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United States
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT
Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2004
Commission file number 001-13695
[LOGO]
COMMUNITY BANK SYSTEM, INC.
(Exact name of registrant as specified in its charter)
Delaware 16-1213679
(State or other jurisdiction (I.R.S. Employer
of incorporation) Identification No.)
5790 Widewaters Parkway, DeWitt, New York 13214-1883
(Address of principal executive offices) (Zip Code)
(315) 445-2282
(Registrant's telephone number, including area code)
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 periods that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.). |X| Yes |_| No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). |X| Yes |_| No
Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of the latest practicable date.
Common Stock, $1.00 par value - 30,574,561 shares outstanding
as of July 27, 2004
TABLE OF CONTENTS
Page
----
Part I. Financial Information
Item 1. Financial Statements (Unaudited)
Consolidated Statements of Condition
June 30, 2004 and December 31, 2003 .............................. 3
Consolidated Statements of Income
Three and six months ended June 30, 2004 and 2003 ................ 4
Consolidated Statement of Changes in Shareholders' Equity
Six months ended June 30, 2004 ................................... 5
Consolidated Statements of Comprehensive Income
Three and six months ended June 30, 2004 and 2003 ................ 6
Consolidated Statements of Cash Flows
Six months ended June 30, 2004 and 2003 .......................... 7
Notes to the Consolidated Financial Statements
June 30, 2004 .................................................... 8
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations ........................................ 14
Item 3. Quantitative and Qualitative Disclosure about Market Risk ........ 31
Item 4. Controls and Procedures .......................................... 32
Part II. Other Information
Item 1. Legal Proceedings ................................................ 33
Item 2. Changes in Securities, Use of Proceeds and Issuer Repurchases
of Equity Securities ............................................. 33
Item 3. Defaults upon Senior Securities .................................. 33
Item 4. Submission of Matters to a Vote of Securities Holders ............ 33
Item 5. Other Information ................................................ 33
Item 6. Exhibits and Reports on Form 8-K ................................. 33
2
Part 1. Financial Information
Item 1. Financial Statements
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF CONDITION (Unaudited)
(In Thousands, Except Share Data)
June 30, December 31,
2004 2003
- --------------------------------------------------------------------------------------------------------------
Cash and due from banks $101,410 $103,923
Available-for-sale investment securities 1,445,560 1,190,882
Held-to-maturity investment securities 138,793 138,652
- ------------------------------------------------------------------------------------------------------------
Total investment securities (fair value of $1,578,867 and $1,327,120, 1,584,353 1,329,534
respectively)
Loans 2,346,735 2,128,509
Allowance for loan losses 32,040 29,095
- ------------------------------------------------------------------------------------------------------------
Net loans 2,314,695 2,099,414
Premises and equipment, net 63,899 61,705
Accrued interest receivable 28,071 25,851
Core deposit intangibles, net 37,803 33,998
Goodwill 190,732 159,596
Other intangibles, net 2,248 2,517
- ------------------------------------------------------------------------------------------------------------
Intangible assets, net 230,783 196,111
Other assets 34,543 38,859
- ------------------------------------------------------------------------------------------------------------
Total assets $4,357,754 $3,855,397
============================================================================================================
Liabilities:
Non-interest bearing deposits $547,632 $498,195
Interest bearing deposits 2,387,301 2,227,293
- ------------------------------------------------------------------------------------------------------------
Total deposits 2,934,933 2,725,488
Federal funds purchased 21,600 36,300
Borrowings 831,250 551,096
Subordinated debt held by unconsolidated subsidiary trusts 80,418 80,390
Accrued interest and other liabilities 48,156 57,295
- ------------------------------------------------------------------------------------------------------------
Total liabilities 3,916,357 3,450,569
- ------------------------------------------------------------------------------------------------------------
Commitment and contingencies (See Note H)
Shareholders' equity:
Preferred stock $1.00 par value, 500,000 shares authorized, 0 shares issued
Common stock, $1.00 par value, 50,000,000 shares authorized;
31,736,528 and 28,746,612 shares issued in 2004 and 2003, respectively 31,737 28,747
Additional paid-in capital 185,257 130,066
Retained earnings 232,410 218,628
Accumulated other comprehensive income 16,287 35,958
Treasury stock, at cost (1,119,287 and 416,300 shares, respectively) (23,850) (8,490)
Employee stock plan - unearned (444) (81)
- ------------------------------------------------------------------------------------------------------------
Total shareholders' equity 441,397 404,828
- ------------------------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $4,357,754 $3,855,397
============================================================================================================
The accompanying notes are an integral part of the consolidated financial
statements.
3
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(In Thousands, Except Per-Share Data)
Three Months Ended Six Months Ended
June 30, June 30,
------------------- ------------------
2004 2003 2004 2003
- ------------------------------------------------------------------------- ------------------- ------------------
Interest income:
Interest and fees on loans $33,259 $30,986 $65,776 $62,201
Interest and dividends on taxable investments 13,149 11,362 25,371 23,736
Interest and dividends on non-taxable investments 5,728 4,671 10,910 9,353
- ------------------------------------------------------------------------- ------------------- -------------------
Total interest income 52,136 47,019 102,057 95,290
- ------------------------------------------------------------------------- ------------------- -------------------
Interest expense:
Interest on deposits 8,521 9,933 17,155 20,569
Interest on federal funds purchased 101 84 187 169
Interest on short-term borrowings 1,176 344 2,211 821
Interest on subordinated debt held by unconsolidated subsidiary trusts 1,393 1,412 2,784 2,836
Interest on long-term borrowings 3,488 3,144 6,309 6,309
- ------------------------------------------------------------------------- ------------------- -------------------
Total interest expense 14,679 14,917 28,646 30,704
- ------------------------------------------------------------------------- ------------------- -------------------
Net interest income 37,457 32,102 73,411 64,586
Less: provision for loan losses 2,300 2,673 4,350 6,073
- ------------------------------------------------------------------------- ------------------- -------------------
Net interest income after provision for loan losses 35,157 29,429 69,061 58,513
- ------------------------------------------------------------------------- ------------------- -------------------
Non-interest income:
Deposit service fees 6,201 5,740 11,985 10,945
Other banking services 246 475 896 1,344
Trust, investment and asset management fees 2,062 1,530 3,764 3,207
Benefit plan administration, consulting and actuarial fees 2,275 1,202 4,659 2,303
Gain (loss) on investment securities & debt extinguishment 135 0 145 (45)
- ------------------------------------------------------------------------- ------------------- -------------------
Total non-interest income 10,919 8,947 21,449 17,754
- ------------------------------------------------------------------------- ------------------- -------------------
Operating expenses:
Salaries and employee benefits 15,392 12,318 30,559 25,018
Occupancy 2,500 2,328 5,130 4,749
Equipment and furniture 2,150 1,977 4,302 3,881
Amortization of intangible assets 1,759 1,251 3,398 2,532
Legal and professional fees 970 859 1,967 1,578
Data processing 1,924 1,740 3,804 3,359
Office supplies 577 466 1,098 1,052
Acquisition expenses 411 5 1,381 5
Other 4,092 4,235 7,892 7,452
- ------------------------------------------------------------------------- ------------------- -------------------
Total operating expenses 29,775 25,179 59,531 49,626
- ------------------------------------------------------------------------- ------------------- -------------------
Income before income taxes 16,301 13,197 30,979 26,641
Income taxes 4,160 3,165 7,683 6,660
- ------------------------------------------------------------------------- ------------------- -------------------
Net income $12,141 $10,032 $23,296 $19,981
========================================================================= =================== ===================
Basic earnings per share $0.41 $0.38 $0.80 $0.77
Diluted earnings per share $0.40 $0.38 $0.77 $0.75
Dividends declared per share $0.16 $0.145 $0.32 $0.29
The accompanying notes are an integral part of the consolidated financial
statements.
4
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)
Six Months Ended June 30, 2004
(In Thousands, Except Share Data)
Common Stock Accumulated
--------------------- Additional Other Employee
Shares Amount Paid-In Retained Comprehensive Treasury Stock Plan
Outstanding Issued Capital Earnings Income Stock -Unearned Total
- -----------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2003, as
previously reported 14,165,156 $14,373 $144,440 $218,628 $35,958 ($8,490) ($81) $404,828
Two-for-one stock split 14,165,156 14,374 (14,374) 0
- -----------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2003, as restated 28,330,312 28,747 130,066 218,628 35,958 (8,490) (81) 404,828
Net income 23,296 23,296
Other comprehensive loss, net of tax (19,671) (19,671)
Dividends declared:
Common, $.32 per share (9,514) (9,514)
Common stock issued under employee
stock plan 397,703 398 3,064 (363) 3,099
Stock and options issued for acquisition 2,592,213 2,592 52,127 54,719
Treasury stock purchased (702,987) (15,360) (15,360)
- -----------------------------------------------------------------------------------------------------------------------------------
Balance at June 30, 2004 30,617,241 $31,737 $185,257 $232,410 $16,287 ($23,850) ($444) $441,397
===================================================================================================================================
See Note B "Stock Split" concerning two-for-one stock split.
The accompanying notes are an integral part of the consolidated financial
statements.
5
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
(In Thousands)
Three Months Ended Six Months Ended
June 30, June 30,
--------------------- ---------------------
2004 2003 2004 2003
- --------------------------------------------------------------------------- --------------------- ---------------------
Other comprehensive (loss) income, before tax:
Change in minimum pension liability adjustment $0 $0 $0 $97
Unrealized (losses) gains on securities:
Unrealized holding (losses) gains arising during period (51,231) 14,779 (32,174) 21,311
Reclassification adjustment for gains included in net income (135) 0 (145) 0
- --------------------------------------------------------------------------- --------------------- ---------------------
Other comprehensive (loss) income, before tax (51,366) 14,779 (32,319) 21,408
Income tax benefit (expense) related to other comprehensive (loss) income 20,069 (5,756) 12,648 (7,521)
- --------------------------------------------------------------------------- --------------------- ---------------------
Other comprehensive (loss) income, net of tax (31,297) 9,023 (19,671) 13,887
Net income 12,141 10,032 23,296 19,981
- --------------------------------------------------------------------------- --------------------- ---------------------
Comprehensive (loss) income ($19,156) $19,055 $3,625 $33,868
=========================================================================== ===================== =====================
The accompanying notes are an integral part of the consolidated financial
statements.
6
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(In Thousands)
Six Months Ended June 30,
-------------------------
2004 2003
- ---------------------------------------------------------------------------------------------------------------
Operating activities:
Net income $23,296 $19,981
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation 3,960 3,482
Amortization of intangible assets 3,398 2,532
Net amortization of premiums and discounts on securities and loans 816 1,142
Amortization of unearned compensation and discount on subordinated debt 127 58
Provision for loan losses 4,350 6,073
(Gain) loss on investment securities and debt extinguishment (145) 45
Loss (gain) on loans and other assets 25 (470)
Proceeds from the sale of loans held for sale 0 61,561
Origination of loans held for sale 0 (56,407)
Change in other operating assets and liabilities 2,200 690
- ---------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 38,027 38,687
- ---------------------------------------------------------------------------------------------------------------
Investing activities:
Proceeds from sales of available-for-sale investment securities 35,755 10,725
Proceeds from maturities of held-to-maturity investment securities 2,203 2,510
Proceeds from maturities of available-for-sale investment securities 94,383 130,816
Purchases of held-to-maturity investment securities (2,418) (2,459)
Purchases of available-for-sale investment securities (373,771) (5,923)
Net increase in loans outstanding (15,483) (60,643)
Cash received for acquisition (net of cash paid of $7,026) 406 0
Capital expenditures (3,310) (3,352)
- ---------------------------------------------------------------------------------------------------------------
Net cash (used) provided by investing activities (262,235) 71,674
- ---------------------------------------------------------------------------------------------------------------
Financing activities:
Net change in demand deposits, NOW accounts, and savings accounts 40,373 65,859
Net change in time deposits (42,992) (29,241)
Net change in federal funds purchased (14,700) (28,300)
Net change in short-term borrowings 91,528 (110,000)
Change in long-term borrowings (net of payments of $40 and $5) 169,002 (5,000)
Issuance of common stock 3,005 1,509
Purchase of treasury stock (15,360) (1,209)
Cash dividends paid (9,113) (7,535)
Other financing activities (48) (77)
- ---------------------------------------------------------------------------------------------------------------
Net cash provided (used) by financing activities 221,695 (113,994)
- ---------------------------------------------------------------------------------------------------------------
Change in cash and cash equivalents (2,513) (3,633)
Cash and cash equivalents at beginning of period 103,923 113,531
- ---------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $101,410 $109,898
===============================================================================================================
Supplemental disclosures of cash flow information:
Cash paid for interest $26,788 $29,968
Cash paid for income taxes $5,730 $6,946
Supplemental disclosures of non-cash financing and investing activities:
Dividends declared and unpaid $4,930 $3,784
Gross change in unrealized (losses) gains on available-for-sale investment
securities ($32,319) $21,311
Acquisition:
Fair value of assets acquired, excluding acquired cash and intangibles $259,551 $0
Fair value of liabilities assumed $235,528 $0
Common stock and options issued $54,719 $0
The accompanying notes are an integral part of the consolidated financial
statements.
