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Article by DailyStocks_admin    (03-10-08 05:53 AM)

Filed with the SEC from Feb 21 to Feb 27:

Massbank (MASB)
Investor Lawrence Seidman filed a lawsuit against Massbank over its board election. Seidman, who has nominated himself and two other candidates for election to the board, said the company attempted to "impede an open and fair election." Seidman, who runs Seidman and Associates, is an activist investor in small regional banking companies. Seidman owns 319,814 shares (7.54%).

BUSINESS OVERVIEW

General
MASSBANK Corp. (sometimes referred to as the Company) is a general business corporation incorporated under the laws of the State of Delaware on August 11, 1986. MASSBANK Corp. was organized for the purpose of becoming the holding company for MASSBANK (the Bank). The Company is a one-bank holding company registered with the Board of Governors of the Federal Reserve System (Federal Reserve Board) under the Bank Holding Company Act of 1956, as amended. As of and since December 2, 1986, the effective date of the reorganization whereby MASSBANK Corp. became the holding company for the Bank, the Bank has been a wholly owned subsidiary of MASSBANK Corp. The only office of MASSBANK Corp., and its principal place of business, is located at the main office of the Bank at 123 Haven Street, Reading, Massachusetts 01867.
On August 28, 2006, Knabssam LLC was formed in the State of Delaware as a limited liability company and wholly owned subsidiary of MASSBANK Corp. The general character of the business of the LLC is to engage in investment in, and ownership and development of, real estate and interest therein. The only real estate the LLC currently owns is approximately 5.49 acres of excess land adjacent to the Bank’s branch in Westford, Massachusetts. Knabssam LLC has entered into an agreement with a local developer giving the developer an option to purchase the parcel. See Note 1 “Real Estate Held for Resale” of Notes to Consolidated Financial Statements contained in the Registrant’s 2006 Annual Report to Stockholders set forth on page 39 of such Annual Report.
MASSBANK Corp. currently has no material assets other than its investment in the Bank. The Company’s primary business, therefore, is managing its investment in the stock of the Bank. MASSBANK Corp. is classified by the Commonwealth of Massachusetts as a securities corporation for tax purposes, which restricts its business to buying, selling, dealing in, or holding securities on its own behalf. In the future, MASSBANK Corp. may become an operating company or acquire banks or companies engaged in bank-related activities. In addition, MASSBANK Corp. may elect to become a financial holding company and to engage in activities permissible to financial holding companies. See “Supervision and Regulation of the Company and its Subsidiaries” later in this Form 10-K.
The principal sources of revenues for MASSBANK Corp. are dividends from the Bank and, to a lesser extent, interest income received from its interest- bearing bank deposits. These revenues are used primarily for the payment of dividends to stockholders and for the repurchase of stock pursuant to the Company’s stock repurchase program. MASSBANK Corp.’s assets at December 31, 2006 are represented by its investment in the Bank of $101.2 million, its investment in Knabssam LLC of $0.6 million, cash of $5.1 million and other assets of $0.2 million. See Note 17 to the Consolidated Financial Statements for Parent Company only financial information. At December 31, 2006, MASSBANK Corp. on a consolidated basis had total assets of $843.5 million, deposits of $723.3 million, and stockholders’ equity of $106.9 million, which represents 12.67% of total assets. Book value per share at December 31, 2006 stood at $24.76, compared to $24.32 at year-end 2005.
The Company does not own or lease any real estate (other than through its subsidiary Knabssam LLC as described above) or personal property. Instead it intends to utilize during the immediate future the premises, equipment and furniture of the Bank without the direct payment of rental fees to the Bank.

Competition
The primary business of MASSBANK Corp. currently is the ongoing business of the Bank. Therefore, the competitive conditions faced by MASSBANK Corp. currently are the same as those faced by the Bank. See “Business of MASSBANK - Competition.” In addition, many banks and financial institutions have formed holding companies. It is likely that these holding companies will attempt to acquire commercial banks, thrift institutions or companies engaged in bank-related activities. MASSBANK Corp. would face competition in undertaking any such acquisitions and in operating any such entity subsequent to its acquisition.
Employees
MASSBANK Corp. does not employ any persons other than its management, which also serves as management of, and is paid by, the Bank. See “Item 10 – Directors and Executive Officers of the Registrant.” MASSBANK Corp. utilizes the support staff of the Bank from time to time and paid the Bank $18 thousand in 2006 for the support.

CEO BACKGROUND

Mr. Brandi, 58, has served as a Director since 1986. He first joined a predecessor bank in 1975 and became a Trustee in 1978. He has served MASSBANK (the ‘‘Bank”) and the Corporation in various capacities over the past 31 years. Mr. Brandi was named President of the Corporation and the Bank in 1986, Chief Executive Officer in 1992 and Chairman in 1993. Mr. Brandi is also Chairman of the Executive Committees of the Corporation and the Bank, a member of the Risk Management and Asset/Liability Committee of the Corporation, and a member of the Trust Committee of the Bank. He is a Director of the Depositors Insurance Fund and a member of its Executive Committee, Watch Bank Committee and Compensation Committee. He is a Director and member of the Audit Committee of the New England Automated Clearing House, and Director and member of the Audit Committee and Chairman of the Risk Management Committee of the Connecticut On Line Computer Center. He also serves as a Director of the Lowell Development and Financial Corp., Director of the Lowell Plan, Treasurer and Director of the Massachusetts Society for the Prevention of Cruelty to Animals and Chairman of its Audit and Investment Committees. He is also a Director and member of the Executive Committee of the Savings Banks Employees Retirement Association and Chairman of its Investment Committee.

Mr. Bufferd, 69, has served as a Director since 1995. He is a member of the Executive Committee of the Corporation and a Director and Executive Committee member of the Bank. He is also a member of the Audit Committee of the Corporation and the Nominating Committee of the Corporation, and the Chairman of the Risk Management and Asset/Liability Committee of the Corporation. Mr. Bufferd has been Treasurer Emeritus of the Massachusetts Institute of Technology since his retirement in May 2006 as Founding President of the MIT Investment Management Company, a position he held since 2004. Prior to that, from 1999 until his retirement, Mr. Bufferd served as Treasurer of the Massachusetts Institute of Technology. Mr. Bufferd serves as a Trustee of the Robert Wood Johnson Foundation and as a Trustee of the Whiting Foundation. He is also a member of the investment advisory boards of the State of Alaska Permanent Fund Corporation, the Grayce B. Kerr Foundation, and the National University of Singapore. In addition, he is the Chairman and a Director of the Harvard Cooperative Society, the Chairman and a Director of the Controlled Risk Insurance Company (‘‘CRICO”), and a Director of each of Adveq, Beth Israel Deaconess Medical Center, Explorations, Inc., M Fund, Inc., Makena LLC, Morgan Stanley Prime Property Fund, and Ram Holdings Ltd. Mr. Bufferd serves on the Compensation Committee of each of the Beth Israel Deaconess Medical Center, CRICO, Explorations, Inc., and the Harvard Cooperative Society.

