Franklin Financial Services Corporation — FY2012 Form 10-K Summary
Business context and reporting period
The filing covers the fiscal year ended December 31, 2012. Franklin Financial Services Corporation is a Pennsylvania bank holding company conducting substantially all business through wholly owned Farmers and Merchants Trust Company, a community bank operating 26 offices in south-central Pennsylvania. The Bank provides commercial, residential mortgage, consumer, trust and investment services. The common stock trades thinly on the OTCQB under “FRAF.”
Financial performance and condition
| Metric | 2012 | 2011 | Change |
|---|---|---|---|
| Total assets | $1.027 billion | $990.2 million | +4% |
| Net interest income | $32.3 million | $32.6 million | -1.2% |
| Net interest margin | 3.50% | 3.73% | -23 bps |
| Provision for loan losses | $5.2 million | $7.5 million | -$2.3 million |
| Noninterest income | $9.5 million | $10.2 million | -7.3% |
| Noninterest expense | $30.6 million | $28.3 million | +8.0% |
| Net income | $5.4 million | $6.6 million | -18% |
| Diluted EPS | $1.32 | $1.66 | -20% |
| Return on average assets | 0.51% | 0.66% | Down |
| Return on average equity | 6.00% | 7.68% | Down |
| Efficiency ratio | 70.44% | 63.46% | Higher expense burden |
Net cash provided by operating activities was $10.6 million, compared with $15.1 million in 2011. Investing activities used $4.5 million, while financing activities provided $37.6 million. Cash and cash equivalents increased to $77.8 million from $34.1 million.
Gross loans declined to $753.6 million from $766.4 million, while net loans were $743.2 million. Deposits increased 11% to $874.4 million, driven by demand, money-management and savings accounts; retail time deposits declined while brokered time deposits increased. Shareholders’ equity rose to $91.6 million from $87.2 million.
Long-term FHLB debt declined to $12.4 million from $48.3 million after $33.1 million of prepaid advances. Repurchase agreements totaled $42.2 million. Liquidity included approximately $35 million available under an FHLB line, $16 million of unsecured correspondent-bank lines and approximately $54 million of Federal Reserve discount-window capacity. The Bank also reported approximately $68.9 million of excess FHLB borrowing capacity, subject to collateral requirements.
Capital remained strong: the Corporation reported a 12.60% total risk-based capital ratio, 11.36% Tier 1 risk-based ratio and 8.29% Tier 1 leverage ratio. The Corporation and Bank were classified as well capitalized.
Material changes versus the prior comparable period
- Net income declined primarily because of lower interest margins, lower noninterest income and higher operating expenses, despite a lower loan-loss provision.
- The net interest margin fell as asset yields declined faster than funding costs in the prolonged low-rate environment. Tax-equivalent net interest income declined 1.3% to $33.9 million.
- Nonperforming loans increased to $37.0 million from $22.5 million; nonperforming assets rose to $42.1 million from $25.8 million. Nonperforming loans were 4.90% of gross loans versus 2.94%.
- Commercial real estate was the principal source of deteriorating credit quality. Watch-list loans increased to $104.3 million from approximately $95.7 million, and impaired loans increased to $39.4 million from $28.0 million.
- The allowance for loan losses increased to $10.4 million, or 1.38% of loans, from $9.7 million, or 1.27%. Net charge-offs declined to $4.6 million from $6.6 million but remained elevated relative to historical levels.
- Other real estate owned increased to $5.1 million from $3.2 million, and the Bank recognized a $582,000 net loss on OREO sales and write-downs.
- The quarterly dividend was reduced from $0.27 to $0.17 per share beginning in the second quarter. Annual dividends declined to $0.78 per share from $1.08. No shares were repurchased; the dividend reinvestment plan raised approximately $1.2 million.
Guidance, outlook, risks and unusual items
- Management expected low short-term rates to persist beyond 2013, creating continued pressure on net interest margin. Interest-rate sensitivity analysis indicated that higher rates would improve net interest income, while a prolonged lower-rate environment would be unfavorable.
- Management expected nonperforming loans to remain at higher-than-normal levels until business activity and consumer confidence improved. Loan collection and foreclosure expense was not expected to decline in 2013.
- The Bank expected 2013 pension expense to be approximately $400,000 lower after making a $6.0 million additional pension contribution in December 2012, which brought the plan to a fully funded status. No 2013 pension contribution was expected.
- Management planned to continue selectively retaining residential mortgages and expected consumer loans to continue running off. Commercial lending was expected to remain the primary area of loan growth.
- Key risks include concentration in Pennsylvania real estate lending, declining collateral values, higher credit losses, competition, interest-rate and funding risk, limited stock liquidity, regulatory changes and dependence of the holding company on dividends from the Bank.
- The Bank remained on FHLB full-collateral-delivery status, reducing borrowing capacity relative to prior arrangements. Management believed its liquidity plan was sufficient, but an interruption or reduction in FHLB funding could adversely affect liquidity.
- The investment portfolio included $4.8 million of trust-preferred securities with $1.1 million of unrealized losses and $2.4 million of private-label mortgage-backed securities. The Bank recorded $100,000 of 2012 other-than-temporary impairment on three private-label securities and participated in litigation concerning alleged underwriting misrepresentations.
- Other unusual items included $439,000 of FHLB prepayment penalties, a $349,000 fourth-quarter OREO write-down, and a $6.0 million pension contribution. Goodwill of $9.0 million was tested and was not impaired.
- The fourth quarter was particularly weak: net income was $344,000, or $0.08 per diluted share, versus $1.9 million, or $0.47 per share, in the fourth quarter of 2011. Management cited margin tightening, lower noninterest income and nonrecurring expenses.
The independent auditor issued an unqualified opinion on the consolidated financial statements and internal control over financial reporting. Management and the auditor concluded that disclosure controls and internal control over financial reporting were effective as of December 31, 2012.
Important facts for investors to verify
- Whether nonperforming loans, impaired loans, OREO and watch-list balances stabilize or require additional provisions and charge-offs.
- The adequacy of the $10.4 million allowance relative to $37.0 million of nonperforming loans and the Bank’s concentrated real estate exposure.
- Whether the 3.50% net interest margin can be maintained or improve as interest rates change.
- The sustainability of the reduced $0.17 quarterly dividend and the holding company’s reliance on Bank dividends.
- Actual availability of FHLB, Federal Reserve and correspondent-bank liquidity, including the effects of collateral-delivery requirements.
- Potential additional losses on private-label mortgage-backed securities, trust-preferred securities, FHLB restricted stock and OREO.
- Progress and potential recoveries from litigation involving private-label mortgage-backed securities.
- The effect of regulatory changes, including Basel III, Dodd-Frank requirements and mortgage-lending rules, on capital, compliance costs and earnings.