Business Context and Reporting Period
Franklin Financial Services Corporation, through Farmers and Merchants Trust Company of Chambersburg, operates a community banking business primarily serving south-central Pennsylvania. This unaudited Form 10-Q covers the three and nine months ended September 30, 2014, with comparisons to September 30, 2013 and December 31, 2013. The company reported 4.2 million common shares outstanding as of October 31, 2014.
Key Financial Metrics
| Metric | Q3 2014 | Q3 2013 | 9M 2014 | 9M 2013 |
|---|---|---|---|---|
| Net interest income | $8.0 million | $8.0 million | $23.7 million | $23.4 million |
| Provision for loan losses | $0 | $350 thousand | $464 thousand | $2.0 million |
| Noninterest income | $2.8 million | $2.5 million | $8.0 million | $7.3 million |
| Noninterest expense | $7.7 million | $7.4 million | $23.1 million | $22.6 million |
| Net income | $2.4 million | $2.2 million | $6.6 million | $5.1 million |
| Diluted EPS | $0.57 | $0.53 | $1.56 | $1.23 |
| Cash dividend per share | $0.17 | $0.17 | $0.51 | $0.51 |
Nine-month net income increased 28.8% year over year. Net interest margin increased to 3.56% from 3.40%, while the efficiency ratio improved to 69.86% from 70.70%. Return on average assets was 0.86% and return on average equity was 8.90%.
- Total assets were $1.023 billion at September 30, 2014, up $38.2 million from year-end 2013.
- Gross loans were $730.6 million, up 1.0%; net loans were $721.7 million, up 1.1%.
- Total deposits were $898.9 million, up $53.1 million, driven by checking, money-management and savings accounts; time deposits declined $11.1 million.
- Investment securities available for sale were $176.1 million, compared with $159.7 million at year-end 2013.
- Cash and cash equivalents were $56.2 million, compared with $40.7 million at year-end.
- Shareholders’ equity was $102.1 million, compared with $95.4 million at year-end.
- Long-term debt was $12.0 million and repurchase-agreement borrowings were $1.6 million at September 30, compared with $12.4 million and $23.8 million, respectively, at year-end.
- Operating cash flow for the first nine months was $9.9 million. Investing activities used $23.3 million, while financing activities provided $28.9 million, resulting in a $15.5 million increase in cash and cash equivalents.
Material Changes Versus Comparable Periods
- Nine-month interest income declined $754 thousand, but interest expense declined $1.0 million, producing a $282 thousand increase in reported net interest income.
- The lower loan-loss provision was the primary earnings benefit: $464 thousand in 2014 versus $1.955 million in 2013.
- Nine-month noninterest income increased $721 thousand, including higher deposit and other service charges and $221 thousand of net securities gains versus $30 thousand in 2013.
- Nine-month noninterest expense rose $460 thousand, primarily from salaries and benefits, occupancy, legal and professional fees, and other expenses.
- Net charge-offs increased to $1.2 million from $958 thousand for the first nine months, while the allowance for loan losses declined to $8.9 million from $9.7 million. Allowance coverage was 1.22% of gross loans versus 1.58% at September 30, 2013.
- Credit quality improved overall. Nonperforming loans were $18.9 million versus $25.2 million at year-end 2013, and nonperforming assets were $22.7 million versus $30.0 million. Nonaccrual loans declined to $18.6 million from $24.6 million.
- Watch-list loans declined to $65.9 million from $76.3 million at year-end. The portfolio had $43.4 million of substandard loans and no loans rated doubtful or loss.
- Regulatory capital strengthened: the Corporation’s total risk-based capital ratio was 15.04%, Tier 1 leverage ratio was 9.51%, and the company stated that it was well capitalized.
Guidance, Outlook, Commentary, Risks and Unusual Items
The filing provides no formal earnings or revenue guidance. Management expects to continue using derivatives to manage interest-rate risk and believes the local economy is positioned for growth as the recession eases. Management also believes the Corporation can meet anticipated liquidity demands. The Federal Reserve’s low-rate environment, tapering of bond purchases and potential rate increases in 2015 were identified as relevant factors.
- Available liquidity included approximately $35 million under an FHLB line, $16 million of unsecured correspondent-bank lines, approximately $29 million of Federal Reserve Discount Window borrowing capacity, and $224.5 million of excess borrowing capacity.
- Unused loan commitments and standby letters of credit totaled $272.0 million and $24.3 million, respectively, at September 30, 2014.
- The investment portfolio had $1.6 million of unrealized losses across 94 temporarily impaired securities. Management deemed the losses temporary, but recorded a $20 thousand OTTI charge during the first nine months. Cumulative credit-related OTTI on private-label mortgage-backed securities was $535 thousand, and management stated that further write-downs were possible.
- Trust-preferred securities had a fair value of $5.3 million and unrealized losses of $588 thousand, with maturities from 2027 to 2028. Private-label mortgage-backed securities had ratings that had declined since purchase and were subject to continuing monitoring.
- The Bank is participating in a class-action lawsuit against a private-label mortgage-backed securities servicer concerning alleged defective warranties and representations.
- Noninterest expense included higher salaries and incentive compensation, legal and professional fees, FHLB loan prepayment penalties and development costs for a potential community office site.
- Subsequent events included planned consolidation of several banking offices, an expected approximately $628 thousand pretax gain from the anticipated acquisition of Integrity Bancshares by S&T Bancorp, and an October 2014 repurchase of approximately $1 million of FHLB stock.
- Management reported no material changes in market-risk exposure, risk factors, legal proceedings or disclosure controls. No material litigation was pending according to management.
Important Facts for Investors to Verify
- Whether the lower provision expense and improved credit metrics are sustainable despite higher year-to-date net charge-offs and continued exposure to commercial real estate.
- The valuation, repayment performance and potential future impairment of trust-preferred and private-label mortgage-backed securities.
- The resolution and potential financial effect of the private-label mortgage-backed securities servicing litigation.
- The composition and utilization of $272.0 million of unfunded commitments and the potential liquidity impact of deposit outflows.
- The effect of future interest-rate changes on the net interest margin, deposit costs, securities valuations and the $10 million interest-rate swap maturing in May 2015.
- Whether office consolidations, potential branch development and other corporate initiatives alter the company’s expense base or market presence.
- The adequacy of the $8.9 million allowance for loan losses given management’s reliance on collateral valuations, appraisals and other subjective estimates.