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FRAF > SEC Filings for FRAF > Form 10-K on 10-Mar-2014All Recent SEC Filings

Show all filings for FRANKLIN FINANCIAL SERVICES CORP /PA/

Form 10-K for FRANKLIN FINANCIAL SERVICES CORP /PA/


10-Mar-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Application of Critical Accounting Policies:

Disclosure of the Corporation's significant accounting policies is included in Note 1 to the consolidated financial statements. These policies are particularly sensitive requiring significant judgments, estimates and assumptions to be made by Management. Senior management has discussed the development of such estimates, and related Management Discussion and Analysis disclosure, with the Audit Committee of the Board of Directors. The following accounting policies are the ones identified by management to be critical to the results of operations:

Allowance for Loan Losses - The allowance for loan losses is the estimated amount considered adequate to cover credit losses inherent in the loan portfolio at the balance sheet date. The allowance is established through the provision for loan losses, charged against income. In determining the allowance for loan losses, Management makes significant estimates and, accordingly, has identified this policy as probably the most critical for the Corporation.

Management performs a monthly evaluation of the adequacy of the allowance for loan losses by asset class. Consideration is given to a variety of factors in establishing this estimate including, but not limited to: current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, borrowers' actual or perceived financial and managerial strengths, the adequacy of the underlying collateral (if collateral dependent) and other relevant factors. This evaluation is inherently subjective, as it requires material estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on impaired loans.

The analysis has two components, specific and general allocations. Expected cash flow or collateral values discounted for market conditions and selling costs are used to establish specific allocations. The Bank's historical loan loss experience and other qualitative factors derived from economic and market conditions are used to establish general allocations for the remainder of the portfolio. The allowance for loan losses was $9.7 million at December 31, 2013.

Management monitors the adequacy of the allowance for loan losses on an ongoing basis and reports its adequacy assessment quarterly to the Credit Risk Oversight Committee of the Board of Directors.

Financial Derivative - As part of its interest rate risk management strategy, the Bank has entered into an interest rate swap agreement. A swap agreement is a contract between two parties to exchange cash flows based upon an underlying notional amount. Under the swap agreement, the Bank pays a fixed rate and receives a variable rate from an unrelated financial institution serving as counter-party to the agreement. The swap is designated as a cash flow hedge and is designed to minimize the variability in cash flows of the Bank's variable rate liabilities attributable to changes in interest rates. The swap in effect converts a portion of a variable rate liability to a fixed rate liability.

The interest rate swap is recorded on the balance sheet at fair value as an asset or liability. To the extent the swap is effective in accomplishing its objective, changes in the fair value are recorded in other comprehensive income. To the extent the swap is not effective, changes in fair value are recorded in interest expense. Cash flow hedges are determined to be highly effective when the Bank achieves offsetting changes in the cash flows of the risk being hedged. The Bank measures the effectiveness of the hedges on a quarterly basis and it has determined the hedges are highly effective. Fair value is heavily dependent upon the market's expectations for interest rates over the remaining term of the swaps.

Restricted Stock - Restricted stock, which is carried at cost, consists of stock of the Federal Home Loan Bank of Pittsburgh (FHLB) and Atlantic Central Bankers Bank (ACBB). Management evaluates the restricted stock for impairment in accordance with ASC Topic 320. Management's determination of whether these investments are impaired is based on their assessment of the ultimate recoverability of their cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of their cost is influenced by criteria such as (1) the significance of the decline in net assets of the banks as compared to the capital stock amount for the banks and the length of time this situation has persisted, (2) commitments by the banks to make payments required by law or regulation and (3) the impact of legislative and regulatory changes on institutions and, accordingly, on the customer base of the banks.

Stock-based Compensation - The Corporation has two stock compensation plans in place consisting of an Employee Stock Purchase Plan (ESPP) and an Incentive Stock Option Plan (ISOP).

The Corporation accounts for stock compensation plans in accordance with FASB Accounting Standards Codification Topic 718, "Stock Compensation." ASC Topic 718 requires compensation costs related to share-based payment transactions to be recognized in the financial statements (with limited exceptions). The amount of compensation cost is measured on the grant-date fair value of the equity or liability instruments issued. Compensation cost is recognized over the period that an employee provides services in exchange for the award.

