FRANKLIN FINANCIAL SERVICES CORP quarterly report, Q3 FY2011

Franklin Financial Services Corporation — 2011 Q3 Form 10-Q Summary

Business context and reporting period

Franklin Financial Services Corporation is the holding company for Farmers and Merchants Trust Company of Chambersburg, a commercial bank serving south-central Pennsylvania. This unaudited Form 10-Q covers the three and nine months ended September 30, 2011, compared with the corresponding 2010 periods. Amounts are in thousands, except per-share data.

Key financial metrics

Metric	Q3 2011	Q3 2010	9M 2011	9M 2010
Net interest income	$8,116	$7,918	$24,095	$23,109
Provision for loan losses	$2,775	$625	$5,442	$1,875
Noninterest income	$2,413	$1,908	$7,362	$6,744
Noninterest expense	$6,996	$6,635	$21,450	$19,820
Net income	$1,059	$1,803	$4,667	$5,937
Diluted EPS	$0.27	$0.46	$1.18	$1.53
Cash dividends per share	$0.27	$0.27	$0.81	$0.81

At September 30, 2011, total assets were $996.9 million, up $45.1 million, or 4.7%, from December 31, 2010.
Gross loans were $766.6 million and net loans were $757.4 million, up 2.4% from year-end. Deposits were $789.3 million, up $55.0 million, or 7.5%.
Cash and cash equivalents were $35.4 million, compared with $22.1 million at December 31, 2010. Operating cash flow for the first nine months was $8.9 million; investing cash flow was negative $38.9 million; financing cash flow was positive $43.3 million.
Long-term debt declined to $48.9 million from $70.9 million, primarily due to a $15.6 million prepayment of Federal Home Loan Bank advances and scheduled maturities. Securities sold under repurchase agreements increased to $63.2 million.
Shareholders’ equity increased to $86.5 million from $82.6 million. The dividend reinvestment plan raised $1.3 million through the issuance of approximately 78,000 shares.
The nine-month net interest margin was 3.67%, compared with 3.47% in 2010; the third-quarter margin was 3.61%, compared with 3.53%. Annualized nine-month ROA was 0.63%, ROE was 7.39%, and the efficiency ratio was 68.40%.
The allowance for loan losses was $9.2 million, or 1.20% of loans, compared with $8.8 million, or 1.18%, at year-end. Net charge-offs were $5.0 million and the annualized net charge-off ratio was 0.88%.

Material changes versus comparable periods

Net income declined 41.3% in the third quarter and 21.4% for the first nine months. The principal adverse factor was the substantially higher provision for loan losses.
Net interest income increased 2.5% in the quarter and 4.3% year to date because lower funding costs more than offset lower asset yields. Nine-month interest expense fell $2.6 million to $7.1 million.
Noninterest income increased 26.5% in the quarter and 9.2% year to date, aided by lower other-than-temporary impairment charges and higher investment and trust service fees. Net OTTI losses recognized in earnings were $55 thousand year to date versus $573 thousand in 2010.
Noninterest expense increased 5.4% in the quarter and 8.2% year to date. Salaries and benefits increased materially; other expense included $344 thousand of FHLB prepayment penalties and costs associated with a core-processing-system upgrade.
Loan growth was concentrated in commercial real estate, up $56.5 million, and commercial, industrial and agricultural loans, up $30.5 million. Residential construction loans fell $61.2 million, principally because certain loans moved to amortizing commercial real estate classifications. Consumer loans declined $3.2 million.
Nonperforming loans declined to $26.2 million from $27.5 million at year-end, but other real estate owned increased to $3.3 million from $0.6 million. Total nonperforming assets were $29.5 million, or 2.96% of assets, unchanged as a percentage from year-end.
Troubled debt restructurings increased substantially to $11.1 million across 29 contracts and eight borrowers, from $656 thousand across two contracts at December 31, 2010. A third-quarter restructuring generated a $1.9 million charge-off.

Outlook, risks, contingencies, and unusual items

Management expects residential real estate and consumer loan portfolios to continue declining because of weak demand and the runoff of indirect lending. It expects commercial loan participation purchases in 2011 to be similar to the $17.4 million purchased in 2010.
Management expects pension expense to increase in 2011 and expects to contribute approximately $2.1 million to the pension plan, satisfying minimum funding requirements.
Management believes the allowance for loan losses is adequate, but identifies economic conditions, collateral values, delinquency trends, charge-offs, appraisals, and borrower cash flows as significant judgmental factors. Additional deterioration could require higher provisions.
Management expects liquidity needs to be met. The Bank reported approximately $169 million available under its FHLB line, $26 million of unsecured correspondent-bank lines, and approximately $24 million available through the Federal Reserve Discount Window. Approximately 93% of the investment portfolio, or $121 million at fair value, was pledged as collateral.
Unused loan commitments and standby letters of credit totaled $256.0 million and $27.2 million, respectively. Management reported no material liability for standby letters of credit and believes collateral and guarantees would cover potential payments.
The investment portfolio included $4.7 million of trust preferred securities and $3.3 million of private-label mortgage-backed securities. Unrealized losses totaled $3.0 million, and management considered the remaining losses temporary; additional write-downs remain possible if credit or market conditions deteriorate.
An internal review found that certain tax-exempt commercial loans had been incorrectly coded as taxable. The company recorded approximately $755 thousand of related prior-period tax benefits in 2011 and deemed the error immaterial to current and prior financial statements. New review and dual-control procedures were implemented, and management concluded disclosure controls were effective at September 30, 2011.
The filing identifies interest-rate changes, funding costs, economic conditions, competition, regulatory changes, technology, taxation, and Dodd-Frank compliance as principal forward-looking risks. Management stated that there were no material changes to previously disclosed risk factors or market-risk exposure.
Regulatory capital remained above “well capitalized” thresholds. At September 30, 2011, the Bank’s total risk-based capital ratio was 11.14%, Tier 1 ratio was 9.93%, and leverage ratio was 7.55%.

Important facts for investors to verify

Whether the sharp increase in provisions, charge-offs, TDRs, watch-list loans, and OREO leads to further credit losses.
The sustainability of the 3.67% net interest margin in a low-rate environment and as loan yields and funding costs reprice.
The credit performance and valuation of trust preferred, private-label mortgage-backed, and other securities with unrealized losses.
Whether the higher 68.4% dividend payout ratio is sustainable given lower earnings and capital needs.
The effectiveness of remediation for loan-tax coding controls and the core-system upgrade.
Liquidity availability after considering pledged securities, brokered deposits, unused commitments, and potential deposit outflows.
Management’s statement that the quarter and year-to-date results are not necessarily indicative of full-year results; the filing provides no formal earnings guidance.