FMFG: Capital Strength Underpins Loan Growth Amidst Deposit Competition - FMFG Stock Research Report

## Executive Summary / Key Takeaways * Farmers and Merchants Bancshares, Inc. (FMFG) demonstrated solid capital strength and continued loan portfolio expansion in Q1 2025, key pillars of its community banking model. * Net interest income saw a modest increase, driven by higher loan balances and yields, partially offset by rising deposit costs reflecting intense industry-wide competition for funding. * While overall assets and deposits declined in the quarter, management indicates adequate liquidity sources to meet anticipated needs over the next 12 months. * Asset quality metrics showed an increase in watch list loans, requiring careful monitoring, though the allowance for credit losses is deemed adequate by management. * The company faces competitive pressures from larger, more technologically advanced institutions and fintechs, necessitating strategic focus on its cost efficiency and community-centric service model. ## The Bedrock of Community Banking: FMFG's Enduring Model Farmers and Merchants Bancshares, Inc., the holding company for Farmers and Merchants Bank, traces its roots back to the Bank's charter in 1919. This long history in Maryland has established FMFG as a deeply embedded community financial institution, focused on providing essential commercial and retail banking services to individuals and businesses. The company's strategic foundation rests on this local presence, fostering relationships that drive its core lending and deposit-gathering activities. A significant step in its evolution was the 2020 merger with Carroll Bancorp, Inc., which expanded its footprint and asset base, albeit introducing goodwill and intangible assets to the balance sheet. Within the broader financial services landscape, FMFG operates as a regional bank, competing directly with institutions of varying sizes. Larger players like M&T Bank Corporation (TICKER:MTB) and PNC Financial Services Group (TICKER:PNC) possess significant scale, broader product suites, and substantial technological resources. These larger competitors often exhibit higher revenue growth rates (MTB 8-10%, PNC 7-9% annually) and superior profitability margins (MTB 25-30% net, PNC 25-28% net) compared to FMFG's more modest growth (3-5%) and margins (18-22% net). FMFG also faces competition from smaller regional peers like Franklin Financial Services Corporation (TICKER:FRAF), which shares a similar geographic focus and community banking approach but has shown slightly higher historical revenue growth. Beyond traditional banks, fintech firms and online banks present indirect competition, offering potentially lower costs and faster digital services that could pressure FMFG's deposit volumes and loan demand, particularly among tech-savvy customers.

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FMFG's competitive positioning is characterized by distinct strengths and vulnerabilities. Its primary advantages lie in its cost leadership and established community distribution channels. The company's efficient branch model contributes to lower operating costs per unit compared to some peers, potentially enabling competitive pricing in cost-sensitive markets. Its deep local ties foster strong customer loyalty, particularly in niche areas like agricultural lending where it holds a notable market share advantage in rural segments. However, FMFG's limited scale results in higher costs per unit compared to larger rivals and can constrain cash flow generation. Furthermore, the company faces technological gaps; while it completed a core system conversion in Q4 2024 (contributing to increased software maintenance costs in Q1 2025), larger competitors like MTB and PNC have invested heavily in digital platforms offering faster processing speeds and broader digital capabilities. Details regarding the specific quantifiable benefits or competitive advantages of FMFG's core technology beyond enabling operations are not available, making a direct comparison of technological moats challenging. Broad industry trends, particularly the trajectory of interest rates, significantly influence FMFG's operating environment. Higher interest rates over the past several years have increased funding costs and intensified competition for deposits across the industry. Conversely, stabilizing interest rates have contributed to loan growth opportunities. ## Financial Performance: Navigating Rate Dynamics FMFG's financial performance in the first quarter of 2025 reflected the ongoing dynamics of the interest rate environment and its strategic focus on loan growth. Net income remained stable at $1.2 million for the three months ended March 31, 2025, consistent with the same period in 2024. Total interest income increased by $820 thousand, or 9.0%, reaching $9.9 million in Q1 2025. This growth was primarily fueled by the loan portfolio, where interest income rose by $1.5 million. This increase was a direct result of a $59.1 million higher average loan balance and an improved loan yield, climbing to 5.64% in Q1 2025 from 5.15% in Q1 2024. This highlights the company's success in expanding its lending activities and benefiting from higher prevailing interest rates on new and repricing loans. However, investment income saw a decline of $502 thousand (28.7%), attributed to a lower average investment balance ($39.9 million decrease) and a decrease in the fully-taxable equivalent yield on the investment portfolio (down to 2.97% from 3.36%). Overall, the fully-taxable equivalent yield on total interest-earning assets increased by 35 basis points to 5.03%. Total interest expense rose by $499 thousand, or 12.8%, to $4.4 million in Q1 2025. This increase stemmed from a $23.0 million increase in the average balance of interest-bearing liabilities and a higher overall cost of funds, which increased to 2.70% from 2.48%. The cost of funds for time deposits specifically increased to 4.15% from 4.01%, reflecting the competitive pressure for deposits in the current rate environment. Costs associated with borrowings (long-term debt, FHLB, etc.) decreased, partially offsetting the rise in deposit costs. The net effect of these movements resulted in net interest income of $5.5 million, a modest increase from $5.2 million in the prior year period.

