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CBU > SEC Filings for CBU > Form 10-Q on 9-Nov-2012All Recent SEC Filings

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Form 10-Q for COMMUNITY BANK SYSTEM INC


9-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Introduction

This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") primarily reviews the financial condition and results of operations of Community Bank System, Inc. (the "Company" or "CBSI") as of and for the three and nine months ended September 30, 2012 and 2011, although in some circumstances the second quarter of 2012 is also discussed in order to more fully explain recent trends. The following discussion and analysis should be read in conjunction with the Company's Consolidated Financial Statements and related notes that appear on pages 3 through 25. All references in the discussion to the financial condition and results of operations are to those of the Company and its subsidiaries taken as a whole. Unless otherwise noted, the term "this year" refers to results in calendar year 2012, "third quarter" refers to the quarter ended September 30, 2012, and earnings per share ("EPS") figures refer to diluted EPS.

This MD&A contains certain forward-looking statements with respect to the financial condition, results of operations and business of the Company. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those proposed by such forward-looking statements are set herein under the caption, "Forward-Looking Statements," on page 43.

Critical Accounting Policies

As a result of the complex and dynamic nature of the Company's business, management must exercise judgment in selecting and applying the most appropriate accounting policies for its various areas of operations. The policy decision process not only ensures compliance with the latest generally accepted accounting principles ("GAAP"), but also reflects management's discretion with regard to choosing the most suitable methodology for reporting the Company's financial performance. It is management's opinion that the accounting estimates covering certain aspects of the business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity in the selection process. These estimates affect the reported amounts of assets, liabilities and shareholders' equity and disclosures of revenues and expenses during the reporting period. Actual results could differ from those estimates. Management believes that critical accounting estimates include:

Acquired loans - Acquired loans are initially recorded at their acquisition date fair values. The carryover of allowance for loan losses is prohibited as any credit losses in the loans are included in the determination of the fair value of the loans at the acquisition date. Fair values for acquired loans are based on a discounted cash flow methodology that involves assumptions and judgments as to credit risk, prepayment risk, liquidity risk, default rates, loss severity, payment speeds, collateral values and discount rate. Subsequent to the acquisition of acquired impaired loans, GAAP requires the continued estimation of expected cash flows to be received. This estimation requires numerous assumptions, interpretations and judgments using internal and third-party credit quality information. Changes in expected cash flows could result in the recognition of impairment through provision for credit losses.

For acquired loans that are not deemed impaired at acquisition, credit discounts representing the principal losses expected over the life of the loan are a component of the initial fair value. Subsequent to the purchase date, the methods utilized to estimate the required allowance for loan losses for the non-impaired acquired loans is similar to originated loans, however, the Company records a provision for loan losses only when the required allowance exceeds any remaining pooled discounts for loans evaluated collectively for impairment. For loans individually evaluated for impairment, a provision is recoded when the required allowance exceeds any remaining discount on the loan.

Allowance for loan losses - The allowance for loan losses reflects management's best estimate of probable loan losses in the Company's loan portfolio. Determination of the allowance for loan losses is inherently subjective. It requires significant estimates including the amounts and timing of expected future cash flows on impaired loans and the amount of estimated losses on pools of homogeneous loans which is based on historical loss experience and consideration of current economic trends, all of which may be susceptible to significant change.

Investment securities - Investment securities are classified as held-to-maturity, available-for-sale, or trading. The appropriate classification is based partially on the Company's ability to hold the securities to maturity and largely on management's intentions with respect to either holding or selling the securities. The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Unrealized gains and losses on available-for-sale securities are recorded in accumulated other comprehensive income or loss, as a separate component of shareholders' equity and do not affect earnings until realized. The fair values of investment securities are generally determined by reference to quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments, or a discounted cash flow model using market estimates of interest rates and volatility. Investment securities with significant declines in fair value are evaluated to determine whether they should be considered other-than-temporarily impaired ("OTTI"). An unrealized loss is generally deemed to be other-than-temporary and a credit loss is deemed to exist if the present value of the expected future cash flows is less than the amortized cost basis of the debt security. The credit loss component of an OTTI write-down is recorded in earnings, while the remaining portion of the impairment loss is recognized in other comprehensive income (loss), provided the Company does not intend to sell the underlying debt security, and it is not more likely than not that the Company will be required to sell the debt security prior to recovery of the full value of its amortized cost basis.