7
COMMUNITY BANK SYSTEM, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
June 30, 2004
NOTE A: BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with instructions to Form 10-Q and Rule 10-01 of
Regulation S-X. These financial statements may not include all information and
footnotes necessary to constitute a complete set of financial statements under
generally accepted accounting principles applicable to annual periods and
accordingly should be read in conjunction with the financial information
contained in the Form 10-K. Management believes these unaudited consolidated
financial statements reflect all adjustments of a normal recurring nature which
are necessary for a fair presentation of the results for the interim periods
presented. The results of operations for the interim periods are not necessarily
indicative of the results that may be expected for the full year or any other
interim period.
NOTE B: ACQUISITION AND OTHER MATTERS
First Heritage Bank
On May 14, 2004, the Company acquired First Heritage Bank ("Heritage"), a
closely held bank headquartered in Wilkes-Barre, Pa with three branches in
Luzerne County, Pennsylvania. First Heritage's three branches operate as part of
First Liberty Bank & Trust, a division of Community Bank, N.A. Consideration
included 2,592,213 shares of common stock with a fair value of $52 million,
stock options with a fair value of $3.0 million, and $6.0 million of cash. The
results of Heritage's operations have been included in the consolidated
financial statements since that date.
The estimated purchase price allocation of the assets acquired and liabilities
assumed, including capitalized acquisition costs is as follows:
(000's omitted)
- -----------------------------------------------------
Cash and due from banks $7,432
Available-for-sale investment securities 43,811
Loans, net of allowance for loan losses 204,120
Premises and equipment, net 3,074
Other assets 1,114
Goodwill 30,788
Core deposit intangibles 6,934
- -----------------------------------------------------
Total assets acquired 297,273
Deposits 212,064
Borrowings 19,672
Other liabilities 3,792
- -----------------------------------------------------
Total liabilities assumed 235,528
- -----------------------------------------------------
Net assets acquired $61,745
=====================================================
Stock Repurchase Program
On May 21, 2004, the Company announced the continuation of a stock repurchase
program previously announced in June 2003. The program provides for the
repurchase of up to 1,400,000 outstanding shares in open market or privately
negotiated transactions through June 2005. The repurchases will be for general
corporate purposes, including those related to acquisition and stock plan
activities. As of June 30, 2004, the Company has purchased 1,119,287 shares at
an aggregate cost of $23.9 million and an average price per share of $21.31.
Stock Split
At a special meeting of the shareholders held on March 26, 2004, the
shareholders approved an amendment to the certificate of incorporation of the
Company to increase the number of authorized shares of common stock to 50
million. This amendment was effected in connection with the previously announced
two-for-one stock split of the Company's common stock. The stock split was
effected in the form of a 100 percent stock dividend, and was paid on April 12,
2004 to shareholders of record on March 17, 2004. Accordingly, all share, option
and per-share amounts have been adjusted in the consolidated financial
statements to reflect the stock split.
8
NOTE C: ACCOUNTING POLICIES
Critical Accounting Policies
Allowance for Loan Losses
Management continually evaluates the credit quality of its loan portfolio, and
performs a formal review of the adequacy of the allowance for loan losses on a
quarterly basis. The allowance reflects management's best estimate of probable
losses inherent in the loan portfolio. Determination of the allowance is
subjective in nature and requires significant estimates.
The Company's allowance methodology consists of two broad components. The first
component includes a determination of estimated general losses in accordance
with SFAS No. 5, "Accounting for Contingencies". This general allowance
component reflects inherent probable losses related to pools of homogeneous
loans that are evaluated collectively, including consumer mortgage loans,
consumer direct and indirect loans, and business loans that are not impaired.
Allowance levels for these loan pools are based principally on historical loss
factors, as well as qualitative factors that are expected to affect loss
experience, including delinquency, underwriting and economic trends and
conditions. The second component of the allowance reflects specific losses
related to individual business loans that are both greater than $500,000 and in
a non-accruing status with respect to interest. Specific losses are based on
discounted estimated cash flows, including any cash flows resulting from the
conversion of collateral.
Income Taxes
Provisions for income taxes are based on taxes currently payable or refundable,
and deferred taxes which are based on temporary differences between the tax
basis of assets and liabilities and their reported amounts in the financial
statements. Deferred tax assets and liabilities are reported in the financial
statements at currently enacted income tax rates applicable to the period in
which the deferred tax assets and liabilities are expected to be realized or
settled.
Intangible Assets
Intangible assets include core deposit intangibles, customer relationship
intangibles and goodwill arising from acquisitions. Core deposit intangibles and
customer relationship intangibles are amortized on either an accelerated or
straight-line basis over periods ranging from 7 to 20 years. Goodwill is
evaluated at least annually for impairment. The carrying value of goodwill and
other intangible assets 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 use of 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.
Retirement Benefits
The Company provides defined benefit pension benefits and post-retirement health
and life insurance benefits to eligible employees. 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 discount rate, rate of future compensation increases and
expected return on plan assets.
Stock-Based Compensation
The Company accounts for stock awards issued to directors, officers and key
employees using the intrinsic value method. This method requires that
compensation expense be recognized to the extent that the fair value of the
stock exceeds the exercise price of the stock award at the grant date. The
Company generally does not recognize compensation expense related to stock
awards because the stock awards generally have fixed terms and exercise prices
that are equal to or greater than the fair value of the Company's common stock
at the grant date.
SFAS 123, "Accounting for Stock-Based Compensation," requires companies that use
the "intrinsic value method" to account for stock compensation plans to provide
pro forma disclosures of the net income and earnings per share effect of stock
options using the "fair value method." Under this method, the fair value of the
option on the date of grant is recognized ratably as compensation expense over
the vesting period of the option.
Management estimated the fair value of options granted using the Black-Scholes
option-pricing model. This model was originally developed to estimate the fair
value of exchange-traded equity options, which (unlike employee stock options)
have no vesting period or transferability restrictions. As a result, the
Black-Scholes model is not necessarily a precise indicator of the value of an
option, but it is commonly used for this purpose. The Black-Scholes model
requires several assumptions, which management developed based on historical
trends and current market observations. These assumptions include:
9
2004 2003
- ----------------------------------------------------------------------
Weighted-average expected life 7.79 8.43
Future dividend yield 3.00% 3.00%
Share price volatility 25.47%-25.59% 27.42%
Weighted average risk-free interest rate 4.02%-4.05% 4.03%
======================================================================
If these assumptions are not accurate, the estimated fair value used to derive
the information presented in the following table also will be inaccurate.
Moreover, the model assumes that the estimated fair value of an option is
amortized over the option's vesting period and would be included in salaries and
employee benefits on the income statement. The pro forma impact of applying the
fair value method of accounting for the periods shown below may not be
indicative of the pro forma impact in future years.
Three Months Ended Six Months Ended
June 30, June 30,
--------------------------------------------------
(000's omitted except per share amounts) 2004 2003 2004 2003
- ---------------------------------------------------------------------------------------------------------------
Net income, as reported $12,141 $10,032 $23,296 $19,981
Less: stock-based compensation expense determined under
fair value method, net of tax 207 162 625 454
- ---------------------------------------------------------------------------------------------------------------
Pro forma net income $11,934 $9,870 $22,671 $19,527
===============================================================================================================
Earnings per share:
As reported:
Basic $0.41 $0.38 $0.80 $0.77
Diluted $0.40 $0.38 $0.77 $0.75
Pro forma:
Basic $0.40 $0.38 $0.78 $0.75
Diluted $0.39 $0.37 $0.75 $0.73
===============================================================================================================
As of June 30, 2004 there were 2,692,955 stock options granted and outstanding.
New Accounting Pronouncements
In December 2003, a bill was signed into law that expands Medicare benefits,
primarily adding a prescription drug benefit for Medicare-eligible retirees
beginning in 2006. The law also provides a federal subsidy to companies that
sponsor post-retirement benefit plans that provide prescription drug coverage.
In May 2004, the Financial Accounting Standards Board ("FASB") issued Staff
Position No. FAS 106-2, "Accounting and Disclosure Requirements Related to the
Medicare Prescription Drug, Improvement and Modernization Act of 2003." This
staff position provides guidance on accounting for the effects of the new
Medicare prescription drug legislation by employers whose prescription drug
benefits are actuarially equivalent to the drug benefit under Medicare Part D.
It also contains basic guidance on related income tax accounting and complex
rules for transition that permit various alternative prospective and retroactive
transition approaches. This guidance is effective for the third quarter of 2004.
The Company's accumulated benefit obligation and net periodic benefit cost do
not reflect an amount associated with this subsidy because it has not yet
determined if its plan provides a drug benefit that is actuarially equivalent to
the Medicare Part D benefit. However, the adoption of this standard is not
expected to have a material impact on results of operations, financial position,
or liquidity of the Company.
In March 2004, the Securities and Exchange Commission issued Staff Accounting
Bulletin No. 105, "Application of Accounting Principles to Loan Commitments."
This staff accounting bulletin deals with loan commitments a Company originates
with the intention of selling. It requires that fair-value measurement include
only differences between the guaranteed interest rate in the loan commitment and
a market interest rate, excluding any expected future cash flows related to the
customer relationship or loan servicing. The Company periodically enters into
such commitments with customers in connection with residential mortgage lending.
The Company has not sold any of its originated loans during 2004 and thus this
standard does not have any impact on its financial condition or results of
operations.
In March 2004, the FASB issued an exposure draft, "Share-Based Payment: an
amendment of FASB No. 123 and 95." This proposed Statement addresses the
accounting for transactions in which an enterprise receives employee services in
exchange for (a) equity instruments of the enterprise or (b) liabilities that
are based on the fair value of the enterprise's equity instruments or that may
be settled by the issuance of such equity instruments. This proposed Statement
would eliminate the accounting for share-based compensation transactions using
APB Opinion No. 25, "Accounting for Stock Issued to Employees," and generally
would require instead that such transactions be accounted for using a
fair-value-based method. A final statement is expected to be issued during the
fourth quarter of 2004 and will be effective as of January 1, 2005. Management
does not expect the impact of the adoption of this exposure draft to be
materially different from the pro forma impacts disclosed under SFAS No. 123.
10
In December 2003, the FASB revised SFAS No. 132, "Employer Disclosures about
Pensions and Other Post-retirement Benefits". This statement retains the
disclosures required by the original standard and requires additional
disclosures about the assets, obligations, cash flows and net periodic benefit
cost of defined benefit pension and post-retirement plans. In addition, this
statement requires interim period disclosure of the components of net periodic
benefit cost and contributions if significantly different from previously
reported amounts. The Company adopted the interim disclosure provisions of this
statement as of March 31, 2004 (see Note G).
