Business Context and Reporting Period
Franklin Financial Services Corporation, through Farmers and Merchants Trust Company of Chambersburg, operates a commercial bank serving south-central Pennsylvania and Washington County, Maryland. This unaudited Form 10-Q covers the three and nine months ended September 30, 2022, compared with the corresponding 2021 periods.
Financial Performance and Position
| Metric | Q3 2022 | Q3 2021 | 9M 2022 | 9M 2021 |
|---|---|---|---|---|
| Net interest income | $14.1 million | $11.6 million | $37.0 million | $33.3 million |
| Net interest margin | 3.28% | 2.89% | 2.96% | 2.91% |
| Noninterest income | $3.7 million | $6.2 million | $11.6 million | $14.9 million |
| Noninterest expense | $12.2 million | $11.0 million | $35.5 million | $31.3 million |
| Net income | $4.6 million | $5.9 million | $11.2 million | $16.0 million |
| Diluted EPS | $1.05 | $1.31 | $2.52 | $3.60 |
| Efficiency ratio | Not separately stated | Not separately stated | 71.34% | 63.70% |
- Net interest income increased 21.3% in the third quarter and 11.2% year to date, driven primarily by higher earning-asset yields and rates. PPP interest and fees declined to zero in the quarter and $388,000 year to date, compared with $1.2 million and $2.8 million, respectively, in the prior-year periods.
- Net income declined 21.0% in the third quarter and 29.7% for the first nine months. Prior-year results benefited from a $1.8 million gain on the sale of the former headquarters and a $1.9 million year-to-date reversal of loan-loss provision.
- Noninterest income declined 40.7% in the quarter and 21.9% year to date, primarily because of lower mortgage-sale gains and the absence of the 2021 headquarters-sale gain. Noninterest expense increased 11.1% in the quarter and 13.5% year to date, reflecting higher salaries, occupancy, data processing, marketing and other costs.
- Total assets were $1.847 billion at September 30, 2022, up 4.1% from year-end 2021. Net loans increased 5.1% to $1.034 billion, led by a $48.6 million increase in commercial real estate loans. Deposits increased 7.6% to $1.705 billion, while time deposits declined 19.4%.
- Cash and cash equivalents were $210.2 million, up from $175.1 million at year-end 2021. Management reported $467.1 million of available liquidity through the Federal Home Loan Bank, Federal Reserve Discount Window and correspondent banks, with no outstanding balances under those facilities.
- Subordinated notes totaled $19.6 million net of issuance costs. The underlying notes have aggregate principal of $20.0 million, fixed rates of 5.00% and 5.25% for their initial periods, and later convert to SOFR-based rates.
- Operating cash flow was $17.7 million for the first nine months, compared with $23.9 million in 2021. Investing activities used $97.4 million, while financing activities provided $114.7 million, resulting in a $35.0 million increase in cash and cash equivalents.
- The allowance for loan losses was $15.0 million, or 1.43% of gross loans, compared with 1.51% at year-end 2021. No provision was recorded in the 2022 quarter or year-to-date period.
Material Changes, Outlook and Risks
- Accumulated other comprehensive loss increased substantially because of higher market interest rates: net unrealized losses on available-for-sale debt securities were $65.0 million at September 30, 2022, compared with a $4.7 million unrealized loss at year-end 2021. The company classified these losses as temporary and recorded no other-than-temporary impairment charge.
- Shareholders’ equity declined $48.9 million to $108.2 million, primarily because of the $54.6 million after-tax decline in accumulated other comprehensive income. Book value was $24.60 per share and tangible book value was $22.55 per share.
- Credit indicators improved. Nonaccrual loans declined to $5.6 million, or 0.53% of gross loans, from $7.4 million, or 0.74%, at year-end 2021. Watch-list loans declined to $18.8 million from $36.6 million. The filing states that management believes the allowance is adequate.
- The bank was well capitalized at September 30, 2022. Bank ratios included 14.36% CET1, 15.61% total risk-based capital and 8.63% Tier 1 leverage. The capital conservation buffer was 7.61%, compared with a 2.5% regulatory buffer.
- The company declared a $0.32 per share fourth-quarter dividend payable November 23, 2022. It repurchased 84,684 shares year to date and had repurchased 85,343 shares under its authorization through September 30, 2022.
- No formal earnings or revenue guidance was provided. Management stated that it believes anticipated liquidity demands can be met and that the local market remains suitable for growth.
- Key forward-looking risks include economic conditions, inflation, interest-rate changes, funding costs, monetary policy, regulation, competition, technology, credit quality and continuing effects of the COVID-19 pandemic.
- CECL adoption is scheduled for January 1, 2023. Management expects a one-time cumulative-effect adjustment to the allowance and retained earnings but had not yet determined the amount. The new model could increase the allowance and future provision expense.
- Off-balance-sheet commitments included $380.5 million of commitments to extend credit and $30.3 million of standby letters of credit. A $1.5 million reserve remained for letters of credit associated with a bankrupt commercial borrower.
- Management reported no material litigation proceedings, no material changes to previously disclosed risk factors, and effective disclosure controls as of September 30, 2022.
Important Facts for Investors to Verify
- Whether rising interest rates continue to expand net interest margin or instead increase deposit funding costs and reduce securities values.
- The magnitude and timing of the January 2023 CECL transition adjustment and its effect on capital, retained earnings and future provisions.
- The sustainability of loan growth, particularly the concentration in commercial real estate, including hotels, offices, shopping centers and construction loans.
- Whether the $65.0 million unrealized securities loss remains temporary and whether the company can avoid selling securities before recovery or maturity.
- Trends in noninterest expense, efficiency ratio, mortgage-sale gains and fee income after the 2021 one-time gains and lower PPP activity.
- Future deposit retention, liquidity usage and access to Federal Home Loan Bank and other wholesale funding sources.
- Progress under the 150,000-share repurchase authorization and the effect of repurchases and dividends on capital levels.