NORWOOD FINANCIAL CORP 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements The Private Securities Litigation Reform Act of 1995 contains safe harbor provisions regarding forward-looking statements. When used in this discussion, the words “believes,” “anticipates,” “contemplates,” “expects,” and similar expressions are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties which could cause actual results to differ materially from those projected. Those risks and uncertainties include:  possible future impairment of intangible assets  our ability to effectively manage future growth  loan losses in excess of our allowance  the impact of the COVID-19 pandemic on us  risk of litigation from participation in the PPP loan program  risks inherent in the COVID-19 loan forbearance programs under the CARES Act  risks inherent in commercial lending  real estate collateral which is subject to declines in value  potential other-than-temporary impairments 28  soundness of other financial institutions  interest rate risks  potential liquidity risk  deposits acquired through competitive bidding  availability of capital  regional economic factors  loss of senior officers  comparatively low legal lending limits  risks of new capital requirements  potential impact of Tax Cuts and Jobs Act  limited market for the Company’s stock  restrictions on ability to pay dividends  common stock may lose value  insider ownership  issuing additional shares may dilute ownership  competitive environment  certain anti-takeover provisions  extensive and complex governmental regulation and associated cost  cybersecurity The Company undertakes no obligation to publicly release the results of any revisions to those forward-looking statements which may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Critical Accounting Policies Note 2 to the Company’s consolidated financial statements for the fiscal year ended December 31, 2021 (included in Item 8 of the Annual Report on Form 10-K for the fiscal year ended December 31, 2021) lists significant accounting policies used in the development and presentation of its financial statements. This discussion and analysis, the significant accounting policies, and other financial statement disclosures identify and address key variables and other qualitative and quantitative factors that are necessary for an understanding and evaluation of the Company and its results of operations. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of deferred tax assets, the fair value of financial instruments, the determination of other-than-temporary impairment on securities and the determination of goodwill impairment. Please refer to the discussion of the allowance for loan losses calculation under “Loans” in the “Changes in Financial Condition” section. The Company uses the modified prospective transition method to account for stock options. Under this method companies are required to record compensation expense, based on the fair value of options over the vesting period. Restricted shares vest over a five-year period. The product of the number of shares granted and the grant date market price of the Company’s common stock determines the fair value of restricted stock. Deferred income taxes reflect temporary differences in the recognition of the revenue and expenses for tax reporting and financial statement purposes, principally because certain items are recognized in different periods for financial reporting and tax return purposes. Although realization is not assured, the Company believes that it is more likely than not that all deferred tax assets will be realized. The fair value of financial instruments is based upon quoted market prices, when available. For those instances where a quoted price is not available, fair values are based upon observable market based parameters as well as unobservable parameters. Any such valuation is applied consistently over time. Management determines the appropriate classification of debt securities at the time of purchase and re-evaluates such designation as of each Consolidated Balance Sheet date. 29 Declines in the fair value of available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, the Company considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent of the Company to not sell the securities and whether it is more likely than not that it will not have to sell the securities before recovery of their cost basis. The Company believes that all unrealized losses on securities at March 31, 2022 and December 31, 2021 represent temporary impairment of the securities, related to changes in interest rates. In connection with acquisitions, the Company recorded goodwill in the amount of $29.3 million, representing the excess of amounts paid over the fair value of net assets of the institutions acquired in purchase transactions, at its fair value at the date of acquisition. Goodwill is tested and deemed impaired when the carrying value of goodwill exceeds its implied fair value. The value of the goodwill can change in the future. We expect the value of the goodwill to decrease if there is a significant decrease in the franchise value of the Company or the Bank. If an impairment loss is determined