UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

Quarterly Report Pursuant to Section 13 or 15(d) of the

Securities Exchange Act of 1934

For the Quarterly period ended September 30, 2014

Commission file number 001-35296

 

FARMERS NATIONAL BANC CORP.

(Exact name of registrant as specified in its charter)

 

 

(330) 533-3341

(Registrant’s telephone number, including area code)

Not applicable

(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

 

 

 

 

 

 

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CONSOLIDATED BALANCE SHEETS

FARMERS NATIONAL BANC CORP. AND SUBSIDIARIES

 

 

See accompanying notes

 

 

 

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CONSOLIDATED STATEMENTS OF INCOME

FARMERS NATIONAL BANC CORP. AND SUBSIDIARIES

 

 

 

See accompanying notes

 

 

 

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CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

FARMERS NATIONAL BANC CORP. AND SUBSIDIARIES

 

 

See accompanying notes

 

 

 

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CONSOLIDATED STATEMENTS OF CASH FLOWS

FARMERS NATIONAL BANC CORP. AND SUBSIDIARIES

 

 

See accompanying notes

 

 

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Principles of Consolidation:

Farmers National Banc Corp. (“Company”) is a one-bank holding company registered under the Bank Holding Company Act of 1956, as amended. The Company provides full banking services through its nationally chartered subsidiary, The Farmers National Bank of Canfield (“Bank”). The Company provides trust services through its subsidiary, Farmers Trust Company (“Trust”), and insurance services through the Bank’s subsidiary, Farmers National Insurance (“Insurance”).  In addition to the Insurance subsidiary, the Bank has created Farmers of Canfield Investment Co. (“Investments”), a new subsidiary with the primary purpose of investing in municipal securities. On July 1, 2013 the Company acquired National Associates, Inc. (“NAI”), a retirement plan consulting firm located in Cleveland, Ohio.  As a result of the acquisition the Company now provides retirement consulting services through NAI. The consolidated financial statements include the accounts of the Company, the Bank and its subsidiaries, along with the Trust and NAI. All significant intercompany balances and transactions have been eliminated in the consolidation.

 

Basis of Presentation:

The unaudited condensed consolidated financial statements have been prepared in conformity with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles (“U.S. GAAP”) for complete financial statements. The financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s 2013 Annual Report to Shareholders included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013. The interim consolidated financial statements include all adjustments (consisting of only normal recurring items) that, in the opinion of management, are necessary for a fair presentation of the financial position and results of operations for the periods presented. The results of operations for the interim periods disclosed herein are not necessarily indicative of the results that may be expected for a full year. Certain items included in the prior period financial statements were reclassified to conform to the current period presentation. There was no effect on net income or total stockholders’ equity.

 

Estimates:

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The allowance for loan losses, deferred tax assets, carrying amount of goodwill and fair values of financial instruments are particularly subject to change.

 

Segments:

The Company provides a broad range of financial services to individuals and companies in northeastern Ohio. Operations are managed and financial performance is primarily aggregated and reported in three lines of business, the Bank segment, the Trust segment and the Retirement Consulting segment.  

 

Comprehensive Income (Loss):

Comprehensive income (loss) consists of net income and other comprehensive income (loss). Other comprehensive income (loss) consists of unrealized gains and losses on securities available for sale and changes in the funded status of the post-retirement health plan, which are recognized as separate components of equity, net of tax effects. For the three and nine month periods ended September 30, 2014, there was no change in the funded status of the post-retirement health plan.

 

Newly Issued but Not Yet Effective Accounting Standards:

In May 2014, FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Topic 606). The ASU creates a new topic, Topic 606, to provide guidance on revenue recognition for entities that enter into contracts with customers to transfer goods or services or enter into contracts for the transfer of nonfinancial assets. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Additional disclosures are required to provide quantitative and qualitative information regarding the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The new guidance is effective for annual reporting periods, and interim reporting periods within those annual periods, beginning after December 15, 2016. Early adoption is not permitted. Management is currently evaluating the impact of the adoption of this guidance on the Company’s consolidated financial statements.

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In January 2014, the FASB issued ASU 2014-04, “Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure.” The objective of the amendments in ASU 2014-04 to Topic 310, “Receivables - Troubled Debt Restructurings by Creditors,” is to reduce diversity by clarifying when an in substance repossession or foreclosure occurs, that is, when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan receivable should be derecognized and the real estate property recognized. The amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2014. An entity can elect to adopt the amendments using either a modified retrospective transition method or a prospective transition method. Early adoption is permitted. The adoption of this guidance is not expected to have a material impact on the Company’s Consolidated Financial Statements.

 

Securities:

The following table summarizes the amortized cost and fair value of the available-for-sale investment securities portfolio at September 30, 2014 and December 31, 2013 and the corresponding amounts of unrealized gains and losses recognized in accumulated other comprehensive income (loss):

 

 

 

 

 

Proceeds from the sale of portfolio securities were $917 thousand and $34.2 million during the three and nine month periods ended September 30, 2014. Gross gains of $2 thousand and $335 thousand were realized on these sales during the three and nine month periods ended September 30, 2014. Gross losses of $1 thousand and $250 thousand were realized on these sales during the three and nine month periods ended September 30, 2014. Proceeds from the sales of equity securities were $54.7 million and $55.6 million during the three and nine month period ended September 30, 2013.  Gross gains of $738 thousand and $994 thousand along with gross losses of $141 thousand were realized on these sales during the three and nine month period ended September 30, 2013.  

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The amortized cost and fair value of the debt securities portfolio are shown by expected maturity. Expected maturities may differ from contractual maturities if issuers have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity date are shown separately.

 

 

 

The following table summarizes the investment securities with unrealized losses at September 30, 2014 and December 31, 2013, aggregated by major security type and length of time in a continuous unrealized loss position.  Unrealized losses for U.S. Treasury and U.S. government sponsored entities and corporate bonds, for less than twelve months, rounded to less than $1 thousand in 2014. In addition, unrealized losses for equity securities rounded to less than $1 thousand in 2013.    

 

 

 

 

 

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Other-Than-Temporary-Impairment

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. Investment securities are generally evaluated for OTTI under FASB Accounting Standards Codification (“ASC”) 320, Investments – Debt and Equity Securities. Consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, whether the market decline was affected by macroeconomic conditions and whether the Company has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. In analyzing an issuer’s financial condition, the Company may consider whether the securities are issued by the federal government or its agencies, or U.S. government sponsored enterprises, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

When OTTI occurs, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis. If an entity intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) OTTI related to other factors, which is recognized in other comprehensive income or loss. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings.

