UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
|X| FOR ANNUAL AND TRANSITIONAL REPORTS PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004
Commission file number 001-13695
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[LOGO]
COMMUNITY BANK SYSTEM, INC.
(Exact name of registrant as specified in its charter)
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New York Stock Exchange
(Name of Each Exchange on Which Registered)
Delaware 16-1213679
(State or other jurisdiction (I.R.S. Employer Identification No.)
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
Securities registered pursuant to Section 12(b) of the Act: Common Stock,
$1.00 Par Value Securities registered pursuant to Section 12(g) of the
Act: None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|.
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment of this Form 10-K. |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes |X| No |_|.
The aggregate market value of the voting stock held by non-affiliates of the
registrant on June 30, 2004 determined using the closing price per share on that
date of $22.79, as reported on the New York Stock Exchange was approximately
$636,000,000.
Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of the latest practicable date.
30,312,681 shares of Common Stock, $1.00 par value, were outstanding on
March 9, 2005.
DOCUMENTS INCORPORATED BY REFERENCE.
List hereunder the following documents if incorporated by reference and
the Part of the Form 10-K into which the document is incorporated: (1) any
annual report to security holders; (2) any proxy or information statement; and
(3) any prospectus filed pursuant to Rule 424(b) or (c) under the Securities Act
of 1933.
Portions of Definitive Proxy Statement for Annual Meeting of Shareholders
to be held on May 11, 2005 (the "Proxy Statement") is incorporated by reference
in Part III of this Annual Report on Form 10-K.
Exhibit Index is located on page 69 of 74
TABLE OF CONTENTS
PART I Page
----
Item 1. Business ............................................................................ 3
Item 2. Properties .......................................................................... 7
Item 3. Legal Proceedings ................................................................... 7
Item 4. Submission of Matters to a Vote of Security Holders ................................. 7
Item 4A. Executive Officers of the Registrant ................................................ 7
PART II
Item 5. Market for Registrant's Common Stock, Related Shareholders Matters and Issuer
Purchases of Equity Securities .................................................... 8
Item 6. Selected Financial Data ............................................................. 9
Item 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations ........................................................................ 11
Item 7A. Quantitative and Qualitative Disclosures about Market Risk .......................... 35
Item 8. Financial Statements and Supplementary Data:
Consolidated Statements of Condition ........................................... 38
Consolidated Statements of Income .............................................. 39
Consolidated Statements of Changes in Shareholders' Equity ..................... 40
Consolidated Statements of Comprehensive Income ................................ 41
Consolidated Statements of Cash Flows .......................................... 42
Notes to Consolidated Financial Statements ..................................... 43
Management's Report on Internal Control over Financial Reporting ............... 65
Report of Independent Registered Public Accounting Firm ........................ 66
Two Year Selected Quarterly Data .................................................... 67
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 67
Item 9A. Controls and Procedures ............................................................. 67
Item 9B. Other Information ................................................................... 67
PART III
Item 10. Directors and Executive Officers of the Registrant .................................. 68
Item 11. Executive Compensation .............................................................. 68
Item 12. Security Ownership of Certain Beneficial Owners and Management ...................... 68
Item 13. Certain Relationships and Related Transactions ...................................... 68
Item 14. Principal Accounting Fees and Services .............................................. 68
PART IV
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K .................... 69
Signatures .................................................................................... 73
2
Part I
This Annual Report on Form 10-K contains certain forward-looking statements with
respect to the financial condition, results of operations and business of
Community Bank System, Inc. These forward-looking statements involve certain
risks and uncertainties. Factors that may cause actual results to differ
materially from those contemplated by such forward-looking statements are set
forth herein under the caption "Forward-Looking Statements." The share and
per-share information in this document has been adjusted to give effect to a
two-for-one stock split of the Company's common stock effected as of April 12,
2004.
Item 1. Business
Community Bank System, Inc. ("the Company") was incorporated on April 15, 1983,
under the Delaware General Corporation Law. Its principal office is located at
5790 Widewaters Parkway, DeWitt, New York 13214. The Company maintains a
web-site at communitybankna.com and firstlibertybank.com. Annual reports on Form
10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and
amendments to those reports, are available on the Company's web-site free of
charge as soon as reasonably practicable after such reports or amendments are
electronically filed with or furnished to the Securities and Exchange
Commission. The information on the web-site is not part of this filing.
The Company's business philosophy is to operate as a community bank with local
decision-making, principally in non-metropolitan markets, providing a broad
array of banking and financial services to retail, commercial, and municipal
customers.
Community Bank System, Inc. is a single bank holding company which wholly-owns
four subsidiaries: Community Bank, N.A. ("the Bank"), Benefit Plans
Administrative Services, Inc. ("BPAS"), CFSI Closeout Corp. ("CFSICC"), and
First of Jermyn Realty Co. ("FJRC"). BPAS owns two subsidiaries, Benefit Plans
Administrative Services LLC (BPA) and Harbridge Consulting Group LLC. BPAS
provides administration, consulting and actuarial services to sponsors of
employee benefit plans. CFSICC and FJRC are inactive companies. The Company also
wholly-owns three unconsolidated subsidiary business trusts formed for the
purpose of issuing mandatorily redeemable preferred securities which are
considered Tier I capital under regulatory capital adequacy guidelines.
The Bank operates 125 customer facilities throughout twenty-two counties of
Upstate New York and five counties of Northeastern Pennsylvania offering a range
of commercial and retail banking services. The Bank owns the following
subsidiaries: Community Investment Services, Inc. ("CISI"), CBNA Treasury
Management Corporation ("TMC"), CBNA Preferred Funding Corporation ("PFC"),
Elias Asset Management, Inc. ("EAM") and First Liberty Service Corp. ("FLSC").
CISI provides broker-dealer and investment advisory services. TMC operates the
cash management, investment, and treasury functions of the Bank. PFC primarily
is an investor in residential real estate loans. EAM provides asset management
services to individuals, corporate pension and profit sharing plans, and
foundations. FLSC provides banking related services to the Pennsylvania branches
of the Bank.
Acquisition History (1999-2004)
Dansville Branch Acquisition
On December 3, 2004, the Company completed the purchase of a branch office in
Dansville, N.Y. ("Dansville") from HSBC Bank USA, N.A with deposits of $32.6
million.
First Heritage Bank
On May 14, 2004, the Company acquired First Heritage Bank ("First Heritage"), a
closely held bank headquartered in Wilkes-Barre, PA with three branches in
Luzerne County, Pennsylvania. First Heritage's three branches operate as part of
First Liberty Bank & Trust, a division of Community Bank, N.A. Consideration
included 2,592,213 shares of common stock with a fair value of $52 million,
employee stock options with a fair value of $3.0 million, and $7.0 million of
cash (including capitalized acquisition costs of $1.0 million).
Grange National Banc Corp.
On November 24, 2003, the Company acquired Grange National Banc Corp.
("Grange"), a $280 million-asset bank holding company based in Tunkhannock, Pa.
Grange's 12 branches operate as part of First Liberty Bank & Trust, a division
of Community Bank, N.A. The Company issued approximately 2,294,000 shares of its
common stock to certain of the former shareholders at a cost of $23.97 per
share. The remaining shareholders received $21.25 per share in cash or
approximately $20.9 million. In addition, Grange stock options representing $5.4
million of fair value were exchanged for options of the Company.
3
Peoples Bankcorp Inc.
On September 5, 2003, the Company acquired Peoples Bankcorp, Inc. ("Peoples"), a
$29-million-asset savings and loan holding company based in Ogdensburg, New
York. Peoples' single branch is being operated as a branch of the Bank's network
of branches in Northern New York.
Harbridge Consulting Group
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 ("Harbridge") and is a leading provider of retirement
and employee benefits consulting services throughout Upstate New York, and is
complementary to BPA, the Company's defined contribution plan administration
subsidiary.
FleetBoston Financial Corporation branches
On November 16, 2001, the Company acquired 36 branches from FleetBoston
Financial Corporation with $470 million in deposits and $177 million in loans.
The branches are located in the Southwestern and Finger Lakes Regions of New
York State.
First Liberty Bank Corp.
On May 11, 2001, the Company completed its acquisition of the $648-million-asset
First Liberty Bank Corp. ("First Liberty"). Pursuant to the terms of the merger,
each share of First Liberty stock was exchanged for 1.12 shares of the Company's
common stock, which amounted to approximately 7.2 million shares. The merger
constituted a tax-free reorganization and was accounted for as a pooling of
interests under APB Opinion 16.
Citizens National Bank of Malone
On January 26, 2001, the Company acquired the $111-million-asset Citizens
National Bank of Malone, a commercial bank with five branches throughout
Franklin and St. Lawrence counties in New York State. The Company issued
1,904,000 shares of its common stock to the former shareholders at a cost of
$13.25 per share. All of the 1,296,200 shares then held in the Company's
treasury were issued in this transaction as part of the total 1,904,000 shares.
Elias Asset Management, Inc.
On April 3, 2000, the Company acquired all the stock of Elias Asset Management,
Inc. (EAM) for cash of $6.5 million. Additional consideration of $3.0 million
was recognized in 2001 based upon performance targets set forth within the stock
purchase agreement. EAM, based in Williamsville, NY, is a nationally recognized
firm that manages assets for individuals, corporate pension and profit sharing
plans, and foundations.
Services
The Bank is a community retail bank committed to the philosophy of serving the
financial needs of customers in local communities. The Bank's branches are
generally located in small towns and villages within its geographic market areas
of Upstate New York and Northeastern Pennsylvania. The Company believes that the
local character of business, knowledge of the customer and customer needs, and
comprehensive retail and small business products, together with responsive
decision-making at the branch and regional level, enable the Bank to compete
effectively. The Bank is a member of the Federal Reserve System and the Federal
Home Loan Bank of New York ("FHLB"), and its deposits are insured by the FDIC up
to applicable limits.
Competition
The financial services business is highly competitive. The Company competes
actively with national and state banks, thrift institutions, credit unions,
retail brokerage firms, mortgage bankers, finance companies, insurance
companies, and other regulated and unregulated providers of financial services.
4
The table below summarizes the Bank's deposits and market share by the
twenty-seven counties of New York and Pennsylvania in which it has customer
facilities. Market share is based on deposits of all commercial banks, credit
unions, savings and loan associations, and savings banks.
Number of
--------------------------------------------
Towns Where
Deposits Company
6/30/2004 Market Has 1st or 2nd
County State (000's) (1) Share Facilities ATM's Towns Market Position
- -----------------------------------------------------------------------------------------------------
Allegany NY $ 193,624 48.6% 10 8 9 9
Lewis NY 80,637 37.7% 4 1 3 3
Yates NY 76,378 32.2% 3 2 2 2
Seneca NY 106,485 30.4% 4 3 4 3
Cattaraugus NY 262,982 30.4% 11 7 7 6
St. Lawrence NY 343,673 26.6% 13 8 11 10
Wyoming PA 76,592 23.5% 3 2 3 2
Franklin NY 83,558 16.9% 5 3 4 4
Chautauqua NY 195,187 13.9% 12 10 10 7
Schuyler NY 18,147 13.8% 1 1 1 0
Jefferson NY 135,393 12.1% 5 5 4 2
Steuben NY 164,712 11.4% 9 6 8 5
Tioga NY 35,724 9.5% 2 2 2 1
Livingston NY 48,106 8.2% 3 3 3 2
Susquehanna PA 38,045 7.3% 3 1 3 3
Lackawanna PA 446,679 6.3% 11 13 8 4
Ontario NY 77,931 5.7% 3 4 3 1
Herkimer NY 30,495 5.5% 1 1 1 1
Wayne NY 47,904 5.3% 2 1 1 0
Luzerne PA 291,214 4.7% 9 8 5 1
Oswego NY 45,446 4.3% 2 2 2 2
Cayuga NY 27,571 3.4% 2 1 2 1
Bradford PA 15,055 1.8% 2 2 2 1
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Subtotal 2,841,538 10.0% 120 94 98 70
Oneida NY 58,592 1.4% 2 1 1 1
Chemung NY 12,292 1.3% 1 1 1 0
Onondaga NY 10,106 0.1% 1 1 1 0
Erie NY 26,407 0.1% 1 0 1 1
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27 Total $2,948,935 4.6% 125 97 102 72
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(1) Deposit market share data as of June 30, 2004, the most recent information
available, calculated by Sheshunoff Information Services, Inc.
Employees
As of December 31, 2004 and 2003 the Company employed 1,301 and 1,259 full-time
equivalent employees, respectively. The Company offers a variety of employment
benefits and considers its relationship with its employees to be good.
5
Supervision and Regulation
Bank holding companies and national banks are regulated by state and federal
law. The following is a summary of certain laws and regulations that govern the
Company and the Bank. To the extent that the following information describes
statutory or regulatory provisions, it is qualified in its entirety by reference
to the actual statutes and regulations thereunder.
Federal Bank Holding Company Regulation
The Company is registered under, and is subject to, the Bank Holding Company Act
of 1956, as amended. This Act limits the type of companies that Community Bank
System, Inc. may acquire or organize and the activities in which it or they may
engage. In general, the Company and the Bank are prohibited from engaging in or
acquiring direct or indirect control of any corporation engaged in non-banking
activities unless such activities are so closely related to banking as to be a
proper incident thereto. In addition, the Company must obtain the prior approval
of the Board of Governors of the Federal Reserve System ("the FRB") to acquire
control of any bank; to acquire, with certain exceptions, more than five percent
of the outstanding voting stock of any other corporation; or, to merge or
consolidate with another bank holding company. As a result of such laws and
regulation, the Company is restricted as to the types of business activities it
may conduct and the Bank is subject to limitations on, among others, the types
of loans and the amounts of loans it may make to any one borrower. The Financial
Modernization Act of 1999 created, among other things, a new entity, the
"financial holding company". Such entities may engage in a broader range of
activities that are "financial in nature", including insurance underwriting,
securities underwriting and merchant banking. Bank holding companies which are
well capitalized and well managed under regulatory standards may convert to
financial holding companies relatively easily through a notice filing with the
FRB, which acts as the "umbrella regulator" for such entities. The Company may
seek to become a financial holding company in the future.
Federal Reserve System
The Company is required by the Board of Governors of the Federal Reserve System
to maintain cash reserves against its deposits. After exhausting other sources
of funds, the Company may seek borrowings from the Federal Reserve for such
purposes. Bank holding companies registered with the FRB are, among other
things, restricted from making direct investments in real estate. Both the
Company and the Bank are subject to extensive supervision and regulation, which
focus on, among other things, the protection of depositors' funds.
The Federal Reserve System also regulates the national supply of bank credit in
order to influence general economic conditions. These policies have a
significant influence on overall growth and distribution of loans, investments
and deposits, and affect the interest rates charged on loans or paid for
deposits.
Fluctuations in interest rates, which may result from government fiscal policies
and the monetary policies of the Federal Reserve System, have a strong impact on
the income derived from loans and securities, and interest paid on deposits.
While the Company and the Bank strive to anticipate changes and adjust their
strategies for such changes, the level of earnings can be materially affected by
economic circumstances beyond their control.
The Bank is subject to minimum capital requirements established, respectively,
by the FRB and the FDIC. For information on these capital requirements and the
Company's and the Bank's capital ratios see "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Capital" and Note P
to the Financial Statements.
Office of Comptroller of the Currency
The Bank is supervised and regularly examined by the Office of the Comptroller
of the Currency ("the OCC"). The various laws and regulations administered by
the OCC affect corporate practices such as payment of dividends, incurring debt,
and acquisition of financial institutions and other companies. It also affects
business practices, such as payment of interest on deposits, the charging of
interest on loans, types of business conducted and location of offices. There
are no regulatory orders or outstanding issues resulting from regulatory
examinations of the Bank.
Sarbanes-Oxley Act of 2002
The Sarbanes Oxley Act of 2002 (the "Sarbanes-Oxley Act") implemented a broad
range of corporate governance, accounting and reporting reforms for companies
that have securities registered under the Exchange Act of 1934. In particular,
the Sarbanes-Oxley Act established, among other things: (i) new requirements for
audit and other key
6
committees involving independence, expertise levels, and specified
responsibilities; (ii) additional responsibilities regarding financial statement
oversight for the Chief Executive Officer and Chief Financial Officer of the
reporting company; (iii) the creation of an independent accounting oversight
board for the accounting industry; (iv) new standards for auditors and
regulation of audits, including independence provisions that restrict non-audit
services that accountants may provide to their audit clients; (v) increased
disclosure and reporting obligations for the reporting company and their
directors and executive officers including accelerated reporting of company
stock transactions; (vi) a prohibition of personal loans to directors and
officers, except certain loans made by insured financial institutions on
nonpreferential terms and in compliance with other bank regulator requirements;
and (vii) a range of new and increased civil and criminal penalties for fraud
and other violation of the securities laws.
Item 2. Properties
The Company has 136 properties, 90 are owned and 46 are located in long-term
leased premises. Real property and related banking facilities owned by the
Company at December 31, 2004 had a net book value of $46.5 million and none of
the properties was subject to any material encumbrances. For the year ended
December 31, 2004, rental fees of $2.5 million were paid on facilities leased by
the Company for its operations.
Item 3. Legal Proceedings
The Company and its subsidiaries are subject in the normal course of business to
various pending and threatened legal proceedings in which claims for monetary
damages are asserted. Management, after consultation with legal counsel, does
not anticipate that the aggregate liability, if any, arising out of litigation
pending against the Company or its subsidiaries will have a material effect on
the Company's consolidated financial position or results of operations.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of the shareholders during the quarter
ended December 31, 2004.
Item 4A. Executive Officers of the Registrant
The executive officers of the Company and the Bank which are elected by the
Board of Directors are as follows:
Name Age Position
---- --- --------
Sanford A. Belden 62 Director, President and Chief Executive Officer of the Company and the Bank. Mr. Belden has held this
position since he joined the Company in October 1992.
Mark E. Tryniski 44 Executive Vice President and Chief Operating Officer of the Bank. Mr. Tryniski joined the Company in
June 2003 as the Treasurer and Chief Financial Officer. In March 2004 he assumed his current position.
He previously served as a partner in the Syracuse office of PricewaterhouseCoopers LLP, with eighteen
years of experience working with SEC registrants in banking and other industries.
Scott A. Kingsley 40 Treasurer of the Company, and Executive Vice President and Chief Financial Officer of the Bank. Mr.
Kingsley joined the Company in August 2004 in his current position. He served as Vice President and
Chief Financial Officer of Carlisle Engineered Products, Inc., a subsidiary of the Carlisle Companies,
Inc., from 1997 until joining the Company.
Brian D. Donahue 48 Executive Vice President and Chief Banking Officer. Mr. Donahue assumed his current position in August
2004. He served as the Bank's Chief Credit Officer from February 2000 to July 2004 and as the Senior
Lending Officer for the Southern Region of the Bank from 1992 until June 2004.
Michael A. Patton 59 President, Financial Services. Mr. Patton assumed his current position in February 2000 and previously
served as the President of the Southern Region of the Bank from January 1992 to January 2000.
James A. Wears 55 President, New York Banking. Mr. Wears assumed his current position in February 2000 and previously
served as the President of the Northern Region of the Bank from January 1992 to January 2000.
Thomas A. McCullough 58 President, Pennsylvania Banking. Mr. McCullough joined the Company in November 2003 in his current
position. He was previously the President and Chief Executive Officer of Grange National Banc Corp.
from 1989 until they merged with the Company.
Steven R. Tokach 58 Senior Vice President and Chief Credit Administrator. Mr. Tokach assumed the Credit Administrator
position in March 2003. He was previously the President of our Pennsylvania franchise since May 2001,
when the Company acquired First Liberty Bank Corp. He was Executive Vice President of First Liberty
Bank Corp. and First Liberty Bank & Trust from 1998 to 2001.
7
Name Age Position
---- --- --------
Timothy J. Baker 53 Senior Vice President and Director of Special Projects. Mr. Baker assumed his current position in
August 2004. He was previously the Senior Operations Officer of the Bank responsible for bank
operations, special projects and technology innovation since from 1995.
W. Valen McDaniel 58 Senior Vice President and Chief Risk Officer. Mr. McDaniel assumed his current position in January
2004. He served as the Company's corporate auditor and risk manager since joining the Company in 1992.
He is responsible for the audit function, compliance, loan review, facilities, and security of the
bank and all subsidiaries.
Joseph J. Lemchak 43 Senior Vice President and Chief Investment Officer. Mr. Lemchak joined the Company in 1990 and since
May 1991 he has served in the duel capacity of Chief Investment Officer and Asset/Liability Manager
for the Bank.
J. David Clark 50 Senior Vice President and Chief Credit Officer. Mr. Clark assumed his current position in October
2004. He was previously the Commercial Market Manager in the Bank's Corning, New York market since
April 1993.
Robert P. Matley 53 Executive Vice President and Senior Lending Officer, PA Banking. Mr. Matley joined the Company in
2004. He was previously employed by First Heritage Bank, having joined that organization in 1994 as
Executive Vice President and Senior Lending Officer. He was promoted to President and Chief Operating
Officer in 2003 and served in that capacity until the merger with the Company in 2004.
Bernadette R. Barber 43 Senior Vice President and Chief Human Resources Officer. Ms. Barber joined the Company in February
2005 in her current position. She has served since 1997 as Vice President of Human Resources and
Administration for The Penn Traffic Company.
Harold M. Wentworth 40 Senior Vice President and Director of Sales and Marketing. Mr. Wentworth assumed his current position
in January 2005. He was previously a manager in the Bank's treasury department and was responsible for
asset liability management and product development.
J. Michael Wilson 34 Senior Vice President and Chief Technology Officer. Mr. Wilson joined the Company in June 2002 as Vice
President of Information Technology and assumed his current position in October 2004. He previously
held the position of Director of Technology Services for Unizan Bank in Ohio.
Part II
Item 5. Market for the Registrant's Common Stock, Related Shareholder Matters
and Issuer Purchases of Equity Securities
The Company's common stock has been trading on the New York Stock Exchange under
the symbol "CBU" since December 31, 1997. Prior to that, the common stock traded
over-the-counter on the NASDAQ National Market under the symbol "CBSI" beginning
on September 16, 1986. There were 30,641,591 shares of common stock outstanding
on December 31, 2004, held by approximately 3,760 registered shareholders of
record. The following table sets forth the high and low prices for the common
stock, and the cash dividends declared with respect thereto, for the periods
indicated. The prices do not include retail mark-ups, mark-downs or commissions.
The information below has been adjusted to reflect the two-for-one stock split
of the Company's common stock effected on April 12, 2004.
Closing Price
High Low ------------------ Quarterly
Year / Qtr Price Price Amount % Change Dividend
- -------------------------------------------------------------------------------
2004
4th $28.66 $25.06 $28.25 12.4% $ 0.18
3rd $26.00 $20.87 $25.13 10.3% $ 0.18
2nd $23.85 $18.86 $22.79 (1.5%) $ 0.16
1st $25.39 $21.76 $23.14 (5.6%) $ 0.16
2003
4th $25.48 $21.98 $24.50 11.6% $ 0.16
3rd $23.18 $18.67 $21.96 15.6% $ 0.16
2nd $19.38 $15.51 $19.00 20.9% $ 0.15
1st $17.12 $15.44 $15.72 0.3% $ 0.15
8
The Company has historically paid regular quarterly cash dividends on its common
stock, and declared a cash dividend of $0.18 per share for the first quarter of
2005. The Board of Directors of the Company presently intends to continue the
payment of regular quarterly cash dividends on the common stock, as well as to
make payment of regularly scheduled dividends on the trust preferred stock when
due, subject to the Company's need for those funds. However, because
substantially all of the funds available for the payment of dividends by the
Company are derived from the Bank, future dividends will depend upon the
earnings of the Bank, its financial condition, its need for funds and applicable
governmental policies and regulations.
The following table provides information as of December 31, 2004 with respect to
shares of common stock that may be issued under the Company's existing equity
compensation plans:
Number of Weighted
Securities to be Average Number of
Issued upon Exercise Price Securities Remaining
Exercise of on Options Available for
Plan Category Outstanding Options (1) Outstanding Future Issuance
- -------------------------------------------------------------------------------------------------------------------------------
Equity compensation plans approved by security holder:
1994 Long Term Incentive Plan 2,409,650 $15.62 0
2004 Long Term Incentive Plan 24,100 $23.24 3,973,900
Equity compensation plans not approved by security holder:
Citizens Advisory Council Plan (2) 2,000 $16.03 6,000
- -------------------------------------------------------------------------------------------------------------------------------
Total 2,435,750 $15.70 3,979,900
===============================================================================================================================
(1) The number of securities includes unvested restricted stock issued of
34,818.
(2) In connection with the acquisition of Citizens National Bank, the Company
formed an advisory council comprised of the former directors of Citizens
National Bank for the purpose of advising the Bank on banking activities in
Citizens National Bank's market area, the transition of business relationships
after the merger, and the continued development of business relationships
throughout Northern New York State. In consideration for serving on this
council, the members have been granted shares of restricted stock that vest over
two years.
Item 6. Selected Financial Data
The following table sets forth selected consolidated historical financial data
of the Company as of and for each of the years in the five-year period ended
December 31, 2004. The historical information set forth under the captions
"Income Statement Data" and "Balance Sheet Data" is derived from the audited
financial statements while the information under the captions "Average Balance
Sheet Data", "Capital and Related Ratios", "Selected Performance Ratios" and
"Asset Quality Ratios" for all periods is unaudited. All financial information
in this table should be read in conjunction with the information contained in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and with the Consolidated Financial Statements and the related notes
thereto included elsewhere in this Annual Report on Form 10-K.
