FRANKLIN FINANCIAL SERVICES CORP quarterly report, Q2 FY2023

Franklin Financial Services Corporation — Q2 2023 Form 10-Q Summary

Business Context and Reporting Period

Franklin Financial Services Corporation is a Pennsylvania bank holding company whose principal subsidiary, Farmers and Merchants Trust Company of Chambersburg, provides commercial banking, lending, investment, trust, and related financial services in south-central Pennsylvania and Washington County, Maryland. This unaudited Form 10-Q covers the three and six months ended June 30, 2023, with comparisons to the corresponding 2022 periods and December 31, 2022 balances.

Key Financial Metrics

Metric	Q2 2023	Q2 2022	Six Months 2023	Six Months 2022
Interest income	$18.5 million	$12.9 million	$35.1 million	$24.4 million
Net interest income	$13.2 million	$12.1 million	$26.0 million	$22.9 million
Provision for credit losses	$0.5 million	$0	$1.1 million	$0
Noninterest income	$3.5 million	$4.1 million	$6.8 million	$8.0 million
Noninterest expense	$12.6 million	$12.0 million	$24.7 million	$23.3 million
Net income	$3.0 million	$3.6 million	$6.3 million	$6.6 million
Diluted EPS	$0.68	$0.80	$1.42	$1.47

Six-month net income decreased 4.9% year over year. Management reported second-quarter net income down 16.8% from Q2 2022 and down 9.6% from Q1 2023. The six-month effective tax rate was 11.2%, including a $280 thousand tax credit; excluding that credit, management indicated an effective rate of approximately 15.2%.

Six-month net interest margin was 3.35%, compared with 2.80% in the prior-year period.
Six-month return on average assets was 0.75% and return on average equity was 10.56%, compared with 0.74% and 9.36%, respectively, in 2022.
The six-month efficiency ratio was 71.48%, compared with 73.70% in the prior-year period.
Total assets were $1.736 billion at June 30, 2023, compared with $1.700 billion at year-end 2022.
Gross loans were $1.145 billion and net loans were $1.131 billion, up 9.0% from year-end 2022.
Total deposits were $1.513 billion, down 2.5% from year-end 2022.
Shareholders’ equity was $119.8 million, compared with $114.2 million at year-end 2022. Book value per share was $27.53 and tangible book value per share was $25.46.

Cash Flow, Debt, Liquidity, and Capital

Cash and cash equivalents were $64.8 million at June 30, 2023, essentially unchanged from year-end 2022.
Six-month operating cash flow was $13.4 million, compared with $9.3 million in 2022. Investing activities used $40.8 million, primarily reflecting a $94.4 million increase in loans, partly offset by securities sales and maturities. Financing activities provided $27.3 million.
The Bank had $70.0 million outstanding under the Federal Reserve Bank Term Funding Program, consisting of $50.0 million due March 22, 2024, at 4.38% and $20.0 million due May 10, 2024, at 4.71%. Debt securities with a fair value of $69.7 million were pledged.
Subordinated notes had a carrying value of $19.6 million and a principal amount of $20.0 million, with maturities in 2030 and 2035.
Available liquidity was reported at $537.5 million, including $420.5 million of Federal Home Loan Bank capacity, $56.9 million of Federal Reserve Discount Window capacity, $4.1 million of remaining BTFP capacity, and $56.0 million from correspondent banks.
The Bank remained well capitalized. Its June 30, 2023 ratios included 14.25% CET1, 15.50% total risk-based capital, and 9.64% Tier 1 leverage, compared with well-capitalized minimums of 6.50%, 10.00%, and 5.00%, respectively.

Material Changes Versus Prior Comparable Period

Higher market rates and loan growth increased interest income and net interest income, but deposit repricing and short-term borrowing costs rose sharply. Interest expense increased to $9.1 million for the first half from $1.5 million in 2022.
Noninterest income declined 15.3% for the first six months. The principal factors were $1.1 million of realized losses on debt securities sold during a portfolio restructuring and lower gains on mortgage loan sales.
Noninterest expense increased 5.9% for the first six months, reflecting higher salaries, occupancy costs associated with the new headquarters and operations center, and a $495 thousand lease termination expense.
The allowance for credit losses on loans was $14.6 million, or 1.28% of gross loans, compared with $14.2 million, or 1.35%, at year-end 2022. The six-month provision for loan losses was $991 thousand following adoption of the CECL model.
The AFS securities portfolio had a fair value of $439.5 million and gross unrealized losses of $57.3 million, compared with $486.8 million and $61.5 million, respectively, at year-end. Management stated that the losses were primarily interest-rate related and that it did not intend, and was not required, to sell the securities before recovery.
Deposits shifted toward higher-cost products: time deposits increased 56.4% to $89.7 million, while interest-bearing checking and savings balances declined. Management estimated that approximately 91% of deposits were FDIC insured or collateralized.
The company repurchased 74,306 shares during Q2 under its 150,000-share authorization. A total of 85,906 shares had been repurchased under the plan by June 30.

Outlook, Management Commentary, Risks, and Unusual Items

No formal earnings or revenue guidance was provided. Management stated that the local economy remained diversified and conducive to growth and that the Bank believed it could meet anticipated liquidity demands. On July 13, 2023, the Board declared a regular quarterly dividend of $0.32 per share, payable August 23, 2023.

Liquidity and deposit stability remain key risks following 2023 banking-sector failures and broader concerns about confidence in financial institutions. Potential effects include deposit outflows, higher liquidity needs, securities-market volatility, increased funding costs, and higher FDIC insurance assessments.
The loan portfolio is concentrated in commercial real estate, which totaled $638.1 million, including exposure to apartments, hotels and motels, offices, shopping centers, development land, and construction loans. Management identified collateral values, borrower cash flow, economic conditions, and interest rates as significant credit risks.
Purchased commercial loan participations totaled $83.8 million, with total exposure including unfunded commitments of $110.5 million.
Nonaccrual loans were $102 thousand, loans 90 days past due and still accruing were $94 thousand, and the watch list totaled $10.0 million. Management stated that the ACL was adequate.
Off-balance-sheet commitments to extend credit totaled $456.9 million, with standby letters of credit of $28.3 million and an ACL for unfunded commitments of $2.0 million.
Management reported no material changes in market-risk exposure, no material pending legal proceedings, and effective disclosure controls as of June 30, 2023.

Important Facts for Investors to Verify

Whether deposit trends, deposit pricing, and reliance on the $70.0 million BTFP borrowing improve or deteriorate after June 30, 2023.
The sensitivity of net interest margin and earnings to additional interest-rate changes and deposit migration into higher-cost products.
Credit performance in the commercial real estate portfolio, particularly office, hotel, construction, and development exposures.
Whether the $57.3 million unrealized AFS securities loss is recovered or leads to additional realized losses, capital pressure, or forced sales.
Future CECL provisions, watch-list migration, nonaccrual levels, charge-offs, and the adequacy of the $14.6 million loan ACL.
The pace of share repurchases, dividend sustainability, and the effect of capital distributions on regulatory capital ratios.
Management’s forward-looking assumptions regarding local economic conditions, liquidity stress testing, funding availability, and potential FDIC assessments.