-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, URV2gT+/Una1ikWOaYDVw5QMVuLPQKGfbRlBdO5A9A/Xk/9KgM1jjeGec2QAJJCm OQxTccXADflCZLlajtMqAQ== 0001169232-03-003746.txt : 20030515 0001169232-03-003746.hdr.sgml : 20030515 20030515100421 ACCESSION NUMBER: 0001169232-03-003746 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 20030331 FILED AS OF DATE: 20030515 FILER: COMPANY DATA: COMPANY CONFORMED NAME: COMMUNITY BANK SYSTEM INC CENTRAL INDEX KEY: 0000723188 STANDARD INDUSTRIAL CLASSIFICATION: NATIONAL COMMERCIAL BANKS [6021] IRS NUMBER: 161213679 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-13695 FILM NUMBER: 03701401 BUSINESS ADDRESS: STREET 1: 5790 WIDEWATERS PKWY CITY: DEWITT STATE: NY ZIP: 13214 BUSINESS PHONE: 8007242262 MAIL ADDRESS: STREET 1: 5790 WIDEWATERS PARKWAY CITY: DEWITT STATE: NY ZIP: 13214 10-Q 1 d55774_10q.txt QUARTERLY REPORT FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 QUARTERLY REPORT Pursuant to Section 13 OR 15(d) of the Securities Exchange Act of 1934 For the three months ended March 31, 2003 Commission file number 0-11716 [GRAPHIC OMITTED] COMMUNITY BANK SYSTEM, INC. (Exact name of registrant as specified in its charter) New York Stock Exchange (Name of Each Exchange on Which Registered) Delaware 16-1213679 (State or other jurisdiction (I.R.S. Employer Identification No. of incorporation) 5790 Widewaters Parkway, DeWitt, New York 13214-1883 (Address of principal executive offices) (Zip Code) (315) 445-2282 (Registrant's telephone number, including area code) 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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date. Common Stock, No par value - 13,034,474 shares outstanding as of May 14, 2003 TABLE OF CONTENTS Page ---- Part I. Financial Information Item 1. Financial Statements (Unaudited) Consolidated Statements of Condition March 31, 2003, December 31, 2002 and March 31, 2002 ................. 3 Consolidated Statements of Income Three months ended March 31, 2003 and 2002 ........................... 4 Consolidated Statement of Shareholders' Equity Three months ended March 31, 2003 .................................... 5 Consolidated Statements of Comprehensive Income Three months ended March 31, 2003 and 2002 ........................... 6 Consolidated Statements of Cash Flows Three months ended March 31, 2003 and 2002 ........................... 7 Notes to Consolidated Financial Statements March 31, 2003 ....................................................... 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations .................... 12 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. Changes in Securities ............................................ 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. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CONDITION (Unaudited) (In Thousands, Except Share Data)
- ------------------------------------------------------------------------------------------------------- March 31, December 31, March 31, 2003 2002 2002 - ------------------------------------------------------------------------------------------------------- Assets Cash and due from banks $ 104,325 $ 113,531 $ 92,115 Investment securities 1,225,081 1,283,565 1,297,471 Loans 1,820,686 1,806,905 1,724,400 Allowance for loan losses 27,350 26,331 24,010 - ------------------------------------------------------------------------------------------------------- Net loans 1,793,336 1,780,574 1,700,390 Premises and equipment, net 56,893 56,997 53,864 Accrued interest receivable 21,876 22,772 24,982 Core deposit intangibles, net 29,488 30,769 35,182 Goodwill, net 104,059 104,059 104,578 - ------------------------------------------------------------------------------------------------------- Intangible assets, net 133,547 134,828 139,760 Other assets 39,782 41,937 38,169 - ------------------------------------------------------------------------------------------------------- Total Assets $3,374,840 $3,434,204 $3,346,751 ======================================================================================================= Liabilities and Shareholders' Equity Liabilities: Deposits Noninterest bearing $ 431,175 $ 439,075 $ 415,547 Interest bearing 2,104,785 2,066,281 2,121,435 - ------------------------------------------------------------------------------------------------------- Total deposits 2,535,960 2,505,356 2,536,982 Federal funds purchased 50,000 33,000 30,000 Borrowings 315,213 430,241 396,425 Company obligated mandatorily redeemable preferred securities of subsidiaries, Community Capital/Statutory Trust I-III, holding solely junior subordinated debentures of the Company 76,889 77,375 77,833 Accrued interest and other liabilities 59,794 63,194 33,421 - ------------------------------------------------------------------------------------------------------- Total liabilities 3,037,856 3,109,166 3,074,661 - ------------------------------------------------------------------------------------------------------- Shareholders' equity: Common stock no par $1.00 stated value for 2003 and 2002 20,000,000 share authorized; 13,017,178, 12,978,554 and 12,936,600 shares outstanding, respectively 13,017 12,979 12,937 Surplus 79,984 79,058 78,684 Undivided profits 200,657 194,483 175,541 Accumulated other comprehensive income 43,414 38,551 5,226 Employee stock plan - unearned (88) (33) (298) - ------------------------------------------------------------------------------------------------------- Total shareholders' equity 336,984 325,038 272,090 - ------------------------------------------------------------------------------------------------------- Total Liabilities and Shareholders' Equity $3,374,840 $3,434,204 $3,346,751 =======================================================================================================
The accompanying notes are an integral part of the consolidated financial statements. 3 COMMUNITY BANK SYSTEM, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Unaudited) (In Thousands, Except Per-Share Data)
- ------------------------------------------------------------------------------ Quarter Ended March 31, - ------------------------------------------------------------------------------ 2003 2002 - ------------------------------------------------------------------------------ Interest income: Interest and fees on loans $31,215 $33,058 Interest and dividends on investments: Taxable 12,315 14,120 Nontaxable 4,682 3,598 Interest on federal funds and deposits with other banks 0 1 - ------------------------------------------------------------------------------ Total interest income 48,212 50,777 - ------------------------------------------------------------------------------ Interest expense: Interest on deposits 10,636 15,169 Interest on federal funds purchased 85 87 Interest on short-term borrowings 477 211 Interest on mandatorily redeemable preferred securities of subsidiaries 1,365 1,473 Interest on long-term borrowings 3,165 3,669 - ------------------------------------------------------------------------------ Total interest expense 15,728 20,609 - ------------------------------------------------------------------------------ Net interest income 32,484 30,168 Less: provision for loan losses 3,400 1,518 - ------------------------------------------------------------------------------ Net interest income after provision for loan losses 29,084 28,650 - ------------------------------------------------------------------------------ Other income: Fiduciary and investment services 871 878 Service charges on deposit accounts 4,375 2,921 Commissions and advisory fees on investment products 1,319 1,970 Other service charges, commissions and fees 2,192 1,960 Other operating income, net 285 6 Net investment security gain and loss on early retirement of long-term borrowings (45) 0 - ------------------------------------------------------------------------------ Total other income 8,997 7,735 - ------------------------------------------------------------------------------ Other expenses: Salaries and employee benefits 12,778 12,125 Occupancy expense, net 2,421 2,322 Equipment and furniture expense 1,904 1,871 Amortization of intangible assets 1,281 1,540 Legal and professional fees 736 854 Data processing expenses 1,604 1,679 Office supplies 586 687 Acquisition and unusual expenses 0 592 Other 3,327 2,979 - ------------------------------------------------------------------------------ Total other expenses 24,637 24,649 - ------------------------------------------------------------------------------ Income before income taxes 13,444 11,736 Income taxes 3,495 3,178 - ------------------------------------------------------------------------------ Net Income $9,949 $8,558 ============================================================================== Earnings per share - Basic $ 0.76 $ 0.66 ============================================================================== Earnings per share - Diluted $ 0.75 $ 0.65 ==============================================================================
The accompanying notes are an integral part of the consolidated financial statements. 4 COMMUNITY BANK SYSTEM, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited) Three Months Ended March 31, 2003 (In Thousands, Except Share Data)
- ----------------------------------------------------------------------------------------------------------------- Common Stock Accumulated Employee ------------------ Other Stock Shares Undivided Comprehensive Plan Outstanding Amount Surplus Profits Income -Unearned Total - ----------------------------------------------------------------------------------------------------------------- Balance at December 31, 2002 12,978,554 $12,979 $79,058 $194,483 $38,551 ($33) $325,038 Net income 9,949 9,949 Other comprehensive income, net of tax 4,863 4,863 Dividends declared: Common, $.29 per share (3,775) (3,775) Common stock issued under employee stock plan 38,624 38 926 (55) 909 - ----------------------------------------------------------------------------------------------------------------- Balance at March 31, 2003 13,017,178 $13,017 $79,984 $200,657 $43,414 ($88) $336,984 =================================================================================================================
The accompanying notes are an integral part of the consolidated financial statements. 5 COMMUNITY BANK SYSTEM, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) (In Thousands)
- ------------------------------------------------------------------------------------------ Quarter Ended March 31, - ------------------------------------------------------------------------------------------ 2003 2002 - ------------------------------------------------------------------------------------------ Other comprehensive income (loss), before tax: Change in minimum pension liability adjustment $ 97 $ 4,919 Unrealized gain (loss) on securities: Unrealized holding gains (losses) arising during period 6,532 (8,484) Reclassification adjustment for gains included in net income in net income 0 0 - ------------------------------------------------------------------------------------------ Other comprehensive income (loss), before tax 6,629 (3,565) Income tax (expense) benefit related to other comprehensive (1,766) 1,510 income (loss) - ------------------------------------------------------------------------------------------ Other comprehensive income (loss), net of tax 4,863 (2,055) Net income 9,949 8,558 - ------------------------------------------------------------------------------------------ Comprehensive income $14,812 $ 6,503 ==========================================================================================
The accompanying notes are an integral part of the consolidated financial statements. 6 COMMUNITY BANK SYSTEM, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (In Thousands)