Ms. Camilli, 48, has served as a Director since 2003. Ms. Camilli is a member of the Risk Management and Asset/Liability Committee of the Corporation and the Nominating Committee of the Corporation. Ms. Camilli is one of the nation’s top economic forecasters and independent economists. Her firm, Camilli Economics, provides clients with ‘real world’ economic guidance for smart business and financial decisions. A frequent commentator, author and speaker, Ms. Camilli appears regularly on CNN, CNBC, The NewsHour with Jim Lehrer, Nightly Business Report, and Bloomberg Business News. Ms. Camilli is on the Board of Directors of the Money Marketers of New York University, the National Association of Business Economists (NABE), and The National Council on Economic Education. She is a contributor to Blue Chip Financial Forecasts. Ms. Camilli is a member of the Financial Women’s Association, the New York Women’s Bond Club, the Forecasters Club, and the New York Association of Business Economists. Her civic activities include serving on the Board of the Epiphany School Foundation.

Mr. Carr, 64, has served as a Director since 2006. Mr. Carr is a member of the Executive Committee of the Corporation and a Director and member of the Executive Committee of the Bank. He is also a member of the Compensation and Option Committee of the Corporation and the Nominating Committee of the Corporation. Mr. Carr retired as partner of Goodwin Procter LLP in 2004. He is a Director of Management Sciences for Health, the Concord Museum, and CC Pools, Inc.

Mr. Costello, 53, has served as a Director since 1993. He is a member of the Audit Committee of the Corporation. Mr. Costello is a teacher at the Brooks School. Mr. Costello was the Chairman of the Board of Directors of The Lowell Plan, a non-profit organization dedicated to the revitalization of the City of Lowell, and is a member of the Board of Governors of Saints Memorial Medical Center in Lowell. Mr. Costello is also the former Editorial Page Editor of the Lowell Sun.

Mr. Latham, 66, has served as a Director since 2005. He is a member of the Insurance Committee of the Corporation and the Risk Management and Asset/Liability Committee of the Corporation. Mr. Latham is a principal in the law firm of Latham, Latham & Lamond, PC in Reading, Massachusetts. Mr. Latham is also a Trustee of Stoneham Theater and Director of the Reading Scholarship Foundation. He has served as an arbitrator for the American Arbitration Association, Chairman of the Regional Board of the American Red Cross, Chairman of the Regional Board of the American Cancer Society, and a Delegate for the Easter Seal Society. He serves as a pro bono counsel for the Reading Ice Arena Authority.

Mr. Marshall, 68, has served as a Director since 1986 and as a Trustee of a predecessor bank since 1972. He is a member of the Executive Committee of the Corporation and a Director and a member of the Executive Committee of the Bank. Mr. Marshall is also Chairman of the Insurance Committee of the Corporation and a member of the Nominating Committee of the Corporation. Mr. Marshall’s affiliations include the Professional Insurance Agents of Massachusetts. Mr. Marshall is associated with various local charitable, civic, and church organizations.

Mr. McCarthy, 58, is the Executive Vice President of Jobs for Massachusetts, a position he has held since 1982.

Mr. Mistry, 64, is the President of Mistry Associates, Inc., a consulting engineering firm, a position he has held since 1979. Mr. Mistry is also currently the President of N M Construction Corporation, a general contracting firm, a position he has held since 1986, and the President of MAI Associates, Inc., a subcontracting firm, a position he has held since 1992.

Ms. Pettinelli, 60, has served as a Director since 1998. She is a member of the Audit Committee of the Corporation, the Compensation and Option Committee of the Corporation, the Nominating Committee of the Corporation, and the Insurance Committee of the Corporation. Ms. Pettinelli was the Director of Clinical Services for the Visiting Nurse Association of Greater Lowell, Inc. from 1986 through April 1995 and has served as its Executive Director thereafter. Ms. Pettinelli serves as President of the Board of Directors of the Home Care Alliance of Massachusetts, and on the Board of Directors of the Visiting Nurse Associations of New England, Inc. and the New England Quilt Museum. Ms. Pettinelli also serves on the Compensation Committees of each of The Home and Healthcare Association of Massachusetts, Inc. and The Visiting Nurse Association of New England, Inc.

Mr. Rucci, 47, has served as a Director since 2005. He is Chairman of the Audit Committee of the Corporation, a member of the Executive Committee of the Corporation, and a Director and member of the Executive Committee of the Bank. Mr. Rucci is the President of the Accounting/Consulting firm of Rucci, Bardaro & Barrett, PC and is Co-Director of the Russell Bedford International Corporate Tax Group. He is a Trustee and Chairman of the Audit and Compliance Committee of Hallmark Health Systems, Inc., and a Director and past President of the Malden Industrial Aid Society. Mr. Rucci is a member of the American Institute of Certified Public Accountants and Massachusetts Society of Certified Public Accountants, where he is a member of the M.A.P. (Management of an Accounting Practice) Committee.

