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ORRF > SEC Filings for ORRF > Form 10-Q on 9-May-2013All Recent SEC Filings

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Quarterly Report

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The Company is a bank holding company (that has elected status as a financial holding company with the Federal Reserve Board), with a wholly-owned bank subsidiary, Orrstown Bank (the "Bank"). The following is a discussion of our consolidated financial condition at March 31, 2013 and results of operations for the three months ended March 31, 2013 and 2012. Throughout this discussion, the yield on earning assets is stated on a fully taxable-equivalent basis and balances represent average daily balances unless otherwise stated. The discussion and analysis should be read in conjunction with our Condensed Consolidated Financial Statements (Unaudited) and Notes thereto presented elsewhere in this report. Certain prior period amounts, presented in this discussion and analysis, have been reclassified to conform to current period classifications.

Certain statements appearing herein which are not historical in nature are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements refer to a future period or periods, reflecting management's current views as to likely future developments, and use words like "may," "will," "expect," "estimate," "anticipate" or similar terms. Because forward-looking statements involve certain risks, uncertainties and other factors over which the Company has no direct control, actual results could differ materially from those contemplated in such statements. These factors include (but are not limited to) the following: general economic conditions, changes in interest rates, changes in the Company's cost of funds, changes in government monetary policy, changes in government regulation and taxation of financial institutions, including changes resulting from the Dodd-Frank Wall Street Reform and Consumer Protection Act and related regulations, changes in the rate of inflation, changes in technology, our ability to attract skilled personnel and retain key members of our senior management team, the intensification of competition within the Company's market area, the outcome of litigation against the Company and other similar factors. For a discussion of these forward-looking statements and important factors that could cause results to differ materially from the forward-looking statements contained in this Report, see "Caution About Forward Looking Statements" section included in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Risk Factors" contained in our Annual Report on Form 10-K for the year ended December 31, 2012.

Critical Accounting Policies

The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States ("GAAP") and follow general practices within the financial services industry in which it operates. Management, in order to prepare the Company's consolidated financial statements, is required to make estimates, assumptions and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the balance sheet date through the date the financial statements are filed with the SEC. As this information changes, the consolidated financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources.

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The most significant accounting policies followed by the Company are presented in Note 1 to the consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, the Company has identified the adequacy of the allowance for loan losses and accounting for income taxes as critical accounting policies.

The allowance for loan losses represents management's estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet.

The Company recognizes deferred tax assets and liabilities for the future effects of temporary differences and tax credits. Enacted tax rates are applied to cumulative temporary differences based on expected taxable income in the periods in which the deferred tax asset or liability is anticipated to be realized. Future tax rate changes could occur that would require the recognition of income or expense in the statement of operations in the period in which they are enacted. Deferred tax assets must be reduced by a valuation allowance if in management's judgment it is "more likely than not" that some portion of the asset will not be realized. Management may need to modify their judgments in this regard from one period to another should a material change occur in the business environment, tax legislation, or in any other business factor that could impair the Company's ability to benefit from the asset in the future. Based upon the Company's prior cumulative taxable losses, projections for future taxable income and other available evidence, management determined that there was not sufficient positive evidence to outweigh the cumulative loss, and concluded it was not more likely than not that the net deferred tax asset would be realized. Accordingly, a full valuation allowance was recorded at March 31, 2013 and December 31, 2012. Management will continue to update its analysis quarterly, and after a period of sustainable taxable income, the valuation allowance may be reversed in part or in total.

Readers of the consolidated financial statements should be aware that the estimates and assumptions used in the Company's current financial statements may need to be updated in future financial presentations for changes in circumstances, business or economic conditions in order to fairly represent the condition of the Company at that time.




The Company recorded a net income of $1,560,000 for the first quarter of 2013 compared to net loss of $8,218,000 for the same period in 2012. Basic and diluted earnings (loss) per share (EPS) for the first quarter of 2013 were $0.19, compared to ($1.02) for the first quarter of 2012. The significant improvement in earnings is primarily the result of improved asset quality which resulted in, or reduction of, the provision for loan losses of $19,200,000 from the three months ended March 31, 2012 to 2013. Net interest income of $8,107,000 was $2,735,000 less for the three months ended March 31, 2013 than in 2012, as largely lower levels of net earning assets led to the decrease.

Net Interest Income

Net interest income, which is the difference between interest income and fees on interest-earning assets and interest expense on interest-bearing liabilities, is the primary component of the Company's revenue. Interest earning assets include loans, securities and interest bearing deposits with banks. Interest bearing liabilities include deposits and borrowed funds. To compare the tax-exempt yields to taxable yields, amounts are adjusted to pretax equivalents based on a 35% federal corporate tax rate.

