ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

GENERAL

The following discussion sets forth management’s discussion and analysis of our consolidated financial condition and results of operations that should be read in conjunction with our consolidated financial statements, related notes, the selected financial data and the statistical information presented elsewhere in this report for a more complete understanding of the following discussion and analysis. Unless otherwise noted, years refer to the Company’s fiscal years ended September 30, 2014 , 2013 and 2012 .

PERFORMANCE SUMMARY

The following is a brief summary of some of the significant factors that affected our operating results in 2014 . See the remainder of this section for a more thorough discussion. We reported net income of $1,783 for the year ended September 30, 2014 , compared to net income of $1,047 for the year ended September 30, 2013 . Basic earnings per share were $0.35 for 2014 compared to $0.20 for the year ended September 30, 2013 . Diluted earnings per share were $0.34 for 2014 compared to $0.20 for the year ended September 30, 2013 . Return on average assets for the year ended September 30, 2014 was 0.32% , compared to 0.19% for the year ended September 30, 2013 . The return on average equity was 3.20% for 2014 and 1.92% for 2013 . An annual cash dividend in the amount of $0.04 per share and $0.02 per share was paid in the fiscal year ended September 30, 2014 and 2013 , respectively.

Key factors behind these results were:

CRITICAL ACCOUNTING ESTIMATES

    

Our consolidated financial statements are prepared in accordance with Accounting Standards Generally Accepted in the United States of America ("GAAP") as applied in the United States. In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events, and apply judgments that affect the reported amount of assets, liabilities, revenue, expenses and the related disclosures. We base our assumptions, estimates and judgments on historical experience, current trends and other factors that management believes to be relevant at the time our consolidated financial statements are prepared. Some of these estimates are more critical than others. Below is a discussion of our critical accounting estimates.

Allowance for Loan Losses.

We maintain an allowance for loan losses to absorb probable incurred losses in our loan portfolio. The allowance is based on ongoing, quarterly assessments of the estimated probable incurred losses in our loan portfolio. In evaluating the level of the allowance for loan loss, we consider the types of loans and the amount of loans in our loan portfolio, historical loss experience, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral and prevailing economic conditions. We follow all applicable regulatory guidance, including the “Interagency Policy Statement on the Allowance for Loan and Lease Losses,” issued by the Federal Financial Institutions Examination Council (FFIEC). We believe that the Bank’s Allowance for Loan Losses Policy conforms to all applicable regulatory requirements. However, based on periodic examinations by regulators, the amount of the allowance for loan losses recorded during a particular period may be adjusted.

Our determination of the allowance for loan losses is based on (1) specific allowances for specifically identified and evaluated impaired loans and their corresponding estimated loss based on likelihood of default, payment history, and net realizable value of underlying collateral; and (2) a general allowance on loans not specifically identified in (1) above, based on historical loss ratios which are adjusted for qualitative and general economic factors. We continue to refine our allowance for loan losses methodology, with an increased emphasis on historical performance adjusted for applicable economic and qualitative factors.

Assessing the allowance for loan losses is inherently subjective as it requires making material estimates, including the amount and timing of future cash flows expected to be received on impaired loans, any of which estimates may be susceptible to significant change. In our opinion, the allowance, when taken as a whole, reflects estimated probable loan losses in our loan portfolio.

Investment Securities.

Management determines the appropriate classification of investment securities at the time of purchase and reevaluates such designation as of each statement of financial position date. Securities are classified as held to maturity when the Company has the positive intent and ability to hold the securities to maturity. Held to maturity securities are stated at amortized cost. Investment securities not classified as held to maturity are classified as available for sale. Securities classified as available for sale are carried at fair value, with unrealized gains and losses reported in other comprehensive income (loss). Amortization of premiums and accretion of discounts are recognized in interest income using the interest method over the estimated lives of the securities.

We evaluate all investment securities on a quarterly basis, and more frequently when economic conditions warrant, to determine if other-than-temporary impairment exists. Management’s evaluation of the portfolio and determination of whether there is an impairment is based on the following three criteria: (1) Bonds with an unrealized loss greater than 10 percent of the bond’s book value, (2) bonds with an unrealized loss greater than 5 percent and less than 10 percent of book value with a greater than 5 percent unrealized loss for 12 consecutive months, and (3) bonds with an unrealized loss greater than 5 percent for less than 12 months.

Current authoritative guidance provides that some portion of unrealized losses may be other-than-temporary and a credit loss is deemed to exist if the present value of the expected future cash flows is less than the amortized cost basis of the debt security. The credit loss component is recorded in earnings as a component of other-than-temporary impairment in the consolidated statements of operations, while the loss component related to other market factors is recognized in other comprehensive income (loss), provided the Bank does not intend to sell the underlying debt security and it is “more likely than not” that the Bank will not have to sell the debt security prior to recovery of the unrealized loss.