The Corporation calculates the compensation cost of the options by using the Black-Scholes method to determine the fair value of the options granted. In calculating the fair value of the options, the Corporation makes assumptions regarding the risk-free rate of return, the expected volatility of the Corporation's common stock, dividend yield and the expected life of the option. These assumptions are made independently for the ESPP and the ISOP and if changed, would change the compensation cost of the options and net income. Note 1 of the accompanying financial statements provides additional information about stock option expense.

Federal Income Taxes - Deferred income taxes are provided on the liability method whereby deferred tax assets are recognized for deductible temporary differences and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance, when in the opinion of management, it is more likely than not that some portion or all deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted through the provision for income taxes for the effects of changes in tax laws and rates on the date of enactment. ASC Topic 740 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Benefits from tax positions should be recognized in the financial statements only when it is more-likely-than-not that the tax position will be sustained upon examination by the appropriate taxing authority that would have full knowledge of all relevant information. A tax position that meets the more-likely-than-not recognition threshold is measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent financial reporting period in which that threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not recognition threshold should be derecognized in the first subsequent financial reporting period in which that threshold is no longer met. ASC Topic 740, "Income Taxes" also provides guidance on the accounting for and disclosure of unrecognized tax benefits, interest and penalties.

Temporary Investment Impairment - Investment securities are written down to their net realizable value when there is impairment in value that is considered to be "other-than-temporary." The determination of whether or not "other-than-temporary" impairment exists is a matter of judgment. Management reviews investment securities regularly for possible impairment that is "other-than-temporary" by analyzing the facts and circumstances of each investment and the expectations for that investment's performance.
"Other-than-temporary" impairment in the value of an investment may be indicated by the length of time and the extent to which market value has been less than cost; the financial condition and near term prospects of the issuer; and whether the Corporation has the intent to sell or is likely to be forced to sell the investment prior to any anticipated recovery in market value.

GAAP versus Non-GAAP Presentations - The Corporation supplements its traditional GAAP measurements with Non-GAAP measurements. The Non-GAAP measurements include Return on Average Tangible Assets, Return on Average Tangible Equity, Tangible Book Value and Tangible Common Equity ratio. As a result of merger transactions, intangible assets (primarily goodwill, core deposit intangibles and customer list) were created. The Non-GAAP disclosures are intended to eliminate the effects of the intangible assets and allow for better comparisons to periods when such assets did not exist. However, not all companies use the same calculation methods for the same non-GAAP measurements and therefore may not be comparable. The following table shows the adjustments made between the GAAP and NON-GAAP measurements:

  GAAP Measurement     Calculation
Return on Average      Net Income / Average Assets
Assets
Return on Average      Net Income / Average Equity
Equity
Book Value             Total Shareholders' Equity / Shares Outstanding
Common Equity Ratio    Total Shareholders' Equity / Total Assets

     Non- GAAP         Calculation
    Measurement
Return on Average      Net Income plus Intangible Amortization (net of tax) /
Tangible Assets        Average Assets less Average Intangible Assets
Return on Average      Net Income plus Intangible Amortization (net of tax) /
Tangible Equity        Average Equity less Average Intangible Assets
Tangible Book Value    Total Shareholders' Equity less Intangible Assets / Shares
                       outstanding
Tangible Common        Total Shareholders' Equity less Intangible Assets / Total
Equity Ratio           Assets less Intangible Assets

Results of Operations:

Management's Overview

The following discussion and analysis is intended to assist the reader in reviewing the financial information presented and should be read in conjunction with the consolidated financial statements and other financial data presented elsewhere herein.

Franklin Financial Services Corporation reported a 16.2% increase in net income for 2013. Net interest income declined by 1.8%; however, the bottom line was increased by a significant reduction in the provision for loan losses. The Corporation saw a reduction in loan charge-offs and an improvement in the quality of its loan portfolio that allowed for a lower provision expense. Noninterest income increased by 4.5% due primarily to an increase in fee income from investment and trust services and a reduction in losses on other real estate owned (OREO). Noninterest expense held steady during the year with only a 1.6% increase over 2012. Diluted earnings per share increased from $1.32 in 2012 to $1.51 in 2013, and the Corporation declared and paid a dividend of $0.68 per share. After closing at more than $1.0 billion in assets on December 31, 2012, the balance sheet contracted during 2013 and closed 2013 at $984.6 million. Net loans decreased $29.5 million, primarily in the commercial loan portfolio. Deposits declined $28.7 million due to reductions in the brokered CD portfolio from scheduled maturities and prepayments of higher rate CDs. Shareholders' equity continued to increase during the year from retained earnings and investments from the dividend reinvestment plan. Other key performance measurements are presented above in Item 6, Selected Financial Data.