MANAGEMENT DISCUSSION FROM LATEST 10K

General
The following discussion should be read in conjunction with the consolidated financial statements and related notes included in this report. Certain amounts reported for prior years have been reclassified to conform to the 2006 presentation.
The preparation of consolidated financial statements requires management to make estimates and assumptions, in the application of certain of its accounting policies, about the effect of matters that are inherently uncertain. These estimates and assumptions affect the reported amounts of certain assets, liabilities, revenues and expenses. Different amounts could be reported under different conditions, or if different assumptions were used in the application of these accounting policies. The accounting policies considered significant in this respect are the determination of the allowance for loan losses and allowance for loan losses on off-balance sheet credit exposures, and the determination of investment securities considered other than temporarily impaired. These significant accounting policies are discussed in the Provisions (Credit) for Loan Losses and Investment Securities Other Than Temporarily Impaired sections of this discussion and analysis and in Note 1 of the “Notes to Consolidated Financial Statements.”
The financial condition and results of operations of Massbank Corp. (the “Company”) essentially reflect the operations of its subsidiary, Massbank (the “Bank”).
The Bank’s principal business has historically consisted of offering savings and other deposits to the general public and using the funds from these deposits to primarily make loans secured by residential real estate and consumer loans, and to make investments in debt and equity securities. Most residential mortgage loans granted by the Bank are for terms of 10, 12, 15 or 20 years and are generally low credit risk loans. The Bank’s debt securities portfolio consists primarily of U.S. Treasury and Government agency securities and Government agency mortgage-backed securities.
The Company’s consolidated net income depends largely upon net interest income, which is the difference between interest and dividend income from loans and investments (“interest-earning assets”), and interest expense on deposits (“interest-bearing liabilities”). Net interest income is significantly affected by loan and investment activity and volumes, including prepayment activity on loans and mortgage-backed securities and calls of callable government agency securities. Net interest income is also affected by general economic conditions, particularly changes in interest rates, competition, government legislation and policies affecting fiscal affairs, monetary policies of the Federal Reserve System, and the actions of the bank regulatory authorities. Earnings results are also affected by the Company’s provision (credit) for loan losses and changes in non-interest income, such as fee-based revenues and securities gains or losses; non-interest expense and income taxes.
Forward-Looking Statement Disclosure
Massbank Corp. may from time to time make written or oral forward-looking statements, including statements contained in this annual report, in the Company’s filings with the Securities and Exchange Commission, in its reports to stockholders and in other Massbank Corp. communications. These statements relate to future, not past events.
These forward-looking statements include, among others, statements with respect to Massbank Corp.’s beliefs, plans, objectives, goals, guidelines, expectations, financial condition, results of operations, future performance and business of the Company. You can identify forward-looking statements by the use of the words “may”, “could”, “should”, “believe”, “expect”, “anticipate”, “intend”, “estimate”, “assume”, “will”, “would”, “plan”, “projects”, “outlook” or similar expressions. These statements are based upon the current beliefs and expectations of the Company’s management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements. These forward-looking statements involve certain risks and uncertainties that are subject to change based on various factors (many of which are beyond Massbank Corp.’s control).
The following factors, among others, could cause the Company’s performance to differ materially from that expressed in any forward-looking statements: (1) the strength of the United States economy in general and the strength of the local economy in which the Company conducts operations may be different than expected; (2) unexpected fluctuations in market interest rates; (3) adverse conditions in the stock market, the public debt market and other capital markets; (4) an increase in the level of non-performing assets; (5) an increase in the competitive pricing pressures within the Company’s market which may result in an increase in the Company’s cost of funds, a decrease in loan originations, a decrease in deposits and assets; (6) adverse legislative and regulatory developments; (7) a significant decline in residential real estate values in the Company’s market area; (8) adverse impacts resulting from the continuing war on terrorism; (9) a significant increase in employee benefit costs; (10) the impact of changes in accounting principles; (11) the impact of inflation or deflation; and (12) Massbank Corp.’s success at managing the risks involved in the foregoing.

Critical Accounting Policies
The Company’s consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles. As such, the Company is required to make estimates and assumptions that affect the reported amounts of assets and liabilities at the balance sheet dates and the reported amounts of income and expense during the reporting periods. Actual amounts could differ from such estimates.
The Company believes that the following accounting policies are among the most critical because they involve significant judgments and uncertainties and could potentially result in materially different results under different assumptions and conditions.
Provisions (Credit) for Loan losses
The provision (credit) for loan losses represents a charge or credit against current earnings and an addition to or deduction from the allowance for loan losses. In determining the amount to provide for loan losses, the key factor is the adequacy of the allowance for loan losses (“loan allowance”). Management uses a methodology to systematically measure the amount of estimated loan loss exposure inherent in the portfolio for purposes of establishing a sufficient loan allowance. The methodology includes three elements: an analysis of individual loans deemed to be impaired, general loss allocations for various types of loans based on loss experience factors and an unallocated allowance. The unallocated allowance is maintained based on management’s assessment of many factors including the risk characteristics of the portfolio, concentrations of credit, current and anticipated economic conditions that may affect the borrowers’ ability to pay, and trends in loan delinquencies and charge-offs.
The provision (credit) for loan losses on off-balance sheet credit exposures represents a charge or credit against current earnings (reported in other non-interest expense) and an addition to or deduct ion from the allowance for loan losses on off-balance sheet credit exposures (“off-balance sheet exposures”). In determining the amount to provide for off-balance sheet exposures, the key factor is the adequacy of the balance. The balance of the off-balance sheet exposures is maintained based on expected drawdowns of committed loans, their loss experience factors, management’s assesment of various other factors including current and anticipated economic conditions that may affect the borrowers’ ability to pay and trends in loan delinquencies and charge-offs.
Any significant changes in assumptions and/or conditions could result in higher than estimated losses that could adversely affect the Company’s earnings results. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowances. Such agencies may require the Bank to recognize additional allowances based on judgements different from those of management, which could also adversely affect the Company’s earnings results.
Investment Securities other than Temporarily Impaired
Management judgment is involved in the evaluation of declines in value (“impairment”) of individual investment securities held by the Company. Declines in value that are deemed other than temporary are recognized in the income statement through write-downs in the recorded value of the affected securities. Management considers many factors in its analysis of other than temporarily impaired securities, including industry analyst reports, sector credit ratings, volatility in market price and other relevant information, such as the financial condition, earnings capacity and near term prospects of the company and the length of time and extent to which the market value has been less than cost.
Whenever a debt or equity security is deemed to be “other than temporarily impaired” due to a fundamental deterioration in its financial condition as determined by management’s analysis, it is written down to its current fair market value. U.S. Treasury Securities and other securities backed by the U.S. Government are never considered impaired due to a fundamental deterioration in financial condition.
If “due to general market conditions” an investment security declines in price from its cost basis by 25% or more for more than a year, between 30% and 40% for more than nine months, between 40% and 50% for more than six months or over 50% for more than ninety days, and in each case the value of the investment security has been below its cost basis for the entire period in question, then the security is considered “other than temporarily impaired” and it is written down to its current fair market value and the loss is recognized in earnings. U.S. Treasury and Government Agency securities fluctuate in value based on changes in market interest rates and other factors; however, they can be redeemed at par value if held to maturity and therefore, if their maturity date is less than one year into the future regardless of their market value they are considered only temporarily impaired. Any unfavorable change in general market conditions could cause an increase in the Company’s impairment write downs of investment securities. This would have an adverse effect on the Company’s earnings results. There were no other than temporary impairment write downs of investment securities in 2006, 2005 or 2004.
Available for sale securities deemed temporarily impaired are carried at market value in the asset section of the Company’s balance sheet. Any change in value, net of income taxes, is reflected in accumulated other comprehensive income in the stockholders’ equity section of the Company’s balance sheet.