NOTE D: EARNINGS PER SHARE
Basic earnings per share is computed based on the weighted-average common shares
outstanding for the period. Diluted earnings per share is based on the
weighted-average shares outstanding adjusted for the dilutive effect of the
assumed exercise of stock options during the year. The dilutive effect of
options is calculated using the treasury stock method of accounting. The
treasury stock method determines the number of common shares that would be
outstanding if all the dilutive options (average market price is greater than
the exercise price) were exercised and the proceeds were used to repurchase
common shares in the open market at the average market price for the applicable
time period. There were 435,868 and 307,492 anti-dilutive stock options
outstanding as of June 30, 2004 and 2003, respectively. The following is a
reconciliation of basic to diluted earnings per share for the three and six
months ended June 30, 2004 and 2003.
Per Share
(000's omitted, except per share data) Income Shares Amount
- -------------------------------------------------------------------------
Three Months Ended June 30, 2004
Basic EPS $12,141 29,821 $0.41
Stock options 849
- -------------------------------------------------------------
Diluted EPS $12,141 30,670 $0.40
=============================================================
Three Months Ended June 30, 2003
Basic EPS $10,032 26,113 $0.38
Stock options 580
- -------------------------------------------------------------
Diluted EPS $10,032 26,693 $0.38
=============================================================
Six Months Ended June 30, 2004
Basic EPS $23,296 29,200 $0.80
Stock options 916
- -------------------------------------------------------------
Diluted EPS $23,296 30,116 $0.77
=============================================================
Six Months Ended June 30, 2003
Basic EPS $19,981 26,085 $0.77
Stock options 506
- -------------------------------------------------------------
Diluted EPS $19,981 26,591 $0.75
=============================================================
NOTE E: INTANGIBLE ASSETS
The gross carrying amount and accumulated amortization for each type of
intangible asset are as follows:
As of June 30, 2004 As of December 31, 2003
------------------------------------ ------------------------------------
Gross Net Gross Net
Carrying Accumulated Carrying Carrying Accumulated Carrying
(000's omitted) Amount Amortization Amount Amount Amortization Amount
- -------------------------------------------------------------------------- ------------------------------------
Amortizing intangible assets:
Core deposit intangibles $62,389 ($24,586) $37,803 $55,455 ($21,457) $33,998
Other intangibles 2,750 (502) 2,248 2,750 (233) 2,517
- -------------------------------------------------------------------------- ------------------------------------
Total amortizing intangibles 65,139 (25,088) 40,051 58,205 (21,690) 36,515
Non-amortizing intangible assets:
Goodwill 190,732 0 190,732 159,596 0 159,596
- -------------------------------------------------------------------------- ------------------------------------
Total intangible assets, net $255,871 ($25,088) $230,783 $217,801 ($21,690) $196,111
========================================================================== ====================================
11
As described in Note B, the increases in the gross carrying amount of core
deposit intangibles and goodwill primarily reflect to the May 2004 acquisition
of First Heritage Bank. No goodwill impairment adjustments were recognized in
2004 and 2003. The estimated aggregate amortization expense for each of the
succeeding fiscal years ended December 31 is as follows:
(000's omitted) Amount
- -----------------------------
July-Dec 2004 $4,016
2005 6,953
2006 5,794
2007 5,440
2008 5,154
Thereafter 12,694
- -----------------------------
Total $40,051
=============================
NOTE F: SUBORDINATED DEBT
The Company sponsors three business trusts, Community Capital Trust I, Community
Capital Trust II, and Community Statutory Trust III, of which 100% of the common
securities is owned by the Company. In accordance with FASB Interpretation No.
46, "Consolidation of Variable Interest Entities, an interpretation of
Accounting Research Bulletin No. 51", these business trusts are not consolidated
with the financial statements of the Company. The trusts were formed for the
purpose of issuing company-obligated mandatorily redeemable preferred securities
to third-party investors and investing the proceeds from the sale of such
preferred securities solely in junior subordinated debt securities of the
Company. The debentures held by each trust are the sole assets of that trust and
were $82,439,000 and $82,410,000 at June 30, 2004 and December 31, 2003,
respectively. Distributions on the preferred securities issued by each trust are
payable semi-annually at a rate per annum equal to the interest rate being
earned by the trust on the debentures held by that trust. The preferred
securities are subject to mandatory redemption, in whole or in part, upon
repayment of the debentures. The Company has entered into agreements which,
taken collectively, fully and unconditionally guarantee the preferred securities
subject to the terms of each of the guarantees. The terms of the preferred
securities of each trust are as follows:
Issuance Preferred Interest Maturity Call Call
Trust Date Securities Rate Date Provision Price
- ------------------------------------------------------------------------------------------------------------------------------------
I 2/3/1997 $30 million 9.75% 2/03/2027 10 year beginning 2007 104.5400% declining to par in 2017
II 7/16/2001 $25 million Six-month LIBOR plus 3.75% 7/16/2031 5 year beginning 2006 107.6875% declining to par in 2011
III 7/31/2001 $24.45 million Three-month LIBOR plus 3.58% 7/31/2031 5 year beginning 2006 107.5000% declining to par in 2011
====================================================================================================================================
NOTE G: BENEFIT PLANS
The Company provides defined benefit pension benefits and post-retirement health
and life insurance benefits to eligible employees. The Company also provides
supplemental pension retirement benefits for several current and former key
employees. The Company accrues for the estimated cost of these benefits through
charges to expense during the years that employees earn these benefits. The
components of the net periodic benefit cost are as follows:
Pension Benefits Post-retirement Benefits
-------------------------------------------- -----------------------------------------
Three Months Ended Six Months Ended Three Months Ended Six Months Ended
June 30, June 30, June 30, June 30,
-------------------- -------------------- ------------------- -------------------
(000's omitted) 2004 2003 2004 2003 2004 2003 2004 2003
- ------------------------------------------------------------ -------------------- ------------------- -------------------
Service cost $480 $356 $960 $711 $69 $45 $156 $90
Interest cost 592 471 1,184 943 92 63 163 127
Expected return on plan assets (790) (642) (1,580) (1,284) 0 0 0 0
Net amortization and deferral 218 216 436 431 13 0 18 0
Amortization of prior service cost 107 (8) 213 (16) 1 8 15 15
Amortization of transition obligation 0 (1) 0 (2) 10 10 20 21
- ------------------------------------------------------------ -------------------- ------------------- -------------------
Net periodic benefit cost $607 $392 $1,213 $783 $185 $126 $372 $253
============================================================ ==================== =================== ===================
12
Supplemental Benefits
---------------------------------------
Three Months Ended Six Months Ended
June 30, June 30,
------------------ ------------------
(000's omitted) 2004 2003 2004 2003
- ----------------------------------------------------------- ------------------
Service cost $88 $33 $175 $65
Interest cost 39 47 78 95
Expected return on plan assets 0 0 0 0
Net amortization and deferral 44 25 89 49
Amortization of prior service cost (34) 40 (68) 81
Amortization of transition obligation 0 0 0 0
- ----------------------------------------------------------- ------------------
Net periodic benefit cost $137 $145 $274 $290
=========================================================== ==================
The Company does not anticipate making a contribution to its defined benefit
plan in 2004.
NOTE H: COMMITMENTS, CONTINGENT LIABILITIES AND RESTRICTIONS
The Company is a party to financial instruments with off-balance-sheet risk in
the normal course of business to meet the financing needs of its customers.
These financial instruments consist primarily of commitments to extend credit
and standby letters of credit. Commitments to extend credit are agreements to
lend to customers, generally having fixed expiration dates or other termination
clauses that may require payment of a fee. These commitments consist principally
of unused commercial and consumer credit lines. Standby letters of credit
generally are contingent upon the failure of the customer to perform according
to the terms of an underlying contract with a third party. The credit risks
associated with commitments to extend credit and standby letters of credit are
essentially the same as that involved with extending loans to customers and are
subject to normal credit policies. Collateral may be obtained based on
management's assessment of the customer's creditworthiness. The fair value of
these commitments is immaterial for disclosure in accordance with FASB
Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others". The
contract amount of commitment and contingencies are as follows:
June 30, December 31,
(000's omitted) 2004 2003
- ------------------------------------------------------------
Commitments to extend credit $430,600 $315,898
Standby letters of credit 21,093 19,163
- ------------------------------------------------------------
Total $451,693 $335,061
============================================================
13
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") for the
three and six months ended June 30, 2004 and 2003, although in some
circumstances the first quarter of 2004 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 13 and the Annual Report on Form 10-K for
the year ended December 31, 2003. 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.
All references to "peer banks", unless otherwise noted, pertain to a group of 78
bank holding companies nationwide having $3 billion to $10 billion in assets and
their associated composite financial results for the three months ending March
31, 2004 (the most recently available disclosure) as provided by the Federal
Reserve Board in the Bank Holding Company Performance Report. Unless otherwise
noted, the term "this year" refers to results in calendar year 2004, "second
quarter" refers to the quarter ended June 30, 2004, earnings per share ("EPS")
figures refer to diluted EPS, and net interest income and net interest margin
are presented on a fully tax-equivalent ("FTE") basis. All common share and
common share-based amounts reflect the two-for-one stock split effected as a
100% stock dividend on April 12, 2004.
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 29.
Critical Accounting Policies
As a result of the complex and dynamic nature of the Company's business,
management must exercise judgement 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, but also reflects on 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 those estimates.
Management believes that critical accounting estimates include:
o Allowance for loan losses - The allowance for loan losses reflects
management's best estimate of probable losses inherent in the loan
portfolio. Determination of the allowance is subjective in nature and
requires significant estimates.
o Actuarial assumptions associated with pension, post-retirement and other
employee benefit plans - These assumptions include discount rate, rate of
future compensation increases and expected return on plan assets.
o 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 judgements 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.
o Carrying value of goodwill and other intangible assets - The carrying
value of goodwill and other intangible assets 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 use of 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.
A summary of the accounting policies used by management is disclosed in Note A,
"Summary of Significant Accounting Policies" on pages 61 - 67 of the most recent
Form 10-K (fiscal year ended December 31, 2003).
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 branch network operates in New York as Community Bank,
N.A., and in Pennsylvania as First Liberty Bank & Trust. The Company
14
also operates five financial services businesses, which provide a broad array of
wealth management and benefits administration and consulting services to bank
and non-bank customers.
The Company's core operating objectives are to: (i) grow the branch network,
primarily through a disciplined acquisition and de novo strategy, (ii) build
high-quality, profitable loan portfolios using both organic and acquisition
strategies, (iii) increase the non-interest 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
businesses, and (iv) utilize technology to deliver customer-responsive products
and services and to reduce operating costs.
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, non-interest income, operating expenses, asset
quality, loan and deposit growth, capital management, performance of individual
banking and financial services business units, liquidity and interest rate
sensitivity, enhancements to customer products and services, technology
advancements, market share, peer comparisons, and the performance of acquisition
and integration activities.
Second quarter and June year-to-date ("YTD") earnings per share were both $0.02
above their respective prior year periods, as higher net interest income and
non-interest income and a lower loan loss provision were partially offset by
higher operating expenses and a greater number of common shares outstanding. On
an operating basis (see Table 1 and related narrative), second quarter and June
YTD return on assets were equivalent to the same periods of 2003, while return
on equity declined slightly due to higher capital levels. Excluding acquisition
activity, revenue generated by the financial services businesses was up for the
current quarter and first six months of the year, as a result of strong revenue
growth at all of the units. Operating expenses for the quarterly and YTD periods
increased primarily due to acquisitions and higher compensation and benefits
costs. The efficiency ratio for the second quarter improved as a result of net
interest income and recurring non-interest income growing at a faster pace than
operating expenses (excluding acquisition costs and intangible amortization).
The YTD efficiency ratio was up marginally year-over-year, mostly due to the
percentage growth of net interest income being slightly below that of operating
expenses.
Asset quality improved over the last year, with reductions in delinquency, net
charge-off and non-performing loan ratios. Excluding acquisition activity, the
Company experienced strong year-over-year loan growth in consumer mortgage and
indirect lending, with slight declines in the business and consumer direct
portfolios. On a geographical basis, loan growth in the New York markets
mirrored the results for the Company, with the Pennsylvania markets reporting an
increase in consumer indirect loans and declines in other portfolios. Excluding
acquisitions, total average deposits for the quarter and first six months of
2004 declined slightly from the levels that existed for the same periods last
year.
