Orrstown Financial Services, Inc. — 2017 Form 10-K
Reporting period: Fiscal year ended December 31, 2017. The filing was signed March 9, 2018. Orrstown is a Pennsylvania-based community banking and financial services holding company, with banking operations in south-central Pennsylvania and Washington County, Maryland; its subsidiary Wheatland Advisors provides investment advisory services.
Financial performance and condition
Amounts below are in millions of dollars unless otherwise indicated.
| Metric | 2017 | 2016 |
|---|---|---|
| Net interest income | $43.4 | $36.5 |
| Total noninterest income, including securities gains | $20.4 | $19.7 |
| Noninterest expense | $50.3 | $48.1 |
| Provision for loan losses | $1.0 | $0.3 |
| Income before tax | $12.4 | $7.9 |
| Net income | $8.1 | $6.6 |
| Diluted EPS | $0.98 | $0.81 |
| Net interest margin, taxable-equivalent | 3.32% | 3.14% |
| Return on average assets / equity | 0.54% / 5.73% | 0.50% / 4.80% |
- Growth: Assets reached $1.559 billion, up 10.2%; loans were $1.010 billion, up 14.3%; deposits were $1.220 billion, up 5.8%. Shareholders’ equity was $144.8 million.
- Revenue and margins: GAAP net interest income rose 18.7%, primarily reflecting loan and securities growth and higher yields. Taxable-equivalent net interest margin rose to 3.32%. Trust and investment management income increased 25.7%, with Wheatland contributing to growth. Mortgage banking income declined 14.4% amid lower refinancing activity and margin pressure.
- Costs and earnings: Noninterest expense increased 4.5%, led by salaries and benefits, which rose 14.3%, and occupancy costs. Net income increased 22.1%, though the tax-reform charge described below substantially affected reported tax expense.
- Cash flows: Operating activities provided $16.4 million; investing activities used $145.9 million, largely reflecting loan growth and securities purchases; financing activities provided $129.1 million, including $67.1 million of net deposit growth and $80.0 million of long-term debt proceeds. Cash and cash equivalents ended at $29.8 million.
- Funding and liquidity: Year-end borrowings comprised $93.6 million of short-term borrowings and $83.8 million of long-term debt, versus $87.9 million and $24.2 million, respectively, in 2016. Available-for-sale securities not pledged totaled $95.4 million. The company reported $381.9 million of additional FHLB borrowing availability, subject to qualifying collateral, and $35 million of unsecured credit lines across the Bank and Parent Company.
- Capital: The Bank was classified as well capitalized. At year-end, its CET1 and Tier 1 risk-based capital ratios were each 11.8%, total risk-based capital was 13.0%, and Tier 1 leverage was 8.7%. The company’s corresponding reported ratios were 12.1%, 12.1%, 13.3%, and 8.9%.
Material changes versus 2016
- Loan growth was broad-based: commercial real estate increased 14.9%, commercial and industrial loans increased 30.7%, and residential mortgage loans increased 11.7%. The company also purchased approximately $15 million of automobile loans.
- Asset-quality indicators weakened year over year: risk assets rose 44.1% to $12.0 million; nonaccrual loans rose to $9.8 million from $7.0 million. Management attributed much of the increase to one commercial loan downgraded to nonaccrual in the fourth quarter.
- The allowance for loan losses was $12.8 million, approximately unchanged in dollars, but declined to 1.27% of loans from 1.45%. Net charge-offs were $1.0 million, compared with $1.0 million in 2016.
- Deposits grew, but the company also increased brokered deposits to $96.4 million from $86.0 million and long-term FHLB debt to $83.8 million from $24.2 million.
- Total dividends declared were $0.42 per share, up from $0.35. The board declared a further $0.12-per-share dividend in January 2018, paid in February.
Outlook, risks, contingencies and unusual items
- Outlook: No specific earnings or financial guidance was provided. Management anticipated continued loan growth in 2018 and described a generally more positive economic outlook, while citing a flatter yield curve, competition for quality loans and pressure on net interest margin and expense leverage as challenges. It also said acquisitions may be considered, subject to regulatory approval and execution risks.
- Tax reform: Federal tax legislation enacted in December 2017 reduced the statutory federal rate to 21% effective January 1, 2018. Remeasurement of deferred tax balances caused a $2.635 million tax expense in 2017. The 2017 fourth quarter reported $3.022 million of tax expense and $6,000 of net income; the filing’s quarterly data does not separately quantify the portion of the quarter’s tax expense attributable to the remeasurement.
- Litigation: The company is defending a securities class action brought by SEPTA concerning historical lending practices and financial reporting. The company says the claims are without merit, but stated that reasonably possible losses or a loss range could not be estimated. Case deadlines were continued by court order in February 2018. The company incurred $645,000 in related indemnification costs in 2017. Separately, it paid a $1 million SEC civil penalty in 2016 to settle administrative proceedings concerning 2010–2011 accounting and related matters, without admitting or denying the SEC’s findings.
- Key risks: Credit deterioration—particularly in commercial real estate and growing commercial and industrial lending—could increase provisions and losses. Other material risks include interest-rate and securities valuation exposure, deposit competition and funding costs, geographic concentration, regulatory and capital requirements, technology and cybersecurity incidents, and dependence of the holding company on regulated Bank dividends.
- Interest-rate sensitivity: The company’s simulation estimated next-12-month net interest income would decline 6.5% under a 100-basis-point rate decrease and 4.9% under a 200-basis-point increase. Estimated market value would decline 7.2% and 5.4%, respectively, under those scenarios. These model-based estimates rely on assumptions and are not forecasts.
- Controls and audit: Management and the independent auditor concluded internal control over financial reporting was effective at December 31, 2017. The auditor issued unqualified opinions on the financial statements and internal controls.
Important facts for investors to verify
- Review the fourth-quarter tax-reform accounting and confirm how the one-time deferred-tax charge affected comparisons of quarterly and annual earnings.
- Track the large commercial loan downgraded in Q4, subsequent nonaccrual trends, charge-offs, criticized loans and adequacy of the allowance.
- Assess whether loan growth can be sustained without further deterioration in credit quality, excessive concentration or weaker pricing.
- Monitor deposit retention, brokered-deposit use, borrowing costs, debt maturities and the availability of collateral-backed liquidity.
- Follow the SEPTA litigation schedule and any developments affecting the company’s ability to estimate or accrue potential losses.
- Compare actual net interest income and margin with management’s stated rate sensitivities, recognizing that the filing provides no formal earnings guidance.