FRANKLIN FINANCIAL SERVICES CORP quarterly report, Q3 FY2023

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Franklin Financial Services Corporation — Q3 2023 Form 10-Q

Business context and reporting period

Franklin Financial Services Corporation is a Pennsylvania bank holding company whose principal subsidiary, Farmers and Merchants Trust Company of Chambersburg, serves markets in south-central Pennsylvania and Washington County, Maryland. This unaudited Form 10-Q covers the three and nine months ended September 30, 2023, with comparisons to the corresponding 2022 periods and December 31, 2022 balances.

Financial performance and condition

  • Third-quarter net income: $3.9 million, or $0.88 diluted earnings per share, versus $4.6 million and $1.05 per share in Q3 2022. Net income increased 22.9% from $3.0 million in Q2 2023.
  • Nine-month net income: $10.1 million, or $2.31 diluted earnings per share, versus $11.2 million and $2.52 per share in the prior-year period, a 9.7% decline.
  • Net interest income: $13.7 million in Q3 and $39.7 million year to date, compared with $14.1 million and $37.0 million, respectively, in 2022. The year-to-date net interest margin increased to 3.33% from 2.96%.
  • Interest expense: $6.4 million in Q3 and $15.5 million year to date, versus $1.0 million and $2.5 million in the comparable 2022 periods, reflecting higher deposit and borrowing costs.
  • Credit costs: Provision for credit losses was $875 thousand in Q3 and $1.9 million year to date, compared with zero in the comparable 2022 periods. The loan allowance was $15.5 million, or 1.29% of gross loans, at September 30, 2023.
  • Noninterest income: $4.0 million in Q3, up 9.6% year over year; $10.8 million year to date, down 7.5%, primarily because of a $1.1 million loss on debt-security sales and lower mortgage loan-sale gains.
  • Noninterest expense: $12.2 million in Q3, essentially unchanged year over year; $36.9 million year to date, up 3.9%, including a $495 thousand lease-termination expense.
  • Loans: Gross loans were $1.207 billion and net loans were $1.191 billion, up 14.8% and 14.9%, respectively, from year-end 2022. Commercial real estate represented $671.2 million, or 56% of gross loans.
  • Deposits: $1.567 billion at September 30, up 1.0% from year-end. Time deposits increased 92.2% to $110.3 million, while interest-bearing checking and savings balances declined 2.8%.
  • Liquidity: Cash and cash equivalents were $74.0 million. Federal Reserve and FHLB borrowings totaled $110.0 million, comprising $70.0 million under the Bank Term Funding Program and $40.0 million of FHLB advances. Reported available liquidity was $539.4 million.
  • Securities: Available-for-sale securities had a fair value of $458.3 million and gross unrealized losses of $67.3 million. Management attributed the unrealized losses primarily to higher interest rates and stated that it did not intend, and was not likely required, to sell the securities before recovery.
  • Cash flow: Year-to-date operating cash flow was $20.6 million; investing activities used $132.1 million, primarily because of $155.7 million of net loan growth; financing activities provided $120.5 million. Cash increased $9.1 million from year-end to $74.0 million.
  • Capital: The bank remained well capitalized. At September 30, 2023, the Bank reported CET1 of 13.03%, total risk-based capital of 14.28%, and Tier 1 leverage of 9.53%.

Material changes versus prior comparable periods

  • Profitability declined year over year because sharply higher funding costs and new credit-loss provisions more than offset stronger loan yields and higher year-to-date net interest income.
  • Loan growth accelerated, led by commercial real estate and residential first-lien loans. Commercial real estate loans increased $104.5 million, or 18.4%, from year-end 2022.
  • Funding composition shifted toward higher-cost time deposits and wholesale borrowings. Total deposits rose modestly, but noninterest-bearing and other lower-cost balances declined.
  • The securities portfolio was restructured, including approximately $40 million of sales that generated a $1.1 million realized loss. Accumulated other comprehensive loss increased to $55.8 million from $51.3 million at year-end.
  • Credit quality remained strong overall: nonaccrual loans were $213 thousand, nonperforming loans were 0.02% of gross loans, and past-due loans totaled $1.9 million. The watch list declined to $10.4 million from $11.6 million at year-end.
  • Return on average assets was 0.78% versus 0.83%, while return on average equity improved to 11.25% from 11.12% for the nine-month periods.

Outlook, commentary, risks and unusual items

  • Management stated that it believes liquidity is sufficient to meet anticipated demands and that the Bank can access additional FHLB, Federal Reserve, correspondent-bank and brokered-deposit funding.
  • Management identified interest-rate changes, inflation, funding costs, deposit volatility, competition, regulation, technology, economic conditions and financial-sector instability as key forward-looking risks.
  • The filing adds specific risks associated with 2023 bank failures and industry concerns, including possible loss of depositor confidence, increased liquidity demands, higher FDIC assessments and further interest-rate volatility.
  • Management believes the loan allowance is adequate, but the CECL estimate depends on economic forecasts, peer loss data, collateral values and other subjective assumptions.
  • Commercial real estate exposure includes office buildings, hotels and construction lending. Management reported $120.0 million of real estate construction loans, including $52.3 million funded with interest reserves.
  • Off-balance-sheet credit commitments were $424.1 million, with $28.3 million of standby letters of credit and a $2.0 million allowance for unfunded commitments.
  • The Board declared a regular $0.32-per-share dividend for the fourth quarter of 2023, payable November 22, 2023. No shares were repurchased during Q3 2023; the existing authorization permits repurchases of up to 150,000 shares through December 21, 2023.
  • No material legal proceedings were reported, and management concluded that disclosure controls were effective as of September 30, 2023.

Important facts for investors to verify

  • Whether elevated deposit pricing and $110.0 million of wholesale borrowings continue to pressure the net interest margin and liquidity.
  • The sustainability and risk concentration of the 14.9% year-to-date loan growth, particularly in commercial real estate, construction, office, hotel and purchased loan participations.
  • Whether the $67.3 million of unrealized securities losses remain primarily interest-rate related and whether securities might need to be sold before recovery.
  • Future CECL provisions, charge-offs, watch-list migration and changes in nonaccrual loans as economic conditions and interest rates evolve.
  • The maturity and refinancing requirements of the $70.0 million BTFP borrowing and $40.0 million of FHLB advances during 2024.
  • The effect of deposit mix changes, uninsured or collateralized deposit levels, brokered and reciprocal deposits, and potential FDIC insurance assessments.
  • Management’s assumptions supporting liquidity stress testing and its statement that anticipated liquidity demands can be met.