On May 14, 2004, the Company completed its acquisition of First Heritage Bank
("First Heritage"), a $275 million-asset, three-branch commercial bank based in
Wilkes-Barre, PA. The Company completed three acquisitions in 2003, including:
(1) Harbridge Consulting Group ("Harbridge"), an actuarial and benefits
consulting firm based in Syracuse, NY that was acquired from
PricewaterhouseCoopers in July, (2) Peoples Bankcorp Inc. ("Peoples"), a $29
million-asset single branch bank in Ogdensburg, NY acquired in September, and
(3) Grange National Banc Corp. ("Grange"), a $280 million-asset bank with twelve
branches in five counties of Northeastern PA, acquired in November.
Net Income and Profitability
As shown in Table 2, second quarter and June YTD earnings per share of $0.40 and
$0.77, respectively, were $0.02 higher than the EPS generated in the same
periods of last year. Net income for the quarter of $12.1 million was up 21%
over second quarter 2003, and net income of $23.3 million for the first six
months of 2004 increased 17% from the amount earned in the equivalent period of
last year. Net interest income for the second quarter of $41.1 million and $80.4
million for the first half of 2004, were up 17% and 14.0% from their respective
prior year periods. Second quarter non-interest income (excluding net gains from
investment securities sales and debt prepayment costs) of $10.8 million was up
21% from second quarter 2003, and the YTD amount of $21.3 million rose 20% from
the prior year level. Operating expenses of $29.8 million for the quarter and
$59.5 million for the first six months of 2004 were up 18% and 20%,
respectively, from the equivalent periods of 2003, a portion of which related to
acquisition expenses that rose $0.4 million for the quarter and $1.4 million on
a YTD basis.
In addition to the earnings results presented above in accordance with generally
accepted accounting principles ("GAAP"), the Company provides earnings results
on a non-GAAP, or operating basis. The determination of operating earnings
excludes the effects of certain items the Company considers to be non-operating,
including acquisition expenses, the results of securities transactions and debt
restructuring activities. Performance as measured by operating earnings is
considered by management to be a useful measure for gauging the underlying
performance of the Company by eliminating the volatility caused by voluntary,
transaction-based items.
Operating earnings per share for the second quarter were $0.40, up 5.3% from the
$0.38 reported in the equivalent period of 2003. On a year-to-date basis,
operating EPS of $0.80 increased $0.05 or 6.7% versus the first six months of
2003. As reflected in Table 2, the primary reasons for the improved earnings for
both time periods were higher net interest income and non-interest income and a
lower
15
loan loss provision, offset by higher operating expenses and an increased level
of weighted average diluted shares. Net interest income increased because of
higher earning-asset levels derived from the acquisitions of Peoples, Grange and
First Heritage, organic consumer mortgage and indirect loan growth, and
investment leverage. The increase in non-interest income for both time frames
was mostly attributable to incremental revenue from Harbridge, strong growth at
the other financial services units, and additional banking fees generated in the
16 branches added through the three whole-bank acquisitions. A significant
decrease in net charge-offs and general improvement in other asset quality
metrics were the primary drivers of the decrease in the loan loss provision,
despite a significant increase in the size of the total loan portfolio. The
quarterly and YTD performance improvements were partially offset by a growth in
operating expenses, in most part due to the four acquisitions made in the
intervening time period, as well as higher compensation and benefit expenses.
A reconciliation of GAAP-based earnings results to operating-based earnings
results and a condensed income statement are as follows:
Table 1: Reconciliation of GAAP Net Income to Operating Net Income
Three Months Ended June 30, Six Months Ended June 30,
--------------------------- -------------------------
(000's omitted) 2004 2003 2004 2003
- ----------------------------------- -------------------------- -------------------------
Net income $12,141 $10,032 $23,296 $19,981
After-tax operating adjustments:
Net securities (gains)/losses (82) 0 (89) 0
Debt prepayment costs 0 0 0 27
Acquisition expenses 252 3 847 3
- ----------------------------------- -------------------------- -------------------------
Net income - operating $12,311 $10,035 $24,054 $20,011
=================================== ========================== =========================
Table 2: Summary Income Statements
Three Months Ended June 30, Six Months Ended June 30,
--------------------------- ---------------------------
(000's omitted, except per share data) 2004 2003 2004 2003
- ----------------------------------------------------------- --------------------------- ---------------------------
Net interest income (FTE) $41,083 $35,064 $80,372 $70,528
Loan loss provision 2,300 2,673 4,350 6,073
Non-interest income 10,784 8,947 21,304 17,799
Gain (loss) on investment securities & debt extinguishment 135 0 145 (45)
Operating expenses 29,364 25,174 58,150 49,621
Acquisition expenses 411 5 1,381 5
- ----------------------------------------------------------- --------------------------- ---------------------------
Income before taxes (FTE) 19,927 16,159 37,940 32,583
Fully tax-equivalent adjustment 3,626 2,962 6,961 5,942
Income taxes 4,160 3,165 7,683 6,660
- ----------------------------------------------------------- --------------------------- ---------------------------
Net income $12,141 $10,032 $23,296 $19,981
=========================================================== =========================== ===========================
Diluted earnings per share $0.40 $0.38 $0.77 $0.75
Diluted earnings per share-operating $0.40 $0.38 $0.80 $0.75
Net Interest Income
Net interest income is the amount that interest and fees on earning assets
(loans and investments) exceeds 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 3, net interest income (with non-taxable income converted to a
fully tax-equivalent basis) for second quarter 2004 was $41.1 million, up $6.0
million or 17% from the same period last year. A $715 million increase in
average earning-assets more than offset $611 million higher interest-bearing
liabilities and a 25-basis point decrease in the net interest margin. As
reflected in Table 4, the volume changes mentioned above drove net interest
income to rise $8.1 million, while the lower net interest margin had a lesser
$2.1 million negative impact on net interest income. June 2004 YTD net interest
income of $80.4 million was up $9.8 million or 14.0% from the year-earlier
period. A $548 million increase in average earning-asset levels had a greater
positive effect than a $455 million rise in interest-bearing liabilities and a
19-basis point decline in the net interest margin. Interest-bearing asset and
liability volume changes resulted in $12.6 million more net interest income,
partially offset by a lower net interest margin that had a negative $2.7 million
impact on net interest income.
Higher second quarter and June YTD average loan balances were primarily
attributable to the $393 million of loans acquired in the three bank
transactions and $96 million of organic loan growth over the past 12 months,
driven principally by strong consumer
16
mortgage demand. Average investments (book value basis) rose $326 million for
the second quarter and $202 million for the YTD period in comparison to the same
periods of last year. The Company made a substantial amount of security
purchases in the third quarter of 2003 and second quarter of 2004 to enhance its
interest rate sensitivity and earnings profile. Investments were at below
average levels in the first half of 2003 because the Company had instituted a
de-leveraging strategy from third quarter 2002 through second quarter 2003,
whereby proceeds from the run-off of investment securities were used to pay down
borrowings until more favorable investment market conditions arose. Total
average deposits were up 13.5% and 10.9% for the quarter and YTD periods in
relation to the previous year, respectively, principally due to the deposits
added through the Peoples, Grange and First Heritage acquisitions. External
borrowings were increased to fund organic loan growth and investment purchases
over the last 12 months, resulting in average borrowings that were up $365
million for the quarter and $261 million for the first half of 2004 in
comparison to the year-earlier periods.
The 4.49% net interest margin in the second quarter dropped 25 basis points
versus the same quarter last year, and the June YTD margin of 4.58% was down 19
basis points from the prior year. These declines were primarily attributable to
the reduced level of interest rates over the last 12 months having a greater
impact on earning-asset yields (quarter down 66 basis points, YTD down 64 basis
points), than on the cost of funds (quarter down 41 basis points, YTD down 44
basis points). The reduction of earning-asset yields was mostly driven by
declines in loan yields of 77 basis points for the quarter and 80 basis points
for the YTD period. Loan originations over much of the last year were at rates
that reflected the record-low rates prevalent in the market at the time,
particularly in the mortgage, home equity and auto financing businesses.
Investment portfolio yields were comparatively more stable (down 50 basis points
for the quarter and 37 basis points YTD), as they benefited from significant
call protection and investment purchases that were concentrated in periods of
higher long-term rates. The Company's net interest margin for the first three
months of 2004 was 70 basis points above the average for peer companies, driven
by a very favorable earning-asset yield (+85 basis points), partially offset by
a slightly higher ratio of interest expense to average earning assets (+15 basis
points).
The second quarter cost of funds was down versus the same quarter of 2003 due to
a 39-basis point drop in deposit costs and a 155-basis point decline in the
average interest rate paid on external borrowings. The decline in the YTD costs
of funds was driven by a 41-basis point fall in deposit costs and borrowing
rates that were down 130 basis points. The deposit costs for both time periods
were impacted to the greatest extent by time deposits rolling-over at lower
current rates, but were also favorably affected by an increase in the percentage
of deposit funding provided by demand deposits and a decline in the proportion
of time deposits. The improvement in borrowing costs for the quarterly and YTD
periods was primarily driven by a shift in the mix of external funding from
higher-rate, longer-term borrowings to low-rate, short-term debt. A portion of
this change was contributed by the prepayment of $25 million of longer-term FHLB
obligations in the fourth quarter of 2003, which were replaced with short-term
borrowings at much lower rates. The shift in the profile of borrowings not only
lowered funding costs, but also serves to reduce the Company's risk exposure to
falling interest rates. In addition, a significant amount of intermediate-term
borrowings at favorable rates were added in the current quarter to fund
investment purchases and organic loan growth, further reducing the overall
borrowing rate due to their below-average cost.
17
Table 3 and 3A below sets forth information relating 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 using a marginal income tax rate of 38.70% in 2004 and
38.94% in 2003. Average balances are computed by summing 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. Average loan balances include
non-accrual loans.
Table 3: Quarterly Average Balance Sheet
Three Months Ended Three Months Ended
(000's omitted except yields and rates) June 30, 2004 June 30, 2003
- ---------------------------------------------------------------------------------------------- -----------------------------------
Avg. Avg.
Average Yield/Rate Average Yield/Rate
Balance Interest Paid Balance Interest Paid
----------------------------------- -----------------------------------
Interest-earning assets:
Time deposits in other banks $629 $1 0.64% $219 $1 1.83%
Taxable investment securities (2) 948,470 13,526 5.74% 727,936 11,608 6.40%
Non-taxable investment securities (2) 506,950 8,881 7.05% 401,535 7,229 7.22%
Loans (net of unearned discount)(1) 2,222,827 33,354 6.04% 1,834,610 31,143 6.81%
---------------------- ----------------------
Total interest-earning assets 3,678,876 55,762 6.10% 2,964,300 49,981 6.76%
Non-interest earning assets 467,079 395,627
---------- ----------
Total assets $4,145,955 $3,359,927
========== ==========
Interest-bearing liabilities:
Interest checking, savings and money market deposits $1,122,467 1,512 0.54% $984,553 1,800 0.73%
Time deposits 1,197,563 7,009 2.35% 1,088,845 8,133 3.00%
Short-term borrowings 416,767 1,277 1.23% 132,775 428 1.29%
Long-term borrowings 376,350 4,881 5.22% 295,533 4,556 6.18%
---------------------- ----------------------
Total interest-bearing liabilities 3,113,147 14,679 1.90% 2,501,706 14,917 2.39%
Non-interest bearing liabilities:
Demand deposits 550,683 456,176
Other liabilities 51,465 59,214
Shareholders' equity 430,660 342,831
---------- ----------
Total liabilities and shareholders' equity $4,145,955 $3,359,927
========== ==========
Net interest earnings $41,083 $35,064
========== ==========
Net interest spread 4.20% 4.37%
Net interest margin on interest-earnings assets 4.49% 4.74%
Fully tax-equivalent adjustment on investments and loans $3,626 $2,962
(1) The impact of interest not recognized on non-accrual loans was immaterial.
(2) Averages for investment securities are based on historical cost basis and
the yields do not give effect to changes in fair value that is reflected
as a component of shareholders' equity and deferred taxes.
18
Table 3A: Year to Date Average Balance Sheet
Six Months Ended Six Months Ended
(000's omitted except yields and rates) June 30, 2004 June 30, 2003
- ---------------------------------------------------------------------------------------------- -----------------------------------
Avg. Avg.
