Orrstown Financial Services(ORRF) - 2020 Q4 - Annual Report

Part I Business The company provides diversified banking and wealth management services, expanding through acquisitions while navigating the COVID-19 pandemic and a competitive regulatory environment General Business and Recent Acquisitions The bank holding company expanded its footprint through acquisitions, reporting total assets of $2.8 billion in 2020 - Expanded its presence in Franklin County, Pennsylvania, with the acquisition of Mercersburg Financial Corporation on October 1, 2018[17] - Expanded into the greater Baltimore, Maryland, market with the acquisition of Hamilton Bancorp, Inc. on May 1, 2019[18] Key Financial Metrics (as of December 31, 2020) | Metric | Amount (Billions) | | :--- | :--- | | Total Assets | $2.8 | | Total Deposits | $2.4 | | Total Shareholders' Equity | $0.246 | COVID-19 Pandemic Response The company implemented client support measures and participated significantly in the SBA's Paycheck Protection Program - The company implemented several client support initiatives in response to COVID-19, including waiving certain ATM and loan late fees, designating loan specialists for assistance, and shifting most operations to a remote work environment[28] - For the year ended December 31, 2020, the company recognized $7.7 million of net deferred SBA PPP fees, with $5.8 million remaining to be recognized[30] SBA Paycheck Protection Program (PPP) Activity | Program Round | Period | Loans Funded | Gross Loan Amount | Net Fee Income to be Recognized | | :--- | :--- | :--- | :--- | :--- | | First Round | Year ended Dec 31, 2020 | ~3,200 | $467.7 million | $13.5 million | | Second Round | Through Mar 8, 2021 | 1,801 | $168.1 million | $7.9 million | Lending Activities and Loan Review The bank's lending is focused on commercial loans, which comprise 77% of the portfolio, supported by a robust internal and third-party loan review process - Commercial loans comprised approximately 77% of the total loan portfolio as of December 31, 2020[27] - The bank's underwriting policy for loans secured by real estate generally limits the loan-to-value ratio to 85% of the appraised value[25] - A majority of residential mortgages originated are sold to secondary market investors like Wells Fargo and Fannie Mae[33] - The company utilizes both internal reviews for large commercial relationships and an outsourced third-party loan review to monitor credit quality and evaluate the adequacy of the ALL[35][36] Deposit and Investment Services The bank offers a full suite of deposit products and provides investment advisory services managing $1.7 billion in assets - The bank offers a full suite of deposit products and treasury management solutions for commercial clients, including sweep accounts, remote deposit capture, and lockbox services[37] - Through its Orrstown Financial Advisors (OFA) division, the bank provides fiduciary and investment services, with assets under management totaling $1.7 billion at December 31, 2020[38] Competition and Strategy The company competes on service and value while pursuing a strategy of core business expansion and potential acquisitions - The bank competes with a wide range of financial institutions, including other banks, credit unions, mortgage companies, and increasingly, financial technology (FinTech) companies[40] - The company's competitive strategy is based on a combination of value, service, and convenience, aiming to build strong client relationships[41] - Strategic initiatives are focused on expanding core businesses and evaluating acquisition, divestiture, and joint venture opportunities to enhance shareholder return and growth potential[42] Regulation and Supervision The company operates under extensive federal and state supervision, with key regulations governing capital adequacy, dividends, and compliance - The company is a registered bank holding company and has elected Financial Holding Company (FHC) status, subjecting it to supervision by the Federal Reserve Board (FRB)[43][51] - To maintain FHC status, the company and its bank must remain well-capitalized and well-managed, and the bank must achieve at least a "Satisfactory" CRA rating[52] - The company's ability to pay dividends is restricted by various federal laws and FRB policies, which are dependent on earnings, capital levels, and overall financial condition[62][64] - The company and the bank are subject to risk-based capital and leverage ratio requirements under the U.S. Basel III capital rules, with both entities' capital ratios above the "well-capitalized" standards as of December 31, 2020[67][73] Risk Factors The company faces material risks related to credit, interest rates, competition, regulation, cybersecurity, and the economic impact of the COVID-19 pandemic Credit Risks Key credit risks include the adequacy of the loan loss allowance, concentration in commercial real estate, and potential liabilities from its PPP lending activities - The determination of the Allowance for Loan Losses (ALL) is highly subjective and requires significant estimates; an