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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 September 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 - 30,606,615 shares outstanding as of
November 4, 2004
TABLE OF CONTENTS
Page
----
Part I. Financial Information
Item 1. Financial Statements (Unaudited)
Consolidated Statements of Condition
September 30, 2004 and December 31, 2003 3
Consolidated Statements of Income
Three and nine months ended September 30, 2004 and 2003 4
Consolidated Statement of Changes in Shareholders' Equity
Nine months ended September 30, 2004 5
Consolidated Statements of Comprehensive Income
Three and nine months ended September 30, 2004 and 2003 6
Consolidated Statements of Cash Flows
Nine months ended September 30, 2004 and 2003 7
Notes to the Consolidated Financial Statements
September 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 28
Item 4. Controls and Procedures 29
Part II. Other Information
Item 1. Legal Proceedings 30
Item 2. Changes in Securities, Use of Proceeds and Issuer Repurchases
of Equity Securities 30
Item 3. Defaults upon Senior Securities 30
Item 4. Submission of Matters to a Vote of Securities Holders 30
Item 5. Other Information 30
Item 6. Exhibits and Reports on Form 8-K 30
2
Part 1. Financial Information
Item 1. Financial Statements
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF CONDITION (Unaudited)
(In Thousands, Except Share Data)
September 30, December 31,
2004 2003
- ------------------------------------------------------------------------------------------------------------------------
Cash and due from banks $ 122,329 $ 103,923
Available-for-sale investment securities 1,467,328 1,190,882
Held-to-maturity investment securities 137,640 138,652
- ------------------------------------------------------------------------------------------------------------------------
Total investment securities (fair value of $1,603,921 and $1,327,120, respectively) 1,604,968 1,329,534
Loans 2,373,751 2,128,509
Allowance for loan losses 32,609 29,095
- ------------------------------------------------------------------------------------------------------------------------
Net loans 2,341,142 2,099,414
Premises and equipment, net 63,836 61,705
Accrued interest receivable 28,905 25,851
Core deposit intangibles, net 35,932 33,998
Goodwill 190,696 159,596
Other intangibles, net 2,116 2,517
- ------------------------------------------------------------------------------------------------------------------------
Intangible assets, net 228,744 196,111
Other assets 34,630 38,859
- ------------------------------------------------------------------------------------------------------------------------
Total assets $ 4,424,554 $ 3,855,397
========================================================================================================================
Liabilities:
Non-interest bearing deposits $ 563,699 $ 498,195
Interest bearing deposits 2,355,389 2,227,293
- ------------------------------------------------------------------------------------------------------------------------
Total deposits 2,919,088 2,725,488
Federal funds purchased 50,000 36,300
Borrowings 841,154 551,096
Subordinated debt held by unconsolidated subsidiary trusts 80,432 80,390
Accrued interest and other liabilities 66,679 57,295
- ------------------------------------------------------------------------------------------------------------------------
Total liabilities 3,957,353 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;
31,954,442 and 28,746,612 shares issued in 2004 and 2003, respectively 31,954 28,747
Additional paid-in capital 186,843 130,066
Retained earnings 241,144 218,628
Accumulated other comprehensive income 38,000 35,958
Treasury stock, at cost (1,400,000 and 416,300 shares, respectively) (30,199) (8,490)
Employee stock plan - unearned (541) (81)
- ------------------------------------------------------------------------------------------------------------------------
Total shareholders' equity 467,201 404,828
- ------------------------------------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $ 4,424,554 $ 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 Nine Months Ended
September 30, September 30,
------------------ --------------------
2004 2003 2004 2003
- ---------------------------------------------------------------------------------------------------------------------------------
Interest income:
Interest and fees on loans $35,267 $ 30,883 $101,043 $ 93,084
Interest and dividends on taxable investments 13,895 11,140 39,266 34,876
Interest and dividends on non-taxable investments 6,061 4,653 16,971 14,006
- ---------------------------------------------------------------------------------------------------------------------------------
Total interest income 55,223 46,676 157,280 141,966
- ---------------------------------------------------------------------------------------------------------------------------------
Interest expense:
Interest on deposits 8,622 8,905 25,777 29,474
Interest on federal funds purchased 95 65 282 234
Interest on short-term borrowings 2,055 573 4,266 1,394
Interest on subordinated debt held by unconsolidated subsidiary trusts 1,460 1,401 4,244 4,237
Interest on long-term borrowings 3,934 3,193 10,243 9,502
- ---------------------------------------------------------------------------------------------------------------------------------
Total interest expense 16,166 14,137 44,812 44,841
- ---------------------------------------------------------------------------------------------------------------------------------
Net interest income 39,057 32,539 112,468 97,125
Less: provision for loan losses 2,300 2,029 6,650 8,102
- ---------------------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 36,757 30,510 105,818 89,023
- ---------------------------------------------------------------------------------------------------------------------------------
Non-interest income:
Deposit service fees 6,756 6,080 18,713 17,025
Other banking services 1,135 (37) 2,059 1,307
Trust, investment and asset management fees 1,935 1,747 5,699 4,954
Benefit plan administration, consulting and actuarial fees 2,338 1,986 6,997 4,289
Gain (loss) on investment securities & debt extinguishment 0 3 145 (42)
- ---------------------------------------------------------------------------------------------------------------------------------
Total non-interest income 12,164 9,779 33,613 27,533
- ---------------------------------------------------------------------------------------------------------------------------------
Operating expenses:
Salaries and employee benefits 15,638 13,225 46,197 38,243
Occupancy 2,570 2,255 7,700 7,004
Equipment and furniture 2,143 1,885 6,445 5,766
Amortization of intangible assets 2,003 1,269 5,401 3,801
Legal and professional fees 1,003 672 2,970 2,250
Data processing 1,973 1,647 5,777 5,006
Office supplies 613 455 1,711 1,507
Acquisition expenses 53 165 1,434 170
Other 3,930 3,633 11,822 11,085
- ---------------------------------------------------------------------------------------------------------------------------------
Total operating expenses 29,926 25,206 89,457 74,832
- ---------------------------------------------------------------------------------------------------------------------------------
Income before income taxes 18,995 15,083 49,974 41,724
Income taxes 4,761 3,354 12,444 10,014
- ---------------------------------------------------------------------------------------------------------------------------------
Net income $14,234 $ 11,729 $ 37,530 $ 31,710
=================================================================================================================================
Basic earnings per share $ 0.47 $ 0.45 $ 1.27 $ 1.22
Diluted earnings per share $ 0.45 $ 0.44 $ 1.23 $ 1.19
Dividends declared per share $ 0.18 $ 0.16 $ 0.50 $ 0.45
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)
Nine Months Ended September 30, 2004
(In Thousands, Except Share Data)
Accumulated
Common Stock Other
--------------------- Additional Compre- Employee
Shares Amount Paid-In Retained hensive Treasury Stock Plan
Outstanding Issued Capital Earnings Income Stock -Unearned Total
- -----------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2003, as previously 14,165,156 $14,373 $144,440 $218,628 $35,958 ($8,490) ($81) $404,828
reported
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 37,530 37,530
Other comprehensive income, net of tax 2,042 2,042
Dividends declared:
Common, $.50 per share (15,014) (15,014)
Common stock issued under employee stock plan 615,617 615 4,650 (460) 4,805
Stock and options issued for acquisition 2,592,213 2,592 52,127 54,719
Treasury stock purchased (983,700) (21,709) (21,709)
- -----------------------------------------------------------------------------------------------------------------------------------
Balance at September 30, 2004 30,554,442 $31,954 $186,843 $241,144 $38,000 ($30,199) ($541) $467,201