Average Yield/Rate Average Yield/Rate
Balance Interest Paid Balance Interest Paid
----------------------------------- -----------------------------------
Interest-earning assets:
Time deposits in other banks $716 $2 0.56% $221 $1 0.91%
Taxable investment securities (2) 882,585 26,121 5.95% 758,775 24,234 6.44%
Non-taxable investment securities (2) 479,943 16,920 7.09% 402,003 14,466 7.26%
Loans (net of unearned discount)(1) 2,167,108 65,975 6.12% 1,821,323 62,531 6.92%
---------------------- ----------------------
Total interest-earning assets 3,530,352 109,018 6.21% 2,982,322 101,232 6.85%
Non-interest earning assets 463,177 393,366
---------- ----------
Total assets $3,993,529 $3,375,688
========== ==========
Interest-bearing liabilities:
Interest checking, savings and money market deposits $1,088,502 3,057 0.56% $985,617 3,734 0.76%
Time deposits 1,185,501 14,098 2.39% 1,094,934 16,835 3.10%
Short-term borrowings 386,465 2,398 1.25% 151,950 990 1.31%
Long-term borrowings 323,414 9,093 5.65% 296,653 9,145 6.22%
---------------------- ----------------------
Total interest-bearing liabilities 2,983,882 28,646 1.93% 2,529,154 30,704 2.45%
Non-interest bearing liabilities:
Demand deposits 535,770 452,717
Other liabilities 53,139 57,613
Shareholders' equity 420,738 336,204
---------- ----------
Total liabilities and shareholders' equity $3,993,529 $3,375,688
========== ==========
Net interest earnings $80,372 $70,528
========== ==========
Net interest spread 4.28% 4.40%
Net interest margin on interest-earnings assets 4.58% 4.77%
Fully tax-equivalent adjustment $6,961 $5,942
(1) The impact of interest not recognized on non-accrual loans was immaterial.
(2) Averages for investment securities are based on historical cost basis and
the yields do not give effect to changes in fair value that is reflected
as a component of shareholders' equity and deferred taxes.
19
As discussed above and disclosed in Table 4 below, the year-over-change in
quarterly and YTD net interest income (fully tax-equivalent basis) may be
analyzed by segregating the volume and rate components of the changes in
interest income and interest expense for each underlying category.
Table 4: Rate/Volume
2nd Quarter 2004 versus 2nd Six Months Ended June 30,
Quarter 2003 2004 versus 2003
Increase (Decrease) Due to Increase (Decrease) Due to
Change in (1) Change in (1)
------------------------------- -------------------------------
Net Net
(000's omitted) Volume Rate Change Volume Rate Change
- ---------------------------------------------------------------------------------------- -------------------------------
Interest earned on:
Time deposits in other banks $1 ($1) $0 $2 ($1) $1
Taxable investment securities 3,241 (1,323) 1,918 3,754 (1,867) 1,887
Non-taxable investment securities 1,851 (199) 1,652 2,753 (299) 2,454
Loans (net of unearned discount) 6,096 (3,885) 2,211 11,030 (7,586) 3,444
Total interest-earning assets (2) $11,191 ($5,410) $5,781 $17,476 ($9,690) $7,786
Interest paid on:
Interest checking, savings and money market deposits $229 ($517) ($288) $365 ($1,042) ($677)
Time deposits 757 (1,881) (1,124) 1,308 (4,045) (2,737)
Short-term borrowings 871 (22) 849 1,457 (49) 1,408
Long-term borrowings 1,121 (796) 325 788 (840) (52)
Total interest-bearing liabilities (2) $3,235 ($3,473) ($238) $4,987 ($7,045) ($2,058)
Net interest earnings (2) $8,069 ($2,050) $6,019 $12,558 ($2,714) $9,844
(1) The change in interest due to both rate and volume has been allocated in
proportion to the relationship of the absolute dollar amounts of change in
each.
(2) Changes due to volume and rate are computed from the respective changes in
average balances and rates and are not a summation of the changes of the
components.
20
Non-interest Income
The Company's sources of non-interest income are of three primary types: banking
services related to loans, deposits and other core customer activities typically
provided through the branch network; financial services, comprised of retirement
plan administration and employee benefit trusts (Benefit Plans Administrative
Services or BPA), actuarial and employee benefit consulting services (Harbridge
Consulting Group or Harbridge), personal trust, investment and insurance
products (Community Investment Services, Inc. or CISI) and investment management
(Elias Asset Management or EAM); and periodic transactions, most often net gains
(losses) from the sale of investments and prepayment of term debt.
Table 5: Non-interest Income
Three Months Ended June 30, Six Months Ended June 30,
--------------------------- -------------------------
(000's omitted) 2004 2003 2004 2003
-------------------------------------------------------- --------------------------- -------------------------
Banking services:
Electronic banking $626 $617 $1,155 $1,163
Mortgage banking 4 268 261 957
Deposit service charges 1,355 1,345 2,692 2,641
Overdraft fees 3,682 3,391 7,134 6,301
Credit life and disability insurance 86 65 141 126
Commissions and other fees 611 459 1,197 1,005
Miscellaneous 83 70 301 96
-------------------------------------------------------- --------------------------- -------------------------
Total banking services 6,447 6,215 12,881 12,289
-------------------------------------------------------- --------------------------- -------------------------
Financial services:
Retirement plan administration and trustee fees 1,422 1,202 2,866 2,303
Actuarial and benefit plan consulting fees 853 0 1,793 0
Asset advisory and management fees 593 369 1,092 878
Investment and insurance product commissions 1,072 808 1,827 1,601
Personal trust 397 353 845 728
-------------------------------------------------------- --------------------------- -------------------------
Total financial services 4,337 2,732 8,423 5,510
-------------------------------------------------------- --------------------------- -------------------------
Sub-total 10,784 8,947 21,304 17,799
Gain (loss) on investment securities & debt prepayment 135 0 145 (45)
-------------------------------------------------------- --------------------------- -------------------------
Total non-interest income $10,919 $8,947 $21,449 $17,754
======================================================== ========================== =========================
Non-interest income/operating income (FTE) 20.8% 20.3% 21.0% 20.2%
As displayed in Table 5, non-interest income (excluding net securities gains and
debt prepayment costs) was $10.8 million in the second quarter and $21.3 million
for the first half of 2004. This corresponded to increases of $1.8 million (21%)
for the quarter and $3.5 million (20%) for the YTD period in comparison to
one-year earlier. A majority of the growth in both time intervals was
attributable to the $1.6 million and $2.9 million increases in financial
services revenue for the quarterly and YTD periods, respectively. Recurring
banking fees were up 3.7% for the current quarter and 4.8% for the first six
months of 2004 versus year-earlier levels.
A majority of the growth in banking non-interest income for both periods was due
to the three whole-bank acquisitions completed over the last nine months, with a
majority of the increase derived from higher overdraft fees. The $291,000 and
$833,000 rise in overdraft income for the quarter and first half of 2004,
respectively, was further enhanced by the conversion of a majority of the
acquired retail accounts to the Company's successful Overdraft FreedomTM
program. In addition, the $205,000 increase in miscellaneous non-interest income
for the first half of 2004 benefited from higher cash surrender values derived
from acquired life insurance policies. These improvements were offset by a
year-over-year decline in mortgage banking income for the quarter (down
$264,000) and first six months of 2004 (down $696,000), which was primarily
attributable to the discontinuation of the sale of longer-term mortgages in the
secondary market in the fourth quarter of 2003. A material amount of gains on
the sale of mortgages were earned in the first half of 2003 as declining
long-term rates increased the market value of mortgages that had been held for
sale.
More than half of the increase in financial services revenue for the second
quarter and first six months of the year was driven by the acquisition of
Harbridge, which accounted for $853,000 and $1,793,000 of the quarterly and YTD
variances, respectively. Strong growth at each of the other financial services
units for both periods also contributed significantly to the year-over-year
increases. BPA generated revenue growth of $220,000 (18%) for the quarter and
$563,000 (24%) for first half of 2004, primarily achieved through obtaining a
significant number of new client relationships and their associated investment
assets. Essentially all of the year-over-year growth at CISI and EAM was
achieved in the current quarter. CISI was up $264,000 for the quarter and was
positively impacted by an
21
increased volume of annuity sales in response to higher interest rates and
additional client relationships developed in the new markets opened up by the
Company's banking acquisitions. Second quarter revenue for EAM increased
$224,000 over the prior year quarter as appreciation in the U.S. equity markets
and the attraction of net new client assets over the past 12 months drove
significant growth (61%). Second quarter and June YTD revenue for the personal
trust business was up 13% and 16% versus the prior year, respectively, as the
unit benefited from increased fees attributable to higher equity asset
valuations and new business generation.
The ratio of non-interest income to operating income (FTE basis, excluding net
security gains and debt prepayment costs) was 20.8% for the second quarter and
21.0% for the first half of the year, 0.5 and 0.8 percentage points higher than
the same periods of last year. The significant growth of the financial services
group was the primary reason non-interest income outpaced net interest income
growth.
There was $145,000 of net security gains in the first half of 2004 from the sale
of securities that were inherited through acquisitions. This compared to $45,000
of debt prepayment costs in the first six months of 2003 associated with the
retirement of $500,000 of the Company's 9.75% fixed-rate subordinated
debentures.
Operating Expenses
Table 6 below sets forth the quarterly and YTD results of the major operating
expense categories for the current and prior year, as well as the efficiency
ratio (defined below), a standard measure of overhead utilization used in the
banking industry.
Table 6: Operating Expenses
Three Months Ended June 30, Six Months Ended June 30,
--------------------------- ----------------------------
(000's omitted) 2004 2003 2004 2003
----------------------------------- --------------------------- ----------------------------
Salaries and employee benefits $15,392 $12,318 $30,559 $25,018
Occupancy 2,500 2,328 5,130 4,749
Equipment and furniture 2,150 1,977 4,302 3,881
Legal and professional fees 970 859 1,967 1,578
Data processing 1,924 1,740 3,804 3,359
Amortization of intangible assets 1,759 1,251 3,398 2,532
Office supplies 577 466 1,098 1,052
Foreclosed property 212 (9) 443 158
Other 3,880 4,244 7,449 7,294
----------------------------------- --------------------------- ----------------------------
Total recurring expenses 29,364 25,174 58,150 49,621
Acquisition expenses 411 5 1,381 5
----------------------------------- --------------------------- ----------------------------
Total operating expenses $29,775 $25,179 $59,531 $49,626
=================================== =========================== ============================
Operating expenses/average assets 2.85% 3.01% 2.93% 2.96%
Efficiency ratio 53.2% 54.4% 53.8% 53.3%
As shown in Table 6, second quarter operating expenses were $29.8 million, up
$4.6 million (18%) from the prior year level, and year-to-date operating
expenses of $59.5 million rose $9.9 million or 20% compared to 2003. The
increases for both periods were primarily attributable to the incremental
recurring operating expenses associated with the acquisitions of Peoples,
Grange, Harbridge and First Heritage during the intervening time period. In
addition, $1.4 million of acquisition expenses were incurred in the first six
months of 2004 versus an immaterial amount in the previous year (no acquisitions
were completed in 2002 and the first half of 2003). A large portion of the
acquisition expenses were associated with $0.9 million of deferred compensation
costs that were recorded in first quarter 2004 but should have been recognized
in 1996 by a bank that was acquired by First Liberty Bank & Trust, prior to its
acquisition by the Company in 2001. The balance of the acquisition expenses was
primarily attributable to professional fees and system conversion costs that
arose due to the acquisitions of First Heritage and Grange.
Recurring operating expenses (excludes acquisition expenses) of $29.4 million
for the quarter and $58.2 million for the first half of 2004 were both up 17%
versus the equivalent prior year periods. As previously mentioned, these
increases were mainly driven by the four acquisitions completed since the end of
June 2003, which affected virtually all expense categories, and amortization of
intangible assets in particular. The year-over-year rise in personnel expenses,
$3.1 million for the second quarter and $5.5 million for the June YTD period,
was also impacted by merit increases, hiring activity and higher pension and
medical costs. Year-to-date legal and professional fees increased versus prior
year in most part due to the increased responsibilities associated with
complying with new governance and regulatory requirements. Lastly, other
expenses in the second quarter were down versus the same period last year
primarily because of costs associated with the retirement of a senior executive
in the second quarter of 2003.
