UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

|X|

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2004

Commission file number 0-15366

ALLIANCE FINANCIAL CORPORATION

(Exact name of Registrant as specified in its charter)

New York

16-1276885

(State or other jurisdiction of

(IRS Employer I.D. #)

incorporation or organization)

120 Madison Street, Syracuse, New York

13202

(Address of principal executive offices)

(Zip Code)

Registrant’s telephone number including area code: (315) 475-4478

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes     X    

No       

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
Yes    X     No        

The number of shares outstanding of the Registrant’s common stock on May 3, 2004: Common Stock, $1.00 Par Value – 3,565,963 shares.

CONTENTS

PART I.

FINANCIAL INFORMATION

Item 1.

Financial Statements (All Unaudited)

Consolidated Statements of Condition as of March 31, 2004 and December 31, 2003

Condensed Consolidated Statements of Income for the Three Months Ended March 31, 2004 and 2003

Consolidated Statement of Changes in Shareholders’ Equity for the Three Months Ended March 31, 2004

Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2004 and 2003

Notes to Consolidated Financial Statements

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

Item 4.

Controls and Procedures

PART II.

OTHER INFORMATION

Item 1.

Legal Proceedings

Item 2.

Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

Item 3.

Defaults Upon Senior Securities

Item 4.

Submission of Matters to a Vote of Security Holders

Item 5.

Other Information

Item 6.

Exhibits and Reports on Form 8-K

Signatures

PART I. FINANCIAL INFORMATION  

Item 1. Financial Statemetns

ALLIANCE FINANCIAL CORPORATION
Consolidated Statements of Condition
(Dollars in Thousands)

The accompanying notes are an integral part of the consolidated financial statements.

2

ALLIANCE FINANCIAL CORPORATION
Condensed Consolidated Statements of Income
(Unaudited)
(Dollars in Thousands, except per share data) 

The accompanying notes are an integral part of the consolidated financial statements.

3

ALLIANCE FINANCIAL CORPORATION
Consolidated Statements of Changes in Shareholders’ Equity
For the Three Months Ended March 31, 2004
(Unaudited)
(Dollars in Thousands)

The accompanying notes are an integral part of the financial statements.

4

ALLIANCE FINANCIAL CORPORATION
Consolidated Statements of Cash Flows
(Unaudited)
(Dollars in Thousands)

The accompanying notes are an integral part of the consolidated financial statements.

-5-

ALLIANCE FINANCIAL CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

A.

Basis of Presentation

The accompanying unaudited financial statements were prepared in accordance with the instructions for Form 10-Q and Regulation S-X and, therefore, do not include information for footnotes necessary for a complete presentation of financial condition, results of operations, and cash flows in conformity with generally accepted accounting principles. The following material under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” is written with the presumption that the users of the interim financial statements have read, or have access to, the latest audited financial statements and notes thereto of the Company, together with Management’s Discussion and Analysis of Financial Condition and Results of Operations as of December 31, 2003 and for the three-year period then ended, included in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2003. Accordingly, only material changes in the results of operations and financial condition are discussed in the remainder of Part I.

All adjustments that in the opinion of management are necessary for a fair presentation of the financial statements have been included in the results of operations for the three months ended March 31, 2004 and 2003.

B.

Earnings Per Share

Basic earnings per share have been computed by dividing net income by the weighted average number of common shares outstanding throughout the three months ended March 31, 2004 and 2003, using 3,556,666 and 3,467,528 weighted average common shares outstanding for the three months ended March 31, 2004 and 2003, respectively. Diluted earnings per share gives the effect to weighted average shares which would be outstanding assuming the exercise of options using the treasury stock method. Weighted average shares outstanding for the three months ended March 31, 2004 and 2003, adjusted for the effect of the assumed exercise of stock options, were 3,645,914 and 3,551,225 for the three months ended March 31, 2004 and 2003, respectively. There were no antidilutive shares as of March 31, 2004.

C.

