Franklin Financial Services Corporation — Q2 2015 Form 10-Q
Business context and reporting period
Franklin Financial Services Corporation is the parent of Farmers and Merchants Trust Company of Chambersburg, a commercial bank serving south-central Pennsylvania, and Franklin Future Fund Inc. The unaudited filing covers the three and six months ended June 30, 2015, with comparisons to June 30, 2014 and December 31, 2014.
Financial results and key metrics
- Net income: $2.5 million for the quarter, up 6.7% from $2.3 million; $5.4 million for the first six months, up 29.3% from $4.1 million.
- Diluted EPS: $0.58 for the quarter versus $0.55; $1.26 year to date versus $0.99.
- Net interest income: $8.0 million for the quarter versus $7.9 million; $15.8 million year to date versus $15.7 million. The year-to-date tax-equivalent net interest margin was 3.60% versus 3.56%.
- Noninterest income: $3.1 million for the quarter, up 8.9%; $6.8 million year to date, up 29.1%.
- Noninterest expense: $7.7 million for the quarter, up 0.6%; $15.2 million year to date, down 1.0%. The year-to-date efficiency ratio was 66.11% versus 70.63%.
- Provision and credit costs: Provision for loan losses was $310 thousand for the quarter and $635 thousand year to date, compared with $266 thousand and $464 thousand, respectively. Net charge-offs were $70 thousand in the quarter and $296 thousand year to date.
- Assets and loans: Total assets were $1.029 billion, up $27.1 million from year-end. Gross loans were $733.2 million, up 0.9%; net loans were $723.8 million, up 0.9%.
- Deposits and liquidity: Deposits were $916.1 million, up 4.0% from year-end. Cash and cash equivalents were $64.4 million, up $15.8 million. Management reported approximately $35 million available under an FHLB line, $16 million of unsecured correspondent-bank lines, $240.8 million of excess borrowing capacity, and approximately $28 million available through the Federal Reserve Discount Window.
- Debt: The Corporation had no short-term or long-term borrowings and no repurchase agreements outstanding at June 30, 2015.
- Capital: Shareholders’ equity was $107.2 million, up from $103.5 million at year-end. The Corporation and Bank were both reported as well capitalized under Basel III. Consolidated common equity Tier 1, total risk-based capital, and Tier 1 leverage ratios were 14.48%, 15.73%, and 10.17%, respectively.
- Credit quality: Nonperforming loans were $9.5 million, or 1.30% of gross loans, versus $12.6 million, or 1.74%, at year-end. Nonperforming assets were $13.5 million, or 1.32% of assets. The allowance for loan losses was $9.45 million, or 1.29% of loans.
- Dividends: Year-to-date dividends declared were $0.36 per share versus $0.34 in the prior-year period. On July 23, 2015, the Board declared a $0.19 quarterly dividend payable August 26, 2015.
Material changes versus comparable periods
- Year-to-date earnings benefited from $899 thousand of nonrecurring noninterest income, including a $728 thousand gain on conversion of equity securities following an acquisition and a $171 thousand gain from liquidation of an offshore insurance investment. Excluding these items, management stated that first-half net income would have been approximately $4.8 million, up about 15%.
- Interest income declined $230 thousand year to date, but interest expense declined $387 thousand as average interest-bearing liabilities and funding costs decreased. This produced a $157 thousand increase in reported net interest income.
- Noninterest income growth was driven by higher investment and trust service fees, deposit service charges, loan service charges, other service charges, the offshore insurance gain, and the conversion gain.
- First-half noninterest expense decreased $154 thousand, reflecting lower advertising, legal and professional fees, occupancy expense, and FDIC insurance expense, partly offset by higher data processing, Pennsylvania bank shares tax, and other expenses.
- Loan growth was concentrated in commercial loans, which increased $13.2 million, while commercial real estate loans declined $9.2 million. Management reported $47.4 million of new commercial loan originations but $25.7 million of unexpected payoffs from three large loans.
- Nonperforming loans and impaired loans improved from year-end, although other real estate owned increased from $3.7 million to $4.0 million. Six nonaccrual loans represented approximately 90% of nonaccrual balances.
- The investment portfolio increased to $176.4 million from $171.8 million. Net unrealized securities gains declined to $1.1 million from $2.4 million, while temporary unrealized losses increased to $1.6 million from $1.4 million.
Outlook, commentary, risks and unusual items
- Management believes the primary market area remains suitable for growth as the economy improves and reported that the Bank expects to meet anticipated liquidity demands.
- Management noted that the Federal Reserve continued to hold short-term rates at historically low levels, while market participants expected possible rate increases in the second half of 2015. Changes in interest rates, funding costs, monetary policy, competition, regulation, taxation, technology, and economic conditions could materially affect results.
- The Bank continues to monitor its trust preferred and private-label mortgage-backed securities. Seven trust preferred securities had a fair value of $5.3 million and unrealized losses of $621 thousand. Private-label mortgage-backed securities had cumulative other-than-temporary impairment charges of $555 thousand, including a $20 thousand charge in the first quarter. Management stated that additional write-downs remain possible if loss trends continue.
- The Bank is participating in a class-action lawsuit against a private-label mortgage-backed securities servicer concerning alleged defective underwriting warranties and representations. Management did not expect pending legal proceedings to be material to financial condition or shareholders’ equity.
- The Bank had $27.4 million of unused commitments and $26.0 million of standby letters of credit at June 30, 2015. Management stated that collateral and guarantees were expected to cover potential payments, and the recorded liability was not material.
- Pension expense was expected to increase to approximately $387 thousand in 2015 from $276 thousand in 2014. Adoption of revised mortality tables could reduce funded status by an estimated $1.6 million and increase 2015 pension expense by $272 thousand above the current estimate, although no adoption date had been determined.
- Subsequent to quarter-end, one nonaccrual credit was fully paid off, another borrower made a $158 thousand paydown, and two large commercial loans totaling $17.4 million were booked. A separate nonaccrual credit could be transferred to other real estate owned depending on the borrower’s settlement performance.
Important facts for investors to verify
- Whether earnings growth remains after excluding the $899 thousand of nonrecurring first-half items.
- Performance of the commercial real estate and commercial loan portfolios, including the $38.2 million watch list, $28.6 million of potential problem loans, and concentrations in land development, hotels, retail, construction, manufacturing, food services, and agriculture.
- Future provision requirements, charge-offs, collateral values, and the adequacy of the $9.45 million allowance for loan losses.
- Potential additional impairment charges on trust preferred and private-label mortgage-backed securities, and developments in the related class-action litigation.
- Interest-rate sensitivity, deposit retention, funding costs, and available borrowing capacity if rates rise or liquidity conditions deteriorate.
- Impact of revised pension mortality assumptions and any resulting contribution, expense, or capital requirements.
- Continuation of the $0.19 quarterly dividend and the effect of dividends and the dividend reinvestment plan on capital ratios.