ORRSTOWN FINANCIAL SERVICES INC annual report, FY2013

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Orrstown Financial Services, Inc. — 2013 Form 10-K

Business context and period. This annual report covers the fiscal year ended December 31, 2013; quarterly data also reports the three months ended December 31. Orrstown is a Pennsylvania bank holding company operating Orrstown Bank, with 22 offices in south-central Pennsylvania and Maryland. The Bank provides commercial, residential and consumer lending, deposit services, and trust and brokerage services.

Financial results and condition

  • Profitability: Net income was $10.0 million ($1.24 per diluted share), versus a $38.5 million loss ($4.77 per share) in 2012. Fourth-quarter 2013 net income was $2.9 million ($0.36 per share), compared with $1.0 million ($0.13 per share) in fourth-quarter 2012.
  • Revenue and margin: Net interest income declined 15.3% to $32.1 million; total noninterest income fell 23.4% to $17.8 million, largely because securities gains dropped to $0.3 million from $4.8 million. Net interest margin was 3.03%, down from 3.12%; the efficiency ratio worsened to 83.3% from 72.2%.
  • Credit costs: The company recorded a $3.15 million negative provision for loan losses, compared with provisions of $48.3 million in 2012 and $58.6 million in 2011. Net loan recoveries were $0.95 million, versus net charge-offs of $68.8 million in 2012.
  • Balance sheet: Year-end assets were $1.178 billion, down from $1.233 billion; loans were $673.0 million, down from $711.6 million; and deposits were $1.000 billion, down from $1.085 billion. Shareholders’ equity rose to $91.4 million from $87.7 million. Tangible book value per share was $11.20.
  • Liquidity and funding: Cash and cash equivalents fell to $37.6 million from $150.7 million, primarily as funds were invested in securities. Available-for-sale securities increased to $406.9 million; $165.0 million was available for liquidity after pledging requirements. The Bank reported approximately $330.4 million of FHLB borrowing capacity, subject to qualifying collateral, and $30 million in unsecured correspondent-bank lines.
  • Debt and cash flow: Short-term borrowings were $59.0 million and long-term debt was $16.1 million, for total borrowings of $75.1 million, compared with $47.1 million a year earlier. Operating cash flow was $33.0 million; investing and financing activities used $89.7 million and $56.4 million, respectively. Cash declined by $113.1 million.
  • Capital: At year-end, the Bank’s total risk-based capital ratio was 14.7%, Tier 1 risk-based ratio 13.4%, and Tier 1 leverage ratio 8.0%; it was categorized as well capitalized under then-current rules. Company and Bank ratios improved from 2012. These ratios do not remove the constraints imposed by the regulatory agreements.

Changes, outlook and material risks

  • Profit returned after two years of substantial losses, mainly because credit costs declined sharply. However, total risk assets rose 14.9% year over year to $26.3 million. Nonaccrual loans increased to $19.3 million from $17.9 million, and accruing restructured loans rose to $6.0 million from $3.1 million. The allowance was $21.0 million, or 82.8% of nonaccrual and accruing restructured loans, versus 110.1% a year earlier.
  • Loan balances continued to contract as repayments and workouts exceeded new originations. Residential mortgage loans grew, while several commercial loan categories declined. Management said it resumed soliciting loan opportunities in the second half of 2013 and anticipated loan growth in 2014.
  • Management cited continuing low-rate pressure on asset yields and margin. It expected lower mortgage origination volumes to affect 2014 mortgage banking revenue and anticipated advertising and promotional spending could increase. No quantified earnings or revenue guidance is provided.
  • The company and Bank remain subject to a 2012 Federal Reserve Written Agreement and Pennsylvania Department of Banking Consent Order. These require approved plans covering management oversight, criticized assets, credit practices, loan-loss reserves and capital. Dividends and share repurchases, and certain Company borrowing or share redemptions, require regulatory approval; the company does not expect near-term dividends or repurchases.
  • A full valuation allowance of $19.0 million remained against deferred tax assets because management judged realization was not more likely than not, despite the return to annual profitability. The 2013 income-tax benefit was $0.2 million.
  • Other key risks include commercial real estate and geographic concentration, interest-rate exposure, deposit competition and maturities, regulatory compliance, and the possibility of further loan losses. The top 25 lending relationships represented 28% of loans. A putative securities class action was pending; the company disputed the allegations and intended to defend itself. Management reported effective internal controls, and the independent auditor gave unqualified opinions on the financial statements and internal controls.

Important facts for investors to verify

  1. Progress toward termination of the Federal Reserve and state regulatory agreements, and any changes to dividend, repurchase or borrowing restrictions.
  2. Whether credit improvement is durable: subsequent nonaccruals, restructured loans, charge-offs, recoveries and allowance coverage, especially for large commercial relationships.
  3. Deposit retention and refinancing needs: $219.1 million of certificates of deposit mature within one year, while year-end deposits declined and short-term borrowings increased.
  4. Effects of the expanding securities portfolio, unrealized losses, interest-rate changes and lower net interest margin on earnings, capital and liquidity.
  5. Realization of deferred tax assets and developments in the securities class action; the filing does not provide a quantified estimate of potential litigation exposure.