Allowance for Loan and Lease Losses

The allowance for loan and lease losses represents management’s best estimate of probable loan and lease losses in the Company’s loan portfolio. Management’s quarterly evaluation of the allowance for loan and lease losses is a comprehensive analysis that builds a total reserve by evaluating the risks within each loan and lease type, or pool, of similar loans and leases. The Company uses a general allocation methodology for all residential and consumer loan pools. This methodology estimates a reserve for each pool based on the average loss rate for the time period that includes the current year and two full prior years. The average loss rate is adjusted to reflect the expected impact that current trends regarding loan growth, delinquency, losses, economic conditions, loan concentrations, policy changes, experience and ability of lending personnel, and current interest rates are likely to have. For commercial loan and lease pools, the Company establishes a specific reserve allocation for all loans and leases in excess of $150,000, which have been risk rated under the Company’s risk rating system as substandard, doubtful, or loss. The specific allocation is based on the most recent valuation of the loan or lease collateral and the customer’s ability to pay. For all other commercial loans and leases, the Company uses the general allocation methodology that establishes a reserve for each risk-rating category. The general allocation methodology for commercial loans and leases considers the same factors that are consideredwhen evaluating residential mortgage and consumer loan pools. The combination of using both the general and specific allocation methodologies reflects management’s best estimate of the probable loan and lease losses in the Company’s loan and lease portfolio.

-6-

A loan or lease is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan or lease agreement. The measurement of impaired loans and leases is generally discounted at the historical effective interest rate, except that all collateral-dependent loans and leases are measured for impairment based on fair value of the collateral.

D.

Stock Based Compensation

The Company’s stock-based compensation plan is accounted for based on the intrinsic value method set forth in Accounting Principles Board (APB) Opinion 25, Accounting for Stock Issued to Employees, and related interpretations. Compensation expense for employee stock options is generally not recognized at the time of the grant if the exercise price of the option equals or exceeds the fair value of the stock on the date of the grant. Compensation expense for restricted share awards is ratably recognized over the period of vesting, usually the restricted period, based on the fair value of the stock on the grant date. Stock options that have been granted by the Company vest based on a combination of years of service and the achievement of certain stock price targets.

The following table illustrates the effect on net income and earnings per share as if the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation, as amended, had been applied to the Company’s stock-based compensation plan:

For The Quarter Ended

March 31, 2004

March 31, 2003

$ 

1,894

$ 

1,690

(7

)

(280

)

$ 

1,887

$ 

1,410

$ 

0.53

$ 

0.49

0.53

0.41

0.52

0.48

0.52

0.40

-7-

The fair value of stock options granted was estimated at the date of grant using the Black-Scholes option pricing model. The Black-Scholes option pricing model was originally developed for use in estimating the fair value of traded options, which have different characteristics from the Company’s employee stock options. The model is also sensitive to changes in assumptions, which can materially affect the fair value estimate. Since changes in the subjective input assumptions can materially affect the fair value estimates, the existing model, in management’s opinion, does not necessarily provide a single reliable measure of the fair value of its stock options. In addition, the pro-forma effect on reported net income and earnings per share for the periods presented should not be considered necessarily representative of the pro forma effects on reported net income and earnings per share for future periods.

In December 2002, the FASB issued SFAS 148, Accounting for Stock-Based Compensation – Transition and Disclosure, which provides alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure provisions of FASB Statement No. 123 to require prominent disclosure about the effects on reported net income of an entity’s accounting policy decisions with respect to stock-based employee compensation. This statement also amends APB Opinion No. 28, Interim Financial Reporting, to require disclosure about those effects in interim financial information. The Company intends to continue to account for stock-based compensation in accordance with Accounting Principles Board (APB) Opinion 25, Accounting for Stock Issued to Employees.

E.

Post-Retirement Benefits

The Company provides post-retirement medical and life insurance benefits through an unfunded plan to qualifying employees. Benefits are available to full-time employees who have worked 15 years and attained age 55. Retirees and certain active employees with more than 20 years of service to the Company continue to receive benefits in accordance with plans that existed at First National Bank of Cortland and Oneida Valley National Bank, prior to the merger of the banks in 1999. The Company does not have a pension plan.

The components of the plan’s net periodic cost for the quarters ended March 31 is as follows:

-8-

Item 2.

Management’s Discussion and Analysis of Financial Condition and

Results of Operations

General

Throughout this analysis, the term “the Company” refers to the consolidated entity of Alliance Financial Corporation, its wholly-owned banking subsidiary, Alliance Bank, N.A. (the “Bank”), and the Bank’s subsidiaries, Alliance Preferred Funding Corp. and Alliance Leasing, Inc. The Company is a New York corporation, which was formed in November 1998 as a result of the merger of Cortland First Financial Corporation and Oneida Valley Bancshares, Inc.