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Noninterest income saw a slight increase of $10 thousand (2.0%) to $514 thousand. This was boosted by a $94 thousand gain on the unwinding of a fair value hedge, a $24 thousand increase in mortgage banking income, and a $15 thousand increase in Bank owned life insurance income. These gains were largely offset by the absence of a non-recurring $143 thousand gain from insurance proceeds recorded in Q1 2024 related to storm damage. Noninterest expense increased by $386 thousand (9.4%) to $4.5 million. Key drivers included a $101 thousand increase in FDIC premiums due to increased rates, higher occupancy and furniture/equipment expenses related to building repairs, office maintenance, and rent, and increased software maintenance costs following the core system conversion in Q4 2024. Other expenses also rose by $96 thousand, including higher ATM expenses and insurance premium taxes. ## Balance Sheet Evolution and Liquidity Position FMFG's balance sheet reflected a decrease in total assets, which fell by $27.0 million (3.2%) to $817.6 million at March 31, 2025, from $844.6 million at December 31, 2024. This contraction was primarily driven by a significant $42.0 million decrease in cash and cash equivalents and a $1.3 million decrease in debt securities.

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Counteracting these decreases was continued growth in the loan portfolio, which increased by $17.0 million (2.9%) to $600.0 million. This growth was concentrated in commercial real estate loans (up $16.9 million) and commercial loans (up $5.5 million), partially offset by decreases in residential real estate and construction/land development loans. Management attributed this loan expansion to the addition of new lending staff over the past 18 months and stabilizing interest rates, indicating a successful execution of their lending strategy despite broader asset contraction.

