Franklin Financial Services Corporation — 2011 Form 10-K Summary
Business context and reporting period
The filing reports fiscal-year results for the year ended December 31, 2011; it is an annual report rather than a quarterly filing. Franklin Financial Services Corporation is a Pennsylvania bank holding company conducting substantially all operations through Farmers and Merchants Trust Company, a community bank with 25 offices in south-central Pennsylvania. The Bank provides commercial, retail, mortgage, consumer, trust and investment services.
The Bank had approximately $986.3 million of assets at year-end, 274 full-time-equivalent employees and approximately 10% of deposits in its primary market. Its common stock trades thinly on the OTC Bulletin Board under “FRAF.”
Key financial metrics
| Metric | 2011 | 2010 | Change |
|---|---|---|---|
| Total assets | $990.2 million | $951.9 million | 4.0% increase |
| Gross loans | $766.4 million | $748.6 million | 2.4% increase |
| Net loans | $756.7 million | $739.8 million | 2.3% increase |
| Total deposits | $788.0 million | $734.3 million | 7.3% increase |
| Long-term debt | $48.3 million | $70.9 million | 31.8% decrease |
| Shareholders’ equity | $87.2 million | $82.6 million | 5.5% increase |
| Net interest income | $32.6 million | $30.8 million | 5.8% increase |
| Net interest margin | 3.73% | 3.53% | 20 basis-point increase |
| Net income | $6.6 million | $7.6 million | 13.7% decrease |
| Diluted EPS | $1.66 | $1.96 | 15.3% decrease |
| Return on average assets | 0.66% | 0.78% | Down 12 basis points |
| Return on average equity | 7.68% | 9.34% | Down 166 basis points |
Noninterest income increased 8.9% to $10.2 million, while noninterest expense increased 7.2% to $28.3 million. The efficiency ratio was 63.46%, essentially unchanged from 63.43% in 2010. The effective tax rate was unusually low at approximately 5.9% based on management’s discussion, although the income-tax note reports 3.9%; the filing text contains this inconsistency. A second-quarter tax-system correction generated approximately $755 thousand of 2011 tax benefits, including $660 thousand related to prior years.
Cash flow, liquidity and capital
- Net cash provided by operating activities was $15.1 million, compared with $12.4 million in 2010.
- Investing activities used $33.6 million, primarily because loan growth and purchases of investment securities exceeded security maturities and sales.
- Financing activities provided $30.5 million, principally from growth in demand, NOW and savings deposits.
- Cash and cash equivalents increased to $34.1 million from $22.1 million.
- The Bank had approximately $31 million available under its FHLB line and approximately $26 million of unsecured correspondent-bank lines at year-end. It also had approximately $23 million of Federal Reserve Discount Window borrowing capacity.
- The FHLB placed the Bank on full collateral-delivery status in December 2011, reducing borrowing capacity relative to prior arrangements. Management implemented a plan involving callable CDs, liability restructuring and additional collateral delivery.
- Capital remained strong: the Corporation reported a 12.14% total risk-based capital ratio, 10.89% Tier 1 risk-based ratio and 8.40% Tier 1 leverage ratio. The Bank was classified as well capitalized.
Material changes versus the prior comparable period
- Net income declined by approximately $1.0 million, primarily because the provision for loan losses more than doubled to $7.5 million from $3.2 million.
- Net charge-offs increased to $6.6 million from $3.4 million, and the charge-off ratio rose to 0.86% from 0.45%.
- The allowance for loan losses increased to $9.7 million, or 1.27% of loans, from $8.8 million, or 1.18%.
- Credit-quality ratios improved modestly: nonperforming loans declined to $22.5 million from $27.5 million, and nonperforming loans as a percentage of gross loans declined to 2.94% from 3.68%. However, other real estate owned increased to $3.2 million from $0.6 million.
