10-Q 1 d61135_10-q.txt QUARTERLY REPORT United States SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended September 30, 2004 Commission file number 001-13695 [LOGO] COMMUNITY BANK SYSTEM, INC. (Exact name of registrant as specified in its charter) Delaware 16-1213679 (State or other jurisdiction (I.R.S. Employer of incorporation) Identification No.) 5790 Widewaters Parkway, DeWitt, New York 13214-1883 (Address of principal executive offices) (Zip Code) (315) 445-2282 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.). |X| Yes |_| No Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). |X| Yes |_| No Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. Common Stock, $1.00 par value - 30,606,615 shares outstanding as of November 4, 2004 TABLE OF CONTENTS Page ---- Part I. Financial Information Item 1. Financial Statements (Unaudited) Consolidated Statements of Condition September 30, 2004 and December 31, 2003 3 Consolidated Statements of Income Three and nine months ended September 30, 2004 and 2003 4 Consolidated Statement of Changes in Shareholders' Equity Nine months ended September 30, 2004 5 Consolidated Statements of Comprehensive Income Three and nine months ended September 30, 2004 and 2003 6 Consolidated Statements of Cash Flows Nine months ended September 30, 2004 and 2003 7 Notes to the Consolidated Financial Statements September 30, 2004 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 14 Item 3. Quantitative and Qualitative Disclosure about Market Risk 28 Item 4. Controls and Procedures 29 Part II. Other Information Item 1. Legal Proceedings 30 Item 2. Changes in Securities, Use of Proceeds and Issuer Repurchases of Equity Securities 30 Item 3. Defaults upon Senior Securities 30 Item 4. Submission of Matters to a Vote of Securities Holders 30 Item 5. Other Information 30 Item 6. Exhibits and Reports on Form 8-K 30 2 Part 1. Financial Information Item 1. Financial Statements COMMUNITY BANK SYSTEM, INC. CONSOLIDATED STATEMENTS OF CONDITION (Unaudited) (In Thousands, Except Share Data)
September 30, December 31, 2004 2003 ------------------------------------------------------------------------------------------------------------------------ Cash and due from banks $ 122,329 $ 103,923 Available-for-sale investment securities 1,467,328 1,190,882 Held-to-maturity investment securities 137,640 138,652 ------------------------------------------------------------------------------------------------------------------------ Total investment securities (fair value of $1,603,921 and $1,327,120, respectively) 1,604,968 1,329,534 Loans 2,373,751 2,128,509 Allowance for loan losses 32,609 29,095 ------------------------------------------------------------------------------------------------------------------------ Net loans 2,341,142 2,099,414 Premises and equipment, net 63,836 61,705 Accrued interest receivable 28,905 25,851 Core deposit intangibles, net 35,932 33,998 Goodwill 190,696 159,596 Other intangibles, net 2,116 2,517 ------------------------------------------------------------------------------------------------------------------------ Intangible assets, net 228,744 196,111 Other assets 34,630 38,859 ------------------------------------------------------------------------------------------------------------------------ Total assets $ 4,424,554 $ 3,855,397 ======================================================================================================================== Liabilities: Non-interest bearing deposits $ 563,699 $ 498,195 Interest bearing deposits 2,355,389 2,227,293 ------------------------------------------------------------------------------------------------------------------------ Total deposits 2,919,088 2,725,488 Federal funds purchased 50,000 36,300 Borrowings 841,154 551,096 Subordinated debt held by unconsolidated subsidiary trusts 80,432 80,390 Accrued interest and other liabilities 66,679 57,295 ------------------------------------------------------------------------------------------------------------------------ Total liabilities 3,957,353 3,450,569 ------------------------------------------------------------------------------------------------------------------------ Commitment and contingencies (See Note H) Shareholders' equity: Preferred stock $1.00 par value, 500,000 shares authorized, 0 shares issued Common stock, $1.00 par value, 50,000,000 shares authorized; 31,954,442 and 28,746,612 shares issued in 2004 and 2003, respectively 31,954 28,747 Additional paid-in capital 186,843 130,066 Retained earnings 241,144 218,628 Accumulated other comprehensive income 38,000 35,958 Treasury stock, at cost (1,400,000 and 416,300 shares, respectively) (30,199) (8,490) Employee stock plan - unearned (541) (81) ------------------------------------------------------------------------------------------------------------------------ Total shareholders' equity 467,201 404,828 ------------------------------------------------------------------------------------------------------------------------ Total liabilities and shareholders' equity $ 4,424,554 $ 3,855,397 ========================================================================================================================
The accompanying notes are an integral part of the consolidated financial statements. 3 COMMUNITY BANK SYSTEM, INC. CONSOLIDATED STATEMENTS OF INCOME (Unaudited) (In Thousands, Except Per-Share Data)
Three Months Ended Nine Months Ended September 30, September 30, ------------------ -------------------- 2004 2003 2004 2003 --------------------------------------------------------------------------------------------------------------------------------- Interest income: Interest and fees on loans $35,267 $ 30,883 $101,043 $ 93,084 Interest and dividends on taxable investments 13,895 11,140 39,266 34,876 Interest and dividends on non-taxable investments 6,061 4,653 16,971 14,006 --------------------------------------------------------------------------------------------------------------------------------- Total interest income 55,223 46,676 157,280 141,966 --------------------------------------------------------------------------------------------------------------------------------- Interest expense: Interest on deposits 8,622 8,905 25,777 29,474 Interest on federal funds purchased 95 65 282 234 Interest on short-term borrowings 2,055 573 4,266 1,394 Interest on subordinated debt held by unconsolidated subsidiary trusts 1,460 1,401 4,244 4,237 Interest on long-term borrowings 3,934 3,193 10,243 9,502 --------------------------------------------------------------------------------------------------------------------------------- Total interest expense 16,166 14,137 44,812 44,841 --------------------------------------------------------------------------------------------------------------------------------- Net interest income 39,057 32,539 112,468 97,125 Less: provision for loan losses 2,300 2,029 6,650 8,102 --------------------------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 36,757 30,510 105,818 89,023 --------------------------------------------------------------------------------------------------------------------------------- Non-interest income: Deposit service fees 6,756 6,080 18,713 17,025 Other banking services 1,135 (37) 2,059 1,307 Trust, investment and asset management fees 1,935 1,747 5,699 4,954 Benefit plan administration, consulting and actuarial fees 2,338 1,986 6,997 4,289 Gain (loss) on investment securities & debt extinguishment 0 3 145 (42) --------------------------------------------------------------------------------------------------------------------------------- Total non-interest income 12,164 9,779 33,613 27,533 --------------------------------------------------------------------------------------------------------------------------------- Operating expenses: Salaries and employee benefits 15,638 13,225 46,197 38,243 Occupancy 2,570 2,255 7,700 7,004 Equipment and furniture 2,143 1,885 6,445 5,766 Amortization of intangible assets 2,003 1,269 5,401 3,801 Legal and professional fees 1,003 672 2,970 2,250 Data processing 1,973 1,647 5,777 5,006 Office supplies 613 455 1,711 1,507 Acquisition expenses 53 165 1,434 170 Other 3,930 3,633 11,822 11,085 --------------------------------------------------------------------------------------------------------------------------------- Total operating expenses 29,926 25,206 89,457 74,832 --------------------------------------------------------------------------------------------------------------------------------- Income before income taxes 18,995 15,083 49,974 41,724 Income taxes 4,761 3,354 12,444 10,014 --------------------------------------------------------------------------------------------------------------------------------- Net income $14,234 $ 11,729 $ 37,530 $ 31,710 ================================================================================================================================= Basic earnings per share $ 0.47 $ 0.45 $ 1.27 $ 1.22 Diluted earnings per share $ 0.45 $ 0.44 $ 1.23 $ 1.19 Dividends declared per share $ 0.18 $ 0.16 $ 0.50 $ 0.45
The accompanying notes are an integral part of the consolidated financial statements. 4 COMMUNITY BANK SYSTEM, INC. CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited) Nine Months Ended September 30, 2004 (In Thousands, Except Share Data)
Accumulated Common Stock Other --------------------- Additional Compre- Employee Shares Amount Paid-In Retained hensive Treasury Stock Plan Outstanding Issued Capital Earnings Income Stock -Unearned Total ----------------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 2003, as previously 14,165,156 $14,373 $144,440 $218,628 $35,958 ($8,490) ($81) $404,828 reported Two-for-one stock split 14,165,156 14,374 (14,374) 0 ----------------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 2003, as restated 28,330,312 28,747 130,066 218,628 35,958 (8,490) (81) 404,828 Net income 37,530 37,530 Other comprehensive income, net of tax 2,042 2,042 Dividends declared: Common, $.50 per share (15,014) (15,014) Common stock issued under employee stock plan 615,617 615 4,650 (460) 4,805 Stock and options issued for acquisition 2,592,213 2,592 52,127 54,719 Treasury stock purchased (983,700) (21,709) (21,709) ----------------------------------------------------------------------------------------------------------------------------------- Balance at September 30, 2004 30,554,442 $31,954 $186,843 $241,144 $38,000 ($30,199) ($541) $467,201 ===================================================================================================================================
See Note B "Stock Split" concerning two-for-one stock split. The accompanying notes are an integral part of the consolidated financial statements. 5 COMMUNITY BANK SYSTEM, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (Unaudited) (In Thousands)
Three Months Ended Nine Months Ended September 30, September 30, ----------------------- ----------------------- 2004 2003 2004 2003 ----------------------------------------------------------------------------------------------------------------------------------- Other comprehensive income (loss), before tax: Change in minimum pension liability adjustment $ 0 $ 0 $ 0 $ 97 Unrealized (losses) gains on securities: Unrealized holding gains (losses) arising during period 35,415 (21,053) 3,241 258 Reclassification adjustment for gains included in net income 0 (3) (145) (3) ----------------------------------------------------------------------------------------------------------------------------------- Other comprehensive income (loss), before tax 35,415 (21,056) 3,096 352 Income tax (expense) benefit related to other comprehensive income (loss) (13,703) 8,200 (1,054) 679 ----------------------------------------------------------------------------------------------------------------------------------- Other comprehensive income (loss), net of tax 21,712 (12,856) 2,042 1,031 Net income 14,234 11,729 37,530 31,710 ----------------------------------------------------------------------------------------------------------------------------------- Comprehensive income (loss) $ 35,946 ($ 1,127) $ 39,572 $ 32,741 ===================================================================================================================================
The accompanying notes are an integral part of the consolidated financial statements. 6 COMMUNITY BANK SYSTEM, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (In Thousands)
