United States
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT
Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2005
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
of incorporation) Identification No.)
5790 Widewaters Parkway, DeWitt, New York 13214-1883
(Address of principal executive offices) (Zip Code)
(315) 445-2282
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter periods that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). |X| Yes |_| No
Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of the latest practical date.
Common Stock, $1.00 par value -30,265,410 shares outstanding as of
August 4, 2005
TABLE OF CONTENTS
Page
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Part I. Financial Information
Item 1. Financial Statements (Unaudited)
Consolidated Statements of Condition
June 30, 2005 and December 31, 2004 3
Consolidated Statements of Income
Three and six months ended June 30, 2005 and 2004 4
Consolidated Statement of Changes in Shareholders' Equity
Six months ended June 30, 2005 5
Consolidated Statements of Comprehensive Income
Three and six months ended June 30, 2005 and 2004 6
Consolidated Statements of Cash Flows
Six months ended June 30, 2005 and 2004 7
Notes to the Consolidated Financial Statements
June 30, 2005 8
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 14
Item 3. Quantitative and Qualitative Disclosure about Market Risk 27
Item 4. Controls and Procedures 28
Part II. Other Information
Item 1. Legal Proceedings 29
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 29
Item 3. Defaults Upon Senior Securities 29
Item 4. Submission of Matters to a Vote of Securities Holders 29
Item 5. Other Information 29
Item 6. Exhibits and Reports on Form 8-K 29
2
Part 1. Financial Information
Item 1. Financial Statements
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF CONDITION (Unaudited)
(In Thousands, Except Share Data)
June 30, December 31,
2005 2004
- --------------------------------------------------------------------------------------------------------------
Cash and cash equivalents $ 105,391 $ 118,345
Available-for-sale investment securities 1,364,127 1,446,695
Held-to-maturity investment securities 142,146 137,644
- --------------------------------------------------------------------------------------------------------------
Total investment securities (fair value of $1,506,798 and $1,582,873,
respectively) 1,506,273 1,584,339
Loans 2,378,900 2,358,493
Allowance for loan losses 32,011 31,778
- --------------------------------------------------------------------------------------------------------------
Net loans 2,346,889 2,326,715
Core deposit intangibles, net 31,612 35,351
Goodwill 195,170 195,163
Other intangibles, net 1,757 1,986
- --------------------------------------------------------------------------------------------------------------
Intangible assets, net 228,539 232,500
Premises and equipment, net 64,563 63,510
Accrued interest receivable 26,179 27,947
Other assets 36,195 40,475
- --------------------------------------------------------------------------------------------------------------
Total assets $ 4,314,029 $ 4,393,831
==============================================================================================================
Liabilities:
Non-interest bearing deposits $ 596,624 $ 567,106
Interest bearing deposits 2,380,893 2,361,872
- --------------------------------------------------------------------------------------------------------------
Total deposits 2,977,517 2,928,978
Federal funds purchased 33,500 13,200
Borrowings 684,430 826,865
Subordinated debt held by unconsolidated subsidiary trusts 80,474 80,446
Accrued interest and other liabilities 65,020 69,714
- --------------------------------------------------------------------------------------------------------------
Total liabilities 3,840,941 3,919,203
- --------------------------------------------------------------------------------------------------------------
Commitment and contingencies (See Note H)
Shareholders' equity:
Preferred stock $1.00 par value, 500,000 shares authorized, 0 shares issued
Common stock, $1.00 par value, 50,000,000 shares authorized;
32,279,551 and 32,041,591 shares issued in 2005 and 2004, respectively 32,280 32,042
Additional paid-in capital 193,623 190,769
Retained earnings 265,000 248,295
Accumulated other comprehensive income 28,089 34,200
Treasury stock, at cost (2,041,901 and 1,400,000 shares, respectively) (45,496) (30,199)
Employee stock plan - unearned (408) (479)
- --------------------------------------------------------------------------------------------------------------
Total shareholders' equity 473,088 474,628
- --------------------------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $ 4,314,029 $ 4,393,831
==============================================================================================================
The accompanying notes are an integral part of the consolidated financial
statements.
3
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(In Thousands, Except Per-Share Data)
Three Months Ended Six Months Ended
June 30, June 30,
---------------------------------------------
2005 2004 2005 2004
- --------------------------------------------------------------------------- ---------------------------------------------
Interest income:
Interest and fees on loans $36,157 $33,259 $ 71,659 $ 65,776
Interest and dividends on taxable investments 12,925 13,149 26,495 25,371
Interest and dividends on non-taxable investments 5,701 5,728 11,852 10,910
- --------------------------------------------------------------------------- ---------------------------------------------
Total interest income 54,783 52,136 110,006 102,057
- --------------------------------------------------------------------------- ---------------------------------------------
Interest expense:
Interest on deposits 10,284 8,521 19,463 17,155
Interest on borrowings 6,816 4,765 13,589 8,707
Interest on subordinated debt held by unconsolidated subsidiary trusts 1,627 1,393 3,196 2,784
- --------------------------------------------------------------------------- ---------------------------------------------
Total interest expense 18,727 14,679 36,248 28,646
- --------------------------------------------------------------------------- ---------------------------------------------
Net interest income 36,056 37,457 73,758 73,411
Less: provision for loan losses 2,134 2,300 4,009 4,350
- --------------------------------------------------------------------------- ---------------------------------------------
Net interest income after provision for loan losses 33,922 35,157 69,749 69,061
- --------------------------------------------------------------------------- ---------------------------------------------
Non-interest income:
Deposit service fees 6,703 6,182 12,780 11,958
Other banking services 241 265 766 923
Trust, investment and asset management fees 1,859 2,080 3,640 3,819
Benefit plan administration, consulting and actuarial fees 2,639 2,257 5,489 4,604
Gain on sales of investment securities 5,164 135 6,890 145
- --------------------------------------------------------------------------- ---------------------------------------------
Total non-interest income 16,606 10,919 29,565 21,449
- --------------------------------------------------------------------------- ---------------------------------------------
Operating expenses:
Salaries and employee benefits 16,212 15,392 32,378 30,559
Occupancy 2,685 2,500 5,717 5,130
Equipment and furniture 2,170 2,150 4,304 4,302
Amortization of intangible assets 1,984 1,759 3,968 3,398
Legal and professional fees 1,112 970 2,313 1,967
Data processing 1,824 1,924 3,534 3,804
Office supplies 539 577 1,124 1,098
Acquisition expenses 6 411 47 1,381
Other 4,668 4,092 8,846 7,892
- --------------------------------------------------------------------------- ---------------------------------------------
Total operating expenses 31,200 29,775 62,231 59,531
- --------------------------------------------------------------------------- ---------------------------------------------
Income before income taxes 19,328 16,301 37,083 30,979
Income taxes 5,047 4,160 9,468 7,683
- --------------------------------------------------------------------------- ---------------------------------------------
Net income $14,281 $12,141 $ 27,615 $ 23,296
=========================================================================== =============================================
Basic earnings per share $ 0.47 $ 0.41 $ 0.91 $ 0.80
Diluted earnings per share $ 0.46 $ 0.40 $ 0.89 $ 0.77
Dividends declared per share $ 0.18 $ 0.16 $ 0.36 $ 0.32
The accompanying notes are an integral part of the consolidated financial
statements.
4
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)
Six Months Ended June 30, 2005
(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, 2004 30,641,591 $ 32,042 $190,769 $ 248,295 $ 34,200 ($30,199) ($479) $ 474,628
Net income 27,615 27,615
Other comprehensive loss, net
of tax (6,111) (6,111)
Dividends declared:
Common, $0.36 per share (10,910) (10,910)
Common stock issued under employee
stock plan, including tax
benefits of $714 237,960 238 2,854 71 3,163
Treasury stock purchased (641,901) (15,297) (15,297)
- -----------------------------------------------------------------------------------------------------------------------------------
Balance at June 30, 2005 30,237,650 $ 32,280 $193,623 $ 265,000 $ 28,089 ($45,496) ($408) $ 473,088
===================================================================================================================================
The accompanying notes are an integral part of the consolidated financial
statements.
5
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
(In Thousands)
Three Months Ended Six Months Ended
June 30, June 30,
----------------------- ----------------------
2005 2004 2005 2004
- ----------------------------------------------------------------------------------------------------- ----------------------
Other comprehensive income (loss), before tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during period $ 15,551 ($51,231) ($3,168) ($32,174)
Reclassification adjustment for gains included in net income (5,164) (135) (6,890) (145)
- ----------------------------------------------------------------------------------------------------- ----------------------
Other comprehensive income (loss), before tax 10,387 (51,366) (10,058) (32,319)
Income tax (expense) benefit related to other comprehensive income (loss) (4,008) 20,070 3,947 12,648
- ----------------------------------------------------------------------------------------------------- ----------------------
Other comprehensive income (loss), net of tax 6,379 (31,296) (6,111) (19,671)
Net income 14,281 12,141 27,615 23,296
- ----------------------------------------------------------------------------------------------------- ----------------------
Comprehensive income (loss) $ 20,660 ($19,155) $ 21,504 $ 3,625
===================================================================================================== ======================
The accompanying notes are an integral part of the consolidated financial
statements.