9
SELECTED CONSOLIDATED FINANCIAL INFORMATION
In thousands except per share data Years Ended December 31,
- --------------------------------------------------------------------------------------------------------------------------------
2004 2003 2002 2001 2000
Income Statement Data:
Interest income $ 212,795 $ 191,129 $ 205,093 $ 198,492 $ 189,665
Interest expense 61,752 59,301 77,243 101,837 99,232
Net interest income 151,043 131,828 127,850 96,655 90,433
Provision for loan losses 8,750 11,195 12,222 7,097 7,722
Net interest income after provision for loan losses 142,293 120,633 115,628 89,558 82,711
Other income 44,373 37,929 30,389 26,252 23,200
Gain (loss) on investment securities & early retirement
of LT borrowings 72 (2,698) 1,673 (113) (159)
Total non-interest income 44,445 35,231 32,062 26,139 23,041
Salaries and employee benefits 61,146 53,164 47,864 40,930 36,743
Occupancy and equipment 18,813 17,125 15,692 12,197 10,308
Amortization of intangible assets 7,414 5,093 5,953 6,679 4,891
Acquisition expenses 1,704 498 700 8,164 400
Other expenses 30,822 26,831 25,077 20,784 18,508
Total operating expense 119,899 102,711 95,286 88,754 70,850
Income before income taxes 66,839 53,153 52,404 26,943 34,902
Provision for income taxes 16,643 12,773 13,887 7,814 10,003
Net income $ 50,196 $ 40,380 $ 38,517 $ 19,129 $ 24,899
Diluted earnings per share (2) $ 1.64 $ 1.49 $ 1.46 $ 0.81 $ 1.16
Diluted earnings per share - cash (1) $ 1.78 $ 1.61 $ 1.60 $ 0.98 $ 1.29
Balance Sheet Data:
Cash and cash equivalents $ 118,345 $ 103,923 $ 113,531 $ 106,554 $ 76,456
Investment securities 1,584,339 1,329,534 1,286,583 1,150,713 930,509
Loans, net of unearned discount 2,358,493 2,128,509 1,806,905 1,732,870 1,515,877
Allowance for loan losses (31,778) (29,095) (26,331) (23,901) (20,035)
Intangible assets 232,500 196,111 134,828 142,342 55,234
Other assets 131,932 126,415 121,731 104,787 93,598
Total assets $4,393,831 $3,855,397 $3,437,247 $3,213,365 $2,651,639
Deposits $2,928,978 $2,725,488 $2,505,356 $2,545,970 $1,948,557
Borrowings 920,511 667,786 543,575 357,931 471,053
Other liabilities 69,714 57,295 63,278 41,484 30,238
Shareholders' equity 474,628 404,828 325,038 267,980 201,791
Total liabilities and shareholders' equity $4,393,831 $3,855,397 $3,437,247 $3,213,365 $2,651,639
Average Balance Sheet Data:
Investment securities $1,454,278 $1,185,487 $1,266,070 $1,042,726 $ 900,250
Loans 2,264,857 1,885,604 1,759,564 1,580,870 1,484,945
Total interest-earning assets 3,719,135 3,071,091 3,025,634 2,623,596 2,385,195
Total assets 4,196,821 3,471,689 3,393,164 2,888,760 2,556,638
Interest-bearing deposits 2,316,696 2,090,749 2,100,960 1,783,938 1,613,918
Borrowings 824,003 508,392 507,893 482,583 447,105
Total interest-earning liabilities 3,140,699 2,599,141 2,608,853 2,266,521 2,061,023
Shareholders' equity $ 440,627 $ 342,679 $ 294,856 $ 239,368 $ 174,498
Capital and Related Ratios:
Tier 1 leverage ratio 6.94% 7.26% 7.05% 6.73% 6.67%
Total risk-based capital to risk-adjusted assets 13.18% 13.01% 13.32% 11.83% 11.70%
Tangible equity to tangible assets 5.82% 5.70% 5.76% 4.09% 5.64%
Cash dividend declared per share (2) $ 0.68 $ 0.61 $ 0.56 $ 0.54 $ 0.52
Dividend payout ratio 40.9% 40.2% 37.7% 65.7% 40.6%
Book value per share (2) $ 15.49 $ 14.29 $ 12.52 $ 10.38 $ 9.55
Tangible book value per share (2) $ 7.90 $ 7.37 $ 7.33 $ 4.87 $ 6.94
Market capitalization (in millions) $ 866 $ 694 $ 407 $ 338 $ 261
Period end common shares outstanding (2) 30,642 28,330 25,957 25,806 21,120
Diluted weighted average shares outstanding (2) 30,670 27,035 26,334 23,650 21,474
Selected Performance Ratios:
Return on assets 1.20% 1.16% 1.14% 0.66% 0.97%
Return on equity 11.39% 11.78% 13.06% 7.99% 14.27%
Net interest margin 4.45% 4.69% 4.62% 3.96% 4.06%
Non-interest income/operating income 21.2% 19.7% 18.6% 20.1% 19.2%
Efficiency ratio 52.8% 53.4% 52.0% 56.8% 54.6%
Asset Quality Ratios:
Allowance for loan loss/loans outstanding 1.35% 1.37% 1.46% 1.38% 1.32%
Non-performing loans/loans outstanding 0.55% 0.62% 0.65% 0.53% 0.50%
Allowance for loan loss/non-performing loans 245% 219% 225% 261% 266%
Net charge-offs/average loans 0.37% 0.54% 0.56% 0.42% 0.42%
Loan loss provision/net charge-offs 104% 109% 125% 108% 124%
Non-performing assets/loans outstanding plus OREO 0.62% 0.67% 0.69% 0.61% 0.58%
(1) Cash earnings exclude the after-tax effect of the amortization of
intangible assets.
(2) All share and share-based amounts reflect the two-for-one stock split
effected as a 100% stock dividend on April 12, 2004.
10
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
This Management's Discussion and Analysis of Financial Condition and Results of
Operations ("MD&A") primarily reviews the financial condition and results of
operations of Community Bank System, Inc. ("the Company") for the past two
years, although in some circumstances a period longer than two years is covered
in order to comply with Securities and Exchange Commission disclosure
requirements or to more fully explain long-term trends. The following discussion
and analysis should be read in conjunction with the Selected Consolidated
Financial Information on page 10 and the Company's Consolidated Financial
Statements and related notes that appear on pages 38 through 64. All references
in the discussion to the financial condition and results of operations are to
the consolidated position and results of the Company and its subsidiaries taken
as a whole.
All financial results reflect the 2001 acquisition of First Liberty in
accordance with the pooling of interests method of accounting. Unless otherwise
noted, all earnings per share ("EPS") figures disclosed in the MD&A refer to
diluted EPS; interest income, net interest income and net interest margin are
presented on a fully tax-equivalent ("FTE") basis. The term "this year" and
equivalent terms refer to results in calendar year 2004, "last year" and
equivalent terms refer to calendar year 2003, and all references to income
statement results correspond to full-year activity unless otherwise noted.
Lastly, all references to "peer banks" pertain to a group of 84 bank holding
companies nationwide having $3 billion to $10 billion in assets and their
associated composite financial results for the nine months ending September 30,
2004 (the most recently available disclosure), as provided by the Federal
Reserve Board's Division of Banking Supervision and Regulation in the Bank
Holding Company Performance Report. All share and share-based amounts reflect
the two-for-one stock split effected as a 100% stock dividend on April 12, 2004.
This Management's Discussion and Analysis of Financial Condition and Results of
Operations contains certain forward-looking statements with respect to the
financial condition, results of operations and business of Community Bank
System, Inc. These forward-looking statements involve certain risks and
uncertainties. Factors that may cause actual results to differ materially from
those contemplated by such forward-looking statements are set herein under the
caption "Forward-Looking Statements" on page 33.
Critical Accounting Policies
As a result of the complex and dynamic nature of the Company's business,
management must exercise judgement in selecting and applying the most
appropriate accounting policies for its various areas of operations. The policy
decision process not only ensures compliance with the latest generally accepted
accounting principles, but also reflects on management's discretion with regard
to choosing the most suitable methodology for reporting the Company's financial
performance. It is management's opinion that the accounting estimates covering
certain aspects of the business have more significance than others due to the
relative importance of those areas to overall performance, or the level of
subjectivity in the selection process. These estimates affect the reported
amounts of assets and liabilities and disclosures of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
Management believes that the critical accounting estimates include:
o 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.
o Actuarial assumptions associated with pension, post-retirement and other
employee benefit plans - These assumptions include discount rate, rate of
future compensation increases and expected return on plan assets. Table 7
on page 20 shows the impact of a one percentage point increase and
decrease of each of these assumptions. Specific discussion of the
assumptions used by management is discussed in Note K on pages 56 through
59.
o Provision for income taxes - The Company is subject to examinations from
various taxing authorities. Such examinations may result in challenges to
the tax return treatment applied by the Company to specific transactions.
Management believes that the assumptions and judgements used to record
tax-related assets or liabilities have been appropriate. Should tax laws
change or the taxing authorities determine that management's assumptions
were inappropriate, an adjustment may be required which could have a
material effect on the Company's results of operations.
o Carrying value of goodwill and other intangible assets - The carrying
value of goodwill and other intangible assets is based upon discounted
cash flow modeling techniques that require management to make estimates
regarding the
11
amount and timing of expected future cash flows. It also requires them to
select a discount rate that reflects the current return requirements of
the market in relation to present risk-free interest rates, required
equity market premiums and company-specific risk indicators.
A summary of the accounting policies used by management is disclosed in Note A
(Summary of Significant Accounting Policies) starting on page 43.
Executive Summary
The Company's business philosophy is to operate as a community bank with local
decision-making, principally in non-metropolitan markets, providing a broad
array of banking and financial services to retail, commercial, and municipal
customers.
The Company's core operating objectives are: (i) grow the branch network,
primarily through a disciplined acquisition strategy, and certain selective de
novo expansions, (ii) build high-quality, profitable loan portfolios using both
organic and acquisition strategies, (iii) increase the non-interest income
component of total revenues through development of banking-related fee income,
growth in existing financial services business units, and the acquisition of
additional financial services and banking businesses, and (iv) utilize
technology to deliver customer-responsive products and services and to reduce
operating costs.
Significant factors management reviews to evaluate achievement of the Company's
operating objectives and its operating results and financial condition include,
but are not limited to: net income and earnings per share, return on assets and
equity, net interest margins, non-interest income, operating expenses, asset
quality, loan and deposit growth, capital management, performance of individual
banking and financial services business units, liquidity and interest rate
sensitivity, enhancements to customer products and services, technology
enhancements, market share, peer comparisons, and the performance of acquisition
and integration activities.
In 2004, the Company reported record earnings as a result of acquired and
organic growth in earning asset levels, strong growth in non-interest income and
improved asset quality, despite a lower net interest margin. Return on assets
improved slightly over 2003, to 1.20%. Return on equity declined slightly to
11.4%, due to strengthened capital levels. Non-interest income, excluding a loss
on early retirement of debt in 2003, increased 17% over 2003 with strong growth
from banking sources, as well as from the Company's employee benefits and wealth
management businesses. The Company's efficiency ratio improved to 52.8% for the
year.
Asset quality improved in 2004, with reductions in delinquency, charge-off and
non-performing loan ratios versus 2003. Excluding acquisition activity, the
Company experienced loan growth in consumer mortgage and consumer direct and
indirect lending, with declines in the business portfolio. On a geographical
basis, the New York markets reported strong growth in consumer mortgage and
consumer direct and indirect loans, with slight declines in business lending.
Excluding acquisitions, the Pennsylvania markets reported declines in all
portfolios. Excluding acquisition activity, total deposits declined slightly
from 2003.
The Company completed two acquisitions in 2004: (1) First Heritage Bank, a $275
million-asset commercial bank with three branches based in Wilkes-Barre, PA,
acquired in May, and (2) a bank branch in Dansville, NY, from HSBC Bank USA,
N.A., acquired in December with deposits of $32.6 million.
Net Income and Profitability
Net income for 2004 was $50.2 million, up $9.8 million or 24% from the prior
year. Earnings per share of $1.64 in 2004 were 10.1% higher than 2003's results.
The growth rate of EPS was below that of net income due to higher weighted
average diluted shares outstanding. The increase in diluted shares was primarily
driven by the 2.6 million and 2.3 million shares of common stock issued in
conjunction with the acquisition of First Heritage in May 2004 and Grange in
November 2003, an increased level of option grants and exercises, and a higher
average common share price (refer to the "Earnings per Share" section of Note A
on page 47 for information regarding the impact of share price on diluted
shares).
In addition to the earnings results presented above in accordance with GAAP, the
Company provides cash earnings per share, which excludes the after-tax effect of
the amortization of intangible assets. Management believes that this information
helps investors understand the effect of acquisition activity in reported
results. Cash earnings per share for 2004 were $1.78, up 10.6% from $1.61 for
the year ended December 31, 2003.
Net income and earnings per share for 2003 were $40.4 million and $1.49, up 4.8%
and 2.1%, respectively, from 2002 results. The 2003 results were impacted by
$2.6 million of debt restructuring charges associated with the early retirement
of higher-rate, medium-term borrowings. In contrast, 2002 earning per share
benefited from net security and debt
12
transaction gains of $1.7 million. In addition, banking services accounted for
$6.5 million of the improvement in 2003, as overdraft volume and the related
fees increased significantly in response to the implementation of the Overdraft
FreedomTM program.
Table 1: Condensed Income Statements
Years Ended December 31,
--------------------------------
(000's omitted, except per share data) 2004 2003 2002
-------------------------------------------------------------------------
Net interest income $151,043 $131,828 $127,850
Loan loss provision 8,750 11,195 12,222
Non-interest income 44,445 35,231 32,062
Operating expenses 119,899 102,711 95,286
-------------------------------------------------------------------------
Income before taxes 66,839 53,153 52,404
Income taxes 16,643 12,773 13,887
-------------------------------------------------------------------------
Net income $ 50,196 $ 40,380 $ 38,517
=========================================================================
Diluted earnings per share $ 1.64 $ 1.49 $ 1.46
Diluted earnings per share-cash (1) $ 1.78 $ 1.61 $ 1.60
(1) Cash earnings exclude the after-tax effect of the amortization
of intangible assets.
The primary factors explaining 2004 performance are discussed in detail in the
remaining sections of this document and are summarized as follows:
o As shown in Table 1 above, net interest income increased 14.6% or $19
million due to a $648 million increase in average earning assets,
partially offset by a 24 basis point decrease in the net interest margin.
Average loans grew $379 million (20%), primarily due to strong consumer
mortgage growth as well as the impact of the acquisitions of First
Heritage in May 2004 and Grange and Peoples in 2003. Average investments
increased $268 million (23%) in 2004 primarily as a result of a leveraging
strategy that began in the third quarter of 2003 and ended during the
second quarter of 2004. The growth in earning assets was funded by $311
million (12.1%) more average deposits and $316 million (62%) higher
average borrowings.
o The loan loss provision of $8.8 million decreased $2.4 million, or 22%,
from the prior year level. Net charge-offs of $8.4 million decreased by
$1.8 million from 2003, reducing the net charge-off ratio (net charge-offs
/ total average loans) to 0.37% for the year. The improved asset quality
position in 2004 was evident in standard metrics such as non-performing
loans as a percentage of total loans (down seven basis points),
non-performing assets as a percentage of loans and other real estate owned
(down five basis points) and delinquent loans (30+ days through
non-accruing) as a percentage of total loans (down 32 basis points).
Additional information on trends and policy related to asset quality is
provided in the asset quality section on pages 25 through 28.
o Non-interest income for 2004 of $44.4 million increased by $9.2 million
(26%) from 2003's level, the eleventh consecutive year of growth. Banking
services accounted for $2.6 million of the improvement, primarily due to
the three whole bank acquisitions over the last 18 months. Financial
services revenue was $3.8 million (30%) higher mostly as a result of the
acquisition of Harbridge at the end of July 2003 and strong growth at the
Company's retirement plan administration business, Benefit Plans
Administrative Services. Gain (loss) on investment securities and debt
prepayment transactions was $72,000 in 2004 as compared to a loss of $2.7
million in 2003. The 2003 loss included $2.6 million of debt restructuring
charges associated with the early retirement of higher-rate, medium-term
borrowings.
o Total operating expenses rose $17.2 million or 17% in 2004 to $119.9
million. Excluding acquisition expenses in both years, 2004 operating
expenses rose $16.0 million or 16%. A majority of the increase was due to
increased personnel expenses associated with the acquisitions in late 2003
and 2004, as well as merit increases, new hires, and higher costs in
employee health and welfare programs. In addition, higher legal and
professional expenses were incurred with a substantial portion of the
increase due to compliance with recently promulgated reporting
requirements. Net occupancy expenses also increased because of a larger
number of facilities due to acquisitions, current and prior year
renovations, and slightly higher property tax and utility rates. In
addition, amortization of intangible assets increased $2.3 million, or 46%
over 2003 due to the amortization of core deposit and customer
relationship intangibles arising from the 2003 and 2004 acquisitions.
13
o The Company's combined effective federal and state tax rate increased 0.9
percentage points in 2004 to 24.9%, primarily as a result of a higher
proportion of income being generated from fully taxable loans and
investments.
Selected Profitability and Other Measures
Return on average assets, return on average equity, dividend payout and equity
to asset ratios for the years indicated are as follows:
Table 2: Selected Ratios
2004 2003 2002
-----------------------------------------------------------
Return on average assets 1.20% 1.16% 1.14%
Return on average equity 11.39% 11.78% 13.06%
Dividend payout ratio 40.9% 40.2% 37.7%
Average equity to average assets 10.50% 9.87% 8.69%
As displayed in Table 2 above, the return on average assets improved in 2004 in
comparison to both 2003 and 2002. This was primarily a result of a greater
proportion of earnings generated from non-interest income and improved
operational efficiencies. Reported return on equity in 2004 was down slightly
from 2003's level. This was mainly a result of the build-up of equity capital
this year from the retention of net profits and the common shares issued in
conjunction with the acquisitions of First Heritage in May 2004 and Grange in
November 2003. Consequently, average shareholders' equity increased 29% this
year, as compared to a 24% increase in reported net income. For similar reasons
average shareholder's equity increased 16% in 2003 well above the 4.8% increase
in net income for the same period, resulting in a decrease in return on equity
in 2003 as compared to 2002. The strengthening of the Company's equity capital
position over the past two years is reflected in the 63 and 118 basis-point
increases in the average equity to average total assets ratios in 2004 and 2003,
respectively.
Net Interest Income
Net interest income is the amount that interest and fees on earning assets
(loans and investments) exceeds the cost of funds, primarily interest paid to
the Company's depositors and interest on external borrowings. Net interest
margin is the difference between the gross yield on earning assets and the cost
of interest bearing funds as a percentage of earning assets.
As disclosed in Table 3, net interest income (with non-taxable income converted
to a fully tax-equivalent basis) totaled $165.6 million in 2004, up $21.6
million or 15% over the prior year. A $648 million increase in average
earning-assets more than offset a $542 million increase in average
interest-bearing liabilities and a 24 basis point decrease in the net interest
margin. As reflected in Table 4, the volume changes mentioned above drove net
interest income to rise $29.1 million, while the lower net interest margin had a
$7.5 million negative impact on net interest income.
The net interest margin declined in each of the quarters of 2004, from 4.67% for
the first quarter, ending with a 4.32% margin for the fourth quarter. This trend
was mostly attributable to the level and changes in market interest rates during
2004. Falling market rates early in the year allowed the Company to reduce or
hold steady rates on deposit interest-bearing accounts in the first three
quarters of 2004. The fourth quarter of 2004 saw interest rates on money market
and time deposit accounts rise slightly in response to increasing market rates.
Similarly, the yield on loans decreased throughout the first three quarters of
the year. The decline in loan yields had a greater negative impact on the margin
in 2004 ($12.1 million) than the benefit derived from deposit rate reductions
($7.2 million). Yields on investments declined 35 basis points during 2004 from
6.53% to 6.18% as investment purchases were at lower rates. Lastly, the average
interest rate paid on borrowings decreased 83 basis points from 4.13% for 2003
to 3.30% for 2004.
The net interest margin for 2003 increased seven basis points from 4.62% in 2002
to 4.69%. Falling market rates prevailed throughout the year. However, the
decline in total average earning asset yields of 56 basis points was less than
the benefit derived from a decline in the cost of funds of 60 basis points,
resulting in the increased net interest margin.
As shown in Table 3, total interest income increased by $24.1 million or 11.9%
in 2004. Table 4 shows that higher average earning assets contributed a positive
$40.5 million variance, partially offset by lower yields with a negative impact
of $16.4 million. Average loans grew a total of $379 million in 2004, the
majority being the result of the $207 million loans acquired in the First
Heritage acquisition in May of 2004 and the $186 million of loans acquired in
the Peoples and Grange acquisitions in late 2003. Interest and fees on loans
increased $11.6 million or 9.2%. The increase was attributable to higher average
loan balances (positive $23.7 million), partially offset by a 60-basis point
drop in loan yields (negative $12.1 million) due to falling capital market
rates. Average loans grew $126 million in 2003, with the vast majority coming
14
from organic consumer mortgage and consumer indirect loan growth. Interest and
fees on loans decreased $5.9 million or 4.5% in 2003 as compared to 2002. An
82-basis point drop in loan yields due to falling interest rates had more of an
impact (negative $15.0 million) than growth in average loans (positive $9.0
million).
In early fourth quarter 2002, management instituted an investment de-leveraging
strategy, allowing the portfolio to run down and using the proceeds to pay down
borrowings due to the lack of investment opportunities offering acceptable
yields. This approach was in effect through June 2003, when it was decided that
investment purchases should be reinitiated to take advantage of more attractive
medium and long-term rates and a steep yield curve, as well as protect the
Company from its interest rate exposure to falling rates. Due to the
de-leveraging strategy being in place for approximately half of 2003 versus a
leveraging strategy for most of 2004, average investment balances for 2004 were
up $268.3 million versus the year-earlier period, primarily in the U.S. treasury
and agency securities and obligations of state and political subdivision
segments of the portfolio (refer to the "Investments" section of the MD&A on
pages 31 through 33 for further information).
Investment interest income in 2004 of $89.8 million was $12.5 million or 16%
higher than the prior year as a result of a larger portfolio (positive $16.9
million impact) partially offset by a decrease in the average investment yield
from 6.53% to 6.18% (negative $4.5 million impact). The decrease in the yield
was principally driven by significant declines in market interest rates from
early 2001 through mid-2003. Consequently, the Company was unable to replace the
run-off of longer-term, higher-yielding securities with equivalent-rate
investments, and the purchase of securities in the relatively low-interest rate
environment in the second half of 2003 and 2004 led to yield declines. However,
the net spread on these medium-term investment purchases were comparable because
they were funded with a mixture of short to medium term low-rate, borrowings. In
addition, the performance of the investment portfolio in 2004 was strong given
the interest rate environment. The Company was able to maintain its yields to a
great extent primarily because of two important strategies: the addition of a
substantial amount of call-protected securities in 2001 and first half of 2002
when rates were higher, and foregoing security purchases in the late-2002 to
mid-2003 period as rates were falling significantly. The success of these
actions was evident in the Company's exceptional 98th percentile ranking within
its peer group for tax-equivalent investment yield for the nine months ended
September 2004. Investment interest income in 2003 of $77.4 million was $8.0
million or 9.4% lower than the prior year as a result of the smaller portfolio
(negative $4.5 million impact) and a decrease in the average investment yield
from 6.74% to 6.53% (negative $3.5 million impact).
The average earning asset yield fell 51 basis points to 6.11% in 2004 because of
the previously mentioned decrease in investment and loan yields and the fact
that the yields on the overall loan portfolio have converged with those of the
investment portfolio. In 2002 the yield on the loan portfolio was 75 basis
points higher than the yield on investments. Loan yields were only 14 basis
points above those produced by investments in 2003 and in 2004 the yield on the
investment portfolio was 11 basis points higher than the yield on the loan
portfolio.
Total average funding (deposits and borrowings) grew by $626.5 million in 2004,
with $310.9 million of the increase coming from deposits, mostly attributable to
the acquisitions of First Heritage, Grange and Peoples. External borrowings were
increased to fund organic loan growth and investment purchases over the last 18
months resulting in average borrowings that were up $315.6 million for 2004 as
compared to the previous year.
The cost of funding was aided by the change in the make-up of both the deposit
base and external borrowings. The fall of market interest rates over the last
two years not only enabled a significant reduction of interest-bearing deposit
rates, but also caused many customers to shift their funds from time deposits to
less restrictive accounts such as savings and demand deposits due to the greatly
diminished rate spread between the two groups of accounts. This is demonstrated
by the percentage of average deposits that were in time deposit accounts
dropping from 45% in 2002 to 41% in 2004, accounting for a portion of the
reduced funding costs beyond the absolute drop in rates. The Company also
changed the proportion of short-term funding in average external borrowings from
28% in 2002 to 54% in 2004 to take advantage of historically low short-term
rates, providing further funding cost savings.
Total interest expense increased by $2.5 million to $61.8 million in 2004. As
shown in Table 4, higher levels of deposits and borrowings accounted for an
$11.3 million increase in interest expense, offset by an $8.9 million decrease
as a result of lower rates on deposits and external borrowings. Interest expense
as a percentage of earning assets fell by 27 basis points to 1.66%. The rate on
interest bearing deposits fell 34 basis points to 1.49%, due largely to declines
in time deposit rates for the first three quarters of 2004. The rate on external
borrowings declined 83 basis points to 3.30% because of substantially lower
market rates and the previously mentioned shift in funding mix towards
short-term borrowings. Total interest expense decreased by $17.9 million to
$59.3 million in 2003 as compared to 2002. Lower rates on deposits and external
borrowings accounted for the majority of the decrease. The rate on interest
bearing deposits fell 73 basis points to 1.83% and the rate on external
borrowings declined 47 basis points to 4.13%.
15
The following table sets forth information related to average interest-earning
assets and interest-bearing liabilities and their associated yields and rates
for the years ended December 31, 2004, 2003 and 2002. Interest income and yields
are on a fully tax-equivalent basis using marginal income tax rates of 38.7% in
2004, 38.9% in 2003, and 39.3% in 2002. Average balances are computed by summing
the daily ending balances in a period and dividing by the number of days in that
period. Loan yields and amounts earned include loan fees. Average loan balances
include non-accrual loans.
Table 3: Average Balance Sheet
(000's omitted except yields and rates) Year Ended December 31, 2004 Year Ended December 31, 2003
------------------------------------- -------------------------------------
Avg. Avg.
Average Yield/Rate Average Yield/Rate
Balance Interest Paid Balance Interest Paid
- ------------------------------------------------------------------------------- -------------------------------------
Interest-earning assets:
Time deposits in other banks $ 868 $ 22 2.53% $ 346 $ 4 1.16%
Taxable investment securities (2) 940,744 54,205 5.76% 779,107 48,212 6.19%
Non-taxable investment securities (2) 512,666 35,626 6.95% 406,034 29,149 7.18%
Loans (net of unearned discount)(1) 2,264,857 137,450 6.07% 1,885,604 125,855 6.67%
----------------------- -----------------------
Total interest-earning assets 3,719,135 227,303 6.11% 3,071,091 203,220 6.62%
Non-interest earning assets 477,686 400,598
---------- ----------
Total assets $4,196,821 $3,471,689
========== ==========
Interest-bearing liabilities:
Interest checking, savings and
money market deposits $1,128,071 6,368 0.56% $1,000,238 6,769 0.68%
Time deposits 1,188,625 28,219 2.37% 1,090,511 31,519 2.89%
Short-term borrowings 442,287 7,242 1.64% 212,512 2,685 1.26%
Long-term borrowings 381,716 19,923 5.22% 295,880 18,328 6.19%
----------------------- -----------------------
Total interest-bearing liabilities 3,140,699 61,752 1.97% 2,599,141 59,301 2.28%
Non-interest bearing liabilities:
Demand deposits 558,552 473,568
Other liabilities 56,943 56,301
Shareholders' equity 440,627 342,679
---------- ----------
Total liabilities and
shareholders' equity $4,196,821 $3,471,689
========== ==========
Net interest earnings $ 165,551 $ 143,919
========== ==========
Net interest spread 4.14% 4.34%
Net interest margin on interest-
earnings assets 4.45% 4.69%
Fully tax-equivalent adjustment $ 14,508 $ 12,091
(000's omitted except yields and rates) Year Ended December 31, 2002
-------------------------------------
Avg.
Average Yield/Rate
Balance Interest Paid
- -------------------------------------------------------------------------------
Interest-earning assets:
Time deposits in other banks $ 525 $ 6 1.14%
Taxable investment securities (2) 906,902 58,458 6.45%
Non-taxable investment securities (2) 358,643 26,899 7.50%
Loans (net of unearned discount)(1) 1,759,564 131,801 7.49%
-----------------------
Total interest-earning assets 3,025,634 217,164 7.18%
Non-interest earning assets 367,530
----------
Total assets $3,393,164
==========
Interest-bearing liabilities:
Interest checking, savings and
money market deposits $ 969,664 11,416 1.18%
Time deposits 1,131,296 42,462 3.75%
Short-term borrowings 141,024 2,586 1.83%
Long-term borrowings 366,869 20,779 5.66%
-----------------------
Total interest-bearing liabilities 2,608,853 77,243 2.96%
Non-interest bearing liabilities:
Demand deposits 441,800
Other liabilities 47,655
Shareholders' equity 294,856
----------
Total liabilities and
shareholders' equity $3,393,164
==========
Net interest earnings $ 139,921
==========
Net interest spread 4.22%
Net interest margin on interest-
earnings assets 4.62%
Fully tax-equivalent adjustment $ 12,071
(1) The impact of interest and fees not recognized on non-accrual loans was
immaterial.
(2) Averages for investment securities are based on historical cost and the
yields do not give effect to changes in fair value that is reflected as a
component of shareholders' equity and deferred taxes.
