Franklin Financial Services Corporation - 10-Q quarterly report FY

INDEX

Franklin Financial Services Corporation

Consolidated Balance Sheets

(Amounts in thousands, except per share data)

The accompanying notes are an integral part of these financial statements

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Franklin Financial Services Corporation

Consolidated Statements of Changes in Shareholders’ Equity (unaudited)

for the nine months ended September 30, 2005 and 2004

The accompanying notes are an integral part of these financial statements.

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Franklin Financial Services Corporation

Consolidated Statements of Cash Flows (unaudited)

The accompanying notes are an integral part of these statements.

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FRANKLIN FINANCIAL SERVICES CORPORATION and SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

Note 1 - Basis of Presentation

The consolidated financial statements include the accounts of Franklin Financial Services Corporation (the Corporation), and its wholly-owned subsidiaries, Farmers and Merchants Trust Company of Chambersburg (the Bank), Franklin Financial Properties Corp. and Franklin Future Fund Inc.  Farmers and Merchants Trust Company of Chambersburg is a commercial bank that has one wholly-owned subsidiary, Franklin Realty Services Corporation.  Franklin Realty Services Corporation is an inactive real-estate brokerage company.  Franklin Financial Properties Corp. holds real estate assets that are leased by the Bank. Franklin Future Fund Inc. was formed in the second quarter of 2005 as a non-bank investment company for the purpose of making venture capital investments within the Corporation’s primary market area.  The activities of non-bank entities are not significant to the consolidated totals.   All significant intercompany transactions and account balances have been eliminated.

In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations, and cash flows at September 30, 2005, and for all periods presented have been made.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted.  It is suggested that these condensed consolidated financial statements be read in conjunction with the audited financial statements and notes thereto included in the Corporation’s 2004 Annual Report on Form 10-K.  The results of operations for the period ended September 30, 2005 are not necessarily indicative of the operating results for the full year.

For purposes of reporting cash flows, cash and cash equivalents include Cash and due from banks, Interest-bearing deposits in other banks and Federal funds sold.  Generally, Federal funds are purchased and sold for one-day periods.

Earnings per share is computed based on the weighted average number of shares outstanding during each period.  A reconciliation of the weighted average shares outstanding used to calculate basic earnings per share and diluted earnings per share follows:

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Note 2 – Comprehensive Income

The components of other comprehensive income (loss) are as follows:

Note 3 – Guarantees

The Corporation does not issue any guarantees that would require liability recognition or disclosure, other than its standby letters of credit.  Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party.  Generally, all letters of credit, when issued have expiration dates within one year.  The credit risk involved in issuing letters of credit is essentially the same as those that are involved in extending loan facilities to customers.  The Bank, generally, holds collateral and/or personal guarantees supporting these commitments.  The Bank had $7.6 million standby letters of credit of as of September 30, 2005 and $5.9 million as of December 31, 2004. Management believes that the proceeds obtained through a liquidation of collateral and the enforcement of guarantees would be sufficient to cover the potential amount of future payments required under the corresponding guarantees.

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Note 4 – Stock Based Compensation

The Corporation has elected to follow the disclosure requirements of FASB Statement No. 123, “Accounting for Stock-Based Compensation.”  Accordingly, no compensation expense for the plans has been recognized in the financial statements of the Corporation.  Had compensation cost for the plans been recognized in accordance with Statement No. 123, the Corporation’s net income and per share amounts would have been reduced to the following pro-forma amounts.

Note 5 – Pensions

The components of pension expense for the periods presented are as follows:

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Management’s Discussion and Analysis of

Results of Operations and Financial Condition

For the Three and Nine Month Periods

Ended September 30, 2005 and 2004

Part 1, Item 2

Forward Looking Statements

Certain statements appearing herein which are not historical in nature are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  Such forward-looking statements refer to a future period or periods, reflecting management’s current views as to likely future developments, and use words such as “may,” “will,” “expect,” “believe,” “estimate,” “anticipate,” or similar terms.  Because forward-looking statements involve certain risks, uncertainties and other factors over which the Corporation has no direct control, actual results could differ materially from those contemplated in such statements.  These factors include (but are not limited to) the following: general economic conditions, changes in interest rates, changes in the Corporation’s cost of funds, changes in government monetary policy, changes in government regulation and taxation of financial institutions, changes in the rate of inflation, changes in technology, the intensification of competition within the Corporation’s market area, and other similar factors.

Critical Accounting Policies

Management has identified critical accounting policies for the Corporation to include Allowance for Loan Losses, Mortgage Servicing Rights, Financial Derivatives, Temporary Investment Impairment and Stock-based Compensation. There were no new critical accounting policies adopted during the interim period nor were there any changes to the critical accounting policies disclosed in the 2004 Annual Report on Form 10-K in regards to application or related judgements and estimates used.  Please refer to Item 7 on pages 9 - 12 of the Corporation’s 2004 Annual Report on Form 10-K for a more detailed disclosure of the critical accounting policies.

