Overview:
1ST Franklin is engaged in the consumer finance business, particularly in making consumer loans to individuals in relatively small amounts for short periods of time. Other lending activities include the purchase of sales finance contracts from various dealers and in making first and second mortgage loans on real estate to homeowners who wish to improve their property or who wish to restructure their financial obligations. The business is operated through a network of 211 branch offices located in the states of Alabama, Georgia, Louisiana, Mississippi and South Carolina.
We also offer optional credit insurance coverage to our customers when making a loan. Such coverage may include credit life insurance, credit accident and health insurance, and/or credit property insurance. Customers may request credit life coverage to help assure the remaining loan balances are repaid if borrowers die before the loans are repaid or they may request accident and health coverage to help continue loan payments if borrowers become sick or disabled for an extended period of time. Customers may also choose property coverage to protect the values of loan collateral against damage, theft or destruction. We write the various insurance products as an agent for a non-affiliated insurance company. Our wholly-owned insurance subsidiaries reinsure the insurance written from the non-affiliated insurance company.
The Company's operations are subject to various state and federal laws and regulations. We believe our operations are in compliance with the applicable state and federal laws and regulations.
Financial Condition:
Total assets of the Company were $295.3 million at June 30, 2004 compared to $292.9 million at December 31, 2003, representing a 1% increase. The main area of growth was in our investment securities portfolio, which increased $4.1 million or 7%. Surplus funds generated by our insurance subsidiaries during the six-month period just ended were positioned in our investment securities portfolio in an attempt to maximize yields.
The Company's investment portfolio consists mainly of U.S. Treasury bonds, government agency bonds and various municipal bonds A significant portion of these investment securities have been designated as “available for sale” (54% as of June 30, 2004 and 62% as of December 31, 2003) with any unrealized gain or loss accounted for in the equity section of the Company’s balance sheet, net of deferred income taxes for those investments held by the Company's insurance subsidiaries. The remainder of the investment portfolio represents securities carried at amortized cost and designated “held to maturity”, as Management has both the ability and intent to hold these securities to maturity.
A rise in the level of receivables managed under the Company’s net loan portfolio also contributed to the increase in total assets. Net loans rose $3.2 million (2%) as a result of higher loan originations during the six-month period ended June 30, 2004. Management expects loan originations to continue to grow during the remainder of 2004, resulting in additional growth in our net loan portfolio.
The aforementioned positioning of surplus cash into investment securities and funds required to finance the increase in net loans were responsible for the $4.7 million (28%) decline in our cash and cash equivalents. Higher operating expenses also contributed to the decline. The Company had $12.2 million on hand at June 30, 2004 as compared to $16.9 million at December 31, 2003.
Overall liabilities were comparable at June 30, 2004 and December 31, 2003. Variances did, however, occur in certain liability categories. Senior and subordinated debt increased a total of $2.9 million during the six-month period just ended due to increased sales of the Company’s debt securities and an increase in the balance outstanding on it’s credit line. Offsetting the increase in senior and subordinated debt was a $2.9 million decline in other liabilities during the same period. The decline in other liabilities was mainly due to the disbursement of the prior year’s accrued incentive bonus and the Company’s annual contribution to the employee profit sharing plan.
Results of Operations:
During the three- and six-month period ended June 30, 2004, total revenues were $24.2 million and $48.1 million, respectively, compared to $22.4 million and $44.9 million during the same comparable periods a year ago. Although revenues rose, net income declined $1.9 million (53%) during the comparable three-month period and $2.6 million (42%) during the comparable six-month period as a result of higher operating costs.
Net Interest Income
Net interest income represents the margin between earnings on loans and investments and interest paid on senior and subordinated debt. It represents a key performance driver in the operations and success of the Company’s operations. Changes in our interest margin are influenced by factors such as the level of average net receivables outstanding and the interest income associated therewith, capitalized loan origination costs, and borrowing costs. Net interest income increased $1.0 million (7%) during the quarter ended June 30, 2004, as compared to the quarter ended June 30, 2003. During the six months just ended, the net interest margin increased $2.3 million (8%) compared to the same period a year ago.
