits with a low cost of funds in addition to a moderate level of borrowings with costs that are more volatile than core deposits.

Comprehensive 5-Year Plan. During the second quarter of 2012, management updated the 5-year strategic plan that was designed to reposition its balance sheet and improve core earnings. Through the plan, management will endeavor to expand its loan portfolio through new originations, increased loan participations, as well as strategic loan and lease receivable purchases. Management also plans to reduce

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the absolute level of borrowings with cash flows from existing loans and investments as well as from new deposit growth. A discussion on DNB's Key Strategies follows below:

Focus on penetrating existing markets to maximize profitability

Grow loans and diversify the mix

Improve asset quality

Focus on profitable customer segments

Grow and diversify non-interest income, primarily wealth management

Focus on reducing DNB's cost of funds by changing DNB's mix of deposits

Focus on cost containment and improving operational efficiencies

Strategic Plan Update. During the year ended December 31, 2012, management focused on reducing our composite cost of funds as well as strengthening DNB's net interest margin. The composite cost of funds for the year ended December 31, 2012 was 0.78% compared to 0.93% in 2011. The net interest margin for the year ended December 31, 2012 was 3.78% compared to 3.72% in 2011. Management continued to actively manage deposits during 2012 to reduce DNB's cost of funds. Time deposits decreased $2.9 million to $102.3 million at December 31, 2012 compared to $105.2 million at December 31, 2011. Transaction and savings accounts increased $35.8 million during the year ended December 31, 2012. Overall, non-interest income increased $862,000 or 23.51% to $4.5 million. Positive trends were observed for the year ended December 31, 2012, in two key business lines that make up total non-interest income: service charges on deposits increased 18.9% or $216,000, and wealth management fees increased 31.59% or $248,000 when compared to the same period in 2011. These increases were partially offset by a $123,000 decrease on gains on sale of Small Business Administration ("SBA") loans. Non-interest expense for the year ended December 31, 2012 showed an increase of 5.70% or $954,000, compared to the same period in 2011. During 2012, DNB had $440,000 of write-downs on OREO and other repossessed property that it held compared to $23,000 of such write-downs during 2011. Absent these write-downs, non-interest expenses increased $537,000 or 3.21% year over year. Approximately $65,000 of the $954,000 increase is attributable to the purchase of assets and the assumption of deposits associated with the Boothwyn branch acquisition which was completed during the second quarter of 2012.

Management's strategies are designed to direct DNB's tactical investment decisions and support financial objectives. DNB's most significant revenue source continues to be net interest income, defined as total interest income less total interest expense, which in 2012 accounted for approximately 82.9% of total revenue. To produce net interest income and consistent earnings growth over the long-term, DNB must generate loan and deposit growth at acceptable economic spreads within its market area. To generate and grow loans and deposits, DNB must focus on a number of areas including, but not limited to, the economy, branch expansion, sales practices, customer satisfaction and retention, competition, customer behavior, technology, product innovation and credit performance of its customers.

Management has made a concerted effort to improve the measurement and tracking of business lines and overall corporate performance levels. Improved information systems have increased DNB's ability to track key indicators and enhance corporate performance levels. Better measurement against goals and objectives and increased accountability will be integral in attaining desired loan, deposit and fee income production.

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III. DNB's Principal Products and Services

Loans and Lending Services. DNB's primary source of earnings and cash flows is derived from its lending function. The commercial loan and lease portfolios amounted to $328.4 million or 82.8% of total loans as of December 31, 2012. DNB focuses on providing these products to small to mid-size businesses throughout Chester and Delaware Counties. In keeping with DNB's goal to match customer business initiatives with products designed to meet their needs, DNB offers a wide variety of fixed and variable rate loans that are priced competitively. DNB serves this market by providing funds for the purchase of business property or ventures, working capital lines, Small Business Administration loans, lease financing for equipment and for a variety of other purposes.

As a community bank, DNB also serves consumers by providing home equity and home mortgages, as well as term loans for the purchase of consumer goods. Residential mortgage and consumer loans remained relatively flat in 2012 compared to 2011, primarily due to the current economic environment, which has lessened consumer demand for home equity loan products as a result of falling housing prices and a higher unemployment rate. In addition to providing funds to customers, DNB also provides a variety of services to its commercial customers. These services, such as cash management, remote capture, commercial sweep accounts, internet banking, letters of credit and other lending services are designed to meet our customer needs and help them become successful. DNB provides these services to assist its customers in obtaining financing, securing business opportunities, providing access to new resources and managing cash flows.

Deposit Products and Services. DNB's primary source of funds is derived from customer deposits, which are typically generated by DNB's thirteen branch offices. DNB's deposit base, while highly concentrated in central Chester County, extends to southern Chester County and into parts of Delaware and Lancaster Counties. In addition, a growing amount of new deposits are being generated through expanded government service offerings and as a part of comprehensive loan or wealth management relationships.