Nine Months Ended September 30, ------------------------------- 2004 2003 --------------------------------------------------------------------------------------------------------------------- Operating activities: Net income $ 37,530 $ 31,710 Adjustments to reconcile net income to net cash provided by operating activities Depreciation 5,985 5,263 Amortization of intangible assets 5,401 3,801 Net amortization of premiums and discounts on securities and loans 1,106 1,710 Amortization of unearned compensation and discount on subordinated debt 244 96 Provision for loan losses 6,650 8,102 (Gain) loss on investment securities and debt extinguishment (145) 42 Loss on loans and other assets 211 379 Proceeds from the sale of loans held for sale 0 67,444 Origination of loans held for sale 0 (61,036) Change in other operating assets and liabilities 5,560 (2,385) --------------------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 62,542 55,126 --------------------------------------------------------------------------------------------------------------------- Investing activities: Proceeds from sales of available-for-sale investment securities 41,490 14,611 Proceeds from maturities of held-to-maturity investment securities 3,937 3,901 Proceeds from maturities of available-for-sale investment securities 115,655 196,867 Purchases of held-to-maturity investment securities (3,035) (132,242) Purchases of available-for-sale investment securities (387,391) (88,779) Net increase in loans outstanding (44,220) (116,498) Cash received (paid) for acquisition (net of cash paid of $7,023 in 2004 and cash acquired of $9,428 in 2003) 409 (1,928) Capital expenditures (5,461) (5,334) --------------------------------------------------------------------------------------------------------------------- Net cash used by investing activities (278,616) (129,402) --------------------------------------------------------------------------------------------------------------------- Financing activities: Net change in demand deposits, NOW accounts, and savings accounts 24,679 80,523 Net change in time deposits (43,143) (56,108) Net change in federal funds purchased 13,700 12,000 Net change in short-term borrowings 101,528 62,455 Change in long-term borrowings (net of payments of $112 and $5,000) 168,930 (5,000) Issuance of common stock (net of restricted stock awards of $654 and $248) 4,611 3,986 Purchase of treasury stock (21,709) (8,490) Cash dividends paid (14,044) (11,320) Other financing activities (72) (111) --------------------------------------------------------------------------------------------------------------------- Net cash provided by financing activities 234,480 77,935 --------------------------------------------------------------------------------------------------------------------- Change in cash and cash equivalents 18,406 3,659 Cash and cash equivalents at beginning of period 103,923 113,531 --------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of period $ 122,329 $ 117,190 ===================================================================================================================== Supplemental disclosures of cash flow information: Cash paid for interest $ 43,335 $ 45,280 Cash paid for income taxes $ 8,889 $ 9,996 Supplemental disclosures of non-cash financing and investing activities: Dividends declared and unpaid $ 5,499 $ 4,147 Gross change in unrealized gains on available-for-sale investment securities $ 3,096 $ 256 Acquisitions: Fair value of assets acquired, excluding acquired cash and intangibles $ 252,119 $ 18,473 Fair value of liabilities assumed $ 235,511 $ 25,664 Common stock and options issued $ 54,719 $ 0
The accompanying notes are an integral part of the consolidated financial statements. 7 COMMUNITY BANK SYSTEM, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) September 30, 2004 NOTE A: BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with instructions to Form 10-Q and Rule 10-01 of Regulation S-X. These financial statements may not include all information and footnotes necessary to constitute a complete set of financial statements under generally accepted accounting principles applicable to annual periods and accordingly should be read in conjunction with the financial information contained in the Form 10-K. Management believes these unaudited consolidated financial statements reflect all adjustments of a normal recurring nature which are necessary for a fair presentation of the results for the interim periods presented. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full year or any other interim period. Certain prior period amounts have been reclassified to conform to the current year presentation. NOTE B: ACQUISITION AND OTHER MATTERS First Heritage Bank On May 14, 2004, the Company acquired First Heritage Bank ("Heritage"), a closely held bank headquartered in Wilkes-Barre, PA with three branches in Luzerne County, Pennsylvania. First Heritage's three branches operate as part of First Liberty Bank & Trust, a division of Community Bank, N.A. Consideration included 2,592,213 shares of common stock with a fair value of $52 million, employee stock options with a fair value of $3.0 million, and $7.0 million of cash (including capitalized acquisition costs of $1.0 million). The results of Heritage's operations have been included in the consolidated financial statements since that date. The estimated purchase price allocation of the assets acquired and liabilities assumed, including capitalized acquisition costs, is as follows: (000's omitted) ---------------------------------------------------------- Cash and due from banks $ 7,432 Available-for-sale investment securities 43,811 Loans, net of allowance for loan losses 204,120 Premises and equipment, net 3,074 Other assets 1,114 Goodwill 30,768 Core deposit intangibles 6,934 ---------------------------------------------------------- Total assets acquired 297,253 Deposits 212,064 Borrowings 19,672 Other liabilities 3,775 ---------------------------------------------------------- Total liabilities assumed 235,511 ---------------------------------------------------------- Net assets acquired $ 61,742 ========================================================== Dansville Branch Acquisition On August 4, 2004, the Company announced it had signed a definitive agreement to purchase a branch office in Dansville, N.Y. from HSBC Bank USA, N.A., pending regulatory approval. The acquisition is expected to close during December 2004. Stock Repurchase Program During the third quarter of 2004 the Company purchased 280,713 common shares completing the previously announced 1.4 million-share repurchase program. The aggregate cost of this program was $30.2 million and the average price per share is $21.57. The repurchases were for general corporate purposes, including those related to acquisition and stock plan activities. Stock Split At a special meeting of the shareholders held on March 26, 2004, the shareholders approved an amendment to the certificate of incorporation of the Company to increase the number of authorized shares of common stock to 50 million. This amendment was effected in connection with the previously announced two-for-one stock split of the Company's common stock. The stock split was effected in the form of a 100 percent stock dividend, and was paid on April 12, 2004 to shareholders of record on March 17, 2004. 8 Accordingly, all share, option and per-share amounts have been adjusted in the consolidated financial statements to reflect the stock split. NOTE C: ACCOUNTING POLICIES Critical Accounting Policies Allowance for Loan Losses Management continually evaluates the credit quality of the Company's loan portfolio, and performs a formal review of the adequacy of the allowance for loan losses on a quarterly basis. The allowance reflects management's best estimate of probable losses inherent in the loan portfolio. Determination of the allowance is subjective in nature and requires significant estimates. The Company's allowance methodology consists of two broad components. The first component includes a determination of estimated general losses in accordance with SFAS No. 5, "Accounting for Contingencies". This general allowance component reflects inherent probable losses related to pools of homogeneous loans that are evaluated collectively, including consumer mortgage loans, consumer direct and indirect loans, and business loans that are not impaired. Allowance levels for these loan pools are based principally on historical loss factors, as well as qualitative factors that are expected to affect loss experience, including delinquency, underwriting and economic trends and conditions. The second component of the allowance reflects specific losses related to individual business loans that are both greater than $0.5 million and in a non-accruing status with respect to interest. Specific losses are based on discounted estimated cash flows, including any cash flows resulting from the conversion of collateral. Income Taxes Provisions for income taxes are based on taxes currently payable or refundable, and deferred taxes which are based on temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are reported in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized or settled. Intangible Assets Intangible assets include core deposit intangibles, customer relationship intangibles and goodwill arising from acquisitions. Core deposit intangibles and customer relationship intangibles are amortized on either an accelerated or straight-line basis over periods ranging from 7 to 20 years. Goodwill is evaluated at least annually for impairment. The carrying value of goodwill and other intangible assets is based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires use of a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums, and company-specific risk indicators. Retirement Benefits The Company provides defined benefit pension benefits and post-retirement health and life insurance benefits to eligible employees. The Company also provides deferred compensation and supplemental executive retirement plans for selected current and former employees and officers. Expense under these plans is charged to current operations and consists of several components of net periodic benefit cost based on various actuarial assumptions regarding future experience under the plans, including discount rate, rate of future compensation increases and expected return on plan assets. Stock-Based Compensation The Company accounts for stock-based awards issued to directors, officers and key employees using the intrinsic value method. This method requires that compensation expense be recognized to the extent that the fair value of the underlying stock exceeds the exercise price of the stock award at the grant date. The Company generally does not recognize compensation expense related to stock awards because the stock awards generally have fixed terms and exercise prices that are equal to or greater than the fair value of the Company's common stock at the grant date. SFAS 123, "Accounting for Stock-Based Compensation," requires companies that use the "intrinsic value method" to account for stock compensation plans to provide pro forma disclosures of the net income and earnings per share effect of stock options using the "fair value method." Under this method, the fair value of the option on the date of grant is recognized ratably as compensation expense over the vesting period of the option. Management estimated the fair value of options granted using the Black-Scholes option-pricing model. This model was originally developed to estimate the fair value of exchange-traded equity options, which (unlike employee stock options) have no vesting period or transferability restrictions. As a result, the Black-Scholes model is not necessarily a precise indicator of the value of an option, but it 9 is commonly used for this purpose. The Black-Scholes model requires several assumptions, which management developed based on historical trends and current market observations. These assumptions include: 2004 2003 ------------------------------------------------------------------------------- Weighted-average expected life 7.78 8.74 Future dividend yield 3.00% 3.00% Share price volatility 25.47%-26.88% 27.29%-27.58% Weighted average risk-free interest rate 4.02%-4.45% 3.81% =============================================================================== If these assumptions are not accurate, the estimated fair value used to derive the information presented in the following table also will be inaccurate. Moreover, the model assumes that the estimated fair value of an option is amortized over the option's vesting period and would be included in salaries and employee benefits on the income statement. The pro forma impact of applying the fair value method of accounting for the periods shown below may not be indicative of the pro forma impact in future years.