- --------------------------------------------------------------------------------------------------- Quarter Ended March 31, - --------------------------------------------------------------------------------------------------- 2003 2002 - --------------------------------------------------------------------------------------------------- Operating Activities: Net income $ 9,949 $ 8,558 Adjustments to reconcile net income to net cash provided by operating activities Depreciation 1,697 1,453 Amortization of intangible assets 1,281 1,540 Net amortization of security premiums and discounts 627 1,181 Amortization of discount of loans (16) (35) Amortization of unearned compensation and discount on junior subordinated debentures 22 133 Provision for loan losses 3,400 1,518 Provision for deferred taxes 1,259 716 Loss on early retirement of long-term borrowings 45 0 Gain on sale of loans and other assets (233) (6) Proceeds from the sale of loans held for sale 30,860 0 Change in interest receivable 896 (2,420) Change in other assets and other liabilities (3,362) (10,213) - --------------------------------------------------------------------------------------------------- Net cash provided by operating activities 46,425 2,425 - --------------------------------------------------------------------------------------------------- Investing Activities: Proceeds from sales of investment securities 6,960 8,350 Proceeds from maturities of held-to-maturity investment securities 1,095 1,239 Proceeds from maturities of available-for-sale investment securities 58,086 42,849 Purchases of held-to-maturity investment securities (1,191) (1,138) Purchases of available-for-sale investment securities (1,242) (210,254) Net change in loans outstanding (46,686) 7,095 Capital expenditures (1,680) (2,044) - --------------------------------------------------------------------------------------------------- Net cash provided (used) by investing activities 15,342 (153,903) - --------------------------------------------------------------------------------------------------- Financing Activities: Net change in demand deposits, NOW accounts, and savings accounts 37,658 17,453 Net change in certificates of deposit (7,054) (26,441) Net change in federal funds purchased 17,000 15,800 Net change in term borrowings (115,545) 133,000 Issuance of common stock 756 735 Cash dividends paid (3,760) (3,480) Other financing activities (28) (28) - --------------------------------------------------------------------------------------------------- Net cash (used) provided by financing activities (70,973) 137,039 - --------------------------------------------------------------------------------------------------- Change in cash and cash equivalents (9,206) (14,439) Cash and cash equivalents at beginning of year 113,531 106,554 - --------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of period $104,325 $ 92,115 =================================================================================================== Supplemental Disclosures of Cash Flow Information: Cash paid for interest $ 16,307 $ 21,443 Cash paid for income taxes $ 1,600 $ 607 =================================================================================================== Supplemental Disclosures of Noncash Financing and Investing Activities: Dividends declared and unpaid $ 3,775 $ 3,491 Gross change in unrealized gains and (losses) on available-for-sale securities $ 6,532 ($ 8,484) Change in minimum pension liability adjustment ($97) ($ 4,919) ===================================================================================================
The accompanying notes are an integral part of the consolidated financial statements. 7 COMMUNITY BANK SYSTEM, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Three Months Ended March 31, 2003 NOTE A: BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments considered necessary for fair presentation have been included. Operating results for the three months ended March 31, 2003 are not necessarily indicative of the results that may be expected for the year ended December 31, 2003. On May 7, 2003, the Company announced that it has signed a definitive agreement with Peoples Bankcorp, Inc. (PBI) to acquire all the stock of PBI and to merge Peoples Bankcorp, Inc. into Community Bank System, Inc. The Company will pay $30 for each outstanding common share of PBI for a total purchase price of approximately $4.2 million. PBI's single branch in Ogdensburg, New York, will be operated as a branch of the Bank, as part of its network of branches in Ogdensburg and Northern New York. NOTE B: CRITICAL ACCOUNTING POLICIES Allowance for Loan Losses When appropriate, an impaired loan is assigned a specific allowance. Specific loan loss allocations for certain identified commercial customers are considered and revised as necessary. Charge-offs of these commercial customers are taken against the specific allocations before being applied against the general reserve. General allocations on the commercial, residential and consumer loan portfolios are reviewed and recalculated quarterly based on historical loss experience and various qualitative judgement factors. These qualitative factors include changes in national and local economic and business conditions, changes in experience, ability and depth of lending management, changes in the portfolio mix and risk profile, and changes in the growth of the loan portfolios. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. The allowance for loan losses reflects management's best estimate of probable loan losses in the Company's loan portfolio. Determination of the allowance for loan losses is inherently subjective. It requires significant estimates including the amounts and timing of expected future cash flows on impaired loans and the amount of estimated losses on pools of homogeneous loans which is based on historical loss experience and consideration of current economic trends, all of which may be susceptible to significant change. Stock-Based Compensation The Company accounts for stock awards issued to directors, officers and key employees using the intrinsic value method. This method requires that compensation expense be recognized to the extent that the fair value of the stock exceeds the exercise price of the stock award at the grant date. The Company generally does not recognize compensation expense related to stock awards because the stock awards generally have fixed terms and exercise prices that are equal to or greater than the fair value of the Company's common stock at the grant date. SFAS 123, "Accounting for Stock-Based Compensation," requires companies that use the "intrinsic value method" to account for stock compensation plans to provide pro forma disclosures of the net income and earnings per share effect of stock options using the "fair value method." Under the intrinsic value method, the excess of the fair value of the stock over the exercise price is recorded as expense on the date at which both the number of shares the recipient is entitled to receive and the exercise price are known. Management estimated the fair value of options granted using the Black-Scholes option-pricing model. This model was originally developed to estimate the fair value of exchange-traded equity options, which (unlike employee stock options) have no vesting period or transferability restrictions. As a result, the Black-Scholes model is not a perfect indicator of the value of an option, but it is commonly used for this purpose. 8 The Black-Scholes model requires several assumptions, which management developed based on historical trends and current market observations. These assumptions include: - -------------------------------------------------- 2003 2002 - -------------------------------------------------- Weighted-average expected life 8.76 8.47 Future dividend yield 3.00% 3.00% Share price volatility 27.58% 28.05% Weighted average risk-free interest rate 4.03% 5.16% ================================================== If these assumptions are not accurate, the estimated fair value used to derive the information presented in the following table also will be inaccurate. Moreover, the model assumes that the estimated fair value of an option is amortized over the option's vesting period and would be included in personnel expense on the income statement. The pro forma impact of applying the fair value method of accounting for the years shown below may not be indicative of the pro forma impact in future years. - --------------------------------------------------------------------- Quarter Ended March 31, (000's omitted, except per share data) 2003 2002 - --------------------------------------------------------------------- Net income: As reported $9,949 $8,558 Pro forma $9,753 $8,386 Earnings per share: As reported: Basic $ 0.76 $ 0.66 Diluted $ 0.75 $ 0.65 Pro forma: Basic $ 0.75 $ 0.65 Diluted $ 0.74 $ 0.64 ===================================================================== NOTE C: EARNINGS PER SHARE Basic-earnings per share are computed based on the weighted-average common shares outstanding for the period. Diluted-earnings per share are based on the weighted-average shares outstanding adjusted for the dilutive effect of the assumed exercise of stock options during the year. The dilutive effect of options is calculated using the treasury stock method of accounting. The treasury stock method determines the number of common shares which would be outstanding if all the in-the-money options (average market price is greater than the exercise price) were exercised and the proceeds were used to repurchase common shares in the open market at the average market price for the applicable time period. The following is a reconciliation of basic to diluted earnings per share for the three months ended March 31, 2003 and 2002. - ----------------------------------------------------------------- Per Share (000's omitted except per share data) Income Shares Amount - ----------------------------------------------------------------- March 31, 2003 Net income $9,949 Basic EPS 9,949 13,029 $0.76 Effect of dilutive securities: Stock options 215 ----------------- Diluted EPS $9,949 13,244 $0.75 ================================================================= March 31, 2002 Net income $8,558 Basic EPS 8,558 12,940 $0.66 Effect of dilutive securities: Stock options 153 ----------------- Diluted EPS $8,558 13,093 $0.65 ================================================================= 9 NOTE D: INTANGIBLE ASSETS Effective January 1, 2002, the Company adopted SFAS 142, "Goodwill and Other Intangible Assets," which addresses financial accounting and reporting for acquired goodwill and other intangible assets and supercedes APB Opinion 17, "Intangible Assets". The statement requires that the Company subject goodwill and other intangible assets to an annual impairment analysis to assess the need to write down the balances and recognize an impairment loss. In addition, amortization of goodwill is no longer being recorded in accordance with this statement. Core deposit intangibles will continue to be amortized. In October 2002, the FASB issued SFAS 147, "Accounting for Certain Acquisitions of Banking and Thrift Institutions." This statement removes acquisitions of financial institutions from the scope of SFAS 72 and FASB Interpretation 9. It reclassifies as goodwill certain "unidentified intangible assets" associated with the Company's branch acquisitions dating as far back as 1994. Financial statements were retroactively restated to January 1, 2002 to remove amortization recorded on Other Intangible Assets. Previously, these intangible assets were being regularly amortized. As discussed above, under FASB 142, goodwill is not required to be amortized, but as an asset, is periodically reviewed for impairment. In accordance with the provisions of SFAS 147, the Company adopted this Statement retroactive to January 1, 2002, with the impact of restatement on previously issued Form 10Q's as of March 31, 2002 contained below. - ----------------------------------------------------------------- Three Months Ended March 31, (000's omitted except per share data) 2002 - ----------------------------------------------------------------- Net income as previously reported $7,438 Branch goodwill amortization, net of tax 1,120 - ----------------------------------------------------------------- Net income as restated $8,558 ================================================================= Basic EPS as previously reported $ 0.57 Diluted EPS as previously reported $ 0.57 Basic EPS as restated $ 0.66 Diluted EPS as restated $ 0.65 - ----------------------------------------------------------------- The Company completed its goodwill impairment analysis during the first quarter 2003, and no adjustment was necessary. The gross carrying amount and accumulated amortization for each type of intangible asset are as follows:
- --------------------------------------------------------------------------------------------- As of March 31, 2003 As of December 31, 2002 - --------------------------------------------------------------------------------------------- Gross Net Gross Net Carrying Accumulated Carrying Carrying Accumulated Carrying (000's omitted) Amount Amortization Amount Amount Amortization Amount - --------------------------------------------------------------------------------------------- Amortized intangible assets: Core deposit intangibles $47,366 ($17,878) $29,488 $47,366 ($16,597) $30,769 Unamortized intangible assets: Goodwill 122,432 (18,373) 104,059 122,432 (18,373) 104,059 - --------------------------------------------------------------------------------------------- Total intangible assets, net $169,798 ($36,251) $133,547 $169,798 ($34,970) $134,828 =============================================================================================
The estimated aggregate amortization expense for each of the succeeding fiscal years ended December 31 is as follows: 2003 $3,689 2004 4,753 2005 4,079 2006 3,406 2007 3,406 2008 3,406 Thereafter 6,749 - ------------------ Total $29,488 ================== 10 NOTE E: MANDATORILY REDEEMABLE PREFERRED SECURITIES On February 3, 1997, the Company formed a wholly-owned subsidiary business trust, Community Capital Trust I (Trust), for the purpose of issuing Company-Obligated Mandatorily Redeemable Preferred Securities representing undivided beneficial interests in the assets of the Trust. The Trust issued $30,000 of 9.75% preferred securities that are non-voting and mandatorily redeemable in 2027 with a ten-year call provision beginning in 2007 at a premium of 104.54% declining to par in 2017. The Company borrowed the proceeds of the preferred securities from the Trust by issuing Junior Subordinated Debentures having substantially similar terms as the preferred securities. The assets of the Trust include the principal amount of the Company's Junior Subordinated Debentures and related accrued interest and were $32,022 at December 31, 2002. The preferred securities mature in 2027 and are treated as Tier 1 capital. The guarantees issued by the Company for the Trust, together with the Company's obligations under the trust agreement, the Junior Subordinated Debentures, and the Indenture under which the Junior Subordinated Debentures were issued, constitute a full and unconditional guarantee by the Company of the preferred securities issued by the Trust. The costs related to the issuance of these securities are capitalized and amortized over the life of the period to redemption on a straight-line basis. On July 16, 2001, the Company formed a wholly-owned subsidiary, Community Capital Trust II, a Delaware business trust. The trust issued $25,000 of 30 year floating-rate Company-obligated pooled capital securities of Community Capital Trust II holding solely parent debentures. On July 31, 2001, the Company formed a wholly-owned subsidiary, Community Statutory Trust III, a Connecticut business trust. The trust issued $24,450 of 30 year floating-rate Company-obligated pooled capital securities of Community Statutory Trust III holding solely parent debentures. The Company borrowed the proceeds of the capital securities from its subsidiaries by issuing deeply subordinated junior debentures having substantially similar terms. The capital securities mature in 2031 and are treated as Tier I capital by the Federal Reserve Bank of New York. Trust II capital securities are a pooled trust preferred fund of MM Community Funding I, Ltd, and are tied to the six- month LIBOR plus 3.75%, with a five-year call provision beginning in 2006 at a premium of 107.6875% declining to par in 2011. Trust III capital securities are a pooled trust preferred fund of First Tennessee/KBW Pooled Trust Preferred Deal III and are tied to the three month LIBOR plus 3.58%, with a five-year call provision beginning in 2006 at a premium of 107.5% declining to par in 2011. All of these securities are guaranteed by the Company. 11 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Introduction This Management's Discussion and Analysis ("MD&A") primarily reviews the financial condition and results of operations of Community Bank System, Inc., and its subsidiaries for the first quarters of 2003 and 2002, although in some circumstances the fourth quarter of 2002 is also discussed in order to more fully explain near-term trends. The following discussion and analysis should be read in conjunction with the Company's Consolidated Financial Statements and related notes that appear on pages 3 through 11. All references in the discussion to financial condition and results of operations are to the consolidated position and results of the Company and its subsidiaries taken as a whole. All references to "peer banks", unless otherwise noted, pertain to a group of 75 bank holding companies nationwide having $3 billion to $10 billion in assets and their associated composite financial results for the 12 months ending December 31, 2002 (the most recently available disclosure) as provided by the Federal Reserve System. Lastly, unless otherwise noted, the term "this year" refers to results in calendar year 2003 and all earnings per share ("EPS") figures disclosed in the MD&A refer to diluted EPS. This Management's Discussion and Analysis of Financial Condition and Results of Operations contains certain forward-looking statements with respect to the financial condition, results of operations and business of Community Bank System, Inc. ("CBSI" or "the Company"). These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements are set herein under the caption, "Forward-Looking Statements," on page 26. Accounting Policies As a result of the complex and dynamic nature of the Company's business, management must exercise judgement in selecting and applying the most appropriate accounting policies for its various areas of operations. The policy decision process not only ensures compliance with the latest generally accepted accounting principles, but also reflects on management's discretion with regard to choosing the most suitable methodology for reporting the Company's financial performance. It is management's opinion that the accounting estimates covering certain aspects of the business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity in the selection process. Management believes that these areas include the allowance for loan losses, fair value of investment securities, fair value methodologies used to review the carrying value of goodwill, and actuarial assumptions associated with the pension, post-retirement and other employee benefit plans. Refer to Note A, "Summary of Significant Accounting Policies", on pages 66 - 71 of the most recent Form 10K (fiscal year ended December 31, 2002) for a complete review of the Company's most important accounting policies. Net Income and Profitability As shown in Table 1, earnings per share (diluted) for the first quarter were $0.75, up 15.4% from the prior year's level of $0.65 and up 2.7% from fourth quarter 2002's results of $0.73. On an operating basis, earnings per share (diluted) rose 10.3% versus first quarter 2002. This measurement excludes acquisition and unusual expenses in the first quarter of last year largely related to the purchase of 36 branches from FleetBoston Financial in mid-November 2001. Net income for the quarter was $9.9 million, up $1.4 million or 16.3% over first quarter 2002's level, and $310,000 or 3.2% higher than was generated during the fourth quarter of 2002. Net interest income (full tax-equivalent) for first quarter 2003 rose to $35.5 million, 8.5% over the same period last year. Compared to fourth quarter 2002, net interest income (full tax-equivalent) was down $1.7 million or 4.6% due to the previously announced strategy not to reinvest securities run-off until longer-term market conditions are more favorable. Noninterest income (excluding securities and debt transactions) of $9.0 million in the first quarter was up $1.3 million (16.9%) from first quarter 2002, and was $1.3 million higher (16.6%) than fourth quarter 2002's level. As revealed in Table 1, the primary reasons for improved first quarter earnings compared to the same period last year were significantly higher net interest income and noninterest income. The increase in net interest income was driven by higher interest earning assets and improved net interest margins. The higher noninterest income was mostly attributable to the incremental fees generated by the Company's Overdraft FreedomTM program (described in the noninterest income section on page 17) initiated in December 2002, and income associated with secondary market mortgage portfolio activity. Increased operating income more than offset a higher loan loss provision which resulted from increased net charge-offs, a higher level of commercial loans identified as impaired, and the revision of one of the qualitative risk factors used to calculate general commercial loan allocations (refer to the asset quality discussion starting on page 23 for further detail). Improvement in first quarter earnings in comparison to the fourth quarter of 2002 was primarily a result of a lower loan loss provision and higher noninterest income, offset partially by lower net interest income and higher noninterest expense. The lower loan loss provision was mostly due to a reduced level of net charge-offs in the first quarter and the impact of the annual update of the historical 12 period used for the general loan loss allowance calculation in the fourth quarter. The increase in first quarter noninterest income was again driven by higher overdraft fees and income derived from the secondary market mortgage portfolio. As mentioned, the drop in net interest income was caused by the decision to deleverage the balance sheet until market interest rates become more attractive for investment purposes. Higher operating expenses were primarily a result of increased personnel and net occupancy expenses, both of which were impacted by normal seasonal fluctuations (front-loaded personnel taxes, weather-related occupancy costs). Each of these items is discussed in further detail in their respective sections of the MD&A (pages 14 through 20). Table 1: Summary Income Statements
