Our results of operations depend primarily on our net interest income. Net interest income is the difference between the interest income we earn on our interest-earning assets, consisting primarily of loans, investment securities (including mortgage-backed securities, other securities and corporate and municipal bonds) and other interest-earning assets (primarily cash and cash equivalents), and the interest paid on our interest-bearing liabilities, consisting primarily of savings accounts, money market accounts, transaction accounts, certificates of deposit and Federal Home Loan Bank advances. Net interest income before provision for loan losses increased $528,000, or 2.2%, to $27.6 million for the year ended December 31, 2006 from $27.0 million for the year ended December 31, 2005. The primary reason for the improvement in our net interest income was a $97.7 million, or 11.4%, increase in our average interest earning assets, to $926.3 million for the year ended December 31, 2006, reflecting strong growth in loans. The favorable impact of the expansion in earning assets was offset to some extent by net interest margin compression of 30 basis points to 2.97% for the year ended December 31, 2006 compared to 3.27% in the same period last year.

 

Our results of operations are also affected by our provision for loan losses, non-interest income and non-interest expense. Non-interest income consists primarily of deposit account fees, financial services fees, increases in cash value-insurance, gains and losses on the sale of securities and miscellaneous other income. Non-interest expense consists primarily of compensation and employee benefits, data processing, occupancy, marketing and public relations, professional services, printing and office supplies, and other operating expenses. Our results of operations also may be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities.

 

Critical Accounting Policies

 

Critical accounting policies are those that involve significant judgments and assumptions by management and that have, or could have, a material impact on our income or the carrying value of our assets. Our critical accounting policies are those related to our allowance for loan losses and valuation allowances associated with deferred tax assets.

 

Allowance for Loan Losses.   The allowance for loan losses is the amount estimated by management as necessary to cover credit losses inherent in the loan portfolio at the balance sheet date. The allowance is established through the provision for loan losses which is charged against income. The methodology for determining the allowance for loan losses is considered a critical accounting policy by management due to the high degree of judgment involved, the subjectivity of the assumptions utilized and the potential for changes in the economic environment that could result in adjustments to the amount of the recorded allowance for loan losses.

 

As a substantial amount of our loan portfolio is collateralized by real estate, appraisals of the underlying value of property securing loans and discounted cash flow valuations of properties are critical in determining the amount of the allowance required for specific loans. Assumptions for appraisals and discounted cash flow valuations are instrumental in determining the value of properties. Overly optimistic assumptions or negative changes to assumptions could significantly affect the valuation of a property securing a loan and the related allowance determined. The assumptions supporting such appraisals and discounted cash flow valuations are reviewed by management to determine that the resulting values reasonably reflect amounts realizable on the related loans.

 

Management performs a quarterly evaluation of the adequacy of the allowance for loan losses. We consider a variety of factors in establishing this estimate including, but not limited to, current economic conditions, delinquency statistics, geographic and industry concentrations, the adequacy of the underlying collateral, the financial strength of the borrower, results of internal loan reviews and other relevant factors. This evaluation is inherently subjective as it requires material estimates by management that may be susceptible to significant change based on changes in economic and real estate market conditions.

 

The evaluation has a specific and general component. The specific component relates to loans that are delinquent or otherwise identified as problem loans through the application of our loan review process and our loan grading system. All such loans are evaluated individually, with principal consideration given to the value of the collateral securing the loans. Specific allowances are established as required by this analysis. The general component is determined by segregating the remaining loans by type of loan, risk weighting (if applicable) and payment history. We also analyze historical loss experience, delinquency trends, general economic conditions and geographic and industry concentrations. This analysis establishes factors that are applied to the loan groups to determine the amount of the general component of the allowance for loan losses.

 

Actual loan losses may be significantly more than the allowances we have established which could have a material negative effect on our financial results.

 

Valuation Allowance for deferred tax assets. The assessment of whether a valuation allowance for the Company’s deferred tax assets is required is also a critical accounting estimate. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of such assets will not be realized. This assessment is made each reporting period based upon an estimate of future taxable income during the periods in which existing temporary differences become deductible.

Business Strategy

 

Our business strategy is to operate as a well-capitalized and profitable community bank dedicated to providing exceptional personal service to our individual and business customers. Over the past several years, we have emphasized the origination of commercial and industrial loans and loans secured by commercial real estate, and we intend to increase our origination of these loans in the future. In addition, we intend to expand our branch network in our primary market area, which consists of Hampden and Hampshire Counties, Massachusetts. We also intend to evaluate opportunities to expand into new markets, including Northern Connecticut. We cannot assure you that we will successfully implement our business strategy.