===================================================================================================================================
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 (LOSS) (Unaudited)
(In Thousands)
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- -----------------------
2004 2003 2004 2003
- -----------------------------------------------------------------------------------------------------------------------------------
Other comprehensive income (loss), before tax:
Change in minimum pension liability adjustment $ 0 $ 0 $ 0 $ 97
Unrealized (losses) gains on securities:
Unrealized holding gains (losses) arising during period 35,415 (21,053) 3,241 258
Reclassification adjustment for gains included in net income 0 (3) (145) (3)
- -----------------------------------------------------------------------------------------------------------------------------------
Other comprehensive income (loss), before tax 35,415 (21,056) 3,096 352
Income tax (expense) benefit related to other comprehensive income (loss) (13,703) 8,200 (1,054) 679
- -----------------------------------------------------------------------------------------------------------------------------------
Other comprehensive income (loss), net of tax 21,712 (12,856) 2,042 1,031
Net income 14,234 11,729 37,530 31,710
- -----------------------------------------------------------------------------------------------------------------------------------
Comprehensive income (loss) $ 35,946 ($ 1,127) $ 39,572 $ 32,741
===================================================================================================================================
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)
Nine Months Ended September 30,
-------------------------------
2004 2003
- ---------------------------------------------------------------------------------------------------------------------
Operating activities:
Net income $ 37,530 $ 31,710
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation 5,985 5,263
Amortization of intangible assets 5,401 3,801
Net amortization of premiums and discounts on securities and loans 1,106 1,710
Amortization of unearned compensation and discount on subordinated debt 244 96
Provision for loan losses 6,650 8,102
(Gain) loss on investment securities and debt extinguishment (145) 42
Loss on loans and other assets 211 379
Proceeds from the sale of loans held for sale 0 67,444
Origination of loans held for sale 0 (61,036)
Change in other operating assets and liabilities 5,560 (2,385)
- ---------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 62,542 55,126
- ---------------------------------------------------------------------------------------------------------------------
Investing activities:
Proceeds from sales of available-for-sale investment securities 41,490 14,611
Proceeds from maturities of held-to-maturity investment securities 3,937 3,901
Proceeds from maturities of available-for-sale investment securities 115,655 196,867
Purchases of held-to-maturity investment securities (3,035) (132,242)
Purchases of available-for-sale investment securities (387,391) (88,779)
Net increase in loans outstanding (44,220) (116,498)
Cash received (paid) for acquisition (net of cash paid of $7,023 in 2004 and cash
acquired of $9,428 in 2003) 409 (1,928)
Capital expenditures (5,461) (5,334)
- ---------------------------------------------------------------------------------------------------------------------
Net cash used by investing activities (278,616) (129,402)
- ---------------------------------------------------------------------------------------------------------------------
Financing activities:
Net change in demand deposits, NOW accounts, and savings accounts 24,679 80,523
Net change in time deposits (43,143) (56,108)
Net change in federal funds purchased 13,700 12,000
Net change in short-term borrowings 101,528 62,455
Change in long-term borrowings (net of payments of $112 and $5,000) 168,930 (5,000)
Issuance of common stock (net of restricted stock awards of $654 and $248) 4,611 3,986
Purchase of treasury stock (21,709) (8,490)
Cash dividends paid (14,044) (11,320)
Other financing activities (72) (111)
- ---------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 234,480 77,935
- ---------------------------------------------------------------------------------------------------------------------
Change in cash and cash equivalents 18,406 3,659
Cash and cash equivalents at beginning of period 103,923 113,531
- ---------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 122,329 $ 117,190
=====================================================================================================================
Supplemental disclosures of cash flow information:
Cash paid for interest $ 43,335 $ 45,280
Cash paid for income taxes $ 8,889 $ 9,996
Supplemental disclosures of non-cash financing and investing activities:
Dividends declared and unpaid $ 5,499 $ 4,147
Gross change in unrealized gains on available-for-sale investment securities $ 3,096 $ 256
Acquisitions:
Fair value of assets acquired, excluding acquired cash and intangibles $ 252,119 $ 18,473
Fair value of liabilities assumed $ 235,511 $ 25,664
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)
September 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.
Certain prior period amounts have been reclassified to conform to the current
year presentation.
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,
employee stock options with a fair value of $3.0 million, and $7.0 million of
cash (including capitalized acquisition costs of $1.0 million). 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 30,768
Core deposit intangibles 6,934
- ----------------------------------------------------------
Total assets acquired 297,253
Deposits 212,064
Borrowings 19,672
Other liabilities 3,775
- ----------------------------------------------------------
Total liabilities assumed 235,511
- ----------------------------------------------------------
Net assets acquired $ 61,742
==========================================================
Dansville Branch Acquisition
On August 4, 2004, the Company announced it had signed a definitive agreement to
purchase a branch office in Dansville, N.Y. from HSBC Bank USA, N.A., pending
regulatory approval. The acquisition is expected to close during December 2004.
Stock Repurchase Program
During the third quarter of 2004 the Company purchased 280,713 common shares
completing the previously announced 1.4 million-share repurchase program. The
aggregate cost of this program was $30.2 million and the average price per share
is $21.57. The repurchases were for general corporate purposes, including those
related to acquisition and stock plan activities.
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.
8
Accordingly, all share, option and per-share amounts have been adjusted in the
consolidated financial statements to reflect the stock split.
NOTE C: ACCOUNTING POLICIES
Critical Accounting Policies
Allowance for Loan Losses
Management continually evaluates the credit quality of the Company's 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 $0.5 million 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-based 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
underlying 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
9
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:
2004 2003
- -------------------------------------------------------------------------------
Weighted-average expected life 7.78 8.74
Future dividend yield 3.00% 3.00%
Share price volatility 25.47%-26.88% 27.29%-27.58%
Weighted average risk-free interest rate 4.02%-4.45% 3.81%
===============================================================================
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 Nine Months Ended
September 30, September 30,
-------------------------- --------------------------
(000's omitted except per share amounts) 2004 2003 2004 2003
- ----------------------------------------------------------------------------------------------------------------
Net income, as reported $ 14,234 $ 11,729 $ 37,530 $ 31,710
Less: stock-based compensation expense
determined under fair value method, net of tax 206 158 831 612
- ----------------------------------------------------------------------------------------------------------------
Pro forma net income $ 14,028 $ 11,571 $ 36,699 $ 31,098
================================================================================================================
Earnings per share:
As reported:
Basic $ 0.47 $ 0.45 $ 1.27 $ 1.22
Diluted $ 0.45 $ 0.44 $ 1.23 $ 1.19
Pro forma:
Basic $ 0.46 $ 0.44 $ 1.24 $ 1.19
Diluted $ 0.44 $ 0.43 $ 1.20 $ 1.17
As of September 30, 2004 there were 2,489,458 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. The Company adopted this standard effective July 1, 2004
and determined its plan does not provide a drug benefit that is actuarially
equivalent to the Medicare Part D benefit. As a result, this standard had no
impact on results of operations, financial position, or liquidity of the
Company.