Net interest income is affected by changes in interest rates, volumes of interest-earning assets and interest-bearing liabilities and the composition of those assets and liabilities. The "net interest spread" and "net interest margin" are two common statistics related to changes in net interest income. The net interest spread represents the difference between the yields earned on interest-earning assets and the rates paid for interest-bearing liabilities. The net interest margin is defined as the ratio of net interest income to average earning assets. Through the use of noninterest bearing, demand deposits, certain other liabilities, and stockholders' equity, the net interest margin exceeds the net interest spread, as these funding sources are non-interest bearing.

The "Analysis of Net Interest Income" table below presents net interest income on a fully taxable equivalent basis, net interest spread and net interest margin for the quarters ended March 31, 2013 and 2012.

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For the three months ended March 31, 2013, net interest income measured on a fully tax equivalent basis decreased $2,932,000 to $8,562,000 from $11,494,000 in the corresponding period in 2012. The primary reason for the decrease in net interest income was a decrease in average earning assets from $1,381,317,000 for the first quarter of 2012 to $1,131,862,000 for the same period in 2013.

Interest income earned on loans decreased from $11,427,000 for the quarter ended March 31, 2012 to $8,529,000 for the same period in 2013, a $2,898,000 decline. The primary reason for the decline was the average balance of loans decreased from $954,070,000 for the first quarter of 2012 to $694,935,000 for the same period in 2013 due largely to the two loans sales which took place in 2012, combined with scheduled amortization of loans. Partially offsetting the volume variance was an increase in rates earned from 4.86% in 2012 to 4.98% in 2013, as the Company has been able to reduce its non-accrual loans.

Securities interest income also declined in 2013 and totaled $1,349,000 for the quarter ended March 31, 2013, a decrease of $904,000, compared to $2,253,000 for the same period in 2012. Although the average balance on securities has increased from $334,645,000 in the first quarter of 2012 to $342,073,000 for the same period in 2013, the volume increase was not enough to offset the decrease in rates earned on securities, which declined from a tax equivalent yield of 2.69% for the three months ended March 31, 2012 to 1.60% in the same period in 2013. The low interest rate environment has resulted in increased refinancing activity and accelerated prepayments on mortgage backed securities, many of which have premiums associated with them. As the prepayments have accelerated, the amortization of the premiums has been faster than in the past, which has placed pressure on the yields earned on the securities. Further, the proceeds from the sales or maturities of securities have been reinvested at lower interest rates, also negatively impacting the yield earned on securities.

Interest expense on deposits and borrowings for the three months ended March 31, 2013 was $1,377,000, a decrease of $870,000, from $2,247,000 in the same period in 2012. The Company's cost of funds on interest bearing liabilities has declined to 0.56% for the quarter ended March 31, 2013 from 0.75% for the same period in 2012. The interest rate environment has allowed the Company to lower the rates offered on its demand deposits, including interest bearing demand, money market and savings in 2013 compared to 2012, and as time deposits and long-term debt mature, it has also been able to replace the funds at slightly lower rates.

The Company's net interest spread of 3.00% declined 28 basis points in the quarter ended March 31, 2013 as compared to the same period in 2012. Net interest margin for the quarter ended March 31, 2013 was 3.07%, a 30 basis point decline from 3.37% for the quarter ended March 31, 2012. Management anticipates continued pressure on the net interest margin in future quarters as rates earned on loans and securities will continue to pay off or mature, and be reinvested at lower interest rates.

The table that follows shows average balances and interest yields on a fully taxable equivalent basis (FTE):

Analysis of Net Interest Income

                                                        March 31, 2013                                     March 31, 2012
                                                             Tax               Tax                              Tax               Tax
                                           Average        Equivalent       Equivalent         Average        Equivalent       Equivalent
(Dollars in thousands)                     Balance         Interest           Rate            Balance         Interest           Rate
Federal funds sold & interest bearing
bank balances                            $    94,854               61             0.26 %    $    92,602     $         61             0.26 %
Securities                                   342,073            1,349             1.60          334,645            2,253             2.69
Loans                                        694,935            8,529             4.98          954,070           11,427             4.86

Total interest-earning assets              1,131,862            9,939             3.56        1,381,317           13,741             4.03

Other assets                                  70,189                                             59,398

Total                                    $ 1,202,051                                        $ 1,440,715

Liabilities and Shareholders' Equity
Interest bearing demand deposits         $   482,401              217             0.18      $   541,673     $        404             0.28
Savings deposits                              75,493               31             0.17           74,019               31             0.17
Time deposits                                384,593              976             1.03          477,890            1,543             1.30
Short term borrowings                         10,916                6             0.22           47,971               52             0.47
Long term debt                                37,330              147             1.60           51,077              217             1.71

