UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2006
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _______________ to _______________
Commission File Number 001-13695
COMMUNITY BANK SYSTEM, INC.
(Exact name of registrant as specified in its charter)
Delaware 16-1213679
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) 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 period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No |_|.
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large accelerated filer |_| Accelerated filer |X| Non-accelerated filer |_|
Indicate by check mark whether the registrant is shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes |_| No |X|
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
29,931,042 shares of Common Stock, $1.00 par value, were
outstanding on November 2, 2006.
TABLE OF CONTENTS
Page
----
Part I. Financial Information
Item 1. Financial Statements (Unaudited)
Consolidated Statements of Condition
September 30, 2006 and December 31, 2005 ........................................................ 3
Consolidated Statements of Income
Three and nine months ended September 30, 2006 and 2005 ......................................... 4
Consolidated Statement of Changes in Shareholders' Equity
Nine months ended September 30, 2006 ............................................................ 5
Consolidated Statements of Comprehensive Income
Three and nine months ended September 30, 2006 and 2005 ......................................... 6
Consolidated Statements of Cash Flows
Nine months ended September 30, 2006 and 2005 ................................................... 7
Notes to the Consolidated Financial Statements
September 30, 2006 .............................................................................. 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 .................................... 29
Item 4. Controls and Procedures ...................................................................... 30
Part II. Other Information
Item 1. Legal Proceedings ............................................................................ 30
Item 1A. Risk Factors ................................................................................. 30
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds .................................. 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 ..................................................................................... 31
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,
2006 2005
--------------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents $ 119,430 $ 114,605
Available-for-sale investment securities, at fair value 1,105,194 1,160,612
Held-to-maturity investment securities (fair value of $140,832 and $139,512, respectively) 145,057 142,505
--------------------------------------------------------------------------------------------------------------------------------
Total investment securities 1,250,251 1,303,117
--------------------------------------------------------------------------------------------------------------------------------
Loans 2,661,562 2,411,769
Allowance for loan losses (35,517) (32,581)
--------------------------------------------------------------------------------------------------------------------------------
Net loans 2,626,045 2,379,188
--------------------------------------------------------------------------------------------------------------------------------
Core deposit intangibles, net 25,226 28,147
Goodwill 213,142 195,195
Other intangibles, net 1,267 1,536
--------------------------------------------------------------------------------------------------------------------------------
Intangible assets, net 239,635 224,878
--------------------------------------------------------------------------------------------------------------------------------
Premises and equipment, net 65,051 65,175
Accrued interest receivable and other assets 73,578 66,029
--------------------------------------------------------------------------------------------------------------------------------
Total assets $ 4,373,990 $ 4,152,992
================================================================================================================================
Liabilities:
Non-interest bearing deposits $ 564,262 $ 601,544
Interest bearing deposits 2,576,042 2,382,425
--------------------------------------------------------------------------------------------------------------------------------
Total deposits 3,140,304 2,983,969
Federal funds purchased 9,900 36,300
Borrowings 618,512 536,288
Subordinated debt held by unconsolidated subsidiary trusts 80,545 80,502
Accrued interest and other liabilities 60,130 58,338
--------------------------------------------------------------------------------------------------------------------------------
Total liabilities 3,909,391 3,695,397
--------------------------------------------------------------------------------------------------------------------------------
Commitment and contingencies (See Note I)
Shareholders' equity:
Preferred stock $1.00 par value, 500,000 shares authorized, 0 shares issued -- --
Common stock, $1.00 par value, 50,000,000 shares authorized; 32,620 32,451
32,620,463 and 32,450,563 shares issued in 2006 and 2005, respectively
Additional paid-in capital 200,089 196,312
Retained earnings 289,708 276,809
Accumulated other comprehensive income 3,798 8,420
Treasury stock, at cost (2,753,161 and 2,493,711 shares, respectively) (61,616) (56,074)
Employee stock plan - unearned -- (323)
--------------------------------------------------------------------------------------------------------------------------------
Total shareholders' equity 464,599 457,595
--------------------------------------------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $ 4,373,990 $ 4,152,992
================================================================================================================================
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,
--------------------- -----------------------
2006 2005 2006 2005
-------------------------------------------------------------------------------------------------- -----------------------
Interest income:
Interest and fees on loans $43,482 $37,133 $121,570 $108,792
Interest and dividends on taxable investments 10,033 11,315 31,407 37,881
Interest and dividends on nontaxable investments 5,646 5,724 17,324 17,576
-------------------------------------------------------------------------------------------------- -----------------------
Total interest income 59,161 54,172 170,301 164,249
-------------------------------------------------------------------------------------------------- -----------------------
Interest expense:
Interest on deposits 16,357 11,140 43,998 30,603
Interest on short-term borrowings 1,327 2,523 3,935 9,301
Interest on subordinated debt held by unconsolidated subsidiary trusts 1,937 1,715 5,624 4,911
Interest on long-term borrowings 5,748 3,748 15,658 10,559
-------------------------------------------------------------------------------------------------- -----------------------
Total interest expense 25,369 19,126 69,215 55,374
-------------------------------------------------------------------------------------------------- -----------------------
Net interest income 33,792 35,046 101,086 108,875
Less: provision for loan losses 1,300 2,275 5,175 6,284
-------------------------------------------------------------------------------------------------- -----------------------
Net interest income after provision for loan losses 32,492 32,771 95,911 102,591
-------------------------------------------------------------------------------------------------- -----------------------
Non-interest income:
Deposit service fees 7,329 7,135 21,001 19,844
Other banking services 1,329 1,411 2,166 2,177
Benefit plan administration, consulting and actuarial fees 3,271 2,767 9,807 8,256
Trust, investment and asset management fees 1,815 1,823 5,631 5,463
Gain on sales of investment securities -- 5,305 -- 12,195
-------------------------------------------------------------------------------------------------- -----------------------
Total non-interest income 13,744 18,441 38,605 47,935
-------------------------------------------------------------------------------------------------- -----------------------
Operating expenses:
Salaries and employee benefits 16,741 16,458 49,948 48,836
Occupancy and equipment 4,350 4,483 13,557 13,355
Data processing and communications 3,359 3,467 9,923 10,258
Amortization of intangible assets 1,520 1,553 4,502 5,521
Legal and professional fees 1,119 923 3,510 3,250
Office supplies and postage 1,004 1,024 3,063 2,914
Business development and marketing 1,095 545 2,909 2,132
Other 2,652 2,274 7,071 6,692
-------------------------------------------------------------------------------------------------- -----------------------
Total operating expenses 31,840 30,727 94,483 92,958
-------------------------------------------------------------------------------------------------- -----------------------
Income before income taxes 14,396 20,485 40,033 57,568
Income taxes 3,517 5,621 9,808 15,089
-------------------------------------------------------------------------------------------------- -----------------------
Net income $10,879 $14,864 $ 30,225 $ 42,479
================================================================================================== =======================
Basic earnings per share $ 0.36 $ 0.49 $ 1.01 $ 1.40
Diluted earnings per share $ 0.36 $ 0.48 $ 1.00 $ 1.37
Dividends declared per share $ 0.20 $ 0.19 $ 0.58 $ 0.55
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, 2006
(In Thousands, Except Share Data)
Common Stock Accumulated
--------------------- Additional Other Employee
Shares Amount Paid-In Retained Comprehensive Treasury Stock Plan
Outstanding Issued Capital Earnings Income Stock -Unearned Total
---------------------------------------------------------------------------------------------
Balance at December 31, 2005 29,956,852 $32,451 $196,312 $276,809 $ 8,420 ($56,074) ($323) $457,595
Net income 30,225 30,225
Other comprehensive loss, net of tax (4,622) (4,622)
Dividends declared:
Common, $0.58 per share (17,326) (17,326)
Common stock issued under
employee stock plan,
including tax benefits of $458 169,900 169 2,498 147 2,814
Employee stock options earned 1,455 1,455
Treasury stock purchased (259,450) (5,542) (5,542)
Reclassification of unearned
restricted stock awards to additional
paid-in capital in accordance with
SFAS No. 123(R) (176) 176
-----------------------------------------------------------------------------------------------------------------------------------
Balance at September 30, 2006 29,867,302 $32,620 $200,089 $289,708 $ 3,798 ($61,616) -- $464,599
===================================================================================================================================
The accompanying notes are an integral part of the consolidated financial
statements.