Retirement benefits - The Company provides defined benefit pension benefits to eligible employees and post-retirement health and life insurance benefits to certain eligible retirees. The Company also provides deferred compensation and supplemental executive retirement plans for selected current and former employees and officers. Expense under these plans is charged to current operations and consists of several components of net periodic benefit cost based on various actuarial assumptions regarding future experience under the plans, including, but not limited to, discount rate, rate of future compensation increases, mortality rates, future health care costs and expected return on plan assets.

Provision for income taxes - The Company is subject to examinations from various taxing authorities. Such examinations may result in challenges to the tax return treatment applied by the Company to specific transactions. Management believes that the assumptions and judgments used to record tax related assets or liabilities have been appropriate. Should tax laws change or the taxing authorities determine that management's assumptions were inappropriate, an adjustment may be required which could have a material effect on the Company's results of operations.

Intangible assets - As a result of acquisitions, the Company has acquired goodwill and identifiable intangible assets. Goodwill represents the cost of acquired companies in excess of the fair value of net assets at the acquisition date. Goodwill is evaluated at least annually, or when business conditions suggest impairment may have occurred and will be reduced to its carrying value through a charge to earnings if impairment exists. Core deposits and other identifiable intangible assets are amortized to expense over their estimated useful lives. The determination of whether or not impairment exists is based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires them to select a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, expected equity market premiums, peer volatility indicators and company-specific market and performance metrics, all of which are susceptible to change based on changes in economic conditions and other factors. Future events or changes in the estimates used to determine the carrying value of goodwill and identifiable intangible assets could have a material impact on the Company's results of operations.

A summary of the accounting policies used by management is disclosed in Note A, "Summary of Significant Accounting Policies" on pages 54-60 of the most recent Form 10-K (fiscal year ended December 31, 2011) filed with the Securities and Exchange Commission on February 29, 2012.

Executive Summary

The Company's business philosophy is to operate as a community bank with local decision-making, principally in non-metropolitan markets, providing a broad array of banking and financial services to retail, commercial and municipal customers. The Company's banking subsidiary is Community Bank, N.A. (the "Bank" or "CBNA"), which operates in Pennsylvania under the name First Liberty Bank and Trust.

The Company's core operating objectives are: (i) grow the branch network, primarily through a disciplined acquisition strategy, and certain selective de novo expansions, (ii) build high-quality, profitable loan and deposit portfolios using both organic and acquisition strategies, (iii) increase the noninterest income component of total revenues through development of banking-related fee income, growth in existing financial services business units, and the acquisition of additional financial services and banking businesses, and (iv) utilize technology to deliver customer-responsive products and services and continually improve operating efficiency.

Significant factors management reviews to evaluate achievement of the Company's operating objectives and its operating results and financial condition include, but are not limited to: net income and earnings per share; return on assets and equity; net interest margins; noninterest income; operating expenses; asset quality; loan and deposit growth; capital management; performance of individual banking and financial services units; liquidity and interest rate sensitivity; enhancements to customer products and services; technology advancements; market share; peer comparisons; and the performance of acquisition activities.

On April 8, 2011, the Company acquired The Wilber Corporation ("Wilber"), the parent company of Wilber National Bank, for $103 million in stock and cash, comprised of $20.4 million in cash and the issuance of 3.35 million additional shares of the Company's common stock. Based in Oneonta, New York, Wilber operated 22 branches in the Central, Greater Capital District and Catskills regions of Upstate New York. The acquisition added approximately $462 million of loans, $298 million of investment securities and $772 million of deposits.

On November 30, 2011, the Company, through its BPAS subsidiary, acquired certain assets and liabilities of CAI Benefits, Inc. ("CAI") a provider of actuarial, consulting and retirement plan administration services, with offices in New York City and Northern New Jersey. The transaction adds valuable service capacity and enhances distribution prospects in support of the Company's broader-based employee benefits business, including daily valuation plan and collective investment fund administration.


