Franklin Financial Services Corporation — 2022 Form 10-K Summary
Reporting period: Fiscal year ended December 31, 2022. The filing is an annual report, not a standalone fourth-quarter report. Franklin operates primarily through Farmers and Merchants Trust Company, a Pennsylvania-chartered community bank with 22 banking offices in south-central Pennsylvania and Maryland.
Business Context
The company provides commercial, residential mortgage, construction, agricultural, consumer, deposit, trust and investment services. Total assets were approximately $1.70 billion at year-end. The loan portfolio is concentrated in the company’s local market and is heavily weighted toward commercial and real estate lending.
Key Financial Metrics
| Metric | 2022 | 2021 | Change |
|---|---|---|---|
| Total assets | $1.700 billion | $1.774 billion | Down 4.2% |
| Net loans | $1.037 billion | $983.7 million | Up 5.4% |
| Deposits | $1.551 billion | $1.584 billion | Down 2.1% |
| Net interest income | $51.6 million | $44.7 million | Up 15.5% |
| Provision for loan losses | $650 thousand | $(2.1) million | Expense versus reversal |
| Noninterest income | $15.3 million | $19.5 million | Down 21.7% |
| Noninterest expense | $48.7 million | $43.2 million | Up 12.6% |
| Net income | $14.9 million | $19.6 million | Down 23.9% |
| Diluted earnings per share | $3.36 | $4.42 | Down 24.0% |
| Net interest margin | 3.11% | 2.88% | Up 23 basis points |
| Return on average assets | 0.83% | 1.17% | Down 34 basis points |
| Efficiency ratio | 71.21% | 66.12% | Higher costs relative to revenue |
Cash Flow, Capital, Debt and Liquidity
- Operating activities generated $25.2 million of cash, compared with $26.3 million in 2021.
- Investing activities used $95.1 million, primarily reflecting purchases of investment securities, loan growth and $12.2 million of capital expenditures.
- Financing activities used $40.4 million, including dividends and treasury-stock repurchases.
- Cash and cash equivalents declined to $64.9 million from $175.1 million at year-end 2021.
- The company had $20.0 million of subordinated notes, recorded net at $19.6 million. The notes mature in 2030 and 2035 and qualify as regulatory capital.
- The Bank had no short-term FHLB borrowings outstanding and reported approximately $403.7 million of available FHLB capacity, $60.2 million of Federal Reserve Discount Window capacity and $56.0 million of correspondent-bank lines.
- Bank capital ratios remained well above regulatory well-capitalized thresholds: CET1 of 14.63%, total risk-based capital of 15.88% and Tier 1 leverage of 9.21% at December 31, 2022.
Material Changes Versus 2021
- Net interest income improved as higher interest rates increased asset yields. The yield on earning assets rose to 3.40% from 3.06%, while the cost of interest-bearing deposits increased to 0.29% from 0.16%.
- Loan growth was driven primarily by a $43.9 million increase in commercial real estate loans. Commercial-purpose loans represented 84% of total loans, and approximately 77% of loans were secured by real estate.
- Noninterest income declined primarily because 2021 included a $1.8 million gain on the sale of the former headquarters, while mortgage-sale gains and debit-card income also decreased.
- Noninterest expense increased $5.4 million. Key drivers included higher salaries and benefits, new-headquarters depreciation, rent for a Hagerstown office and implementation of a customer relationship management system.
- Shareholders’ equity decreased $42.9 million to $114.2 million. Retained earnings increased, but accumulated other comprehensive loss increased by $50.7 million because of declines in the fair value of the available-for-sale investment portfolio.
- Unrealized investment losses totaled $61.5 million before tax at year-end, but management concluded the losses were temporary and recorded no impairment charges in 2022.
- Credit quality improved materially. Nonaccrual loans declined to $120 thousand from $7.4 million, watch-list loans declined to $11.6 million from $36.6 million, and impaired loans declined to $3.0 million from $11.6 million.
- Net charge-offs were $1.5 million, primarily related to the sale of a $5.1 million nonaccrual commercial real estate loan. The allowance for loan losses declined to $14.2 million, or 1.35% of gross loans, from $15.1 million, or 1.51%.
Guidance, Outlook, Risks and Unusual Items
- Management stated that further near-term increases in interest rates were expected to negatively affect results, while longer-term higher rates could benefit the company. The filing does not provide formal earnings or revenue guidance.
- Interest-rate sensitivity analysis projected a 15.9% decline in annual net interest income under a gradual 400-basis-point rate increase and a 3.6% decline under a 100-basis-point increase, based on stated assumptions.
- Management believes liquidity is adequate, but liquidity is materially reliant on FHLB funding. The inability to access FHLB funding could adversely affect liquidity.
- Key risks include concentrations in commercial real estate and local markets, borrower credit deterioration, declining collateral values, deposit repricing and competition for deposits, unrealized investment losses, cybersecurity and operational disruptions, regulatory changes, LIBOR-to-SOFR transition and market-sensitive trust-fee income.
- Estimated uninsured deposits were $132.0 million, or 8.5% of total deposits. Money-management deposits represented 37% of deposits and generally reprice with market conditions.
- The company adopted the CECL accounting standard on January 1, 2023 and reported that the effect was immaterial.
- The independent auditor issued an unqualified opinion. The allowance for loan losses, particularly the qualitative allowance allocation, was identified as a critical audit matter.
- Management concluded that disclosure controls and internal control over financial reporting were effective as of December 31, 2022.
- Management did not expect pending litigation to have a material adverse effect on financial position, but stated that potential losses from certain matters could not be estimated and had not been specifically accrued.
Important Facts for Investors to Verify
- Whether deposit outflows and higher deposit costs compress net interest margin as rate competition continues.
- The composition, maturity and collateral quality of the commercial real estate portfolio, including hotels, offices, shopping centers and construction loans.
- Whether the large available-for-sale securities loss position is ultimately recovered or realized through asset sales.
- The sustainability of the company’s liquidity sources, particularly FHLB access, if deposit balances decline further.
- Whether credit quality remains strong after the 2022 sale of a large nonaccrual loan and whether charge-offs or allowance requirements increase.
- The effect of higher operating costs, new facilities and technology investments on the efficiency ratio.
- The company’s ability to maintain dividends and repurchases while preserving capital and funding loan growth.