FRANKLIN FINANCIAL SERVICES CORP quarterly report, Q1 FY2012

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Franklin Financial Services Corporation — Q1 2012 Form 10-Q

Business context and reporting period

Franklin Financial Services Corporation is a Pennsylvania-based bank holding company whose principal subsidiary is Farmers and Merchants Trust Company of Chambersburg. The unaudited report covers the three months ended March 31, 2012, compared primarily with the three months ended March 31, 2011 and December 31, 2011 balance-sheet amounts.

Financial performance and condition

  • Net income: $1.369 million, down 26.0% from $1.849 million; diluted EPS was $0.34 versus $0.47.
  • Revenue: Interest income was $9.951 million and noninterest income was $2.563 million, producing total revenue of approximately $12.514 million, down approximately $308 thousand year over year.
  • Net interest income: $7.984 million, up 1.1% from $7.895 million. The tax-equivalent net interest margin declined to 3.57% from 3.71% because asset yields fell faster than funding costs.
  • Credit costs: The provision for loan losses increased to $1.950 million from $900 thousand. Net charge-offs were $2.166 million versus $503 thousand, primarily reflecting a $1.6 million charge-off on a commercial real estate loan.
  • Noninterest expense: $7.010 million, essentially unchanged from $7.022 million. The efficiency ratio improved to 64.15% from 65.88%.
  • Profitability: Annualized return on average assets was 0.55% versus 0.78%; return on average equity was 6.33% versus 8.98%.
  • Assets and loans: Total assets were $1.036 billion, up $45.7 million, while gross loans declined 0.4% to $763.6 million and net loans declined 0.3% to $754.1 million.
  • Deposits and liquidity: Deposits increased 6.0% to $835.5 million. Cash and cash equivalents rose to $86.4 million from $34.1 million at year-end, supported primarily by deposit growth and financing activities.
  • Debt: Securities sold under repurchase agreements were $52.3 million and long-term debt was $46.7 million, compared with $48.3 million at December 31, 2011.
  • Capital: Shareholders’ equity increased to $88.3 million. The Corporation and Bank remained well capitalized; the Corporation’s total risk-based capital ratio was 12.18% and leverage ratio was 8.39%.
  • Cash flow: Operating cash flow was $3.3 million, investing cash flow was $4.5 million, financing cash flow was $44.5 million, and the net increase in cash and cash equivalents was $52.2 million.

Material changes versus comparable periods

  • Net income and EPS declined primarily because the loan-loss provision increased by $1.05 million.
  • Funding costs improved: interest expense fell $438 thousand to $1.967 million, and the average cost of interest-bearing liabilities fell to 0.98% from 1.27%.
  • Noninterest income increased 1.6%, with higher investment and trust fees, ATM and other service fees, debit-card income, and property-sale and insurance-recovery income. This partly offset lower loan service charges, which benefited from a $243 thousand prepayment penalty in the prior-year period.
  • Nonperforming loans increased to $25.8 million from $22.5 million, and nonperforming assets increased to $28.9 million from $25.8 million. The nonperforming-loan ratio rose to 3.38% from 2.94%.
  • The allowance for loan losses declined to $9.5 million from $9.7 million despite the higher provision, because charge-offs exceeded the provision. Coverage of nonperforming loans declined to 36.84% from 43.16%.
  • Commercial real estate loans increased 3.1% to $370.0 million, while residential construction loans declined 28.1% to $15.3 million and consumer loans declined 8.3% to $12.3 million.
  • The investment portfolio declined to $121.7 million from $125.3 million, while net unrealized gains improved to approximately $1.7 million. No other-than-temporary impairment charges were recorded.
  • The Board reduced the regular quarterly dividend declared for Q2 2012 to $0.17 per share from $0.27 per share, citing lower earnings and an uncertain economic and regulatory environment.

Guidance, outlook, commentary, risks and unusual items

  • Management expects commercial lending to remain the primary source of loan growth, while residential mortgage and consumer portfolios are expected to continue running off or remain subdued.
  • Management expects investment-portfolio yields to continue declining as higher-yielding securities mature or pay down and reinvestment rates remain low.
  • The Federal Reserve’s low-rate policy was viewed as unfavorable for bank earnings and was expected to pressure the yield curve and net interest margin.
  • Management expects pension expense of approximately $1.1 million for 2012 and plans to contribute $1.2 million to the pension plan.
  • Loan quality deteriorated during the quarter. Watch-list loans increased to $100.3 million from $93.5 million, and potential problem loans increased to $74.5 million from $71.0 million.
  • Two residential real estate development relationships totaling approximately $5.2 million were added to impaired loans; one $2.9 million relationship was restructured as a troubled debt restructuring. Nine contracts totaling $5.4 million were recorded as new TDRs during the quarter.
  • The Bank’s investment portfolio included trust-preferred securities with fair value of $4.6 million and unrealized losses of $1.3 million, plus private-label mortgage-backed securities with fair value of $2.8 million and unrealized losses of $346 thousand. Management considered these impairments temporary, but noted that additional write-downs could occur if loss trends continue.
  • Approximately 85% of the debt investment portfolio was pledged as collateral. The Bank reported approximately $28 million available under its FHLB line, $16 million in unsecured correspondent-bank lines, and approximately $57 million available through the Federal Reserve Discount Window.
  • Unused loan commitments and standby letters of credit totaled approximately $255.0 million; standby letters of credit alone were $28.7 million. Management stated that liquidity was sufficient to meet anticipated demands.
  • Management identified economic conditions, interest rates, funding costs, monetary policy, regulation, taxation, competition, technology, collateral values and credit quality as principal risks. No material changes to previously disclosed risk factors or market-risk exposure were reported.
  • No material pending legal proceedings were reported. Disclosure controls and procedures were judged effective as of March 31, 2012.

Important facts for investors to verify

  • Whether the increase in nonperforming loans, impaired loans, watch-list loans and TDRs leads to additional charge-offs or provision expense.
  • The adequacy of the $9.5 million allowance for loan losses relative to the 3.38% nonperforming-loan ratio and 36.84% coverage ratio.
  • Performance and valuation of commercial real estate exposures, residential development loans, trust-preferred securities and private-label mortgage-backed securities.
  • Whether the reduced $0.17 quarterly dividend is temporary or signals a sustained change in payout policy.
  • The sustainability of deposit growth, reliance on brokered deposits, and available borrowing capacity after pledged collateral and maturing FHLB obligations.
  • The effect of continued low interest rates and declining asset yields on net interest margin and future earnings.
  • The filing’s statement that first-quarter results are not necessarily indicative of full-year results, and that forward-looking expectations remain subject to economic, regulatory and credit-market uncertainty.