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SUBK > SEC Filings for SUBK > Form 10-K on 4-Mar-2014All Recent SEC Filings

Show all filings for SUFFOLK BANCORP

Form 10-K for SUFFOLK BANCORP


4-Mar-2014

Annual Report


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

Safe Harbor Statement Pursuant to the Private Securities Litigation Reform Act of 1995

Certain statements contained in this discussion are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These can include remarks about the Company, the banking industry, the economy in general, expectations of the business environment in which the Company operates, projections of future performance, and potential future credit experience. These remarks are based upon current management expectations, and may, therefore, involve risks and uncertainties that cannot be predicted or quantified and are beyond the Company's control and are subject to a variety of uncertainties that could cause future results to vary materially from the Company's historical performance, or from current expectations. These remarks may be identified by such forward-looking statements as "should," "expect," "believe," "view," "opportunity," "allow," "continues," "reflects," "typically," "usually," "anticipate," or similar statements or variations of such terms. Factors that could affect the Company include particularly, but are not limited to: increased capital requirements mandated by the Company's regulators; the Company's ability to raise capital; competitive factors, including price competition; changes in interest rates; increases or decreases in retail and commercial economic activity in the Company's market area; variations in the ability and propensity of consumers and businesses to borrow, repay, or deposit money, or to use other banking and financial services; results of regulatory examinations or changes in law, regulations or regulatory practices; the Company's ability to attract and retain key management and staff; any failure by the Company to maintain effective internal control over financial reporting; larger-than-expected losses from the sale of assets; the potential that net charge-offs are higher than expected or for further increases in our provision for loan losses; and a failure by the Company to meet the deadlines under SEC rules for filing its periodic reports (or any permitted extension thereof). Further, it could take the Company longer than anticipated to implement its strategic plans to increase revenue and manage non-interest expense, or it may not be possible to implement those plans at all. Finally, new and unanticipated legislation, regulation, or accounting standards may require the Company to change its practices in ways that materially change the results of operations. We have no obligation to update any forward-looking statements to reflect events or circumstances after the date of this document. For more information, see the risk factors described in this Annual Report on Form 10-K and other filings with the Securities and Exchange Commission.

Non-GAAP Disclosure

This discussion includes a non-GAAP financial measure of the Company's tangible common equity ("TCE") ratio. A non-GAAP financial measure is a numerical measure of historical or future financial performance, financial position or cash flows that excludes or includes amounts that are required to be disclosed in the most directly comparable measure calculated and presented in accordance with generally accepted accounting principles in the United States ("U.S. GAAP"). The Company believes that this non-GAAP financial measure provides both management and investors a more complete understanding of the underlying operational results and trends and the Company's marketplace performance. The presentation of this additional information is not meant to be considered in isolation or as a substitute for the numbers prepared in accordance with U.S. GAAP and may not be comparable to similarly titled measures used by other financial institutions.

Executive Summary

The Company is a one-bank holding company incorporated in 1985. The Company operates as the parent for its wholly owned subsidiary, the Bank, a national bank founded in 1890. The income of the Company is primarily derived through the operations of the Bank and the REIT.

The Bank is a full-service bank serving the needs of its local residents through 25 branches, exclusive of four branches scheduled to be closed in the first quarter of 2014, in Nassau and Suffolk Counties, New York and loan production offices in Garden City and Melville, New York. The Bank offers a full line of domestic commercial and retail banking services and wealth management services. The Bank's primary lending area includes all of Suffolk County and the adjacent markets of Nassau County and New York City. The Bank makes commercial real estate floating and fixed rate loans, commercial and industrial loans to manufacturers, wholesalers, distributors, developers/contractors and retailers and agricultural loans. The Bank also makes loans secured by residential mortgages, and both fixed and floating rate second mortgage loans with a variety of plans for repayment. Real estate construction loans are also offered.

In order to expand the Company geographically into western Suffolk and Nassau Counties and to diversify the lending business of the Company, loan production offices were opened in Garden City and Melville in 2013 and 2012, respectively. As part of our strategy to move westward, the loan production office in Garden City serves the major business markets in central and western Long Island. Seasoned banking professionals have joined the Company to augment both interest and fee income through the origination of commercial and industrial loans, the generation of high quality multifamily and jumbo mortgages to be retained in the portfolio and conforming mortgages for sale in secondary markets. The Bank finances most of its activities with deposits, including demand, saving, N.O.W. and money market deposits, as well as time deposits. It may also rely on other sources of funds, including inter-bank overnight loans. The Company's chief competition includes local banks within its market area, as well as New York City money center banks and regional banks.


