Franklin Financial Services Corporation — Q3 2017 Form 10-Q
Business Context and Reporting Period
Franklin Financial Services Corporation is a Pennsylvania bank holding company whose principal subsidiary, Farmers and Merchants Trust Company of Chambersburg, operates a commercial bank serving south-central Pennsylvania. The filing covers the unaudited three and nine months ended September 30, 2017, compared primarily with the corresponding 2016 periods and December 31, 2016 balance-sheet data.
Financial Highlights
| Metric | Three Months Ended September 30 | Nine Months Ended September 30 |
|---|---|---|
| Net interest income | $9.4 million, versus $8.8 million | $27.7 million, versus $25.8 million |
| Provision for loan losses | $250 thousand, versus $1.15 million | $420 thousand, versus $3.325 million |
| Noninterest income | $3.0 million, versus $2.8 million | $9.1 million, versus $8.6 million |
| Noninterest expense | $8.3 million, versus $8.0 million | $24.4 million, versus $23.5 million |
| Net income | $3.1 million, versus $2.1 million | $9.4 million, versus $6.4 million |
| Diluted earnings per share | $0.70, versus $0.48 | $2.17, versus $1.48 |
| Net interest margin | 3.71% annualized | 3.71% annualized |
- Total assets were $1.166 billion at September 30, 2017, up $38.1 million, or 3.4%, from year-end 2016.
- Net loans were $900.0 million, up $17.2 million, or 1.9%, from year-end. Commercial loans drove growth, while residential real estate loans declined.
- Total deposits were $1.033 billion, up $51.0 million, or 5.2%. Noninterest-bearing deposits increased $13.0 million and interest-bearing checking and savings increased $37.4 million.
- Investment securities declined to $132.3 million from $143.9 million at year-end as maturities were redeployed into loans.
- Cash and cash equivalents increased to $71.4 million from $36.7 million. The company had no short-term borrowings at September 30, compared with $24.3 million at year-end.
- Operating cash flow for the first nine months was $13.6 million, compared with $9.7 million in 2016. Investing activities used $3.6 million, while financing activities provided $24.6 million.
- Shareholders’ equity increased to $124.6 million from $116.5 million. The company declared $0.69 per share of dividends for the first nine months, including $0.24 per share for the third quarter.
- The allowance for loan losses was $11.5 million, or 1.27% of gross loans. The company recorded net recoveries of $48 thousand year-to-date.
- Return on average assets was 1.11%, return on average equity was 10.50%, and the efficiency ratio was 63.00% for the nine months ended September 30, 2017.
Material Changes Versus Prior Comparable Period
- Net income increased 48.2% for the quarter and 48.3% year-to-date, primarily because of higher loan-related interest income and substantially lower loan-loss provisions.
- Quarterly net interest income increased $649 thousand, while tax-equivalent net interest income increased approximately $760 thousand. Management attributed the increase to both higher balance-sheet volume and modestly improved rates.
- The nine-month provision for loan losses fell $2.9 million from 2016, when the company recorded elevated expense related to a large commercial loan charge-off.
- Noninterest income increased 6.0% in the quarter and 5.1% year-to-date, led by investment and trust services fees, loan service charges, and growth in assets under management.
- Noninterest expense increased 4.1% in the quarter and 3.9% year-to-date, mainly due to salaries, benefits, staffing, incentive compensation, health insurance, data processing, and legal and professional fees.
- Loan quality improved: nonperforming loans declined to $3.1 million from $5.4 million at year-end, and nonperforming assets declined to $5.8 million from $10.4 million. The watch list declined to $17.0 million from $18.5 million.
- Other real estate owned declined to $2.6 million from $4.9 million following property sales, although the company recorded $60 thousand of write-downs.
- Accumulated other comprehensive loss improved to $3.6 million from $4.2 million, primarily due to higher unrealized gains on available-for-sale securities.
Guidance, Outlook, Risks, Contingencies, and Unusual Items
- Management expects commercial lending to remain the primary area of loan growth, while new purchased loan participations are expected to decline. Consumer loans are expected to continue declining.
- Management expects 2017 pension expense of approximately $459 thousand, compared with $922 thousand in 2016. No 2017 pension contribution was made or expected.
- Management believes liquidity is adequate and that all anticipated liquidity demands can be met. At quarter-end, the Bank reported approximately $310 million of unused FHLB borrowing capacity and approximately $20 million of Federal Reserve Discount Window capacity.
- Available liquidity is subject to deposit outflows, wholesale funding availability, interest-rate changes, and the ability to pledge or sell securities. Management noted that loss of FHLB access could materially impair short-term funding flexibility.
- The company had $301.3 million of unused loan commitments and standby letters of credit, creating potential off-balance-sheet funding exposure.
- The portfolio included 93 temporarily impaired securities with $51.1 million of fair value and $820 thousand of unrealized losses. Management classified the losses as temporary, but noted that additional write-downs could occur on private-label mortgage-backed securities if loss trends continue.
- A $2.5 million OREO property, representing approximately 95% of total OREO, was under contract subject to due diligence; the final outcome was uncertain at the filing date.
- The company disclosed the Kalan et al. litigation. No specific accrual was recorded because management could not assess the likelihood of an unfavorable outcome or estimate a loss range. The potential exposure could be material, and the filing states that ultimate losses could exceed any future accrual or estimate.
- The company adopted 2017 stock-compensation and callable-debt-security accounting updates without financial statement impact. Management expected the pending revenue-recognition, financial-instruments, and lease standards to have no material or only limited effects, while the expected-credit-loss standard could result in earlier and potentially larger loan-loss recognition.
- On October 12, 2017, the Board declared a $0.24 per share fourth-quarter dividend and authorized repurchases of up to 100,000 shares from October 16, 2017 through September 30, 2018.
- The Bank and holding company remained well capitalized under Basel III. The Bank’s total risk-based capital ratio was 16.82%, Tier 1 leverage ratio was 10.34%, and common equity Tier 1 ratio was 15.56% at September 30, 2017.
Most Important Facts to Verify
- Whether commercial real estate and commercial loan growth remains prudent given the concentration of the $911.5 million loan portfolio in commercial lending.
- Whether the improvement in credit quality and the low provision expense are sustainable, particularly after the future adoption of the current expected credit loss model.
- The status and eventual sale proceeds of the $2.5 million OREO property and any related valuation adjustments.
- Developments, potential class-action status, and loss exposure in the Kalan litigation, for which no accrual was recorded.
- Performance and impairment risk in trust-preferred and private-label mortgage-backed securities, including the $595 thousand of cumulative private-label impairment charges.
- Deposit retention, liquidity stress-test results, and continued access to FHLB and Federal Reserve funding.
- The effect of the authorized 100,000-share repurchase program on capital, liquidity, and per-share results.