6
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(In Thousands)
Six Months Ended June 30,
-------------------------
2005 2004
- ------------------------------------------------------------------------------------------------------------
Operating activities:
Net income $ 27,615 $ 23,296
Adjustments to reconcile net income to net cash provided by operating
activities
Depreciation 4,144 3,960
Amortization of intangible assets 3,968 3,398
Net amortization of premiums and discounts on securities and loans 463 816
Amortization of unearned compensation and discount on subordinated debt 154 127
Provision for loan losses 4,009 4,350
Gain on investment securities (6,890) (145)
(Gain) loss on loans and other assets (57) 25
Change in other operating assets and liabilities 6,053 2,200
- -----------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 39,459 38,027
- -----------------------------------------------------------------------------------------------------------
Investing activities:
Proceeds from sales of available-for-sale investment securities 150,638 35,755
Proceeds from maturities of held-to-maturity investment securities 3,371 2,203
Proceeds from maturities of available-for-sale investment securities 67,054 94,383
Purchases of held-to-maturity investment securities (7,946) (2,418)
Purchases of available-for-sale investment securities (138,692) (373,771)
Net increase in loans outstanding (23,455) (15,483)
Cash received from acquisition (net of cash paid of $7,026 in 2004) 0 406
Capital expenditures (5,145) (3,310)
- -----------------------------------------------------------------------------------------------------------
Net cash provided (used) by investing activities 45,825 (262,235)
- -----------------------------------------------------------------------------------------------------------
Financing activities:
Net change in demand deposits, checking, savings and money market deposits 24,564 40,373
Net change in time deposits 23,975 (42,992)
Net change in federal funds purchased 20,300 (14,700)
Net change in short-term borrowings (243,000) 91,528
Proceeds on long-term borrowings (net of payments of $148 and $40) 99,852 169,002
Issuance of common stock 2,327 3,005
Purchase of treasury stock (15,297) (15,360)
Cash dividends paid (10,959) (9,113)
Other financing activities 0 (48)
- -----------------------------------------------------------------------------------------------------------
Net cash (used) provided by financing activities (98,238) 221,695
- -----------------------------------------------------------------------------------------------------------
Change in cash and cash equivalents (12,954) (2,513)
Cash and cash equivalents at beginning of year 118,345 103,923
- -----------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 105,391 $ 101,410
===========================================================================================================
Supplemental disclosures of cash flow information:
Cash paid for interest $ 34,458 $ 26,788
Cash paid for income taxes $ 7,131 $ 5,730
Supplemental disclosures of non-cash financing and investing activities:
Dividends declared and unpaid $ 5,466 $ 4,930
Gross change in unrealized gains on available-for-sale investment securities ($10,058) ($32,319)
Acquisitions:
Fair value of assets acquired, excluding acquired cash and intangibles $ 0 $ 252,119
Fair value of liabilities assumed $ 0 $ 235,528
Common stock and options issued $ 0 $ 54,719
The accompanying notes are an integral part of the consolidated financial
statements.
7
COMMUNITY BANK SYSTEM, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
June 30, 2005
NOTE A: BASIS OF PRESENTATION
The interim financial data as of June 30, 2005 and for the six months ended June
30, 2005 and June 30, 2004 is unaudited; however, in the opinion of the Company,
the interim data includes all adjustments, consisting only of normal recurring
adjustments, necessary for a fair statement of the results for the interim
periods. The results of operations for the interim periods are not necessarily
indicative of the results that may be expected for the full year or any other
interim period.
NOTE B: OTHER MATTERS
On December 15, 2004, the Board of Directors approved a twelve-month
authorization to repurchase up to 500,000 of its outstanding shares in open
market or privately negotiated transactions. As of March 31, 2005, the Company
had repurchased the 500,000 shares at an aggregate cost of $11.9 million and an
average price per share of $23.83. On April 20, 2005, the Company announced a
twenty-month authorization to repurchase up to 1,500,000 of its outstanding
shares. Through June 30, 2005, the Company has repurchased 141,901 shares at an
aggregate cost of $3.4 million and an average price per share of $23.83. The
repurchased shares will be used for general corporate purposes, including those
related to stock plan activities.
NOTE C: ACCOUNTING POLICIES
Critical Accounting Policies
Allowance for Loan Losses
Management continually evaluates the credit quality of the Company's loan
portfolio, and performs a formal review of the adequacy of the allowance for
loan losses on a quarterly basis. The allowance reflects management's best
estimate of probable losses inherent in the loan portfolio. Determination of the
allowance is subjective in nature and requires significant estimates. The
Company's allowance methodology consists of two broad components, 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.
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.
8
Intangible Asse
Intangible assets include core deposit intangibles, customer relationship
intangibles and goodwill arising from acquisitions. Core deposit intangibles and
customer relationship intangibles are amortized on either an accelerated or
straight-line basis over periods ranging from 7 to 20 years. Goodwill is
evaluated at least annually for impairment. The carrying value of goodwill and
other intangible assets is based upon discounted cash flow modeling techniques
that require management to make estimates regarding the amount and timing of
expected future cash flows. It also requires use of a discount rate that
reflects the current return requirements of the market in relation to present
risk-free interest rates, required equity market premiums, and company-specific
risk indicators.
Retirement Benefits
The Company provides defined benefit pension benefits and post-retirement health
and life insurance benefits to eligible employees. The Company also provides
deferred compensation and supplemental executive retirement plans for selected
current and former employees and officers. Expense under these plans is charged
to current operations and consists of several components of net periodic benefit
cost based on various actuarial assumptions regarding future experience under
the plans, including discount rate, rate of future compensation increases and
expected return on plan assets.
Stock-Based Compensation
The Company accounts for stock-based awards issued to directors, officers and
key employees using the intrinsic value method. This method requires that
compensation expense be recognized to the extent that the fair value of the
underlying stock exceeds the exercise price of the stock award at the grant
date. The Company generally does not recognize compensation expense related to
stock awards because the stock awards generally have fixed terms and exercise
prices that are equal to or greater than the fair value of the Company's common
stock at the grant date.
SFAS 123, "Accounting for Stock-Based Compensation," requires companies that use
the "intrinsic value method" to account for stock compensation plans to provide
pro forma disclosures of the net income and earnings per share effect of stock
options using the "fair value method." Under this method, the fair value of the
option on the date of grant is recognized ratably as compensation expense over
the vesting period of the option.
Management estimated the fair value of options granted using the Black-Scholes
option-pricing model. This model was originally developed to estimate the fair
value of exchange-traded equity options, which (unlike employee stock options)
have no vesting period or transferability restrictions. As a result, the
Black-Scholes model is not necessarily a precise indicator of the value of an
option, but it 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:
2005 2004
- --------------------------------------------------------------------------------
Weighted-average expected life 7.76 7.79
Future dividend yield 3.00% 3.00%
Share price volatility 26.78% 25.47 - 25.59%
Weighted average risk-free interest rate 4.17% 4.02 - 4.05%
================================================================================
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.
9
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
periods.
Three Months Ended Six Months Ended
June 30, June 30,
----------------------------------------------
(000's omitted except per share amounts) 2005 2004 2005 2004
- ----------------------------------------------------------------------------------------------------------
Net income, as reported $14,281 $12,141 $27,615 $23,296
Plus: stock-based compensation expense determined under
intrinsic method, net of tax 43 33 78 58
Less: stock-based compensation expense determined under
fair value method, net of tax (390) (240) (895) (683)
- ----------------------------------------------------------------------------------------------------------
Pro forma net income $13,934 $11,934 $26,798 $22,671
==========================================================================================================
Earnings per share:
As reported:
Basic $ 0.47 $ 0.41 $ 0.91 $ 0.80
Diluted $ 0.46 $ 0.40 $ 0.89 $ 0.77
Pro forma:
Basic $ 0.46 $ 0.40 $ 0.88 $ 0.78
Diluted $ 0.45 $ 0.39 $ 0.87 $ 0.75
As of June 30, 2005 there were 2,564,000 stock options outstanding.
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. 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. In
April 2005, the Securities and Exchange Commission approved a new rule which
delays the effective date of SFAS 123R. The provisions of this statement will
become effective January 1, 2006 for all equity awards granted after the
effective date. 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.
10
NOTE D: EARNINGS PER SHARE
Basic earnings per share are computed based on the weighted-average common
shares outstanding for the period. Diluted earnings per share are based on the
weighted-average shares outstanding adjusted for the dilutive effect of the
assumed exercise of stock options during the year. The dilutive effect of
options is calculated using the treasury stock method of accounting. The
treasury stock method determines the number of common shares that would be
outstanding if all the dilutive options (average market price is greater than
the exercise price) were exercised and the proceeds were used to repurchase
common shares in the open market at the average market price for the applicable
time period. There were 412,561 anti-dilutive stock options outstanding for the
three months and six months ended June 30, 2005. The following is a
reconciliation of basic to diluted earnings per share for the three and six
months ended June 30, 2005 and 2004.