Table of Contents
Overview of Results of Operations and Financial Condition for the Year Ended December 31, 2013

At December 31, 2013, the Company, on a consolidated basis, had total assets of $1.7 billion, total deposits of $1.5 billion and stockholders' equity of $167 million. The Company recorded net income of $12.7 million, or $1.10 per diluted common share, in 2013, compared with a net loss of $1.7 million, or ($0.17) per diluted common share, in 2012. The increase in 2013 net income primarily reflects an $8.6 million improvement in non-interest income, a $7.2 million decrease in the provision for loan losses and a $3.0 million reduction in total operating expenses in 2013 versus 2012. Somewhat offsetting these positive factors was a $4.4 million increase in income tax expense in 2013.

The $8.6 million increase in non-interest income resulted from improvements in several categories, including a $755 thousand increase in income from bank owned life insurance, a $7.8 million gain on the sale of Visa, Inc.'s ("Visa") Class B shares in 2013 and a $620 thousand increase in the net gain on the sale of securities available for sale. The gain on the sale of the Visa shares and the increase in the net gain on the sale of securities available for sale should not be considered indicative of future results.

Total operating expenses declined by $3.0 million or 4.9% to $58.6 million in 2013 from $61.6 million in 2012, primarily due to reductions in employee compensation and benefits ($2.8 million), other operating expenses ($3.4 million), accounting and audit fees ($553 thousand) and consulting and professional services ($463 thousand). Partially offsetting these improvements was an increase in occupancy expense ($687 thousand), which includes $507 thousand in accelerated depreciation related to two branches closed in 2013 and four branches scheduled to be closed in the first quarter of 2014. Additional one-time branch closing costs of $2.1 million and $231 thousand were recorded in branch consolidation costs and equipment expense, respectively, in 2013.

Net interest income was flat in 2013 versus 2012 as growth in average loans outstanding of $46 million and investment securities were offset by a 28 basis point narrowing of the Company's net interest margin to 3.91% in 2013 from 4.19% a year ago. Generally, the Company's net interest margin is impacted not only by the average balance and mix of the Company's interest-earning assets and interest-bearing liabilities, but also by the level of market interest rates. These rates are significantly influenced by the actions of the Federal Open Market Committee of the Board of Governors of the Federal Reserve System ("FOMC") policy makers. The Company's average cost of funds declined by seven basis points to 0.20% in 2013 versus 0.27% a year ago.

The Company recorded income tax expense of $3.7 million in 2013 resulting in an effective tax rate of 22.6% versus an income tax benefit of $714 thousand in 2012.

The Company's return on average assets and return on average common stockholders' equity were 0.76% and 7.78%, respectively, for 2013 versus (0.11%) and (1.22%), respectively, for 2012.

The Company experienced an overall increase in the total loan portfolio of $288 million, from $781 million at December 31, 2012 to $1.1 billion at December 31, 2013, a 36.9% year-over-year growth rate. The geographic and product diversification strategies implemented in our lending businesses are working well. Each of our lending businesses, commercial, multifamily and residential, are contributing to this momentum. The Company is increasing market share by preserving our eastern Suffolk lending franchise while simultaneously expanding west.

As part of the Bank's desire to diversify its portfolio on both a product and geographic basis, an initiative aimed at the development of a multifamily mortgage portfolio has given the Bank more exposure to a favorable geographic area that had previously been a minimal segment of the portfolio. This effort is primarily concentrated in the five boroughs of New York City and targets rent-controlled or rent-stabilized buildings. It has been well-established that the incidence of loss in multifamily loan transactions is lower than almost all other loan categories as their performance over time has shown limited defaults, even during the worst period of the recent recession. The property value for these buildings is directly attributable to the cash flow from rents and the rate of return investors need on their invested capital. Rental rates are a function of demand for apartments and the vacancy rates in New York City (where the majority of the Bank's assets are located) are currently at historical lows. Average rental rates for an apartment in Manhattan are above $3,000/month for the first time ever. New apartments are coming to market but are being absorbed rapidly.

