Franklin Financial Services Corporation — 2019 Form 10-K Summary
Business context and reporting period
Franklin Financial Services Corporation is a Pennsylvania bank holding company conducting substantially all business through wholly owned Farmers and Merchants Trust Company of Chambersburg. The Bank operates 22 community banking offices in south-central Pennsylvania and provides commercial, retail, mortgage, consumer, trust and investment services. The filing covers the fiscal year ended December 31, 2019, with comparative information for 2018.
Key financial metrics
| Metric | 2019 | 2018 | Change |
|---|---|---|---|
| Total assets | $1.269 billion | $1.210 billion | +4.9% |
| Total deposits | $1.125 billion | $1.083 billion | +3.9% |
| Gross loans | $934.6 million | $973.4 million | -4.0% |
| Net loans | $922.6 million | $961.0 million | -4.0% |
| Net interest income | $42.1 million | $40.7 million | +3.6% |
| Provision for loan losses | $0.2 million | $10.0 million | -$9.7 million |
| Noninterest income | $15.4 million | $12.6 million | +22.1% |
| Noninterest expense | $38.3 million | $37.4 million | +2.5% |
| Net income | $16.1 million | $6.1 million | +163.1% |
| Diluted EPS | $3.67 | $1.39 | +164.0% |
| Net interest margin | 3.68% | 3.78% | -10 bps |
| Return on average assets | 1.29% | 0.52% | +77 bps |
| Return on average equity | 13.17% | 5.34% | +783 bps |
Net income benefited substantially from the lower loan-loss provision compared with 2018, when a loan participation impairment materially increased credit costs. Interest income rose $4.4 million, but interest expense increased $2.9 million as the cost of interest-bearing funds rose from 0.49% to 0.78%. The efficiency ratio improved to 65.36% from 68.27%.
Noninterest income growth was supported by investment and trust services fees, mortgage production fees, securities gains, property-sale gains and other unusual items. Investment and trust services fees were $6.1 million, including approximately $5.5 million of asset-management fees. Trust and investment assets under management increased to $790.9 million from $684.8 million.
Net cash provided by operating activities was $19.0 million, compared with $9.3 million in 2018. Investing activities used $23.5 million, primarily reflecting $104.8 million of securities purchases offset by securities cash flows and a $38.1 million net decrease in loans. Financing activities provided $35.4 million. Cash and cash equivalents increased to $83.8 million from $53.0 million.
The Bank had no long-term debt outstanding at year-end and no ending short-term borrowings. FHLB borrowing capacity was $378.9 million, all available; additional liquidity included approximately $16 million of Federal Reserve Discount Window capacity and a $6.0 million unsecured correspondent line. Shareholders’ equity increased to $127.5 million from $118.4 million. Dividends paid were $5.1 million, or $1.17 per share, and treasury-stock purchases totaled $3.8 million.
Material changes versus the prior comparable period
- Net income increased by $10.0 million, primarily because the 2018 results included a $10.0 million loan participation-related legal settlement expense and $9.95 million of loan-loss provision expense.
- The 2019 loan-loss provision declined to $237 thousand from $9.954 million. Net charge-offs were $686 thousand, compared with $9.331 million in 2018; the allowance remained 1.28% of gross loans.
- Gross loans declined $38.8 million, primarily from approximately $35 million of purchased participation payoffs. Management continued shifting toward in-market lending and away from loans without direct customer relationships.
- Investment securities increased to $187.4 million from $131.5 million, while interest-bearing deposits in other banks increased to approximately $77.2 million from $36.0 million.
- Deposits grew $42.8 million, led by interest-bearing commercial and municipal deposits and higher time deposits.
- Noninterest expense increased $945 thousand, principally from salaries and benefits, data processing, professional fees and a building feasibility study. The 2018 expense base included a $2.4 million provision for off-balance-sheet credit losses that was not repeated in 2019.
- The Corporation adopted the new lease standard in 2019, recognizing a right-of-use asset and lease liability of approximately $6.2 million without a material effect on earnings or retained earnings.
- Other real estate owned declined to zero from $2.7 million after property dispositions, producing a $326 thousand net gain in noninterest income.
