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ORRF > SEC Filings for ORRF > Form 10-Q on 8-Aug-2013All Recent SEC Filings

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Form 10-Q for ORRSTOWN FINANCIAL SERVICES INC


8-Aug-2013

Quarterly Report


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

The Company is a bank holding company, with the Bank as its wholly-owned subsidiary. At June 30, 2013, the Company had total assets of $1,191,217,000, total liabilities of $1,103,413,000 and total shareholders' equity of $87,804,000. Currently, the U.S. economy appears to be slowly recovering from one of its longest and most severe economic recessions in recent history. The economic recovery has been slower than anticipated, but signs of growth that began to appear in the fourth quarter of 2012 have continued into the first half of 2013, which helped the Company generate net income of $3,408,000 for the second quarter of 2013 compared to a net loss of $9,914,000 for the same period in 2012. However, the continued uncertainty with the economy, together with the challenging regulatory environment, will continue to affect the Company and the markets in which it does business, and may impact the Company's results in the future. American households are being affected by higher social security and payroll taxes and higher fuel costs, all of which affect household spending and may slow economic growth.

Caution About Forward Looking Statements

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. Forward-looking statements are statements that include projections, predictions, expectations, or beliefs about events or results or otherwise are not statements of historical facts, including, but not limited to, statements related to new business development, new loan opportunities, growth in the balance sheet and fee based revenue lines of business, reducing risk assets, and mitigating losses in the


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future. Actual results and trends could differ materially from those set forth in such statements and there can be no assurances that we will achieve the desired level of new business development and new loans, growth in the balance sheet and fee based revenue lines of business, continue to reduce risk assets or mitigate losses in the future. Factors that could cause actual results to differ from those expressed or implied by the forward looking statements include, but are not limited to, the following: ineffectiveness of the Company's business strategy due to changes in current or future market conditions; the effects of competition, including industry consolidation and development of competing financial products and services; changes in laws and regulations, including the Dodd-Frank Wall Street Reform and Consumer Protection Act; interest rate movements; changes in credit quality; inability to raise capital under favorable conditions, volatilities in the securities markets; deteriorating economic conditions, and other risks and uncertainties, including those detailed in the Company's Form 10-K for the fiscal year ended December 31, 2012, and the Form 10-Q for the quarter ended March 31, 2013 and in this Form 10-Q under the sections titled "Risk Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operation" and in other filings made with the Securities and Exchange Commission. The statements are valid only as of the date hereof and the Company disclaims any obligation to update this information.

The following is a discussion of our consolidated financial condition at June 30, 2013 and results of operations for the three and six months ended June 30, 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.

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.

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 its judgment 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 June 30, 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.


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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.

RESULTS OF OPERATIONS

QUARTER ENDED JUNE 30, 2013 COMPARED TO QUARTER ENDED JUNE 30, 2012

Summary

The Company recorded net income of $3,408,000 for the second quarter of 2013 compared to a net loss of $9,914,000 for the same period in 2012. Basic and diluted earnings (loss) per share for the second quarter of 2013 were $0.42, compared to ($1.23) for the second quarter of 2012. Second quarter earnings were positively impacted by a negative provision for loan losses, or a reversal of amounts previously provided, of $1,400,000 compared to provision expense of $23,000,000 for the same period in 2012. During the quarter, the Company received payments on classified loans with partial charge-offs recorded. As payments received during the quarter exceeded the carrying value of these loans, the excess was included in recoveries of loan amounts previously charged off. In connection with our quarterly evaluation of the adequacy of the allowance for loan losses, it was determined that large recoveries specific to loans in one customer relationship were not needed to replenish the reserve, and was reflected in income through a negative provision for loan losses. Net interest income of $7,701,000 was $1,845,000 less for the three months ended June 30, 2013 than in the same period in 2012, due primarily to a decrease in net earning assets.

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 June 30, 2013 and 2012.

For the three months ended June 30, 2013, net interest income measured on a fully tax equivalent basis decreased $2,016,000 to $8,113,000 from $10,129,000 in the corresponding period in 2012. The primary reason for the decrease in net interest income was a decrease in average earning assets from $1,344,493,000 for the second quarter of 2012 to $1,123,672,000 for the same period in 2013.

Interest income earned on loans decreased from $10,372,000 for the quarter ended June 30, 2012 to $8,140,000 for the same period in 2013, a $2,232,000 decline. The primary reason for the decline was a decrease in the average balance of loans from $880,371,000 for the second quarter of 2012 to $674,847,000 for the same period in 2013 primarily due to the loan sales which took place in 2012, combined with scheduled amortization of loans. Partially offsetting the volume variance was an increase in rates earned from 4.62% in the second quarter of 2012 to 4.84% in the second quarter of 2013, as the Company has been able to significantly reduce its non-accrual loans.

