Executive Summary / Key Takeaways

• First Keystone Corporation (FKYS) is demonstrating a financial turnaround, reporting net income of $1.05 million in Q1 2025 compared to a significant net loss in Q1 2024, primarily due to the absence of a large goodwill impairment charge recognized in the prior year.
• The company achieved solid net interest income growth and margin expansion in Q1 2025, driven by increased interest and fees on a growing loan portfolio, which expanded by 1.7% during the quarter, particularly in Real Estate and State/Political Subdivisions.
• Asset quality metrics show some deterioration, with non-performing assets increasing by 19.3% and net charge-offs rising significantly in Q1 2025, prompting a higher provision for credit losses as the company navigates an uncertain economic environment.
• Liquidity remains stable, supported by a core deposit base and substantial borrowing capacity, although a slight decrease in overall deposits necessitated increased borrowings to fund loan growth.
• While facing competitive pressures from larger, more technologically advanced institutions, FKYS leverages its community banking model and long history, though continued investment in digital capabilities is crucial to enhance efficiency and maintain competitiveness.

Setting the Scene: A Community Bank's Foundation and Strategy

First Keystone Corporation, through its wholly owned subsidiary First Keystone Community Bank, operates as a community-focused financial institution deeply rooted in Northeastern Pennsylvania. With a network of 19 full-service branches, the company's business model centers on traditional banking activities: attracting retail and commercial deposits and deploying those funds into a diversified loan portfolio, primarily within its local market area.

The company's history, marked by strategic acquisitions like the Pocono Community Bank in 2007 and a Danville branch in 2004, has shaped its current footprint and customer base. More recently, the issuance of $25 million in subordinated notes in 2020 underscored a strategic intent to support organic growth and general corporate purposes, signaling a commitment to internal expansion alongside potential external opportunities. This blend of historical growth through acquisition and a focus on organic initiatives defines FKYS's approach to building its balance sheet and serving its community.

In the competitive landscape, FKYS operates alongside a mix of larger regional banks like PNC Financial Services Group (PNC) and Citizens Financial Group (CFG), as well as similarly sized community banks such as NBT Bancorp (NBTB) and Peoples Financial Services Corp (PFIS). While larger players benefit from scale, broader market reach, and more extensive digital infrastructure, FKYS competes by emphasizing personalized service and deep local relationships cultivated over its 160-year history. This community focus is a tangible asset, fostering customer loyalty that can contribute to deposit stability and potentially higher margins in niche services like trust management. However, this positioning also presents challenges, particularly in matching the operational efficiencies and technological capabilities of larger rivals.

Operationally, FKYS relies on standard banking technologies to support its branch network and customer interactions, including internet banking services. Recent investments have been directed towards enhancing infrastructure, such as replacing the ATM fleet and implementing new disaster recovery systems, reflecting a focus on maintaining reliable service and security. While the company utilizes a third-party vendor for sophisticated CECL modeling, it does not appear to possess proprietary or differentiated technology that provides a unique competitive edge in product features or processing speed compared to the advanced digital platforms offered by larger banks. The competitive analysis suggests FKYS may face higher operating costs per unit and slower digital transaction processing compared to more technologically integrated competitors, highlighting an area for potential strategic focus.

Financial Performance: A Return to Profitability

The first quarter of 2025 marked a significant shift in First Keystone's reported profitability compared to the prior year. The company posted net income of $1.05 million for the three months ended March 31, 2025, a substantial increase from the net loss of $18.38 million reported in the same period of 2024. This dramatic improvement was primarily attributable to the absence of the $19.13 million goodwill impairment charge that impacted the first quarter of 2024. On a per-share basis, this translated to earnings of $0.17 per share in Q1 2025, a stark contrast to the loss of $3.00 per share in Q1 2024.

Beyond the one-time impairment effect, the core banking operations showed positive trends. Net interest income, the difference between interest earned on assets and interest paid on liabilities, increased by $1.29 million, or 17.3%, to $8.77 million in Q1 2025 from $7.47 million in Q1 2024. This expansion was driven by a 7.5% increase in total interest income, primarily from higher interest and fees on loans, while total interest expense saw a modest 0.3% decrease. Consequently, the net interest margin improved to 2.58% in Q1 2025, up from 2.25% in Q1 2024, indicating enhanced profitability on interest-earning assets.

Non-interest income also contributed positively, increasing by $415,000, or 30.9%, to $1.76 million. This growth was supported by a decrease in net securities losses and increases across various fee-based categories, including trust department income (up 7.0%), service charges and fees (up 4.0%), ATM/debit card income (up 5.0%), and net gains on sales of mortgage loans (up 81.8%). A notable boost came from $235,000 in gains from life insurance proceeds recognized in Q1 2025, which were absent in Q1 2024.

