FRANKLIN FINANCIAL SERVICES CORP quarterly report, Q2 FY2017

Franklin Financial Services Corporation: 2017 Q2 Form 10-Q Summary

Business Context and Reporting Period

Franklin Financial Services Corporation is a Pennsylvania bank holding company whose principal subsidiary is Farmers and Merchants Trust Company of Chambersburg. The company serves south-central Pennsylvania through commercial banking, lending, investment and trust services. This unaudited Form 10-Q covers the three and six months ended June 30, 2017, with comparisons to the same periods in 2016 and to December 31, 2016.

Key Financial Metrics

Metric	Three Months Ended June 30, 2017	Three Months Ended June 30, 2016	Six Months Ended June 30, 2017	Six Months Ended June 30, 2016
Interest income	$9.938 million	$8.988 million	$19.483 million	$18.087 million
Net interest income	$9.348 million	$8.440 million	$18.312 million	$16.994 million
Provision for loan losses	$50 thousand	$1.875 million	$170 thousand	$2.175 million
Noninterest income	$3.155 million	$2.856 million	$6.081 million	$5.809 million
Noninterest expense	$8.161 million	$7.730 million	$16.118 million	$15.525 million
Net income	$3.342 million	$1.561 million	$6.362 million	$4.288 million
Diluted earnings per share	$0.77	$0.36	$1.46	$1.00

Second-quarter net income increased approximately 114%; first-half net income increased approximately 48%.
Net interest income increased approximately 11% in the quarter and 8% year to date. The six-month net interest margin was 3.72%, compared with 3.63% in the prior-year period.
Return on average assets was 1.13% and return on average equity was 10.75% for the first six months, compared with 0.80% and 7.56%, respectively, in the prior-year period.
The first-half efficiency ratio was 62.77%, compared with 65.04% in the prior-year period.
Total assets were $1.135 billion at June 30, 2017, up $7.2 million from year-end 2016.
Net loans were $890.1 million, up $7.3 million, or 0.8%, from year-end. Commercial loans increased $15.0 million, while commercial real estate loans declined $3.8 million.
Deposits were $1.007 billion, up $25.3 million, or 2.6%, from year-end. Growth was concentrated in interest-bearing checking and savings accounts; time deposits declined $2.5 million.
Investment securities declined $7.8 million from year-end to $136.0 million as maturities and cash flows were redeployed into loans.
Cash and cash equivalents were $45.7 million, up $9.1 million from year-end. The company had no short-term borrowings at June 30, 2017, compared with $24.3 million at year-end.
Shareholders’ equity increased to $122.4 million from $116.5 million. Book value per share was $28.19 and tangible book value per share was $26.12.
The quarterly dividend increased to $0.24 per share from $0.21 in the comparable 2016 quarter. The board declared another $0.24 per share dividend for the third quarter of 2017.

Material Changes Versus Prior Comparable Period

The major earnings improvement resulted from higher loan-related interest income and a substantially lower loan-loss provision. The 2016 provision included the effect of a large commercial real estate charge-off.
Average loans increased materially year over year, particularly commercial, industrial and agricultural loans. Average loan balances for the second quarter were $905.3 million versus $814.1 million in 2016.
Noninterest income increased 10.5% in the second quarter, primarily from higher investment and trust service fees, past-due fees collected on the payoff of a large nonaccrual loan, and a vendor rebate. Some of these items may not recur.
Noninterest expense increased 5.6% in the quarter and 3.8% year to date, driven primarily by salaries and benefits, including incentive compensation, health insurance, merit increases, staffing and stock-option compensation.
Credit quality improved. Nonperforming loans declined to $3.1 million from $5.4 million at year-end, and nonperforming assets declined to $6.2 million from $10.4 million. Nonperforming loans were 0.35% of gross loans.
The allowance for loan losses increased to $11.3 million, or 1.25% of gross loans, from $11.1 million at year-end. The company recorded net recoveries of $62 thousand during the first half of 2017, compared with $1.9 million of net charge-offs in the prior-year period.
Other real estate owned declined to $3.1 million from $4.9 million, mainly because a property carried at approximately $1.8 million was sold during the first quarter.

Guidance, Outlook, Risks and Unusual Items

Management expects commercial lending to remain the primary source of loan growth, focused on in-market lending, while purchased loan participations are expected to decline.
Management expects pension expense of approximately $459 thousand in 2017, compared with $922 thousand in 2016, and expects no pension contributions in 2017.
The company believes it can meet anticipated liquidity demands. At June 30, 2017, the Bank reported approximately $307 million of available FHLB borrowing capacity and approximately $21 million of Federal Reserve Discount Window borrowing capacity.
Unused commitments and standby letters of credit totaled $295.2 million at June 30, 2017. These off-balance-sheet commitments could create funding or credit exposure if drawn.
The Bank was well capitalized under Basel III. The Bank’s June 30 ratios included CET1 of 15.46%, Tier 1 risk-based capital of 15.46%, total risk-based capital of 16.72% and Tier 1 leverage of 10.35%.
Interest-rate risk remains significant. The Federal Reserve raised the federal funds target range by 0.25% in June 2017, and management noted a flattening yield curve and uncertainty regarding further rate changes.
The portfolio included $45.5 million of securities with temporary unrealized losses totaling $817 thousand. Management determined the losses were temporary and recorded no additional other-than-temporary impairment during the period. The private-label mortgage-backed securities portfolio had $595 thousand of cumulative credit-related impairment charges, and additional write-downs remain possible if loss trends worsen.
Other real estate owned includes a property carried at approximately $2.5 million that was under contract but subject to due diligence through November 2017; the final outcome was uncertain.
The company is a defendant in the Kalan et al. litigation. Management could not evaluate the likelihood of an unfavorable outcome or estimate a loss range and therefore recorded no specific accrual. An adverse outcome could materially affect future results.
Management identified no material changes in market-risk exposure, disclosure controls or internal control over financial reporting during the quarter.
Upcoming accounting standards include CECL, effective January 1, 2020. Management expects earlier recognition and potentially a larger allowance for credit losses but had not quantified the impact.

Most Important Facts for Investors to Verify

Whether commercial loan growth and the higher loan yield can continue without deterioration in credit quality or a material increase in the allowance for loan losses.
The recurrence and sustainability of noninterest income related to the large nonaccrual-loan payoff, vendor rebate and trust-service fees.
Exposure to commercial real estate, municipal lending, purchased loan participations and the $295.2 million of unused commitments.
The resolution, potential class-action status and ultimate financial exposure associated with the Kalan litigation.
The sale status and recoverability of the approximately $2.5 million OREO property and the potential for further securities impairment.
The effect of future interest-rate movements, deposit pricing and the flattening yield curve on net interest margin and liquidity.
The eventual balance-sheet and earnings effect of adopting the CECL expected-credit-loss model.