Form 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
QUARTERLY REPORT
PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2003
Commission file number 0-11716
[LOGO] COMMUNITY BANK SYSTEM, INC.
(Exact name of registrant as specified in its charter)
New York Stock Exchange
(Name of Each Exchange on Which Registered)
Delaware 16-1213679
(State or other (I.R.S. Employer Identification No.)
jurisdiction of incorporation)
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. Yes |_| No |X|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12-b-2 of the Act). |X| Yes |_| No
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practical date.
Common Stock, No par value - 12,991,977 shares outstanding as of August 11, 2003
TABLE OF CONTENTS
Page
----
Part I. Financial Information
Item 1. Financial Statements (Unaudited)
Consolidated Statements of Condition
June 30, 2003 and December 31, 2002 ............................... 3
Consolidated Statements of Income
Three and six months ended June 30, 2003 and 2002 ................. 4
Consolidated Statement of Shareholders' Equity
Six months ended June 30, 2003 .................................... 5
Consolidated Statements of Comprehensive Income
Six months ended June 30, 2003 and 2002 ........................... 6
Consolidated Statements of Cash Flows
Six months ended June 30, 2003 and 2002 ........................... 7
Notes to Consolidated Financial Statements
June 30, 2003 ..................................................... 8
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations ........................................... 13
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 ........................................... 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. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CONDITION
(In Thousands, Except Share Data)
June 30,
2003 December 31,
(Unaudited) 2002
- ---------------------------------------------------------------------------------------------------------------
Assets
Cash and due from banks $ 109,898 $ 113,531
Held-to-maturity investment securities 6,818 7,412
Available-for-sale investment securities 1,159,994 1,276,153
- ---------------------------------------------------------------------------------------------------------------
Total investment securities (fair value of $1,167,102 and $1,283,819) 1,166,812 1,283,565
Loans 1,858,015 1,806,905
Allowance for loan losses 27,417 26,331
- ---------------------------------------------------------------------------------------------------------------
Net loans 1,830,598 1,780,574
Premises and equipment, net 56,759 56,997
Accrued interest receivable 21,272 22,772
Core deposit intangibles, net 28,237 30,769
Goodwill, net 104,059 104,059
- ---------------------------------------------------------------------------------------------------------------
Intangible assets, net 132,296 134,828
Other assets 38,626 41,937
- ---------------------------------------------------------------------------------------------------------------
Total Assets $ 3,356,261 $ 3,434,204
===============================================================================================================
Liabilities and Shareholders' Equity
Liabilities:
Deposits
Non-interest bearing $ 465,377 $ 439,075
Interest-bearing 2,076,597 2,066,281
- ---------------------------------------------------------------------------------------------------------------
Total deposits 2,541,974 2,505,356
Federal funds purchased 4,700 33,000
Borrowings 315,164 430,241
Company obligated mandatorily redeemable preferred securities
of subsidiaries, Community Capital/Statutory Trust I-III, holding
Solely junior subordinated debentures of the Company 76,903 77,375
Accrued interest and other liabilities 65,701 63,194
- ---------------------------------------------------------------------------------------------------------------
Total Liabilities 3,004,442 3,109,166
- ---------------------------------------------------------------------------------------------------------------
Shareholders' equity:
Common stock no par $1.00 stated value for 2003 and 2002; 20,000,000 share
authorized; 13,050,957 and 12,978,554 shares
issued, respectively 13,051 12,979
Additional paid-in capital 80,703 79,058
Retained earnings 206,905 194,483
Accumulated other comprehensive income 52,438 38,551
Treasury stock, at cost (32,200 shares for 2003) (1,209) 0
Employee stock plan - unearned (69) (33)
- ---------------------------------------------------------------------------------------------------------------
Total Shareholders' Equity 351,819 325,038
- ---------------------------------------------------------------------------------------------------------------
Total Liabilities and Shareholders' Equity $ 3,356,261 $ 3,434,204
===============================================================================================================
The accompanying notes are an integral part of the consolidated financial
statements.
3
COMMUNITY BANK SYSTEM, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(In Thousands, Except Per-share Data)
Three Months Ended Six Months Ended
June 30, June 30,
- ------------------------------------------------------------------------------------------------------------------------
2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------------------------------
Interest Income:
Interest and fees on loans $ 30,986 $ 32,078 $ 62,201 $ 65,136
Interest and dividends on investments:
Taxable 11,296 14,885 23,611 29,006
Nontaxable 4,671 4,260 9,353 7,858
- ------------------------------------------------------------------------------------------------------------------------
Total interest income 46,953 51,223 95,165 102,000
- ------------------------------------------------------------------------------------------------------------------------
Interest Expense:
Interest on deposits 9,933 13,842 20,569 29,011
Interest on federal funds purchased 84 149 169 236
Interest on short-term borrowings 344 404 821 615
Interest on mandatorily redeemable preferred securities 1,346 1,423 2,711 2,896
Interest on long-term borrowings 3,144 3,968 6,309 7,637
- ------------------------------------------------------------------------------------------------------------------------
Total interest expense 14,851 19,786 30,579 40,395
- ------------------------------------------------------------------------------------------------------------------------
Net interest income 32,102 31,437 64,586 61,605
Less: provision for loan losses 2,673 3,384 6,073 4,902
- ------------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 29,429 28,053 58,513 56,703
- ------------------------------------------------------------------------------------------------------------------------
Non-interest Income:
Fiduciary and investment services 921 899 1,792 1,777
Service charges on deposit accounts 4,930 3,120 9,305 6,041
Commissions and advisory fees on investment products 1,196 1,943 2,515 3,913
Other service charges, commissions and fees 1,878 1,615 4,070 3,575
Other operating income (loss), net 273 (10) 558 (4)
Gain (loss) on investment securities and early retirement of
long-term borrowings 0 1,144 (45) 1,144
- ------------------------------------------------------------------------------------------------------------------------
Total non-interest income 9,198 8,711 18,195 16,446
- ------------------------------------------------------------------------------------------------------------------------
Operating Expenses:
Salaries and employee benefits 12,400 12,266 25,178 24,391
Occupancy 2,328 2,077 4,749 4,399
Equipment and furniture 1,977 1,983 3,881 3,854
Amortization of intangible assets 1,251 1,504 2,532 3,044
Legal and professional fees 877 681 1,613 1,535
Data processing 1,947 1,739 3,721 3,412
Office supplies 466 610 1,052 1,297
Acquisition expenses 5 108 5 700
Other 4,179 3,110 7,336 6,095
- ------------------------------------------------------------------------------------------------------------------------
Total operating expenses 25,430 24,078 50,067 48,727
- ------------------------------------------------------------------------------------------------------------------------
Income before income taxes 13,197 12,686 26,641 24,422
Income taxes 3,165 3,416 6,660 6,594
- ------------------------------------------------------------------------------------------------------------------------
Net Income $ 10,032 $ 9,270 $ 19,981 $ 17,828
========================================================================================================================
Earnings Per Share - Basic $ 0.77 $ 0.71 $ 1.53 $ 1.38
========================================================================================================================
Earnings Per Share - Diluted $ 0.75 $ 0.70 $ 1.50 $ 1.36
========================================================================================================================
Dividends Per Share $ 0.29 $ 0.27 $ 0.58 $ 0.54
========================================================================================================================
The accompanying notes are an integral part of the consolidated financial
statements.
4
COMMUNITY BANK SYSTEM, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (UNAUDITED)
SIX MONTHS ENDED JUNE 30, 2003
(In Thousands, Except Share Data)
Common Stock Accumulated
------------------------- Additional Other Employee
Shares Paid-in Retained Comprehensive Treasury
Outstanding Amount Capital Earnings Income Stock
- -----------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2002 12,978,554 $ 12,979 $ 79,058 $ 194,483 $ 38,551 $ 0
Net income 19,981
Other comprehensive income, net of tax 13,887
Dividends declared:
Common, $.58 per share (7,559)
Common stock issued under employee
stock plan 72,403 72 1,645
Treasury stock purchased (32,200) (1,209)
- -----------------------------------------------------------------------------------------------------------------------------
Balance at June 30, 2003 13,018,757 $ 13,051 $ 80,703 $ 206,905 $ 52,438 ($1,209)
=============================================================================================================================
Stock Plan
-Unearned Total
- -------------------------------------------------------------------
Balance at December 31, 2002 ($33) $ 325,038
Net income 19,981
Other comprehensive income, net of tax 13,887
Dividends declared:
Common, $.58 per share (7,559)
Common stock issued under employee
stock plan (36) 1,681
Treasury stock purchased (1,209)
- -------------------------------------------------------------------
Balance at June 30, 2003 ($69) $ 351,819
===================================================================
The accompanying notes are an integral part of the consolidated financial
statements.
5
COMMUNITY BANK SYSTEM, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
(IN THOUSANDS)
Six Months Ended June 30,
2003 2002
- ----------------------------------------------------------------------------------------------
Other comprehensive income, before tax:
Change in minimum pension liability adjustment $ 97 $ 4,919
Unrealized gain on securities:
Unrealized holding gains arising during period 21,311 26,586
Reclassification adjustment for gains included in net income 0 (1,139)
- ----------------------------------------------------------------------------------------------
Other comprehensive income, before tax 21,408 30,366
Income tax expense related to other comprehensive income (7,521) (12,101)
- ----------------------------------------------------------------------------------------------
Other comprehensive income, net of tax 13,887 18,265
Net income 19,981 17,828
- ----------------------------------------------------------------------------------------------
Comprehensive income $ 33,868 $ 36,093
==============================================================================================
The accompanying notes are an integral part of the consolidated financial
statements.
