FRAF

Business Context and Reporting Period

Company: Franklin Financial Services Corp (and subsidiaries, including Farmers and Merchants Trust Company of Chambersburg)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: June 30, 2009
Business Overview: A Pennsylvania-based bank holding company operating primarily in Franklin, Cumberland, Fulton, and Huntingdon Counties. The company provides commercial banking, trust, and mortgage services.

Key Financial Metrics (Six Months Ended June 30, 2009)

Key Ratios (Annualized):
- Return on Average Equity (ROE): 9.99%
- Return on Average Assets (ROA): 0.80%
- Net Interest Margin: 3.54%
- Efficiency Ratio: 65.09%

Material Changes vs. Prior Period

• Profitability Decline: Net income decreased 25% to $3.74 million from $4.98 million in the prior year period. Diluted EPS fell to $0.98 from $1.30.
• Net Interest Margin Compression: The net interest margin declined to 3.54% from 4.10% year-over-year due to a 93 basis point drop in asset yields, while liability costs only decreased by 51 basis points.
• Expense Increases: Noninterest expense rose 10.4% to $13.1 million. Significant drivers included a $809,000 increase in FDIC insurance (due to a special assessment) and higher pension expenses ($255k expense vs. $21k income in 2008).
• Asset Growth: Total assets increased $64.2 million to $966.7 million. Net loans grew $26.6 million, driven by a $36.7 million increase in commercial, industrial, and agricultural loans, partially offset by declines in residential mortgage and consumer loans.
• Deposit Growth: Total deposits increased $82.7 million (13.2%), with significant growth in time deposits ($65.6 million increase), including $29.7 million in brokered time deposits.
• Credit Quality Deterioration: Nonperforming assets rose to 1.26% of total assets (from 0.44% at year-end 2008). Nonperforming loans increased to $11.7 million, driven by construction/land development and agricultural credits. The allowance coverage ratio for nonperforming loans dropped to 67.62% from 183.93%.

Guidance, Outlook, Risks, and Unusual Items

• Outlook: Management expects net interest margin to remain under pressure if short-term rates stay low. Loan growth is projected to continue, but the mortgage portfolio is expected to run off as the bank originates but does not retain loans.
• Capital Management: The dividend payout ratio increased to 55% due to lower earnings. Management decided not to increase the dividend in Q2 to preserve capital and is exploring other capital sources.
• Subsequent Event (CIT Group): The bank holds $3 million in debt securities issued by CIT Group, Inc. Following news of CIT's liquidity issues and a discount tender offer, the bank accepted the offer. If successful, the bank expects a pretax loss of $250,000 on the August 2009 bond. A larger loss is possible if CIT declares bankruptcy.
• Investment Portfolio: The portfolio contains $6.8 million in unrealized losses on 129 securities. Management deemed impairments on debt securities temporary. However, $421,000 in other-than-temporary impairment charges were recognized on equity securities.
• FDIC Assessment: A $450,000 special assessment is payable in September 2009, with a potential additional assessment of up to 5 basis points later in the year.

Investor Verification Checklist

• CIT Group Exposure: Verify the final outcome of the CIT tender offer and potential impact on the $3 million holding.
• Nonperforming Loans: Monitor the specific construction and agricultural credits driving the rise in nonperforming assets and the adequacy of the allowance coverage ratio (currently 67.62%).
• FDIC Assessments: Confirm the timing and total cost of the special assessments and any future basis point increases.
• Net Interest Margin: Track the spread between asset yields and liability costs in a low-rate environment.
• Brokered Deposits: Assess the stability and cost of the $46.2 million in brokered time deposits.