A more detailed discussion of the areas that had the greatest effect on the reported results follows.

Net Interest Income

The most important source of the Corporation's earnings is net interest income, which is defined as the difference between income on interest-earning assets and the expense of interest-bearing liabilities supporting those assets. Principal categories of interest-earning assets are loans and securities, while deposits, securities sold under agreements to repurchase (Repos), short-term borrowings and long-term debt are the principal categories of interest-bearing liabilities. For the purpose of this discussion, balance sheet items refer to the average balance for the year and net interest income is adjusted to a fully taxable-equivalent basis. This tax-equivalent adjustment facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Corporation's 34% Federal statutory rate. The components of net interest income are detailed in Tables 1, 2 and 3.

2013 versus 2012

Summary: Tax equivalent net interest income (Table 1) declined by 2% during 2013. The average balance of interest-earning assets declined during the year and the yield on these assets fell by 29 basis points; therefore, tax-equivalent interest income declined (see Table 3). Likewise, Table 3 also shows that the average balance of interest-bearing liabilities declined during the year and the cost of these deposits also fell by 29 basis points. As a result, tax-equivalent net interest income declined by $675 thousand and the net interest margin as a percentage of earning assets fell from 3.50% in 2012 to 3.47% in 2013. Table 2 shows that changes in interest rates had a larger negative effect on net interest income than did the changes in the balance sheet.

Assets: Table 3 shows the average balance and yield on the major asset classes on the Corporation's balance sheet. Average interest earning assets and the yield on these assets declined during 2013. The low interest rate environment that continues to be supported by Federal Reserve actions continues to push asset yields down on both new assets and the repricing of existing assets.

The investment portfolio averaged $152.6 million in 2013 compared to $134.7 million in 2012. Despite the increase in the average balance, the yield on the portfolio declined from 2.96% in 2012 to 2.68% in 2013. The Bank purchased $69.1 million of new securities in 2013, primarily in the U.S. Government Agency mortgaged backed securities sector.

Average loan balances fell during the year, with every category showing a reduction from the 2012 averages except for residential mortgages. The commercial loan portfolio declined $34.3 million and the yield fell by 20 basis points during the year. The low interest rate environment continues to be an incentive for pre-payments and refinancing, and good quality credits are in demand by many lenders eager to increase volume. As a result, the Bank has lost some balances to prices that it felt was unable to match. Approximately 86% of the commercial loan portfolio is variable rate with rates tied to short-term market rates like Prime or Libor. Until there is an increase in short-term rates, the yield on the commercial loan portfolio is likely to decline.

The bank retained more of its mortgage production in 2013; therefore, the average balance increased during the year. However, the yield on the mortgage portfolio declined year over year. The Bank retained primarily shorter term mortgages and sold longer term mortgages in the secondary market. With a slight increase in mortgage rates during the year, refinancing activity slowed. The Bank believes that mortgage activity in 2014 will see a shift from refinance to purchase activity.

Consumer lending, including home equity products, continued to decline. Home equity products declined, on average by approximately $7 million compared to 2012 and the yield fell by 32 basis points. The Bank's home equity loan products are fixed rate and the home equity line of credit products are variable rate. Both products have seen new production rates decline, but the lower volume was the largest factor contributing to the decline in interest income on these products.

Liabilities: Table 3 shows the average balance and cost of the major interest-bearing liabilities classes on the Corporation's balance sheet. The average balance of interest-bearing liabilities declined by $15.9 million in 2013 and the cost fell by 29 basis points. Every category of interest-bearing deposits, except time deposits (CDs) increased during the year. The interest-bearing checking and money management accounts showed the largest balance increases. The increase in interest checking and money management came primarily in the municipal account categories in the Bank's fully insured deposit products. The average balance of CDs declined primarily due to a reduction in brokered CDs. The reduction in brokered CDs was due to action taken by the Bank to "call" and payoff higher rate brokered CDs, and by scheduled maturities. The cost of interest-bearing deposits fell from .70% in 2012 to .50% in 2013 driven down by an 18 basis point reduction on the rate of the money management product.