The following discussion presents material changes in the Company’s results of operations and financial condition during the three months ended March 31, 2004, which are not otherwise apparent from the consolidated financial statements included in this report.

This discussion and analysis contains certain forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995) 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 include, among others, the following possibilities: (1) an increase in competitive pressures in the banking industry; (2) changes in the interest rate environment that reduce margins; (3) changes in the regulatory environment; (4) general economic conditions, either nationally or regionally, that are less favorable than expected, resulting in, among other things, a deterioration in credit quality; (5) changes in business conditions and inflation; (6) changes in the securities markets; (7) changes occur in technology used in the banking business; (8) an inability to maintain and increase market share and control expenses; and (9) other factors detailed from time to time in the Company’s SEC filings.

Operating results for the three months ended March 31, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.

RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 2004

Earnings Summary and Executive Overview

Net income was $1,894,000, or $0.52 per diluted share, for the first quarter of 2004 compared with $1,690,000, or $0.48, per diluted share, for the same period in 2003. Net income increased $204,000, or 12.1%, while diluted earnings per share were up $0.04, or 8.3% for the comparable periods. The return on average assets and return on average shareholder’s equity were 0.90% and 11.19%, respectively, for the three months ended March 31, 2004, compared with 0.87% and 10.68%, respectively, for the first quarter of 2003. The 2004 first quarter was highlighted by new branch openings and improvement in credit quality. Two new full service branches were opened in Onondaga County during the quarter that together added $23,000,000 in new deposits to the Bank’s December 31, 2003 total. A marked decline in the quarterly rate of loan losses, combined with improvement in other loan quality indicators, all but eliminated the 2004 first quarter provision expense and was primarily responsible for the earnings growth over the comparable period in the prior year.

-9-

Analysis of Net Interest Income and the Net Interest Margin

For the three months ended March 31, 2004 compared to the three months ended March 31, 2003, net interest income increased $57,000, or 0.8%, to $6,988,000. The increase resulted as a $68,996,000, or 9.5%, increase in average earning assets generated additional income that more than offset the negative impact of a net interest margin that declined 31 basis points, from 4.03% for the quarter ended March 31, 2003 to 3.72% for the quarter ended March 31, 2004. The increase in average earning assets was the result of loan portfolio growth that exceeded 15% over the past twelve months. The decline in the net interest margin for the comparable periods resulted as lower market interest rates continued to push asset yields lower, and to a greater degree than the Bank’s ability to reduce the costs of interest bearing liabilities.

Total interest income for the quarter ended March 31, 2004 declined $422,000, or 4%, compared with that reported for the quarter ended March 31, 2003, primarily as a result of lower yields on earning assets. Investment income, which declined $439,000, or 12.5%, for the comparable periods, fell as a result of a 57-basis point decline in the average tax-equivalent yield on the portfolio. The decline reflects lower yields on portfolio reinvestments over the past twelve months. Average investments increased $1,803,000, or 0.6%, for the comparable periods. Loan and lease income increased $13,000, or 0.2%, for the linked periods, as growth in the size of the loan and lease portfolio generated increased revenues that offset declining revenues from lower loan and lease yields. Average net loans and leases increased $63,849,000, or 15.4%, with double-digit percentage growth reported in indirect auto, single family residential mortgage, and commercial loans and leases. The change in the overall mix of average loans over the past twelve months reflected an increase of 3.7% in the percentage of indirect auto loans to total loans, with slight declines in the percentage of loan categories. Average loan and lease yields declined 87 basis points with lower yields on indirect auto, residential mortgage, and home equity-dominated consumer loan categories most responsible for the overall yield decline.

