Orrstown Financial Services, Inc. — 2018 Third-Quarter Form 10-Q
Business context and reporting period. Orrstown is a Pennsylvania-based community bank holding company, with banking operations in south-central Pennsylvania and Maryland and an investment-advisory subsidiary. This unaudited filing covers the quarter and nine months ended September 30, 2018; comparisons are with the corresponding 2017 periods unless stated otherwise. Amounts below are in millions of dollars unless noted.
Financial performance and condition
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Net interest income | $12.704 | $11.081 | $36.741 | $32.036 |
| Net income | $4.016 | $2.774 | $11.653 | $8.084 |
| Diluted EPS | $0.49 | $0.34 | $1.41 | $0.98 |
| Noninterest income | $5.492 | $5.256 | $16.699 | $15.214 |
| Noninterest expense | $13.336 | $13.087 | $39.677 | $37.650 |
- Net interest margin on a taxable-equivalent basis was 3.28% for Q3 and 3.29% for the nine-month period, versus 3.31% and 3.34%, respectively, in 2017. Management attributed the margin declines principally to the lower tax rate used in the taxable-equivalent calculation.
- Efficiency ratio improved to 70.1% in Q3 and 73.0% year to date, compared with 79.4% and 78.4%. The filing attributes this to income growth outpacing expense growth.
- At September 30, total assets were $1,720.755, loans $1,084.941, deposits $1,429.170, shareholders’ equity $145.557, and the allowance for loan losses $13.812. Since December 31, 2017, assets rose $161.906, loans rose $74.929 (7.4%), and deposits rose $209.655 (17.2%).
- Short-term borrowings were $45.353, down from $93.576 at year-end; long-term debt was $83.543, little changed from $83.815. Management said deposit growth funded loan and securities growth and reduced borrowings. Approximately $58 million of deposit growth reflected relationships moving from repurchase agreements into an insured reciprocal-deposit program.
- Nine-month cash flows: operating activities provided $15.130; investing activities used $161.424; financing activities provided $157.504. Cash and cash equivalents ended at $41.017, up from $29.807 at year-end.
- The Bank was categorized as well capitalized. At September 30, its total capital-to-risk-weighted-assets ratio was 13.2%, Tier 1 risk-based ratio 12.0%, CET1 ratio 12.0%, and Tier 1 leverage ratio 8.7%.
Changes, outlook, and material items
- Growth in loan and securities balances, higher asset yields, and higher market rates contributed to increased net interest income. Interest expense also rose as deposit and borrowing balances and funding costs increased.
- Q3 provision for loan losses was $0.200, versus $0.100; the nine-month provision was $0.600, versus $0.200. The allowance was 1.27% of loans at September 30, unchanged from year-end. Net recoveries were $0.175 for Q3 and $0.416 year to date.
- Credit indicators improved from year-end: nonaccrual loans were $5.458 versus $9.843, and nonperforming assets were $5.744 versus $10.804. Classified loans totaled $13.795, down from $19.962 at year-end. Management cautioned that loan growth may require additional provisions; credit exposure is concentrated in the company’s regional market and includes commercial real estate lending.
- Available-for-sale securities were $489.356, up from $415.308 at year-end. Accumulated other comprehensive loss reached $5.472, compared with income of $2.845 at year-end; nine-month after-tax OCI loss was $8.317. Management attributed unrealized losses mainly to higher rates and wider spreads and said it did not intend, and was not more likely than not required, to sell affected securities before recovery.
- Noninterest income excluding securities gains increased, while securities gains declined to $0.029 for Q3 and $0.891 year to date. Q3 life-insurance income included death benefits. Merger-related expense was $0.319 for Q3 and $0.473 year to date. Branch expansion in Lancaster County was expected to add operating and promotional costs.
- After quarter-end, on October 1, Orrstown completed its acquisition of Mercersburg Financial Corporation for approximately $30 million in stock and cash; preliminary purchase accounting was not complete. On October 23, Orrstown agreed to acquire Hamilton Bancorp for $4.10 cash and 0.54 Orrstown shares per Hamilton share, subject to conditions; closing was expected in Q2 2019. No formal earnings guidance is provided.
- A shareholder securities class action remains pending; the company says it intends to defend itself and cannot reasonably estimate potential losses or a range. Separately, the company previously settled an SEC proceeding relating to 2010–2011 accounting matters, paying a $1 million penalty that had been reserved and expensed in 2016.
- Two employee email accounts were compromised in a phishing incident. The company reported no fraudulent payments and no known customer-account impact; Q3 included $0.144 of related investigation and remediation costs. Management also disclosed that litigation, cybersecurity, interest-rate changes, credit quality, and acquisition integration could adversely affect results. Disclosure controls were assessed as effective, with no material change in internal control over financial reporting reported for the quarter.
Important facts for investors to verify
- Whether loan growth, funding costs, and deposit mix sustain net interest income and margin as rates and competition change.
- Credit quality trends, especially commercial real estate exposures, criticized loans, collateral values, and the adequacy of the allowance as the portfolio expands.
- The effect of securities valuation changes on accumulated other comprehensive income, equity, and liquidity.
- Mercersburg integration, final purchase accounting, and expected costs; Hamilton approvals, closing conditions, consideration adjustments, and integration risks.
- Developments in the pending class action and any changes to the company’s assessment of potential exposure.
- Whether branch expansion and cybersecurity remediation create additional expenses or operational risks beyond those disclosed.