Franklin Financial Services Corporation: FY2016 Form 10-K Summary
Business context and reporting period
Franklin Financial Services Corporation is a Pennsylvania bank holding company conducting substantially all operations through wholly owned Farmers and Merchants Trust Company of Chambersburg. The Bank operates 22 community banking offices in south-central Pennsylvania and provides commercial, retail, mortgage, consumer, trust and investment services. This filing covers the fiscal year ended December 31, 2016; quarterly data identify fourth-quarter 2016 net income of $1.7 million.
Financial performance and condition
| Metric | FY2016 | FY2015 | Change |
|---|---|---|---|
| Net interest income | $34.7 million | $32.2 million | +7.7% |
| Provision for loan losses | $3.8 million | $1.3 million | +$2.5 million |
| Noninterest income | $11.6 million | $12.7 million | -8.3% |
| Noninterest expense | $33.2 million | $31.1 million | +6.5% |
| Income before taxes | $9.4 million | $12.5 million | -24.7% |
| Net income | $8.1 million | $10.2 million | -20.7% |
| Diluted EPS | $1.88 | $2.40 | -21.7% |
| Net interest margin | 3.62% | 3.59% | +3 basis points |
| Return on average equity | 7.04% | 9.52% | Down |
| Efficiency ratio | 68.26% | 67.39% | Higher |
- Total assets increased 8.9% to $1.127 billion, driven primarily by commercial loan growth.
- Gross loans increased 14.3% to $893.9 million; net loans rose 14.4% to $882.8 million. Commercial loans represented approximately 74% of gross loans and commercial-purpose loans approximately 83% of the portfolio under the filing’s classifications.
- Deposits increased 6.9% to $982.1 million, including a $18.3 million increase in noninterest-bearing checking deposits. Shareholders’ equity increased to $116.5 million from $111.4 million.
- Cash and cash equivalents ended at $36.7 million, compared with $39.2 million in 2015. Operating activities provided $14.9 million, while investing activities used $102.7 million, primarily because net loan growth used $114.8 million. Financing activities provided $85.3 million, including deposit growth and $24.3 million of short-term borrowings.
- The Bank had no long-term debt outstanding. FHLB borrowing capacity was $278.6 million, with $254.3 million available at year-end; additional borrowing capacity included approximately $23 million at the Federal Reserve Discount Window and a $6 million unsecured correspondent line.
- Total risk-based capital was 15.55% for the Bank and 15.67% for the Corporation; the Bank’s Tier 1 leverage ratio was 10.02%. Both the Corporation and Bank were classified as well capitalized.
- Nonperforming loans declined to $5.4 million, or 0.61% of gross loans, from $5.7 million, or 0.73%. Nonperforming assets declined to $10.4 million, or 0.92% of assets. The allowance for loan losses was $11.1 million, or 1.24% of loans.
- Trust assets under management increased to $622.6 million from $586.7 million. The Corporation declared cash dividends of $0.82 per share, compared with $0.74 in 2015, and repurchased 34,048 shares for $795,000.
Material changes versus the prior comparable period
- Loan growth, especially in commercial lending, increased interest income and net interest income, but commercial loan growth also contributed to a higher provision for loan losses.
- Net charge-offs increased to $2.8 million from $310,000, principally because of a $2.7 million charge-off on one commercial real estate loan. Excluding that charge-off, management stated that 2016 net charge-offs would have been approximately $21,000.
- Noninterest income decreased largely because 2015 included a nonrecurring $728,000 gain on conversion of an investment security and other nonrecurring income. Investment and trust services fees were broadly stable, while loan service charges declined.
- Noninterest expense rose by $2.0 million. Significant items included a $1.2 million write-down of one other-real-estate-owned property, a $564,000 pension settlement charge, higher salaries and benefits, and increased legal and professional fees associated with litigation.
- The effective tax rate decreased to 13.9% from 18.2%, reflecting lower pretax income, more tax-exempt income and the effects of the higher loan-loss provision and OREO write-down.
- Other real estate owned declined to $4.9 million from $6.5 million after dispositions and a $1.2 million valuation adjustment.
Guidance, outlook, commentary, risks and unusual items
- Management expects commercial lending to remain the primary source of loan growth, primarily through in-market lending, while purchased loan participations are expected to decline. Consumer loans are expected to continue running down, and 2017 mortgage activity is expected to be weighted toward purchase-money mortgages as refinancing slows.
- Management expects monetary-policy normalization to be gradual but could not predict the timing or magnitude of 2017 rate changes. Interest-rate sensitivity modeling indicated projected one-year net interest income would increase 1.3% under a 200-basis-point increase and decrease 2.3% under a 100-basis-point decrease, subject to modeling assumptions.
- The loan portfolio is concentrated geographically and by commercial and real estate exposure. Approximately 69% of loans were secured by real estate, and commercial-purpose loans were approximately 83% of total loans. A downturn in south-central Pennsylvania or declines in collateral values could increase credit losses.
- Management’s allowance estimate is highly judgmental. Commercial real estate, construction and commercial loans may be particularly sensitive to economic conditions, business performance and collateral liquidation values.
- The investment portfolio included $1.1 million of private-label mortgage-backed securities, primarily Alt-A securities. The Bank recorded $40,000 of other-than-temporary impairment in 2016 and stated that additional write-downs remain possible if loss trends continue.
- Liquidity is materially dependent on access to the Federal Home Loan Bank of Pittsburgh. Management believes anticipated liquidity needs can be met, but loss or restriction of FHLB access could materially impair liquidity.
- Off-balance-sheet commitments included $277.4 million of unused commitments to extend credit and $23.9 million of standby letters of credit. The filing states that many commitments may expire undrawn.
- The Corporation disclosed the Kalan et al. litigation. No specific accrual was recorded because the likelihood and amount of any loss could not be estimated; the filing states that exposure could ultimately exceed any accrued or estimated amount.
- The Corporation reported $9.0 million of goodwill and concluded that it was not impaired. The pension plan was underfunded by $819,000 at year-end, and 2016 included a nonrecurring $564,000 settlement loss.
- Future accounting changes include the current expected credit loss standard, which management expects could result in earlier recognition of credit losses and potentially a larger allowance, although the impact had not been determined.
Most important facts for an investor to verify
- Whether rapid commercial and commercial real estate loan growth is producing sustainable returns without a corresponding increase in credit losses.
- The performance, collateral coverage and resolution status of the $15.1 million of impaired loans, $13.4 million of troubled debt restructurings and $4.9 million of OREO.
- The adequacy of the $11.1 million allowance for loan losses, particularly under adverse local economic and real estate scenarios.
- The availability and terms of FHLB, Federal Reserve and correspondent-bank liquidity facilities, and the effect of deposit runoff or higher funding costs.
- The potential financial and reputational impact of the Kalan litigation and any future legal expense or settlement.
- The sustainability of the $0.82 per-share dividend and share repurchases given lower earnings, regulatory capital requirements and the holding company’s dependence on dividends from the Bank.
- The assumptions supporting the valuation of private-label mortgage-backed securities, OREO, goodwill, deferred tax assets and pension obligations.
- The limited trading liquidity of the OTCQX-listed common stock and the resulting difficulty of establishing or exiting an investment position.