Results of Operations

Summary

Total assets topped the $600 million mark, reaching $608.7 million at September 30, 2005 as a result of continued loan growth.  The Corporation reported net income for the first nine months of 2005 of $4.5 million, a 17.7% increase over prior year income of $3.8 million.   For the third quarter of 2005, net income was $1.6 million, compared to $1.4 million for the third quarter of 2004.  Diluted earnings per share for the first nine months of 2005 were $1.33 versus $1.13 in 2004.  On a year-to-date basis, the Corporation increased net interest income by $1.1 million or 9.6% versus the prior year.

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Other key performance ratios as of, or for the nine months ended September 30 are listed below:

A more detailed discussion of the operating results for the three and nine months ended September 30, 2005, follows:

Net Interest Income

Comparison of three and nine months ending September 30, 2005 to the three and nine months ending September 30, 2004:

Net interest income is the difference between the interest earned on assets and the interest expense on liabilities.  The Corporation’s interest earning assets are comprised of interest-bearing deposits and federal funds sold, investment securities, and loans. Interest–bearing liabilities are comprised of deposits and short and long-term borrowings. Changes in net interest income are primarily attributable to either changes in the average volume or changes in average rates for interest-earning assets and interest-bearing liabilities. For the third quarter of 2005, net interest income was $4.5 million. This represents an increase of $489 thousand, or 12.2% over the third quarter 2004 net interest income of $4.0 million.

Interest income for the third quarter increased $1.5 million from the prior period as a result of growth in interest-earning assets and an increase in market interest rates. Average interest-earning assets increased $30 million over the prior year quarter.  Most of the increase in average earning assets was in the loan portfolio, primarily commercial loans. Interest income on commercial loans for the third quarter increased $1.1 million compared to the third quarter of 2004.  The average balance of investment securities increased $6.2 million compared to the prior year quarter and interest income on investments increased $289 thousand. The yield on interest-earning assets was 5.70 % for the third quarter of 2005 versus 4.93% for the third quarter of 2004.

Average interest-bearing liabilities for the third quarter of 2005 increased $24 million from the prior year quarter.  Interest expense increased $979 thousand quarter over quarter. The increases in balances and interest expense were fueled by strong growth in Money Management accounts. The average balance of these accounts grew $30.6 million and interest expense increased  $615 thousand.   The cost of interest-bearing liabilities also increased from 1.87% to 2.67%, quarter over quarter.

Net interest income for the first nine months of 2005 was $13.0 million, a $1.2 million increase from $11.8 million reported in 2004. Interest income increased $3.2 million (17.7%) during 2005 to $21.5 million. The increase in interest income was driven by an increase in interest on loans of $2.3 million and an increase in interest from investments of $838 thousand.  Interest income from loans grew primarily due to an increase in the balance of average loans outstanding.  Interest income from investments grew primarily from an increase in market interest rates during the period. Income on interest bearing deposits and fed funds sold increased $114 thousand from the previous year, primarily the result of increases in the federal funds rate during the past year.

Interest expense was $8.5 million for the first nine months of 2005, an increase of $2.1 million (32.8%) from interest expense of $6.4 million in 2004.  Interest expense on deposit accounts increased

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These fees have increased $172 thousand (39.4%) from $437 thousand in 2004 to $609 thousand in 2005.  Approximately $140 thousand of expenses have been incurred in 2005 for compliance with Section 404 of Sarbanes Oxley Act of 2002. Data processing costs have decreased $72 thousand year-over-year as the result of a first quarter credit provided by the Bank’s core system processor as an incentive to renew its contract for three years. Other expense is up $151 thousand from the previous year and includes a loss of $57 thousand from the sale of real estate in the second quarter. This real estate was owned by the Corporation and used by the Bank as administrative office space, but was no longer needed for that purpose. All other noninterest expense categories remained fairly constant compared to the prior year.

The Corporation recorded income tax expense of $509 thousand for the first nine months of 2005 versus $730 thousand during the same period in 2004.  During the first quarter of 2005, the Corporation reversed income tax expense when it became apparent that an accrual for additional taxes was no longer warranted. This reversal is expected to be a non-recurring event and is responsible for the lower than normal income tax expense. The Corporation’s effective tax rate for the first nine months of 2005 was 10.2% compared to 16.1% the previous year.