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. In October 2004, the FASB delayed the effective date of
this statement to periods beginning after June 15, 2005. Management does not
expect the impact of the adoption of this exposure draft if adopted in its
current version to be materially different from the pro forma impacts disclosed
under SFAS No. 123.
10
NOTE D: EARNINGS PER SHARE
Basic earnings per share are computed based on the weighted-average common
shares outstanding for the period. Diluted earnings per share are 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 427,114 and 433,622 anti-dilutive stock options
outstanding for the three and nine months ended September 30, 2004,
respectively, compared to zero and 15,000 for the three and nine months ended
September 30, 2003. The following is a reconciliation of basic to diluted
earnings per share for the three and nine months ended September 30, 2004 and
2003.
Per Share
(000's omitted, except per share data) Income Shares Amount
- --------------------------------------------------------------------------------------------
Three Months Ended September 30, 2004
Basic EPS $14,234 30,580 $0.47
Stock options 965
- -----------------------------------------------------------------------------
Diluted EPS $14,234 31,545 $0.45
=============================================================================
Three Months Ended September 30, 2003
Basic EPS $11,729 26,022 $0.45
Stock options 794
- -----------------------------------------------------------------------------
Diluted EPS $11,729 26,816 $0.44
=============================================================================
Nine Months Ended September 30, 2004
Basic EPS $37,530 29,664 $1.27
Stock options 933
- -----------------------------------------------------------------------------
Diluted EPS $37,530 30,597 $1.23
=============================================================================
Nine Months Ended September 30, 2003
Basic EPS $31,710 26,064 $1.22
Stock options 617
- -----------------------------------------------------------------------------
Diluted EPS $31,710 26,681 $1.19
=============================================================================
11
NOTE E: INTANGIBLE ASSETS
The gross carrying amount and accumulated amortization for each type of
intangible asset are as follows:
As of September 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 ($26,457) $ 35,932 $ 55,455 ($21,457) $ 33,998
Other intangibles 2,750 (634) 2,116 2,750 (233) 2,517
------------------------------------- -------------------------------------
Total amortizing intangibles 65,139 (27,091) 38,048 58,205 (21,690) 36,515
Non-amortizing intangible assets:
Goodwill 190,696 0 190,696 159,596 0 159,596
------------------------------------- -------------------------------------
Total intangible assets, net $255,835 ($27,091) $228,744 $217,801 ($21,690) $196,111
===================================== =====================================
As described in Note B, the increases in the gross carrying amount of core
deposit intangibles and goodwill primarily relate 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 ending December 31 is as follows:
(000's omitted)Amount
- -------------------------------
Oct-Dec 2004 $2,013
2005 6,953
2006 5,794
2007 5,440
2008 5,154
Thereafter 12,694
-------
Total $38,048
=======
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 are 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 $81,439,000 and $82,410,000 at September 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
====================================================================================================================================
12
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 Nine Months Ended Three Months Ended Nine Months Ended
September 30, September 30, September 30, September 30,
------------------ --------------------- ------------------ -----------------
(000's omitted) 2004 2003 2004 2003 2004 2003 2004 2003
- ----------------------------------------------------------------------------------------------------------------------------------
Service cost $ 480 $ 481 $ 1,440 $ 1,193 $ 78 $ 45 $233 $136
Interest cost 592 505 1,776 1,448 81 63 244 190
Expected return on plan assets (790) (642) (2,371) (1,925) 0 0 0 0
Net amortization and deferral 218 298 655 729 9 0 28 0
Amortization of prior service cost 107 (8) 320 (25) 8 8 22 22
Amortization of transition obligation 0 (1) 0 (3) 10 10 31 31
- ---------------------------------------------------------------------------------------------------------------------------------
Net periodic benefit cost $ 607 $ 633 $ 1,820 $ 1,417 $186 $126 $558 $379
=================================================================================================================================
Supplemental Benefits
---------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ -----------------
(000's omitted) 2004 2003 2004 2003
- ---------------------------------------------------------------------------------
Service cost $ 88 $ 39 $ 263 $104
Interest cost 39 58 116 153
Expected return on plan assets 0 0 0 0
Net amortization and deferral 44 40 133 89
Amortization of prior service cost (34) 40 (101) 121
Amortization of transition obligation 0 0 0 0
- ---------------------------------------------------------------------------------
Net periodic benefit cost $ 137 $177 $ 411 $467
=================================================================================
The Company is not required for regulatory purposes to make a contribution to
its defined benefit pension plan. However, it may make a discretionary
contribution in the fourth quarter of 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 is as follows:
September 30, December 31,
(000's omitted) 2004 2003
- ------------------------------------------------------------------------------
Commitments to extend credit $440,176 $315,898
Standby letters of credit 24,310 19,163
- -----------------------------------------------------------------------------
Total $464,486 $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") for the three and nine
months ended September 30, 2004 and 2003, although in some circumstances the
second 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. Unless otherwise stated, 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" pertain to a group of 79 bank holding companies
nationwide having $3 billion to $10 billion in assets and their associated
composite financial results for the six months ending June 30, 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, "third quarter" refers to the
quarter ended September 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 27.
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.
Third quarter earnings per share were $0.01 above the prior year's third
quarter, as higher net interest income and non-interest income were partially
offset by higher operating expenses and a greater number of common shares
outstanding. On a year-to-date ("YTD") basis, earnings per share were $0.04
above the first nine months of 2003, resulting from higher net interest income
and non-interest income and a lower loan loss provision, partially offset by
higher operating expenses and a greater number of common shares outstanding. On
an operating basis (see Table 1 and related narrative), third quarter and
September YTD net income increased 21% and 20%, respectively, compared 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 nine
months of the year. Operating expenses for the quarterly and YTD periods
increased primarily due to acquisitions and higher compensation and benefits
costs. The efficiency ratio for the quarter and YTD periods 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).