The Bank has dedicated credit analysts/underwriters and a portfolio manager for the multifamily product line that have extensive experience in this type of lending. The portfolio of multifamily loans continues to perform satisfactorily with no delinquencies reported and risk ratings solidly in the pass range. At December 31, 2013, the Company's multifamily loans totaled $185 million, and represented 17.3% of the Company's total loans, compared to only $9 million or 1.2% at December 31, 2012.

The Company's core deposit franchise continues to be among the best in the region. Core deposits, consisting of demand, N.O.W., saving and money market deposits, totaled $1.3 billion at December 31, 2013, representing 85% of total deposits at that date. Demand deposits totaled $629 million at December 31, 2013 and represented 42% of total deposits at that date. The deposit product mix continues to be a primary strength of the Company and resulted in an average cost of funds of 20 basis points in 2013.


Table of Contents
On the expense side, management continues to work diligently to balance the increased investments needed to grow the lending businesses with offsetting operating expense reductions in other areas, and believe we will see continued improvement as we move forward. Several of the major projects previously announced on the expense reduction side are performing better than expected. During 2013 we announced the phased-in closing of six branches in Suffolk County that, once fully implemented, will reduce annual operating expenses by an estimated $2.4 million. Further, the assumptions used in deciding to close these branches relating to deposit runoff and expense savings are proving to be conservative.

Overview of Asset Quality for the Year Ended December 31, 2013

Credit performance strengthened in 2013 as important credit metrics showed improvement. This improvement is largely attributable to the successful conclusion of several negotiated workout transactions, the upgrading of several large relationships to accrual status based on sustained improvement in financial performance and the successful completion of an $8 million sale of both non-accrual and classified loans during the fourth quarter of 2013.

Non-accrual loans, excluding loans categorized as held-for-sale, totaled $15 million or 1.42% of total loans outstanding at December 31, 2013 versus $16 million or 2.10% of loans outstanding at December 31, 2012. At December 31, 2013, approximately 71% of the Company's non-accrual loans were current with respect to principal and interest payments. The allowance for loan losses as a percentage of total non-accrual loans amounted to 114% at December 31, 2013 versus 108% at December 31, 2012. Total accruing loans delinquent 30 days or more amounted to $3 million or 0.33% of loans outstanding at December 31, 2013 versus $14 million or 1.81% of loans outstanding at December 31, 2012.

Total criticized and classified loans were $43 million at December 31, 2013 versus $99 million at December 31, 2012. Criticized loans are those loans that require some degree of heightened monitoring but are not classified. Classified loans were $37 million at December 31, 2013 as compared to $54 million at December 31, 2012. The allowance for loan losses as a percentage of total classified loans was 47% and 33%, respectively, at the same dates.

At December 31, 2013, the Company had $16 million in troubled debt restructurings ("TDRs"), primarily consisting of commercial and industrial loans, commercial real estate loans and residential mortgages totaling $6 million, $6 million and $4 million, respectively. The Company had TDRs amounting to $17 million at December 31, 2012.

At December 31, 2013, the Company's allowance for loan losses amounted to $17 million or 1.62% of period-end loans outstanding. The allowance as a percentage of loans outstanding was 2.28% at December 31, 2012.

Net loan charge-offs of $1.8 million, inclusive of a charge-off of $1.5 million incurred in connection with the fourth quarter 2013 loan sale mentioned above, were recorded in 2013 versus $30.7 million in 2012. As a percentage of average total loans outstanding, these net amounts represented 0.20% for 2013 and 3.57% for 2012.

The Company held no OREO at December 31, 2013. The Company held OREO amounting to $1.6 million at December 31, 2012.

The Company's investment portfolio does not contain any mortgage obligations with underlying collateral that could be classified as sub-prime.

Critical Accounting Policies, Judgments and Estimates

The Company's accounting and reporting policies conform to U.S. GAAP and general practices within the banking industry. The preparation of the financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates.

