Citizens Financial Services, Inc. — Q2 2016 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2016. Financial statement amounts below are in millions unless otherwise noted. The company is a Pennsylvania bank holding company operating primarily through First Citizens Community Bank. Comparisons are affected by its December 2015 acquisition of The First National Bank of Fredericksburg (FNB); 2016 includes the acquired business, while 2015 does not.
Financial performance and position
| Metric | Q2 2016 | Six months 2016 |
|---|---|---|
| Net interest income | $9.171; up 21.3% year over year | $18.376; up 21.3% |
| Net interest margin, tax-equivalent | 3.62%, versus 3.77% in Q2 2015 | 3.62%, versus 3.81% in 2015 |
| Provision for loan losses | $0.135, versus $0.120 | $0.270, versus $0.240 |
| Non-interest income | $1.983, up 1.4% | $3.899, up 5.9% |
| Non-interest expense | $7.301, up 34.5% | $14.213, up 32.1% |
| Net income | $3.031, down 5.0% | $6.314, versus $6.309 |
| Basic and diluted EPS | $0.91, versus $1.04 | $1.88, versus $2.06 |
- Quarterly annualized return on assets was 1.02% and return on equity was 9.88%, compared with 1.36% and 12.45%, respectively, in Q2 2015. For the six-month periods, the corresponding figures were 1.06% and 10.34%, versus 1.36% and 12.41%.
- Six-month operating cash flow was $6.246, compared with $5.448 in 2015. Investing activities used $12.232; financing activities provided $8.424. Cash and cash equivalents ended at $26.822, up $2.438 from year-end.
- At June 30, total assets were $1,179.518; net loans $701.756; available-for-sale securities $360.944; deposits $1,003.482; borrowed funds $38.786; and stockholders’ equity $124.456.
- Since December 31, 2015, total assets increased 1.4%, loans increased $14.084 (gross), deposits increased $15.451, and borrowed funds decreased $2.845.
- The company reported a 19.0% effective tax rate for the first six months, versus 19.4% in 2015. The filing attributes the below-statutory rate primarily to tax-exempt income and affordable-housing tax credits.
Material changes versus comparable periods
- Net interest income grew substantially as average interest-earning assets expanded following the FNB acquisition and organic loan growth. However, the tax-equivalent margin declined as acquired and newly purchased assets generally earned lower yields.
- Six-month total interest income rose $3.349, while interest expense rose $0.121. Average yield on interest-earning assets fell to 4.08% from 4.36%; the average rate paid on interest-bearing liabilities fell to 0.56% from 0.67%.
- Expense growth, chiefly from the FNB branches and employees, outpaced revenue growth. Management also cited merit increases, hiring agricultural lending teams, higher employee benefit costs, security-related customer fraud charges, and professional fees. This expense increase contributed to lower quarterly net income and EPS.
- Average shares used for EPS rose to 3.350 million for the six-month period from 3.056 million in 2015. The filing notes a 1% stock dividend and share issuances; net income was nearly unchanged while EPS declined.
- Non-performing loans rose to $11.310 at June 30 from $7.154 at year-end, an increase of 58.1%. Non-accrual loans were $10.206, versus $6.531 at year-end. Management attributed much of the rise to a commercial relationship placed on non-accrual during Q2.
- The allowance for loan losses increased to $7.359 from $7.106; it equaled 1.04% of loans, compared with 1.02% at year-end. Net charge-offs were $0.017 for the six months.
Outlook, risks and unusual items
- No earnings or revenue guidance was provided. Management said results for the first six months are not necessarily indicative of full-year results.
- Management cited loan-growth opportunities in central and south-central Pennsylvania, including agricultural lending, and expected additional agricultural loan demand in the second half. Regulatory approval was received for a Mount Joy, Pennsylvania branch, which the company anticipated opening in September 2016. A second agricultural lending team began July 1.
- Management said liquidity needs were met through cash, core deposits, maturing assets and borrowing access. The Bank had approximately $310.4 of FHLB borrowing capacity, of which $16.5 was outstanding; a $10.0 federal funds line and approximately $3.9 Federal Reserve borrowing line were undrawn. The company itself reported $3.7 of liquid assets on an unconsolidated basis.
- Both the company and Bank were categorized as well capitalized. At June 30, company ratios included 16.16% total risk-based capital, 15.10% Tier 1 risk-based capital, 14.07% common equity Tier 1, and 9.40% Tier 1 leverage.
- Credit risk is concentrated in the company’s regional markets and lending, including agriculture and businesses supporting natural-gas exploration. Management described four customer relationships as approximately 68.1% of non-performing loans. One $3.7 commercial relationship was affected by the slowdown in natural-gas exploration; another borrower’s bankruptcy-related payment dispute was being litigated. Management reported no specific reserve for those two relationships and a $0.197 specific reserve for a separate trucking-related relationship.
- Other identified risks include changing interest rates, local economic weakness and unemployment, borrower delinquencies, agricultural input costs and product prices, fraud and information theft, competition, regulatory change, and successful integration of acquisitions. The company’s rate-shock model estimated one-year net interest income declines of 1.55% under a +100 bp shock and 6.83% under +400 bp; management cautioned that actual results could differ from model assumptions.
- Off-balance-sheet commitments to extend credit were $186.943 and standby letters of credit were $13.884 at June 30. Management reported no litigation known to have a material adverse effect and no material change in risk factors from the 2015 Form 10-K.
- Unusual items included $0.350 of charges related to customer account compromises and fraudulent charges, and a $0.100 education tax-credit contribution delayed from 2015 by Pennsylvania’s budget impasse. The company also recorded $2.278 of six-month other comprehensive income, largely from unrealized available-for-sale securities gains.
Most important facts for investors to verify
- How much of the reported loan, deposit, revenue and expense growth reflects FNB acquisition effects versus organic growth, and whether integration costs or savings will change.
- The status, collateral coverage and potential loss exposure of the large non-performing commercial relationships, especially those tied to natural-gas activity and bankruptcy proceedings.
- Whether elevated non-performing loans and management’s increased qualitative credit-risk factors result in higher future provisions or charge-offs.
- Whether loan growth can sustain net interest income while margins remain below prior-year levels and acquired assets carry lower yields.
- The persistence of fraud-related losses, higher operating expenses, and the company’s ability to convert revenue growth into earnings growth.
- Liquidity and capital resilience under deposit outflows, interest-rate changes, or deterioration in regional economic and agricultural conditions.