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FISI > SEC Filings for FISI > Form 10-K on 18-Mar-2013All Recent SEC Filings

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Form 10-K for FINANCIAL INSTITUTIONS INC


18-Mar-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following is a discussion and analysis of our financial position and results of operations and should be read in conjunction with the information set forth under Part I, Item 1A, "Risks Factors", and our consolidated financial statements and notes thereto appearing under Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K.

OVERVIEW

Business Overview

Financial Institutions, Inc. is a financial holding company headquartered in New York State, providing banking and nonbanking financial services to individuals and businesses primarily in our Western and Central New York footprint. We have also expanded our indirect lending network to include relationships with franchised automobile dealers in the Capital District of New York and Northern Pennsylvania. Through our wholly-owned banking subsidiary, Five Star Bank, we provide a wide range of services, including business and consumer loan and depository services, as well as other traditional banking services. Through our nonbanking subsidiary, Five Star Investment Services, we provide brokerage and investment advisory services to supplement our banking business.

Our primary sources of revenue are net interest income (interest earned on our loans and securities, net of interest paid on deposits and other funding sources) and noninterest income, particularly fees and other revenue from financial services provided to customers or ancillary services tied to loans and deposits. Business volumes and pricing drive revenue potential, and tend to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, economic growth, and competitive conditions within the marketplace. We are not able to predict market interest rate fluctuations with certainty and our asset/liability management strategy may not prevent interest rate changes from having a material adverse effect on our results of operations and financial condition.

2012 Significant Events

Branch Acquisitions. During 2012, we successfully completed the acquisition of eight retail bank branch locations in Upstate New York. Former HSBC Bank USA, N.A. branches located in Albion, Elmira, Elmira Heights, and Horseheads were acquired in August, complementing the former First Niagara Bank, N.A. locations in Batavia, Brockport, Medina, and Seneca Falls acquired in June. Through the acquisition we assumed deposits of $286.8 million and acquired in-market performing loans of $75.6 million. The acquisition of these branch offices was a marked success. We were able to integrate the offices and customer accounts seamlessly. Through detailed planning, we ensured that our sales and support staff members were ready to assist customers with any questions or issues. The feedback we received from our customers was positive and executing on our detailed planning process ultimately resulted in deposit retention rates that were better than expected. We incurred approximately $3.0 million in pre-tax expense during 2012 related to the branch acquisitions.

The combined assets acquired and deposits assumed in the two transactions were recorded at their estimated fair values as follows:

                    Cash                            $ 195,778
                    Loans                              75,635
                    Bank premises and equipment         1,938
                    Goodwill                           11,599
                    Core deposit intangible asset       2,042
                    Other assets                          339

                    Total assets acquired           $ 287,331

                    Deposits assumed                $ 286,819
                    Other liabilities                     512

                    Total liabilities assumed       $ 287,331

In anticipation of the branch acquisitions, we leveraged our balance sheet through the execution of short-term FHLB advances in order to "pre-acquire" investment securities. This strategy allowed us to purchase securities over time and carry out a dollar cost averaging strategy. Our purchase of investment securities was comprised of mortgage-backed securities, U.S. Government agencies and sponsored enterprise bonds and tax-exempt municipal bonds. The cash received at the time of closing the transactions was used to pay down the short-term FHLB advances used to fund the purchase of the investment securities.

For detailed information on the accounting for the branch acquisitions, see Note 2, Branch Acquisitions, of the notes to consolidated financial statements.

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MANAGEMENT'S DISCUSSION AND ANALYSIS

Leadership Transition. In August 2012, Peter G. Humphrey our former President and Chief Executive Officer retired. Mr. Humphrey continues to serve as a member of our Board of Directors. Following Mr. Humphrey's retirement, our Board of Directors appointed John E. Benjamin to serve as our Interim Chief Executive Officer in August 2012. At the same time, we also announced the promotion of Richard Harrison as Chief Operating Officer and Martin Birmingham as President and Chief of Community Banking. Mr. Harrison and Mr. Birmingham were instrumental in the structuring, negotiating and integrating the branch office acquisitions. We incurred approximately $2.6 million in pre-tax expense during 2012 related to the retirement of Mr. Humphrey.

