Franklin Financial Services Corporation — Q1 2017 Form 10-Q
Reporting period: Three months ended March 31, 2017; filed May 8, 2017. The unaudited consolidated results include the company, Farmers and Merchants Trust Company of Chambersburg, and Franklin Future Fund Inc. The principal business is community banking in south-central Pennsylvania, with commercial, real estate, consumer lending, deposits, investment and trust services.
Financial condition and results
| Metric | Q1 2017 | Comparable period or prior year-end |
|---|---|---|
| Total assets | $1.131 billion | $1.127 billion at Dec. 31, 2016; $1.036 billion at Mar. 31, 2016 |
| Net loans | $892.3 million | $882.8 million at Dec. 31, 2016; $760.8 million at Mar. 31, 2016 |
| Total deposits | $1.007 billion | $982.1 million at Dec. 31, 2016; $917.4 million at Mar. 31, 2016 |
| Net interest income | $9.0 million | $8.6 million in Q1 2016 |
| Net income | $3.0 million | $2.7 million in Q1 2016 |
| Diluted EPS | $0.70 | $0.64 in Q1 2016 |
| Cash dividend declared | $0.21 per share | $0.19 in Q1 2016 |
| Cash and cash equivalents | $39.7 million | $36.7 million at Dec. 31, 2016; $59.1 million at Mar. 31, 2016 |
- Total revenue, defined by management as interest income plus noninterest income, increased $420 thousand year over year. Interest income rose $448 thousand, while interest expense increased $36 thousand.
- Net interest margin was 3.69%, compared with 3.70% in Q1 2016. Management attributed the increase in tax-equivalent net interest income primarily to balance-sheet volume, partly offset by lower rates.
- Noninterest income declined 0.9% to $2.9 million. Investment and trust fees and debit card income increased, but loan service charges and other income declined.
- Noninterest expense increased 2.1% to $8.0 million, principally from higher salaries and benefits, pension expense, staffing, merit increases and data-processing costs. The efficiency ratio improved to 63.62% from 64.67%.
- Return on average assets was 1.08% and return on average equity was 10.33%, compared with 1.04% and 9.75%, respectively, in Q1 2016.
- The provision for loan losses decreased to $120 thousand from $300 thousand. Net recoveries were $83 thousand, and the allowance for loan losses increased to $11.3 million, or 1.25% of gross loans.
- Shareholders’ equity increased to $119.2 million from $116.5 million at year-end, supported by net income, retained earnings, dividend reinvestment activity and improved accumulated other comprehensive income.
Material changes versus prior periods
- Loans increased $9.5 million, or 1.1%, during the quarter, led by commercial real estate and commercial lending. Commercial real estate loans rose $6.7 million and commercial loans rose $3.9 million.
- Deposits increased $24.5 million, or 2.5%, primarily through interest-bearing checking and savings accounts. Time deposits decreased $886 thousand.
- Investment securities declined $6.7 million from year-end to $137.2 million. The portfolio reported a net unrealized gain of $432 thousand, versus a net unrealized loss of $20 thousand at year-end.
- Short-term borrowings declined from $24.3 million at year-end to zero at March 31, 2017.
- Nonperforming assets declined to $8.4 million from $10.4 million, reflecting a reduction in other real estate owned. Nonperforming loans were $5.3 million, or 0.58% of gross loans, compared with 0.61% at year-end.
- Operating cash flow was $3.1 million, compared with $2.4 million in Q1 2016. Investing activities generated $320 thousand, compared with $14.3 million of cash used in Q1 2016, while financing activities used $457 thousand versus $32.0 million provided in the prior-year period.
Capital, liquidity, outlook and risks
- The Bank remained well capitalized under Basel III. At March 31, 2017, the Bank reported a 14.91% CET1 ratio, 14.91% Tier 1 risk-based capital ratio, 16.18% total risk-based capital ratio and 10.25% Tier 1 leverage ratio.
- Management stated that it believes the Bank can meet anticipated liquidity demands. Available sources included approximately $296.0 million of FHLB borrowing capacity and approximately $21 million of Federal Reserve Discount Window borrowing capacity. All investment securities were classified as available for sale, although approximately $75.9 million was pledged as collateral.
- Unused loan commitments and standby letters of credit totaled approximately $301.7 million at March 31, 2017. These off-balance-sheet commitments could create future funding requirements if drawn.
- Management expects commercial lending to remain the primary area of loan growth, while purchased loan participations are expected to decline. Management expects the consumer loan portfolio to continue declining.
- The filing provides no formal earnings or revenue guidance. Management stated that local economic conditions remained suitable for growth, but results remain sensitive to interest rates, funding costs, monetary policy, regulation, competition and broader economic conditions.
- Interest-rate risk is significant because the company is a financial institution. The Federal Reserve raised the federal funds target range in March 2017, and the timing and magnitude of further changes were described as data dependent.
- Management identified potential additional write-down risk in private-label mortgage-backed securities, which had $595 thousand of cumulative impairment charges. Unrealized losses on securities were considered temporary at quarter-end, but credit deterioration or adverse market conditions could produce future charges.
- The company held $3.1 million of other real estate owned, including a $2.5 million property under contract with a due-diligence period extending to November 2017. The outcome of the sale was not certain.
- The company disclosed the Kalan et al. litigation. No specific accrual was recorded because the likelihood and amount of any loss could not yet be evaluated; the filing states that ultimate exposure could be higher than any future estimate or accrual.
- The company adopted ASU 2016-09 and ASU 2017-09 during Q1 2017 with no effect on the consolidated financial statements. The expected 2020 CECL adoption may result in earlier recognition and possibly a larger allowance for credit losses; the impact remains under evaluation.
Investor verification items
- Verify the sustainability of commercial real estate and commercial loan growth, including concentration, purchased participations and the $19.0 million watch list.
- Review allowance adequacy in light of $15.4 million of impaired loans, $5.3 million of nonaccrual loans and management’s use of collateral valuations and qualitative reserves.
- Assess potential losses from private-label mortgage-backed securities, trust preferred securities and other securities with extended unrealized losses.
- Monitor the $2.5 million OREO property sale, related valuation assumptions and any additional write-downs.
- Evaluate liquidity under stress, including the $301.7 million of unfunded commitments, pledged securities and reliance on FHLB and Federal Reserve borrowing capacity.
- Follow the Kalan litigation for developments, class-action status, potential damages and any required accrual.
- Confirm future effects of CECL, interest-rate changes, deposit pricing and the company’s quarterly dividend decision.