Securities interest income also declined in 2013 and totaled $1,211,000 for the quarter ended June 30, 2013, a decrease of $547,000, compared to $1,758,000 for the same period in 2012. Although the average balance on securities has increased from $337,180,000 in the second quarter of 2012 to $370,675,000 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 2.09% for the three months ended June 30, 2012 to 1.31% 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. In the past several months, the five and ten year U.S. Treasury rates have increased, which should slow down prepayments on mortgage-backed securities, and we anticipate will increase yields earned on these securities.


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Interest expense on deposits and borrowings for the three months ended June 30, 2013 was $1,288,000, a decrease of $795,000, from $2,083,000 for the same period in 2012. The Company's cost of funds on interest bearing liabilities has declined to 0.53% for the quarter ended June 30, 2013 from 0.70% 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 mature, it has also been able to replace the funds at slightly lower rates.

The Company's net interest spread of 2.83% declined 5 basis points in the quarter ended June 30, 2013 as compared to the same period in 2012. Net interest margin for the quarter ended June 30, 2013 was 2.90%, a 6 basis point decline from 2.96%, for the quarter ended June 30, 2012. Management anticipates continued pressure on the net interest margin in future quarters as rates earned on loans 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) for the quarters ended June 30, 2013 and 2012:

Analysis of Net Interest Income



                                                  June 30, 2013                                    June 30, 2012
                                                       Tax              Tax                             Tax              Tax
                                     Average        Equivalent      Equivalent        Average        Equivalent      Equivalent
(Dollars in thousands)               Balance         Interest          Rate           Balance         Interest          Rate
Assets
Federal funds sold & interest
bearing bank balances              $    78,150     $         50            0.26 %   $   126,942     $         82            0.25 %
Securities                             370,675            1,211            1.31         337,180            1,758            2.09
Loans                                  674,847            8,140            4.84         880,371           10,372            4.62

Total interest-earning assets        1,123,672            9,401            3.36       1,344,493           12,212            3.58

Other assets                            72,908                                           75,104

Total                              $ 1,196,580                                      $ 1,419,597

Liabilities and Shareholders'
Equity
Interest bearing demand deposits   $   480,467     $        191            0.16     $   514,762     $        356            0.26
Savings deposits                        78,897               32            0.17          74,938               31            0.17
Time deposits                          365,983              916            1.00         495,844            1,475            1.20
Short term borrowings                   16,236                8            0.20          42,738               41            0.42
Long term debt                          35,671              141            1.59          47,675              180            1.52

Total interest bearing
liabilities                            977,254            1,288            0.53       1,175,957            2,083            0.70

Non-interest bearing demand
deposits                               119,244                                          116,838
Other                                   11,292                                            8,856

Total Liabilities                    1,107,790                                        1,301,651
Shareholders' Equity                    88,790                                          117,946

Total                              $ 1,196,580                             0.46 %   $ 1,419,597                             0.63 %

Net interest income (FTE)/ net
interest spread                                           8,113            2.83 %                         10,129            2.88 %

Net interest margin                                                        2.90 %                                           2.96 %

Tax-equivalent adjustment                                  (412 )                                           (583 )

Net interest income                                $      7,701                                     $      9,546

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.

Provision for Loan Losses

The Company recorded a negative provision for loan losses, or a reversal of amounts previously provided, of $1,400,000 for the three months ended June 30, 2013. During the quarter, the Company received payments on classified loans with partial charge-offs recorded. As payments received during the quarter exceeded the carrying value of these loans, the excess was included in recoveries of loan amounts previously charged off. In connection with our quarterly evaluation of the adequacy of the allowance for loan losses, we considered significantly lower charge-offs in 2013 than those experienced in 2012, as well as lower levels of nonperforming loans. After the evaluation, it was determined that large recoveries specific to loans in one customer relationship were not needed to replenish the reserve, and was reflected in income through a negative provision for loan losses.


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

Noninterest Income

Noninterest income, excluding securities gains, totaled $4,664,000 for the three months ended June 30, 2013, compared to $4,432,000 for the same period in 2012. The following contributed to the net increase in noninterest income:

Trust department and brokerage income, in total, increased $53,000, or 3.4%, to $1,590,000 for the three months ended June 30, 2013 compared to the same period in 2012. Favorable market conditions, combined with new business opportunities led to the enhanced revenue stream.

Mortgage banking revenue for the quarter ended June 30, 2013 was $1,105,000, a $378,000, or 52.0%, increase from the 2012 quarter's total of $727,000. Revenues were influenced by a low interest rate environment, coupled with greater stability in the real estate market, allowing for favorable refinancing conditions. In addition, the low interest rate environment has positively impacted the fair value of our mortgage servicing rights, which allowed for the recovery of $289,000 of our impairment reserve in the second quarter of 2013, compared to an additional charge of $145,000 in the second quarter of 2012.

