MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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, 2006, the business was operated through a network of 225 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:
The year 2006 is on pace to becoming a very successful year for the Company. Loan originations during the nine-month period ended September 30, 2006 were approximately $45 million or 17% above levels achieved during the same period last year. This growth in loan originations has resulted in an expansion of our customer base and an increase in our net loan portfolio.
The loan growth has also enabled us to improve our financial performance during the current year. Our asset base grew $21.5 million (7%) to $346.4 million at September 30, 2006 compared to $324.9 million at December 31, 2005. Revenues were up $7.7 million (10%) during the nine-month period just ended as compared to the same period a year ago and net income grew $1.1 million over the same comparable period.
We expanded our market area with the opening of six new branch offices during the current year. At least one additional office is planned to be opened prior to year-end. Our strategic plan for the future includes the continued expansion of our branch operating network.
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-month periods ended September 30, 2006 and 2005. Information about the Company’s liquidity, funding sources, critical accounting policies and other matters is also discussed.
Financial Condition:
The Company’s cash position improved by $5.5 million (39%) at September 30, 2006 as compared to December 31, 2005. Increases in cash flows from financing activities, particularly from sales of the Company’s subordinated debt, and cash flows from operating activities resulted in the increase in our cash and cash equivalents.
The Company held cash in restricted accounts of approximately $1.8 million and $1.6 million at September 30, 2006 and December 31, 2005, respectively. These restricted accounts are held by the Company’s insurance subsidiaries in order to meet certain deposit requirements applicable to insurance companies in the State of Georgia and to meet the reserve requirements of the Company’s reinsurance agreements.
As a result of the aforementioned higher loan originations in the first nine months of this year, our net loan portfolio grew $13.4 million (6%) to $238.1 million at September 30, 2006 compared to $224.7 million at December 31, 2005. Historically, the majority of our loan originations occur in the fourth quarter of each year. We therefore expect to see continued growth in our loan portfolio during the remainder of the year.
Investment securities increased $2.2 million or 3% at September 30, 2006 as compared to the prior year-end. Surplus funds generated by our insurance subsidiaries resulted in the majority of the increase. 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” (71% as of September 30, 2006 and 68% as of December 31, 2005) with any unrealized gain or loss, net of deferred income taxes, accounted for in the equity section of the Company’s balance sheet. The remainder of the Company’s 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.
Senior debt of the Company includes our bank credit line borrowings, senior demand notes outstanding and commercial paper issued. As of September 30, 2006, the Company’s senior debt outstanding declined $6.8 million (4%) as compared to December 31, 2005. The decrease was due to a decline in sales of our senior demand notes. We attribute this to investors opting to move their funds into higher yielding, longer term securities offered by the Company. Our subordinated debentures outstanding increased $21.3 million or 55% during the same comparable period.
Other liabilities increased $.9 million (6%) during the nine-month period just ended as compared to the prior year-end, mainly due to higher accruals for salary expense and an increase in accrued interest expense on subordinated debentures.
Results of Operations:
As previously mentioned, the increase in loan originations during the current year has resulted in increases in the Company’s revenues, resulting in higher net income. Net income grew $.4 million (37%) during the three-month period ended September 30, 2006 as compared to the same period a year ago and $1.1 million (21%) during the nine-month comparable period. Slight declines in our loan loss provision during the comparable periods also added to the increase in net income.
Net Interest Margin
The Company’s net interest margin represents the spread between earnings on loans and investments and interest paid on the Company’s senior and subordinated debt. Interest rates on the majority of loans offered by the Company are typically fixed and do not change as a result of volatility in market rates; however, interest paid on the Company’s debt securities is impacted by general market interest rate volatility. In order for our investment securities to be competitive, we adjust rates according to market conditions.
One of the most significant factors influencing our financial performance this year has been an increase in borrowing cost. Higher interest rates coupled with an overall increase in our average borrowings has caused interest expense to increase $1.2 million (61%) during the three-month period ended September 30, 2006 as compared to the same period a year ago. During the nine-month period just ended, interest expense increased $2.7 million (47%) as compared to the comparable period a year ago.
Although our average borrowing costs increased significantly, we experienced enhanced earnings from the growth in our loan and investment portfolios during the same time periods. Interest income grew $2.7 million (15%) and $6.0 million (11%) for the three- and nine-month periods just ended as compared to the same periods a year ago. The growth in our net interest income has more than offset the increase in our interest cost.
The net impact of the above factors resulted in our net interest margin increasing $1.5 million, or 9%, during the three-month period just ended compared to the same period in 2005. During the nine-month comparable periods, the margin increased $3.3 million, or 7%.
Management projects that average net receivables will continue to grow during the remainder of the year, and earnings are expected to increase accordingly. However, we also project additional increases in borrowing costs which could impact our margins. There can be no assurance that any increases in net receivables would not be more than offset by further increases in borrowing costs.
Insurance Income Our insurance operations have historically generated approximately 1/3 of the Company’s revenues each year. The operations are a integral part of our overall operations. Net insurance income increased $1.2 million (24%) and $2.2 million (14%) during the three- and nine-month periods ended September 30, 2006 as compared to the same periods in 2005. The increases were associated with the growth in loan receivables as many customers chose optional credit insurance at their loan origination. The impact of hurricanes Katrina and Rita in 2005 also contributed to the increase in insurance income during the current year. Higher claim reserves directly attributed to the hurricanes resulted in lower insurance income in 2005.