The Board of Directors subsequently appointed Mr. Birmingham as President and Chief Executive Officer, effective March 1, 2013.

2012 Performance Summary

Our net income was $23.4 million for the year ended December 31, 2012, compared to a net income of $22.8 million for the year ended December 31, 2011. For 2012, net income available to common shareholders was $22.0 million, or $1.60 per diluted common share, compared to 2011 net income available to common shareholders of $19.6 million, or $1.49 per diluted common share. Cash dividends of $0.57 and $0.47 per common share were declared in 2012 and 2011, respectively.

We had total assets of $2.764 billion at December 31, 2012 compared to $2.336 billion at December 31, 2011. At December 31, 2012, shareholders' equity totaled $253.9 million with book value per common share at $17.15, compared to $237.2 million with book value per common share at $15.92 at the end of 2011. The Tier 1 capital ratio was 10.70% as of December 31, 2012 compared to 12.20% at December 31, 2011.

Key factors behind these results are discussed below.

At December 31, 2012, total loans were $1.706 billion, up $220.9 million or 15% from year-end 2011. At December 31, 2012, total loans included $64.5 million in loans obtained in the branch acquisitions. Total deposits at December 31, 2012, were $2.262 billion, up $330.2 million or 17% from year-end 2011, primarily attributable to $286.8 million in retail deposits assumed from the branch acquisitions. Our deposit mix remains favorably weighted in demand, savings and money market accounts, which comprised 71% of total deposits at the end of 2012 compared to 64% of total deposits at the end of 2011.

Nonperforming loans were $9.1 million or 0.53% of total loans at December 31, 2012, compared to $7.1 million or 0.48% of total loans at December 31, 2011.

The provision for loan losses was $7.1 million and $7.8 million, respectively, for 2012 and 2011. Net charge-offs were $5.7 million in 2012 (or 0.36% of average loans) compared to $5.0 million in 2011 (or 0.36% of average loans).

At year-end 2012, the allowance for loan losses of $24.7 million represented 1.45% of total loans (covering 271% of non-performing loans), compared to $23.3 million or 1.57% (covering 329% of non-performing loans) at year-end 2011. Excluding loans acquired in the branch acquisitions during 2012, the allowance for loan losses was 1.51% of total loans at year-end 2012.

Taxable equivalent net interest income was $90.8 million for 2012 or 8% higher than $83.9 million in 2011. Taxable equivalent interest income increased $2.7 million, while interest expense decreased by $4.2 million. The increase in taxable equivalent net interest income was a function of a favorable volume variance (increasing taxable equivalent net interest income by $11.7 million), partially offset by an unfavorable rate variance (decreasing taxable equivalent net interest income by $4.8 million).

The net interest margin for 2012 was 3.95%, 9 basis points lower than 4.04% in 2011.

Noninterest income was $24.8 million for 2012 compared to $23.9 million for 2011. Core fee-based revenues (defined as service charges on deposit accounts, ATM and debit fees, and broker-dealer fees and commissions) totaled $15.4 million for 2012, a $580 thousand or 4% increase from $14.9 million in 2011. Net mortgage banking income was $2.0 million for 2012, an increase of $323 thousand or 19% from $1.7 million in 2011.

Net investment securities gains (defined as net gain on sales and calls of investment securities and impairment charges on investment securities) were $2.6 million for 2012 compared to $3.0 million for 2011.

Noninterest expense for 2012 was $71.4 million, an increase of $7.6 million or 12% over 2011. As previously mentioned, noninterest expense for 2012 includes pre-tax expenses of approximately $3.0 million related to the branch acquisitions and $2.6 million incurred in association with the retirement of our former CEO. Noninterest expense for 2011 includes a loss on extinguishment of debt of $1.1 million, recognized as a result of redeeming our 10.20% junior subordinated debentures. Excluding these expenses, which we consider to be non-recurring in nature, noninterest expense increased $3.1 million or 5% when comparing 2012 to 2011.