Total interest expense declined $479,000, or 13.6%, to $3,036,000 for the quarter ended March 31, 2004 when compared with the same period in 2003, as lower market interest rates positively impacted the average rate paid on interest-bearing liabilities, reducing it by 45 basis points. The decline in the average rate paid on interest-bearing liabilities, by far offset increased costs associated with a $58,948,000, or 9.1%, increase in average interest-bearing liabilities. Deposit expense declined $395,000, or 16.5%, primarily due to a decline of 39 basis points in the average rate paid on interest-bearing deposits. The lower average rate paid reflected lower rates paid on all categories of deposits, with the greatest impact resulting from a 52-basis point reduction in the time deposit category. For the comparable periods, average interest-bearing deposits increased $28,177,000, or 5.6%, with double-digit growth in public fund, business, and personal money market balances generating nearly all the growth. Average non interest-bearing demand deposits increased $3,341,000, or 5.9%, for the comparable periods, and were 10.1% of total average deposits for both periods. For the comparable periods, there was a slight change in the average deposit mix, as average time deposits as a percentage of total average deposits declined nearly 2.5%, to 38.9%, while average savings and money market balances increased 2.9%, to 36.7% of total average deposits. Interest expense on borrowings for the comparable periods declined $84,000, or 7.5%, as the average rate paid on borrowings was lower by 74 basis points, while average borrowings increased $30,771,000, or 21.3%. One-third of the increase in average borrowings was attributable to the Company’s 2003 fourth quarter issuance of $10,310,000 in 30-year LIBOR-based floating rate junior subordinated debentures. The Company borrowed the proceeds of the capital securities from its wholly owned subsidiary, Alliance Financial Capital Trust I, which had issued $10,000,000 in similar term Company-obligated pooled capital securities. The capital securities held by the trust qualify as Tier I capital for the Company under Federal Reserve guidelines.

-10-

The following table sets forth information concerning average interest-earning assets and interest-bearing liabilities and the average yields and rates thereon for the periods indicated. Interest income and yield

information is adjusted for items exempt from federal income taxes and assumes a 34% tax rate. Nonaccrual loans have been included in the average balances. Securities are shown at average amortized cost.

2004

2003

Avg.
Balance

Amt of
Interest

Avg. Yield/
Rate Paid

Avg.
Balance

Amt of
Interest

Avg. Yield/
Rate Paid

$ 

8,702

$ 

20

0.92

%

$ 

5,358

$ 

17

1.27

%

$

233,955

$

2,322

3.97

%

$

241,270

$

2,814

4.67

%

$

71,467

$

1,155

6.46

%

$

62,349

$

1,074

6.89

%

$

172,875

$

2,690

6.22

%

$

152,943

$

2,725

7.13

%

$

148,126

$

2,144

5.79

%

$

134,335

$

2,091

6.23

%

$

99,932

$

1,278

5.12

%

$

70,936

$

1,175

6.63

%

$

58,693

$

808

5.51

%

$

57,563

$

915

6.36

%

793,750

10,417

5.25

%

724,754

10,811

5.97

%

50,375

48,756

(6,179

)

(5,188

)

7,073

10,740

$

845,019

$

779,062

$

84,638

$

56

0.26

%

$

82,408

$

67

0.33

%

$

217,939

$

462

0.85

%

$

189,940

$

529

1.11

%

$

230,651

$

1,475

2.56

%

$

232,703

$

1,791

3.08

%

$

175,392

$

1,043

2.38

%

$

144,621

$

1,128

3.12

%

708,620

3,036

1.71

%

649,672

3,515

2.16

%

59,856

56,515

8,850

9,550

67,693

63,325

$

845,019

$

779,062

$

7,381

$

7,296

3.72

%

4.03

%

3.54

%

3.81

%

$

393

$

365

-11-

The following table sets forth the dollar volume of increase (decrease) in interest income and interest expense resulting from changes in the volume of earning assets and interest-bearing liabilities, and from changes in rates for the periods indicated. Volume changes are computed by multiplying the volume difference by the prior period’s rate. Rate changes are computed by multiplying the rate difference by the prior period’s balance. The change in interest income and expense due to both rate and volume has been allocated equally between the volume and rate variances.

FOR THE QUARTER END
MARCH 31, 2004 COMPARED TO MARCH 31, 2003
INCREASE (DECREASE) DUE TO

VOLUME

RATE

NET CHG

$

33

$

(30

)

$

3

428

(920

)

(492

)

488

(407

)

81

1,389

(1,424

)

(35

)

752

(699

)

53

1,548

(1,445

)

103

227

(334

)

(107

)

$

4,865

$

(5,259

)

$

(394

)

$

28

$

(39

)

$

(11

)

369