16
As discussed above, the change in net interest income (fully tax-equivalent
basis) may be analyzed by segregating the volume and rate components of the
changes in interest income and interest expense for each underlying category.
Table 4: Rate/Volume
------------------------------ ------------------------------
2004 Compared to 2003 2003 Compared to 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 $10 $8 $18 ($2) $0 ($2)
Taxable investment securities 9,485 (3,492) 5,993 (7,981) (2,265) (10,246)
Non-taxable investment securities 7,437 (960) 6,477 3,439 (1,189) 2,250
Loans (net of unearned discount) 23,730 (12,135) 11,595 9,033 (14,979) (5,946)
Total interest-earning assets (2) $40,477 ($16,394) $24,083 $3,222 ($17,166) ($13,944)
Interest paid on:
Interest checking, savings
and money market deposits $803 ($1,204) ($401) $349 ($4,996) ($4,647)
Time deposits 2,666 (5,966) (3,300) (1,483) (9,460) (10,943)
Short-term borrowings 3,578 979 4,557 1,058 (959) 99
Long-term borrowings 4,774 (3,179) 1,595 (4,274) 1,823 (2,451)
Total interest-bearing liabilities (2) $11,329 ($8,878) $2,451 ($286) ($17,656) ($17,942)
Net interest earnings (2) $29,139 ($7,507) $21,632 $2,117 $1,881 $3,998
(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 employee benefit trusts (Benefit Plans
Administrative Services or BPA), employee benefit actuarial and consulting
services (Harbridge Consulting Group or Harbridge), personal trust, investment
and insurance products (Community Investment Services, Inc. or CISI) and
investment management (Elias Asset Management or EAM); and periodic
transactions, most often net gains (losses) from the sale of investments and
prepayment of term debt.
Table 5: Non-interest Income
Years Ended December 31,
--------------------------------
(000's omitted) 2004 2003 2002
- ------------------------------------------------------------------------------------------
Banking services:
Electronic banking $ 2,585 $ 2,604 $ 2,375
Mortgage banking 525 518 175
Deposit service charges 5,475 5,374 5,310
Overdraft fees 14,867 13,476 6,937
Credit life and disability insurance 1,206 856 1,082
Commissions and other 2,974 2,199 2,662
- ------------------------------------------------------------------------------------------
Total banking services 27,632 25,027 18,541
Financial services:
Retirement plan administration and trustee fees 5,820 4,668 3,845
Actuarial and benefit plan consulting fees 3,478 1,552 0
Asset advisory and management fees 1,832 1,890 2,606
Investment and insurance product commissions 3,907 3,339 3,715
Personal trust 1,704 1,453 1,682
- ------------------------------------------------------------------------------------------
Total financial services 16,741 12,902 11,848
Gain (loss) on investment securities & debt prepayment 72 (2,698) 1,673
- ------------------------------------------------------------------------------------------
Total non-interest income $44,445 $35,231 $32,062
==========================================================================================
Non-interest income/operating income (FTE) 21.2% 19.7% 18.6%
As displayed in Table 5, total non-interest income in 2004 increased by 26.2% to
$44 million, largely as a result of higher overdraft volume, the acquisition of
Harbridge, growth at BPA and the absence of losses on the early retirement of
long-term borrowings. Total non-interest income for 2003 was up $3.2 million or
9.9% from 2002's level, driven by significantly higher overdraft volume, the
acquisition of Harbridge and the growth at BPA. These improvements were offset
by substantially higher losses on the early retirement of long-term borrowings,
the absence of gains on the sale of securities and decreases in the other
financial services group businesses.
Non-interest income as a percent of operating income (FTE basis) was 21.2% in
2004, up 1.5 percentage points from the prior year, an all-time high for the
Company. This increase was primarily driven by the aforementioned strong growth
in overdraft fees and BPA revenue, as well as the acquisition of Harbridge. This
ratio is considered an important measure for determining the progress the
Company is making on one of its primary long-term strategies, expansion of
non-interest income in order to diversify its revenue sources and reduce
reliance on net interest margins that may be strongly impacted by general
interest rate and other market conditions.
The largest portion of the Company's recurring non-interest income is the wide
variety of fees earned from general banking services, which reached $27.6
million in 2004, up 10.4% from the prior year. Total banking services
contributed 62% of 2004 non-interest income. A large portion of the income
growth was attributable to overdraft fees, up $1.4 million (10.3%) over 2003's
level, due in large part to the incremental transaction volume generated from
the accounts added through the First Heritage, Grange and Peoples acquisitions.
In addition, commissions and other increased $0.8 million, due to higher
commissions and cash surrender values derived from life insurance policies
acquired in the 2003 and 2004 acquisitions. Fees from the general banking
services was $25.0 million in 2003, up $6.5 million or 35% from 2002 primarily
driven by the success of the Company's Overdraft FreedomTM program implemented
in December 2002.
18
As disclosed in Table 5, non-interest income from financial services rose $3.8
million or 30% in 2004 to $16.7 million. Financial services revenue now
comprises 38% of total non-interest income, excluding net gains (losses) on the
sale of investment securities and retirement of debt. This compares to 34% in
2003, with the increase primarily due to seven more months of revenue from
Harbridge, which was acquired at the end of July 2003, resulting in $1.9 million
of incremental revenue for the financial services group in the current year.
Another impressive year of revenue growth at BPA (up $1.2 million or 25%) was
driven by a significant number of new plans under administration and growth in
the market value of client assets. These two businesses are part of the BPAS
subsidiary, and operate collaboratively to offer clients a full array of
employee benefits, recordkeeping and consulting services throughout much of the
country. BPAS revenue of $9.3 million in 2004 was $3.1 million higher than prior
year results. BPAS revenue for 2003 was $6.2 million, up $2.4 million from 2002
primarily due to the acquisition of Harbridge in July of 2003 as well as strong
organic growth at BPA.
CISI and personal trust had positive growth of $568,000 (17%) and $251,000
(17%), respectively, as improving market conditions have positively impacted
both businesses. Increased volume of annuity sales in response to higher
interest rates and additional client relationships developed in the new markets
opened up by the Company's acquisitions has had a positive impact. Additionally,
CISI has obtained a large number of higher net-worth investors caused by recent
retirees rolling over their 401(k) plans and/or receiving inheritances. In 2003,
CISI, Elias and personal trust were all negatively impacted by the challenging
retail investment market conditions of the past few years. Non-interest income
for 2003 was down $376 million (10%), $716 million (27%) and $229 million (14%)
at CISI, Elias and personal trust, respectively as compared to 2002.
Assets under management from the Company's financial services businesses rose
considerably over the last two years reaching $2.102 billion at the end of 2004,
compared to $1.807 billion at year-end 2003 and $1.364 billion at year-end 2002.
Market-driven gains in equity-based assets were augmented by attraction of new
client assets. BPA in particular was very successful at growing its asset base,
as demonstrated by the $259 million or 34% increase in its assets under
administration.
The total financial services group contributed $2.1 million (excluding
allocation of indirect corporate expense) or 3.1% of the Company's pre-tax
income this year, reflecting nearly a 12% margin. In 2003, financial services'
contribution was $1.6 million or 2.9% of total pre-tax income, with a margin of
12%. The higher earnings were the result of new client business at BPA, CISI and
personal trust as well as a full year of Harbridge as compared to only five
months in 2003. The increase in percentage contribution was primarily due to
higher growth in the financial services businesses than the banking business's
increase in net interest income and decline of the provision for loan losses.
There was a total net gain on security and debt transactions of $72,000 this
year compared to a net loss of $2.7 million in 2003. The loss in 2003 was
primarily composed of $2.6 million of charges associated with the early
retirement of $25 million of longer-term FHLB borrowings that were replaced with
lower rate, short-term borrowings, which are expected to provide a long-term
earnings benefit as well as reduce interest rate risk. The $1.7 million net gain
in 2002 included $2.6 million of gains on $80 million of investment sales, and a
$0.9 million prepayment penalty on the retirement of approximately $11 million
of intermediate-term FHLB borrowings. The security and debt gains and losses
taken over the last three years are illustrative of the Company's active
management of its investment portfolio and external borrowings to achieve a
desirable total return through the combination of net interest income,
transaction gains/losses and changes in market value across financial market
cycles.
Operating Expenses
As shown in Table 6, operating expenses rose $17.2 million or 17% in 2004 to
$119.9 million. Excluding acquisition expenses, operating expenses were up $16.0
million or 15.6% in 2004, reflective mostly of incremental operating expenses
associated with the acquisitions of First Heritage in 2004 and Harbridge, Grange
and Peoples in 2003. This year's operating expenses as a percent of average
assets were 2.86%, down from 2.96% in 2003 and higher than the 2.81% in 2002.
The decrease in this ratio for 2004 was principally due to the acquisitions in
late 2003 and the first half of 2004 (Grange and First Heritage), whereby
average assets increased significantly (21%), while operating expenses only
increased 17%. The increase in this ratio for 2003 was principally due to the
acquisition of a financial services unit whose revenue is not driven by earning
assets (Harbridge), and the charge-offs resulting from higher overdraft volume,
another significant revenue generating tool with a limited underlying asset
base.
The efficiency ratio, a performance measurement tool widely used by banks, is
defined by the Company as operating expenses (excluding acquisition expenses and
intangible amortization) divided by operating income (fully tax-equivalent net
interest income plus non-interest income, excluding net securities and debt
gains and losses). Lower ratios correspond to higher efficiency. In 2004 the
efficiency ratio decreased 0.6 percentage points to 52.8% due in part to the
investment leverage strategy in effect during the first half of 2004. The
efficiency ratio for 2003 was 1.4 percentage points higher than the 52.0% ratio
for 2002. This was primarily a result of net interest income being tempered for
much of the year due to the
19
investment de-leveraging strategy, rising pension and medical expenses and the
impact from reduced pre-tax margins in the financial services businesses in
2003, as discussed earlier.
Table 6: Operating Expenses
Years Ended December 31,
----------------------------------
(000's omitted) 2004 2003 2002
----------------------------------------------------------------------
Salaries and employee benefits $ 61,146 $ 53,164 $ 47,864
Occupancy 10,177 9,297 8,154
Equipment and furniture 8,636 7,828 7,538
Legal and professional fees 4,578 3,183 3,272
Data processing 7,737 6,800 6,574
Amortization of intangible assets 7,414 5,093 5,953
Office supplies 2,232 1,996 2,321
Foreclosed property 994 561 902
Acquisition expenses 1,704 498 700
Other 15,281 14,291 12,008
----------------------------------------------------------------------
Total operating expenses $119,899 $102,711 $ 95,286
======================================================================
Operating expenses/average assets 2.86% 2.96% 2.81%
Efficiency ratio 52.8% 53.4% 52.0%
Higher personnel expenses accounted for 46% of 2004's increase in operating
costs, primarily the result of three acquisitions in 2003 and the First Heritage
acquisition in 2004. The remainder of the increases in personnel expense reflect
higher benefit costs, merit increases and new hiring activity. Total full-time
equivalent staff at the end of 2004 was 1,301 compared to 1,259 at year-end 2003
and 1,120 at year-end 2002.
Medical expenses were up in 2004 due to a general rise in the cost of medical
care, administration and insurance, as well as a greater number of insured
employees. Qualified and non-qualified pension expenses decreased slightly in
2004 principally due to a change in the Company's defined benefit pension plan
from a standard annuity paid benefit, to a cash balance design, offset by a
reduction of the discount rate applied to future payments to 5.9% from 6.1%
(increases current expenses in present value terms) and additional obligations
for employees added through acquisition and organic growth. The three
assumptions that have the largest impact on the calculation of annual pension
expense are the aforementioned discount rate, the rate applied to future
compensation increases and the expected rate of return on plan assets. Table 7
contains the results of a sensitivity analysis conducted to determine what the
impact of a 1.0 percentage point increase and decrease in these three
assumptions would have on the annual pension expense for the two plans. Also,
see Note K to the financial statements for further information concerning the
pension plan.
Table 7: Pension Plan Sensitivity Analysis
One Percentage Point
--------------------
(000's omitted) Increase Decrease
----------------------------------------------------
Discount rate ($611) $ 707
Rate of compensation increase $ 324 ($289)
Expected return on plan assets ($402) $ 402
Total non-personnel expenses increased $9.2 million or 19% in 2004. Excluding
acquisition-related expenses, non-personnel expenses were up $8.0 million or 16%
from 2003's level. As displayed in Table 6, this was largely caused by higher
occupancy expense (up $.9 million), equipment and furniture expense ($.8
million), legal and professional fees ($1.4 million), data processing expense
($.9 million), amortization of intangible assets ($2.3 million) and other
expenses ($1.0 million). The increase in occupancy expense and equipment and
furniture expense in 2004 was mainly due to incremental costs from recently
acquired facilities, expenses arising from renovations and repairs, the effect
of higher rates and severe weather on maintenance and utilities expenses and the
general increase in property taxes in many of the locations we do business in.
The increase in legal and professional fees over the prior year was caused, in
most part, by the additional responsibilities associated with complying with new
governance and regulatory requirements. Data processing and other expenses were
up primarily due to incremental recurring operating expense associated with the
five acquisitions completed during the last eighteen months. Intangible
amortization in 2004 was up versus the prior year due to the amortization of
core deposit and customer relationship intangibles arising from the 2003 and
2004 acquisitions.
20
Total non-personnel expenses increased $2.1 million or 4.5% in 2003 as compared
to 2002, largely caused by higher occupancy expense (up $1.1 million), and other
expenses (up $2.3 million) and partially offset by lower intangible amortization
(down $0.9 million). The increase in occupancy expense in 2003 was mainly due to
incremental costs from recently acquired facilities. Other expenses include two
volume-driven expense items that were up considerably due to record levels of
business activity. Intangible amortization in 2003 was down versus the prior
year because the drop in accelerated amortization of core deposit intangibles
from the FleetBoston branch acquisitions had a greater impact than the
amortization of intangibles added as a result of the three acquisitions
completed in 2003.
Acquisition expenses totaled $1.7 million in 2004, up from $498,000 in 2003.
These expenditures were primarily comprised of severance and employee benefits
of $1.0 million, legal and consulting fees of $491,000, and system conversion
costs of $130,000 and $39,000 of other general administrative expenses.
Acquisition expenses totaled $498,000 in 2003, down from $700,000 in 2002. These
expenditures were primarily comprised of legal and consulting fees of $213,000,
$191,000 of system conversion costs and $94,000 of other general administrative
expenses. The majority of these expenses were incurred in conjunction with the
Company's largest acquisition of 2003, Grange National Banc Corp., in November
2003.
Income Taxes
The Company estimates its tax expense based on the amount it expects to owe the
respective tax authorities, plus the impact of deferred tax items. Taxes are
discussed in more detail in Note I of the Consolidated Financial Statements on
page 55. Accrued taxes represent the net estimated amount due or to be received
from taxing authorities. In estimating accrued taxes, management assesses the
relative merits and risks of the appropriate tax treatment of transactions
taking into account statutory, judicial and regulatory guidance in the context
of the Company's tax position. If the final resolution of taxes payable differs
from our estimates due to regulatory determination or legislative or judicial
actions, adjustments to tax expense may be required.
The effective tax rate for 2004 increased by 0.9 percentage points to 24.9%.
This increase was primarily due to a larger proportion of income from fully
taxable sources in 2004, in comparison to 2003.
The effective tax rate for 2003 of 24.0% was down from the 26.5% rate in 2002.
This decline was primarily due to the benefits realized on a larger proportion
of income from tax-exempt investment securities in 2003, versus 2002.
Capital
Shareholders' equity ended 2004 at $474.6 million, up $69.8 million or 17% from
one year earlier. This increase reflects $54.7 million of common stock issued in
conjunction with the acquisition of First Heritage, net income of $50.2 million
and $8.9 million from the issuance of shares through employee stock plans. These
increases were partially offset by common dividends declared of $20.5 million,
treasury share purchases of $21.7 million and a $1.8 million decline in the
market value adjustment ("MVA", represents the after-tax, unrealized change in
value of available-for-sale securities in the Company's investment portfolio).
Excluding accumulated other comprehensive income in both 2004 and 2003, capital
rose by $71.6 million or 19%. Shares outstanding rose by 2,311,000 during the
year, comprised of 2,592,000 issued to First Heritage shareholders and 703,000
added through employee stock plans, offset by the purchase of 984,000 treasury
shares.
The Company's ratio of tier I capital to assets (or tier I leverage ratio), the
basic measure for which regulators have established a 5% minimum to be
considered "well-capitalized," decreased 32 basis points in 2004 to 6.94%. This
was due to the net issuance of common stock and the capital-building
contribution from retained earnings (net income less dividends declared) offset
by the proportionately higher organic and acquired growth of the investment and
loan portfolios. The tangible equity/tangible assets ratio was 5.82% at the end
of 2004 versus 5.70% one year earlier. The Company manages organic and acquired
growth in a manner that enables it to continue to build upon its strong capital
base, and maintain the Company's ability to take advantage of future strategic
growth opportunities.
Cash dividends declared on common stock in 2004 of $20.5 million represented an
increase of 26% over the prior year. This growth was mostly a result of
dividends per share of $0.68 for 2004 increasing from $0.61 in 2003 due to
quarterly dividends per share being raised from $0.16 to $0.18 (+12.5%) in the
third quarter of 2004 and from $0.145 to $0.16 (+10.3%) in the third quarter of
2003. The increase in dollar amount of dividends declared also reflects an
increase in the number of shares outstanding at the end of this year, primarily
a result of the 2.6 million shares issued in May 2004 to First Heritage
shareholders.
21
The dividend payout ratio for this year was 40.9% compared to 40.2% in 2003, and
37.7% in 2002, and near the top of the Company's targeted payout range for
dividends on common stock of 30 to 40%.
Liquidity
Liquidity risk is measured by the Company's ability to raise cash when needed at
a reasonable cost and with a minimum of loss. The Company must be capable of
meeting all obligations to its customers at any time and, therefore, the active
management of its liquidity position is critical. Given the uncertain nature of
our customers' demands as well as the Company's desire to take advantage of
earnings enhancement opportunities, the Company must have available adequate
sources of on and off balance sheet funds that can be acquired in time of need.
Accordingly, in addition to the liquidity provided by balance sheet cashflows,
liquidity must be supplemented with additional sources such as credit lines from
correspondent banks, Federal Home Loan Bank, and Federal Reserve Bank. Other
funding alternatives may also be appropriate from time to time, including
wholesale and retail repurchase agreements, large certificates of deposit, and
brokered CD relationships.
The Company'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 as a percentage of
total assets); and second, a projection of subsequent cash availability over an
additional 60 days. As of December 31, 2004, this ratio was 15.4% and 17.5% for
the respective time periods, excluding the Company's capacity to borrow
additional funds from the Federal Home Loan Bank and other sources. There is
currently $134 million in additional Federal Home Loan Bank borrowing capacity
based on the Company's year-end collateral levels. Additionally, the Company has
$11 million in unused capacity at the Federal Reserve Bank and $47 million in
unused capacity from an unsecured line of credit with other correspondent banks.
In addition to the 30 and 90-day basic surplus/deficit model, longer-term
liquidity over a minimum of five years is measured and a liquidity worksheet
projecting sources and uses of funds is prepared. To measure longer-term
liquidity, a baseline projection of loan and deposit growth for five years is
made to reflect how liquidity levels could change over time. This five-year
measure reflects ample liquidity for loan growth over the next five years.
Though remote, the possibility of a funding crisis exists at all financial
institutions and therefore must be planned for. Management has addressed this
issue by formulating a Liquidity Contingency Plan, which has been reviewed and
approved by both the Board of Directors and the Company's Asset/Liability
Management Committee. The plan addresses those actions the Company would take in
response to both a short-term and long-term funding crisis.
A short-term funding crisis would most likely result from a shock to the
financial system, either internal or external, which disrupts orderly short-term
funding operations. Such a crisis should be temporary in nature and would not
involve a change in credit ratings. A long-term funding crisis would most likely
be the result of drastic credit deterioration at the Company. Management
believes that both circumstances have been fully addressed, backed up with
detailed action plans and trigger points for monitoring such events.
Intangible Assets
Intangible assets at the end of 2004 of $232.5 million were up $36.4 million
from the prior year-end due to $43.4 million of additional intangible assets
arising from the acquisitions of First Heritage Bank and a branch located in
Dansville, as well as $0.4 million of goodwill adjustments related primarily to
fair value adjustments associated with the 2003 acquisitions, offset by $7.4
million of amortization during the year.
Intangible assets consist of goodwill, core deposit value and customer
relationships arising from acquisitions. Goodwill represents the excess cost of
an acquisition over the fair value of the net assets acquired. Goodwill at
December 31, 2004 equaled $195 million, comprised of $184 million related to
banking acquisitions and $11 million arising from the acquisition of financial
services businesses. Goodwill is subjected to an annual impairment analysis to
determine whether the carrying value of the acquired net assets exceeds their
fair value, which would necessitate a write-down of the goodwill. The Company
completed its goodwill impairment analyses during 2004 and 2003 and no
adjustments were necessary. The impairment analysis was based upon discounted
cash flow modeling techniques that require management to make estimates
regarding the amount and timing of expected future cash flows. It also requires
them to select a discount rate that reflects the current return requirements of
the market in relation to present risk-free interest rates, required equity
market premiums and company-specific risk indicators. Management believes that
there is a low probability of future impairment with regard to the goodwill
associated with whole-bank acquisitions. The performance of Elias Asset
Management weakened subsequent to its acquisition in 2000 as a result of adverse
market conditions, however, its performance stabilized in 2004
22
as market conditions improved. Additional declines in EAM's operating results
may result in impairment to its recorded goodwill of $7.3 million.
Core deposit intangibles represent the premium the Company has paid for deposits
acquired in excess of the cost incurred had the funds been purchased in the
capital markets. Core deposit intangibles are amortized on either an accelerated
or straight-line basis over periods ranging from seven to twenty years. The
recognition of a customer relationship intangible arose due to the acquisition
of Harbridge. This asset was determined based on a methodology that calculates
the present value of the projected future revenue derived from the acquired
customer base. This asset is being amortized over eleven years on an accelerated
basis.
Loans
The Company's loans outstanding, by type, as of December 31 are as follows:
Table 8: Loans Outstanding
(000's omitted) 2004 2003 2002 2001 2000
- -------------------------------------------------------------------------------------------------------------
Consumer mortgage $ 801,412 $ 739,593 $ 510,309 $ 443,767 $ 416,160
Business lending 831,244 689,436 629,874 643,834 576,887
Consumer direct and indirect 725,885 699,562 666,838 645,487 523,832
- -------------------------------------------------------------------------------------------------------------
Gross loans 2,358,541 2,128,591 1,807,021 1,733,088 1,516,879
Less: unearned discount 48 82 116 218 1,002
- -------------------------------------------------------------------------------------------------------------
Net loans 2,358,493 2,128,509 1,806,905 1,732,870 1,515,877
Allowance for loan loss 31,778 29,095 26,331 23,901 20,035
- -------------------------------------------------------------------------------------------------------------
Loans, net of allowance for loan losses $2,326,715 $2,099,414 $1,780,574 $1,708,969 $1,495,842
=============================================================================================================
As disclosed in Table 8 above, gross loans outstanding, reached a record level
of $2.359 billion as of year-end 2004, up $230 million or 10.8% compared to
twelve months earlier. The acquisitions of First Heritage and Dansville
accounted for $212 million of that growth. Excluding the impact of these
acquisitions (at time of completion), total loans rose $18 million or 1% from
the prior year. All of the organic loan growth was produced in the consumer
mortgage and installment lines of business, with declines experienced in
business lending. The organic loan growth was attributable to the New York
market, with the Pennsylvania market experiencing a net decline in loans
outstanding.
The compounded annual growth rate ("CAGR") for the Company's total loan
portfolio between 2000 and 2003 was 8.3% with approximately 7% of the growth
coming from whole bank and branch acquisitions and the balance from organic
growth. The greatest overall expansion occurred in the consumer mortgage
segment, which grew at a 14% CAGR (including the impact of acquisitions) over
that time frame. The consumer mortgage growth was primarily driven by record
mortgage refinancing volumes over the last three years, as well as the
acquisition of consumer-oriented banks in the intervening period. The other loan
categories grew at compounded annual growth rates of between 5% and 7% from 2000
to 2004. As a consequence, the consumer mortgages segment accounted for 34% of
the total loan portfolio at year-end 2004 versus 27% at the end of 2000.
The weighting of retail lending in the Company's loan portfolio enables it to be
highly diversified. Approximately 65% of loans outstanding at the end of 2004
were made to consumers borrowing on an installment and residential mortgage loan
basis. The commercial portfolio is also broadly diversified by industry type as
demonstrated by the following distributions at year-end 2004: real estate
development (16%), healthcare (11%), general services (11%), motor vehicle and
parts dealers (9%), construction (7%), agriculture (6%), restaurant & lodging
(6%), retail trade (6%), manufacturing (5%) and wholesale trade (5%). A variety
of other industries with less than a 3% share of the total portfolio comprise
the remaining 18%. Over the last year, the mix of loans has become more weighted
towards business lending due to the high proportion of commercial loans in First
Heritage's portfolio.
The consumer mortgage segment of the Company's loan portfolio is comprised of
fixed (94%) and adjustable rate (6%) residential lending. Approximately $21
million of the $62 million growth in consumer mortgages was attributable to the
acquisition of First Heritage. Excluding the impact of this acquisition, this
segment was up $41 million or 5.6% in 2004 due to continued strong mortgage
volumes in the historically low interest rate environment. All of the organic
growth was generated in the New York market, as Pennsylvania experienced a net
decline in 2004 despite a significant volume of new originations.
The combined total of general-purpose business lending, dealer floor plans,
mortgages on commercial property, and farm loans is characterized as the
Company's business lending activity. Approximately $170 million in business
loans added
23
through the First Heritage acquisition offset the $28 million (4.1%) decrease
from ongoing operations in 2004. The majority of this decrease was attributable
to the Pennsylvania market, with the New York market experiencing a slight
decrease. Lending efforts in First Liberty's traditional markets continue to be
challenged by a modest economic recovery, diminished capital spending levels in
the commercial sector, an extremely competitive pricing environment and the
Company's dedication to maintaining strong credit quality standards. Management
has worked aggressively to address the loan generation challenges in
Pennsylvania by adding enhanced management, lending and credit administration
resources, and strong business relationships via the acquisition of First
Heritage in 2004 and Grange in 2003. The enhanced scale and coverage of the
Pennsylvania business combined with the new management team's continued
commitment to business development efforts, positions them to fully take
advantage of growth opportunities in this key market as economic conditions
continue to improve and increased capital spending leads to expanded borrowing
activity in the commercial sector.
Consumer installment loans, both those originated directly (such as personal
loans and home equity loans and lines of credit), and indirectly (originated
predominantly in automobile, marine and recreational vehicle dealerships), rose
$26 million (3.8%) from one year ago. Excluding acquisitions, consumer
installment loans increased $5 million year over year. Historically low interest
rates, aggressive dealer and manufacturer incentives on new vehicles, and very
competitive pricing on used vehicles have existed in these product types for
more than a year. Consumer installment loans increased in the New York markets
during the last 12 months, while the Pennsylvania markets decreased slightly.
The following table shows the maturities and type of interest rates for business
and construction loans as of December 31, 2004:
Table 9: Maturity Distribution of Business and Construction Loans (1)
Maturing
Maturing in After One Maturing
One Year or but Within After Five
(000's omitted) Less Five Years Years
------------------------------------------------------------------------------------
Commercial, financial and agricultural $328,497 $376,030 $120,629
Real estate - construction 11,304
------------------------------------------------------------------------------------
Total $339,801 $376,030 $120,629
====================================================================================
Fixed or predetermined interest rates $ 83,198 $189,120 $ 43,802
Floating or adjustable interest rates 256,603 186,910 76,827
------------------------------------------------------------------------------------
Total $339,801 $376,030 $120,629
====================================================================================
(1) Scheduled repayments are reported in the maturity category in which
the payment is due.
