ORRSTOWN FINANCIAL SERVICES INC quarterly report, Q3 FY2020

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Orrstown Financial Services, Inc. — Q3 2020 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2020. Comparisons are with the corresponding 2019 periods unless otherwise noted. Dollar amounts are in millions unless stated otherwise.

Business context and financial performance

Orrstown is a community bank serving central Pennsylvania and Maryland. At quarter-end, it reported $2.782 billion in assets and $232.8 million in shareholders’ equity. Results reflect COVID-19 impacts, SBA Paycheck Protection Program (PPP) lending, and the 2019 Hamilton acquisition. The company discontinued its Wheatland Advisors subsidiary effective July 31, 2020.

  • Q3: Net interest income was $20.8 million, up 15%; net income was $5.0 million, down 28%; diluted EPS was $0.45 versus $0.62. Interest income was $24.2 million and noninterest income was $6.9 million.
  • Nine months: Net interest income was $59.9 million, up 17%; net income was $16.4 million, up 29%; diluted EPS was $1.49 versus $1.23. Interest income was $73.2 million and noninterest income was $21.1 million.
  • Margins: Taxable-equivalent net interest margin was 3.24% in Q3, versus 3.30% a year earlier; for nine months it was 3.34%, versus 3.45%. Lower market rates reduced asset yields, while lower funding costs supported net interest income.
  • Credit costs: Provision for loan losses was $2.2 million in Q3 and $5.0 million for nine months, compared with $0.3 million and $0.9 million, respectively, in 2019. Management attributed the increase chiefly to COVID-related qualitative reserve adjustments.
  • Cash flow: For nine months, operating activities provided $16.3 million, investing activities provided $103.3 million, and financing activities used $88.3 million. Cash and cash equivalents increased $31.3 million to $87.3 million.
  • Balance sheet and funding: Loans were $2.030 billion, up $385.5 million from year-end; deposits were $2.279 billion, up $404.0 million. PPP loans, net of deferred fees and costs, were $458.1 million. FHLB advances and other borrowings were $183.4 million, repurchase agreements $17.4 million, and subordinated notes $31.9 million.
  • Liquidity and capital: The company reported $52.1 million of unencumbered securities, $841.0 million of maximum FHLB borrowing capacity, and $396.8 million of remaining PPPLF availability. The Bank was classified as well capitalized; its total risk-based capital ratio was 14.3% and Tier 1 leverage ratio 8.5%.

Material changes versus comparable periods

  • Q3 net interest income rose $2.7 million, supported by larger average balances and lower interest expense; Q3 diluted EPS nevertheless fell, with prior-year investment-security gains contributing to the comparison.
  • Nine-month net income increased despite a $4.7 million year-over-year reduction in investment-security gains. Mortgage banking income rose $2.2 million, and the company recorded $2.8 million of gains on portfolio-loan sales.
  • Loan growth was concentrated in commercial and industrial loans and largely reflected PPP originations. PPP loans generated $4.0 million of deferred-fee income in the first nine months; $9.5 million of net deferred fees remained unrecognized at quarter-end.
  • The allowance for loan losses rose to $19.7 million from $14.7 million at year-end; allowance to total loans was 0.97%, or 1.3% excluding SBA-guaranteed loans. Nonperforming loans were 0.39% of gross loans, down from 0.65% at year-end.
  • Noninterest expenses were $19.3 million in Q3, up 6% year over year, including $1.3 million of branch-consolidation and related expenses. For nine months, expenses were $56.0 million, down 3%.

Outlook, risks, contingencies and unusual items

  • No numerical earnings or revenue guidance is provided. Management cited uncertainty around the pandemic, economic conditions and stimulus, and said PPP-related deposits and borrowings may decline significantly into the first half of 2021 as funds are used and loans forgiven.
  • COVID-19-related payment deferrals totaled $78.4 million at September 30, down from $239.3 million at June 30. Hospitality exposure is notable: hotel/motel deferrals were $22.3 million, or 45.9% of that non-PPP segment; restaurant/bar deferrals were $7.2 million.
  • Special Mention loans increased $68.4 million from year-end, primarily reflecting commercial downgrades, including in hospitality. Management warned that pandemic-related economic deterioration could require additional loan-loss provisions.
  • Mortgage servicing-right impairment charges were $1.0 million for nine months, attributed to sharply lower interest rates. Goodwill testing following the pandemic-related decline in market value found no impairment as of August 31, 2020.
  • The company recorded $1.3 million of Q3 branch-consolidation and loan-production-office exit costs as it consolidated six branches, exited three loan production offices, and adjusted back-office operations. Management said the changes respond to digital-service preferences and are intended to reduce future costs.
  • A securities class action related to the company’s 2010–2012 disclosures remains pending. The company disputes the claims; it stated that a possible loss or loss range cannot currently be reasonably estimated. A separate Hamilton merger-related action settled for $135,000 in 2020.
  • Other risks include uncertainty in PPP forgiveness and the SBA guarantee, interest-rate sensitivity, credit quality, litigation costs, and the transition away from LIBOR. The filing reports no material change in previously disclosed risk factors.

Important facts for investors to verify

  • Whether PPP fee recognition, forgiveness timing, and related deposit and PPPLF funding runoff affect future earnings and liquidity as expected.
  • Whether COVID-related deferrals, hospitality exposures, and the increase in Special Mention loans lead to further downgrades, provisions, or charge-offs.
  • Whether mortgage banking strength persists and how continuing rate changes affect servicing-right valuations and net interest margin.
  • The realized cost savings and execution costs from branch and office consolidations, and any further restructuring actions.
  • Developments in the SEPTA litigation, including the pending motions and appeal; the filing provides no estimable loss range.