Business Context and Reporting Period
Franklin Financial Services Corporation is a Pennsylvania bank holding company whose principal subsidiary, Farmers and Merchants Trust Company of Chambersburg, provides commercial banking, lending, trust and investment services in south-central Pennsylvania. This unaudited Form 10-Q covers the three and nine months ended September 30, 2016, compared with the corresponding 2015 periods.
Financial Performance and Condition
| Metric | Three months ended September 30 | Nine months ended September 30 |
|---|---|---|
| Net interest income | $8.8 million, versus $8.2 million | $25.8 million, versus $24.0 million |
| Provision for loan losses | $1.2 million, versus $0.4 million | $3.3 million, versus $1.0 million |
| Noninterest income | $2.8 million, versus $3.0 million | $8.6 million, versus $9.8 million |
| Noninterest expense | $8.0 million, versus $7.9 million | $23.5 million, versus $23.0 million |
| Net income | $2.1 million, versus $2.6 million | $6.4 million, versus $7.9 million |
| Diluted earnings per share | $0.48, versus $0.61 | $1.48, versus $1.87 |
- Year-to-date net income decreased 19.8%, primarily because the provision for loan losses increased by $2.3 million and 2015 included approximately $899 thousand of nonrecurring noninterest income.
- Year-to-date net interest income increased $1.8 million. Loan growth contributed to higher interest income, while interest expense declined $158 thousand.
- The year-to-date net interest margin was 3.61%, compared with 3.59% in 2015. Return on average assets was 0.79% and return on average equity was 7.42%.
- Total assets were $1.107 billion at September 30, 2016, up $71.8 million, or 6.9%, from year-end 2015. Net loans increased $76.0 million, or 9.8%, to $847.9 million, primarily through commercial lending growth.
- Total deposits increased $60.0 million, or 6.5%, to $978.6 million. Noninterest-bearing deposits rose $22.3 million, while interest-bearing checking and savings increased $46.2 million; time deposits declined $8.4 million.
- Shareholders’ equity increased to $116.9 million from $111.4 million. Book value per share was $27.19 and tangible book value per share was $25.09.
Cash Flow, Debt and Liquidity
- For the nine months, operating activities provided $9.7 million of cash, investing activities used $74.8 million, and financing activities provided $66.4 million. Cash and cash equivalents ended at $40.6 million, compared with $39.2 million at December 31, 2015.
- Short-term borrowings were $8.5 million at September 30, 2016, compared with none at year-end. The filing does not provide a separate long-term debt balance in the presented balance sheet.
- Management reported approximately $130 million available under an FHLB line of credit, $6.0 million of unsecured correspondent-bank lines, approximately $266.7 million of excess FHLB borrowing capacity, and approximately $23 million of Federal Reserve Discount Window borrowing capacity.
- Unused loan commitments and standby letters of credit totaled $299.1 million. Management stated that the Bank expects to meet anticipated liquidity demands.
- The Bank was classified as well capitalized under Basel III. At September 30, 2016, the Corporation’s total risk-based capital ratio was 15.86% and Tier 1 leverage ratio was 10.07%; the Bank’s corresponding ratios were 15.79% and 10.03%.
Material Changes Versus Prior Comparable Period
- Loan growth materially improved interest revenue, but credit costs increased substantially. The allowance for loan losses rose to $10.7 million from $10.1 million, while net charge-offs for the first nine months were approximately $2.7 million.
- A single participated commercial real estate credit generated approximately $2.7 million of total 2016 charge-offs, including a $759 thousand charge-off in the third quarter after the loan was sold.
- Noninterest income declined $1.1 million year over year because 2015 included a $728 thousand gain on conversion of an investment security and other nonrecurring gains. Investment and trust services fees also declined year to date.
- Noninterest expense increased $493 thousand year to date. Salaries and benefits rose $782 thousand, legal and professional fees rose $303 thousand, and stock option compensation added $88 thousand; intangible amortization declined $181 thousand because the core deposit intangible was fully amortized in 2015.
- Nonperforming assets declined to $11.8 million from $12.2 million at year-end, but nonperforming loans increased to $5.9 million from $5.7 million. The watch list declined to $23.1 million from $27.9 million.
- Other real estate owned declined to $5.9 million from $6.5 million, reflecting property sales and valuation adjustments. Five properties were sold during 2016 at a total net loss of $31 thousand.
Guidance, Outlook, Risks and Unusual Items
- No formal earnings or financial guidance was provided. Management described the local economy as diverse and generally supportive of growth, while noting that interest rates remained historically low and that Federal Reserve policy could affect funding costs and asset yields.
- Management believes the allowance for loan losses is adequate, but acknowledges that collateral values, economic conditions, delinquency trends and expected cash flows involve significant judgment and could require additional provisions or charge-offs.
- The loan portfolio is concentrated in commercial real estate and commercial lending. Commercial real estate totaled $375.3 million and commercial loans totaled $254.3 million at September 30, 2016. The Bank held $132.0 million of purchased loan participations.
- Investment securities included $5.4 million of trust preferred securities with $555 thousand of unrealized losses and private-label mortgage-backed securities with cumulative credit-related impairment charges of $585 thousand. Management considered the remaining unrealized losses temporary, but stated that additional write-downs remain possible if loss trends continue.
- The Corporation is involved in litigation described in a July 29, 2016 Form 8-K. Management does not currently expect a material adverse effect on financial position, but stated that the effect on future results cannot yet be determined and that additional legal expenses are expected.
- Pension expense is expected to be approximately $922 thousand in 2016 versus $387 thousand in 2015, including an estimated $564 thousand settlement expense related to lump-sum distributions. No pension contributions were made or expected in 2016.
- The Board authorized quarterly share repurchases of up to $350 thousand through March 31, 2017. The Corporation repurchased 30,196 shares for $700 thousand through September 30, 2016, and declared a $0.21 per-share fourth-quarter dividend.
- Pending accounting standards include CECL, cash-flow presentation, revenue recognition, financial instruments and leases. Management was evaluating the impact of several standards; it did not expect the revenue-recognition or financial-instruments amendments to have a material effect.
Investor Verification Points
- Verify the sustainability of the 9.8% loan growth, particularly the concentration in commercial real estate, municipal lending and purchased loan participations.
- Review subsequent charge-offs, delinquency migration, collateral valuations and allowance adequacy following the large participated-loan loss.
- Assess interest-rate sensitivity, deposit mix, funding costs and the potential effect of Federal Reserve policy on net interest margin.
- Follow the disclosed lawsuit, related legal costs and any subsequent loss contingency updates.
- Monitor trust preferred and private-label mortgage-backed securities for additional impairment charges.
- Confirm implementation planning and potential capital or earnings effects of CECL and other pending accounting standards.