Three Months Ended Nine Months Ended September 30, September 30, -------------------------- -------------------------- (000's omitted except per share amounts) 2004 2003 2004 2003 ---------------------------------------------------------------------------------------------------------------- Net income, as reported $ 14,234 $ 11,729 $ 37,530 $ 31,710 Less: stock-based compensation expense determined under fair value method, net of tax 206 158 831 612 ---------------------------------------------------------------------------------------------------------------- Pro forma net income $ 14,028 $ 11,571 $ 36,699 $ 31,098 ================================================================================================================ Earnings per share: As reported: Basic $ 0.47 $ 0.45 $ 1.27 $ 1.22 Diluted $ 0.45 $ 0.44 $ 1.23 $ 1.19 Pro forma: Basic $ 0.46 $ 0.44 $ 1.24 $ 1.19 Diluted $ 0.44 $ 0.43 $ 1.20 $ 1.17
As of September 30, 2004 there were 2,489,458 stock options granted and outstanding. New Accounting Pronouncements In December 2003, a bill was signed into law that expands Medicare benefits, primarily adding a prescription drug benefit for Medicare-eligible retirees beginning in 2006. The law also provides a federal subsidy to companies that sponsor post-retirement benefit plans that provide prescription drug coverage. In May 2004, the Financial Accounting Standards Board ("FASB") issued Staff Position No. FAS 106-2, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003." This staff position provides guidance on accounting for the effects of the new Medicare prescription drug legislation by employers whose prescription drug benefits are actuarially equivalent to the drug benefit under Medicare Part D. It also contains basic guidance on related income tax accounting and complex rules for transition that permit various alternative prospective and retroactive transition approaches. The Company adopted this standard effective July 1, 2004 and determined its plan does not provide a drug benefit that is actuarially equivalent to the Medicare Part D benefit. As a result, this standard had no impact on results of operations, financial position, or liquidity of the Company. In March 2004, the FASB issued an exposure draft, "Share-Based Payment: an amendment of FASB No. 123 and 95." This proposed Statement addresses the accounting for transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. This proposed Statement would eliminate the accounting for share-based compensation transactions using APB Opinion No. 25, "Accounting for Stock Issued to Employees," and generally would require instead that such transactions be accounted for using a fair-value-based method. A final statement is expected to be issued during the fourth quarter of 2004. In October 2004, the FASB delayed the effective date of this statement to periods beginning after June 15, 2005. Management does not expect the impact of the adoption of this exposure draft if adopted in its current version to be materially different from the pro forma impacts disclosed under SFAS No. 123. 10 NOTE D: EARNINGS PER SHARE Basic earnings per share are computed based on the weighted-average common shares outstanding for the period. Diluted earnings per share are based on the weighted-average shares outstanding adjusted for the dilutive effect of the assumed exercise of stock options during the year. The dilutive effect of options is calculated using the treasury stock method of accounting. The treasury stock method determines the number of common shares that would be outstanding if all the dilutive options (average market price is greater than the exercise price) were exercised and the proceeds were used to repurchase common shares in the open market at the average market price for the applicable time period. There were 427,114 and 433,622 anti-dilutive stock options outstanding for the three and nine months ended September 30, 2004, respectively, compared to zero and 15,000 for the three and nine months ended September 30, 2003. The following is a reconciliation of basic to diluted earnings per share for the three and nine months ended September 30, 2004 and 2003.
Per Share (000's omitted, except per share data) Income Shares Amount -------------------------------------------------------------------------------------------- Three Months Ended September 30, 2004 Basic EPS $14,234 30,580 $0.47 Stock options 965 ----------------------------------------------------------------------------- Diluted EPS $14,234 31,545 $0.45 ============================================================================= Three Months Ended September 30, 2003 Basic EPS $11,729 26,022 $0.45 Stock options 794 ----------------------------------------------------------------------------- Diluted EPS $11,729 26,816 $0.44 ============================================================================= Nine Months Ended September 30, 2004 Basic EPS $37,530 29,664 $1.27 Stock options 933 ----------------------------------------------------------------------------- Diluted EPS $37,530 30,597 $1.23 ============================================================================= Nine Months Ended September 30, 2003 Basic EPS $31,710 26,064 $1.22 Stock options 617 ----------------------------------------------------------------------------- Diluted EPS $31,710 26,681 $1.19 =============================================================================
11 NOTE E: INTANGIBLE ASSETS The gross carrying amount and accumulated amortization for each type of intangible asset are as follows:
As of September 30, 2004 As of December 31, 2003 ------------------------------------- ------------------------------------- Gross Net Gross Net Carrying Accumulated Carrying Carrying Accumulated Carrying (000's omitted) Amount Amortization Amount Amount Amortization Amount ------------------------------------- ------------------------------------- Amortizing intangible assets: Core deposit intangibles $ 62,389 ($26,457) $ 35,932 $ 55,455 ($21,457) $ 33,998 Other intangibles 2,750 (634) 2,116 2,750 (233) 2,517 ------------------------------------- ------------------------------------- Total amortizing intangibles 65,139 (27,091) 38,048 58,205 (21,690) 36,515 Non-amortizing intangible assets: Goodwill 190,696 0 190,696 159,596 0 159,596 ------------------------------------- ------------------------------------- Total intangible assets, net $255,835 ($27,091) $228,744 $217,801 ($21,690) $196,111 ===================================== =====================================
As described in Note B, the increases in the gross carrying amount of core deposit intangibles and goodwill primarily relate to the May 2004 acquisition of First Heritage Bank. No goodwill impairment adjustments were recognized in 2004 and 2003. The estimated aggregate amortization expense for each of the succeeding fiscal years ending December 31 is as follows: (000's omitted)Amount ------------------------------- Oct-Dec 2004 $2,013 2005 6,953 2006 5,794 2007 5,440 2008 5,154 Thereafter 12,694 ------- Total $38,048 ======= NOTE F: SUBORDINATED DEBT The Company sponsors three business trusts, Community Capital Trust I, Community Capital Trust II, and Community Statutory Trust III, of which 100% of the common securities are owned by the Company. In accordance with FASB Interpretation No. 46, "Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51", these business trusts are not consolidated with the financial statements of the Company. The trusts were formed for the purpose of issuing company-obligated mandatorily redeemable preferred securities to third-party investors and investing the proceeds from the sale of such preferred securities solely in junior subordinated debt securities of the Company. The debentures held by each trust are the sole assets of that trust and were $81,439,000 and $82,410,000 at September 30, 2004 and December 31, 2003, respectively. Distributions on the preferred securities issued by each trust are payable semi-annually at a rate per annum equal to the interest rate being earned by the trust on the debentures held by that trust. The preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the debentures. The Company has entered into agreements which, taken collectively, fully and unconditionally guarantee the preferred securities subject to the terms of each of the guarantees. The terms of the preferred securities of each trust are as follows:
Issuance Preferred Interest Maturity Call Call Trust Date Securities Rate Date Provision Price ------------------------------------------------------------------------------------------------------------------------------------ I 2/3/1997 $30 million 9.75% 2/03/2027 10 year beginning 2007 104.5400% declining to par in 2017 II 7/16/2001 $25 million Six-month LIBOR plus 3.75% 7/16/2031 5 year beginning 2006 107.6875% declining to par in 2011 III 7/31/2001 $24.45 million Three-month LIBOR plus 3.58% 7/31/2031 5 year beginning 2006 107.5000% declining to par in 2011 ====================================================================================================================================
12 NOTE G: BENEFIT PLANS The Company provides defined benefit pension benefits and post-retirement health and life insurance benefits to eligible employees. The Company also provides supplemental pension retirement benefits for several current and former key employees. The Company accrues for the estimated cost of these benefits through charges to expense during the years that employees earn these benefits. The components of the net periodic benefit cost are as follows:
Pension Benefits Post-retirement Benefits ---------------------------------------------- -------------------------------------- Three Months Ended Nine Months Ended Three Months Ended Nine Months Ended September 30, September 30, September 30, September 30, ------------------ --------------------- ------------------ ----------------- (000's omitted) 2004 2003 2004 2003 2004 2003 2004 2003 ---------------------------------------------------------------------------------------------------------------------------------- Service cost $ 480 $ 481 $ 1,440 $ 1,193 $ 78 $ 45 $233 $136 Interest cost 592 505 1,776 1,448 81 63 244 190 Expected return on plan assets (790) (642) (2,371) (1,925) 0 0 0 0 Net amortization and deferral 218 298 655 729 9 0 28 0 Amortization of prior service cost 107 (8) 320 (25) 8 8 22 22 Amortization of transition obligation 0 (1) 0 (3) 10 10 31 31 --------------------------------------------------------------------------------------------------------------------------------- Net periodic benefit cost $ 607 $ 633 $ 1,820 $ 1,417 $186 $126 $558 $379 ================================================================================================================================= Supplemental Benefits --------------------------------------- Three Months Ended Nine Months Ended September 30, September 30, ------------------ ----------------- (000's omitted) 2004 2003 2004 2003 --------------------------------------------------------------------------------- Service cost $ 88 $ 39 $ 263 $104 Interest cost 39 58 116 153 Expected return on plan assets 0 0 0 0 Net amortization and deferral 44 40 133 89 Amortization of prior service cost (34) 40 (101) 121 Amortization of transition obligation 0 0 0 0 --------------------------------------------------------------------------------- Net periodic benefit cost $ 137 $177 $ 411 $467 =================================================================================