Asset quality improved over 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
installment lending, with a slight decline in business lending. On a
geographical basis, excluding acquisitions, the New York markets accounted for
all of the Company's loan growth, with a slight decline experienced in the
Pennsylvania markets. Excluding acquisitions, total average deposits for the
quarter and first nine 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, third quarter earnings per share of $0.45 and September YTD
earnings per share of $1.23 were $0.01 and $0.04 higher, respectively, than the
EPS generated in the same periods of last year. Net income for the quarter of
$14.2 million was up 21% over third quarter 2003, and net income of $37.5
million for the first nine months of 2004 increased 18% from the amount earned
in the equivalent period of last year. Net interest income for the third quarter
of $42.9 million and $123.2 million for the first nine months of 2004, were up
21% and 16% from their respective prior year periods. Third quarter non-interest
income (excluding net gains from investment securities sales and debt prepayment
costs) of $12.2 million was up 24% from third quarter 2003 (15%, excluding a
$0.8 million impairment loss on secondary market mortgage activities recorded in
the third quarter last year), and the YTD amount of $33.5 million rose 21% from
the prior year level. Operating expenses of $29.9 million for the quarter and
$89.5 million for the first nine months of 2004 were up 19% and 20%,
respectively, from the equivalent periods of 2003, a portion of which related to
acquisition expenses, which declined $0.1 million for the quarter, but were $1.3
million higher 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 third quarter were $0.45, up 2.3% from the
$0.44 reported in the equivalent period of 2003. On a year-to-date basis,
operating EPS of $1.25 increased $0.06 or 5.0% versus the first nine months of
2003. As reflected in Table 2, the
15
primary reasons for the improved earnings were higher net interest income and
non-interest income and a lower loan loss provision (on a YTD basis only),
offset by higher operating expenses and a greater number of weighted average
diluted shares outstanding. Net interest income increased because of higher
earning-asset levels derived from the acquisitions of Peoples, Grange and First
Heritage, organic consumer mortgage and installment loan growth, and investment
leverage. The increase in non-interest income was 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 YTD 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.
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 Nine Months Ended
September 30, September 30,
--------------------- -----------------------
(000's omitted) 2004 2003 2004 2003
- -----------------------------------------------------------------------------------------
Net income $14,234 $ 11,729 $ 37,530 $ 31,710
After-tax operating adjustments:
Net securities gains 0 (2) (89) (2)
Debt prepayment costs 0 0 0 27
Acquisition expenses 32 101 879 104
- -----------------------------------------------------------------------------------------
Net income - operating $14,266 $ 11,828 $ 38,320 $ 31,839
=========================================================================================
Table 2: Summary Income Statements
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ----------------------
(000's omitted, except per share data) 2004 2003 2004 2003
- ----------------------------------------------------------------------------------------------
Net interest income (FTE) $ 42,850 $35,548 $123,223 $106,077
Loan loss provision 2,300 2,029 6,650 8,102
Non-interest income 12,164 9,776 33,468 27,575
Gain (loss) on investment securities
& debt extinguishment 0 3 145 (42)
Operating expenses 29,873 25,041 88,023 74,662
Acquisition expenses 53 165 1,434 170
- ----------------------------------------------------------------------------------------------
Income before taxes (FTE) 22,788 18,092 60,729 50,676
Fully tax-equivalent adjustment 3,793 3,009 10,755 8,952
Income taxes 4,761 3,354 12,444 10,014
- ----------------------------------------------------------------------------------------------
Net income $ 14,234 $11,729 $ 37,530 $ 31,710
==============================================================================================
Diluted earnings per share $ 0.45 $ 0.44 $ 1.23 $ 1.19
Diluted earnings per share-operating $ 0.45 $ 0.44 $ 1.25 $ 1.19
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 third quarter 2004 was $42.9 million, up $7.3
million or 21% from the same period last year. An $869 million increase in
average earning-assets more than offset a $751 million increase in
interest-bearing liabilities and a 28 basis point decrease in the net interest
margin. As reflected in Table 4, the volume changes mentioned above drove net
interest income to rise $9.6 million, while the lower net interest margin had a
$2.3 million negative impact on net interest income. September 2004 YTD net
interest income of $123.2 million was up $17.1 million or 16% from the
year-earlier period. A $656 million increase in average earning-asset levels had
a greater positive effect than a $554 million rise in interest-bearing
liabilities and a 22 basis point decline in the net interest margin.
Interest-bearing asset and liability
16
volume changes resulted in $22.3 million more net interest income, offset by a
lower net interest margin that had a negative $5.1 million impact.
Average loans increased $483 million for the quarter and $392 million for the
nine months ended September 30, 2004 in comparison to the same periods in 2003,
while average investments (book value basis) rose $386 million for the third
quarter and $264 million for the YTD period. The increases in average loans and
investments were the result of acquisitions, organic loan growth and security
purchases. Third quarter and September YTD average deposits were $398 million
and $317 million higher, respectively, than the same periods in the prior year.
These increases were 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 $448 million for the quarter and
$324 million for the first nine months of 2004 in comparison to the year-earlier
periods.
The 4.35% net interest margin in the third quarter dropped 28 basis points
versus the same quarter last year, and the September YTD margin of 4.50% was
down 22 basis points from the prior year. The declines in the net interest
margin were primarily attributable to lower interest rates over the last 12
months having a greater impact on earning-asset yields (quarter down 47 basis
points, YTD down 59 basis points), than on the cost of funds (quarter down 19
basis points, YTD down 37 basis points). The reduction of earning-asset yields
was mostly driven by declines in loan yields of 60 basis points for the quarter
and 73 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
products. Investment portfolio yields were comparatively more stable (down 28
basis points for the quarter and 35 basis points YTD), and benefited from call
protection and security purchases that were concentrated in periods of higher
long-term rates. The decrease in the cost of funds was caused by deposit costs
dropping 22 basis points for the quarter and 34 basis points YTD, while external
borrowing rates declined 97 basis points for the quarter and 119 basis points
year-to-date. The deposit costs for both time periods were impacted by time
deposits rolling-over at lower rates and shifts in the deposit portfolio towards
demand deposits. The improvements in borrowing costs were primarily driven by a
shift in the mix of external funding from higher-rate, longer-term borrowings to
lower-rate, shorter-term debt. A portion of this change was attributable to the
prepayment of $25 million of longer-term Federal Home Loan Bank ("FHLB")
obligations in the fourth quarter of 2003, which were replaced with short-term
borrowings at much lower rates. In addition, a significant amount of
intermediate-term borrowings at comparable favorable rates were added in the
second quarter of 2004.
The Company's net interest margin for the first six months of 2004 was favorable
to peer companies, driven by a higher earning-asset yield, partially offset by a
slightly larger ratio of interest expense to average earning assets.
17
Tables 3 and 3A below set 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) September 30, 2004 September 30, 2003
- ---------------------------------------------------------------------------------------------- ----------------------------------
Avg. Avg.