24
Asset Quality
The following table presents information concerning non-performing assets:
Table 10: Non-performing Assets
As of December 31,
-------------------------------------------------------
(000's omitted) 2004 2003 2002 2001 2000
- ---------------------------------------------------------------------------------------------------------------------
Non-accrual loans $11,798 $11,940 $ 9,754 $ 7,186 $ 5,473
Accruing loans 90+ days delinquent 1,158 1,307 1,890 1,914 1,930
Restructured loans 0 28 43 75 116
- ---------------------------------------------------------------------------------------------------------------------
Total non-performing loans 12,956 13,275 11,687 9,175 7,519
Other real estate 1,645 1,077 704 1,427 1,293
- ---------------------------------------------------------------------------------------------------------------------
Total non-performing assets $14,601 $14,352 $12,391 $10,602 $ 8,812
=====================================================================================================================
Allowance for loan losses to total loans 1.35% 1.37% 1.46% 1.38% 1.32%
Allowance for loan losses to non-performing loans 245% 219% 225% 261% 266%
Non-performing loans to total loans 0.55% 0.62% 0.65% 0.53% 0.50%
Non-performing assets to total loans and other real estate 0.62% 0.67% 0.69% 0.61% 0.58%
The Company places a loan on nonaccrual status when the loan becomes ninety days
past due (or sooner, if management concludes collection of interest is
doubtful), except when, in the opinion of management, it is well-collateralized
and in the process of collection. As shown in Table 10 above, non-performing
loans, defined as non-accruing loans plus accruing loans 90 days or more past
due, ended 2004 at $13.0 million, down approximately $0.3 million or 2.4% from
one year earlier despite a $230 million increase in loans outstanding. The ratio
of non-performing loans to total loans declined seven basis points from twelve
months earlier to 0.55%. The ratio of non-performing assets (which includes
troubled debt restructuring and other real estate, or OREO, in addition to
non-performing loans) to total loans plus OREO decreased to 0.62% at year-end
2004, down five basis points from one-year earlier. The improvement in both
ratios was driven by improvements in the economy, enhanced collection and
recovery efforts, and the charge-off and disposition of certain problematic
loans over the last two years. Had nonaccrual loans as of December 31, 2004 been
current in accordance with their original terms, additional interest income of
approximately $1.0 million would have been recorded. At year end 2004, there
were 30 OREO properties with a value of $1.6 million as compared to 25 OREO
properties at a value of $1.1 million a year earlier.
Total delinquencies, defined as loans 30 days or more past due or in nonaccrual
status, finished the current year at 1.45% of total loans outstanding versus
1.77% at the end of 2003. As of year-end 2004, total delinquency ratios for
commercial loans, consumer loans, and real estate mortgages were 1.57%, 2.08%,
and 1.00%, respectively. These measures were 2.18%, 2.36% and 1.10%,
respectively, as of December 31, 2003. Delinquency levels, particularly in the
30 to 89 days category, tend to be somewhat volatile due to their measurement at
a point in time, and therefore management believes that it is useful to look at
this ratio over a longer period. The total average delinquency ratio for 2004
was 1.52% versus 1.76% in 2003.
25
The changes in the allowance for loan losses for the last five years is as
follows:
Table 11: Allowance for Loan Loss Activity
Years Ended December 31,
----------------------------------------------------------------------
(000's omitted) 2004 2003 2002 2001 2000
- ----------------------------------------------------------------------------------------------------------------------------------
Amount of loans outstanding at end of period $2,358,493 $2,128,509 $1,806,905 $1,732,870 $1,515,877
Daily average amount of loans (net of unearned discount) $2,264,857 $1,885,604 $1,759,564 $1,580,870 $1,484,945
Allowance for loan losses at beginning of period $ 29,095 $ 26,331 $ 23,901 $ 20,035 $ 18,528
Charge-offs:
Business lending 3,621 5,521 5,071 2,310 3,423
Consumer mortgage 535 239 221 282 93
Consumer direct and indirect 7,624 7,351 6,723 6,070 3,964
- ----------------------------------------------------------------------------------------------------------------------------------
Total charge-offs 11,780 13,111 12,015 8,662 7,480
Recoveries:
Business lending 871 417 281 313 181
Consumer mortgage 48 78 119 56 72
Consumer direct and indirect 2,437 2,353 1,823 1,709 1,012
- ----------------------------------------------------------------------------------------------------------------------------------
Total recoveries 3,356 2,848 2,223 2,078 1,265
- ----------------------------------------------------------------------------------------------------------------------------------
Net charge-offs 8,424 10,263 9,792 6,584 6,215
Provision for loan losses 8,750 11,195 12,222 7,097 7,722
Allowance on acquired loans (1) 2,357 1,832 0 3,353 0
- ----------------------------------------------------------------------------------------------------------------------------------
Allowance for loan losses at end of period $ 31,778 $ 29,095 $ 26,331 $ 23,901 $ 20,035
==================================================================================================================================
Net charge-offs to average loans outstanding 0.37% 0.54% 0.56% 0.42% 0.42%
(1) This reserve addition is attributable to loans purchased from First
Heritage Bank in 2004, Peoples Bankcorp Inc. and Grange National Banc Corp
in 2003 and Citizens National Bank of Malone and FleetBoston Financial
Corporation in 2001.
As displayed in Table 11 above, total net charge-offs in 2004 were $8.4 million,
down $1.8 million from the prior year, principally due to significantly improved
results in the business lending portfolio. Net charge-offs in 2003 were $0.5
million above 2002's level, and were impacted by the increased size of the
average loan portfolio, resulting from both organic and acquired loan growth in
2003. In addition, a prolonged period of economic weakness from late 2000
through early 2003 impacted the net charge-off levels in both 2002 and 2003,
with the greatest impact being realized in the business loan segment.
Due to the significant increase in average loan balances in 2004 and 2003 as a
result of the factors mentioned above, management believes that net charge-offs
as a percent of average loans ("net charge-off ratio") offers a clearer
representation of asset quality trends. The net charge-off ratio for 2004 was
down 17 basis points from last year to 0.37%. This year's ratio benefited from
improved recovery performance, as evidenced by the $0.5 million increase in
recoveries to $3.4 million, representing 27% of average gross charge-offs for
the latest two years, compared to 23% in 2003.
Business loan net charge-offs decreased in 2004, totaling $2.8 million or 0.35%
of average business loans outstanding versus $5.1 million and 0.80% in 2003. The
primary reason for the decreased net charge-off ratio for business loans was
generally improved economic conditions in the markets served by the Company, as
well as the charge-off of a number of business loans in 2003 that had been
identified as weak and had been specifically reserved for in previous periods.
Consumer direct and indirect loan net charge-offs increased slightly to $5.2
million this year from $5.0 million in 2003, but the net charge-off ratio
dropped slightly from 0.74% in 2003 to 0.73% in 2004 due to larger average
balances. Consumer mortgage net charge-offs rose $0.3 million to $0.5 due to the
much larger size of the portfolio. The net charge-off ratio of 0.06% was higher
than the prior year, but remains low.
All the primary asset quality metrics deteriorated in 2002 and continued into
2003, in comparison to the 1999 to 2001 period. This was principally due to the
weakened economic conditions in the Company's markets, and was manifested most
strongly in the business loan portfolio. Based on almost all measurements, the
asset quality profile of the Company began to improve in 2003 in conjunction
with gradually improving economic conditions and strengthened credit
administration and loan review resources. Significant changes and enhancements
were made to lending and credit administration functions in 2003 and through
2004, and these improvements had a significantly positive impact on credit
management performance in 2004.
26
Management continually evaluates the credit quality of the Company's loan
portfolio and conducts a formal review of the allowance for loan loss adequacy
on a quarterly basis. The two primary components of the loan review process that
are used to determine proper allowance levels are specific and general loan loss
allocations.
Measurement of specific loan loss allocations is typically based on expected
future cash flows, collateral values and other factors that may impact the
borrower's ability to pay. Impaired loans greater than $500,000 are evaluated
for specific loan loss allocations, as defined in SFAS No. 114, "Accounting by
Creditors for Impairment of a Loan," as amended. Consumer mortgages and consumer
direct and indirect loans are considered smaller balance homogeneous loans and
are evaluated collectively. The Company considers a loan to be impaired when,
based on current information and events, it is probable that the Company will be
unable to collect all amounts according to the contractual terms of the loan
agreement or the loan is delinquent 90 days or more.
The second component of the allowance establishment process, general loan loss
allocations, is composed of two calculations that are computed on the four main
loan segments: commercial, consumer direct, consumer indirect and residential
real estate. The first calculation determines an allowance level based on the
latest three years of historical net charge-off data for each loan category
(commercial loans exclude balances with special loan loss allocations). The
second calculation is qualitative and takes into consideration five major
factors affecting the level of loan loss risk: portfolio risk migration patterns
(internal credit quality trends); the growth of the segments of the loan
portfolio; economic and business environment trends in the Company's markets
(includes review of bankruptcy, unemployment, population, consumer spending and
regulatory trends); industry, geographical and product concentrations in the
portfolio; and the perceived effectiveness of managerial resources and lending
practices and policies. These two allowance calculations are added together to
determine the general loan loss allocation. The allowance levels computed from
the specific and general loan loss allocation methods are combined to derive the
necessary allowance for loan loss to be reflected on the Consolidated Statement
of Condition.
The loan loss provision is calculated by subtracting the previous period
allowance for loan loss, net of the interim period net charge-offs, from the
current required allowance level. This provision is then recorded as an expense
in the income statement for that period.
Members of senior management and the loan committee of the Board of Directors
review the adequacy of the allowance for loan loss quarterly. Management is
committed to continually improving the credit assessment and risk management
capabilities of the Company and will dedicate the resources necessary to ensure
advancement in this critical area of operations.
The allowance for loan loss was increased to $31.8 million at year-end 2004 from
$29.1 million at the end of 2003. The $2.7 million increase was primarily due to
$230 million more in loans outstanding, offset by an overall improvement in the
Company's asset quality profile. The ratio of the allowance for loan loss to
total loans decreased to 1.35% for year-end 2004 versus 1.37% at the end of last
year. Management believes the year-end 2004 allowance for loan losses to be
adequate in light of the probable losses inherent in the Company's loan
portfolio.
The loan loss provision decreased by $2.4 million or 22% in 2004 as a result of
management's assessment of the probable losses in the loan portfolio, and the
reduced level of charge-offs in 2004, as discussed above. The loan loss
provision as a percentage of average loans decreased from 0.59% in 2003 to 0.39%
this year in most part due to the provision last year being elevated to cover
higher risk levels in the business loan segment of the portfolio. The loan loss
provision covered net charge-offs by 104% this year versus 109% in 2003,
reflective of the improvements in asset quality trends during the year.
The net charge-off ratio in 2004 was more consistent with the ratios of the 1999
to 2001 period, as shown in Table 11 above. As previously noted, there was a
strong correlation between the increased level of net charge-offs in 2002 and
2003 and the performance of the overall economy. The Company's net charge-off
ratio was also above 50 basis points during the 1990 to 1992 period, when the
ratio fluctuated between 51 and 59 basis points. Not surprisingly, similar to
the period from mid-2001 through late 2003, that time frame included a recession
and the first stage of an economic recovery. The net charge-off ratio dropped
significantly in the years immediately following that period. In 2004, the
Company realized the benefits of one of management's primary goals, which was to
steadily bring the net charge-off ratio back to a range that was consistent with
historical performance.
27
The following table shows management's allocation of the allowance for loan
losses by loan type as of December 31:
Table 12: Allowance for Loan Losses by Loan Type
2004 2003 2002 2001 2000
----------------- ----------------- ----------------- ----------------- -----------------
Loan Loan Loan Loan Loan
(000's omitted) Allowance Mix Allowance Mix Allowance Mix Allowance Mix Allowance Mix
- -------------------- ----------------- ----------------- ----------------- ----------------- -----------------
Consumer mortgage $ 1,810 34.0% $ 1,724 34.7% $ 479 28.2% $ 406 25.6% $ 1,483 27.5%
Business lending 16,439 35.2% 15,549 32.4% 16,765 34.9% 14,417 37.2% 7,386 38.0%
Consumer direct and
indirect 11,487 30.8% 11,112 32.9% 8,978 36.9% 8,970 37.2% 8,314 34.5%
Unallocated 2,042 710 109 108 2,852
- -------------------- ---------------- ---------------- ---------------- ---------------- ----------------
Total $31,778 100.0% $29,095 100.0% $26,331 100.0% $23,901 100.0% $20,035 100.0%
==================== ================ ================ ================ ================ ================
As demonstrated in Table 12 above and discussed previously, the risk inherit in
the consumer mortgage portfolio is much lower than that of the other segments of
the loan portfolio. The risk differential is illustrated by the average net
charge-off ratio of 0.04% over the last three years for consumer mortgages
compared to the 0.68% average for the rest of the portfolio over the same time
frame. This is manifested in the comparatively small $1.8 million allowance
attributable to consumer mortgages, representing only 0.2% of the their ending
balance versus 1.8% for the remaining portion of the loan portfolio. The
increase in the unallocated portion of the allowance for loan losses over 2003
related principally to the portfolio and reserves acquired as part of the First
Heritage acquisition. As that acquired portfolio is further subjected to the
Company's established risk rating and review procedures, it is expected that
some portion of the unallocated reserve will be allocated to the specific
product categories.
Funding Sources
The Company utilizes a variety of funding sources to support the earning asset
base as well as to achieve targeted growth objectives. Overall funding is
comprised of three primary sources that possess a variety of maturity,
stability, and price characteristics: deposits of individuals, partnerships and
corporations (IPC deposits); collateralized municipal deposits (public funds);
and external borrowings.
The average daily amount of deposits and the average rate paid on each of the
following deposit categories are summarized below for the years indicated:
Table 13: Average Deposits
2004 2003 2002
--------------------------- ---------------------------- ----------------------------
Average Average Average Average Average Average
(000's omitted, except rates) Balance Rate Paid Balance Rate Paid Balance Rate Paid
- ----------------------------------- --------------------------- ---------------------------- ----------------------------
Noninterest-bearing demand deposits $ 558,552 0.00% $ 473,568 0.00% $ 441,800 0.00%
Interest-bearing demand deposits 300,377 0.24% 274,688 0.24% 262,313 0.47%
Regular savings deposits 521,582 0.66% 430,263 0.80% 402,728 1.32%
Money market deposits 306,112 0.72% 295,287 0.89% 304,623 1.60%
Time deposits 1,188,625 2.37% 1,090,511 2.89% 1,131,296 3.75%
- ----------------------------------- ---------- ---------- ----------
Total deposits $2,875,248 1.20% $2,564,317 1.49% $2,542,760 2.12%
=================================== ========== ========== ==========
As displayed in Table 13 above, total average deposits for 2004 equaled $2.875
billion, up $311 million or 12.1% from the prior year. This increase was
principally the result of deposits obtained through the First Heritage
acquisition in 2004 and the Grange and Peoples acquisitions in late 2003. The
Dansville branch acquisition did not have a significant impact on full-year
average deposit levels because it was completed late in the year. Average
deposits in 2003 were up $22 million or 0.8% from 2002. The acquisitions of
Peoples and Grange did not have a significant impact on full-year average
deposit levels because they were completed relatively late in the year.
The Company's funding composition continues to benefit from a high level of IPC
deposits, which reached an all-time high in 2004 with an average balance of
$2.692 billion, an increase of $295 million or 12.3% over the comparable 2003
period. This was largely due to the $210 million and $219 million in IPC
deposits added in conjunction with the acquisition of First Heritage in May 2004
and Grange in late 2003, respectively. IPC deposits are frequently considered to
be a bank's most attractive source of funding because they are generally stable,
do not need to be collateralized, have a relatively low cost, and provide a
strong customer base for which a variety of loan, deposit and other financial
service-related products can be sold.
Full-year average deposits of local municipalities increased $16 million or 9.5%
during 2004, $7.3 million as a result of the Grange, First Heritage and
Dansville acquisitions. The Company is required to collateralize all local
government deposits
28
with marketable securities from its investment portfolio. Because of this
stipulation, management considers this source of funding to be equivalent to
external borrowings. As such, the Company generally prices these deposits
consistent with alternative external borrowing rates.
The mix of average deposits in 2004 changed slightly in comparison to 2003. The
weightings of demand deposit and savings account balances all increased from
their 2003 levels, while interest checking, money market and time deposit
weightings decreased. This change in mix largely reflects less willingness by
certain customers to being locked into lower CD rates and accounts with higher
minimum balance requirements (interest checking and money market) given the
market-driven contraction of interest rate spreads between these accounts and
the ones with less restrictions on withdrawels, such as demand deposits and
savings. This shift in the deposit mix resulted in a greater drop in the overall
cost of funds on deposits than would have been achieved through the reduction of
interest rates alone. As a result of market interest rates remaining at
historically low levels for an extended period of time, spreads between these
groups of accounts have stabilized and customers appear to be more willing to
hold term deposits given the lack of viable alternatives with similar
risk/return characteristics. This factor combined with the Company's ongoing
commitment to continually expand its advantageous IPC deposit base to fund
earning-asset growth, prompted the development of a new money market product in
the fourth quarter of 2004 that has been an effective tool for attracting new
customer funds.
The remaining maturities of time deposits in amounts of $100,000 or more
outstanding as of December 31 are as follows:
Table 14: Time Deposit > $100,000 Maturities
(000's omitted) 2004 2003
--------------------------------------------------------
Less than three months $ 69,239 $ 60,504
Three months to six months 32,163 24,351
Six months to one year 41,768 48,306
Over one year 36,364 35,080
--------------------------------------------------------
Total $179,534 $168,241
========================================================
External borrowings are defined as funding sources available on a national
market basis, generally requiring some form of collateralization. Borrowing
sources for the Company include the Federal Home Loan Bank of New York and
Federal Reserve Bank of New York, as well as access to the national repurchase
agreement market through established relationships with primary market security
dealers. The Company also had approximately $80 million in fixed and
floating-rate subordinated debt outstanding at the end of 2004 that is held by
unconsolidated subsidiary trusts. External borrowings averaged $824 million or
22% of total funding sources for all of 2004 as compared to $508 million or 17%
of total funding sources for 2003. As shown in Table 15 below, at year-end 2004,
$649 million or 71% of external borrowings had remaining terms of one year or
less, up considerably from $397 million and 60% at the end of 2003. This change
in external funding mix is due to an increase in short and medium term
borrowings to take advantage of historically low short term rates, as well as,
to reduce the Company's sensitivity to falling interest rates and to provide
more flexibility with regard to altering future debt levels.
During fourth quarter 2003, $25 million in longer-term Federal Home Loan Bank
borrowings were retired early and replaced with significantly lower rate,
short-term debt, resulting in an earnings charge of $2.6 million. This strategy
was implemented because the projected cost of the replacement debt, including
prepayment charges, was favorable on a long-term, economic basis in comparison
to holding the existing borrowings.
As displayed in Table 3 on page 16, the overall mix of funding has shifted in
2004. The percentage of funding derived from deposits decreased to 78% in 2004
from 83% in 2003 and 2002. Short and medium term FHLB borrowings increased
during the year principally to fund security purchases. These borrowings carry
relatively short maturities and help provide funding cost stability for a period
of time that is complementary to our asset/liability profile.
29
The following table summarizes the outstanding balance of short-term borrowings
of the Company as of December 31:
Table 15: Short-term Borrowings
(000's omitted, except rates) 2004 2003 2002
---------------------------------------------------------------------------
Federal funds purchased $ 13,200 $ 36,300 $ 33,000
Term borrowings at banks
90 days or less 465,000 361,000 215,000
Over 90 days 171,000 0 0
Commercial loans sold with recourse 74 0 0
Capital lease obligations 0 96 241
---------------------------------------------------------------------------
Balance at end of period $649,274 $397,396 $248,241
===========================================================================
Daily average during the year $442,287 $212,512 $141,024
Maximum month-end balance $649,274 $397,396 $248,241
Weighted average rate during the year 1.64% 1.26% 1.83%
Year-end average rate 2.51% 1.28% 1.50%
The following table shows the maturities of various contractual obligations as
of December 31, 2004:
Table 16: Maturities of Contractual Obligations
Maturing Maturing
Maturing After One After Three
Within Year but Years but Maturing
One Year Within Within After
(000's omitted) or Less Three Years Five Years Five Years Total
- --------------------------------------------------------------------------------------------------------------------------------
Federal funds purchased $ 13,200 $ 0 $ 0 $ 0 $ 13,200
Federal Home Loan Bank advances 636,000 -- 15,000 175,000 826,000
Subordinated debt held by unconsolidated subsidiary trusts 80,446 80,446
Commercial loans sold with recourse 74 236 -- 555 865
Operating leases 2,204 3,810 2,282 4,374 12,670
- --------------------------------------------------------------------------------------------------------------------------------
Total $651,478 $ 4,046 $ 17,282 $260,375 $933,181
================================================================================================================================
Financial Instruments with Off-Balance Sheet Risk
The Company is a party to financial instruments with off-balance-sheet risk in
the normal course of business to meet the financing needs of its customers.
These financial instruments consist primarily of commitments to extend credit
and standby letters of credit. Commitments to extend credit are agreements to
lend to customers, generally having fixed expiration dates or other termination
clauses that may require payment of a fee. These commitments consist principally
of unused commercial and consumer credit lines. Standby letters of credit
generally are contingent upon the failure of the customer to perform according
to the terms of an underlying contract with a third party. The credit risks
associated with commitments to extend credit and standby letters of credit are
essentially the same as that involved with extending loans to customers and are
subject to normal credit policies. Collateral may be obtained based on
management's assessment of the customer's creditworthiness. The fair value of
these commitments is immaterial for disclosure in accordance with FASB
Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others".
The contract amount of these off-balance sheet financial instruments as of
December 31 is as follows:
Table 17: Off-Balance Sheet Financial Instruments
(000's omitted) 2004 2003
--------------------------------------------------------
Commitments to extend credit $429,751 $315,898
Standby letters of credit 22,948 19,163
--------------------------------------------------------
Total $452,699 $335,061
========================================================
30
Investments
The objective of the Company's investment portfolio is to hold low-risk,
high-quality earning assets that provide favorable returns and are another
effective tool to actively manage its asset/liability position to maximize
future net interest income operation. This must be accomplished within the
following constraints: (a) implementing certain interest rate risk management
strategies which achieve a relatively stable level of net interest income; (b)
providing both the regulatory and operational liquidity necessary to conduct
day-to-day business activities; (c) considering investment risk-weights as
determined by the regulatory risk-based capital guidelines; and (d) generating a
favorable return without undue compromise of the other requirements.
As displayed in Table 18 below, the book value of the Company's investment
portfolio increased $258 million or 20% during the year to $1.529 billion as a
result of the First Heritage acquisition and the leveraging strategy that began
in the third quarter of 2003 and ended during the second quarter of 2004.
Average investment balances (book value basis) for 2004 were up $268 million or
23% versus the prior year.
Investment interest income in 2004 was $10 million or 14.9% higher than the
prior year as a result of the increased average balances in the portfolio,
offset by the decrease in the average investment yield from 6.53% to 6.18%. The
decline in the yield was primarily due to the maturity of securities from the
portfolio that had been issued in the higher interest rate environments of
previous periods and were replaced with investments that carry comparatively
lower yields. This was expected given the fact that longer-term market interest
rates, despite modest increases in the third quarter of 2003 and all of 2004,
were still at historically low levels. However, the impact of lower investment
yields was mostly offset by the funding of the purchases with very low rate
medium and short-term borrowings, resulting in similar net spreads.
In order to protect the Company against its exposure to falling interest rates,
the vast majority of the investment purchases in 2003 and 2004 were in
intermediate-term US Agency securities with average call protection in excess of
six years. Investments sales, excluding Federal Home Loan Bank, in the current
year totaled $18 million and were all related to securities inherited from
acquired companies, and resulted in an immaterial amount of net gains. The sales
were based on the Company's total return strategy (see below) or to remove
securities that no longer adhere to investment policy guidelines. Those proceeds
that were reinvested resulted in an improved interest rate risk position. As of
December 31, 2004 the investment portfolio had a weighted average life of 5.9
years as compared to 6.6 as of December 31, 2003.
The investment portfolio has limited credit risk due to the composition
continuing to heavily favor U.S. Agency debentures, U.S. Agency mortgage-backed
pass-throughs, U.S. Agency CMOs and municipal bonds insured by third parties. As
of year-end 2004, these four AAA-rated (highest possible rating) security types
accounted for 97% of the portfolio's total book value, excluding Federal Home
Loan Bank stock and Federal Reserve Bank stock, or 52%, 3%, 5% and 37%
respectively. These four security types comprised 98% of total investments as of
December 31, 2003 at 48%, 6%, 7% and 37%, respectively. The change in the
investment mix reflects management's strategy over the last several years of
primarily purchasing medium-term, call-protected US Agency and municipal bonds
that offer both attractive yields and are free from short-term reinvestment
risk. MBS and CMO securities typically possess a high level of this latter risk,
particularly in periods with high levels of mortgage refinancing such as have
existed over the last few years in the extremely low interest rate environment.
As a consequence, the Company has avoided investing in these types of securities
during this period, and this fact combined with high run-off rates explains the
significant drop in their weighting in the total investment portfolio.
The Company has utilized total return as its primary methodology for managing
investment portfolio assets. Under this analytical method, shareholder value is
maximized through both interest income and market value appreciation. The
commitment to this approach is reflected in the fact that no security sales were
conducted in 2004 outside of minor transactions associated with the investments
of acquired banks, despite the significant level of market gains in the
portfolio (see MVA discussion in the following paragraph). Management chose not
to take gains in the current year to increase short-term earnings at the expense
of profitability in future periods.
Ninety one percent of the investment portfolio was classified as
available-for-sale at year-end 2004 versus eighty nine percent at the end of
2003. The net pre-tax market value gain over book value for the
available-for-sale portfolio as of December 31, 2004 was $55.8 million, $3.1
million lower than it was one year earlier.
31
The following table sets forth the amortized cost and market value for the
Company's investment securities portfolio:
Table 18: Investment Securities
2004 2003 2002
------------------------- ------------------------- -------------------------
Amortized Amortized Amortized
Cost/Book Fair Cost/Book Fair Cost/Book Fair
(000's omitted) Value Value Value Value Value Value
- ----------------------------------------- ------------------------- ------------------------- -------------------------
Held-to-Maturity Portfolio:
U.S. treasury and agency securities $ 127,490 $ 125,906 $ 127,635 $ 125,003 $ 0 $ 0
Obligations of state and political
subdivisions 6,576 6,694 7,459 7,677 7,412 7,666
Other securities 3,578 3,578 3,558 3,558 3,018 3,018
- ----------------------------------------- ------------------------- ------------------------- -------------------------
Total held-to-maturity portfolio 137,644 136,178 138,652 136,238 10,430 10,684
- ----------------------------------------- ------------------------- ------------------------- -------------------------
Available-for-Sale Portfolio:
U.S. treasury and agency securities 630,058 650,767 456,913 479,454 380,243 411,278
Obligations of state and political
subdivisions 545,698 573,551 443,930 470,210 404,864 420,605
Corporate securities 40,443 43,898 27,712 30,251 27,972 30,225
Collateralized mortgage obligations 70,986 72,444 89,566 93,552 235,286 245,368
Mortgage-backed securities 50,347 52,664 76,628 80,177 131,755 137,211
- ----------------------------------------- ------------------------- ------------------------- -------------------------
Sub-total 1,337,532 1,393,324 1,094,749 1,153,644 1,180,120 1,244,687
Equity securities (1) 43,515 43,515 29,185 29,185 25,814 25,814
Federal Reserve Bank common stock 9,856 9,856 8,053 8,053 5,652 5,652
- ----------------------------------------- ------------------------- ------------------------- -------------------------
Total available-for-sale portfolio 1,390,903 1,446,695 1,131,987 1,190,882 1,211,586 1,276,153
Net unrealized gain on available-for-sale
portfolio 55,792 0 58,895 0 64,567 0
- ----------------------------------------- ------------------------- ------------------------- -------------------------
Total $1,584,339 $1,582,873 $1,329,534 $1,327,120 $1,286,583 $1,286,837
========================================= ========================= ========================= =========================
(1) Includes $42,480, $28,365 and $24,575 of FHLB common stock at December 31,
2004, 2003, and 2002, respectively.