On July 20, 2012, Community Bank, N.A. (the" Bank"), the wholly-owned banking subsidiary of the Company, completed its acquisition of 16 retail branches in central, northern and western New York from HSBC Bank USA, N.A. ("HSBC"), acquiring approximately $106 million in loans and $697 million of deposits. The assumed deposits consist primarily of core deposits (checking, savings and money market accounts) and the purchased loans consist of in-market performing loans primarily residential real estate loans. Under the terms of the purchase agreement, the Bank paid First Niagara Bank, N.A. ("First Niagara") (who acquired HSBC's Upstate New York banking business and assigned its right to purchase the 16 branches to the Bank) a blended deposit premium of 3.4%, or approximately $24 million.

On September 7, 2012, the Bank completed its acquisition of three branches in central New York from First Niagara, acquiring approximately $54 million of loans and $101 million of deposits. The assumed deposits consist primarily of core deposits (checking, savings and money market accounts) and the purchased loans consist of in-market performing loans, primarily residential real estate loans. Under the terms of the purchase agreement, the Bank paid a blended deposit premium of 3.1%, or approximately $3 million.

In late January 2012, the Company completed a public common stock offering and raised $57.5 million through the issuance of 2.13 million shares. The net proceeds of the offering were approximately $54.9 million. The Company used the capital raised in this offering to support the HSBC and First Niagara branch acquisitions.

Third quarter 2012 net income of $18.4 million decreased $1.6 million or 8.2% as compared to the third quarter of 2011, while earnings per share for the quarter of $0.46 were $0.08 or 14.8% lower than the third quarter of the prior year. The current year results included $4.8 million of acquisition-related expenses, or $0.08 per share, compared with $0.4 million in the prior year period. September year-to-date net income of $58.3 million was $4.1 million or 7.6% higher than the respective prior year period. Year-to-date earnings per share were $1.46, a decrease of $0.04 from the equivalent prior year period. The year-to-date results for both periods include $0.09 of acquisition related expenses. Both quarterly and year-to-date results experienced higher net interest income generated from earning asset growth resulting from the HSBC and First Niagara branch acquisitions, combined with the Wilber acquisition in the second quarter of 2011 and organic loan growth, partially offset by a lower net interest margin. Also contributing to higher net income was growth of noninterest income due to incremental deposit service fees from the HSBC, First Niagara and Wilber acquisitions, higher debit card-related revenue, higher employee benefits administration and consulting revenues, primarily driven by the CAI acquisition and solid revenue growth from the wealth management businesses, which benefitted from more favorable market conditions. These were partially offset by higher provisions for loan losses, higher operating expenses due in large part to the additional operating costs and one-time acquisition related expenses from the HSBC, First Niagara and Wilber acquisitions, and a higher effective income tax rate. Additionally, earnings per share were impact by the 2.13 million shares issued in January 2012 in support of the HSBC and First Niagara branch acquisitions and the 3.35 million shares issued in April 2011 in conjunction with the Wilber acquisition.

Asset quality in the third quarter of 2012 remained stable and favorable in comparison to averages for peer financial organizations. Third quarter loan net charge-off ratios were higher than those experienced in the third quarter of 2011, but lower than the level of net charge-offs in the first and second quarters of 2012. Nonperforming loan ratios were higher than experienced in the third quarter of last year, but lower than the first and second quarter of 2012. The current quarter provision for loan losses was higher than the third quarter of 2011 as a result of organic loan growth and the need for an allowance on loans acquired during the third quarter of 2012. Delinquency ratios increased from the third quarter of 2011, but were below those experienced in the fourth quarter of 2011. The Company generated year-over-year growth in average interest-earning assets for the quarter, reflective of the pre-investment of approximately $600 million of expected liquidity from the HSBC branch acquisition, as well as organic loan growth. Average deposits in the third quarter of 2012 were higher than the third quarter of 2011 and the fourth quarter of 2011, driven by the HSBC and First Niagara acquisitions as well as organic deposit growth. Average borrowings decreased during the third quarter of 2012, as the Company extinguished all overnight obligations upon the completion of the branch acquisitions.

Net Income and Profitability

As shown in Table 1, net income for the third quarter and September YTD of $18.4 million and $58.3 million decreased 8.2% versus the third quarter of 2011 and increased 7.6% compared to the first nine months of 2011. Earnings per share for the third quarter of $0.46 were $0.08 lower that the EPS generated in the third quarter of 2011, and earnings per share of $1.46 for the first nine months of 2012 decreased $0.04 from the amount earned in the first nine months of 2011. Included in these results were $4.8 million and $5.2 million of acquisition expenses for the three and nine months ending September 30, 2012, respectively, as compared to $0.4 million and $4.7 million for the comparative periods of 2011. Earnings per share for both periods were impacted by the public common stock offering in January 2012 in support of the branch acquisitions and the issuance of 3.35 million shares in conjunction with the Wilber acquisition in the second quarter of 2011.


