Overview:
1ST Franklin Financial Corporation (the “Company” or “we”) 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 the making of first and second mortgage loans on real estate to homeowners. The business is operated through a network of 212 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 any outstanding loan balance is repaid if the customer dies before the loan is repaid or they may request accident and health coverage to help continue loan payments if the customer becomes 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 these 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 applicable state and federal laws and regulations. Financial Condition:
Total assets of the Company declined $7.2 million (2%) during the quarter ending March 31, 2005 to $305.2 million as compared $312.4 million at December 31, 2004. The decline in assets was principally due to a $13.4 million (6%) decrease in the Company’s net loan portfolio. Historically, our loan originations are slowest during the first quarter of each year and loan payments typically exceed funds disbursed on new loans. During the first quarter of 2005, the decrease in our net loan portfolio was more significant than in prior years, approximately double the decrease experienced during the first quarter of 2004. Management attributes the additional decline to the impact of our recent computer conversion, as described below.
On January 1, 2005, the Company completed the conversion of its loan and accounting systems to a new computer system. This culminated a two-year project for the Company which was a major undertaking. All facets of the Company’s operational processes were affected. As with any new system, challenges were encountered during the post-conversion period. During the months of January and February, our primary focus was system related. We worked on fine-tuning our procedures and our employees worked diligently on becoming proficient and comfortable working on the new system. Consequently, our business development efforts were not as concerted, which contributed to the aforementioned decrease in our loan portfolio.
The Company’s cash position improved during the quarter as cash and cash equivalents grew $6.0 million, or 24%. The growth in cash was mainly generated from the excess of loan payments over loan disbursements.
During the quarter just ended, our investment securities increased approximately $1.8 million (3%) as compared to the prior year-end. This was due to an increase in surplus funds generated by the Company’s insurance subsidiaries. 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” (61% as of March 31, 2005 and 59% as of December 31, 2004) 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 secu rities to maturity.
Overall liabilities declined $9.8 million, or 4%, during the quarter ended March 31, 2005 as compared to December 31, 2004. The Company repaid the $10.4 million balance on its credit line outstanding at December 31, 2004, which was a major factor contributing to the overall decline in liabilities. During the fourth quarter of 2004, the Company had utilized a portion of the available borrowings under its credit line to fund a portion of its loan originations. Other factors contributing to the decline were the disbursements in February of the prior year’s incentive bonus and profit sharing contribution totaling approximately $4.4 million.
Results of Operations:
The Company experienced significant improvement in its net income during the quarter ended March 31, 2005 as compared to the quarter ended March 31, 2004. Net income grew $1.1 million (55%) to $3.1 million during the quarter ended March 31, 2005 on total revenues of $25.4 million. Most of the growth was in net interest income.
Net Interest Income
As a financial institution, the Company’s primary source of income is its net interest margin. The margin is the spread between earnings on loans and investments and interest paid on the Company’s 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 $1.2 million (8%) during the quarter ended March 31, 2005, as compared to the quarter ended March 31, 2004.
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 $241.7 million during the quarter ended March 31, 2005 as compared to $229.5 million during the quarter ended March 31, 2004. The higher level of average net receivables generated an additional $1.3 million (8%) in interest income during the period just ended as compared to the same comparable period a year ago.
The average outstanding debt level on our senior and subordinated indebtedness was $205.6 million during the three-month period just ended, as compared to $191.5 during the same period a year ago; however, the lower interest rate environment has minimized the impact on our interest expense. During the quarter ended March 31, 2005, interest expense increased $.1 million (7%) as compared to the same quarter a year ago.
Although market rates have been at historical lows over the past few years, rates are trending up. 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 currently anticipate that rates will increase significantly and do not project a material impact on our margin for the remainder of this year.
Insurance Income
The Company, as agent for a non-affiliated insurance company, offers optional credit insurance coverage to customers when making a loan. 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. Net insurance income rose $.1 million (2%) during the three-month period ended March 31, 2005 as compared to the same period a year ago, mainly due to the increase in average net receivables.
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 declined $.2 million (7%) during the three-month period just ended as compared to the same period in 2004. The decline resulted from a $.3 million (11%) decrease in net write-offs during the same comparable period. We are pleased with the lower loan losses experienced during the quarter just ended; however, we remain cautious in our projections for the remainder of the year.
We continually monitor the credit-worthiness of the loan portfolio. Additions will be made to the allowance for loan losses when we deem it appropriate to recognize probable losses in the current portfolio.
Other Operating Expenses
There were only moderate increases in the categories of expenses listed under “Other Operating Expenses” during the comparable periods. These categories include personnel expense, occupancy expense and miscellaneous other operating expenses. Although salary expense increased during the quarterly period just ended as compared to the same quarterly period a year ago, a reduction in employee health claims enabled the Company to keep the increase in personnel expense at 3%.
Occupancy expense increased $.2 million, or 9%, during the quarter just ended as compared to the same quarter a year ago. Higher maintenance cost on new computer equipment, increases in utilities and rent expense led to the increase in occupancy expense.
Other miscellaneous operating expenses were relatively constant during the comparable periods. A $.5 million reduction in costs directly related to the conversion to the new computer system during the quarter just ended as compared to the same quarter a year ago was a significant factor in keeping increases in other operating expenses minimal. Reductions in advertising expenditures also contributed. These reductions offset increases in other overhead expenses during the period just ended.
Effective income tax rates were 17% and 21% during the three-months period ended March 31, 2005 and 2004, respectively. 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 lower rates during the current year period were also due to income 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 minimize increases in interest costs during the current year. Although rates are expected to rise, we do not currently expect rates to increase to a level which would cause a significant impact on our operating performance for the remainder of the current 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, 2004 for a detailed analysis of our market risk exposure.
Liquidity and Capital Resources:
As of March 31, 2005 and December 31, 2004, the Company had $23.4 million and $17.4 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 March 31, 2005, the Company had $1.6 million in demand deposits with Liberty Bank & Trust. The Company’s investments in marketable securities can be converted into cash, if necessary. As of March 31, 2005 and December 31, 2004, respectively, 89% and 95% 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 policyholder’s surplus or statutory earnings before recognizing realized investment gains of the individual insurance subsidiaries. At December 31, 2004, Frandisco Property and Casualty Insurance Company and Frandisco Life Insurance Company had policyholders’ surplus of $30.9 million and $30.1 million, respectively. The maximum aggregate amount of dividends these subsidiaries c an pay to the Company in 2005 without prior approval of the Georgia Insurance Commissioner is approximately $7.4 million.
Liquidity requirements of the Company are financed through the collection of receivables and through the issuance of short and long term debt securities, including commercial paper. 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 sales and issuances, the Company has an external source of funds through the use of a credit agreement. The agreement provides for available unsecured borrowings of $30.0 million and is scheduled to expire on September 25, 2005 on its own terms. The Company expects to renew this credit agreement prior to its expiration, 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 borrowing s under the agreement were $30.0 million and $19.6 million at March 31, 2005 and December 31, 2004, respectively. | 