insufficient ALL could decrease earnings[97] - Lending on commercial real estate exposes the company to greater risk of loss, as repayment is often dependent on the income produced by the underlying properties[101] - Participation in the SBA PPP exposes the company to litigation risk and the credit risk that the SBA may deny its guarantee if deficiencies in origination or servicing are identified[104][105] Interest Rate and Investment Risks The company's financial condition is highly sensitive to interest rate changes and the upcoming transition away from LIBOR - Changes in interest rates can adversely affect net interest margin, the ability to originate loans, and the value of interest-earning assets[107][108] - The planned discontinuance of LIBOR after 2021 and transition to a new reference rate like SOFR presents risks to financial instruments that use LIBOR, potentially impacting their value and yield[110][112] Competition and Business Strategy Risks Performance is sensitive to economic conditions in its concentrated markets, substantial competition, and significant cybersecurity threats - The business is concentrated in south central Pennsylvania and the greater Baltimore region, making its financial performance highly dependent on local economic conditions[116] - The company faces substantial competition from other financial institutions and FinTech companies, which could reduce profitability by affecting loan volumes and interest rates[117][118] - The company is highly dependent on computer systems and is subject to significant security risks, including cyber attacks, which could lead to business disruption and financial exposure[123][124] - Volatility in interest rates stemming from the COVID-19 pandemic could negatively affect net interest income, lending activities, and profitability[133] Mergers and Acquisitions Risks The company's growth-by-acquisition strategy involves risks related to integration, realizing synergies, potential goodwill impairment, and shareholder dilution - Integrating acquired companies involves significant challenges, including combining personnel, systems, and corporate cultures, which could cause business interruptions and loss of key employees[139][141] - Failure to realize the expected benefits from mergers could adversely impact the carrying value of goodwill, potentially leading to impairment charges[138] - Future acquisitions may result in the issuance of additional stock, which would dilute the ownership interests of current shareholders[143] Regulatory, Legal, and Compliance Risks The company is exposed to risks from extensive regulation, accounting policy changes like CECL, anti-money laundering rules, and pending litigation - The company is subject to extensive federal and state regulation that limits how it conducts business, imposes capital requirements, and restricts its ability to pay dividends[144][145] - The upcoming adoption of ASU 2016-13 (CECL) will substantially change the accounting for credit losses and is likely to have a negative impact on the ALL and the company's capital position[153][155] - Noncompliance with the Bank Secrecy Act and other anti-money laundering regulations could result in significant fines and reputational damage[157] - The company is involved in pending litigation with SEPTA, and an adverse outcome could result in material losses[159] Liquidity and Stock Ownership Risks The parent company depends on bank dividends for liquidity, while stock price volatility and potential credit downgrades pose risks to capital access - The Parent Company is a holding company that depends on dividends from its bank subsidiary to fund its operations and shareholder dividends, and these payments are subject to regulatory restrictions[161][168] - The ability to raise additional capital in the future is not guaranteed and may not be available on favorable terms, potentially diluting the ownership of current investors[163][164] - The market price of the company's common stock is subject to volatility due to factors including operational results, market conditions, and general economic trends[166] General Risk Factors General risks include the uncertain impact of the COVID-19 pandemic, reliance on key personnel, potential internal control failures, and reputational damage - The COVID-19 pandemic has caused a significant economic downturn and its future impact on the company's business remains uncertain[169][170] - The company's success depends on its ability to attract and retain skilled management and key personnel[174][175] - Failures in internal controls, whether from human error or misconduct, could result in significant harm, including client remediation costs, regulatory fines, and reputational damage[176][178] Unresolved Staff Comments The company reports that it has no unresolved staff comments from the SEC - None[182] Properties The company is consolidating its physical branch network to improve efficiency in response to evolving client preferences for digital channels - The company's principal executive offices are in Shippensburg, PA, with additional