The Company:
1ST Franklin Financial Corporation and its consolidated subsidiaries (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. As of September 30, 2005, the business was operated through a network of 218 branch offices located in 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 insurance 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 insurance coverage to help continue loan payments if the customer becomes sick or disabled for an extended period of time. Customers may also choose property insurance coverage to protect the value of loan collateral against damage, theft or destruction. We write these various insurance products as an agent for a non-affiliated insurance company. Under various agreements, our wholly-owned insurance subsidiaries, Frandisco Life Insurance Company and Frandisco Property and Casualty Insurance Company, reinsure the in surance coverage on our customers written on behalf of this 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.
Overview:
Total assets of the Company amounted to $314.6 million at September 30, 2005 compared to $312.4 million at December 31, 2004, representing a 1% increase. The main area of growth was in our investment securities portfolio managed by our insurance subsidiaries.
Gross revenues were $25.6 million during the three-month period ended September 30, 2005 as compared to $24.9 million for the same three-month period in 2004. During the nine-month comparable periods of 2005 and 2004, gross revenues were $75.7 million and $73.0 million, respectively. Although revenues increased in 2005, higher operating costs caused net income to decline $.6 million (30%) during the same comparable three-month periods and $.4 million (6%) for the comparable nine-month periods.
Some of our branch locations in the southern areas of Louisiana and Mississippi were impacted by hurricanes Katrina and Rita during the quarter just ended. The hurricanes were devastating, leaving areas destroyed and many people homeless. Our hearts and prayers go to those who lost loved ones and/or their homes and possessions. We are thankful that none of our employees were injured; however, some did lose their homes. Twenty-eight of our branch locations were affected in some way. Immediately after the storms, power was out and communications with these branch locations were sporadic. Most were back in operation within a week of each storm, with the exception of one branch, which sustained severe damage. It is currently sharing a location with another branch. Many of our customers in the storm areas were severely impacted. We have been and/or continue to attempt to contact customers to as sess their situations and to offer assistance with respect to their obligations due to the Company. In certain instances, we are extending payment dates, waiving delinquent charges, or otherwise modifying our loan agreements to help our affected customers. However, we do not believe that these concessions will result in a material loss of revenue or earnings for the Company. Many opted for credit insurance on their loans and we are assisting them with filing insurance claims for their losses. See our analysis of insurance income later in this discussion for further comments on the hurricanes’ affect on our operations. The Company does not expect losses as a result of borrower financial difficulties to have a material impact on our loan loss provision.
Five new branch offices were opened by us during the current year. In addition, we completed an acquisition of a finance company with one branch office, bringing the total number of our new offices in 2005 to six.
The following portions of Management’s Discussion and Analysis of Financial Condition and Results of Operations focus in more detail on the Company’s balance sheet and results of operations for the three and nine months ended September 30, 2005 and 2004. Information about the Company’s liquidity, funding sources, critical accounting policies and other matters is also discussed. Financial Condition:
The aforementioned increase in total assets was mainly attributable to an increase in the Company’s cash and investment securities portfolios. An increase in miscellaneous other assets also contributed to the increase.
Cash and cash equivalents increased $.4 million (3%) to $17.9 million at September 30, 2005 as compared to December 31, 2004. An increase in loan payments in our branch offices and surplus funds generated by our property and casualty insurance subsidiary were the main reasons for the increase.
Increased investing of surplus funds by our life insurance subsidiary was the primary reason for the $6.6 million (10%) increase in our investment portfolio at September 30, 2005 as compared to the prior year-end. 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” (67% as of September 30, 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 securities to maturit y.
An increase in prepaid income taxes by our insurance subsidiaries was the main factor for the $.6 million (5%) increase in miscellaneous other assets. Higher prepaid expenses also contributed to this increase.
The Company’s loan portfolio (net of unearned finance charges, unearned insurance and allowance for loan losses) was $213.6 million at September 30, 2005 as compared to $218.9 million at December 31, 2004. Historically, our loan originations are slowest during the first quarter of each year and loan payments typically exceed funds disbursed on new loans in this period. Continued increases in loan originations during the third quarter have offset a portion of the decline in the loan portfolio which occurred in the first quarter. Based on previous experience, we believe loan originations during the remaining quarter of this year will result in our loan portfolio reaching approximately the same level of loans outstanding at December 31, 2004.
Results of Operations:
Higher loan losses, interest costs and personnel expenses were the major factors causing the aforementioned declines in our net income for the three- and nine-month periods ended September 30, 2005 as compared to the same comparable periods a year ago. The impact of the recent hurricanes described herein also contributed to the decline.
Net Interest Margin
A key component in the Company’s operating results is its net interest margin. Net interest margin represents the spread between earnings on loans and investments and interest paid on the Company’s senior and subordinated debt. 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 $.6 million (4%) during the three-month period ended September 30, 2005 as compared to the quarter ended September 30, 2004. During the nine-month period just ended, net interest income increased $2.5 million (6%) as compared to the same nine-month 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. Although our net receivables outstanding at September 30, 2005 were below the prior year-end levels, the overall average was higher due to the volume of loans generated in the fourth quarter of 2004. Average net receivables were $243.0 million during the nine-month period ended September 30, 2005 as compared to $237.2 million during the nine-month period ended September 30, 2004. The higher level of average net receivables generated an additional $.8 million (4%) and $3.0 million (6%) in interest income during the three- and nine-month periods just ended as compared to the same comparable periods a year ago.