Provision for Loan Losses
Credit losses during the three- and nine-month periods ended September 30, 2006 were slightly lower than the level of losses experienced during the same periods in 2005. Net balances on accounts of individuals who declared bankruptcy decreased $2.3 million to $9.5 million at September 30, 2006 as compared to $11.8 million at September 30, 2005. The federal bankruptcy laws which became effective October 17, 2005 appear to have resulted in a lower number of bankruptcy filings by the Company’s loan customers than were experienced prior to these laws being enacted. The reduction in personal bankruptcy filings was one factor contributing to lower net charge offs. A portion of the decrease in net charge offs was also the result of the sale of selected accounts. In May 2006, Management sold a block of previously charged off accounts to an unaffiliated debt recovery company. The transaction allowed the Company to recover a portion of the funds due on those accounts.
As a result of the lower credit losses and an improvement in the credit quality of the Company’s loan portfolio, our provision for loan losses declined $.1 million (2%) during the three-month period just ended as compared to the same period a year ago. During the nine-month comparable periods, our loan loss provision declined $.2 million, or 2%.
We continually monitor the credit-worthiness of our loan portfolio. The Company maintains an allowance for loan losses to cover probable losses in the current loan portfolio. At September 30, 2006, we believe the allowance is adequate to cover losses inherent in the portfolio. Additions will be made to this allowance if and when we deem it appropriate to recognize additional probable losses. Any additions to the allowance will be charged against the provision for loan losses.
Other Revenue
A decrease in return-check fee income, rental income and other miscellaneous non-interest related income caused other revenue to decline $.1 million (18%) during the nine-month period just ended as compared to the same period in 2005. Other revenue also decreased slightly during the three-month comparable period for the same reasons.
Other Operating Expenses
Other operating expenses include personnel expense, occupancy expense and other miscellaneous operating expenses. This general category of expenses increased $1.9 million (13%) and $3.9 million (9%) during the three- and nine-month periods ended September 30, 2006, respectively, as compared to the comparable periods in 2005.
The majority of the aforementioned increase in other operating expenses was due to higher personnel expense during the comparable periods. Merit salary increases, increases in employee medical and life insurance expenses, higher payroll tax expense and decreases in deferred salary expense caused personnel expense to increase $1.3 million (15%) and $2.2 million (8%) during the three- and nine-month periods ended September 30, 2006 as compared to the same periods in 2005. An increase in the Company’s accrued profit sharing contribution expense also contributed to the increase in personnel cost during the nine-month period ended September 30, 2006
Occupancy expense increased $.1 million (2%) and $.3 million (5%) during the three- and nine-month periods just ended as compared to same periods a year ago mainly due to higher rent expense. Rent expense increased as a result of leases on new branch locations and renewals on various existing leases. Higher office maintenance costs and higher utility costs also contributed to the increase in occupancy expense.
Increases in various overhead expenses such as advertising, collection expenses, travel expenses, consultant fees, computer expenses, training expenses and increases in taxes and licenses caused increases in miscellaneous other operating expenses during the current year. During the three-month period just ended, other operating expenses increased $.6 million (15%) as compared to the same period a year ago. During the nine-month period ended September 30, 2006, miscellaneous other operating expenses increased $1.4 million, or 12%. Also contributing to the increase from the prior period was a non-recurring gain on the sale of a building in 2005 which reduced other operating expenses that year.
Income Taxes:
Effective income tax rates were 27% and 24% during the nine-month periods ended September 30, 2006 and 2005, respectively, and 38% and 31% during the three-month periods then ended. The Company has elected 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. During the quarter just ended, losses of the S Corporation were higher than losses incurred during the same quarter a year ago. The higher effective income tax rate during the third quarter of 2006 was due to the higher losses incurred by the S Corporation during that period 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 were below st atutory 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, as well as investments in tax exempt bonds held by the Company’s property insurance subsidiary.
Quantitative and Qualitative Disclosures About Market Risk:
As previously discussed, higher interest rates have impacted the Company’s interest costs during the current year. If rates continue to increase, the Company’s net interest margin could be materially impacted. 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, 2005 for a detailed analysis of our market risk exposure.
Liquidity and Capital Resources:
As of September 30, 2006 and December 31, 2005, the Company had $19.5 million and $14.0 million, respectively, invested in cash and short-term investments readily convertible into cash with original maturities of three months or less. The Company’s investments in marketable securities can be converted into cash, if necessary. As of September 30, 2006 and December 31, 2005, 95% and 97%, respectively, 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 policyholders’ surplus or statutory earnings before recognizing realized investment gains of the individual insurance subsidiaries. At December 31, 2005, Frandisco Property and Casualty Insurance Company and Frandisco Life Insurance Company had policyholders’ surplus of $30.0 million and $31.7 million, respectively. The maximum aggregate amount of dividends these subsidiar ies can pay to the Company in 2006 without prior approval of the Georgia Insurance Commissioner is approximately $7.6 million.
Liquidity requirements of the Company are financed through the collection of receivables and through the sale of short- and long-term debt securities. The Company’s continued liquidity 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, the Company has an external source of funds available under a credit agreement. The credit agreement provides for unsecured borrowings of up to $30.0 million, subject to certain limitations, and is scheduled to expire on November 25, 2006. The Company expects to renew or replace its credit agreement prior to expiration. While the Company expects that it will be able to renew or enter into a new credit agreement in a timely manner, the Company cannot provide any assurances that the agreement will be replaced or renewed in a timely manner, or if so, on comparable terms. Available borrowings under the agreement were $14.2 million and $21.0 million at September 30, 2006 and December 31, 2005, respectively. | 