Per Share
(000's omitted, except per share data) Income Shares Amount
- --------------------------------------------------------------------------------
Three Months Ended June 30, 2005
Basic EPS $14,281 30,401 $0.47
Stock options 539
- ---------------------------------------------------------------------
Diluted EPS $14,281 30,940 $0.46
=====================================================================
Three Months Ended June 30, 2004
Basic EPS $12,141 29,821 $0.41
Stock options 849
- ---------------------------------------------------------------------
Diluted EPS $12,141 30,670 $0.40
=====================================================================
Six Months Ended June 30,2005
Basic EPS $27,615 30,490 $0.91
Stock options 575
- ---------------------------------------------------------------------
Diluted EPS $27,615 31,065 $0.89
=====================================================================
Six Months Ended June 30,2004
Basic EPS $23,296 29,200 $0.80
Stock options 916
- ---------------------------------------------------------------------
Diluted EPS $23,296 30,116 $0.77
=====================================================================
NOTE E: INTANGIBLE ASSETS
The gross carrying amount and accumulated amortization for each type of
intangible asset are as follows:
As of June 30, 2005 As of December 31, 2004
--------------------------------------- ---------------------------------------
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 ($32,079) $ 31,612 $ 63,691 ($28,340) $ 35,351
Other intangibles 2,750 (993) 1,757 2,750 (764) 1,986
- ------------------------------------ --------------------------------------- ---------------------------------------
Total amortizing intangibles 66,441 (33,072) 33,369 66,441 (29,104) 37,337
Non-amortizing intangible assets:
Goodwill 195,170 0 195,170 195,163 0 195,163
- ------------------------------------ --------------------------------------- ---------------------------------------
Total intangible assets, net $261,611 ($33,072) $228,539 $261,604 ($29,104) $232,500
==================================== ======================================= =======================================
No goodwill impairment adjustments were recognized in 2005 or 2004.
11
The estimated aggregate amortization expense for each of the succeeding fiscal
years ended December 31 is as follows:
(000's omitted) Amount
- ----------------- -------
July-Dec 2005 $ 3,275
2006 6,047
2007 5,657
2008 5,335
2009 4,836
Thereafter 8,219
- ----------------- -------
Total $33,369
================= =======
NOTE F: MANDATORILY REDEEMABLE PREFERRED SECURITIES
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 or quarterly
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 Amount Interest Maturity Call Call
Date Rate Date Provision Price
- --------------------------------------------------------------------------------------------------------------------------
I 2/3/1997 $30 million 9.75% 2/03/2027 10 year beginning 2007 104.5400% declining to
par in 2017
II 7/16/2001 $25 million 6 month LIBOR plus 3.75% (6.71%) 7/16/2031 5 year beginning 2006 107.6875% declining to
par in 2011
III 7/31/2001 $24.5 million 3 month LIBOR plus 3.58% (6.79%) 7/31/2031 5 year beginning 2006 107.5000% declining to
par in 2011
==========================================================================================================================
NOTE G: BENEFIT PLANS
The Company provides defined benefit pension benefits and post-retirement health
and life insurance benefits to eligible employees. The Company also provides
supplemental pension retirement benefits for several current and former key
employees. The Company accrues for the estimated cost of these benefits through
charges to expense during the years that employees earn these benefits. The net
periodic benefit cost for the three and six months ended June 30 is as follows:
Pension Benefits Post-retirement Benefits
-------------------------------------------- --------------------------------------
Three Months Ended Six Months Ended Three Months Ended Six Months Ended
June 30, June 30, June 30, June 30,
------------------ --------------------- ------------------ ----------------
(000's omitted) 2005 2004 2005 2004 2005 2004 2005 2004
- ----------------------------------------------------------- --------------------- ------------------ ----------------
Service cost $ 630 $ 568 $ 1,282 $ 1,135 $110 $ 69 $220 $156
Interest cost 657 631 1,302 1,262 104 92 207 163
Expected return on plan assets (876) (790) (1,754) (1,580) 0 0 0 0
Net amortization and deferral 331 262 635 525 19 13 39 18
Amortization of prior service cost 29 73 59 145 28 1 55 15
Amortization of transition obligation 0 0 0 0 10 10 21 20
- ----------------------------------------------------------- --------------------- ------------------ ----------------
Net periodic benefit cost $ 771 $ 744 $ 1,524 $ 1,487 $271 $185 $542 $372
=========================================================== ===================== ================== ================
The Company is not required for regulatory purposes to make a contribution to
its defined benefit pension plan.
12
NOTE H: COMMITMENTS, CONTINGENT LIABILITIES AND RESTRICTIONS
The Company is a party to financial instruments with off-balance-sheet risk in
the normal course of business to meet the financing needs of its customers.
These financial instruments consist primarily of commitments to extend credit
and standby letters of credit. Commitments to extend credit are agreements to
lend to customers, generally having fixed expiration dates or other termination
clauses that may require payment of a fee. These commitments consist principally
of unused commercial and consumer credit lines. Standby letters of credit
generally are contingent upon the failure of the customer to perform according
to the terms of an underlying contract with a third party. The credit risks
associated with commitments to extend credit and standby letters of credit are
essentially the same as that involved with extending loans to customers and are
subject to normal credit policies. Collateral may be obtained based on
management's assessment of the customer's creditworthiness.
The contract amount of commitment and contingencies are as follows:
June 30, December 31,
(000's omitted) 2005 2004
- --------------------------------------------------------------------------------
Commitments to extend credit $447,663 $429,751
Standby letters of credit 22,394 22,948
- ------------------------------------------------------------------------------
Total $470,057 $452,699
==============================================================================
13
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Introduction
This Management's Discussion and Analysis of Financial Condition and Results of
Operations ("MD&A") primarily reviews the financial condition and results of
operations of Community Bank System, Inc. ("the Company" or "CBSI") as of and
for the three and six months ended June 30, 2005 and 2004, although in some
circumstances the first quarter of 2005 is also discussed in order to more fully
explain recent trends. The following discussion and analysis should be read in
conjunction with the Company's Consolidated Financial Statements and related
notes that appear on pages 3 through 13. All references in the discussion to the
financial condition and results of operations are to those of the Company and
its subsidiaries taken as a whole.
Unless otherwise noted, the term "this year" refers to results in calendar year
2005, "second quarter" refers to the quarter ended June 30, 2005, "year to date"
or ("YTD") refers to the six months ended June 30, 2005, earnings per share
("EPS") figures refer to diluted EPS, and net interest income and net interest
margin are presented on a fully tax-equivalent ("FTE") basis. All share and
share-based amounts reflect the two-for-one stock split effected as a 100% stock
dividend on April 12, 2004.
This MD&A contains certain forward-looking statements with respect to the
financial condition, results of operations and business of the Company. These
forward-looking statements involve certain risks and uncertainties. Factors that
may cause actual results to differ materially from those proposed by such
forward-looking statements are set herein under the caption, "Forward-Looking
Statements," on page 27.
Critical Accounting Policies
As a result of the complex and dynamic nature of the Company's business,
management must exercise judgement in selecting and applying the most
appropriate accounting policies for its various areas of operations. The policy
decision process not only ensures compliance with the latest generally accepted
accounting principles, but also reflects on management's discretion with regard
to choosing the most suitable methodology for reporting the Company's financial
performance. It is management's opinion that the accounting estimates covering
certain aspects of the business have more significance than others due to the
relative importance of those areas to overall performance, or the level of
subjectivity in the selection process. These estimates affect the reported
amounts of assets and liabilities and disclosures of revenues and expenses
during the reporting period. Changes in the circumstances considered when
determining management's estimates and assumptions could result in changes to
those estimates. Actual results could differ from those estimates. Management
believes that critical accounting estimates include:
o Allowance for loan losses - The allowance for loan losses reflects
management's best estimate of probable losses inherent in the loan
portfolio. Determination of the allowance is subjective in nature and
requires significant estimates 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.
o Provision for income taxes - The Company is subject to examinations from
various taxing authorities. Such examinations may result in challenges to
the tax return treatment applied by the Company to specific transactions.
Management believes that the assumptions and judgements used to record tax
related assets or liabilities have been appropriate. Should tax laws
change or the taxing authorities determine that management's assumptions
were inappropriate, an adjustment may be required which could have a
material effect on the Company's results of operations.
o Carrying value of goodwill and other intangible assets - The carrying
value of goodwill and other intangible assets is based upon discounted
cash flow modeling techniques that require management to make estimates
regarding the amount and timing of expected future cash flows. It also
requires use of a discount rate that reflects the current return
requirements of the market in relation to present risk-free interest
rates, required equity market premiums, and company-specific risk
indicators.
A summary of the accounting policies used by management is disclosed in Note A,
"Summary of Significant Accounting Policies" on pages 43-48 of the most recent
Form 10-K (fiscal year ended December 31, 2004).
14
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.
Second quarter and June year-to-date ("YTD") earnings per share were $0.06 and
$0.12, respectively above their respective prior year periods, driven by higher
earning asset levels, improved asset quality, higher non-interest income,
including security gains, and lower acquisition expenses. These were partially
offset by higher recurring operating expenses, a higher cost of funds, and a
slightly higher effective tax rate. In the quarter, the Company continued to
make progress on its objective of shortening the average life of its investment
portfolio, generating a $0.10 per share after-tax gain through the sale of
securities that had optimized their total return and interest-rate sensitivity
characteristics. Cash earnings per share (which excludes the after-tax effect of
the amortization of intangibles assets) were $0.50 versus $0.43 for the prior
year's second quarter.
Asset quality improved in the second quarter of 2005 in comparison to the same
period last year, with reductions in non-performing and delinquent loan ratios.