Our growth in the net interest margin was primarily due to increases in finance charge income earned on our loan portfolio. Average net receivables were $234.5 million during the six months ended June 30, 2004 as compared to $216.4 million during the six months ended June 30, 2003. The higher level of average net receivables generated an additional $1.1 million (7%) and $2.4 million (8%) in interest income during the three- and six-month period just ended as compared to the same comparable periods a year ago, respectively.
The lower interest rate environment allowed the Company to reduce interest expense slightly during the six-month period ended June 30, 2004 as compared to the same period a year ago, which had a positive impact on net interest income. Although our average debt level on senior and subordinated debt rose to $192.4 million during the first half of 2004, as compared to $182.4 million during the first half of 2003, average interest rates on outstanding borrowings decreased to 3.5% as compared to 3.6% for the same comparable period. During the quarter ended June 30, 2004, we experienced a slight increase in interest expense compared to the quarter ended June 30, 2003, mainly due to a rise in the average debt level outstanding.
Various economic indicators and the recent increase in the prime rate by the Federal Reserve suggest interest rates are beginning an upward trend. As market rates rise, the Company may need to offer higher rates on its senior and subordinated debt in order to remain competitive. Any such increase may negatively impact our net interest margin. However, we do not anticipate that rates will increase significantly and do not project a material impact on our margin for the remainder of this year.
Insurance Income
Net insurance income rose $.5 million (10%) and $.7 million (7%) during the three- and six-month periods ended June 30, 2004 as compared to the same periods a year ago, respectively. As average net receivables increase, the Company typically sees an increase in the number of loan customers requesting credit insurance, thereby leading to higher levels of insurance in force.
Provision for Loan Losses
The provision for loan losses reflects the level of net charge offs and adjustments to the allowance for loan losses, which we believe is sufficient to cover credit losses inherent in the outstanding loan portfolio at the balance sheet date. Our provision for loan losses rose $.4 million (12%) during the three-month period just ended as compared to the same period in 2003. During the six-month period just ended, the provision rose $.9 million or 15%. Write-offs of non-performing loans were the major causes of the increases. Net write-offs increased $.3 million (10%) and $.9 million (15%) during the three- and six-month periods ended June 30, 2004 as compared to the same periods during 2003. Also contributing to the increase in the provision were adjustments to our allowance for loan losses to keep pace with our growth in the loan portfolio.
We continually monitor the credit-worthiness of the loan portfolio. Additions will be made to the allowance for losses when we deem it appropriate to protect against probable losses in the current portfolio.
Other Operating Expenses
The primary cause of the decline in net income during the current year has been due to significant increases in operating overhead. Other operating expenses increased approximately $3.0 million (25%) and $4.7 million (19%) during the three- and six-month periods ended June 30, 2004 as compared to the same periods ended June 30, 2003, respectively.
As previously disclosed in our March 31, 2004 quarterly report and the Company’s annual report for 2003, we are in the process of converting our branch office loan accounting system to a new service provider. The project began during the third quarter of 2002 and was divided into two phases. Phase one involved the conversion of our investment center to the new system, which was completed on October 3, 2003. Phase Two involves the conversion of our branch office network and accounting system. The scope of the project has been a major undertaking for the Company. We have implemented a data communication network, which links all the branch offices in our five-state territory on the new system. We are assisting the new service provider in modifying its existing system to meet the needs of the consumer finance industry. Training on the new system began at the end of January 2004, and all e mployees will have completed extensive training prior to the completion of the conversion. Management’s goal is to convert to a premier loan accounting system, which enables the Company to operate more efficiently and provides additional services to our customers. The additional development and testing necessary to implement such a first-class system has shifted the anticipated completion date of the conversion from the second quarter of this year to the beginning of 2005.
