Orrstown Financial Services, Inc. — Q1 2019 Form 10-Q
Reporting period: Three months ended March 31, 2019; balance-sheet comparisons are to December 31, 2018. Unless otherwise noted, dollar amounts are in millions. Orrstown is a community banking and financial services holding company operating primarily in south-central Pennsylvania and Washington County, Maryland. Results include Mercersburg, acquired October 1, 2018, from the acquisition date onward.
Financial results and position
| Metric | Q1 2019 | Comparable / change |
|---|---|---|
| Interest income | $19.57 | $14.28 in Q1 2018 |
| Net interest income | $14.69 | $11.68 in Q1 2018; up 25.7% |
| Net interest margin, taxable-equivalent | 3.41% | 3.26% in Q1 2018 |
| Noninterest income | $5.23 | $5.70 in Q1 2018; down 8.3% |
| Noninterest expense | $16.18 | $13.07 in Q1 2018; up 23.8% |
| Net income | $3.10 | $3.63 in Q1 2018 |
| Diluted EPS | $0.33 | $0.44 in Q1 2018 |
| Net cash from operating activities | $0.43 | $4.96 in Q1 2018 |
Reported interest plus noninterest income was $24.79 million, versus $19.98 million a year earlier. The increase in net interest income reflected higher average loan and securities balances and yields; the reported margin improved year over year. Net income declined despite that growth, as expenses rose and securities gains fell to $0.34 million from $0.82 million. Q1 2019 expense included $0.65 million of merger costs and a $0.62 million write-off of a cyber-insurance claim receivable. The effective tax rate was 7.0%, including an approximately $0.19 million tax benefit related to a change in tax law.
- Balance sheet and funding: Total assets were $1,973.3 million, up from $1,934.4 million at year-end. Loans were $1,265.5 million, up $17.9 million; deposits were $1,620.7 million, up $61.9 million. Cash and cash equivalents were $77.2 million, down from $88.8 million.
- Debt and liquidity: Short-term borrowings fell to $9.6 million from $64.1 million, while long-term debt rose to $103.4 million from $83.5 million. Subordinated notes were $31.8 million. The company reported its usual liquidity sources, including deposits, loan and securities cash flows, mortgage loan sales and FHLB borrowing; no specific liquidity shortfall was reported.
- Capital and equity: Shareholders’ equity was $179.2 million, versus $173.4 million. The Bank was categorized as well capitalized; its total risk-based capital ratio was 13.2%, and its capital conservation buffer was 5.2%, above the 2.50% requirement.
- Credit quality: The allowance for loan losses was $14.3 million, or 1.13% of loans, versus $14.0 million, or 1.12%, at year-end. Q1 provision was $0.40 million; net charge-offs were $0.13 million. Nonperforming assets were $5.2 million, or 0.26% of assets, compared with $5.3 million, or 0.27%, at year-end. Classified loans declined to $12.0 million from $12.7 million.
- Shareholder returns: The quarterly dividend was $0.15 per share, up from $0.12 in Q1 2018. Tangible book value per share, a non-GAAP measure, was $17.25, up from $16.73 at year-end.
Material changes and notable events
- Mercersburg’s October 2018 acquisition contributed to year-over-year balance-sheet and operating growth. Management attributed higher personnel, occupancy, equipment and data-processing costs partly to the expanded operations.
- On May 1, 2019, after quarter-end, Orrstown completed its acquisition of Hamilton Bancorp for approximately $50 million in stated consideration, comprising about 1.765 million shares and $13.4 million cash. Hamilton reported year-end 2018 assets of $496.3 million, loans of $369.5 million and deposits of $384.2 million. Purchase accounting was not complete at the filing date.
- Available-for-sale securities were $490.2 million, up $24.4 million from year-end. Securities-related unrealized gains improved accumulated other comprehensive income by $3.8 million after tax during the quarter.
- Adoption of the lease standard added $8.0 million of operating lease liabilities and $7.5 million of related assets at January 1, 2019; management said the adoption did not materially affect net income or cash flows.
Outlook, risks and contingencies
The filing provides no numerical earnings or growth guidance. Management said loan growth could be tempered by strong competition and weaker demand, particularly in residential and consumer lending. It expects credit-loss provisioning may be affected by loan growth, economic conditions and portfolio risk; management considers the current allowance adequate but notes estimates may change. The company planned to adopt the expected-credit-loss standard, CECL, on January 1, 2020, and said the financial impact could not yet be reasonably estimated.
Interest-rate simulations indicated Orrstown was better positioned for a moderately rising-rate environment than for a substantial increase or a decline in rates. A 100-basis-point rise was estimated to change next-12-month net interest income by -0.1% and market value by +8.6%; a 100-basis-point decline was estimated to change them by -2.5% and -18.0%, respectively. The company reported it did not then use hedging instruments. These estimates depend on assumptions and may not predict actual outcomes.
The insurer denied coverage for a claim related to a 2017 phishing incident; Orrstown wrote off the $0.62 million receivable and intends to contest the denial, but recovery is uncertain. The company also disclosed ongoing securities litigation brought by SEPTA. In April 2019, SEPTA sought leave to file a third amended complaint; defendants opposed the request. Orrstown disputes the allegations, intends to defend itself, and said reasonably possible losses could not be estimated. Management reported no other legal proceedings expected to have a material effect. Forward-looking results remain subject to acquisition integration, competition, interest rates, credit quality, economic conditions, litigation and other risks.
Important facts for investors to verify
- Whether Hamilton integration, purchase accounting and anticipated benefits affect future expenses, capital and earnings as expected.
- Whether loan growth, criticized credits, charge-offs and CECL implementation require higher credit-loss provisions.
- Whether deposit pricing and funding costs continue to pressure net interest income and margin.
- Whether the cyber-insurance dispute produces any recovery, and how the SEPTA litigation progresses or affects potential exposure.
- How much of reported earnings growth is sustainable apart from acquisition effects, securities gains and unusual expenses or tax benefits.