Income tax expense for the third quarter of 2005 was $421 thousand versus $310 thousand for the third quarter of 2004. The Corporation’s effective tax rate for the third quarter of 2005 was 20.4% compared to 17.9% for third quarter of 2004. The increase in income tax expense quarter over quarter is due to a 19.5% increase in pre-tax income quarter over quarter as tax-free income has remained stable. All taxable income for the Corporation is taxed at a rate of 34%.

Financial Condition

Total assets grew to $608.6 million on September 30, 2005, up 8.1% from $563.3 million on December 31, 2004.  Of the $45.4 million increase in total assets since prior year-end, $42.3 million of growth has occurred in the loan portfolio.   Commercial loan activity was the driver of loan growth during the period, up $37.9 million. This growth came from an increase in local lending business, supplemented with purchased commercial loan participations. The Bank is pleased with the growth in commercial loans as it reflects positively on the initiative put in place by Management to generate commercial loan growth. Consumer loans have increased $13.3 million, with most of the growth occurring during the third quarter, primarily the result of a home equity loan promotion that was in place during the quarter. Mortgage loans decreased $8.5 million during the first nine months of the year as new mortgage origination activity slowed and the Bank has reduced the amount of fixed rate mortgages it holds.  Loans held-for-sale have decreased during the period since the Bank has stopped funding loan production from its joint venture mortgage banking company. This company discontinued operations in the first quarter. Loans held-for- sale are comprised of $563 thousand of loans previously funded for the mortgage banking company. Efforts continue to find a buyer for these loans. The remaining loans held-for-sale are mortgage loans that were originated by the Bank for its customers.

Total deposits have grown by $35.7 million to $435.5 million at September 30, 2005.  Nearly all deposit categories have increased since December 31, 2004, including an increase in noninterest bearing demand deposits of $7.7 million since year-end.   The majority of deposit growth has occurred in the Bank’s Money Management product. This product has grown by 39.6% from $80.4 million at December 31, 2004 to $112.2 million at September 30, 2005.  The growth is the result of both new accounts being opened and larger balances in existing accounts. The Money Management product has a tiered interest rate, indexed to the 91-day Treasury bill and has become a very attractive product in the market as short-term interest rates continued to rise during the year.  Certificate-of-deposit balances, which had been relatively flat for most of the year, increased slightly during the third quarter as the result of a CD promotion offered during the quarter. Securities sold under agreements to repurchase (Repos) have

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increased $17.5 million (41.8%) since year-end 2004. At September 30, 2005, Repos totaled $59.3 million.  The Repo product also has an indexed interest rate and is offered to commercial deposit customers as part of a comprehensive cash management program.  Other short-term borrowings have decreased since the Bank is no longer funding loans held-for-sale that were originated by its joint venture mortgage banking company. Long term debt increased slightly as the Bank took a new advance from the Federal Home Loan Bank of Pittsburgh to match fund a commercial loan during the second quarter of the year.

Total shareholders’ equity recorded a net increase of $814 thousand to $55.5 million at September 30, 2005 from $54.6 million at December 31, 2004.  The increase in retained earnings more than offset the decrease in other comprehensive income, primarily unrealized losses on securities. The Corporation declared dividends of $2.4 million and repurchased 15,000 shares of its common stock to be held as Treasury shares during the year.

Capital adequacy is currently defined by regulatory agencies through the use of several minimum required ratios.  At September 30, 2005, the Corporation was well capitalized as defined by the banking regulatory agencies.  The Corporation’s total risk-based, Tier 1 risk-based and Tier 1 leverage ratios at September 30, 2005 were 13.74%, 12.47% and 8.88%, respectively.

Loan Quality

Nonperforming loans decreased from $942 thousand at year-end 2004 to $740 thousand at September 30, 2005.   The nonperforming loans to total loans ratio also fell from .27% to .19% over the same period.  Included in nonperforming loans at September 30, 2005 were nonaccrual loans totaling $286 thousand and loans past due 90 days or more totaling $454 thousand compared with $355 thousand and $587 thousand, respectively, at December 31, 2004.  The Corporation held no foreclosed real estate on September 30, 2005 or December 31, 2004. The Bank was in a net loan recovery position for the first nine months of both 2005 and 2004.  Net loans recovered in 2005 total $7 thousand and $283 thousand for 2004. The net recovery position produced an annualized ratio of net loans (recovered) to average loans of -.04% for the nine months ended September 30, 2005 and -.07% for the nine months ended September 30, 2004. The net recovery position in 2005 is primarily the result of the recovery of a previously charged off commercial credit of $266 thousand. Likewise, the net recovery position in 2004 is primarily the result of the recovery of a previously charged off commercial credit of $283 thousand.

