Business Context and Reporting Period
Franklin Financial Services Corporation, through Farmers and Merchants Trust Company of Chambersburg, operates a commercial banking business primarily serving south-central Pennsylvania. This unaudited Form 10-Q covers the three months ended March 31, 2021, with comparisons to March 31, 2020 and December 31, 2020.
Key Financial Metrics
| Metric | Q1 2021 | Comparable / Prior Period |
|---|---|---|
| Total assets | $1.598 billion | $1.535 billion at Dec. 31, 2020 |
| Deposits | $1.421 billion | $1.355 billion at Dec. 31, 2020 |
| Gross loans | $1.001 billion | $1.010 billion at Dec. 31, 2020 |
| Net loans | $984.8 million | $992.9 million at Dec. 31, 2020 |
| Net interest income | $10.8 million | $10.3 million in Q1 2020 |
| Net interest margin | 3.03% | 3.53% in Q1 2020 |
| Net income | $4.8 million | $1.7 million in Q1 2020 |
| Diluted EPS | $1.09 | $0.39 in Q1 2020 |
| Noninterest income | $4.2 million | $3.9 million in Q1 2020 |
| Noninterest expense | $10.2 million | $9.5 million in Q1 2020 |
| Operating cash flow | $10.4 million | $2.5 million in Q1 2020 |
| Cash and cash equivalents | $107.6 million | $57.1 million at Dec. 31, 2020 |
Profitability and Capital
- Net income increased 181% year over year, primarily because the $3.0 million loan-loss provision in Q1 2020 became an $800 thousand recovery in Q1 2021.
- Return on average assets was 1.23%, return on average equity was 13.47%, and the efficiency ratio was 66.06%.
- The effective tax rate was 15.4%, compared with a tax benefit of 6.6% in Q1 2020.
- Shareholders’ equity was $140.7 million, down from $145.2 million at year-end, primarily because accumulated other comprehensive income declined by $8.4 million as securities valuations fell.
- The Bank remained well capitalized. Its March 31, 2021 CET1, total risk-based capital, and Tier 1 leverage ratios were 14.63%, 15.89%, and 8.65%, respectively.
Credit Quality, Debt, and Liquidity
- The allowance for loan losses was $16.1 million, or 1.61% of gross loans, compared with 1.66% at year-end. Excluding PPP loans, the ratio was 1.71%.
- Net recoveries were $147 thousand in Q1 2021. Nonperforming loans totaled $8.8 million, or 0.88% of gross loans, compared with 0.87% at year-end.
- PPP loans totaled $55.9 million at March 31, 2021 and were 100% guaranteed by the SBA, subject to fulfillment of the guarantee and forgiveness requirements.
- The company had $20.0 million of subordinated notes outstanding, recorded at $19.6 million net of issuance costs. The notes carry fixed rates of 5.00% and 5.25% during their initial periods and qualify as Tier 2 capital.
- Reported available liquidity was $466.9 million, consisting primarily of Federal Home Loan Bank capacity of $366.1 million, Federal Reserve Discount Window capacity of $23.9 million, correspondent-bank capacity of $21.0 million, and PPPLF capacity of $55.9 million. No amounts were outstanding under these facilities at March 31, 2021.
Material Changes Versus Comparable Periods
- Net interest income increased $592 thousand, despite the net interest margin declining from 3.53% to 3.03%. Lower funding costs and higher earning-asset balances partly offset lower asset yields.
- Average earning assets increased to $1.502 billion from $1.200 billion, driven by a $212.3 million increase in average investment securities and higher average loans and deposits.
- Interest expense declined to $748 thousand from $1.4 million as the cost of interest-bearing deposits fell to 0.18% from 0.61%. The 2021 period includes interest on the subordinated notes.
- Noninterest income rose 8.7% to $4.2 million, led by a $638 thousand increase in mortgage loan-sale gains and a $191 thousand increase in investment and trust service fees. The increase was partly offset by the absence of an $812 thousand bank-owned life insurance gain recorded in Q1 2020.
- Noninterest expense increased 6.7% to $10.2 million, including higher salaries, data-processing costs, FDIC insurance, and pension expense.
- Deposits increased $66.5 million, or 4.9%, from year-end, while net loans declined $8.1 million, or 0.8%. The filing attributes deposit growth partly to government stimulus payments, lower spending, and heightened demand for bank deposits during the pandemic.
- Available-for-sale securities had a fair value of $422.2 million and a net unrealized gain of $2.0 million, down from $12.6 million at year-end. Gross unrealized losses increased to $5.6 million from $701 thousand; management considered these losses temporary and non-credit-related.
- Loan deferrals and modifications totaled approximately $68.1 million, or about 7% of gross loans, compared with approximately $196.5 million, or 19%, at June 30, 2020. Hotel-related modifications represented $45.6 million of the March 31 balance.
Outlook, Risks, Contingencies, and Unusual Items
- Management did not provide formal earnings guidance. It stated that declining COVID-19 cases, increased vaccinations, and easing restrictions suggested an economic recovery, but the extent and timing remained uncertain.
- Management expects liquidity resources to meet anticipated pandemic-related demands, including reduced cash collections from loan deferrals. However, the company identified reliance on Federal Home Loan Bank funding and the potential inability to replace that funding quickly as a liquidity risk.
- Credit risk remains concentrated in commercial real estate, including hotels, office buildings, land development, and shopping centers. Hotel borrowers represented the largest exposure among modified loans, and future performance as deferrals expire is identified as critical.
- The allowance for loan losses was reduced following a recovery in Q1 2021. Future deterioration in economic conditions, collateral values, unemployment, loan delinquencies, or modified loans could require renewed provisions.
- The company is implementing the current expected credit loss standard, which is effective January 1, 2023 for the Corporation. Management expects a one-time cumulative-effect adjustment to the allowance and potentially earlier or higher credit-loss provisions, but the eventual impact has not been determined.
- Off-balance-sheet commitments included $361.3 million of commitments to extend credit and $21.3 million of standby letters of credit. A $2.1 million reserve related to letters of credit issued for a bankrupt commercial borrower remained outstanding.
- Management stated that no pending litigation is currently expected to have a material adverse effect, although potential losses from other matters could not be estimated.
- The filing reports effective disclosure controls and no material changes to internal control over financial reporting.
Facts Investors Should Verify
- Whether loan deferrals, particularly the $45.6 million hotel portfolio, return to regular payment status as modifications expire.
- The sustainability of the Q1 loan-loss recovery and whether credit costs rise under the CECL framework beginning in 2023.
- The effect of lower market interest rates on the 3.03% net interest margin and future asset yields.
- The magnitude and duration of unrealized losses in the available-for-sale securities portfolio and their potential effect on tangible capital.
- The timing and economic impact of SBA forgiveness and recognition of remaining PPP loan fees; the filing references both approximately $1.7 million and $1.9 million of remaining net PPP fees, so the precise value is unclear from the filing text.
- Future deposit retention, liquidity availability, and reliance on government-supported funding programs.
- Whether the authorized repurchase plan for up to 150,000 shares will be used; no shares had been repurchased through March 31, 2021.