FRANKLIN FINANCIAL SERVICES CORP quarterly report, Q3 FY2013

Franklin Financial Services Corporation — Form 10-Q Summary

Reporting period: Quarter and nine months ended September 30, 2013. The company is a Pennsylvania-based bank holding company whose principal subsidiary is Farmers and Merchants Trust Company of Chambersburg. Financial statements are unaudited and dollars are in thousands unless otherwise stated.

Financial position and performance

Metric	Q3 2013	Q3 2012	9M 2013	9M 2012
Total revenue	$11,445	$11,937	$34,209	$36,945
Net interest income	$7,996	$8,036	$23,436	$24,211
Provision for loan losses	$350	$825	$1,955	$3,600
Net income	$2,185	$1,747	$5,091	$5,021
Diluted EPS	$0.53	$0.43	$1.23	$1.24
Net interest margin	3.51%	3.42%	3.40%	3.51%

Assets and loans: Total assets were $1.003 billion, down from $1.027 billion at December 31, 2012. Gross loans declined 4.4% to $720.2 million and net loans declined 4.6% to $708.8 million. Investment securities increased 22.0% to $162.8 million.
Deposits and debt: Deposits were $865.8 million, down 1.0% from year-end. Securities sold under repurchase agreements declined to $23.9 million from $42.2 million. Long-term debt was $12.4 million.
Liquidity: Cash and cash equivalents were $61.6 million, down $16.2 million from year-end. The Bank reported approximately $35 million available under an FHLB line, $16 million of unsecured correspondent-bank lines, and approximately $33 million of Federal Reserve Discount Window capacity.
Capital: Shareholders’ equity increased to $93.4 million. The company reported a 13.92% total risk-based capital ratio, 12.66% Tier 1 risk-based ratio, and 8.90% Tier 1 leverage ratio at September 30, 2013; management characterized the company and bank as well capitalized.
Cash flow: Nine-month operating cash flow was $12.7 million versus $10.7 million in the prior-year period. Investing activities used $0.5 million, while financing activities used $28.4 million, primarily reflecting deposit and repurchase-agreement changes. Ending cash was $61.6 million versus $104.2 million a year earlier.
Returns and efficiency: Nine-month return on average assets was 0.66%, return on average equity was 7.37%, and the efficiency ratio was 70.70%.

Material changes versus comparable periods

Third-quarter net income rose 25.1% year over year, while nine-month net income increased 1.4%. The quarterly improvement primarily reflected lower loan-loss provision expense and higher noninterest income.
Nine-month net interest income declined 3.2%, and the net interest margin declined from 3.51% to 3.40%, primarily because asset yields declined faster than funding costs.
Interest expense fell substantially, to $945 thousand in Q3 and $3.5 million year to date, as deposit and borrowing costs declined.
Noninterest income increased 13.4% in Q3 and 0.3% year to date. Investment and trust services fees were the primary contributor, partly offset by lower loan service charges.
Noninterest expense increased 0.4% in Q3 and 2.9% year to date, driven by occupancy, technology, professional fees, and other operating costs. Pension expense declined following a $6.0 million supplemental pension contribution in December 2012.
Loan quality improved: nonperforming loans decreased to $28.8 million from $37.0 million at year-end, nonperforming assets declined to $33.6 million from $42.1 million, and watch-list loans declined to $87.1 million from $104.3 million.
The allowance for loan losses increased to $11.4 million, or 1.58% of loans, from $10.4 million, or 1.38%, at year-end. Year-to-date net charge-offs were $958 thousand versus $3.2 million in the prior-year period.
Accumulated other comprehensive loss increased to $5.9 million from $4.1 million, primarily because of unrealized investment-security losses associated with higher interest rates.

Outlook, risks, contingencies, and unusual items

Management expected the low interest-rate environment to continue beyond 2013, potentially pressuring net interest margins as asset yields decline while liability costs have limited room to fall.
Management expected investment-portfolio yields to continue declining as higher-yielding securities mature or pay down and are reinvested at lower rates.
The Bank expected to continue selectively retaining residential mortgage production during 2013, while home-equity lending and commercial lending remained weak or in runoff.
Management expected 2013 pension expense of approximately $560 thousand versus $1.1 million in 2012 and did not expect additional pension contributions in 2013.
Investment securities included $5.1 million of trust preferred securities with $789 thousand of unrealized losses and $2.1 million of private-label mortgage-backed securities. The Bank recorded $25 thousand of additional other-than-temporary impairment during Q3 and had cumulative credit losses of $515 thousand on the private-label portfolio. Additional write-downs remain possible.
The Bank was involved in a class-action lawsuit concerning alleged defective warranties and representations by a private-label mortgage-backed securities servicer. Management stated that no pending legal proceedings were material to financial condition or shareholders’ equity.
Unused loan commitments and standby letters of credit totaled $238.5 million. Standby letters of credit were $20.4 million, and management believed collateral and guarantees would cover potential payments.
New regulatory capital rules were scheduled to become effective beginning in 2015. Management expected compliance with the fully implemented rules and expected to elect the provision allowing unrealized gains and losses on securities to be excluded from regulatory capital.
The Board declared a regular quarterly dividend of $0.17 per share for the fourth quarter of 2013, payable November 27, 2013.

Investor verification priorities

Verify whether commercial loan runoff continues and whether the decline in nonperforming loans is sustained without materially higher charge-offs.
Review the adequacy of the $11.4 million allowance relative to $28.8 million of nonperforming loans, $37.4 million of impaired loans, and collateral-dependent exposures.
Monitor net interest margin compression, reinvestment yields, deposit mix, and the effect of continued low interest rates.
Assess liquidity available from the FHLB, Federal Reserve, correspondent lines, and unpledged securities, including the effect of the FHLB’s transitional release from collateral-delivery requirements.
Evaluate unrealized losses and potential future impairment in municipal, trust preferred, and private-label mortgage-backed securities.
Confirm the effect of the 2015 capital rules and the company’s ability to maintain well-capitalized status while continuing dividends.