CITIZENS & NORTHERN CORP annual report, FY2017

Citizens & Northern Corporation — FY 2017 Form 10-K

Business context and reporting period. Citizens & Northern is a community banking holding company serving North Central Pennsylvania and Southern New York. This annual report covers the fiscal year ended December 31, 2017; it also provides unaudited quarterly results, including fourth-quarter 2017. Unless otherwise stated, dollar amounts below are in millions.

Financial performance and condition

Earnings: Net income was $13.4 million, or $1.10 per diluted share, versus $15.8 million and $1.30 in 2016. Return on average assets was 1.08% and return on average equity was 7.11%.
Revenue and margins: Interest income was $45.9 million and net interest income was $41.9 million, up 3.8% from 2016. Net interest margin increased to 3.82% from 3.76%. Noninterest income excluding securities gains rose 4.1% to $16.2 million; reported total other income, including securities gains, was $16.4 million.
Expenses and profitability: Noninterest expense rose 6.4% to $37.0 million; the efficiency ratio increased to 60.74% from 59.22%. Pretax income was $20.6 million, down from $21.1 million.
Cash flow: Operating cash flow was $19.4 million; investing activities used $30.9 million, chiefly reflecting loan growth; financing activities provided $19.9 million. Cash and cash equivalents ended the year at $37.0 million, up from $28.6 million.
Balance sheet and funding: Consolidated assets were $1,277.0 million, deposits $1,008.4 million, net loans $806.9 million, and stockholders’ equity $188.4 million. Borrowings totaled $71.0 million, comprising $61.8 million short-term and $9.2 million long-term.
Credit and capital: The allowance for loan losses was $8.9 million, or 1.09% of loans; net charge-offs were 0.05% of average loans. Regulatory capital ratios remained well above minimum requirements: consolidated total risk-based capital was 23.07% and Tier 1 leverage was 14.23%.
Shareholder returns: The declared dividend was $1.04 per share, equal to 94.55% of diluted EPS. No shares were repurchased under the 600,000-share authorization during 2017.

Material changes versus 2016

Reported earnings fell largely because of a one-time $2.159 million deferred-tax-asset write-down following enactment of the federal tax-rate reduction. Excluding that charge, management presented adjusted net income of $15.593 million, or $1.28 per diluted share, compared with $15.762 million and $1.30 in 2016.
Average loans increased 8.0% to $780.6 million, while average available-for-sale securities declined $33.2 million. Year-end gross loans grew 8.5% to $815.7 million; deposits increased 2.5% to $1,008.4 million.
Nonperforming assets rose to $18.7 million from $17.8 million, and nonperforming assets as a share of assets increased to 1.47% from 1.43%. Nonaccrual loans increased to $13.4 million from $8.7 million, while loans 90 days past due and still accruing declined to $3.7 million from $6.8 million.
Short-term borrowings increased to $61.8 million from $26.2 million, while long-term borrowings fell to $9.2 million from $38.5 million. The company repaid $37 million of higher-cost borrowings and replaced funding in part with FHLB advances.
Available-for-sale securities had a $2.4 million net unrealized loss at year-end, compared with a $1.5 million loss in 2016. Management considered the losses temporary and reported no impairment losses in earnings.

Outlook, commentary, risks and unusual items

Management estimated an effective tax rate of approximately 15% for 2018, citing the new 21% federal corporate tax rate; it expected the lower rate to reduce taxes on an ongoing basis. The 2017 effective rate was 34.75%, including the deferred-tax remeasurement charge.
Management estimated 2018 premises and equipment purchases of approximately $3.0 million and said it did not expect these to materially harm financial condition. It expected capital levels to remain above well-capitalized standards.
Liquidity sources included $11.3 million of overnight interest-bearing deposits, $356.3 million of available credit facilities, and $196.8 million of unencumbered available-for-sale securities. Management stated it was well positioned to meet obligations, while noting that access to credit facilities depends on counterparties and market conditions.
Key risks include regional economic concentration, credit losses and collateral values, interest-rate sensitivity, cybersecurity and technology dependence, competition, regulation, and securities-market volatility. The loan portfolio is concentrated in the company’s regional markets; participation loans totaled $61.2 million, including $53.8 million to businesses outside those markets.
Residential mortgage loans sold and serviced totaled $169.7 million. Repurchased loans arising from identified underwriting or documentation noncompliance had an outstanding balance of $1.8 million. The MPF Original program’s maximum credit-enhancement obligation was $5.7 million, against which a $260,000 allowance was recorded.
The filing identifies material estimation judgment in the loan-loss allowance, securities valuation, and deferred-tax-asset recoverability. Legal proceedings were described as ordinary-course matters, with management not expecting a material adverse effect. The independent auditor issued unqualified opinions on the financial statements and internal control over financial reporting.

Most important facts for investors to verify

Whether loan growth can continue without further deterioration in nonaccrual loans, nonperforming assets, and specific commercial-loan exposures.
Whether the $2.159 million tax remeasurement is appropriately separated from recurring earnings, and whether the approximately 15% 2018 tax-rate estimate is realized.
How higher short-term borrowing and deposit costs affect net interest margin as rates change; the company’s model projected lower one-year net interest income in both rising- and falling-rate scenarios.
Whether participation-loan exposures outside the core market and mortgage-sale representations, warranties, and credit-enhancement obligations remain controlled.
Whether dividends remain sustainable given the 94.55% dividend-to-diluted-EPS payout ratio and applicable regulatory restrictions.