6
COMMUNITY BANK SYSTEM, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(IN THOUSANDS)
Six Months Ended June 30,
2003 2002
- ----------------------------------------------------------------------------------------------------------------------
Operating Activities:
Net income $ 19,981 $ 17,828
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation 3,482 3,191
Amortization of intangible assets 2,532 3,044
Net amortization of premiums and discounts on securities and loans 1,142 1,969
Amortization of unearned compensation and discount on junior subordinated debentures 58 236
Provision for loan losses 6,073 4,902
Loss (gain) on sale of investment securities and early retirement of long-term 45 (1,144)
borrowings
(Gain) loss on sale of loans and other assets (470) 4
Proceeds from the sale of loans held for sale 61,561 0
Origination of loans held for sale (56,407) 0
Change in other assets and other liabilities 693 (14,442)
- ----------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 38,690 15,588
- ----------------------------------------------------------------------------------------------------------------------
Investing Activities:
Proceeds from sales of available-for-sale investment securities 10,725 63,513
Proceeds from maturities of held-to-maturity investment securities 2,510 3,231
Proceeds from maturities of available-for-sale investment securities 130,816 87,184
Purchases of held-to-maturity investment securities (1,917) (2,075)
Purchases of available-for-sale investment securities (5,923) (303,115)
Net increase in loans outstanding (60,643) (23,180)
Capital expenditures (3,352) (4,347)
- ----------------------------------------------------------------------------------------------------------------------
Net cash provided (used) by investing activities 72,216 (178,789)
- ----------------------------------------------------------------------------------------------------------------------
Financing Activities:
Net change in demand deposits, NOW accounts, and savings accounts 65,858 24,841
Net change in time deposits (29,240) (57,550)
Net change in federal funds purchased (28,300) 26,900
Net change in borrowings and trust preferred securities (115,545) 167,505
Issuance of common stock 1,509 994
Purchase of treasury stock (1,209) 0
Cash dividends paid (7,535) (6,970)
Other financing activities (77) (56)
- ----------------------------------------------------------------------------------------------------------------------
Net cash (used) provided by financing activities (114,539) 155,664
- ----------------------------------------------------------------------------------------------------------------------
Change in cash and cash equivalents (3,633) (7,537)
Cash and cash equivalents at beginning of year 113,531 106,554
- ----------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents At End of Period $ 109,898 $ 99,017
======================================================================================================================
Supplemental Disclosures of Cash Flow Information:
Cash paid for interest $ 29,861 $ 39,728
Cash paid for income taxes $ 6,946 $ 5,224
======================================================================================================================
Supplemental Disclosures of Noncash Financing and Investing Activities:
Dividends declared and unpaid $ 3,784 $ 3,499
Gross change in unrealized gains on available-for-sale securities $ 21,311 $ 25,447
Change in minimum pension liability adjustment ($97) ($4,919)
======================================================================================================================
The accompanying notes are an integral part of the consolidated financial
statements.
7
COMMUNITY BANK SYSTEM, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
June 30, 2003
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. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments, consisting
only of normal recurring adjustments, considered necessary for a fair statement
have been included. Operating results for the three and six months ended June
30, 2003 are not necessarily indicative of the results that may be expected for
the year ended December 31, 2003.
Note B: Other Matters
On July 31, 2003, the Company acquired PricewaterhouseCoopers' Upstate New York
Global Human Resource Solutions consulting group. This practice has been renamed
Harbridge Consulting Group and is a leading provider of retirement and employee
benefits consulting services throughout Upstate New York, and will be
complementary to Benefit Plans Administrative Services, Inc., the company's
defined contribution plan administration subsidiary.
On June 9, 2003, the Company announced that it signed a definitive agreement
with Grange National Banc Corp. ("Grange") to acquire all of the stock of Grange
and to merge Grange National Banc Corp. into Community Bank System, Inc. The
Company will pay either $42.50 in cash for each outstanding common share or
exchange each share of Grange common stock for 1.209 shares of the Company's
common stock, subject to specific terms defined in the agreement. Grange's 12
branches will operate as part of First Liberty Bank & Trust, a division of
Community Bank, N.A. The acquisition is expected to close during the fourth
quarter of 2003, pending approval by Grange shareholders and customary
regulatory approval.
On June 9, 2003, the Company announced that its Board of Directors had
authorized a stock repurchase program to acquire up to 700,000 common shares, or
approximately 5.4% of total outstanding shares, over the course of the ensuing
twelve months. As of June 30, 2003, 32,200 shares had been repurchased at an
aggregate cost of $1.21 million and an average price per share of $37.53.
On May 7, 2003, the Company announced that it signed a definitive agreement with
Peoples Bankcorp, Inc. (PBI) to acquire all the stock of PBI and to merge
Peoples Bankcorp, Inc. into Community Bank System, Inc. The Company will pay $30
for each outstanding common share of PBI for a total purchase price of
approximately $4.2 million. PBI's single branch in Ogdensburg, New York, will be
operated as a branch of the Bank's network of branches in Ogdensburg and
Northern New York. The acquisition is expected to close during the third quarter
of 2003.
Note C: Critical Accounting Policies
Allowance for Loan Losses
The allowance for loan losses reflects management's best estimate of probable
loan losses in the Company's loan portfolio. Determination of the allowance for
loan losses is inherently subjective. It requires significant estimates
including the amounts and timing of expected future cash flows on impaired loans
and the amount of estimated losses on pools of homogeneous loans which is based
on historical loss experience and consideration of current economic trends, all
of which may be susceptible to significant change.
When appropriate, an impaired loan is assigned a specific allowance. Specific
loan loss allocations for certain commercial loans are considered and revised as
necessary. Charge-offs of these commercial loans are taken against the specific
allocations before being applied against the general reserve. General
allocations on the commercial, residential and consumer loan portfolios are
reviewed and recalculated quarterly based on historical loss experience and
various qualitative judgement factors. These qualitative factors include changes
in national and local economic and business conditions, changes in experience,
ability and depth of lending management, changes in the portfolio mix and risk
profile, and changes in the growth of the loan portfolios. Loan losses are
charged off against the allowance, while recoveries of amounts previously
charged off are credited to the allowance.
8
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.
Stock-based Compensation
The Company accounts for stock awards issued to directors, officers and key
employees using the intrinsic value method. This method requires that
compensation expense be recognized to the extent that the fair value of the
stock exceeds the exercise price of the stock award at the grant date. The
Company generally does not recognize compensation expense related to stock
awards because the stock awards generally have fixed terms and exercise prices
that are equal to or greater than the fair value of the Company's common stock
at the grant date.
Statement of Financial Accounting Standard ("SFAS') No. 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 the intrinsic value method, the excess of the fair value of
the stock over the exercise price is recorded as expense on the date at which
both the number of shares the recipient is entitled to receive and the exercise
price are known.
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 a perfect indicator of the value of an option, but it
is commonly used for this purpose.
The Black-Scholes model requires several assumptions, which management developed
based on historical trends and current market observations. These assumptions
include:
----------------------------
2003 2002
----------------------------
Weighted-average expected life 8.43 6.74
Future dividend yield 3.00% 3.00%
Share price volatility 27.42% 27.82%
Weighted average risk-free interest rate 4.03% 3.814%-5.157%
If these assumptions are not accurate, the estimated fair value used to derive
the information presented in the following table will also 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 expense on the income statement. The pro forma impact of
applying the fair value method of accounting for the three and six months ended
June 30, 2003 and 2002 shown below may not be indicative of the pro forma impact
in future periods.
Quarter Ended Six Months Ended
(000's omitted except per share amounts) June 30, June 30,
2003 2002 2003 2002
----------------------------------------------------
Net income, as reported $ 10,032 $ 9,270 $ 19,981 $ 17,828
Less: stock-based compensation expense determined under
fair value method, net of tax 282 292 478 465
----------------------------------------------------
Proforma net income $ 9,750 $ 8,978 $ 19,503 $ 17,363
====================================================
Earnings per share:
As reported:
Basic $ 0.77 $ 0.71 $ 1.53 $ 1.38
Diluted $ 0.75 $ 0.70 $ 1.50 $ 1.36
Pro forma:
Basic $ 0.75 $ 0.69 $ 1.50 $ 1.34
Diluted $ 0.73 $ 0.68 $ 1.47 $ 1.32
9
New Accounting Pronouncements
In May 2003, the Financial Accounting Standards Board ("FASB") issued SFAS No.
150 " Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity," which establishes standards for how an issuer
classifies and measures certain financial instruments with characteristics of
both liabilities and equity. It requires that an issuer classify a financial
instrument that is within its scope as a liability, including certain preferred
securities. Effective July 1, 2003, the Company adopted this pronouncement,
which had no impact on the financial condition or results of operations.
In April 2003, the FASB issued SFAS No. 149 "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." This Statement amends and
clarifies financial accounting and reporting for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities under SFAS No. 133. SFAS No. 149 is generally effective for
contracts entered into or modified after June 30, 2003 and is effective for
hedging relationships designated after June 30, 2003. This pronouncement is not
expected to have any impact on the Company's financial condition or results of
operations.
In November 2002, FASB Interpretation ("FIN") No. 45, "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others was issued. This Interpretation elaborates on the
disclosures to be made by a guarantor in its interim and annual financial
statements about its obligations under certain guarantees that is has issued. It
also clarifies that a guarantor is required to recognize, at the inception of a
guarantee, a liability for the fair value of the obligation undertaken in
issuing the guarantee. The initial recognition and measurement provisions are
applicable on a prospective basis to guarantees issued or modified after
December 31, 2002. The disclosure requirements are effective for financial
statements of interim or annual periods ending after December 15, 2002. The
company has complied with the disclosure requirements. The recognition and
measurement provisions were adopted effective January 1, 2003.
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 which would be
outstanding if all the in-the-money 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 no antidilutive stock options as of June 30, 2003. The
following is a reconciliation of basic to diluted earnings per share for three
and six months ended June 30, 2003 and 2002.