The most significant factor causing our higher overhead expenses relates to our computer conversion. Costs associated with the conversion have been the main causes of the aforementioned increases in other operating expenses during the comparable periods. These costs include the additional personnel expense incurred in training employees on the new system, networking costs, costs associated with testing and development, and costs of new equipment. The conversion may continue to have a negative impact on the operating results for the remainder of 2004; however, we are diligently working to insure a smooth transition and to minimize any adverse operating results.
Although the conversion project has been the primary cause of the higher operating expenses during 2004, other factors also contributed to the increases. An increase in our employee base and merit salary increases effective February 1, 2004 added to our higher overhead. Another factor were costs associated with the opening of eight new branch offices during the current year. Increases in legal and audit expenses also contributed to the higher operating expenses.
Effective income tax rates were 24% and 11% during the six-month periods ended June 30, 2004 and 2003, respectively, and 23% and 14% during the three-month periods then ended. The Company files under S Corporation status for income tax reporting purposes. Taxable income or loss of an S Corporation is included in the individual tax returns of the stockholders of the Company. Income taxes are reported for the Company's insurance subsidiaries. The tax rates are also below statutory rates due to certain benefits provided by law to life insurance companies, which reduced the effective tax rate of the Company’s insurance subsidiary. The higher rates during the current year periods were due to losses of the S Corporation being passed to the shareholders for tax reporting, whereas income earned by the insurance subsidiaries was taxed at the corporate level.
Quantitive and Qualitative Disclosures about Market Risk:
As previously discussed, the lower interest rate environment has enabled the Company to reduce interest expense during the current year. Although rates are expected to rise, we don’t believe rates will increase to a level which would cause a significant impact on our operating performance for the remainder of the year. There has been no change during the current year that is expected to have a material impact on our exposure to changes in market conditions. Please refer to the market risk analysis discussed in our annual report on Form 10-K as of and for the year ended December 31, 2003 for a detailed analysis of our market risk exposure.
Liquidity and Capital Resources:
As of June 30, 2004 and December 31, 2003, the Company had $12.2 million and $16.9 million, respectively, invested in cash and short-term investments readily convertible into cash with original maturities of three months or less. Beneficial owners of the Company are also beneficial owners of Liberty Bank & Trust. As of June 30, 2004, the Company had $115,620 in demand deposits with Liberty Bank & Trust. The Company’s investments in marketable securities can be converted into cash, if necessary. As of June 30, 2004 and December 31, 2003, respectively, 94% and 93% of the Company’s cash and cash equivalents and investment securities were maintained in our insurance subsidiaries. State insurance regulations limit the use an insurance company can make of its assets. Dividend payments to the Company by its wholly owned insurance subsidiaries are subject to annual limitations and are restricted to the greater of 10% of statutory surplus or statutory earnings before recognizing realized investment gains of the individual insurance subsidiaries. At December 31, 2003, Frandisco Property and Casualty Insurance Company and Frandisco Life Insurance Company had statutory surplus of $22.2 million and $24.5 million, respectively. The maximum aggregate amount of dividends these subsidiaries can pay to the Company in 2004 without prior approval of the Georgia Insurance Commissioner is approximately $6.9 million.
Liquidity requirements of the Company are financed through the collection of receivables and through the issuance of debt securities. Continued liquidity of the Company is therefore dependent on the collection of its receivables and the sale of debt securities that meet the investment requirements of the public. In addition to the securities program, the Company has an external source of funds through the use of a credit agreement. The agreement provides for available unsecured borrowings of $21.0 million and is scheduled to expire on September 25, 2004. The Company expects to renew this credit agreement when it expires, but there can be no assurance that the lender will renew this credit facility upon the same or similar terms, or at all, or that any replacement will be available to the Company in such event. Available borrowings under the agreement were $18.2 and $21.0 million at June 30, 2004 and December 31, 2003, respectively.
Other:
There are six legal proceedings pending against the Company in the state of Mississippi alleging fraud and deceit in the Company's sale of credit insurance, refinancing practices and use of arbitration agreements. The plaintiffs seek statutory, compensatory and punitive damages. The cases have been removed to Federal District Court. In two of the cases, the Company has been dismissed from the court proceedings but motions to compel arbitration have been granted. Management believes that it is too early to assess the Company's potential liability in connection with the six suits. The Company is diligently contesting and defending these cases.