The average balance of securities sold under agreements to repurchase declined by $19.2 million as the Bank has been transitioning these accounts to a fully insured checking account product. The Bank is going to continue this process in 2014 and expects that all repurchase accounts will be closed by the end of 2014. Average long-term debt declined significantly year over year due to the Bank prepaying $33.1 million of FHLB advances in 2012. The Bank did not prepay any FHLB advances in 2013 or take any new advances.

Table 2 shows that both volume and rate factors contributed to the reduction in interest expense in 2013.

2012 versus 2011

Summary: The Corporation's 2012 net interest income was virtually flat compared to 2011. Tax equivalent net interest income for the year was $33.9 million compared to $34.4 million in 2011, a decline of 1.3%. Despite an increase of $48.0 million in average earning assets for 2012 compared to 2011, the margin was negatively affected by the low interest rate environment that pushed asset yields down faster than liability costs. As a result, the net interest margin as a percentage of earning assets fell to 3.50% in 2012 compared to 3.73% in 2011. The larger balance sheet increased net interest income by $248 thousand, but lower rates drove net interest income down by $680 thousand, resulting in a net decline of $432 thousand year over year.

Assets: Average interest earning assets for 2012 grew by 5.2% over the 2011 average. Despite the growth, lower yielding assets resulted in a decline of $2.6 million in interest income compared to 2011. The assets produced a yield of 4.22% compared to 4.73% in 2011. The mix of assets and lower rates resulted in $2.7 million less tax equivalent interest income than in 2011. Table 2 presents information on the affect that changes in volume (balance sheet size) and the changes in rates have on tax-equivalent interest income. Table 3 presents information on the average balance and yields on average earning assets.

Throughout the year, the Bank experienced strong deposit growth, but loan balances were down slightly and average investments increased minimally. Therefore, interest-bearing deposits at banks (the Bank's lowest yielding asset class) absorbed the increase in funds and was $48.9 million more in 2012 than in the prior year.

The investment portfolio increased by $2.3 million on average with the allocation between taxable and nontaxable securities remaining fairly consistent. Low interest rates on new purchases have driven the yield on the portfolio down from 3.41% in 2011 to 2.96% in 2012. The Bank purchased $43.7 million in new securities during the year, primarily in the municipal and U.S. Agency mortgage backed securities sectors.

The loan portfolio averaged $761.5 million for 2012 and earned an average yield of 4.81%. Compared to 2011, the average balance declined by $3.2 million and the yield fell by 28 basis points. The increase in the average balance of the commercial loan portfolio was not enough to offset the continued decline of consumer related loan balances. The loan portfolio generated $36.6 million of interest income, $2.3 million less than in 2011. Lower rates in 2012 were responsible for $2.0 million (85%) of the reduction in loan interest. In addition, the increase in the Bank's nonperforming loans negatively affected interest income.

Commercial loans increased by $9.5 million over the 2011 average portfolio balance. Commercial lending activity was slow in 2012 and there was not a lot of opportunity to lend new dollars. New loans continued to be booked at lower rates and existing loans repriced downward. Approximately 83% of the commercial loan portfolio is variable rate. The portfolio was also affected by several large municipal loans that refinanced via a bond issue at rates the Bank was unwilling to match. Like the overall loan portfolio, interest income from the commercial portfolio was negatively affected the most by lower rates in 2012.

For 2012, the average balance of the residential mortgage portfolio remained flat compared to the prior year after several years of declining balances. Mortgage lending was strong due to the low rates, and those consumers with good credit and equity in their homes, took advantage of refinancing opportunities. In 2012, the Bank held more of its mortgage production in its portfolio than in past years and this offset the amortization and pay-offs in the portfolio. The Bank did not retain all mortgages originated in 2012, only those identified as part of a selective retention program.

Consumer lending, including home equity products, continued to decline. Home equity products declined, on average by approximately $12 million compared to 2011 and the yield fell by 58 basis points. The Bank's home equity loan products are fixed rate and the home equity line of credit products are variable rate. Both products have seen new production rates decline, but the lower volume was the largest factor contributing to the decline in interest income on these products.

Liabilities: Interest-bearing liabilities increased 5.1% to $828.4 million on average for 2012. The cost of these funds fell from 1.16% in 2011 to .83% in 2012. Interest-bearing deposits increased 9.8% on average and the cost fell from .99% in 2011 to .70% in 2012. The cost of all interest-bearing liabilities decreased year over year and these rate reductions were the largest contributor to lower interest expense in 2012. Table 2 presents information on the affect that changes in volume (balances sheet size) and changes in rates have on interest expense. Table 3 presents information on the average balance and cost of interest-bearing liabilities.