The Company is not required for regulatory purposes to make a contribution to its defined benefit pension plan. However, it may make a discretionary contribution in the fourth quarter of 2004. NOTE H: COMMITMENTS, CONTINGENT LIABILITIES AND RESTRICTIONS The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist primarily of commitments to extend credit and standby letters of credit. Commitments to extend credit are agreements to lend to customers, generally having fixed expiration dates or other termination clauses that may require payment of a fee. These commitments consist principally of unused commercial and consumer credit lines. Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of an underlying contract with a third party. The credit risks associated with commitments to extend credit and standby letters of credit are essentially the same as that involved with extending loans to customers and are subject to normal credit policies. Collateral may be obtained based on management's assessment of the customer's creditworthiness. The fair value of these commitments is immaterial for disclosure in accordance with FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others". The contract amount of commitment and contingencies is as follows: September 30, December 31, (000's omitted) 2004 2003 ------------------------------------------------------------------------------ Commitments to extend credit $440,176 $315,898 Standby letters of credit 24,310 19,163 ----------------------------------------------------------------------------- Total $464,486 $335,061 ============================================================================= 13 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Introduction This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") primarily reviews the financial condition and results of operations of Community Bank System, Inc. ("the Company") for the three and nine months ended September 30, 2004 and 2003, although in some circumstances the second quarter of 2004 is also discussed in order to more fully explain recent trends. The following discussion and analysis should be read in conjunction with the Company's Consolidated Financial Statements and related notes that appear on pages 3 through 13 and the Annual Report on Form 10-K for the year ended December 31, 2003. Unless otherwise stated, all references in the discussion to the financial condition and results of operations are to those of the Company and its subsidiaries taken as a whole. All references to "peer banks" pertain to a group of 79 bank holding companies nationwide having $3 billion to $10 billion in assets and their associated composite financial results for the six months ending June 30, 2004 (the most recently available disclosure) as provided by the Federal Reserve Board in the Bank Holding Company Performance Report. Unless otherwise noted, the term "this year" refers to results in calendar year 2004, "third quarter" refers to the quarter ended September 30, 2004, earnings per share ("EPS") figures refer to diluted EPS, and net interest income and net interest margin are presented on a fully tax-equivalent ("FTE") basis. All common share and common share-based amounts reflect the two-for-one stock split effected as a 100% stock dividend on April 12, 2004. This MD&A contains certain forward-looking statements with respect to the financial condition, results of operations and business of the Company. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those proposed by such forward-looking statements are set herein under the caption, "Forward-Looking Statements," on page 27. Critical Accounting Policies As a result of the complex and dynamic nature of the Company's business, management must exercise judgement in selecting and applying the most appropriate accounting policies for its various areas of operations. The policy decision process not only ensures compliance with the latest generally accepted accounting principles, but also reflects on management's discretion with regard to choosing the most suitable methodology for reporting the Company's financial performance. It is management's opinion that the accounting estimates covering certain aspects of the business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity in the selection process. These estimates affect the reported amounts of assets and liabilities and disclosures of revenues and expenses during the reporting period. Actual results could differ from those estimates. Management believes that critical accounting estimates include: o Allowance for loan losses - The allowance for loan losses reflects management's best estimate of probable losses inherent in the loan portfolio. Determination of the allowance is subjective in nature and requires significant estimates. o Actuarial assumptions associated with pension, post-retirement and other employee benefit plans - These assumptions include discount rate, rate of future compensation increases and expected return on plan assets. o Provision for income taxes - The Company is subject to examinations from various taxing authorities. Such examinations may result in challenges to the tax return treatment applied by the Company to specific transactions. Management believes that the assumptions and judgements used to record tax-related assets or liabilities have been appropriate. Should tax laws change or the taxing authorities determine that management's assumptions were inappropriate, an adjustment may be required which could have a material effect on the Company's results of operations. o Carrying value of goodwill and other intangible assets - The carrying value of goodwill and other intangible assets is based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires use of a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums, and company-specific risk indicators. A summary of the accounting policies used by management is disclosed in Note A, "Summary of Significant Accounting Policies" on pages 61 - 67 of the most recent Form 10-K (fiscal year ended December 31, 2003). Executive Summary The Company's business philosophy is to operate as a community bank with local decision-making, principally in non-metropolitan markets, providing a broad array of banking and financial services to retail, commercial and municipal customers. The Company's branch network operates in New York as Community Bank, N.A., and in Pennsylvania as First Liberty Bank & Trust. The Company 14 also operates five financial services businesses, which provide a broad array of wealth management and benefits administration and consulting services to bank and non-bank customers. The Company's core operating objectives are to: (i) grow the branch network, primarily through a disciplined acquisition and de novo strategy, (ii) build high-quality, profitable loan portfolios using both organic and acquisition strategies, (iii) increase the non-interest income component of total revenues through development of banking-related fee income, growth in existing financial services business units, and the acquisition of additional financial services businesses, and (iv) utilize technology to deliver customer-responsive products and services and to reduce operating costs. Significant factors management reviews to evaluate achievement of the Company's operating objectives and its operating results and financial condition include, but are not limited to: net income and earnings per share, return on assets and equity, net interest margins, non-interest income, operating expenses, asset quality, loan and deposit growth, capital management, performance of individual banking and financial services business units, liquidity and interest rate sensitivity, enhancements to customer products and services, technology advancements, market share, peer comparisons, and the performance of acquisition and integration activities. Third quarter earnings per share were $0.01 above the prior year's third quarter, as higher net interest income and non-interest income were partially offset by higher operating expenses and a greater number of common shares outstanding. On a year-to-date ("YTD") basis, earnings per share were $0.04 above the first nine months of 2003, resulting from higher net interest income and non-interest income and a lower loan loss provision, partially offset by higher operating expenses and a greater number of common shares outstanding. On an operating basis (see Table 1 and related narrative), third quarter and September YTD net income increased 21% and 20%, respectively, compared to the same periods of 2003, while return on equity declined slightly due to higher capital levels. Excluding acquisition activity, revenue generated by the financial services businesses was up for the current quarter and first nine months of the year. Operating expenses for the quarterly and YTD periods increased primarily due to acquisitions and higher compensation and benefits costs. The efficiency ratio for the quarter and YTD periods improved as a result of net interest income and recurring non-interest income growing at a faster pace than operating expenses (excluding acquisition costs and intangible amortization). Asset quality improved over last year, with reductions in delinquency, net charge-off and non-performing loan ratios. Excluding acquisition activity, the Company experienced strong year-over-year loan growth in consumer mortgage and installment lending, with a slight decline in business lending. On a geographical basis, excluding acquisitions, the New York markets accounted for all of the Company's loan growth, with a slight decline experienced in the Pennsylvania markets. Excluding acquisitions, total average deposits for the quarter and first nine months of 2004 declined slightly from the levels that existed for the same periods last year. On May 14, 2004, the Company completed its acquisition of First Heritage Bank ("First Heritage"), a $275 million-asset, three-branch commercial bank based in Wilkes-Barre, PA. The Company completed three acquisitions in 2003, including: (1) Harbridge Consulting Group ("Harbridge"), an actuarial and benefits consulting firm based in Syracuse, NY that was acquired from PricewaterhouseCoopers in July, (2) Peoples Bankcorp Inc. ("Peoples"), a $29 million-asset single branch bank in Ogdensburg, NY acquired in September, and (3) Grange National Banc Corp. ("Grange"), a $280 million-asset bank with twelve branches in five counties of Northeastern PA, acquired in November. Net Income and Profitability As shown in Table 2, third quarter earnings per share of $0.45 and September YTD earnings per share of $1.23 were $0.01 and $0.04 higher, respectively, than the EPS generated in the same periods of last year. Net income for the quarter of $14.2 million was up 21% over third quarter 2003, and net income of $37.5 million for the first nine months of 2004 increased 18% from the amount earned in the equivalent period of last year. Net interest income for the third quarter of $42.9 million and $123.2 million for the first nine months of 2004, were up 21% and 16% from their respective prior year periods. Third quarter non-interest income (excluding net gains from investment securities sales and debt prepayment costs) of $12.2 million was up 24% from third quarter 2003 (15%, excluding a $0.8 million impairment loss on secondary market mortgage activities recorded in the third quarter last year), and the YTD amount of $33.5 million rose 21% from the prior year level. Operating expenses of $29.9 million for the quarter and $89.5 million for the first nine months of 2004 were up 19% and 20%, respectively, from the equivalent periods of 2003, a portion of which related to acquisition expenses, which declined $0.1 million for the quarter, but were $1.3 million higher on a YTD basis. In addition to the earnings results presented above in accordance with generally accepted accounting principles ("GAAP"), the Company provides earnings results on a non-GAAP, or operating basis. The determination of operating earnings excludes the effects of certain items the Company considers to be non-operating, including acquisition expenses, the results of securities transactions and debt restructuring activities. Performance as measured by operating earnings is considered by management to be a useful measure for gauging the underlying performance of the Company by eliminating the volatility caused by voluntary, transaction-based items. Operating earnings per share for the third quarter were $0.45, up 2.3% from the $0.44 reported in the equivalent period of 2003. On a year-to-date basis, operating EPS of $1.25 increased $0.06 or 5.0% versus the first nine months of 2003. As reflected in Table 2, the 15 primary reasons for the improved earnings were higher net interest income and non-interest income and a lower loan loss provision (on a YTD basis only), offset by higher operating expenses and a greater number of weighted average diluted shares outstanding. Net interest income increased because of higher earning-asset levels derived from the acquisitions of Peoples, Grange and First Heritage, organic consumer mortgage and installment loan growth, and investment leverage. The increase in non-interest income was attributable to incremental revenue from Harbridge, strong growth at the other financial services units, and additional banking fees generated in the 16 branches added through the three whole-bank acquisitions. A significant decrease in net charge-offs and general improvement in other asset quality metrics were the primary drivers of the decrease in the YTD loan loss provision, despite a significant increase in the size of the total loan portfolio. The quarterly and YTD performance improvements were partially offset by a growth in operating expenses, in most part due to the four acquisitions made in the intervening time period. A reconciliation of GAAP-based earnings results to operating-based earnings results and a condensed income statement are as follows: Table 1: Reconciliation of GAAP Net Income to Operating Net Income
Three Months Ended Nine Months Ended September 30, September 30, --------------------- ----------------------- (000's omitted) 2004 2003 2004 2003 ----------------------------------------------------------------------------------------- Net income $14,234 $ 11,729 $ 37,530 $ 31,710 After-tax operating adjustments: Net securities gains 0 (2) (89) (2) Debt prepayment costs 0 0 0 27 Acquisition expenses 32 101 879 104 ----------------------------------------------------------------------------------------- Net income - operating $14,266 $ 11,828 $ 38,320 $ 31,839 =========================================================================================
Table 2: Summary Income Statements
