Franklin Financial Services Corporation — 2018 Q2 Form 10-Q
Business context and reporting period
Franklin Financial Services Corporation is the parent of Farmers and Merchants Trust Company of Chambersburg, a commercial bank serving south-central Pennsylvania, and Franklin Future Fund Inc. This unaudited Form 10-Q covers the three and six months ended June 30, 2018, with comparisons to the corresponding 2017 periods and December 31, 2017 balance-sheet data.
Key financial metrics
| Metric | Three months ended June 30, 2018 | Six months ended June 30, 2018 |
|---|---|---|
| Net interest income | $10.1 million | $19.8 million |
| Provision for loan losses | $9.1 million | $9.3 million |
| Noninterest income | $3.2 million | $6.4 million |
| Noninterest expense | $11.2 million | $19.8 million |
| Net income (loss) | $(5.2) million | $(1.7) million |
| Diluted EPS | $(1.18) | $(0.38) |
| Net interest margin | Not separately stated for the quarter in the summary table; management reported 3.78% tax-equivalent margin | 3.75% |
- Total assets were $1.178 billion at June 30, 2018, compared with $1.180 billion at year-end 2017.
- Gross loans increased 2.5% to $967.3 million; net loans were $954.8 million. Commercial real estate loans increased $36.5 million, while commercial loans declined $7.5 million, principally because of the Participation charge-off.
- Deposits increased 1.0% to $1.058 billion. The company reported no short-term borrowings at quarter-end.
- Cash and cash equivalents were $29.5 million, down from $58.6 million at December 31, 2017. Management identified available FHLB borrowing capacity of $330.5 million and Federal Reserve Discount Window borrowing capacity of approximately $19 million.
- The allowance for loan losses was $12.5 million, or 1.29% of gross loans, versus $11.8 million, or 1.25%, at year-end 2017.
- Shareholders’ equity declined to $111.2 million from $115.1 million. The company declared cash dividends of $0.27 per share for the quarter and $0.51 per share year-to-date.
- The Bank remained well capitalized: total risk-based capital was 14.39%, CET1 was 13.13%, and Tier 1 leverage was 9.24% at June 30, 2018.
Material changes versus prior comparable periods
- Second-quarter net interest income increased $751 thousand, or approximately 8%, from 2017; six-month net interest income increased $1.5 million, or approximately 8%.
- Noninterest income increased 2.1% in the quarter and 4.7% year-to-date, led by higher investment and trust services fees and debit-card income.
- Noninterest expense increased 37.1% in the quarter and 23.1% year-to-date. The principal unusual item was a $2.4 million reserve for off-balance-sheet credit losses, supplemented by higher salaries, legal and professional costs, data processing, advertising, and FDIC insurance expense.
- The provision for loan losses rose from $50 thousand to $9.1 million in the quarter and from $170 thousand to $9.3 million year-to-date.
- Nonperforming loans increased to $5.8 million from $2.7 million at year-end 2017, and nonperforming assets increased to $8.4 million from $5.3 million.
- Net cash used in operating activities was $2.2 million and net cash used in investing activities was $36.1 million for the first six months, driven principally by loan growth and the $10 million legal settlement payment. Financing activities provided $9.2 million.
Guidance, outlook, commentary, risks and unusual items
- The most significant event was the impairment of a $14.4 million commercial loan participation associated with a borrower alleged to have experienced fraudulent activities. The borrower ceased operations and filed for bankruptcy. Franklin charged off $8.7 million of loans, established a $2.4 million reserve for related letters-of-credit exposure, and maintained a $225 thousand specific reserve on a remaining loan.
- Management characterized the fraud-related loss as an isolated occurrence and stated that the allowance for loan losses was adequate at June 30, 2018. Actual losses could differ from current estimates, particularly as collateral and bankruptcy recoveries develop.
- The Bank’s watch-list loans totaled $16.0 million, including $5.7 million of nonaccrual loans. The filing reports no loans rated Doubtful or Loss.
- The Bank paid $10 million in May 2018 to settle the Kalan litigation. The amount had been accrued in 2017, so the payment reduced cash but was not a new 2018 expense. Final court approval was entered July 31, 2018, after quarter-end.
- Management expects 2018 pension expense of approximately $500 thousand, compared with $459 thousand in 2017, and made a $1.0 million pension contribution during the first quarter.
- Management stated that it can meet anticipated liquidity demands. However, liquidity depends on deposit stability, loan repayments, securities liquidity, and continued access to FHLB and other funding sources.
- Interest-rate risk remains material. The Federal Reserve raised the federal funds target range in June 2018, while the yield curve flattened. The filing provides no formal earnings or rate guidance.
- The company adopted ASC 606 and other accounting updates in 2018 without a material reported effect. CECL adoption is expected January 1, 2020; management expects earlier and potentially larger credit-loss recognition but had not determined the ultimate impact.
- Off-balance-sheet commitments included $297.5 million of commitments to extend credit and $29.1 million of standby letters of credit at June 30, 2018.
Important facts for investors to verify
- Resolution, recoveries, collateral values, and any additional losses related to the fraudulent borrower participation and bankruptcy.
- Whether nonperforming loans, watch-list loans, and the allowance for loan losses continue to increase.
- The sustainability of quarterly dividends while earnings are negative and the year-to-date dividend payout ratio is negative 132.6%.
- Actual deposit trends, cash balances, unused FHLB capacity, and reliance on secured or emergency funding.
- The effect of rising funding costs and a flattening yield curve on net interest margin.
- Potential balance-sheet recognition and implementation costs from the 2019 lease standard and 2020 CECL standard.
- Future legal proceedings or contingencies not covered by the Kalan settlement; management states that potential outcomes for certain matters cannot currently be estimated.