Citizens Financial Services, Inc. — Q3 2018 Form 10-Q
Business context and reporting period. The Pennsylvania-based bank holding company, through First Citizens Community Bank and its insurance subsidiary, reported unaudited results for the quarter and nine months ended September 30, 2018. It operated 29 banking facilities and served markets in Pennsylvania and southern New York. The December 2017 acquisition of a State College branch contributed to loan and operating growth. Management cautioned that nine-month results are not necessarily indicative of full-year results.
Financial performance and condition
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Net interest income | $11.770 million | $10.617 million | $34.941 million | $31.018 million |
| Provision for loan losses | $0.475 million | $0.500 million | $1.300 million | $1.740 million |
| Noninterest income | $2.010 million | $1.921 million | $5.758 million | $5.844 million |
| Noninterest expense | $7.788 million | $7.247 million | $23.322 million | $21.604 million |
| Net income | $4.581 million | $3.650 million | $13.519 million | $10.421 million |
| Diluted EPS | $1.31 | $1.04 | $3.85 | $2.96 |
- Q3 net income rose 25.5%; nine-month net income rose 29.7%. Nine-month annualized return on assets was 1.30% versus 1.12%, and return on equity was 13.13% versus 10.81%.
- Net interest margin on a fully taxable-equivalent basis was 3.64% for Q3 and 3.65% year to date, compared with 3.79% and 3.78%, respectively. Management attributed much of the margin comparison decline to the lower federal tax rate’s effect on tax-equivalent yields. Higher funding costs also weighed on spread: nine-month interest-bearing liability cost increased to 0.84% from 0.59%.
- At September 30, total assets were $1.408 billion, up $46.0 million from year-end 2017. Net loans were $1.048 billion, up $58.6 million; deposits were $1.175 billion, up $69.9 million; and borrowed funds were $86.1 million, down $28.6 million. Stockholders’ equity was $134.4 million, up 4.2%.
- Nine-month operating cash flow was $14.9 million, investing cash outflow was $52.6 million, and financing cash inflow was $35.7 million. Cash and cash equivalents ended at $16.5 million, down $2.0 million from year-end.
- The allowance for loan losses was $12.4 million, or 1.17% of loans, versus $11.2 million, or 1.12%, at year-end 2017. Net charge-offs were $107,000 for the nine-month period.
- Regulatory capital ratios remained above “well capitalized” thresholds. At September 30, the Company’s total risk-based capital ratio was 13.40%, common equity Tier 1 ratio 11.45%, and Tier 1 leverage ratio 9.09%. Management said the Company and Bank met applicable requirements.
Material changes versus comparable periods
- Growth in loan balances and interest income drove higher net interest income: nine-month net interest income increased 12.7%. Average loans grew substantially, particularly commercial and agricultural lending; the State College acquisition and expanded lending teams contributed.
- Funding costs rose as average interest-bearing liabilities increased and deposit and borrowing rates climbed. Nine-month interest expense increased $2.5 million year over year.
- Noninterest expense rose 8.0% for nine months, including higher salaries and benefits, professional fees, and occupancy costs. Management linked staffing and occupancy increases partly to added locations and the State College branch; higher legal fees related to a customer bankruptcy.
- Nine-month noninterest income declined 1.5%, chiefly because available-for-sale securities generated an $8,000 net loss versus a $204,000 gain in 2017. Brokerage and insurance income increased, while trust fees and gains on loans sold declined.
- Nonperforming loans increased to $14.8 million from $10.7 million at year-end 2017, or 38.3%; the nonperforming-loan ratio rose to 1.40% from 1.07%. Management attributed much of the increase to several customer relationships, including agricultural borrowers facing depressed milk prices.
- Available-for-sale securities were $240.4 million, down from $254.8 million at year-end. Accumulated other comprehensive loss widened to $6.1 million from $3.4 million, principally reflecting unrealized securities losses.
Outlook, risks, contingencies, and unusual items
- No formal earnings or revenue guidance is provided. Management said liquidity was adequate, supported by deposits, cash, portfolio cash flows, FHLB access, and other funding lines. A new full-service Denver, Pennsylvania branch and closure of the Narvon limited branch were expected in Q4 2018.
- Credit concentration is notable: dairy-industry loans totaled $153.5 million, or 14.5% of loans. Four customer relationships represented 67.2% of nonperforming loans. The filing describes exposure to weak milk prices and reduced natural-gas exploration activity; management considered the allowance adequate but warned that economic deterioration, collateral declines, or delayed borrower information could require higher provisions.
- Interest-rate sensitivity modeling estimated prospective one-year net interest income would decline 12.68% under a 400-basis-point rate increase. Management noted that results depend on modeling assumptions and actual outcomes may differ.
- Liquidity access included approximately $503.1 million of FHLB borrowing capacity, with $101.3 million outstanding through loans and letters of credit; a $10 million federal funds line and an approximately $4 million Federal Reserve borrower-in-custody line were undrawn. The Company had $20 million of brokered certificates of deposit outstanding.
- The Bank was named in the Arnold v. First Citizens National Bank bankruptcy litigation involving alleged avoidable payments and liens connected to Cornerstone Homes. Management said reserves were adequate and did not expect the proceedings to materially affect financial condition or results, while acknowledging an adverse outcome could be material.
- Three previously modified troubled loans totaling $1.426 million defaulted during the nine months. The filing notes that restructured loans carry higher recidivism risk.
- Accounting changes included adoption of revenue-recognition and financial-instrument guidance; management reported no material revenue-recognition impact. The company expected a one-time allowance adjustment upon adoption of the expected-credit-loss standard, but could not yet estimate its magnitude. It preliminarily expected the lease standard to increase assets and liabilities by less than 1%.
Important facts for investors to verify
- Whether elevated nonperforming loans—especially agricultural and dairy-related exposures—stabilize, and whether collateral values and the loan-loss allowance remain adequate.
- Whether loan growth and asset yields can continue to outpace higher deposit and borrowing costs, given the reported margin compression.
- The sustainability and composition of deposit growth, including municipal balances and the $20 million of brokered CDs, and the resulting liquidity and funding costs.
- Developments in the Cornerstone Homes litigation and any changes to reserves, as well as the effect of credit-loss accounting adoption on the allowance and earnings.
- Progress on the planned branch changes and whether related growth offsets higher operating expenses.