22
The Company's efficiency ratio (recurring operating expenses excluding
intangible amortization divided by the sum of net interest income (FTE) and
recurring non-interest income) was 53.2% for the second quarter, 1.2 percentage
points below the comparable period of 2003. Recurring operating income grew 18%
versus the 15% increase in core operating expenses (as defined above). Organic
income expansion generated principally through loan growth, investment leverage
and increased revenue from the financial services segment resulted in higher
margins due to the significant proportion of fixed costs inherent in the
Company's expense structure. The efficiency ratio of 53.8% for the first half of
2004 was up 0.5 percentage points from a year-earlier due to core operating
expenses increasing 16%, while recurring operating income grew at a lesser, 15%
pace. First quarter 2004 year-over-year net interest income growth lagged the
percentage increase in operating expenses primarily due to a lower net interest
margin and the escalation of certain employee benefit costs.
Income Taxes
The June YTD effective income tax rate was raised 0.8 percentage points to 24.8%
in the second quarter of 2004 principally as a result of a higher proportion of
income being generated from fully taxable loans and investments. The YTD
effective tax rate was only slightly below (0.2 percentage points) the rate for
the first half of 2003. The full six-month impact of the tax rate increase was
incurred in the current quarter, and therefore the rate of 25.5% was above the
YTD and projected full year rate. The quarterly tax rate was 1.5 percentage
points above the tax rate for second quarter 2003, when the YTD rate lowered
from 26.0% to 25.0%.
23
Investments
As reflected in Table 7 below, the book value (excludes unrealized gains) of
investments at the end of the quarter increased $287 million from year-end 2003
and was up $473 million versus June 30, 2003. As previously mentioned, the
year-over-year and quarterly growth in the book value of the investment
portfolio was driven by strategic security purchases made over the last four
quarters to enhance the Company's interest rate sensitivity profile and take
advantage of improved investment market conditions. In addition, the strong
capital positions and excess deposits held by the three banks the Company
acquired over the past nine months provided further support for investment
purchases. The investment portfolio at the end of second quarter 2003 was at a
reduced level due to the de-leveraging strategy that had been in place for more
than three quarters. During that time frame the Company used cash flow from the
run-off of investments to support loan growth and repay borrowings until
reinvestment opportunities became more attractive.
The carrying value of investments (includes unrealized gains on
available-for-sale securities) was $1.6 billion at the end of the second
quarter, up $255 million from December 31, 2003 and $414 million higher than the
end of second quarter 2003. The increases in carrying value were well below that
of the book value changes for the equivalent six and twelve-month periods
because of the decline in the value of unrealized gains (market value adjustment
or "MVA"), caused primarily by the significant rise in interest rates during
second quarter 2004. The MVA at June 30, 2004 of $26.6 million was down $32
million (-55%) from year-end 2003 and was $59 million (-69%) lower than its
level at the end of second quarter 2003, despite the increased size of the
underlying portfolio.
Table 7: Investments
June 30, 2004 December 31, 2003 June 30, 2003
------------------------ ------------------------ ------------------------
Amortized Amortized Amortized
Cost/Book Market Cost/Book Market Cost/Book Market
(000's omitted) Value Value Value Value Value Value
- ------------------------------------------------------------------------------- ------------------------ ------------------------
Held-to-Maturity Portfolio:
U.S. Treasury securities and obligations of U.S.
government corporations and agencies $127,563 $121,957 $127,635 $125,003 $0 $0
Obligations of state and political subdivisions 7,653 7,773 7,459 7,677 6,818 7,108
Other securities 3,577 3,577 3,558 3,558 3,559 3,559
- ------------------------------------------------------------------------------- ------------------------ ------------------------
Total held-to-maturity portfolio 138,793 133,307 138,652 136,238 10,377 10,667
- ------------------------------------------------------------------------------- ------------------------ ------------------------
Available-for-Sale Portfolio:
U.S. Treasury securities and obligations of U.S.
government corporations and agencies 637,166 646,271 456,913 479,454 356,392 389,910
Obligations of state and political subdivisions 543,574 555,393 443,930 470,210 403,837 440,359
Corporate securities 42,177 43,552 27,712 30,251 27,646 31,451
Collateralized mortgage obligations (CMO's) 82,003 84,205 89,566 93,552 163,951 170,819
Mortgage-backed securities 60,182 62,257 76,628 80,177 100,092 105,256
- ------------------------------------------------------------------------------- ------------------------ ------------------------
Sub-total 1,365,102 1,391,678 1,094,749 1,153,644 1,051,918 1,137,795
Equity securities (1) 44,026 44,026 29,185 29,185 16,543 16,543
Federal Reserve Bank common stock 9,856 9,856 8,053 8,053 5,656 5,656
- ------------------------------------------------------------------------------- ------------------------ ------------------------
Total available-for-sale portfolio 1,418,984 1,445,560 1,131,987 1,190,882 1,074,117 1,159,994
Net unrealized gain on available-for-sale portfolio 26,576 0 58,895 0 85,877 0
- ------------------------------------------------------------------------------- ------------------------ ------------------------
Total carrying value $1,584,353 $1,578,867 $1,329,534 $1,327,120 $1,170,371 $1,170,661
======================== ======================== ========================
24
Loans
As shown in Table 8, loans ended the first quarter at $2.3 billion, up $218
million (10.3%) year-to-date and $489 million (26%) higher than one year
earlier. Most of the YTD and year-over-year increases in loan balances was
attributable to acquisitions, which added $206 million to the loan portfolio in
2004 and $393 million over the last 12 months. Excluding the impact of
acquisitions, total loans grew $12 million or 0.5% in the first half of 2004 and
$96 million or 5.2% over the past year. All of the loan growth for both periods
was produced in the consumer mortgage and consumer indirect lines of business.
The organic loan growth for the six and 12-month intervals was generated in the
New York markets, with declines in Pennsylvania. Over the last year the mix of
loans has become more weighted towards consumer mortgages because of the strong
growth in that segment, and business lending due to the high proportion of
commercial loans in First Heritage's portfolio.
Table 8: Loans
(000's omitted) June 30, 2004 December 31, 2003 June 30, 2003
--------------------- -------------------- -------------------- -------------------
Consumer mortgage $780,550 33% $739,593 35% $545,828 29%
Business lending 853,034 36% 689,436 32% 637,985 34%
Consumer indirect 340,868 15% 325,241 15% 305,549 17%
Consumer direct 372,283 16% 374,239 18% 368,653 20%
--------------------- ------------------- ------------------- -------------------
Total loans $2,346,735 100% $2,128,509 100% $1,858,015 100%
===================== =================== =================== ===================
Total consumer mortgages increased $41 million in the first six months of 2004
and $235 million year-over year. Excluding the impact of acquisitions, consumer
mortgages were up $20 million (2.7%) over the last two quarters and $112 million
(21%) over the last year. The year-over-year growth rate would have been even
higher had $14 million of longer-term mortgages not been sold in the secondary
market in the third quarter of 2003. Volumes have slowed in the past six months
as the record levels of refinancing activity that were driven by 40-year low
mortgage rates in 2003 have diminished in a rising interest rate environment.
The growth for both the six and 12-month time frames was derived principally
from activity in the New York markets.
Business loans rose $164 million over the latest six months and were up $215
million from one year ago. All of the growth for both periods came from the
loans acquired in the First Heritage transaction in May 2004. Excluding those
loans, business lending was down $6 million or 0.9% from December 2003's level.
Excluding the impact of all three bank acquisitions, business loans fell $23
million or 3.5% over the last 12 months. The New York markets were down
year-over-year but increased over the past six months, while the Pennsylvania
markets experienced declines over both periods. A relatively slow economic
recovery in our primary markets, restricted capital spending by companies,
competitive conditions and the desire to maintain solid asset quality standards
have limited growth in certain of our markets. However, business loans continue
to grow on an organic basis, as the sequential increase produced in the second
quarter of 2004 was the highest it has been in two and a half years.
Consumer indirect loans, largely borrowings originated in automobile, marine and
recreational vehicle dealerships, rose $16 million (4.8%) in the last six months
and $35 million (11.6%) on a year-over-year basis. Only an immaterial amount of
consumer indirect loans was added in the three bank acquisitions. Historically
low interest rates, aggressive dealer and manufacturer incentives on new
vehicles, and very competitive pricing on used vehicles have helped maintain
solid growth in auto, boat and recreational vehicle sales over the last year.
These market factors as well as the Company's addition of new originating
dealers, strong relationships with current dealers and ability to offer
competitive rates have contributed to 10 straight quarters of consumer indirect
lending growth. Consumer indirect loans increased in both the New York and
Pennsylvania markets during the six and 12-month time frames.
Consumer direct loans are comprised of installment loans, personal loans,
student loans (which are sold once principal repayment begins) and variable and
fixed rate home equity loans and lines of credit. This segment declined by $2
million in the first half of 2004 and was up $4 million from one year ago.
Excluding loans added through acquisition, consumer direct loans were down $18
million (-4.8%) from year-end 2003 and declined $29 million (-7.9%) versus June
30, 2003. A certain amount of consumer installment and home equity loans
continue to be paid off through conventional mortgage refinancings. Promotional
rates, the reduction of rates on larger loans and marketing campaigns were
initiated in the current quarter to promote new home equity volume, but
extremely competitive conditions in this segment has made it difficult to grow
this part of the loan portfolio at profitable yield levels. Total consumer
direct loans were down for both periods in the New York and Pennsylvania
markets.
25
Asset Quality
Table 9 below exhibits the major components of non-performing loans and assets
and key asset quality metrics for the periods ending June 30, 2004 and 2003 and
December 31, 2003.
Table 9: Non-performing Assets
(000's omitted) June 30, 2004 December 31, 2003 June 30, 2003
------------------------------------------------------------ -------------- ------------------ --------------
Non-accrual loans $11,142 $11,940 $12,678
Accruing loans 90+ days delinquent 1,234 1,307 2,457
Restructured loans 856 28 30
------------------------------------------------------------ -------------- ------------------ --------------
Total non-performing loans 13,232 13,275 15,165
Other real estate 1,044 1,077 943
------------------------------------------------------------ -------------- ------------------ --------------
Total non-performing assets $14,276 $14,352 $16,108
============================================================ ============== ================== ==============
Allowance for loan losses to total loans 1.37% 1.37% 1.48%
Allowance for loan losses to non-performing loans 242% 219% 181%
Non-performing loans to total loans 0.56% 0.62% 0.82%
Non-performing assets to total loans and other real estate 0.61% 0.67% 0.87%
Delinquent loans (30 days + to non-accruing) to total loans 1.50% 1.77% 1.79%
Net charge-offs to average loans outstanding (quarterly) 0.26% 0.54% 0.57%
Loan loss provision to net charge-offs (quarterly) 160% 113% 103%
As displayed in Table 9, non-performing assets at June 30, 2004 were $14.3
million, a decrease of $0.1 million versus year-end 2003 and $1.8 million below
the level at the end of second quarter 2003. The improvement over the last six
months was due to a reduction in installment 90+ day delinquencies and
commercial non-accrual levels despite the addition of First Heritage's
portfolio, contributing to a six-basis point drop in the ratio of non-performing
assets to total loans. The decline in non-performing assets over the last year
was primarily attributable to non-performing commercial loans falling by $2.0
million. This improvement combined with the substantial increase in the size of
the loan portfolio resulted in the ratio of non-performing assets to total loans
plus OREO to decline 26 basis points versus June 30, 2003 to 0.61%, reflecting
an overall improvement in asset quality.