Per Share
(000's omitted, except per share data) Income Shares Amount
- -----------------------------------------------------------------------------------------------
Quarter Ended June 30, 2003 Net income $10,032
Basic EPS 10,032 13,056 $ 0.77
Effect of dilutive
securities:
Stock options 290
------------------
Diluted EPS $10,032 13,346 $ 0.75
==============================================================================================
Quarter Ended June 30, 2002 Net income $ 9,270
Basic EPS 9,270 12,973 $ 0.71
Effect of dilutive
securities:
Stock options 221
------------------
Diluted EPS $ 9,270 13,194 $ 0.70
==============================================================================================
Six Months Ended June 30, 2003 Net income $19,981
Basic EPS 19,981 13,043 $ 1.53
Effect of dilutive
securities:
Stock options 253
------------------
Diluted EPS $19,981 13,296 $ 1.50
==============================================================================================
Six Months Ended June 30, 2002 Net income $17,828
Basic EPS 17,828 12,957 $ 1.38
Effect of dilutive
securities:
Stock options 193
------------------
Diluted EPS $17,828 13,150 $ 1.36
==============================================================================================
10
Note E: Intangible Assets
In October 2002, the FASB issued SFAS No. 147, "Accounting for Certain
Acquisitions of Banking and Thrift Institutions." This statement removes
acquisitions of financial institutions from the scope of SFAS 72 and FASB
Interpretation 9. It reclassifies as goodwill certain "unidentified intangible
assets" associated with the Company's branch acquisitions dating as far back as
1994. Financial statements were retroactively restated to January 1, 2002 to
remove amortization recorded on Other Intangible Assets. Previously, these
intangible assets were being regularly amortized. In accordance with the
provisions of SFAS No 147, the Company adopted this Statement retroactive to
January 1, 2002, with the impact of restatement on previously issued Form 10-Q's
as of June 30, 2002 contained below.
Three Months Ended Six Months Ended
(000's omitted, except per share data) June 30, 2002 June 30, 2002
------------------ ----------------
Net income as previously reported $ 8,179 $15,617
Branch goodwill amortization, net of tax 1,091 2,211
------- -------
Net income restated $ 9,270 $17,828
======= =======
Basic EPS as previously reported $ 0.63 $ 1.21
Diluted EPS as previously reported $ 0.62 $ 1.19
Basic EPS as restated $ 0.71 $ 1.38
Diluted EPS as restated $ 0.70 $ 1.36
Effective January 1, 2002, the Company adopted SFAS No 142, "Goodwill and Other
Intangible Assets," which addresses financial accounting and reporting for
acquired goodwill and other intangible assets and supercedes APB Opinion 17,
"Intangible Assets". The statement requires that the Company subject goodwill
and other intangible assets to an annual impairment analysis to assess the need
to write down the balances and recognize an impairment loss. In addition,
amortization of goodwill is no longer being recorded in accordance with this
statement. Core deposit intangibles will continue to be amortized.
The Company completed its goodwill impairment analysis during the first quarter
of 2003, and no adjustment was necessary. The gross carrying amount and
accumulated amortization for each type of intangible asset are as follows:
As of June 30, 2003 As of December 31, 2002
Gross Net Gross Net
Carrying Accumulated Carrying Carrying Accumulated Carrying
(000's omitted) Amount Amortization Amount Amount Amortization Amount
---------------------------------------- ----------------------------------------
Amortized intangible assets:
Core deposit intangibles $ 47,366 ($19,129) $ 28,237 $ 47,366 ($16,597) $ 30,769
Unamortized intangible assets:
Goodwill 122,432 (18,373) 104,059 122,432 (18,373) 104,059
---------------------------------------- ----------------------------------------
Total intangible assets, net $ 169,798 ($37,502) $ 132,296 $ 169,798 ($34,970) $ 134,828
======================================== ========================================
The estimated aggregate amortization expense for each of the succeeding fiscal
years ended December 31 is as follows:
July-Dec. 2003 $ 2,438
2004 4,753
2005 4,079
2006 3,406
2007 3,406
2008 3,406
Thereafter 6,749
- ---------------- -------
Total $28,237
================ =======
11
NOTE F: MANDATORILY REDEEMABLE PREFERRED SECURITIES
On July 16, 2001, the Company formed a wholly-owned subsidiary, Community
Capital Trust II, a Delaware business trust. The trust issued $25,000 of 30 year
floating-rate Company-obligated pooled capital securities of Community Capital
Trust II holding solely parent debentures. On July 31, 2001, the Company formed
a wholly-owned subsidiary, Community Statutory Trust III, a Connecticut business
trust. The trust issued $24,450 of 30 year floating-rate Company-obligated
pooled capital securities of Community Statutory Trust III holding solely parent
debentures. The Company borrowed the proceeds of the capital securities from its
subsidiaries by issuing deeply subordinated junior debentures having
substantially similar terms. The capital securities mature in 2031 and are
treated as Tier I capital by the Federal Reserve Bank of New York. Trust II
capital securities are a pooled trust preferred fund of MM Community Funding I,
Ltd, and are tied to the six- month LIBOR plus 3.75%, with a five-year call
provision beginning in 2006 at a price of 107.6875% declining to par in 2011.
Trust III capital securities are a pooled trust preferred fund of First
Tennessee/KBW Pooled Trust Preferred Deal III and are tied to the three month
LIBOR plus 3.58%, with a five-year call provision beginning in 2006 at a price
of 107.5% declining to par in 2011. All of these securities are guaranteed by
the Company.
On February 3, 1997, the Company formed a wholly-owned subsidiary business
trust, Community Capital Trust I (Trust), for the purpose of issuing
Company-obligated mandatorily redeemable preferred securities representing
undivided beneficial interests in the assets of the Trust. The Trust issued
$30,000 of 9.75% preferred securities that are non-voting and mandatorily
redeemable in 2027 with a ten-year call provision beginning in 2007 at a price
of 104.54% declining to par in 2017. The Company borrowed the proceeds of the
preferred securities from the Trust by issuing Junior Subordinated Debentures
having substantially similar terms as the preferred securities. The assets of
the Trust include the principal amount of the Company's Junior Subordinated
Debentures and related accrued interest and were $32,025 at June 30, 2003. The
preferred securities mature in 2027 and are treated as Tier 1 capital. The
guarantees issued by the Company for the Trust, together with the Company's
obligations under the trust agreement, the Junior Subordinated Debentures, and
the Indenture under which the Junior Subordinated Debentures were issued,
constitute a full and unconditional guarantee by the Company of the preferred
securities issued by the Trust. The costs related to the issuance of these
securities are capitalized and amortized over the life of the period to
redemption on a straight-line basis.
Note G: Commitment and Contigencies
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. Standby letters of credit generally
are contingent upon the failure of the customer to perform according to the
terms of the underlying contract with the third party. The credit risk
associated with commitments to extend credit and standby letters of credit is
essentially the same as that involved with the extending loans to customers and
is subject to normal credit policies. Collateral may be obtained based on
management's assessment of the customer's creditworthiness.
The contract amount of commitment and contingencies are as follows:
- --------------------------------------------------------------
June 30, December 31,
(000's omitted) 2003 2003
- --------------------------------------------------------------
Standby letters of credit $ 19,631 $ 19,728
Commitments to extend credit 331,833 332,422
- --------------------------------------------------------------
Total $ 351,464 $ 352,150
==============================================================
12
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. and its subsidiaries ("CBSI" or "the
Company") for the three and six months ended June 30, 2003 and 2002, although in
some circumstances the first quarter of 2003 is also discussed in order to more
fully explain near-term 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. All references in the
discussion to financial condition and results of operations are to the
consolidated position and results of the Company and its subsidiaries taken as a
whole.
All references to "peer banks", unless otherwise noted, pertain to a group of 76
bank holding companies nationwide having $3 billion to $10 billion in assets and
their associated composite financial results for the three months ending March
31, 2003 (the most recently available disclosure) as provided by the Federal
Reserve System in the Bank Holding Company Performance Report. Unless otherwise
noted, the term "this year" refers to results in calendar year 2003, 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.
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.
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. Management believes that these areas
include the allowance for loan losses, fair value of investment securities, fair
value methodologies used to review the carrying value of goodwill, and actuarial
assumptions associated with the pension, post-retirement and other employee
benefit plans. Refer to Note A, "Summary of Significant Accounting Policies", on
pages 66 - 71 of the most recent Form 10-K (fiscal year ended December 31, 2002)
for a complete review of the Company's most important accounting policies.
Net Income and Profitability
As shown in Table 1, earnings per share for the second quarter were $0.75, up
7.1% from second quarter 2002's level of $0.70. Year-to-date EPS of $1.50 was
$0.14 or 10.3% higher than the prior year amount. Net income for the quarter and
six-month period were $10.0 million and $20.0 million, respectively, up 8.2% and
12.1% over the equivalent periods of 2002. Net interest income FTE for second
quarter 2003 rose to $35.1 million, $641,000 or 1.9% over the same period last
year. Net interest income FTE for the first six months of 2003 was $70.5
million, up $3.4 million or 5.1% versus the first six months of 2002. Second
quarter non-interest income (excluding securities gains and debt extinguishment)
of $9.2 million was up $1.6 million (22%) from second quarter 2002, and
year-to-date non-interest income of $18.2 million was $2.9 million (19.2%)
higher than 2002's level. Operating expenses were up $1.4 million or 5.6% for
the quarter and $1.3 million or 2.8% for the June year-to-date period.
As reflected in Table 1, the primary reasons for improved second quarter
earnings compared to the same period last year were higher recurring
non-interest income, a lower loan loss provision and higher net interest income.
The increase in non-interest income was mostly attributable to the incremental
fees generated by the Company's Overdraft Freedom(TM) program initiated in
December 2002, and income associated with secondary market mortgage portfolio
activity (refer to non-interest income section beginning on page 18). The lower
loan loss provision was mostly a result of a reduced level of net charge-offs
(refer to the asset quality discussion starting on page 23). Higher net interest
income was driven by a 21-basis point increase in the net interest margin (refer
to net interest income section on page 14). These performance improvements were
partially offset by an increase in operating expenses that was primarily
attributable to higher retirement, occupancy and volume-driven expense levels
(see operating expenses section starting on page 20).