- ---------------------------------------------------------------------------------------------------------------- March 31, March 31, December 31, Change from 1Q '02 Change from 4Q '02 (000's omitted) 2003 2002 2002 Amount Percent Amount Percent - ---------------------------------------------------------------------------------------------------------------- Net interest income (full tax-equiv.) $35,464 $32,697 $37,173 $2,767 8.5% ($1,709) - 4.6% Loan loss provision 3,400 1,518 5,041 1,882 124.0% (1,641) -32.6% Noninterest income 9,042 7,735 7,753 1,307 16.9% 1,289 16.6% Net investment security gain and loss on early retirement of long-term borrowings (45) 0 313 (45) -100.0% (358) -114.4% Noninterest expense 24,637 24,057 24,027 580 2.4% 610 2.5% Acquisition and unusual expenses 0 592 0 (592) -100.0% 0 0.0% - ---------------------------------------------------------------------------------------------------------------- Income before taxes (full tax-equiv.) 16,424 14,265 16,171 2,159 15.1% 253 1.6% Full tax-equivalent adjustment 2,980 2,529 3,326 451 17.8% (346) -10.4% Income taxes 3,495 3,178 3,206 317 10.0% 289 9.0% - ---------------------------------------------------------------------------------------------------------------- Net income $ 9,949 $ 8,558 $ 9,639 $1,391 16.3% $ 310 3.2% ================================================================================================================ Diluted earnings per share $ 0.75 $ 0.65 $ 0.73 $ 0.10 15.4% $ 0.02 2.7% Diluted earnings per share-operating (1) $ 0.75 $ 0.68 $ 0.73 $ 0.07 10.3% $ 0.02 2.7% - ----------------------------------------------------------------------------------------------------------------
(1) Operating adjusted amounts and ratios exclude the after-tax effect of acquisition and unusual expenses, and accordingly, are not presented in accordance with Generally Accepted Accounting Principles (GAAP). 13 Net Interest Income Net interest income is the amount that interest and fees on earning assets (loans and investments) exceeds the cost of funds, primarily interest paid to the Bank's depositors, interest on capital market borrowings, and dividends paid on the Company's trust preferred stock. 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 full tax-equivalent basis) for first quarter 2003 rose to $35.5 million, 8.5% over the same period last year. The primary reason for the growth was a 28-basis-point increase in the bank-wide net interest margin to 4.80%. As reflected in Table 3, the higher margin accounted for nearly three-quarters (73%) of the $2.8 million improvement (tax-equivalent basis) in net interest income, with a $65 million increase in average earning assets (up 2.2%) contributing the remainder. Compared to fourth quarter 2002, net interest income on a tax equivalent basis was down $1.7 million or 4.6%. Approximately 72% of the reduction reflects a planned $55 million decrease in average earning assets, while the balance was caused by a three-basis-point decrease in the net interest margin. The trend in the margin over the last four quarters reflects a slower decrease in earning asset yields than in the cost of funds, indicative of the interest rate sensitivity of the Bank's balance sheet during this period, coupled with loan and deposit repricing strategies. Approximately 37% of earning assets reprice within one year. This is a function of the cash flow of the investment portfolio, the mix of 62% fixed rate loans and 38% variable rate loans (including loans that mature within 90 days) in the portfolio, and expected loan amortization/pay-downs. Fifty-one percent of total interest-bearing liabilities are regularly repriced (maturing CDs, money market accounts, and certain borrowings) and another 26% are repriced periodically (interest-checking and savings). Maturing CDs continued to reprice downward during the first quarter as measured by the favorable 77-basis-point spread between the rate on CDs running off and the lower rate at which they are being renewed. This favorable spread has been fairly constant for the last three quarters. In addition, rates on other non-CD deposits were lowered further in the first quarter, though the overall cost of deposits benefited primarily from a full quarter's impact of the reductions made in the fourth quarter of 2002 that were consistent with the Federal Reserve's rate decrease. See pages 27-28 for an analysis of the Company's net interest income sensitivity going forward under alternative interest rate and balance sheet assumptions. The slight narrowing in margin compared to fourth quarter 2002 reflects unusual investment income items in each quarter. An additional $269,000 in interest income was booked in the first quarter due to accretion of discounts on called bonds, following $736,000 in the fourth quarter largely for the same reason. Had these items not occurred, the first quarter net interest margin would have been 4.76% compared to 4.74% in the fourth quarter. Earning assets at quarter-end were $39 million lower (down 1.3%) from one year earlier, comprised of $96 million more loans (up 5.6%), offset by $135 million less securities (down 11%). Investments have been allowed to run off during the period, reflective of the Company's strategy to use cash flow to support loan growth and repay borrowings until reinvestment and leverage opportunities become attractive. Nearly half of the investment run-off ($65 million) occurred in first quarter 2003, partially offset by $14 million in loan growth. Approximately $62 million in borrowings has been paid down over the last twelve months as a result of the above investment deleveraging strategy, causing the borrowings-to-earning-asset ratio to drop 1.8 percentage-points to 14.9%. The corresponding pay- down of lower rate, shorter maturity long-term borrowings, caused the rate on total long-term borrowings (which also includes the Company's trust preferred issuances) to increase 47 basis points in the first quarter versus the year-earlier period despite lower market interest rates. However, a strategic shift in the mix of borrowing activity towards short-term borrowings enabled the Company to reduce the cost of funds on overall external borrowings by 79 basis points over the same time frame. 14 Table 2 below sets forth certain information concerning average interest-earning assets and interest-bearing liabilities and their associated yields and rates for the quarters indicated below. Interest income and resultant yield information in the tables are on a fully tax-equivalent basis using a marginal federal income tax rate of 35%. Averages balances are computed using daily balances. Yields and amounts earned include loan fees. Nonaccrual loans have been included in interest-earning assets for purposes of these computations. Table 2: Quarterly Average Balance Sheet
- ------------------------------------------------------------------------------------------------------------------------------------ First Quarter Ended Fourth Quarter Ended March 31, December 31, - ------------------------------------------------------------------------------------------------------------------------------------ 2003 2002 2002 - ------------------------------------------------------------------------------------------------------------------------------------ Avg. Avg. Avg. Amt. Yield/ Amt. Yield/ Amt. Yield/ (000's omitted except yields Avg. Of Rate Avg. Of Rate Avg. Of Rate and rates) Balance Interest Paid Balance Interest Paid Balance Interest Paid - ------------------------------------------------------------------------------------------------------------------------------------ ASSETS Interest-earning assets: Time deposits in other banks $ 223 $ 0 0.00% $ 357 $1 1.14% $ 394 $2 2.01% Taxable investment securities 786,767 12,568 6.48% 898,231 14,428 6.51% 850,383 14,086 6.57% Nontaxable investment securities 402,476 7,237 7.29% 299,673 5,687 7.70% 403,508 7,384 7.26% Loans (net of unearned discount)(1) 1,807,889 31,387 7.04% 1,733,863 33,190 7.76% 1,797,678 33,207 7.33% ------------------- -------------------- ------------------- Total interest-earning assets 2,997,355 51,192 6.93% 2,932,124 53,306 7.37% 3,051,963 54,679 7.11% Noninterest earning assets: Cash and due from banks 102,443 99,356 103,169 Premises and equipment, net 57,114 53,799 56,657 Other assets 192,916 196,881 194,762 Allowance for loan losses (26,327) (23,915) (24,338) Net unrealized gains on available-for-sale portfolio 64,934 26,748 63,407 ---------- ---------- ---------- Total assets $3,388,435 $3,284,993 $3,445,620 ========== ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY: Interest-bearing liabilities: Savings deposits $986,693 1,934 0.79% $959,169 3,195 1.35% $972,360 2,216 0.90% Time deposits 1,101,091 8,702 3.21% 1,157,663 11,974 4.19% 1,112,447 9,552 3.41% Short-term borrowings 171,339 562 1.33% 59,958 298 2.02% 217,122 905 1.65% Long-term borrowings 294,637 4,530 6.24% 361,715 5,142 5.77% 306,781 4,833 6.25% ------------------- -------------------- ------------------- Total interest-bearing liabilities 2,553,760 15,728 2.50% 2,538,505 20,609 3.29% 2,608,710 17,506 2.66% Noninterest bearing liabilities: Demand deposits 449,219 427,901 454,038 Other liabilities 55,953 43,296 61,893 Shareholders' equity 329,503 275,291 320,979 ---------- ---------- ---------- Total liabilities and shareholders' equity $3,388,435 $3,284,993 $3,445,620 ========== ========== ========== Net interest earnings $35,464 $32,697 $37,173 ======= ======= ======= Net interest spread 4.43% 4.08% 4.45% Net interest margin on interest-earnings 4.80% 4.52% 4.83% assets Federal tax exemption on nontaxable investment securities and loans included in interest income $2,980 $2,529 $3,326 - ------------------------------------------------------------------------------------------------------------------------------------
(1) The impact of interest not recognized on nonaccrual loans and interest income that would have been recorded if the restructured loans had been current in accordance with their original terms was immaterial. 15 The changes in net interest income (full tax-equivalent basis) by volume and rate component are shown below for each major category of interest-earning assets and interest-bearing liabilities. Table 3: Quarterly Rate/Volume
- ----------------------------------------------------------------------- ---------------------------------- 1st Quarter 2003 versus 1st 1st Quarter 2003 versus 4th Quarter 2002 Quarter 2002 - ----------------------------------------------------------------------- ---------------------------------- Increase (Decrease) Due to Increase (Decrease) Due to Change 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) ($1) ($1) ($1) ($1) ($2) Taxable investment securities (1,781) (79) (1,860) (1,276) (242) (1,518) Nontaxable investment securities 3,444 (1,894) 1,550 (149) 2 (147) Loans (net of unearned discount) 7,311 (9,114) (1,803) 1,077 (2,897) (1,820) Total interest-earning assets(2) $ 6,467 ($8,581) ($2,114) ($1,437) ($2,050) ($3,487) Interest paid on: Savings deposits $ 613 ($1,874) ($1,261) $ 200 ($ 482) ($ 282) Time deposits (561) (2,711) (3,272) (125) (725) (850) Short-term borrowings 918 (654) 264 (178) (165) (343) Long-term borrowings (2,787) 2,175 (612) (286) (17) (303) Total interest-bearing liabilities(2) $ 862 ($5,743) ($4,881) ($452) ($1,326) ($1,778) Net interest earnings (2) $ 739 $ 2,028 $ 2,767 ($1,228) ($481) ($1,709) - ------------------------------------------------------------------------------------------------------------
(1) The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of change in each. (2) Changes due to volume and rate are computed from the respective changes in average balances and rates of the totals; they are not a summation of the changes of the components. 16 Noninterest Income The Company's sources of noninterest income are of three primary types: general banking services related to loans, deposits and other core customer activities typically provided through the branch network; financial services, comprised of retirement plan administration and consulting (BPA), personal trust, employee benefit trust (EBT), investment and insurance products (CISI); and periodic transactions, most often net gains (losses) from the sale of investments, prepayment of term debt, or other occasional events.