Non-performing loans were 0.56% of total loans outstanding at the end of the
second quarter versus 0.62% at year-end 2003 and 0.82% at June 30, 2003. This
ratio improved in comparison to year-end 2003 and one year ago due to the
aforementioned positive developments in the commercial and installment
portfolios over the last year. The Company's non-performing loan ratios for the
second and first (0.66%) quarters of 2004 compared very favorably to the peer
bank mean of 0.78% at the end of first quarter 2004. The allowance for loan loss
to non-performing loans ratio, a general measure of coverage adequacy, was 242%
at the end of the second quarter, up from the coverage ratios of 219% at
year-end 2003 and 181% at June 30, 2003.
Delinquent loans (30 days through non-accruing and restructured loans) as a
percent of total loans was 1.50% at the end of the second quarter, its lowest
level since first quarter 2001. This ratio improved 27 basis points in
comparison to year-end 2003 and 29 basis points versus June 30, 2003. The
reduction of the delinquency ratio from its level six months ago was driven by
the non-performing loan improvements discussed above as well as significant
declines in installment and real estate loans 30 to 89 days past due. The
decrease in the delinquency ratio in comparison to one-year earlier was again
attributable to commercial loans, which experienced a decline in loans 30 to 89
days delinquent in addition to the improved non-performing metrics. As of March
31, 2004, the median peer bank delinquency ratio of 1.57% was seven basis points
above the Company's second quarter ratio and eight basis points lower than its
ratio at that time.
26
Table 10: Allowance for Loan Loss Activity
Three Months Ended June 30, Six Months Ended June 30,
---------------------------- ----------------------------
(000's omitted) 2004 2003 2004 2003
---------------------------------------------------------- ---------------------------- ----------------------------
Amount of loans outstanding at end of period $2,346,735 $1,858,015 $2,346,735 $1,858,015
Daily average amount of loans (net of unearned discount) $2,222,827 $1,834,610 $2,167,108 $1,821,323
Allowance for loan losses at beginning of period $28,821 $27,350 $29,095 $26,331
Charge-offs:
Business lending 613 1,522 1,732 2,702
Consumer mortgage 34 46 130 87
Consumer direct 686 701 1,444 1,388
Consumer indirect 1,154 980 2,205 2,054
---------------------------------------------------------- ---------------------------- ----------------------------
Total charge-offs 2,487 3,249 5,511 6,231
Recoveries:
Business lending 437 56 579 122
Consumer mortgage 10 4 22 8
Consumer direct 187 189 371 405
Consumer indirect 415 394 777 709
---------------------------------------------------------- ---------------------------- ----------------------------
Total recoveries 1,049 643 1,749 1,244
---------------------------------------------------------- ---------------------------- ----------------------------
Net charge-offs 1,438 2,606 3,762 4,987
Provision for loan losses 2,300 2,673 4,350 6,073
Allowance on acquired loans 2,357 0 2,357 0
---------------------------------------------------------- ---------------------------- ----------------------------
Allowance for loan losses at end of period $32,040 $27,417 $32,040 $27,417
========================================================== ============================ ============================
Net charge-offs to average loans outstanding 0.26% 0.57% 0.35% 0.55%
As displayed in Table 10, net charge-offs during the second quarter were $1.4
million, $1.2 million less than the equivalent 2003 period, driven by
significant declines in the business lending segment. This decrease occurred
despite a $388 million increase in average loan balances, and resulted in a
31-basis point drop in the net charge-off ratio (net charge-offs as a percentage
of average loans outstanding) to 0.26%, its lowest quarter-end level in more
than four years. On a year-to-date basis net charge-offs were down $1.2 million
versus the prior year period, while average loans were up $346 million for the
same period, resulting in a 20-basis point decline in the YTD net charge-off
ratio to 0.35%. Lower business loan net charge-offs were again the main
contributor to this substantial improvement, reflecting strengthening economic
conditions and the effectiveness of increased credit risk management resources.
The increased proportion of comparatively low-risk consumer mortgages in the
loan portfolio (35% of total average loans in first half of 2004 versus 29% one
year earlier) also helped reduce the overall level of charge-offs in relation to
total average loan balances.
The business lending net charge-off ratio for the quarter declined 84 basis
points versus prior year to 0.09%, and on a year-to-date basis was down 50 basis
points to 0.32% of average business loans. The second quarter consumer indirect
net charge-off ratio was up 11 basis points versus the same quarter of 2003 to
0.90%, but the June YTD ratio of 0.88% improved by five basis points in
comparison to prior year. The consumer direct net charge-off ratio of 0.55% for
the quarter was equal to the year earlier period and the ratio of 0.59% for the
first half of 2004 was up six basis points versus the same time interval last
year. The net charge-off ratio for consumer mortgages was 0.01% and 0.03% for
the second quarter and first six months of 2004, respectively, in line with the
equivalent periods of 2003. This ratio has averaged only 0.04% of average
consumer mortgage balances over the last eight quarters.
A required loan loss allowance of $32.0 million was determined as of June 30,
2004, resulting in a $2.3 million loan loss provision for the quarter compared
to $2.7 million one year earlier. The second quarter loan loss provision was
$0.9 million higher than net charge-offs mainly due to the additional allowance
needed to cover the $35 million of organic loan growth in the quarter, the
downgrade of risk ratings on certain business loans, and an increase in the
historical loss factors for installment loans. The loan loss provision for the
first half of 2004 of $4.4 million was down $1.7 million or 28% versus the prior
year, driven by the overall improvement in asset quality. The allowance for loan
losses rose $4.6 million or 17% over the last 12 months, versus a 26% increase
in loans outstanding. Consequently, the ratio of allowance for loan loss to
loans outstanding declined 11 basis points to 1.37%. The reduction in this ratio
reflects a higher proportion of high-credit quality consumer mortgages in the
loan portfolio and improving trends in net charge-off, non-performing and
delinquency ratios.
27
Deposits
As shown in Table 11, average deposits of $2.9 billion in the second quarter
were up $224 million compared to fourth quarter 2003 and increased $341 million
versus the same quarter of last year. Deposits of $212 million were added in the
second quarter as a result of the acquisition of First Heritage, and
approximately $249 million of deposits were acquired in conjunction with the
Peoples and Grange transactions in the second half of 2003. Excluding the impact
of these acquisitions, average deposits for the quarter were down approximately
1% from their level in the second and fourth quarters of 2003.
Over the past year the deposit mix continued to shift towards demand deposits
and more liquid interest-bearing deposits (interest checking and savings
accounts). This shift in deposit mix may have reflected customers' unwillingness
to be locked into CD rates for extended periods of time and hold money in
accounts with higher minimum balance requirements at low interest rates,
especially given the diminished interest rate spread between these accounts and
shorter-term or less restrictive interest-bearing accounts. The greatly reduced
opportunity cost of holding money in non-interest and low-interest bearing
accounts contributed to the average balances for demand deposit, interest
checking and savings accounts increasing to 48% of total deposits in second
quarter 2004 versus 45% in the same quarter last year. This shift in mix,
combined with CDs being rolled over at lower interest rates and periodic
reductions of other interest-bearing deposit rates, helped drive down the second
quarter cost of deposits by 39 basis points on a year-over-year basis.
Excluding the impact of acquisitions, average IPC (individuals and businesses)
deposits in the current quarter decreased 1.8% from fourth quarter 2004's level
and 1.7% from one year ago. This mostly reflects the competitive conditions in
our primary markets and the relative attractiveness of alternative funding
sources. Average second quarter public funds deposits were up 9.1% and 15% and
from the second and fourth quarters of 2003, respectively, excluding acquired
deposits. On a total deposit basis, however, this funding source only accounted
for 6.7% of average deposits in second quarter 2004, comparable to the ratio one
year earlier, in part due to the minimal amount of public funds held by the
three banks acquired by the Company over the last year.
Table 11: Average Deposits
Three Months Ended
---------------------------------------
June 30, December 31, June 30,
(000's omitted) 2004 2003 2003
---------------------------- ----------- ------------ -----------
Demand deposits $550,683 $505,015 $456,176
Interest checking deposits 301,509 283,752 269,110
Savings deposits 516,507 448,064 425,580
Money market deposits 304,451 300,558 289,863
Time deposits 1,197,563 1,109,350 1,088,845
---------------------------- ----------- ------------ -----------
Total deposits $2,870,713 $2,646,739 $2,529,574
============================ =========== ============ ===========
IPC deposits $2,678,002 $2,485,165 $2,362,357
Public fund deposits 192,711 161,574 167,217
---------------------------- ----------- ------------ -----------
Total deposits $2,870,713 $2,646,739 $2,529,574
============================ =========== ============ ===========
Borrowings
At the end of the first quarter, borrowings of $933 million increased $265
million from December 31, 2003 and were up $533 million from the June 30, 2003
level. The increases over both the six and 12-month periods were dictated by
organic loan growth, investment security purchases and organic deposit declines.
In the first half of 2004 short-term borrowings increased $96 million and
long-term borrowings were up $169 million. Over the last 12 months, short-term
borrowings increased $389 million and long-term borrowings rose by $144 million.
A higher proportion of short-term borrowings has been utilized in comparison to
one year ago due to the significant amount of longer-term, core deposits added
through acquisitions, to take advantage of an unusually steep yield curve, to
reduce the Company's sensitivity to falling interest rates and to provide more
flexibility with regard to altering future debt levels. The percentage of
long-term borrowings increased in the current quarter due to the addition of a
substantial amount of eighteen month FHLB borrowings that were used to fund
securities purchases. These borrowings still carry relatively short maturities
and help provide funding cost stability for a period of time that is
complementary to our asset/liability profile.
Shareholders' Equity
At a special meeting of the shareholders held on March 26, 2004, the
shareholders approved an amendment to the certificate of incorporation of the
Company to increase the number of authorized shares of common stock from 20
million to 50 million shares. This amendment was adopted in connection with the
previously announced two-for-one stock split of the Company's common stock. The
split was effected in the form of a 100% stock dividend that was paid on April
12, 2004 to shareholders of record as of March 17, 2004.
28
The Company announced on May 21, 2004 that its Board of Directors had approved
the continuation of a stock repurchase program previously announced on June 9,
2003. The program provides for the purchase of up to 1,400,000 of its shares,
which may be repurchased from time to time, in open market or privately
negotiated transactions over the course of the subsequent 12 months. All
reacquired shares will become treasury shares and will be used for general
corporate purposes. As of the end of the second quarter, 1,119,287 shares had
been repurchased through this program at an aggregate cost of $23.9 million and
an average price per share of $21.31.
Total common shares of 30.6 million were outstanding as of June 30, 2004, up 2.3
million from year-end 2003 and 4.6 million higher than the level at the end of
second quarter 2003. The increase over the last twelve months was comprised of
4.9 million shares issued in conjunction with the Grange and First Heritage
acquisitions and 0.7 million shares issued through the employee stock plan,
partially offset by 1.0 million of treasury stock purchases.
Total shareholders' equity equaled $441 million at the end of the second
quarter, $37 million higher than the balance at December 31, 2003. This increase
consisted of $55 million of common stock and options issued in the First
Heritage acquisition, net income of $23 million and $3 million from shares
issued under the employee stock plan, partially offset by a $20 million decline
in the after-tax investment market value adjustment (a component of other
comprehensive income), treasury stock purchases of $15 million and dividends
declared of $9 million. Over the past 12 months total shareholders' equity
increased by $90 million as shares issued in the Grange and First Heritage
acquisitions and employee stock plan and capital growth from net income more
than offset declines caused by a drop in the market value adjustment, dividends
declared and treasury stock purchases.
The Company's Tier I leverage ratio, a primary measure of regulatory capital for
which 5% is the requirement to be "well-capitalized," was 6.98% at the end of
the second quarter, down 28 basis points from year-end 2003 and 79 basis points
lower than its level one year ago. These declines were primarily caused by the
treasury share purchases made over the last 12 months and increased investment
levels prompted by a more favorable interest rate environment. The tangible
equity-to-assets ratio declined 60 basis points versus year-end 2003 and was
down 1.7 percentage points in comparison to June 30, 2003. A decline in the
market value adjustment due to a significant rise in interest rates in the
current quarter was the primary driver of the drop in this ratio in addition to
the factors discussed above. The decline in the tangible equity-to-assets ratio
was more pronounced than that of the Tier I leverage ratio primarily because the
market value adjustment component of equity is excluded from that regulatory
ratio.