As reflected in Table 1, third quarter net interest income of $58.8 million was up $4.2 million or 7.7% from the comparable prior year period and net interest income for the first nine months of 2012 increased $16.2 million or 10.5% over the first nine months of 2011. The improvement resulted from an increase in interest-earning assets, primarily due to the HSBC and First Niagara branch acquisitions in the third quarter of 2012, the pre-investing of a portion of the net liquidity expected to be received from the HSBC branch acquisition in the first half of 2012 combined with the Wilber acquisition from the second quarter of 2011 and organic loan growth, partially offset by a lower net interest margin in the first nine months of 2012. The provision for loan losses increased $1.6 million and $3.3 million as compared to the third quarter and first nine months of 2012, respectively, reflective of the $2.6 million increase in year-to-date net charge-offs, solid organic loan growth and $0.5 million for certain loans acquired in the HSBC and First Niagara branch acquisitions where the carrying value exceeded the estimated net recoverable value. Third quarter and year-to-date noninterest income was $25.6 million and $72.7 million, respectively, up $2.3 million or 10.1% from the third quarter of 2011 and up $5.9 million or 8.9% from the first nine months of 2011, primarily due to the HSBC, First Niagara, Wilber and CAI acquisitions. Contributing to the increase was a $1.6 million increase in revenue generated from the Company's wealth management group, principally from activities related to the trust operations acquired from Wilber, as well as solid organic growth aided by more favorable market conditions.

Operating expenses of $56.1 million for the third quarter increased $8.0 million or 17% from the comparable prior year period. Excluding acquisition expenses of $4.8 million in the third quarter of 2012 and $0.4 million in the third quarter of 2011, operating expenses increased $3.6 million or 7.5%. Operating expenses for the first nine months of 2012 were $12.3 million or 8.6% higher than the first nine months of 2011. Excluding acquisition expenses of $5.2 million and $4.7 million in the first nine months of 2012 and 2011, respectively, operating expenses increased $11.8 million or 8.6%. The increase in operating expenses, excluding acquisition related expenses, is reflective of additional operating costs associated with the HSBC, First Niagara, Wilber and CAI acquisitions completed in July and September of 2012 and April and November of 2011, respectively, partially offset by lower FDIC insurance costs and business development and marketing expenses.

A condensed income statement is as follows:

Table 1: Condensed Income Statements

                                        Three Months Ended    Nine Months Ended
                                           September 30,        September 30,
     (000's omitted, except per share
     data)                                2012      2011        2012      2011
     Net interest income                  $58,775   $54,568    $170,455 $154,278
     Provision for loan losses              2,643     1,043       6,442    3,143
     Noninterest income                    25,568    23,222      72,732   66,815
     Gain (loss) on sale of
     investment securities & debt
     extinguishments, net                     291       (6)         291        8
     Acquisition expenses                   4,796       381       5,221    4,689
     All other operating expenses          51,289    47,712     149,637  137,846
     Income before taxes                   25,906    28,648      82,178   75,423
     Income taxes                           7,539     8,640      23,914   21,269
     Net income                           $18,367   $20,008     $58,264  $54,154

     Diluted weighted average common
     shares outstanding                    40,139    37,312      39,842   36,112
     Diluted earnings per share             $0.46     $0.54       $1.46    $1.50

Net Interest Income

Net interest income is the amount by which interest and fees on earning assets (loans, investments and cash equivalents) exceed the cost of funds, primarily interest paid to the Company's depositors and interest on external borrowings. Net interest margin is the difference between the gross yield on earning assets and the cost of interest-bearing funds as a percentage of earning assets.