The year-to-date increase in earnings in comparison to the first six months of
2002 was primarily a result of higher net interest income and non-interest
income, offset partially by increased loan loss provision and operating
expenses. The rise in net interest income was driven by a 24 basis point
increase in the net interest margin, and higher non-interest income was again
mostly due to increases in overdraft fees and income derived from secondary
market mortgage activity. The rise in the loan loss provision was primarily
attributable to increased specific allocations on certain commercial loans in
the first quarter of 2003. Higher operating expenses were
13
mostly a result of increased occupancy, pension and retired executive
compensation costs. Each of these items is discussed in further detail in their
respective sections of the MD&A.
Table 1: Summary Income Statements
Quarter Ended Six Months Ended
(000's omitted, except per share amounts) June 30, 2003 June 30, 2002 June 30, 2003 June 30, 2002
------------------------------ -------------------------------
Net interest income (FTE) $ 35,064 $ 34,423 $ 70,528 $ 67,120
Loan loss provision 2,673 3,384 6,073 4,902
Non-interest income 9,198 7,567 18,240 15,302
Gain (loss) on investment securities and early retirement of
long-term borrowings 0 1,144 (45) 1,144
Operating expenses 25,425 23,970 50,062 48,027
Acquisition expenses 5 108 5 700
------------------------------ -------------------------------
Income before taxes (FTE) 16,159 15,672 32,583 29,937
Full tax-equivalent adjustment 2,962 2,986 5,942 5,515
Income taxes 3,165 3,416 6,660 6,594
------------------------------ -------------------------------
Net income $ 10,032 $ 9,270 $ 19,981 $ 17,828
============================== ===============================
Diluted earnings per share $ 0.75 $ 0.70 $ 1.50 $ 1.36
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 Bank's depositors, interest on external borrowings and dividends paid on the
Company's trust preferred securities. 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 2, net interest income (with non-taxable income converted to a
fully tax-equivalent basis) for second quarter 2003 rose to $35.1 million,
$641,000 or 1.9% higher than the same period last year. An increase in the net
interest margin, loan growth and reduced external borrowings had a greater
impact than a lower level of investment securities. As reflected in Table 4, the
higher margin accounted for $4.9 million of the net interest income improvement.
This was offset by $4.3 million less net interest income due to volume changes,
most notably, lower taxable investment securities levels.
The second quarter's 21-basis point improvement in the net interest margin
versus the prior year period was primarily driven by the reduction of the cost
of interest-bearing deposits and the stability of taxable investment security
yields, which more than offset lower loan yields and slightly higher blended
rates on external borrowings. The Company has been diligent about expeditiously
reducing interest-bearing deposit rates to match the drop in market interest
rates. As a result, the second quarter's cost of interest-bearing deposits
declined 71 basis points from the prior year level, reflecting the Federal
Reserve's two rate cuts over the intervening period. The Company was able to
maintain the yields on taxable securities because of the decisions to invest in
call-protected medium-term securities in 2001 and early 2002, and to discontinue
purchasing taxable investments thereafter until market conditions improved. Both
of these decisions were made as a result of asset/liability management that
dictated the Company protect itself against the environment that would pose the
most earnings risk, specifically falling market interest rates. Lower loan
yields reflect the aforementioned reduced market rates, while the higher rates
paid on external borrowings were caused by a shift in the mix towards
longer-term borrowings and trust preferred securities as shorter-term maturity
borrowings were paid off.
Changes in investment and borrowing levels were driven by the Company's
previously announced de-leveraging strategy of using proceeds from the run-off
of investment securities to pay down borrowings until more favorable investment
conditions arose. As a result of this activity, second quarter average
investments (book value) fell by $171 million and external borrowings dropped by
$102 million versus the year-earlier period. Average loan growth of $93 million
or 5.3% for the same time periods helped to partially offset the lower level of
investment securities.
Table 3 displays that year-to-date net interest income was $70.5 million, up
$3.4 million or 5.1% in comparison to the equivalent prior year period. This
change was mostly the result of a higher net interest margin, as average earning
asset and liability levels for the first six months of 2003 were only marginally
lower than the year-earlier period. This is evidenced by a relatively minor
$454,000 negative impact from the change in balance sheet volume, as reflected
in Table 4. Loan growth of $83 million offset a majority of the $90 million net
reduction of the investment portfolio. Growth of non-interest bearing demand
deposits ($20 million) also somewhat counter-balanced the $32 million decline in
interest-bearing deposits. This change in deposit mix along with the pay-down of
$29
14
million of borrowings resulted in a shift towards lower-cost funding, helping to
lower the overall costs of funds (including demand deposits) 63 basis points to
2.07%
The year-to-date net interest margin in comparison to the first six months of
2002, benefited from significantly lower interest-bearing deposit rates (down 78
basis points) and flat taxable investment yields, which more than compensated
for lower loan yields (down 68 basis points). In addition, a strategic shift in
the mix of borrowing activity towards short-term borrowings enabled the Company
to reduce the cost of funds on overall external borrowings by 30 basis points
over the same time frame. These factors helped to drive the $3.9 million of the
net interest margin improvement that was attributable to interest rate-related
changes, as shown in Table 4.
Tables 2 and 3 below set forth certain information concerning average
interest-earning assets and interest-bearing liabilities and their associated
yields and rates for the periods indicated. Interest income and resultant yield
information in the tables are on a fully tax-equivalent basis using a marginal
federal income tax rate of 35%. Averages balances are computed using daily
balances. Yields and amounts earned include loan fees. Non-accrual loans have
been included in interest-earning assets for purposes of these computations.
Table 2: Quarterly Average Balance Sheet
Quarter Ended Quarter Ended
June 30, 2003 June 30, 2002
--------------------------------- ---------------------------------
Avg. Avg.
Avg. Amt. Of Yield/Rate Avg. Amt. Of Yield/Rate
(000's omitted except yields and rates) Balance Interest Paid Balance Interest Paid
--------------------------------- ---------------------------------
Assets:
Interest-earning assets:
Time deposits in other banks $ 219 $ 1 1.83% $ 506 $ 2 1.59%
Taxable investment securities 724,397 11,542 6.39% 957,541 15,215 6.37%
Nontaxable investment securities 401,535 7,229 7.22% 338,740 6,719 7.96%
Loans (net of unearned discount)(1) 1,834,610 31,143 6.81% 1,742,110 32,273 7.43%
-------------------- --------------------
Total interest-earning assets 2,960,761 49,915 6.76% 3,038,897 54,209 7.15%
Non-interest earning assets 395,639 351,768
---------- ----------
Total assets $3,356,400 $3,390,665
========== ==========
Liabilities and Shareholders' Equity:
Interest-bearing liabilities:
Interest checking, savings and money market deposits $ 984,553 1,800 0.73% $ 978,650 3,163 1.30%
Time deposits 1,088,845 8,133 3.00% 1,129,039 10,679 3.79%
Short-term borrowings 132,775 428 1.29% 110,971 553 2.00%
Long-term borrowings 292,075 4,490 6.17% 416,069 5,391 5.20%
-------------------- --------------------
Total interest-bearing liabilities 2,498,248 14,851 2.38% 2,634,729 19,786 3.01%
Non-interest bearing liabilities:
Demand deposits 456,176 437,612
Other liabilities 59,146 36,888
Shareholders' equity 342,830 281,436
---------- ----------
Total liabilities and shareholders' equity $3,356,400 $3,390,665
========== ==========
Net interest earnings $ 35,064 $ 34,423
========== ==========
Net interest spread 4.38% 4.14%
Net interest margin on interest-earnings assets 4.75% 4.54%
Fully tax-equivalent adjustment $ 2,962 $ 2,986
(1) The impact of interest not recognized on nonaccrual loans and interest
income that would have been recorded if the restructured loans had been
current in accordance with their original terms was immaterial.
15
Table 3: Year to Date Average Balance Sheet
Six Months Ended Six Months Ended
June 30, 2003 June 30, 2002
--------------------------------- ---------------------------------
Avg. Avg.
Avg. Amt. Of Yield/Rate Avg. Amt. Of Yield/Rate
(000's omitted except yields and rates) Balance Interest Paid Balance Interest Paid
--------------------------------- ---------------------------------
Assets:
Interest-earning assets:
Time deposits in other banks $ 221 $ 1 0.91% $ 432 $ 3 1.40%
Taxable investment securities 755,410 24,109 6.44% 928,049 29,643 6.44%
Nontaxable investment securities 402,003 14,466 7.26% 319,315 12,406 7.83%
Loans (net of unearned discount)(1) 1,821,323 62,531 6.92% 1,738,009 65,463 7.60%
--------------------- ---------------------
Total interest-earning assets 2,978,957 101,107 6.84% 2,985,805 107,515 7.26%
Non-interest earning assets 393,372 352,316
---------- ----------
Total assets $3,372,329 $3,338,121
========== ==========
Liabilities and Shareholders' Equity:
Interest-bearing liabilities:
Interest checking, savings and money market deposits $ 985,617 3,734 0.76% $ 968,963 6,358 1.32%
Time deposits 1,094,934 16,835 3.10% 1,143,272 22,653 4.00%
Short-term borrowings 151,950 990 1.31% 85,606 851 2.00%
Long-term borrowings 293,349 9,020 6.20% 389,042 10,533 5.46%
--------------------- ---------------------
Total interest-bearing liabilities 2,525,850 30,579 2.44% 2,586,883 40,395 3.15%
Non-interest bearing liabilities:
Demand deposits 452,717 432,783
Other liabilities 57,558 40,074
Shareholders' equity 336,204 278,381
---------- ----------
Total liabilities and shareholders' equity $3,372,329 $3,338,121
========== ==========
Net interest earnings $ 70,528 $ 67,120
======== ========
Net interest spread 4.40% 4.11%
Net interest margin on interest-earnings assets 4.77% 4.53%
Fully tax-equivalent adjustment $ 5,942 $ 5,515
16
The changes in net interest income (full tax-equivalent basis) by volume and
rate components are shown below for each major category of interest-earning
assets and interest-bearing liabilities.