in the future, we will reflect the loss as an expense for the period in which the impairment is determined, leading to a reduction of our net income for that period by the amount of the impairment loss. Changes in Financial Condition General Total assets as of March 31, 2022 were $2.078 billion compared to $2.069 billion as of December 31, 2021. The increase was due primarily to a $28.1 million increase in securities available-for-sale and a $16.7 million increase in loans receivable. The increases were funded with $25.0 million of deposit growth. Securities The fair value of securities available for sale as of March 31, 2022 was $434.9 million compared to $406.8 million as of December 31, 2021. The increase in the securities portfolio is the result of purchases executed to invest excess liquidity and to provide pledging for public deposits. The Company has securities in an unrealized loss position. In management’s opinion, the unrealized losses reflect changes in interest rates subsequent to the acquisition of specific securities. Management believes that the unrealized losses on all holdings represent temporary impairment of the securities, as the Company has the intent and ability to hold these investments until maturity or market price recovery. Loans Loans receivable totaled $1.372 billion at March 31, 2022 compared to $1.355 billion as of December 31, 2021. The $16.7 million increase recorded during the first three months of 2022 was due primarily to a $12.9 million increase in commercial real estate loans. The allowance for loan losses totaled $16,660,000 as of March 31, 2022, and represented 1.21% of total loans outstanding, compared to $16,442,000, or 1.21% of total loans outstanding, at December 31, 2021. The Company had net charge-offs for the three months ended March 31, 2022 of $82,000 compared to $141,000 in the corresponding period in 2021. The Company’s management assesses the adequacy of the allowance for loan losses on a quarterly basis. The process includes an analysis of the risks inherent in the loan portfolio. It includes an analysis of impaired loans and a historical review of credit losses by loan type. Other factors considered include concentration of credit in specific industries, economic and industry conditions, trends in delinquencies and loan classifications, and loan growth. In addition, management has included qualitative factors during 2022 which are specifically related to the economic impact of the COVID-19 pandemic. Management considers the allowance adequate at March 31, 2022 based on the Company’s criteria. However, there can be no assurance that the allowance for loan losses will be adequate to cover significant losses, if any, which might be incurred in the future. As of March 31, 2022, non-performing loans totaled $708,000 or 0.05% of total loans compared to $643,000, or 0.05%, of total loans at December 31, 2021. At March 31, 2022, non-performing assets totaled $1,298,000, or 0.06%, of total assets, compared to $2,385,000, or 0.12%, of total assets at December 31, 2021. 30 The following table sets forth information regarding non-performing loans and foreclosed real estate at the dates indicated: (dollars in thousands) March 31, 2022 December 31, 2021 Loans accounted for on a non-accrual basis: Real Estate Residential $ 460 $ 469 Commercial 101 103 Agricultural — — Construction — — Commercial and financial loans 16 16 Other agricultural loans — — Consumer loans to individuals 131 55 Total non-accrual loans 708 643 Accruing loans which are contractually past due 90 days or more — — Total non-performing loans 708 643 Foreclosed real estate 590 1,742 Total non-performing assets $ 1,298 $ 2,385 Purchased credit impaired loans (a) $ 6,814 $ 8,304 Allowance for loans losses $ 16,660 $ 16,442 Coverage of non-performing loans (a) (b) 2,353% % 2,557% % Non-performing loans to total loans(a) 0.05 % 0.05 % Non-performing loans to total assets(a) 0.03 % 0.03 % Non-performing assets to total assets(a) 0.06 % 0.12 % (a) Purchased impaired loans are loans obtained in acquisition transactions that as of the acquisition date were specifically identified as displaying signs of credit deterioration and for which the Company did not expect to collect all contractually required principal and interest payments. Those loans were impaired at the date of acquisition, were recorded at estimated fair value and were generally delinquent in payments. The Company estimated the timing and amount of expected cash flows in excess of the estimated fair value and established an accretable discount on the acquisition date relating to these impaired loans that is recognized in interest income. (b) For loans acquired with specific evidence of deterioration in credit quality, a specific credit fair value adjustment is established at the date of acquisition and will not impact the allowance for loan losses unless actual losses exceed the established fair value adjustment. Deposits During the three-month period ended March 31, 2022, total deposits increased $25.0 million due primarily to growth in municipal relationships. The following table sets forth deposit balances as of the dates indicated: (dollars in thousands) March 31, 2022 