As of September 30, 2014, the Company’s security portfolio consisted of 378 securities, 91 of which were in an unrealized loss position. The majority of the unrealized losses on the Company’s securities are related to its holdings of mortgage-backed securities, collateralized mortgage obligations, state and political subdivision securities, and small business administration securities as discussed below.

Unrealized losses on debt securities issued by state and political subdivisions have not been recognized into income. Generally these securities have maintained their investment grade ratings and management does not have the intent and is not required to sell these securities before their anticipated recovery. The fair value is expected to recover as the securities approach their maturity date.

All of the Company’s holdings of collateralized mortgage obligations and residential mortgage-backed securities were issued by U.S. government-sponsored entities. Unrealized losses on these securities have not been recognized into income. Because the decline in fair value is attributable to changes in interest rates and illiquidity, and not credit quality, the issues are guaranteed by the issuing entity and which the U.S. government has affirmed its commitment to support, and because the Company does not have the intent to sell these residential mortgage-backed securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Company does not consider these securities to be OTTI.

Management does not believe any unrealized losses on small business administration securities represent an other-than-temporary impairment. The securities are issued and backed by the full faith and credit of the U.S. government and the Company does not have the intent to sell these securities before their anticipated recovery. The fair value of these securities is expected to recover as they approach their maturity.

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Loans:

Loan balances were as follows:

 

 

The following tables present the activity in the allowance for loan losses by portfolio segment for the three and nine month periods ended September 30, 2014 and 2013:

Three Months Ended September 30, 2014

 

 

Nine Months Ended September 30, 2014

 

 

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Three Months Ended September 30, 2013

 

 

Nine Months Ended September 30, 2013

 

 

 

The following tables present the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of September 30, 2014 and December 31, 2013. The recorded investment in loans includes the unpaid principal balance and unamortized loan origination fees and costs, but excludes accrued interest receivable, which is not considered to be material:

September 30, 2014

 

 

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December 31, 2013

 

 

The following tables present information related to impaired loans by class of loans as of September 30, 2014 and December 31, 2013:

 

 

 

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The following table presents the average recorded investment in impaired loans by class and interest income recognized by loan class for the three and nine month periods ended September 30, 2014 and 2013:

 

 

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Cash basis interest recognized during the three and nine month periods ended September 30, 2014 was materially equal to interest income recognized. Interest income recognized and cash basis interest recognized during impairment for the three and nine month periods ended September 30, 2013 was immaterial.

Nonaccrual loans and loans past due 90 days or more still on accrual include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.

The following table presents the recorded investment in nonaccrual and loans past due 90 days or more still on accrual by class of loans as of September 30, 2014 and December 31, 2013:

 

 

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The following table presents the aging of the recorded investment in past due loans as of September 30, 2014 and December 31, 2013 by class of loans:

 

 

 

 

 

Troubled Debt Restructurings:

Total troubled debt restructurings were $8.4 million and $8.3 million at September 30, 2014 and December 31, 2013, respectively. The Company has allocated $253 thousand and $397 thousand of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of September 30, 2014 and December 31, 2013. There were $26 thousand and $16 thousand in commitments to lend additional amounts to borrowers with loans that were classified as troubled debt restructurings at September 30, 2014 and December 31, 2013.

During the three and nine month periods ended September 30, 2014 and 2013, the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans included one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; a permanent reduction of the recorded investment in the loan; a permanent increase of the recorded investment in the loan due to an advance of new monies; a deferral of principal payments; or a legal concession.

Troubled debt restructuring modifications involved a reduction of the notes stated interest rate in the range of 0.4% and 2.8%. There were also extensions of the maturity dates on these and other troubled debt restructurings in the range of 27 months to 71 months.

 

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The following table presents loans by class modified as troubled debt restructurings that occurred during the three and nine month periods ended September 30, 2014 and 2013:

 

 

 

 

 

 

 

 

 

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There were $10 thousand in charge offs with no increase to the provision for loan losses during the three month period ended September 30, 2014, as a result of troubled debt restructurings.  There were $42 thousand in charge offs resulting in an $11 thousand increase to the provision for loan losses during the nine month period ended September 30, 2014. There was $1 thousand in charge offs and no increase to the provision for loan losses during the three month period ended September 30, 2013, as a result of troubled debt restructurings.  During the nine month period ended September 30, 2013, there were $17 thousand in charge offs and no increase to the provision for loan losses due to the troubled debt restructurings described above.  

 

There was one residential real estate loan for which there were payment defaults within twelve months following the modification of the troubled debt restructuring during the three and nine month periods ended September 30, 2014.  This loan was past due at September 30, 2014.  There was no effect on the provision for loan losses as a result of this default during 2014.  A loan is considered to be in payment default once it is 30 days contractually past due under the modified terms.

There were two commercial loans and one commercial real estate loan modified as troubled debt restructuring for which there were payments defaults within twelve months following the modification during the three and nine months periods ended September 30, 2013. Two of the three loans were past due at September 30, 2013.  There was no additional provision or any impact to the allowance for loan losses associated with these loans.

 

 

Credit Quality Indicators:

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company establishes a risk rating at origination for all commercial loan and commercial real estate relationships. For relationships over $750 thousand, management monitors the loans on an ongoing basis for any changes in the borrower’s ability to service their debt. Management also affirms the risk ratings for the loans and leases in their respective portfolios on an annual basis. The Company uses the following definitions for risk ratings:

Special Mention. Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date. Special mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.

Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. Substandard loans are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans.

As of September 30, 2014 and December 31, 2013, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:

 

 

 

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The Company considers the performance of the loan portfolio and its impact on the allowance for loan losses. For residential, consumer indirect and direct loan classes, the Company also evaluates credit quality based on the aging status of the loan, which was previously presented, and by payment activity.

The following table presents the recorded investment in residential, consumer indirect and direct auto loans based on payment activity as of September 30, 2014 and December 31, 2013. Nonperforming loans are loans past due 90 days or more and still accruing interest and nonaccrual loans.

 

 

 

 

 

Interest-Rate Swaps:

The Company uses a program that utilizes interest-rate swaps as part of its asset/liability management strategy. The interest-rate swaps are used to help manage the Company’s interest rate risk position and not as derivatives for trading purposes. The notional amount of the interest-rate swaps does not represent amounts exchanged by the parties. The amount exchanged is determined by reference to the notional amount and the other terms of the individual interest-rate swap agreements.