Table 4: Rate/volume
2nd Quarter 2003 versus 2nd Six Months Ended June 30, 2003
Quarter 2002 vs 2002
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 ($3) $2 ($1) ($1) ($1) ($2)
Taxable investment securities (3,963) 290 (3,673) (5,510) (24) (5,534)
Nontaxable investment securities 3,663 (3,153) 510 4,477 (2,417) 2,060
Loans (net of unearned discount) 7,971 (9,101) (1,130) 7,179 (10,111) (2,932)
Total interest-earning assets (2) ($1,369) ($2,925) ($4,294) ($246) ($6,162) ($6,408)
Interest paid on:
Interest checking, savings and money market
deposits $132 ($1,495) ($1,363) $321 ($2,945) ($2,624)
Time deposits (369) (2,177) (2,546) (924) (4,894) (5,818)
Short-term borrowings 515 (640) (125) 915 (776) 139
Long-term borrowings (5,514) 4,613 (901) (4,690) 3,177 (1,513)
Total interest-bearing liabilities (2) ($982) ($3,953) ($4,935) ($933) ($8,883) ($9,816)
Net interest earnings (2) ($4,305) $4,946 $641 ($454) $3,862 $3,408
(1) The change in interest due to both rate and volume has been allocated to
volume and rate changes 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 of the totals; they are not a summation of the
changes of the components.
17
Non-interest Income
The Company's sources of non-interest income are of three primary types: general
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 consulting (BPA), employee benefit trust
(EBT), personal trust, investment and insurance products (CISI) and investment
management (Elias Asset Management); and periodic transactions, most often net
gains (losses) from the sale of investments, prepayment of term debt, or other
occasional events.
Table 5: Non-interest Income
Three Months Ended Six Months Ended
---------------------- -----------------------
June 30, June 30, June 30, June 30,
(000's omitted) 2003 2002 2003 2002
--------- --------- --------- ---------
Financial services:
Personal trust $ 353 $ 440 $ 728 $ 954
Benefit plan administration and trust fees 1,490 1,095 2,825 2,198
Asset management fees 386 785 913 1,563
Investment product commissions 809 1,158 1,601 2,350
Credit life and disability insurance 65 72 126 128
--------- --------- --------- ---------
Total financial services 3,103 3,550 6,193 7,193
Banking services:
Electronic banking 617 546 1,163 1,152
Mortgage banking 268 66 957 185
Deposit service charges 1,345 1,332 2,641 2,646
Overdraft fees 3,391 1,582 6,301 3,013
Commissions and other fees 459 506 1,005 1,122
Miscellaneous income (loss) 15 (15) (20) (9)
--------- --------- --------- ---------
Total banking services 6,095 4,017 12,047 8,109
--------- --------- --------- ---------
Sub-total 9,198 7,567 18,240 15,302
Gain (loss) on investment securities and early retirement
of long-term borrowings 0 1,144 (45) 1,144
--------- --------- --------- ---------
Total non-interest income $ 9,198 $ 8,711 $ 18,195 $ 16,446
========= ========= ========= =========
Non-interest income as a percentage of operating
income (excludes investment security gain & debt ext.) 20.8% 18.0% 20.5% 18.6%
As displayed in Table 5, non-interest income (excluding securities gains and
penalties on debt extinguishment) was $9.2 million in the second quarter, an
increase of $1.6 million or 22% from one year earlier. It rose by $2.9 million
or 19.2% for the year-to-date period versus the prior year. The primary reason
for the increase in both periods from prior year levels was general banking
fees, which climbed $2.1 million or 52% for the second quarter and $3.9 million
or 49% on a year-to-date basis.
Overdraft fee increases of $1.8 million and $3.3 million for second quarter and
year-to date periods, respectively, accounted for the vast majority of the total
rise in non-interest income. This was due in large part to the significantly
higher level of transaction volume generated from the Company's Overdraft
Freedom(TM) program, which was introduced in early December 2002 (for a
description of this program refer to page 45 of the Company's December 31, 2002
10-K). The balance of the quarterly and year-to-date improvements essentially
came from income associated with the secondary mortgage portfolio. The Company
resumed sale of secondary-market-eligible mortgages in late 2002, when rates
fell below the desirable holding-yield threshold, after approximately one year
of holding all mortgages in portfolio. The new sales activity was the main
reason why second quarter mortgage banking fees rose $202,000 for the second
quarter and $772,000 for the first six-months of 2003 versus the equivalent
prior year periods. Secondary sales resulted in gains being realized on the sale
of mortgages (rates declined while loans were held for sale) and a larger
servicing portfolio ($132 million at 6/30/03 versus $109 million at 6/30/02 and
$104 million at 12/31/02) that increased mortgage servicing rights and generated
higher servicing fees.
Financial services revenues of $3.1 million in the second quarter decreased
$447,000 or 12.6% from the same period last year, and year-to-date revenue of
$6.2 million was down $1.0 million or 13.9%. Strong performance at the Company's
Benefit Plans
18
Administrative Services (BPA) subsidiary was more than offset by weakness in the
other financial services units. BPA, a provider of actuarial, daily valuation,
compliance and custodial services in support of retirement plans, generated
revenue growth of $395,000 (36%) and $627,000 (29%) for the quarter and
year-to-date periods, respectively, through the acquisition of a significant
number of new client relationships and their associated investment assets.
Revenue from Elias Asset Management (EAM), the Company's subsidiary which
manages investments for institutions and high net worth individuals, was
negatively impacted by the performance of the US equity markets and their impact
on asset-based management fees (average month-end S&P 500 index values for the
March - May 2003 period were 17% below prior year levels) and the loss of some
clients during the extended period of market weakness. The Company's
broker-dealer, Community Investment Services, Inc. (CISI), also had lower
revenues, largely because of their inability to duplicate the strong annuity
income produced in the year-earlier period as lower interest rates have reduced
both sales volume and commission rates. Personal trust revenue was negatively
affected by equity market valuations, as well as the timing of estate
settlements. As a whole, revenue for these three businesses was down $835,000 or
35% compared to second quarter 2002 and $1.6 million or 33% versus the first six
months of 2002.
Financial services' assets under management or administration were $1.578
billion as of quarter-end, up 15.1% from the year-earlier level and 9.6% higher
than the end of the previous quarter. Essentially all of the growth has come
from BPA, where assets under administration increased 16.8% in the current
quarter and grew 71% over the last 12 months. The impact of difficult equity
market conditions were evident in EAM's asset levels, which were down 18.4%
versus June 30, 2002 and increased only slightly (1.8%) in the most recent
quarter.
The ratio of total non-interest income to operating income (FTE basis, excluding
net security gains and penalties on debt extinguishment) was 20.8% for second
quarter 2003, 2.8 percentage points higher than the same period last year. On a
year-to-date basis, this ratio climbed to 20.5%, well above the 18.6% posted in
the prior-year period. In both cases, the significant growth of recurring
non-interest income, driven by increased overdraft fees and secondary market
mortgage activity, outpaced net interest income growth, which was tempered by
the de-leveraging strategy put in place in the second half of 2002.
There were no security or debt prepayment transactions in the second quarter of
2003 or the first quarter of 2002. Second quarter 2002 included $1.1 million of
net security gains associated with the sale of approximately $52 million of
collateralized mortgage obligations (CMOs). These securities were sold to lock
in a favorable total investment return (8.2%) and to avoid the erosion of market
value appreciation that was likely in a falling interest rate environment due to
accelerated prepayment speeds. A $45,000 premium was paid in the first quarter
of 2003 to repurchase a $500,000 block of the Company's 9.75% fixed-rate trust
preferred securities, further lowering funding costs.
19
Operating Expenses
Table 6 below sets forth the quarterly and year-to-date results of the major
operating expense categories for the current and prior year, as well as
efficiency ratios (defined below), a standard measure of overhead utilization
used in the banking industry.
Table 6: Operating Expenses
Three Months Ended Six Months Ended
----------------------- ----------------------
June 30, June 30, June 30, June 30,
(000's omitted) 2003 2002 2003 2002
----------------------- ----------------------
Salaries and employee benefits $ 12,400 $ 12,266 $ 25,178 $ 24,391
Occupancy 2,328 2,077 4,749 4,399
Equipment and furniture 1,977 1,983 3,881 3,854
Legal and professional fees 877 681 1,613 1,535
Data processing 1,947 1,739 3,721 3,412
Amortization of intangible assets 1,251 1,504 2,532 3,044
Office supplies 466 610 1,052 1,297
Foreclosed property (9) 290 158 618
Deposit insurance premiums 98 109 202 231
Other 4,090 2,711 6,976 5,246
----------------------- ----------------------
Total recurring expenses 25,425 23,970 50,062 48,027
Acquisition expenses 5 108 5 700
----------------------- ----------------------
Total operating expenses $ 25,430 $ 24,078 $ 50,067 $ 48,727
======================= ======================
Financial services $ 2,854 $ 2,645 $ 5,435 $ 5,370
Banking services 22,576 21,433 44,632 43,357
----------------------- ----------------------
Total operating expenses $ 25,430 $ 24,078 $ 50,067 $ 48,727
======================= ======================
Total operating expenses as
a percentage of average assets 3.04% 2.84% 2.99% 2.90%
Efficiency ratio 54.6% 53.5% 53.5% 54.6%
As shown in Table 6, second quarter 2003 operating expenses were $25.4 million,
up 5.6% from the prior year level. Year-to-date operating expenses of $50.1
million increased only 2.8% versus the first six months of 2002. The first half
of 2002 included $700,000 of acquisition-related expenses, $108,000 of which
were incurred in the second quarter. These expenses primarily pertained to
consulting expenses associated with the restructuring of loan and deposit
centers necessitated by the increased level of business volume arising from the
three 2001 acquisitions. An insignificant amount of acquisition expenses have
been incurred thus far in 2003. On a recurring basis (excluding acquisition
expenses), second quarter operating expenses were up 6.1% versus prior year, and
year-to-date expenses increased 4.2% from the level experienced in the first six
months of 2003.
