FRAF

Business Context and Reporting Period

Company: Franklin Financial Services Corp (FRAF)
Reporting Period: Fiscal year ended December 31, 2008
Business Overview: A Pennsylvania bank holding company operating primarily through its subsidiary, Farmers and Merchants Trust Company (F&M Trust). The bank serves Franklin, Cumberland, Fulton, and Huntingdon Counties with 25 community banking offices. Operations include commercial, retail, and trust services.
Key Event: On November 29, 2008, the Corporation completed the acquisition of Community Financial, Inc., adding approximately $62 million in trust assets under management and a new office location in Camp Hill, PA.

Key Financial Metrics

Material Changes vs. Prior Period

• Earnings Decline: Net income decreased 7.1% to $8.6 million. This decline was primarily driven by non-recurring losses on asset valuations, including a $1.2 million loss on the exchange of an equity method investment (American Home Bank) and $888,000 in write-downs on equity securities deemed other-than-temporarily impaired.
• Net Interest Income Growth: Despite falling interest rates, tax-equivalent net interest income increased 15% to $31.5 million. This was driven by a 15% increase in earning assets and a significant reduction in interest expense (down 32.6%) as the Fed Funds rate dropped from 4.25% to 0.25%.
• Asset Quality Improvement: Nonperforming loans decreased from $5.8 million (1.01% of loans) in 2007 to $4.0 million (0.59% of loans) in 2008. Net charge-offs increased to $1.2 million but remained low relative to the loan portfolio.
• Capital Position: Shareholders' equity decreased by $4.6 million, largely due to $8.4 million in unrealized losses on securities and pension adjustments recorded in Accumulated Other Comprehensive Income (AOCI).

Outlook, Risks, and Management Commentary

• Guidance & Outlook: Management expects 2009 pension expense to increase by approximately $500,000 due to low interest rates affecting plan performance. FDIC insurance assessments are expected to rise significantly in 2009, potentially exceeding $750,000, plus a special emergency assessment of 20 basis points expected to cost over $1 million.
• Strategic Decisions: The Corporation opted not to participate in the U.S. Treasury's Troubled Asset Relief Program (TARP/CPP), citing a strong capital position and a desire to avoid restrictions on dividends and share repurchases.
• Key Risks:
  • Commercial Loan Concentration: Approximately 69% of the loan portfolio consists of commercial loans, which carry higher risk than residential or consumer lending.
  • Interest Rate Risk: The bank is exposed to interest rate risk; while a falling rate environment benefited net interest income in 2008, further declines could compress margins if asset yields fall faster than liability costs.
  • Investment Portfolio: The portfolio holds $57 million in temporarily impaired securities with $7 million in unrealized losses. Management believes these are temporary, but additional write-downs on equity securities are possible in 2009.
  • Liquidity: The bank relies on the Federal Home Loan Bank (FHLB) for funding. Concerns regarding the FHLB's capital strength could impact funding availability.

Investor Verification Checklist

• Asset Quality: Verify the adequacy of the $7.4 million allowance for loan losses given the 69% concentration in commercial loans and the economic recession.
• Investment Valuation: Review the $7 million in unrealized losses on debt and equity securities to assess the risk of future "other-than-temporary" impairment charges.
• Capital Adequacy: Confirm that the bank remains "well-capitalized" under regulatory standards despite the $8.4 million reduction in equity from AOCI adjustments.
• FDIC Assessments: Monitor the impact of the new FDIC special assessment and rate increases on 2009 profitability.
• Acquisition Integration: Assess the performance of the newly acquired Community Financial, Inc. assets and the conversion of the Camp Hill office into a retail banking location.