The objective of the interest-rate swaps is to protect the related fixed rate commercial real estate loans from changes in fair value due to changes in interest rates. The Company has a program whereby it lends to its borrowers at a fixed rate with the loan agreement containing a two-way yield maintenance provision, which will be invoked in the event of prepayment of the loan, and is expected to exactly offset the fair value of unwinding the swap. The yield maintenance provision represents an embedded derivative which is bifurcated from the host loan contract and, as such, the swaps and embedded derivatives are not designated as hedges. Accordingly, both instruments are carried at fair value and changes in fair value are reported in current period earnings.

Summary information about these interest-rate swaps at periods ended September 30, 2014 and December 31, 2013 is as follows:

 

 

 

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The fair value of the yield maintenance provisions and interest-rate swaps is recorded in other assets and other liabilities, respectively, in the consolidated balance sheets. Changes in the fair value of the yield maintenance provisions and interest-rate swaps are reported in earnings, as other noninterest income in the consolidated statements of income. For the three and nine month periods ended September 30, 2014 and 2013 there were no net gains or losses recognized in earnings.

 

Earnings Per Share:

The computation of basic and diluted earnings per share is shown in the following table:

 

 

 

There were no outstanding stock options for the three and nine month periods ended September 30, 2014.  Stock options for 5,000 shares of common stock that were outstanding during the three and nine month periods ended September 30, 2013 were not considered in computing diluted earnings per share because they were antidilutive.

 

Stock Based Compensation:

During 2012, the Company, with the approval of shareholders, created the 2012 Equity Incentive Plan (the “Plan”). The Plan permits the award of up to 500 thousand shares to the Company’s directors and employees to promote the Company’s long-term financial success by motivating performance through long-term incentive compensation and to better align the interests of its employees with those of its shareholders. 46,957 share awards were granted under the Plan during February 2014. Expense recognized for the Plan was $29 thousand and $87 thousand for the three and nine month periods ended September 30, 2014.  As of September 30, 2014, there was $260 thousand of total unrecognized compensation expense related to the nonvested shares granted under the Plan.  The remaining cost is expected to be recognized over 2.25 years. There were no shares awarded or expense recognized during the three and nine month periods ended September 30, 2013.

The following is the activity under the Plan during the nine months ended September 30, 2014:

 

 

The Company’s Stock Option Plan, which was shareholder-approved and has since expired, permitted the grant of share options to its directors, officers and employees for up to 375 thousand shares of common stock. Option awards were granted with an exercise price equal to the market price of the Company’s common stock at the date of grant; those option awards had vesting periods of 5 years and had 10-year contractual terms. During the first quarter of 2014 the last remaining 5,000 outstanding options were exercised and the Company satisfied these options with the reissuance of treasury shares.

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The fair value of each option award is estimated on the date of grant using a Black-Scholes model. Total compensation cost charged against income for the stock option plan for the three and nine month periods ended September 30, 2014 and 2013 was not material. No related income tax benefit was recorded.  

Other Comprehensive Income (Loss):

The following table represents the detail of other comprehensive income (loss) for three and nine month periods ended September 30, 2014 and 2013.

 

 

 

 

 

(1) Pre-tax reclassification adjustments relating to available-for-sale securities are reported in security gains and the tax impact is included in income tax expense on the consolidated statements of income.

 

 

Fair Value:

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:

Level 1 – Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2 – Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

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Level 3 – Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

Investment Securities: The Company uses a third party service to estimate fair value on available for sale securities on a monthly basis. This service provider is considered a leading evaluation pricing service for U.S. domestic fixed income securities. They subscribe to multiple third-party pricing vendors, and supplement that information with matrix pricing methods. The fair values for investment securities are determined by quoted market prices in active markets, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on quoted prices for similar assets in active markets, quoted prices for similar assets in markets that are not active or inputs other than quoted prices, which provide a reasonable basis for fair value determination. Such inputs may include interest rates and yield curves, volatilities, prepayment speeds, credit risks and default rates. Inputs used are derived principally from observable market data (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). The fair values of Level 3 investment securities are determined by using unobservable inputs to measure fair value of assets for which there is little, if any market activity at the measurement date, using reasonable inputs and assumptions based on the best information at the time, to the extent that inputs are available without undue cost and effort. For the period ended September 30, 2014 and for the year ended December 31, 2013, the fair value of Level 3 investment securities was immaterial.

Derivative Instruments: The fair values of derivative instruments are based on valuation models using observable market data as of the measurement date (Level 2).

Impaired Loans: At the time loans are considered impaired, collateral dependent impaired loans are valued at the lower of cost or fair value and non-collateral dependent loans are valued based on discounted cash flows. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair values are commonly based on recent real estate appraisals. These appraisals may use a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial and commercial real estate properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by the Company. Once received, a member of the Appraisal Department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics. On an annual basis, the Company compares the actual selling price of collateral that has been sold to the most recent appraised value to determine what adjustments should be made to appraisals to arrive at fair value.

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Assets measured at fair value on a recurring basis, including financial assets for which the Company has elected the fair value option, are summarized below:

 

 

 

There were no significant transfers between Level 1 and Level 2 during the three and nine month periods ended September 30, 2014 and 2013.

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The table below presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3):

 

 

Assets measured at fair value on a non-recurring basis are summarized below:

 

 

 

Impaired loans that are measured for impairment using the fair value of the collateral for collateral dependent loans, had a principal balance of $1.1 million with a valuation allowance of $357 thousand at September 30, 2014, resulting in an additional provision for loan losses of $338 thousand and $554 thousand for the three and nine month period. At December 31, 2013, impaired loans had a principal balance of $4.2 million, with a valuation allowance of $363 thousand. Loans measured at fair value during the three and nine months ended September 30, 2013 resulted in an additional provision for loan losses of $431 thousand and $714 thousand. Excluded from the fair value of impaired loans, at September 30, 2014 and December 31, 2013, discussed above are $4.2 million and $3.0 million of loans classified as troubled debt restructurings and measured using the present value of cash flows, which are not carried at fair value.