5
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
(In Thousands)
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ----------------------
2006 2005 2006 2005
-------------------------------------------------------------------------------------------------- ----------------------
Other comprehensive loss, before tax:
Change in minimum pension liability adjustment $ 0 $ 0 ($117) $ 0
Unrealized gain (loss) on securities:
Unrealized holding gain (loss) arising during period 12,063 (16,842) (7,432) (20,010)
Reclassification adjustment for gain included in net income 0 (5,305) 0 (12,195)
-------------------------------------------------------------------------------------------------- ----------------------
Other comprehensive gain (loss), before tax: 12,063 (22,147) (7,549) (32,205)
Income tax (expense) benefit related to other comprehensive gain (loss) (4,627) 8,546 2,927 12,492
-------------------------------------------------------------------------------------------------- ----------------------
Other comprehensive gain (loss), net of tax: 7,436 (13,601) (4,622) (19,713)
Net income 10,879 14,864 30,225 42,479
-------------------------------------------------------------------------------------------------- ----------------------
Comprehensive income $ 18,315 $ 1,263 $ 25,603 $ 22,766
================================================================================================== ======================
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,
------------------------
2006 2005
----------------------------------------------------------------------------------------------------------------
Operating activities:
Net income $ 30,225 $ 42,479
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation 6,456 6,412
Amortization of intangible assets 4,502 5,521
Net amortization of premiums and discounts on securities and loans 971 772
Amortization of unearned compensation and discount on subordinated debt 95 227
Provision for loan losses 5,175 6,284
Gain on investment securities 0 (12,195)
Gain on sale of loans and other assets (97) (40)
Proceeds from the sale of loans held for sale 14,388 0
Origination of loans held for sale (14,347) 0
Excess tax benefits from share-based payment arrangements (245) 0
Change in other operating assets and liabilities 4,577 3,656
----------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 51,700 53,116
----------------------------------------------------------------------------------------------------------------
Investing activities:
Proceeds from sales of available-for-sale investment securities 33,719 310,336
Proceeds from maturities of held-to-maturity investment securities 3,802 3,855
Proceeds from maturities of available-for-sale investment securities 88,118 98,097
Purchases of held-to-maturity investment securities (6,627) (8,294)
Purchases of available-for-sale investment securities (70,909) (158,292)
Net increase in loans outstanding (56,110) (58,287)
Cash paid for acquisition, net of cash acquired of $1,097 and $0 (38,971) 0
Capital expenditures (4,142) (8,166)
----------------------------------------------------------------------------------------------------------------
Net cash (used in) provided by investing activities (51,120) 179,249
----------------------------------------------------------------------------------------------------------------
Financing activities:
Net change in demand deposits, NOW accounts and savings accounts (35,057) 11,739
Net change in time deposits 53,091 44,696
Net change in federal funds purchased (26,400) 47,600
Net change in short-term borrowings (70,000) (362,000)
Change in long-term borrowings (net of payments of $91 and $148) 102,648 99,773
Issuance of common stock 2,309 2,738
Purchase of treasury stock (5,542) (24,217)
Cash dividends paid (17,049) (16,425)
Tax benefits from share-based payment arrangements 245 0
----------------------------------------------------------------------------------------------------------------
Net cash provided by (used in) financing activities 4,245 (196,096)
----------------------------------------------------------------------------------------------------------------
Change in cash and cash equivalents 4,825 36,269
Cash and cash equivalents at beginning of period 114,605 118,405
----------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 119,430 $ 154,674
================================================================================================================
Supplemental disclosures of cash flow information:
Cash paid for interest $ 66,919 $ 54,054
Cash paid for income taxes 5,621 10,446
Supplemental disclosures of non-cash financing and investing activities:
Dividends declared and unpaid 5,972 5,687
Gross change in unrealized gain on available-for-sale investment securities (7,432) (32,205)
Acquisitions:
Fair value of assets acquired, excluding acquired cash and intangibles 208,963 0
Fair value of liabilities assumed 188,155 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, 2006
NOTE A: BASIS OF PRESENTATION
The interim financial data as of September 30, 2006 and for the three and nine
months ended September 30, 2006 and 2005 is unaudited; however, in the opinion
of the Company, the interim data includes all adjustments, consisting only of
normal recurring adjustments, necessary for a fair statement of the results for
the interim periods. The results of operations for the interim periods are not
necessarily indicative of the results that may be expected for the full year or
any other interim period.