The dividend payout ratio (dividends declared divided by net income) for the
first half of 2004 was 40.8%, up 3.0 percentage points from one year ago. The
ratio rose because dividends declared increased 26%, higher than the 17% growth
in net income. The rise in dividends declared was caused by shares outstanding
increasing 18%, mostly attributable to the Grange and First Heritage
acquisitions, and dividends per share being raised 10.3% in third quarter 2003,
from $0.145 to $0.160.
Liquidity
Management of the Company's liquidity is critical due to the potential for
unexpected fluctuations in deposits and loans. Adequate sources of both on and
off-balance sheet funding are in place to effectively respond to such unexpected
fluctuations.
The Bank's primary approach to measuring liquidity is known as the Basic
Surplus/Deficit model. It is used to calculate liquidity over two time periods:
first, the amount of cash that could be made available within 30 days
(calculated as liquid assets less short-term liabilities); and second, a
projection of subsequent cash availability over an additional 60 days. The
minimum policy level of liquidity under the Basic Surplus/Deficit approach is
7.5% of total assets for both the 30 and 90-day time horizons. As of June 30,
2004, this ratio was 14.6% for both time periods, excluding the Company's
capacity to borrow additional funds from the Federal Home Loan Bank.
To measure longer-term liquidity, a baseline projection of loan and deposit
growth for five years is made to reflect how current liquidity levels could
change over time. This five-year measure reflects adequate liquidity to fund
loan and other asset growth over the next five years.
Forward-Looking Statements
This document contains comments or information that constitute forward-looking
statements (within the meaning of the Private Securities Litigation Reform Act
of 1995), which involve significant risks and uncertainties. Actual results may
differ materially from the results discussed in the forward-looking statements.
Moreover, the Company's plans, objectives and intentions are subject to change
based on various factors (some of which are beyond the Company's control).
Factors that could cause actual results to differ from those discussed in the
forward-looking statements include: (1) risks related to credit quality,
interest rate sensitivity and liquidity; (2) the strength of the U.S. economy in
general and the strength of the local economies where the Company conducts its
business; (3) the effect of, and changes in, monetary and fiscal policies and
laws, including interest rate policies of the Board of Governors of the Federal
Reserve System; (4) inflation, interest rate, market and monetary fluctuations;
(5) the timely development of new products and services and customer perception
of the overall value thereof (including features, pricing and quality) compared
to competing
29
products and services; (6) changes in consumer spending, borrowing and savings
habits; (7) technological changes; (8) any acquisitions or mergers that might be
considered or consummated by the Company and the costs and factors associated
therewith; (9) the ability to maintain and increase market share and control
expenses; (10) the effect of changes in laws and regulations (including laws and
regulations concerning taxes, banking, securities and insurance) and accounting
principles generally accepted in the United States; (11) changes in the
Company's organization, compensation and benefit plans and in the availability
of, and compensation levels for, employees in its geographic markets; (12) the
costs and effects of litigation and of any adverse outcome in such litigation;
(13) other risk factors outlined in the Company's filings with the Securities
and Exchange Commission from time to time; and (14) the success of the Company
at managing the risks of the foregoing.
The foregoing list of important factors is not exclusive. Such forward-looking
statements speak only as of the date on which they are made and the Company does
not undertake any obligation to update any forward-looking statement, whether
written or oral, to reflect events or circumstances after the date on which such
statement is made. If the Company does update or correct one or more
forward-looking statements, investors and others should not conclude that the
Company would make additional updates or corrections with respect thereto or
with respect to other forward-looking statements.
30
Item 3. Quantitative and Qualitative Disclosure about Market Risk
Market risk is the risk of loss in a financial instrument arising from adverse
changes in market rates, prices or credit risk. Credit risk associated with the
Company's loan portfolio has been previously discussed in the asset quality
section of Management's Discussion and Analysis of Financial Condition and
Results of Operations. Management believes that the tax risk of the Company's
municipal investments associated with potential future changes in statutory,
judicial and regulatory actions is minimal. The Company has an insignificant
amount of credit risk in its investment portfolio because essentially all of the
fixed-income securities in the portfolio are AAA-rated (highest possible
rating). Therefore, almost all the market risk in the investment portfolio is
related to interest rates.
The ongoing monitoring and management of both interest rate risk and liquidity,
in the short and long term time horizons is an important component of the
Company's asset/liability management process, which is governed by limits
established in the policies reviewed and approved annually by the Board of
Directors. The Board of Directors delegates responsibility for carrying out the
policies to the Asset/Liability Committee (ALCO) which meets each month and is
made up of the Company's senior management as well as regional and
line-of-business managers who oversee specific earning asset classes and various
funding sources.
As the Company does not believe it is possible to reliably predict future
interest rate movements, it has maintained an appropriate process and set of
measurement tools which enable it to identify and quantify sources of interest
rate risk in varying rate environments. The primary tool used by the Company in
managing interest rate risk is income simulation.
While a wide variety of strategic balance sheet and treasury yield curve
scenarios are tested on an ongoing basis, the following reflects the Company's
one-year net interest income sensitivity based on:
o Asset and liability levels using June 30, 2004 as a starting point.
o There are assumed to be conservative levels of balance sheet growth-- low
to mid single digit growth in loans, investments and deposits, augmented
by necessary changes in borrowings and retained earnings, with no growth
in other major components of the balance sheet.
o The prime rate and federal funds rates are assumed to move up 200 basis
points and down 100 basis points over a 12-month period while flattening
the long end of the treasury curve to spreads over federal funds that are
more consistent with historical norms. Deposit rates are assumed to move
in a manner that reflects the historical relationship between deposit rate
movement and changes in the federal funds rate, generally reflecting
10%-70% of the movement of the federal funds rate.
o Cash flows are based on contractual maturity, optionality and amortization
schedules along with applicable prepayments derived from internal
historical data and external sources.
Net Interest Income Sensitivity Model
Calculated annualized
increase (decrease) in
Change in interest projected net interest
rates income at June 30, 2004
------------------------------------------------
+ 200 basis points (2.4%)
- 100 basis points (1.6%)
In the model, both the rising and falling rate environments reflect a reduction
in net interest income (NII) from a flat rate environment due to the assumed
flattening of the yield curve. The modeled NII in a falling rate environment is
initially more favorable than if rates were to rise due to a faster initial
reaction from core deposit pricing and short-term capital market borrowing
rates. Over a longer time period, however, the growth in NII improves in a
rising rate environment as a result of lower yielding earning assets running off
and being replaced at increased rates.
The analysis does not represent a Company forecast and should not be relied upon
as being indicative of expected operating results. These hypothetical estimates
are based upon numerous assumptions: the nature and timing of interest rate
levels (including yield curve shape), prepayments on loans and securities,
deposit decay rates, pricing decisions on loans and deposits,
reinvestment/replacement of asset and liability cash flows, and other factors.
While the assumptions are developed based upon current economic and local market
conditions, the Company cannot make any assurances as to the predictive nature
of these assumptions, including how customer preferences or competitor
influences might change. Furthermore, the sensitivity analysis does not reflect
actions that ALCO might take in responding to or anticipating changes in
interest rates.
31
Item 4. Controls and Procedures
As of June 30, 2004, the Chief Executive Officer and Chief Financial Officer of
the Company evaluated the Company's disclosure controls and procedures related
to the recording, processing, summarization and reporting of information in the
Company's reports that it files with the Securities and Exchange Commission
(SEC). These disclosure controls and procedures have been designed to ensure
that (a) material information relating to the Company, including its
consolidated subsidiaries, is made known to the Company's management, including
their officers, by other employees of the Company and its subsidiaries, and (b)
this information is recorded, processed, summarized, evaluated and reported, as
applicable, within the time periods specified in the SEC's rules and forms.
Based upon this evaluation, these officers concluded that the design and
effectiveness of the disclosure controls and procedures is sufficient to
accomplish their purpose.
There have been no significant changes in the Company's internal controls or
other factors that could significantly affect these controls subsequent to the
date of their evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
32
Part II. Other Information
Item 1. Legal Proceedings.
The Company and its subsidiaries are subject in the normal course of business to
various pending and threatened legal proceedings in which claims for monetary
damages are asserted. Management, after consultation with legal counsel, does
not anticipate that the aggregate liability, if any, arising out of litigation
pending against the Company or its subsidiaries will have a material effect on
the Company's consolidated financial position or results of operations.
Item 2. Changes in Securities, Use of Proceeds and Issuer Repurchases of Equity
Securities.
(e) On May 21, 2004, the Company announced the continuation of a stock
repurchase program previously announced in June 2003. The program provides for
the repurchase of up to 1,400,000 of its outstanding shares in open market or
privately negotiated transactions through June 2005. The repurchases will be for
general corporate purposes, including those related to acquisition and stock
plan activities. The following table shows treasury stock purchases under this
authorization during the first six months 2004.
Total Number Number of Shares
Number of Average Price of Shares Remaining to be
Shares Purchased Per share Purchased Purchased
- --------------------------------------------------------------------------------
January 2004 0 $0.00 416,300 983,700
February 2004 0 0.00 416,300 983,700
March 2004 122,800 22.29 539,100 860,900
April 2004 40,958 22.69 580,058 819,942
May 2004 131,642 21.07 711,700 688,300
June 2004 407,587 21.88 1,119,287 280,713
- ---------------------------------------------------------------------------
Total 702,987 $21.85 1,119,287 280,713
===========================================================================
Item 3. Defaults Upon Senior Securities.
Not applicable.
Item 4. Submission of Matters to a Vote of Securities Holders.
At the annual meeting of the shareholders held on May 19, 2004, the shareholders
elected four nominees of the Board of Directors and approved the Community Bank
System, Inc. 2004 Long-Term Incentive Compensation Program.
For Against/Abstain Unvoted
----------------------------------------
John M. Burgess 12,580,183 395,355 0
Nicholas A. DiCerbo 12,584,263 391,275 0
James A. Gabriel 12,584,299 391,239 0
Harold S. Kaplan 12,527,018 448,520 0
2004 Long-Term Incentive Compensation Program 5,619,366 4,822,907 2,533,265
Item 5. Other Information.
Not applicable
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit No. Description
- ----------- -----------
10.1 2004 Long-Term Incentive Compensation Program. Incorporated by
reference to Appendix A to the Definitive Proxy Statement on
Schedule 14A filed on April 15, 2004 (File No. 001-13695). **
10.2 Employment Agreement, effective May 1, 2004, by and between
Community Bank System, Inc., Community Bank, N.A. and Steven
R. Tokach. * **
33
10.3 Employment Agreement, effective August 2, 2004, by and between
Community Bank System, Inc., Community Bank, N.A. and Scott A.
Kingsley. * **
10.4 Supplemental Retirement Plan Agreement, effective August 2,
2004, by and between Community Bank System, Inc. and Scott A.
Kingsley. * **
31.1 Certification of Sanford A. Belden, President and Chief
Executive Officer of the Registrant, pursuant to Rule
13a-15(e) or Rule 15d-15(e) under the Securities Exchange Act
of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification of Mark E. Tryniski, Treasurer, Chief Operating
Officer and Financial Officer of the Registrant, pursuant to
Rule 13a-15(e) or Rule 15d-15(e) under the Securities Exchange
Act of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification of Sanford A. Belden, President and Chief
Executive Officer of the Registrant, pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
32.2 Certification of Mark E. Tryniski, Treasurer, Chief Operating
Officer and Financial Officer of the Registrant, pursuant to
18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
* Filed herewith
** Denotes management contract or compensatory plan or arrangement
(b) Reports on Form 8-K:
o Form 8-K related to quarterly earnings press release was filed on April
22, 2004.
o Form 8-K related to additional information about fees paid to the
Company's independent accountants as reported in the 2004 proxy statement
was filed on May 6, 2004.
34
SIGNATURES
Pursuant to the requirements of The Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Community Bank System, Inc.
Date: August 4, 2004 /s/ Sanford A. Belden
---------------------
Sanford A. Belden, President, Chief
Executive Officer and Director
Date: August 4, 2004 /s/ Mark E. Tryniski
--------------------
Mark E. Tryniski, Treasurer, Chief
Operating Officer and Chief Financial
Officer
35