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Impaired commercial real estate loans, both owner occupied and non-owner occupied are valued by independent external appraisals. These external appraisals are prepared using the sales comparison approach and income approach valuation techniques. Management makes subsequent unobservable adjustments to the impaired loan appraisals. Impaired loans other than commercial real estate and other real estate owned are not considered material.

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at period ended September 30, 2014 and December 31, 2013:

 

 

 

The carrying amounts and estimated fair values of financial instruments not previously disclosed at September 30, 2014 and December 31, 2013 are as follows:

 

 

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The methods and assumptions used to estimate fair value, not previously described, are described as follows:

Cash and Cash Equivalents: The carrying amounts of cash and short-term instruments approximate fair values and are classified as either Level 1 or Level 2. The Company has determined that cash on hand and non-interest bearing due from bank accounts are Level 1 whereas interest bearing federal funds sold and other are Level 2.

Restricted Stock: It is not practical to determine the fair value of restricted stock due to restrictions placed on its transferability.

Loans: Fair values of loans, excluding loans held for sale, are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

Loans held for sale: The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification.

Accrued Interest Receivable/Payable: The carrying amounts of accrued interest receivable and payable approximate fair value resulting in a Level 1, Level 2 or Level 3 classification. The classification is the result of the association with securities, loans and deposits.

Deposits: The fair values disclosed for demand deposits – interest and non-interest checking, passbook savings, and money market accounts – are, by definition, equal to the amount payable on demand at the reporting date resulting in a Level 1 classification. The carrying amounts of variable rate certificates of deposit approximate their fair values at the reporting date resulting in a Level 2 classification. Fair value for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

Short-term Borrowings: The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings, generally maturing within ninety days, approximate their fair values resulting in a Level 2 classification.

Long-term Borrowings: The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification.

Off-balance Sheet Instruments: The fair value of commitments is not considered material.

 

Segment Information:

The reportable segments are determined by the products and services offered, primarily distinguished between banking, trust and retirement consulting operations. They are also distinguished by the level of information provided to the chief operating decision makers in the Company, who use such information to review performance of various components of the business, which are then aggregated. Loans, investments, and deposits provide the revenues in the banking operation. All operations are domestic.  

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Significant segment totals are reconciled to the financial statements as follows:

 

 

 

 

 

 

 

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The Bank segment includes Farmers National Insurance and Farmers of Canfield Investment Co.

Business Combination:

On July 1, 2013, the Company completed the acquisition of all outstanding stock of the retirement planning consultancy National Associates, Inc. of Cleveland, Ohio.  The transaction involved both cash and stock totaling $4.4 million, including up to $1.5 million of future payments, contingent upon NAI meeting income performance targets, with an estimated fair value at the acquisition date of $920,000.  The fair market value of the contingent consideration was determined using the Monte Carlo Simulation.  The simulation’s key assumptions included a two year period with an estimated volatility of 20%.  Expected EBITDA had a base of 6% with a maximum 12% and a discount rate of 11.9%.  The acquisition is part of the Company’s plan to increase the levels of noninterest income and to complement the existing retirement services currently being offered.

Goodwill of $2.6 million, which is recorded on the balance sheet of NAI, arising from the acquisition consisted largely of synergies and the cost savings resulting from the combining of the operations of the companies.  The goodwill is not expected to be deductible for income tax purposes.  The fair value of other intangible assets of $2.3 million is related to client relationships, company name and noncompetition agreements.  The following table summarizes the consideration paid for NAI and the amounts of the assets acquired and liabilities assumed.  

 

 

NAI contributed $395 thousand and $1.4 million of gross revenues to the Company for the three and nine month periods ended September 30, 2014.  The resulting net income (loss) contributed was $(17) thousand and $97 thousand during the three and nine month periods ended September 30, 2014.  NAI contributed $280 thousand of gross revenue and a $(98) thousand net loss to the Company for the three and nine month periods ended September 30, 2013.

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The following table presents pro forma information as if the acquisition had occurred at the beginning of 2013.  The pro forma information includes adjustments for amortization of intangibles arising from the transaction and the related income tax effects.  The pro forma financial information is not necessarily indicative of the results of operations that would have occurred had the transactions been effected on the assumed dates.

 

 

 

 

 

Forward Looking Statements

Discussions in this report that are not statements of historical fact (including statements that include terms such as “will,” “may,” “should,” “believe,” “expect,” “anticipate,” “estimate,” “project,” “intend,” and “plan”) are forward-looking statements that involve risks and uncertainties. Any forward-looking statement is not a guarantee of future performance and actual future results could differ materially from those contained in forward-looking information. Factors that could cause or contribute to such differences include, without limitation, risks and uncertainties detailed from time to time in the Company’s filings with the Securities and Exchange Commission, including without limitation, the risk factors disclosed in Item 1A, “Risk Factors,” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

Many of these factors are beyond the Company’s ability to control or predict, and readers are cautioned not to put undue reliance on those forward-looking statements. The following list, which is not intended to be an all-encompassing list of risks and uncertainties affecting the Company, summarizes several factors that could cause the Company’s actual results to differ materially from those anticipated or expected in these forward-looking statements:

Other factors not currently anticipated may also materially and adversely affect the Company’s results of operations, cash flows and financial position. There can be no assurance that future results will meet expectations. While the Company believes that the forward-looking statements in this report are reasonable, the reader should not place undue reliance on any forward-looking statement. In addition, these statements speak only as of the date made. The Company does not undertake, and expressly disclaims, any obligation to update or alter any statements whether as a result of new information, future events or otherwise, except as may be required by applicable law.

Overview

Net income for the three months ended September 30, 2014 was $2.3 million, compared to $1.6 million for the same period last year.  The increase in the quarterly income over the same period in 2013 can be attributed primarily to $1.3 million in gross severance costs in the third quarter of 2013.  On a per share basis, net income for the third quarter ended September 30, 2014 was $0.12 per diluted share, compared to $0.09 for the quarter ended September 30, 2013 and $0.13 for the second quarter ended June 30, 2014.

Net income for the nine months ended September 30, 2014 was $6.8 million, compared to $5.5 million for the same nine month period in 2013. On a per share basis, net income for the nine months ended September 30, 2014 was $0.36, an increase of 24.1% compared to the same nine month period in 2013. Total gross loans were $647.0 million at September 30, 2014, compared to $611.3 million at

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September 30, 2013. This represents an increase of 5.8%.  The increase in loans is a direct result of Farmers’ focus on loan growth utilizing a talented lending and credit team while adhering to a sound underwriting discipline. Most of the increase in loans has occurred in the commercial real estate, commercial and industrial and residential real estate loan portfolios.  Average loan balances for the nine month period ended September 30, 2014 comprised 59.0% of the Bank's average earning assets, an improvement compared to 55.7% during the same period in 2013. Non-performing assets to total assets remain at a safe level, currently at 0.67%. Early stage delinquencies also continue to remain at manageable levels, at $4.9 million or 0.76% of total loans at September 30, 2014.