As shown in Table 2a, net interest income (with nontaxable income converted to a fully tax-equivalent basis) for the third quarter of 2012 was $63.1 million, a $4.7 million or 8.1% increase from the same period last year. The increase was a result of a $889.7 million increase in third quarter interest-earning assets versus the prior year having a greater impact than the $569.6 million increase in average interest-bearing liabilities and a 25-basis point decrease in the net interest margin. As reflected in Table 3, the third quarter volume increase from interest-bearing assets combined with the rate decrease on interest-bearing liabilities had a $15.7 million favorable impact on net interest income, while the rate decrease on interest-bearing assets and the volume increase on interest bearing liabilities had an $11.0 million unfavorable impact on net interest income. September 2012 YTD net interest income of $183.2 million increased $17.1 million or 10.3% from the year-earlier period. An $833.0 million increase in interest-earning assets had a greater impact than the $601.7 million increase in average interest-bearing liabilities and an 18-basis point decrease in net interest margin. The increase in interest-earning assets and a lower rate on interest-bearing liabilities had a $43.5 million favorable impact that was partially offset by a $26.5 million unfavorable impact from the decrease in the yield on interest-bearing assets and the increase in interest-bearing liability balances.


Average investments, including cash equivalents, for the third quarter and YTD periods were $662.7 million and $589.7 million higher, respectively, than the comparable periods of 2011 reflective of the purchase of approximately $600 million of U.S. Treasury securities late in the first quarter of 2012 and the acquired Wilber portfolio. The Company actively redeployed maturing loan and investment cash flows and excess funding supplied by deposit growth, and as well as the pre-investment of a portion of the excess liquidity from the branch acquisitions. Third quarter 2012 average loan balances increased $227.1 million as compared to the third quarter of 2011 due to organic loan growth principally in the consumer mortgage and indirect portfolios as well as approximately $94 million of acquired loans from the HSBC and First Niagara branch acquisition in the third quarter of 2012. Year-to-date average loans increased $243.3 million due to the impact of the acquired HSBC, First Niagara and Wilber loans and organic growth, principally in the consumer mortgage and indirect portfolios. In comparison to the prior year, total average interest-bearing deposits were up $483.4 million or 12%, and $448.8 million or 12%, for the quarter and YTD periods, respectively, as a result of the HSBC, First Niagara and Wilber acquisitions and organic growth. Quarterly and YTD average borrowings increased $86.3 million or 10.4% and $152.8 million or 18%, respectively, reflective of the initiative to use overnight borrowings to fund the pre-investment of a portion of the liquidity expected from the branch acquisitions in the third quarter of 2012. These borrowings were repaid upon the completion of the HSBC branch acquisition in July of 2012.

The net interest margin of 3.79% and 3.90% for the third quarter and YTD period, respectively, decreased 25 basis points and 18 basis points as compared to the third quarter and first nine months of 2011, respectively. Earning asset yields declined by 59 basis points and 49 basis points for the quarter and year-to-date periods, respectively, reflective of lower yields on loans and investment securities. This was partially offset by the reduction of deposit rates in the current rate environment, the expiration of the interest rate swap agreement on the trust preferred securities and the addition of low-rate overnight borrowings during the first seven months of the year, resulting in a 34-basis point and 30-basis point reduction in the total cost of funds in comparison to the third quarter and year-to-date periods of 2011, respectively.

The decrease in the earning-asset yield was attributable to a 43-basis point and 51-basis point decrease in investment yields, including cash equivalents, for the quarter and YTD period as compared to the prior year periods, largely a result of the purchase of $888 million of U.S. Treasury, obligations of state and political subdivisions and other securities with an average yield of 2.69% during the first half of 2012. Additionally, contributing to the decrease in earning-asset yield for the quarter and YTD periods was a 56-basis point and 36-basis point decline in the loan yield as compared to the third quarter and YTD periods of 2011, respectively, as a result of lower rates on fixed-rate new loan volume due to the decline in interest rates to levels below those prevalent in prior years and certain existing adjustable and fixed-rate loans repricing downward.

The third quarter cost of funds decreased versus the prior year quarter due to a 30-basis point decrease in interest-bearing deposit rates, a higher proportion of funding being supplied from low and noninterest bearing deposits and a 71-basis point decrease in the average interest rate paid on external borrowings. The decreases in the cost of funds were reflective of disciplined deposit pricing, whereby interest rates on selected categories of deposit accounts were lowered throughout 2011 and the first nine months of 2012 in response to market conditions. Additionally, the proportion of customer deposits held in higher cost time deposits has continued to decline over the last twelve months. The decrease in the average rate paid on external borrowings was . . .

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