Total interest bearing liabilities           990,733            1,377             0.56        1,192,630            2,247             0.75

Non-interest bearing demand deposits         112,410                                            109,628
Other                                         11,219                                             10,259

Total Liabilities                          1,114,362                                          1,312,517
Shareholders' Equity                          87,689                                            128,198

Total                                    $ 1,202,051                              0.49 %    $ 1,440,715                              0.66 %

Net interest income (FTE)/ net
interest spread                                                 8,562             3.00 %                          11,494             3.28 %

Net interest margin                                                               3.07 %                                             3.37 %

Tax-equivalent adjustment                                        (455 )                                             (652 )

Net interest income                                      $      8,107                                       $     10,842

NOTES: Yields and interest income on tax-exempt assets have been computed on a fully taxable equivalent basis assuming a 35% tax rate. For yield calculation purposes, nonaccruing loans are included in the average loan balance.

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Provision for Loan Losses

The Company recorded no provision for loan losses for the three months ended March 31, 2013 compared to $19,200,000 for the same period in 2012 and $1,000,000 for the linked quarter ended December 31, 2012. The Company continues to reduce its level of nonperforming and restructured loans, and with lower charge-offs in the last two quarters, it was determined that a provision for loan losses was not required in the first quarter of 2013. Despite no provision and net charge-offs of $1,249,000, the reduction in nonperforming loans allowed for improvements in the ratio of the allowance for loan losses to nonaccrual and restructured loans still accruing from 110.1% at December 31, 2012 to 126.7% at March 31, 2013.

See further discussion in the "Allowance for Loan Losses" section.

Noninterest Income

Noninterest income, excluding securities gains, totaled $4,310,000 for the three months ended March 31, 2013, compared to $3,963,000 for the same period in 2012.

Trust department and brokerage income, in total, increased $266,000, or 17.8%, to $1,764,000 for the three months ended March 31, 2013 compared to the same period in 2012. The Company has been able to attract new products, accounts and customers which contributed to the increase.

Mortgage banking activities revenue for the quarter ended March 31, 2013 was $752,000, a $260,000 increase from the 2012 quarter's total of $492,000. The low interest rate environment has positively impacted loan origination volume, as refinancing activity has increased. In addition, the low interest rate environment has positively impacted the fair value of our mortgage servicing rights, which allowed for the recovery of $68,000 of our impairment reserve in the first quarter of 2013, compared to an additional charge of $104,000 in the first quarter of 2012.

Other income (loss) consists principally of losses on the sale of other real estate owned in both periods presented.

Securities gains totaled $122,000 for the three months ended March 31, 2013 compared to $2,231,000 for the same period in 2012. In 2013, asset/liability management strategies and favorable interest rate conditions led to the sale of securities. These same factors, as well as maintaining capital levels factored into the decision as to the extent and timing of security gains in the first quarter of 2012.

Noninterest Expenses

Noninterest expenses amounted to $10,949,000 for the three months ended March 31, 2013 relatively consistent with the $10,886,000 for the corresponding prior year period.

Salaries and employee benefits totaled $5,746,000 for the three months ended March 31, 2013, compared to $4,657,000 for the three months ended March 31, 2012, an increase of $1,089,000. A large component of the difference pertains to health insurance costs, in which favorable cumulative claims history allowed for the reduction of a self-insured reserve of $400,000 in the first quarter of 2012, with no similar benefit in 2013. In addition, with the Company's return to profitability, certain incentive based employee benefits have been restored, which has resulted in approximately $250,000 in increased expenses.

Advertising and bank promotions expense decreased $161,000 to $211,000 for the three months ended March 31, 2013 from $372,000 for the same period in 2012. This reduction in expense relates to the nature and timing of promotions, which were more heavily weighted in the first quarter of 2012 than 2013.

FDIC insurance expense increased $144,000 to $665,000 for the three months ended March 31, 2013. The increase in expense is the result of an increased risk rating and associated increased depository insurance rate which has been partially offset by a reduction in the Bank's assets and deposits.

Professional service fees, including loan review assistance, legal fees and accounting expenses, have decreased $40,000 to $761,000 in the first quarter of 2013 from $801,000 in the same period in 2012. During the first quarter of 2013, the Company has been able to reduce consulting fees by $215,000 over the same period in 2012. Partially offsetting these savings were increased legal costs associated with claims against the Company, including a settlement of one claim in the first quarter of 2013 that resulted in a charge of $216,000.

Asset quality related costs, including collection problem loan and real estate owned expenses, total $225,000 for the three months ended March 31, 2013, an $870,000 reduction from $1,095,000 for the same period in 2012. Significant reductions in nonperforming assets led to the 79.5% reduction in asset quality related costs.