Financial Overview
Comparison of the years 2006 and 2005
Massbank Corp. provides a broad range of banking services through its subsidiary, Massbank (“the Bank”). The Bank offers a full range of retail and commercial deposit products through its fifteen banking offices located in Eastern Massachusetts. The Bank’s lending business includes residential and commercial real estate mortgages, construction loans, commercial loans and a variety of consumer loans. The Bank’s loan portfolio is concentrated among borrowers from the municipalities in which it operates banking offices and all of the contiguous cities and towns. The Bank also invests a significant portion of its funds in U.S. Treasury and Government agency securities, mortgage-backed securities, Federal funds sold and other authorized investments. The Bank’s earnings depend largely upon net interest income. Securities gains are also an important source of revenue for the Bank.
The Bank faces strong competition from banks and other financial services providers in its market area. The principal methods of competition are through interest rates, financing terms and other customer conveniences. Among the external factors affecting Massbank ’s operating results are market interest rates, the shape of the U.S. Treasury securities yield curve, the condition of the financial markets and both regional and national economic conditions.
Fiscal 2006 was a challenging year for the Company. The flat-to-inverted yield curve environment in 2006 made it difficult for the Company to profitably grow deposits. Additionally, rising short-term interest rates influenced by the rate setting actions of the Federal Reserve Bank resulted in increased competition for shorter-term deposits. In this environment, the Company decided to more aggressively price its medium term certificates of deposit (CDs) contributing to a shifting of deposits from savings to these CD maturities.
In 2006, the Company generated net income of $7.0 million, or $1.61 per diluted share, compared with $7.3 million or $1.66 per diluted share in 2005. Return on average assets in 2006 improved to 0.82% from 0.79% in the prior year. Return on average equity was 6.74% in 2006 compared to 6.84% in 2005.
The major factors affecting the comparison of earnings and diluted earnings per share between 2006 and 2005 were:
• The decrease in net interest income of $672 thousand due primarily to a decrease in average earning assets.

• The provision for loan losses of $123 thousand versus a credit for loan losses of $53 thousand the prior year.

• The increase in net securities gains of $118 thousand.

• The increase in other non-interest income of $170 thousand.

• The decrease in non-interest expense of $154 thousand.

• The decrease in income tax expense of $110 thousand due to lower income before taxes partially offset by an increase in the Company’s effective income tax rate.

Financial Condition
The Company’s total assets decreased $55.2 million, or 6.1% to $843.5 million at December 31, 2006 from $898.7 million at December 31, 2005. The reduction in total assets reflects a decrease in investments of $46.9 million and a decrease in total loans of $16.8 million.
Deposits decreased $61.4 million, or 7.8% to $723.3 million at year-end 2006 from $784.7 million at year-end 2005. This was due to increased competition for deposits, more attractive returns on other investment opportunities and various other market factors.

Investments
At December 31, 2006 the Company’s investment portfolio consisted of short-term investments, term Federal funds sold, and securities available for sale, held to maturity and trading totaling $590.6 million representing 70.0% of total assets. This reflects a decrease of $46.9 million compared to $637.6 million or 70.9% of total assets at December 31, 2005. M assbank ’s investment portfolio is concentrated in U.S. Treasury and Government agency securities and 15-year contractual life mortgage-backed securities issued by Federal National Mortgage Association (“FNMA”), Federal Home Loan Mortgage Corporation (“FHLMC”) and other agency issuers. U.S. Treasury and Government agency securities totaled $261.3 million at year-end 2006. This included $161.3 million in callable agency securities. The mortgage-backed securities portfolio totaled $139.9 million at December 31, 2006, essentially unchanged from the prior year. The Company also holds $7.4 million in equity securities at year-end 2006. Massbank ’s strategy is to purchase liquid investments with short to intermediate maturities in the current interest rate environment. If the currently inverted Treasury yield curve becomes more normalized in 2007, the Company will likely add to its mortgage-backed securities portfolio and reduce its short-term investments and term Federal funds sold which totaled $180.2 million at December 31, 2006. In such event, we believe that this would likely improve the Company’s net interest margin.

