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CBU > SEC Filings for CBU > Form 10-K on 3-Mar-2014All Recent SEC Filings

Show all filings for COMMUNITY BANK SYSTEM, INC.

Form 10-K for COMMUNITY BANK SYSTEM, INC.


3-Mar-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations

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 the Company for the past two years, although in some circumstances a period longer than two years is covered in order to comply with SEC disclosure requirements or to more fully explain long-term trends. The following discussion and analysis should be read in conjunction with the Selected Consolidated Financial Information on page 21 and the Company's Consolidated Financial Statements and related notes that appear on pages 51 through 92. All references in the discussion to the financial condition and results of operations are to the consolidated position and results of the Company and its subsidiaries taken as a whole.

Unless otherwise noted, all earnings per share ("EPS") figures disclosed in the MD&A refer to diluted EPS; interest income, net interest income and net interest margin are presented on a fully tax-equivalent ("FTE") basis. The term "this year" and equivalent terms refer to results in calendar year 2013, "last year" and equivalent terms refer to calendar year 2012, and all references to income statement results correspond to full-year activity unless otherwise noted.

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 contemplated by such forward-looking statements are set herein under the caption "Forward-Looking Statements" on page 48.

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 and liabilities and disclosures of revenues and expenses during the reporting period. Actual results could differ from these estimates. Management believes that the critical accounting estimates include:

Acquired loans - Acquired loans are initially recorded at their acquisition date fair values 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.

Acquired loans deemed impaired at acquisition are recorded in accordance with ASC 310-30, The excess of undiscounted cash flows expected at acquisition over the estimated fair value is referred to as the accretable discount. The difference between contractually required payments at acquisition and the undiscounted cash flows expected to be collected at acquisition is referred to as the non-accretable discount, which represents estimated future credit losses and other contractually required payments that the Company does not expect to collect. Subsequent decreases in expected cash flows are recognized as impairments through a charge to the provision for credit losses resulting in an increase in the allowance for loan losses. Subsequent improvements in expected cash flows result in a recovery of previously recorded allowance for loan losses or a reversal of a corresponding amount of the non-accretable discount, which the Company then reclassifies as an accretable discount that is recognized into interest income over the remaining life of the loans using the interest method.

For acquired loans that are not deemed impaired at acquisition, the difference between the acquisition date fair value and the outstanding balance represents the fair value adjustment for a loan and includes both credit and interest rate considerations. Subsequent to the purchase date, the methods used to estimate the allowance for loan losses for the acquired non-impaired loans is consistent with the policy described below. However, the Company compares the net realizable value of the loans to the carrying value, for loans collectively evaluated for impairment. The carrying value represents the net of the loan's unpaid principal balance and the remaining purchase discount (or premium) that has yet to be accreted into interest income. When the carrying value exceeds the net realizable value, an allowance for loan losses is recognized. 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 on impaired loans, appraisal values of underlying collateral for collateral dependent 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. 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 other-than-temporary impairment 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. During 2013, the Company sold certain held-to-maturity securities. As a result of the transaction, the Company will not be able to use the held-to-maturity classification for the foreseeable future.

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 the 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, required equity market premiums and company-specific risk indicators, all of which are susceptible to change based on changes in economic and market 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", starting on page 56.

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 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 non-interest income component of total revenue 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, performance of specific product lines, liquidity and interest rate sensitivity, enhancements to customer products and services, technology advancements, market share changes, peer comparisons, and the performance of acquisition and integration activities.

On April 8, 2011, the Company acquired The Wilber Corporation, the parent company of Wilber National Bank ("Wilber"), 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, $297 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, 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, the Bank completed its acquisition of 16 retail branches in central, northern and western New York from 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 (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 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.

On December 13, 2013, the Bank completed its acquisition of eight retail branch-banking locations across its Northeast Pennsylvania markets from B of A, acquiring approximately $0.9 million in loans and $303 million of deposits. The assumed deposits consist of $220 million of core deposits (checking, savings and money market accounts) and $83 million of time deposits. Under the terms of the purchase agreement, the Bank paid B of A a blended deposit premium of 2.4%, or approximately $7.3 million.

The Company reported net income for the year ended December 31, 2013 of $78.8 million or 2.3% above 2012's reported net income of $77.1 million. Earnings per share of $1.94 for the full year 2013 were $0.01 above the prior year level. The increase in net income was due to higher revenue from both increased net interest income and higher non-interest income, a lower provision for loan losses, and lower acquisition and litigation settlement expenses. Offsetting higher revenue was increased operating expenses and a net loss on the sale of investment securities and debt extinguishments. The 2013 results included $2.2 million or $0.4 per share of acquisition expenses related to the B of A branch acquisition and $6.6 million or $0.12 per share net loss on the sale of investment securities and debt extinguishments. This compares to the 2012 results which included $5.7 million or $0.10 per share of acquisition expenses related to the HSBC and First Niagara branch acquisitions and a $2.5 million or $0.05 per share litigation settlement charge. The loss in 2013 on the sale of investment securities and debt extinguishments resulted from the sale of the Company's portfolio of bank and insurance trust preferred collateralized debt obligation (CDO) securities in response to the uncertainties created by the initial announcement of the final rules implementing Section 619 of the Dodd-Frank Act, commonly known as the "Volcker Rule." The litigation settlement charge in 2012 pertains to the settlement of a class action lawsuit related to the processing of retail debit card transactions and its impact on overdraft fees.