32
The following table sets forth as of December 31, 2004, the maturities of
investment securities and the weighted-average yields of such securities, which
have been calculated on the cost basis, weighted for scheduled maturity of each
security, and adjusted to a fully tax-equivalent basis:
Table 19: Maturities of Investment Securities
Maturing Maturing
Maturing After One After Five Total
Within Year but Years but Maturing Amortized
One Year Within Within After Cost/Book
(000's omitted, except rates) or Less Five Years Ten Years Ten Years Value
- --------------------------------------------------------------------------------------------------------------------------------
Held-to-Maturity Portfolio:
U.S. treasury and agency securities $ 0 $ 0 $ 99,344 $ 28,146 $ 127,490
Obligations of state and political subdivisions 4,387 1,959 230 0 6,576
Other securities 0 0 22 3,556 3,578
- --------------------------------------------------------------------------------------------------------------------------------
Total held-to-maturity portfolio $ 4,387 $ 1,959 $ 99,596 $ 31,702 $ 137,644
================================================================================================================================
Weighted Average Yield for Year (1) 3.89% 6.30% 4.71% 5.46% 4.88%
Available-for-Sale Portfolio:
U.S. treasury and agency securities $ 0 $ 20,000 $ 458,221 $ 151,837 $ 630,058
Obligations of state and political subdivisions 5,263 35,927 228,903 275,605 545,698
Corporate securities 0 0 25,044 15,399 40,443
Collateralized mortgage obligations 0 1,090 17,297 52,599 70,986
Mortgage-backed securities 0 2,832 1,280 46,235 50,347
- --------------------------------------------------------------------------------------------------------------------------------
Total available-for-sale portfolio $ 5,263 $ 59,849 $ 730,745 $ 541,675 $1,337,532
================================================================================================================================
Weighted Average Yield for Year (1) 8.06% 5.82% 5.58% 6.47% 5.96%
(1) Weighted average yields on the tax-exempt obligations have been computed
on a fully tax equivalent basis assuming a marginal federal tax rate of
35.0%. These yields are an arithmetic computation of accrued income
divided by average balance; they may differ from the yield to maturity,
which considers the time value of money.
Impact of Inflation and Changing Prices
The Company's financial statements have been prepared in terms of historical
dollars, without considering changes in the relative purchasing power of money
over time due to inflation. Unlike most industrial companies, virtually all of
the assets and liabilities of a financial institution are monetary in nature. As
a result, interest rates have a more significant impact on a financial
institution's performance than the effect of general levels of inflation.
Interest rates do not necessarily move in the same direction or in the same
magnitude as the prices of goods and services. Notwithstanding this, inflation
can directly affect the value of loan collateral, in particular real estate.
New Accounting Pronouncements
See Accounting Pronouncement Section of Note A of the notes to the consolidated
financial statements on page 48 for additional accounting pronouncements.
Forward-Looking Statements
This document contains comments or information that constitute forward-looking
statements (within the meaning of the Private Securities Litigation Reform Act
of 1995), which involve significant risks and uncertainties. Actual results may
differ materially from the results discussed in the forward-looking statements.
Moreover, the Company's plans, objectives and intentions are subject to change
based on various factors (some of which are beyond the Company's control).
Factors that could cause actual results to differ from those discussed in the
forward-looking statements include: (1) risks related to credit quality,
interest rate sensitivity and liquidity; (2) the strength of the U.S. economy in
general and the strength of the local economies where the Company conducts its
business; (3) the effect of, and changes in, monetary and fiscal policies and
laws, including interest rate policies of the Board of Governors of the Federal
Reserve System; (4) inflation, interest rate, market and monetary fluctuations;
(5) the timely development of new products and services and customer perception
of the overall value thereof (including features, pricing and quality) compared
to competing products and services; (6) changes in consumer spending, borrowing
and savings habits; (7) technological changes; (8) any acquisitions or mergers
that might be considered or consumated by the Company and the costs and factors
associated therewith; (9) the ability to
33
maintain and increase market share and control expenses; (10) the effect of
changes in laws and regulations (including laws and regulations concerning
taxes, banking, securities and insurance) and accounting principles generally
accepted in the United States; (11) changes in the Company's organization,
compensation and benefit plans and in the availability of, and compensation
levels for, employees in its geographic markets; (12) the costs and effects of
litigation and of any adverse outcome in such litigation; (13) other risk
factors outlined in the Company's filings with the Securities and Exchange
Commission from time to time; and (14) the success of the Company at managing
the risks of the foregoing.
The foregoing list of important factors is not exclusive. Such forward-looking
statements speak only as of the date on which they are made and the Company does
not undertake any obligation to update any forward-looking statement, whether
written or oral, to reflect events or circumstances after the date on which such
statement is made. If the Company does update or correct one or more
forward-looking statements, investors and others should not conclude that the
Company will make additional updates or corrections with respect thereto or with
respect to other forward-looking statements.
34
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Market Risk
Market risk is the risk of loss in a financial instrument arising from adverse
changes in market rates, prices or credit risk. Credit risk associated with the
Company's loan portfolio has been previously discussed in the asset quality
section of Management's Discussion and Analysis of Financial Condition and
Results of Operations. Although more than a third of the securities portfolio at
year-end 2004 was invested in municipal bonds, management believes that the tax
risk of the Company's municipal investments associated with potential future
changes in statutory, judicial and regulatory actions is minimal. The Company
also believes that it has an insignificant amount of credit risk in its
investment portfolio because essentially all of the fixed-income securities in
the portfolio are AAA-rated (highest possible rating). The Company does not have
any material foreign currency exchange rate risk exposure. Therefore, almost all
the market risk in the investment portfolio is related to interest rates.
The ongoing monitoring and management of both interest rate risk and liquidity,
in the short and long term time horizons is an important component of the
Company's asset/liability management process, which is governed by limits
established in the policies reviewed and approved annually by the Board of
Directors. The Board of Directors delegates responsibility for carrying out the
policies to the Asset/Liability Committee (ALCO), which meets each month. The
committee is made up of the Company's senior management as well as regional and
line-of-business managers who oversee specific earning asset classes and various
funding sources.
Asset/Liability Management
The primary objective of the Company's asset/liability management process is to
maximize earnings and return on capital within acceptable levels of risk. 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
that enable it to identify and quantify sources of interest rate risk in varying
rate environments. The primary tools used by the Company in managing interest
rate risk are the income simulation model and economic value of equity modeling.
Interest Rate Risk
Interest rate risk (IRR) can result from the timing differences in the
maturity/repricing of an institution's assets, liabilities, and off-balance
sheet contracts; the effect of embedded options, such as loan prepayments,
interest rate caps, and deposit withdrawals; and differences in the behavior of
lending and funding rates, sometimes referred to as basis risk; an example of
basis risk would occur if floating rate assets and liabilities, with otherwise
identical repricing characteristics, were based on market indexes that were
imperfectly correlated.
Given the potential types and differing related characteristics of IRR, it is
important that the Company maintain an appropriate process and set of
measurement tools that enable it to identify and quantify its primary sources of
IRR. The Company also recognizes that effective management of IRR includes an
understanding of when potential adverse changes in interest rates will flow
through the income statement. Accordingly, the Company will manage its position
so that it monitors its exposure to net interest income over both a one year
planning horizon and a longer-term strategic horizon.
It is the Company's objective to manage its exposure to interest rate risk,
bearing in mind that it will always be in the business of taking on rate risk
and that rate risk immunization is not possible. Also, it is recognized that as
exposure to interest rate risk is reduced, so too may net interest margin be
reduced.
Income Simulation
Income simulation is tested on a wide variety of balance sheet and treasury
yield curve scenarios. The simulation projects changes in net interest income
caused by the effect of changes in interest rates. The model requires management
to make assumptions about how the balance sheet is likely to evolve through time
in different interest rate environments. Loan and deposit growth rate
assumptions are derived from management's outlook, as are the assumptions used
for new loan yields and deposit rates. Loan prepayment speeds are based on a
combination of current industry averages and internal historical prepayments.
Balance sheet and yield curve assumptions are analyzed and reviewed by the ALCO
Committee regularly.
35
The following table reflects the Company's one-year net interest income
sensitivity, using December 31, 2004 asset and liability levels as a starting
point.
The prime rate and federal funds rates are assumed to move up 300 basis points
and down 100 basis points over a 12-month period while flattening the long end
of the treasury curve to spreads over federal funds that are more consistent
with historical norms. Deposit rates are assumed to move in a manner that
reflects the historical relationship between deposit rate movement and changes
in the federal funds rate, generally reflecting 10%-65% of the movement of the
federal funds rate.
Cash flows are based on contractual maturity, optionality and amortization
schedules along with applicable prepayments derived from internal historical
data and external sources.
Net Interest Income Sensitivity Model
Calculated increase (decrease) in Projected
Net Interest Income at December 31
-------------------------------------------
Changes in Interest Rates 2004 2003
-----------------------------------------------------------------------
+ 200 basis points ($4,300,000) ($3,900,000)
-100 basis points ($1,200,000) ($2,100,000)
In the 2004 model, both the rising and falling rate environments reflect a
reduction in net interest income (NII) from a flat rate environment due to the
assumed flattening of the yield curve. The modeled NII in a falling rate
environment is initially more favorable than if rates were to rise due to a
faster initial reaction from core deposit pricing and short-term capital market
borrowing rates. Over a longer time period, however, the growth in NII improves
significantly in a rising rate environment as a result of lower yielding earning
assets running off and being replaced at increased rates.
The analysis does not represent a Company forecast and should not be relied upon
as being indicative of expected operating results. These hypothetical estimates
are based upon numerous assumptions: the nature and timing of interest rate
levels (including yield curve shape), prepayments on loans and securities,
deposit decay rates, pricing decisions on loans and deposits,
reinvestment/replacement of asset and liability cash flows, and other factors.
While the assumptions are developed based upon current economic and local market
conditions, the Company cannot make any assurances as to the predictive nature
of these assumptions, including how customer preferences or competitor
influences might change. Furthermore, the sensitivity analysis does not reflect
actions that ALCO might take in responding to or anticipating changes in
interest rates.
Management uses a "value of equity" model to supplement the modeling technique
described above. Those supplemental analyses are based on discounted cash flows
associated with on- and off-balance sheet financial instruments. Such analyses
are modeled to reflect changes in interest rates and shifts in the maturity
curve of interest rates and provide management with a long-term interest rate
risk metric.
36
Item 8. Financial Statements and Supplementary Data
The following consolidated financial statements and independent auditor's
reports of Community Bank System, Inc. are contained on pages 38 through 66 of
this item.
o Consolidated Statements of Condition, December 31, 2004 and 2003
o Consolidated Statements of Income, Years ended December 31, 2004, 2003,
and 2002
o Consolidated Statements of Changes in Shareholders' Equity, Years ended
December 31, 2004, 2003, and 2002
o Consolidated Statements of Comprehensive Income, Years ended December 31,
2004, 2003, and 2002
o Consolidated Statements of Cash Flows, Years ended December 31, 2004,
2003, and 2002
o Notes to Consolidated Financial Statements, December 31, 2004
o Management's Report on Internal Control over Financial Reporting
o Report of Independent Registered Public Accounting Firm
Quarterly Selected Data (Unaudited) for 2004 and 2003 are contained on page 67.
37
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF CONDITION
(In Thousands, Except Share Data)
December 31, December 31,
2004 2003
- ----------------------------------------------------------------------------------------------------------------------
Cash and due from banks $ 118,345 $ 103,923
Available-for-sale investment securities 1,446,695 1,190,882
Held-to-maturity investment securities 137,644 138,652
- ----------------------------------------------------------------------------------------------------------------------
Total investment securities (fair value of $1,582,873 and $1,327,120, respectively) 1,584,339 1,329,534
Loans 2,358,493 2,128,509
Allowance for loan losses 31,778 29,095
- ----------------------------------------------------------------------------------------------------------------------
Net loans 2,326,715 2,099,414
Core deposit intangibles, net 35,351 33,998
Goodwill 195,163 159,596
Other intangibles, net 1,986 2,517
- ----------------------------------------------------------------------------------------------------------------------
Intangible assets, net 232,500 196,111
Premises and equipment, net 63,510 61,705
Accrued interest receivable 27,947 25,851
Other assets 40,475 38,859
- ----------------------------------------------------------------------------------------------------------------------
Total assets $ 4,393,831 $ 3,855,397
======================================================================================================================
Liabilities:
Non-interest bearing deposits $ 567,106 $ 498,195
Interest bearing deposits 2,361,872 2,227,293
- ----------------------------------------------------------------------------------------------------------------------
Total deposits 2,928,978 2,725,488
Federal funds purchased 13,200 36,300
Borrowings 826,865 551,096
Subordinated debt held by unconsolidated subsidiary trusts 80,446 80,390
Accrued interest and other liabilities 69,714 57,295
- ----------------------------------------------------------------------------------------------------------------------
Total liabilities 3,919,203 3,450,569
- ----------------------------------------------------------------------------------------------------------------------
Commitments and contingencies (See Note N)
Shareholders' equity:
Preferred stock $1.00 par value, 500,000 shares authorized, 0 shares issued
Common stock, $1.00 par value, 50,000,000 shares authorized;
32,041,591 and 28,746,612 shares issued in 2004 and 2003, respectively 32,042 28,747
Additional paid-in capital 190,769 130,066
Retained earnings 248,295 218,628
Accumulated other comprehensive income 34,200 35,958
Treasury stock, at cost (1,400,000 and 416,300 shares, respectively) (30,199) (8,490)
Employee stock plan - unearned (479) (81)
- ----------------------------------------------------------------------------------------------------------------------
Total shareholders' equity 474,628 404,828
- ----------------------------------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $ 4,393,831 $ 3,855,397
======================================================================================================================
The accompanying notes are an integral part of the consolidated financial
statements.
38
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands, Except Per-Share Data)
Years Ended December 31,
------------------------------------
2004 2003 2002
- ----------------------------------------------------------------------------------------------------------------
Interest income:
Interest and fees on loans $ 137,077 $ 125,256 $ 130,860
Interest and dividends on taxable investments 52,744 47,047 57,133
Interest and dividends on non-taxable investments 22,974 18,826 17,100
- ----------------------------------------------------------------------------------------------------------------
Total interest income 212,795 191,129 205,093
- ----------------------------------------------------------------------------------------------------------------
Interest expense:
Interest on deposits 34,587 38,288 53,878
Interest on short-term borrowings 7,242 2,685 2,586
Interest on subordinated debt held by unconsolidated subsidiary trusts 5,750 5,632 5,985
Interest on long-term borrowings 14,173 12,696 14,794
- ----------------------------------------------------------------------------------------------------------------
Total interest expense 61,752 59,301 77,243
- ----------------------------------------------------------------------------------------------------------------
Net interest income 151,043 131,828 127,850
Less: provision for loan losses 8,750 11,195 12,222
- ----------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 142,293 120,633 115,628
- ----------------------------------------------------------------------------------------------------------------
Non-interest income:
Deposit service fees 25,201 23,121 16,480
Other banking services 2,431 1,906 2,061
Trust, investment and asset management fees 7,443 6,682 8,003
Benefit plan administration, consulting and actuarial fees 9,298 6,220 3,845
Gain (loss) on investment securities & debt extinguishments 72 (2,698) 1,673
- ----------------------------------------------------------------------------------------------------------------
Total non-interest income 44,445 35,231 32,062
- ----------------------------------------------------------------------------------------------------------------
Operating expenses:
Salaries and employee benefits 61,146 53,164 47,864
Occupancy 10,177 9,297 8,154
Equipment and furniture 8,636 7,828 7,538
Amortization of intangible assets 7,414 5,093 5,953
Legal and professional fees 4,578 3,183 3,272
Data processing 7,737 6,800 6,574
Office supplies 2,232 1,996 2,321
Acquisition expenses 1,704 498 700
Other 16,275 14,852 12,910
- ----------------------------------------------------------------------------------------------------------------
Total operating expenses 119,899 102,711 95,286
- ----------------------------------------------------------------------------------------------------------------
Income before income taxes 66,839 53,153 52,404
Income taxes 16,643 12,773 13,887
- ----------------------------------------------------------------------------------------------------------------
Net income $ 50,196 $ 40,380 $ 38,517
================================================================================================================
Basic earnings per share $ 1.68 $ 1.54 $ 1.48
Diluted earnings per share $ 1.64 $ 1.49 $ 1.46
Dividends declared per share $ 0.68 $ 0.61 $ 0.56
The accompanying notes are an integral part of the consolidated financial
statements.
39
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
Years ended December 31, 2002, 2003 and 2004
(In Thousands, Except Share Data)
Common Stock Accumulated
---------------------- Additional Other Employee
Shares Amount Paid-In Retained Comprehensive Treasury Stock Plan
Outstanding Issued Capital Earnings Income Stock -Unearned Total
---------------------------------------------------------------------------------------------------
Balance at December 31,
2001, as previously reported 12,902,812 $12,903 $77,710 $170,472 $7,281 $0 ($386) $267,980
Two-for-one stock split 12,902,812 12,904 (12,904) 0
- -----------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 25,805,624 25,807 64,806 170,472 7,281 0 (386) 267,980
2001, as restated
Net income 38,517 38,517
Other comprehensive income,
net of tax 31,270 31,270
Dividends declared:
Common, $0.56 per share (14,506) (14,506)
Common stock issued under
employee stock plan,
including tax benefits
of $219 151,484 151 1,273 353 1,777
- -----------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2002 25,957,108 $25,958 $66,079 $194,483 $38,551 $0 ($33) $325,038
Net income 40,380 40,380
Other comprehensive loss,
net of tax (2,593) (2,593)
Dividends declared:
Common, $0.61 per share (16,235) (16,235)
Common stock issued under
employee stock plan,
including tax benefits
of $1,410 495,322 495 5,913 (48) 6,360
Stock issued for acquisition 2,294,182 2,294 58,074 60,368
Treasury stock purchased (416,300) (8,490) (8,490)
- -----------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 28,330,312 $28,747 $130,066 $218,628 $35,958 ($8,490) ($81) $404,828
2003
Net income 50,196 50,196
Other comprehensive loss,
net of tax (1,758) (1,758)
Dividends declared:
Common, $0.68 per share (20,529) (20,529)
Common stock issued under
employee stock plan,
including tax benefits
of $3,165 702,766 703 8,576 (398) 8,881
Stock and options issued
for acquisition 2,592,213 2,592 52,127 54,719
Treasury stock purchased (983,700) (21,709) (21,709)
- -----------------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 2004 30,641,591 $32,042 $190,769 $248,295 $34,200 ($30,199) ($479) $474,628
===================================================================================================================================
The accompanying notes are an integral part of the consolidated financial
statements.
40
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In Thousands)
Years Ended December 31,
----------------------------------
2004 2003 2002
- ----------------------------------------------------------------------------------------------------------------
Other comprehensive (loss) income, before tax:
Change in minimum pension liability adjustment $ 0 $ 92 $ 4,919
Unrealized (losses) gains on securities:
Unrealized holding (losses) gains arising during period (3,031) (5,727) 49,796
Reclassification adjustment for (gains) losses included in net income (72) 54 (2,598)
- ----------------------------------------------------------------------------------------------------------------
Other comprehensive (loss) income, before tax (3,103) (5,581) 52,117
Income tax benefit (expense) related to other comprehensive (loss) income 1,345 2,988 (20,847)
- ----------------------------------------------------------------------------------------------------------------
Other comprehensive (loss) income, net of tax (1,758) (2,593) 31,270
Net income 50,196 40,380 38,517
- ----------------------------------------------------------------------------------------------------------------
Comprehensive income $ 48,438 $ 37,787 $ 69,787
================================================================================================================
The accompanying notes are an integral part of the consolidated financial
statements.
41
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands of Dollars, except Share Data)
Years Ended December 31,
-----------------------------------
2004 2003 2002
- ----------------------------------------------------------------------------------------------------------------------------------
Operating activities:
Net income $ 50,196 $ 40,380 $ 38,517
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation 8,025 7,139 6,596
Amortization of intangible assets 7,414 5,093 5,953
Net amortization of premiums and discounts on securities and loans 1,392 2,303 3,256
Amortization of unearned compensation and discount on subordinated debt 439 172 443
Provision for loan losses 8,750 11,195 12,222
Provision for deferred taxes 1,286 898 4,458
(Gain) loss on investment securities and debt extinguishments (72) 2,698 (1,673)
Loss (gain) on loans and other assets 211 350 (28)
Proceeds from the sale of loans held for sale 0 67,482 9,103
Origination of loans held for sale 0 (61,036) (14,858)
Change in other operating assets and liabilities 7,823 (3,604) (11,815)
- ----------------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 85,464 73,070 52,174
- ----------------------------------------------------------------------------------------------------------------------------------
Investing activities:
Proceeds from sales of available-for-sale investment securities 51,889 41,227 96,294
Proceeds from maturities of held-to-maturity investment securities 4,852 5,229 4,521
Proceeds from maturities of available-for-sale investment securities 127,222 242,614 197,928
Purchases of held-to-maturity investment securities (3,991) (133,517) (4,577)
Purchases of available-for-sale investment securities (395,252) (141,658) (383,598)
Net increase in loans outstanding (26,278) (151,520) (77,906)
Cash received (paid) for acquisition, net of cash (paid) acquired of ($7,023), $23,986, $0 21,939 (9,630) 0
Capital expenditures (7,377) (8,322) (8,831)
- ----------------------------------------------------------------------------------------------------------------------------------
Net cash used by investing activities (226,996) (155,577) (176,169)
- ----------------------------------------------------------------------------------------------------------------------------------
Financing activities:
Net change in demand deposits, NOW accounts, and savings accounts 25,068 39,745 25,005
Net change in time deposits (66,203) (68,220) (65,619)
Net change in federal funds purchased (23,100) 3,300 18,800
Net change in short-term borrowings 87,328 147,356 202,976
Change in long-term borrowings (net of payments of $177, $30,000 and $252,000) 168,865 (30,000) (37,000)
Issuance of common stock 5,344 4,819 1,151
Purchase of treasury stock (21,709) (8,490) 0
Cash dividends paid (19,543) (15,466) (14,228)
Other financing activities (96) (145) (113)
- ----------------------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 155,954 72,899 130,972
- ----------------------------------------------------------------------------------------------------------------------------------
Change in cash and cash equivalents 14,422 (9,608) 6,977
Cash and cash equivalents at beginning of year 103,923 113,531 106,554
- ----------------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of year $ 118,345 $ 103,923 $ 113,531
==================================================================================================================================
Supplemental disclosures of cash flow information:
Cash paid for interest $ 59,644 $ 60,062 $ 79,250
Cash paid for income taxes $ 9,422 $ 13,095 $ 6,429
Supplemental disclosures of non-cash financing and investing activities:
Dividends declared and unpaid $ 5,515 $ 4,529 $ 3,760
Gross change in unrealized gains on available-for-sale investment securities ($3,103) ($5,673) $ 47,198
Acquisitions:
Fair value of assets acquired, excluding acquired cash and intangibles $ 258,416 $ 260,902 $ 0
Fair value of liabilities assumed $ 268,611 $ 257,532 $ 0
Common stock and options issued $ 54,719 $ 60,368 $ 0
The accompanying notes are an integral part of the consolidated financial
statements.
42
COMMUNITY BANK SYSTEM, INC.
NOTE A: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations
Community Bank System, Inc. is a single bank holding company which wholly-owns
four consolidated subsidiaries: Community Bank, N.A. (the Bank), Benefit Plans
Administrative Services, Inc. (BPAS), CFSI Closeout Corp. (CFSICC), and First of
Jermyn Realty Co. (FJRC). BPAS owns two subsidiaries, Benefit Plans
Administrative Services LLC and Harbridge Consulting Group LLC. BPAS provides
administration, consulting and actuarial services to sponsors of employee
benefit plans. CFSICC and FJRC are inactive companies.
The Bank operates 125 customer facilities throughout 22 counties of Upstate New
York and five counties of Northeastern Pennsylvania. The Bank owns the following
subsidiaries: Community Investment Services, Inc. (CISI), CBNA Treasury
Management Corporation (TMC), CBNA Preferred Funding Corporation (PFC), Elias
Asset Management, Inc. (EAM) and First Liberty Service Corp. (FLSC). CISI
provides broker-dealer and investment advisory services. TMC operates the cash
management, investment, and treasury functions of the Bank. PFC primarily is an
investor in residential real estate loans. EAM provides asset management
services to individuals, corporate pension and profit sharing plans, and
foundations. FLSC provides banking-related services to the Pennsylvania branches
of the Bank.
The Company wholly-owns three unconsolidated subsidiary business trusts formed
for the purpose of issuing mandatorily redeemable preferred securities which are
considered Tier I capital under regulatory capital adequacy guidelines (see Note
H).
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries. All inter-company accounts and transactions have
been eliminated in consolidation. Certain prior period amounts have been
reclassified to conform with the current period presentation.
Critical Accounting Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
Critical accounting estimates include the allowance for loan losses, actuarial
assumptions associated with the pension, post-retirement and other employee
benefit plans, the provision for income taxes, and the carrying value of
goodwill and other intangible assets.
Risk and Uncertainties
In the normal course of its business, the Company encounters economic and
regulatory risks. There are three main components of economic risk: interest
rate risk, credit risk and market risk. The Company is subject to interest rate
risk to the degree that its interest-bearing liabilities mature or reprice at
different speeds, or on different basis, from its interest-earning assets. The
Company's primary credit risk is the risk of default on the Company's loan
portfolio that results from the borrowers' inability or unwillingness to make
contractually required payments. Market risk reflects potential changes in the
value of collateral underlying loans, the fair value of investment securities,
and loans held for sale.
The Company is subject to regulations of various governmental agencies. These
regulations can and do change significantly from period to period. The Company
also undergoes periodic examinations by the regulatory agencies which may
subject it to further changes with respect to asset valuations, amounts of
required loan loss allowances, and operating restrictions resulting from the
regulators' judgements based on information available to them at the time of
their examinations.
Revenue Recognition
The Company recognizes income on an accrual basis. CISI recognizes fee income
when investment and insurance products are sold to customers. EAM provides asset
management services to brokerage firms and clients and recognizes income ratably
over the contract period during which service is performed. Revenue from BPA's
administration and
43
recordkeeping services is recognized ratably over the service contract period.
Revenue from consulting and actuarial services is recognized when services are
rendered. All inter-company revenue and expense among related entities are
eliminated in consolidation.
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash on
hand, amounts due from banks and highly liquid investments with original
maturities of less than ninety days. The carrying amounts reported in the
balance sheet for cash and cash equivalents approximate those assets' fair
values.