The majority of DNB's deposit mix consists of low costing core deposits, (demand, NOW and savings accounts). The remaining deposits are comprised of rate-sensitive money market and time products. DNB offers tiered savings and money market accounts, designed to attract high dollar, less volatile funds. Certificates of deposit and IRAs are traditionally offered with interest rates commensurate with their terms.

Non-Deposit Products and Services. DNB offers non-deposit products and services through its subsidiaries under the names "DNB Investments & Insurance" and "DNB First Investment Management & Trust." Revenues under these entities were $1.0 million and $785,000 for 2012 and 2011, respectively.

DNB Investments & Insurance. Through a partnership with Cetera Investment Services, LLC, DNB Investments & Insurance offers a complete line of investment and insurance products.

        Fixed & Variable Annuities      401(k) plans
        401(k) Rollovers                Stocks
        Self-Directed IRAs              Bonds
        Mutual Funds                    Full Services Brokerage/Cash Management
        Long Term Care Insurance        529 College Savings Plans
        Life Insurance                  Estate Accounts
        Disability Insurance            Self Employed Pension (SEP)

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DNB First Investment Management & Trust. DNB First Investment Management & Trust offers a full line of services, which includes the following:

                    Investment Management      Investment Advisory
                    Estate Settlement          Trust Administration
                    Custody Services           Financial Planning
                    Trust Tax Preparation      Client Bill Paying

IV. Material Challenges, Risks and Opportunities

A. Interest Rate Risk Management.

Interest rate risk is the exposure to adverse changes in net interest income due to changes in interest rates. DNB considers interest rate risk a predominant risk in terms of its potential impact on earnings. Interest rate risk can occur for any one or more of the following reasons: (a) assets and liabilities may mature or re-price at different times; (b) short-term or long-term market rates may change by different amounts; or (c) the remaining maturity of various assets or liabilities may shorten or lengthen as interest rates change.

The principal objective of DNB's interest rate risk management is to evaluate the interest rate risk included in certain on and off balance sheet accounts, determine the level of risk appropriate given DNB's business strategy, operating environment, capital and liquidity requirements and performance objectives, and manage the risk consistent with approved guidelines. Through such management, DNB seeks to reduce the vulnerability of its operations to changes in interest rates. DNB's Asset Liability Committee (the "ALCO") is responsible for reviewing DNB's asset/liability policies and interest rate risk position and making decisions involving asset liability considerations. The ALCO meets on a monthly basis and reports trends and DNB's interest rate risk position to the Board of Directors on a quarterly basis. The extent of the movement of interest rates is an uncertainty that could have a negative impact on DNB's earnings. (See additional discussion in Item 7a. Quantitative and Qualitative Disclosures About Market Risk on page 45 of this Form 10-K.)

1. Net Interest Margin

DNB's net interest margin is the ratio of net interest income to average interest-earning assets. Unlike the interest rate spread, which measures the difference between the rates on earning assets and interest paying liabilities, the net interest margin measures that spread plus the effect of net free funding sources. This is a more meaningful measure of profitability because a bank can have a narrow spread but a high level of equity and non-interest-bearing deposits, resulting in a good net interest margin. One of the most critical challenges DNB faced over the last several years was the impact of historically low interest rates and a narrower spread between short-term rates and long-term rates as noted in the tables below.

                                                         December 31

                                 2012       2011       2010       2009       2008       2007

  Prime                           3.25%      3.25%      3.25%      3.25%      3.25%      7.25%
  Federal Funds Sold ("FFS")     0.25       0.25       0.25       0.25       0.25       4.25
  6 month US Treasury            0.12       0.05       0.19       0.20       0.27       3.51

                                                  Historical Yield Spread
                                                        December 31

                                 2012       2011       2010       2009       2008      2007

  FFS to 5 year US Treasury       0.70%      0.64%      1.68%      2.44%      1.30%     (0.62 )%
  FFS to 10 year US Treasury     1.72       1.73       3.04       3.60       2.00       (0.04 )

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In general, financial institutions price their fixed rate loans off of 5 and 10 year treasuries and price their deposits off of shorter indices, like the Federal Funds Sold rate. As you can see in the table above, the spread between the Federal Funds Sold rate and the 5 year treasury has ranged from 2.44% to a negative 0.62% during the last 6 years. The spread between the Federal Funds Sold rate and the 10 year treasury has ranged from 3.60% to a negative 0.04% during the last 6 years. As a result of the compression between long and short term rates, many banks, including DNB, have seen their net interest margin fluctuate during the last 6 years.

The table below provides, for the periods indicated, information regarding:
(i) DNB's average balance sheet; (ii) the total dollar amounts of interest income from interest-earning assets and the resulting average yields (tax-exempt yields have been adjusted to a tax equivalent basis using a 34% tax rate);
(iii) the total dollar amounts of interest expense on interest-bearing liabilities and the resulting average costs; (iv) net interest income; (v) net interest rate spread; and (vi) net interest margin. Average balances were calculated based on daily balances. Non-accrual loan balances are included in total loans. Loan fees and costs are included in interest on total loans.