Loans
Massbank ’s loan portfolio at December 31, 2006 totaled $208.9 million representing 24.8% of total assets compared to $225.7 million representing 25.1% of total assets at December 31, 2005. The loan portfolio consists predominantly of residential mortgages. Residential mortgage loans amounted to $194.3 million at year-end 2006, representing approximately 93.0% of the total loan portfolio as compared to $213.6 million representing 94.6% of the total loan portfolio as of December 31, 2005. Commercial real estate loans increased from $2.3 million at December 31, 2005 to $5.0 million at year-end 2006, as the bank has focused more on this type of lending this past year.
Non-Performing Assets
Non-accrual loans, generally those loans that are 90 days or more delinquent, were near historical lows totaling $137 thousand at December 31, 2006, representing 0.07% of total loans. This compares to $257 thousand representing 0.11% of total loans at December 31, 2005. The Bank generally places all loans on non-accrual status when 90 days delinquent. The Bank had no real estate acquired through foreclosure at year-end 2006.
Deposits
Deposits have traditionally been the Bank’s primary source of funds for lending and investment activities. Massbank attracts deposits within its primary market area by offering a variety of deposit instruments including demand and NOW accounts, money market accounts, different types of savings accounts, certificates of deposit and retirement savings plans. Deposit flows vary significantly and are influenced by prevailing interest rates, market conditions, economic conditions and competition. The Bank’s management attempts to manage its deposits through selective pricing and marketing.
Total deposits at December 31, 2006 were $723.3 million, compared to $784.7 million at December 31 ,2005. Increased competition for deposits and more attractive returns on other investment opportunities were the principal reasons for the deposit outflows.
In 2006, savings deposits decreased $96.7 million or 21.9% year-over-year, to $344.8 million from $441.5 million at year-end 2005. Conversely, certificates of deposit increased by $38.7 million or 14.8% to $299.7 million at year-end 2006 as customers continued to shift deposits from savings accounts to certificates of deposit seeking a higher rate of return on their deposits. Demand and NOW deposits totaled $78.9 million at December 31, 2006 compared to $82.3 million at December 31, 2005. For information concerning deposit balances at year-end 2006 and 2005, the average cost and the maturity distribution of the deposits and related rate structure of the Bank’s time certificates of deposit, see Note 10 of Notes to Consolidated Financial Statements.
Stockholders’ Equity
Total stockholders’ equity increased $1.6 million or 1.5% to $106.9 million at December 31, 2006, from $105.3 million at year-end 2005. Book value per share increased $0.44 or 1.8% to $24.76 per share at December 31, 2006, from $24.32 per share at December 31, 2005.
The increase in total stockholders’ equity was due principally to the 2006 net income of $7.0 million and the payments and related tax benefits received from the exercise of stock options by the Company’s officers and directors of $0.9 million. This was partially offset by the payment of dividends to stockholders of $4.7 million and the Company’s repurchase of 49,500 shares of treasury stock at a cost of $1.6 million.
As of December 31, 2006, the Company has recognized as a component of other comprehensive income, the under-funded status of its defined benefit pension plan, net of tax, in accordance with the provisions of Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” See Consolidated Statements of Changes in Stockholders’ Equity.

Results of Operations
Comparison of the years 2006 and 2005
Net Interest Income
Net interest income is the primary source of Massbank ’s operating income. Net interest income is affected by the volume and mix of average interest earning-assets and interest-bearing liabilities, market interest rates, the shape of the U.S. Treasury securities (interest rate) yield curve and other factors. In 2006, short-term interest rates rose at a greater rate than intermediate and long rates. This caused the yield curve to “invert.” An inverted curve significantly limits the ability to benefit from investing assets at long term rates. Because of this situation, we maintain a significant position of short term investments. Due to our current asset mix and other factors, we would expect to benefit from an increase in interest rates along with a steeper interest rate yield curve.
Net interest income on a fully taxable equivalent (FTE) basis totaled $21.1 million in 2006 compared to $21.7 million in 2005, reflecting a decrease of 3.1%. The decrease in net interest income in 2006 is primarily attributable to lower levels of interest earning assets partially offset by lower levels of interest bearing liabilities and an improvement in net interest margin. The Company’s average earning assets in 2006 declined $70.8 million or 7.8% to $833.8 million, from $904.6 million in 2005. Average deposits declined $66.1 million or 8.1% to $750.4 million in 2006, from $816.6 million in 2005. The market for deposits was very competitive in 2006. Financial institutions were aggressive in pricing their deposit products in order to retain deposits. Massbank chose not to match these competitors’ rates in order to protect its net interest margin.
The Company’s net interest margin (net interest income on a FTE basis divided by average interest earning assets) for the year ended December 31, 2006 increased 13 basis points to 2.53% from 2.40% in the prior year. The increase in margin was driven by the increases to short term interest rates in 2006. This was partially offset by the unfavorable changes in the mix of our deposits and competitive market conditions which contributed to our increased funding costs.
The tables on pages 26 and 27 set forth, among other things, the extent to which changes in interest rates and changes in the average balances of interest earning assets and interest-bearing liabilities have affected interest income and expense during the years indicated. Information is provided for each category of interest-earning assets and interest-bearing liabilities, on changes due to (1) changes in volume and (2) changes in interest rates.
Interest on investment securities available for sale (AFS) on a fully taxable equivalent basis was $12.1 million in 2006 compared to $9.9 million in 2005. The average balance of investment securities AFS was $308.7 million with an average yield of 3.93% for the year ended December 31, 2006 compared to an average balance of $313.7 million with an average yield of 3.16% for the year ended December 31, 2005. The increase in yield is primarily due to the replacement yields on new securities purchased being higher because of a rise in market interest rates and to a lesser extent a change in mix of securities in the portfolio.
Interest on mortgage-backed securities AFS and held to maturity was $7.6 million in 2006 compared to $7.2 million in 2005. The average balance of mortgage-backed securities was $141.0 million with an average yield of 5.39% in 2006 compared to an average balance of $134.8 million with an average yield of 5.35% in 2005. The increase in yield is due primarily to the higher replacement yields on the securities purchased in 2006. However, with the flat-to-inverted yield curve environment in 2006, the Company only purchased $25.9 million in mortgage-backed securities during the year as compared to $49.3 million in 2005. Principal repayments (including prepayments) on our mortgage-backed securities portfolio in 2006 declined to $26.7 million, from $31.5 million in the prior year.
Interest on trading securities was $0.2 million in 2006, down from $0.8 million in the prior year. The average balance of trading securities was $5.7 million in 2006 compared to $32.2 million in 2005. The average yield on these securities improved to 3.55% in the recent year, from 2.40% in 2005 due primarily to rising market interest rates.
Interest income on Federal funds sold and short-term investments was $8.0 million in 2006, up 30.0% from $6.2 million in the prior year. The average balance of these investments was $161.2 million with an average yield of 4.97% in 2006 compared to an average balance of $193.8 million with an average yield of 3.18% in 2005. The significant improvement in yield was driven by the Federal Reserve’s increases to the short-term interest rates. The Federal Reserve Bank Board’s Federal Open Market Committee raised the target interest rate for Federal Funds four times in 2006, increasing the rate from 4.25% to 5.25% by mid-year 2006.
Interest on loans fell to $12.1 million in 2006, from $12.8 million in 2005. The average balance for mortgage and other loans in 2006 was $217.3 million with an average yield of 5.56%. This compares to an average balance for mortgage and other loans of $230.1 million in 2005 with an average yield of 5.56%. The decline in average balances is due to principal payments, pay downs and prepayments on mortgages and lower loan origination volume in 2006 compared to 2005. Loan originations totaled $21.7 million in 2006 compared to $48.9 million in 2005. This is primarily attributable to a decline in mortgage refinancing activity due to the rise in market interest rates and a decline in new and existing home sales in the Bank’s market area.
Interest on total deposits was $19.0 million in 2006 compared to $15.1 million in 2005. The average balance of total deposits was $750.4 million with an average cost of 2.53% in 2006 compared to an average balance of $816.6 million with an average cost of 1.85% in 2005. The decrease in average balance was due primarily to increased competition for deposits and more attractive returns on other investment opportunities. The year-over-year increase in the average cost of funds is due primarily to the increases to short-term interest rates over the past year (which were partially passed on to our customers) as well as changes in the mix of deposits.