Allowance for Loan Losses - In management's opinion, one of the most critical accounting policies impacting the Company's financial statements is the evaluation of the allowance for loan losses. The allowance for loan losses is a valuation allowance for probable incurred losses, increased by the provision for loan losses and recoveries, and decreased by loan charge-offs. For all classes of loans, when a loan, in full or in part, is deemed uncollectible, it is charged against the allowance for loan losses. This happens when the loan is past due and the borrower has not shown the ability or intent to make the loan current, or the borrower does not have sufficient assets to pay the debt, or the value of the collateral is less than the balance of the loan and is not considered likely to improve soon. The allowance for loan losses is determined by a continuous analysis of the loan portfolio. Such analysis includes changes in the size and composition of the portfolio, the Company's own historical loan losses, industry-wide losses, current and anticipated economic trends, and details about individual loans. It also includes estimates of the actual value of collateral, other possible sources of repayment and estimates that are susceptible to significant changes due to changes in appraisal values of collateral, national and regional economic conditions and other relevant factors. All non-accrual loans over $250 thousand in the commercial and industrial, commercial real estate and real estate construction loan classes and all TDRs are evaluated individually for impairment. Management will use judgment to determine if there are other loans outside of these two categories that fit the definition of impaired. All other loans are generally evaluated as homogeneous pools with similar risk characteristics. In assessing the adequacy of the allowance for loan losses, management reviews the loan portfolio by separate classes that have similar risk and collateral characteristics; e.g., commercial and industrial, commercial real estate, multifamily, real estate construction, residential mortgages, home equity and consumer loans.


Table of Contents
The allowance for loan losses consists of specific and general components. The specific component relates to loans that are individually classified as impaired. Specific reserves are established based on an analysis of the most probable sources of repayment and liquidation of collateral. Impaired loans that are collateral dependent are reviewed based on their collateral and the estimated time required to recover the Company's investment in the loans, as well as the cost of doing so, and the estimate of the recovery. Non-collateral dependent impaired loans are reviewed based on the present value of estimated future cash flows, including balloon payments, if any, using the loan's effective interest rate. While every impaired loan is evaluated individually, not every loan requires a specific reserve. Specific reserves fluctuate based on changes in the underlying loans, anticipated sources of repayment, and charge-offs. The general component covers non-impaired loans and is based on historical loss experience for each loan class from a rolling twelve quarter period and modifying those percentages, if necessary, after adjusting for current qualitative and environmental factors that reflect changes in the estimated collectability of the loan class not captured by historical loss data. These factors augment actual loss experience and help estimate the probability of loss within the loan portfolio based on emerging or inherent risk trends. These qualitative factors are applied as an adjustment to historical loss rates and require judgments that cannot be subjected to exact mathematical calculation. There are no formulas for translating them into a specific basis point adjustment of the Company's historical loss rate for a pool of loans having similar risk characteristics. These adjustments reflect management's overall estimate of the extent to which current losses on a pool of loans will differ from historical loss experience. These adjustments are subjective estimates and management reviews them on a quarterly basis. TDRs are also considered impaired with impairment generally measured at the present value of estimated future cash flows using the loan's effective interest rate at inception or using the fair value of collateral, less estimated costs to sell, if repayment is expected solely from the collateral.

Deferred Tax Assets and Liabilities - Deferred tax assets and liabilities are the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities, computed using enacted tax rates. Deferred tax assets are recognized if it is more likely than not that a future benefit will be realized. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. The realization of deferred tax assets (net of a recorded valuation allowance) is largely dependent upon future taxable income, future reversals of existing taxable temporary differences and the ability to carryback losses to available tax years. In assessing the need for a valuation allowance, the Company considers all relevant positive and negative evidence, including taxable income in carryback years, scheduled reversals of deferred tax liabilities, expected future taxable income and available tax planning strategies.

Other-Than-Temporary Impairment ("OTTI") of Investment Securities - Management evaluates securities for OTTI on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the statement of operations and 2) OTTI related to other factors, which is recognized in other comprehensive income
(loss). The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings.

Material Changes in Financial Condition

Total assets of the Company were $1.7 billion at December 31, 2013. When compared to December 31, 2012, total assets increased by $77 million. This change largely reflects increases in loans, bank owned life insurance and interest-bearing time deposits in other banks of $288 million, $39 million and $10 million, respectively, partially offset by a decline in cash and cash equivalents of $253 million as we continue our redeployment of lower-yielding overnight interest-bearing deposits into higher yielding assets. Total loans were $1.1 billion at December 31, 2013 as compared to $781 million at December 31, 2012. Total investment securities were $412 million at December 31, 2013 and $410 million at December 31, 2012.