Table 4: Noninterest Income - -------------------------------------------------------------------------------------------- Three Months Ended March 31, - -------------------------------------------------------------------------------------------- Change from 1Q '02 Change from 4Q '02 (000's omitted) 2003 Amount Percent Amount Percent - -------------------------------------------------------------------------------------------- Personal trust $375 ($139) -27.0% $23 6.5% EBT/BPA 1,335 233 21.1% 86 6.9% Elias Asset Management 527 (250) -32.2% 41 8.4% CISI 792 (401) -33.6% 136 20.7% Insurance - CBNA 61 6 10.9% (39) -39.0% - -------------------------------------------------------------------------------------------- Total financial services 3,090 (551) -15.1% 247 8.7% Electronic banking 546 (60) -9.9% (59) -9.8% Mortgage banking 689 569 474.2% 652 1762.2% Deposit service charges 1,296 (17) -1.3% 2 0.2% Overdraft fees 2,910 1,479 103.4% 722 33.0% Commissions 546 (68) -11.1% (55) -9.2% Miscellaneous income (loss) (35) (45) -450.0% (220) -118.9% - -------------------------------------------------------------------------------------------- Total general banking services 5,952 1,858 45.4% 1,042 21.2% - -------------------------------------------------------------------------------------------- Total noninterest income excluding investment security gain, net and loss on early retirement of long-term borrowings 9,042 1,307 16.9% 1,289 16.6% Investment security gain, net and loss on early retirement of long-term borrowings (45) (45) 0.00% (358) -114.4% - -------------------------------------------------------------------------------------------- Total noninterest income $8,997 $1,262 16.3% $931 11.5% ============================================================================================ Noninterest income as a percentage of operating income (excludes investment security gain, net and other timing adjustments) 20.4% 2.1% 3.2% - --------------------------------------------------------------------------------------------
As displayed in Table 4, noninterest income (excluding securities and debt transactions) was $9.0 million in the first quarter, an increase of $1.3 million or 16.9% from one year earlier. It rose by nearly the same amount or 16.6% from the fourth quarter 2002 level. The primary reason for the increase in both quarters was general banking revenues, which climbed $1.9 million or 45% compared to first quarter 2002 and $1.0 million or 21% versus fourth quarter 2002. The greatest portion of the increase came from overdraft fees generated from the Company's Overdraft Freedom(TM) program, introduced in early December 2002. Overdraft FreedomTM is a program currently offered to retail customers whereby the Bank may pay overdrawn amounts for qualified customers up to a certain predetermined limit for which they are charged the standard overdraft fee. This is a courtesy service to customers in good standing that may allow them to avoid late and non-payment penalties from creditors and vendors and help them in their effort to avoid the negative consequences of returned checks. Total first quarter overdraft fees climbed by $1.5 million (103%) versus the same period last year and by $722,000 versus the linked quarter. In the first quarter, related net charges (write-off of uncollected overdrawn funds and fees, net of recoveries, classified in other expense) represented approximately 11.4% of net fee income (after 5.2% in refunds). This compares to net charges that equaled 11.0% and 6.7% of net fee income in the fourth and first quarters of 2002, respectively. After net charges, total overdrafts produced $2.6 million of income this quarter, an increase of $1.2 million from one year earlier, and $619,000 more than collected in the linked quarter. Recurring Overdraft Freedom(TM) overhead costs related to staffing and processing expense are less than $350,000 per annum. Mortgage banking fees accounted for the balance of the improvement in general banking revenues. The Company resumed sale of secondary-market-eligible mortgages in excess of 20-year maturities in late 2002, when rates fell below the desirable holding yield 17 threshold. Since fourth quarter 2001, new production had been held in portfolio because of its attractive yield and the ability to fund it through the (then) newly-acquired FleetBoston branch core deposits. Total first quarter mortgage banking fees of $689,000 (includes fees from servicing the portfolio, gains (losses) on the sale of loans, and changes in the valuation of mortgage serving rights) rose $569,000 versus first quarter 2002 and were $652,000 above the linked quarter's level. The servicing portfolio as of March 31, 2003 was $123 million, with servicing rights representing 0.43% of the portfolio. Financial services revenues of $3.1 million in the first quarter decreased $551,000 or 15% from the same period last year, and rose $247,000 or 8.7% compared to the prior quarter. The primary cause of the decrease over the last four quarters is the weakened condition of the U.S. equity markets. Revenues from Elias Asset Management (EAM), the Company's subsidiary which manages investments for institutions and high net worth individuals, were negatively impacted by the performance of equity markets and their impact on fees generated from account balances and activity. Personal trust revenues were also reduced, though to a lesser extent because of the higher portion of fixed income investments held by its clients. The Company's broker-dealer, Community Investment Services, Inc. (CISI), also had lower revenues, largely because of unusually high annuity sales a year ago. As a whole, revenues for these three businesses were off by $790,000 or 32% compared to first quarter 2002. Though such revenues are impacted by investment mix, style, and a variety of customer-specific factors, by way of comparison, the Standard & Poor's 500 index (S&P) and the New York Stock Exchange index (NYSE) were each down approximately 26% over the same time period. First quarter 2003 revenues from the above equity market-related businesses rose $200,000 or 13% compared to fourth quarter 2002. Growth was positive for each of them, in contrast to a 3.6% decline for the S&P and a 5.4% decline for the NYSE. Reflective of continued strong new business generation, the Company's Benefit Plans Administrative Services (BPA) subsidiary was largely unaffected by the equity market weakness. First quarter revenues reached $1.3 million, up a strong 21% versus the comparable quarter last year, and were 6.9% higher than the prior quarter. BPA provides actuarial, daily valuation recordkeeping, and custodial services to organizations that offer retirement plans to their employees. It markets these services to mutual fund companies, other banks and broker-dealers, which in turn sell full-service retirement plans to their end-user customers. Financial services' assets under management or administration were $1.439 billion as of quarter end, a 3.6% reduction from the year earlier level. Assets fell at the three equity market-related businesses, ranging from -4% to -34%, partially offset by BPA's growth in assets under administration of 50%. Over the last 90 days, total financial services' assets under management or administration have increased 5.5%, driven by growth at BPA. Financial services revenues contributed 34% of total recurring noninterest income for the first quarter versus 47% one year earlier. The ratio declined largely because of the softness in financial services revenues as discussed above, coupled with the increase in banking fees provided by the Overdraft Freedom(TM) program and restoration of secondary market mortgage sales. On a pretax operating basis (excluding money market interest and nonrecurring items), the combined contribution of the financial services businesses was $509,000 in the first quarter compared to $916,000 one year earlier. These results constitute 3.8% and 7.8% of company-wide pretax income, respectively. The ratio of noninterest income to operating income was 20.4% for first quarter 2003, 2.1 percentage points higher than the same period last year. The improvement reflects the unusually large increase in recurring noninterest income (up 23%) compared to a 10.5% increase in net interest income (FTE, adjusted for certain investment income items discussed above). Securities transactions this quarter were limited to a $45,000 premium paid to repurchase a second $500,000 block of the Company's 9.75% fixed-rate trust preferred securities (the first block was acquired in second quarter 2002), further lowering funding costs. There were no securities transactions in the first quarter of last year. In the linked fourth quarter, $18 million of securities were sold, generating $1.2 million in gains, partially offset by a $925,000 penalty on the repurchase of approximately $11 million in intermediate-term Federal Home Loan Bank (FHLB) debt. In accordance with historic practice, all of these transactions benefited the Company on an economic basis. 18 Table 5 below reconciles differences between the line of business income breakdown in Table 4 and regulatory reporting definitions as reflected on the Call Report and the Consolidated Statements of Income.
Table 5: Noninterest Income - ----------------------------------------------------------------------------------------------------------- Quarter Ended March 31, 2003 - ----------------------------------------------------------------------------------------------------------- Regulatory Reporting Categories ---------------------------------------------------------------------- Commissions Loss on Fiduciary Service and Other Early (000's omitted) and Charges Advisory Service Other Retirement Investment on Fees on Charges, Operating of Services Deposit Investment Commissions Income Borrowings Total Accounts Products And Fees - ----------------------------------------------------------------------------------------------------------- Personal trust $375 $375 EBT/BPA 496 $839 1,335 Elias Asset Management $527 527 CISI 792 792 Insurance - CBNA 61 61 - ----------------------------------------------------------------------------------------------------------- Total financial services 871 1,319 900 3,090 Electronic banking $169 377 546 Mortgage banking 369 $320 689 Deposit service charges 1,296 1,296 Overdraft fees 2,910 2,910 Commissions 546 546 Miscellaneous income (loss) (35) (35) - ----------------------------------------------------------------------------------------------------------- Total general banking services 4,375 1,292 285 5,952 - ----------------------------------------------------------------------------------------------------------- Total 871 4,375 1,319 2,192 285 9,042 Loss on early retirement of borrowings ($45) (45) - ----------------------------------------------------------------------------------------------------------- Total noninterest income $871 $4,375 $1,319 $2,192 $285 ($45) $8,997 ===========================================================================================================
19 Noninterest Expense As shown in Table 6, first quarter 2003 noninterest expense of $24.6 million was essentially flat with the equivalent 2002 period, and $610,000 or 2.5% higher than the fourth quarter of 2002.
Table 6: Noninterest Expense - --------------------------------------------------------------------------------- Three Months Ended March 31, - --------------------------------------------------------------------------------- Change from 1Q '02 Change from 4Q '02 (000's omitted) 2003 Amount Percent Amount Percent - --------------------------------------------------------------------------------- Personnel expense $12,778 $653 5.4% $1,021 8.7% Net occupancy expense 2,421 99 4.3% 446 22.6% Equipment expense 1,904 33 1.8% (66) -3.4% Legal and professional fees 736 (118) -13.8% (266) -26.5% Data processing expense 1,604 (75) -4.5% (349) -17.9% Amortization of intangibles 1,281 (259) -16.8% (31) -2.4% Stationery and supplies 586 (101) -14.7% 20 3.5% Foreclosed property expense 167 (161) -49.1% (5) -2.9% Deposit insurance premiums 104 (18) -14.8% 0 0.0% Other 3,056 527 20.8% (160) -5.0% - -------------------------------------------------------------------------------- Total before one-time expenses 24,637 580 2.4% 610 2.5% Acquisition and unusual expenses 0 (592) -100.0% 0 0.0% - -------------------------------------------------------------------------------- Total noninterest expense $24,637 ($12) 0.0% $610 2.5% ================================================================================ Financial services noninterest $2,581 ($144) -5.3% ($29) -1.1% expense Banking noninterest expense 22,056 132 0.6% 639 3.0% - -------------------------------------------------------------------------------- Total noninterest expense $24,637 ($12) 0.0% $610 2.5% ================================================================================ Total noninterest expenses as a percentage of average assets 2.95% -0.02% 0.18% Efficiency ratio-recurring 53.3% -3.0% 2.1% - --------------------------------------------------------------------------------
The Company's efficiency ratio, which excludes intangible amortization, net securities gains/losses, acquisition costs, and unusual income and expense items, was 53.3% for the first quarter, a 3.0-percentage-point improvement from the comparable 2002 quarter. The ratio rose 2.1 percentage points versus fourth quarter 2002, largely because of the planned $1.2 million-reduction in net interest income (full-tax equivalent) as a result of the Company's investment deleveraging strategy. Consequently, the increase in recurring operating income was limited to growth in noninterest income, which rose $1.5 million or nearly 20%, for a net change of $244,000. By comparison, overhead rose $1.1 million or 4.7%. There were no acquisition and unusual expenses in the current and linked quarters. Such first quarter 2002 expenses were $592,000, primarily limited to consulting fees related to restructuring the loan and deposit operations centers to handle the higher volumes caused by 2001's acquisitions. Amortization of deposit intangibles decreased $259,000 and $31,000 compared to first quarter 2002 and fourth quarter 2002, respectively. These declines were primarily due to the use of the accelerated method of amortization as prescribed by GAAP. Recurring overhead (excluding intangible amortization and 2002's acquisition and unusual expenses) rose a modest $839,000 or 3.7% in the first quarter compared to the same quarter last year. Compared to fourth quarter 2002, recurring overhead rose $641,000 or 2.8%. Recurring banking expense (excluding intangible amortization) rose $983,000 in the first quarter compared to the same quarter last year. Eighty percent of the increase is explained by higher personnel expense (up 7.7%) caused by expanded benefit costs and annual merit increases. Staffing rose by six, with additions limited to selected expertise in commercial lending, loan review, auditing, finance, and technology. All other banking expense rose a net of $192,000, with the largest single reason for increase being the $249,000 in additional charges related to the Overdraft Freedom(TM) program. Compared to fourth quarter 2002, recurring banking expense rose $670,000 or 3.3%. As previously mentioned, a portion of the increases in personnel expense (up $978,000) and net occupancy expense (up $452,000) was due to seasonal factors (taxes and weather), and a good deal of their combined increase was offset by 20 reductions in almost all other major expense categories. The banking efficiency ratio improved to 51.0% in the first quarter compared to 54.2% one year earlier and 48.7% in the linked quarter. Financial services recurring overhead decreased by $144,000 in the first quarter compared to the same period last year (down 5.3%) and decreased $29,000 (down 1.1%) versus the linked quarter. These changes were primarily driven by personnel expense. In certain components of the financial services business, personnel costs are commission-based and directly track revenue changes. In addition, non-commissioned staffing is being very carefully controlled in light of continued soft equity market conditions and their impact on fees tied to assets under management. The efficiency ratio for financial services was 83.5% in the first quarter, up from 77.0% one year earlier but an improvement of 4.6 percentage points from the linked quarter. Income and Income Taxes First quarter 2003 income before taxes of $13.4 million was up $1.7 million or 15% from the prior year's amount. The effective income tax rate was 26.0% for the first quarter of 2003 compared to 27.0% for the first quarter of 2002. This reduction was mainly related to the benefits realized on a larger proportion of income from tax-exempt securities. Investments As reflected in Table 7, investments were $1.225 billion at the end of the first quarter, a decrease of $58 million or 4.6% from the balances at December 31, 2002. Average investments of $1.445 billion for the first quarter 2003 were down $65 million or 5.2% from the fourth quarter 2002. As previously mentioned, investments have been allowed to run off during the period, reflective of the Company's strategy to use cash flow to support loan growth and repay borrowings until reinvestment and leverage opportunities become more attractive.
