Orrstown Financial Services, Inc. — 2018 Form 10-K Summary
Business context and reporting period
This annual report covers the fiscal year ended December 31, 2018; it is not a standalone fourth-quarter filing. Orrstown is a Pennsylvania-based community banking holding company operating primarily in south-central Pennsylvania and Washington County, Maryland, with wealth-management operations through Wheatland Advisors and Orrstown Financial Advisors. The October 1, 2018 acquisition of Mercersburg Financial Corporation is included from its closing date and affects year-over-year comparability.
Key financial and operating metrics
Unless otherwise indicated, amounts are in millions of dollars.
| Metric | 2018 | 2017 |
|---|---|---|
| Total interest and noninterest income | $86.7 | $71.4 |
| Net interest income | $51.4 | $43.4 |
| Net income | $12.8 | $8.1 |
| Diluted EPS | $1.50 | $0.98 |
| Tax-equivalent net interest margin | 3.31% | 3.32% |
| Return on average assets / equity | 0.75% / 8.56% | 0.54% / 5.73% |
| Net cash from operating activities | $22.5 | $16.4 |
- At year-end, assets were $1,934.4 million, loans $1,247.7 million, deposits $1,558.8 million, and shareholders’ equity $173.4 million. Loans grew 23.5% year over year, with approximately 55% of the increase from acquired loans; deposits rose 27.8%, about half from Mercersburg.
- Interest expense rose to $13.5 million from $7.6 million as deposit and borrowing costs increased. The net interest spread narrowed six basis points to 3.16%; loan and securities yields rose, but funding costs also moved higher.
- The provision for loan losses was $0.8 million versus $1.0 million. The allowance was $14.0 million, or 1.12% of loans, compared with $12.8 million, or 1.27%, a year earlier. Nonperforming assets fell to $5.3 million from $10.8 million.
- Operating cash flow was $22.5 million; investing cash flow was negative $139.4 million and financing cash flow was positive $175.9 million. Cash and cash equivalents ended the year at $88.8 million, up from $29.8 million.
- Year-end borrowings included $64.1 million short-term, $83.5 million long-term debt, and $31.9 million subordinated notes, net of issuance costs. The notes had $32.5 million principal, a 6.0% fixed rate through December 2023, then a LIBOR-based floating rate to maturity in 2028.
- Liquidity included $301.6 million of unpledged available-for-sale securities and reported FHLB borrowing capacity of $554.3 million, of which $224.0 million in advances and letters of credit was outstanding. Time deposits of $259.9 million mature within one year; brokered deposits totaled $126.6 million.
Material changes versus the prior comparable period
- Net income increased 58% and diluted EPS rose from $0.98 to $1.50. Growth in net interest income and a lower 2018 effective tax rate contributed; results also reflect Mercersburg and acquisition-related effects.
- Noninterest expenses increased 15.2% to $58.0 million, including $3.2 million of merger-related costs. Noninterest income rose 7.2% to $21.9 million; mortgage banking revenue declined 8.8%, while other service charges and life-insurance income increased.
- The effective tax rate was 11.4%, down from 34.9% in 2017. The prior-year rate included $2.6 million of tax expense from remeasuring deferred tax balances after federal tax reform lowered the statutory rate.
- Mercersburg consideration totaled $29.9 million, comprising $25.1 million in stock and $4.9 million in cash. It added $141.1 million of loans and $160.4 million of deposits at acquisition; $11.9 million of goodwill and a $3.8 million core deposit intangible were recorded.
- Available-for-sale securities had a $5.8 million after-tax unrealized loss in 2018, versus a $3.8 million gain in 2017, reducing year-end equity through accumulated other comprehensive income.
- Fourth-quarter 2018 net income was $1.2 million, versus $6,000 in fourth-quarter 2017. The 2017 quarter included $3.0 million of income tax expense; 2018 results included $5.0 million of noninterest expense, principally reflecting merger costs recognized during the year.
Outlook, management commentary, risks, and contingencies
- Management expects continued loan growth and says asset-backed securities and CMO cash flows may help meet anticipated 2019 loan demand. It notes intense loan competition and a flat yield curve as challenges to margin growth. No formal numerical earnings or margin guidance is provided.
- The Hamilton Bancorp merger was expected to close in the second quarter of 2019, subject to regulatory and shareholder approvals and other conditions. The agreement provides for $4.10 cash plus 0.54 Orrstown shares per Hamilton share, with potential cash-consideration adjustments for identified loan issues. Closing, integration, cost savings, and accretion are uncertain.
- Key risks include credit deterioration, commercial real estate and commercial lending concentrations, interest-rate and deposit-cost pressures, regional economic conditions, acquisition integration, regulatory changes, and the expected transition from LIBOR. Management said the company and Bank were well capitalized; the Bank was classified as well capitalized by regulators.
- Orrstown disclosed a July 2018 phishing incident that gave an unauthorized party access to two employee email accounts; the filing states it did not cause a material revenue loss. Cybersecurity and third-party service-provider incidents remain risks.
- The SEPTA securities litigation remained ongoing; the company said it could not reasonably estimate a loss or range and intended to defend the claims. Separately, the company settled an SEC investigation in 2016 and paid a $1.0 million civil penalty, previously expensed.
- Management identified the forthcoming expected-credit-loss accounting standard (CECL) as potentially affecting the allowance and regulatory capital; the impact was still being evaluated. The filing also notes that the January 2019 lease-standard adoption added an approximately $7.0 million right-of-use asset and $8.5 million lease liability.
Most important facts for investors to verify
- How much of reported loan, deposit, and earnings growth is organic versus attributable to Mercersburg, and whether acquired-loan marks and integration costs affect future results.
- Hamilton merger status, final consideration, regulatory conditions, integration expenses, and realized synergies.
- Credit trends in commercial real estate and commercial and industrial loans, acquired PCI loans, allowance adequacy, and the treatment of purchased-loan discounts.
- Deposit repricing, brokered-deposit reliance, near-term time-deposit maturities, and the effect of changing rates on net interest margin and liquidity.
- Developments and potential exposure in the SEPTA litigation, cybersecurity controls following the phishing incident, and the eventual CECL impact on reserves and capital.
- Dividend sustainability: 2018 dividends were $0.51 per share, and future payments depend on earnings, capital needs, and regulatory restrictions on Bank dividends to the holding company.