- Commercial lending drove growth. Commercial, industrial and agricultural real estate loans increased to $359.0 million from $304.2 million, and commercial and industrial loans increased to $182.7 million from $146.7 million. Residential construction loans declined sharply to $21.3 million from $79.6 million.
- Deposit growth was concentrated in liquid products: money market deposits increased to $326.2 million from $289.8 million, while retail time deposits declined to $147.5 million from $161.4 million.
- FHLB debt declined by $22.5 million after scheduled repayments and $15.6 million of early prepayments. The Bank incurred approximately $344 thousand of penalties on prepaid advances.
- Noninterest income benefited from a $538 thousand recovery of prior legal expenses, higher debit-card fees and lower securities impairment charges. Debit-card income exceeded $1.0 million, up 16.1%.
- The quarterly pattern was uneven: quarterly net income was $1.85 million, $1.76 million, $1.06 million and $1.90 million, respectively, from the first through fourth quarters.
Guidance, outlook, risks and unusual items
- Management expected short-term interest rates to remain at historically low levels into 2014, creating continued pressure on asset yields and net interest income. Management expected funding costs to decline further as higher-cost FHLB advances mature or are replaced.
- Commercial lending is expected to remain the primary source of loan growth. Residential mortgage, home-equity and consumer lending were expected to remain slow, while the indirect consumer portfolio was expected to run off substantially by the end of 2012.
- Management expected 2012 net charge-offs to be below 2011 levels, but acknowledged that nonperforming loans could remain elevated and that foreclosure and collection expenses could increase.
- The loan portfolio is concentrated in south-central Pennsylvania and approximately 75% of loans were secured by real estate, including 47% in commercial, industrial and agricultural real estate. Declining property values or localized economic weakness could produce additional losses.
- The watch list increased to $93.5 million from $69.9 million, and potential problem loans increased to $71.0 million from $42.4 million. Five relationships represented approximately 71% of nonaccrual loans.
- At the time of filing, a review of a $5.2 million loan participation was incomplete. A preliminary estimate indicated a possible additional pretax loss of $0 to $1.1 million, in addition to a $467 thousand specific reserve.
- The investment portfolio included $4.6 million of trust-preferred securities with $1.3 million of unrealized losses and $2.9 million of private-label mortgage-backed securities with $0.5 million of unrealized losses. Additional write-downs remained possible if credit performance deteriorated.
- The Bank was participating in litigation concerning alleged misrepresentations related to certain private-label mortgage-backed securities. Management did not expect ordinary-course litigation to have a material adverse effect, but outcomes remain uncertain.
- Off-balance-sheet commitments included $221.6 million of unused lending commitments and $28.2 million of standby letters of credit. Management stated that expected draws could be funded in the normal course.
- The Corporation declared regular cash dividends of $1.08 per share, or $0.27 per quarter. Dividend capacity depends on the Bank’s earnings, capital and regulatory restrictions.
- The independent auditor issued unqualified opinions on the consolidated financial statements and internal control over financial reporting.
Most important facts for investors to verify
- Reconcile the reported 2011 effective tax rate discrepancy between the MD&A and Note 12, and assess the recurring versus nonrecurring benefit from the tax-system correction.
- Review subsequent credit performance, updated appraisals and potential loss exposure for the $5.2 million loan participation, including the additional February 2012 charge-off disclosed for another nonaccrual credit.
- Assess whether the $9.7 million allowance adequately covers the $22.5 million of nonperforming loans, $93.5 million watch list and $71.0 million of potential problem loans.
- Evaluate the effect of FHLB collateral-delivery status and 2012 debt maturities on liquidity, funding costs and contingency funding capacity.
- Monitor commercial real estate concentration, local property values, construction exposure and other real estate owned for further deterioration.
- Verify the sustainability of the $1.08 per-share dividend against earnings, payout ratio, capital requirements and the Bank’s ability to upstream dividends.
- Review the carrying values and future impairment risk of trust-preferred securities, private-label mortgage-backed securities and FHLB restricted stock.