MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview:
The following narrative is Management’s discussion and analysis of the foremost factors that influenced our operating results and financial condition as of and for the three- and nine-month periods ended September 30, 2007 and 2006. This analysis and the accompanying interim financial information should be read in conjunction with the audited consolidated financial statements included in the Company’s December 31, 2006 Annual Report. Results achieved in any interim period are not necessarily reflective of the results to be expected for the full year period.
The Company:
1ST Franklin Financial Corporation and its consolidated subsidiaries (the “Company” or “we”) are 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 September 30, 2007, the business was operated through a network of 234 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.
Financial Condition:
At September 30, 2007, the Company reported total assets of $386.6 million compared to $362.6 million at December 31, 2006, representing a $24.0 million (7%) increase. Growth in our loan portfolio, investment portfolio and cash position were the primary drivers of the increase in our asset base. The Company believes it is well positioned for continued growth in the future.
Our net loan portfolio represented 68% of our overall assets at September 30, 2007. The net loan portfolio grew $14.0 million (6%) to $263.9 million at September 30, 2007 compared to $249.9 million at December 31, 2006. The Company originates and services all its performing consumer loans. There are no active loans packaged and brokered for sale to third parties. Based on historical trends, we expect continued growth in our loan portfolio through the remainder of the year.
Cash and cash equivalents increased $3.8 million (16%) and investment securities increased $3.4 million (5%) at September 30, 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” (74% as of September 30, 2007 and 71% as of 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 abil ity and intent to hold these securities to maturity.
The Company held cash in restricted accounts of approximately $2.0 million and $1.9 million at September 30, 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.
Also contributing to the increase in total overall assets was an increase in miscellaneous other assets of $2.5 million (18%) at September 30, 2007 as compared to 2006 year-end. Purchases of equipment and leasehold improvements associated with eight new branch offices opened this year, replacement of certain equipment in most of the offices and a number of office relocations contributed to the increase in other assets. Recognition of an insurance recovery of $.9 million was another factor contributing to the increase in other assets. The Company has been attempting to recover certain attorney costs related to an ongoing lawsuit originally filed against the Company in 2002. Although the Company has liability insurance in place, the Company had previously been unsuccessful in obtaining the reimbursement of any costs associated with defending the lawsuit from its insurance carrier. In September of this year, t he Company was successful in securing an agreement with the insurance company to reimburse us for the majority of the fees which have been incurred since the lawsuit was filed.
Senior debt includes borrowings against our bank credit line and senior demand notes and commercial paper sold to our investors. Our senior debt declined $6.6 million (4%) at September 30, 2007 as compared to the prior year-end. A $13.7 million decline in outstanding borrowings under the Company’s bank credit line during the nine-month period just ended was the main reason for the decline in senior debt outstanding. Investments in our senior demand notes also declined $1.9 million during the same period. Offsetting a portion of the decrease in senior debt was a $9.0 million increase in sales of commercial paper to investors seeking more favorable interest rates. Our loan originations typically are at their highest levels during the fourth quarter of each year. As a result, we expect an increase in the usage under our line of credit facility during the remainder of 2007.
Other liabilities increased $1.0 million (6%) during the nine-month period just ended as compared to the prior year-end, mainly due to increases in accrued interest on our subordinated debt, an increase in accrued salary expense and an increase in payroll taxes due. A reduction in our obligation for capital leases and a reduction in our accrual for profit sharing contributions partially offset the overall increase in other liabilities. Equipment previously obtained through capital leases was sold to an equipment vendor during the quarter just ended, with the vendor buying out the leases and assuming the related lease obligations. The accrual for profit sharing contributions was lower due to the payout of the prior year’s contribution in February and a change in the employee 401k/Profit Sharing Plan to an employer match program effective June 1, 2007.
Subordinated debt was $85.5 million at September 30, 2007 as compared to $67.2 million at December 31, 2006. Subordinated debt consists of the Company’s variable rate subordinated debentures, which are sold to investors at various interest rates determined from time to time by the Company. The Company uses the proceeds from the sale of its subordinated debentures to fund its operations. In order to ensure the continued sale of subordinated debentures, the Company must offer competitive interest rates to investors. As interest rates paid on the subordinated debentures increased during the period, these higher yields have resulted in increased sales of the subordinated debentures.