 

Highlights of our business strategy are as follows:

 

Remaining a Community-Oriented Financial Institution . We were established in 1882 and have been operating continuously since that time, growing through internal growth and a series of five mutual-to-mutual business combinations that occurred between 1960 and 1994. We have been, and continue to be, committed to meeting the financial needs of the communities in which we operate, and we are dedicated to providing quality personal service to our customers. We provide a broad range of individualized consumer and business financial services from our main office, 12 branch offices, two offsite ATMs and one drive-up facility.

 

Expanding our Branch Network. We currently operate from 13 full-service banking offices and a drive-up only facility. We also maintain two financial services facilities that offer insurance and investment products and financial planning services. We intend to evaluate new branch expansion opportunities, through acquisitions and de novo branching, to expand our presence within and outside our primary market area, including Northern Connecticut, and our current business plan calls for the acquisition and establishment of additional branch offices. In addition, we intend to evaluate acquisitions of other financial institutions, as opportunities present themselves.

 

Increasing our Commercial Real Estate and Commercial and Industrial Lending. We intend to continue to increase our origination of higher-yielding commercial real estate and commercial and industrial loans as a means of increasing our interest income and improving our net interest margin. These loans also are generally originated with rates that are fixed for five years or less, which assists us in managing our interest rate risk. In support of this initiative we have supplemented our existing staff of commercial loan officers, increased our credit analysis resources and enhanced the outside loan review process. We originated $108.3 million of commercial real estate and $28.9 million of commercial and industrial loans during the year ended December 31, 2006. At December 31, 2006, our commercial real estate and commercial and industrial loans totaled $175.6 million and $69.8 million, respectively. The additional capital raised from our initial public offering in 2005 has increased our commercial lending capacity by enabling us to originate more loans and loans with larger balances. Originating more commercial real estate and commercial and industrial loans exposes us to increased risks, as discussed in the Risk Factors section of this Form 10-K.

 

Maintaining High Asset Quality. We have emphasized maintaining strong asset quality by following conservative underwriting criteria and by originating loans secured primarily by real estate. We will continue to focus on maintaining high asset quality as we seek to expand our commercial lending activities. Our non-performing assets at December 31, 2006 were $1.9 million, or 0.18% of total assets, and our net charge-offs were 0.02% of our average loans outstanding for the year ended December 31, 2006.

 

Increasing our Share of Lower-Cost Deposits. We remain committed to gathering lower cost and more stable core deposits. We attract and retain core deposits with competitive products and rates, excellent customer service, a comprehensive marketing program and a well-established incentive-based cross-sales program. Our efforts to attract and retain core deposits have resulted in an increase in the total number of accounts. However, the increased number of accounts has not translated into increased balances during 2005 and 2006 as many customers have elected to shift transaction, savings and money market balances to higher yielding certificates of deposits. At December 31, 2006, consumer and commercial demand deposits comprised 14.17% of our total deposits, compared to 14.27% of our total deposits at December 31, 2005.

 

Increasing and Diversifying our Sources of Non-interest Income. In order to reduce our reliance on net interest income and the impact of market rates on our financial results, we have sought to diversify our revenue stream. In connection with our success in growing our deposit base, our fee income derived from deposits has increased. Through our Financial Services Group, a division of United Bank, we offer United Bank customers and others a complete range of non-deposit investment products and financial planning services, including mutual funds, debt, equity and government securities, insurance products, fixed and variable annuities, financial planning for individual and commercial customers and estate planning services. In 2006 United Bank purchased Levine Securities in Northampton, Massachusetts in order to expand our market and capitalize on the establishment of a new branch. United Financial Services Group offers these services through its partnership with NFP Securities, Inc. We have also invested in bank-owned life insurance for certain executive officers and directors, providing another source of non-interest income through the recognition of the growing cash surrender value of this insurance over time.

 

Comparison of Financial Condition at December 31, 2006 and 2005

 

Total assets increased $102.9 million, or 11.4%, to $1.0 billion at December 31, 2006 from $906.5 million at December 31, 2005. The increase reflected substantial growth in net loans, partially offset by a decrease in securities available for sale. The growth in assets was partially funded by cash flows from the investment portfolio and increases in both deposits ($32.1 million) and Federal Home Loan Bank of Boston advances ($67.9 million). Securities available for sale decreased $36.2 million, or 15.8%, to $190.2 million at December 31, 2006 from $226.5 million at December 31, 2005 as management elected to use cash flows from the investment portfolio to fund loan growth. Total cash and cash equivalents increased $9.6 million, to $25.4 million at December 31, 2006, reflecting routine fluctuations in cash balances and the intentional accumulation of funds to support future loan growth.