Average Yield/Rate Average Yield/Rate
Balance Interest Paid Balance Interest Paid
- ---------------------------------------------------------------------------------------------- ----------------------------------
Interest-earning assets:
Time deposits in other banks $ 903 $ 1 0.44% $ 318 $ 1 1.25%
Taxable investment securities (2) 1,005,990 14,259 5.64% 764,613 11,443 5.94%
Non-taxable investment securities (2) 546,395 9,401 6.85% 402,105 7,215 7.12%
Loans (net of unearned discount)(1) 2,362,596 35,355 5.95% 1,879,858 31,026 6.55%
--------------------- ---------------------
Total interest-earning assets 3,915,884 59,016 6.00% 3,046,894 49,685 6.47%
Non-interest earning assets 482,376 390,122
---------- ----------
Total assets $4,398,260 $3,437,016
========== ==========
Interest-bearing liabilities:
Interest checking, savings and money market deposits $1,169,332 1,627 0.55% $996,872 1,511 0.60%
Time deposits 1,193,700 6,995 2.33% 1,062,968 7,394 2.76%
Short-term borrowings 512,074 2,150 1.67% 207,925 638 1.22%
Long-term borrowings 439,423 5,394 4.88% 295,509 4,594 6.17%
--------------------- ---------------------
Total interest-bearing liabilities 3,314,529 16,166 1.94% 2,563,274 14,137 2.19%
Non-interest bearing liabilities:
Demand deposits 577,949 483,142
Other liabilities 53,983 54,028
Shareholders' equity 451,799 336,572
---------- ----------
Total liabilities and shareholders' equity $4,398,260 $3,437,016
========== ==========
Net interest earnings $42,850 $35,548
======= =======
Net interest spread 4.06% 4.28%
Net interest margin on interest-earning assets 4.35% 4.63%
Fully tax-equivalent adjustment on investments and loans $3,793 $ 3,009
(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
Nine Months Ended Nine Months Ended
(000's omitted except yields and rates) September 30, 2004 September 30, 2003
------------------------------------ ------------------------------------
Avg. Avg.
Average Yield/Rate Average Yield/Rate
Balance Interest Paid Balance Interest Paid
- --------------------------------------------------------------------------------------------- ------------------------------------
Interest-earning assets:
Time deposits in other banks $ 779 $ 3 0.51% $ 253 $ 2 1.06%
Taxable investment securities (2) 924,020 40,378 5.84% 760,743 35,678 6.27%
Non-taxable investment securities (2) 502,255 26,323 7.00% 402,037 21,682 7.21%
Loans (net of unearned discount)(1) 2,232,746 101,331 6.06% 1,841,049 93,556 6.79%
---------------------- ----------------------
Total interest-earning assets 3,659,800 168,035 6.13% 3,004,082 150,918 6.72%
Non-interest earning assets 469,624 392,273
---------- ----------
Total assets $4,129,424 $3,396,355
========== ==========
Interest-bearing liabilities:
Interest checking, savings and money market deposits $1,115,642 4,684 0.56% $989,410 5,245 0.71%
Time deposits 1,188,254 21,094 2.37% 1,084,162 24,229 2.99%
Short-term borrowings 428,640 4,547 1.42% 170,814 1,628 1.27%
Long-term borrowings 362,366 14,487 5.34% 296,268 13,739 6.20%
---------------------- ----------------------
Total interest-bearing liabilities 3,094,902 44,812 1.93% 2,540,654 44,841 2.36%
Non-interest bearing liabilities:
Demand deposits 549,933 462,970
Other liabilities 53,422 56,405
Shareholders' equity 431,167 336,328
---------- ----------
Total liabilities and shareholders' equity $4,129,424 $3,396,357
========== ==========
Net interest earnings $123,223 $106,077
======== ========
Net interest spread 4.20% 4.36%
Net interest margin on interest-earning assets 4.50% 4.72%
Fully tax-equivalent adjustment $10,755 $8,952
(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
------------------------------ --------------------------------
3rd Quarter 2004 versus 3rd Nine Months Ended September
Quarter 2003 30, 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 3,449 (633) 2,816 7,261 (2,561) 4,700
Non-taxable investment securities 2,494 (308) 2,186 5,268 (627) 4,641
Loans (net of unearned discount) 7,422 (3,093) 4,329 18,488 (10,713) 7,775
Total interest-earning assets (2) $13,322 ($3,991) $ 9,331 $30,908 ($13,791) $ 17,117
Interest paid on:
Interest checking, savings and money market deposits $ 247 ($ 131) $ 116 $ 616 ($ 1,177) ($ 561)
Time deposits 847 (1,246) (399) 2,174 (5,309) (3,135)
Short-term borrowings 1,208 304 1,512 2,716 203 2,919
Long-term borrowings 1,909 (1,109) 800 2,804 (2,056) 748
Total interest-bearing liabilities (2) $ 3,800 ($1,771) $ 2,029 $ 8,819 ($ 8,848) ($ 29)
Net interest earnings (2) $ 9,622 ($2,320) $ 7,302 $22,267 ($ 5,121) $ 17,146
(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 has three sources of non-interest income: 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 Nine Months Ended
September 30, September 30,
--------------------- ----------------------
(000's omitted) 2004 2003 2004 2003
- ---------------------------------------------------------------------------------------------------------------
Banking services:
Electronic banking $ 758 $ 812 $ 1,913 $ 1,975
Mortgage banking 191 (795) 452 162
Deposit service charges 1,406 1,367 4,098 4,008
Overdraft fees 3,957 3,479 11,091 9,780
Credit life and disability insurance 1,000 661 1,141 787
Commissions and other 579 519 2,077 1,620
- --------------------------------------------------------------------------------- ----------------------
Total banking services 7,891 6,043 20,772 18,332
- --------------------------------------------------------------------------------- ----------------------
Financial services:
Retirement plan administration and trustee fees 1,441 1,166 4,307 3,469
Actuarial and benefit plan consulting fees 897 820 2,690 820
Asset advisory and management fees 461 526 1,553 1,404
Investment and insurance product commissions 1,085 868 2,912 2,469
Personal trust 389 353 1,234 1,081
- --------------------------------------------------------------------------------- ----------------------
Total financial services 4,273 3,733 12,696 9,243
- --------------------------------------------------------------------------------- ----------------------
Sub-total 12,164 9,776 33,468 27,575
Gain (loss) on investment securities & debt prepayment 0 3 145 (42)
- --------------------------------------------------------------------------------- ----------------------
Total non-interest income $12,164 $ 9,779 $33,613 $ 27,533
================================================================================= ======================
Non-interest income/operating income (FTE) 22.1% 21.6% 21.4% 20.6%
As displayed in Table 5, non-interest income (excluding net securities gains and
debt prepayment costs) for the third quarter 2004 was $2.4 million (24%) higher
than third quarter 2003 and $5.9 million (21%) higher than the prior year YTD
period. On a quarterly and year-to-date basis, banking services increased $1.9
million (31%) and $2.4 million (13%), respectively, while financial services
increased $0.5 million (15%) and $3.5 million (37%), respectively.
The quarterly and year-to-date increases in banking services were primarily the
result of a $0.3 million increase in the annual dividend received from the New
York Bankers Association, a $0.8 million impairment loss recognized in the third
quarter of 2004 on mortgage loans commitments which were reclassified from
held-for-sale to portfolio loans, and growth in deposit fees and commissions
mainly caused by the three whole bank acquisitions over the last year.
The majority of the increase in financial services income for the third quarter
of 2004 was driven by BPA and CISI, while Harbridge also impacted the results
for the nine months ended September 30, 2004. BPA generated revenue growth of
$0.3 million (24%) for the quarter and $0.8 million (24%) for first nine months
of 2004 driven by continued strong new business development. CISI had quarterly
and year-to-date revenue growth of $0.2 million (25%) and $0.4 million (18%),
respectively, as it has been positively impacted by improving market conditions.
