Franklin Financial Services Corporation — FY2014 Form 10-K Summary
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 of Chambersburg, a community bank with 22 offices in south-central Pennsylvania. The filing covers the fiscal year ended December 31, 2014, with comparative financial information for 2013 and 2012. The bank provides commercial, consumer, residential mortgage, trust and investment services.
Key financial metrics
| Metric | 2014 | 2013 | Change |
|---|---|---|---|
| Total assets | $1.001 billion | $984.6 million | Up 1.7% |
| Net income | $8.402 million | $6.232 million | Up 34.8% |
| Diluted EPS | $2.00 | $1.51 | Up $0.49 |
| Net interest income | $31.614 million | $31.664 million | Down 0.2% |
| Tax-equivalent net interest income | $33.592 million | $33.260 million | Up 1.0% |
| Net interest margin | 3.56% | 3.47% | Up 9 basis points |
| Provision for loan losses | $764 thousand | $2.920 million | Down $2.156 million |
| Noninterest income | $10.861 million | $9.877 million | Up 10.0% |
| Noninterest expense | $31.303 million | $31.094 million | Up 0.7% |
| Net loans | $717.4 million | $713.7 million | Up 0.5% |
| Total deposits | $881.2 million | $845.7 million | Up 4.2% |
| Shareholders’ equity | $103.5 million | $95.4 million | Up 8.5% |
| Cash and cash equivalents | $48.6 million | $40.7 million | Up $7.8 million |
| Net cash from operating activities | $14.4 million | $15.4 million | Down $1.0 million |
| Net cash used in investing activities | $12.9 million | $3.6 million | Higher investment outflow |
| Net cash from financing activities | $6.4 million | $(48.9) million | Improved |
Return on average assets was 0.83%, return on average equity was 8.44%, and the efficiency ratio was 70.83%. The bank remained well capitalized: total risk-based capital was 15.49%, Tier 1 risk-based capital was 14.19%, and the Tier 1 leverage ratio was 9.69% at year-end.
Material changes versus the prior comparable period
- Profitability improved primarily because the provision for loan losses fell sharply as credit quality and charge-offs improved. Net charge-offs declined to $1.355 million from $3.597 million.
- Nonperforming loans declined to $12.613 million from $25.247 million, while nonperforming assets declined to $16.279 million from $29.955 million. The nonperforming-loan ratio improved to 1.74% from 3.49%.
- The allowance for loan losses declined to $9.111 million, or 1.25% of loans, from $9.702 million, or 1.34%. Management stated that the allowance was adequate, but its determination remains judgmental.
- Net loans increased modestly. Commercial loans increased 1.2% year-end to year-end, residential real estate loans increased 1.2%, while residential construction and consumer loans declined.
- Deposits increased $35.5 million, driven by noninterest-bearing and interest-bearing checking, money management and savings accounts. Time deposits declined $15.3 million.
- The bank purchased $41.2 million of investment securities, increasing securities available for sale to $171.8 million from $159.7 million. Unrealized securities losses improved substantially to $1.393 million from $3.476 million.
- Long-term debt was fully repaid during 2014. The bank incurred $182 thousand of prepayment penalties in connection with the repayment.
- Noninterest income increased across most fee categories, including trust and investment fees, deposit fees, other service charges and debit card income. Net securities gains were $280 thousand versus $33 thousand.
- Noninterest expense was broadly stable. Salary expense increased partly because of salary adjustments, incentive compensation and severance related to the January 2015 consolidation of three offices.
- Shareholders’ equity increased by $8.1 million. The company declared and paid $0.68 per share of regular dividends and did not repurchase shares.
Guidance, outlook, risks and unusual items
- Management expected 2015 provision expense to return toward a more normalized level after the unusually low 2014 provision.
- Management did not expect commercial loan production to increase substantially in 2015. It expected commercial lending to remain the primary growth area and residential mortgage activity to be primarily purchase-money lending.
- Management expected consumer loans to continue running off and home equity lending not to increase significantly. Prolonged low short-term rates were identified as a continuing pressure on net interest margin.
- The loan portfolio is concentrated geographically and in real estate. Approximately 74% of loans were secured by real estate, including approximately 45% commercial, industrial and agricultural real estate loans.
- Liquidity sources included $35.0 million available under an FHLB line, approximately $16 million of unsecured correspondent-bank lines and approximately $29 million of Federal Reserve discount-window capacity. Management believed anticipated liquidity needs could be met.
- Off-balance-sheet commitments included $248.3 million of unused lending commitments and $22.7 million of standby letters of credit. Actual draws may be lower, but these commitments create credit and liquidity exposure.
- The bank held $1.7 million of private-label mortgage-backed securities, primarily Alt-A securities, and recorded $20 thousand of other-than-temporary impairment in 2014. Management warned that additional write-downs were possible if loss trends continued.
- The bank participated in litigation concerning alleged underwriting misrepresentations related to certain private-label mortgage-backed securities. The resolution was unknown at filing.
- Management projected a higher 2015 pension expense because of a lower discount rate. Potential adoption of new mortality tables was estimated to reduce funded status by $1.6 million and increase 2015 pension expense by $272 thousand, although an adoption date had not been determined.
- Goodwill of $9.016 million was tested for impairment and was not impaired. The customer-list intangible was written off in 2014; remaining intangible assets were $181 thousand.
- The company expected a pretax gain of approximately $628 thousand in the first quarter of 2015 upon completion of S&T Bancorp’s acquisition of Integrity Bancshares, in which the bank held shares.
- Interest-rate sensitivity modeling showed projected net interest income of $30.992 million under a gradual 100-basis-point decline and $32.635 million under a gradual 400-basis-point increase, versus a $31.468 million unchanged-rate scenario. Management cautioned that these modeled results depend on assumptions.
- Other principal risks include competitive loan and deposit pricing, real estate collateral values, allowance adequacy, interest-rate movements, cybersecurity and operational-system disruptions, regulatory changes, and the limited trading market for the company’s common stock.
Important facts for investors to verify
- Whether the improvement in nonperforming loans and charge-offs is sustained and whether the $9.111 million allowance remains adequate as provisions normalize.
- The concentration and performance of commercial real estate, construction, purchased loan participations and other geographically concentrated exposures.
- The effect of continued low rates or an eventual rate increase on net interest margin, deposit pricing and variable-rate commercial-loan yields.
- The potential for additional losses on private-label mortgage-backed securities, including the status and outcome of related litigation.
- The timing and amount of the expected Integrity Bancshares transaction gain and whether it is ultimately realized.
- The impact of pension assumptions, potential mortality-table changes and future required contributions.
- Liquidity coverage of the $248.3 million in unused commitments and $22.7 million in standby letters of credit under stressed funding conditions.
- Regulatory capital and dividend restrictions as Basel III requirements phase in, including the bank’s continued ability to upstream dividends to the holding company.
- The company’s thinly traded OTCQX stock, dividend sustainability and the absence of share repurchases during 2014.