The Company:
1ST Franklin Financial Corporation and its consolidated subsidiaries (the “Company” or “we”) is engaged in the consumer finance business, primarily in making consumer loans to individuals in relatively small amounts for short periods of time. Other lending-related 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 March 31, 2007, the business was operated through a network of 226 branch offices located in Alabama, Georgia, Louisiana, Mississippi and South Carolina. An additional branch was opened during April in the state of Louisiana.
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:
As of March 31, 2007, total assets of the Company were $357.8 million compared to $362.6 million at December 31, 2006. The $4.8 million decline represents a 1% reduction and was mainly due to a decrease in our net loan portfolio. Loan originations are somewhat seasonal for the Company. Historically, the first quarter of each year is the slowest in terms of the volume of loans generated. With each succeeding quarter of the year, we have historically seen loan originations increase, with the fourth quarter culminating in the highest level of originations. The first quarter of 2007 followed historical trends. Net loans declined $5.8 million (2%) as compared to the prior year-end with loan repayments received exceeding new loan disbursements.
Although total assets declined, operating results for the quarter just ended were positive. Total revenues grew $4.3 million (16%) to $31.2 million during the three-month period ended March 31, 2007 as compared to $26.9 million during the three-month period ended March 31, 2006. Net income during the same comparable period grew $1.4 million or 67%.
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-month periods ended March 31, 2007 and 2006. Information about the Company’s liquidity, funding sources, critical accounting policies and other matters is also discussed.
Financial Condition:
Surplus cash generated from operations and from financing and investing activities during the quarter ended March 31, 2007 was approximately $.7 million. Cash and cash equivalents amounted to $24.7 million at March 31, 2007 compared to $24.0 million at December 31, 2006.
The Company held cash in restricted accounts of approximately $2.0 million and $1.9 million at March 31, 2007 and December 31, 2006, 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 contained in the Company’s reinsurance agreements.
As previously mentioned, our net loan portfolio declined during the quarter just ended. Based on historical trends, we expect to begin seeing growth in the portfolio during the second quarter and through the remainder of the year.
Investment securities increased $1.3 million, or 2%, at March 31, 2007 as compared to the prior year-end. Surplus funds generated by our insurance subsidiaries accounted for 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 March 31, 2007 and December 31, 2006) with any unrealized gain or loss, net of deferred income taxes, accounted for as accumulated other comprehensive income 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 as “held to maturity,” as Management has both the ability and intent to hold these securities to maturity.
A $17.8 million reduction in borrowings against the Company’s bank credit line during the quarter just ended was the main reason for the $12.9 million (7%) decline in senior debt outstanding. In addition to our bank borrowings, senior debt includes senior demand notes and commercial paper outstanding. Increased sales of our senior demand notes and commercial paper partially offset some of the decline from the reduced bank borrowings.
Other liabilities decreased $2.5 million (16%) during the three-month period just ended as compared to the prior year-end. The decrease was mainly due to disbursements of the Company’s incentive bonus and profit sharing contribution, both of which had been accrued from the prior year.
Results of Operations:
As previously mentioned, our operating results for the quarter ended March 31, 2007 were very positive with significant increases in revenues and net income as compared to the same quarter a year ago. The primary components causing the increases were higher interest and fee income generated from the Company’s loan portfolio and increases in other revenue.
Net Interest Margin
Our net interest margin (the difference between earnings on loans and investments and interest paid on the Company’s senior and subordinated debt) grew $1.5 million (9%) during the quarter just ended as compared to the same quarter a year ago. The growth was mainly due to a $2.7 million increase in interest and fee income on loans and investments. During the quarter just ended, average earning assets were approximately 10% higher than during the quarter ended March 31, 2006.
The increase in interest and fee revenue was partially offset by the impact of higher funding costs during the current year as compared the first quarter of 2006. Interest expense increased $1.2 million (50%) during the quarter just ended as compared to the same quarter ended a year ago as a result of an increase in average debt outstanding and higher interest rates paid on the debt. Average senior and subordinated debt, collectively, was $243.6 million and $218.0 million at March 31, 2007 and 2006, respectively.
Management projects that average net receivables will continue to grow through the remainder of the year, and earnings are expected to increase accordingly. However, we also project additional increases in borrowing costs which could negatively 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 Net insurance income increased $.7 million or 11% during the quarter ended March 31, 2007 as compared to the same quarter a year ago. The increase was mainly due to an overall growth in insurance premiums from the Company’s optional credit insurance products.
Provision for Loan Losses
Provision for loan losses increased $.3 million (9%) during the three-month period ended March 31, 2007 as compared to the three-month period ended March 31, 2006. Higher credit losses were the cause for the increase in the provision for loan losses. Our net charge offs were $3.8 million during the three-month period just ended compared to $3.3 million during the same three-month period a year ago.