NOTE B: ACQUISITION AND OTHER MATTERS
ES&L Bancorp
On August 11, 2006, the Company acquired ES&L Bancorp ("Elmira"), the parent
company of Elmira Savings and Loan, F.A., a federally chartered thrift in an
all-cash transaction valued at approximately $40 million. Elmira operated two
branches in the cities of Elmira and Ithaca, New York. The results of Elmira'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 $ 1,097
Available-for-sale investment securities 3,651
Loans net of allowance for loan losses 195,911
Premises and equipment, net 2,134
Other assets 6,170
Goodwill 17,947
Core deposits intangibles 1,313
--------------------------------------------------------
Total assets acquired 228,223
--------------------------------------------------------
Deposits 138,301
Borrowings 49,576
Other liabilities 278
--------------------------------------------------------
Total liabilities assumed 188,155
--------------------------------------------------------
Net assets acquired $ 40,068
========================================================
ONB Corporation
On August 3, 2006, the Company announced an agreement to acquire ONB Corporation
("ONB") in an all-cash transaction valued at approximately $15.7 million. ONB is
the parent company of Ontario National Bank, a federally chartered national bank
operating four branches in the villages of Clifton Springs, Phelps and Palmyra,
New York. As of September 30, 2006 the Company held approximately $95 million in
assets, including $60 million in loans. The acquisition is expected to close in
the fourth quarter of 2006.
Stock Repurchase Program
On April 20, 2005, the Company announced a twenty-month authorization to
repurchase up to 1,500,000 of its outstanding shares. Through September 30,
2006, the Company has repurchased against this authorization 853,161 shares at
an aggregate cost of $19.5 million and an average price per share of $22.86. The
repurchased shares will be used for general corporate purposes, including those
related to stock plan activities.
NOTE C: ACCOUNTING POLICIES
Critical Accounting Policies
Allowance for Loan Losses
Management continually evaluates the credit quality of the Company's loan
portfolio and performs a formal review of the adequacy of the allowance for loan
losses on a quarterly basis. The allowance reflects management's best estimate
of probable losses inherent in the loan portfolio. Determination of the
allowance is subjective in nature and requires significant estimates. The
Company's allowance methodology consists of two broad components, general and
specific loan loss allocations.
8
The general loan loss allocation is composed of two calculations that are
computed on four main loan segments: commercial, consumer direct, consumer
indirect and residential real estate. The first calculation determines an
allowance level based on the latest three years of historical net charge-off
data for each loan category (commercial loans exclude balances with specific
loan loss allocations). The second calculation is qualitative and takes into
consideration five major factors affecting the level of loan loss risk:
portfolio risk migration patterns (internal credit quality trends); the growth
of the segments of the loan portfolio; economic and business environment trends
in the Company's markets (includes review of bankruptcy, unemployment,
population, consumer spending and regulatory trends); industry, geographical and
product concentrations in the portfolio; and the perceived effectiveness of
managerial resources and lending practices and policies. These two calculations
are added together to determine the general loan loss allocation. The specific
loan loss allocation relates to individual commercial loans that are both
greater than $0.5 million and in a non-accruing status with respect to interest.
Specific losses are based on discounted estimated cash flows, including any cash
flows resulting from the conversion of collateral.
Loan losses are charged off against the allowance, while recoveries of amounts
previously charged off are credited to the allowance. A provision for loan loss
is charged to operations based on management's periodic evaluation of factors
previously mentioned.
Income Taxes
Provisions for income taxes are based on taxes currently payable or refundable,
and deferred taxes which are based on temporary differences between the tax
basis of assets and liabilities and their reported amounts in the financial
statements. Deferred tax assets and liabilities are reported in the financial
statements at currently enacted income tax rates applicable to the period in
which the deferred tax assets and liabilities are expected to be realized or
settled.
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.
New Accounting Pronouncements
In June 2006, the Financial Accounting Standards Board ("FASB") issued FASB
Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an
interpretation of FASB Statement No. 109" (FIN 48). FIN 48 clarifies the
accounting for uncertainty in income taxes recognized in a company's financial
statements and prescribes a recognition threshold and measurement attribute for
the financial statement recognition and measurement of a tax position taken or
expected to be taken in an income tax return. FIN 48 also provides guidance on
derecognition, classification, interest and penalties, accounting in interim
periods, disclosure and transition. FIN 48 is effective for fiscal years
beginning after December 15, 2006. The Company is currently analyzing the
effects FIN 48 will have on its financial statements.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets, an amendment of FASB Statement No. 140" (SFAS 158"). SFAS 156
requires all separately recognized servicing assets and servicing liabilities to
be initially measured at fair value, if practicable. The standard permits an
entity to subsequently measure each class of servicing assets or servicing
liabilities at fair value and report changes in fair value in the statement of
income in the period in which the changes occur. SFAS 156 is effective for the
Company as of January 1, 2007. The Company is currently evaluating the impact of
adopting SFAS 156.
In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for
Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB
Statements No. 87, 88, 106 and 132(R)" ("SFAS 158"). SFAS 158 requires an
employer to recognize the funded status of defined benefit pension and other
postretirement benefit plans as an asset or liability. SFAS 158 is effective for
the Company as of December 31, 2006. The Company is currently evaluating the
effects SFAS 158 will have on its financial statements.
9
In September 2006, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 108, "Considering the Effects of Prior Year
Misstatements When Quantifying Misstatements in Current Year Financial
Statements" ("SAB 108"), which provides interpretive guidance on how the effects
of the carryover or reversal of prior year misstatements should be considered in
quantifying a current year misstatement. The provisions of SAB 108 are required
in annual financial statements for fiscal year 2006. The Company does not
believe that the adoption of SAB 108 will materially impact our consolidated
financial statements.
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements"
("SFAS 157"). SFAS 157 does not address "what" to measure at fair value;
instead, it addresses "how" to measure fair value. SFAS 157 applies (with
limited exceptions) to existing standards that require assets or liabilities to
be measured at fair value. SFAS 157 establishes a fair value hierarchy, giving
the highest priority to quoted prices in active markets and the lowest priority
to unobservable data and requires new disclosures for assets and liabilities
measured at fair value based on their level in the hierarchy. SFAS 157 is
effective for financial statements issued for fiscal years beginning after
November 15, 2007. The Company is currently evaluating the impact of adopting
SFAS 157.