A legal proceeding is pending against the Company in the state of Georgia alleging violation of usury statutes. The Company is diligently contesting and defending this case. Management believes that it is too early to assess the Company's potential liability in connection with this suit.
A more detailed summary of the aforementioned legal proceedings appears in the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, under Part II, Item 1.
The Company is involved in various other claims and lawsuits incidental to its business. In the opinion of Management, the ultimate resolution of such claims and lawsuits will not have a material effect on the Company's financial position, liquidity or results of operations.
Recent Accounting Pronouncements:
In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities ("FIN 46"). FIN 46 clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements (ARB 51), to certain entities in which equity investors do not have characteristics of controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN No. 46, as revised, was adopted January 1, 2004 by the Company and, as the Company does not have any investments in entities that qualify as Variable Interest Entities, this adoption did not have a significant impact on the Company's financial statements.
Critical Accounting Policies:
The accounting and reporting policies of 1st Franklin and its subsidiaries are in accordance with accounting principles generally accepted in the United States and conform to general practices within the financial services industry. The more critical accounting and reporting policies include the allowance for loan losses, revenue recognition, accounting for securities, loans, insurance claims reserve and income taxes. In particular, 1st Franklin's accounting policies relating to the allowance for loan losses revenue recognition are the most complex.
The allowance for loan losses is based on the Company's previous loss experience, a review of specifically identified loans where collection is doubtful and Management's evaluation of the inherent risks and changes in the composition of the Company's loan portfolio. Specific provision for loan losses is made for impaired loans based on a comparison of the recorded carrying value in the loan to either the present value of the loan’s expected cash flow, the loan’s estimated market price or the estimated fair value of the underlying collateral.
Accounting principles generally accepted in the United States require that an interest yield method be used to calculate the income recognized on accounts which have precomputed charges. An interest yield method is used by the Company on each individual precomputed account to calculate income for on-going precomputed accounts, however, state regulations often allow interest refunds to be made according to the Rule of 78's method for payoffs and renewals. Since the majority of the Company's precomputed accounts are paid off or renewed prior to maturity, the result is that most of the precomputed accounts effectively yield on a Rule of 78's basis.
Precomputed finance charges are included in the gross amount of certain direct cash loans, sales finance contracts and certain real estate loans. These precomputed charges are deferred and recognized as income on an accrual basis using the effective interest method. Some other cash loans and real estate loans, which are not precomputed, have income recognized on a simple interest accrual basis. Income is not accrued on a loan that is more than 60 days past due.
Loan fees and origination costs are deferred and recognized as an adjustment to the loan yield over the contractual life of the related loan.
The property and casualty credit insurance policies written by the Company are reinsured by the property and casualty insurance subsidiary. The premiums are deferred and earned over the period of insurance coverage using the pro-rata method or the effective yield method, depending on whether the amount of insurance coverage generally remains level or declines.
The credit life and accident and health policies written by the Company are reinsured by the life insurance subsidiary. The premiums are deferred and earned using the pro-rata method for level-term life policies and the effective yield method for decreasing-term life policies. Premiums on accident and health policies are earned based on an average of the pro-rata method and the effective yield method.
Different assumptions in the application of these policies could result in material changes in the consolidated financial position or consolidated results of operations. Please refer to Note 1 in the "Notes to Consolidated Financial Statements" in the Company’s Form 10-K as of and for the year ended December 31, 2003 for details regarding all of the Company’s critical and significant accounting policies.
Forward Looking Statements:
Certain information in the previous discussion and other statements contained in this Quarterly Report, which are not historical facts, may be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may involve known and unknown risks and uncertainties. The Company's results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements contained herein. Possible factors, which could cause future results to differ from expectations, are, but are not limited to, adverse economic conditions including the interest rate environment, federal and state regulatory changes, unfavorable outcome of litigation and other factors referenced elsewhere in our filings with the Securities and Exchange Commission. | 