Franklin Financial Services Corporation — 2013 Form 10-K
Reporting period: Fiscal year ended December 31, 2013; quarterly data includes the three months ended December 31, 2013. Franklin is a Pennsylvania bank holding company conducting substantially all business through Farmers and Merchants Trust Company, a community bank with 25 offices in south-central Pennsylvania.
Financial performance and condition
| Metric | 2013 | 2012 | Change |
|---|---|---|---|
| Net income | $6.232 million | $5.365 million | +16.2% |
| Diluted EPS | $1.51 | $1.32 | +$0.19 |
| Net interest income | $31.664 million | $32.252 million | -1.8% |
| Provision for loan losses | $2.920 million | $5.225 million | -44.1% |
| Noninterest income | $9.877 million | $9.451 million | +4.5% |
| Noninterest expense | $31.094 million | $30.601 million | +1.6% |
| Net interest margin | 3.47% | 3.50% | -3 basis points |
| Return on average assets | 0.61% | 0.51% | Improved |
| Return on average equity | 6.72% | 6.00% | Improved |
| Efficiency ratio | 72.01% | 70.44% | Higher |
Dollars are as reported in the filing; financial statement amounts are generally in thousands unless otherwise indicated.
- Balance sheet: Total assets declined 4.2% to $984.6 million. Net loans declined 4.0% to $713.7 million, primarily because commercial real estate and other commercial balances decreased. Investment securities increased to $159.7 million from $133.3 million.
- Funding and debt: Total deposits declined 3.3% to $845.7 million, with time deposits falling to $113.9 million from $178.1 million. Repurchase agreements declined to $23.8 million from $42.2 million. Long-term FHLB debt was approximately $12.4 million at year-end.
- Liquidity: Cash and cash equivalents declined to $40.7 million from $77.8 million, while operating cash flow increased to $15.4 million from $10.6 million. Available liquidity included approximately $38 million on an FHLB line, $16 million of unsecured correspondent-bank lines, and approximately $46 million available through the Federal Reserve Discount Window. The filing states that FHLB borrowing capacity increased to $170 million in February 2014.
- Cash flows: Investing activities used $3.6 million, including $69.1 million of investment-security purchases offset by security maturities, paydowns and a $26.4 million net decrease in loans. Financing activities used $48.9 million, primarily from reductions in time deposits and repurchase agreements and dividends paid.
- Capital: Shareholders’ equity increased 4.1% to $95.4 million. The Corporation reported a 14.24% total risk-based capital ratio, 12.97% Tier 1 risk-based ratio and 9.14% Tier 1 leverage ratio. The Corporation and Bank were classified as well capitalized.
- Credit quality: Nonperforming loans declined to $25.2 million from $37.0 million, and nonperforming assets declined to $30.0 million from $42.1 million. Nonperforming loans were 3.49% of gross loans versus 4.90%. The allowance for loan losses declined to $9.7 million, or 1.34% of loans, while net charge-offs declined to $3.6 million from $4.6 million.
- Shareholder returns: The Corporation declared and paid $0.68 per share in regular cash dividends, compared with $0.78 in 2012. No shares were repurchased. Year-end market value was $17.10 per share versus $14.00 in 2012; the common stock remains thinly traded on OTCQB under FRAF.
Material changes versus the prior comparable period
- Net income improved mainly because of the lower loan-loss provision and improved credit quality, despite lower net interest income and margin compression.
- Interest income declined 7.9%, but interest expense declined 36.5%, reflecting lower deposit costs, reduced brokered CDs and substantially lower long-term debt balances.
- Investment and trust services fees increased 8.4%, and trust assets under management increased to $574.7 million from $520.4 million. Losses on other real estate owned also decreased.
- Commercial lending contracted amid slow loan demand, intense competition and pricing pressure. Commercial real estate loans declined 9.5%, while residential real estate loans increased 2.9%.
- Watch-list loans declined to $76.3 million from $104.3 million. However, the portfolio remains concentrated: approximately 75% of loans were secured by real estate, including 45% in commercial, industrial and agricultural real estate.
- Other comprehensive loss was $646 thousand, compared with other comprehensive income of $1.081 million in 2012, primarily reflecting unrealized investment-security losses.
Guidance, outlook, risks and unusual items
- Management expected short-term interest rates to remain low into 2015 and stated that prolonged low rates would pressure net interest margin. The Bank’s balance sheet was described as asset sensitive, with projected one-year net interest income increasing under rising-rate scenarios and declining under falling-rate scenarios.
- Management expected 2014 mortgage activity to shift from refinancing toward purchase-money mortgages, with continued selective mortgage retention. Commercial loan production was not expected to be substantially higher, and consumer balances were expected to continue running off.
- The Bank planned to continue moving repurchase accounts into fully insured deposit products and expected to close all repurchase accounts by the end of 2014.
- Basel III requirements begin taking effect in 2015. Management believed the Bank would remain well capitalized under the new rules.
- Residential mortgage Ability-to-Repay and Qualified Mortgage rules became effective January 10, 2014. Management expected higher compliance costs, possible effects on mortgage volume and increased liability exposure.
- A nonrecurring $667 thousand deferred-compensation expense was recorded in the fourth quarter after the FDIC reversed an earlier determination that the payment was impermissible.
- The investment portfolio included $5.1 million of trust preferred securities with $871 thousand of unrealized losses and $2.0 million of private-label mortgage-backed securities. The Bank recorded $75 thousand of other-than-temporary impairment charges and stated that additional write-downs could occur if private-label mortgage-backed securities deteriorate.
- The Bank participates in litigation concerning alleged misrepresentations related to certain private-label mortgage-backed securities; the outcome was not known. Management stated that ordinary-course litigation was not expected to have a material adverse effect.
- Off-balance-sheet exposure included $219.4 million of unused commitments to extend credit and $20.2 million of standby letters of credit. Management believed expected draws could be funded through normal operations.
- Key risks include concentrated commercial real estate exposure, localized economic and collateral values, allowance adequacy, interest-rate changes, deposit competition, regulatory changes, liquidity access and the limited trading market for the common stock.
Facts investors should verify
- Whether the improvement in earnings remains sustainable after the unusually large reduction in loan-loss provision and the fourth-quarter deferred-compensation charge.
- Trends in nonperforming loans, watch-list loans, troubled debt restructurings, OREO and commercial real estate collateral values.
- Whether loan balances and net interest margin stabilize as low-rate pressure and competitive pricing continue.
- Actual deposit retention, certificate-of-deposit maturities, repurchase-account migration and available borrowing capacity.
- Potential future impairment of private-label mortgage-backed securities, trust preferred securities or FHLB restricted stock, including the status of related litigation.
- The effect of Basel III and Ability-to-Repay/Qualified Mortgage requirements on capital, compliance costs and mortgage production.
- Dividend capacity, given that the parent depends substantially on dividends from the regulated Bank and such payments are subject to regulatory restrictions.