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MANAGEMENT'S DISCUSSION AND ANALYSIS

RESULTS OF OPERATIONS FOR THE YEARS ENDED

DECEMBER 31, 2012 AND DECEMBER 31, 2011

Net Interest Income and Net Interest Margin

Net interest income is the primary source of our revenue. Net interest income is the difference between interest income on interest-earning assets, such as loans and investment securities, and the interest expense on interest-bearing deposits and other borrowings used to fund interest-earning and other assets or activities. Net interest income is affected by changes in interest rates and by the amount and composition of earning assets and interest-bearing liabilities, as well as the sensitivity of the balance sheet to changes in interest rates, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities and repricing frequencies.

Interest rate spread and net interest margin are utilized to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on earning assets and the rate paid for interest-bearing liabilities that fund those assets. The net interest margin is expressed as the percentage of net interest income to average earning assets. The net interest margin exceeds the interest rate spread because noninterest-bearing sources of funds ("net free funds"), principally noninterest-bearing demand deposits and stockholders' equity, also support earning assets. To compare tax-exempt asset yields to taxable yields, the yield on tax-exempt investment securities is computed on a taxable equivalent basis. Net interest income, interest rate spread, and net interest margin are discussed on a taxable equivalent basis.

The following table reconciles interest income per the consolidated statements of income to interest income adjusted to a fully taxable equivalent basis for the years ended December 31 (in thousands):

                                                          2012           2011           2010
Interest income per consolidated statements of
income                                                  $ 97,567       $ 95,118       $ 96,509
Adjustment to fully taxable equivalent basis               2,284          2,062          1,895

Interest income adjusted to a fully taxable
equivalent basis                                          99,851         97,180         98,404
Interest expense per consolidated statement of
income                                                     9,051         13,255         17,720

Net interest income on a taxable equivalent basis       $ 90,800       $ 83,925       $ 80,684

Taxable equivalent net interest income of $90.8 million for 2012 was $6.9 million or 8% higher than 2011. The impact of a decline in average yields on our assets was diminished by a $217.4 million or 10% increase in interest-earning assets. The average balance of loans rose $199.6 million or 14% to $1.593 billion, reflecting growth in every loan category. Consistent with our strategic plan, we continue to pursue loan development efforts in the commercial and consumer indirect lending portfolios in accordance with prudent underwriting standards.

The increase in taxable equivalent net interest income was a function of a favorable volume variance as balance sheet changes in both volume and mix increased taxable equivalent net interest income by $11.7 million, partially offset by an unfavorable rate variance that decreased taxable equivalent net interest income by $4.8 million. The change in mix and volume of earning assets increased taxable equivalent interest income by $11.2 million, while the change in volume and composition of interest-bearing liabilities decreased interest expense by $474 thousand, for a net favorable volume impact of $11.7 million on taxable equivalent net interest income. Rate changes on earning assets reduced interest income by $8.5 million, while changes in rates on interest-bearing liabilities lowered interest expense by $3.7 million, for a net unfavorable rate impact of $4.8 million.

The net interest margin for 2012 was 3.95% compared to 4.04% in 2011.

The decrease in net interest margin was attributable to a 7 basis point lower contribution from net free funds (primarily attributable to lower rates on interest-bearing liabilities reducing the value of noninterest-bearing deposits and other net free funds). The interest rate spread decreased by 2 basis points to 3.85% for the year ended December 31, 2012, as a 32 basis point decrease in the yield on earning assets more than offset the 30 basis point decrease in the cost of interest-bearing liabilities.

The Federal Reserve left the Federal funds rate unchanged at 0.25% during 2010 through 2012. During 2011, the Federal Reserve disclosed that short-term interest rates would be held near zero through at least the middle of 2013, in anticipation of low growth and little risk of inflation. In April 2012, the Federal Reserve further announced that interest rates will likely remain at exceptionally low levels through late 2014. As a result of the Federal Reserve's policy, we expect net interest margin and interest rate spread to continue to tighten.

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MANAGEMENT'S DISCUSSION AND ANALYSIS

For 2012, the yield on average earning assets of 4.35% was 32 basis points lower than 2011. Loan yields decreased 44 basis points to 5.09%. Commercial mortgage and consumer indirect loans in particular, down 28 and 84 basis points, respectively, continued to experience lower yields given the competitive pricing pressures and re-pricing of loans in a low interest rate environment. The yield on investment securities dropped 27 basis points to 2.66%, also impacted by the lower interest rate environment, prepayments of mortgage-related investment securities and the impact of investing the excess cash related to our branch acquisitions into low yielding securities. Overall, earning asset rate changes reduced interest income by $8.5 million.