NOTE D: STOCK BASED COMPENSATION
The Company has a long-term incentive program for directors, officers and
employees. Under this program, the Company authorized 4,024,000 shares of
Company common stock for the grant of incentive stock options, nonqualified
stock options, restricted stock awards, retroactive stock appreciation rights,
and offset options. The offset options in its Director's Stock Balance Plan vest
and become exercisable immediately and expire one year after the date the
director retires or two years in the event of death. The remaining options have
a ten-year term, and vest and become exercisable on a grant-by-grant basis,
ranging from immediate vesting to ratably over a five-year period. Activity in
this long-term incentive program is as follows:
Stock Options Restricted Stock
----------------------------------- ------------------------------
Weighted Average Weighted Average
Exercise Price of Grant Date Fair
Outstanding Shares Outstanding Value of Shares
----------------------------------------------------------------------------- ------------------------------
December 31, 2004 2,400,932 $15.59 34,818 $23.07
Granted 579,484 24.33 3,197 23.84
Exercised (417,824) 11.55 (16,921) 22.61
Forfeited (16,902) 17.86 0 0
---------------------------------------------------- ----------
Outstanding at December 31, 2005 2,545,690 18.23 21,094 23.56
Granted 392,211 23.61 0 0
Exercised (179,164) 13.65 (7,545) 23.09
Forfeited (21,296) 23.03 (4,206) 24.39
---------------------------------------------------- ----------
Outstanding at September 30, 2006 2,737,441 19.26 9,343 23.56
============================================================================= ==============================
Exercisable at September 30, 2006 1,851,534 $17.65 0 0
============================================================================= ==============================
The weighted average remaining contractual term of outstanding and exercisable
stock options at September 30, 2006 is 6.8 years and 6.2 years, respectively.
The aggregate intrinsic value of outstanding and exercisable stock options at
September 30, 2006 is $10.6 million and $9.6 million, respectively.
The Company adopted Statement of Financial Accounting Standards No. 123(R),
Share-Based Payment ("SFAS 123(R)"), on January 1, 2006 using the modified
prospective method. Under this method, awards that are granted, modified, or
settled after December 31, 2005, are measured and accounted for in accordance
with SFAS 123(R). Also under this method, expense is recognized for unvested
awards that were granted prior to January 1, 2006, based upon the fair value
determined at the grant date under SFAS 123(R). Stock based compensation expense
is recognized ratably over the requisite service period for all awards. Prior to
the adoption of SFAS 123(R), the Company accounted for stock compensation under
the intrinsic value method permitted by Accounting Principles Board Opinion No
25, Accounting for Stock Issued to Employees ("APB No. 25") and related
interpretations. Accordingly, the Company previously recognized no compensation
cost for employee stock options that were granted with an exercise price equal
to the market value of the underlying common stock on the date of grant.
As a result of applying the provisions of SFAS 123(R) during the three and nine
months ended September 30, 2006, the Company recognized stock-based compensation
expense related to incentive and non-qualified stock options of $0.4 million and
$1.5 million, respectively and a related income tax benefit of $51,000 and
$238,000, respectively. Compensation expense related to restricted stock
recognized in the income statement for the three and nine months ended September
30, 2006 was $16,000 and $47,000, respectively. Compensation expense related to
restricted stock recognized in the income statement for the three and nine
months ended September 30, 2005 was $59,000 and $180,000, respectively.
10
The following table illustrates the effect on net income and earnings per share
if the fair value based method established in SFAS No. 123(R) had been applied
in 2005:
Three months ended Nine months ended
(000's omitted except per share amounts) September 30, 2005 September 30, 2005
------------------------------------------------------------------------------------------------------------
Net income, as reported $14,864 $42,479
Plus: stock-based compensation expense as reported, net of tax 41 116
Less: stock-based compensation expense determined under
fair value method, net of tax (332) (1,224)
------------------------------------------------------------------------------------------------------------
Pro forma net income $14,573 $41,371
============================================================================================================
Earnings per share:
As reported:
Basic $0.49 $1.40
Diluted $0.48 $1.37
Pro forma:
Basic $0.48 $1.36
Diluted $0.47 $1.34
Management estimated the fair value of options granted using the Black-Scholes
option-pricing model. This model was originally developed to estimate the fair
value of exchange-traded equity options, which (unlike employee stock options)
have no vesting period or transferability restrictions. As a result, the
Black-Scholes model is not necessarily a precise indicator of the value of an
option, but it is commonly used for this purpose. The Black-Scholes model
requires several assumptions, which management developed based on historical
trends and current market observations.
Nine months ended
September 30,
--------------------------------------------------------------------------
2006 2005
--------------------------------------------------------------------------
Weighted Average Fair Value of Options Granted $ 6.10 $ 6.37
Assumptions:
Weighted-average expected life (in years) 7.78 7.76
Future dividend yield 3.00% 3.00%
Share price volatility 26.46% 26.78%
Weighted average risk-free interest rate 4.37% 4.17%
==========================================================================
Unrecognized stock based compensation expense related to non-vested stock
options totaled $4.3 million at September 30, 2006, which will be recognized as
expense over the next five years. The weighted average period over which this
unrecognized expense is expected to be recognized is 1.7 years. The total fair
value of shares vested during the nine months ended September 30, 2006 and 2005
were $1.5 million and $1.7 million, respectively.
During the nine months ended September 30, 2006 and 2005, proceeds from stock
option exercises totaled $2.4 million and $3.1 million, respectively, and the
related windfall tax benefits from exercise were approximately $245,000 and
$694,000, respectively. During the nine months ended September 30, 2006 and
2005, 179,164 and 292,370 shares, respectively, were issued in connection with
stock option exercise. All shares issued were new shares issued from available
authorized shares. The total intrinsic value of options exercised during the
nine months ended September 30, 2006 and 2005 were $1.5 million and $3.8
million, respectively.
NOTE E: 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 1,376,605 and 1,353,086 weighted-average anti-dilutive
stock options outstanding for the three and nine months ended September 30, 2006
compared to 831,447 and 804,451 weighted-average anti-dilutive stock options
outstanding for the three and nine months ended September 30, 2005. The
following is a reconciliation of basic to diluted earnings per share for the
three and nine months ended September 30, 2006 and 2005.
11
Per Share
(000's omitted, except per share data) Income Shares Amount
-------------------------------------------------------------------------------------
Three Months Ended September 30, 2006
Basic EPS $10,879 29,932 $ 0.36
Stock options 402
-----------------------------------------------------------------------
Diluted EPS $10,879 30,334 $ 0.36
=======================================================================
Three Months Ended September 30, 2005
Basic EPS $14,864 30,178 $ 0.49
Stock options 534
-----------------------------------------------------------------------
Diluted EPS $14,864 30,712 $ 0.48
=======================================================================
Nine Months Ended September 30, 2006
Basic EPS $30,225 29,967 $ 1.01
Stock options 406
-----------------------------------------------------------------------
Diluted EPS $30,225 30,373 $ 1.00
=======================================================================
Nine Months Ended September 30, 2005
Basic EPS $42,479 30,385 $ 1.40
Stock options 562
-----------------------------------------------------------------------
Diluted EPS $42,479 30,947 $ 1.37
=======================================================================
NOTE F: INTANGIBLE ASSETS
The gross carrying amount and accumulated amortization for each type of
intangible asset are as follows:
As of September 30, 2006 As of December 31, 2005
----------------------------------------- -----------------------------------------
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 $ 64,474 ($39,248) $ 25,226 $ 63,161 ($35,014) $ 28,147
Other intangibles 2,750 (1,483) 1,267 2,750 (1,214) 1,536
----------------------------------- ----------------------------------------- -----------------------------------------
Total amortizing intangibles 67,224 (40,731) 26,493 65,911 (36,228) 29,683
Non-amortizing intangible assets:
Goodwill 213,142 0 213,142 195,195 0 195,195
----------------------------------- ----------------------------------------- -----------------------------------------
Total intangible assets, net $280,366 ($40,731) $239,635 $261,106 ($36,228) $224,878
=================================== ========================================= =========================================
No goodwill impairment adjustments were recognized in 2006 or 2005.