 

Net loans increased $125.6 million, or 19.9%, to $756.2 million at December 31, 2006 from $630.6 million at December 31, 2005. One- to four-family residential mortgage loans increased $33.9 million, or 11.9%, to $319.1 million at December 31, 2006, reflecting continued strong demand in our primary market area given the stable real estate market and the relatively low interest rate environment. The increase was due to management’s decision to retain substantially all originations of residential mortgage loans in portfolio. Commercial real estate and commercial and industrial loans increased $25.5 million, or 17.0%, to $175.6 million and $10.2 million, or 18.0%, to $69.8 million, respectively, as a result of stable economic conditions in our primary market area, competitive pricing, attractive products and services, established relationships, successful business development efforts and the hiring of additional commercial lenders to diversify our lending activities. Construction loans increased $25.9 million, or 89.7%, to $54.8 million due to strong demand for commercial and residential funding, successful business development efforts, the solid real estate market and the relatively low interest rate environment. A significant portion of these loans mature in less than two years and will either covert to permanent financing or pay-off in full. We continued to focus our efforts on growing the commercial real estate, commercial and industrial, and construction loan portfolios in order to improve net interest rate spread by increasing our origination of these generally higher-yielding loans. Home equity loans increased $26.7 million, or 31.0%, reflecting strong consumer demand, a solid economy, an attractive product offering and competitive rates.

 

Total deposits increased $32.1 million, or 4.9%, to $685.7 million at December 31, 2006 mainly due to an increase of $39.4 million in certificate of deposit balances. During the period, customer demand for deposits shifted from savings towards higher-yielding certificates of deposit accounts. Demand deposits grew $3.9 million, or 4.2%, due to increased marketing and promotional activity in an effort to attract new customers and retain existing funds. Money market account balances expanded $10.3 million, or 6.7%, reflecting strong customer demand, attractive products and competitive pricing. At December 31, 2006, core deposits totaled $364.7 million, or 49.3% of deposits.

 

Federal Home Loan Bank advances increased $67.9 million, or 66.7%, to $169.8 million at December 31, 2006 from $101.9 million at December 31, 2005 to fund balance sheet growth. We have used a portion of such advances to “match fund” certain fixed-rate residential and commercial real estate loans in order to reduce our interest rate risk. Repurchase agreements increased $2.0 million to $10.4 million at December 31, 2006 from $8.4 million at December 31, 2005, reflecting routine fluctuations in these overnight accounts.

 

Total stockholders’ equity increased $706,000, or 0.5%, to $137.7 million at December 31, 2006 from $137.0 million at December 31, 2005. This increase reflected net income of $4.9 million for the year ended December 31, 2006, the equity offset to the recognition of $1.1 million in ESOP and stock-based compensation expenses and a $514,000 decrease in the net unrealized loss on securities available for sale. These items were offset to a large extent by share repurchases totaling $4.4 million and payment of cash dividends aggregating $1.5 million.

 

Comparison of Operating Results for the Years Ended December 31, 2006 and 2005

 

Net Income. Net income increased $555,000, or 12.7%, to $4.9 million for the year ended December 31, 2006 from $4.4 million for the year ended December 31, 2005. The results for 2006 reflected growth in average earning assets and non-interest income, somewhat mitigated by net interest margin compression and higher non-interest expenses, excluding the impact of a $3.6 million expense related to the contribution to fund the United Charitable Foundation in 2005. Excluding the effect of the charitable contribution, net income would have amounted to $6.6 million in 2005.

 

Average balances and yields . The following table sets forth average balance sheets, average yields and costs, and certain other information for the periods indicated. No tax-equivalent yield adjustments were made, as the effect thereof was not material. All average balances are daily average balances. Non-accrual loans were included in the computation of average balances, but have been reflected in the table as loans carrying a zero yield.

 

 

   
Years Ended December 31,
  
   
2006
  
2005
  
       
Interest
          
Interest
      
   
Average
  
and
  
Yield/
  
Average
  
and
  
Yield/
  
   
Balance
  
Dividends
  
Cost
  
Balance
  
Dividends
  
Cost
  
   
(Dollars in thousands)
  
                           
Interest-earning assets:
                          
Loans:
                         
Residential real estate
  
$
410,340
  
$
23,817
    
5.80
%   
$
362,208
  
$
20,168
    
5.57
%
Commercial real estate
   
189,694
   
12,485
   
6.58
%
  
158,820
   
9,781
   
6.16
%
Commercial and industrial
    
64,164
   
4,595
   
7.16
%
  
54,954
   
3,525
   
6.41
%
Consumer and other
    
29,005