Three Months Ended Nine Months Ended September 30, September 30, ---------------------- ---------------------- (000's omitted, except per share data) 2004 2003 2004 2003 ---------------------------------------------------------------------------------------------- Net interest income (FTE) $ 42,850 $35,548 $123,223 $106,077 Loan loss provision 2,300 2,029 6,650 8,102 Non-interest income 12,164 9,776 33,468 27,575 Gain (loss) on investment securities & debt extinguishment 0 3 145 (42) Operating expenses 29,873 25,041 88,023 74,662 Acquisition expenses 53 165 1,434 170 ---------------------------------------------------------------------------------------------- Income before taxes (FTE) 22,788 18,092 60,729 50,676 Fully tax-equivalent adjustment 3,793 3,009 10,755 8,952 Income taxes 4,761 3,354 12,444 10,014 ---------------------------------------------------------------------------------------------- Net income $ 14,234 $11,729 $ 37,530 $ 31,710 ============================================================================================== Diluted earnings per share $ 0.45 $ 0.44 $ 1.23 $ 1.19 Diluted earnings per share-operating $ 0.45 $ 0.44 $ 1.25 $ 1.19
Net Interest Income Net interest income is the amount that interest and fees on earning assets (loans and investments) exceeds the cost of funds, primarily interest paid to the Company's depositors and interest on external borrowings. Net interest margin is the difference between the gross yield on earning assets and the cost of interest-bearing funds as a percentage of earning assets. As shown in Table 3, net interest income (with non-taxable income converted to a fully tax-equivalent basis) for third quarter 2004 was $42.9 million, up $7.3 million or 21% from the same period last year. An $869 million increase in average earning-assets more than offset a $751 million increase in interest-bearing liabilities and a 28 basis point decrease in the net interest margin. As reflected in Table 4, the volume changes mentioned above drove net interest income to rise $9.6 million, while the lower net interest margin had a $2.3 million negative impact on net interest income. September 2004 YTD net interest income of $123.2 million was up $17.1 million or 16% from the year-earlier period. A $656 million increase in average earning-asset levels had a greater positive effect than a $554 million rise in interest-bearing liabilities and a 22 basis point decline in the net interest margin. Interest-bearing asset and liability 16 volume changes resulted in $22.3 million more net interest income, offset by a lower net interest margin that had a negative $5.1 million impact. Average loans increased $483 million for the quarter and $392 million for the nine months ended September 30, 2004 in comparison to the same periods in 2003, while average investments (book value basis) rose $386 million for the third quarter and $264 million for the YTD period. The increases in average loans and investments were the result of acquisitions, organic loan growth and security purchases. Third quarter and September YTD average deposits were $398 million and $317 million higher, respectively, than the same periods in the prior year. These increases were principally due to the deposits added through the Peoples, Grange and First Heritage acquisitions. External borrowings were increased to fund organic loan growth and investment purchases over the last 12 months, resulting in average borrowings that were up $448 million for the quarter and $324 million for the first nine months of 2004 in comparison to the year-earlier periods. The 4.35% net interest margin in the third quarter dropped 28 basis points versus the same quarter last year, and the September YTD margin of 4.50% was down 22 basis points from the prior year. The declines in the net interest margin were primarily attributable to lower interest rates over the last 12 months having a greater impact on earning-asset yields (quarter down 47 basis points, YTD down 59 basis points), than on the cost of funds (quarter down 19 basis points, YTD down 37 basis points). The reduction of earning-asset yields was mostly driven by declines in loan yields of 60 basis points for the quarter and 73 basis points for the YTD period. Loan originations over much of the last year were at rates that reflected the record-low rates prevalent in the market at the time, particularly in the mortgage, home equity and auto financing products. Investment portfolio yields were comparatively more stable (down 28 basis points for the quarter and 35 basis points YTD), and benefited from call protection and security purchases that were concentrated in periods of higher long-term rates. The decrease in the cost of funds was caused by deposit costs dropping 22 basis points for the quarter and 34 basis points YTD, while external borrowing rates declined 97 basis points for the quarter and 119 basis points year-to-date. The deposit costs for both time periods were impacted by time deposits rolling-over at lower rates and shifts in the deposit portfolio towards demand deposits. The improvements in borrowing costs were primarily driven by a shift in the mix of external funding from higher-rate, longer-term borrowings to lower-rate, shorter-term debt. A portion of this change was attributable to the prepayment of $25 million of longer-term Federal Home Loan Bank ("FHLB") obligations in the fourth quarter of 2003, which were replaced with short-term borrowings at much lower rates. In addition, a significant amount of intermediate-term borrowings at comparable favorable rates were added in the second quarter of 2004. The Company's net interest margin for the first six months of 2004 was favorable to peer companies, driven by a higher earning-asset yield, partially offset by a slightly larger ratio of interest expense to average earning assets. 17 Tables 3 and 3A below set forth information relating to average interest-earning assets and interest-bearing liabilities and their associated yields and rates for the periods indicated. Interest income and yields are on a fully tax-equivalent basis using a marginal income tax rate of 38.70% in 2004 and 38.94% in 2003. Average balances are computed by summing the daily ending balances in a period and dividing by the number of days in that period. Loan yields and amounts earned include loan fees. Average loan balances include non-accrual loans. Table 3: Quarterly Average Balance Sheet
Three Months Ended Three Months Ended (000's omitted except yields and rates) September 30, 2004 September 30, 2003 ---------------------------------------------------------------------------------------------- ---------------------------------- Avg. Avg. Average Yield/Rate Average Yield/Rate Balance Interest Paid Balance Interest Paid ---------------------------------------------------------------------------------------------- ---------------------------------- Interest-earning assets: Time deposits in other banks $ 903 $ 1 0.44% $ 318 $ 1 1.25% Taxable investment securities (2) 1,005,990 14,259 5.64% 764,613 11,443 5.94% Non-taxable investment securities (2) 546,395 9,401 6.85% 402,105 7,215 7.12% Loans (net of unearned discount)(1) 2,362,596 35,355 5.95% 1,879,858 31,026 6.55% --------------------- --------------------- Total interest-earning assets 3,915,884 59,016 6.00% 3,046,894 49,685 6.47% Non-interest earning assets 482,376 390,122 ---------- ---------- Total assets $4,398,260 $3,437,016 ========== ========== Interest-bearing liabilities: Interest checking, savings and money market deposits $1,169,332 1,627 0.55% $996,872 1,511 0.60% Time deposits 1,193,700 6,995 2.33% 1,062,968 7,394 2.76% Short-term borrowings 512,074 2,150 1.67% 207,925 638 1.22% Long-term borrowings 439,423 5,394 4.88% 295,509 4,594 6.17% --------------------- --------------------- Total interest-bearing liabilities 3,314,529 16,166 1.94% 2,563,274 14,137 2.19% Non-interest bearing liabilities: Demand deposits 577,949 483,142 Other liabilities 53,983 54,028 Shareholders' equity 451,799 336,572 ---------- ---------- Total liabilities and shareholders' equity $4,398,260 $3,437,016 ========== ========== Net interest earnings $42,850 $35,548 ======= ======= Net interest spread 4.06% 4.28% Net interest margin on interest-earning assets 4.35% 4.63% Fully tax-equivalent adjustment on investments and loans $3,793 $ 3,009
(1) The impact of interest not recognized on non-accrual loans was immaterial. (2) Averages for investment securities are based on historical cost basis and the yields do not give effect to changes in fair value that is reflected as a component of shareholders' equity and deferred taxes. 18 Table 3A: Year to Date Average Balance Sheet
Nine Months Ended Nine Months Ended (000's omitted except yields and rates) September 30, 2004 September 30, 2003 ------------------------------------ ------------------------------------ Avg. Avg. Average Yield/Rate Average Yield/Rate Balance Interest Paid Balance Interest Paid --------------------------------------------------------------------------------------------- ------------------------------------ Interest-earning assets: Time deposits in other banks $ 779 $ 3 0.51% $ 253 $ 2 1.06% Taxable investment securities (2) 924,020 40,378 5.84% 760,743 35,678 6.27% Non-taxable investment securities (2) 502,255 26,323 7.00% 402,037 21,682 7.21% Loans (net of unearned discount)(1) 2,232,746 101,331 6.06% 1,841,049 93,556 6.79% ---------------------- ---------------------- Total interest-earning assets 3,659,800 168,035 6.13% 3,004,082 150,918 6.72% Non-interest earning assets 469,624 392,273 ---------- ---------- Total assets $4,129,424 $3,396,355 ========== ========== Interest-bearing liabilities: Interest checking, savings and money market deposits $1,115,642 4,684 0.56% $989,410 5,245 0.71% Time deposits 1,188,254 21,094 2.37% 1,084,162 24,229 2.99% Short-term borrowings 428,640 4,547 1.42% 170,814 1,628 1.27% Long-term borrowings 362,366 14,487 5.34% 296,268 13,739 6.20% ---------------------- ---------------------- Total interest-bearing liabilities 3,094,902 44,812 1.93% 2,540,654 44,841 2.36% Non-interest bearing liabilities: Demand deposits 549,933 462,970 Other liabilities 53,422 56,405 Shareholders' equity 431,167 336,328 ---------- ---------- Total liabilities and shareholders' equity $4,129,424 $3,396,357 ========== ========== Net interest earnings $123,223 $106,077 ======== ======== Net interest spread 4.20% 4.36% Net interest margin on interest-earning assets 4.50% 4.72% Fully tax-equivalent adjustment $10,755 $8,952
(1) The impact of interest not recognized on non-accrual loans was immaterial. (2) Averages for investment securities are based on historical cost basis and the yields do not give effect to changes in fair value that is reflected as a component of shareholders' equity and deferred taxes. 19 As discussed above and disclosed in Table 4 below, the year-over-change in quarterly and YTD net interest income (fully tax-equivalent basis) may be analyzed by segregating the volume and rate components of the changes in interest income and interest expense for each underlying category. Table 4: Rate/Volume
------------------------------ -------------------------------- 3rd Quarter 2004 versus 3rd Nine Months Ended September Quarter 2003 30, 2004 versus 2003 ------------------------------ -------------------------------- Increase (Decrease) Due to Increase (Decrease) Due to Change in (1) Change in (1) ------------------------------ -------------------------------- Net Net (000's omitted) Volume Rate Change Volume Rate Change --------------------------------------------------------------------------------------------------------------------------------- Interest earned on: Time deposits in other banks $ 1 ($ 1) $ 0 $ 2 ($ 1) $ 1 Taxable investment securities 3,449 (633) 2,816 7,261 (2,561) 4,700 Non-taxable investment securities 2,494 (308) 2,186 5,268 (627) 4,641 Loans (net of unearned discount) 7,422 (3,093) 4,329 18,488 (10,713) 7,775 Total interest-earning assets (2) $13,322 ($3,991) $ 9,331 $30,908 ($13,791) $ 17,117 Interest paid on: Interest checking, savings and money market deposits $ 247 ($ 131) $ 116 $ 616 ($ 1,177) ($ 561) Time deposits 847 (1,246) (399) 2,174 (5,309) (3,135) Short-term borrowings 1,208 304 1,512 2,716 203 2,919 Long-term borrowings 1,909 (1,109) 800 2,804 (2,056) 748 Total interest-bearing liabilities (2) $ 3,800 ($1,771) $ 2,029 $ 8,819 ($ 8,848) ($ 29) Net interest earnings (2) $ 9,622 ($2,320) $ 7,302 $22,267 ($ 5,121) $ 17,146
(1) The change in interest due to both rate and volume has been allocated in proportion to the relationship of the absolute dollar amounts of change in each. (2) Changes due to volume and rate are computed from the respective changes in average balances and rates and are not a summation of the changes of the components. 20 Non-interest Income The Company has three sources of non-interest income: banking services related to loans, deposits and other core customer activities typically provided through the branch network; financial services, comprised of retirement plan administration and employee benefit trusts (Benefit Plans Administrative Services or BPA), actuarial and employee benefit consulting services (Harbridge Consulting Group or Harbridge), personal trust, investment and insurance products (Community Investment Services, Inc. or CISI) and investment management (Elias Asset Management or EAM); and periodic transactions, most often net gains (losses) from the sale of investments and prepayment of term debt. Table 5: Non-interest Income
