FRANKLIN FINANCIAL SERVICES CORP quarterly report, Q2 FY2016

Franklin Financial Services Corporation — 2016 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 also owns Franklin Financial Properties Corp. and Franklin Future Fund Inc. The unaudited report covers the three and six months ended June 30, 2016, compared primarily with the same periods in 2015 and with December 31, 2015 balance-sheet data.

Key financial metrics

Metric	Three months ended June 30, 2016	Three months ended June 30, 2015	Six months ended June 30, 2016	Six months ended June 30, 2015
Total interest income	$9.0 million	$8.6 million	$18.1 million	$17.1 million
Net interest income	$8.4 million	$8.0 million	$17.0 million	$15.8 million
Provision for loan losses	$1.9 million	$0.3 million	$2.2 million	$0.6 million
Noninterest income	$2.9 million	$3.1 million	$5.8 million	$6.8 million
Noninterest expense	$7.7 million	$7.7 million	$15.5 million	$15.2 million
Net income	$1.6 million	$2.5 million	$4.3 million	$5.4 million
Diluted EPS	$0.36	$0.58	$1.00	$1.26

Second-quarter net income decreased approximately 37%, while first-half net income decreased 20.0%. First-half diluted EPS declined 20.6%.
First-half total revenue, defined as interest income plus noninterest income, was approximately $23.9 million, essentially unchanged from 2015. Net interest income increased 7.2%.
First-half net interest margin was 3.63%, compared with 3.60% in 2015. The efficiency ratio improved to 65.04% from 66.11%.
Return on average assets was 0.80% and return on average equity was 7.56%, versus 1.07% and 10.28%, respectively, for the first half of 2015.
Total assets were $1.084 billion at June 30, 2016, up $48.8 million, or 4.7%, from year-end 2015.
Gross loans increased 5.7% to $826.7 million; net loans increased 5.8% to $816.3 million. Commercial real estate loans increased 9.1% to $371.8 million, and total commercial loans increased 7.4% to $598.1 million.
Deposits increased 5.1% to $965.6 million, driven by noninterest-bearing, interest-checking, money-management and savings accounts. Time deposits declined 6.0%.
Cash and cash equivalents were $41.0 million. The company reported no borrowings at quarter-end, with approximately $130 million available under an FHLB line, $6 million of unsecured correspondent-bank lines and approximately $23 million available through the Federal Reserve Discount Window.
Shareholders’ equity increased to $115.9 million from $111.4 million at year-end. Regulatory capital remained strong; the bank reported a 14.59% CET1 ratio, 15.85% total risk-based capital ratio and 10.17% Tier 1 leverage ratio and was classified as well capitalized.
For the first six months, operating activities provided $4.7 million of cash, investing activities used $48.7 million, and financing activities provided $45.9 million. Cash increased $1.9 million from year-end.

Material changes versus prior comparable periods

The principal adverse change was the increase in provision expense to $2.2 million for the first half from $0.6 million in 2015. Net charge-offs rose to $1.9 million from $0.3 million, including a $1.9 million second-quarter charge-off on a participated commercial real estate loan.
Noninterest income declined 14.2% for the first half. The 2015 period benefited from a $728 thousand gain on conversion of an investment security, a $171 thousand gain related to an offshore insurance investment, and higher loan-related fees.
Noninterest expense increased 2.5% for the first half, primarily from salaries and benefits, legal and professional fees, Pennsylvania bank shares tax, advertising and card-processing costs. These increases were partly offset by the elimination of intangible amortization and lower other expenses.
Nonperforming loans increased to $8.3 million, or 1.00% of gross loans, from $5.7 million, or 0.73%, at year-end. Nonperforming assets increased to $14.5 million, or 1.33% of assets, from $12.2 million, or 1.18%.
The allowance for loan losses increased modestly to $10.3 million, but coverage of nonperforming loans declined to 124.66% from 175.78%. Watch-list loans totaled $27.3 million, including $22.3 million rated substandard.
The investment portfolio increased to $163.6 million at fair value. Net unrealized gains improved to $3.2 million from $1.1 million at year-end; however, seven trust-preferred securities carried $798 thousand of unrealized losses and private-label mortgage-backed securities had $575 thousand of cumulative credit-related impairment charges.

Outlook, commentary, risks and unusual items

No formal earnings or financial guidance was provided. Management stated that the local south-central Pennsylvania economy remained diversified and that the market was suitable for growth, while noting that interest rates remained historically low.
Management expects 2016 pension expense of approximately $809 thousand, compared with $387 thousand in 2015, including an expected pension settlement expense of approximately $450 thousand in the second half of 2016. No pension contribution was expected in 2016.
Management expects additional legal expenses related to a lawsuit brought against the Corporation in 2015. Management stated that no pending legal proceeding was expected to be material to shareholders’ equity or financial condition, but the filing does not quantify potential legal exposure.
Management believes the allowance for loan losses and liquidity resources are adequate. Nevertheless, an additional charge-off may be required on the participated hotel loan because the property’s sale timing and ultimate sale price are uncertain.
Other real estate owned totaled $6.2 million across six properties. One significant property was subject to an agreement of sale with a lengthy due-diligence and approval process, so the final outcome was uncertain.
Standby letters of credit totaled $29.4 million, and unused loan commitments and standby letters of credit totaled $309.0 million. Management stated that these commitments generally do not present significant liquidity risk, but they remain contingent exposures.
The company authorized quarterly common-stock repurchases of up to $350 thousand through March 31, 2017 and repurchased 15,521 shares for $350 thousand in April 2016. The board declared a third-quarter dividend of $0.21 per share after quarter-end.
The company is evaluating the future impact of CECL, lease accounting and other recently issued accounting standards. It does not expect the revenue-recognition and financial-instruments standards to have a material effect, but the CECL and lease impacts were not yet quantified.
Disclosure controls and procedures were deemed effective, and management reported no material changes in internal control over financial reporting.

Important facts for investors to verify

Whether the elevated commercial real estate exposure, including hotels, land development and multifamily properties, produces additional nonaccrual loans, charge-offs or provision expense.
The resolution, collateral value and ultimate recovery associated with the $3.4 million nonaccrual hotel loan and the related participated-loan charge-off.
Whether the $27.3 million watch list and $19.0 million of potential problem loans improve or deteriorate.
The sustainability of loan growth and deposit growth while interest rates remain low and asset yields decline.
Potential additional legal expenses or liabilities from the disclosed lawsuit.
Future write-down risk in trust-preferred and private-label mortgage-backed securities, including the possibility of further impairment charges.
The effect of the expected pension settlement expense and the eventual adoption of CECL on earnings, capital and the allowance for credit losses.
The filing’s statement that the bank is well capitalized, including continued compliance with Basel III requirements as the capital-conservation buffer phases in.