The Company experienced year-over-year loan growth in consumer mortgage and
consumer installment lending on an organic basis, with declines in the business
lending portfolio. All loan portfolios increased in the second quarter of 2005
as compared to the first quarter. The investment portfolio decreased $97 million
and $68 million as compared to the second quarter of 2004 and December 31, 2004,
respectively. At June 30, 2005 total deposits increased $42.6 million from June
30, 2004's level and $48.5 million since December 31, 2004, as borrowings
decreased $135 million and $122 million during the same time periods.
The Company completed two acquisitions in 2004, including: (1) First Heritage
Bank, a $275 million-asset three branch commercial bank 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
As shown in Table 1, earnings per share for the second quarter and June YTD of
$0.46 and $0.89, respectively, were $0.06 and $0.12 higher than the EPS
generated in the same periods of last year. Net income for the quarter of $14.3
million was up 17.6% over the second quarter of 2004 and net income of $27.6
million for the first six months of 2005 increased 18.5% from the amount earned
in the first six months of 2004. Net interest income for the second quarter of
$36.1 million was down $1.4 million or 3.7% from the prior year comparable
period, while net interest income for the first six months of 2005 of $73.8
million was up $0.3 million over the first half of 2004. Second quarter
non-interest income including securities gains of $16.6 million was up $5.7
million (52%) from the second quarter 2004 and the YTD amount of $29.6 million
rose 38% from the prior year level. Operating expenses of $31.2 million for the
quarter and $62.2 million for the first six months of 2005 were up 4.8% and
4.5%, respectively, from the prior year's comparable periods.
In addition to the earnings results presented above in accordance with generally
accepted accounting principles ("GAAP"), the Company provides cash earnings per
share, which excludes the after-tax effect of the amortization of intangible
assets ($0.04 and $0.08 EPS for the three and six months ended June 30, 2005 and
$.03 and $0.07 EPS for the three and six months ended June 30, 2004). Management
believes that this information helps investors better understand the effect of
acquisition activity in reported results. Cash earnings per share for the second
quarter and the first six months of 2005 were $0.50 and $0.97, respectively, up
16.3% from $0.43 for the second quarter of 2004 and up 15.5% from $0.84 for the
first six months of 2004.
As reflected in Table 1, the primary reasons for improved earnings for both
periods were higher non-interest income including securities gains and a lower
loan loss provision, offset by higher operating expenses. Net interest income
decreased for the second quarter of 2005 as compared to the second quarter of
2004. The increase in the cost of funds more than offset the increase in average
earning assets derived primarily from the acquisitions of First Heritage and
Dansville and organic consumer mortgage and consumer installment loan growth.
The improvement in asset quality metrics and change in portfolio composition
were the primary reasons for the decrease in loan loss provision, despite an
increase in the overall loan portfolio. The increase in non-interest income,
excluding
15
security gains, was mostly attributable to a strong performance by the employee
benefits consulting and plan administration business and additional banking
service fees. These revenue improvements were partially offset by a growth in
operating expenses resulting mostly from the acquisitions made in 2004, as well
as higher compensation and benefit expenses.
Table 1: Summary Income Statements
Three Months Ended Six Months Ended
June 30, June 30,
------------------- -------------------
(000's omitted, except per share data) 2005 2004 2005 2004
-------------------------------------------------------------- -------------------
Net interest income $36,056 $37,457 $73,758 $73,411
Provision for loan losses 2,134 2,300 4,009 4,350
Non-interest income 16,606 10,919 29,565 21,449
Operating expenses 31,200 29,775 62,231 59,531
-------------------------------------------------------------- -------------------
Income before taxes 19,328 16,301 37,083 30,979
Income taxes 5,047 4,160 9,468 7,683
-------------------------------------------------------------- -------------------
Net income $14,281 $12,141 $27,615 $23,296
============================================================== ===================
Diluted earnings per share $ 0.46 $ 0.40 $ 0.89 $ 0.77
Diluted earnings per share-cash (1) $ 0.50 $ 0.43 $ 0.97 $ 0.84
(1) Cash earnings exclude the after-tax effect of the amortization
of intangible assets.
Net Interest Income
Net interest income is the amount by which interest and fees on earning assets
(loans and investments) exceed the cost of funds, primarily interest paid to the
Company's depositors and interest on external borrowings. Net interest margin is
the difference between the gross yield on earning assets and the cost of
interest-bearing funds as a percentage of earning assets.
As shown in Table 2, net interest income (with non-taxable income converted to a
fully tax-equivalent basis) for the second quarter 2005 was $39.6 million, down
$1.5 million or 3.6% from the same period last year. A $71 million increase in
interest-bearing liabilities and a 33-basis point decrease in the net interest
margin more than offset a $138 million increase in average earning-assets. As
reflected in Table 3, the volume changes mentioned above improved net interest
income by $1.5 million over the prior year's second quarter, while the lower net
interest margin adversely impacted net interest income by $3.0 million. June
2005 YTD net interest income of $81.1 million was up $0.7 million or 0.9% from
the year-earlier period. A $314 million increase in average earning asset levels
had a greater positive effect than a $236 million rise in interest-bearing
liabilities and a 33 basis point decline in the net interest margin.
Interest-bearing asset and liability volume changes resulted in $6.9 million
more net interest income, partially offset by a lower net interest margin that
had a negative $6.2 million impact on net interest income.
Higher second quarter and June YTD loan balances were attributable to $212
million of loans acquired in the First Heritage and Dansville transactions and
the $27 million of organic loan growth over the past 12 months, driven
principally by consumer installment and consumer mortgage demand. Average
investments for the second quarter were consistent with the same period last
year at $1.5 billion. Average YTD investments are $133.9 million higher than a
year ago due to significant purchases made in the second quarter of 2004. Total
average deposits were up 3.6% and 5.7% for the quarter and YTD periods in
relation to the previous year, respectively, principally due to the deposits
added in the First Heritage and Dansville acquisitions. Average external
borrowings were increased to fund organic loan growth and investment purchases
in the third quarter of 2004, resulting in average borrowings that were up $8.8
million for the quarter and $129 million for the first half of 2005 in
comparison to the year earlier period.
The net interest margin of 4.16% for the second quarter and 4.25% for the year
to date period dropped 33 basis points versus the same periods in the prior
year. These declines were primarily attributable to increases in the cost of
funds (quarter up 38 basis points, YTD up 28 basis points), due principally to
the effect of the nine rate hikes (25 basis points each) by the Federal Reserve
since last June, while earning assets yields changed minimally (quarter
increased three basis points, YTD down six basis points). The reduction of
earning-asset yields was driven by declines in investment yields of 15 basis
points for the quarter and 23 basis points for the YTD period, while loan yields
increased 14 basis points for the quarter and five basis points for the
year-to-date period. The decrease in investment yields was the result of the
sale and maturity of certain investments, a portion of whose proceeds were used
to lower borrowings versus reinvestment in the current flat yield curve
environment.
16
The second quarter cost of funds increased 38 basis points due to a 20 basis
point increase in deposit costs and a 110 basis point increase in the average
interest rate paid on external borrowings. The increase in the YTD costs of
funds was driven by a nine basis point increase in deposit costs and borrowing
rates that were up 78 basis points.
Tables 2 and 2A below set forth information related to average interest-earning
assets and interest-bearing liabilities and their associated yields and rates
for the periods indicated. Interest income and yields are on a fully
tax-equivalent basis using marginal income tax rates of 38.6% in 2005 and 38.7%
in 2004. 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 2: Quarterly Average Balance Sheet
Three Months Ended Three Months Ended
(000's omitted except yields and rates) June 30, 2005 June 30, 2004
- --------------------------------------------------------------------------------------------- ---------------------------------
Avg. Avg.
Average Yield/Rate Average Yield/Rate
Balance Interest Paid Balance Interest Paid
- --------------------------------------------------------------------------------------------- ---------------------------------
Interest-earning assets:
Time deposits in other banks $ 803 $ 10 5.00% $ 629 $ 1 0.64%
Taxable investment securities (2) 943,212 13,287 5.65% 948,470 13,526 5.74%
Non-taxable investment securities (2) 519,843 8,743 6.75% 506,950 8,882 7.05%
Loans (net of unearned discount)(1) 2,352,533 36,276 6.18% 2,222,827 33,354 6.04%
--------------------- ---------------------
Total interest-earning assets 3,816,391 58,316 6.13% 3,678,876 55,763 6.10%
Non-interest earning assets 490,472 467,079
---------- ----------
Total assets $4,306,863 $4,145,955
========== ==========
Interest-bearing liabilities:
Interest checking, savings and money market deposits $1,179,777 2,189 0.74% $1,122,467 1,512 0.54%
Time deposits 1,202,087 8,095 2.70% 1,197,563 7,009 2.35%
Short-term borrowings 462,913 3,852 3.34% 416,767 1,277 1.23%
Long-term borrowings 338,957 4,591 5.43% 376,350 4,881 5.22%
--------------------- ---------------------
Total interest-bearing liabilities 3,183,734 18,727 2.36% 3,113,147 14,679 1.90%
Non-interest bearing liabilities:
Demand deposits 591,650 550,683
Other liabilities 63,127 51,465
Shareholders' equity 468,352 430,660
---------- ----------
Total liabilities and shareholders' equity $4,306,863 $4,145,955
========== ==========
Net interest earnings $39,589 $41,084
======= =======
Net interest spread 3.77% 4.20%
Net interest margin on interest-earnings assets 4.16% 4.49%
Fully tax-equivalent adjustment on investments and loans $ 3,533 $ 3,627
(1) The impact of interest not recognized on non-accrual loans was immaterial.