Three Months Ended Nine Months Ended September 30, September 30, --------------------- ---------------------- (000's omitted) 2004 2003 2004 2003 --------------------------------------------------------------------------------------------------------------- Banking services: Electronic banking $ 758 $ 812 $ 1,913 $ 1,975 Mortgage banking 191 (795) 452 162 Deposit service charges 1,406 1,367 4,098 4,008 Overdraft fees 3,957 3,479 11,091 9,780 Credit life and disability insurance 1,000 661 1,141 787 Commissions and other 579 519 2,077 1,620 --------------------------------------------------------------------------------- ---------------------- Total banking services 7,891 6,043 20,772 18,332 --------------------------------------------------------------------------------- ---------------------- Financial services: Retirement plan administration and trustee fees 1,441 1,166 4,307 3,469 Actuarial and benefit plan consulting fees 897 820 2,690 820 Asset advisory and management fees 461 526 1,553 1,404 Investment and insurance product commissions 1,085 868 2,912 2,469 Personal trust 389 353 1,234 1,081 --------------------------------------------------------------------------------- ---------------------- Total financial services 4,273 3,733 12,696 9,243 --------------------------------------------------------------------------------- ---------------------- Sub-total 12,164 9,776 33,468 27,575 Gain (loss) on investment securities & debt prepayment 0 3 145 (42) --------------------------------------------------------------------------------- ---------------------- Total non-interest income $12,164 $ 9,779 $33,613 $ 27,533 ================================================================================= ====================== Non-interest income/operating income (FTE) 22.1% 21.6% 21.4% 20.6%
As displayed in Table 5, non-interest income (excluding net securities gains and debt prepayment costs) for the third quarter 2004 was $2.4 million (24%) higher than third quarter 2003 and $5.9 million (21%) higher than the prior year YTD period. On a quarterly and year-to-date basis, banking services increased $1.9 million (31%) and $2.4 million (13%), respectively, while financial services increased $0.5 million (15%) and $3.5 million (37%), respectively. The quarterly and year-to-date increases in banking services were primarily the result of a $0.3 million increase in the annual dividend received from the New York Bankers Association, a $0.8 million impairment loss recognized in the third quarter of 2004 on mortgage loans commitments which were reclassified from held-for-sale to portfolio loans, and growth in deposit fees and commissions mainly caused by the three whole bank acquisitions over the last year. The majority of the increase in financial services income for the third quarter of 2004 was driven by BPA and CISI, while Harbridge also impacted the results for the nine months ended September 30, 2004. BPA generated revenue growth of $0.3 million (24%) for the quarter and $0.8 million (24%) for first nine months of 2004 driven by continued strong new business development. CISI had quarterly and year-to-date revenue growth of $0.2 million (25%) and $0.4 million (18%), respectively, as it has been positively impacted by improving market conditions. In addition, CISI has obtained a large number of higher net-worth investors caused by recent retirees rolling over their 401k plans and/or receiving inheritances. The growth in Harbridge's revenue for the nine months ended September 30, 2004 was due to their acquisition on July 31, 2003, resulting in the inclusion of nine months of revenue in 2004 versus two months in 2003. The quarterly and year-to-date increase in the ratio of non-interest income to operating income (FTE basis, excluding net security gains and debt prepayment costs) resulted from the growth in non-interest income outpacing the growth in net interest income. 21 Operating Expenses The following table sets forth the quarterly and year-to-date components of operating expenses for the current and prior year, as well as the efficiency ratio (defined below), a standard measure of overhead utilization used in the banking industry. Table 6: Operating Expenses
Three Months Ended Nine Months Ended September 30, September 30, --------------------- --------------------- (000's omitted) 2004 2003 2004 2003 ------------------------------------------------------------ --------------------- Salaries and employee benefits $15,638 $13,225 $46,197 $38,243 Occupancy 2,570 2,255 7,700 7,004 Equipment and furniture 2,143 1,885 6,445 5,766 Legal and professional fees 1,003 672 2,970 2,250 Data processing 1,973 1,647 5,777 5,006 Amortization of intangible assets 2,003 1,269 5,401 3,801 Office supplies 613 455 1,711 1,507 Foreclosed property 178 155 621 313 Other 3,752 3,478 11,201 10,772 ------------------------------------------------------------ --------------------- Total recurring expenses 29,873 25,041 88,023 74,662 Acquisition expenses 53 165 1,434 170 ------------------------------------------------------------ --------------------- Total operating expenses $29,926 $25,206 $89,457 $74,832 ============================================================ ===================== Operating expenses/average assets 2.70% 2.89% 2.85% 2.94% Efficiency ratio 50.7% 52.4% 52.7% 53.0%
The third quarter and the year-to-date operating expenses for 2004 were $4.7 million (19%) and $14.6 million (20%) higher than the expenses in the same periods of 2003. The increases for both periods were primarily attributable to the incremental recurring operating expenses associated with the four acquisitions completed during the last year. More than fifty percent of the increase for the quarter and year-to-date periods relates to higher personnel costs that were impacted by the acquisitions, merit increases, hiring activity and higher benefit costs. The increase in legal and professional fees over the prior year was caused, in most part, by the additional responsibilities associated with complying with new governance and regulatory requirements. The 2004 acquisition expenses include $0.9 million of deferred compensation costs that were recorded in first quarter 2004 but should have been recognized in 1996 by a bank that was acquired by First Liberty Bank & Trust, prior to its acquisition by the Company in 2001. The Company's efficiency ratio (recurring operating expenses excluding intangible amortization divided by the sum of net interest income (FTE) and recurring non-interest income) improved 1.7 percentage points for the quarter and 0.3 percentage points on a year-to-date basis when comparing to the same periods of the prior year. Recurring operating income grew at a faster rate than core operating expenses. Organic income expansion generated principally through loan growth, investment leverage and increased revenue from the financial services businesses resulted in higher margins due to the significant proportion of fixed costs inherent in the Company's expense structure. Income Taxes The September YTD effective income tax rate was 24.9% for 2004 and 24.0% in 2003. The quarterly effective rate of 25.1% was 2.9 percentage points above the 22.2% rate recorded in third quarter of 2003. As in prior periods, the difference between the Company's effective income tax rate and its statutory rate for the quarter and year-to-date is due primarily to interest generated from tax-exempt securities. 22 Investments As reflected in Table 7 below, the carrying value of investments increased $275 million from year-end 2003 and $312 million from September 30, 2003. The growth in the investment portfolio for both time periods was driven by the leveraging strategy that began in the third quarter of 2003 and ended during the second quarter of 2004. It was also impacted, to a lesser degree, by the investments added through the three bank acquisitions over the last twelve months. The overall mix of securities within the portfolio remained relatively consistent, with a slight increase towards U.S. treasury securities and agencies. The change in the carrying value of investments is impacted by the amount of net unrealized gains in the portfolio at a point in time. The net unrealized gains increased by $3.1 million since December 31, 2003 but decreased $2.8 million since September 30, 2003, indicative of the interest rate movements during the respective time periods and the changing composition of the portfolio. Table 7: Investments
September 30, 2004 December 31, 2003 September 30, 2003 ----------------------- ----------------------- ----------------------- Amortized Amortized Amortized Cost/Book Market Cost/Book Market Cost/Book Market (000's omitted) Value Value Value Value Value Value ----------------------------------------------------------------------------- ----------------------- ----------------------- Held-to-Maturity Portfolio: U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 127,526 $ 126,333 $ 127,635 $ 125,003 $ 127,671 $ 128,593 Obligations of state and political subdivisions 6,536 6,682 7,459 7,677 7,545 7,765 Other securities 3,578 3,578 3,558 3,558 3,526 3,526 ----------------------------------------------------------------------------- ----------------------- ----------------------- Total held-to-maturity portfolio 137,640 136,593 138,652 136,238 138,742 139,884 ----------------------------------------------------------------------------- ----------------------- ----------------------- Available-for-Sale Portfolio: U.S. Treasury securities and obligations of U.S. government corporations and agencies 632,113 656,282 456,913 479,454 425,025 455,428 Obligations of state and political subdivisions 546,084 576,304 443,930 470,210 401,495 423,484 Corporate securities 42,108 45,346 27,712 30,251 27,608 30,564 Collateralized mortgage obligations (CMO's) 75,850 77,598 89,566 93,552 117,363 122,846 Mortgage-backed securities 54,384 57,000 76,628 80,177 85,115 89,107 ----------------------------------------------------------------------------- ----------------------- ----------------------- Sub-total 1,350,539 1,412,530 1,094,749 1,153,644 1,056,606 1,121,429 Equity securities 44,942 44,942 29,185 29,185 26,858 26,858 Federal Reserve Bank common stock 9,856 9,856 8,053 8,053 5,656 5,656 ----------------------------------------------------------------------------- ----------------------- ----------------------- Total available-for-sale portfolio 1,405,337 1,467,328 1,131,987 1,190,882 1,089,120 1,153,943 Net unrealized gain on available-for-sale portfolio 61,991 0 58,895 0 64,823 0 ----------------------------------------------------------------------------- ----------------------- ----------------------- Total carrying value $1,604,968 $1,603,921 $1,329,534 $1,327,120 $1,292,685 $1,293,827 ============================================================================= ======================= =======================
Loans As shown in Table 8, loans ended the third quarter at $2.4 billion, up $245 million (11.5%) year-to-date and $449 million (23%) higher than one-year earlier. Most of the YTD and year-over-year increases in loan balances were attributable to acquisitions, which added $206 million to the loan portfolio in 2004 and $378 million over the last 12 months. Excluding the impact of acquisitions, total loans grew $39 million or 1.8% in the first nine months of 2004 and $72 million or 3.7% over the past year. All of the organic loan growth for both periods was produced in the consumer mortgage and installment lines of business, with slight declines experienced in business lending. The organic loan growth for the nine and 12-month intervals was generated in the New York markets, with slight declines in Pennsylvania. Over the last year the mix of loans has become more weighted towards consumer mortgages because of the strong growth in that portfolio, and business lending due to the high proportion of commercial loans in First Heritage's portfolio. Table 8: Loans
(000's omitted) September 30, 2004 December 31, 2003 September 30, 2003 --------------------------------------------- ------------------- ------------------- Consumer mortgage $ 793,120 33% $ 739,593 35% $ 606,312 32% Business lending 847,844 36% 689,436 32% 630,886 33% Consumer installment 732,787 31% 699,480 33% 687,055 35% --------------------------------------------- ------------------- ------------------- Total loans $2,373,751 100% $2,128,509 100% $1,924,253 100% ============================================= =================== ===================
