Orrstown Financial Services, Inc. — Q2 2018 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2018. The company is a Pennsylvania-based community bank holding company, with banking and wealth-management operations. Unless noted otherwise, dollar amounts below are in millions.
Financial performance
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Net interest income | $12.35 | $10.72 | $24.04 | $20.96 |
| Net income | $4.01 | $3.31 | $7.64 | $5.31 |
| Diluted EPS | $0.48 | $0.40 | $0.92 | $0.65 |
| Noninterest income | $5.51 | $5.62 | $11.21 | $9.96 |
| Noninterest expense | $13.27 | $12.42 | $26.34 | $24.56 |
- Q2 net interest income rose 15.3%; six-month net interest income rose 14.7%. Loan and securities growth and higher market rates lifted interest income, while deposit and borrowing costs also increased.
- Tax-equivalent net interest margin was 3.32% in Q2 versus 3.35% a year earlier, and 3.29% for the first half versus 3.35%. Management attributed the year-over-year margin decline principally to the lower statutory tax rate used in the tax-equivalent calculation.
- Q2 noninterest income before securities gains increased 9.9% year over year, but total noninterest income declined 2.1% because securities gains fell to $0.05 million from $0.65 million. First-half total noninterest income increased 12.5%, including securities gains of $0.86 million versus $0.66 million.
- Q2 noninterest expense increased 6.9% and first-half expense increased 7.2%, reflecting growth-related staffing and equipment, incentive and share-based compensation, and $0.15 million of merger-related expense in the first half.
- Efficiency ratio improved to 72.1% for Q2 from 76.0%, and to 74.6% for the first half from 77.8%, as revenue growth outpaced expense growth. The company reported effective tax rates of 8.5% for Q2 and 10.2% for the first half, versus 13.5% and 15.0% in 2017, respectively; the lower federal tax rate and tax-advantaged income contributed.
Financial position, cash flow, and credit
- At June 30, total assets were $1.64 billion, up from $1.56 billion at year-end 2017. Loans were $1.06 billion, up 5.3%; deposits were $1.33 billion, up 8.7%. Management said deposit growth funded loan and investment growth.
- Cash and cash equivalents were $22.6 million, down from $29.8 million at year-end. First-half operating cash flow was $13.9 million, investing cash outflow was $95.0 million, and financing cash inflow was $73.8 million.
- Short-term borrowings were $63.8 million, down from $93.6 million; long-term debt was $83.6 million, approximately unchanged. Shareholders’ equity was $145.1 million. The decline in accumulated other comprehensive income, primarily from unrealized securities losses, was $5.54 million after tax.
- The allowance for loan losses was $13.44 million, or 1.26% of loans, versus $12.80 million and 1.27% at year-end. First-half provision was $0.40 million; net recoveries were $0.24 million. Nonaccrual loans fell to $5.00 million from $9.84 million at year-end, principally after a commercial real estate loan payoff. Nonperforming assets were $5.39 million, or 0.33% of assets.
- Regulatory capital remained above minimums: the Bank reported total capital to risk-weighted assets of 13.1%, CET1 of 11.9%, and Tier 1 leverage of 8.7%. It was classified as well capitalized.
Outlook, risks, and unusual items
- No specific earnings or financial guidance was provided. Management said new Lancaster County branch openings planned for the second half of 2018 are expected to add operating costs. It cited strong competition for loans and noted that continued portfolio growth may require additional loan-loss provisions.
- The company agreed to acquire Mercersburg Financial Corporation, which had approximately $183 million in assets. Closing was expected in Q4 2018, subject to regulatory and shareholder approvals and other conditions. Consideration is a mix of cash and Orrstown shares, with the agreement providing for 85% stock and 15% cash in aggregate, subject to proration and adjustment. Completion, integration, cost savings, and expected benefits are uncertain.
- Interest-rate sensitivity analysis indicated the company was better positioned for a moderate rate increase than for a larger increase or a rate decline. A 100-basis-point increase was modeled to reduce next-12-month net interest income by 2.9%; a 200-basis-point increase by 6.4%. These are model estimates and depend on assumptions.
- Unrealized losses on available-for-sale securities were $6.27 million at quarter-end; management attributed them primarily to rate and spread changes and said it did not intend, and was not more likely than not required, to sell the securities before recovery. The portfolio’s fair value was $449.4 million.
- A putative securities class action relating to 2010–2012 disclosures remained pending. The company said it believed the claims were without merit and would defend them; it could not reasonably estimate a possible loss or range. The company previously settled a separate SEC matter concerning 2010–2011 accounting and related issues, without admitting or denying the findings, and paid a $1.0 million penalty in 2016.
- Management reported disclosure controls were effective at June 30, 2018, with no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether Mercersburg receives required approvals and closes on schedule, and the final consideration, integration costs, and realized benefits.
- Subsequent changes in nonperforming loans, criticized loan ratings, allowance adequacy, and commercial real estate and construction exposures.
- Deposit pricing and funding costs relative to asset yields, net interest margin trends, and actual sensitivity to changing interest rates.
- Available-for-sale securities valuation and the potential impact of further rate-driven losses on equity and liquidity.
- Developments in the SEPTA litigation, including whether a loss estimate becomes reasonably possible or estimable.