(2) Averages for investment securities are based on historical cost basis and
the yields do not give effect to changes in fair value that is reflected
as a component of shareholders' equity and deferred taxes.
17
Table 2a: Year to Date Average Balance Sheet
Six Months Ended Six Months Ended
(000's omitted except yields and rates) June 30, 2005 June 30, 2004
- --------------------------------------------------------------------------------------------- ---------------------------------
Avg. Avg.
Average Yield/Rate Average Yield/Rate
Balance Interest Paid Balance Interest Paid
- --------------------------------------------------------------------------------------------- ---------------------------------
Interest-earning assets:
Time deposits in other banks $ 858 $ 14 3.29% $ 716 $ 2 0.56%
Taxable investment securities (2) 957,550 27,200 5.73% 882,585 26,119 5.95%
Non-taxable investment securities (2) 538,714 18,235 6.83% 479,943 16,922 7.09%
Loans (net of unearned discount)(1) 2,347,528 71,867 6.17% 2,167,108 65,976 6.12%
--------------------- ---------------------
Total interest-earning assets 3,844,650 117,316 6.15% 3,530,352 109,019 6.21%
Non-interest earning assets 498,580 463,177
---------- ----------
Total assets $4,343,230 $3,993,529
========== ==========
Interest-bearing liabilities:
Interest checking, savings and money market deposits $1,181,010 4,141 0.71% $1,088,502 3,057 0.56%
Time deposits 1,200,589 15,322 2.57% 1,185,501 14,098 2.39%
Short-term borrowings 449,620 6,778 3.04% 386,465 2,398 1.25%
Long-term borrowings 388,824 10,007 5.19% 323,414 9,093 5.65%
--------------------- ---------------------
Total interest-bearing liabilities 3,220,043 36,248 2.27% 2,983,882 28,646 1.93%
Non-interest bearing liabilities:
Demand deposits 589,675 535,770
Other liabilities 63,562 53,139
Shareholders' equity 469,950 420,738
---------- ----------
Total liabilities and shareholders' equity $4,343,230 $3,993,529
========== ==========
Net interest earnings $81,068 $80,373
======= =======
Net interest spread 3.88% 4.28%
Net interest margin on interest-earnings assets 4.25% 4.58%
Fully tax-equivalent adjustment $ 7,310 $ 6,962
(1) The impact of interest not recognized on non-accrual loans was immaterial.
(2) Averages for investment securities are based on historical cost basis and
the yields do not give effect to changes in fair value that is reflected
as a component of shareholders' equity and deferred taxes.
18
As discussed above and disclosed in Table 3 below, the quarterly and
year-to-date 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 3: Rate/Volume
--------------------------------- ---------------------------------
2nd Quarter 2005 versus 2nd Six Months Ended June 30, 2005
Quarter 2004 versus June 30, 2004
--------------------------------- ---------------------------------
Increase (Decrease) Due to Change Increase (Decrease) Due to Change
in (1) in (1)
--------------------------------- ---------------------------------
Net Net
(000's omitted) Volume Rate Change Volume Rate Change
--------------------------------- ---------------------------------
Interest earned on:
Time deposits in other banks $ 0 $ 9 $ 9 $ 0 $ 12 $ 12
Taxable investment securities (75) (164) (239) 2,158 (1,077) 1,081
Non-taxable investment securities 222 (361) (139) 2,010 (697) 1,313
Loans (net of unearned discount) 1,983 939 2,922 5,521 370 5,891
Total interest-earning assets (2) $ 2,098 $ 455 $ 2,553 $9,604 ($1,307) $8,297
Interest paid on:
Interest checking, savings and money market deposits $ 81 $ 596 $ 677 $ 276 $ 808 $1,084
Time deposits 27 1,059 1,086 181 1,043 1,224
Short-term borrowings 156 2,419 2,575 449 3,931 4,380
Long-term borrowings (500) 210 (290) 1,729 (815) 914
Total interest-bearing liabilities (2) $ 340 $ 3,708 $ 4,048 $2,390 $ 5,212 $7,602
Net interest earnings (2) $ 1,498 ($2,993) ($1,495) $6,867 ($6,172) $ 695
(1) The change in interest due to both rate and volume has been allocated in
proportion to the relationship of the absolute dollar amounts of change in
each.
(2) Changes due to volume and rate are computed from the respective changes in
average balances and rates and are not a summation of the changes of the
components.
19
Non-interest Income
The Company's sources of non-interest income are as follows: general banking
services related to loans, deposits and other core customer activities typically
provided through the branch network; retirement plan administration and employee
benefit, actuarial and consulting services (Benefit Plans Administrative
Services, Inc. or BPAS), trust services, 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 investment securities and prepayment of term debt.
Table 4: Non-interest Income
Three Months Ended Six Months Ended
June 30, June 30,
----------------------- ----------------------
(000's omitted) 2005 2004 2005 2004
---------------------------------------------------------------------------------------- ----------------------
Deposit service charges and fees $ 5,399 $ 5,037 $ 10,293 $ 9,826
Benefit plan administration, consulting and actuarial fees 2,639 2,257 5,489 4,604
Trust, investment and asset management fees 1,859 2,080 3,640 3,819
Commissions and other 898 780 1,816 1,639
Electronic banking 703 626 1,328 1,155
Mortgage banking (56) 4 109 261
---------------------------------------------------------------------------------------- ----------------------
Sub-total 11,442 10,784 22,675 21,304
Gain on investment securities 5,164 135 6,890 145
---------------------------------------------------------------------------------------- ----------------------
Total non-interest income $ 16,606 $ 10,919 $ 29,565 $ 21,449
======================================================================================== ======================
Non-interest income/operating income (FTE) 29.6% 21.0% 26.7% 21.1%
As displayed in Table 4, non-interest income (excluding securities gains) was
$11.4 million in the second quarter and $22.7 million for the first half of
2005. This corresponded to increases of $0.7 million (6.1%) for the quarter and
$1.4 million (6.4%) for the YTD period in comparison to one year earlier. A
majority of the growth in both time intervals was attributable to the $0.5
million and $0.7 million increases in recurring bank fees for the quarter and
year to date periods, respectively. Benefit plan administration, consulting and
actuarial fees were up 16.9% for the current quarter and 19.2% for the first six
months of 2005 versus year-earlier levels. Gain on the sale of investment
securities increased $5.0 million and $6.7 million for the quarter and year to
date periods, respectively, as the Company took advantage of market conditions
to sell certain securities in order to shorten the average length of the
portfolio and maximize their expected total return. As a result, the expected
life-to-maturity of the portfolio was reduced from 7.0 years at June 30, 2004 to
5.0 years at the end of the current quarter.
Electronic banking, deposit service charges and overdraft fees contributed $0.4
million and $0.6 million to the year-over-year increase in the quarter and YTD
periods, respectively. This was due in large part to the incremental transaction
volume generated from the accounts added through the First Heritage and
Dansville acquisitions. These improvements were partially offset by a decline in
mortgage banking income.
A strong performance at BPAS generated revenue growth of $0.4 million (17%) for
the quarter and $0.9 million (19%) for the first half of 2005, achieved
primarily through enhanced service offerings to both new and existing clients.
Second quarter and June YTD revenue for trust services was up 13.6% and 6.2%
versus the prior year, respectively, also achieved through new client
relationships and the investment of additional assets by established clients. In
comparison to the second quarter in the prior year, EAM and CISI revenues were
down due to softer demand for their traditional investment products.
Year-to-date, CISI has increased 3.5% as compared to the first half of 2004,
while EAM was down slightly for the same period.
The ratio of non-interest income to operating income (FTE basis) was 29.6% for
the quarter and 26.7% for the year-to-date period as compared to 21.0% and 21.1%
for the comparable periods in 2004. Excluding net security gains, the ratio of
non-interest income to operating income (FTE basis) was 22.4% and 21.9% for the
second quarter and YTD periods of 2005, respectively, as compared to 20.8% and
21.0% for the comparable periods in 2004.
20
Operating Expenses
Table 5 below sets forth the quarterly and year-to-date results of the major
operating expense categories for the current and prior year, as well as
efficiency ratios (defined below), a standard measure of overhead utilization
used in the banking industry.
Table 5: Operating Expenses
Three Months Ended Six Months Ended
June 30, June 30,
-------------------- --------------------
(000's omitted) 2005 2004 2005 2004
---------------------------------------------------------- --------------------
Salaries and employee benefits $16,212 $15,392 $32,378 $30,559
Occupancy 2,685 2,500 5,717 5,130
Equipment and furniture 2,170 2,150 4,304 4,302
Legal and professional fees 1,112 970 2,313 1,967
Data processing 1,824 1,924 3,534 3,804
Amortization of intangible assets 1,984 1,759 3,968 3,398
Office supplies 539 577 1,124 1,098
Foreclosed property 501 212 765 443
Acquisition expenses 6 411 47 1,381
Other 4,167 3,880 8,081 7,449
---------------------------------------------------------- --------------------
Total operating expenses $31,200 $29,775 $62,231 $59,531
========================================================== ====================
Operating expenses/average assets 2.91% 2.89% 2.89% 3.00%
Efficiency ratio 57.2% 53.2% 56.1% 53.8%
As shown in Table 5, second quarter 2005 operating expenses were $31.2 million,
up $1.4 million or 4.8% from the prior year level, and year-to-date operating
expenses of $62.2 million rose $2.7 million or 4.5% compared to 2004. The
increases for both periods were primarily attributable to higher personnel and
occupancy costs, amortization of intangibles and business development expenses.