The second quarter increase in recurring operating expenses versus prior year
was mainly attributable to increased volume-driven costs (overdrafts, mortgage
loan origination, ATM), recruiting expenses, costs related to the retirement of
the predecessor Chief Financial Officer and higher occupancy costs, partially
offset by lower intangible amortization and foreclosed property expenses.
Recruiting costs rose primarily as a result of expenses associated with the
hiring of a new Chief Financial Officer. The rise in occupancy expense was
driven by increased utilities and maintenance costs due to higher rates and
extended winter weather conditions. Foreclosed property expenses dropped by
almost $300,000 due to lower OREO balances, an insurance settlement in second
quarter 2003 and less write-downs in the first half of 2003. Amortization of
intangibles continues to decline over time primarily due to the use of the
accelerated method of amortization.
The marginal increase in year-to-date recurring operating expenses was mostly
attributable to the same items discussed in the quarterly variance discussion
above: higher volume-driven costs, retiree compensation and recruiting expenses,
partially offset by reduced intangible amortization and foreclosed property
expenses. In addition, personnel expense increased $787,000 in the first six
months of 2003 due to the impact of new hires, merit increases and higher
pension expenses. This was partially offset by lower office supply expenses,
which were elevated in the first half of 2002 due to the need to purchase new
checks, forms and stationery in conjunction with the 2001 acquisitions.
20
The Company's efficiency ratio (non-interest expense excluding intangible
amortization and acquisition expenses divided by the sum of net interest income
(FTE) and non-interest income excluding net securities gains/losses) was 54.6%
for the second quarter, 1.1 percentage points above the comparable 2002 quarter.
This resulted from operating expenses (as defined above) increasing 7.6%, while
recurring operating income grew at a lesser, 5.4% pace. Despite very strong
non-interest income growth, recurring operating income expansion was limited by
the effect the investment de-leveraging strategy had on net interest income (up
1.9%).
The efficiency ratio for the first six months of 2003 improved by 1.1 percentage
points versus the equivalent 2002 period, largely because of the strength of
recurring non-interest income growth (19.2%) and the modest increase in cash
operating expenses (5.7%). In addition, first-half 2003 net interest income was
up 5.1%, as the de-leveraging strategy had less of an impact on the first
quarter year-over-year variance than was experienced in the second quarter
(first quarter 2003 net-interest income was up 8.5% versus prior year). This was
primarily due to the investment portfolio being near an all-time high level in
second quarter 2002 (portfolio was increased significantly in late 2001 and the
first half of 2002 as a result of excess funding supplied by 2001 acquisitions),
and was at a six-quarter low in second quarter 2003 (de-leveraging strategy
implemented in fourth quarter of 2002).
Income and Income Taxes
Second quarter 2003 income before taxes of $13.2 million was up $511,000 or 4.0%
from the prior year's amount. The year-to-date effective income tax rate was
reduced to 25.0% from 26.0% in the second quarter as a result of a higher than
expected proportion of income generated from tax-exempt securities and loans.
Due to the full year-to-date impact of the rate change being realized in the
quarter, the income tax rate for the second quarter was 24.0% versus 26.9% in
the second quarter of 2002.
Investments
As reflected in Table 7, the carrying value of investments (including unrealized
gains on available-for-sale securities) was $1.167 billion at the end of the
second quarter, a decrease of $117 million or 9.1% from the balance at December
31, 2002. Excluding unrealized gains, the investment portfolio's ending balance
was down $138 million or 11.3% in the second quarter versus fourth quarter 2002.
The decline in the carrying value of investments was less than that of book
balances because unrealized gains rose by $21.3 million or 33%, despite the
reduced size of the portfolio. This was caused by the positive impact that
significantly lower interest rates had on the market value of available-for-sale
investments. The book value of investments at the end of second quarter 2003 was
down $200 million or 15.6% from the second quarter of 2002. As previously
mentioned, investments have been allowed to run off during the last nine months,
reflective of the Company's strategy to use cash flow to support loan growth and
repay borrowings until reinvestment and leverage opportunities become more
attractive.
Table 7: Investments
June 30, 2003 December 31, 2002 June 30, 2002
---------------------------- ---------------------------- ----------------------------
Amortized Market Amortized Market Amortized Market
(000's omitted) Cost/Book Value Value Cost/Book Value Value Cost/Book Value Value
---------------------------- ---------------------------- ----------------------------
Held-to-Maturity Portfolio
Obligations of states and political $ 6,818 $ 7,108 $ 7,412 $ 7,666 $ 6,685 $ 7,183
subdivisions
Available-for-Sale Portfolio
U.S. Treasury securities and
obligations of U.S. Government
corporations and agencies 356,392 389,910 380,243 411,278 358,072 377,368
Obligations of state and political 403,837 440,359 404,864 420,605 376,220 384,054
subdivisions
Corporate securities 27,646 31,451 27,972 30,225 43,291 45,281
Collateralized mortgage
obligations (CMO) 163,951 170,819 235,286 245,368 300,847 310,480
Mortgage-backed securities 100,092 105,256 131,755 137,211 164,009 168,072
Equity securities 16,543 16,543 25,814 25,814 26,420 26,420
Federal Reserve Bank common stock 5,656 5,656 5,652 5,652 5,652 5,652
------------------------ ---------------------------- --------------------------
Total available-for-sale portfolio 1,074,117 1,159,994 1,211,586 1,276,153 1,274,511 1,317,327
------------------------ ---------------------------- --------------------------
Total portfolio 1,080,935 $1,167,102 1,218,998 $1,283,819 1,281,196 $1,324,510
========== ========== ==========
Net unrealized gain on
available-for-sale portfolio 85,877 64,567 42,816
----------- -------------- -----------
Total carrying value $ 1,166,812 $ 1,283,565 $ 1,324,012
=========== =============== ===========
21
Loans
As shown in Table 8, loans ended the second quarter at $1.858 billion, up $51
million over the last six months, and $107 million or 6.1% higher than one year
earlier. Loans increased $37 million over the past three months, the largest
quarterly increase in three years (excluding the impact of acquired loans).
Virtually all of the net growth during the last 12 months has been from retail
borrowers. As previously noted, sales of new secondary-market-eligible
production resumed in late 2002, amounting to placement of $9 million in fourth
quarter 2002, and $31 million and $21 million in the first and second quarters
of 2003, respectively. Had these mortgages been retained in portfolio, loans
would have risen $168 million or 9.6% over the latest twelve months. Overall,
the increase over the past 12 months in total outstanding loans is attributable
principally to the New York markets, with total outstanding loans declining in
Pennsylvania.
Table 8: Loans
(000's omitted) June 30, 2003 December 31, 2002 June 30, 2002
----------------- ----------------- -----------------
Business lending $ 637,985 34% $ 629,903 35% $ 631,125 36%
Consumer mortgage 545,828 29% 510,309 28% 464,737 27%
Consumer direct 368,653 20% 379,313 21% 386,433 22%
Consumer indirect 305,549 17% 287,380 16% 268,889 15%
---------- --- ---------- --- ---------- ---
Total loans $1,858,015 100% $1,806,905 100% $1,751,184 100%
========== === ========== === ========== ===
Despite resumed secondary market sales, consumer mortgages continued to be the
main drivers of loan growth, up $36 million in the first half of 2003 due to the
most favorable refinancing environment seen in decades. The new markets opened
up by our 36-branch FleetBoston purchase have generated $73 million in portfolio
production since their mid-November 2001 acquisition. Over the last 12 months,
bank-wide consumer mortgages have increased $81 million or 17.4% to $546
million. This increase relates to activity in the New York markets. Although
originations are up significantly over prior year in the Pennsylvania market,
outstanding balances have declined as a result of secondary market sales and
re-financings. Excluding the sale of $62 million of secondary market mortgages,
total consumer mortgages would have been up $142 million or 31% from their level
at June 30, 2002.
Business loans rose $8.1 million during the first six months of 2003. Business
lending has essentially been flat over the last 12 months, as evidenced by the
1.1% ($6.9 million) of loan growth over that period. More specifically, the New
York markets have experienced marginal levels of loan growth, with the
Pennsylvania market experiencing a decline. As has been the case for the past
two years, a soft economy, restricted capital spending by companies, the desire
to maintain solid asset quality standards, and the unwillingness to succumb to
competitive pressure to lend at unprofitable yields, has limited the growth
opportunities in many of our markets.
Consumer indirect loans, largely borrowings originated in automobile, marine and
recreational vehicle dealerships, rose $18.2 million during the first half of
2003, reflecting traditionally strong second quarter results (up $15 million in
the quarter). Over the last twelve months indirect loans were up $37 million or
13.6%, with historically low interest rates, aggressive dealer and manufacturer
incentives on new vehicles, and very competitive pricing on used vehicles
driving strong growth in car, boat and recreational vehicle sales. Both the New
York and Pennsylvania markets contributed growth, each of which added new
originating dealers in 2002.
Consumer direct loans declined by $10.7 million in the first six months of 2003,
a portion of which reflects reduced demand for this type of loan due to soft
economic conditions. In addition, a certain amount of installment and home
equity loans continues to be paid off through conventional mortgage
re-financings. However, the decline in the latest quarter was only marginal
($1.6 million or 0.4%), as recent home equity loan promotional campaigns began
to have an impact. June 30, 2003 consumer direct loans were down $17.8 million
or 4.6% versus the year-earlier level, with both the New York and Pennsylvania
markets experiencing declines.
22
Asset Quality
Table 9 below exhibits the major components of non-performing loans and assets
and key asset quality metrics for the periods ending June 30, 2003 and 2002 and
December 31, 2002.