Deposits decreased $2.2 million, from $915.2 million at December 31, 2013 to $913.0 million at September 30, 2014, as customers begin to move some cash into other investment options. At September 30, 2014, core deposits – savings and money market accounts, time deposits less than $100 thousand, demand deposits and interest bearing demand deposits – represented approximately 91.2% of total deposits.

Stockholders’ equity totaled $121.4 million, or 10.7% of total assets, at September 30, 2014, an increase of $8.4 million, or 7.4%, compared to $113.0 million at December 31, 2013.  Contributing to the increase is a $4.9 million, net of tax, improvement in the mark to market adjustment in the securities available for sale portfolio due to decreases in long-term interest rates and a $5.1 million increase in retained net income.  Shareholders received a total of $0.12 per share in cash dividends paid in the past four quarters. Book value per share increased from $6.02 per share at December 31, 2013 to $6.54 per share at September 30, 2014.  The Company’s tangible book value per share also increased from $5.47 per share at December 31, 2013 to $6.02 per share at September 30, 2014.  The increases in book value and tangible book value per share were also the result of the mark to market adjustments, net of tax, in the securities available for sale portfolio and the increases to retained earnings from profit retention.

Results of Operations

The following is a comparison of selected financial ratios and other results at or for the three and six months ended June 30, 2014 and 2013:

 

 

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*The tangible common equity ratio is calculated by dividing total common stockholders’ equity by total assets, after reducing both amounts by intangible assets. The tangible common equity ratio is not required by U.S. GAAP or by applicable bank regulatory requirements, but is a metric used by management to evaluate the adequacy of the Company’s capital levels. Since there is no authoritative requirement to calculate the tangible common equity ratio, the Company’s tangible common equity ratio is not necessarily comparable to similar capital measures disclosed or used by other companies in the financial services industry. Tangible common equity and tangible assets are non-U.S. GAAP financial measures and should be considered in addition to, not as a substitute for or superior to, financial measures determined in accordance with U.S. GAAP. With respect to the calculation of the actual unaudited tangible common equity ratio as of September 30, 2014 and 2013, reconciliations of tangible common equity to U.S. GAAP total common stockholders’ equity and tangible assets to U.S. GAAP total assets are set forth below:

 

 

 

Net Interest Income. The following schedule details the various components of net interest income for the periods indicated. All asset yields are calculated on a tax-equivalent basis where applicable. Security yields are based on amortized cost.

 

 

 

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Average Balance Sheets and Related Yields and Rates

(Dollar Amounts in Thousands)

 

 

 

 

 

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Average Balance Sheets and Related Yields and Rates

(Dollar Amounts in Thousands)

 

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Net Interest Income.  Net interest income was $9.3 million for the third quarter of 2014, compared to $8.8 million in the third quarter of 2013.  The net interest margin to average earning assets on a fully taxable equivalent basis increased 11 basis points to 3.58% for the three months ended September 30, 2014, compared to 3.47% for the same three month period in the prior year.  The increase in net interest margin was largely a result of increased investment security return rates, specifically on the mortgage backed securities portfolio.  In addition, higher time deposit rates matured and were being moved to products with lower interest rates.  In comparing the quarters ended September 30, 2014 and 2013, yields on earning assets increased 6 basis points, while the cost of interest bearing liabilities decreased 4 basis points.

Net interest income increased to $27.1 million for the nine month period ended September 30 2014, compared to $26.9 million in the same period in 2013. The annualized net interest margin to average earning assets on a fully taxable equivalent basis was 3.57% for the nine months ended September 30, 2014, compared to 3.59% for the same period in the prior year.  The decline is primarily a result of the 22 basis point increase made in the taxable security portfolio not being enough to overcome the 31 basis point decline in the loan portfolio rate of return.

Noninterest Income.  Noninterest income was $3.9 million for the third quarter of 2014, decreasing 7.0% from $4.2 million in the same quarter of 2013. The largest driver of the decrease is the change in security gains.  During the three months ended September 30, 2013 there were $597 thousand of security gains compared to $1 thousand during the three month period ended September 30, 2014.  Trust fees increased $193 thousand to $1.6 million in comparing the same time period in 2013. Retirement plan consulting fees increased to $395 thousand compared to $280 thousand in the third quarter of 2013. Investment commission also helped offset the reduction in security gains by increasing $205 thousand, comparing the third quarter of 2014 to the same time period in 2013. Other operating income decreased $63 thousand, which is primarily the result of a gain on sale of land owned by the Company in the third quarter of 2013.

Noninterest income for the nine months ended September 30, 2014 was $11.1 million, compared to $10.3 million during the same period in 2013. The increase in noninterest income is due to service charges on deposit accounts of $1.9 million in 2014 compared to $1.6 million in 2013 and retirement plan consulting fees increasing to $1.4 million compared to $280 thousand in 2013.  Trust fees also increased from $4.1 million during the nine months ended September 30, 2013 to $4.6 million during the same nine month time period during 2014.

Noninterest Expense.  Noninterest expense totaled $9.8 million for the third quarter of 2014, which was $1.2 million less than the $10.9 million during the same quarter in 2013.  This decrease was the result of $1.3 million in severance costs recorded in the third quarter of 2013.

Noninterest expenses for the nine months ended September 30, 2014 was $28.3 million, compared to $29.8 million for the same nine month period in 2013, representing a decrease of $1.5 million, or 5.2%. The decrease is primarily the result of the previously mentioned decrease in salaries and employee benefits.  Reductions in merger related costs and state and local taxes contributed $569 thousand to the decrease between the nine month periods.

The Company’s tax equivalent efficiency ratio for the nine month period ended September 30, 2014 was 69.9% compared to 77.2% for the same period in 2013. The positive change in the efficiency ratio was the result of the $837 thousand increase in noninterest income and the $1.5 million decrease in noninterest expenses as explained in a previous paragraphs. Management has focused on increasing the levels of noninterest income and reducing the level of noninterest expenses.  One of the steps implemented in this process was the decision to close two retail branch locations during the fourth quarter of 2013.