Total non-interest expense, while significantly lower year-over-year due to the 2024 impairment, saw increases in underlying operational costs. Salaries and employee benefits rose, reflecting efforts to offer competitive wages and support growth. Occupancy, furniture and equipment, and computer expenses increased by 11.9%, driven by depreciation on new ATMs and disaster recovery system costs. Data processing fees also increased by 23.5%. Other non-interest expense saw a significant 27.6% increase, including a $307,000 fraud write-off in Q1 2025.

The effective income tax rate increased to 6.70% in Q1 2025 from 1.10% in Q1 2024, primarily due to higher overall operating income relative to tax-exempt income.

Loan Portfolio Dynamics and Asset Quality Trends

The loan portfolio remains the primary earning asset for First Keystone, showing continued growth. Total gross loans increased by $15.73 million, or 1.7%, reaching $964.18 million as of March 31, 2025, compared to $948.45 million at the end of 2024. This growth was broad-based across several categories:

• Real Estate loans, the largest segment, grew by $11.86 million (1.4%) to $863.66 million.
• State and Political Subdivisions loans saw the highest percentage growth, increasing by $2.49 million (11.2%) to $24.63 million.
• Commercial and Industrial loans increased by $1.12 million (1.7%) to $68.22 million.
• Agricultural loans grew by $0.18 million (19.0%) to $1.12 million.
• Consumer loans increased by $0.08 million (1.3%) to $6.54 million.

While loan growth is positive for interest income, asset quality metrics showed some deterioration in the first quarter. Total non-performing assets increased by $960,000, or 19.3%, reaching $5.93 million as of March 31, 2025, compared to $4.97 million at December 31, 2024. This increase was driven by both higher non-accrual loans ($4.72 million vs. $4.21 million) and an increase in loans past-due 90 days or more and still accruing interest ($1.21 million across 10 loans vs. $756,000 across 6 loans). The past-due loans were reported as well secured and in the process of collection.

The allowance for credit losses (ACL) increased to $8.07 million at March 31, 2025, from $7.67 million at December 31, 2024. This increase was supported by a higher provision for credit losses of $751,000 in Q1 2025, compared to $264,000 in Q1 2024. Management cited its analysis of the current loan portfolio, including historic losses, past-due trends, current economic conditions, loan portfolio growth, and continued credit risk from geopolitical and economic concerns, as reasons for the increased provision.

Net charge-offs saw a significant jump, totaling $355,000 in Q1 2025, compared to net recoveries of $7,000 in Q1 2024. This was primarily due to two specific charge-offs: $116,000 on a trucking transportation loan and $245,000 on a loan to a manufacturer of hemp-based biodegradable plastic food containers.

Individually evaluated loans, which include non-accrual and certain other loans, also increased to $5.03 million from $4.52 million. The largest individually evaluated relationships included a $1.60 million student housing loan, a $1.44 million multi-use property renovation loan, and a $582,000 golf course/catering venue loan, all secured by commercial real estate. Management evaluates these loans based on collateral value, which may be discounted based on market conditions and expertise.

The increase in non-performing assets and charge-offs, while specific to a few loans, reflects the broader economic uncertainty that management is closely monitoring. The company's ACL coverage relative to non-performing assets decreased to 136.05% at March 31, 2025, from 154.37% at December 31, 2024, indicating a lower buffer against potential future losses in the non-performing segment, although the overall ACL to total loans ratio slightly increased to 0.84% from 0.79%.

Funding, Liquidity, and Capital Strength

First Keystone's funding primarily comes from customer deposits. Total deposits saw a slight decrease of $487,000 in Q1 2025, ending the quarter at $1.05 billion. This was driven by a $6.09 million decrease in interest-bearing deposits (mainly demand and savings), partially offset by a $5.60 million increase in non-interest-bearing deposits. The decline in interest-bearing deposits occurred despite an increase in time deposits ($31.49 million) resulting from new higher-rate CD promotions, suggesting outflows from lower-yielding deposit types.

To support loan growth that outpaced deposit accumulation, total borrowings increased by $5.86 million to $246.29 million. These borrowings primarily consist of short-term and long-term advances from the Federal Home Home Loan Bank (FHLB) and securities sold under repurchase agreements.

