Franklin Financial Services Corporation — Form 10-Q Summary
Business context and reporting period
Franklin Financial Services Corporation is a Pennsylvania bank holding company whose principal subsidiary is Farmers and Merchants Trust Company of Chambersburg. The filing covers the unaudited three and nine months ended September 30, 2018, compared with the same periods in 2017. The company reported 4.4 million shares outstanding as of October 31, 2018.
Financial performance and condition
| Metric | Q3 2018 | Q3 2017 | 9M 2018 | 9M 2017 |
|---|---|---|---|---|
| Interest income | $11.5 million | $10.1 million | $33.0 million | $29.5 million |
| Interest expense | $1.1 million | $0.6 million | $2.9 million | $1.8 million |
| Net interest income | $10.4 million | $9.4 million | $30.1 million | $27.7 million |
| Provision for loan losses | $0.3 million | $0.3 million | $9.6 million | $0.4 million |
| Noninterest income | $3.1 million | $3.0 million | $9.5 million | $9.1 million |
| Noninterest expense | $8.6 million | $8.3 million | $28.4 million | $24.4 million |
| Net income | $4.0 million | $3.1 million | $2.3 million | $9.4 million |
| Basic/diluted EPS | $0.91/$0.91 | $0.71/$0.70 | $0.53/$0.53 | $2.18/$2.17 |
- Net interest margin was 3.77% for the first nine months, compared with 3.72% in the comparable 2017 period. The reported third-quarter tax-equivalent margin was 3.80%, compared with 3.69%.
- Total assets were $1.195 billion at September 30, 2018, up $15.0 million, or approximately 1.3%, from year-end 2017.
- Gross loans were $971.0 million, up $27.3 million, or 2.9%, from year-end. Net loans were $958.5 million.
- Commercial real estate loans increased $47.4 million, while commercial and industrial loans declined $11.7 million and residential one-to-four-family loans declined $10.6 million.
- Deposits increased $24.7 million, or 2.4%, to $1.072 billion, primarily from interest-bearing checking and savings accounts. The company had no short-term borrowings at quarter-end.
- Shareholders’ equity was $114.0 million, down from $115.1 million at year-end. The decline primarily reflected dividends exceeding year-to-date net income.
- Cash and cash equivalents were $44.8 million, down $13.8 million from year-end. Year-to-date operating cash flow was $2.0 million, investing cash flow was negative $38.5 million, and financing cash flow was positive $22.7 million.
- The allowance for loan losses was $12.5 million, or 1.29% of gross loans, compared with 1.25% at year-end 2017.
- The Bank reported regulatory capital ratios above well-capitalized thresholds, including a 14.68% total risk-based capital ratio and a 9.48% Tier 1 leverage ratio at September 30, 2018.
Material changes versus comparable periods
- Third-quarter net income increased 30.0% year over year, supported by higher loan-related interest income, a 5.0% increase in noninterest income, and a lower effective tax rate of 14.1% versus 20.1%.
- Nine-month net income fell 75.4% year over year. The decline resulted primarily from a $9.2 million year-to-date increase in loan-loss provision and a $2.4 million reserve for off-balance-sheet credit exposure related to a distressed commercial loan participation.
- Net interest income increased $0.9 million in the quarter and $2.4 million year to date, as loan growth and higher loan yields more than offset increased deposit funding costs.
- Nine-month noninterest expense increased $4.0 million, or 16.3%, including higher salaries and benefits, advertising, data processing, FDIC insurance, and the off-balance-sheet reserve.
- Nonperforming loans increased to $5.7 million from $2.7 million at year-end, while nonperforming assets increased to $8.3 million from $5.3 million. Nonperforming loans were 0.58% of gross loans and nonperforming assets were 0.70% of total assets.
- Accumulated other comprehensive loss increased to $7.8 million from $6.0 million, primarily due to higher unrealized losses on available-for-sale debt securities as interest rates rose.
Guidance, outlook, commentary, risks and unusual items
- Management expects commercial lending, particularly in-market lending, to remain the primary area of loan growth. No formal earnings guidance was provided.
- Management described the local South Central Pennsylvania economy as diversified and generally supportive of growth. The filing notes that interest-rate decisions, funding costs, competition, regulation, taxation, technology and general economic conditions could materially affect results.
- A $14.4 million commercial loan participation was impaired after alleged fraudulent activities by personnel of the borrower. The Bank charged off $8.7 million of loans, retained approximately $2.9 million of related loans at September 30, and held $2.4 million of exposure through three standby letters of credit. The borrower is in bankruptcy, and the timing and amount of additional recoveries remain uncertain.
- The Bank received or expected $1.3 million of bankruptcy-court proceeds in October 2018 and had reduced the related loan balance to approximately $1.6 million after that payment. Further proceeds were expected, but the filing does not provide a clear final recovery estimate.
- The $10 million Kalan litigation settlement was paid in May 2018 and had already been accrued in 2017. The court granted final approval and dismissed the case with prejudice in July 2018.
- The Bank held $2.7 million of other real estate owned, primarily a 196-acre residential development property. The property was under contract subject to buyer due diligence through May 2019.
- Available-for-sale securities had a fair value of $125.4 million and $2.4 million of unrealized losses across 192 temporarily impaired securities. Management concluded the losses were temporary and recorded no additional impairment charge.
- The company adopted ASC 606 and other accounting updates in 2018 without a material effect. It expected operating leases to be recognized on the balance sheet under ASC 842 beginning January 1, 2019, although the balance-sheet impact had not been determined. The company was also evaluating the expected impact of CECL, effective January 1, 2020, which could result in earlier and potentially larger credit-loss recognition.
- Liquidity sources included $337.7 million of available FHLB borrowing capacity and approximately $19 million of Federal Reserve Discount Window borrowing capacity. Management stated that it believed anticipated liquidity demands could be met.
Investor verification points
- Verify the ultimate recovery from the bankrupt commercial loan participation and the $2.4 million standby-letter-of-credit exposure.
- Assess whether the elevated loan-loss provision and nonperforming-loan levels are isolated to the participation or indicate broader commercial-credit deterioration.
- Monitor commercial real estate concentration, including the $475.8 million portfolio and exposure to hotels, offices, land development and manufacturing facilities.
- Review the effect of rising deposit costs and future Federal Reserve rate changes on the net interest margin.
- Confirm the balance-sheet impact of adopting ASC 842 lease accounting and the expected allowance impact of CECL.
- Evaluate dividend sustainability given the nine-month payout ratio of 146.9% and shareholders’ equity decline.
- Confirm the timing and proceeds from the proposed sale of the principal OREO property and any related valuation changes.