The estimated aggregate amortization expense for each of the succeeding fiscal
years ended December 31 is as follows:
(000's omitted) Amount
-----------------------------
Oct-Dec 2006 $ 1,551
2007 5,847
2008 5,503
2009 4,982
2010 3,133
Thereafter 5,477
--------------- -------
Total $26,493
=============== =======
12
NOTE G: MANDATORILY REDEEMABLE PREFERRED SECURITIES
The Company sponsors three business trusts, Community Capital Trust I, Community
Capital Trust II, and Community Statutory Trust III, of which 100% of the common
stock is owned by the Company. The trusts were formed for the purpose of issuing
company-obligated mandatorily redeemable preferred securities to third-party
investors and investing the proceeds from the sale of such preferred securities
solely in junior subordinated debt securities of the Company. The debentures
held by each trust are the sole assets of that trust. Distributions on the
preferred securities issued by each trust are payable semi-annually or quarterly
at a rate per annum equal to the interest rate being earned by the trust on the
debentures held by that trust. The preferred securities are subject to mandatory
redemption, in whole or in part, upon repayment of the debentures. The Company
has entered into agreements which, taken collectively, fully and unconditionally
guarantee the preferred securities subject to the terms of each of the
guarantees. The terms of the preferred securities of each trust are as follows:
Issuance Par Maturity
Date Amount Interest Rate Date Call Provision Call Price
------------------------------------------------------------------------------------------------------------------------------------
I 2/3/1997 $30 million 9.75% 2/03/2027 10 year beginning 2007 104.5400% declining to par in 2017
II 7/16/2001 $25 million 6 month LIBOR plus 3.75% (9.30%) 7/16/2031 5 year beginning 2006 107.6875% declining to par in 2011
III 7/31/2001 $24.5 million 3 month LIBOR plus 3.58% (9.07%) 7/31/2031 5 year beginning 2006 107.5000% declining to par in 2011
====================================================================================================================================
NOTE H: BENEFIT PLANS
The Company provides defined benefit pension benefits and post-retirement health
and life insurance benefits to eligible employees. The Company also provides
supplemental pension retirement benefits for several current and former key
employees. The Company accrues for the estimated cost of these benefits through
charges to expense during the years that employees earn these benefits. The net
periodic benefit cost for the three and nine months ended September 30 is 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) 2006 2005 2006 2005 2006 2005 2006 2005
----------------------------------------------------------- --------------------- ------------------- ------------------
Service cost $ 719 $ 641 $ 2,216 $ 1,922 $130 $110 $391 $330
Interest cost 635 651 1,902 1,953 119 104 355 311
Expected return on plan assets (827) (877) (2,482) (2,631) 0 0 0 0
Net amortization and deferral 270 318 900 953 27 19 81 58
Amortization of prior service cost 13 29 (71) 89 27 28 82 82
Amortization of transition obligation $ 0 0 0 0 10 10 31 31
----------------------------------------------------------- --------------------- ------------------- ------------------
Net periodic benefit cost $ 810 $ 762 $ 2,465 $ 2,286 $313 $271 $940 $812
=========================================================== ===================== =================== ==================
The Company is not required for regulatory purposes to make a contribution to
its defined benefit pension plan.
NOTE I: COMMITMENTS, CONTINGENT LIABILITIES AND RESTRICTIONS
The Company is a party to financial instruments with off-balance-sheet risk in
the normal course of business to meet the financing needs of its customers.
These financial instruments consist primarily of commitments to extend credit
and standby letters of credit. Commitments to extend credit are agreements to
lend to customers, generally having fixed expiration dates or other termination
clauses that may require payment of a fee. These commitments consist principally
of unused commercial and consumer credit lines. Standby letters of credit
generally are contingent upon the failure of the customer to perform according
to the terms of an underlying contract with a third party. The credit risks
associated with commitments to extend credit and standby letters of credit are
essentially the same as that involved with extending loans to customers and are
subject to normal credit policies. Collateral may be obtained based on
management's assessment of the customer's creditworthiness.
The contract amount of commitment and contingencies are as follows:
September 30, December 31,
(000's omitted) 2006 2005
--------------------------------------------------------------------
Commitments to extend credit $437,628 $434,640
Standby letters of credit 24,337 25,638
--------------------------------------------------------------------
Total $461,965 $460,278
====================================================================
13
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Introduction
This Management's Discussion and Analysis of Financial Condition and Results of
Operations ("MD&A") primarily reviews the financial condition and results of
operations of Community Bank System, Inc. ("the Company" or "CBSI") as of and
for the three and nine months ended September 30, 2006 and 2005, although in
some circumstances the second quarter of 2006 is also discussed in order to more
fully explain recent trends. The following discussion and analysis should be
read in conjunction with the Company's Consolidated Financial Statements and
related notes that appear on pages 3 through 13. All references in the
discussion to the financial condition and results of operations are to those of
the Company and its subsidiaries taken as a whole.
Unless otherwise noted, the term "this year" refers to results in calendar year
2006, "third quarter" refers to the quarter ended September 30, 2006, earnings
per share ("EPS") figures refer to diluted EPS, and net interest income and net
interest margin are presented on a fully tax-equivalent ("FTE") basis.
This MD&A contains certain forward-looking statements with respect to the
financial condition, results of operations and business of the Company. These
forward-looking statements involve certain risks and uncertainties. Factors that
may cause actual results to differ materially from those proposed by such
forward-looking statements are set herein under the caption, "Forward-Looking
Statements," on page 28.