Income Taxes. Income tax expense totaled $688 thousand for the quarter ended September 30, 2014 and $143 thousand for the quarter ended September 30, 2013. The increase in the current quarter tax expense can be attributed to the $1.2 million increase in income before taxes which was partly due to the $1.3 million severance costs in the three month period ended September 30, 2013. The effective tax rate for the three month period ended September 30, 2014 was 23.2%, compared to 8.1% for the same period in 2013. The effective tax rate increase compared to the same period in 2013 was primarily due to the decrease in tax exempt income, as a percentage of total income, from tax exempt municipal securities, loans to municipalities and bank owned life insurance income. During the three month period ended September 30, 2013 there was $217 thousand in death benefits on bank owned life insurance.

Income tax expense was $2.0 million for the first nine months of 2014 and $1.0 million for the first nine months of 2013.  The effective tax rate for the nine month period of 2014 was 23.0%, compared to 16.0% for the same period in 2013.  The effective tax rate increase over the same period in 2013 was due to the decrease in income from tax exempt municipal securities and loans as a percentage of total income as mentioned in the quarter discussion above.

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Other Comprehensive Income.  For the quarter ended September 30, 2014, the change in net unrealized gains or losses on securities, net of reclassifications, resulted in an unrealized gain, net of tax, of $342 thousand, compared to an unrealized loss of $4.3 million for the same period in 2013. The increase in fair value for the three month period ended September 30, 2014 compared to 2013 is the result of market interest rate fluctuations.

For the nine months of 2014, the change in net unrealized gains on securities, net of reclassifications, resulted in an unrealized gain, net of tax, of $4.9 million, compared to an unrealized loss of $11.9 million for the same period in 2013. The increase in fair value for the three and nine month periods ended September 30, 2014 is the result of the continuing low long term interest rates.

Financial Condition

Cash and cash equivalents. Cash and cash equivalents increased $781 thousand during the first nine months of 2014. The Company expects these levels to remain steady over the next few months.

Securities. Securities available-for-sale decreased by $18.1 million since December 31, 2013.  As securities matured and were paid down, the proceeds were used to fund increases in the loan portfolio as well as withdrawals on deposit accounts.

Loans. Gross loans increased $16.3 million since December 31, 2013. Most of the increase occurred in the commercial real estate, commercial and industrial and residential real estate loan portfolios. The increase in loan balances was not enough to overcome the low interest rate environment that caused loan income to remain equal for the first nine months of 2014 and 2013.  On a fully tax equivalent basis, loans contributed $23.4 million of total interest income during both nine month periods ended September 30, 2014 and 2013.

 Allowance for Loan Losses. The following table indicates key asset quality ratios that management evaluates on an ongoing basis. The unpaid principal balance of non-performing loans and non-performing assets was used in the calculation of amounts and ratios on the table below for quarters prior to the current quarter ended September 30, 2014.  For the current quarter, recorded investment amounts were used in the calculations.

Asset Quality History

(In Thousands of Dollars)

 

 

For the three months ended September 30, 2014, management recorded a $425 thousand provision for loan losses, compared to providing $340 thousand over the same three month period in the prior year. The larger provision recorded for the three month period ended September 30, 2014 was primarily a result of the loan portfolio’s growth and increased net charge-offs.  The percentage of growth in total loans was more than the provision for the three month period ended September 30, 2014 as compared to the same period in 2013. As a result, the ratio of allowance for loan losses to gross loans declined from 1.2% at September 30, 2013 to 1.1% at September 30, 2014.  In support of the lower allowance for loan losses to gross loans ratio, the Bank had an improved ratio of non-performing loans as a percentage of total loans from 1.5% at September 30, 2013 to 1.1% at September 30, 2014. Net charge-offs were $448 thousand and exceeded the provision by $23 thousand during the quarter ended September 30, 2014.

For the nine month period ended September 30, 2014, a $1.1 million provision was recorded compared to $765 thousand for the first nine months of 2013.  The larger provision for the nine month period in the current year was primarily the result of a combined $1.3 million of net charge-offs.  The consumer and residential real estate portfolios received most of the allocation of the allowance for loan losses for the nine month period ended September 30, 2014.  The increase to the provision in the first nine months of 2014 was

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due to charge-offs and other factors mentioned in the previous paragraph.  In addition, net charge offs exceeded the provision during the nine month period ended September 30, 2014 by $235 thousand.  Also, loans 30–89 days delinquent increased $2.6 million to $4.9 million since September 30, 2013.

Based on the evaluation of the adequacy of the allowance for loan losses, management believes that the allowance for loan losses at September 30, 2014 is adequate and reflects probable incurred losses in the portfolio. The provision for loan losses is based on management’s judgment after taking into consideration all factors connected with the collectability of the existing loan portfolio. Management evaluates the loan portfolio in light of economic conditions, changes in the nature and volume of the loan portfolio, industry standards and other relevant factors. Specific factors considered by management in determining the amounts charged to operating expenses include previous credit loss experience, the status of past due interest and principal payments, the quality of financial information supplied by loan customers and the general condition of the industries in the community to which loans have been made.

Deposits. Total deposits decreased $2.2 million from $915.2 million at December 31, 2013 to $913.0 million at September 30, 2014, as customers begin to move some cash into other investment options.  Time deposits decreased $15.8 million and were offset by an increase in non-interest bearing demand and savings deposits of $13.1 million during the first nine month period of 2014, making up the majority of the deposits decrease. The Company’s strategy is to maintain deposit balances while pricing deposit rates to remain competitive within the market. At September 30, 2014, core deposits, which include, savings and money market accounts, time deposits less than $100 thousand, demand deposits and interest bearing demand deposits represented approximately 91% of total deposits.

Borrowings. Total borrowings decreased $10.8 million, or 10.6%, since December 31, 2013. The decrease in borrowings is the result of a $3.6 million decrease in securities sold under repurchase agreements and a $6.0 million decrease in Federal Funds Purchased at September 30, 2014 as public entities moved funds between securities sold under repurchase agreements and other investment accounts in an effort to maximize returns.