Asset quality remained favorable in 2013, with lower year-end net loan charge-off ratios, non-performing loan ratios and loan delinquency ratios as compared to 2012. The Company experienced year-over-year growth in average interest-earning assets, reflective of strong organic loan growth and the HSBC and First Niagara branch acquisitions, completed in the third quarter of 2012, partially offset by a balance sheet restructuring in the first half of 2013 whereby certain longer duration investment securities were sold and a portion of the Company existing FHLB borrowings were retired. Average deposits increased in 2013 as compared to 2012, reflective of the HSBC and First Niagara branch acquisitions and organic growth in core deposits, offset by a reduction in time deposit balances. Average external borrowings in 2013 decreased from 2012 reflective of the Company's balance sheet restructuring program during the first half of the year.


During the fourth quarter, the Company announced that its subsidiary, Harbridge, reached an agreement to acquire a professional services practice from EBS-RMSCO, Inc., a subsidiary of The Lifetime Healthcare Companies. This professional services practice, which provides actuarial valuation and consulting services to clients who sponsor pension and post-retirement medical and welfare plans, enhances the Company's participation in the Western New York marketplace and is expected to add incremental revenue of approximately $1.2 million annually. The transaction was completed as planned on January 1, 2014.

Net Income and Profitability

Net income for 2013 was $78.8 million, an increase of $1.8 million, or 2.3%, from 2012's earnings of $77.1 million. Earnings per share for 2013 were $1.94, up $0.01 from 2012's earnings per share of $1.93. The 2013 results included $6.6 million or $0.12 per share net loss on the sale of certain investment securities and debt extinguishments resulting from the sale of the Company's portfolio of CDO securities in response to the uncertainties created by the December 2013 announcement of the final rules implementing the Volker Rule as well as $2.2 million or $0.04 per share of acquisition expenses related to the B of A branch acquisition in December 2013. The 2012 results included $5.7 million, or $0.10 per share, of acquisition expenses related principally to the HSBC and First Niagara branch acquisitions, which were completed in the third quarter of 2012, as well as a $2.5 million or $0.05 per share litigation settlement charge.

Net income for 2012 was $77.1 million, up $3.9 million or 5.4% from 2011's earnings of $73.1 million. Earnings per share for 2012 were $1.93, down 4.0% from 2011's earnings per share of $2.01. The 2012 results included $5.7 million, or $0.10 per share of acquisition expenses principally related to the Company's acquisition of the HSBC and First Niagara branch acquisitions, as well as a $2.5 million or $0.05 per share litigation settlement charge. The 2011 results included $4.8 million or $0.09 per share of acquisition expenses, associated with the Wilber acquisition completed in April 2011. Fully diluted shares outstanding increased 9.5% in 2012 over 2011, due principally to the full-year impact of the shares issued in the Wilber acquisition in early 2011 and the additional shares issued in early 2012 in support of the HSBC and First Niagara branch acquisitions.

Table 1: Condensed Income Statements

                                             Years Ended December 31,
     (000's omitted, except per
     share data)                     2013     2012     2011     2010     2009
     Net interest income           $238,094 $230,424 $209,413 $181,684 $165,500
     Provision for loan losses        7,992    9,108    4,736    7,205    9,790
     Gain on sales of investment
     securities, net                 80,768      291       30        0        7
     Loss on debt extinguishments    87,336        0       91        0        0
     Noninterest income             108,748   98,955   89,283   88,792   83,528
     Acquisition expenses,
     litigation settlement, and
     contract termination charges     2,181    8,247    4,831    1,365    1,621
     Other noninterest expenses     219,074  203,510  185,541  175,521  184,557
     Income before taxes            111,027  108,805  103,527   86,385   53,067
     Income taxes                    32,198   31,737   30,385   23,065   11,622
     Net income                     $78,829  $77,068  $73,142  $63,320  $41,445

     Diluted weighted average
     common shares outstanding       40,726   39,927   36,454   33,553   32,992
     Diluted earnings per share       $1.94    $1.93    $2.01    $1.89    $1.26

The Company operates in three business segments: banking, employee benefit services and wealth management services. Employee benefit services, which includes BPAS, Harbridge and HB&T provides employee benefit trust, collective investment fund, retirement plan administration, actuarial, VEBA/HRA and health and welfare consulting services. Employee benefit services provides services to 3,600 plan sponsors and 350,000 participants, holds $16 billion in assets under custody or administration, employs 235 professionals and operates out of nine offices located throughout the U.S. and Puerto Rico. Wealth management services activities include trust services provided by the personal trust unit within CBNA, investment and insurance products and services provided by CISI and CBNA Insurance and asset advisory services provided by Nottingham. The banking segment provides a wide array of lending and depository-related products and services to individuals, businesses, and municipal enterprises. In addition to general liquidity and intermediation services, the Banking segment provides treasury management solutions, capital financing products, and payment processing services. For additional financial information on the Company's segments, refer to Note T: Segment Information in the Notes to Consolidated Financial Statements.