Investment Securities
The Company has classified its investments in debt and equity securities as
held-to-maturity or available-for-sale. Held-to-maturity securities are those
for which the Company has the positive intent and ability to hold to maturity,
and are reported at cost, which is adjusted for amortization of premiums and
accretion of discounts. Securities not classified as held-to-maturity are
classified as available-for-sale and are reported at fair market value with net
unrealized gains and losses reflected as a separate component of shareholders'
equity, net of applicable income taxes. None of the Company's investment
securities has been classified as trading securities. Equity securities are
stated at cost and include restricted stock of the Federal Reserve Bank of New
York and Federal Home Loan Bank of New York. Investment securities are reviewed
regularly for other than temporary impairment. Where there is other than
temporary impairment, the carrying value of the investment security is reduced
to the estimated fair value, with the impairment loss recognized in the
consolidated statements of income as other expense.
The average cost method is used in determining the realized gains and losses on
sales of investment securities. Premiums and discounts on securities are
amortized and accreted, respectively, on a systematic basis over the period to
maturity, estimated life, or earliest call date of the related security.
Fair values for investment securities are based on quoted market prices, where
available. If quoted market prices are not available, fair values are based on
quoted market prices of comparable instruments.
Loans
Loans are stated at unpaid principal balances, net of unearned income. Mortgage
loans held for sale are carried at the lower of cost or fair value and are
included in loans as the balance of such loans was not significant. Fair values
for variable rate loans that reprice frequently are based on carrying values.
Fair values for fixed rate loans are estimated using discounted cash flows and
interest rates currently being offered for loans with similar terms to borrowers
of similar credit quality. The carrying amount of accrued interest approximates
its fair value.
Interest on loans is accrued and credited to operations based upon the principal
amount outstanding. Unearned discount on installment loans is recognized as
income over the term of the loan, principally by the interest method.
Non-refundable loan fees and related direct costs are included in the loan
balances and are deferred and amortized over the life of the loan as an
adjustment to loan yield using the effective interest method. Premiums and
discounts on purchased loans are amortized on an accelerated method over the
life of the loans.
Impaired and Other Nonaccrual Loans
The Company places a loan on nonaccrual status when the loan becomes ninety days
past due (or sooner, if management concludes collection is doubtful), except
when, in the opinion of management, it is well-collateralized and in the process
of collection. A loan may be placed on nonaccrual status earlier than ninety
days past due if there is deterioration in the financial position of the
borrower or if other conditions of the loan so warrant. When a loan is placed on
nonaccrual status, uncollected accrued interest is reversed against interest
income and the deferral and amortization of non-refundable loan fees and related
direct costs is discontinued. Interest income during the period the loan is on
nonaccrual status is recorded on a cash basis after recovery of principal is
reasonably assured. Nonaccrual loans are returned to accrual status when
management determines that the borrower's performance has improved and that both
principal and interest are collectible. This generally requires a sustained
period of timely principal and interest payments.
Commercial loans greater than $500,000 are evaluated individually for impairment
in accordance with FASB No. 114, "Accounting by Creditors for Impairment of a
Loan." A loan is considered impaired, based on current information and events,
if it is probable that the Company will be unable to collect the scheduled
payments of principal or interest when due according to the contractual terms of
the loan agreement. The measurement of impaired loans is generally based upon
the present value of expected future cash flows or the fair value of the
collateral, if the loan is collateral-dependent.
44
The Company's charge-off policy by loan type is as follows:
o Commercial loans are generally charged-off to the extent outstanding
principal exceeds the fair value of estimated proceeds from collection
efforts, including liquidation of collateral. The charge-off is recognized
when the loss becomes reasonably quantifiable.
o Consumer installment loans are generally charged-off to the extent
outstanding principal balance exceeds the fair value of collateral, and
are recognized by the end of the month in which the loan becomes 120 days
past due.
o Loans secured by 1-4 family residential real estate are generally
charged-off to the extent outstanding principal exceeds the fair value of
the property, and are recognized when the loan becomes 180 days past due.
Allowance for Loan Losses
Management continually evaluates the credit quality of the Company's loan
portfolio, and performs a formal review of the adequacy of the allowance for
loan losses on a quarterly basis. The allowance reflects management's best
estimate of probable losses inherent in the loan portfolio. Determination of the
allowance is subjective in nature and requires significant estimates. The
Company's allowance methodology consists of two broad components, general and
specific loan loss allocations.
The general loan loss allocation is composed of two calculations that are
computed on four main loan segments: commercial, consumer direct, consumer
indirect and residential real estate. The first calculation determines an
allowance level based on the latest three years of historical net charge-off
data for each loan category (commercial loans exclude balances with specific
loan loss allocations). The second calculation is qualitative and takes into
consideration five major factors affecting the level of loan loss risk:
portfolio risk migration patterns (internal credit quality trends); the growth
of the segments of the loan portfolio; economic and business environment trends
in the Company's markets (includes review of bankruptcy, unemployment,
population, consumer spending and regulatory trends); industry, geographical and
product concentrations in the portfolio; and the perceived effectiveness of
managerial resources and lending practices and policies. These two calculations
are added together to determine the general loan loss allocation. The specific
loan loss allocation relates to individual commercial loans that are both
greater than $0.5 million and in a non-accruing status with respect to interest.
Specific losses are based on discounted estimated cash flows, including any cash
flows resulting from the conversion of collateral.
Loan losses are charged off against the allowance, while recoveries of amounts
previously charged off are credited to the allowance. A provision for loan loss
is charged to operations based on management's periodic evaluation of factors
previously mentioned.
Intangible Assets
Intangible assets include core deposit intangibles, customer relationship
intangibles and goodwill arising from acquisitions. Core deposit intangibles and
customer relationship intangibles are amortized on either an accelerated or
straight-line basis over periods ranging from 7 to 20 years. Goodwill is
evaluated at least annually for impairment. The carrying value of goodwill and
other intangible assets is based upon discounted cash flow modeling techniques
that require management to make estimates regarding the amount and timing of
expected future cash flows. It also requires use of a discount rate that
reflects the current return requirements of the market in relation to present
risk-free interest rates, required equity market premiums, and company-specific
risk indicators.
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation.
Computer software costs that are capitalized only include external direct costs
of obtaining and installing the software. The annual provision for depreciation
is computed using the straight-line method over the assets' estimated useful
lives. Maintenance and repairs are charged to expense as incurred.
Long-lived depreciable assets are evaluated periodically for impairment when
events or changes in circumstances indicate the carrying amount may not be
recoverable. Impairment exists when the expected undiscounted future cash flows
of a long-lived asset are less than its carrying value. In that event, the
Company recognizes a loss for the difference between the carrying amount and the
estimated fair value of the asset based on a quoted market price, if applicable,
or a discounted cash flow analysis. Impairment losses are recorded in other
expenses on the income statement.
45
Other Real Estate
Properties acquired through foreclosure, or by deed in lieu of foreclosure, are
carried at the lower of the unpaid loan balance or fair value less estimated
costs of disposal. Subsequent changes in value are reported as adjustments to
the carrying amount, not to exceed the initial carrying value of the asset at
the time of transfer. Changes in value subsequent to transfer are recorded in
operating expenses on the income statement. Gains or losses not previously
recognized resulting from the sale of other real estate are recognized as an
expense on the date of sale. At December 31, 2004 and 2003, other real estate,
included in other assets, amounted to $1,645,000 and $1,077,000, respectively.
Mortgage Servicing Rights
Originated mortgage servicing rights are recorded at their allocated fair value
at the time of sale of the underlying loan, and are amortized in proportion to
and over the period of estimated net servicing income or loss. The Company uses
a valuation model that calculates the present value of future cash flows to
determine the fair value of servicing rights. In using this valuation method,
the Company incorporates assumptions that market participants would use in
estimating future net servicing income, which includes estimates of the
servicing cost per loan, the discount rate, and prepayment speeds. The carrying
value of the originated mortgage servicing rights is periodically evaluated for
impairment using these same market assumptions.
Deposits
The fair value of deposit obligations are based on current market rates for
alternative funding sources, principally the Federal Home Loan Bank of New York.
The carrying value of accrued interest approximates fair value.
Borrowings
The carrying amounts of federal funds purchased and short-term borrowings
approximate their fair values. Fair values for long-term borrowings are
estimated using discounted cash flows and interest rates currently being offered
on similar borrowings.
Since the Company considers debt extinguishments to be a component of its
interest rate risk management, any related gains or losses are not deemed
extraordinary and are presented in the non-interest income section of the
consolidated statements of income.
Treasury Stock
On June 9, 2003, the Company announced a twelve-month authorization to
repurchase up to 1,400,000 of its outstanding shares in open market or privately
negotiated transactions. As of December 31, 2004, the Company has repurchased
all of the shares at an aggregate cost of $30,199,000 or $21.57 per share. The
repurchases were for general corporate purposes, including those related to
acquisition and stock plan activities.
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.
Retirement Benefits
The Company provides defined benefit pension benefits and post-retirement health
and life insurance benefits to eligible employees. The Company also provides
deferred compensation and supplemental executive retirement plans for selected
current and former employees and officers. Expense under these plans is charged
to current operations and consists of several components of net periodic benefit
cost based on various actuarial assumptions regarding future experience under
the plans, including discount rate, rate of future compensation increases and
expected return on plan assets.
Assets Under Management or Administration
Assets held in fiduciary or agency capacities for customers are not included in
the accompanying consolidated statements of condition as they are not assets of
the Company. Substantially all fees associated with providing asset management
services are recorded on an accrual basis of accounting and are included in
non-interest income. Assets
46
under management or administration at December 31, 2004 and 2003 were
$2,102,000,000 and $1,807,000,000, respectively.
Earnings Per Share
Basic earnings per share are computed based on the weighted-average common
shares outstanding for the period. Diluted earnings per share are based on the
weighted-average shares outstanding adjusted for the dilutive effect of the
assumed exercise of stock options during the year. The dilutive effect of
options is calculated using the treasury stock method of accounting. The
treasury stock method determines the number of common shares that would be
outstanding if all the dilutive options (average market price is greater than
the exercise price) were exercised and the proceeds were used to repurchase
common shares in the open market at the average market price for the applicable
time period.
At a special meeting of the shareholders held on March 26, 2004, the
shareholders approved an amendment to the certificate of incorporation of the
Company to increase the number of authorized shares of common stock to 50
million. This amendment was effected in connection with the previously announced
two-for-one stock split of the Company's common stock. The stock split was
effected in the form of a 100 percent stock dividend, and was paid on April 12,
2004 to shareholders of record on March 17, 2004. Accordingly, all share, option
and per-share amounts have been adjusted in the consolidated financial
statements to reflect the stock split.
Stock-Based Compensation
The Company accounts for stock-based awards issued to directors, officers and
key employees using the intrinsic value method. This method requires that
compensation expense be recognized to the extent that the fair value of the
underlying stock exceeds the exercise price of the stock award at the grant
date. The Company generally does not recognize compensation expense related to
stock awards because the stock awards generally have fixed terms and exercise
prices that are equal to or greater than the fair value of the Company's common
stock at the grant date.
SFAS 123, "Accounting for Stock-Based Compensation," requires companies that use
the "intrinsic value method" to account for stock compensation plans to provide
pro forma disclosures of the net income and earnings per share effect of stock
options using the "fair value method." Under this method, the fair value of the
option on the date of grant is recognized ratably as compensation expense over
the vesting period of the option.
Management estimated the fair value of options granted using the Black-Scholes
option-pricing model. This model was originally developed to estimate the fair
value of exchange-traded equity options, which (unlike employee stock options)
have no vesting period or transferability restrictions. As a result, the
Black-Scholes model is not necessarily a precise indicator of the value of an
option, but it is commonly used for this purpose. The Black-Scholes model
requires several assumptions, which management developed based on historical
trends and current market observations. These assumptions include:
2004 2003 2002
- ----------------------------------------------------------------------------------------
Weighted-average expected life (in years) 7.33-7.43 7.55-8.76 6.74
Future dividend yield 3.00% 3.00% 3.00%
Share price volatility 26.88%-27.02% 25.59%-27.58% 27.82%
Weighted average risk-free interest rate 4.02%-4.45% 3.82%-4.03% 3.81%-5.16%
========================================================================================
If these assumptions are not accurate, the estimated fair value used to derive
the information presented in the following table also will be inaccurate.
Moreover, the model assumes that the estimated fair value of an option is
amortized over the option's vesting period and would be included in salaries and
employee benefits on the income statement.
47
The pro forma impact of applying the fair value method of accounting for the
periods shown below may not be indicative of the pro forma impact in future
years.
(000's omitted except per share amounts) 2004 2003 2002
- ------------------------------------------------------------------------------------------------------------------
Net income, as reported $50,196 $40,380 $38,517
Stock-based compensation expense included in net income, as reported 228 64 216
Stock-based compensation expense determined under fair value method, net of tax (886) (738) (555)
- ------------------------------------------------------------------------------------------------------------------
Pro forma net income $49,538 $39,706 $38,178
==================================================================================================================
Earnings per share:
As reported:
Basic $ 1.68 $ 1.54 $ 1.48
Diluted $ 1.64 $ 1.49 $ 1.46
Pro forma:
Basic $ 1.66 $ 1.51 $ 1.47
Diluted $ 1.61 $ 1.47 $ 1.45
Fair Values of Financial Instruments
The Company determines fair values based on quoted market values where available
or on estimates using present values or other valuation techniques. Those
techniques are significantly affected by the assumptions used, including the
discount rate and estimates of future cash flows. In that regard, the derived
fair value estimates cannot be substantiated by comparison to independent
markets and, in many cases, could not be realized in immediate settlement of the
instrument. SFAS 107, "Disclosures about Fair Value of Financial Instruments,"
excludes certain financial instruments and all non-financial instruments from
its disclosure requirements. Accordingly, the aggregate fair value amounts
presented do not represent the underlying value of the Company. The fair values
of investment securities, loans, deposits, and borrowings have been disclosed in
footnotes C, D, G, and H, respectively.
New Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board revised SFAS No. 123,
"Accounting for Stock-Based Compensation." SFAS 123R establishes accounting
requirements for share-based compensation to employees and carries forward prior
guidance on accounting for awards to non-employees. The provisions of this
statement will become effective July 1, 2005 for all equity awards granted after
the effective date. SFAS 123R requires an entity to recognize compensation
expense based on an estimate of the number of awards expected to actually vest,
exclusive of awards expected to be forfeited. Management does not expect the
impact of the adoption of this pronouncement to be materially different from the
pro forma impacts disclosed under SFAS No. 123.
NOTE B: ACQUISITIONS
Dansville Branch Acquisition
On December 3, 2004, the Company completed the purchase of a branch office in
Dansville, N.Y. from HSBC Bank USA, N.A with deposits of $32.6 million.
First Heritage Bank
On May 14, 2004, the Company acquired First Heritage Bank ("Heritage"), a
closely held bank headquartered in Wilkes-Barre, PA with three branches in
Luzerne County, Pennsylvania. First Heritage's three branches operate as part of
First Liberty Bank & Trust, a division of Community Bank, N.A. Consideration
included 2,592,213 shares of common stock with a fair value of $52 million,
employee stock options with a fair value of $3.0 million, and $7.0 million of
cash (including capitalized acquisition costs of $1.0 million).
Grange National Banc Corp.
On November 24, 2003, the Company acquired Grange National Banc Corp.
("Grange"), a $280 million-asset bank holding company based in Tunkhannock, Pa.
Grange's 12 branches operate as part of First Liberty Bank & Trust, a division
of Community Bank, N.A. The Company issued 2,294,182 shares of its common stock
to certain of the former shareholders at a cost of $23.97 per share. The
remaining shareholders received $21.25 in cash or approximately $20.9 million.
In addition, Grange stock options representing $5.4 million of fair value were
exchanged for options of the Company.
48
Peoples Bankcorp Inc.
On September 5, 2003, the Company acquired Peoples Bankcorp, Inc. ("Peoples"), a
$29-million-asset savings and loan holding company based in Ogdensburg, New
York. Peoples' single branch is being operated as a branch of the Bank's network
of branches in Northern New York.
Harbridge Consulting Group
On July 31, 2003, the Company acquired PricewaterhouseCoopers' Upstate New York
Global Human Resource Solutions consulting group. This practice was renamed
Harbridge Consulting Group ("Harbridge") and is a leading provider of retirement
and employee benefits consulting services throughout Upstate New York, and is
complementary to Benefit Plans Administrative Services, LLC., the Company's
defined contribution plan administration subsidiary.
Acquisition Expenses
The Company incurred certain expenses in connection with the above acquisitions.
The following table shows the components of acquisition expenses that are
presented in the consolidated statements of income for the years ended December
31:
(000's omitted) 2004 2003 2002
- --------------------------------------------------------------------------------
Severance and employee benefits $1,044 $ 0 $ 97
Legal and professional fees 491 213 455
Data processing 130 191 16
Other 39 94 132
- --------------------------------------------------------------------------------
Total $1,704 $498 $700
================================================================================
NOTE C: INVESTMENT SECURITIES
The amortized cost and estimated fair value of investment securities as of
December 31 are as follows:
2004 2003
---------------------------------------------- ----------------------------------------------
Gross Gross Estimated Gross Gross Estimated
Amortized Unrealized Unrealized Fair Amortized Unrealized Unrealized Fair
(000's omitted) Cost Gains Losses Value Cost Gains Losses Value
- --------------------------- ---------------------------------------------- ----------------------------------------------
Held-to-Maturity Portfolio:
U.S. treasury and agency
securities $ 127,490 $ 356 $1,940 $ 125,906 $ 127,635 $ 235 $2,867 $ 125,003
Obligations of state and
political subdivisions 6,576 120 2 6,694 7,459 218 0 7,677
Other securities 3,578 0 0 3,578 3,558 0 0 3,558
- --------------------------- ---------------------------------------------- ----------------------------------------------
Total held-to-maturity
portfolio 137,644 476 1,942 136,178 138,652 453 2,867 136,238
Available-for-Sale
Portfolio:
U.S. treasury and agency
securities 630,058 20,917 208 650,767 456,913 22,638 97 479,454
Obligations of state and
political subdivisions 545,698 27,899 46 573,551 443,930 26,291 11 470,210
Corporate securities 40,443 3,460 5 43,898 27,712 2,539 0 30,251
Collateralized mortgage
obligations 70,986 1,680 222 72,444 89,566 3,987 1 93,552
Mortgage-backed securities 50,347 2,351 34 52,664 76,628 3,668 119 80,177
- --------------------------- ---------------------------------------------- ----------------------------------------------
Sub-total 1,337,532 56,307 515 1,393,324 1,094,749 59,123 228 1,153,644
Equity securities 53,371 0 0 53,371 37,238 0 0 37,238
- --------------------------- ---------------------------------------------- ----------------------------------------------
Total available-for-sale
portfolio 1,390,903 $56,307 $ 515 $1,446,695 1,131,987 $59,123 $ 228 $1,190,882
Net unrealized gain on
available-for-sale
portfolio 55,792 0 58,895 0
- --------------------------- ---------- ---------- ---------- ----------
Total $1,584,339 $1,582,873 $1,329,534 $1,327,120
=========================== ========== ========== ========== ==========
49
A summary of investment securities as of December 31, 2004 that have been in a
continuous unrealized loss position for less than or greater than twelve months
is as follows:
Less than 12 Months 12 Months or Longer Total
--------------------- -------------------- --------------------
Gross Gross Gross
Fair Unrealized Fair Unrealized Fair Unrealized
(000's omitted) Value Losses Value Losses Value Losses
- ------------------------------------- --------------------- -------------------- --------------------
Held-to-Maturity Portfolio:
U.S. treasury and agency securities $0 $0 $88,060 ($1,940) 88,060 (1,940)
Obligations of state and political
subdivisions 1,567 (2) 0 0 1,567 (2)
- ------------------------------------- --------------------- -------------------- --------------------
Total held-to-maturity portfolio $1,567 ($2) $88,060 ($1,940) $89,627 ($1,942)
===================================== ===================== ==================== ====================
Available-for-Sale Portfolio:
U.S. treasury and agency securities $22,633 ($208) $0 $0 $22,633 ($208)
Obligations of state and political
subdivisions 7,731 (46) 0 0 7,731 (46)
Corporate securities 1,061 (5) 0 0 1,061 (5)
Collateralized mortgage obligations 7,915 (222) 0 0 7,915 (222)
Mortgage-backed securities 950 (17) 1,197 (17) 2,147 (34)
- ------------------------------------- --------------------- -------------------- --------------------
Total available-for-sale portfolio $40,290 ($498) $1,197 ($17) $41,487 ($515)
===================================== ===================== ==================== ====================
Management does not believe any individual unrealized loss as of December 31,
2004 represents an other than temporary impairment. The unrealized losses
reported for the agency and mortgage-backed securities relate primarily to
securities issued by FHLB, FNMA and FHLMC and are currently rated AAA by Moody's
Investor Services and Standards & Poor. The unrealized losses in the portfolios
are primarily attributable to changes in interest rates. The Company has both
the intent and ability to hold these securities for the time necessary to
recover the amortized cost. The unrealized losses of $3,095,000 as of December
31, 2003 were less than 12 months old.
The amortized cost and estimated fair value of debt securities at December 31,
2004, by contractual maturity, are shown below. Expected maturities will differ
from contractual maturities because borrowers may have the right to call or
prepay obligations with or without call or prepayment penalties.
Held-to-Maturity Available-for-Sale
------------------------ ------------------------
Carrying Fair Carrying Fair
(000's omitted) Value Value Value Value
- -------------------------------------- ------------------------ ------------------------
Due in one year or less $ 4,387 $ 4,395 $ 5,263 $ 5,414
Due after one through five years 1,959 2,044 55,927 57,916
Due after five years through ten years 99,596 98,533 712,168 736,972
Due after ten years 31,702 31,206 442,841 467,914
- -------------------------------------- ------------------------ ------------------------
Sub-total 137,644 136,178 1,216,199 1,268,216
Collateralized mortgage obligations 0 0 70,986 72,444
Mortgage-backed securities 0 0 50,347 52,664
- -------------------------------------- ------------------------ ------------------------
Total $ 137,644 $ 136,178 $1,337,532 $1,393,324
====================================== ======================== ========================
Cash flow information on investment securities for the years ended December 31
is as follows:
(000's omitted) 2004 2003 2002
- --------------------------------------------------------------------------------------------------------
Proceeds from the sales of investment securities $ 51,889 $ 41,227 $ 96,294
Gross gains on sales of investment securities 187 11 2,593
Gross losses on sales of investment securities 115 65 0
Proceeds from the sales of mortgage-backed securities and CMO's 3,679 20,823 56,451
Proceeds from the maturities of mortgage-backed securities and CMO's 51,652 204,746 174,524
Purchases of mortgage-backed securities and CMO's $ 10,915 $ 27,092 $ 25,664
Investment securities with a carrying value of $699,806,000 and $563,341,000 at
December 31, 2004 and 2003, respectively, were pledged to collateralize certain
deposits and borrowings.
50
NOTE D: LOANS
Major classifications of loans at December 31 are summarized as follows:
(000's omitted) 2004 2003
- --------------------------------------------------------------------------------
Consumer mortgage $ 801,412 $ 739,593
Business lending 831,244 689,436
Consumer direct and indirect 725,885 699,562
- --------------------------------------------------------------------------------
Gross loans 2,358,541 2,128,591
Unearned discount 48 82
- --------------------------------------------------------------------------------
Net loans 2,358,493 2,128,509
Allowance for loan losses 31,778 29,095
- --------------------------------------------------------------------------------
Loans, net of allowance for loan losses $2,326,715 $2,099,414
================================================================================
The estimated fair value of loans at December 31, 2004 and 2003 was $2.4 billion
and $2.1 billion, respectively. Non-accrual loans of $11,798,000 and $11,940,000
and accruing loans ninety days past due of $1,158,000 and $1,307,000 at December
31, 2004 and 2003, respectively, are included in net loans.
Changes in loans to directors and officers and other related parties for the
years ended December 31 are summarized as follows:
(000's omitted) 2004 2003
- -------------------------------------------------------------------------------
Balance at beginning of year $ 14,838 $ 15,735
New loans 9,796 3,313
Payments (1,481) (4,210)
- -------------------------------------------------------------------------------
Balance at end of year $ 23,153 $ 14,838
===============================================================================
Mortgage loans serviced for others are not included in the accompanying
consolidated statements of condition. The unpaid principal balances of mortgage
loans serviced for others were $107,155,000, $126,324,000, and $103,663,000 at
December 31, 2004, 2003, and 2002, respectively. Custodial escrow balances
maintained in connection with the foregoing loan servicing, and included in
demand deposits, were approximately and $813,000 and $773,000 at December 31,
2004 and 2003, respectively. At December 31, 2004 and 2003, mortgage servicing
rights, included in other assets, amounted to $459,000 and $456,000
respectively.
Changes in the allowance for loan losses for the years ended December 31 are
summarized as follows:
(000's omitted) 2004 2003 2002
- -------------------------------------------------------------------------------
Balance at beginning of year $ 29,095 $ 26,331 $ 23,901
Provision for loan losses 8,750 11,195 12,222
Reserve on acquired loans 2,357 1,832 0
Charge offs (11,780) (13,111) (12,015)
Recoveries 3,356 2,848 2,223
- -------------------------------------------------------------------------------
Balance at end of year $ 31,778 $ 29,095 $ 26,331
===============================================================================
As of December 31, 2004 and 2003, the Company had impaired loans of $2,271,000
and $5,682,000, respectively. The specifically allocated allowance for loan loss
recognized on these impaired loans was $900,000 and $1,825,000 at December 31,
2004 and 2003, respectively. For the years ended December 31, 2004 and 2003 the
Company had average impaired loans of $2,399,000 and $7,100,000. There was no
interest income recognized on these loans in 2004 or 2003.
51
NOTE E: PREMISES AND EQUIPMENT
Premises and equipment consist of the following at December 31:
(000's omitted) 2004 2003
- -------------------------------------------------------------------------------
Land and land improvements $ 9,340 $ 8,616
Bank premises owned 57,519 53,560
Equipment and construction in progress 46,010 42,146
- -------------------------------------------------------------------------------
Premises and equipment, gross 112,869 104,322
Less: Accumulated depreciation (49,359) (42,617)
- -------------------------------------------------------------------------------
Premises and equipment, net $ 63,510 $ 61,705
===============================================================================
NOTE F: INTANGIBLE ASSETS
The gross carrying amount and accumulated amortization for each type of
intangible asset are as follows:
As of December 31, 2004 As of December 31, 2003
--------------------------------------- ---------------------------------------
Gross Net Gross Net
Carrying Accumulated Carrying Carrying Accumulated Carrying
(000's omitted) Amount Amortization Amount Amount Amortization Amount
- --------------------------------- --------------------------------------- ---------------------------------------
Amortizing intangible assets:
Core deposit intangibles $63,691 ($28,340) $35,351 $55,455 ($21,457) $33,998
Other intangibles 2,750 (764) 1,986 2,750 (233) 2,517
- --------------------------------- --------------------------------------- ---------------------------------------
Total amortizing intangibles 66,441 (29,104) 37,337 58,205 (21,690) 36,515
Non-amortizing intangible assets:
Goodwill 195,163 0 195,163 159,596 0 159,596
- --------------------------------- --------------------------------------- ---------------------------------------
Total intangible assets, net $261,604 ($29,104) $232,500 $217,801 ($21,690) $196,111
================================= ======================================= =======================================
The increases in the gross carrying amount of core deposit intangibles and
goodwill relate to the 2004 acquisition of First Heritage Bank ($30,946,000 in
goodwill), a branch acquisition in Dansville, NY ($4,191,000 in goodwill) and
$430,000 of goodwill adjustments mainly related to adjusting certain real
property from the 2003 acquisitions to fair value. No goodwill impairment
adjustments were recognized in 2004 and 2003.