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In order to better understand how noninterest expenses increased in relation to related increases in revenue, operating expense levels are often measured in the financial services industry by the efficiency ratio, which expresses non-interest expense, as a percentage of tax-equivalent net interest income and noninterest income. The Company's efficiency ratio was 84.3% for the three months ended March 31, 2013, compared to 67.7% for the same period in 2012. The increase in the ratio was primarily driven by a decrease in net interest income, without a corresponding decline in noninterest expenses.

Income Tax Expense

Income tax expense totaled $30,000 for the three months ended March 31, 2013, on pre-tax income of $1,590,000, compared to income tax benefit of $4,832,000 recorded on pre-tax loss of $13,050,000 for the three months ended March 31, 2012. During the third quarter of 2012, an evaluation was completed on the net deferred tax asset that existed, which principally resulted from credit and credit related losses and expenses that the company experienced. As a result of the taxable losses that were generated during 2012, and our inability to fully offset the tax to the two preceding carryback years allowed by tax regulation, our net deferred tax asset was dependent on tax planning strategies and future taxable income. Based on forecasted taxable income in the near future, combined with limited tax planning strategies, we were not able to conclude that the deferred tax asset would more likely than not be realized in its entirety, and as such, a valuation allowance was established for the full amount beginning in the third quarter of 2012. An updated evaluation was completed at March 31, 2013, and we continue to believe that the valuation allowance is appropriate, and as such, the $30,000 expense for the quarter pertains to alternative minimum tax, in which an incremental valuation allowance is required on the deferred tax asset.


A substantial amount of time is devoted by management to overseeing the investment of funds in loans and securities and the formulation of policies directed toward the profitability and minimization of risk associated with such investments.

Securities Available for Sale

The Company utilizes securities available for sale as a tool for managing interest rate risk, enhancing income through interest and dividend income, to provide liquidity and to provide collateral for certain deposits and borrowings. As of March 31, 2013, securities available for sale were $349,733,000, an increase of $47,763,000 from December 31, 2012's balance of $301,970,000. The growth in the portfolio for each security type is the result of investing the Company's excess liquidity in the securities available for sale portfolio, as loan balances have declined and securities return a better yield than overnight funds.

Loan Portfolio

The Company offers various products to meet the credit needs of our borrowers, principally consisting of commercial real estate loans, commercial and industrial loans, and retail loans consisting of loans secured by residential properties, and to a lesser extent, installment loans. No loans are extended to non-domestic borrowers or governments.

The risks associated with lending activities differ among the various loan classes, and are subject to the impact of changes in interest rates, market conditions of collateral securing the loans, and general economic conditions. All of these factors may adversely impact the borrower's ability to repay its loans, and impact the associated collateral.

The Company has various types of commercial real estate which have differing levels of credit risk associated with them. Owner-occupied commercial real estate loans are generally dependent upon the successful operation of the borrower's business, with the cash flows generated from the business being the primary source of repayment of the loan. If the business suffers a downturn in sales or profitability, the borrower's ability to repay the loan could be in jeopardy.

Non-owner occupied and multi-family commercial real estate loans and non-owner occupied residential properties present a different credit risk to the Company than owner-occupied commercial real estate, as the repayment of the loan is dependent upon the borrower's ability to generate a sufficient level of occupancy to produce rental income that exceeds debt service requirements and operating expenses. Lower occupancy or lease rates may result in a reduction in cash flows, which hinder the ability of the borrower to meet debt service requirements, and may result in lower collateral values. The Company generally recognizes that greater risk is inherent in these credit relationships as compared to owner occupied loans mentioned above in its loan pricing.

Acquisition and development loans consist of 1-4 family residential construction and commercial and land development loans. The risk of loss on these loans is largely dependent on the Company's ability to assess the property's value at the completion of the project, which should exceed the property's construction costs. During the construction phase, a number of factors could potentially negatively impact the collateral value, including cost overruns, delays in completing the project, competition, and real estate market conditions which may change based on the supply of similar properties in the area. In the event the collateral value at the completion of the project is not sufficient to cover the outstanding loan balance, the Company must rely upon other repayment sources, including the guarantors of the project or other collateral securing the loan.

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Commercial and industrial loans include advances to local and regional businesses for general commercial purposes and include permanent and short-term working capital, machinery and equipment financing, and may be either in the form of lines of credit or term loans. Although commercial and industrial loans may be unsecured to our highest rated borrowers, the majority of these loans are secured by the borrower's accounts receivable, inventory and machinery and equipment. In a significant number of these loans, the collateral also includes the business real estate or the business owner's personal real estate or assets. . . .

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