FRANKLIN FINANCIAL SERVICES CORP quarterly report, Q2 FY2022

Franklin Financial Services Corporation — Q2 2022 Form 10-Q Summary

Business context and reporting period

Franklin Financial Services Corporation is a Pennsylvania-based bank holding company whose principal subsidiary, Farmers & Merchants Trust Company of Chambersburg, serves south-central Pennsylvania and western Maryland. The filing covers the three and six months ended June 30, 2022. The financial statements are unaudited.

Financial performance and condition

Metric	Q2 2022	Q2 2021	Six months 2022	Six months 2021
Net interest income	$12.1 million	$10.8 million	$22.9 million	$21.7 million
Provision for loan losses	$0	$(1.1) million credit	$0	$(1.9) million credit
Noninterest income	$4.1 million	$4.5 million	$8.0 million	$8.7 million
Noninterest expense	$12.0 million	$10.1 million	$23.3 million	$20.3 million
Net income	$3.6 million	$5.3 million	$6.6 million	$10.1 million
Diluted EPS	$0.80	$1.19	$1.47	$2.28
Net interest margin	2.90%	2.82%	2.80%	2.92%

Second-quarter net income declined 32%; six-month net income declined 35%. The comparison was affected by the $1.1 million and $1.9 million loan-loss provision credits recorded in the 2021 periods.
Net interest income increased because of higher earning-asset balances and Federal Reserve rate increases. PPP interest and fees fell to $4 thousand in Q2 2022 from $746 thousand in Q2 2021, and to $388 thousand year-to-date from $1.6 million.
Noninterest income declined primarily because mortgage originations and gains on loan sales slowed. Six-month gain on sale of loans fell $828 thousand, or 61.9%.
Noninterest expense rose 19.0% in Q2 and 14.9% year-to-date, driven by higher salaries and incentives, data-processing costs, marketing, and other expenses.
The efficiency ratio increased to 73.70% year-to-date from 65.55% in the prior-year period. Annualized return on average assets was 0.74%, and annualized return on average equity was 9.36%.

Balance sheet, liquidity, debt, and capital

Total assets were $1.832 billion, up from $1.774 billion at December 31, 2021. Cash and cash equivalents were $198.3 million, including approximately $177.8 million of interest-earning deposits held primarily at the Federal Reserve.
Gross loans increased 3.6% to $1.035 billion, while net loans increased to $1.020 billion. Commercial real estate loans rose $40.0 million, partly offset by an $8.3 million decline in non-real-estate commercial loans. PPP loans declined to $215 thousand from $7.8 million.
Deposits increased 6.0% to $1.679 billion, led by a $67.1 million increase in interest-bearing checking deposits. Time deposits declined $11.2 million.
The available-for-sale securities portfolio had a fair value of $509.8 million and an amortized cost of $554.4 million. Net unrealized losses increased to $44.6 million from a $4.1 million net unrealized gain at year-end, primarily because of higher interest rates. Management classified the losses as temporary and recorded no other-than-temporary impairment charge.
Shareholders’ equity declined to $121.8 million from $157.1 million, principally because accumulated other comprehensive loss increased by $38.4 million as securities values fell. Book value per share was $27.54 and tangible book value per share was $25.50.
Subordinated notes had a carrying value of $19.6 million and a face amount of $20.0 million. The notes bear fixed rates of 5.00% and 5.25% until their respective conversion dates and then reference 90-day SOFR plus a spread.
Available liquidity was reported at $446.8 million, consisting of $358.2 million of Federal Home Loan Bank capacity, $32.6 million of Federal Reserve Discount Window capacity, and $56.0 million of correspondent-bank capacity, with no outstanding balances reported against these sources.
The Bank remained well capitalized. At June 30, 2022, its CET1 ratio was 14.34%, total risk-based capital ratio was 15.60%, and Tier 1 leverage ratio was 8.56%.

Material changes versus the prior comparable period

Profitability weakened despite higher net interest income because the prior year benefited from loan-loss provision reversals and 2022 incurred substantially higher operating expenses.
Q2 net interest margin improved to 2.90% from 2.82%, but the six-month margin declined to 2.80% from 2.92%.
Credit indicators improved: nonaccrual loans declined to $5.7 million, or 0.55% of gross loans, from $7.4 million, or 0.74%, at year-end 2021. The allowance for loan losses was $15.0 million, or 1.45% of gross loans, versus 1.51% at year-end.
The commercial real estate portfolio expanded, while the commercial portfolio contracted primarily because of PPP forgiveness. The watch list declined to $19.1 million from $36.6 million.
The company repurchased 46,791 shares during the second quarter under a 150,000-share authorization and declared a $0.32 per-share quarterly dividend.

Outlook, risks, contingencies, and unusual items

No formal earnings or operating guidance is provided. Management stated that the local market remains positioned for growth and that it expects to meet anticipated liquidity demands.
Management cited risks from inflation, interest-rate changes, funding costs, monetary policy, regulation, competition, technology, and continuing effects of the COVID-19 pandemic. Rising rates may support asset yields but can reduce securities values and increase funding costs.
CECL adoption is scheduled for January 1, 2023. Management expects a one-time cumulative-effect adjustment to the allowance and retained earnings, but the amount of the impact had not been determined. A third-party vendor and test implementation were in progress.
Off-balance-sheet commitments totaled $393.4 million for commitments to extend credit and $28.4 million of standby letters of credit. A $1.5 million reserve remained for letters of credit associated with a bankrupt commercial borrower.
There were 14 performing troubled debt restructurings totaling $4.4 million, no new TDRs in the first half of 2022, and $9.8 million of impaired loans with a $514 thousand specific reserve.
Management reported no material pending legal proceedings or material changes to previously disclosed risk factors. It also stated that disclosure controls were effective as of June 30, 2022.

Important facts for investors to verify

Assess the sensitivity of net interest margin, deposit costs, and earnings to additional Federal Reserve rate increases and changes in deposit mix.
Evaluate the potential effect of the $44.6 million securities unrealized loss and future rate movements on tangible capital and liquidity.
Review the size, collateral quality, and concentration of the $562.8 million commercial real estate portfolio, including hotels, offices, shopping centers, and construction loans.
Monitor the January 2023 CECL adoption adjustment and any resulting increase in the allowance or provision expense.
Reconcile recurring expense growth, including staffing and technology investments, against expected revenue growth and future efficiency improvements.
Verify the adequacy of the $1.5 million standby-letter-of-credit reserve and the treatment of other off-balance-sheet commitments.