Additionally, in the second quarter of 2005 higher costs were incurred related
to the disposal of several foreclosed properties. Offsetting these increases is
a $0.4 million and $1.3 million decrease in acquisition expenses for the second
quarter and YTD 2005 periods, respectively. In the first quarter of 2004
expenses of $0.9 million relating to an acquisition in a prior year were
recorded. Recurring operating expenses (excluding acquisition expenses) were up
6.2% and 6.9% for the second quarter and the first six months of 2005 versus the
equivalent prior year periods, respectively. The second quarter and YTD
increases in recurring operating expenses were mainly attributable to the
acquisitions of First Heritage and Dansville in the second and fourth quarters
of 2004, respectively, which affected virtually all expense categories. The $0.8
million and $1.8 million rise in personnel expenses for the second quarter and
YTD period in comparison to the prior year were also impacted by merit
increases. In addition, business development expenses, which are included in
other expenses, increased $0.3 million for the quarter and $0.4 million for the
YTD period, due to a more robust marketing strategy.
The Company's efficiency ratio (recurring operating expense excluding intangible
amortization divided by the sum of net interest income (FTE) and recurring
non-interest income) was 57.2% for the second quarter, four percentage points
above the comparable quarter of 2004. This resulted from operating expenses (as
described above) increasing 5.8% primarily due to acquisitions and higher
personnel costs, while recurring operating income decreased 1.6% due to a lower
net interest margin. The efficiency ratio of 56.1% for the first half of 2005
was up 2.3 basis points from a year earlier due to core operating expenses
increasing 6.3% while recurring operating income grew at a lesser, 2.0% pace.
Income Taxes
The second quarter effective income tax rate was 26.1%, a slight increase from
the 25.5% rate used in the second quarter of 2004. The YTD effective tax rate
was 25.5% as compared to 24.8% for the first half of 2004. The increased
effective tax rate for 2005 was principally a result of a lower proportion of
income being generated from tax-exempt securities and loans.
21
Investments
As reflected in Table 6 below, the carrying value of investments (including
unrealized gains on available-for-sale securities) was $1.5 billion at the end
of the second quarter, a decrease of $78 million from December 31, 2004 and June
30, 2004. The book value (excluding unrealized gains) of investments was down
$68 million from year-end 2004 and down $97 million versus June 30, 2004. The
decrease in the portfolio was the result of the decision to sell certain
securities and not fully reinvest cash flows from maturing securities to take
advantage of market conditions to shorten the average life of the portfolio and
maximize the expected total return. As a result, the expected life-to-maturity
of the portfolio was reduced from 7.0 years at June 30, 2004 to 5.0 years at the
end of the current quarter. The overall mix of securities within the portfolio
remained relatively consistent, with a slight decline in the proportion of U.S.
treasury and agency securities. The change in the carrying value of investments
is impacted by the amount of net unrealized gains in the portfolio at a point in
time. Net unrealized gains decreased by $10.1 million and increased by $19.2
million since December 31, 2004 and June 30, 2004, respectively. This
fluctuation is indicative of the interest rate movements during the respective
time periods and the decrease in the portfolio.
Table 6: Investments
June 30, 2005 December 31, 2004 June 30, 2004
------------------------ ------------------------ ------------------------
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 $ 127,418 $ 127,899 $ 127,490 $ 125,906 $ 127,563 $ 121,957
Obligations of state and political subdivisions 5,257 5,301 6,576 6,694 7,653 7,773
Other securities 9,471 9,471 3,578 3,578 3,577 3,577
- --------------------------------------------------- ------------------------ ------------------------ ------------------------
Total held-to-maturity portfolio 142,146 142,671 137,644 136,178 138,793 133,307
- --------------------------------------------------- ------------------------ ------------------------ ------------------------
Available-for-Sale Portfolio:
U.S. treasury and agency securities 577,103 597,548 630,058 650,767 637,166 646,271
Obligations of state and political subdivisions 525,463 547,373 545,698 573,551 543,574 555,393
Corporate securities 35,815 36,941 40,443 43,898 42,177 43,552
Collateralized mortgage obligations 82,301 82,893 70,986 72,444 82,003 84,205
Mortgage-backed securities 51,483 53,144 50,347 52,664 60,182 62,257
- --------------------------------------------------- ------------------------ ------------------------ ------------------------
Sub-total 1,272,165 1,317,899 1,337,532 1,393,324 1,365,102 1,391,678
Equity securities 46,228 46,228 53,371 53,371 53,882 53,882
- --------------------------------------------------- ------------------------ ------------------------ ------------------------
Total available-for-sale portfolio 1,318,393 1,364,127 1,390,903 1,446,695 1,418,984 1,445,560
Net unrealized gain on available-for-sale portfolio 45,734 0 55,792 0 26,576 0
- --------------------------------------------------- ------------------------ ------------------------ ------------------------
Total $1,506,273 $1,506,798 $1,584,339 $1,582,873 $1,584,353 $1,578,867
=================================================== ======================== ======================== ========================
22
Loans
As shown in Table 7, loans ended the second quarter at $2.4 billion, up $20
million (0.9%) year-to-date and up $32 million (1.4%) versus one year earlier.
All of the loan growth for both periods was produced in the consumer mortgage
and consumer installment portfolios. Consistent with prior years, the Company
experienced softness within our lending portfolio in the first quarter, due
principally to seasonal (weather-related) trends and demands. In the second
quarter, loans increased $44.5 million with increases in the consumer
installment portfolio ($35.9 million), business portfolio ($7.4 million) and
consumer mortgage portfolio ($1.2 million).
Table 7: Loans
(000's omitted) June 30, 2005 December 31, 2004 June 30, 2004
------------------------------------------ ------------------ ------------------
Consumer mortgage $ 803,127 34% $ 801,412 34% $ 780,550 33%
Business lending 824,007 35% 831,244 35% 853,034 36%
Consumer installment 751,766 31% 725,837 31% 713,151 31%
------------------------------------------ ------------------ ------------------
Total loans $2,378,900 100% $2,358,493 100% $2,346,735 100%
========================================== ================== ==================
Total consumer mortgages increased $23 million year-over year and $2 million in
the first six months of 2005. Over the last several years, record levels of
refinancing activity were driven by mortgage rates that were at or near 40-year
lows. Consumer mortgages growth slowed in the first quarter of 2005 as the pace
of refinancings slowed after an extended period of elevated demand in the
low-rate environment. The growth for both the twelve and six-month time frames
were derived principally from activity in the New York markets.
Business lending increased $7.4 million in the second quarter, after
experiencing declines (excluding acquisitions) in the last three quarters. This
growth was from the New York market, while the Pennsylvania market was
essentially flat. Despite the increase in the second quarter, business lending
declined $7.2 million in the first six months of 2005 and was down $29 million
from one year ago. These results were impacted by competitive economic
conditions in our primary markets as well as seasonal factors and the planned
payoff of an $8 million relationship in Pennsylvania during the first quarter of
2005.
Consumer installment loans, largely borrowings originated in automobile, marine
and recreational vehicle dealerships as well as branch originated home equity
and installment loans, rose $25.9 million (3.6%) over the last six months and
$38.6 million (5.4%) on a year-over-year basis. Continued low interest rates (by
historical standards), aggressive dealer and manufacturer incentives on new
vehicles, and enhanced business development efforts have helped drive strong
growth in this segment over the last two years. Consumer installment loans
increased in both the New York and Pennsylvania markets during the six-month and
year over year time frames.
23
Asset Quality
Table 8 below exhibits the major components of non-performing loans and assets
and key asset quality metrics for the periods ending June 30, 2005 and 2004 and
December 31, 2004.
Table 8: Non-performing Assets
June 30, December 31, June 30,
(000's omitted, except ratios) 2005 2004 2004
------------------------------------------------------------- -------- ------------ --------
Non-accrual loans $12,455 $11,798 $11,142
Accruing loans 90+ days delinquent 898 1,158 1,234
Restructured loans 0 0 856
------------------------------------------------------------- -------- ------------ --------
Total non-performing loans 13,353 12,956 13,232
Other real estate 684 1,645 1,044
------------------------------------------------------------- -------- ------------ --------
Total non-performing assets $14,037 $14,601 $14,276
============================================================= ======== ============ ========
Allowance for loan losses to total loans 1.35% 1.35% 1.37%
Allowance for loan losses to non-performing loans 240% 245% 242%
Non-performing loans to total loans 0.56% 0.55% 0.56%
Non-performing assets to total loans and other real estate 0.59% 0.62% 0.61%
Delinquent loans (30 days old to non-accruing) to total loans 1.32% 1.45% 1.50%
Net charge-offs to average loans outstanding (quarterly) 0.34% 0.49% 0.26%
Loan loss provision to net charge-offs (quarterly) 106% 72% 160%
As displayed in Table 8, non-performing loans at June 30, 2005 were $13.4
million, an increase of $0.4 million versus year-end 2004 and slightly above the
level at the end of the second quarter 2004. During the second quarter of 2005,
$2.7 million of non-performing consumer mortgages were sold. Offsetting this
decrease was the movement of one large floor plan relationship into
non-performing status. Total non-performing assets including other real estate
decreased $0.2 million from one-year ago and decreased $0.6 million from
year-end 2004, the decrease being the result of disposing of several other real
estate properties.