Critical Accounting Policies
As a result of the complex and dynamic nature of the Company's business,
management must exercise judgment 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 inherently subjective. It
requires significant estimates including the amounts and timing of
expected future cash flows on impaired loans and the amount of estimated
losses on pools of homogeneous loans which is based on historical loss
experience and consideration of current economic trends, all of which may
be susceptible to significant change.
o Actuarial assumptions associated with pension, post-retirement and other
employee benefit plans - These assumptions include discount rate, rate of
future compensation increases and expected return on plan assets.
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 44-49 of the most recent
Form 10-K (fiscal year ended December 31, 2005).
14
Executive Summary
The Company's business philosophy is to operate as a community bank with local
decision-making, principally in non-metropolitan markets, providing a broad
array of banking and financial services to retail, commercial and municipal
customers.
The Company's core operating objectives are: (i) grow the branch network,
primarily through a disciplined acquisition strategy, and certain selective de
novo expansions, (ii) build high-quality, profitable loan and deposit portfolios
using both organic and acquisition strategies, (iii) increase the non-interest
income component of total revenues through development of banking-related fee
income, growth in existing financial services business units, and the
acquisition of additional financial services and banking businesses, and (iv)
utilize technology to deliver customer-responsive products and services and to
reduce operating costs.
Significant factors management reviews to evaluate achievement of the Company's
operating objectives and its operating results and financial condition include,
but are not limited to: net income and earnings per share, return on assets and
equity, net interest margins, non-interest income, operating expenses, asset
quality, loan and deposit growth, capital management, performance of individual
banking and financial services units, liquidity and interest rate sensitivity,
enhancements to customer products and services, technology enhancements, market
share, peer comparisons, and the performance of acquisition and integration
activities.
On August 11, 2006, the Company completed its acquisition of ES&L Bancorp, Inc.
("Elmira"), a $210 million asset bank based in Elmira, New York, in an all-cash
transaction valued at approximately $40 million.
Third quarter and September year-to-date ("YTD") earnings per share were $0.36
and $1.00, respectively, a decrease of $0.12 and $0.37 as compared to the
respective prior year periods. The decrease was driven by a higher cost of
funds, lower investment interest income, stock option expense as a result of the
adoption of Statement of Financial Accounting Standards (SFAS) 123(R),
Share-Based Payment, and the absence of gains on the sale of investment
securities recorded in the third quarter and first nine months of 2005. These
were partially offset by higher loan interest income and higher non-interest
income (excluding gain on sales of investment securities). Cash earnings per
share (which excludes the after-tax effect of the amortization of intangibles
assets and acquisition-related market value adjustments) were $0.40 versus $0.53
for the prior year's third quarter and $0.37 for the second quarter of 2006.
Asset quality continued to improve in the third quarter of 2006 in comparison to
the first two quarters of 2006 and the same period last year, with reductions in
the net charge-off, non-performing loan and total delinquent loan ratios. The
Company experienced year-over-year loan growth in all portfolios: consumer
installment, consumer mortgage and business lending, due to both the Elmira
acquisition and organic loan growth. The size of the investment portfolio was
below that of third quarter of the prior year as the Company repositioned its
balance sheet in 2005 by selling certain securities in its investment portfolio
and using the proceeds to pay off variable and short-term borrowings. Average
deposits increased in the third quarter of 2006 as compared to the second
quarter of 2006 and the third quarter of 2005, again due to both organic growth
and the Elmira acquisition. External borrowings, principally overnight
borrowings and other short-term instruments, increased during the same time
periods, due to the funding requirements of Elmira.
On August 3, 2006, the Company announced an agreement to acquire ONB Corporation
(ONB) in an all-cash transaction valued at approximately $15.7 million. ONB is
the parent company of Ontario National Bank, a federally chartered national bank
operating four branches in the villages of Clifton Springs, Phelps and Palmyra,
New York. As of September 30, 2006, ONB held approximately $95 million in
assets, including $60 million in loans. The acquisition is expected to close in
the fourth quarter of 2006.
Net Income and Profitability
As shown in Table 2, earnings per share for the third quarter and September YTD
of $0.36 and $1.00, respectively, were $0.12 and $0.37 lower than the EPS
generated in the same periods of last year. Net income for the quarter of $10.9
million was 27% lower than the third quarter of 2005 and net income of $30.2
million for the first nine months of 2006 decreased 29% from the amount earned
in the first nine months of 2005. As compared to the second quarter of 2006, net
income increased $1.0 million or 10.1% and earnings per share increased $0.03 or
9.1%.
Third quarter net interest income of $33.8 million was down $1.3 million or 3.6%
from the comparable prior year period, while net interest income for the first
nine months of 2006 decreased $7.8 million or 7.2% over the first nine months of
2005. The provision for loan losses decreased $1.0 million or 43% as compared to
the third quarter of 2005 and decreased $1.1 million or 18% for the first nine
months of 2006 compared to the equivalent period of 2005 as a result of strong
asset quality. Third quarter non-interest income, excluding securities gains,
was $13.7 million, up $0.6 million (4.6%) from third quarter 2005 and the YTD
amount of $38.6 million rose $2.9 million or 8.0% from the prior year level.
There were no security gains recorded in 2006, while the third quarter and YTD
periods of 2005 included $5.3 million and $12.2 million of net gains,
respectively. Operating expenses of $31.8 million for the quarter and $94.5
million for the first nine months of 2006 were up 3.6% and 1.6%, respectively,
from the comparable prior year periods.
15
Excluding the impact of adopting SFAS 123(R), Share-Based Payment, total
operating expenses for the third quarter increased 2.3% versus the prior year
and were consistent for the YTD periods.
In addition to the earnings results presented above in accordance with generally
accepted accounting principles ("GAAP"), the Company provides cash earnings per
share, which excludes the after-tax effect of the amortization of intangible
assets and acquisition-related market value adjustments. Management believes
that this information helps investors better understand the effect of
acquisition activity in reported results. Cash earnings per share for the third
quarter and the first nine months of 2006 were $0.40 and $1.13, respectively,
down 25% and 26% from the $0.53 and $1.52 earned in the comparable periods of
2005.
As reflected in Table 2, the primary reasons for lower earnings in both periods
were lower net interest income, gains on sales of investment securities and
slightly higher operating expenses, partially offset by increases in
non-interest income excluding securities gain and a lower loan loss provision.
The decrease in net interest income for both periods was due to a higher cost of
funds and lower average investment balances, partially offset by both acquired
and organic loan growth and higher loan yields. Excluding security gains,
non-interest income increased due to a strong performance by the employee
benefits consulting and plan administration business and higher banking service
fees. The decrease in security gains was due to $5.3 million and $12.2 million
of gains on the sale of securities recognized in the third quarter and first
nine months of 2005, respectively, with no corresponding gains in the comparable
period of 2006. Improved net charge-off and non-performing loan ratios were the
primary reasons for the decrease in loan loss provision, despite an increase in
total loans outstanding. Excluding stock option costs, operating expenses
increased for the quarter primarily due to higher business development and
marketing expenditures as well as costs associated with the Elmira acquisition,
partially offset by reductions in customer processing costs and occupancy costs.