 The allowance for loan losses was $5.4 million at September 30, 2005, up from $4.9 million at December 31, 2004.  The allowance as a percentage of total loans was 1.38% at September 30, 2005 down slightly from 1.40% at prior year-end.  The allowance provided coverage for nonperforming loans at a rate of approximately 7.3 times at September 30, 2005.

Economy:

The Corporation has identified Franklin and Cumberland Counties as its primary market areas. These counties have an unemployment rate of 3.3% and 3.5%, respectively according to data released by the Pennsylvania Department of Labor and Industry.  These unemployment rates compare very favorably to the state unemployment rate of 5.0% and are among the lowest unemployment rates in the state.  The local economy is not overly dependent on any one industry or business.

The Corporation continues to watch the actions of the Federal Reserve Open Market Committee as it contemplates additional short-term rate changes.  Short-term rates have increased eight times since September 2004; however, intermediate and long-term rates have remained flat or even fallen during this

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time resulting in a flat yield curve. Many economists believe short-term rates will continue to rise throughout the remainder of the year and into 2006. An increase in short-term interest rates effects both the assets and liabilities of the Corporation that are sensitive to interest rate changes.

Liquidity

The Corporation’s liquidity ratio (net cash, short-term and marketable assets divided by net deposits and short-term liabilities) was 24% at September 30, 2005 compared with 30% at December 31, 2004.  The Corporation has the ability to borrow funds from the Federal Home Loan Bank of Pittsburgh (FHLB), if necessary, to enhance its liquidity position.  At September 30, 2005, the unused funding available to the Corporation from FHLB was $171 million. In addition to the funding available through FHLB, the Corporation also has unpledged and available-for-sale investment securities with a market value of $58.8 million at September 30, 2005.  These securities could be used for liquidity purposes. Management believes that liquidity is adequate to meet the needs of the Corporation and monitors its future needs on a regular basis.

Off Balance Sheet Commitments

The Corporation’s financial statements do not reflect various commitments that are made in the normal course of business, which may involve some liquidity risk.  These commitments consist mainly of unfunded loans and letters of credit made under the same standards as on-balance sheet instruments.  Because these instruments have fixed maturity dates, and because many of them will expire without being drawn upon, they do not generally present any significant liquidity risk to the Corporation.  Unused commitments and standby letters of credit totaled $99.2 million and $96.3 million, respectively, at September 30, 2005 and December 31, 2004.

The Corporation has entered into various contractual obligations to make future payments.  These obligations include time deposits, long-term debt and operating leases.  At September 30, 2005, the total of these obligations did not change significantly from what was reported at December 31, 2004.

The Bank has entered into interest rate swap agreements as vehicles to partially hedge cash flows associated with interest expense on variable rate deposit accounts. Under the swap agreements, the Bank receives a variable rate and pays a fixed rate. The Bank had swap agreements with a total notional amount of $15 million outstanding at September 30, 2005 and December 31, 2004.

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PART I, Item 3

Quantitative and Qualitative Disclosures about Market Risk

There were no material changes in the Corporation’s exposure to market risk during the quarter ended September 30, 2005. For more information on market risk refer to the Corporation’s 2004 Annual Report on Form 10-K.

PART I, Item 4

Controls and Procedures

Evaluation of Controls and Procedures

The Corporation is required to maintain controls and procedures designed to ensure that information required to be disclosed in the reports that the company files or submits under the Securities and Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission.

The Corporation, under the direction of its Chief Executive Officer and its Chief Financial Officer, conducted an evaluation of the effectiveness of the design and operation of the Corporation’s disclosure controls and procedures pursuant to SEC Rule 13a-15(b). Based upon that evaluation, the Corporation’s Chief Executive Officer and Chief Financial Officer concluded that the Corporation’s disclosure controls and procedures were effective as of September 30, 2005.

Changes in Internal Controls

The Corporation’s management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934.  The Corporation’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

The Corporation, under the direction of its Chief Executive Officer and its Chief Financial Officer, conducted an evaluation of the effectiveness of the Corporation’s internal control over financial reporting as of December 31, 2004.  Management’s assessment identified a material weakness in the Corporation’s internal control over financial reporting because of ineffective controls related to the review of computations and methodology pertaining to a limited number of complex, non-routine transactions which could potentially aggregate to material misstatements in financial reporting.

In order to address the material weakness described above, the Corporation has developed and is in the process of completing the implementation of procedures to ensure that those complex, non-routine transactions identified in management’s evaluation of internal control over financial reporting have a sufficient level of review to ensure that the risk of misstatement is minimized.

There were no changes during the third quarter of 2005 in the Company’s internal control over financial reporting, other than those previously mentioned, which materially affected, or which are reasonably likely to affect, the Company’s internal control over financial reporting.

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FRANKLIN FINANCIAL SERVICES CORPORATION

and SUBSIDIARIES

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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