Citizens Financial Services, Inc. — Q3 2012 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2012; comparisons are with the corresponding 2011 periods unless otherwise noted. Amounts are in millions of dollars unless stated. The company is a Pennsylvania community banking holding company serving north-central Pennsylvania and southern New York. Its bank subsidiary converted from a national bank to a Pennsylvania state-chartered bank and trust company on June 29, 2012.
Financial results and key metrics
| Metric | Q3 2012 | Nine months 2012 | Comparable-period change |
|---|---|---|---|
| Interest income | $9.474 | $28.724 | Q3 down 1.4%; nine months up 0.3% |
| Net interest income | $7.615 | $22.838 | Q3 up 5.7%; nine months up 7.6% |
| Provision for loan losses | $0.105 | $0.315 | Q3 down $0.045; nine months down $0.210 |
| Non-interest income | $1.946 | $5.691 | Q3 up 6.5%; nine months up 9.9% |
| Non-interest expense | $4.959 | $14.352 | Q3 up 10.2%; nine months up 3.1% |
| Net income | $3.464 | $10.666 | Q3 up 2.6%; nine months up 14.0% |
| EPS, basic and diluted | $1.19 | $3.66 | Prior-year periods: $1.15 and $3.18 |
For the first nine months, return on assets was 1.62% versus 1.49%, and return on equity was 17.74% versus 17.65%. Q3 annualized ROA was 1.58% versus 1.57%; ROE was 16.78% versus 18.48%. Tax-equivalent net interest margin was 3.99% for both Q3 and the nine-month period, compared with 3.90% and 3.94%, respectively, in 2011. The effective tax rate was 23.1% for the nine months and 23.0% for Q3.
Balance sheet at September 30: Assets were $876.2, down 0.3% from year-end 2011; net loans were $492.5, up 2.4%; available-for-sale securities were $322.0, up 1.0%; deposits were $729.2, down 0.7%; borrowed funds were $48.0, down $5.9; and stockholders’ equity was $90.0, up 10.4%. The allowance for loan losses was $6.734, or 1.35% of loans, versus $6.487, or 1.33%, at year-end.
Cash flow and liquidity: Nine-month operating cash flow was $10.768, investing cash outflow was $16.385, and financing cash outflow was $14.105. Cash and cash equivalents fell $19.722 to $10.710. Management said liquidity needs were supported by cash, maturing assets and available funding sources. The Bank had $31.3 outstanding against approximately $244.3 of FHLB borrowing capacity; a $10.0 federal-funds line and approximately $14.1 Federal Reserve borrower-in-custody line were undrawn.
Capital: The company reported total risk-based capital of 17.70% and Tier 1 risk-based capital of 16.41%; the Bank reported 16.89% and 15.64%, respectively. Both reported ratios exceeded the stated “well capitalized” thresholds.
Material changes and operating drivers
- Nine-month earnings growth reflected lower funding costs and higher net interest income, lower loan-loss provision, and higher non-interest income. Q3 profit growth was modest as expense growth outpaced revenue growth.
- Interest expense fell $1.542 for the first nine months, principally from lower deposit and borrowing rates. Average interest-earning assets increased, but yields declined in the low-rate environment.
- Nine-month non-interest income rose $0.514, including securities gains of $0.561 versus $0.351 and gains on loans sold of $0.287 versus $0.111. Mortgage refinancing activity drove higher loan-sale gains.
- Nine-month non-interest expense rose $0.432. Salaries and benefits increased $0.566, partly from merit increases and additional staffing; professional fees increased $0.175, primarily related to the bank charter conversion.
- Total loans grew $11.7, with growth in commercial real estate, construction, commercial and other, and municipal lending. Residential and agricultural real estate balances declined. Deposits shifted toward savings and money-market accounts while certificates of deposit declined $14.5.
- Cash dividends were $2.611 for the nine months; the company also issued a 1% stock dividend and repurchased shares. Cash dividends per share were $0.300 for Q3 and $0.895 for the nine-month period.
Outlook, risks and unusual items
- The filing provides no quantitative earnings or revenue guidance. Management cautioned that nine-month results are not necessarily indicative of full-year results.
- Management described a revised investment strategy that increased portfolio duration through selected mortgage-backed securities and longer-term agency securities, while seeking to limit extension risk. Securities portfolio yield declined to 3.19% from 3.55% on a tax-equivalent basis.
- Credit risk is concentrated regionally: borrowers are primarily in north-central Pennsylvania and southern New York, where repayment capacity is affected by local conditions. Management cited rising local unemployment and a slowdown in Marcellus Shale development; lower milk prices and higher feed costs also affected agricultural credit assumptions. Natural-gas activity and related lease and royalty income have supported local real estate values, but changes in regulation or gas prices could affect customers and loan quality.
- Non-performing loans were $8.694, down 7.9% from year-end, but approximately 79.1% were associated with three customer relationships. One relationship accounted for 56.9% of non-performing loans and was current through October 31, 2012, though the borrower’s financial condition remained weak. Non-performing assets were $9.157, or 1.83% of loans.
- One TDR was completed in Q3 2012; four were completed during the nine months. Management notes that restructured loans may carry elevated default risk. The allowance is based partly on management estimates, and regulators may require additional reserves.
- Off-balance-sheet contractual commitments totaled $82.126, including $76.921 of commitments to extend credit and $5.205 of standby letters of credit. The filing reported no material litigation known to management and no material change in risk factors from the 2011 Form 10-K.
- Other notable items: the bank charter conversion increased professional and operating costs; securities sales generated gains; and a $7.5 trust-preferred borrowing was hedged with a swap expiring December 17, 2013, which had a $0.251 liability at quarter-end.
Important facts for investors to verify
- Track whether net interest income and margin remain resilient as asset yields fall and deposits reprice; assess the sustainability of securities and loan-sale gains.
- Review the three large non-performing borrower relationships, collateral and guarantees, subsequent payment performance, and changes in classified loans and the allowance.
- Monitor local economic conditions, including Marcellus Shale activity, unemployment, agricultural input costs and commodity prices, for effects on borrowers and collateral values.
- Assess deposit trends, cash levels, funding capacity and the maturity profile of borrowings and securities; distinguish available borrowing capacity from immediately available cash.
- Confirm that reported capital ratios and dividend capacity remain adequate under applicable regulatory requirements, including any effects of evolving capital rules.