We consider the following factors in determining whether a credit loss exists and the period over which the debt security is expected to recover:

Interest income on securities for which other-than-temporary impairment has been recognized in earnings is recognized at a rate commensurate with the expected future cash flows and amortized cost basis of the securities after the impairment.

Gains and losses on the sale of securities are recorded on the trade date and determined using the specific-identification method.

To determine if other-than-temporary impairment exists on a debt security, the Bank first determines if (1) it intends to sell the security or (2) it is more likely than not that it will be required to sell the security before its anticipated recovery. If either of the foregoing conditions is met, the Bank will recognize other-than-temporary impairment in earnings equal to the difference between the security’s fair value and its adjusted cost basis. If neither of the foregoing conditions is met, the Bank determines (a) the amount of the impairment related to credit loss and (b) the amount of the impairment due to all other factors. The difference between the present values of the cash flows expected to be collected and the amortized cost basis is the credit loss. The credit loss is the amount of the other-than-temporary impairment that is recognized in earnings and is a reduction to the cost basis of the security. The amount of the total impairment related to all other factors (excluding credit loss) is included in other comprehensive income (loss).

We monitor our portfolio investments on an on-going basis and we have historically obtained quarterly independent valuations of our non-agency residential mortgage-backed securities. This analysis was utilized to ascertain whether any decline in market value was other-than-temporary. In determining whether an impairment is other-than-temporary, we consider the following factors: the length of time and the extent to which the market value has been below cost; recent events specific to the issuer including investment downgrades by rating agencies and economic conditions within the issuer’s industry; whether it is more likely than not that we will be required to sell the security before there would be a recovery in value; and the credit performance of the underlying collateral backing the securities, including delinquency rates, cumulative losses to date, and prepayment speed.

The independent valuation process included:

For securities that are considered other-than-temporarily impaired and for which we have the ability and intent to hold these securities until the recovery of our amortized cost basis, we recognize other-than-temporary impairment in accordance with accounting principles generally accepted in the United States. Under these principles, we separate the amount of the other-than-temporary impairment into the amount that is credit related and the amount due to all other factors. The credit loss component is recognized in earnings and is the difference between the security’s amortized cost basis and the present value of expected future cash flows. The amount due to other factors is recognized in other comprehensive income (loss).

Foreclosed and Repossessed Properties.

Foreclosed and repossessed properties acquired through or in lieu of loan foreclosures or repossessions are initially recorded at the lower of carrying cost or fair value, less estimated costs to sell, which establishes a new cost basis. Fair value is determined using a market valuation determined by third party appraisals or broker estimates. If fair value declines subsequent to foreclosure, a write-down is recorded through expense based on an updated third party appraisal less estimated selling costs.

Income Taxes.

Amounts provided for income tax expenses are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable under tax laws. Deferred income taxes, which arise principally from temporary differences between the amounts reported in the financial statements and the tax basis of certain assets and liabilities, are included in the amounts provided for income taxes. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income and tax planning strategies which will create taxable income during the periods in which those temporary differences become deductible. Management considers the

scheduled reversal of deferred tax liabilities, projected future taxable income, and if necessary, tax planning strategies in making this assessment.

The assessment of tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgments concerning certain accounting pronouncements and application of specific provisions of federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management’s current assessment, the impact of which could be material to our consolidated results of our operations and reported earnings. We believe that the deferred tax assets and liabilities are adequate and properly recorded in the accompanying consolidated financial statements. As of September 30, 2014 , management does not believe a valuation allowance related to the realizability of its deferred tax assets is necessary.

Intangible Assets.

Intangible assets consist primarily of core deposit intangibles resulting from several bank acquisitions. Core deposit intangibles are recorded as an asset on our consolidated balance sheets, and are amortized on a straight-line basis over their estimated remaining useful lives, which were initially determined at the time of acquisition. See Note 1; “Nature of Business and Summary of Significant Accounting Policies” and Note 6; “Intangible Assets” to our consolidated financial statements.

STATEMENT OF OPERATIONS ANALYSIS

2014 compared to 2013

Unless otherwise stated, all monetary amounts in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, other than share, per share and capital ratio amounts, are stated in thousands.

Net Interest Income. Net interest income represents the difference between the dollar amount of interest earned on interest bearing assets and the dollar amount of interest paid on interest bearing liabilities. The interest income and expense of financial institutions are significantly affected by general economic conditions, competition, policies of regulatory authorities and other factors.

Interest rate spread and net interest margin are used to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on interest earning assets and the rate paid for interest bearing liabilities that fund those assets. Net interest margin is expressed as the percentage of net interest income to average interest earning assets. Net interest margin exceeds interest rate spread because non-interest bearing sources of funds (“net free funds”), principally demand deposits and stockholders’ equity, also support interest earning assets. The narrative below discuses net interest income, interest rate spread, and net interest margin.