Total stockholders equity stood at $106.48 million at March 31, 2025, a slight decrease from $106.78 million at year-end 2024. This change was primarily due to dividends paid ($1.74 million) exceeding net income ($1.05 million), partially offset by an improvement of $390,000 in accumulated other comprehensive loss (AOCI). The improvement in AOCI reflects changes in the fair value of available-for-sale securities and derivatives. Importantly, the Bank has opted out of including AOCI fluctuations in its regulatory capital calculations, ensuring stability in its capital ratios despite market volatility affecting the securities portfolio.

Liquidity remains a key focus, managed by the company's Asset/Liability Management Committee (ALCO). Sources include core deposits, maturing securities, loan payments, and available borrowing capacity. As of March 31, 2025, the company reported substantial unused borrowing capacity, including $534.84 million at the FHLB, $15.00 million at ACBB, and $7.77 million at the Federal Discount Window, providing ample resources to meet funding needs. Net cash provided by operating activities was $308,000 in Q1 2025, lower than the $2.05 million in Q1 2024 (excluding the non-cash impairment), reflecting changes in various balance sheet items.

As of March 31, 2025, the Bank continued to meet the definition of a well-capitalized institution under regulatory requirements, with robust capital ratios including a Common Equity Tier 1 capital ratio of 14.66%, a Tier 1 risk-based capital ratio of 14.66%, and a Total risk-based capital ratio of 15.46%, all comfortably above the fully phased-in Basel III minimums plus buffer. This strong capital base provides a foundation for continued asset growth and resilience against potential future credit losses.

Market Risk and Outlook

First Keystone's primary market risk is interest rate risk, stemming from mismatches in the repricing of assets and liabilities. The company's ALCO actively manages this risk using various tools, including earnings simulation and net present value analysis. As of March 31, 2025, the company's cumulative gap at one year indicated a liability-sensitive position, meaning that in a rising rate environment, liability costs could increase faster than asset yields, potentially compressing margins.

However, the company's earnings simulation modeling suggests that net interest income is projected to decrease modestly in both increasing and decreasing rate scenarios over the next year, remaining within policy guidelines. For instance, a 200 basis point immediate increase in rates is projected to decrease net interest income by 1.49%, while a 200 basis point decrease is projected to decrease it by 3.15%. The model's sensitivity in decreasing rate scenarios is noted as less reliable given the current rate environment, where deposit rates may have limited room to fall further compared to asset yields. The net present value analysis, which measures the economic value at risk, also shows projected changes within policy limits under various rate shock scenarios. The company also uses interest rate swaps to hedge against interest rate movements, designating them as fair value hedges for fixed-rate assets and cash flow hedges for wholesale funding.

Looking ahead, management commentary reflects the continued uncertainty in the economic environment. Factors such as persistent inflation, geopolitical conflicts, labor costs, and the trajectory of Federal Reserve policy are highlighted as potential stressors. These conditions could impact borrowers' ability to repay loans, potentially leading to increased delinquencies, non-performing assets, and charge-offs, which would necessitate further additions to the allowance for credit losses. The extent of these impacts is uncertain and may have lagged effects.

Despite these headwinds, the company's strategic focus remains on lending to creditworthy borrowers and maintaining a well-diversified loan portfolio. The emphasis on asset quality, supported by internal and external loan review processes and a dedicated loan workout department, is crucial in mitigating credit risk in this environment. The company expects to maintain adequate liquidity to manage through current conditions, leveraging its core deposit base and borrowing capacity.

While specific quantitative guidance for future earnings or loan growth was not provided, the Q1 2025 results demonstrate a return to profitability following the prior year's impairment. The underlying trends of loan growth and net interest margin expansion, coupled with a strong capital position, provide a foundation. However, the increase in non-performing assets and the need for a higher provision signal that credit quality bears close monitoring as economic conditions evolve.

Conclusion

First Keystone Corporation is emerging from a challenging 2024 marked by a significant goodwill impairment, demonstrating renewed profitability in the first quarter of 2025. The core banking business shows resilience, with solid loan growth driving improved net interest income and margin expansion. The company's long-standing community banking model and local relationships remain foundational strengths in a competitive market dominated by larger, more digitally advanced institutions.

However, the operating environment presents clear headwinds. Rising non-performing assets and increased charge-offs in Q1 2025 underscore the potential impact of economic uncertainty on credit quality, necessitating a higher provision for loan losses. While liquidity and capital levels are robust, supporting future growth and providing a buffer against risk, the need for continued investment in digital capabilities to enhance efficiency and compete effectively with larger rivals is apparent. The retirement of the long-time CEO and the appointment of a new leader also mark a period of transition. For investors, the story of First Keystone is one of a community bank navigating complex economic crosscurrents. The focus will be on the company's ability to sustain loan growth while effectively managing credit risk in a volatile environment and strategically investing in operational efficiencies to maintain its competitive standing.