FIDELITY D & D BANCORP INC annual report, FY2013

Fidelity D & D Bancorp, Inc. — 2013 Form 10-K

Reporting period: Fiscal year ended December 31, 2013; comparisons are primarily with fiscal 2012. This is an annual report, not a fourth-quarter-only filing. The company is a Pennsylvania bank holding company operating The Fidelity Deposit and Discount Bank, focused mainly on Lackawanna and Luzerne Counties.

Financial performance and condition

Metric	FY2013 / year-end 2013	FY2012 / year-end 2012
Total assets	$623.8 million	$601.5 million
Net loans	$469.2 million	$424.6 million
Total deposits	$529.7 million	$514.7 million
Net interest income	$20.9 million	$20.6 million
Net income	$7.1 million; diluted EPS $3.02	$4.9 million; diluted EPS $2.14
Net interest margin	3.80%	3.80%
Return on average assets / equity	1.15% / 11.70%	0.81% / 8.62%
Shareholders’ equity	$66.1 million; 10.59% of assets	$58.9 million; 9.80% of assets
Cash and cash equivalents	$13.2 million	$21.8 million

• Net interest income rose about 1% as lower funding costs more than offset modestly lower interest income. Interest income was $23.9 million and interest expense $3.0 million.
• Net income increased 45%, with the largest single contributor being the fourth-quarter sale of the entire pooled trust preferred securities portfolio, which management reported generated a $2.9 million net gain. Total investment-security gains in the income statement were $3.2 million.
• Provision for loan losses declined to $2.55 million from $3.25 million. Net charge-offs were $2.59 million, versus $2.39 million.
• Non-performing assets fell to $9.0 million, or 1.44% of assets, from $17.7 million, or 2.94%. Non-performing loans were 1.22% of loans, compared with 3.12%. The allowance was $8.9 million, or 1.86% of loans, versus 2.02%.
• Other operating expenses increased 3% to $19.1 million. The efficiency ratio worsened to 64.99% from 63.40%.
• Cash from operating activities was $23.1 million; investing activities used $46.2 million and financing activities provided $14.5 million. Cash declined by $8.6 million during the year.
• Year-end debt included $8.6 million of short-term borrowings and $16.0 million of FHLB long-term debt, bearing 5.26% and scheduled to mature in 2016.

Material changes and notable items

• Assets increased 4%, loans grew about 8% on the selected financial data basis, and deposits rose 3%. Loan growth was led by commercial, commercial real estate, consumer, and residential lending.
• The company sold its pooled trust preferred securities in the fourth quarter, eliminating that investment exposure and contributing materially to earnings and the improvement in reported capital. The portfolio had been carried at a substantial unrealized loss at year-end 2012.
• Shareholders’ equity rose 12% to $66.1 million, supported by earnings, improved accumulated other comprehensive income, and stock issued through employee purchase and dividend reinvestment plans; cash dividends declared were $2.6 million.
• Management changed its allowance methodology in the fourth quarter, using a trailing twelve-quarter historical loss average and excluding qualifying SBA-guaranteed and cash-secured portions of loans. The latter change reduced the allowance requirement by approximately $0.2 million; management described the averaging-method change as immaterial.
• The company reported 15 foreclosed properties at year-end, compared with 12 a year earlier; foreclosed assets were $2.1 million. Increased ORE costs and property write-downs contributed to expenses.

Outlook, risks, and contingencies

• Management expected continued commercial-loan growth in 2014, funded mainly by deposit growth, and anticipated net interest margin to stabilize or improve modestly. It expected short-term rates to remain low well into 2015, while noting that rising longer-term rates could affect securities values and funding costs.
• Management expected non-performing assets to continue declining in 2014, while cautioning that they could rise temporarily as the bank worked through problem credits and foreclosed properties. Residential mortgage activity was expected to be stagnant; consumer lending, particularly auto lending, was expected to grow.
• Local economic conditions remained challenging: the Scranton–Wilkes-Barre unemployment rate was 7.7% at year-end, and local foreclosures increased 60% in 2013. The company’s geographic concentration and real-estate exposure leave it sensitive to local employment, property values, and borrower repayment capacity.
• Other key risks include interest-rate and margin pressure, credit losses and reserve-estimation uncertainty, competition, regulatory changes including Basel III and Dodd-Frank implementation, cybersecurity and technology risks, and dependence on the bank subsidiary for dividends.
• Available liquidity sources were reported at approximately $351.4 million, or 56% of assets, including cash, securities and loans held for sale, and borrowing capacity. Management considered liquidity strong and adequate. The company also had $89.8 million of commitments to extend credit and $7.7 million of standby letters of credit; commitments may not be fully drawn.
• Management reported no pending legal proceedings expected to have a material effect. The financial statements received an unqualified independent auditor opinion. Management assessed disclosure controls and internal control over financial reporting as effective; the auditor did not provide an internal-control attestation.

Important facts for investors to verify

• How much of 2013 earnings growth is repeatable after the pooled trust preferred securities sale gain; review recurring fee income, loan-sale gains, and operating costs.
• Whether the improvement in non-performing assets continues, including subsequent performance of criticized loans, TDRs, and foreclosed properties.
• The adequacy of the $8.9 million loan-loss allowance under the revised methodology and the effect of local economic conditions on commercial real estate credit.
• Whether loan growth can be funded with stable, low-cost deposits without weakening underwriting or compressing the net interest margin.
• The sensitivity of earnings, securities values, and capital to interest-rate changes, as well as the effect of Basel III requirements as they are phased in.
• The sustainability of dividends, given regulatory limits on subsidiary-bank distributions and the company’s reliance on those distributions.