administrative offices in Harrisburg, PA[183] - The company is actively consolidating its branch network to improve efficiency, with five branches consolidated in January 2020 and an additional six branch locations closed in the first quarter of 2021[185] Legal Proceedings Information regarding the company's legal proceedings is incorporated by reference from the Consolidated Financial Statements - Details on legal proceedings are provided in Note 23 to the Consolidated Financial Statements[186] Mine Safety Disclosures This item is not applicable to the company - Not applicable[186] Part II Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The company's stock trades on NASDAQ, with increased dividends in 2020, an active share repurchase program, and stock performance trailing key indices - As of December 31, 2020, 261,320 shares may yet be purchased under the company's authorized share repurchase program[191] Dividend Per Share | Year | Dividend per Share | | :--- | :--- | | 2020 | $0.68 | | 2019 | $0.60 | Stock Performance Comparison (Value of $100 Invested on 12/31/15) | Index | 12/31/20 Value | | :--- | :--- | | Orrstown Financial Services, Inc. | $105.80 | | SNL Bank $1B-$5B Index | $138.81 | | S&P 500 Index | $203.04 | | NASDAQ Composite Index | $271.64 | Selected Financial Data The company shows significant five-year growth in assets, loans, and deposits, with marked improvement in net income and key performance ratios in 2020 Selected Financial Highlights (2018-2020) | Metric (in thousands, except per share data) | 2020 | 2019 | 2018 | | :--- | :--- | :--- | :--- | | Net Interest Income | $83,607 | $69,295 | $52,157 | | Net Income | $26,463 | $16,924 | $12,805 | | Diluted EPS | $2.40 | $1.61 | $1.50 | | Total Assets | $2,750,572 | $2,383,274 | $1,934,388 | | Total Loans | $1,979,690 | $1,644,330 | $1,247,657 | | Total Deposits | $2,356,880 | $1,875,522 | $1,558,756 | | Return on Average Equity | 11.66% | 8.21% | 8.56% | | Return on Average Assets | 1.00% | 0.76% | 0.75% | Management's Discussion and Analysis of Financial Condition and Results of Operations Net income increased significantly in 2020, driven by loan growth and PPP fees, despite higher provisions for loan losses due to pandemic-related uncertainty Results of Operations Net income rose to $26.5 million in 2020, driven by higher net interest income from loan growth and PPP fees, partially offset by an increased provision for loan losses - The increase in net interest income in 2020 was driven by organic commercial loan growth and the recognition of SBA PPP processing fee income[212] - The provision for loan losses increased significantly in 2020 primarily as a result of increased uncertainty related to the COVID-19 pandemic[216] - Noninterest expenses decreased in 2020 due to lower merger-related and branch consolidation expenses ($1.3 million in 2020 vs. $9.0 million in 2019)[217] Key Operating Results (2019 vs. 2020) | Metric (in millions) | 2020 | 2019 | Change | | :--- | :--- | :--- | :--- | | Net Income | $26.5 | $16.9 | +$9.6 | | Diluted EPS | $2.40 | $1.61 | +$0.79 | | Net Interest Income | $83.6 | $69.3 | +$14.3 | | Provision for Loan Losses | $5.3 | $0.9 | +$4.4 | | Noninterest Expenses | $74.1 | $77.3 | -$3.2 | Financial Condition Total assets grew 15.4% to $2.75 billion in 2020, driven by PPP loan originations and related deposit growth, while capital ratios remained strong - The loan portfolio increased by $335.4 million (20.4%) in 2020, primarily due to the origination of $403.3 million in SBA PPP loans[275] - Total deposits grew by $481.4 million (25.7%) in 2020, largely due to deposits generated through the SBA PPP program[319] - The Allowance for Loan Losses (ALL) increased by $5.5 million to $20.2 million at year-end 2020, reflecting a $2.8 million qualitative reserve specifically for COVID-19 related risks[285][286] Balance Sheet Highlights (as of Dec 31) | Metric (in millions) | 2020 | 2019 | | :--- | :--- | :--- | | Total Assets | $2,750.6 | $2,383.3 | | Net Loans | $1,959.5 | $1,629.7 | | Total Deposits | $2,356.9 | $1,875.5 | | Total Shareholders' Equity | $246.2 | $223.2 | Quantitative and Qualitative Disclosures About Market Risk The company's primary market risk is interest rate risk, which is managed via simulation analysis showing different sensitivities for short-term earnings and long-term value - The company's primary market risk is interest rate risk, managed by an asset/liability committee using tools like simulation analysis and net present value analysis[354][355][358] Interest Rate Sensitivity Analysis (as of Dec 31, 2020) | Change in Market Interest Rates | % Change in Net Interest Income (Earnings at Risk) | % Change in Market Value (Value at Risk) | | :--- | :--- | :--- | | -100 bps | -0.8% | -99.6% | | +100 bps | +1.7% | +70.7% | | +200 bps | +2.4% | +116.4% | Financial Statements and Supplementary Data This section contains the company's audited consolidated financial statements, accompanying notes, and independent auditor's report for the year ended December 31, 2020 Financial Statements The financial statements