The estimated aggregate amortization expense for each of the five succeeding
fiscal years ended December 31 is as follows:
2005 $ 7,243
2006 6,047
2007 5,657
2008 5,335
2009 4,836
Thereafter 8,219
- --------------------------------------------------------------------------
Total $37,337
==========================================================================
NOTE G: DEPOSITS
Deposits consist of the following at December 31:
(000's omitted) 2004 2003
- --------------------------------------------------------------------------------
Demand $ 567,106 $ 498,195
Interest checking 313,639 294,563
Savings 536,460 470,166
Money market 321,461 288,212
Time 1,190,312 1,174,352
- --------------------------------------------------------------------------------
Total deposits $2,928,978 $2,725,488
================================================================================
52
The estimated fair value of deposits at December 31, 2004 and 2003 was
approximately $2.7 billion and $2.5 billion, respectively.
At December 31, 2004 and 2003, time certificates of deposit in denominations of
$100,000 and greater totaled $179,534,000 and $168,241,000 respectively. The
approximate maturities of time deposits at December 31, 2004 are as follows:
(000's omitted) Amount
- --------------------------------------------------------------------------------
2005 $ 920,488
2006 132,051
2007 78,405
2008 30,727
2009 28,053
Thereafter 588
- --------------------------------------------------------------------------------
Total $1,190,312
================================================================================
NOTE H: BORROWINGS
Outstanding borrowings at December 31 are as follows:
(000's omitted) 2004 2003
- ---------------------------------------------------------------------------------------
Short-term borrowings:
Federal funds purchased $ 13,200 $ 36,300
Federal Home Loan Bank advances 636,000 361,000
Commercial loans sold with recourse 74 0
Capital lease obligations 0 96
- ---------------------------------------------------------------------------------------
Total short-term borrowings 649,274 397,396
Long-term borrowings:
Federal Home Loan Bank advances 190,000 190,000
Commercial loans sold with recourse 791 0
Subordinated debt held by unconsolidated subsidiary trusts,
net of discount of $1,463 and $1,519 80,446 80,390
- ---------------------------------------------------------------------------------------
Total long-term borrowings 271,237 270,390
- ---------------------------------------------------------------------------------------
Total borrowings $920,511 $667,786
=======================================================================================
The weighted-average interest rates on short-term borrowings for the years ended
December 31, 2004 and 2003 were 1.64% and 1.26%, respectively. Federal Home Loan
Bank advances are collateralized by a blanket lien on the Company's residential
real estate loan portfolio and various investment securities.
53
Long-term borrowings at December 31, 2004 have maturity dates as follows:
Weighted
(000's omitted, except rate) Amount Average Rate
- --------------------------------------------------------------------------------
October 3, 2007 $ 236 3.00%
January 23, 2008 (callable) 10,000 5.44%
January 28, 2008 (callable) 5,000 5.48%
April 14, 2010 (callable) 25,000 6.35%
September 27, 2010 (callable) 50,000 5.88%
October 12, 2010 (callable) 50,000 5.84%
November 1, 2010 (callable) 50,000 5.77%
October 30, 2012 258 3.00%
October 16, 2013 193 3.00%
November 23, 2014 56 2.75%
November 29, 2014 48 3.00%
February 3, 2027 (callable) 30,779 9.75%
July 16, 2031 (callable) 25,110 5.38%
July 31, 2031 (callable) 24,557 5.12%
- --------------------------------------------------------------------------------
Total $271,237 6.19%
================================================================================
The estimated fair value of long-term borrowings at December 31, 2004 and 2003
was approximately $319.0 million and $314.0 million, respectively.
In December 2003, the Company prepaid $25.0 million of Federal Home Loan Bank
("FHLB") advances with maturity dates ranging from January 30, 2008 to February
4, 2008 and a weighted-average rate of 5.31%. In December 2002, the Company
prepaid $11.0 million of FHLB advances with maturity dates ranging from December
15, 2003 to December 31, 2004 and a weighted-average rate of 6.17%. As a result
of these prepayments, the Company incurred penalties of $2.6 million in 2003 and
$925,000 in 2002. These penalties have been reflected in the consolidated
statements of income as gain (loss) on investment securities and debt
extinguishments.
The Company sponsors three business trusts, Community Capital Trust I, Community
Capital Trust II, and Community Statutory Trust III, of which 100% of the common
stock is owned by the Company. The trusts were formed for the purpose of issuing
company-obligated mandatorily redeemable preferred securities to third-party
investors and investing the proceeds from the sale of such preferred securities
solely in junior subordinated debt securities of the Company. The debentures
held by each trust are the sole assets of that trust. Distributions on the
preferred securities issued by each trust are payable semi-annually at a rate
per annum equal to the interest rate being earned by the trust on the debentures
held by that trust. The preferred securities are subject to mandatory
redemption, in whole or in part, upon repayment of the debentures. The Company
has entered into agreements which, taken collectively, fully and unconditionally
guarantee the preferred securities subject to the terms of each of the
guarantees. The terms of the preferred securities of each trust are as follows:
Issuance Interest Maturity Call Call
Date Amount Rate Date Provision Price
- ------------------------------------------------------------------------------------------------------------------------------------
I 2/3/1997 30,000 9.75% 2/03/2027 10 year beginning 2007 104.5400% declining to par in 2017
II 7/16/2001 25,000 6 month LIBOR plus 3.75% (5.74%) 7/16/2031 5 year beginning 2006 107.6875% declining to par in 2011
III 7/31/2001 24,450 3 month LIBOR plus 3.58% (5.74%) 7/31/2031 5 year beginning 2006 107.5000% declining to par in 2011
====================================================================================================================================
In the fourth quarter 2003, as a result of applying the provisions of FIN 46,
the Company de-consolidated these subsidiary trusts from its financial
statements. The de-consolidation of the net assets and results of operations of
the trusts had an immaterial impact on the Company's financial statements. The
Company continues to be obligated to repay the debentures held by the trusts and
guarantees repayment of the preferred securities issued by the trusts. The
preferred securities held by the trusts qualify as Tier I capital for the
Company under Federal Reserve Board guidelines.
54
NOTE I: INCOME TAXES
The provision for income taxes for the years ended December 31 is as follows:
(000's omitted) 2004 2003 2002
- --------------------------------------------------------------------------------
Current:
Federal $14,677 $11,534 $ 9,268
State 680 341 161
Deferred:
Federal 1,229 758 3,764
State 57 140 694
- --------------------------------------------------------------------------------
Total income taxes $16,643 $12,773 $13,887
================================================================================
Components of the net deferred tax liability, included in other
assets/liabilities, as of December 31 are as follows:
(000's omitted) 2004 2003
- -------------------------------------------------------------------------------
Allowance for loan losses $ 10,644 $ 10,537
Employee and director benefits 2,599 2,118
Other 1,478 1,501
- -------------------------------------------------------------------------------
Deferred tax asset 14,721 14,156
- -------------------------------------------------------------------------------
Investment securities 23,273 24,216
Intangible assets 8,145 4,910
Loan origination costs 3,998 3,324
Depreciation 5,264 3,526
Pension 531 1,586
Mortgage servicing rights 177 178
- -------------------------------------------------------------------------------
Deferred tax liability 41,388 37,740
- -------------------------------------------------------------------------------
Net deferred tax liability ($26,667) ($23,584)
===============================================================================
The Company has determined that no valuation allowance is necessary as it is
more likely than not that deferred tax assets will be realized through carryback
of future deductions to taxable income in prior years, future reversals of
existing temporary differences, and through future taxable income.
A reconciliation of the differences between the federal statutory income tax
rate and the effective tax rate for the years ended December 31 is shown in the
following table:
2004 2003 2002
- ------------------------------------------------------------------------------
Federal statutory income tax rate 35.0% 35.0% 35.0%
Increase (reduction) in taxes resulting from:
Tax-exempt interest (11.3%) (11.2%) (9.9%)
State income taxes, net of federal benefit 0.6% 0.1% 0.6%
Other 0.6% 0.1% 0.8%
- ------------------------------------------------------------------------------
Effective income tax rate 24.9% 24.0% 26.5%
==============================================================================
55
NOTE J: LIMITS ON DIVIDENDS AND OTHER REVENUE SOURCES
The Company's ability to pay dividends to its shareholders is largely dependent
on the Bank's ability to pay dividends to the Company. In addition to state law
requirements and the capital requirements discussed below, the circumstances
under which the Bank may pay dividends are limited by federal statutes,
regulations, and policies. For example, as a national bank, the Bank must obtain
the approval of the Office of the Comptroller of the Currency (OCC) for payments
of dividends if the total of all dividends declared in any calendar year would
exceed the total of the Bank's net profits, as defined by applicable
regulations, for that year, combined with its retained net profits for the
preceding two years. Furthermore, the Bank may not pay a dividend in an amount
greater than its undivided profits then on hand after deducting its losses and
bad debts, as defined by applicable regulations. At December 31, 2004, the Bank
had approximately $27,758,000 in undivided profits legally available for the
payments of dividends.
In addition, the Federal Reserve Board and the OCC are authorized to determine
under certain circumstances that the payment of dividends would be an unsafe or
unsound practice and to prohibit payment of such dividends. The Federal Reserve
Board has indicated that banking organizations should generally pay dividends
only out of current operating earnings.
There are also statutory limits on the transfer of funds to the Company by its
banking subsidiary, whether in the form of loans or other extensions of credit,
investments or assets purchases. Such transfer by the Bank to the Company
generally is limited in amount to 10% of the Bank's capital and surplus, or 20%
in the aggregate. Furthermore, such loans and extensions of credit are required
to be collateralized in specific amounts.
NOTE K: BENEFIT PLANS
Pension and post-retirement plans
The Company provides defined benefit pension and other post-retirement health
and life insurance benefits to qualified employees and retirees. Using a
measurement date of December 31, the following table shows the funded status of
the Company's plans reconciled with amounts reported in the Company's
consolidated statements of condition:
Pension Benefits Post-retirement Benefits
---------------------- ------------------------
(000's omitted) 2004 2003 2004 2003
- ------------------------------------------------ ---------------------- ----------------------
Change in benefit obligation:
Benefit obligation at the beginning of year $ 42,739 $ 34,864 $ 5,083 $ 4,159
Service cost 2,557 1,831 311 275
Interest cost 2,433 2,157 325 260
Participant contributions 0 0 227 186
Plan amendment/acquisition (881) 493 95 220
Other loss 0 1,218 0 0
Deferred actuarial loss 2,209 3,521 902 391
Benefits paid (1,444) (1,345) (573) (408)
- ------------------------------------------------ ---------------------- ----------------------
Benefit obligation at end of year 47,613 42,739 6,370 5,083
- ------------------------------------------------ ---------------------- ----------------------
Change in plan assets:
Fair value of plan assets at beginning of year 36,784 29,133 0 0
Actual return of plan assets 3,907 6,815 0 0
Participant contributions 0 0 227 186
Employer contributions 2,500 2,181 346 222
Benefits paid (1,444) (1,345) (573) (408)
- ------------------------------------------------ ---------------------- ----------------------
Fair value of plan assets at end of year 41,747 36,784 0 0
- ------------------------------------------------ ---------------------- ----------------------
Unfunded status (5,866) (5,955) (6,370) (5,083)
Unrecognized actuarial loss 14,454 14,057 1,480 615
Unrecognized prior service (benefit) cost (783) 899 331 361
Unrecognized transition liability 0 0 328 369
- ------------------------------------------------ ---------------------- ----------------------
Prepaid (accrued) benefit cost $ 7,805 $ 9,001 ($ 4,231) ($ 3,738)
================================================ ====================== ======================
In 2004, the Company amended its defined benefit pension plan to allow for a
cash balance option. Participants in the plan as of December 31, 2003 were given
an option to continue to have their benefits calculated under the traditional
56
plan formula or have their benefits determined as an account balance under a
cash balance formula. All new participants to the plan will automatically
participate in the cash balance option. In addition, the plan was amended to
provide for the payment of certain benefits formerly accrued and payable under
the Deferred Compensation Plan for Certain Executive Employees.
The Company has unfunded supplemental pension plans for certain key executives.
The projected benefit obligation and accrued benefit cost included in the
preceding table related to these plans was $3,128,000 and $2,798,000 for 2004
and $2,606,000 and $2,245,000 for 2003, respectively. The accumulated benefit
obligation for the defined benefit pension was $40,659,000 and $35,025,000 as of
December 31, 2004 and 2003, respectively.
The weighted-average assumptions used to determine the benefit obligations as of
December 31 are as follows:
Pension Benefits Post-retirement Benefits
---------------- ------------------------
2004 2003 2004 2003
- ------------------------------ ---------------- ------------------------
Discount rate 5.60% 5.90% 5.60% 5.90%
Expected return on plan assets 8.75% 8.75% 0.00% 0.00%
Rate of compensation increase 4.00% 4.00% 0.00% 0.00%
============================== ================ ========================
The net periodic benefit cost as of December 31 is as follows:
Pension Benefits Post-retirement Benefits
------------------------------- -----------------------------
(000's omitted) 2004 2003 2002 2004 2003 2002
- ---------------------------------- ------------------------------- -----------------------------
Service cost $ 2,557 $ 1,831 $ 1,415 $ 311 $ 275 $ 159
Interest cost 2,433 2,157 1,926 325 260 241
Expected return on plan assets (3,160) (2,567) (2,268) 0 0 0
Net amortization and deferral 1,066 1,142 403 37 8 0
Amortization of prior service cost 155 129 131 30 30 30
Amortization of transition (asset)
obligation 0 (4) (19) 41 41 41
Other expense 0 1,218 0 0 0 0
- ---------------------------------- ------------------------------- -----------------------------
Net periodic benefit cost $ 3,051 $ 3,906 $ 1,588 $ 744 $ 614 $ 471
================================== =============================== =============================
Other expense represents a $1.2 million adjustment recorded in the fourth
quarter of 2003 to reflect the proper actuarial impact of indexing salary levels
associated with certain benefits frozen in 1988. The weighted-average
assumptions used to determine the net periodic pension cost for the years ended
December 31 are as follows:
Pension Benefits Post-retirement Benefits
-------------------- ------------------------
2004 2003 2002 2004 2003 2002
- ------------------------------ -------------------- --------------------
Discount rate 5.90% 6.10% 6.75% 5.90% 6.10% 6.75%
Expected return on plan assets 8.75% 9.00% 9.00% 0.00% 0.00% 0.00%
Rate of compensation increase 4.00% 4.00% 4.00% 0.00% 0.00% 0.00%
============================== ==================== ====================
The amount of benefit payments that are expected to be paid over the next ten
years are as follows:
Pension Post-retirement
(000's omitted) Benefits Benefits
- --------------------------------------------------------------------------------
2005 $ 2,866 $ 289
2006 2,666 308
2007 3,278 332
2008 4,607 350
2009 3,302 383
2010-2014 $21,541 $ 2,577
================================================================================
The payments reflect future service and are based on various assumptions
including retirement age and form of payment (lump-sum versus annuity). Actual
results may differ from these estimates.
57
The expected long-term rate of return was estimated by taking into consideration
asset allocation, reviewing historical returns on type of assets held and
current economic factors. The asset allocation for the defined benefit pension
plan as of December 31, by asset category, is as follows:
2004 2003
- -------------------------------------------------------------------------------
Equity securities 69% 70%
Debt securities 19% 20%
Cash 12% 10%
- -------------------------------------------------------------------------------
Total 100% 100%
===============================================================================
Plan assets include $2,571,000 (6%) and $2,230,000 (6%) of Community Bank
System, Inc. stock at December 31, 2004 and 2003, respectively.
The investment objective for the defined benefit pension plan is to achieve an
average annual total return over a five-year period equal to the assumed rate of
return used in the actuarial calculations. At a minimum performance level, the
portfolio should earn the return obtainable on high quality intermediate-term
bonds. The Company's perspective regarding portfolio assets combines both
preservation of capital and moderate risk-taking. Asset allocation favors
equities, with a target allocation of approximately 75% equity securities, 20%
fixed income securities and 5% cash. No more than 10% of the portfolio can be in
stock of the Company. Due to the volatility in the market, the target allocation
is not always desirable and asset allocations will fluctuate between acceptable
ranges. Prohibited transactions include purchase of securities on margin,
uncovered call options, short sale transactions, and use of real estate,
unlisted limited partnerships, derivative products or venture capital loans as
fixed income investment vehicles.
The Company makes contributions to its funded qualified pension plan as required
by government regulation or as deemed appropriate by management after
considering the fair value of plan assets, expected return on such assets, and
the value of the accumulated benefit obligation. Based upon current information,
the Company does not expect to make contributions to the funded qualified
pension plan in 2005. The Company funds the payment of benefit obligations for
the supplemental pension and post-retirement plans because such plans do not
hold assets for investment.
The assumed health care cost trend rate used in the post-retirement health plan
at December 31,2004 was 9.0% for medical costs and 13.0% for prescription drugs.
The rate to which the cost trend rate is assumed to decline (the ultimate trend
rate) and the year that the rate reaches the ultimate trend rate is 5.0% and
2013, respectively.
Assumed health care cost trend rates have a significant effect on the amounts
reported for the health care plan. A one-percentage-point increase in the trend
rate would increase the service and interest cost components by $35,000 and
increase the benefit obligation by $264,000. A one-percentage-point decrease in
the trend rate would decrease the service and interest cost components by $8,000
and decrease the benefit obligation by $141,000.
401(k) Employee Stock Ownership Plan
The Company has a 401(k) Employee Stock Ownership Plan in which employees can
contribute from 1% to 90% of eligible compensation, with up to 6% being eligible
for matching contributions in the form of Company common stock. The Plan also
permits the Company to distribute a discretionary profit-sharing component in
the form of Company common stock to all participants except certain executive
employees. The expense recognized under this plan for the years ended December
31, 2004, 2003 and 2002 was $1,583,000, $1,309,000 and $1,026,000, respectively.
Deferred Compensation Plan for Certain Executive Employees
The Company has a Deferred Compensation Plan for Certain Executive Employees in
which participants may contribute up to 15% of their eligible compensation less
any amounts contributed to the 401(k) Employee Stock Ownership Plan. Any
discretionary profit-sharing amounts that the executive receives from the
Company must be contributed to the Deferred Compensation Plan in the form of
Company common stock. The expense recognized under this plan for the years ended
December 31, 2004, 2003 and 2002 was $159,000, $119,000 and $68,000,
respectively.
Other Deferred Compensation Arrangements
In addition to the supplemental pension plans for certain executives, the
Company has nonqualified deferred compensation for several former directors,
officers, and key employees. All benefits provided under these plans are
unfunded and payments to plan participants are made by the Company. At December
31, 2004 and 2003, the Company has recorded a liability of $5,373,000 and
$3,775,000, respectively. The expense recognized under these plans for the years
ended December 31, 2004, 2003, and 2002 was $1,727,000, $947,000 and $398,000,
respectively.
58
Deferred Compensation Plan for Directors
Directors may defer all or a portion of their director fees under the Deferred
Compensation Plan for Directors. Under this plan, there is a separate account
for each participating director which is credited with the amount of shares
which could have been purchased with the director's fees as well as any
dividends on such shares. On the distribution date, the director will receive
common stock equal to the accumulated share balance in his account. As of
December 31, 2004 and 2003, there were 65,090 and 56,901 shares credited to the
participants' accounts, for which a liability of $1,097,000 and $894,000 was
accrued, respectively. The expense recognized under the plan for the years ended
December 31, 2004, 2003 and 2002, was $206,000, $113,000, and $106,000,
respectively.
Director Stock Balance Plan
The Company has a Stock Balance Plan for non-employee directors who have
completed six months of service. The Plan is a nonqualified, noncontributory
defined benefit plan. The Plan provides benefits for service prior to January 1,
1996 based on a predetermined formula and benefits for service after January 1,
1996 based on the performance of the Company's common stock. Participants become
fully vested after six years of service. The directors can elect to receive
offset stock options that may reduce the Company's liability under the Plan.
These options vest immediately and expire one year after the date the director
retires or two years in the event of death. Benefits are payable in the form of
cash and/or Company stock (as elected by the director) on January 1st of the
year after the director retires from the Board. As of December 31, 2004 and
2003, the accrued pension liability was $287,000 and $251,000, respectively. The
expense recognized under this plan for the years ended December 31, 2004, 2003
and 2002, was $36,000, $38,000 and $69,000, respectively. The expense and
related liability were calculated using a dividend rate of 3.00%, stock price
appreciation of 6.00%, and a discount rate of 5.6% for 2004, 5.9% for 2003, and
6.10% for 2002.
NOTE L: STOCK-BASED COMPENSATION PLANS
The Company has a long-term incentive program for directors, officers, and key
employees. Under this program the Company authorized 4,024,000 shares of Company
common stock for the grant of incentive stock options, restricted stock awards,
nonqualified stock options, retroactive stock appreciation rights, and offset
options to its Stock Balance Plan (see Note K). The offset options vest and
become exercisable immediately and expire one year after the date the director
retires or two years in the event of death. The remaining options have a
ten-year term. They vest and become exercisable on a grant-by-grant basis,
ranging from immediate vesting to ratably over a five-year period. Option
activity in this plan is as follows:
Weighted
Average
Exercise Price
Options of Shares Shares
Outstanding Outstanding Exercisable
- --------------------------------------------------------------------------------
December 31, 2001 1,901,488 $ 12.67 1,300,700
Granted 413,404 13.20
Exercised (173,286) 8.94
Forfeited (4,278) 12.62
- --------------------------------------------------------------------------------
December 31, 2002 2,137,328 $ 13.07 1,411,006
- --------------------------------------------------------------------------------
Granted 843,138 10.89
Exercised (545,158) 10.99
Forfeited (7,826) 14.22
- --------------------------------------------------------------------------------
December 31, 2003 2,427,482 $ 12.78 1,519,893
================================================================================
Granted 669,139 18.37
Exercised (685,143) 8.35
Forfeited (10,546) 16.13
- --------------------------------------------------------------------------------
December 31, 2004 2,400,932 $ 15.59 1,383,369
================================================================================
Approximately 222,000 and 390,000 options were exchanged in 2004 and 2003 in
connection with the Heritage and Grange acquisitions, respectively.
59
At December 31, 2004 the range of exercise prices and other information relating
to the Company's stock options is as follows:
Options Outstanding Options Exercisable
------------------------------------------ -----------------------
Weighted Weighted Weighted
Average Average Average
Range of Exercise Remaining Exercise
Exercise Price Shares Price Life (years) Shares Price
- --------------- ------------------------------------------ -----------------------
$3.65 - $5.15 76,044 $ 4.12 1.7 76,044 $ 4.12
$5.15 - $7.72 40,716 6.77 0.8 40,716 6.77
$7.72 - $10.30 69,516 9.13 3.3 69,516 9.13
$10.30 - $12.87 520,454 12.12 5.6 374,419 12.09
$12.87 - $15.44 452,121 13.57 6.1 275,261 13.86
$15.44 - $18.02 782,979 16.32 7.2 489,283 16.71
$18.02 - $20.59 15,000 18.96 8.4 3,000 18.96
$20.59 - $23.17 19,008 22.62 9.4 4,008 22.95
$23.17 - $24.15 425,094 24.15 9.1 51,122 24.15
- --------------------------------------------------------------------------------------
Total / Average 2,400,932 $ 15.59 6.6 1,383,369 $ 13.83
======================================================================================
Information concerning the grants of stock options and restricted stock is as
follows:
Weighted
Weighted Average
Awards Average Grant Date
Granted Exercise Price Fair Value
- ------------------------------------------------------------------------------
2004:
Option price = fair market value 446,860 $ 24.09 $ 6.05
Option price < fair market value 222,279 $ 6.87 $ 13.28
Restricted stock 32,418 $ 23.76 $ 23.76
2003:
Option price = fair market value 449,476 $ 15.78 $ 4.12
Option price < fair market value 393,662 $ 5.31 $ 13.73
Restricted stock 8,000 $ 19.12 $ 19.12
2002:
Option price = fair market value 373,404 $ 13.20 $ 3.59
Option price < fair market value 40,000 $ 13.18 $ 4.33
==============================================================================
The Company used the Black-Scholes option-pricing model to estimate the weighted
average grant date fair value. The assumptions used in the model are disclosed
in Note A - Stock Based Compensation. Compensation expense related to restricted
stock recognized in the income statement for the years ended December 31, 2004,
2003, and 2002 was $372,000, $105,000 and $353,000, respectively.
On February 21, 1995, the Company adopted a Stockholder Protection Rights
Agreement. Under the Plan, each stockholder received one right, representing the
right to purchase one share of common stock for $42.50 for each share of stock
owned. All of the rights expire on February 21, 2005, but the Company may redeem
the rights earlier for $.005 per right, subject to certain limitations. Rights
will become exercisable if a person or group acquires 15% or more of the
Company's outstanding shares. Until that time, the rights will trade with the
common stock; any transfer of common stock will also constitute a transfer of
the associated right. If the rights become exercisable, they will begin to trade
apart from the common stock. If one of a number of "flip-in events" occurs, each
right will entitle the holder to purchase common stock having a market value
equivalent of two times the exercise price. In January 2005, the Board of
Directors voted to permit the agreement to expire in February 2005.
60
NOTE M: EARNINGS PER SHARE
The following is a reconciliation of basic to diluted earnings per share for the
years ended December 31:
Per
Share
(000's omitted, except per share data) Income Shares Amount
- -------------------------------------------------------------------------------
Year Ended December 31, 2004
Basic EPS $50,196 29,916 $ 1.68
Stock options 754
- ---------------------------------------------------------------------
Diluted EPS $50,196 30,670 $ 1.64
=====================================================================
Year Ended December 31, 2003
Basic EPS $40,380 26,299 $ 1.54
Stock options 736
- ---------------------------------------------------------------------
Diluted EPS $40,380 27,035 $ 1.49
=====================================================================
Year Ended December 31, 2002
Basic EPS $38,517 25,946 $ 1.48
Stock options 388
- ---------------------------------------------------------------------
Diluted EPS $38,517 26,334 $ 1.46
=====================================================================
There were 424,594, 0 and 469,744 anti-dilutive stock options outstanding for
the years ended December 31, 2004, 2003 and 2002, respectively.
NOTE N: COMMITMENTS, CONTINGENT LIABILITIES AND RESTRICTIONS
The Company is a party to financial instruments with off-balance-sheet risk in
the normal course of business to meet the financing needs of its customers.
These financial instruments consist primarily of commitments to extend credit
and standby letters of credit. Commitments to extend credit are agreements to
lend to customers, generally having fixed expiration dates or other termination
clauses that may require payment of a fee. These commitments consist principally
of unused commercial and consumer credit lines. Standby letters of credit
generally are contingent upon the failure of the customer to perform according
to the terms of an underlying contract with a third party. The credit risks
associated with commitments to extend credit and standby letters of credit are
essentially the same as that involved with extending loans to customers and are
subject to normal credit policies. Collateral may be obtained based on
management's assessment of the customer's creditworthiness. The fair value of
these commitments is immaterial for disclosure in accordance with FASB
Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others". The
contract amount of commitment and contingencies is as follows:
(000's omitted) 2004 2003
- --------------------------------------------------------------------------------
Commitments to extend credit $429,751 $315,898
Standby letters of credit 22,948 19,163
- --------------------------------------------------------------------------------
Total $452,699 $335,061
================================================================================
The fair value of these financial instruments approximates carrying value.
The Company has unused lines of credit of $47,000,000 at December 31, 2004. The
Company has unused borrowing capacity of approximately $134,492,000 through
collateralized transactions with the Federal Home Loan Bank and $11,325,000
through collateralized transactions with the Federal Reserve Bank.
The Company is required to maintain a reserve balance, as established by the
Federal Reserve Bank of New York. The required average total reserve for the
14-day maintenance period of December 23, 2004 through January 5, 2005 was
$58,779,000 of which $2,000,000 was required to be on deposit with the Federal
Reserve Bank of New York. The remaining $56,779,000 was represented by cash on
hand.
