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, operates 22 community banking offices in south-central Pennsylvania. The Bank provides commercial, retail, mortgage, consumer, trust and investment services. The audited filing covers the fiscal year ended December 31, 2015, with comparative information for 2014 and 2013. The consolidated financial statements received an unqualified audit opinion from BDO USA, LLP.
Key Financial Metrics
| Metric | 2015 | 2014 | Change |
|---|---|---|---|
| Total assets | $1.035 billion | $1.001 billion | +3.4% |
| Net loans | $771.9 million | $717.4 million | +7.6% |
| Total deposits | $918.5 million | $881.2 million | +4.2% |
| Net interest income | $32.2 million | $31.6 million | +2.0% |
| Noninterest income | $12.7 million | $11.1 million | +13.7% |
| Noninterest expense | $31.1 million | $31.6 million | -1.4% |
| Net income | $10.2 million | $8.4 million | +21.4% |
| Diluted EPS | $2.40 | $2.00 | +20.0% |
| Net interest margin | 3.59% | 3.56% | +3 basis points |
| Return on average assets | 1.00% | 0.83% | Improved |
| Return on average equity | 9.52% | 8.44% | Improved |
| Efficiency ratio | 67.39% | 70.83% | Improved |
| Cash dividends per share | $0.74 | $0.68 | +8.8% |
Cash Flow, Debt and Liquidity
- Operating activities generated $13.7 million of cash, compared with $14.4 million in 2014.
- Investing activities used $49.6 million, primarily because loan growth used $58.5 million of cash; financing activities provided $26.5 million.
- Cash and cash equivalents declined to $39.2 million from $48.6 million.
- The Bank had no long-term debt outstanding at year-end. Repurchase agreements were eliminated, and short-term borrowings were zero at year-end.
- Available liquidity included approximately $35 million under an FHLB line, $6 million under an unsecured correspondent-bank line and $24 million through the Federal Reserve Discount Window. Maximum FHLB borrowing capacity was approximately $252 million.
- Unused loan commitments were $265.4 million and standby letters of credit were $25.9 million.
Credit Quality and Capital
- The allowance for loan losses increased to $10.1 million, or 1.29% of loans, from $9.1 million, or 1.25%, in 2014.
- Net charge-offs declined to $310 thousand from $1.4 million. Nonperforming loans declined to $5.7 million, or 0.73% of gross loans, from $12.6 million, or 1.74%.
- Nonperforming assets were $12.2 million, or 1.18% of assets, compared with $16.3 million, or 1.63%, in 2014. Other real estate owned increased to $6.5 million from $3.7 million.
- Commercial loans increased 10.1% to $556.6 million and represented the primary source of loan growth. Approximately 71% of loans were secured by real estate.
- The Corporation reported a 15.08% Common Equity Tier 1 ratio, 16.34% total risk-based capital ratio and 10.59% Tier 1 leverage ratio. The Bank was classified as well capitalized under Basel III.
Material Changes Versus the Prior Comparable Period
- Net income rose $1.8 million, driven by lower funding costs, modestly higher net interest income, stronger fee income and lower operating expenses.
- Interest expense fell 25.4%, or $809 thousand, as time deposits declined, deposit costs decreased and all long-term debt matured in 2014.
- Loan balances grew $55.5 million, primarily in commercial lending, while investment securities declined $12.3 million as portfolio cash flows were redirected toward loans.
- Noninterest income increased $1.5 million. The increase included a $728 thousand gain on the conversion of an investment security and approximately $171 thousand from liquidation of an offshore insurance investment; management identified these items as nonrecurring.
- The effective tax rate declined to 18.2% from 19.3%, partly because the Corporation reduced a deferred-tax valuation allowance by $200 thousand.
- Credit metrics improved materially, although the provision for loan losses increased to $1.3 million from $764 thousand because of loan growth and changes in reserve methodology.
- Shareholders’ equity increased to $111.4 million from $103.5 million. The dividend reinvestment plan contributed approximately $1.2 million, and no shares were repurchased.
Outlook, Commentary, Risks and Unusual Items
- Management expected commercial lending and loan participations to remain the primary areas of future loan growth, while consumer lending and residential mortgage balances were expected to remain pressured.
- Management expected 2016 interest-rate normalization to be gradual. The Bank’s modeled net interest income increased under rising-rate scenarios but declined under a 100-basis-point decline scenario.
- The Bank’s cumulative one-year interest-rate gap was negative, although management stated that the benefit from further liability repricing declines was limited because deposit rates were already low.
- Management identified commercial real estate concentration, real-estate collateral values, allowance adequacy, local economic conditions, competition, interest-rate changes, cybersecurity and operational disruptions as material risks.
- Investment securities included $5.3 million of trust-preferred securities with a $669 thousand unrealized loss and $1.4 million of private-label mortgage-backed securities. The filing states that additional write-downs could occur if loss trends continue.
- Other real estate owned increased because of foreclosures and included a $3.0 million commercial property acquired in 2015. A $250 thousand valuation reduction was recorded on another property.
- The pension plan was slightly underfunded at year-end by $308 thousand. Management noted that adopting newer mortality tables could reduce funded status by an estimated $1.6 million and increase 2016 pension expense by $272 thousand over its existing estimate.
- The filing reports no material pending legal proceedings, no unresolved SEC staff comments and effective disclosure and internal financial reporting controls.
Important Facts for Investors to Verify
- Verify whether the 2015 earnings increase is sustainable after excluding the $728 thousand investment-security conversion gain, other nonrecurring income and the tax valuation-allowance benefit.
- Review commercial real estate and commercial loan concentrations, purchased loan participations, collateral values and the adequacy of the $10.1 million allowance for loan losses.
- Monitor the increase in other real estate owned and the potential for further valuation adjustments or foreclosure-related losses.
- Assess sensitivity to interest-rate changes, particularly the negative cumulative one-year repricing gap and the large concentration of variable-rate commercial loans.
- Evaluate liquidity against $265.4 million of unused commitments, $25.9 million of standby letters of credit and the decline in cash and cash equivalents.
- Review the investment portfolio’s trust-preferred and private-label mortgage-backed securities for credit deterioration and potential other-than-temporary impairment.
- Consider regulatory dividend restrictions, the phase-in of the Basel III capital conservation buffer and the Corporation’s dependence on dividends from its Bank subsidiary.
- Account for the limited trading market for the OTCQX-listed common stock and the resulting liquidity risk for shareholders.