December 31, 2021 Non-interest bearing demand $ 438,979 $ 440,652 Interest-bearing demand 223,153 196,786 Money market deposit accounts 322,862 309,439 Savings 310,797 281,214 Time deposits <$250,000 266,951 271,464 Time deposits >$250,000 219,035 257,238 Total $ 1,781,777 $ 1,756,793 31 Borrowings Other borrowings as of March 31, 2022, totaled $26.8 million compared to $30.0 million as of December 31, 2021. Short-term borrowings, which consist of securities sold under agreements to repurchase and overnight borrowings from the FHLB, increased $2.8 million due to growth in repurchase agreements. Other borrowings consisted of the following: (dollars in thousands) March 31, 2022 December 31, 2021 Notes with the FHLB: Amortizing fixed rate borrowing due March 2022 at 1.75% $ — $ 227 Amortizing fixed rate borrowing due August 2022 at 1.94% 854 1,364 Amortizing fixed rate borrowing due October 2022 at 1.88% 973 1,386 Amortizing fixed rate borrowing due October 2023 at 3.24% 3,343 3,856 Amortizing fixed rate borrowing due December 2023 at 3.22% 1,842 2,097 Fixed rate term borrowing due December 2023 at 1.95% 10,000 10,000 Amortizing fixed rate borrowing due December 2023 at 1.73% 4,578 5,190 Amortizing fixed rate borrowing due April 2024 at 0.91% 5,254 5,878 $ 26,844 $ 29,998 Stockholders’ Equity and Capital Ratios As of March 31, 2022, stockholders’ equity totaled $186.8 million, compared to $205.3 million as of December 31, 2021. The net change in stockholders’ equity included $7.1 million of net income, which was partially offset by $2.3 million of dividends declared. In addition, total equity decreased $23.5 million due to a decrease in the fair value of securities in the available for sale portfolio, net of tax. This decrease in fair value is the result of a change in interest rates and spreads, which may impact the value of the securities. Because of interest rate volatility, the Company’s accumulated other comprehensive income could materially fluctuate for each interim and year-end period. A comparison of the Company’s consolidated regulatory capital ratios is as follows: March 31, 2022 December 31, 2021 Tier 1 Capital (To average assets) 8.78% 8.51% Tier 1 Capital (To risk-weighted assets) 12.48% 12.49% Common Equity Tier 1 Capital (To risk-weighted assets) 12.48% 12.49% Total Capital (To risk-weighted assets) 13.64% 13.66% Effective January 1, 2015, the Company and the Bank became subject to new regulatory capital rules, which, among other things, impose a new common equity Tier 1 minimum capital requirement (4.5% of risk-weighted assets), set the minimum leverage ratio for all banking organizations at a uniform 4% of total assets, increase the minimum Tier 1 capital to risk-based assets requirement (from 4% to 6% of risk-weighted assets) and assign a higher risk weight (150%) to exposures that are more than 90 days past due or are on nonaccrual status and to certain commercial real estate facilities that finance the acquisition, development or construction of real property. The new rules also require unrealized gains and losses on certain “available-for-sale” securities holdings to be included for purposes of calculating regulatory capital requirements unless a one-time opt out is exercised which the Company and the Bank have done. The final rule limits a banking organization’s dividends, stock repurchases and other capital distributions, and certain discretionary bonus payments to executive officers, if the banking organization does not hold a “capital conservation buffer” consisting of 2.5% of common equity Tier 1 capital to risk-weighted assets above regulatory minimum risk-based requirements. The capital conservation buffer requirement was phased in beginning January 1, 2016 and ending January 1, 2019, when the full capital conservation buffer requirement became effective. The Company and the Bank are in compliance with their respective new capital requirements, including the capital conservation buffer, as of March 31, 2022. 32 Liquidity As of March 31, 2022, the Company had cash and cash equivalents of $166.0 million in the form of cash, due from banks and short-term deposits with other institutions. In addition, the Company had total securities available for sale of $434.9 million which could be used for liquidity needs. Total liquidity of $600.9 million as of March 31, 2022, represents 28.9% of total assets compared to $613.5 million and 29.7% of total assets as of December 31, 2021. The Company also monitors other liquidity measures, all of which were within the Company’s policy guidelines as of March 31, 2022 and December 31, 2021. Based upon these measures, the Company believes its liquidity is adequate. Capital Resources The Company has a line of credit commitment from Atlantic Community Bankers Bank for $7,000,000 which expires June 30, 2022. There were no borrowings under this line as of March 31, 2022 and December 31, 2021. The Company has a line of credit commitment available which has no stated expiration date from PNC Bank for $16,000,000. There were no borrowings under this line as of March 31, 2022 and December 31, 2021. The Company has a line of credit commitment available which has no stated expiration date from