The average outstanding amount of our senior and subordinated indebtedness was $205.3 million during the nine-month period just ended, as compared to $197.8 during the same period a year ago; however, the lower interest rate environment has minimized the impact on our interest expense. During the three- and nine-month periods ended September 30, 2005, interest expense increased $.2 million (11%) and $.5 million (9%) as compared to the same periods a year ago, respectively. The weighted average borrowing cost on the Company’s debt securities was 3.64% during the nine-month period just ended as compared to 3.51% during the same period in 2004.
Although market interest rates were at historical lows over the past few years, rates are trending up. The Federal Reserve Board has raised interest rates nine times between September 1, 2004 and September 30, 2005. The Company continually monitors the rates it pays on its senior and subordinated debt in order to remain competitive. As a result, we have increased rates we pay on some of our debt securities during the current year. Any increases may negatively impact our net interest margin; however, we do not expect further increases to have a material impact on our interest margin for the remainder of the year.
Insurance Income Our net insurance income declined $.5 million (9%) and $.7 million (4%) during the three-and nine-month periods ended September 30, 2005 from the comparable periods in 2004. As previously mentioned, hurricanes Katrina and Rita impacted some of our operations in Louisiana and Mississippi. The decline in net insurance income during the 2005 comparable periods was mainly due to higher claim reserves based on losses projected by the Company’s property and casualty subsidiary as a result of the storms. As of September 30, 2005, this insurance subsidiary had set aside $.5 million for storm related claims, whereas no similar losses were recognized in the 2004 comparable period.
Provision for Loan Losses
Higher credit losses during the current year were the primary cause of the $1.0 million (23%) and $1.8 million (16%) increases in the Company’s provision for loan losses during the three- and nine-month periods just ended as compared to the same comparable periods a year ago. The Company experienced a $.9 million (23%) increase in net charge offs during the three- month period just ended compared to the same period in 2004. During the nine-month comparable periods, net charge offs increased $1.6 million (16%).
Also contributing to the current year increases in the provision for loan losses were adjustments to the allowance for loan losses which we believe are sufficient to cover credit losses inherent in the outstanding loan portfolio at the balance sheet date.
Our projections indicate loan losses may continue to increase during the remainder of the year. These projections are based on an upward trend in delinquent accounts and a significant number of bankruptcy filings by the Company’s customers. The Company experienced a surge in bankruptcy filings up to and during October 2005 as a result of new federal bankruptcy laws which became effective October 17, 2005. The increase in filings in the month of October 2005 was approximately double previous monthly levels.
We continually monitor the credit-worthiness of our loan portfolio. Additions will be made to the allowance for loan losses as probable losses are recognized in the current portfolio.
Other Operating Expenses
Other operating expenses include personnel expense, occupancy expense and miscellaneous other operating expenses. The categories experiencing material variances during the current year as compared to the prior year were personnel expense and other miscellaneous expenses.
Personnel expense increased $1.5 million (6%) during the nine-month period just ended as compared to the same nine-month period in 2004. During the three-month comparable periods, personnel expense increased $.4 million, or 5%. Higher salary expense during the current year, due to merit increases and additional employees required to staff the new branch offices, was a significant factor resulting in the increase in personnel expense. Other factors contributing to the increase were higher medical claims incurred by the Company’s employee health insurance plan and lower bonus accruals during 2004. The implementation of a drug awareness program effective July 1st also contributed to the increase in personnel expense during the nine month period just ended.
Miscellaneous other operating expenses declined $.7 million (15%) and $1.3 million (10%) during the three- and nine-month periods ended September 30, 2005 as compared to the same periods in 2004. Non-recurring costs incurred in 2004 but not in 2005 related to the conversion to the Company’s new computer system was the primary factor responsible for the decline in other miscellaneous operating expenses. During July 2005 the Company sold a building and land it had previously been leasing to Liberty Bank & Trust. The sale generated a one-time gain which also contributed to the reduction in other miscellaneous expenses. Offsetting some of the decrease in other expenses were increases in legal and audit expenses and costs associated with compliance work done associated with a project to ensure compliance with certain provisions of the Sarbanes-Oxley Act.
Income Taxes:
Effective income tax rates were 24% for the nine-month periods ended September 30, 2005 and 2004, and 31% and 26% during the three-month periods then ended, 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 higher rate during the quarter just ended was due to higher losses incurred by the S Corporation being passed to the shareholders for tax reporting, whereas income earned by the insurance subsidiaries was taxed at the corporate level. The tax rates for the other periods are below statutory rates due to certain benefits provided by law to life insurance companies, which reduced the effective tax rate of the Company’s life insurance subsidiary and investments in tax exempt b onds held by the Company’s property insurance subsidiary.
Quantitative 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 trending up, 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 discussion contained 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 September 30, 2005 and December 31, 2004, the Company had $17.9 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. Until July 20, 2005, beneficial owners of the Company were also beneficial owners of Liberty Bank & Trust. Effective July 20, 2005, Liberty Bank & Trust merged with Habersham Bank and the Company’s beneficial owners no longer maintain an ownership interest in Liberty Bank & Trust or Habersham Bank. The Company’s investments in marketable securities can be converted into cash, if necessary. As of September 30, 2005 and December 31, 2004, respectively, 93% and 95% of the Company’s cash and cash equivalents and investment securities were maintained in its 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 subsidiari es can 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 was scheduled to expire on September 25, 2005 on its own terms, but was renewed for a one year term expiring September 25, 2006. Available borrowings under the agreement were $30.0 million and $19.6 million at September 30, 2005 and December 31, 2004, respectively.
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