FRANKLIN FINANCIAL SERVICES CORP quarterly report, Q2 FY2011

Franklin Financial Services Corporation — 2011 Q2 Form 10-Q Summary

Business context and reporting period

Franklin Financial Services Corporation is the holding company for Farmers and Merchants Trust Company of Chambersburg and related subsidiaries. The filing covers the quarter and six months ended June 30, 2011. The company primarily operates as a community banking organization serving Franklin, Fulton, Cumberland and Huntingdon counties in Pennsylvania. Financial statements are unaudited and amounts are in thousands, except per-share data.

Key financial metrics

Metric	Three months ended June 30, 2011	Three months ended June 30, 2010	Six months ended June 30, 2011	Six months ended June 30, 2010
Total interest income	$10,493	$10,866	$20,793	$21,782
Net interest income	$8,085	$7,645	$15,980	$15,191
Provision for loan losses	$1,767	$625	$2,667	$1,250
Noninterest income	$2,426	$2,442	$4,948	$4,837
Noninterest expense	$7,433	$6,525	$14,454	$13,186
Net income	$1,758	$2,159	$3,608	$4,133
Diluted EPS	$0.45	$0.56	$0.92	$1.07

Tax-equivalent net interest margin was 3.74% for the second quarter and 3.71% year to date, compared with 3.48% and 3.46%, respectively, in the prior-year periods.
Return on average equity was 8.64% for the first six months, versus 10.21% in 2010. Return on average assets was 0.74%, versus 0.84%.
Total assets exceeded $1 billion for the first time, reaching $1.01 billion at June 30, 2011, up $54.6 million from year-end 2010.
Gross loans increased 3.1% to $772.0 million; net loans increased 3.0% to $761.8 million. Deposits increased 8.2% to $794.9 million.
Cash and cash equivalents increased to $40.6 million from $22.1 million at year-end. Investment securities increased to $132.4 million from $117.6 million.
Shareholders’ equity increased to $86.2 million from $82.6 million. The quarterly and year-to-date dividend was maintained at $0.27 and $0.54 per share, respectively.
Net cash provided by operating activities was $4.9 million; investing activities used $38.0 million, primarily reflecting loan growth and securities purchases; financing activities provided $51.6 million. Cash increased by $18.5 million during the first six months.
Long-term debt declined to $49.3 million from $70.9 million, while securities sold under repurchase agreements increased to $65.3 million from $51.2 million.

Material changes versus prior comparable periods

First-half net income declined 12.7%, primarily because the provision for loan losses increased by $1.4 million and noninterest expense increased by $1.3 million. Total revenue declined $878 thousand year over year.
Net interest income improved despite lower interest income because funding costs declined materially. Average interest-bearing liability costs fell to 1.24% from 1.66% year to year.
Second-quarter noninterest expense increased 13.9%, led by a 16.9% increase in salaries and benefits and higher other expenses. Other expenses included a $172 thousand prepayment penalty on FHLB advances; year-to-date prepayment penalties totaled $344 thousand.
The allowance for loan losses increased to $10.2 million from $8.8 million, or 1.31% of loans versus 1.18% at year-end. Year-to-date net charge-offs were $1.3 million compared with $436 thousand in the prior-year period.
Credit quality weakened. Nonperforming loans increased to $32.7 million from $27.5 million, nonperforming assets increased to $33.2 million from $28.2 million, and nonperforming loans as a percentage of gross loans rose to 4.24% from 3.68%.
Residential construction loans declined 17.8% to $65.4 million, while commercial real estate loans increased 5.4% to $320.7 million and commercial, industrial and agricultural loans increased 19.4% to $175.1 million.
Temporarily impaired securities improved: unrealized losses declined to $2.1 million across 66 securities from $3.2 million across 85 securities at year-end. However, the company recorded $55 thousand of net other-than-temporary impairment expense on two bonds during the quarter.

Guidance, outlook, commentary, risks and unusual items

Management expects the residential real estate portfolio to continue declining because of weaker consumer demand and the sale of most new mortgage originations. The indirect consumer lending portfolio is also expected to run off.
Management expects fewer commercial loan participations to be available for purchase in 2011, although commercial lending activity remained strong through June.
Management believes the allowance for loan losses was adequate at June 30, 2011, but noted that economic weakness, updated appraisals and further deterioration in collateral values could increase future provisions and charge-offs.
The loan watch list increased to $83.8 million from $69.9 million at year-end. Impaired loans totaled $37.0 million, and nine troubled debt restructurings totaled $5.4 million, compared with one TDR totaling $656 thousand at year-end.
In July 2011, the Bank charged off $1.9 million on two commercial real estate-secured loans in a shared national credit following regulatory direction. The exposure had been specifically reserved at June 30, 2011, but the charge-off was not recorded in the second quarter.
The company identified a control weakness involving incorrect tax coding for certain tax-exempt commercial loans. It recorded approximately $755 thousand of previously unrecognized tax benefits in the second quarter, including approximately $660 thousand related to 2008 through 2010 and $95 thousand related to the first quarter of 2011. Management considered the error immaterial to prior periods and implemented additional review controls.
The second-quarter tax benefit produced a federal income tax benefit of $447 thousand. Management stated that the first-half effective tax rate would have been approximately 22.6% without the prior-period tax adjustments, compared with the reported 5.25%.
Management estimated that market pressure from the Durbin Amendment could reduce annual debit-card interchange revenue by approximately $400 thousand beginning October 1, 2011.
Liquidity was supported by approximately $169 million available under an FHLB line, $26 million of unsecured correspondent-bank lines and approximately $31 million available at the Federal Reserve Discount Window. Approximately 96% of the investment portfolio was pledged as collateral at June 30, 2011.
Unused loan commitments and standby letters of credit totaled $226.2 million, including $27.9 million of standby letters of credit. Management stated that it believed anticipated liquidity needs could be met.
The company and bank were reported as well capitalized. The bank’s total risk-based capital, Tier 1 capital and leverage ratios were 11.20%, 9.95% and 7.61%, respectively.
Management identified general economic conditions, unemployment, real estate values, interest rates, funding costs, regulatory changes, competition, loan losses and securities impairment as principal risks. No material changes to previously disclosed risk factors or market-risk exposure were reported.

Most important facts for investors to verify

Whether elevated nonperforming loans, watch-list balances, TDRs and the July $1.9 million charge-off lead to additional credit losses.
The adequacy of the $10.2 million allowance relative to construction, commercial real estate and commercial lending concentrations.
The sustainability of reported earnings given the unusual $755 thousand tax benefit and the higher provision and operating expenses.
The effect of potential debit-card fee pressure, regulatory compliance costs and changes in corporate checking products on future noninterest income and funding costs.
The credit performance and valuation of trust preferred securities and private-label mortgage-backed securities, including the possibility of further impairment charges.
Liquidity availability after considering pledged securities, collateralized borrowings, brokered deposits and the company’s continuing loan growth.
Progress in remediating the tax-coding control weakness and reviewing controls after the July 2011 core-processing-system upgrade.