ORRSTOWN FINANCIAL SERVICES INC quarterly report, Q1 FY2020

Orrstown Financial Services, Inc. — Q1 2020 Form 10-Q

Reporting period: Three months ended March 31, 2020. Orrstown is a community banking holding company serving Pennsylvania and Maryland. Results include the impact of the May 2019 Hamilton Bancorp acquisition; year-over-year comparisons are therefore not fully comparable.

Financial performance and position

MetricQ1 2020 / March 31, 2020Comparable period / prior year-end
Net income$5.1 million; diluted EPS $0.46$3.1 million; diluted EPS $0.33 in Q1 2019
Net interest income$18.3 million$14.8 million in Q1 2019
Net interest margin3.41% on a taxable-equivalent basis; 3.21% excluding purchase-accounting effects3.43%; 3.36% excluding purchase accounting in Q1 2019
Noninterest income$7.1 million, including $1.9 million gain on portfolio loan sales$5.1 million in Q1 2019
Noninterest expense$18.3 million$16.2 million in Q1 2019
Provision for loan losses$925,000$400,000 in Q1 2019
Loans / allowanceLoans $1.657 billion; allowance $15.8 million, or 0.95% of loansLoans $1.644 billion; allowance $14.7 million, or 0.89%, at December 31, 2019
Deposits / cashDeposits $1.897 billion; cash and cash equivalents $57.1 millionDeposits $1.876 billion; cash $56.0 million at December 31, 2019
BorrowingsFHLB advances $201.2 million; repurchase agreements $10.9 million; subordinated notes $31.9 millionAt December 31, 2019: $209.7 million, $8.3 million and $31.8 million, respectively
Shareholders’ equity$210.6 million; tangible book value per share $16.53$223.2 million; $17.65 at December 31, 2019
Operating cash flow$4.4 million provided$429,000 provided in Q1 2019

Material changes and operating drivers

  • Net income rose year over year, supported by higher net interest income and noninterest income. Average earning assets and liabilities increased substantially, primarily following the Hamilton acquisition.
  • Loan interest income increased $5.0 million year over year; securities interest income fell $612,000, and interest expense increased $807,000. The reported loan yield was 4.93% in both periods, supported in part by purchase-accounting accretion.
  • Noninterest income included gains from selling $9.2 million of classified loans and an $11.0 million recreational-vehicle loan portfolio. These sales generated $1.878 million of total gains.
  • Noninterest expense increased 13.3%, mainly reflecting acquired and expanded operations, compensation and intangible amortization. Q1 2020 included a $486,000 recovery of a prior-year insurance-claim write-off; Q1 2019 included $645,000 of merger and branch-consolidation costs.
  • Net recoveries were $223,000 in Q1 2020, versus net charge-offs of $131,000 in Q1 2019. Nonperforming loans were 0.47% of loans, compared with 0.65% at year-end; management said the decline partly reflected a $2.6 million acquired loan being reclassified to the purchased-credit-impaired pool.
  • Shareholders’ equity declined $12.7 million, principally because of a $14.6 million after-tax other comprehensive loss, including securities and cash-flow-hedge valuation losses, partly offset by net income.

Outlook, risks and unusual items

  • COVID-19: Management increased qualitative credit-loss assumptions and the loan-loss provision. It warned that the pandemic, economic contraction, unemployment and market volatility could materially affect credit estimates, asset values, earnings, liquidity and capital. No specific full-year earnings guidance was provided.
  • PPP and loan deferrals: After quarter-end, through May 5, the Bank had funded nearly 2,000 Paycheck Protection Program loans totaling $423.8 million; it anticipated approximately 2,500 loans totaling $450.0 million. Expected fees exceeded $12 million, to be recognized through net interest income over the loans’ estimated six-month life. By April 30, it had processed deferrals on $179.6 million of commercial loans and $18.5 million of consumer loans. PPP processing, SBA guarantee and repayment risks are disclosed.
  • Market and securities exposure: AFS securities were $479.6 million, with net unrealized losses of $17.9 million versus $607,000 at year-end. Management attributed the increase to market-rate declines and COVID-19 uncertainty and reported no cumulative OTTI. The securities valuation losses affected equity through OCI rather than Q1 net income.
  • Capital and liquidity: The Bank was reported as well capitalized, with a 5.4% capital conservation buffer versus a 2.5% requirement. The Company reported access to the Federal Reserve PPP liquidity facility. Customers’ potential deposit withdrawals and credit-line draws remain risks.
  • Interest-rate risk: Two new cash-flow hedges had $100 million aggregate notional. Management’s simulation indicated better 12-month positioning in a moderately rising-rate environment than in a declining-rate environment, a change from year-end; results depend on assumptions and do not reflect future management actions.
  • Legal matters: A Hamilton merger-related action settled for $135,000 in mootness fees, paid in April. A separate long-running securities class action had a third amended complaint reinstating claims and defendants; the Company intends to defend itself, but said potential losses could not be reasonably estimated.
  • Other items: The Company recorded a $501,000 mortgage-servicing-right impairment tied to rapidly falling rates. It concluded no goodwill impairment existed at March 31. It had not yet selected a replacement index for LIBOR contracts, but was preparing fallback language for loans maturing after 2021.

Important facts for investors to verify

  • Whether PPP loans are originated, serviced and guaranteed in compliance with SBA requirements, and the timing and realization of the disclosed fee income.
  • How pandemic-related borrower stress, loan deferrals and economic forecasts affect future provisions, charge-offs, nonperforming loans and the allowance.
  • Whether AFS securities’ unrealized losses recover, and whether any securities must be sold or incur credit impairment.
  • Whether core earnings remain supported after the portfolio-sale gains and other unusual items, and how expense growth and purchase-accounting accretion evolve.
  • Developments in the securities litigation and any resulting financial or reputational exposure.
  • Deposit stability, customer draws on credit commitments, funding costs and regulatory capital as economic conditions change.