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Total liabilities decreased by $29.4 million (3.7%) to $759.0 million. The primary factor was a $23.2 million decrease in total deposits, which fell to $735.6 million. This decline was notable across several categories, including brokered CDs (down $27.7 million), certificates of deposit (down $3.4 million), and noninterest-bearing checking accounts (down $2.8 million). An increase in money market accounts (up $8.7 million) partially mitigated these decreases. Management explicitly linked the deposit decline to "competition for deposits among all financial institutions due to higher interest rates," underscoring a key challenge in the current environment. Additionally, advances from the Federal Home Loan Bank of Atlanta decreased by $5.0 million, further contributing to the liability reduction. Despite the decrease in deposits and overall assets, management expressed confidence in the company's liquidity position. FMFG maintains access to approximately $70.1 million under a secured FHLB line of credit, $41.3 million under a Reserve Bank facility, and $23.5 million in overnight federal funds lines of credit. Management believes these sources provide adequate liquidity to meet anticipated needs over the next 12 months. Uninsured deposits represented 23.5% of total deposits at March 31, 2025, a factor that warrants ongoing monitoring in the current banking climate. Stockholders equity increased by $2.3 million (4.0%) to $58.6 million, primarily benefiting from net income generated during the quarter and a decrease in accumulated other comprehensive loss, which improved due to unrealized gains on available-for-sale securities as market conditions shifted. The Bank remains categorized as well capitalized under regulatory frameworks, indicating a strong capital buffer relative to risk-weighted assets. ## Asset Quality and Risk Considerations Maintaining asset quality is paramount for a community bank like FMFG. The company employs underwriting standards and continuous monitoring to mitigate credit risk across its diverse loan portfolio, which includes commercial real estate, construction/land development, residential, commercial, and consumer loans. Each category carries specific risks, such as reliance on property cash flow for commercial real estate or business profitability for commercial loans, which are addressed through practices like loan-to-value standards and personal guarantees. Watch list loans, comprising loans classified as Special Mention, Substandard, and Doubtful, increased to $12.7 million at March 31, 2025, from $8.1 million at December 31, 2024 (excluding collateral-dependent loans). This increase signals potential financial difficulties among a portion of borrowers and necessitates intense supervision by management. Nonaccrual loans totaled $2.6 million at March 31, 2025, with an allocated allowance for credit losses of $466 thousand. The allowance for credit losses on loans stood at $4.3 million at March 31, 2025, relatively flat compared to year-end 2024. Management believes this reserve is adequate to cover expected losses inherent in the loan portfolio. The ratio of the allowance to total loans slightly decreased to 0.71% from 0.72%, primarily due to a decrease in the duration of loans per the CECL calculation. A net provision for credit losses of $30 thousand was recorded in Q1 2025, compared to $0 in Q1 2024. The investment securities portfolio also carries risk, particularly interest rate risk, which has resulted in significant unrealized losses on available-for-sale securities ($21.5 million at March 31, 2025). These losses are primarily due to increases in market interest rates since the securities were purchased. Management views these losses as temporary and does not intend to sell the securities before a recovery of cost, nor does it believe it will be required to sell them prematurely. The company uses interest rate swap agreements as fair value hedges to manage a portion of this interest rate risk. Other real estate owned (OREO) remained unchanged at $1.2 million, consisting of one apartment property acquired in the 2020 merger that is being marketed for sale. Collateral-dependent loans and OREO are subject to nonrecurring fair value adjustments based on appraisals, classified as Level 3 measurements, highlighting the judgment involved in their valuation. Key risks facing FMFG include changes in interest rates, deposit flows, loan demand, competitive actions, changes in asset quality, and regulatory changes. The increase in watch list loans and the competitive deposit environment are particularly pertinent challenges in the current period. ## Outlook and Strategic Focus While specific forward-looking guidance figures were not provided, the trends observed in Q1 2025 offer insight into FMFG's near-term trajectory and strategic priorities. The continued growth in the loan portfolio, driven by new lending staff and stabilizing rates, suggests that loan expansion remains a key focus and potential driver of future interest income. The increase in loan yields indicates successful pricing strategies in the current rate environment. However, the persistent competition for deposits and the resulting increase in funding costs present a headwind to net interest margin expansion. FMFG's ability to attract and retain deposits in a competitive market will be crucial for funding future loan growth and managing its cost of funds. The decrease in total deposits and cash balances highlights the intensity of this competition. The increase in watch list loans signals the need for continued vigilance in credit risk management. While the allowance is currently deemed adequate, a sustained increase in problem assets could necessitate higher provisions for credit losses, impacting future profitability. From a strategic perspective, FMFG appears focused on leveraging its core community banking strengths to drive loan growth while managing funding costs and asset quality in a dynamic environment. The core system conversion in Q4 2024, while contributing to short-term expense increases, may represent an investment aimed at improving operational efficiency or enhancing customer service over the longer term, potentially helping to address some of the technological gaps relative to larger competitors. The filing for a new Dividend Reinvestment Plan also indicates a focus on capital management and shareholder relations. The competitive landscape, particularly the technological advantages held by larger banks and fintechs, remains a long-term challenge. FMFG's ability to maintain or enhance its digital offerings and operational efficiency will be important for retaining and attracting customers in an increasingly digital banking world, balancing its community-focused model with evolving customer expectations. ## Conclusion Farmers and Merchants Bancshares, Inc. continues to operate as a well-capitalized community bank deeply rooted in its Maryland markets. The first quarter of 2025 demonstrated the company's ability to generate loan growth and improve loan yields, contributing to a modest increase in net interest income. This performance underscores the effectiveness of its relationship-based lending model and recent investments in lending staff. However, the period also highlighted significant challenges, most notably the intense competition for deposits driven by higher interest rates, which led to a decrease in total deposits and increased funding costs. The rise in watch list loans warrants close attention, although management believes current reserves are sufficient. While FMFG benefits from cost efficiency and strong local ties, it faces ongoing competitive pressure from larger, more technologically advanced institutions. The impact and future benefits of the recent core system conversion, beyond the initial cost increase, will be important to monitor as the company seeks to enhance its operational capabilities in a competitive digital landscape. For investors, FMFG represents a community banking story with a focus on relationship lending and capital strength. The key factors to watch will be the company's success in navigating the competitive deposit environment, managing asset quality trends, and leveraging technology to maintain its relevance and efficiency in the face of larger, more digitally advanced rivals. The ability to sustain loan growth while effectively managing funding costs and credit risk will be critical to future profitability and shareholder value creation.