FRANKLIN FINANCIAL SERVICES CORP quarterly report, Q3 FY2019

Franklin Financial Services Corporation — Q3 2019 Form 10-Q Summary

Business context and reporting period

Franklin Financial Services Corporation is a Pennsylvania bank holding company whose principal subsidiary, Farmers and Merchants Trust Company of Chambersburg, provides commercial banking, lending, investment and trust services primarily in south-central Pennsylvania. The filing covers the unaudited three and nine months ended September 30, 2019, compared with the corresponding 2018 periods and December 31, 2018 balance-sheet data.

Financial performance and condition

Metric	Q3 2019	Q3 2018	YTD 2019	YTD 2018
Net interest income	$10.8 million	$10.4 million	$31.7 million	$30.1 million
Provision for loan losses	$(162) thousand	$250 thousand	$237 thousand	$9.6 million
Noninterest income	$3.5 million	$3.1 million	$10.3 million	$9.5 million
Noninterest expense	$9.0 million	$8.6 million	$28.0 million	$28.4 million
Net income	$4.5 million	$4.0 million	$11.7 million	$2.3 million
Diluted earnings per share	$1.03	$0.91	$2.66	$0.53

Year-to-date return on average assets was 1.26%, return on average equity was 12.89%, and the efficiency ratio was 65.31%.
Year-to-date net interest margin was 3.75%, compared with 3.77% in 2018. The net interest spread narrowed to 3.57% from 3.66%, while the cost of funds increased to 0.65% from 0.37%.
Total assets were $1.302 billion at September 30, 2019, up 7.6% from year-end 2018. Cash and cash equivalents increased to $150.1 million from $53.0 million.
Gross loans declined 3.7% to $937.2 million; net loans were $925.0 million. The allowance for loan losses was $12.2 million, or 1.30% of loans.
Deposits increased 7.1% to $1.160 billion, driven primarily by municipal and other interest-bearing deposits. The company reported no borrowings at September 30, 2019.
Shareholders’ equity increased to $126.1 million from $118.4 million at year-end 2018. The company declared $0.87 per share in dividends during the first nine months and repurchased 102,978 shares.
The Bank remained well capitalized. At September 30, 2019, the Bank’s CET1 ratio was 14.27%, total risk-based capital ratio was 15.52%, and Tier 1 leverage ratio was 9.28%.

Cash flow, liquidity and debt

Year-to-date operating cash flow was $14.6 million, compared with $2.0 million in 2018.
Investing activities provided $12.0 million, principally reflecting a $35.7 million decrease in loans, partially offset by $57.7 million of purchases of available-for-sale securities.
Financing activities provided $70.6 million, primarily from deposit growth, after $3.8 million of dividends and $3.8 million of treasury-stock purchases.
Management stated that the Bank believed it could meet anticipated liquidity demands. Available liquidity sources included approximately $52.3 million of unencumbered securities, $368 million of available Federal Home Loan Bank capacity, approximately $16.5 million of Federal Reserve discount-window capacity, and a $6.0 million unsecured correspondent-bank line.

Material changes versus prior comparable periods

Third-quarter net income increased 12.5% year over year, while nine-month net income increased approximately fivefold. The nine-month comparison was heavily affected by the 2018 $8.7 million charge-off of a loan participation and related provisions.
Net interest income increased $0.5 million in the quarter and $1.6 million year to date as growth in interest-earning assets and loan yields more than offset higher deposit costs.
The third-quarter negative loan-loss provision reflected a reduction in loans and the resulting lower allowance requirement. The allowance declined modestly from $12.4 million at year-end 2018.
Noninterest income increased 11.5% in the quarter and 9.0% year to date. Drivers included higher investment and trust fees, debit-card and other service fees, mortgage-related activity, and higher debt-security gains.
Loan composition shifted away from commercial lending and purchased participations. Commercial loans declined $37.1 million to $237.0 million, and purchased commercial participations represented 7.9% of gross loans versus 9.6% at year-end 2018.
Loan quality weakened modestly: nonaccrual loans increased to $4.8 million from $2.3 million at year-end, nonperforming loans increased to $4.9 million from $2.7 million, and nonperforming assets increased to $7.6 million from $5.3 million.
The watch list increased to $14.4 million from $10.3 million at year-end, primarily because a $5.2 million commercial real estate loan was downgraded to special mention.
The company adopted the new lease standard on January 1, 2019, recognizing a $6.2 million right-of-use asset and lease liability without a material effect on earnings or retained earnings.

Outlook, commentary, risks and unusual items

No formal earnings or revenue guidance was provided. Management expected commercial lending in its local market to remain the primary area of loan growth and noted that 2019 mortgage production for secondary-market programs had doubled from 2018.
Management described the local economy as diversified and favorable for growth, but identified risks from economic conditions, interest rates, funding costs, monetary policy, regulation, taxation, technology, competition and global trade uncertainty.
The Bank had $317.7 million of unfunded commitments to extend credit and $26.7 million of standby letters of credit. A $2.4 million allowance related to letters of credit for a commercial borrower that declared bankruptcy in 2018 remained outstanding.
Management considered available-for-sale securities with $683 thousand of unrealized losses to be temporarily impaired and recorded no other-than-temporary impairment charge.
The company held $2.7 million of other real estate owned, including a property carried at approximately $2.6 million that management expected to sell in 2019 without an anticipated loss.
Management expected 2019 pension expense of approximately $420 thousand, compared with $500 thousand in 2018.
The Corporation is evaluating the current expected credit loss standard. The filing states that implementation could result in earlier and potentially larger credit-loss recognition; the CECL model was being run in test mode during the second quarter of 2019. The filing identified a January 2023 effective date for the company.
Management stated that no material litigation proceedings were pending, but noted that outcomes of other legal matters could not be estimated. The previously accrued $10.0 million settlement related to the Kalan litigation was paid in May 2018.

Most important facts for investors to verify

Whether the recent increase in nonaccrual, nonperforming and watch-list loans stabilizes or leads to higher provisions and charge-offs.
The sustainability of earnings growth after excluding the unusually high 2018 credit-loss provisions and related off-balance-sheet credit-loss expense.
The effect of rising deposit costs and changing interest rates on the 3.75% net interest margin.
The quality and concentration of the commercial real estate, municipal, construction and purchased-participation portfolios.
The ultimate impact and implementation timing of CECL on the allowance for loan losses and capital.
Execution of the commercial-lending strategy, mortgage-production expansion and reduction in relationship-light loan participations.
Progress on the significant other-real-estate-owned property and the $2.4 million standby-letter-of-credit exposure.
Future share repurchases, dividends and their effect on capital ratios and tangible book value.