Results of Operations:
The current year’s results of operations have exceeded budgeted expectations. Through September 30, 2007, net income was $3.3 million ahead of projections, reaching $11.9 million. Based on historical results, we project net income will continue to increase in the fourth quarter mainly due to the aforementioned expected increases in loan originations.
Current year operating results have been driven by solid revenue growth. During the three- and nine-month periods ended September 30, 2007, revenues were $33.2 million and $95.9 million, respectively, compared to $29.0 million and $83.5 million during the same respective three- and nine-month periods in 2006. The revenue growth has surpassed that of expenses, resulting in higher net income. Net income grew $2.9 million (185%) during the three-month period just ended as compared to the same period a year ago. Our net income for the nine-month comparable period has increased $5.7 million or 94%.
Net Interest Margin
Net interest margin is the measure of difference between earnings on the Company’s loan and investment portfolios and interest paid on the Company’s senior and subordinated debt. Variations in our net interest margin are a key element in the success and/or failure of the Company’s operating results. During the three- and nine-month periods ended September 30, 2007, our net interest margin increased $1.6 million (9%) and $4.5 million (9%), respectively, compared to the same periods a year ago. This growth was mainly due to increases in interest and fee income earned on loans and investments. Interest income increased $2.5 million (12%) and $7.6 million (13%) during the three- and nine-month comparable periods, respectively. The previously mentioned growth in the loan and investment portfolios is primarily responsible for the rise in interest income.
Higher funding costs did counteract a portion of the increase in interest income. The Company’s interest expense increased $.9 million (26%) for the three-month period ended September 30, 2007 as compared to the same three-month period ended a year ago. During the nine-month comparable periods, interest expense increased $3.2 million (37%). Factors responsible for the increases were higher average borrowings outstanding and a fluctuation in interest rates. Average borrowings outstanding increased $24.8 million during the nine-month period just ended as compared to the same period a year ago. During the same period, average interest rates paid on borrowings increased to 5.95% from 4.81%.
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 represents the difference between premiums earned and claims and insurance related expenses. During the three- and nine-month periods just ended, our net insurance income increased $.4 million (6%) and $1.5 million (8%), respectively, as compared to the same periods in 2006. The increases were mainly a result of the growth in our loan portfolio. Growth in our loan portfolio typically leads to increases in insurance in-force as many of our loan customers elect to purchase optional credit insurance coverage offered by the Company as described above.
Provision for Loan Losses
The Company experienced an upward trend in nonperforming loans and net charge offs during the reporting period this year as compared to the same period a year ago. Net charge offs were $5.1 million and $13.0 million during the three-month and nine-month periods ended September 30, 2007, respectively, as compared to $4.7 million and $11.8 million during the same respective periods in 2006. The Company attributes some of the increases to rising bankruptcy filings during the current year. Bankruptcy filings during the last four months have returned to levels the Company experienced prior to the revised bankruptcy laws becoming effective October, 2005.
As a result of the increases in net charge offs and the upward trend in nonperforming loans and bankruptcy filings, the Company increased it’s loan loss provision $.6 million (12%) and $1.0 million (8%) during the three- and nine-month periods just ended, respectively, as compared to the same periods a year ago. The Company continually reviews its loan portfolio and maintains an allowance for loan losses that in Management’s opinion is appropriate to cover probable losses in the portfolio. The provision for loan losses reflects the expense to the Company to maintain an appropriate allowance.
During June 2007, Management completed the sale of various charged off receivables which had not had any collections in recent years. The sale allowed us to recover approximately $35,000 of the amount originally charged off and offset some of the increase in the provision for loan losses in the second quarter.
As a result of the current interest rate environment, the lending industry has been exposed to an increasing number of payment delinquencies and has undertaken an increasing number of foreclosures, all of which has been described in various media. Many of the challenges facing various lenders are concentrated within the sub-prime real estate marketplace.
