CITIZENS FINANCIAL SERVICES INC quarterly report, Q3 FY2019

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Citizens Financial Services, Inc. — Q3 2019 Form 10-Q

Business context and period. Unaudited results for the quarter and nine months ended September 30, 2019, compared with the same 2018 periods. The Pennsylvania-based company operates First Citizens Community Bank and related insurance and realty subsidiaries, serving markets in Pennsylvania and southern New York. The filing states that interim results are not necessarily indicative of full-year results.

Financial performance and condition

  • Profitability: Q3 net income was $5.196 million, up 13.4% year over year; diluted EPS was $1.48 versus $1.30. Nine-month net income was $14.447 million, up 6.9%; diluted EPS was $4.10 versus $3.81. Nine-month annualized return on assets was 1.33% (1.30% in 2018) and return on equity was 12.99% (13.13%).
  • Revenue and margins: Q3 net interest income increased 9.6% to $12.899 million; nine-month net interest income rose 6.3% to $37.150 million. Tax-equivalent net interest margin was 3.82% for Q3 versus 3.64%, and 3.71% year to date versus 3.65%. Nine-month noninterest income rose 8.3% to $6.237 million. Noninterest expense increased 7.1% to $24.973 million. The filing does not provide a clear overall operating-margin figure.
  • Credit costs: Provision for loan losses was $0.400 million in Q3 and $1.150 million for nine months, versus $0.475 million and $1.300 million, respectively, in 2018. The allowance was $13.679 million, or 1.23% of loans, at September 30.
  • Cash flow: Nine-month operating cash flow was $15.936 million, investing cash flow was negative $39.475 million, and financing cash flow was $26.828 million. Cash and cash equivalents increased $3.289 million to $20.086 million.
  • Balance sheet and funding: Total assets were $1.475 billion, up $44.3 million from year-end 2018. Gross loans were $1.115 billion and net loans $1.101 billion. Deposits totaled $1.199 billion, up $14.1 million; borrowed funds were $109.840 million, up $18.6 million. Stockholders’ equity was $151.678 million.
  • Capital and liquidity: The Bank was categorized as well capitalized. September 30 ratios included total risk-based capital of 13.19%, common equity Tier 1 of 11.94%, and Tier 1 leverage of 9.12%. Management said liquidity was adequate, citing cash, core deposits, FHLB capacity and other funding sources. FHLB borrowing capacity was approximately $536.3 million, with $137.9 million outstanding.
  • Dividends: Cash dividends were $0.450 per share in Q3 and $1.331 per share for nine months; the year-to-date payout ratio was 32.7%.

Material changes versus comparable periods

  • Growth in loan balances and yields drove higher interest income; average interest-earning assets increased and the nine-month tax-equivalent yield rose to 4.61% from 4.33%.
  • Funding costs also rose: the average rate paid on interest-bearing liabilities increased to 1.12% from 0.84% for the first nine months, contributing to higher interest expense.
  • Nine-month loan growth was $33.2 million from year-end, led by commercial and agricultural real estate. Construction loans declined $22.5 million; commercial real estate rose $30.0 million and agricultural real estate rose $21.4 million.
  • Nonperforming loans declined to $13.326 million from $13.792 million at year-end, while foreclosed assets increased to $3.497 million from $0.601 million. The allowance-to-loans ratio rose to 1.23% from 1.19%.
  • Available-for-sale securities increased to $247.027 million from $241.010 million. Accumulated other comprehensive loss improved to $0.289 million from $3.921 million, primarily reflecting securities valuation changes.

Outlook, commentary, risks and unusual items

  • Outlook: No numerical earnings or revenue guidance is provided. Management described investment purchases as focused on liquidity and yield while managing interest-rate exposure. A modeled parallel 100-basis-point rate increase reduced prospective one-year net interest income by 2.15%; a 400-basis-point increase reduced it by 10.35%. Actual results may differ from the model.
  • Proposed acquisition: The company agreed to acquire MidCoast Community Bancorp in September 2019. Consideration is $6.50 cash or 0.1065 company shares per MidCoast share, with cash limited to 25% of MidCoast shares. Closing was expected in the first half of 2020, subject to regulatory and shareholder approvals. The agreement includes a potential termination right tied to a greater-than-20% decline in the company’s share value and a $1.2 million termination fee payable by MidCoast in certain circumstances. Q3 and year-to-date merger costs were $275,000.
  • Credit and regional risks: The loan portfolio is concentrated in the company’s Pennsylvania and southern New York service areas and includes $156.1 million of dairy-industry loans, 14.0% of total loans. Four borrower relationships represented 65.5% of nonperforming loans. Management cited depressed milk prices and weaker natural-gas exploration activity as borrower risks. The filing also identifies sensitivity to interest rates, regional economic conditions, competition, fraud, regulation and agriculture-related conditions.
  • Other notable items: A commercial-customer bankruptcy settlement transferred $3.1 million of loans to foreclosed assets; foreclosed assets rose substantially. The company formed a realty subsidiary to manage and sell acquired properties and notified regulators of its intention to close a Lebanon, Pennsylvania branch. It adopted lease accounting in 2019, recognizing $1.454 million of right-of-use assets and lease liabilities at adoption. Management expected the new credit-loss standard to require a cumulative adjustment but said the impact could not yet be determined.
  • Contingencies and controls: Management reported no known litigation expected to have a material adverse effect and no material change in risk factors from the 2018 Form 10-K. Disclosure controls were deemed effective; no material change in internal control over financial reporting was reported.

Important facts for investors to verify

  • Progress, approvals, final consideration and integration costs for the MidCoast transaction.
  • Performance and collateral coverage of the four large nonperforming relationships, and developments in dairy and natural-gas-related borrowers.
  • Whether the increase in foreclosed assets results in further expenses, losses or cash-flow effects.
  • Deposit pricing and funding mix, including the increase in borrowed funds and sensitivity of earnings to interest-rate changes.
  • The eventual effective date and estimated retained-earnings and allowance impact of the expected credit-loss accounting standard.
  • Whether reported loan growth, margins and expense trends continue; management cautions that interim results do not necessarily indicate full-year performance.