In addition, CISI has obtained a large number of higher net-worth investors
caused by recent retirees rolling over their 401k plans and/or receiving
inheritances. The growth in Harbridge's revenue for the nine months ended
September 30, 2004 was due to their acquisition on July 31, 2003, resulting in
the inclusion of nine months of revenue in 2004 versus two months in 2003.
The quarterly and year-to-date increase in the ratio of non-interest income to
operating income (FTE basis, excluding net security gains and debt prepayment
costs) resulted from the growth in non-interest income outpacing the growth in
net interest income.
21
Operating Expenses
The following table sets forth the quarterly and year-to-date components of
operating expenses 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 Nine Months Ended
September 30, September 30,
--------------------- ---------------------
(000's omitted) 2004 2003 2004 2003
- ------------------------------------------------------------ ---------------------
Salaries and employee benefits $15,638 $13,225 $46,197 $38,243
Occupancy 2,570 2,255 7,700 7,004
Equipment and furniture 2,143 1,885 6,445 5,766
Legal and professional fees 1,003 672 2,970 2,250
Data processing 1,973 1,647 5,777 5,006
Amortization of intangible assets 2,003 1,269 5,401 3,801
Office supplies 613 455 1,711 1,507
Foreclosed property 178 155 621 313
Other 3,752 3,478 11,201 10,772
- ------------------------------------------------------------ ---------------------
Total recurring expenses 29,873 25,041 88,023 74,662
Acquisition expenses 53 165 1,434 170
- ------------------------------------------------------------ ---------------------
Total operating expenses $29,926 $25,206 $89,457 $74,832
============================================================ =====================
Operating expenses/average assets 2.70% 2.89% 2.85% 2.94%
Efficiency ratio 50.7% 52.4% 52.7% 53.0%
The third quarter and the year-to-date operating expenses for 2004 were $4.7
million (19%) and $14.6 million (20%) higher than the expenses in the same
periods of 2003. The increases for both periods were primarily attributable to
the incremental recurring operating expenses associated with the four
acquisitions completed during the last year. More than fifty percent of the
increase for the quarter and year-to-date periods relates to higher personnel
costs that were impacted by the acquisitions, merit increases, hiring activity
and higher benefit costs. The increase in legal and professional fees over the
prior year was caused, in most part, by the additional responsibilities
associated with complying with new governance and regulatory requirements. The
2004 acquisition expenses include $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 Company's efficiency ratio (recurring operating expenses excluding
intangible amortization divided by the sum of net interest income (FTE) and
recurring non-interest income) improved 1.7 percentage points for the quarter
and 0.3 percentage points on a year-to-date basis when comparing to the same
periods of the prior year. Recurring operating income grew at a faster rate than
core operating expenses. Organic income expansion generated principally through
loan growth, investment leverage and increased revenue from the financial
services businesses resulted in higher margins due to the significant proportion
of fixed costs inherent in the Company's expense structure.
Income Taxes
The September YTD effective income tax rate was 24.9% for 2004 and 24.0% in
2003. The quarterly effective rate of 25.1% was 2.9 percentage points above the
22.2% rate recorded in third quarter of 2003. As in prior periods, the
difference between the Company's effective income tax rate and its statutory
rate for the quarter and year-to-date is due primarily to interest generated
from tax-exempt securities.
22
Investments
As reflected in Table 7 below, the carrying value of investments increased $275
million from year-end 2003 and $312 million from September 30, 2003. The growth
in the investment portfolio for both time periods was driven by the leveraging
strategy that began in the third quarter of 2003 and ended during the second
quarter of 2004. It was also impacted, to a lesser degree, by the investments
added through the three bank acquisitions over the last twelve months. The
overall mix of securities within the portfolio remained relatively consistent,
with a slight increase towards U.S. treasury securities and agencies. The change
in the carrying value of investments is impacted by the amount of net unrealized
gains in the portfolio at a point in time. The net unrealized gains increased by
$3.1 million since December 31, 2003 but decreased $2.8 million since September
30, 2003, indicative of the interest rate movements during the respective time
periods and the changing composition of the portfolio.
Table 7: Investments
September 30, 2004 December 31, 2003 September 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 $ 127,526 $ 126,333 $ 127,635 $ 125,003 $ 127,671 $ 128,593
Obligations of state and political subdivisions 6,536 6,682 7,459 7,677 7,545 7,765
Other securities 3,578 3,578 3,558 3,558 3,526 3,526
- ----------------------------------------------------------------------------- ----------------------- -----------------------
Total held-to-maturity portfolio 137,640 136,593 138,652 136,238 138,742 139,884
- ----------------------------------------------------------------------------- ----------------------- -----------------------
Available-for-Sale Portfolio:
U.S. Treasury securities and obligations of U.S.
government corporations and agencies 632,113 656,282 456,913 479,454 425,025 455,428
Obligations of state and political subdivisions 546,084 576,304 443,930 470,210 401,495 423,484
Corporate securities 42,108 45,346 27,712 30,251 27,608 30,564
Collateralized mortgage obligations (CMO's) 75,850 77,598 89,566 93,552 117,363 122,846
Mortgage-backed securities 54,384 57,000 76,628 80,177 85,115 89,107
- ----------------------------------------------------------------------------- ----------------------- -----------------------
Sub-total 1,350,539 1,412,530 1,094,749 1,153,644 1,056,606 1,121,429
Equity securities 44,942 44,942 29,185 29,185 26,858 26,858
Federal Reserve Bank common stock 9,856 9,856 8,053 8,053 5,656 5,656
- ----------------------------------------------------------------------------- ----------------------- -----------------------
Total available-for-sale portfolio 1,405,337 1,467,328 1,131,987 1,190,882 1,089,120 1,153,943
Net unrealized gain on available-for-sale portfolio 61,991 0 58,895 0 64,823 0
- ----------------------------------------------------------------------------- ----------------------- -----------------------
Total carrying value $1,604,968 $1,603,921 $1,329,534 $1,327,120 $1,292,685 $1,293,827
============================================================================= ======================= =======================
Loans
As shown in Table 8, loans ended the third quarter at $2.4 billion, up $245
million (11.5%) year-to-date and $449 million (23%) higher than one-year
earlier. Most of the YTD and year-over-year increases in loan balances were
attributable to acquisitions, which added $206 million to the loan portfolio in
2004 and $378 million over the last 12 months. Excluding the impact of
acquisitions, total loans grew $39 million or 1.8% in the first nine months of
2004 and $72 million or 3.7% over the past year. All of the organic loan growth
for both periods was produced in the consumer mortgage and installment lines of
business, with slight declines experienced in business lending. The organic loan
growth for the nine and 12-month intervals was generated in the New York
markets, with slight 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 portfolio, and business lending due to the high proportion of
commercial loans in First Heritage's portfolio.