Provisions (Credit) for Loan Losses
In 2006, the Bank recorded a provision for loan losses of $123 thousand compared to a negative or credit provision for loan losses of $53 thousand in 2005. The provision was to increase the Bank’s allowance for possible losses on its outstanding loan balances due to certain recently funded loan commitments. At the same time, because of the funding of the loan commitments, the Bank reduced its allowance for possible losses on outstanding loan commitments by $172 thousand. This compares to a negative provision or reduction of $71 thousand in this allowance over the prior year. These credits are included in other non-interest expense. On a combined basis, the Bank reduced its overall allowance on loan balances and outstanding loan commitments by $49 thousand in 2006, as compared to a reduction of $124 thousand in 2005.
The Bank’s loan portfolio decreased $16.8 million or 7.4% from $225.7 million at December 31, 2005 to $208.9 million at December 31, 2006. In determining the amount to provide for loan losses, the key factor is the adequacy of the allowance for loan losses. Management uses a methodology to systematically measure the amount of estimated loan loss exposure inherent in the portfolio for the purposes of establishing a sufficient allowance for loan losses. The methodology includes three elements: an analysis of individual loans deemed to be impaired, general loss allocations for various loan types based on loss experience factors, and an unallocated allowance which is maintained based on management’s assessment of many factors including the risk characteristics of the portfolio, concentrations of credit, current and anticipated economic conditions that may effect the borrowers’ ability to pay, and trends in loan delinquencies and charge-offs. At December 31, 2006, the allowance for loan losses was $1.4 million representing 0.66% of total loans and over ten times the balance of non-accrual loans. This compares to $1.3 million representing 0.56% of total loans and almost five times the balance of non-accrual loans at December 31, 2005. Non-accrual loans were near historical lows totaling $137 thousand at December 31, 2006, down from $257 thousand a year earlier. The Bank had net recoveries of loans previously charged-off of $6 thousand in 2006 compared to $1 thousand in net charge-offs in 2005.
The Bank’s allowance for loan losses on off-balance sheet credit exposures (shown separately on the balance sheet) totaled $345 thousand and $517 thousand, respectively, at December 31, 2006 and 2005.
Non-Interest Income
Non-interest income consists of gains or losses on securities, deposit account service fees and other non-interest income. Non-interest income for the year ended December 31, 2006 increased $288 thousand or 15.0% to $2.2 million, from $1.9 million for the year ended December 31, 2005. The increase is due primarily to an increase in net gains on securities available for sale and trading of $118 thousand, from $679 thousand in 2005 to $797 thousand in 2006 and option fess of $150 thousand generated in 2006. The Company has granted a local developer an option to purchase a parcel of land that the Company owns and is not being used for operations purposes. As consideration for this option, the developer will make quarterly option payments of $75,000 to the Company until the option is either exercised and the closing transaction for the purchase occurs or the option is allowed to lapse. The Closing is expected to take place in the third quarter of 2007. Option payments received are not applied towards the purchase price and are not refundable.
Deposit account service fees, deferred compensation plan income and other non-interest income combined increased $20 thousand in 2006 compared to the prior year.
Non-Interest Expense
Non-interest expense totaled $12.4 million for the twelve months ended December 31, 2006 compared to $12.5 million for the prior year, a decrease of $154 thousand or 1.2%. Salaries and employee benefits, the largest component of non-interest expense decreased $125 thousand or 1.7% to $7.3 million in 2006 from $7.5 million in 2005.
The decrease in salaries and employee benefits is due principally to a reduction in the number of bank employees and a decrease in pension expense. These were partially offset by the share based compensation expense recorded by the Company with respect to stock option grants in 2006 and the increased costs of other employee benefits.
Deferred compensation plan expense increased $91 thousand to $263 thousand in 2006 from $172 thousand in 2005. This increase was offset by the increased earnings on plan assets reflected in non-interest income of $94 thousand.
The Company’s other expenses consisting of occupancy and equipment, data processing, professional services, advertising and marketing, deposit insurance and other expenses totaled $4.8 million in 2006 reflecting a decrease of $120 thousand or 2.5% from the prior year. The decrease essentially results from a higher negative provision for off-balance sheet credit exposures in 2006 than the prior year. In 2006, the Bank reduced its allowance for possible losses on outstanding commitments by $172 thousand versus a reduction of $71 thousand in 2005.
Income Tax Expense
For the years ended December 31, 2006 and 2005, income tax expense amounted to $3.7 million and $3.8 million, respectively. The decrease in income tax expense is primarily due to lower income before taxes partially offset by an increase in the Company’s effective income tax rate. The Company’s effective income tax rate for the year ended December 31, 2006 was 34.39%, up from 34.12% for the year ended December 31, 2005. For additional information with respect to Massbank ’s income taxes, see Note 12 of Notes to Consolidated Financial Statements.

MANAGEMENT DISCUSSION FOR LATEST QUARTER
Critical Accounting Policies

The Company’s consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles. As such, the Company is required to make estimates and assumptions that affect the reported amounts of assets and liabilities at the balance sheet dates and the reported amounts of income and expense during the reporting periods. Actual amounts could differ from such estimates.

The Company believes that the following accounting policies are among the most critical because they involve significant judgments and uncertainties and could potentially result in materially different results under different assumptions and conditions.

Provisions (Credit) for Loan Losses

The provision (credit) for loan losses represents a charge or credit against current earnings and an addition to or deduction from the allowance for loan losses. In determining the amount to provide for loan losses, the key factor is the adequacy

of the allowance for loan losses (“loan allowance”). Management uses a methodology to systematically measure the amount of estimated loan loss exposure inherent in the portfolio for purposes of establishing a sufficient loan allowance. The methodology includes three elements: an analysis of individual loans deemed to be impaired, general loss allocations for various types of loans based on loss experience factors, and an unallocated allowance. The unallocated allowance is maintained based on management’s assessment of many factors including the risk characteristics of the portfolio, concentrations of credit, current and anticipated economic conditions that may affect borrowers’ ability to pay and trends in loan delinquencies and charge-offs.