show significant growth in assets to $2.75 billion and a 56% increase in net income to $26.5 million for 2020 Consolidated Balance Sheet Highlights (as of Dec 31) | (in thousands) | 2020 | 2019 | | :--- | :--- | :--- | | Total Assets | $2,750,572 | $2,383,274 | | Net Loans | $1,959,539 | $1,629,675 | | Total Deposits | $2,356,880 | $1,875,522 | | Total Liabilities | $2,504,323 | $2,160,025 | | Total Shareholders' Equity | $246,249 | $223,249 | Consolidated Income Statement Highlights (Year Ended Dec 31) | (in thousands) | 2020 | 2019 | 2018 | | :--- | :--- | :--- | :--- | | Net Interest Income | $83,607 | $69,295 | $52,157 | | Provision for Loan Losses | $5,325 | $900 | $800 | | Noninterest Income | $28,309 | $28,539 | $21,024 | | Noninterest Expenses | $74,080 | $77,300 | $57,936 | | Net Income | $26,463 | $16,924 | $12,805 | Notes to Consolidated Financial Statements The notes detail accounting policies, acquisitions, loan portfolio quality, capital adequacy, and the company's decision to delay adoption of the CECL standard - The company has delayed the implementation of ASU No. 2016-13 (CECL) until the extended deadline for smaller reporting companies, which is for fiscal years beginning after December 15, 2022[201][461] - The May 2019 acquisition of Hamilton Bancorp, Inc. involved total consideration of $50.8 million and resulted in $6.1 million of goodwill[468][469] - As of December 31, 2020, the company had $18.2 million in loans under COVID-19 related payment deferral programs, down significantly from $78.4 million at September 30, 2020[293][294] - At December 31, 2020, the Bank was categorized as "well capitalized" under regulatory standards, with a total risk-based capital ratio of 14.7% against a 10.0% requirement[616][619] Changes in and Disagreements With Accountants on Accounting and Financial Disclosure The company reports no changes in or disagreements with its accountants on accounting and financial disclosure - None[683] Controls and Procedures Management concluded that the company's disclosure controls and procedures were effective as of year-end 2020 - Based on an evaluation as of December 31, 2020, the CEO and CFO concluded that the company's disclosure controls and procedures were effective[684] - No changes in internal control over financial reporting occurred during the fourth quarter of 2020 that have materially affected, or are reasonably likely to materially affect, internal controls[684] Other Information The company reports no other information for this item - None[686] Part III Directors, Executive Officers and Corporate Governance Information is incorporated by reference from the 2021 proxy statement, and the company confirms adoption of a code of ethics for senior financial officers - Information regarding directors, executive officers, and corporate governance is incorporated by reference from the 2021 Annual Meeting of Shareholders proxy statement[688] - The company has adopted a code of ethics for senior financial officers, available on its website[687] Executive Compensation All information regarding executive compensation is incorporated by reference from the company's 2021 proxy statement - Information regarding executive compensation is incorporated by reference from the 2021 Annual Meeting of Shareholders proxy statement[689] Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters As of year-end 2020, 881,920 securities remained available for future issuance under equity compensation plans Equity Compensation Plan Information (as of Dec 31, 2020) | Plan Category | Securities to be issued upon exercise | Weighted-average exercise price | Securities remaining available for future issuance | | :--- | :--- | :--- | :--- | | Equity compensation plan approved by security holders | 0 | n/a | 881,920 | Certain Relationships and Related Transactions, and Director Independence All information regarding related party transactions and director independence is incorporated by reference from the 2021 proxy statement - Information regarding certain relationships, related transactions, and director independence is incorporated by reference from the 2021 Annual Meeting of Shareholders proxy statement[692] Principal Accountant Fees and Services All information regarding fees paid to the principal accountant is incorporated by reference from the 2021 proxy statement - Information regarding principal accountant fees and services is incorporated by reference from the 2021 Annual Meeting of Shareholders proxy statement[693] Part IV Exhibits and Financial Statement Schedules This section lists all documents filed with the Form 10-K, including financial statements, material contracts, and required certifications - The consolidated financial statements are incorporated by reference from Item 8[695] - All financial statement schedules have been omitted as they are not required or are inapplicable[695] - A comprehensive list of exhibits filed with the report is provided, including material contracts and required certifications[697][698] Form 10-K Summary This item is not applicable - Not applicable[700]