Citizens Financial Services, Inc. — Q2 2018 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2018; financial statements are unaudited. Citizens is a Pennsylvania bank holding company operating through First Citizens Community Bank and First Citizens Insurance Agency in Pennsylvania and southern New York. Comparisons below are year over year unless otherwise noted; balance-sheet comparisons are against December 31, 2017.
Financial performance and position
| Metric | Q2 2018 | Six months 2018 |
|---|---|---|
| Net income | $4.691 million, up 35.3% | $8.938 million, up 32.0% |
| Basic/diluted EPS | $1.34, versus $0.99 | $2.55, versus $1.93 |
| Net interest income | $11.751 million, up 13.0% | $23.171 million, up 13.6% |
| Provision for loan losses | $0.325 million, versus $0.625 million | $0.825 million, versus $1.240 million |
| Noninterest income | $1.842 million, down 2.4% | $3.748 million, down 4.5% |
| Noninterest expense | $7.702 million, up 7.5% | $15.534 million, up 8.2% |
| Net interest margin, tax-equivalent | 3.70%, versus 3.82% | 3.67%, versus 3.79% |
Quarterly and six-month returns on assets were 1.34% and 1.29%, respectively; returns on equity were 13.68% and 13.15%. For the six-month period, reported net interest margin is lower year over year, while net interest income grew with the larger loan book. Management attributes much of the tax-equivalent margin comparison to the decline in the federal statutory tax rate.
- Assets and lending: Total assets were $1.398 billion. Total loans were $1.040 billion and net loans $1.028 billion, up 4.0% and $38.9 million, respectively, from year-end. Loan growth was concentrated in agricultural real estate and construction lending.
- Funding and liquidity: Deposits totaled $1.119 billion, up $13.6 million. Borrowed funds rose $19.0 million to $133.7 million, principally from additional overnight FHLB advances. Cash and cash equivalents were $15.6 million, down $2.9 million. Management cites core deposits, FHLB capacity, correspondent-bank lines, and portfolio cash flows as liquidity sources. The Bank had approximately $494.4 million of FHLB borrowing capacity, with $151.1 million outstanding via loans and letters of credit; its $10 million federal funds line and approximately $4.4 million Federal Reserve borrower-in-custody line were undrawn.
- Cash flows: Six-month operating cash flow was $9.6 million, investing cash outflow was $41.3 million, and financing cash inflow was $28.7 million. Cash declined $2.9 million to $15.6 million. Net loan growth used $39.4 million of cash; deposits provided $13.6 million and net short-term borrowings provided $19.0 million.
- Capital and dividends: Stockholders’ equity was $132.3 million, up 2.5% from year-end. The Company and Bank were categorized as well capitalized. At June 30, the Company’s total risk-based capital ratio was 13.23% and Tier 1 leverage ratio was 8.94%; the Bank’s were 12.65% and 8.51%. Six-month dividends were $0.87 per share, or $3.1 million.
Material changes versus comparable periods
- Net income growth reflected higher net interest income and a lower loan-loss provision. Interest income increased alongside loan growth; interest expense also rose as deposit costs and borrowings increased.
- Commercial and agricultural lending growth was supported by lending teams in central and south-central Pennsylvania and the December 2017 acquisition of the State College branch. Average agricultural loans increased $105.9 million in the first half year over year, and average commercial loans increased $68.1 million.
- Noninterest expense rose, particularly salaries and benefits, reflecting merit increases, additional staffing and the State College location. Other real estate owned expenses increased, including legal fees associated with a customer in foreclosure.
- Noninterest income declined mainly because there were no available-for-sale securities sale gains in 2018, compared with $195,000 in the first half of 2017, and gains on loans sold fell by $117,000. Service charges and brokerage/insurance income increased.
- Available-for-sale securities declined to $250.0 million from $254.8 million; accumulated other comprehensive loss widened to $5.4 million from $3.4 million, primarily reflecting unrealized securities losses.
Outlook, risks, contingencies and unusual items
- The filing gives no specific earnings or revenue guidance. Management says first-half results are not necessarily indicative of full-year results.
- Credit quality warrants attention: nonperforming loans rose $1.3 million, or 11.7%, from year-end to $12.0 million. Nonaccrual loans were $10.9 million; the allowance for loan losses was $11.9 million, or 1.15% of total loans. Management considers the allowance adequate but says economic deterioration, collateral-value declines, or regulatory review could require additional provisions.
- Three customer relationships represented 58.5% of nonperforming loans. Disclosed exposures include a natural-gas-services-related commercial borrower, a borrower involved in bankruptcy litigation, and a dairy borrower affected by depressed milk prices. The Company reports that these relationships had no specific reserve at June 30; one agricultural relationship included $1.0 million of loans subject to Farm Service Agency guarantees.
- Dairy-industry loans totaled $144.4 million, or 13.9% of loans. The company also flags regional dependence on agriculture, economic conditions, natural gas activity, interest rates, competition, fraud, regulation and execution of strategic initiatives.
- Contractual off-balance-sheet commitments were $225.0 million, including $209.5 million of commitments to extend credit and $15.5 million of standby letters of credit.
- Interest-rate simulation estimated prospective one-year net interest income would decline 5.95% under a +200 basis-point shock and 12.22% under +400 basis points. These are model estimates and actual results may differ.
- Management reported no known litigation expected to have a material adverse effect; pending matters are described as ordinary-course litigation. It reported no material change in risk factors and no material change in internal control over financial reporting.
- The 2018 federal statutory tax rate was 21%, versus 34% in 2017 for tax-equivalent comparisons. The effective tax rate was 15.4% for the first half. The company anticipates $634,000 of tax credits from low-income housing partnerships over 4.5 years, including $70,000 in 2018.
- The filing expects the upcoming credit-loss standard (CECL) to require a one-time allowance adjustment, but says its size and overall impact cannot yet be determined. Management preliminarily estimates the new lease standard would increase assets and liabilities by less than 1%.
Most important facts for investors to verify
- Whether loan growth, particularly agricultural and commercial growth, can continue without worsening delinquencies, nonperforming loans or credit concentration risk.
- Performance and collateral coverage of the three large nonperforming customer relationships, including developments in the bankruptcy case and the dairy borrower’s repayment capacity.
- Whether deposit pricing and increased borrowing costs continue to pressure net interest margin as rates change.
- Whether the allowance remains adequate and how adoption of CECL will affect provisions, capital and retained earnings.
- Liquidity and capital capacity relative to continued loan growth, off-balance-sheet commitments and the company’s dividend and share-repurchase activity.