The primary factors explaining 2013 earnings performance are discussed in the remaining sections of this document and are summarized as follows:

Banking
As shown in Table 1 above, net interest income increased $7.7 million, or 3.3%, due to a $94.9 million increase in average earning assets and a three-basis point increase in the net interest margin. Average loans grew $326.5 million due to strong organic growth in the consumer mortgage, consumer indirect, direct and business lending portfolios, as well as loans acquired in the HSBC and First Niagara branch transactions. Partially offsetting the strong loan growth was a decrease in the average book value of investments, including cash equivalents of $231.6 million or 8.4% due to the balance sheet restructuring in the first half of 2013 and the sale of the CDO portfolio in December in response to the final rules implementing the Volcker Rule. Average interest-bearing deposits increased $322.9 million or 7.6% due to the HSBC, First Niagara, and B of A branch acquisitions and organic core deposit growth. Average borrowings decreased $380.4 million or 40% as compared to the prior year, primarily due to the balance sheet restructuring in the first half of 2013.

The loan loss provision of $8.0 million decreased $1.1 million or 12%, from the prior year level. Net charge-offs of $6.6 million decreased by $1.9 million or 22% from 2012, lowering the net charge-off ratio (net charge-offs / total average loans) six basis points to 0.17% for the year. Nonperforming loans as a percentage of total loans and nonperforming assets as a percentage of loans and other real estate owned, decreased 21 and 22 basis points, respectively, as of December 31, 2013 as compared to December 31, 2012 and remain well below averages for the Company's peers. Additional information on trends and policy related to asset quality is provided in the asset quality section on pages 39 through 43.

Excluding gain on sale of investment securities and loss on debt extinguishments, banking noninterest income for 2013 of $54.6 million increased by $4.5 million, or 8.9%, from 2012's level due to both organic and acquired growth. Fees from banking services were $3.2 million or 7.3%, higher primarily due to higher debit card related revenue and the banking acquisitions completed over the last two years. Additionally, mortgage banking revenue increased $0.8 million in 2013 and included the recovery of $0.4 million of previously recorded valuation allowances related to mortgage servicing rights.

Total banking noninterest expenses, including acquisition expenses, litigation settlement, and contract termination charges increased $7.8 million, or 4.6%, in 2013 to $178.7 million, reflective of acquired and organic growth initiatives and investments in technology infrastructure over the past two years. Excluding acquisition expenses, litigation settlement, and contract termination charges, banking noninterest expenses increased $13.9 million or 8.5% due in most part to the three acquisitions completed over the last two years.

Employee Benefit Services
Employee benefit services revenue for 2013 of $39.5 million increased $2.8 million or 7.5% from the prior year level benefiting from new and expanded customer relationships, along with positive equity market influences.

The growth in employee benefit services noninterest expenses for 2013, which totaled $31.7 million, was limited to $0.3 million or 0.9% from the prior year level due to the successful integration of the CAI business acquired in late 2011 and the full year effect of certain operating efficiencies implemented during 2012.

Wealth Management Services
Wealth management services revenue for 2013 of $16.3 million increased $2.7 million or 20% from the prior year level due to positive market conditions, as well as additional resources and customers from both organic and acquired growth initiatives.

Wealth management services noninterest expenses of $12.5 million increased $1.5 million or 14% from the prior year level to support the acquired and organic revenue growth.


Selected Profitability and Other Measures

Return on average assets, return on average equity, dividend payout and equity
to asset ratios for the years indicated are as follows:

                            Table 2: Selected Ratios

                                                 2013   2012   2011
               Return on average assets          1.09%  1.08%  1.18%
               Return on average equity          9.04%  8.82% 10.36%
               Dividend payout ratio             56.0%  54.3%  49.3%

Average equity to average assets 12.11% 12.22% 11.42%

As displayed in Table 2 above, both the return on average assets and the return on average equity increased in 2013 as compared to 2012 and remained below the 2011 ratios. The increase in return on average assets was the result of net income increasing at a faster pace than average assets due in large part to noninterest income growth and a lower provision for loan losses. The increase in return on average equity was due to increased net income while average equity declined primarily due to the balance sheet restructure in the first half of the year and market-related changes in the unrealized gains and losses on the . . .

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