A reconciliation of GAAP-based earnings results to cash-based earnings results
and a condensed income statement are as follows:
Table 1: Reconciliation of GAAP Net Income to Cash Net Income
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- -----------------------
(000's omitted) 2006 2005 2006 2005
------------------------------------ ----------------------- -----------------------
Net income $10,879 $14,864 $30,225 $42,479
After-tax cash adjustments:
Amortization of premium on net
assets acquired in merger 200 222 612 436
Amortization of intangible assets 1,149 1,119 3,399 4,074
------------------------------------ ----------------------- -----------------------
Net income - cash $12,228 $16,205 $34,236 $46,989
==================================== ======================= =======================
Table 2: Summary Income Statements
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- -------------------------
(000's omitted, except per share data) 2006 2005 2006 2005
--------------------------------------------- ----------------------- -------------------------
Net interest income $33,792 $35,046 $101,086 $108,875
Provision for loan losses 1,300 2,275 5,175 6,284
Non-interest income excluding security gains 13,744 13,136 38,605 35,740
Gains on sales of investment securities 0 5,305 0 12,195
Operating expenses 31,840 30,727 94,483 92,958
--------------------------------------------- ----------------------- -------------------------
Income before taxes 14,396 20,485 40,033 57,568
Income taxes 3,517 5,621 9,808 15,089
--------------------------------------------- ----------------------- -------------------------
Net income $10,879 $14,864 $ 30,225 $ 42,479
============================================= ======================= =========================
Diluted earnings per share $ 0.36 $ 0.4 $ 1.00 $ 1.37
Diluted earnings per share - cash (1) $ 0.40 $ 0.5 $ 1.13 $ 1.52
(1) Cash earnings are reconciled to GAAP net income in Table 1.
16
Net Interest Income
Net interest income is the amount by which interest and fees on earning assets
(loans, investments and cash) exceed the cost of funds, primarily interest paid
to the Company's depositors and interest on external borrowings. Net interest
margin is the difference between the gross yield on earning assets and the cost
of interest-bearing funds as a percentage of earning assets.
As shown in Table 3, net interest income (with non-taxable income converted to a
fully tax-equivalent basis) for third quarter 2006 was $37.6 million, down $1.0
million or 2.7% from the same period last year. A $103.4 million increase in
interest-bearing liabilities and a 19 basis point decrease in the net interest
margin more than offset a $72.3 million increase in average interest-earning
assets. As reflected in Table 4, the volume and rate increases to interest
bearing liabilities had a $6.2 million negative impact on net interest income,
while the volume and rate increases to interest bearing assets had a smaller
$5.2 million favorable impact to net interest income. September 2006 YTD net
interest income of $112.1 million was down $7.7 million or 6.4% from the
year-earlier period. A $55.7 million decrease in earning assets and a 21 basis
point decrease in the net interest margin more than offset a $66.3 million
decrease in interest bearing liabilities. Interest bearing asset and liability
volume changes resulted in $1.7 million less net interest income, while a lower
net interest margin had a negative $5.9 million impact on net interest income.
Higher third quarter and September YTD average loan balances were attributable
to $55.7 million of quarterly average organic loan growth since the third
quarter of 2005, driven by growth in all portfolios: consumer installment,
consumer mortgage and business lending, as well as a $105.0 million increase in
third quarter 2006 average loans from the Elmira acquisition. Average
investments for the third quarter and YTD periods were $110 million and $170
million less than the respective periods of 2005. The decrease was principally a
result of the Company's decision to sell certain securities and not fully
reinvest cash flows from maturing securities in a flat yield-curve environment,
in order to take advantage of market conditions to shorten the average life of
the portfolio, improve its interest-rate sensitivity profile in a rising-rate
environment, and maximize the expected total return. In comparison to the prior
year, total average deposits were up $110.2 million or 3.7% for the quarter and
$65.8 million or 2.2% for the YTD period as a result of growth in both IPC and
public fund balances. Average deposits acquired in the Elmira acquisition for
the third quarter and YTD periods were $68.1 million and $22.9 million,
respectively. Cash flows from the investment sales and maturities were used to
pay down external borrowings over the last twelve months, resulting in average
quarterly and YTD borrowings being $50.5 million and $152.2 million lower in the
third quarter of 2006 and the first nine months of 2006, in comparison to the
comparable 2005 periods.
The net interest margin of 3.87% for the third quarter and 3.98% for the year to
date period dropped 19 basis points and 21 basis points, respectively, versus
the same periods in the prior year. These declines were primarily attributable
to an increase in the cost of funds (quarter up 63 basis points, YTD up 55 basis
points), due principally to the effect of the eight rate hikes (25 basis points
each) by the Federal Reserve since September 2005, while earning assets yields
increased at a slower rate (quarter up 42 basis points, YTD up 31 basis points).
The change in the earning-asset yield was driven by an increase in loan yields
of 60 basis points for the quarter and 45 basis points for the YTD period, while
investment yields increased 5 basis points for the quarter and three basis
points for the YTD period. Results included the impact of the Elmira
acquisition, which had lower net interest margin attributes than the Company's
historical averages.
The third quarter cost of funds increased 63 basis points due to a 62 basis
point increase in deposit costs and a 96 basis point increase in the average
interest rate paid on external borrowings. The increase in the YTD cost of funds
was driven by a 56 basis point increase in deposit costs and borrowing rates
that were up 108 basis points. Interest rates on selected categories of deposit
accounts were raised throughout 2005 and the first nine months of 2006 in
response to the Federal Reserve rate increases. Additionally, customers
continued to transfer funds from low rate and non-interest earning accounts to
higher yielding checking and time deposit accounts. The increase in the
borrowing rates is mostly attributable to the rate increases by the Federal
Reserve. Additionally, the long-term rate was impacted by the more than 100
basis point increase in three and six month LIBOR (London Interbank Offered
Rates) over the last twelve months, from which the interest rate on the majority
of the mandatorily redeemable preferred securities is based.
17
Table 3 below sets forth information related to average interest-earning assets
and interest-bearing liabilities and their associated yields and rates for the
periods indicated. Interest income and yields are on a fully tax-equivalent
basis using marginal income tax rates of 38.4% in 2006 and 38.6% in 2005.
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 and
loans held for sale.