Table 8: Loans
(000's omitted) September 30, 2004 December 31, 2003 September 30, 2003
- --------------------------------------------- ------------------- -------------------
Consumer mortgage $ 793,120 33% $ 739,593 35% $ 606,312 32%
Business lending 847,844 36% 689,436 32% 630,886 33%
Consumer installment 732,787 31% 699,480 33% 687,055 35%
- --------------------------------------------- ------------------- -------------------
Total loans $2,373,751 100% $2,128,509 100% $1,924,253 100%
============================================= =================== ===================
23
Total consumer mortgages increased $54 million in the first nine months of 2004
and $187 million year-over year. Excluding the impact of acquisitions, consumer
mortgages were up $33 million (4.4%) over the last three quarters and $77
million (12.6%) over the last year. Volumes have slowed in the past nine 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 nine and 12-month time frames was derived principally
from activity in the New York markets.
Business loans rose $158 million over the latest nine months and were up $217
million from one year ago. All of the growth came from the loans acquired in the
First Heritage (May 2004) and Grange (November 2003) transactions. Excluding the
loans acquired from First Heritage and Grange (for the twelve month period
only), business lending was down $12 million or 1.7% from December 2003's level
and declined $21 million or 3.3% over the last 12 months. The New York markets
were slightly higher during the nine-month time period and was flat in the
12-month time frame, while the Pennsylvania markets experienced slight declines
over both periods.
Consumer installment loans, both those originated directly (such as personal
loans and home equity loans and lines of credit), and indirectly (originated
predominantly in automobile, marine and recreational vehicle dealerships), rose
$33 million (4.8%) in the last nine months and $46 million (6.7%) on a
year-over-year basis. Excluding acquisitions, consumer installment loans
increased $17 million (2.5%) in the first nine months of 2004, and $16 million
(2.4%) from one year ago. Historically low interest rates, aggressive dealer and
manufacturer incentives on new vehicles, and very competitive pricing on used
vehicles have existed in these product types for more than a year. Consumer
installment loans increased in the New York markets during the last nine and
12-month time frames, while the Pennsylvania markets were flat.
Asset Quality
Table 9 below exhibits the major components of non-performing loans and assets
and key asset quality metrics for the periods ending September 30, 2004 and 2003
and December 31, 2003.
Table 9: Non-performing Assets
September 30, December 31, September 30,
(000's omitted) 2004 2003 2003
- ----------------------------------------------------------------------------- ------------ -------------
Non-accrual loans $13,511 $11,940 $10,518
Accruing loans 90+ days delinquent 1,808 1,307 3,018
Restructured loans 806 28 29
- -------------------------------------------------------------------------------------------------------------
Total non-performing loans 16,125 13,275 13,565
Other real estate 734 1,077 812
- -------------------------------------------------------------------------------------------------------------
Total non-performing assets $16,859 $14,352 $14,377
=============================================================================================================
Allowance for loan losses to total loans 1.37% 1.37% 1.41%
Allowance for loan losses to non-performing loans 202% 219% 200%
Non-performing loans to total loans 0.68% 0.62% 0.70%
Non-performing assets to total loans and other real estate 0.71% 0.67% 0.75%
Delinquent loans (30 days old to non-accruing) to total loans 1.47% 1.77% 1.64%
Net charge-offs to average loans outstanding (quarterly) 0.29% 0.54% 0.53%
Loan loss provision to net charge-offs (quarterly) 133% 113% 80%
As displayed in Table 9, non-performing assets at September 30, 2004 were $16.9
million, an increase of $2.5 million versus year-end 2003 and the end of third
quarter 2003. The changes over the last nine and 12-month periods were due
primarily to an increase in commercial non-accrual levels and one restructured
commercial relationship. A small portion of the increase was related to acquired
loans. Non-performing loans were 0.68% of total loans outstanding at the end of
the third quarter versus 0.62% at year-end 2003 and 0.70% at September 30, 2003.
The ratio of non-performing assets to total loans and other real estate remained
below 0.75% for the fourth consecutive quarter. The allowance for loan loss to
non-performing loans ratio, a general measure of coverage adequacy, was 202% at
the end of the third quarter, compared to coverage ratios of 219% at year-end
2003 and 200% at September 30, 2003.
Delinquent loans (30 days through non-accruing and restructured loans) as a
percent of total loans was 1.47% at the end of the third quarter, its lowest
level since first quarter 2001. This ratio improved 30 basis points in
comparison to year-end 2003 and 17 basis points versus September 30, 2003. The
quarterly ratio of loan loss provision to net charge-offs was 133% for the third
quarter of 2004, compared to 80% and 113% for the third and fourth quarters of
2003, respectively.
24
Table 10: Allowance for Loan Loss Activity
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------- ---------------------
(000's omitted) 2004 2003 2004 2003
- --------------------------------------------------------------------------- ---------------------
Allowance for loan losses at beginning of period $32,040 $27,417 $29,095 $26,331
Charge-offs:
Business lending 504 1,269 2,236 3,971
Consumer mortgage 95 53 225 140
Consumer installment 1,842 2,010 5,491 5,452
- --------------------------------------------------------------------------- ---------------------
Total charge-offs 2,441 3,332 7,952 9,563
Recoveries:
Business lending 89 179 668 301
Consumer mortgage 13 34 35 42
Consumer installment 608 587 1,756 1,701
- --------------------------------------------------------------------------- ---------------------
Total recoveries 710 800 2,459 2,044
- --------------------------------------------------------------------------- ---------------------
Net charge-offs 1,731 2,532 5,493 7,519
Provision for loan losses 2,300 2,029 6,650 8,102
Allowance on acquired loans 0 203 2,357 203
- --------------------------------------------------------------------------- ---------------------
Allowance for loan losses at end of period $32,609 $27,117 $32,609 $27,117
=========================================================================== =====================
Net charge-offs to average loans outstanding:
Business lending 0.19% 0.69% 0.27% 0.78%
Consumer mortgage 0.04% 0.01% 0.03% 0.02%
Consumer installment 0.68% 0.83% 0.71% 0.75%
Total loans 0.29% 0.53% 0.33% 0.55%
As displayed in Table 10, net charge-offs during the third quarter were $1.7
million, $0.8 million less than the equivalent 2003 period, driven by
significant declines in the charge-offs of the business lending portfolio. This
decrease occurred despite a $483 million increase in average loan balances, and
resulted in a 24 basis point drop in the net charge-off ratio (net charge-offs
as a percentage of average loans outstanding) to 0.29%. On a year-to-date basis
net charge-offs were down $2.0 million versus the prior year period, while
average loans were up $392 million for the same period, resulting in a 22 basis
point decline in the YTD net charge-off ratio to 0.33%. Lower business loan net
charge-offs were again the main contributor to this substantial improvement,
reflecting stabilizing economic conditions and the effectiveness of increased
credit risk management resources. The increased proportion of comparatively
low-risk consumer mortgages in the loan portfolio (33% of total average loans as
of September 30, 2004 versus 32% one year earlier) also helped reduce the
overall level of charge-offs in relation to total average loan balances.