Zions Bank for $17,000,000. There were no borrowings under this line as of March 31, 2022 and December 31, 2021. The Bank’s maximum borrowing capacity with the Federal Home Loan Bank was approximately $617,532,000 as of March 31, 2022, of which $26,844,000 was outstanding in the form of borrowings as of March 31, 2022. As of December 31, 2021, the maximum borrowing capacity was $607,092,000, of which $29,998,000 of borrowings was outstanding as of December 31, 2021. Additionally, as of March 31, 2022, the Bank had secured Letters of Credit from the Federal Home Loan Bank in the amount of $122,802,000 as collateral for specific municipal deposits. These Letters of Credit reduce the availability under the maximum borrowing capacity. As of December 31, 2021, there was $127,850,000 outstanding in the form of Letters of Credit. Advances and Letters of Credit from the Federal Home Loan Bank are secured by qualifying assets of the Bank. Non-GAAP Financial Measures This report contains or references fully taxable-equivalent (fte) interest income and net interest income, which are non-GAAP financial measures. Interest income (fte) and net interest income (fte) are derived from GAAP interest income and net interest income using an assumed tax rate of 21%. We believe the presentation of interest income (fte) and net interest income (fte) ensures comparability of interest income and net interest income arising from both taxable and tax-exempt sources and is consistent with industry practice. Interest income (fte) and Net interest income (fte) is reconciled to GAAP interest income and net interest income on page 35. Fully taxable equivalent interest income and net interest income is also reflected in the table on page 36. Although the Company believes that these non-GAAP financial measures enhance investors’ understanding of our business and performance, these non-GAAP financial measures should not be considered an alternative to GAAP measures. ‎ 33 Results of Operations NORWOOD FINANCIAL CORP Consolidated Average Balance Sheets with Resultant Interest and Rates (Tax-Equivalent Basis, Three Months Ended March 31, dollars in thousands) 2022 2021 Average Average Average Average Balance Interest Rate Balance Interest Rate (2) (1) (3) (2) (1) (3) Assets Interest-earning assets: Interest-bearing deposits with banks $ 168,006 $ 78 0.19% $ 116,485 $ 43 0.15% Securities available for sale: Taxable 363,738 1,466 1.61 191,695 769 1.60 Tax-exempt (1) 75,083 542 2.89 53,726 434 3.23 Total securities available for sale (1) 438,821 2,008 1.83 245,421 1,203 1.96 Loans receivable (1) (4) (5) 1,355,221 15,443 4.56 1,418,522 16,260 4.59 Total interest-earning assets 1,962,048 17,529 3.57 1,780,428 17,506 3.93 Non-interest earning assets: Cash and due from banks 23,275 20,733 Allowance for loan losses (16,573) (13,868) Other assets 103,862 115,896 Total non-interest earning assets 110,564 122,761 Total Assets $ 2,072,612 $ 1,903,189 Liabilities and Stockholders&apos; Equity Interest-bearing liabilities: Interest-bearing demand and money market $ 520,850 $ 202 0.16 $ 423,774 $ 220 0.21 Savings 308,370 63 0.08 246,663 35 0.06 Time 500,375 794 0.63 533,199 1,000 0.75 Total interest-bearing deposits 1,329,595 1,059 0.32 1,203,636 1,255 0.42 Short-term borrowings 62,512 48 0.31 64,277 69 0.43 Other borrowings 28,407 139 1.96 40,890 201 1.97 Total interest-bearing liabilities 1,420,514 1,246 0.35 1,308,803 1,525 0.47 Non-interest bearing liabilities: Demand deposits 433,823 382,332 Other liabilities 15,015 14,811 Total non-interest bearing liabilities 448,838 397,143 Stockholders&apos; equity 203,260 197,243 Total Liabilities and Stockholders&apos; Equity $ 2,072,612 $ 1,903,189 Net interest income/spread (tax equivalent basis) 16,283 3.22% 15,981 3.46% Tax-equivalent basis adjustment (182) (205) Net interest income $ 16,101 $ 15,776 Net interest margin (tax equivalent basis) 3.32% 3.59% (1) Interest and yields are presented on a tax-equivalent basis using a marginal tax rate of 21%. (2) Average balances have been calculated based on daily balances. (3) Annualized (4) Loan balances include non-accrual loans and are net of unearned income. (5) Loan yields include the effect of amortization of deferred fees, net of costs. ‎ 34 Rate/Volume Analysis. The following table shows the fully taxable equivalent effect of changes in volumes and rates on interest income and interest expense. Increase/(Decrease) Three months ended March 31, 2022 Compared to Three months ended March 31, 2021 Variance due to Volume Rate Net (dollars in thousands) Interest-earning assets: Interest-bearing deposits with banks $ 21 $ 14 $ 35 Securities available for sale: Taxable 688 9 697 Tax-exempt securities 167 (59) 108 Total securities 855 (50) 805 Loans receivable (716) (101) (817) Total interest-earning assets 160 (137) 23 Interest-bearing liabilities: Interest-bearing demand and money market 41 (59) (18) Savings 12 16 28 Time (53) (153) (206) Total interest-bearing deposits — (196) (196) Short-term borrowings (1) (20) (21) Other borrowings (61) (1) (62) Total interest-bearing liabilities (62) (217) (279) Net interest income (tax-equivalent basis) $ 222 $ 80 $ 302 Changes in net interest income that