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CBU > SEC Filings for CBU > Form 10-Q on 8-Nov-2013All Recent SEC Filings

Show all filings for COMMUNITY BANK SYSTEM, INC. | Request a Trial to NEW EDGAR Online Pro

Form 10-Q for COMMUNITY BANK SYSTEM, INC.


8-Nov-2013

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, 2013 and 2012, although in some circumstances the second quarter of 2013 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 27. 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 2013, "third quarter" refers to the quarter ended September 30, 2013 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 45.

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 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, purchase 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 purchase discounts for loans evaluated collectively for impairment. For loans individually evaluated for impairment, a provision is recorded 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 and evaluation of collateral values 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 the amount and timing of future cash flows, prepayment speed assumptions, expected interest rate curve, and the selection of discount rates that appropriately reflect market and credit risks. 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 55-60 of the most recent Form 10-K (fiscal year ended December 31, 2012) filed with the Securities and Exchange Commission on March 1, 2013.

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"). During the third quarter, the Company rebranded its First Liberty Bank and Trust operations in Pennsylvania to Community Bank, N.A. This provided a uniform brand identification to customers across the Bank's footprint and allows for greater efficiency in marketing efforts at a time when the Bank has announced the acquisition of eight new branch-banking locations in Northeast Pennsylvania from Bank of America, N.A.

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 profitable loan and deposit volume 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 to improve efficiencies.

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 July 20, 2012, the Bank, 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 consisted primarily of core deposits (checking, savings and money market accounts) and the purchased loans consisted 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 consisted primarily of core deposits (checking, savings and money market accounts) and the purchased loans consisted 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 support of the HSBC and First Niagara branch acquisitions, the Company completed a public common stock offering in late January 2012 and raised $57.5 million through the issuance of 2.13 million shares. The net proceeds of the offering were approximately $54.9 million.

Third quarter and September year-to-date net income of $22.0 million and $63.4 million, respectively, were $3.6 million or 20% and $5.1 million or 8.7% higher than the respective prior year periods. Earnings per share were $0.54 and $1.56 for the three and nine months ended September 30, 2013, $0.08 and $0.10 higher than the third quarter and first nine months of 2012. Contributing to the higher YTD net income was higher net interest income that resulted from earning asset growth, generated organically and from the HSBC and First Niagara branch acquisitions, partially offset by a lower net interest margin. Additionally, the higher net income was a result of a lower provision for loan losses and growth of noninterest income. Noninterest income was up due to incremental deposit service fees, including those from the HSBC and First Niagara acquisitions, higher debit card-related revenue, higher employee benefits administration and consulting revenues, and solid revenue growth from the wealth management businesses, which benefitted from favorable market conditions and organic growth. These were offset by higher operating expenses due in large part to the additional operating costs from the HSBC and First Niagara acquisitions, as well as a slightly higher effective income tax rate, partially offset by lower non-recurring acquisition expenses.

Asset quality in the third quarter of 2013 remained stable and favorable in comparison to averages for peer financial organizations. Third quarter nonperforming loan and delinquency loan ratios were lower than those experienced in the last eight quarters. The current quarter provision for loan losses was lower than the third quarter of 2012 as a result of these favorable asset quality metrics. The loan net charge-off ratio for the third quarter of 2013 was higher than the second quarter of 2013, but was lower than the average net charge-off ratio for the last eight quarters. The Company generated year-over-year average loan growth due to the HSBC and First Niagara branch acquisitions, as well as organic loan growth. During the first half of 2013, the Company initiated a balance sheet restructuring program through the sale of certain longer duration investment securities and the retirement of a portion of the Company's existing FHLB borrowings. Average deposits in the third quarter of 2013 were higher than the third quarter of 2012 and the fourth quarter of 2012, driven by the HSBC and First Niagara acquisitions and organic deposit growth.

In July 2013, the Company entered into a purchase and assumption agreement to acquire eight branch-banking locations across its Northeast Pennsylvania markets from Bank of America, N.A. ("B of A"). Under the terms of the agreement, Community Bank will acquire approximately $340 million in deposits at a deposit premium of approximately 2.4%. The transaction is expected to close during the fourth quarter of 2013.