The cost of average interest-bearing liabilities of 0.50% in 2012 was 30 basis points lower than 2011. The average cost of interest-bearing deposits was 0.50% in 2012, 24 basis points lower than 2011, reflecting the sustained low-rate environment. The cost of borrowings decreased 110 basis points to 0.48% for 2012, primarily a result of the redemption of the Company's 10.20% junior subordinated debentures during the third quarter of 2011. The interest-bearing liability rate changes reduced interest expense by $3.7 million during 2012.

Average interest-earning assets of $2.297 billion in 2012 were $217.4 million or 10% higher than 2011. Average investment securities increased $17.9 million while average loans increased $199.6 million or 14%. The growth in average loans was comprised of increases in all loan categories, with consumer loans up $130.5 million, commercial loans up $63.4 million and residential mortgage loans up $5.6 million.

Average interest-bearing liabilities of $1.825 billion in 2012 were up $162.9 million or 10% versus 2011. The impacts of the recent recession continue to positively impact our deposit balances, as consumers tend to save more when consumer confidence is low. On average, interest-bearing deposits grew $156.2 million, while average noninterest-bearing demand deposits (a principal component of net free funds) increased by $62.0 million. Average borrowings increased $6.7 million, representing a $22.6 million increase and $15.9 million decrease in short-term and long-term borrowings, respectively.

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MANAGEMENT'S DISCUSSION AND ANALYSIS

The following tables present, for the periods indicated, information regarding:
(i) the average balance sheet; (ii) the amount of interest income from interest-earning assets and the resulting annualized yields (tax-exempt yields have been adjusted to a tax-equivalent basis using the applicable Federal tax rate in each year); (iii) the amount of interest expense on interest-bearing liabilities and the resulting annualized rates; (iv) net interest income;
(v) net interest rate spread; (vi) net interest income as a percentage of average interest-earning assets ("net interest margin"); and (vii) the ratio of average interest-earning assets to average interest-bearing liabilities. Investment securities are at amortized cost for both held to maturity and available for sale securities. Loans include net unearned income, net deferred loan fees and costs and non-accruing loans. Dollar amounts are shown in thousands.

                                                                                                       Years ended December 31,
                                                                    2012                                         2011                                         2010
                                                     Average                      Average         Average                      Average         Average                      Average
                                                     Balance        Interest        Rate          Balance        Interest        Rate          Balance        Interest        Rate
Interest-earning assets:
Federal funds sold and other interest-earning
deposits                                           $       113      $      -          0.29 %    $       140      $      -          0.20 %    $     5,034      $      10         0.21 %
Investment securities:
Taxable                                                525,912         12,202         2.32          545,112         14,185         2.60          571,856         17,101         2.99
Tax-exempt                                             177,731          6,526         3.67          140,657          5,890         4.19          108,900          5,416         4.97

Total investment securities                            703,643         18,728         2.66          685,769         20,075         2.93          680,756         22,517         3.31
Loans:
Commercial business                                    242,100         11,263         4.65          215,598         10,311         4.78          206,167          9,939         4.82
Commercial mortgage                                    407,737         22,182         5.44          370,843         21,216         5.72          338,149         20,389         6.03
Residential mortgage                                   127,363          6,637         5.21          121,742          6,868         5.64          138,954          8,157         5.87
Home equity                                            257,537         10,984         4.27          216,428          9,572         4.42          202,189          9,224         4.56
Consumer indirect                                      533,589         27,371         5.13          444,527         26,549         5.97          382,977         25,379         6.63
Other consumer                                          25,058          2,686        10.72           24,686          2,589        10.49           26,950          2,789        10.35

Total loans                                          1,593,384         81,123         5.09        1,393,824         77,105         5.53        1,295,386         75,877         5.86

Total interest-earning assets                        2,297,140         99,851         4.35        2,079,733         97,180         4.67        1,981,176         98,404         4.97