Table 7: Investments - ---------------------------------------------------------------------------------------------------------------- March 31, 2003 December 31, 2002 - ---------------------------------------------------------------------------------------------------------------- Amortized Market Amortized Market (000's omitted) Cost/Book Value Value Cost/Book Value Value - ---------------------------------------------------------------------------- ----------------------------------- Amount Mix % Amount Mix % Amount Mix % Amount Mix % - ---------------------------------------------------------------------------- ----------------------------------- Held to Maturity Portfolio Obligations of states and political $7,506 100% $7,766 100% $7,412 100% $7,666 100% subdivisions - ---------------------------------------------------------------------------- ----------------------------------- Total $7,506 100% $7,766 100% $7,412 100% $7,666 100% ============================================================================ =================================== Available for Sale Portfolio - ---------------------------- U.S. Treasury securities and obligations of U.S. government corporations and agencies $370,363 32% $399,832 33% $380,243 32% $411,278 32% Obligations of state and political subdivisions 401,773 35% 426,113 35% 404,864 34% 420,605 33% Corporate securities 27,935 3% 30,685 2% 27,972 2% 30,225 3% Collateralized mortgage obligations (CMO) 206,239 18% 215,220 18% 235,286 19% 245,368 19% Mortgage-backed securities 115,702 10% 121,261 10% 131,755 11% 137,211 11% - ---------------------------------------------------------------------------- ----------------------------------- Total 1,122,012 98% 1,193,111 98% 1,180,120 98% 1,244,687 98% Equity securities 18,808 2% 18,808 2% 25,814 2% 25,814 2% Federal Reserve Bank common stock 5,656 0% 5,656 0% 5,652 0% 5,652 0% - ---------------------------------------------------------------------------- ----------------------------------- Total 1,146,476 100% $1,217,575 100% 1,211,586 100% $1,276,153 100% ======================= ========================= Net unrealized gain on available for sale portfolio 71,099 64,567 ---------- ---------- Total carrying value $1,225,081 $1,283,565 ========== ==========
Loans As shown in Table 8, loans ended the first quarter at $1.821 billion, up $14 million over the last 90 days, and $96 million or 5.6% higher than one year earlier. Virtually all of the net growth during the last 12 months has been from retail borrowers. While the prior three quarters have had increases in the $27-$28 million range, the current quarter rose about half those amounts, largely because of reduced mortgages originated for retention in portfolio. As previously noted, sales of new secondary-market-eligible production resumed in late 2002, amounting to placement of $9 million in the fourth quarter and $31 million in the first quarter. Had these mortgages been retained, loans would have risen $136 million over the last twelve months or 7.9%. All loan growth has occurred in the New York franchise (up 8.1%), offset by a slight reduction in the Pennsylvania franchise (down 3.6%). 21
Table 8: Loans - --------------------------------------------------------------------------------------------------------------------------- March 31, December 31, March 31, Change from 1Q '02 Change from 4Q '02 (000's omitted) 2003 Mix 2002 Mix 2002 Mix Amount Percent Amount Percent - --------------------------------------------------------------------------------------------------------------------------- Consumer mortgage $ 520,480 28.6% $ 510,309 28.2% $455,522 26.4% $64,958 14.3% $10,171 2.0% Business lending 639,176 35.1% 629,903 34.9% 638,024 37.0% 1,152 0.2% 9,273 1.5% Consumer indirect 290,790 16.0% 287,380 15.9% 253,375 14.7% 37,415 14.8% 3,410 1.2% Consumer direct 370,240 20.3% 379,313 21.0% 377,279 21.9% (7,039) -1.9% (9,073) -2.4% - --------------------------------------------------------------------------------------------------------------------------- Total loans $1,820,686 100.0% $1,806,905 100.0% $1,724,200 100.0% $96,486 5.6% $13,781 0.8% ===========================================================================================================================
Despite resumed secondary market sales, consumer mortgages extended their two-year trend as the largest source of portfolio growth, up $10.2 million in the first quarter due to the most favorable refinancing environment seen in decades, along with the convenience and efficiency of our branch offices in originating these loans. The new markets opened up by our 36-branch FleetBoston purchase have generated $59 million in portfolio production since their mid-November 2001 acquisition. Over the last twelve months, bank-wide consumer mortgages have increased $65 million or 14% to $520 million (29% of total loans outstanding). All the growth has been in the New York franchise. Business lending, after being flat-to-down since the second quarter of 2001 (excluding loans acquired via FleetBoston), rose $9.3 million this quarter. This was primarily due to the impact of seasonal floor plan borrowing by existing automobile dealers and take-downs under lines of credit by several of our larger commercial borrowers. This increase essentially offset the reduction in outstandings that took place over the last nine months of 2002, resulting in minimal 12-month loan growth of $1.2 million or 0.2%. Business loans ended the quarter at $639 million or 35% of total loans outstanding. Both the New York and Pennsylvania franchises have been flat. Consumer indirect loans, largely borrowing originated in automobile dealer showrooms, rose $3.4 million during the first quarter over the prior quarter, reflecting seasonal softness that began in fourth quarter 2002 when loans increased just $7.0 million. The traditionally strong third and second quarters registered increases of $11 million and $15 million, respectively, in 2002. Indirect loans at March 31, 2003 were $291 million (16% of total loans outstanding), a rise of $37 million or 15% over the last 12 months. Both the New York and Pennsylvania markets contributed growth, each of which added new originating dealers in 2002. Overall, used vehicles constitute 76% of CBU's indirect auto loans outstanding. Consumer direct loans declined by $9.1 million in the first quarter, a portion of which reflects reduced demand for this type of loan due to soft economic conditions. In addition, a certain amount of installment and home equity loans continues to be paid off through conventional mortgage refinancings. Consumer direct loans at quarter end were $370 million (20% of total loans outstanding), down $7.0 million or 1.9% over the last 12 months. Outstandings in the New York franchise responded positively in the second and third quarters of last year to the spring homeowner loan program, which included promotional rates on home equity loans and direct installment loans. Loans then trailed off in the following two quarters. Outstandings in the Pennsylvania franchise have been decreasing steadily. The following table reconciles the differences between the line of business loan breakdown reflected above as compared to regulatory reporting definitions reflected on the Call Report. Table 9: Loan Reconciliation to Call Report - ------------------------------------------------------------------------------- Line of Business as of March 31, 2003 ------------------------------------------------- Consumer Consumer Consumer Business Total (000's omitted) Direct Indirect Mortgages Lending Loans - ------------------------------------------------------------------------------- Regulatory Reporting Categories: Loans secured by real estate: Residential $217,360 $518,586 $33,254 $769,200 Commercial 42 1,800 272,214 274,056 Farm 32 22,935 22,967 Agricultural loans 156 25,025 25,181 Commercial loans 12,311 7 255,172 267,490 Installment loans to individuals 137,314 $290,790 87 7,657 435,848 Other loans 3,125 22,919 26,044 - ------------------------------------------------------------------------------- Total loans 370,340 290,790 520,480 639,176 1,820,786 Unearned discount 100 100 - ------------------------------------------------------------------------------- Net loans $370,240 $290,790 $520,480 $639,176 $1,820,686 =============================================================================== 22 Asset Quality As displayed in Table 10, asset quality as of March 31, 2003 reflects a $4.2 million increase in nonperforming assets during the first quarter to $16.6 million (including 90-day delinquencies). The bulk of this change is attributable to four commercial customers with balances over $400,000 previously identified as weak (two of them in the building supply business), which together total $2.9 million of the $3.8 million in additional nonaccruals. The approximate $400,000 increase in loans delinquent 90 days or more represents the net of three commercial loans totaling $535,000 moving to nonaccrual (including one of the above two building supply borrowers), three loans with balances totaling $513,000 becoming delinquent, and a number of new loans under $100,000 becoming delinquent. Compared to one year ago, nonperforming assets are higher by $526,000 or 3.3%. However, as a percent of loans outstanding plus OREO (other real estate owned), nonperforming assets were 0.91% at quarter end compared to 0.93% one year earlier and 0.69% at December 31, 2002.