Net interest income was $19,758 for 2014 , compared to $19,263 for 2013 . The net interest margin for 2014 was 3.61% compared to 3.62% for 2013 . The 1 bp decrease in net interest margin was mainly attributable to a 3 bp increase in interest rate spread resulting from a 22 bp decline in return on interest earning assets, which was offset by a 25 bp decrease in the cost of interest bearing liabilities during 2014 . Prevailing market interest rates remain at historically low levels. As a result, on average, both our interest earning assets and interest bearing liabilities were repriced at lower interest rates during 2014 .

As shown in the rate/volume analysis table below, positive volume changes resulted in a $1,048 increase in net interest income in 2014 . Average loan volume increases were due to commercial real estate and indirect consumer loan growth in the current fiscal year over the prior fiscal year, arising from management's strategy to continue to diversify its credit portfolio. Interest bearing liabilities volume increases were primarily due to increases in FHLB advances, which represented the most cost efficient funding option for the afore-mentioned loan growth. The increase and changes in the composition of interest earning assets resulted in a $542 decrease in interest income for 2014 , offset by a $1,037 decrease in interest expense due to the composition change in interest bearing liabilities. Rate changes on interest earning assets caused a decrease in interest income by $1,727 , but were partially offset by rate changes on interest bearing liabilities that reduced interest expense by $1,174 , for a net impact of a $553 decrease in net interest income due to changes in interest rates between 2014 and 2013 .

For 2014 , the yield on interest earning assets declined to 4.39% from 4.61% for 2013 . This was caused primarily by a decrease of 40 bp in the loan yield and a 4 bp decline in the yield on investment securities, both reflecting sustained low market interest rates and a continued commitment to stronger credit quality. The average loan yield was 5.00% in 2014 and 5.40% in 2013 , respectively. Competitive pricing on new and refinanced loans which resulted in loan growth at lower rates, as well as increased prepayments due to the current low rate environment, both contributed to reduced loan yields in 2014 . Yields on securities decreased largely due to increases in holdings of lower risk and lower yielding securities, as well as volatility in prepayments.

 

For 2014 , the cost of interest bearing liabilities decreased 25 bps from 1.10% in 2013 , to 0.85% , resulting, in part, from a continuing decrease in interest rates, generally, in 2014 . The combined average cost of interest bearing deposits was 0.82% , down 28 bp from 2013 , primarily resulting from the continued low short-term interest rate environment during 2014 . The average rate paid on FHLB advances increased to 1.10% in 2014 from 1.07% in 2013 . The primary factor contributing to the increase in interest rate spread between the periods was an increase in the average balance of outstanding higher rate longer term FHLB borrowings.

We have remained liability sensitive in the short term during the most recent two fiscal years, in which interest rates have declined to historically low levels. However, continued low interest rates will likely reduce our net interest margin.

Average Balances, Net Interest Income, Yields Earned and Rates Paid. The following table shows interest income from average interest earning assets, expressed in dollars and yields, and interest expense on average interest bearing liabilities, expressed in dollars and rates. Also presented is the weighted average yield on interest earning assets, rates paid on interest bearing liabilities and the resultant spread at September 30 for each of the last three fiscal years shown below. No tax equivalent adjustments were made. Non-accruing loans have been included in the table as loans carrying a zero yield.

Average interest earning assets were $546,835 in 2014 compared to $532,505 in 2013 . Average loans outstanding increased to $451,933 in 2014 from $429,403 in 2013 . Average loans to average interest bearing assets increased to 83% in 2014 from 81% in 2013 . Interest income on loans decreased $589 , of which $1,181 related to the increase in average outstanding balances and $1,770 related to a reduction in interest income due to lower yields on such loans. Increases in average loans outstanding in 2014 were the result of commercial real estate and indirect consumer loan growth. Balances of securities increased $1,569 on average between the periods due to market opportunities and liquidity reasons. Interest income on securities increased $28 from volume changes and decreased $29 from the impact of the rate environment, for a net $1 decrease in interest income on securities in our investment portfolio between 2014 and 2013 .

Average interest bearing liabilities increased $15,620 in 2014 from their 2013 levels, while average net free funds (the total of non-interest bearing demand deposits, accrued expenses, other liabilities and stockholders’ equity less non-interest earning assets) increased $2,047. The increase in average interest bearing liabilities was primarily due to increases in demand deposits and FHLB advances. The increase in average net free funds was primarily due to a decrease in non-interest earning assets. Average interest bearing deposits increased $4,537, or 1.04% to $440,242 . Interest expense on interest bearing deposits increased $15 during 2014 from the volume and mix changes and decreased $1,191 from the impact of the rate environment, resulting in an aggregate decrease of $1,176 in interest expense on interest bearing deposits.