Capital Resources. Total stockholders’ equity increased to $121.4 million, or 10.7% of total assets, at September 30, 2014, an increase of $8.4 million, or 7.4%, compared to $113.0 million at December 31, 2013.  Contributing to the increase is $4.9 million improvement in the mark to market adjustment in the securities available for sale portfolio due to decreases in long-term interest rates during the period and a $5.1 million increase in retained net income.  Shareholders have received $0.03 per share in cash dividends each quarter over the last four quarters. Book value per share increased from $6.02 per share at December 31, 2013 to $6.54 per share at September 30, 2014.  The Company’s tangible book value per share also increased from $5.47 per share at December 31, 2013 to $6.02 per share at September 30, 2014.  The increases in book value and tangible book value per share were also the result of the mark to market adjustments in the securities available for sale portfolio and the increases to retained earnings from profit retention.

The capital management function is a regular process that consists of providing capital for both the current financial position and the anticipated future growth of the Company. As of September 30, 2014 the Company’s total risk-based capital ratio stood at 16.54%, and the Tier I risk-based capital ratio and Tier I leverage ratio were at 15.52% and 9.89%, respectively. Management believes that the Company and the Bank meet all capital adequacy requirements to which they are subject, as of September 30, 2014.

Critical Accounting Policies

The Company follows financial accounting and reporting policies that are in accordance with U.S. GAAP. These policies are presented in Note 1 of the consolidated audited financial statements in the Company’s Annual Report to Shareholders included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013. Critical accounting policies are those policies that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. The Company has identified two accounting policies that are critical accounting policies and an understanding of these policies is necessary to understand the Company’s financial statements. These policies relate to determining the adequacy of the allowance for loan losses and other-than-temporary impairment of securities. Additional information regarding these policies is included in the notes to the aforementioned 2013 consolidated financial statements, Note 1 (Summary of Significant Accounting Policies), Note 2 (Securities), Note 3 (Loans), and the sections captioned “Investment Securities” and “Loan Portfolio.”

Management believes that the accounting for goodwill and other intangible assets also involves a higher degree of judgment than most other significant accounting policies. U.S. GAAP establishes standards for the amortization of acquired intangible assets and the impairment assessment of goodwill. Goodwill arising from business combinations represents the value attributable to unidentifiable intangible assets in the business acquired. The Company’s goodwill relates to the value inherent in the banking industry and that value is dependent upon the ability of the Company’s trust and NAI subsidiaries to provide quality, cost-effective services in a competitive marketplace. The goodwill value is supported by revenue that is in part driven by the volume of business transacted. A decrease in earnings resulting from a decline in the customer base or the inability to deliver cost-effective services over sustained periods can lead to impairment of goodwill that could adversely impact earnings in future periods. U.S. GAAP requires an annual evaluation of

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goodwill for impairment, or more frequently if events or changes in circumstances indicate that the asset might be impaired. The fair value of the goodwill, which resides on the books of the Trust and NAI, is estimated by reviewing the past and projected operating results for the subsidiaries and comparable industry information.

Liquidity

The Company maintains, in the opinion of management, liquidity sufficient to satisfy depositors’ requirements and meet the credit needs of customers. The Company depends on its ability to maintain its market share of deposits as well as acquiring new funds. The Company’s ability to attract deposits and borrow funds depends in large measure on its profitability, capitalization and overall financial condition. The Company’s objective in liquidity management is to maintain the ability to meet loan commitments, purchase securities or to repay deposits and other liabilities in accordance with their terms without an adverse impact on current or future earnings. Principal sources of liquidity for the Company include assets considered relatively liquid, such as federal funds sold, cash and due from banks, as well as cash flows from maturities and repayments of loans, and securities.

Along with its liquid assets, the Bank has additional sources of liquidity available which help to ensure that adequate funds are available as needed. These other sources include, but are not limited to, loan repayments, the ability to obtain deposits through the adjustment of interest rates and the purchasing of federal funds and borrowings on approved lines of credit at major domestic banks. At September 30, 2014, these lines of credit totaled $25.0 million of which the Bank had not borrowed against these lines. In addition, the Company has two revolving lines of credit with correspondent banks totaling $6.5 million. The outstanding balance at September 30, 2014 was $350 thousand. Management feels that its liquidity position is adequate and continues to monitor the position on a monthly basis. As of September 30, 2014, the Bank had outstanding balances with the Federal Home Loan Bank of Cincinnati (“FHLB”) of $18.6 million with additional borrowing capacity of approximately $91.4 million with the FHLB as well as access to the Federal Reserve Discount Window, which provides an additional source of funds. The Bank views its membership in the FHLB as a solid source of liquidity.

The primary investing activities of the Company are originating loans and purchasing securities. During the first nine months of 2014, net cash provided by investing activities amounted to $8.8 million, compared to $21.2 million used in the same period in 2013.  Proceeds from maturities and repayments of securities available for sale were down to $35.9 million from $62.4 million during the first nine months of 2013.  Proceeds from sales of securities available for sale amounted to $34.2 million provided during the first nine months of 2014 compared to $55.6 million provided during the same period in 2013.  Cash used to purchase investment securities totaled $42.5 million during the nine month period ended September 30, 2014 compared to $111.7 million used during the same period in 2013.  There was $8.0 million less used by net loan originations and payments during the first nine months of 2014 compared to the first nine months of 2013. The cash used by lending activities during this and last year’s first nine month periods can be attributed to the positive activity in the consumer real estate and commercial loan portfolios.

The primary financing activities of the Company are obtaining deposits, repurchase agreements and other borrowings. Net cash used in financing activities amounted to $16.4 million for the first nine months of 2014, compared to $9.1 million provided by financing activities for the same period in 2013. This increase in cash used can be attributed to the change in net change in short-term borrowings, deposits and FHLB advance borrowings. During the nine month period ended September 30, 2014 cash used by short-term borrowings was $9.6 million compared to $18.4 million provided during the same nine month period in 2013. Deposits used $15.6 million during the first nine months of 2013 compared to $2.2 million used in the current year. There was also $10 million provided by FHLB advances during the first nine months of 2013 compared to none in 2014.  

