Franklin Financial Services Corporation — Q1 2015 Form 10-Q
Business context and reporting period
Franklin Financial Services Corporation is a Pennsylvania bank holding company whose principal subsidiary, Farmers and Merchants Trust Company of Chambersburg, serves south-central Pennsylvania. The filing covers the three months ended March 31, 2015; financial statements are unaudited and amounts are in thousands except per-share data.
Key financial metrics
| Metric | Q1 2015 / Mar. 31, 2015 | Comparable / Dec. 31, 2014 |
|---|---|---|
| Total assets | $1,019,337 | $1,001,448 |
| Net loans | $713,748 | $717,420 |
| Total deposits | $905,395 | $881,181 |
| Shareholders’ equity | $105,962 | $103,521 |
| Net income | $2,884 | Q1 2014: $1,826 |
| Diluted EPS | $0.68 | Q1 2014: $0.44 |
| Cash dividend declared per share | $0.17 | Q1 2014: $0.17 |
| Net interest income | $7,885 | Q1 2014: $7,744 |
| Net interest margin | 3.66% | Q1 2014: 3.57% |
| Noninterest income | $3,652 | Q1 2014: $2,380 |
| Noninterest expense | $7,489 | Q1 2014: $7,688 |
| Efficiency ratio | 66.09% | Q1 2014: 72.64% |
| Return on average assets | 1.17% | Q1 2014: 0.74% |
| Return on average equity | 11.21% | Q1 2014: 7.72% |
Net cash provided by operating activities was $3,857, investing activities used $1,756, and financing activities provided $14,633. Cash and cash equivalents increased $16,734 to $65,327. The Corporation reported no short-term or long-term borrowings at March 31, 2015.
Material changes versus the prior comparable period
- Net income increased 57.9% year over year, although management stated that two nonrecurring items increased noninterest income by $899: a $171 gain from liquidation of an offshore insurance investment and a $728 gain on conversion of equity securities. Excluding these items, management estimated net income of approximately $2.3 million, up about 25%.
- Net interest income increased $141, while tax-equivalent net interest income increased $185 to $8,388. Lower funding costs were the principal benefit: interest expense declined $189 to $641, and the average cost of interest-bearing liabilities declined from 0.43% to 0.35%.
- Noninterest income increased $1,272, or 53.4%, primarily from the conversion gain, higher investment and trust service fees, improved other real estate results, and higher service charges. A $20 securities impairment charge was also recorded.
- Noninterest expense declined $199, or 2.6%, to $7,489. Lower salaries, occupancy, advertising, and FDIC insurance costs more than offset higher data processing, professional fees, and other expenses.
- The provision for loan losses increased $127 to $325. Net charge-offs increased to $226 from $155, and the allowance for loan losses rose to $9,210 from $9,111.
- Assets increased $17.9 million from year-end, investment securities increased $5.0 million, and net loans declined $3.7 million, or 0.5%. Deposits increased $24.2 million, primarily from noninterest-bearing and interest-bearing checking accounts.
Credit quality, capital, liquidity, and risks
- Nonperforming loans were $11,522, or 1.59% of gross loans, versus $12,613, or 1.74%, at year-end. Nonperforming assets were $15,540, or 1.52% of assets. Other real estate owned increased to $4,018 from $3,666.
- Nonaccrual loans totaled $11,391, including $7,789 of commercial real estate loans. Watch-list loans were $40.1 million, and potential problem loans were $28.6 million. Management identified six significant nonaccrual credits representing 86% of nonaccrual balances; foreclosure, bankruptcy, forbearance, and collateral liquidation issues remain relevant for certain credits.
- The loan portfolio is concentrated in commercial real estate and commercial loans, which totaled $503.1 million, or approximately 69.6% of gross loans. The filing notes exposure to land development, office buildings, hotels and motels, farmland, retail, construction, food services, agriculture, and manufacturing.
- The investment portfolio had a fair value of $176.7 million and $1.2 million of unrealized losses across 68 temporarily impaired securities. Trust preferred securities had $756 of unrealized losses, and private-label mortgage-backed securities generated a $20 impairment charge in the quarter, bringing cumulative impairment charges on that portfolio to $555. Management cautioned that additional write-downs are possible if loss trends continue.
- The Corporation and Bank were reported as well capitalized under Basel III. At March 31, the Corporation’s common equity Tier 1, total risk-based capital, and Tier 1 leverage ratios were 14.19%, 15.45%, and 10.12%, respectively; the Bank’s corresponding ratios were 14.03%, 15.28%, and 9.94%.
- Management stated that liquidity was adequate. Available sources included approximately $35 million under an FHLB line, $16 million of unsecured correspondent-bank lines, approximately $234.5 million of excess borrowing capacity, and approximately $28 million of Federal Reserve discount-window capacity.
- Unused commitments and standby letters of credit totaled $270.1 million and $24.0 million, respectively. Management believes collateral and guarantees support the standby letters of credit and that anticipated liquidity demands can be met.
Outlook, management commentary, and unusual items
- Management expects the local market area to remain suitable for growth as economic conditions improve. It noted that the Federal Reserve continued to maintain historically low short-term rates, while market participants expected possible rate increases in the second half of 2015.
- The Corporation expects 2015 pension expense of approximately $387, compared with $276 in 2014. Adoption of updated mortality tables could reduce funded status by an estimated $1.6 million and increase 2015 pension expense by approximately $272, although no adoption date had been determined.
- Management changed its allowance methodology from an eight-quarter to a 20-quarter rolling loss history, citing improving charge-offs and a more stable economy. The filing states that the allowance was adequate at March 31, 2015, but the estimate remains subject to collateral values, economic conditions, credit performance, and management judgment.
- On April 23, 2015, the Board declared a $0.19 per-share dividend for the second quarter, payable May 27, 2015. The first-quarter dividend was $0.17 per share.
- Key forward-looking risks include economic conditions, interest rates, funding costs, monetary policy, regulation and taxation, technology, competition, credit losses, collateral values, and liquidity conditions. Management reported no material changes in risk factors, no material pending legal proceedings, and effective disclosure controls as of March 31, 2015.
Important facts for investors to verify
- Separate recurring earnings from the $899 of nonrecurring income benefits when assessing the sustainability of Q1 earnings.
- Monitor commercial real estate concentration, watch-list and potential problem loans, the six significant nonaccrual credits, and the adequacy of the $9.2 million allowance.
- Track future performance of trust preferred and private-label mortgage-backed securities, including the potential for additional impairment charges and the related class-action litigation.
- Verify the effect and timing of updated pension mortality tables on funded status, contributions, and expense.
- Assess the effect of any Federal Reserve rate changes on loan yields, deposit pricing, net interest margin, securities values, and liquidity.
- Confirm the continued availability of borrowing capacity and the potential funding requirements associated with $270.1 million of unused commitments and standby letters of credit.