Net Income and Profitability

As shown in Table 1, net income for the third quarter and September YTD of $22.0 million and $63.4 million, respectively, increased $3.6 million or 20% and $5.1 million or 8.7%, respectively, as compared to the three and nine month periods of 2012. Earnings per share for the third quarter of $0.54 was $0.08 higher than the EPS generated in the third quarter of 2012 and earnings per share for the first nine months of 2013 increased $0.10 from the amount earned in the first nine months of 2012. Included in the 2012 results were $4.8 million or $0.08 earnings per share and $5.2 million or $0.09 earnings per share of acquisition expenses for the three and nine months ended September 30, 2012, respectively.

As reflected in Table 1, third quarter and September YTD net interest income of $60.6 million and $177.5 million, respectively, was up $1.8 million and $7.0 million from the comparable prior year periods. The improvement resulted from a higher net interest margin, primarily due to the balance sheet restructuring activities completed in the first six months of 2013, along with a year-to-date increase in interest-earning assets, primarily due to organic loan growth as well as the HSBC and First Niagara branch acquisitions in the third quarter of 2012. The provision for loan losses decreased $0.6 million and $1.6 million as compared to the third quarter and first nine months of 2012, respectively, reflective of lower net charge-off levels and the continuation of generally stable and favorable asset quality metrics.

Third quarter and year-to-date noninterest income was $27.6 million and $80.5 million, respectively, up $2.0 million or 7.9% from the third quarter of 2012 and up $7.8 million or 10.7% from the first nine months of 2012, primarily due to the HSBC and First Niagara branch acquisitions and organic growth across the franchise. Contributing to the increase was a $4.2 million increase in revenue generated during the first nine months of 2013 from the Company's benefit trust administration and wealth management groups, principally resulting from new customer additions and favorable market conditions. During the first half of 2013, the Company sold $648.7 million of investment securities, realizing $63.8 million of gains and utilized the proceeds to retire $501.6 million of FHLB borrowings with $63.5 million of early extinguishment costs.

Operating expenses of $55.0 million and $164.0 million for the third quarter and September YTD periods, respectively, decreased $1.0 million or 1.9% as compared to the third quarter of 2012, and increased $9.1 million or 5.9% from the first nine months of 2012. Excluding non-recurring acquisition expenses, operating expenses increased $3.7 million or 7.2% and $14.3 million or 9.5% for the quarter and YTD periods, respectively, as compared to the comparable periods of 2012, reflective of additional operating costs associated with the HSBC and First Niagara branch acquisitions completed in the third quarter of 2012.


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)                                2013      2012        2013      2012
     Net interest income                  $60,601   $58,775    $177,458 $170,455
     Provision for loan losses              2,093     2,643       4,807    6,442
     Noninterest income                    27,594    25,568      80,502   72,732
     Gain on sales of investment
     securities                                 0       291      63,799      291
     Loss on debt extinguishments               0         0    (63,500)        0
     Noninterest expenses                  55,044    56,085     163,972  154,858
     Income before taxes                   31,058    25,906      89,480   82,178
     Income taxes                           9,069     7,539      26,128   23,914
     Net income                           $21,989   $18,367     $63,352  $58,264

     Diluted weighted average common
     shares outstanding                    40,850    40,139      40,587   39,842
     Diluted earnings per share             $0.54     $0.46       $1.56    $1.46

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 2013 was $64.3 million, a $1.2 million or 1.9% increase from the same period last year, resulting from a $228.3 million decrease in average interest-bearing liabilities and a 15-basis point increase in the net interest margin, more than offsetting the $156.6 million decrease in third quarter interest-earning assets versus the prior year. As reflected in Table 3, the third quarter rate decrease on interest bearing liabilities and the volume decrease on interest-bearing liabilities had a $7.1 million favorable impact on net interest income while the volume decrease from interest-bearing assets combined with the rate decrease on interest-bearing assets had a $5.9 million unfavorable impact on net interest income. September YTD net interest income of $188.9 million, as reflected in table 2b, increased $5.7 million or 3.1% from the year-earlier period, a result of a $155.9 million increase in interest-earning assets and a three basis point increase in net interest margin. The increase in interest-earning assets, the small decrease in interest bearing liabilities and the lower rate on interest-bearing liabilities had a $23.7 million favorable impact that was partially offset by an $18.0 million unfavorable impact from the decrease in the yield on interest-bearing assets.