61
NOTE O: LEASES
The Company leases buildings and office space under agreements that expire in
various years. Rental expense included in operating expenses amounted to
$2,486,000, $1,940,000 and $1,896,000 in 2004, 2003 and 2002, respectively. The
future minimum rental commitments as of December 31, 2004 for all non-cancelable
operating leases are as follows:
2005 $ 2,204
2006 2,022
2007 1,788
2008 1,280
2009 1,002
Thereafter 4,374
- --------------------------------------------------------------------------------
Total $12,670
================================================================================
NOTE P: REGULATORY MATTERS
The Company and the Bank are subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory and possibly additional
discretionary actions by regulators that, if undertaken, could have a direct
material effect on the Company's financial statements. Under capital adequacy
guidelines and the regulatory framework for prompt corrective action, the
Company and the Bank must meet specific capital guidelines that involve
quantitative measures of the Company's and the Bank's assets, liabilities, and
certain off-balance sheet items as calculated under regulatory accounting
practices. The Company's and the Bank's capital amounts and classification are
also subject to qualitative judgments by the regulators about components, risk
weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Company and Bank to maintain minimum total core capital to risk
weighted assets of 8%, and tier I capital to risk weighted assets and tier I
capital to average assets of 4%. Management believes, as of December 31, 2004,
that the Company and Bank meet all capital adequacy requirements to which they
are subject.
As of December 31, 2004 and 2003, the most recent notification from the Office
of the Comptroller of the Currency categorized the Company and Bank as "well
capitalized" under the regulatory framework for prompt corrective action. To be
categorized as "well capitalized," the Company and Bank must maintain minimum
total core capital to risk weighted assets of 10%, tier I capital to risk
weighted assets of 6% and tier I capital to average assets of 5%. There are no
conditions or events since that notification that management believes have
changed the institution's category. In addition, there were no significant
capital requirements imposed or agreed to during the regulatory approval process
of any of our acquisitions.
The capital ratios and amounts of the Company and the Bank as of December 31 are
presented below:
2004 2003
-------------------- --------------------
(000's omitted) Company Bank Company Bank
- -------------------------------------- -------------------- --------------------
Tier 1 capital to average assets
Amount $284,928 $276,654 $249,641 $245,809
Ratio 6.94% 6.74% 7.26% 7.28%
Minimum required amount $164,229 $164,069 $137,607 $134,977
Tier 1 capital to risk weighted assets
Amount $284,928 $276,654 $249,641 $245,809
Ratio 11.93% 11.61% 11.76% 11.63%
Minimum required amount $ 95,536 $ 95,337 $ 84,916 $ 84,576
Total core capital to risk weighted assets
Amount $314,783 $306,447 $276,177 $272,339
Ratio 13.18% 12.86% 13.01% 12.88%
Minimum required amount $191,072 $190,675 $169,831 $169,151
62
NOTE Q: PARENT COMPANY STATEMENTS
The condensed balance sheets of the parent company at December 31 is as follows:
(000's omitted) 2004 2003
- --------------------------------------------------------------------------------
Assets:
Cash $ 11,772 $ 24,429
Investment securities 2,885 2,885
Investment in and advances to subsidiaries 548,781 482,407
Other assets 3,562 3,023
- --------------------------------------------------------------------------------
Total assets $567,000 $512,744
================================================================================
Liabilities and shareholders' equity:
Accrued interest and other liabilities $ 8,926 $ 7,526
Borrowings 83,446 100,390
Shareholders' equity 474,628 404,828
- --------------------------------------------------------------------------------
Total liabilities and shareholders' equity $567,000 $512,744
================================================================================
The condensed statements of income of the parent company for the years ended
December 31 is as follows:
(000's omitted) 2004 2003 2002
- --------------------------------------------------------------------------------------
Revenues:
Dividends from subsidiaries $41,500 $42,771 $29,587
Interest on investments 179 6 10
Other income 28 0 0
- --------------------------------------------------------------------------------------
Total revenues 41,707 42,777 29,597
- --------------------------------------------------------------------------------------
Expenses:
Interest on long term notes and debentures 6,061 5,765 6,112
Other expenses 13 84 9
- --------------------------------------------------------------------------------------
Total expenses 6,074 5,849 6,121
- --------------------------------------------------------------------------------------
Income before tax benefit and equity in undistributed
net income of subsidiaries 35,633 36,928 23,476
Income tax benefit 1,461 1,364 1,572
- --------------------------------------------------------------------------------------
Income before equity in undistributed net income
of subsidiaries 37,094 38,292 25,048
Equity in undistributed net income of subsidiaries 13,102 2,088 13,469
- --------------------------------------------------------------------------------------
Net income $50,196 $40,380 $38,517
======================================================================================
63
The statements of cash flows of the parent company for the years ended December
31 is as follows:
(000's omitted) 2004 2003 2002
- -------------------------------------------------------------------------------------------------------------
Operating activities:
Net income $ 50,196 $ 40,380 $ 38,517
Adjustments to reconcile net income to net cash provided by operating
activities
Equity in undistributed net income of subsidiaries (13,102) (2,088) (13,469)
Net change in other assets and other liabilities 3,157 1,633 (886)
- -------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 40,251 39,925 24,162
- -------------------------------------------------------------------------------------------------------------
Investing activities:
Purchase of investment securities 0 (227) (76)
Capital contributions to subsidiaries 0 (33,131) (831)
- -------------------------------------------------------------------------------------------------------------
Net cash used in investing activities 0 (33,358) (907)
- -------------------------------------------------------------------------------------------------------------
Financing activities:
Net change in borrowings (17,000) 20,000 (6,100)
Issuance of common stock 5,344 4,819 1,151
Purchase of treasury stock (21,709) (8,490) 0
Cash dividends paid (19,543) (15,466) (14,228)
- -------------------------------------------------------------------------------------------------------------
Net cash (used) provided by financing activities (52,908) 863 (19,177)
- -------------------------------------------------------------------------------------------------------------
Change in cash and cash equivalents (12,657) 7,430 4,078
Cash and cash equivalents at beginning of year 24,429 16,999 12,921
- -------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of year $ 11,772 $ 24,429 $ 16,999
=============================================================================================================
Supplemental disclosures of cash flow information:
Cash paid for interest $ 5,943 $ 5,841 $ 6,412
Supplemental disclosures of non-cash financing activities
Dividends declared and unpaid $ 5,515 $ 4,529 $ 3,760
64
Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Exchange Act Rule
13a - 15(f). Under the supervision and with the participation of our management,
including our principal executive officer and principal financial officer, we
conducted an evaluation of the effectiveness of our internal control over
financial reporting based on the framework in Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission. Based on our evaluation under the framework in Internal Control -
Integrated Framework, our management concluded that our internal control over
financial reporting was effective as of December 31, 2004.
Our management's assessment of the effectiveness of our internal control over
financial reporting as of December 31, 2004 has been audited by
PricewaterhouseCoopers LLP, an independent registered public accounting firm, as
stated in their report which is included herein.
Community Bank System, Inc.
Date: March 14, 2005
/s/ Sanford A. Belden
- ---------------------------
Sanford A. Belden,
President, Chief Executive Officer and Director
/s/ Scott A. Kingsley
- ---------------------------
Scott A. Kingsley,
Treasurer and Chief Financial Officer
65
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of Community Bank System, Inc.
We have completed an integrated audit of Community Bank System, Inc.'s 2004
consolidated financial statements and of its internal control over financial
reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated
financial statements in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Our opinions, based on our audits,
are presented below.
Consolidated financial statements
In our opinion, the consolidated financial statements listed in the accompanying
index present fairly, in all material respects, the financial position of
Community Bank System, Inc. and its subsidiaries at December 31, 2004 and 2003,
and the results of their operations and their cash flows for each of the three
years in the period ended December 31, 2004 in conformity with accounting
principles generally accepted in the United States of America. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these statements in accordance with the
standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit of financial statements includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
Internal control over financial reporting
Also, in our opinion, management's assessment, included in Management's Report
on Internal Control Over Financial Reporting appearing under Item 8, that the
Company maintained effective internal control over financial reporting as of
December 31, 2004 based on criteria established in Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO), is fairly stated, in all material respects, based on those
criteria. Furthermore, in our opinion, the Company maintained, in all material
respects, effective internal control over financial reporting as of December 31,
2004, based on criteria established in Internal Control - Integrated Framework
issued by the COSO. The Company's management is responsible for maintaining
effective internal control over financial reporting and for its assessment of
the effectiveness of internal control over financial reporting. Our
responsibility is to express opinions on management's assessment and on the
effectiveness of the Company's internal control over financial reporting based
on our audit. We conducted our audit of internal control over financial
reporting in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. An audit of internal control over financial reporting includes
obtaining an understanding of internal control over financial reporting,
evaluating management's assessment, testing and evaluating the design and
operating effectiveness of internal control, and performing such other
procedures as we consider necessary in the circumstances. We believe that our
audit provides a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (i) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (ii)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the
company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
/s/ PricewaterhouseCoopers LLP
- ------------------------------
PricewaterhouseCoopers LLP
Syracuse, New York
March 11, 2005
66
TWO YEAR SELECTED QUARTERLY DATA (Unaudited)
2004 Results 4th 3rd 2nd 1st
(000's omitted, except per share data) Quarter Quarter Quarter Quarter Total
- -----------------------------------------------------------------------------------------------------------------
Net interest income $ 38,575 $ 39,057 $ 37,457 $ 35,954 $151,043
Provision for loan losses 2,100 2,300 2,300 2,050 8,750
- -----------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 36,475 36,757 35,157 33,904 142,293
Non-interest income 10,832 12,164 10,919 10,530 44,445
Operating expenses 30,442 29,926 29,775 29,756 119,899
- -----------------------------------------------------------------------------------------------------------------
Income before income taxes 16,865 18,995 16,301 14,678 66,839
Income taxes 4,199 4,761 4,160 3,523 16,643
- -----------------------------------------------------------------------------------------------------------------
Net income $ 12,666 $ 14,234 $ 12,141 $ 11,155 $ 50,196
=================================================================================================================
Basic earnings per share $ 0.41 $ 0.47 $ 0.41 $ 0.39 $ 1.68
Diluted earnings per share $ 0.40 $ 0.45 $ 0.40 $ 0.38 $ 1.64
=================================================================================================================
2003 Results 4th 3rd 2nd 1st
(000's omitted, except per share data) Quarter Quarter Quarter Quarter Total
- -----------------------------------------------------------------------------------------------------------------
Net interest income $ 34,703 $ 32,539 $ 32,102 $ 32,484 $131,828
Provision for loan losses 3,093 2,029 2,673 3,400 11,195
- -----------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 31,610 30,510 29,429 29,084 120,633
Non-interest income 7,698 9,779 8,947 8,807 35,231
Operating expenses 27,879 25,206 25,179 24,447 102,711
- -----------------------------------------------------------------------------------------------------------------
Income before income taxes 11,429 15,083 13,197 13,444 53,153
Income taxes 2,759 3,354 3,165 3,495 12,773
- -----------------------------------------------------------------------------------------------------------------
Net income $ 8,670 $ 11,729 $ 10,032 $ 9,949 $ 40,380
=================================================================================================================
Basic earnings per share $ 0.32 $ 0.45 $ 0.38 $ 0.38 $ 1.54
Diluted earnings per share $ 0.31 $ 0.44 $ 0.38 $ 0.38 $ 1.49
=================================================================================================================
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
None
Item 9A. Controls and Procedures
Under the supervision and with the participation of our management, including
our chief executive officer and chief financial officer, we conducted an
evaluation of our disclosure controls and procedures, as such term is defined
under Rule 13a - 15(e) under the Securities Exchange Act of 1934. Based upon
this evaluation, our chief executive officer and our chief financial officer
concluded that our disclosure controls and procedures were effective as of the
end of the period covered by this annual report. Management's annual report on
internal control over financial reporting is included under the heading "Report
on Internal Control Over Financial Reporting" at Item 8 of this Annual Report on
Form 10-K. The attestation report of the registered public accounting firm is
included under the heading "Report of the Independent Registered Public
Accounting Firm" at Item 8 of this Annual Report on Form 10-K.
The Company continually assesses the adequacy of its internal control over
financial reporting and enhances its controls in response to internal control
assessments, and internal and external audit and regulatory recommendations. No
change in internal control over financial reporting during the quarter ended
December 31, 2004 or through the date of this Annual Report on Form 10-K have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate due to changes in conditions, or that the degree of compliance with
the policies or procedures may deteriorate.
Item 9B. Other Information
None
67
Part III
Item 10. Directors and Executive Officers of the Registrant
The information concerning Directors of the Company required by this Item 10 is
incorporated herein by reference to the sections entitled "Nominees for Director
and Directors Continuing in Office" and "Section 16(a) Beneficial Ownership
Reporting Compliance" in the Company's Proxy Statement. The information
concerning executive officers of the Company required by this Item 10 is
incorporated by reference to Item 4A of this Annual Report on Form 10-K. The
Company has adopted a code of ethics that applies to its principal executive
officer, principal financial officer, principal accounting officer or
controller, or persons performing similar functions. The text of the code of
ethics is posted on the Company's web-site at www.communitybankna.com. The
Company intends to satisfy the requirements under Item 5.05 of Form 8-K
regarding an amendment to, or a waiver from, the code of ethics that relates to
certain elements thereof, by posting such information on its web-site referenced
above. In addition, information concerning Audit Committee and Audit Committee
Financial Expert is included in the Proxy Statement under the caption "Audit
Committee Report" and is incorporated herein by reference.
Item 11. Executive Compensation
The information required by this Item 11 is incorporated herein by reference to
the section entitled "Compensation of Executive Officers" in the Company's Proxy
Statement.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information required by this Item 12 is incorporated herein by reference to
the section entitled "Nominees for Director and Directors Continuing in Office"
in the Company's Proxy Statement.
Item 13. Certain Relationships and Related Transactions
The information required by this Item 13 is incorporated herein by reference to
the section entitled "Transactions with Management" in the Company's Proxy
Statement.
Item 14. Principal Accounting Fees and Services
The information required by this Item 14 is incorporated herein by reference to
the section entitled "Audit Fees" in the Company's Proxy Statement.
68
Part IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K
A. Documents Filed
1. The following consolidated financial statements of Community Bank
System, Inc. and subsidiaries are included in Item 8:
- Consolidated Statements of Condition, December 31, 2004 and
2003
- Consolidated Statements of Income, Years ended December 31,
2004, 2003, and 2002
- Consolidated Statements of Changes in Shareholders' Equity,
Years ended December 31, 2004, 2003, and 2002
- Consolidated Statements of Comprehensive Income, Years ended
December 31, 2004, 2003, and 2002
- Consolidated Statement of Cash Flows, Years ended December 31,
2004, 2003, and 2002
- Notes to Consolidated Financial Statements, December 31, 2004
- Report of Independent Registered Public Accounting Firm
- Quarterly selected data, Years ended December 31, 2004 and
2003 (unaudited)
2. Schedules are omitted since the required information is either not
applicable or shown elsewhere in the financial statements.
3. The exhibits filed as part of this report and exhibits incorporated
herein by reference to other documents are listed below:
2.1 Agreement and Plan of Merger, dated January 6, 2004 and amended
March 11, 2004, by and among Community Bank System, Inc., Community
Bank, N.A., and First Heritage Bank. Incorporated by reference to
Annex A to the proxy statement/prospectus included in Registration
Statement on Form S-4 filed on March 12, 2004, as amended
(Registration No. 333-113581).
2.2 Amended and Restated Agreement and Plan of Merger, dated June 7,
2003, by and between Community Bank System, Inc. and Grange National
Banc Corp. Incorporated by reference to Annex A to the proxy
statement/prospectus included in the Registration Statement on Form
S-4 filed on August 20, 2003, as amended (Registration No.
333-107949).
2.3 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 (Registration No.
001-13695).
2.4 Agreement and Plan of Merger, dated November 29, 2000, by and
between Community Bank System, Inc. and First Liberty Bank Corp.
Incorporated by reference to Exhibit No. 2.1 to the Current Report
on Form 8-K filed on December 20, 2000 (Registration No. 001-13695).
2.5 Agreement regarding the Agreement and Plan of Merger, dated
September 26, 2000, by and between Community Bank, N.A. and The
Citizens National Bank of Malone. Incorporated by reference to
Exhibit No. 10.1 to the Registration Statement on Form S-4 filed on
October 20, 2000 (Registration No. 333-48374).
69
2.6 Purchase and Assumption Agreement, dated December 6, 1994, by
and between Community Bank System, Inc. and The Chase Manhattan
Bank, N.A. Incorporated by reference to Exhibit No. 10.01 to the
Registration Statement on Form S-2 filed on April 11, 1995
(Registration No. 033-58539).
3.1 Certificate of Amendment of Certificate of Incorporation of
Community Bank System, Inc. Incorporated by reference to Exhibit No.
3.1 to the Quarterly Report on Form 10-Q filed on May 5, 2004
(Registration No. 001-13695).
3.2 Bylaws of Community Bank System, Inc., as amended. Incorporated
by reference to Exhibit No. 3.2 to the Registration Statement on
Form S-4 filed on October 20, 2000 (Registration No. 333-48374).
4.1 Junior Subordinated Deferrable Interest Debentures, dated as
February 3, 1997, by and between Community Bank System, Inc. and The
Chase Manhattan Bank. Incorporated by reference to Exhibit No. 4.1
to the Registration Statement on Form S-4 filed on June 25, 1997
(Registration No. 333-30045).
4.2 Amended and Restated Declaration of Trust of Community Capital
Trust I, dated as February 3, 1997, by and between Community Bank
System, Inc. and The Chase Manhattan Bank. Incorporated by reference
to Exhibit No. 4.5 to the Registration Statement on Form S-4 filed
on June 25, 1997 (Registration No. 333-30045).
4.3 Form of Common Stock Certificate. Incorporated by reference to
Exhibit No. 4.1 to the Amendment No. 1 to the Registration Statement
on Form S-3 filed on October 24, 2001 (Registration No. 333-68866).
10.1 Employment Agreement, effective March 1, 2004, by and between
Community Bank System, Inc. and Sanford A. Belden. Incorporated by
reference to Exhibit No. 10.1 to the Annual Report on Form 10-K
filed on March 12, 2004 (Registration No. 001-13695). **
10.2 Post-2004 Supplemental Retirement Agreement, effective January
1, 2005, by and between Community Bank System, Inc., Community Bank
N.A. and Sanford Belden. * **
10.3 Pre-2005 Supplemental Retirement Agreement, effective December
31, 2004, by and between Community Bank System, Inc., Community Bank
N.A. and Sanford Belden. * **
10.4 Employment Agreement, effective March 8, 2004, by and between
Community Bank System, Inc. and Mark E. Tryniski. Incorporated by
reference to Exhibit No. 10.4 to the Annual Report on Form 10-K
filed on March 12, 2004 (Registration No. 001-13695). **
10.5 Supplemental Retirement Plan Agreement, effective July 1, 2003,
by and between Community Bank System Inc. and Mark E. Tryniski.
Incorporated by reference to Exhibit No. 10.5 to the Annual Report
on Form 10-K filed on March 12, 2004 (Registration No. 001-13695).
**
10.6 Employment Agreement, effective August 2, 2004, by and between
Community Bank System, Inc., Community Bank, N.A. and Scott A.
Kingsley. Incorporated by reference to Exhibit No. 10.3 to the
Quarterly Report on Form 10-Q filed on August 4, 2004 (Registration
No. 001-13695). **
10.7 Supplemental Retirement Plan Agreement, effective August 2,
2004, by and between Community Bank System Inc. and Scott A.
Kingsley. Incorporated by reference to Exhibit No. 10.4 to the
Quarterly Report on Form 10-Q filed on August 4, 2004 (Registration
No. 001-13695). **
10.8 Agreement dated December 23, 2002, by and between Community
Bank System, Inc., Community Bank N.A. and David G. Wallace.
Incorporated by reference to Exhibit 10.2 to the Annual Report on
Form 10-K filed on March 23, 2003 (Registration No. 001-13695). **
10.9 Employment Agreement, effective August 1, 2004, by and between
Community Bank System, Inc., Community Bank, N.A. and Brian D.
Donahue. Incorporated by reference to Exhibit No. 10.1 to the
Quarterly Report on Form 10-Q filed on November 8, 2004
(Registration No. 001-13695). **
10.10 Employment Agreement, effective March 20, 2003, by and between
Community Bank System, Inc. and Michael A. Patton. Incorporated by
reference to Exhibit No. 10.8 to the Annual Report on Form 10-K
filed on March 12, 2004 (Registration No. 001-13695). **
70
10.11 Supplemental Retirement Plan Agreement, effective February 1,
2004, by and between Community Bank System Inc. and Michael A.
Patton. Incorporated by reference to Exhibit No. 10.9 to the Annual
Report on Form 10-K filed on March 12, 2004 (Registration No.
001-13695). **
10.12 Employment Agreement, effective March 20, 2003, by and between
Community Bank System, Inc. and James A. Wears. Incorporated by
reference to Exhibit No. 10.6 to the Annual Report on Form 10-K
filed on March 12, 2004 (Registration No. 001-13695). **
10.13 Supplemental Retirement Plan Agreement, effective February 1,
2004, by and between Community Bank System Inc. and James A. Wears.
Incorporated by reference to Exhibit No. 10.7 to the Annual Report
on Form 10-K filed on March 12, 2004 (Registration No. 001-13695).
**
10.14 Employment Agreement, effective November 21, 2003, by and
between Community Bank System, Inc. and Thomas A. McCullough.
Incorporated by reference to Exhibit No. 10.10 to the Annual Report
on Form 10-K filed on March 12, 2004 (Registration No. 001-13695).
**
10.15 Supplemental Retirement Plan Agreement, effective March 26,
2003, by and between Community Bank System Inc. and Thomas
McCullough. Incorporated by reference to Exhibit No. 10.11 to the
Annual Report on Form 10-K filed on March 12, 2004 (Registration No.
001-13695). **
10.16 Employment Agreement, effective May 1, 2004, by and between
Community Bank System, Inc., Community Bank N.A. and Steven R.
Tokach. Incorporated by reference to Exhibit No. 10.2 to the
Quarterly Report on Form 10-Q filed on August 4, 2004 (Registration
No. 001-13695). **
10.17 Employment Agreement, effective September 1, 2002, by and
between Community Bank System, Inc., Community Bank N.A. and Timothy
J. Baker. Incorporated by reference to Exhibit No. 10.2 to the
Quarterly Report on Form 10-Q filed on November 8, 2004
(Registration No. 001-13695). **
10.18 Change of Control Agreement, effective November 30, 2001 by
and between Community Bank System, Inc., Community Bank N.A. and W.
Valen McDaniel. * **
10.19 Employment Agreement, effective September 1, 2002, by and
between Community Bank System, Inc., Community Bank N.A. and Joseph
J. Lemchak. Incorporated by reference to Exhibit No. 10.4 to the
Quarterly Report on Form 10-Q filed on November 8, 2004
(Registration No. 001-13695). **
10.20 Employment Agreement, effective October 1, 2004, by and
between Community Bank System, Inc., Community Bank N.A. and J.
David Clark. Incorporated by reference to Exhibit No. 10.3 to the
Quarterly Report on Form 10-Q filed on November 8, 2004
(Registration No. 001-13695). **
10.21 Employment Agreement, effective May 15, 2004, by and between
Community Bank System, Inc., Community Bank N.A. and Robert P.
Matley. * **
10.22 Change of Control Agreement, effective August 20, 2002 by and
between Community Bank System, Inc., Community Bank N.A. and J.
Michael Wilson. * **
10.23 Employment Agreement, effective April 3, 2000, by and between
Community Bank System, Inc. and David J. Elias. Incorporated by
reference to Exhibit No. 10.12 to the Annual Report on Form 10-K
filed on March 12, 2004 (Registration No. 001-13695). **
10.24 2004 Long-Term Incentive Compensation Program. Incorporated by
reference to Appendix A to the Definitive Proxy Statement on
Schedule 14A filed on April 15, 2004 (Registration No. 001-13695).
**
10.25 Stock Balance Plan for Directors, as amended. Incorporated by
reference to Annex I to the Definitive Proxy Statement on Schedule
14A filed on March 31, 1998 (Registration No. 001-13695).**
10.26 Deferred Compensation Plan for Directors, as amended.
Incorporated by reference to Annex I to the Definitive Proxy
Statement on Schedule 14A filed on March 31, 1998 (Registration No.
001-13695).**
10.27 Community Bank System, Inc. Pension Plan Amended and Restated
as of January 1, 2004. **
21.1 Subsidiaries of Community Bank System, Inc.
71
Jurisdiction of
Name Incorporation
---- ---------------
Community Bank, N.A New York
Community Capital Trust I Delaware
Community Capital Trust II Delaware
Community Statutory Trust III Connecticut
Community Financial Services, Inc. New York
Benefit Plans Administrative Services, Inc. New York
Benefit Plans Administrative Services LLC New York
Harbridge Consulting Group LLC New York
CBNA Treasury Management Corporation New York
Community Investment Services, Inc. New York
CBNA Preferred Funding Corp. Delaware
CFSI Close-Out Corp. New York
Elias Asset Management, Inc. Delaware
First Liberty Service Corporation Delaware
First of Jermyn Realty Co. Delaware
23.1 Consent of PricewaterhouseCoopers LLP. *
31.1 Certification of Sanford A. Belden, President and Chief
Executive Officer of the Registrant, pursuant to Rule 13a-15(e) or
Rule 15d-15(e) under the Securities Exchange Act of 1934, as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. *
31.2 Certification of Scott A. Kingsley, Treasurer 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 Scott A. Kingsley, 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. *
* Filed herewith
** Denotes management contract or compensatory plan or
arrangement
B. Reports on Form 8-K
o Form 8-K related to quarterly earnings press release was filed
on January 25, 2005.
o Form 8-K related to quarterly earnings press release was filed
on October 25, 2004.
C. Not applicable
72
SIGNATURES
Pursuant to the requirements of Section 13 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.
By: /s/ Sanford A. Belden
-----------------------
Sanford A. Belden
President, Chief Executive Officer and Director
March 14, 2005
Pursuant to the requirements of the Securities and Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated on the 14th day of March 2005.
/s/ James A. Gabriel
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James A. Gabriel, Director and
Chairman of the Board of Directors
/s/ Scott A. Kingsley
- --------------------------
Scott A. Kingsley
Treasurer and Chief Financial Officer
Directors:
/s/ Brian R. Ace
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Brian R. Ace, Director
/s/ John M. Burgess
- --------------------------
John M. Burgess, Director
/s/ Paul M. Cantwell, Jr.
- --------------------------
Paul M. Cantwell, Jr., Director
/s/ William M. Dempsey
- --------------------------
William M. Dempsey, Director
/s/ Nicholas A. DiCerbo
- --------------------------
Nicholas A. DiCerbo, Director
/s/ Lee T. Hirschey
- --------------------------
Lee T. Hirschey, Director
/s/ Harold S. Kaplan
- --------------------------
Harold S. Kaplan, Director
/s/ Saul Kaplan
- --------------------------
Saul Kaplan, Director
/s/ Charles E. Parente
- --------------------------
Charles E. Parente, Director
/s/ David C. Patterson
- --------------------------
David C. Patterson, Director
/s/ Peter A. Sabia
- --------------------------
Peter A. Sabia, Director
/s/ Sally A. Steele
- --------------------------
Sally A. Steele, Director
73
NEW YORK STOCK EXCHANGE
The undersigned Chief Executive Officer of Community Bank System, Inc. certifies
to the New York Stock Exchange that, as of the date of this certification, he is
unaware of any violation by Community Bank System, Inc. of the New York Stock
Exchange's corporate governance listing standards in effect as of the date of
this certification.
Date: March 14, 2005
/s/ Sanford A. Belden
- --------------------------
Sanford A. Belden,
President, Chief Executive Officer and Director
74