Less: Allowance for loan losses                         24,305                                       21,567                                       20,883
Other noninterest-earning assets                       246,423                                      218,983                                      206,303

Total assets                                       $ 2,519,258                                  $ 2,277,149                                  $ 2,166,596

Interest-bearing liabilities:
Deposits:
Interest-bearing demand                            $   423,096            598         0.14      $   383,122            614         0.16      $   382,517            705         0.18
Savings and money market                               586,329            998         0.17          451,030          1,056         0.23          414,953          1,133         0.27
Certificates of deposit                                693,353          6,866         0.99          712,411          9,764         1.37          726,330         13,015         1.79

Total interest-bearing deposits                      1,702,778          8,462         0.50        1,546,563         11,434         0.74        1,523,800         14,853         0.97
Short-term borrowings                                  121,735            589         0.48           99,122            500         0.50           49,104            365         0.74
Long-term borrowings                                        -              -            -            15,905          1,321         8.31           37,043          2,502         6.75

Total borrowings                                       121,735            589         0.48          115,027          1,821         1.58           86,147          2,867         3.33

Total interest-bearing liabilities                   1,824,513          9,051         0.50        1,661,590         13,255         0.80        1,609,947         17,720         1.10

Noninterest-bearing deposits                           430,240                                      368,268                                      329,853
Other liabilities                                       16,506                                       15,041                                       15,485
Shareholders' equity                                   247,999                                      232,250                                      211,311

Total liabilities and shareholders' equity         $ 2,519,258                                  $ 2,277,149                                  $ 2,166,596

Net interest income (tax-equivalent)                                $  90,800                                    $  83,925                                    $  80,684

Interest rate spread                                                                  3.85 %                                       3.87 %                                       3.87 %

Net earning assets                                 $   472,627                                  $   418,143                                  $   371,229

Net interest margin (tax-equivalent)                                                  3.95 %                                       4.04 %                                       4.07 %

Ratio of average interest-earning assets to
average interest-bearing liabilities                    125.90 %                                     125.17 %                                     123.06 %

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                      MANAGEMENT'S DISCUSSION AND ANALYSIS



Rate/Volume Analysis

The following table presents, on a tax-equivalent basis, the relative
contribution of changes in volumes and changes in rates to changes in net
interest income for the periods indicated. The change in interest not solely due
to changes in volume or rate has been allocated in proportion to the absolute
dollar amounts of the change in each (in thousands):



                                             Change from 2012 to 2011                  Change from 2011 to 2010
Increase (decrease) in:                 Volume         Rate         Total         Volume         Rate         Total
Interest income:
Federal funds sold and other
interest-earning deposits              $     -       $     -       $     -       $     (5 )    $     (5 )    $    (10 )
Investment securities:
Taxable                                    (487 )      (1,496 )      (1,983 )        (772 )      (2,144 )      (2,916 )
Tax-exempt                                1,422          (786 )         636         1,418          (944 )         474

Total investment securities                 935        (2,282 )      (1,347 )         646        (3,088 )      (2,442 )
Loans:
Commercial business                       1,239          (287 )         952           452           (80 )         372
Commercial mortgage                       2,041        (1,075 )         966         1,905        (1,078 )         827
Residential mortgage                        308          (539 )        (231 )        (980 )        (309 )      (1,289 )
Home equity                               1,763          (351 )       1,412           636          (288 )         348
Consumer indirect                         4,879        (4,057 )         822         3,829        (2,659 )       1,170
Other consumer                               39            58            97          (237 )          37          (200 )

Total loans                              10,269        (6,251 )       4,018         5,605        (4,377 )       1,228

Total interest income                    11,204        (8,533 )       2,671         6,246        (7,470 )      (1,224 )

Interest expense:
Deposits:
Interest-bearing demand                      60           (76 )         (16 )           1           (92 )         (91 )
Savings and money market                    271          (329 )         (58 )          93          (170 )         (77 )
Certificates of deposit                    (255 )      (2,643 )      (2,898 )        (245 )      (3,006 )      (3,251 )

Total interest-bearing deposits              76        (3,048 )      (2,972 )        (151 )      (3,268 )      (3,419 )
. . .
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