Business Context and Reporting Period
Company: Franklin Financial Services Corp (FRAF)
Reporting Period: Fiscal year ended December 31, 2009
Business Overview: A Pennsylvania bank holding company operating primarily through its subsidiary, Farmers and Merchants Trust Company (F&M Trust). The bank operates 25 community offices in Franklin, Cumberland, Fulton, and Huntingdon Counties, Pennsylvania. It focuses on commercial, retail, and trust banking services. In late 2008, the company acquired Community Financial, Inc., adding trust assets and a new office location.
Key Financial Metrics
| Metric | 2009 | 2008 |
|---|---|---|
| Net Income | $6.585 million | $8.595 million |
| Earnings Per Share (Diluted) | $1.71 | $2.24 |
| Total Assets | $979.4 million | $902.5 million |
| Total Loans (Net) | $730.6 million | $668.9 million |
| Total Deposits | $738.4 million | $627.3 million |
| Net Interest Income | $29.1 million | $30.1 million |
| Net Interest Margin | 3.44% | 4.03% |
| Provision for Loan Losses | $3.438 million | $1.193 million |
| Noninterest Income | $8.880 million | $6.538 million |
| Noninterest Expense | $25.929 million | $23.189 million |
| Return on Average Assets | 0.69% | 1.01% |
| Return on Average Equity | 8.69% | 10.99% |
| Shareholders' Equity | $78.8 million | $73.1 million |
| Long-term Debt | $94.7 million | $106.1 million |
Material Changes vs. Prior Period
- Profitability Decline: Net income decreased 23.4% to $6.6 million, driven by a lower net interest margin and a significant increase in the provision for loan losses.
- Net Interest Margin Compression: The net interest margin fell to 3.44% from 4.03% due to a low-rate environment where asset yields repriced downward faster than deposit costs.
- Loan Loss Provision Spike: The provision for loan losses more than doubled to $3.4 million (from $1.2 million) as nonperforming loans increased to $18.3 million (up from $4.0 million) and net charge-offs rose to $1.9 million.
- Balance Sheet Growth: Despite the recession, total assets grew 8.5% and deposits grew 17.7%, fueled by commercial loan growth and an increase in brokered time deposits.
- Expense Increases: Noninterest expenses rose 11.8%, primarily due to a $1.3 million increase in FDIC insurance assessments and higher legal fees related to a lawsuit involving a pre-acquisition entity.
Guidance, Outlook, Risks, and Unusual Items
- Outlook: Management expects the low interest rate environment to persist in 2010, continuing to pressure net interest margins. The local economy is expected to lag national trends but remains diversified.
- Capital Position: The Corporation and its bank subsidiary are classified as "well capitalized," exceeding all regulatory requirements. The company opted out of the TARP Capital Purchase Program to avoid restrictions on dividends and share repurchases.
- Key Risks:
- Credit Risk: Approximately 75% of the loan portfolio is commercial, which is more sensitive to economic downturns. Nonperforming loans rose to 2.47% of gross loans.
- Investment Portfolio: The bank holds $5.9 million in "Alt-A" mortgage-backed securities and $6.0 million in trust-preferred securities, which have experienced rating declines and unrealized losses. Management monitors these for potential future write-downs.
- Liquidity: While liquidity is sufficient, the bank relies on the Federal Home Loan Bank (FHLB) for funding. Concerns regarding the capital strength of the FHLB system pose a potential risk.
- Unusual Items:
- FDIC Assessments: The bank paid a $4.0 million prepaid assessment in late 2009 for future years and a $450,000 special assessment in 2009.
- Legal Contingency: Legal fees increased due to a lawsuit regarding the acquired Community Financial entity; management believes a significant portion of these fees may be recoverable following a favorable interim ruling.
Investor Verification Checklist
- Allowance Adequacy: Verify if the $8.9 million allowance for loan losses (1.21% of loans) is sufficient given the sharp rise in nonperforming assets and the concentration in commercial real estate.
- Investment Write-downs: Monitor the $5.4 million in unrealized losses on investment securities, specifically the Alt-A MBS and trust-preferred holdings, for potential "other-than-temporary" impairment charges in 2010.
- FDIC Cost Impact: Assess the long-term impact of the increased FDIC assessment rates and prepaid assessments on future profitability.
- Net Interest Margin: Evaluate the bank's ability to manage funding costs and asset yields in a prolonged low-interest-rate environment.
- Legal Recovery: Confirm the status of the lawsuit regarding Community Financial and the likelihood of recovering the associated legal fees.