Management is currently negotiating the sale of various charged off receivables which have not had any collections in recent years. If successful, the sale will allow a recovery of a portion of the amount originally charged off.
The Company maintains an allowance for loan losses to cover probable losses in its current loan portfolio. There was no increase in the allowance during the quarter just ended as 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.
Recently there has been a great deal of media coverage regarding increasing foreclosures and challenges facing various lenders in the sub-prime real estate marketplace. Many of these institutions extended adjustable rate loans to borrowers in past years when rates were at historical low levels. Many of the adjustable rate loans are now re-pricing at higher interest rates and a number of borrowers are not able to afford the new payment levels and/or terms. The Company does not believe it has exposure to these risks as we are not in this type of lending market and do not offer these types of real estate loans. All real estate loans currently extended by the Company are at fixed interest rates and payments.
Other Revenue
Other revenue increased $.8 million (466%) during the three-month period just ended as compared to the same quarter a year ago. The primary reason for the increase was due to commissions earned from the sale of auto club memberships. Effective October 2006, the Company began selling auto club memberships as an agent for a third party provider. Approximately $.8 million in commissions were generated on sales of these memberships in the first quarter of 2007.
Other Operating Expenses
Three primary components comprise our other operating expenses. They are personnel expense, occupancy expense and other miscellaneous operating expenses. Overall other operating expenses increased $1.2 million (7%) during the three-month period just ended as compared to the same three-month period a year ago. The primary component causing the increase was higher personnel cost. Personnel expense grew $.8 million (8%) during the first quarter of 2007 as compared to the comparable prior year period mainly due to merit-salary increases awarded in February 2007, increases in accruals for incentive awards and increases in payroll taxes. Expansion of the Company’s employee base also contributed to the increase in personnel expense.
Occupancy expenses increased $.1 million during the three-month period ended March 31, 2007 as compared to the same three-month period ended March 31, 2006. Increases in maintenance costs, depreciation expense on equipment and increased rent expense were the primary factors causing the higher occupancy expense.
During the three-month period just ended, miscellaneous other operating expenses increased $.3 million, or 7%, compared to the same three-month period a year ago. This increase was driven primarily by increases in advertising/business promotion expenses, collection expenses, computer expenses, stationary and supplies, and taxes and licenses. An increase in expenses related to the sale of the Company’s debt securities also contributed to higher other operating expense.
Income Taxes:
The Company has elected to be treated as an S Corporation 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, rather then being taxed at the corporate level. Notwithstanding this election, however, income taxes continue to be reported for, and paid by, the Company's insurance subsidiaries as they are not allowed to be treated as an S Corporation, and for the Company’s state taxes in Louisiana, which does not recognize S Corporation status. Deferred income tax assets and liabilities are recognized and provisions for current and deferred income taxes continue to be recorded by the Company’s subsidiaries. The deferred income tax assets and liabilities are due to certain temporary differences between reported income and expenses for financial statement and income tax purposes.
Effective income tax rates were 17% and 23% during the three-month periods ended March 31, 2007 and 2006, respectively. The higher rates experienced during the prior year period were due to higher losses at the S Corporation level which were passed to the shareholders of the Company for tax reporting, whereas income earned at the insurance subsidiary level was taxed at the corporate level. The S Corporation reported a gain during the three-month period just ended as compared to a loss during the same three-month period a year ago.
Quantitative and Qualitative Disclosures About Market Risk:
As previously discussed, higher interest rates have continued to impact the Company’s interest costs through March 31, 2007. 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, 2006 for a more detailed analysis of our market risk exposure.
Liquidity and Capital Resources:
As of March 31, 2007 and December 31, 2006, the Company had $24.7 million and $24.0 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 March 31, 2007 and December 31, 2006, 97% and 96%, 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, 2006, Frandisco Property and Casualty Insurance Company and Frandisco Life Insurance Company had policyholders’ surplus of $34.3 million and $36.0 million, respectively. The maximum aggregate amount of dividends these subsidiaries can pay to the Company in 2007 without prior approval of the Georgia Insurance Commissioner is approximately $8.3 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 its securities sales, the Company has an external source of funds available under a credit agreement with Wachovia Bank, N.A. and BMO Capital Markets Financing, Inc. The credit agreement provides for unsecured borrowings of up to $50.0 million, subject to certain limitations, and is scheduled to expire on December 15, 2009. Any amounts then outstanding will be due and payable on such date. The credit agreement contains covenants customary for financing transactions of this type. Available borrowings under the agreement were $43.0 million and $25.1 million at Mar ch 31, 2007 and December 31, 2006, respectively, at interest rates of 7.75% and 7.25%, respectively. | 