could not be specifically identified as either a rate or volume change were allocated proportionately to changes in volume and changes in rate. ‎ 35 Comparison of Operating Results for the Three Months Ended March 31, 2022 to March 31, 2021 General For the three months ended March 31, 2022, net income totaled $7,128,000 compared to $5,542,000 earned in the similar period in 2021. The increase in net income for the three months ended March 31, 2022 was due primarily to a $1,346,000 increase in other income and a $1,200,000 decrease in the provision for loan losses. Earnings per share for the three-months ended March 31, 2022 were $0.87 per share for basic shares and fully diluted shares, compared to $0.68 per share for basic shares and $0.67 per share for fully diluted shares for the three months ended March 31, 2021. The resulting annualized return on average assets and annualized return on average equity for the three months ended March 31, 2022 were 1.39% and 14.22%, respectively, compared to 1.18% and 11.39%, respectively, for the same period in 2021. The following table sets forth changes in net income: (dollars in thousands) Three months ended March 31, 2022 to March 31, 2021 Net income three months ended March 31, 2021 $ 5,542 Change due to: Net interest income 325 Provision for loan losses 1,200 Net gains on sales of securities and loans (50) Net gains on sales of foreclosed real estate owned 424 Service charges and fees 223 Earnings and proceeds on bank-owned life insurance (198) Other income 947 Salaries and employee benefits (478) Occupancy, furniture and equipment (87) All other expenses (137) Income tax expense (583) Net income three months ended March 31, 2022 $ 7,128 Net Interest Income Net interest income on a fully taxable equivalent basis (fte) for the three months ended March 31, 2022 totaled $16,283,000 which was $302,000 higher than the comparable period in 2021. The increase in net interest income was due primarily to an $805,000 increase in interest income (fte) on securities due to purchases of securities. The fte net interest spread and net interest margin were 3.22% and 3.32%, respectively, for the three months ended March 31, 2022 compared to 3.46% and 3.59%, respectively, for the same period in 2021. See “Non-GAAP Financial Measures” described above on page 34. For the three-months ended March 31, 2022, interest income (fte) totaled $17,529,000 with a yield on average earning assets of 3.57% compared to $17,506,000 and 3.93% for the 2021 period. Average loans decreased $63.3 million during the three-months ended March 31, 2022, over the comparable period of 2021, while average securities increased $193.4 million. Average earning assets totaled $1.962 billion for the three months ended March 31, 2022, an increase of $181.6 million over the average for the same period in 2021. See “Non-GAAP Financial Measures” described above on page 34. Interest expense for the three months ended March 31, 2022 totaled $1,246,000 at an average cost of 0.35% compared to $1,525,000 and 0.47%, respectively, for the same period in 2021. The decrease in interest expense during the three-months ended March 31, 2022 reflects the overall lower level of market interest rates. The average cost of time deposits, which is the most significant component of funding costs, decreased 0.12% compared to the same three-month period of last year. Provision for Loan Losses The Company’s provision for loan losses for the three months ended March 31, 2022 was $300,000, compared to $1,500,000 for the three months ended March 31, 2021. The decreased provision reflects a reduction in certain qualitative factors related to the COVID-19 pandemic. The Company makes provisions for loan losses in an amount necessary to maintain the allowance for loan losses at an acceptable level. The Company recorded a net charge-off of $82,000 for the quarter ended March 31, 2022, compared to a net charge-off of $141,000 for the similar period in 2021. At March 31, 2022, the allowance for loan losses represented 1.21% of loans receivable. Additionally, the allowance for loan losses represented 2,353% of non-performing loans, excluding loans acquired with credit quality deterioration. 36 Other Income Other income totaled $3,338,000 for the three months ended March 31, 2022, compared to $1,992,000 for the same period in 2021. The increase was due primarily to $875,000 of income recognized on previously acquired purchased impaired loans that were carried at a discount, and a $427,000 gain on the sale of a property carried in Foreclosed Real Estate Owned. All other categories of other income increased $44,000, net. Other Expense Other expense for the three months ended March 31, 2022 totaled $10,157,000, which was $702,000 higher than the same period of 2021, due primarily to a $478,000 increase in salaries and employee benefits costs. Income Tax Expense Income tax expense totaled $1,854,000 for an effective tax rate of 20.7% for the three months ended March 31, 2022 compared to $1,271,000 for an effective tax rate of 18.7% for the three months ended March 31, 2021. The increase in the effective tax rate in the 2022 period reflects the increased level of taxable income. ‎ 37