Table 9: Nonperforming Assets
June 30, December 31, June 30,
(000's omitted) 2003 2002 2002
------------- ------------- -------------
Non-accrual loans $ 12,678 $ 9,754 $ 10,029
Accruing loans 90+ days delinquent 2,457 1,890 1,141
------------- ------------- -------------
Total nonperforming loans 15,135 11,644 11,170
Restructured loans 30 43 59
Other real estate 943 704 1,671
------------- ------------- -------------
Total non-performing assets $ 16,108 $ 12,391 $ 12,900
============= ============= =============
Allowance for loan losses to total loans 1.48% 1.46% 1.36%
Allowance for loan losses to non-performing loans 181% 226% 214%
Non-performing loans to total loans 0.81% 0.64% 0.64%
Non-performing assets to total loans and other real estate 0.87% 0.69% 0.74%
As displayed in Table 9, non-performing assets at June 30, 2003 were $16.1
million, an increase of $3.7 million versus year-end 2002 and $3.2 million
higher than the end of June 2002. Most of the increase was caused by higher
non-accrual loans and loans 90 or more days delinquent. The majority of the
change in non-accruals over the last six months was attributable to four
commercial customers with balances over $300,000 previously identified as weak,
which together total $2.3 million of the $2.9 million in additional
non-accruals. The $567,000 increase in loans delinquent 90 days or more, mostly
represents a rise in small commercial loan (under $50,000) delinquencies and
approximately $216,000 more delinquent installment loans. Non-performing loan
levels have declined recently, as evidenced by a $706,000 decrease in these
loans over the last three months.
Nonperforming loans were 0.81% of total loans outstanding at quarter end versus
0.64% at both year-end 2002 and June 30, 2002. This ratio improved from the
first quarter 2003's 0.87% level, as non-accruing loans decreased by $899,000.
The current and previous quarter's non-performing loan ratio also compared
favorably with the peer bank median of 0.95% at the end of first quarter 2003.
The allowance for loan loss to nonperforming loans ratio, a general measure of
coverage adequacy, was 181% at the end of the second quarter, below the
Company's coverage ratio of 226% and 214% at year-end 2002 and June 30, 2002,
respectively, but above the 173% coverage ratio at the end of first quarter
2003.
Delinquent loans (30 days through non-accruing) as a percent of total loans was
1.79% at the end of the second quarter, a nine basis-point decrease from
year-end 2002, and essentially flat with the 1.77% delinquency ratio at June 30,
2002. The current delinquency level is seven basis points below the Company's
average of 1.86% over the last eight quarters. As of March 31, 2003, the median
peer bank delinquency ratio was 1.96%.
23
Table 10: Allowance for Loan Loss Activity
Quarter Ended Six Months Ended
(000's omitted) June 30, 2003 June 30, 2002 June 30, 2003 June 30, 2002
---------------------------- ----------------------------
Allowance for loan losses at beginning of period $ 27,350 $ 24,010 $ 26,331 $ 23,901
Charge-offs:
Business lending 1,522 2,575 2,702 3,157
Consumer mortgage 46 0 86 0
Consumer direct 701 643 1,388 1,282
Consumer indirect 980 883 2,055 1,730
---------------------------- ----------------------------
Total charge-offs 3,249 4,101 6,231 6,169
Recoveries:
Business lending 56 134 122 196
Consumer mortgage 4 3 8 106
Consumer direct 190 137 405 294
Consumer indirect 393 316 709 653
---------------------------- ----------------------------
Total recoveries 643 590 1,244 1,249
Net charge-offs 2,606 3,511 4,987 4,920
Provision for loan losses 2,673 3,384 6,073 4,902
---------------------------- ----------------------------
Allowance for loan losses at end of period $ 27,417 $ 23,883 $ 27,417 $ 23,883
============================ ============================
Net charge-offs to average loans outstanding 0.57% 0.81% 0.55% 0.57%
As displayed in Table 10, net charge-offs during the second quarter were $2.6
million, $905,000 less than the equivalent 2002 period, partially due to the
prior year including partial write-downs on two large commercial credits. For
the first six months of 2003, net charge-offs were up only $67,000 or 1.4%
versus the first half of 2002. Net charge-offs continue to be above historical
norms due to weakness in the business loan sector, which is still being
adversely impacted by soft economic conditions in our primary markets.
Business loan net charge-offs for the second quarter were $1.5 million, $1.0
million below the year-ago quarter. Year-to-date business loan net charge-offs
of $2.6 million were $381,000 less than the first six months of 2002. The vast
majority of the business loans that have been charged-off thus far in 2003 had
previously been identified as impaired and had specific allowance allocations
assigned to them. Consumer direct loan net charge-offs for the quarter and first
six months of 2003 were relatively flat versus prior year, while consumer
indirect net charge-offs were stable for the quarter, but were up on a
year-to-date basis due to increased loan volume. Consumer mortgage net
charge-offs continue to be at immaterial levels.
Net charge-offs as a percentage of average loans outstanding ("net charge-off
ratio"), were 0.57% and 0.55% for the second quarter and the first six months of
2003, respectively. In comparison to 2002, these results were favorable by 24
basis points for the quarter and down two basis points on a year-to-date basis.
These variances were primarily driven by business loan net charge-off ratios,
which were 0.93% of average loans for the quarter and 0.82% year-to-date, versus
1.54% and 0.93% in the prior year. Consumer direct loan net charge-off ratios of
0.55% for the quarter and 0.53% for the first six months of 2003 were
essentially flat with the equivalent prior year periods. The consumer indirect
net charge-off ratio of 0.79% for the second quarter was eight basis points
below the year-earlier quarter and 28 basis points lower than the ratio in the
first quarter of 2003. This second quarter improvement helped to lower the
year-to-date net charge-off ratio for consumer indirect loans to 0.93%, eight
basis points higher than the ratio for first six months of 2002. Consumer
mortgage net charge-off ratios were negligible for the second quarter and
year-to-date, and have remained below 0.15% of average mortgage balances for the
last eight quarters.
In accordance with the Company's current allowance for loan loss policy,
specific allocations recognizing probable losses in the business loan portfolio
are determined based on the evaluation of the customers' ability to make their
principal and interest payments as scheduled and the sufficiency of the
collateral securing the credit. If both of these items are deemed to be
deficient, an allowance allocation is assigned to the loan to cover the
potential shortfall. Specific allocations were down slightly in the current
quarter to $5.5 million, but were up $438,000 on a year-to-date basis. The level
of specific allocations is a function of allocations added and removed,
pay-downs and charge-offs. During the first six months of 2003 approximately
$2.4 million of new specific allocations were added and $2.0 million of specific
allocations were charged-off.
An overall review of the asset quality of the portfolio is completed each
quarter. As noted above, specific loan loss allocations for certain commercial
customers identified as weak are evaluated and adjusted as necessary. General
allocations against all other commercial loans and the consumer product lines
are reviewed and recalculated quarterly based on historical loss experience,
performance trends, and various judgmental factors. In accordance with this
review, one of the qualitative risk factors related to business loans was
increased in the first quarter, resulting in an additional $416,000 being
included in the allowance for loan loss at the end of the latest quarter.
24
As a result of this process, a required loan loss allowance of $27.4 million was
determined as of June 30, 2003, necessitating a $2.7 million loan loss provision
for the quarter compared to $3.4 million one year earlier. The year-to-date
provision of $6.1 million was $1.2 million higher than the prior year period.
This was due mostly to higher loan balances, the revised business loan risk
factor, and higher business loan specific allocations, as discussed above.
The allowance for loan losses has risen $3.5 million or 14.8% over the last 12
months, versus a 6.1% increase in loans outstanding. Consequently, the ratio of
allowance for loan loss to loans outstanding has climbed 12 basis points to
1.48%, two basis points below the all-time high level reached at the end of the
previous quarter, and commensurate with the probable risk in the loan portfolio
at this time.
During the first quarter of 2003, the Company appointed Steven R. Tokach,
previously President of Pennsylvania Banking, to a newly-designated Chief Credit
Administrator position on a company-wide basis. In addition, a consultant with
extensive credit administration experience in Upstate New York has been retained
to further strengthen credit administration practices.
Deposits
As shown in Table 11 below, second quarter average deposits of $2.530 billion
were down slightly from the averages for the fourth and second quarters of 2002.
Average deposits in the second quarter were down 0.4% compared to fourth quarter
2002 and fell 0.6% versus second quarter 2002. Both reductions reflect the
recent trend of time deposit run-off and lower money market account balances
more than offsetting increases in liquid interest-bearing deposits such as
interest checking and savings accounts. This shift in deposit mix may reflect
customers' unwillingness to be locked into CD rates for extended periods of time
and hold money in accounts with higher minimum balance requirements given the
current low level of interest rates, especially given the diminished interest
rate spread between these accounts and shorter-term or less restrictive
interest-bearing accounts. The greatly reduced opportunity cost of holding money
in non-interest bearing accounts has also helped to drive up the average
balances for demand deposit accounts, as evidenced by a second quarter increase
of 4.0% versus the year-earlier period. The shift in the deposit mix towards
non-interest and lower interest-bearing accounts contributed further funding
cost benefits beyond the absolute drop in interest rates, helping to lower the
overall cost of deposits from 2.18% in second quarter 2002 to 1.58% in the
current quarter.
Average IPC (individuals and businesses) deposits were relatively flat over the
latest 12 months, reflective of the economic conditions in our primary markets.
Second quarter 2003 public fund deposits increased on an average basis versus
fourth quarter 2002, reflective of the timing of municipality expenditures. The
decline in public fund deposits versus the year-earlier period is likely
partially due to the impact state budget cutbacks are having on local government
and school fiscal conditions. In addition, the Company's demand for public fund
CDs has diminished due to extremely attractive external borrowing rates and
reduced funding needs as a result of its de-leveraging strategy.