23 Total consumer mortgages increased $54 million in the first nine months of 2004 and $187 million year-over year. Excluding the impact of acquisitions, consumer mortgages were up $33 million (4.4%) over the last three quarters and $77 million (12.6%) over the last year. Volumes have slowed in the past nine months as the record levels of refinancing activity that were driven by 40-year low mortgage rates in 2003 have diminished in a rising interest rate environment. The growth for both the nine and 12-month time frames was derived principally from activity in the New York markets. Business loans rose $158 million over the latest nine months and were up $217 million from one year ago. All of the growth came from the loans acquired in the First Heritage (May 2004) and Grange (November 2003) transactions. Excluding the loans acquired from First Heritage and Grange (for the twelve month period only), business lending was down $12 million or 1.7% from December 2003's level and declined $21 million or 3.3% over the last 12 months. The New York markets were slightly higher during the nine-month time period and was flat in the 12-month time frame, while the Pennsylvania markets experienced slight declines over both periods. Consumer installment loans, both those originated directly (such as personal loans and home equity loans and lines of credit), and indirectly (originated predominantly in automobile, marine and recreational vehicle dealerships), rose $33 million (4.8%) in the last nine months and $46 million (6.7%) on a year-over-year basis. Excluding acquisitions, consumer installment loans increased $17 million (2.5%) in the first nine months of 2004, and $16 million (2.4%) from one year ago. Historically low interest rates, aggressive dealer and manufacturer incentives on new vehicles, and very competitive pricing on used vehicles have existed in these product types for more than a year. Consumer installment loans increased in the New York markets during the last nine and 12-month time frames, while the Pennsylvania markets were flat. Asset Quality Table 9 below exhibits the major components of non-performing loans and assets and key asset quality metrics for the periods ending September 30, 2004 and 2003 and December 31, 2003. Table 9: Non-performing Assets
September 30, December 31, September 30, (000's omitted) 2004 2003 2003 ----------------------------------------------------------------------------- ------------ ------------- Non-accrual loans $13,511 $11,940 $10,518 Accruing loans 90+ days delinquent 1,808 1,307 3,018 Restructured loans 806 28 29 ------------------------------------------------------------------------------------------------------------- Total non-performing loans 16,125 13,275 13,565 Other real estate 734 1,077 812 ------------------------------------------------------------------------------------------------------------- Total non-performing assets $16,859 $14,352 $14,377 ============================================================================================================= Allowance for loan losses to total loans 1.37% 1.37% 1.41% Allowance for loan losses to non-performing loans 202% 219% 200% Non-performing loans to total loans 0.68% 0.62% 0.70% Non-performing assets to total loans and other real estate 0.71% 0.67% 0.75% Delinquent loans (30 days old to non-accruing) to total loans 1.47% 1.77% 1.64% Net charge-offs to average loans outstanding (quarterly) 0.29% 0.54% 0.53% Loan loss provision to net charge-offs (quarterly) 133% 113% 80%
As displayed in Table 9, non-performing assets at September 30, 2004 were $16.9 million, an increase of $2.5 million versus year-end 2003 and the end of third quarter 2003. The changes over the last nine and 12-month periods were due primarily to an increase in commercial non-accrual levels and one restructured commercial relationship. A small portion of the increase was related to acquired loans. Non-performing loans were 0.68% of total loans outstanding at the end of the third quarter versus 0.62% at year-end 2003 and 0.70% at September 30, 2003. The ratio of non-performing assets to total loans and other real estate remained below 0.75% for the fourth consecutive quarter. The allowance for loan loss to non-performing loans ratio, a general measure of coverage adequacy, was 202% at the end of the third quarter, compared to coverage ratios of 219% at year-end 2003 and 200% at September 30, 2003. Delinquent loans (30 days through non-accruing and restructured loans) as a percent of total loans was 1.47% at the end of the third quarter, its lowest level since first quarter 2001. This ratio improved 30 basis points in comparison to year-end 2003 and 17 basis points versus September 30, 2003. The quarterly ratio of loan loss provision to net charge-offs was 133% for the third quarter of 2004, compared to 80% and 113% for the third and fourth quarters of 2003, respectively. 24 Table 10: Allowance for Loan Loss Activity
Three Months Ended Nine Months Ended September 30, September 30, --------------------- --------------------- (000's omitted) 2004 2003 2004 2003 --------------------------------------------------------------------------- --------------------- Allowance for loan losses at beginning of period $32,040 $27,417 $29,095 $26,331 Charge-offs: Business lending 504 1,269 2,236 3,971 Consumer mortgage 95 53 225 140 Consumer installment 1,842 2,010 5,491 5,452 --------------------------------------------------------------------------- --------------------- Total charge-offs 2,441 3,332 7,952 9,563 Recoveries: Business lending 89 179 668 301 Consumer mortgage 13 34 35 42 Consumer installment 608 587 1,756 1,701 --------------------------------------------------------------------------- --------------------- Total recoveries 710 800 2,459 2,044 --------------------------------------------------------------------------- --------------------- Net charge-offs 1,731 2,532 5,493 7,519 Provision for loan losses 2,300 2,029 6,650 8,102 Allowance on acquired loans 0 203 2,357 203 --------------------------------------------------------------------------- --------------------- Allowance for loan losses at end of period $32,609 $27,117 $32,609 $27,117 =========================================================================== ===================== Net charge-offs to average loans outstanding: Business lending 0.19% 0.69% 0.27% 0.78% Consumer mortgage 0.04% 0.01% 0.03% 0.02% Consumer installment 0.68% 0.83% 0.71% 0.75% Total loans 0.29% 0.53% 0.33% 0.55%
As displayed in Table 10, net charge-offs during the third quarter were $1.7 million, $0.8 million less than the equivalent 2003 period, driven by significant declines in the charge-offs of the business lending portfolio. This decrease occurred despite a $483 million increase in average loan balances, and resulted in a 24 basis point drop in the net charge-off ratio (net charge-offs as a percentage of average loans outstanding) to 0.29%. On a year-to-date basis net charge-offs were down $2.0 million versus the prior year period, while average loans were up $392 million for the same period, resulting in a 22 basis point decline in the YTD net charge-off ratio to 0.33%. Lower business loan net charge-offs were again the main contributor to this substantial improvement, reflecting stabilizing economic conditions and the effectiveness of increased credit risk management resources. The increased proportion of comparatively low-risk consumer mortgages in the loan portfolio (33% of total average loans as of September 30, 2004 versus 32% one year earlier) also helped reduce the overall level of charge-offs in relation to total average loan balances. A required loan loss allowance of $32.6 million was determined as of September 30, 2004, resulting in a $2.3 million loan loss provision for the quarter compared to $2.0 million one year earlier. The third quarter loan loss provision was $0.6 million higher than net charge-offs mainly due to the additional allowance needed to cover organic loan growth in the quarter, the downgrade of risk ratings on certain business loans, and a slight increase in the historical loss factors for installment loans. The loan loss provision for the first nine months of 2004 of $6.7 million was down $1.5 million or 18% versus the prior year, driven by the overall improvement in asset quality. The allowance for loan losses rose $5.5 million or 20% over the last 12 months, versus a 23% increase in loans outstanding. Consequently, the ratio of allowance for loan loss to loans outstanding declined four basis points to 1.37%. The reduction in this ratio reflects a higher proportion of high-credit quality consumer mortgages in the loan portfolio and improving trends in net charge-off, non-performing and delinquency ratios. Deposits As shown in Table 11, average deposits of $2.9 billion in the third quarter were up $294 million compared to fourth quarter 2003 and increased $398 million versus the same quarter of last year. This increase was the result of deposits obtained through acquisitions. The deposit mix has shifted towards demand deposits and liquid interest-bearing deposits (interest checking and savings accounts) with 49% of total deposits in these accounts in the third quarter 2004 versus 47% in the third and fourth quarters of 2003. This shift in mix, combined with CDs being rolled over at lower interest rates helped reduce the third quarter cost of deposits. 25 Excluding the impact of acquisitions, average IPC (individuals, partnerships and corporations) deposits in the current quarter decreased 1.9% from fourth quarter 2004's level and 2.5% from one year ago. This mostly reflects the relative attractiveness of alternative funding sources over the last year. Excluding acquired deposits, average third quarter public funds were up 2.5% from third quarter 2003 and relatively flat compared to the fourth quarter of 2003. Table 11: Average Deposits Three Months Ended --------------------------------------------- September 30, December 31, September 30, (000's omitted) 2004 2003 2003 ---------------------------------------------------------------------------- Demand deposits $ 577,949 $ 505,015 $ 483,142 Interest checking deposits 302,757 283,752 274,803 Savings deposits 555,015 448,064 431,414 Money market deposits 311,560 300,558 290,655 Time deposits 1,193,700 1,109,350 1,062,968 ---------------------------------------------------------------------------- Total deposits $2,940,981 $2,646,739 $2,542,982 ============================================================================ IPC deposits $2,774,231 $2,485,165 $2,388,529 Public fund deposits 166,750 161,574 154,453 ---------- ---------- ---------- Total deposits $2,940,981 $2,646,739 $2,542,982 ========== ========== ========== Borrowings At the end of the third quarter, borrowings of $972 million increased $304 million from December 31, 2003 and were up $358 million from the third quarter of 2003. The increases over both the nine and 12-month periods were dictated by organic loan growth, investment security purchases and organic deposit declines. Short-term borrowings increased $135 million and $214 million over the last nine and 12 months, while long-term borrowings were up $169 million and $144 million over the same time periods. A higher proportion of short-term borrowings has been utilized in comparison to one year ago due to the amount of longer-term, core deposits added through acquisitions, to reduce the Company's sensitivity to falling interest rates and to provide more flexibility with regard to altering future debt levels. The amount of long-term borrowings increased in the last nine months due to the addition of $118 million of eighteen-month FHLB borrowings that were used to fund securities purchases. These borrowings carry relatively short maturities and help provide funding cost stability for a period of time that is complementary to our asset/liability profile. Shareholders' Equity Total shareholders' equity increased $62.4 million since December 31, 2003 and equaled $467 million at September 30, 2004. This increase consisted of $54.7 million of common stock and options issued in the First Heritage acquisition, net income of $37.5 million, $4.8 million of common stock issued under the employee stock plan, and a $2.1 million increase in the after-tax market value adjustment on available-for-sale investments, offset by treasury stock purchases of $21.7 million and dividends declared of $15.0 million. The Company's Tier I leverage ratio, a primary measure of regulatory capital for which 5% is the requirement to be "well-capitalized," was 6.72% at the end of the third quarter, down 54 basis points from year-end 2003 and 68 basis points lower than its level one year ago. The tangible equity-to-assets ratio was 5.68% at September 30, 2004 a decline of two basis points versus year-end 2003 and 20 basis points lower than it was at the end of September 2003. The declines in these ratios were primarily caused by treasury share purchases made over the last 12 months. During the third quarter 2004 the Company completed its purchase of common shares under its previously announced 1.4 million-share repurchase program with an aggregate cost of $30.2 million and average price per share of $21.57. In addition, the Company's Board of Directors declared a 12.5% increase in the quarterly cash dividend on its common stock to $0.18 per share. As a result of the increase in the per share dividend amount and the overall increase in the common shares outstanding, the dividend payout ratio (dividends declared divided by net income) for the first nine months of 2004 was 40%, up 3.0 percentage points from one year ago. 26 Liquidity Management of the Company's liquidity is critical due to the potential for unexpected fluctuations in deposits and loans. Adequate sources of both on and off-balance sheet funding are in place to effectively respond to such unexpected fluctuations. The Bank's primary approach to measuring liquidity is known as the Basic Surplus/Deficit model. It is used to calculate liquidity