KBRA Affirms Ratings For Orrstown Financial Services, Inc.

KBRA affirms the senior unsecured debt rating of BBB, the subordinated debt rating of BBB-, and the short-term debt rating of K3 for Shippensburg, Pennsylvania-based Orrstown Financial Services, Inc. (NASDAQ: ORRF) (“the company”). In addition, KBRA affirms the deposit and senior unsecured debt ratings of BBB+, the subordinated debt rating of BBB, and the short-term deposit and debt ratings of K2 for the subsidiary, Orrstown Bank. The Outlook for all long-term ratings is Stable.

Key Credit Considerations

ORRF’s ratings reflect conservative underwriting, a relatively granular loan portfolio, and manageable single sector concentrations. Office CRE represented 10% of total loans at 1Q23 with properties predominately located in suburbs outside of city centers with a moderate mix of medical or service-oriented professional-related tenants, and are solidly collateralized with average LTV of less than 60%. Overall credit losses have been well contained over time with the annual NCO ratio averaging ~0.04% since 2015. While we acknowledge the benign credit environment, both pre- and post-pandemic, proactive credit administration and generally well-supported collateral have been notable in limiting loss content. With that said, the NPA ratio has exceeded 1.0% in recent quarters, mainly due to a downgrade of a $15 million C&D loan in 4Q22 that encountered delays stemming from COVID-related disruptions. While the downgrade of this comparatively larger loan does not appear to reflect any systemic concerns and is seemingly solidly-collateralized, any additional degradation in the NPA ratio or slow or costly workouts or resolutions could compound late cycle credit concerns or potentially result in unforeseen credit losses. In consideration of the elevated NPA ratio, and a slightly heightened risk profile, with the RWA density and investor CRE concentration tracking higher than many rated peers, the Stable Outlook incorporates expectations that capital ratios, particularly consolidated CET1 (10.4% at 1Q23), will trend towards pre-COVID levels or higher within a reasonable time frame. We acknowledge ORRF’s capital ratios have historically been managed more conservatively or in line with peers, however, somewhat more aggressive capital management in the form of material CRE loan growth and elevated stock repurchases over the past year, which was further burdened by a meaningful settlement charge related to a legacy legal matter, has resulted in a CET1 ratio that is 130 bps lower compared to 1Q22.

The ratings recognize a solid funding profile, reflecting comparatively lower deposit costs (total cost of ~1.00% at 1Q23) reinforced by a durable deposit base moderately derived from the retail channel which has historically been less price sensitive. Moreover, utilization of noncore funding sources has been limited. Deposit trends from 4Q22 to 1Q23, and also during the week following the bank failures near mid-March 2023, did not exhibit outflows of any significance, with core deposit mix and balance relatively unchanged. Uninsured deposits are low (~19% of total deposits or ~$475 million as of March 31, 2023) and supported by ample liquidity capacity with cash, unpledged securities, and available FHLB lines providing ~$1.2 billion in combined coverage. Bottom line earnings fell to 0.77% in 2022, weighed down by the aforementioned legal settlement charge. However, excluding non-core items, adjusted earnings have generally been in line with peers with core ROA largely tracking in the 1.10% to 1.20% range since 2019, although recent years' earnings stability was partly attributable to a greater shift in the earning assets mix towards higher risk weighted loans, resulting in margin trends outpacing many peers. Earnings are expected to slightly regress in the near term given ascending deposit costs and muted loan growth expectations. However, a solid fee income mix, largely generated from durable fee verticals (e.g., wealth, interchange), and operating efficiencies derived from recent branch optimization strategies are anticipated to provide some earnings protections.

Rating Sensitivities

A rating upgrade is not likely in the intermediate term. However, degradation in credit quality measures, whether from additional NPA formation or meaningful credit losses, substantial earnings compression, a stagnant or declining CET1 ratio due, in part, to aggressive capital management or balance sheet growth, or unforeseen deterioration in the funding and liquidity profiles, could lead to rating pressures.

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