The increase in the loan portfolio largely reflects growth of multifamily and commercial real estate loans of $175 million and $109 million, respectively, during 2013. The increase in the investment portfolio largely reflects purchases of U.S. Government agency securities and mortgage-backed securities of U.S. Government-sponsored enterprises of $62 million and $44 million, respectively, during 2013. These were partially offset by sales and principal paydowns of collateralized mortgage obligations ("CMOs") of U.S. Government-sponsored enterprises totaling $61 million and calls of U.S. Government agency securities of $18 million during 2013. Higher interest rates in 2013 negatively impacted the market value of the Company's available for sale investment portfolio by approximately $23 million at December 31, 2013 when compared to December 31, 2012.


Table of Contents
At December 31, 2013, total deposits were $1.5 billion, an increase of $79 million when compared to December 31, 2012. This increase was primarily due to growth in saving, N.O.W. and money market deposits of $84 million coupled with higher demand deposit balances of $13 million. These were partially offset by decreases in higher-cost time certificates of $100,000 or more and other time deposits of $7 million and $11 million, respectively. Core deposit balances, which consist of demand, saving, N.O.W. and money market deposits, represented 85% and 83% of total deposits at December 31, 2013 and December 31, 2012, respectively. Demand deposit balances represented 42% of total deposits at December 31, 2013 versus 43% at December 31, 2012. The Company had no borrowed funds outstanding at either December 31, 2013 or December 31, 2012.

Material Changes in Results of Operations

2013 versus 2012

The Company recorded net income of $12.7 million for 2013 versus a net loss of $1.7 million in 2012. The increase in 2013 net income primarily reflects an $8.6 million improvement in non-interest income, a $7.2 million decrease in the provision for loan losses and a $3.0 million reduction in total operating expenses in 2013 versus 2012. Somewhat offsetting these positive factors was a $4.4 million increase in income tax expense in 2013.

Net interest income was flat in 2013 versus 2012 as growth in average investment securities and loans outstanding of $93 million and $46 million, respectively, were offset by a 28 basis point narrowing of the Company's net interest margin to 3.91% in 2013 from 4.19% a year ago. The Company's average cost of funds declined by seven basis points to 0.20% in 2013 versus 0.27% a year ago.

The Company's average total interest-earning asset yield for the year ended December 31, 2013 was 4.10%, down 35 basis points from the comparable 2012 period principally due to an 89 basis point reduction in the average yield on the Company's investment securities portfolio to 3.72% in 2013 from 4.61% in 2012. This is largely a result of principal paydowns on CMOs of U.S. Government-sponsored enterprises and calls of U.S. Government agency securities, as these securities had higher yields than those of the U.S. Government agency securities and mortgage-backed securities of U.S. Government-sponsored enterprises subsequently purchased. In addition, the average yield on the Company's loans outstanding declined 43 basis points to 5.16% for the year ended December 31, 2013 from 5.59% for the same period in 2012. The lower yields reflect the lower rate environment that has been prevalent.

The Company's total cost of funds declined by seven basis points to 0.20% for 2013 versus 0.27% in 2012. The Company's lower funding cost resulted largely from average core deposits of $1.2 billion for the year ended December 31, 2013, with average demand deposits representing 41% of average total deposits. The average cost of time deposits declined 27 basis points to 0.72% in 2013 compared to 2012. The Company also experienced a $13 million decrease in the average balance of time deposits for the year ended December 31, 2013 versus the same period in 2012. (See also Distribution of Assets, Liabilities and Stockholders' Equity: Net Interest Income and Rates and Analysis of Changes in Net Interest Income contained herein.)

The Company recorded a $1.3 million provision for loan losses for the year ended December 31, 2013 as compared to $8.5 million for the comparable 2012 period. The $1.3 million provision for loan losses recorded in 2013 was due principally to the impact of a charge-off of $1.5 million incurred in connection with the loan sale completed in the fourth quarter of 2013 and should not be considered indicative of future results.

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