Off-Balance Sheet Arrangements

In the normal course of business, to meet the financial needs of our customers, we are a party to financial instruments with off-balance sheet risk. These financial instruments generally include commitments to originate mortgage, commercial and consumer loans, and involve to varying degrees, elements of credit and interest rate risk in excess of amounts recognized in the Consolidated Balance Sheets. The Bank’s maximum exposure to credit loss in the event of nonperformance by the borrower is represented by the contractual amount of those instruments. Because some commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The same credit policies are used in making commitments as are used for on-balance sheet instruments. Collateral is required in instances where deemed necessary. Undisbursed balances of loans closed include funds not disbursed but committed for construction projects. Unused lines of credit include funds not disbursed, but committed for, home equity, commercial and consumer lines of credit. Financial standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. Those guarantees are primarily used to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Total unused commitments were $147.4 million at September 30, 2014 and $134.3 at December 31, 2013.  Additionally, the Company has committed up to a $3 million subscription in a Small Business Investment Company fund (SBIC).  At September 30, 2014 the Company had invested $1.3 million in this fund.

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Recent Market and Regulatory Developments

In response to the current national and international economic recession, and in an effort to stabilize and strengthen the financial markets and banking industries, the United States Congress and governmental agencies have taken a number of significant actions over the past several years, including the passage of legislation and the implementation of a number of programs. The most recent of these actions was the passage into law, on July 21, 2010, of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The Dodd-Frank Act is the most comprehensive change to banking laws and the financial regulatory environment since the Great Depression of the 1930s. The Dodd-Frank Act affects almost every aspect of the nation’s financial services industry and mandates change in several key areas, including regulation and compliance, securities regulation, executive compensation, regulation of derivatives, corporate governance, and consumer protection.

The extent to which the Dodd-Frank Act and initiatives thereunder will succeed in addressing the credit markets or otherwise result in an improvement in the national economy is uncertain. In addition, because many aspects of this legislation still remain subject to intensive agency rulemaking and subsequent public comment prior to implementation, it is difficult to predict at this time the ultimate effect of the Dodd-Frank Act on the Company. It is likely, however, that the Company’s expenses will increase as a result of new compliance requirements.

In July 2013, the Federal banking regulators approved a final rule to implement the revised capital adequacy standards of the Basel Committee on Banking Supervision, commonly called Basel III, and to address relevant provisions of the Dodd-Frank Act.  The final rule strengthens the definition of regulatory capital, increases risk-based capital requirements, makes selected changes to the calculation of risk-weighted assets, and adjusts the prompt corrective action thresholds.  Community banking organizations, such as the Company and the Bank, become subject to the new rule on January 1, 2015 and certain provisions of the new rule will be phased in over the period of 2015 through 2019.

The final rule:

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The Company’s management is currently evaluating the provisions of the final rule and their expected impact on the Company.

Various legislation affecting financial institutions and the financial industry will likely continue to be introduced in Congress, and such legislation may further change banking statutes and the operating environment of the Company in substantial and unpredictable ways, and could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance depending upon whether any of this potential legislation will be enacted, and if enacted, the effect that it or any implementing regulations, would have on the financial condition or results of operations of the Company or any of its subsidiaries. With the enactment of the Dodd-Frank Act, the nature and extent of future legislative and regulatory changes affecting financial institutions remains very unpredictable at this time.

Also, such statutes, regulations and policies are continually under review by Congress and state legislatures and federal and state regulatory agencies and are subject to change at any time, particularly in the current economic and regulatory environment. Any such change in statutes, regulations or regulatory policies applicable to the Company could have a material effect on the business of the Company.

 

The Company’s ability to maximize net income is dependent, in part, on management’s ability to plan and control net interest income through management of the pricing and mix of assets and liabilities. Because a large portion of assets and liabilities of the Company are monetary in nature, changes in interest rates and monetary or fiscal policy affect its financial condition and can have significant impact on the net income of the Company. Additionally, the Company’s balance sheet is currently liability sensitive and in the low interest rate environment that exists today, the Company’s net interest margin should maintain current levels throughout the near future.

The Company considers the primary market exposure to be interest rate risk. Simulation analysis is used to monitor the Company’s exposure to changes in interest rates, and the effect of the change to net interest income. The following table shows the effect on net interest income and the net present value of equity in the event of a sudden and sustained 300 basis point increase or 100 basis decrease in market interest rates:

 

 

The results of the simulation indicate that in an environment where interest rates rise 100, 200 and 300 basis points or fall 100 basis points over a 12 month period, using September 30, 2014 amounts as a base case, and considering the increase in deposit liabilities, and the volatile financial markets. It should be noted that the change in the net present value of equity exceeded policy when the simulation model assumed a sudden decrease in rates of 100 basis points. This was primarily because the positive impact on the fair value of assets would not be as great as the negative impact on the fair value of certain liabilities. Specifically, because core deposits typically bear relatively low interest rates, their fair value would be negatively impacted as the rates could not be adjusted by the full extent of the sudden decrease in rates. Management does not believe that a 100 basis rate decline is realistic in the current interest rate environment. The remaining results of this analysis comply with internal limits established by the Company. A report on interest rate risk is presented to the Board of Directors and the Asset/Liability Committee on a quarterly basis. The Company has no market risk sensitive instruments held for trading purposes, nor does it hold derivative financial instruments, and does not plan to purchase these instruments in the near future.

 

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Based on their evaluation, as of the end of the period covered by this Quarterly Report on Form 10-Q, the Company’s Chief Executive Officer and Chief Financial Officer have concluded the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) are effective. There were no changes in the Company’s internal controls over financial reporting (as defined in Rule 13a–15(f) under the Exchange Act) that occurred during the fiscal quarter ended September 30, 2014, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

 

 

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PART II - OTHER INFORMATION

 

In the opinion of management there are no outstanding legal actions that will have a material adverse effect on the Company’s financial condition or results of operations.

 

There have been no material changes to the Company’s risk factors from those disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2013.

 

 

Purchases of equity securities by the issuer.

On July 29, 2014, the Company announced that its Board of Directors approved a voluntary odd-lot buyback program.  Shareholders who own 99 or fewer shares of the Company’s common stock are eligible to participate in the buyback.  The program authorizes the purchase of 38,596 shares.  There were no share purchases settled during the three month period ended September 30, 2014.

On September 28, 2012, the Company announced that its Board of Directors approved a stock repurchase program that authorizes the repurchase of up to 920,000 shares of its outstanding common stock in the open market or in privately negotiated transactions.  

The following table summarizes the treasury stock activity under the program during the three month period ended September 30, 2014.

 

 

Not applicable.

 

Not applicable.

 

Not applicable.

 

 

 

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The following exhibits are filed or incorporated by reference as part of this report:

 

 

 

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

FARMERS NATIONAL BANC CORP.

Dated: November 6, 2014

 

Dated: November 6, 2014

 

 

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