Franklin Financial Services Corporation — 2017 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, 2017, with comparative information for 2016 and 2015. The company’s common stock trades thinly on the OTCQX market under “FRAF.”
Financial performance and condition
| Metric | 2017 | 2016 | Change |
|---|---|---|---|
| Total assets | $1.180 billion | $1.127 billion | +4.7% |
| Gross loans | $943.7 million | $893.9 million | +5.6% |
| Net loans | $931.9 million | $882.8 million | +5.6% |
| Deposits | $1.047 billion | $982.1 million | +6.6% |
| Shareholders’ equity | $115.1 million | $116.5 million | -1.2% |
| Net interest income | $37.4 million | $34.7 million | +7.7% |
| Noninterest income | $12.2 million | $11.6 million | +5.0% |
| Noninterest expense | $43.2 million | $33.2 million | +30.1% |
| Net income | $2.2 million | $8.1 million | -73.1% |
| Diluted EPS | $0.50 | $1.88 | -73.4% |
The fully tax-equivalent net interest margin increased to 3.72% from 3.62%, supported by loan growth, higher loan yields and three Federal Reserve rate increases. The efficiency ratio deteriorated to 82.59% from 68.26%, primarily because of the $10 million legal settlement reserve. Return on average assets declined to 0.19% from 0.74%, and return on average equity declined to 1.80% from 7.04%.
Credit quality improved. Nonperforming loans declined to $2.7 million, or 0.28% of gross loans, from $5.4 million, or 0.61%. Nonperforming assets declined to $5.3 million, or 0.45% of assets, from $10.4 million, or 0.92%. The allowance for loan losses was $11.8 million, or 1.25% of loans, compared with $11.1 million, or 1.24%. Net recoveries were $47 thousand in 2017 versus $2.8 million of net charge-offs in 2016.
Commercial lending represented $719.9 million, or approximately 76%, of gross loans; management separately states that commercial-purpose loans represented 84% of the portfolio. Approximately 68% of loans were secured by real estate. Trust assets under management increased to $686.9 million from $622.6 million, supporting higher investment and trust-services fees.
Operating cash flow was $16.3 million, compared with $14.9 million in 2016. Investing activities used $32.2 million, principally because of a $49.9 million net increase in loans. Financing activities provided $37.9 million, principally from deposit growth. Cash and cash equivalents increased to $58.6 million from $36.7 million.
The Bank had no long-term debt and no short-term borrowings outstanding at December 31, 2017. It had $314.6 million of available FHLB borrowing capacity, approximately $20 million of Federal Reserve Discount Window capacity and a $6 million unsecured correspondent-bank line. Liquidity is principally dependent on deposits and access to FHLB funding.
Capital remained strong. The Corporation reported a 14.06% CET1 ratio, 15.31% total risk-based capital ratio and 9.73% Tier 1 leverage ratio. The Bank was classified as well capitalized under Basel III, with a 15.19% total risk-based capital ratio and a 9.64% Tier 1 leverage ratio.
Material changes versus the prior comparable period
- Net income fell $5.9 million, principally because of the $10 million legal settlement accrual and a $2.3 million deferred-tax-asset revaluation charge.
- Excluding the tax revaluation, management reported an estimated 2017 effective tax rate of 22.1%, versus the reported 62.1% rate.
- Net interest income increased $2.7 million and noninterest income increased $584 thousand, led by investment and trust-services fees.
- The provision for loan losses decreased to $670 thousand from $3.8 million, reflecting improved credit performance and the absence of the prior-year $2.7 million commercial real estate charge-off.
- Loans increased $49.8 million, led by commercial real estate and commercial loans, while residential real estate loans declined $10.0 million.
- Deposits increased $65.1 million, with noninterest-bearing checking and interest-bearing checking showing strong growth; money-management balances declined modestly.
- Investment securities declined to $127.3 million from $143.9 million as maturities and calls exceeded purchases. Temporary unrealized losses declined to $1.0 million from $1.6 million.
- Quarterly results show a fourth-quarter net loss of $7.3 million, or $1.67 diluted loss per share, driven by the legal reserve and tax revaluation. The first three quarters were profitable.
Guidance, outlook, commentary and risks
Management did not provide formal earnings or revenue guidance. It expects commercial lending to remain the primary source of loan growth and expects purchased loan participations to decline. Management expects monetary-policy normalization to be gradual, but the timing and magnitude of 2018 rate changes were described as uncertain.
The December 2017 Tax Cuts and Jobs Act reduced the federal corporate tax rate to 21% beginning January 1, 2018. The company expects a future tax benefit overall but recognized a $2.3 million 2017 charge from revaluing deferred tax assets.
The Kalan putative class action alleges ERISA, RICO and fiduciary-duty violations and sought at least $40 million of damages. The Bank entered into a December 29, 2017 settlement term sheet requiring a $10 million payment, accrued in 2017, subject to preliminary and final court approval. Management expects additional legal expenses until the matter is fully resolved.
Key risks include concentration in commercial and real-estate lending within a limited geographic area; potential insufficiency of the allowance for loan losses; interest-rate and funding-cost pressure; reliance on short-term certificates of deposit and FHLB funding; intense competition; cyber and operational risks; market sensitivity of trust-management fees; and the limited trading market for the common stock. Approximately $49.3 million, or 65%, of certificates of deposit were scheduled to mature within one year.
Off-balance-sheet commitments included $300.1 million of unused commitments to extend credit and $28.6 million of standby letters of credit. The company believes expected draws can be funded in the normal course, but these commitments expose the Bank to credit and liquidity risk.
The independent auditor, BDO USA, LLP, issued unqualified opinions on the consolidated financial statements and internal control over financial reporting. Management and the auditor concluded that disclosure controls and internal control over financial reporting were effective as of December 31, 2017.
Most important facts for investors to verify
- Confirm final court approval, payment timing and any additional costs related to the $10 million Kalan settlement.
- Assess whether the sharp decline in 2017 earnings is primarily nonrecurring or signals a sustained deterioration in operating efficiency.
- Monitor commercial real estate and commercial-loan concentrations, collateral values, watch-list loans and allowance adequacy.
- Evaluate the effect of rising deposit costs and future Federal Reserve rate changes on the 3.72% net interest margin.
- Track retention of the $49.3 million of certificates of deposit maturing within one year and continued availability of FHLB liquidity.
- Assess the effect of the 21% corporate tax rate on future earnings and deferred-tax balances.
- Review the pending CECL credit-loss standard, expected to be adopted in 2020, which management anticipates may result in earlier and potentially larger loss recognition.
- Verify the filing’s inconsistent narrative reference stating that 2017 net income was down from “2017”; the comparative amount is clearly 2016.