Table 10: Nonperforming Assets - --------------------------------------------------------------------------------------------------------------- March March December Change from 1Q Change from 4Q 31, 31, 31, '02 '02 (000's omitted) 2003 2002 2002 Amount Percent Amount Percent - --------------------------------------------------------------------------------------------------------------- Nonaccrual loans $13,577 $11,351 $9,754 $2,226 19.6% $3,823 39.2% Accruing loans 90+ days delinquent 2,264 3,167 1,890 (903) -28.5% 374 19.8% - --------------------------------------------------------------------------------------------------------------- Total nonperforming loans 15,841 14,518 11,644 1,323 9.1% 4,197 36.0% Restructured loans 39 76 43 (37) -48.7% (4) -9.3% Other real estate 700 1,460 704 (760) -52.1% (4) -0.6% - --------------------------------------------------------------------------------------------------------------- Total nonperforming assets $16,580 $16,054 $12,391 $ 526 3.3% $4,189 33.8% =============================================================================================================== Allowance for loan losses to total loans 1.50% 1.39% 1.46% 0.11% 0.04% Allowance for loan losses to nonperforming loans 172.7% 165.4% 226.1% 7.3% -53.4% Allowance for loan losses to nonperforming assets 165.0% 149.6% 212.5% 15.4% -47.5% Nonperforming loans to total loans 0.87% 0.84% 0.64% 0.03% 0.23% Nonperforming assets to total loans and other real estate 0.91% 0.93% 0.69% -0.02% 0.22% - ---------------------------------------------------------------------------------------------------------------
As displayed in Table 11, net charge-offs during the last 90 days were $2.4 million. This compares to $2.8 million in the fourth quarter of 2002 and $1.4 million in first quarter 2002. For the last 12 months, quarterly net charge-offs have averaged $2.7 million compared to the preceding 12-month period average of $1.7 million.
Table 11: Allowance for Loan Loss Activity - ----------------------------------------------------------------------------------------------------------------------- March 31, March 31, December 31, Change from 1Q '02 Change from 4Q '02 (000's omitted) 2003 2002 2002 Amount Percent Amount Percent - ----------------------------------------------------------------------------------------------------------------------- Loans outstanding at end of period $1,820,686 $1,724,400 $1,806,905 $ 96,286 5.6% $13,781 0.8% - ----------------------------------------------------------------------------------------------------------------------- Average loans (net of unearned discount) 1,807,889 1,733,863 1,797,678 74,026 4.3% 10,211 0.6% - ----------------------------------------------------------------------------------------------------------------------- Allowance for loan losses at beginning of period 26,331 23,901 24,080 2,430 10.2% 2,251 9.3% Loans charged off: Commercial, financial, and agricultural 1,180 582 1,050 598 102.7% 130 12.4% Real estate 75 0 164 75 100.0% (89) -54.3% Installment and check credit 1,727 1,486 2,040 241 16.2% (313) -15.3% - ----------------------------------------------------------------------------------------------------------------------- Total loans charged off 2,982 2,068 3,254 914 44.2% (272) -8.4% Recoveries of loan previously charged off: Commercial, financial and agricultural 66 62 33 4 6.5% 33 100.0% Real estate 4 103 2 (99) -96.1% 2 100.0% Installment and check credit 531 494 429 37 7.5% 102 23.8% - ----------------------------------------------------------------------------------------------------------------------- Total recoveries 601 659 464 (58) -8.8% 137 29.5% - ----------------------------------------------------------------------------------------------------------------------- Net loans charged off 2,381 1,409 2,790 972 69.0% (409) -14.7% Provision for loan losses 3,400 1,518 5,041 1,882 124.0% (1,641) -32.6% - ----------------------------------------------------------------------------------------------------------------------- Allowance for loan losses at end of period $ 27,350 $ 24,010 $ 26,331 $ 3,340 13.9% $ 1,019 3.9% ======================================================================================================================= Net charge-offs to average loans outstanding 0.53% 0.33% 0.62% 0.20% -0.09% - -----------------------------------------------------------------------------------------------------------------------
23 The primary reason for the overall increase in charge-offs over the last four quarters is the impact of the softening economy, largely on the Company's business borrowers, including partial or full charge-offs of loans made to three large commercial customers. Until the economy begins to strengthen, it is difficult to estimate whether the current 12-month run-rate for commercial net charge-offs of $1.3 million per quarter will be reduced. The prior 12-month run-rate was $538,000. Commercial net charge-offs for the first quarter were $1.1 million, $805,000 of which pertained to loans that were classified as nonperforming. In accordance with industry accounting standards for the Company's loan loss allowance, specific allocations recognizing probable losses in the commercial portfolio were increased during the quarter by approximately $580,000 to $5.7 million or 0.87% of that portfolio; this compares to $5.1 million or 0.79% of the portfolio as of year-end 2002 and $4.4 million or 0.68% one year earlier. Before the impact of charge-offs or elimination of specific allocations no longer justified, new specific allocations in the first quarter on loans over $50,000 were $1.8 million compared to $1.0 million in fourth quarter 2002. Consumer installment net charge-offs for the first quarter were $1.2 million, which was in line with the average for the prior four quarters and approximately 14% higher than 2001's run rate. The higher net charge-offs in part reflect differences in underwriting criteria on acquired loans associated with the Company's 2001 branch acquisition. Consumer mortgage charge-offs continue to be historically de minimus. As a percent of average loans outstanding, net charge-offs for the first quarter were 0.53%, 0.09% less than in fourth quarter 2002 and below the 0.56% average for all of 2002. Commercial net charge-offs were 0.70% of average outstandings compared to 0.63% in the linked quarter and 0.74% for 2002 as a whole. Consumer installment loan net charge-offs equaled 0.98% of average loans for the quarter just ended, well under 1.27% for fourth quarter 2002 and a virtual match to the 0.99% reported for all of 2002. Mortgage and home equity net charge-offs continue to have a negligible impact. Regular bottom-up review of the asset quality of the portfolio is completed each quarter. As noted above, specific loan loss allocations for certain commercial customers identified as weak are considered and revised as necessary. General allocations against all other commercial loans and the consumer product lines are reviewed and recalculated quarterly based on historical loss experience, performance trends, and various quantifiable judgement factors. In accordance with this review, one of the qualitative risk factors related to commercial loans was increased this quarter, causing an additional $414,000 to be added to the allowance. As a result of this process, a required loan loss allowance of $27.4 million was determined as of March 31, 2003, necessitating a $3.4 million loan loss provision for the quarter compared to $1.5 million one year earlier and $5.0 million in fourth quarter 2002. The total loan loss provision for the first quarter represented 143% of net charge-offs, 18 percentage points above the 125% average for 2002 as a whole. The allowance for loan losses has risen 14% over the last 12 months compared to a 5.6% increase in loans outstanding. Consequently, the ratio to loans outstanding has climbed 11 basis points to 1.50%, the highest in the Company's history and commensurate with the probable risk in the portfolio at this time. Nonperforming loans (90 days past due and non-accruing) were 0.87% of loans outstanding at quarter end versus 0.64% as of December 31, 2002. This latter ratio compared very favorably with the peer bank median of 0.94% for year-end 2002. Peer bank allowance coverage of nonperforming loans, a general comparative measure of adequacy, was 207% at year end 2002, less favorable than the Company's coverage ratio of 226% at that time. The Company's coverage ratio decreased during the quarter just ended to 173%, still eight percentage points higher than one year earlier. While present coverage is below the Company's longer-term historic norm, the dollar amount of the allowance nonetheless represents 121% of cumulative three-year net charge-offs (2000-2002) and is 2.8 times 2002's full-year net charge-offs. Delinquent loans (30 days through nonaccruing) as a percent of total outstandings decreased three basis points from year end to 1.85%, which compares to 1.89% at March 31, 2002. The current delinquency level is well within the range of 1.77%-1.96% experienced over the last eight quarters. As of December 31, 2002, the median peer bank delinquency ratio was 1.97%. During the first quarter, the Company appointed Steven R. Tokach, previously President of Pennsylvania Banking, to a newly-designated Chief Credit Administrator position. In addition, a consultant with deep credit administration experience in Upstate New York has been retained to further strengthen credit administration practices. 24 Deposits Total deposits at March 31, 2003 were $2.536 billion, $30.6 million or 1.2% above the balance at year-end 2002 and virtually unchanged from one year earlier. First quarter average total deposits of $2.537 billion remained essentially flat with the averages for the fourth and first quarters of 2002 (down 0.1% and 0.3%, respectively). First quarter 2003 public fund deposits increased on a period-end and average basis versus fourth quarter 2002, reflective of the timing of the receipt of property taxes by municipalities; they were essentially flat with the prior year first quarter balances. As shown in Table 12, average balances for IPC (individual and business) deposits in the first quarter were down slightly compared to fourth quarter 2002 and first quarter 2002 (-1.0% and -0.2%, respectively). Both reductions reflect the recent trend of time deposit run-off and lower money market account balances more than offsetting increases in liquid interest-bearing deposits such as interest checking and savings accounts. This shift in deposit mix may reflect customers' unwillingness to be locked into CD rates for extended periods of time given low market-driven rates and the diminished interest rate spread between CDs and shorter-term interest-bearing accounts. Despite the impact of lower time and money market deposits, total IPC deposits in the first quarter were down very slightly from a year ago because of 4.8% growth in demand deposits; in contrast, IPC demand deposits were off 3.1% compared to fourth quarter 2002, largely due to seasonal factors. As of March 31, 2003, IPC deposits were down minimally compared to year-end 2002 (-0.2%) and virtually equaled the balances at the year-earlier date. IPC deposits in the 36 former FleetBoston branches purchased in mid-November 2001 have risen 4% since that time.