over two time periods: first, the amount of cash that could be made available within 30 days (calculated as liquid assets less short-term liabilities); and second, a projection of subsequent cash availability over an additional 60 days. The minimum policy level of liquidity under the Basic Surplus/Deficit approach is 7.5% of total assets for both the 30 and 90-day time horizons. As of September 30, 2004, this ratio for the 30 and 90-day time period was 15.1% and 14.7%, respectively, excluding the Company's capacity to borrow additional funds from the Federal Home Loan Bank. To measure longer-term liquidity, a baseline projection of loan and deposit growth for five years is made to reflect how current liquidity levels could change over time. This five-year measure reflects adequate liquidity to fund loan and other asset growth over the next five years. New Accounting Pronouncements See New Accounting Pronouncement section of Note C to the consolidated financial statements. Forward-Looking Statements This document contains comments or information that constitute forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995), which involve significant risks and uncertainties. Actual results may differ materially from the results discussed in the forward-looking statements. Moreover, the Company's plans, objectives and intentions are subject to change based on various factors (some of which are beyond the Company's control). Factors that could cause actual results to differ from those discussed in the forward-looking statements include: (1) risks related to credit quality, interest rate sensitivity and liquidity; (2) the strength of the U.S. economy in general and the strength of the local economies where the Company conducts its business; (3) the effect of, and changes in, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System; (4) inflation, interest rate, market and monetary fluctuations; (5) the timely development of new products and services and customer perception of the overall value thereof (including features, pricing and quality) compared to competing products and services; (6) changes in consumer spending, borrowing and savings habits; (7) technological changes; (8) any acquisitions or mergers that might be considered or consummated by the Company and the costs and factors associated therewith; (9) the ability to maintain and increase market share and control expenses; (10) the effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) and accounting principles generally accepted in the United States; (11) changes in the Company's organization, compensation and benefit plans and in the availability of, and compensation levels for, employees in its geographic markets; (12) the costs and effects of litigation and of any adverse outcome in such litigation; (13) other risk factors outlined in the Company's filings with the Securities and Exchange Commission from time to time; and (14) the success of the Company at managing the risks of the foregoing. The foregoing list of important factors is not exclusive. Such forward-looking statements speak only as of the date on which they are made and the Company does not undertake any obligation to update any forward-looking statement, whether written or oral, to reflect events or circumstances after the date on which such statement is made. If the Company does update or correct one or more forward-looking statements, investors and others should not conclude that the Company would make additional updates or corrections with respect thereto or with respect to other forward-looking statements. 27 Item 3. Quantitative and Qualitative Disclosure about Market Risk Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates, prices or credit risk. Credit risk associated with the Company's loan portfolio has been previously discussed in the asset quality section of Management's Discussion and Analysis of Financial Condition and Results of Operations. Management believes that the tax risk of the Company's municipal investments associated with potential future changes in statutory, judicial and regulatory actions is minimal. The Company has an insignificant amount of credit risk in its investment portfolio because essentially all of the fixed-income securities in the portfolio are AAA-rated (highest possible rating). Therefore, almost all the market risk in the investment portfolio is related to interest rates. The ongoing monitoring and management of both interest rate risk and liquidity, in the short and long term time horizons is an important component of the Company's asset/liability management process, which is governed by limits established in the policies reviewed and approved annually by the Board of Directors. The Board of Directors delegates responsibility for carrying out the policies to the Asset/Liability Committee (ALCO) which meets each month and is made up of the Company's senior management as well as regional and line-of-business managers who oversee specific earning asset classes and various funding sources. As the Company does not believe it is possible to reliably predict future interest rate movements, it has maintained an appropriate process and set of measurement tools which enable it to identify and quantify sources of interest rate risk in varying rate environments. The primary tool used by the Company in managing interest rate risk is income simulation. While a wide variety of strategic balance sheet and treasury yield curve scenarios are tested on an ongoing basis, the following reflects the Company's one-year net interest income sensitivity based on: o Asset and liability levels using September 30, 2004 as a starting point. o There are assumed to be conservative levels of balance sheet growth-- low to mid single digit growth in loans, investments and deposits, augmented by necessary changes in borrowings and retained earnings, with no growth in other major components of the balance sheet. o The prime rate and federal funds rates are assumed to move up 200 basis points and down 100 basis points over a 12-month period while flattening the long end of the treasury curve to spreads over federal funds that are more consistent with historical norms. Deposit rates are assumed to move in a manner that reflects the historical relationship between deposit rate movement and changes in the federal funds rate, generally reflecting 10%-75% of the movement of the federal funds rate. o Cash flows are based on contractual maturity, optionality and amortization schedules along with applicable prepayments derived from internal historical data and external sources. Net Interest Income Sensitivity Model Calculated annualized increase (decrease) in Change in interest projected net interest income rates at September 30, 2004 ----------------------------------------------------------- + 200 basis points (3.1%) - 100 basis points (1.1%) In the model, both the rising and falling rate environments reflect a reduction in net interest income (NII) from a flat rate environment due to the assumed flattening of the yield curve. The modeled NII in a falling rate environment is initially more favorable than if rates were to rise due to a faster initial reaction from core deposit pricing and short-term capital market borrowing rates. Over a longer time period, however, the growth in NII improves in a rising rate environment as a result of lower yielding earning assets running off and being replaced at increased rates. The analysis does not represent a Company forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions: the nature and timing of interest rate levels (including yield curve shape), prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows, and other factors. While the assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurances as to the predictive nature of these assumptions, including how customer preferences or competitor influences might change. Furthermore, the sensitivity analysis does not reflect actions that ALCO might take in responding to or anticipating changes in interest rates. 28 Item 4. Controls and Procedures As of September 30, 2004, the Chief Executive Officer and Chief Financial Officer of the Company evaluated the Company's disclosure controls and procedures related to the recording, processing, summarization and reporting of information in the Company's reports that it files with the Securities and Exchange Commission (SEC). These disclosure controls and procedures have been designed to ensure that (a) material information relating to the Company, including its consolidated subsidiaries, is made known to the Company's management, including their officers, by other employees of the Company and its subsidiaries, and (b) this information is recorded, processed, summarized, evaluated and reported, as applicable, within the time periods specified in the SEC's rules and forms. Based upon this evaluation, these officers concluded that the design and effectiveness of the disclosure controls and procedures is sufficient to accomplish their purpose. There have been no significant changes in the Company's internal controls or other factors that could significantly affect these controls during the quarter ended September 30, 2004, including any corrective actions with regard to significant deficiencies and material weaknesses. 29 Part II. Other Information Item 1. Legal Proceedings. The Company and its subsidiaries are subject in the normal course of business to various pending and threatened legal proceedings in which claims for monetary damages are asserted. Management, after consultation with legal counsel, does not anticipate that the aggregate liability, if any, arising out of litigation pending against the Company or its subsidiaries will have a material effect on the Company's consolidated financial position or results of operations. Item 2. Changes in Securities, Use of Proceeds and Issuer Repurchases of Equity Securities. (e) During the third quarter of 2004 the Company purchased 280,713 common shares completing the previously announced 1.4 million-share repurchase program. The aggregate cost of this program was $30.2 million and the average price per share is $21.57. The repurchases were for general corporate purposes, including those related to acquisition and stock plan activities. The following table shows treasury stock purchases under this authorization during the first nine months 2004.
Total Number Number of Shares Number of Average Price of Shares Remaining to be Shares Purchased Per Share Purchased Purchased ------------------------------------------------------------------------------------------------ January 2004 0 $ 0.00 416,300 983,700 February 2004 0 0.00 416,300 983,700 March 2004 122,800 22.29 539,100 860,900 April 2004 40,958 22.69 580,058 819,942 May 2004 131,642 21.07 711,700 688,300 June 2004 407,587 21.88 1,119,287 280,713 July 2004 48,800 22.47 1,168,087 231,913 August 2004 231,913 22.65 1,400,000 0 September 2004 0 1,400,000 0 ------------------------------------------------------------------------------------------------ Total 983,700 $22.07 1,400,000 0 ================================================================================================
Item 3. Defaults Upon Senior Securities. Not applicable. Item 4. Submission of Matters to a Vote of Securities Holders. There were no matters submitted to a vote of the shareholders during the quarter ending September 30, 2004. Item 5. Other Information. Not applicable Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit No. Description ----------- ----------- 10.1 Employment Agreement, effective August 1, 2004, by and between Community Bank System, Inc., Community Bank, N.A. and Brian D. Donahue. * ** 10.2 Employment Agreement, effective September 1, 2002, by and between Community Bank System, Inc., Community Bank, N.A. and Timothy J. Baker. * ** 10.3 Employment Agreement, effective October 1, 2004, by and between Community Bank System, Inc., Community Bank, N.A. and J. David Clark. * ** 10.4 Employment Agreement, effective September 1, 2002, by and between Community Bank System, Inc., Community Bank, N.A. and Joseph J. Lemchak. * ** 30 31.1 Certification of Sanford A. Belden, President and Chief Executive Officer of the Registrant, pursuant to Rule 13a-15(e) or Rule 15d-15(e) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Scott A. Kingsley, Treasurer, Chief Financial Officer of the Registrant, pursuant to Rule 13a-15(e) or Rule 15d-15(e) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of Sanford A. Belden, President and Chief Executive Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of Scott A. Kingsley, Treasurer, Chief Financial Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * Filed herewith ** Denotes management contract or compensatory plan or arrangement (b) Reports on Form 8-K: o Form 8-K related to quarterly earnings press release was filed on July 23, 2004. 31 SIGNATURES Pursuant to the requirements of The Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Community Bank System, Inc. Date: November 5, 2004 /s/ Sanford A. Belden --------------------- Sanford A. Belden, President, Chief Executive Officer and Director Date: November 5, 2004 /s/ Scott A. Kingsley --------------------- Scott A. Kingsley, Treasurer and Chief Financial Officer 32