Business context and reporting period
Franklin Financial Services Corporation is a Pennsylvania bank holding company conducting substantially all business through Farmers and Merchants Trust Company, a community bank with 22 offices in south-central Pennsylvania. The Form 10-K covers the fiscal year ended December 31, 2018, with comparisons primarily to 2017. The Bank had approximately $1.2 billion of assets and 255 full-time equivalent employees at year-end.
The loan portfolio is concentrated in the local market and in commercial lending, particularly commercial real estate. The common stock traded on OTCQX under FRAF; management announced in March 2019 that Nasdaq listing was approved, with trading expected to begin around May 1, 2019.
Financial performance and condition
| Metric | 2018 | 2017 | Change |
|---|---|---|---|
| Total assets | $1.210 billion | $1.180 billion | +2.5% |
| Total loans | $973.4 million | $943.7 million | +3.1% |
| Net loans | $961.0 million | $931.9 million | +3.1% |
| Deposits | $1.083 billion | $1.047 billion | +3.4% |
| Shareholders’ equity | $118.4 million | $115.1 million | +2.8% |
| Net interest income | $40.7 million | $37.4 million | +8.7% |
| Provision for loan losses | $10.0 million | $0.7 million | Significant increase |
| Noninterest income | $12.6 million | $12.2 million | +3.6% |
| Noninterest expense | $37.4 million | $43.2 million | -13.4% |
| Net income | $6.1 million | $2.2 million | +181.5% |
| Diluted earnings per share | $1.39 | $0.50 | +178% |
- Fully tax-equivalent net interest margin increased to 3.78% from 3.72%, while the yield on earning assets rose to 4.16% from 3.96%. Interest income increased 12.5%, but interest expense increased 69.2% as deposit costs rose with market rates.
- Return on average assets was 0.52%, return on average equity was 5.34%, and the non-GAAP efficiency ratio was 68.27%.
- Cash and cash equivalents totaled $53.0 million at year-end versus $58.6 million in 2017. Operating cash flow was $9.3 million, investing activities used $47.5 million, and financing activities provided $32.5 million.
- The Bank had no long-term debt and no short-term borrowings outstanding at year-end. It had $348.6 million of available FHLB borrowing capacity, approximately $17 million of Federal Reserve discount-window availability, and a $6 million unsecured correspondent-bank line.
- Capital remained strong: the Bank reported a 13.80% CET1 ratio, 13.80% Tier 1 risk-based capital ratio, 15.06% total risk-based capital ratio, and 9.68% Tier 1 leverage ratio. The Bank was classified as well capitalized.
- Cash dividends declared increased to $1.05 per share from $0.93. The year-end market price was $31.50 per share and book value was $26.85 per share.
Material changes versus the prior comparable period
- Net income increased primarily because 2017 included a $10 million legal-settlement accrual related to the Kalan litigation and a $2.3 million deferred-tax-asset revaluation charge following the Tax Cuts and Jobs Act. These items did not recur in 2018.
- The improvement was substantially offset by a $9.3 million net loan charge-off and a $10.0 million loan-loss provision in 2018 associated largely with an impaired commercial loan participation.
- The Bank recorded $9.6 million of gross charge-offs and $258 thousand of recoveries. Excluding the affected participation, 2018 net charge-offs would have been approximately $32 thousand.
- Commercial loans increased 5.8% to $762.0 million, including commercial real estate growth of 13.9% to $488.0 million. Residential real estate loans declined 6.1% to $196.1 million.
- Purchased commercial loan participations declined to $93.4 million, or 11.2% of commercial-purpose loans, from $115.3 million, or 14.5%, as management reduced participation exposure.
- Nonperforming loans were $2.7 million, or 0.27% of gross loans, broadly unchanged from 2017. Nonperforming assets were $5.3 million, or 0.44% of total assets.
- The allowance for loan losses increased to $12.4 million, or 1.28% of loans, from $11.8 million, or 1.25%.
Guidance, outlook, commentary, risks and unusual items
- Management expects commercial lending, particularly in-market lending, to remain the primary source of loan growth. It believes the local economy remains suitable for growth, but competition for quality loans and deposits is strong.
- The Federal Reserve raised the federal funds target range four times in 2018. Management noted that officials anticipated fewer and more gradual increases in 2019, creating uncertainty for deposit costs, loan demand and net interest income.
- The major unusual item was the commercial participation impairment. Fraud was allegedly committed by borrower executives or personnel. The Bank had no remaining loan balance related to the participation at December 31, 2018, but retained $2.4 million of exposure through three letters of credit and recorded a corresponding reserve. One proof of claim had been submitted in the borrower’s bankruptcy proceeding.
- The $10 million Kalan settlement was paid in May 2018 from available assets and had already been accrued in 2017. Management reported no other proceedings expected to materially affect financial position, but stated that potential losses from other legal matters cannot be estimated clearly.
- Other principal risks include concentration in commercial real estate and local borrowers, collateral-value declines, interest-rate and deposit repricing risk, reliance on FHLB funding for contingency liquidity, short-term certificate-of-deposit maturities, cybersecurity and vendor-system disruptions, LIBOR transition risk, and dependence of trust-fee income on equity-market values.
- The Bank had $271.7 million of unused loan commitments and $25.4 million of standby letters of credit. Management believes anticipated draws can be funded in the normal course.
- The company expected to adopt the new lease standard in 2019 and estimated recognition of a $5 million to $6 million right-of-use asset and lease liability. It also expected CECL implementation in 2020, which may result in earlier and potentially higher credit-loss provisions.
- Goodwill of $9.0 million was tested and determined not to be impaired. Securities had $1.5 million of gross unrealized losses at year-end, which management considered temporary.
Important facts for investors to verify
- Reconcile the 2018 earnings improvement for the nonrecurring 2017 legal and tax charges against the recurring effects of higher loan-loss provisions and deposit funding costs.
- Monitor commercial real estate concentration, hotel and motel exposure, purchased participations, local economic conditions and the adequacy of the $12.4 million allowance for loan losses.
- Track recovery prospects for the $2.4 million letters-of-credit exposure in bankruptcy and any additional claims or charges related to the impaired participation.
- Evaluate deposit repricing risk, especially the 40% of deposits in money-management products and the $36.4 million of time deposits scheduled to mature in 2019.
- Assess liquidity dependence on the FHLB, including the availability and collateral requirements of the $348.6 million borrowing capacity.
- Review the effect of the planned Nasdaq listing, ongoing stock liquidity, dividend policy and the company’s reliance on dividends from the Bank subsidiary.
- Confirm the eventual balance-sheet and capital effects of lease accounting and CECL adoption, as the filing provides estimates but not final implementation amounts.