PEOPLES FINANCIAL SERVICES CORP. quarterly report, Q2 FY2018

Business context and reporting period

Peoples Financial Services Corp. is a Pennsylvania bank holding company operating Peoples Security Bank and Trust through 27 community banking offices in Pennsylvania and New York. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2018. Unless noted otherwise, dollar amounts below are in millions.

Financial performance and position

• Q2 net interest income was $17.65, up from $16.14; six-month net interest income was $34.84, up from $31.98. Tax-equivalent net interest margin declined to 3.58% from 3.68% in Q2 and to 3.57% from 3.71% for the first half.
• Q2 noninterest income was $3.66, versus $6.38 a year earlier; six-month noninterest income was $7.24, versus $10.16. The prior-year periods included a $2.28 gain on the sale of the merchant services business. Q2 2018 included a $0.29 gain on the sale of the credit-card portfolio.
• Six-month provision for loan losses was $2.10, down from $2.40. The allowance was $19.57, or 1.12% of loans. Net charge-offs were $1.49, or 0.17% of average loans, up from $0.56, or 0.07%, in the first half of 2017; a $1.15 commercial real estate credit was charged off in Q2.
• Six-month operating cash flow was $15.05; investing activities used $75.14 and financing activities provided $57.99. Cash and cash equivalents declined $2.11 over the period.
• Bank capital ratios at June 30: Tier 1 leverage 9.59%, Tier 1 risk-based 11.51%, total risk-based 12.61%, and common equity Tier 1 11.51%. The Bank reported that it was well-capitalized and met fully phased-in Basel III capital requirements.
• Q2 return on average assets was 1.08% versus 1.11%; return on average equity was 8.90% versus 8.71%. For the first half, ROA was 1.08% versus 1.04%, and ROE was 8.90% versus 8.13%.

Material changes versus comparable periods

• Loans grew $60.3, or 7.2% annualized, from year-end, led by commercial real estate loans, which increased $81.1. Consumer loans declined $16.8, including the effects of credit-card and student-loan portfolio sales and lower indirect auto originations.
• Deposits were essentially flat. Noninterest-bearing deposits increased $19.8 while interest-bearing deposits declined $19.9, partly due to seasonal public-deposit outflows and rate-sensitive customers.
• Short-term borrowings rose $63.8 and funded most of the loan growth. The company reported FHLB borrowing capacity of $664.4, with $236.3 outstanding in total FHLB borrowings at June 30.
• Q2 net income increased 5.3% and first-half net income increased 12.9%. Higher net interest income and lower taxes contributed; the lower 2018 statutory tax rate reduced the effective tax rate to 12.0% in Q2 and 11.8% for the first half, from 22.6% and 21.8%, respectively.
• First-half noninterest expense increased 0.8% to $26.58. Salaries and benefits rose 7.9% and occupancy and equipment costs rose 14.2%, reflecting market expansion; merchant-services expense fell substantially following the 2017 business sale.
• Unrealized losses on available-for-sale securities increased: accumulated other comprehensive loss was $8.75 at June 30 versus $6.21 at year-end, including $3.52 of after-tax unrealized securities losses versus $0.98.

Outlook, commentary, risks, and unusual items

• No company earnings or revenue guidance is provided. Management said loan growth exceeded projections and described continued expansion in the Lehigh Valley and Greater Delaware Valley. The Board’s stated intention was to continue cash dividends, subject to results, capital, legal restrictions, and other factors; declared dividends were $0.65 per share for the first half.
• Management considered the allowance adequate and reported improved nonperforming assets: $11.01, or 0.63% of loans and foreclosed assets, versus $11.58, or 0.68%, at year-end. Troubled debt restructurings increased to $3.31 from $3.07. Foreclosed assets increased to $0.50 from $0.28.
• Interest-rate risk remains important. The company reported that a modeled instantaneous +100-basis-point rate shock would reduce projected 12-month net interest income by 0.4%; the modeled impacts were within ALCO policy limits. The filing also notes that model assumptions and actual repricing behavior may differ.
• Management identified risks including interest-rate changes, economic and real-estate conditions, credit quality, deposit flows, competition, regulation, third-party service providers, and cybersecurity. It said there were no material changes to previously disclosed risk factors and no legal proceedings expected to have a material effect.
• Unfunded loan commitments and standby letters of credit totaled $398.9. Management did not consider expected drawings a significant liquidity risk, but commitments represent potential funding needs.
• The company was evaluating the expected-credit-loss standard (CECL), effective for it beginning in 2020, and said adoption could affect loan and securities credit-loss allowances; the amount was not yet determined. Future minimum lease commitments were approximately $3.1 before renewal options.
• The filing attributes the lower tax rate to the Tax Cuts and Jobs Act. Other notable items include $0.37 of BOLI death-benefit proceeds included in current-period service charges and an $0.09 positive credit valuation adjustment on swaps for the first half.

Important facts for investors to verify

1. Whether rapid commercial real estate growth and the large commercial real estate charge-off alter portfolio risk, allowance adequacy, or future credit costs.
2. Whether deposit trends and higher reliance on short-term FHLB funding remain sustainable as funding costs rise and loan growth continues.
3. Whether net interest margin stabilizes amid rate increases, deposit repricing, and the filing’s differing static-gap and simulation signals.
4. How recurring earnings compare after separating the merchant-business sale gain in 2017, the credit-card sale gain in 2018, BOLI proceeds, and other period-specific items.
5. Whether unrealized securities losses, liquidity needs, unfunded commitments, and eventual CECL adoption materially affect capital or earnings.
6. The company reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.