FRANKLIN FINANCIAL SERVICES CORP quarterly report, Q3 FY2020

Franklin Financial Services Corporation — Q3 2020 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2020; filed November 9, 2020. Franklin operates primarily through Farmers and Merchants Trust Company of Chambersburg, a community bank serving south-central Pennsylvania.

Financial Performance and Condition

Metric	Q3 2020	Q3 2019	9M 2020	9M 2019
Net income	$3.5 million	$4.5 million	$8.2 million	$11.7 million
Diluted EPS	$0.79	$1.03	$1.89	$2.66
Net interest income	$10.4 million	$10.8 million	$31.0 million	$31.7 million
Provision for loan losses	$375 thousand	$(162) thousand recovery	$5.35 million	$237 thousand
Noninterest income	$3.6 million	$3.5 million	$10.9 million	$10.3 million
Noninterest expense	$9.6 million	$9.0 million	$28.8 million	$28.0 million
Net interest margin	3.02%	3.65%	3.25%	3.75%

Year-to-date return on average assets was 0.80%, return on average equity was 8.33%, and the efficiency ratio was 66.93%.
Total assets were $1.511 billion at September 30, 2020, up from $1.269 billion at December 31, 2019.
Gross loans were $1.023 billion, up 9.5% from year-end; net loans were $1.006 billion, up 9.0%.
Deposits were $1.337 billion, up 18.8% from year-end, driven by noninterest-bearing checking and interest-bearing transaction accounts.
Cash and cash equivalents were $71.2 million, compared with $83.8 million at year-end.
Available-for-sale debt securities were $346.5 million, compared with $187.4 million at year-end, and generated $9.5 million of net unrealized gains before tax at September 30, 2020.
Shareholders’ equity was $139.6 million, compared with $127.5 million at year-end. Book value per share increased to $31.93 from $29.30.
Cash provided by operating activities was $2.4 million, while investing activities used $242.2 million, primarily for securities purchases and loan growth. Financing activities provided $227.2 million, primarily from deposit growth and subordinated notes.
The allowance for loan losses was $17.2 million, or 1.68% of gross loans, versus $12.0 million, or 1.28%, at year-end. Excluding PPP loans, the allowance ratio was 1.79%.
The Bank was well capitalized at September 30, 2020. Consolidated total risk-based capital was 17.62% and Tier 1 leverage was 8.75%; Bank ratios were 15.25% and 8.61%, respectively.

Material Changes Versus Prior Period

Net income declined 23.0% in Q3 and 29.6% for the first nine months, primarily because of lower asset yields, a substantially higher loan-loss provision, and higher operating expenses.
Net interest margin declined 63 basis points in Q3 and 50 basis points year-to-date as market rates reduced earning-asset yields. Lower deposit costs partially offset the pressure.
Year-to-date loan-loss provision expense increased by $5.1 million to $5.35 million. Management attributed the increase primarily to COVID-19-related qualitative adjustments.
Noninterest income increased year-to-date by $561 thousand, including higher mortgage-related loan service charges and an $812 thousand bank-owned life insurance gain. These benefits were partly offset by lower deposit fees, securities gains, and equity-security valuations.
Commercial loans increased 28.8% to $296.3 million, primarily because of $63.4 million of Paycheck Protection Program loans. PPP loans were 100% SBA-guaranteed, subject to program compliance, and carried $1.9 million of deferred fees remaining for recognition.
The Corporation issued $20.0 million of subordinated notes in August 2020. The notes qualify as Tier 2 capital and bear fixed rates of 5.00% or 5.25% before converting to SOFR-based rates after their applicable fixed-rate periods.
Nonperforming loans increased to $9.5 million, or 0.93% of gross loans, from $3.9 million, or 0.42%, at year-end. Nonaccrual loans increased to $9.1 million, largely due to a $5.7 million hotel loan.
The commercial loan watch list increased to $48.1 million from $11.6 million at year-end, primarily because of hotel-related downgrades.

Outlook, Risks, Contingencies, and Unusual Items

COVID-19 remains the principal uncertainty. The pandemic could increase delinquencies, credit losses, allowance requirements, securities impairments, operating disruption, and liquidity pressure.
Approximately $82.5 million to $83 million of loans had been modified or deferred at September 30, 2020, down from approximately $196 million at June 30. Hotels represented $60.8 million, or most of the modified balance; hotel occupancy and average daily rates were below the prior year.
Management stated that loan quality could deteriorate as modified loans exit their deferral periods. The allowance estimate is sensitive to economic conditions, classified loans, collateral values, delinquency trends, and other judgmental assumptions.
Available liquidity was reported at approximately $497.1 million, including Federal Home Loan Bank capacity of $387.9 million, Federal Reserve Discount Window capacity of $24.8 million, correspondent-bank capacity of $21.0 million, and PPPLF capacity of $63.4 million. Management believed anticipated liquidity needs could be met.
Off-balance-sheet commitments included $327.5 million of commitments to extend credit and $21.4 million of standby letters of credit. A $2.1 million reserve remained for letters of credit associated with a commercial borrower bankruptcy.
The CARES Act produced a $1.1 million income-tax benefit in the second quarter through an NOL carryback. The nine-month effective tax rate was 7.3%, excluding the NOL benefit, compared with 15.2% in the prior-year period.
The Board declared a $0.30 per share fourth-quarter dividend payable November 25, 2020. Stock repurchases were suspended in March 2020, and no shares were repurchased during the third quarter.
Management reported no material litigation expected to adversely affect financial position, but stated that potential losses for certain matters could not be estimated. Disclosure controls and procedures were deemed effective.

Important Facts for Investors to Verify

Whether hotel and other pandemic-sensitive borrowers resume payments after loan deferrals expire, and whether the $48.1 million watch list continues to expand.
The adequacy of the $17.2 million allowance for loan losses under prolonged economic weakness and the future adoption of CECL, scheduled for January 2023.
The pace and profitability of PPP loan forgiveness, including recognition of the remaining $1.9 million in deferred fees and continued SBA guarantee eligibility.
The sustainability of net interest margin after the sharp decline in market rates and the impact of the $20 million subordinated notes on funding costs.
Future securities-market movements and the potential effect on accumulated other comprehensive income and capital.
Liquidity availability under stressed deposit outflows, reduced loan cash flows, and possible limitations on Federal Home Loan Bank or other wholesale funding.
Exposure to PPP-related litigation or loss of SBA guarantees if program-originating, certification, underwriting, or servicing deficiencies are identified.