Average Balances, Rates, and Interest Income and Expense
(Dollars in thousands)

                                                             Year Ended December 31
                                    2012                              2011                              2010
                        Average                Yield/     Average                Yield/     Average                Yield/
                        Balance    Interest     Rate      Balance    Interest     Rate      Balance    Interest     Rate

Taxable                $ 154,498   $   3,163      2.05 % $ 147,324   $   3,250      2.21 % $ 181,056   $   4,722      2.61 %
Tax-exempt                18,540         912      4.92       5,656         328      5.79       1,845          97      5.28

Total securities         173,038       4,075      2.36     152,980       3,578      2.34     182,901       4,819      2.63
Cash and cash
equivalents               21,888          41      0.19      26,374          56      0.21      36,177          78      0.21
Total loans and
leases                   400,721      22,114      5.52     408,796      22,886      5.60     371,528      21,302      5.73

assets                   595,647      26,230      4.41     588,150      26,520      4.51     590,606      26,199      4.44
assets                    25,517                            24,489                            26,988

Total assets           $ 621,164                         $ 612,639                         $ 617,594

Savings deposits       $ 327,893   $     901      0.27 % $ 318,085   $   1,045      0.33 % $ 296,930   $   1,913      0.64 %
Time deposits            103,288       1,531      1.48     123,444       2,190      1.77     151,201       2,992      1.98
Brokered Deposits             17           -      0.28          20           -      0.20           -           -         -

deposits                 431,198       2,432      0.56     441,549       3,235      0.73     448,131       4,905      1.09
Federal funds
purchased                     71           -      0.59          11           -      0.99          10           -      0.99
Federal Reserve
borrowing                      -           -         -           -           -      0.73           -           -      0.77
agreements                20,419          71      0.34      25,966         142      0.55      24,419         197      0.81
FHLBP advances            20,000         848      4.23      20,329         864      4.25      33,077       1,500      4.53
Other borrowings           9,864         404      4.10      10,284         403      3.92      10,009         460      4.60

liabilities              481,552       3,755      0.78     498,139       4,644      0.93     515,646       7,062      1.37
Demand deposits           80,114                            61,951                            51,963
Other liabilities          5,155                             3,570                             4,257
Stockholders' equity      54,343                            48,979                            45,728

Total liabilities
and stockholders'
equity                 $ 621,164                         $ 612,639                         $ 617,594

Net interest income                $  22,475                         $  21,876                         $  19,137

Interest rate spread                              3.63 %                            3.58 %                            3.07 %

Net interest margin                               3.78 %                            3.72 %                            3.24 %

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2. Rate / Volume Analysis

During 2012, net interest income, before the provision for credit losses, increased $599,000 or 2.74% on a tax equivalent basis. As shown in the Rate/Volume Analysis on the following page, $639,000 was attributable to volume changes and $40,000 to rate changes. The volume changes were mostly attributable to increased levels of investment securities of $19.7 million and demand deposits of $18.2 million, offset by decreased levels of time deposits of $20.2 million. The average balance of investment securities was $172.7 million in 2012 compared to $153.0 million in 2011. The average balance of demand deposits was $80.1 million in 2012 compared to $62.0 million in 2011. The average balance of time deposits was $103.3 million in 2012 compared to $123.4 million in 2011. The decrease in yields on interest-earning assets and the decrease in rates on interest-bearing liabilities offset each other, resulting in a $40,000 unfavorable difference. The tax equivalent yield on securities increased to 2.36% in 2012 from 2.34% in 2011. The favorable change due to rate on savings deposits was $171,000 which had an average rate of 0.27% in 2012 and 0.33% in 2011. The favorable change due to rate on time deposits was $361,000 which had an average rate of 1.48% in 2012 and 1.77% in 2011. DNB's composite cost of funds decreased to 0.78% in 2012 compared to 0.93% in 2011.

The following table sets forth, among other things, the extent to which changes in interest rates and changes in the average balances of interest-earning assets and interest-bearing liabilities have affected interest income and expense for the periods noted (tax-exempt yields have been adjusted to a tax equivalent basis using a 34% tax rate). For each category of interest-earning assets and interest-bearing liabilities, information is provided with respect to changes attributable to (i) changes in rate (change in rate multiplied by old volume) and (ii) changes in volume (change in volume multiplied by new rate). The net change attributable to the combined impact of rate and volume has been allocated proportionately to the change due to rate and the change due to volume.

Rate / Volume Analysis
(Dollars in thousands)

                                        2012 Versus 2011              2011 Versus 2010
                                          Change Due To                 Change Due To
                                     Rate    Volume    Total      Rate     Volume     Total

    Interest-earning assets:
    Loans and leases                $ (327 ) $  (445 ) $ (772 ) $   (502 ) $ 2,086   $  1,584
    Investment securities:
. . .
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