Non-performing loans were 0.56% of total loans outstanding at the end of the
second quarter consistent with the 0.55% at year-end 2004 and 0.56% at June 30,
2004. The allowance for loan losses to non-performing loans ratio, a general
measure of coverage adequacy, was 240% at the end of the second quarter compared
to 245% at year-end 2004 and 242% at June 30, 2004.
Delinquent loans (30 days through non-accruing) as a percent of total loans was
1.32% at the end of the second quarter, a 13 basis-point decrease from year-end
2004 and 18 basis points below the 1.50% delinquency ratio at June 30, 2004.
Real estate and installment loan delinquency ratios at the end of the second
quarter improved in comparison to both of the earlier periods. Commercial loan
delinquency ratios improved from the second quarter of 2004, but declined from
the fourth quarter of 2004. The current delinquency level at the end of the
quarter was 26 basis points below the Company's average of 1.58% over the
previous eight quarters.
24
Table 9: Allowance for Loan Losses Activity
Three Months Ended Six Months Ended
June 30, June 30,
-------------------- --------------------
(000's omitted, except ratios) 2005 2004 2005 2004
---------------------------------------------------------------------------------------------------
Allowance for loan losses at beginning of period $31,898 $28,821 $31,778 $29,095
Charge-offs:
Business lending 854 613 1,561 1,732
Consumer mortgage 274 34 297 130
Consumer installment 1,882 1,840 3,597 3,649
---------------------------------------------------------------------------------------------------
Total charge-offs 3,010 2,487 5,455 5,511
Recoveries:
Business lending 330 437 371 579
Consumer mortgage 22 10 29 22
Consumer installment 637 602 1,279 1,148
---------------------------------------------------------------------------------------------------
Total recoveries 989 1,049 1,679 1,749
---------------------------------------------------------------------------------------------------
Net charge-offs 2,021 1,438 3,776 3,762
Provision for loan losses 2,134 2,300 4,009 4,350
Allowance on acquired loans 0 2,357 0 2,357
---------------------------------------------------------------------------------------------------
Allowance for loan losses at end of period $32,011 $32,040 $32,011 $32,040
===================================================================================================
Net charge-offs to average loans outstanding:
Business lending 0.26% 0.09% 0.29% 0.32%
Consumer mortgage 0.13% 0.01% 0.07% 0.03%
Consumer installment 0.68% 0.71% 0.64% 0.72%
Total loans 0.34% 0.26% 0.32% 0.35%
As displayed in Table 9, net charge-offs during the second quarter were $2.0
million, $0.6 million higher than the equivalent 2004 period, as all loan
classifications, business, consumer mortgage and consumer installment
experienced increases. The net charge-off ratio (net charge-offs as a percentage
of average loans outstanding) for the second quarter was 0.34%, eight basis
points higher than the comparable quarter of 2004, and nine basis points lower
than average charge off ratio for the previous eight quarters. The increase for
the quarter was primarily due to an additional charge related to the sale of
$2.7 million of non-performing consumer mortgages. On a year-to-date basis, net
charge-offs increased less than $0.1 million, versus the prior year period,
while average loans were up $0.2 million, resulting in a three basis point
decline in the YTD net charge-off ratio to 0.32%
The business lending net charge-off ratio for the quarter increased 17 basis
points to 0.26% and on a year to date basis declined three basis points to 0.29%
from the comparable periods in the prior year. The quarterly fluctuation is a
result of lower than average net charges-offs in the second quarter of the prior
year. The consumer mortgage net charge-off ratio increased twelve basis points
from the same period in 2004 mostly as a result of the previously mentioned sale
of non-performing mortgages. The net charge off ratio for consumer installments
was 0.68% and 0.64% for the second quarter and first six months of 2005,
respectively; lower than the average for the last eight quarters of 0.72%.
A required loan loss allowance of $32.0 million was determined as of June 30,
2005, necessitating a $2.1 million loan loss provision for the quarter, compared
to $2.3 million one year earlier. The second quarter 2005 loan loss provision
was $0.1 million higher than net charge-offs mainly due to the slight increase
in the charge-off level in the quarter. The allowance for loan losses decreased
slightly over the last 12 months, while the loan portfolio grew 1.4%.
Consequently, the ratio of allowance for loan loss to loans outstanding
decreased from 1.37% to 1.35%, which was consistent with the level at December
31, 2004.
Deposits
As shown in Table 10, average deposits of $2.974 billion in the second quarter
were up $34 million compared to fourth quarter 2004 and increased $103 million
versus the same quarter of last year. Deposits totaling $33 million and $212
million were added as a result of the acquisitions of Dansville in December 2004
and First Heritage in May 2004, respectively.
In 2004 and continuing into 2005, the deposit mix shifted towards demand
deposits and more liquid interest-bearing deposits (money market accounts). This
shift in deposit mix may have reflected customers' rising rate expectations and
consequently their unwillingness to be locked into rates and products for
extended periods of time. New product introductions, proactive marketing and
increased yields on money market accounts in the first half of the year resulted
in the average balances for money market accounts increasing from 10.6% of the
total deposits to 11.7% of total deposits. This shift in mix, combined with
increasing interest rates on money market
25
and time deposit accounts increased the quarterly cost of deposits from 1.49% at
December 31, 2004 to 1.73% at June 30, 2005 compared to 1.48% at June 30, 2004.
Excluding the impact of acquisitions, average IPC (individuals and businesses)
second quarter deposits decreased $14.7 million or 0.6% versus December 31, 2004
and were down $43.3 million or 1.7% compared to the year earlier period, mostly
reflecting the competitive conditions in our primary markets. Average public
funds, excluding acquisitions, have increased $25.4 million or 14.3% and $11.0
million or 5.7% over the same periods. A decrease in IPC deposits and an inflow
of public funds deposits in the first half of the year is a common seasonal
fluctuation in our markets as payment of local property taxes shifts funds from
one category to the other.
Table 10: Average Deposits
June 30, December 31, June 30,
(000's omitted) 2005 2004 2004
----------------------------- ---------- ------------ ----------
Demand deposits $ 591,650 $ 584,223 $ 550,683
Interest checking deposits 311,932 309,817 301,509
Savings deposits 518,463 542,954 516,507
Money market deposits 349,382 312,317 304,451
Time deposits 1,202,087 1,189,729 1,197,563
----------------------------- ---------- ---------- ----------
Total deposits $2,973,514 $2,939,040 $2,870,713
============================= ========== ========== ==========
IPC deposits $2,767,250 $2,759,269 $2,677,712
Public fund deposits 206,264 179,771 193,001
----------------------------- ---------- ---------- ----------
Total deposits $2,973,514 $2,939,040 $2,870,713
============================= ========== ========== ==========
Borrowings
At the end of the second quarter, borrowings of $798 million were down $122
million from December 31, 2004 and down $135 million from the second quarter
2004 level. The reduction in borrowings over the last six months was the result
of the decision to not fully reinvest the cash flows from sales and maturities
of investments in the current flat yield curve environment.
Shareholders' Equity
On April 20, 2005 the Company announced that its Board of Directors had
authorized a stock repurchase program to acquire up to 1,500,000 of its shares,
or approximately 5%, of its outstanding common stock. The shares may be
repurchased from time to time, in open market or privately negotiated
transactions over the course of the subsequent 20 months. All reacquired shares
will become treasury shares and will be used for general corporate purposes.
Through June 30, 2005, the Company has repurchased 141,901 shares at an
aggregate cost of $3.4 million.
Total shareholders' equity equaled $473 million at the end of the second
quarter, a decrease of $1.5 million from the balance at December 31, 2004. This
change consisted of net income of $27.6 million, $3.2 million from shares issued
under the employee stock plan, offset by a change in the after-tax market value
adjustment on the available-for-sale investment portfolio of $6.1 million,
dividends declared of $10.9 million and treasury stock purchases of $15.3
million. Over the past 12 months total shareholders' equity increased by $32
million, as net income, and increases in paid-in capital from shares issued
under the employee stock plan more than offset dividends declared, treasury
stock purchases, and a lower market value adjustment.
The Company's Tier I leverage ratio, a primary measure of regulatory capital for
which 5% is the requirement to be "well-capitalized," was 7.14% at the end of
the second quarter, up 20 basis points from year-end 2004 and 13 basis points
higher than its level one year ago. These increases were primarily the result of
increases in stockholders equity as discussed above, while average total assets
have decreased slightly. The tangible equity-to-assets ratio of 5.99% increased
17 basis points versus year-end 2004 and 89 basis points versus June 30, 2004,
for similar reasons.