Credit quality, capital and liquidity
Credit metrics remained manageable but deteriorated in selected areas. Nonperforming assets declined to $3.9 million, or 0.31% of total assets, from $5.3 million, but nonaccrual loans increased to $3.8 million from $2.3 million. Nonperforming loans were 0.42% of gross loans versus 0.27% in 2018. Watch-list loans increased to $11.6 million from $10.3 million, including a $5.2 million commercial real estate loan downgraded to OAEM. Commercial real estate represented 53% of gross loans, and approximately 75% of loans were secured by real estate.
At December 31, 2019, the Bank was well capitalized under Basel III. Its common equity Tier 1, Tier 1 risk-based, total risk-based and Tier 1 leverage ratios were 14.62%, 14.62%, 15.87% and 9.59%, respectively. The Bank’s capital conservation buffer was 7.87%, well above the 2.50% regulatory buffer. Management expected not to elect the community bank leverage ratio framework.
Outlook, management commentary, risks and unusual items
Management described the local economy as diversified and generally supportive of growth, but identified intense competition, limited geographic diversification and pressure on traditional banking margins. The Bank expects commercial lending to remain the primary area of future loan growth, primarily through in-market relationships.
The filing was signed March 13, 2020 and discusses significant early-2020 uncertainty related to COVID-19, potential supply-chain disruption, recession risk, market volatility, low Treasury yields and possible additional Federal Reserve rate cuts. The filing does not provide formal quantitative earnings guidance.
- Interest-rate risk is significant. The Bank reported a negative cumulative one-year repricing gap and projected that a 100-basis-point rate decline would reduce one-year net interest income by 4.5%, while a 100-basis-point increase would increase it by 3.2%, based on management’s model.
- Commercial real estate and commercial loans are concentrated in south-central Pennsylvania and depend heavily on borrower cash flow and collateral values.
- Short-term funding sensitivity is material: 70% of certificates of deposit, or $62.3 million, mature within one year, and money-management deposits of $429.2 million generally reprice with market rates.
- Liquidity relies significantly on access to the FHLB. Management believes anticipated liquidity needs can be met, but loss of FHLB access could materially impair liquidity management.
- Off-balance-sheet commitments included $310.2 million of commitments to extend credit and $26.4 million of standby letters of credit. A $2.4 million allowance related to letters of credit issued for a bankrupt commercial borrower remained outstanding at year-end; one $250 thousand letter was cancelled in February 2020.
- The Bank has material contracts indexed to LIBOR and was evaluating transition options, including SOFR, ahead of the anticipated end of LIBOR-based submissions after 2021.
- Management identified cybersecurity, changing consumer-protection regulation, competition, market-sensitive trust fees and possible insufficiency of the loan-loss allowance as principal risks.
- Goodwill of $9.0 million was tested using a qualitative assessment and was not considered impaired. Securities with $1.686 million of unrealized losses were deemed temporarily impaired, with no other-than-temporary impairment charge recorded.
- The independent auditor reported an unqualified opinion on the 2019 financial statements and effective internal control over financial reporting.
Most important facts for investors to verify
- Whether the reduction in loan balances and purchased participations is offset by sustainable in-market commercial loan growth.
- Trends in nonaccrual loans, watch-list loans, commercial real estate exposure and charge-offs as economic conditions change.
- Whether the $11.966 million allowance for loan losses remains adequate, particularly before adoption of the expected-credit-loss model scheduled for 2023.
- The effect of lower interest rates on the negative one-year repricing position, deposit costs and net interest margin.
- Retention and repricing behavior for money-management accounts and the $62.3 million of certificates of deposit maturing within one year.
- Continued access to the $378.9 million of FHLB capacity and other contingent liquidity sources.
- Potential exposure from the $310.2 million of unfunded credit commitments, $26.4 million of standby letters of credit and related bankruptcy matter.
- Progress and contractual consequences of the LIBOR transition and the anticipated implementation of the CECL credit-loss model.
- Effects of the COVID-19-related market disruption described in the filing, which occurred after the December 31, 2019 reporting date.