A required loan loss allowance of $32.6 million was determined as of September
30, 2004, resulting in a $2.3 million loan loss provision for the quarter
compared to $2.0 million one year earlier. The third quarter loan loss provision
was $0.6 million higher than net charge-offs mainly due to the additional
allowance needed to cover organic loan growth in the quarter, the downgrade of
risk ratings on certain business loans, and a slight increase in the historical
loss factors for installment loans. The loan loss provision for the first nine
months of 2004 of $6.7 million was down $1.5 million or 18% versus the prior
year, driven by the overall improvement in asset quality. The allowance for loan
losses rose $5.5 million or 20% over the last 12 months, versus a 23% increase
in loans outstanding. Consequently, the ratio of allowance for loan loss to
loans outstanding declined four 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.
Deposits
As shown in Table 11, average deposits of $2.9 billion in the third quarter were
up $294 million compared to fourth quarter 2003 and increased $398 million
versus the same quarter of last year. This increase was the result of deposits
obtained through acquisitions. The deposit mix has shifted towards demand
deposits and liquid interest-bearing deposits (interest checking and savings
accounts) with 49% of total deposits in these accounts in the third quarter 2004
versus 47% in the third and fourth quarters of 2003. This shift in mix, combined
with CDs being rolled over at lower interest rates helped reduce the third
quarter cost of deposits.
25
Excluding the impact of acquisitions, average IPC (individuals, partnerships and
corporations) deposits in the current quarter decreased 1.9% from fourth quarter
2004's level and 2.5% from one year ago. This mostly reflects the relative
attractiveness of alternative funding sources over the last year. Excluding
acquired deposits, average third quarter public funds were up 2.5% from third
quarter 2003 and relatively flat compared to the fourth quarter of 2003.
Table 11: Average Deposits
Three Months Ended
---------------------------------------------
September 30, December 31, September 30,
(000's omitted) 2004 2003 2003
- ----------------------------------------------------------------------------
Demand deposits $ 577,949 $ 505,015 $ 483,142
Interest checking deposits 302,757 283,752 274,803
Savings deposits 555,015 448,064 431,414
Money market deposits 311,560 300,558 290,655
Time deposits 1,193,700 1,109,350 1,062,968
- ----------------------------------------------------------------------------
Total deposits $2,940,981 $2,646,739 $2,542,982
============================================================================
IPC deposits $2,774,231 $2,485,165 $2,388,529
Public fund deposits 166,750 161,574 154,453
---------- ---------- ----------
Total deposits $2,940,981 $2,646,739 $2,542,982
========== ========== ==========
Borrowings
At the end of the third quarter, borrowings of $972 million increased $304
million from December 31, 2003 and were up $358 million from the third quarter
of 2003. The increases over both the nine and 12-month periods were dictated by
organic loan growth, investment security purchases and organic deposit declines.
Short-term borrowings increased $135 million and $214 million over the last nine
and 12 months, while long-term borrowings were up $169 million and $144 million
over the same time periods. A higher proportion of short-term borrowings has
been utilized in comparison to one year ago due to the amount of longer-term,
core deposits added through acquisitions, to reduce the Company's sensitivity to
falling interest rates and to provide more flexibility with regard to altering
future debt levels. The amount of long-term borrowings increased in the last
nine months due to the addition of $118 million of eighteen-month FHLB
borrowings that were used to fund securities purchases. These borrowings 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
Total shareholders' equity increased $62.4 million since December 31, 2003 and
equaled $467 million at September 30, 2004. This increase consisted of $54.7
million of common stock and options issued in the First Heritage acquisition,
net income of $37.5 million, $4.8 million of common stock issued under the
employee stock plan, and a $2.1 million increase in the after-tax market value
adjustment on available-for-sale investments, offset by treasury stock purchases
of $21.7 million and dividends declared of $15.0 million.
The Company's Tier I leverage ratio, a primary measure of regulatory capital for
which 5% is the requirement to be "well-capitalized," was 6.72% at the end of
the third quarter, down 54 basis points from year-end 2003 and 68 basis points
lower than its level one year ago. The tangible equity-to-assets ratio was 5.68%
at September 30, 2004 a decline of two basis points versus year-end 2003 and 20
basis points lower than it was at the end of September 2003. The declines in
these ratios were primarily caused by treasury share purchases made over the
last 12 months.
During the third quarter 2004 the Company completed its purchase of common
shares under its previously announced 1.4 million-share repurchase program with
an aggregate cost of $30.2 million and average price per share of $21.57. In
addition, the Company's Board of Directors declared a 12.5% increase in the
quarterly cash dividend on its common stock to $0.18 per share. As a result of
the increase in the per share dividend amount and the overall increase in the
common shares outstanding, the dividend payout ratio (dividends declared divided
by net income) for the first nine months of 2004 was 40%, up 3.0 percentage
points from one year ago.
26
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 September
30, 2004, this ratio for the 30 and 90-day time period was 15.1% and 14.7%,
respectively, 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.
New Accounting Pronouncements
See New Accounting Pronouncement section of Note C to the consolidated financial
statements.
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 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.
27
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 September 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%-75% 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 income
rates at September 30, 2004
-----------------------------------------------------------
+ 200 basis points (3.1%)
- 100 basis points (1.1%)
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.
28
Item 4. Controls and Procedures
As of September 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 during the quarter
ended September 30, 2004, including any corrective actions with regard to
significant deficiencies and material weaknesses.
29
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) During the third quarter of 2004 the Company purchased 280,713 common shares
completing the previously announced 1.4 million-share repurchase program. The
aggregate cost of this program was $30.2 million and the average price per share
is $21.57. The repurchases were 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 nine 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
July 2004 48,800 22.47 1,168,087 231,913
August 2004 231,913 22.65 1,400,000 0
September 2004 0 1,400,000 0
- ------------------------------------------------------------------------------------------------
Total 983,700 $22.07 1,400,000 0
================================================================================================
Item 3. Defaults Upon Senior Securities.
Not applicable.
Item 4. Submission of Matters to a Vote of Securities Holders.
There were no matters submitted to a vote of the shareholders during the quarter
ending September 30, 2004.
Item 5. Other Information.
Not applicable
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit No. Description
- ----------- -----------
10.1 Employment Agreement, effective August 1, 2004, by and between
Community Bank System, Inc., Community Bank, N.A. and Brian D.
Donahue. * **
10.2 Employment Agreement, effective September 1, 2002, by and
between Community Bank System, Inc., Community Bank, N.A. and
Timothy J. Baker. * **
10.3 Employment Agreement, effective October 1, 2004, by and
between Community Bank System, Inc., Community Bank, N.A. and
J. David Clark. * **
10.4 Employment Agreement, effective September 1, 2002, by and
between Community Bank System, Inc., Community Bank, N.A. and
Joseph J. Lemchak. * **
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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 Scott A. Kingsley, Treasurer, Chief 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 Scott A. Kingsley, Treasurer, Chief 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 July 23,
2004.
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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: November 5, 2004 /s/ Sanford A. Belden
---------------------
Sanford A. Belden, President, Chief
Executive Officer and Director
Date: November 5, 2004 /s/ Scott A. Kingsley
---------------------
Scott A. Kingsley, Treasurer and Chief
Financial Officer
32