The dividend payout ratio (dividends declared divided by net income) for the
first half of 2005 was 39.5%, down 1.3 percentage points from one year ago. The
ratio declined because dividends declared increased 14.7%, a lower percentage
increase than the 18.5% growth in net income. The expansion of dividends
declared was caused by the dividend per share being raised 12.5% in August 2004,
from $0.16 to $0.18, offset by a 1.2% decrease in the number of shares
outstanding.
26
Liquidity
Management of the Company's liquidity is critical due to the potential for
unexpected fluctuations in deposits and loans. Adequate sources of both on and
off-balance sheet funding are in place to effectively respond to such unexpected
fluctuations.
The 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); and second, a
projection of subsequent cash availability over an additional 60 days. The
minimum policy level of liquidity under the Basic Surplus/Deficit approach is
7.5% of total assets for both the 30 and 90-day time horizons. As of June 30,
2005, this ratio was 14.0% for both periods excluding the Company's capacity to
borrow additional funds from the Federal Home Loan Bank.
To measure longer-term liquidity, a baseline projection of loan and deposit
growth for five years is made to reflect how current liquidity levels could
change over time. This five-year measure reflects adequate liquidity to fund
loan and other asset growth over the next five years.
New Accounting Pronouncements
See New Accounting Pronouncement section of Note C to the consolidated financial
statements.
Forward-Looking Statements
This document contains comments or information that constitute forward-looking
statements (within the meaning of the Private Securities Litigation Reform Act
of 1995), which involve significant risks and uncertainties. Actual results may
differ materially from the results discussed in the forward-looking statements.
Moreover, the Company's plans, objectives and intentions are subject to change
based on various factors (some of which are beyond the Company's control).
Factors that could cause actual results to differ from those discussed in the
forward-looking statements include: (1) risks related to credit quality,
interest rate sensitivity and liquidity; (2) the strength of the U.S. economy in
general and the strength of the local economies where the Company conducts its
business; (3) the effect of, and changes in, monetary and fiscal policies and
laws, including interest rate policies of the Board of Governors of the Federal
Reserve System; (4) inflation, interest rate, market and monetary fluctuations;
(5) the timely development of new products and services and customer perception
of the overall value thereof (including features, pricing and quality) compared
to competing products and services; (6) changes in consumer spending, borrowing
and savings habits; (7) technological changes; (8) any acquisitions or mergers
that might be considered or consummated by the Company and the costs and factors
associated therewith; (9) the ability to maintain and increase market share and
control expenses; (10) the effect of changes in laws and regulations (including
laws and regulations concerning taxes, banking, securities and insurance) and
accounting principles generally accepted in the United States; (11) changes in
the Company's organization, compensation and benefit plans and in the
availability of, and compensation levels for, employees in its geographic
markets; (12) the costs and effects of litigation and of any adverse outcome in
such litigation; (13) other risk factors outlined in the Company's filings with
the Securities and Exchange Commission from time to time; and (14) the success
of the Company at managing the risks of the foregoing.
The foregoing list of important factors is not all-inclusive. Such
forward-looking statements speak only as of the date on which they are made and
the Company does not undertake any obligation to update any forward-looking
statement, whether written or oral, to reflect events or circumstances after the
date on which such statement is made. If the Company does update or correct one
or more forward-looking statements, investors and others should not conclude
that the Company would make additional updates or corrections with respect
thereto or with respect to other forward-looking statements.
Item 3. Quantitative and Qualitative Disclosure about Market Risk
Market risk is the risk of loss in a financial instrument arising from adverse
changes in market rates, prices or credit risk. Credit risk associated with the
Company's loan portfolio has been previously discussed in the asset quality
section of Management's Discussion and Analysis of Financial Condition and
Results of Operations. Management believes that the tax risk of the Company's
municipal investments associated with potential future changes in statutory,
judicial and regulatory actions is minimal. The Company has an insignificant
amount of credit risk in its investment portfolio because essentially all of the
fixed-income securities in the portfolio are AAA-rated (highest possible
rating). Therefore, almost all the market risk in the investment portfolio is
related to interest rates.
The ongoing monitoring and management of both interest rate risk and liquidity,
in the short and long term time horizons is an important component of the
Company's asset/liability management process, which is governed by limits
established in the policies reviewed and approved annually by the Board of
Directors. The Board of Directors delegates responsibility for carrying out the
policies to the Asset/Liability Committee (ALCO) which meets each month and is
made up of the Company's senior management as well as regional and
line-of-business managers who oversee specific earning asset classes and various
funding sources.
27
As the Company does not believe it is possible to reliably predict future
interest rate movements, it has maintained an appropriate process and set of
measurement tools, which enable it to identify and quantify sources of interest
rate risk in varying rate environments. The primary tool used by the Company in
managing interest rate risk is income simulation.
While a wide variety of strategic balance sheet and treasury yield curve
scenarios are tested on an ongoing basis, the following reflects the Company's
one-year net interest income sensitivity based on:
o Asset and liability levels using June 30, 2005 as a starting point.
o There are assumed to be conservative levels of balance sheet growth--low
to mid single digit growth in loans and deposits, while using the
cashflows from investment contractual maturities and prepayments to repay
short-term capital market borrowings.
o The prime rate and federal funds rates are assumed to move up 200 basis
points and down 100 basis points over a 12-month period while moving 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.
o Cash flows are based on contractual maturity, optionality and amortization
schedules along with applicable prepayments derived from internal
historical data and external sources.
Net Interest Income Sensitivity Model
Calculated annualized
increase (decrease) in
projected net interest
Change in interest income
rates at June 30, 2005
------------------------------------------------
+ 200 basis points (1.1%)
- 100 basis points (0.3%)
The modeled net interest income 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 net interest income improves in a rising
rate environment as a result of lower yielding earning assets running off and
being replaced at increased rates.
The analysis does not represent a Company forecast and should not be relied upon
as being indicative of expected operating results. These hypothetical estimates
are based upon numerous assumptions: the nature and timing of interest rate
levels (including yield curve shape), prepayments on loans and securities,
deposit decay rates, pricing decisions on loans and deposits,
reinvestment/replacement of asset and liability cash flows, and other factors.
While the assumptions are developed based upon current economic and local market
conditions, the Company cannot make any assurances as to the predictive nature
of these assumptions, including how customer preferences or competitor
influences might change. Furthermore, the sensitivity analysis does not reflect
actions that ALCO might take in responding to or anticipating changes in
interest rates.
Item 4. Controls and Procedures
We maintain disclosure controls and procedures designed to ensure that we are
able to collect the information we are required to disclose in the reports we
file with the Securities and Exchange Commission, or SEC, and to process,
summarize and disclose this information within the time periods specified in the
rules of the SEC. Based on their evaluation of our disclosure controls and
procedures, our management, with the participation of the Chief Executive and
the Chief Financial Officer, has concluded that, as of the end of the period
covered by this Quarterly Report on Form 10-Q, these disclosure controls and
procedures were effective to ensure that we are able to record, process,
summarize and report the information we are required to disclose in the reports
we file with the SEC within the required time periods.
There have been no significant changes in our internal controls over financial
reporting or in other factors that could significantly affect these controls
subsequent to the date of the evaluation referenced in the paragraph above.
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.
28
Part II. Other Information
Item 1. Legal Proceedings.
The Company and its subsidiaries are subject in the normal course of business to
various pending and threatened legal proceedings in which claims for monetary
damages are asserted. Management, after consultation with legal counsel, does
not anticipate that the aggregate liability, if any, arising out of litigation
pending against the Company or its subsidiaries will have a material effect on
the Company's consolidated financial position or results of operations.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
On April 20, 2005, the Company announced a twenty-month authorization to
repurchase up to 1,500,000 of its outstanding shares in open market or privately
negotiated transactions. These repurchases will be for general corporate
purposes, including those related to stock plan activities. The following table
shows treasury stock purchases during the second quarter 2005.
Total Number Number of Shares
Number of Average Price of Shares Remaining to be
Shares Purchased Per share Purchased Purchased
- --------------------------------------------------------------------------------
April 2005 0 $ 0.00 0 1,500,000
May 2005 0 0.00 0 1,500,000
June 2005 141,901 23.83 141,901 1,358,099
- --------------------------------------------------------------------------------
Total 141,901 $ 23.83 141,901 1,358,099
================================================================================
Item 3. Defaults Upon Senior Securities.
Not applicable.
Item 4. Submission of Matters to a Vote of Securities Holders.
At the annual meeting of the shareholders held on May 11, 2005, the shareholders
elected four nominees of the Board of Directors.
For Against/Abstain Unvoted
-----------------------------------------------
Brian R. Ace 25,176,885 135,706 0
Paul M. Cantwell, Jr. 24,538,802 773,789 0
William M. Dempsey 24,604,222 708,369 0
Lee T. Hirschey 24,954,916 357,675 0
Item 5. Other Information.
Not applicable
Item 6. Exhibits and Reports on Form 8-K
Exhibit No. Description
- ----------- -----------
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
Reports on Form 8-K:
o Form 8-K related to quarterly earnings press release was filed on July 26,
2005.
29
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Community Bank System, Inc.
Date: August 5, 2005 /s/ Sanford A. Belden
---------------------
Sanford A. Belden, President, Chief
Executive Officer and Director
Date: August 5, 2005 /s/ Scott A. Kingsley
---------------------
Scott A. Kingsley, Treasurer and Chief
Financial Officer
30