Average investments, including cash equivalents, for the third quarter and YTD periods were $434.3 million and $201.1 million, lower than the comparable periods of 2012, respectively, reflective of the balance sheet restructuring program completed in the first half of 2013. During the first six months of 2013, the Company sold $648.7 million of U.S. Treasury and agency securities, realizing $63.8 million of gains. The proceeds were utilized to retire $501.6 million of higher rate FHLB borrowings with $63.5 million of associated early extinguishments costs. These actions enhanced the Company's regulatory capital position and reduced the expected duration of the investment portfolio, while positively impacting expected future net interest income generation. During the third quarter of 2013, the Company purchased $200 million of U.S. Treasury securities in anticipation of the excess funding expected from the pending branch acquisition in the fourth quarter of 2013.

Third quarter and September YTD average loan balances increased $277.6 million and $357.0 million, respectively, as compared to the same periods of 2012, due to the approximately $123 million of acquired HSBC and First Niagara loans in the third quarter of 2012 and strong organic loan growth, principally in the consumer mortgage and indirect portfolios. In comparison to the prior year, total average interest-bearing deposits were up $101.4 million or 2.3% and $430.9 million or 10.4% for the quarter and YTD periods, respectively, a result of the HSBC and First Niagara branch acquisitions and organic growth during the first half of 2013. Quarterly and YTD average borrowings decreased $329.7 million and $442.5 million, respectively, reflective of the restructuring program in the first half of 2013 which retired $501.6 million of FHLB borrowings, partially offset by the initiative in the third quarter of 2013 to use short-term borrowings to pre-invest a portion of the liquidity expected from the branch acquisitions in the fourth quarter of 2013.


The net interest margin of 3.94% for the third quarter increased 15 basis points as compared to the third quarter of 2012. The rates on interest-bearing liabilities decreased 51 basis points, due primarily to the balance sheet restructuring previously discussed, as well as the continued decline in rates paid on interest-bearing deposits. Incremental yield accretion from the favorable disposition of an acquired impaired commercial relationship increased net interest margin for the third quarter of 2013 by three basis points. This was partially offset by a 26-basis point reduction in interest-earning asset yields, reflective of lower yields on loans and investment securities versus last year's third quarter. The net interest margin of 3.93% for the first nine months of 2013 increased three basis points from the comparable period of 2012. The yield on interest-earning assets declined 37 basis points, and the rates on interest-bearing liabilities declined 48 basis points for the first nine months of 2013 as compared to the first nine months of 2012. Year-to-date net interest margin was positively impacted by the balance sheet restructuring activities in the first half of 2013. Proactive management of deposit funding costs continue to have a positive effect on net interest margin, but have not been able to fully offset declining asset yields.

The decrease in the earning-asset yield was partially attributable to a 15-basis point and a 24-basis point decrease in investment yield, including cash equivalents, for the third quarter and YTD periods, respectively, as compared to the prior year periods, due to the sale and maturing of higher rate investments being replaced with lower rate investments and cash equivalents. Additionally, contributing to the decrease in earning-asset yield for the quarter was a 49-basis point and 57-basis point decline in the loan yield as compared to the third quarter and YTD periods of 2012, respectively, a result of lower yields on fixed-rate new loan volume due to the decline in interest rates to levels below those prevalent in prior periods and certain existing adjustable and fixed-rate loans repricing downward.

The third quarter cost of funds decreased versus the prior year quarter due to an 18-basis point decrease in interest-bearing deposit rates, and a higher proportion of funding being supplied from low and noninterest bearing deposits, as well as a 154-basis point decrease in the average interest rate paid on external borrowings as a result of the balance sheet restructuring during the first half of 2013. The cost of funds for the first nine months of 2013 decreased versus the prior year period due to a 21-basis point decrease in interest-bearing deposit rates, and a higher proportion of funding being supplied from low and noninterest bearing deposits, as well as a 30-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 2012 and the first nine months of 2013 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.


Table 2 below sets forth information related to average interest-earning assets and interest-bearing liabilities and their associated yields and rates for the periods indicated. Interest income and yields are on a fully tax-equivalent basis ("FTE") using a marginal income tax rate of 38.79% in both 2013 and 2012. Average balances are computed by accumulating the daily ending balances in a period and dividing by the number of days in that period. Loan yields and amounts earned include loan fees, deferred loan costs and accretion of acquired loan marks. Average loan balances include nonaccrual loans and loans held for sale.

Table 2a: Quarterly Average Balance Sheet

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