Many of these lending institutions extended adjustable rate loans to borrowers in past years when interest rates were at historical low levels. A number of these 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 any material direct exposure to these risks as we do not operate 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 with fixed payments. Notwithstanding this however, and despite the Company’s efforts to evaluate its customers’ creditworthiness and ability to repay borrowings, the Company cannot provide any assurances that it will not be, directly or indirectly, affected by the increasing number of payment delinquencies and foreclosures. Certa in of the Company’s customers may be borrowers on these, or similar loans from other lenders, and any increases in payment amounts or rates experienced by these customers may adversely affect their ability to make payments on any loans extended by the Company. In addition, the Company may be exposed to an increasing number of bankruptcy filings by its customers as a result of their inability to make timely payments to other lenders. Any of the foregoing could have a material adverse effect on the Company’s financial condition or results of operations. Management continues to monitor the ongoing challenges facing the sub-prime real estate marketplace and the creditworthiness of its own customers.
Other Revenue
Other revenue increased $1.1 million (621%) and $2.9 million (565%) during the three-and nine-month periods just ended September 30, 2007 as compared to the same periods a year ago. The primary reason for the increases 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 $2.8 million in commissions were generated on sales of these memberships in the first nine months of 2007.
Other Operating Expenses
Personnel expense increased $1.7 million (6%) during the nine-month period just ended as compared the same period a year ago. Increases in salary expense due to a larger employee base and merit salary increases awarded in February 2007 were the primary factors responsible for the increase. Higher incentive bonus accruals, profit sharing/401k matching contributions and payroll taxes were other factors contributing to the increase in personnel expense during the nine months just ended. Effective June 2007, the Company converted its profit sharing 401(k) plan to a new provider and began matching a portion of employees’ 401(k) plan contributions. The cost involved in converting to the new provider also contributed to the increase in personnel expense during the current year.
During the three-month period just ended, there was only a minimal increase (less than 1%) in personnel expense as compared to the same three-month period in 2006. Although salary expense and incentive bonus accruals were higher during the period, a $.5 million reduction in medical insurance claims incurred by the Company’s employee health insurance plan offset the majority of the increase. Effective July 1, 2007, the Company increased the health insurance premiums paid by employees which also helped to reduce increases in personnel expense during the quarter just ended.
Increases in rent expense due to leases on eight new branch offices opened this year and increases in rent expense for leases renewed in existing offices were mainly responsible for the $.1 million (4%) and $.4 million (6%) increase in occupancy expense during the three- and nine month periods just ended, respectively, compared to the same comparable periods in 2006. Increases in depreciation on fixed assets and increases in maintenance of equipment were other factors contributing to the increase in occupancy expense.
The Company experienced a reduction in other operating expenses of $.7 million (16%) and $.3 million (2%) during the three- and nine-month periods just ended, respectively, as compared to the same periods a year ago. The reduction was mainly due to the aforementioned recovery of legal fees from our liability insurance carrier. As described above, the Company recovered $.9 million in legal fees it had previously paid out to its attorneys for defending a case from 2002 to the present. We recognized the recovery against other operating expenses in September of this year.
Although overall other operating expenses declined, certain expenses within this category increased during the comparable periods. Expenses related to collection activities, technology, travel and postage increased during the current comparable periods as compared to the previous year.
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 shareholders 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 18% and 27% during the nine-month periods ended September 30, 2007 and 2006, respectively, and 20% and 38% during the three-month periods then ended. The higher rates experienced during the prior year periods were due to 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 income during the current year periods just ended as compared to losses during the same comparable periods 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 September 30, 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 September 30, 2007 and December 31, 2006, the Company had $27.9 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 September 30, 2007 and December 31, 2006, 96% 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 Comp any 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. At September 30, 2007, the Company was in compliance with all covenants. Avail able borrowings under the agreement were $38.8 million and $25.1 million at September 30, 2007 and December 31, 2006, respectively, at interest rates of 7.25% and 7.25%, respectively. Management believes the Company’s liquidity position is adequate to fund ongoing needs for the foreseeable future. | 