Table 12: Average Deposits - ----------------------------------------------------------------------------------------------------------- March 31, December 31, March 31, Change from 1Q '02 Change from 4Q '02 (000's omitted) 2003 2002 2002 Amount Percent Amount Percent - ----------------------------------------------------------------------------------------------------------- Noninterest-bearing demand deposits $ 449,219 $ 454,038 $ 427,901 $21,318 5.0% ($4,819) -1.1% Interest-bearing demand deposits 270,947 263,490 260,146 10,801 4.2% 7,457 2.8% Regular savings deposits 415,628 407,701 390,005 25,623 6.6% 7,927 1.9% Money market deposits 300,118 301,169 309,018 (8,900) -2.9% (1,051) -0.3% Time deposits 1,101,091 1,112,447 1,157,663 (56,572) -4.9% (11,356) -1.0% - ------------------------------------------------------------------------------------------------------------ Total deposits $2,537,003 $2,538,845 $2,544,733 ($7,730) -0.3% ($1,842) -0.1% ============================================================================================================ IPC deposits $2,352,885 $2,377,777 $2,357,754 ($4,869) -0.2% ($24,892) -1.0% Public fund deposits 184,118 161,068 186,979 (2,861) -1.5% 23,050 14.3% - ------------------------------------------------------------------------------------------------------------ Total deposits $2,537,003 $2,538,845 $2,544,733 ($7,730) -0.3% ($1,842) -0.1% ============================================================================================================
Borrowings At the end of the first quarter 2003, borrowings and federal funds purchased of $365 million were $98 million or 21% lower than they were at the end of 2002. Short-term borrowings decreased by $110 million, long-term borrowings decreased by $5 million and federal funds purchased increased by $17 million. The decrease in combined borrowings is the result of the investment deleveraging strategy previously discussed. Refer to the net interest income section on page 14 for further review of borrowing activity over the past 12 months. Other Assets and Liabilities Other assets and liabilities had a net liability balance of $20.0 million at March 31, 2003 versus a net liability position of $21.3 million at December 31, 2002. The change was mainly attributable to an increase in deferred taxes related to the market value adjustment and assorted timing differences. Shareholders' Equity Total shareholders' equity equaled $337 million at the end of the first quarter, $11.9 million higher than the balance at December 31, 2002. This increase consisted of $909,000 from shares issued under the employee stock plan, an after-tax market value adjustment of $4.9 million and net income of $9.9 million, offset by dividends declared of $3.8 million. Over the past 12 months total shareholders' equity increased by $64.9 million, a majority of which came from $41.0 million of net income and a $38.1 million increase in the after-tax market value adjustment, reduced by dividends declared of $14.8 million. 25 The Company's Tier I leverage ratio, a primary measure of regulatory capital for which 5% is the requirement to be `well-capitalized,' reached 7.44% at the end of the first quarter, its strongest level in a decade. The tangible equity-to-assets ratio has risen 215 basis points over the last 12 months from 4.13% to 6.28%. Excluding the impact of the change in the market value adjustment (which impacts both asset and equity levels), the tangible-equity-to-assets ratio at March 31, 2003 would have risen by 108 basis points versus one year earlier. The dividend payout ratio (dividends declared divided by net income) for first quarter 2003 was 37.9%, compared to 39.0% and 40.8% for the fourth and first quarters of 2002, respectively. First quarter 2003's ratio was lower than the prior year period, despite a $0.02 higher dividend declared per share ($0.29 vs. $0.27), because of the $1.4 million (16.3%) increase in net income. The first quarter 2003 dividend payout ratio fell from fourth quarter 2002's level due to net income rising $310,000 or 3.2%, while dividends declared per share were constant. Liquidity Due to the potential for unexpected fluctuations in deposits and loans, active management of the Company's liquidity is critical. In order to respond to these circumstances, adequate sources of both on and off-balance sheet funding are in place. CBSI's primary approach to measuring liquidity is known as the Basic Surplus/Deficit model. It is used to calculate liquidity over two time periods: first, the amount of cash that could be made available within 30 days (calculated as liquid assets less short-term liabilities); and second, a projection of subsequent cash availability over an additional 60 days. The minimum policy level of liquidity under the Basic Surplus/Deficit approach is 7.5% of total assets for both the 30 and 90-day time horizons. As of March 31, 2003, this ratio was 14.5% for both time periods, excluding the Company's capacity to borrow additional funds from the Federal Home Loan Bank. To measure longer-term liquidity, a baseline projection of loan and deposit growth for five years is made to reflect how current liquidity levels could change over time. This five-year measure reflects ample liquidity for loan growth over the next five years. Forward-Looking Statements This document contains comments or information that constitute forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995), which involve significant risks and uncertainties. Actual results may differ materially from the results discussed in the forward-looking statements. Moreover, the Company's plans, objectives and intentions are subject to change based on various factors (some of which are beyond the Company's control). Factors that could cause actual results to differ from those discussed in the forward-looking statements include: (1) risks related to credit quality, interest rate sensitivity and liquidity; (2) the strength of the U.S. economy in general and the strength of the local economies where the Company conducts its business; (3) the effect of, and changes in, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System; (4) inflation, interest rate, market and monetary fluctuations; (5) the timely development of new products and services and customer perception of the overall value thereof (including features, pricing and quality) compared to competing products and services; (6) changes in consumer spending, borrowing and savings habits; (7) technological changes; (8) any acquisitions or mergers that might be considered by the Company and the costs and factors associated therewith; (9) the ability to maintain and increase market share and control expenses; (10) the effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) and accounting principles generally accepted in the United States; (11) changes in the Company's organization, compensation and benefit plans and in the availability of, and compensation levels for, employees in its geographic markets; (12) the costs and effects of litigation and of any adverse outcome in such litigation; (13) 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 will make additional updates or corrections with respect thereto or with respect to other forward-looking statements. 26 Item 3. Quantitative and Qualitative Disclosure about Market Risk Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates, prices or credit risk. The Company has an immaterial amount of credit risk because essentially all of the fixed-income securities in the investment portfolio are AAA-rated (highest possible rating). In addition, equity investments make up less than 3% of the overall investment portfolio, and therefore, almost all the price risk is related to interest rates, the primary market risk exposure of the Bank. The ongoing monitoring and management of this risk, over both a short-term tactical and longer-term strategic time horizon, is an important component of the Company's asset/liability management process, which is governed by policies established by its Board of Directors and reviewed and approved annually. The Board of Directors delegates responsibility for carrying out the asset/liability management policies to the Asset/Liability Management Committee (ALCO). In this capacity, ALCO develops guidelines and strategies impacting the Company's asset/liability management activities based upon estimated market risk sensitivity, policy limits, and overall market interest rate levels and trends. As the Company does not believe it is possible to reliably predict future interest rate movements, it has maintained an appropriate process and set of measurement tools which enable it to identify and quantify sources of interest rate risk in varying rate environments. The primary tool used by the Company in managing interest rate risk is income simulation. The analysis begins by measuring the impact of differences in maturity and repricing of all balance sheet positions. Such work is further augmented by adjusting for prepayment and embedded option risk found naturally in certain asset and liability classes. Finally, balance sheet growth and funding expectations are added to the analysis in order to reflect the strategic initiatives set forth by the Company. Changes in net interest income are reviewed after subjecting the balance sheet to an array of treasury yield curve possibilities. The following reflects the Company's one-year net interest income sensitivity based on asset and liability levels on March 31, 2003, assuming conservative levels of balance sheet growth-- low single digit growth in loans and deposits along with natural run-off of investments, augmented by any necessary changes in borrowings, with no growth in other major portions of the balance sheet. On that basis, a variety of scenarios was tested, including moving the prime and federal funds rates up 200 basis points and down 100 basis points over a 12 month period while flattening the long end of the treasury curve to spreads over federal funds that are more consistent with historical norms.
Table 13: Management Model Net Interest Income Dollar Change During First 12 Rate Change Months In Basis Points Versus No Change In Rates Percent Change -------------------------------------------------------------------------------------- + 200 bp $1.7 million 1.3% - 100 bp -$3.7 million -3.0%
When compared to no change in interest rates during the first 12 months, net interest income performs better in the rising rate environment than in the falling rate environment due in large part to significant levels of core deposits, which are not as volatile in terms of rate movement as are other funding sources. 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. 27 Item 4. Controls and Procedures Under the supervision and with the participation of our management, including the President and Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of the design and operation of our disclosure controls and procedures within 90 days of the filing date of this quarterly report, and, based on their evaluation, our President and Chief Executive Officer and Chief Financial Officer have concluded that these controls and procedures are effective. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation. Disclosure controls and procedures are our controls and other procedures that are designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company is accumulated and communicated to our management, including our President and Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. 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 to various pending and threatened legal proceedings in which claims for monetary damages are asserted. Management, after consultation with legal counsel, does not anticipate that the aggregate liability, if any, arising out of litigation pending against the Company or its subsidiaries will have a material effect on the Company's consolidated financial position. Item 2. Changes in Securities. There have been no changes in securities during the quarter ended March 31, 2003. Item 3. Defaults Upon Senior Securities. There were no defaults upon senior securities during the quarter ended March 31, 2003. Item 4. Submission of Matters to a Vote of Securities Holders. There were no matters submitted to a vote of the shareholders during the quarter ended March 31, 2003. Item 5. Other Information. Not applicable Item 6. Exhibits and Reports on Form 8-K a) Exhibits required by Item 601 of Regulation S-K: (21) Subsidiaries of the registrant
Name Jurisdiction of Incorporation Community Bank, N.A. New York Community Capital Trust I Delaware Community Capital Trust II Delaware Community Statutory Trust III Connecticut Community Financial Services, Inc. New York Benefit Plans Administrative Services, Inc. New York CBNA Treasury Management Corporation New York Community Investment Services, Inc. New York CBNA Preferred Funding Corporation Delaware CFSI Close-Out Corp. New York Elias Asset Management, Inc. Delaware First Liberty Service Corporation Delaware First of Jermyn Realty Co. Delaware
b) Exhibits required by the Sarbanes-Oxley Act of 2002 (99.1) 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 the Sarbanes-Oxley Act of 2002. (99.2) Certification of David G. Wallace, Treasurer and Chief Financial Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to the Sarbanes-Oxley Act of 2002. c) Reports on Form 8-K: Form 8-K related to quarterly press release was filed on April 25, 2003 Form 8-K announcing the Agreement and Plan of Merger with Peoples Bankcorp, Inc. on May 8, 2003 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: May 15, 2003 /s/ Sanford A. Belden ------------------------------------ Sanford A. Belden, President, Chief Executive Officer and Director Date: May 15, 2003 /s/ David G. Wallace ------------------------------------ David G. Wallace, Treasurer and Chief Financial Officer 30 I, Sanford A. Belden, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Community Bank System, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 15, 2003 /s/ Sanford A. Belden - ----------------------------------------------- Sanford A. Belden, President, Chief Executive Officer and Director 31 I, David G. Wallace, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Community Bank System, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Dated: May 15, 2003 /s/ David G. Wallace - ------------------------------------- David G. Wallace, Treasurer and Chief Financial Officer 32 EX-99.1 3 d55774_ex99-1.txt CERTIFICATION Exhibit 99.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Community Bank System, Inc. (the "Company") on Form 10-Q for the quarter ended March 31, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Sanford A. Belden, President and Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge: (1) the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Sanford A. Belden - ----------------------------------------------- Sanford A. Belden President, Chief Executive Officer and Director May 15, 2003 33 EX-99.2 4 d55774_ex99-2.txt CERTIFICATION Exhibit 99.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Community Bank System, Inc. (the "Company") on Form 10-Q for the quarter ended March 31, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, David G. Wallace, Treasurer and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge: (1) the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ David G. Wallace - -------------------- David G. Wallace Treasurer and Chief Financial Officer May 15, 2003 34 -----END PRIVACY-ENHANCED MESSAGE-----