ORRSTOWN FINANCIAL SERVICES INC annual report, FY2023

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Business context and reporting period

Orrstown Financial Services, Inc. (NASDAQ: ORRF) is a Pennsylvania-based bank holding company operating Orrstown Bank, a community bank serving south-central Pennsylvania and parts of Maryland. This Form 10-K reports the fiscal year ended December 31, 2023; quarterly figures below are for Q4. Unless noted, amounts are in millions.

Key financial results and condition

  • FY 2023 earnings: Net income was $35.7 million, up from $22.0 million in 2022; diluted EPS was $3.42 versus $2.06. The 2022 comparison included a $13.0 million legal-settlement charge and $3.2 million restructuring charge. Management’s non-GAAP adjusted net income was $36.6 million in 2023 versus $34.8 million in 2022; adjusted diluted EPS was $3.51 versus $3.25.
  • Q4: Net income was $7.6 million and diluted EPS was $0.73, compared with $9.6 million and $0.91 in Q4 2022. Net interest income was $26.0 million versus $27.5 million.
  • Revenue and margins: FY net interest income increased 5% to $104.9 million. Tax-equivalent net interest margin edged down to 3.80% from 3.81%; net interest spread declined to 3.39% from 3.70%. Deposit interest expense rose sharply as funding costs repriced.
  • Other income and expenses: Noninterest income declined 4.8% to $25.7 million, chiefly from lower swap fees. Noninterest expense fell 12.5% to $83.8 million, largely because 2022 included the settlement and restructuring charges; 2023 included $1.1 million of merger costs. Salaries and benefits rose 6.2% to $51.0 million, and FDIC insurance expense rose 81% to $2.0 million.
  • Loans and credit: Loans grew 7% excluding PPP forgiveness, reaching $2.30 billion at year-end. The allowance for credit losses was $28.7 million, or 1.25% of loans, versus $25.2 million and 1.17% in 2022. Nonaccrual loans increased to $25.5 million, or 1.11% of loans, from $20.6 million and 0.96%. Net charge-offs were $581,000, up from $162,000.
  • Balance sheet and liquidity: Assets were $3.06 billion; deposits were $2.56 billion, up 3%; shareholders’ equity was $265.1 million. Cash and cash equivalents totaled $65.2 million. Uninsured, uncollateralized deposits were $442.7 million, or 17% of deposits. Management reported approximately $1.0 billion of combined FHLB and Federal Reserve borrowing capacity; $381.9 million of time deposits were due within one year.
  • Debt and capital: FHLB advances and other borrowings totaled $137.5 million, and subordinated notes were $32.1 million. The subordinated notes’ rate reset to floating SOFR plus 3.16%; it was 8.78% at year-end. The Bank’s regulatory capital ratios exceeded well-capitalized standards; its capital conservation buffer was 4.8% against a 2.5% requirement.
  • Cash flow and shareholder returns: Operating cash flow was $43.7 million; investing activities used $153.2 million, principally reflecting loan growth. FY dividends were $0.80 per share, up from $0.76. The company repurchased 130,592 shares during 2023.

Material changes versus prior periods

  • Interest income rose with loan growth and higher rates, but deposit and borrowing costs increased faster, weighing on spread and leaving net interest margin nearly flat.
  • Commercial real estate lending remained a major concentration: CRE loans equaled 307% of risk-based capital, and the portfolio had grown 69% over three years. Construction and land-development loans were 44% of risk-based capital. Office-space loans totaled $226.5 million, about 2% of CRE loans.
  • Credit indicators weakened: nonaccrual loans, net charge-offs, and certain criticized loan categories increased. The company adopted CECL on January 1, 2023, increasing the loan allowance by $2.4 million and reducing retained earnings, net of tax, by $2.0 million.
  • Unrealized losses on available-for-sale securities narrowed by $14.0 million during 2023; year-end gross unrealized losses were $36.9 million. Management attributed them primarily to market rates and spreads, and reported no securities credit-loss allowance.
  • FY 2022 results were affected by a $13.0 million legal-settlement provision and $3.2 million restructuring charge. The settlement was finalized and dismissed with prejudice in 2023.

Outlook, risks and contingencies

No numerical earnings or margin guidance is provided. Management cited intense competition for deposits and quality loans, an inverted yield curve, higher funding costs, and challenges to margin growth and expense management. The Bank is liability-sensitive in its interest-rate model: a 200-basis-point increase was projected to reduce 12-month net interest income by 1.0%, while a 200-basis-point decrease was projected to reduce it by 5.9%; these are model estimates subject to assumptions.

Orrstown agreed to a merger of equals with Codorus Valley Bancorp on December 12, 2023. Codorus Valley shareholders are to receive 0.875 Orrstown shares per share, with former Orrstown shareholders expected to own approximately 56% of the combined company and Codorus Valley shareholders 44%. Closing was expected in Q3 2024, subject to shareholder and regulatory approvals and other conditions. The filing warns of execution, integration, cost, employee-retention and business-disruption risks; a termination fee of $8.3 million may apply in specified circumstances.

Other material risks include CRE and commercial lending exposure, deposit outflows and funding costs, interest-rate and securities-value volatility, local economic conditions, cybersecurity and operational risks, regulatory changes, and competition. A putative class action alleges improper overdraft fees and seeks damages and injunctive relief; the filing does not provide a clear estimate of potential loss. The 2022 SEPTA securities class action settlement was fully approved, dismissed, and no appeal was filed. The independent auditor issued an unqualified opinion and concluded internal control over financial reporting was effective at year-end.

Important facts for investors to verify

  • Progress, approvals, final terms, integration costs and expected benefits of the Codorus Valley merger.
  • Trends in deposit mix, uninsured deposits, time-deposit maturities, borrowing needs and the cost of funds.
  • CRE concentrations and underwriting performance, including office, construction, criticized and nonaccrual loans; assess allowance adequacy under CECL.
  • Interest-rate sensitivity and the effects of further rate changes on net interest income, securities values and subordinated-debt expense.
  • Outcome and potential financial impact of the overdraft-fee litigation, and any subsequent regulatory or legal developments.
  • Whether earnings, margins, credit quality and dividends remain sustainable after excluding or accounting for merger-related and other unusual items.