Table 11: Average Deposits
June 30, December 31, June 30,
(000's omitted) 2003 2002 2002
------------- ------------- -------------
Demand deposits $ 456,176 $ 454,038 $ 437,612
Interest checking deposits 269,110 263,490 265,050
Savings deposits 425,581 407,701 405,061
Money market deposits 289,862 301,169 308,539
Time deposits 1,088,845 1,112,447 1,129,039
------------- ------------- -------------
Total deposits $ 2,529,574 $ 2,538,845 $ 2,545,301
============= ============= =============
IPC deposits $ 2,362,357 $ 2,377,777 $ 2,353,487
Public fund deposits 167,217 161,068 191,814
------------- ------------- -------------
Total deposits $ 2,529,574 $ 2,538,845 $ 2,545,301
============= ============= =============
25
Borrowings
At the end of the second quarter 2003, borrowings and federal funds purchased of
$320 million were $143 million or 31% lower than they were at the end of 2002.
Short-term borrowings decreased by $110 million, long-term borrowings decreased
by $5 million and federal funds purchased decreased by $28 million. At June 30,
2003, trust preferred securities were $472,000 lower than year-end 2002
primarily as a result of the purchase of a block of the fixed-rate portion of
these securities, as noted in the non-interest income section on page 19. The
decrease in combined borrowings is a result of the investment de-leveraging
strategy previously discussed. Refer to the net interest income section on page
14 for further review of borrowing activity over the past 12 months.
Other Assets and Liabilities
Other assets and liabilities had a net liability balance of $27.0 million at
June 30, 2003 versus a net liability position of $21.3 million at December 31,
2002. The change was mainly attributable to an increase in deferred taxes
related to the market value adjustment and other timing differences.
Shareholders' Equity
On June 9, 2003 the Company announced that its Board of Directors had authorized
a stock repurchase program to acquire up to 700,000 of its shares, or
approximately 5.4%, of its outstanding common stock. The shares may be
repurchased from time to time, in open market or privately negotiated
transactions over the course of the next 12 months. All reacquired shares will
become treasury shares and will be used for general corporate purposes.
Total shareholders' equity equaled $352 million at the end of the second
quarter, $26.8 million higher than the balance at December 31, 2002. This
increase consisted of net income of $20.0 million, a change in the after-tax
market value adjustment of $13.9 million and $1.7 million from shares issued
under the employee stock plan, offset by dividends declared of $7.6 million and
treasury stock purchases of $1.2 million (32,200 shares). Over the past 12
months total shareholders' equity increased by $53.3 million, a majority of
which came from net income and an increase in the after-tax market value
adjustment.
The Company's Tier I leverage ratio, a primary measure of regulatory capital for
which 5% is the requirement to be `well-capitalized,' reached 7.77% at the end
of the second quarter, its strongest level in a decade. The tangible
equity-to-assets ratio has risen 185 basis points over the last 12 months from
4.96% to 6.81%. Excluding the impact of the change in the market value
adjustment (which impacts both asset and equity levels), the tangible
equity-to-assets ratio at June 30, 2003 would have risen by 92 basis points
versus one year earlier.
The dividend payout ratio (dividends declared divided by net income) for second
quarter 2003 was 37.7%, flat with the ratio for the second quarter of 2002. The
two quarters' ratios were similar because dividends declared were raised 8.2%
(based on dividends per share of $0.29 vs. $0.27 in prior year and applicable
shares for both periods), the same percentage increase as net income. The June
2003 year-to-date dividend payout ratio of 37.8% fell slightly from the
equivalent prior year level of 39.2% due to net income rising 12.1%, while
dividends declared increased 8.2%.
Liquidity
Due to the potential for unexpected fluctuations in deposits and loans, active
management of the Company's liquidity is critical. In order to respond to these
circumstances, adequate sources of both on and off-balance sheet funding are in
place.
CBSI's primary approach to measuring liquidity is known as the Basic
Surplus/Deficit model. It is used to calculate liquidity over two time periods:
first, the amount of cash that could be made available within 30 days
(calculated as liquid assets less short-term liabilities); and second, a
projection of subsequent cash availability over an additional 60 days. The
minimum policy level of liquidity under the Basic Surplus/Deficit approach is
7.5% of total assets for both the 30 and 90-day time horizons. As of June 30,
2003, this ratio was 13.2% and 13.3% for the respective time periods, excluding
the Company's capacity to borrow additional funds from the Federal Home Loan
Bank.
To measure longer-term liquidity, a baseline projection of loan and deposit
growth for five years is made to reflect how current liquidity levels could
change over time. This five-year measure reflects ample liquidity for loan
growth over the next five years.
26
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 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) the ability to hire and retain key management personnel; (14) other risk
factors outlined in the Company's filings with the Securities and Exchange
Commission from time to time; and (15) the success of the Company at managing
the risks of the foregoing.
The foregoing list of important factors is not all-inclusive. 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 will 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. The Company has an immaterial
amount of credit risk because essentially all of the fixed-income securities in
the investment portfolio are AAA-rated (highest possible rating). Therefore,
almost all the market risk of the bank is related to interest rates. The ongoing
monitoring and management of this risk, over both a short-term tactical and
longer-term strategic time horizon, is an important component of the Company's
asset/liability management process, which is governed by policies established by
its Board of Directors and reviewed and approved annually.
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. The analysis begins by
measuring the impact of differences in maturity and repricing of all balance
sheet positions, embedded option risk and balance sheet growth.
Changes in net interest income are reviewed after subjecting the balance sheet
to an array of treasury yield curve possibilities. The following reflects the
Company's one-year net interest income sensitivity based on asset and liability
levels on June 30, 2003, assuming conservative levels of balance sheet growth--
low single digit growth in loans and deposits along with replacement of
year-to-date investment run-off, augmented by any necessary changes in
borrowings, with no growth in other major portions of the balance sheet. On that
basis, a variety of scenarios was tested, including moving the prime and federal
funds rates 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.
Table 13: Management Model
Net Interest Income
Rate Change Dollar Change During First 12 Months
In Basis Points Versus No Change In Rates Percent Change
- -------------------------------------------------------------------------------------------------
+ 200 bp -$0.5 million -0.4%
- 100 bp -$2.8 million -2.2%
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
Under the supervision and with the participation of our management, including
the President and Chief Executive Officer and Chief Financial Officer, the
Company has evaluated the effectiveness of the design and operation of our
disclosure controls and procedures within 90 days of the filing date of this
quarterly report, and, based on their evaluation, our President and Chief
Executive Officer and Chief Financial Officer have concluded that these controls
and procedures are effective. There were no significant changes in our internal
controls or in other factors that could significantly affect these controls
subsequent to the date of their evaluation.
Disclosure controls and procedures are our controls and other procedures that
are designed to ensure that information required to be disclosed in the reports
that the Company files or submits under the Exchange Act is recorded, processed,
summarized and reported, within the time periods specified in the Securities and
Exchange Commission's rules and forms. Disclosure controls and procedures
include, without limitation, controls and procedures designed to ensure that
information required to be disclosed by the Company is accumulated and
communicated to our management, including our President and Chief Executive
Officer and Chief Financial Officer, as appropriate to allow timely decisions
regarding required disclosure.
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.
Item 2. Changes in Securities.
There have been no changes in securities during the quarter ended June 30, 2003.
Item 3. Defaults Upon Senior Securities.
There were no defaults upon senior securities during the quarter ended June 30,
2003.
Item 4. Submission of Matters to a Vote of Securities Holders.
The Annual Meeting of Shareholders of the Company was held on May 28, 2003. The
shareholders elected four nominees of the Board of Directors whose terms will
expire at the Annual Meeting in 2006.
Number of Shares of Common Stock
For Withheld
--------------------------------------
Sanford A. Belden 11,164,026 151,609
Lee T. Hirschey 11,019,464 296,169
Peter A. Sabia 11,121,475 194,162
David C. Patterson 11,167,115 148,521
The directors whose terms in office continued after the meeting were John M.
Burgess, Paul M. Cantwell, Jr., William M. Dempsey, Nicholas A. DiCerbo, James
A. Gabriel, Harold S. Kaplan , Saul Kaplan, and William N. Sloan.
Item 5. Other Information.
Not applicable
Item 6. Exhibits and Reports on Form 8-K
Exhibit No. Description
- ----------- -----------
2.1 Agreement and Plan of Merger, dated May 6, 2003, by
and among the Registrant, PB Acquisition Corp. and
Peoples Bankcorp, Inc. (incorporated by reference to
Exhibit 2.1 to the Current Report on Form 8-K of the
Registrant filed on May 8, 2003).
2.2 Agreement and Plan of Merger, dated June 9, 2003, by
and between the Registrant and Grange National Banc
Corp. (incorporated by reference to Exhibit 2.1 to
the Current Report on Form 8-K of the Registrant
filed on June 17, 2003).
31.1 Certification of Sanford A. Belden, President and
Chief Executive Officer of the Registrant, pursuant
to Rule 13a-15(e) or Rule 15d-15(e) under the
Securities Exchange Act of 1934, as adopted pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Mark E. Tryniski, Treasurer and
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 Mark E. Tryniski, Treasurer and
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.
30
Reports on Form 8-K:
o Form 8-K related to quarterly earnings press release was filed on July 18,
2003
o Form 8-K announcing the Purchase Agreement with PricewaterhouseCoopersLLP
to acquire its Upstate New York Global Human Resource Solutions was filed
on June 20, 2003
o Form 8-K announcing the Agreement and Plan of Merger with Grange National
Banc. Corp. was filed on June 17, 2003
o Form 8-K announcing share repurchase program was filed on June 9, 2003
o Form 8-K/A related to Peoples Bankcorp, Inc. Agreement and Plan of Merger
was filed on May 22, 2003
31
Signatures
Pursuant to the requirements of The Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Community Bank System, Inc.
Date: August 13, 2003
/s/ Sanford A. Belden
---------------------------------
Sanford A. Belden, President,
Chief Executive Officer and
Director
Date: August 13, 2003 /s/ Mark E. Tryniski
---------------------------------
Mark E. Tryniski,
Treasurer and Chief
Financial Officer
32