The provision (credit) for loan losses on off-balance sheet credit exposures represents a charge or credit against current earnings (reported in other non-interest expense) and an addition to or deduction from the allowance for loan losses on off-balance sheet credit exposures (“off-balance sheet exposures”). In determining the amount to provide for off-balance sheet exposures, the key factor is

the adequacy of the balance. The balance of the off-balance sheet exposures is maintained based on expected draw downs of committed loans, their loss experience factors, management’s assessment of various other factors including current and anticipated economic conditions that may affect the borrowers’ ability to pay and trends in loan delinquencies and charge-offs.

Any significant changes in these assumptions and/or conditions could result in higher than estimated losses that could adversely affect the Company’s earnings results. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowances. Such agencies may require the Bank to recognize additional allowances based on judgments different from those of management, which could also adversely affect the Company’s earnings results.

Investment Securities Other Than Temporarily Impaired

Management judgment is involved in the evaluation of declines in value (“impairment”) of individual investment securities held by the Company. Declines in value that are deemed other than temporary are recognized in the income statement

through write-downs in the recorded value of the affected securities. Management considers many factors in their analysis of other than temporarily impaired securities, including industry analyst reports, sector credit ratings, volatility in market price and other relevant information, such as the financial condition, earnings capacity and near term prospects of the company and the length of time and extent to which the market value has been less than cost.

Investment Securities Other Than Temporarily Impaired (continued)

Whenever a debt or equity security is deemed to be “other than temporarily impaired” due to a fundamental deterioration in its financial condition as determined by management’s analysis, it is written down to its current fair market value. U.S. Treasury securities and other securities backed by the U.S. Government are never considered impaired due to a fundamental deterioration in financial condition.

If “due to general market conditions” an investment security declines in price from its cost basis by 25% or more for more than a year, between 30% and 40% for more than nine months, between 40% and 50% for more than six months or over 50% for more than ninety days, and in each case the value of the investment security has been below its cost basis for the entire period in question, then the security is considered “other than temporarily impaired” and it is written down to its current fair market value and the loss is recognized in earnings. U.S. Treasury and Government Agency securities fluctuate in value based on changes in market interest rates and other factors; however, they can be redeemed at par value if held to maturity and therefore, if their maturity date is less than one year into the future, regardless of their fair market value, they are considered only temporarily impaired. Any unfavorable change in general market conditions could cause an increase in the Company’s impairment write downs of investment securities. This would have an adverse effect on the Company’s earnings results. There were no other than temporary impairment write downs of investment securities in the first nine months of 2007 and 2006.

Securities available for sale deemed temporarily impaired are carried at fair market value in the asset section of the Company’s balance sheet. Any change in value is reflected in accumulated other comprehensive income (loss) in the stockholders’ equity section of the Company’s balance sheet.

FINANCIAL OVERVIEW

MASSBANK Corp. provides a broad range of banking services through its subsidiary, MASSBANK (“the Bank”). The Bank offers a full range of retail and commercial deposit products through its fifteen banking offices located in Eastern Massachusetts. The Bank’s lending business includes residential and commercial real estate mortgages, construction loans, commercial loans and a variety of consumer loans. The Bank’s loan portfolio is concentrated among borrowers from the municipalities in which it operates banking offices and all of the contiguous cities and towns. The Bank also invests a significant portion of its funds in U.S. Treasury and Government agency securities, mortgage-backed securities, federal funds sold and other authorized investments. The Bank’s earnings depend largely upon net interest income. Securities gains are also an important source of revenue for the Bank.

The Bank faces strong competition from banks and other financial services providers in its market area. The principal methods of competition are through interest rates, financing terms and other customer conveniences. Among the external factors affecting MASSBANK’s operating results are market interest rates, the shape of the U.S. Treasury securities yield curve, the condition of the financial markets and both regional and national economic conditions.

For the quarter ended September 30, 2007, MASSBANK Corp. reported net income of $2,126,000 compared to $1,731,000 for the quarter ended September 30, 2006, an increase of $395,000 or 22.8%. Diluted and basic earnings per share were $0.49 for the third quarter of 2007 compared to $0.40 for the same period in 2006, an increase of 22.5%.

The Company’s return on average assets and return on average equity for the third quarter of 2007 increased to 1.05% and 8.00%, respectively, from 0.82% and 6.72%, respectively, for the third quarter of the prior year.

FINANCIAL OVERVIEW (continued)

The major factors affecting the Company’s increased earnings results for the third quarter of 2007 compared to the same quarter of 2006 were:




The decrease in net interest income of $535,000.




The decrease in provision for loan losses of $82,000.




The change from net gains to net losses on securities available for sale of $184,000.




The increase in net trading securities gains of $2,121,000.




The decrease in deferred compensation plan income of $39,000.




The increase in other non-interest income of $91,000.




The increase in non-interest expense of $831,000.




The increase in income tax expense of $310,000.

Financial Condition

The Company’s total assets were $817.0 million at September 30, 2007, compared to $843.5 million at December 31, 2006 reflecting a decrease of $26.5 million. This includes an increase of $6.8 million in total investments offset by a decrease of $15.5 million in total loans and a decrease of $17.8 million in other assets. Deposits, the primary funding source for the Company’s assets, decreased $29.9 million during the first nine months of 2007, from $723.3 million at December 31, 2006 to $693.4 million at September 30, 2007 due to intense competition for short-term deposits and more attractive returns in the equity securities markets. The decline in deposits was also due in part to management’s decision to seek to protect the Company’s net interest margin. Borrowed funds, which represent the Company’s short-term borrowings from the Federal Reserve Bank of Boston discount window, amounted to $10.0 million at September 30, 2007. There were no such borrowings as of year-end 2006.

Investments

At September 30, 2007, the Company’s total investments were $597.4 million representing 73.1% of total assets compared to $590.6 million representing 70.0% of total assets at December 31, 2006. Total investments have increased $6.8 million from year-end 2006. The increase in total investments includes an increase in short-term investments, primarily federal funds sold, of $23.2 million. In addition, term federal funds sold were increased by $22.0 million to lock these funds in at a higher rate in anticipation of the Federal Reserve Bank reducing its (overnight) federal funds target interest rate.

