Franklin Financial Services Corporation — 2020 Form 10-K Summary
Business Context and Reporting Period
Franklin Financial Services Corporation is a Pennsylvania bank holding company conducting substantially all operations through Farmers and Merchants Trust Company of Chambersburg, a community bank with 22 offices in south-central Pennsylvania. The filing covers the fiscal year ended December 31, 2020; it is an annual report, not a quarterly filing. Results were materially affected by the COVID-19 pandemic, historically low interest rates, the SBA Paycheck Protection Program (PPP), and customer payment deferrals.
Key Financial Metrics
| Metric | 2020 | 2019 | Change |
|---|---|---|---|
| Total assets | $1.535 billion | $1.269 billion | +21.0% |
| Net loans | $992.9 million | $922.6 million | +7.6% |
| Deposits | $1.355 billion | $1.125 billion | +20.4% |
| Shareholders’ equity | $145.2 million | $127.5 million | +13.8% |
| Net interest income | $42.0 million | $42.1 million | -0.4% |
| Provision for loan losses | $4.6 million | $237 thousand | Substantially higher |
| Noninterest income | $15.1 million | $15.4 million | -2.2% |
| Noninterest expense | $39.4 million | $38.3 million | +2.7% |
| Net income | $12.8 million | $16.1 million | -20.6% |
| Diluted EPS | $2.93 | $3.67 | -20.2% |
| Net interest margin | 3.21% | 3.68% | -47 basis points |
| Return on average assets | 0.91% | 1.29% | Lower |
| Return on average equity | 9.56% | 13.17% | Lower |
Interest income declined 6.7% because asset yields fell, while interest expense declined 44.1% as deposit costs fell. The yield on earning assets decreased from 4.29% to 3.51%, while the cost of total deposits decreased from 0.64% to 0.28%. The efficiency ratio increased to 67.32% from 65.36%.
Cash flow from operating activities was $6.4 million, compared with $19.0 million in 2019. Investing activities used $277.3 million, primarily because the Bank purchased $240.7 million of investment securities and increased loans. Financing activities provided $244.2 million, mainly from deposit growth and $19.5 million of net subordinated-note proceeds. Cash and cash equivalents declined to $57.1 million from $83.8 million.
Material Changes Versus 2019
- Loan growth was driven primarily by approximately $52.3 million of PPP loans outstanding at year-end; approximately $1.3 million of PPP fees remained to be recognized.
- The investment portfolio increased to $397.3 million from $187.9 million, principally through municipal bond purchases.
- Deposits increased $229.2 million, with growth in noninterest-bearing checking, interest-bearing checking, money management, and savings accounts. Time deposits declined 14.8%.
- The allowance for loan losses increased to $16.8 million, or 1.66% of gross loans, from $12.0 million, or 1.28%. The increase reflected higher qualitative reserves related to pandemic-related economic risk.
- Credit quality weakened: nonperforming loans increased to $8.7 million from $3.9 million, nonperforming loans as a percentage of gross loans increased to 0.87% from 0.42%, and watch-list loans increased to $66.1 million from $11.6 million.
- Modified or deferred loans declined to $67.6 million at year-end from $196.5 million at June 30, 2020. Most remaining modifications involved hotels, entertainment, and rental real estate.
- Noninterest income benefited from higher mortgage-sale gains and bank-owned life insurance gains but was reduced by lower deposit fees and the absence of 2019 gains on bank premises and other real estate.
- The effective tax rate fell to 2.0% from 15.2%, including a $1.1 million tax benefit from the CARES Act NOL carryback. Without that benefit, management stated the 2020 effective rate would have been 10.5%.
Debt, Capital, Liquidity, and Dividends
In August 2020, the Corporation issued $20.0 million of unsecured subordinated notes: $15.0 million due in 2030 at 5.00% initially and $5.0 million due in 2035 at 5.25% initially. The notes qualify as Tier 2 capital for the Corporation. There were no short-term borrowings outstanding at year-end.
- Bank total risk-based capital ratio: 15.33%; Corporation total risk-based capital ratio: 17.69%.
- Bank Tier 1 leverage ratio: 8.54%; Corporation Tier 1 leverage ratio: 8.69%.
- The Bank was classified as well capitalized under Basel III, with a 7.33% capital conservation buffer.
- Available liquidity totaled approximately $486.7 million, including $387.7 million of FHLB capacity, $25.6 million of Federal Reserve Discount Window capacity, $21.0 million of correspondent-bank lines, and $52.3 million of PPPLF capacity. None was outstanding at year-end.
- Unfunded loan commitments were $357.9 million and standby letters of credit were $22.3 million. A $2.1 million reserve remained for letters of credit associated with a commercial borrower bankruptcy.
- Regular cash dividends paid were $1.20 per share, and the payout ratio was 40.8%. The filing states that there were no current restrictions on dividend payments, although regulatory limitations could apply if capital or other conditions deteriorate.
Guidance, Outlook, Commentary, Risks, and Unusual Items
Management expected commercial lending to remain the primary area of loan growth and believed the Bank could meet anticipated liquidity demands. It also noted that economic recovery depended heavily on the course of COVID-19, vaccine distribution, employment, and restrictions affecting hospitality, food service, retail, and other service sectors. The filing cited an expectation of 3% to 4% U.S. GDP growth in 2021 but did not provide formal earnings or revenue guidance.
- Credit risk is concentrated geographically in south-central Pennsylvania and by loan type in commercial and real estate lending. Approximately 72% of loans were secured by real estate and 85% were for commercial purposes.
- Hotel exposure was a significant pandemic-related concern. Modified hotel loans totaled $46.5 million, with reported December 2020 occupancy of 36% versus 51% in December 2019.
- COVID-19 could increase future credit losses, allowance requirements, loan deferrals, securities impairments, operating disruptions, and litigation exposure related to PPP processing and SBA guarantees.
- The Bank has material contracts indexed to USD LIBOR and was evaluating alternatives, including SOFR, as LIBOR discontinuation dates approached.
- Interest-rate risk remains significant. The one-year cumulative interest-rate gap was negative, and the filing’s model projected net interest income decreasing 3.4% under a gradual 100-basis-point rate decline versus the unchanged-rate scenario.
- Goodwill of $9.0 million was tested quantitatively in 2020. Estimated fair value exceeded carrying value by 24%, and no impairment was recorded.
- The independent auditor issued an unqualified opinion. Critical audit matters were the qualitative allowance for loan losses and the annual goodwill impairment evaluation. The auditor was not engaged to provide an opinion on internal control effectiveness because the Company is a smaller reporting company.
Important Facts for Investors to Verify
- Whether hotel and other pandemic-related loan modifications continue to perform after deferral periods expire, particularly the $46.5 million modified hotel portfolio.
- Whether watch-list loans, nonperforming loans, and the $16.8 million allowance for loan losses adequately reflect evolving credit conditions.
- The timing of PPP forgiveness, recognition of the remaining $1.3 million of PPP fees, and the continued validity of SBA guarantees.
- The sustainability of deposit growth, the cost of money-management deposits, and the refinancing or retention risk for $57.1 million of time deposits maturing within one year.
- The effect of the enlarged securities portfolio, municipal concentration, unrealized gains, and interest-rate movements on liquidity, capital, and net interest income.
- The impact of the $20.0 million subordinated debt issuance, including fixed-to-floating rate conversions and future SOFR exposure.
- The expected effect of CECL adoption scheduled for January 1, 2023, which management stated could result in earlier and potentially higher credit-loss recognition.
- Any developments involving PPP-related litigation, SBA repayment or guarantee disputes, LIBOR transition, cybersecurity incidents, or unresolved legal matters.