The decline in other income consists principally of losses on the sale of other real estate owned in the second quarter of 2013 of $32,000 compared to gains of $58,000 in the same period in 2012.

There were no securities gains for the three months ended June 30, 2013 compared to $2,595,000 for the same period in 2012. Strategic conditions and interest rate conditions, as well as a desire to maintain capital levels factored into the extent and timing of securities gains in the second quarter of 2012.

Noninterest Expenses

Noninterest expenses amounted to $10,327,000 for the three months ended June 30, 2013 compared to $10,733,000 for the corresponding prior year period.

Salaries and employee benefits totaled $5,387,000 for the three months ended June 30, 2013, compared to $4,977,000 for the three months ended June 30, 2012, an increase of $410,000. A large component of the difference pertains to an increase in the Company's number of full-time equivalents, which has increased as we enhance our enterprise risk management area and place less reliance on outside consultants. An additional factor contributing to the increase in salaries and benefit expense was the restoration of certain incentive based employee benefits as a result of the Company's return to profitability, which totaled $200,000 for the three months ended June 30, 2013, with no similar expenses recorded in 2012.

During 2013, the Company has evaluated its current telecommunication contracts and devices assigned to personnel. As a result of this evaluation and favorable negotiations the Company has been able to reduce its telephone expense by 53.9%, which totaled $84,000 for the three months ended June 30, 2013 compared to $182,000 for the same period in 2012.

Advertising and bank promotions expense decreased $34,000 to $274,000 for the three months ended June 30, 2013 from $308,000 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 second quarter of 2012 than 2013.

FDIC insurance expense decreased from $710,000 for the three months ended June 30, 2012 to $626,000 for the same period in 2013. The decrease is the result of the reduction in the Bank's assets and deposits.

Professional service fees, including loan review assistance, legal fees and accounting expenses, have decreased $174,000 to $577,000 in the second quarter of 2013 from $751,000 in the same period in 2012. During the second quarter of 2013, the Company has been able to reduce its reliance on outside consultants which is the primary reason for the favorable variance.

Asset quality related costs, including collection and problem loan and real estate owned expenses, were $216,000 for the three months ended June 30, 2013, a $463,000 reduction from $679,000 for the same period in 2012. Significant reductions in nonperforming assets led to the 68.2% reduction in asset quality related costs.

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. As a result of the decline in net interest income, partially offset by a slight decrease in noninterest expense, the Company's efficiency ratio was 80.1% for the three months ended June 30, 2013, compared to 72.7% for the same period in 2012.

Income Tax Expense

Income tax expense totaled $30,000 for the three months ended June 30, 2013, on pre-tax income of $3,438,000, compared to income tax benefit of $7,246,000 recorded for the three months ended June 30, 2012. During the third quarter of 2012, an evaluation


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was completed on the net deferred tax asset that existed at that time, 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 at that time, 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 June 30, 2013, and we continue to believe that the valuation allowance is appropriate, and as such, the expense recorded during 2013 pertains to estimated alternative minimum tax.

SIX MONTHS ENDED JUNE 30, 2013 COMPARED TO SIX MONTHS ENDED JUNE 30, 2012

Summary

The Company recorded net income of $4,968,000 for the six months ended June 30, 2013 compared to a net loss of $18,132,000 for the same period in 2012. Basic and diluted earnings (loss) per share for the six months ended June 30, 2013 were $0.61, compared to ($2.25) for the six months ended June 30, 2012. Year-to-date earnings were positively impacted by a negative provision for loan losses of $1,400,000 for the six months ended June 30, 2013, compared to a provision expense of $42,200,000 in 2012.

Net Interest Income

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 six months ended June 30, 2013 and 2012.

For the six months ended June 30, 2013, net interest income measured on a fully tax equivalent basis decreased $4,948,000 to $16,675,000 from $21,623,000 in the corresponding period in 2012. The primary reason for the decrease in net interest income was a decrease in average earning assets from $1,362,904,000 for the six months ended 2012 to $1,127,744,000 for the same period in 2013. Compression in net interest margin from 3.16% for the six months ended June 30, 2012 to 2.98% for the same period in 2013 also contributed to the decline.

Interest income earned on loans decreased from $21,799,000 for the quarter ended June 30, 2012 to $16,669,000 for the same period in 2013, a $5,130,000 decline. The primary reason for the decline was that average balance of loans decreased from $917,219,000 for the six months ended June 30, 2012 to $684,835,000 for the same period in 2013 due largely to the two loan sales which took place in 2012, . . .

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