The Money Management product was the Bank's largest funding source in 2012 and it increased 18.4% on average over 2011. The rate on this product declined by 35 basis points during the year and was the primary reason for the $718 thousand decrease in interest expense. All customer segments in this product grew during the year with the balance of the fully-insured option product more than doubling.

The sweep repurchase product declined by more than $8 million during the year and the rate fell by 10 basis points to .15%. The balance of this product is highly dependent on the operating cash flow needs of its commercial users, but some money did move to the fully-insured Money Management product.

Long-term debt is comprised of advances from FHLB Pittsburgh. The Bank did not take any new advances during 2012. The decline in the average balance was primarily the result of the Bank pre-paying $33.1 million of debt that had scheduled maturities in 2012 and 2013.

                          Table 1. Net Interest Income



(Dollars in thousands)           2013         % Change          2012         % Change          2011
Interest income               $   36,042            (7.9 )   $   39,142            (6.3 )   $   41,791
Interest expense                   4,378           (36.5 )        6,890           (24.7 )        9,154
Net interest income               31,664            (1.8 )       32,252            (1.2 )       32,637
Tax equivalent adjustment          1,596                          1,683                          1,730
Tax equivalent net interest
income                        $   33,260            (2.0 )   $   33,935            (1.3 )   $   34,367

Table 2 identifies increases and decreases in tax equivalent net interest income to either changes in average volume or to changes in average rates for interest-earning assets and interest-bearing liabilities. Numerous and simultaneous balance and rate changes occur during the year. The amount of change that is not due solely to volume or rate is allocated proportionally to both. All nontaxable interest income has been adjusted to a tax-equivalent basis, using a tax rate of 34%.

      Table 2. Rate-Volume Analysis of Tax Equivalent Net Interest Income



                                      2013 Compared to 2012                       2012 Compared to 2011
Increase (Decrease) due to:        Increase (Decrease) due to:                 Increase (Decrease) due to:
(Dollars in thousands)          Volume         Rate           Net          Volume           Rate           Net
Interest earned on:
Interest-bearing
obligations in other banks
and Federal funds sold        $       (6 )   $      12     $       6     $      140       $       8     $     148
Investment securities:
Taxable                              271          (213 )          58            (14 )          (611 )        (625 )
Nontaxable                           138          (101 )          37            155             (61 )          94
Loans:
Commercial, industrial and
agricultural                      (1,544 )      (1,219 )      (2,763 )          454          (1,388 )        (934 )
Residential mortgage                 801          (529 )         272             12            (210 )        (198 )
Home equity loans and lines         (412 )        (206 )        (618 )         (754 )          (434 )      (1,188 )
Consumer                            (158 )         (21 )        (179 )          (60 )            67             7
Loans                             (1,313 )      (1,975 )      (3,288 )         (348 )        (1,965 )      (2,313 )
Total net change in
interest income                     (910 )      (2,277 )      (3,187 )          (67 )        (2,629 )      (2,696 )

Interest expense on:
Interest-bearing checking             40            30            70             10             (26 )         (16 )
Money market deposit
accounts                             132          (692 )        (560 )          512          (1,230 )        (718 )
Savings accounts                       5           (16 )         (11 )            5              (6 )          (1 )
Time deposits                       (556 )        (277 )        (833 )         (115 )          (626 )        (741 )
Securities sold under
agreements to repurchase             (28 )          (2 )         (30 )          (19 )           (53 )         (72 )
Short-term borrowings                  -             -             -             (1 )             -            (1 )
Long-term debt                    (1,054 )         (94 )      (1,148 )         (707 )            (8 )        (715 )
Total net change in
interest expense                  (1,461 )      (1,051 )      (2,512 )         (315 )        (1,949 )      (2,264 )
Change in net interest
income                        $      551     $  (1,226 )   $    (675 )   $      248       $    (680 )   $    (432 )

The following table presents average balances, tax-equivalent (T/E) interest income and expense, and yields earned or rates paid on the assets or liabilities. All nontaxable interest income has been adjusted to a tax-equivalent basis, using a tax rate of 34%.

. . .

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