Upon adoption of FAS 159 effective January 1, 2007, the Company selected the fair value option for all its U.S. Treasury and Government Agency securities available for sale, a portfolio totaling $261.3 million as of January 1, 2007. As a result, these securities were moved from the available for sale category to the trading account. As shown in the detail from the condensed consolidated balance sheets on page 24, in the first nine months of 2007 the Company’s portfolio of securities available for sale decreased $273.2 million while the Company’s portfolio of trading securities increased $232.0 million.

Loans

The loan portfolio, net of allowance for loan losses, decreased $15.5 million or 7.5% in the first nine months of 2007. At September 30, 2007, the loan portfolio, net of allowance for loan losses, totaled $192.0 million representing 23.5% of total assets compared to $207.5 million representing 24.6% of total assets at December 31, 2006. The decrease in loans is due to regular principal payments and prepayments exceeding the volume of new loan originations. New loan originations decreased $3.7 million to $13.4 million in the first nine months of 2007 from $17.1 million in the same period of 2006. Mortgage loan origination activity (particularly refinancing activity) has decreased significantly in the Bank’s market area.

The Bank’s loan portfolio consists predominately of residential mortgages. Residential mortgage loans (excluding residential construction loans) amounted to $178.4 million at September 30, 2007, representing 92.2% of the total loan portfolio. See page 42 of this Form 10-Q for a table setting forth the composition of the loan portfolio at September 30, 2007 and December 31, 2006.

Non-Performing Assets

Non-accrual loans, generally those loans that are 90 days or more delinquent, remain near historical lows totaling $206,000 at September 30, 2007 compared to $137,000 at December 31, 2006 and $5,000 as of September 30, 2006. The Bank had no impaired loans or real estate acquired through foreclosure at September 30, 2007.

Deposits

Deposits have traditionally been the Bank’s primary source of funds for lending and investment activities. MASSBANK attracts deposits within its primary market area by offering a variety of deposit instruments including demand and NOW accounts, money market accounts, different types of savings accounts, certificates of deposit and retirement savings plans. Deposit flows vary significantly and are influenced by prevailing interest rates, market conditions, economic conditions and competition. The Bank’s management attempts to manage its deposits through selective pricing and marketing.

Deposits at September 30, 2007 totaled $693.4 million, reflecting a decrease of $29.9 million or 4.1% from $723.3 million at December 31, 2006. In the first nine months of 2007 there was an outflow of deposits due to increased competition for deposits and some deposits being reinvested in the stock market and other types of investments. The decline in deposits was also due in part to management’s decision to seek to protect the Company’s net interest margin.

For information concerning deposit balances at September 30, 2007 and December 31, 2006, see page 45 of this Form 10-Q.

Borrowed Funds

The Bank has the ability to obtain advances from the Federal Reserve Bank of Boston discount window. On September 28, 2007, as part of the Bank’s test of its business continuity plan, the Bank borrowed $10.0 million for three days. The loan was repaid on October 1, 2007.

Stockholders’ Equity

Total stockholders’ equity increased $0.5 million to $107.4 million at September 30, 2007, from $106.9 million at December 31, 2006. This represents a book value of $25.18 per share at September 30, 2007, up $0.42 from $24.76 per share at December 31, 2006.

The increase in stockholders’ equity was essentially the result of the following: the Company’s net income for the first nine months of 2007 of $5.6 million, the payments and related tax benefits received from the exercise of stock options by the Company’s officers and directors of $0.5 million and a decrease in accumulated other comprehensive loss of $0.5 million due to an increase in market of the Company’s available for sale securities portfolio, partially offset by the payment of dividends to stockholders of $3.6 million and the Company’s repurchase of treasury stock in the amount of $2.5 million.

The Company’s total stockholders’ equity as of September 30, 2007 includes a $2.2 million cumulative effect adjustment, net of tax, recorded as a reduction in retained earnings as of January 1, 2007 due to the early adoption of FAS 159. The charge to retained earnings was offset by a corresponding increase in other comprehensive income, included as an element of stockholders’ equity, thus having no overall impact on total stockholders’ equity.

Comparison of Operating Results for the Three Months ended September 30, 2007 and 2006.

Net interest income

Net interest income for the three months ended September 30, 2007 was $4,645,000 compared to $5,180,000 for the same period in 2006. The decrease in net interest income was due in part to a flat yield curve, increased funding costs due to intense competition for deposits and a decrease in the Company’s average earning assets.

Average earning assets for the third quarter of 2007 declined to $786.1 million, from $822.2 million in the third quarter of the prior year due to a decrease in deposits. Average total deposits were $699.0 million for the third quarter of 2007 compared to $741.0 million for the same quarter last year. Deposits declined due in part to management’s decision to seek to protect the Company’s net interest margin. The Company’s net interest margin for the recent quarter was 2.37% compared to 2.53% for the same quarter in 2006.

Interest and Dividend Income

Interest and dividend income on a fully taxable equivalent basis for the three months ended September 30, 2007 decreased $43,000 to $10,030,000 from $10,073,000 for the three months ended September 30, 2006. The decrease in interest and dividend income resulted from a decrease of $36.1 million in average earning assets, partially offset by an increase in interest income resulting from an improvement in yield on the Company’s average earning assets. As reflected in the table on page 28 of this report, the yield on the Company’s average earning assets in the third quarter of 2007 was 5.10%, as compared to 4.90% in the same quarter of 2006.

Interest Expense

Total interest expense for the three months ended September 30, 2007 increased $496,000, or 10.2% to $5,368,000 from $4,872,000 for the three months ended September 30, 2006. The increase in interest expense is due primarily to higher interest rates and the continued shift in the Bank’s deposit mix from savings accounts to certificates of deposit accounts. This has resulted in an increase in the Company’s average cost of funds, from 2.61% in the third quarter of 2006 to 3.04% in the third quarter of 2007. The increase in interest expense resulting from the higher average cost of funds was partially offset by a decrease in interest expense resulting from a decrease in the Company’s average deposits. The Company’s average deposits in the recent quarter, as shown in the table on page 29, decreased $42.0 million or 5.7% to $699.0 million, from $741.0 million in the same quarter of the prior year.

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