Table 3: Quarterly Average Balance Sheet
Three Months Ended Three Months Ended
(000's omitted except yields and rates) September 30, 2006 September 30, 2005
-----------------------------------------------------------------------------------------------------------------------------------
Avg. Avg.
Average Yield/Rate Average Yield/Rate
Balance Interest Paid Balance Interest Paid
-----------------------------------------------------------------------------------------------------------------------------------
Interest-earning assets:
Time deposits in other banks $ 34,264 $ 431 4.99% $ 13,105 $ 106 3.20%
Taxable investment securities (1) 741,764 10,031 5.37% 840,872 11,581 5.46%
Non-taxable investment securities (1) 512,721 8,823 6.83% 523,212 8,753 6.64%
Loans (net of unearned discount) 2,558,137 43,640 6.77% 2,397,410 37,265 6.17%
--------------------- ---------------------
Total interest-earning assets 3,846,886 62,925 6.49% 3,774,599 57,705 6.07%
------- -------
Non-interest earning assets 425,828 456,167
---------- ----------
Total assets $4,272,714 $4,230,766
========== ==========
Interest-bearing liabilities:
Interest checking, savings and money market deposits $1,161,076 3,186 1.09% $1,168,047 2,352 0.80%
Time deposits 1,379,074 13,171 3.79% 1,218,291 8,788 2.86%
Short-term borrowings 125,013 1,327 4.21% 338,405 2,523 2.96%
Long-term borrowings 534,811 7,685 5.70% 371,877 5,463 5.83%
--------------------- ---------------------
Total interest-bearing liabilities 3,199,974 25,369 3.15% 3,096,620 19,126 2.45%
------- -------
Non-interest bearing liabilities:
Demand deposits 558,060 601,702
Other liabilities 57,684 63,885
Shareholders' equity 456,996 468,559
---------- ----------
Total liabilities and shareholders' equity $4,272,714 $4,230,766
========== ==========
Net interest earnings $37,556 $38,579
======= =======
Net interest spread 3.34% 3.62%
Net interest margin on interest-earnings assets 3.87% 4.06%
Fully tax-equivalent adjustment $ 3,764 $ 3,533
(1) 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, 2006 September 30, 2005
------------------------------------------------------------------------------------------------------------------------------------
Avg. Avg.
Average Yield/Rate Average Yield/Rate
Balance Interest Paid Balance Interest Paid
------------------------------------------------------------------------------------------------------------------------------------
Interest-earning assets:
Time deposits in other banks $ 24,917 $ 910 4.88% $ 8,664 $ 190 2.94%
Taxable investment securities (1) 764,116 31,715 5.55% 918,230 38,780 5.65%
Non-taxable investment securities (1) 517,680 26,689 6.89% 533,436 26,990 6.76%
Loans (net of unearned discount) 2,462,185 121,962 6.62% 2,364,296 109,132 6.17%
--------------------- ---------------------
Total interest-earning assets 3,768,898 181,276 6.43% 3,824,626 175,092 6.12%
-------- --------
Non-interest earning assets 426,721 480,693
---------- ----------
Total assets $4,195,619 $4,305,319
========== ==========
Interest-bearing liabilities:
Interest checking, savings and money market deposits $1,139,608 8,475 0.99% $1,178,517 6,493 0.74%
Time deposits 1,331,294 35,523 3.57% 1,206,555 24,110 2.67%
Short-term borrowings 138,578 3,935 3.80% 412,141 9,301 3.02%
Long-term borrowings 504,507 21,282 5.64% 383,113 15,470 5.40%
--------------------- ---------------------
Total interest-bearing liabilities 3,113,987 69,215 2.97% 3,180,326 55,374 2.33%
-------- --------
Non-interest bearing liabilities:
Demand deposits 571,088 591,124
Other liabilities 54,692 64,384
Shareholders' equity 455,852 469,485
---------- ----------
Total liabilities and shareholders' equity $4,195,619 $4,305,319
========== ==========
Net interest earnings $112,061 $119,718
======== ========
Net interest spread 3.46% 3.79%
Net interest margin on interest-earnings assets 3.98% 4.19%
Fully tax-equivalent adjustment $ 10,975 $ 10,843
(1) 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 quarterly change in net
interest income (fully tax-equivalent basis) may be analyzed by segregating the
volume and rate components of the changes in interest income and interest
expense for each underlying category.
Table 4: Rate/Volume
Nine Months Ended September 30, 2006
3rd Quarter 2006 versus 3rd Quarter 2005 versus September 30, 2005
------------------------------------------ ------------------------------------------
Increase (Decrease) Due to Change in (1) Increase (Decrease) Due to Change in (1)
------------------------------------------ ------------------------------------------
Volume Rate Net Change Volume Rate Net Change
------------------------------------------ ------------------------------------------
(000's omitted)
Interest earned on:
Time deposits in other banks $ 242 $ 83 $ 325 $ 532 $ 188 $ 720
Taxable investment securities (1,344) (206) (1,550) (6,407) (658) (7,065)
Non-taxable investment securities (177) 248 71 (806) 505 (301)
Loans (net of unearned discount) 2,597 3,777 6,374 4,638 8,192 12,830
Total interest-earning assets (2) 1,122 4,098 5,220 (2,580) 8,764 6,184
Interest paid on:
Interest checking, savings and money
market deposits (14) 848 834 (221) 2,203 1,982
Time deposits 1,269 3,114 4,383 2,690 8,723 11,413
Short-term borrowings (1,993) 797 (1,196) (7,320) 1,954 (5,366)
Long-term borrowings 2,342 (120) 2,222 5,093 719 5,812
Total interest-bearing liabilities (2) 657 5,586 6,243 (1,177) 15,018 13,841
Net interest earnings (2) $ 729 $(1,752) $(1,023) $(1,724) $ (5,933) $ (7,657)
(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's sources of non-interest income are of three primary types: general
banking services related to loans, deposits and other core customer activities
typically provided through the branch network; employee benefit plan
administration, actuarial and consulting services (BPA-Harbridge), trust
services, investment and insurance products (Community Investment Services, Inc.
or CISI) and asset management (Nottingham Advisors or Nottingham); and periodic
transactions, most often net gains (losses) from the sale of investment
securities and prepayment of term debt.
Table 5: Non-interest Income
Three Months Ended Nine Months Ended
September 30, September 30,
(000's omitted) 2006 2005 2006 2005
------------------------------------------------------ ---------------------- ----------------------
Deposit service charges and fees $ 7,329 $ 7,135 $21,001 $19,844
Benefit plan administration, consulting
and actuarial fees 3,271 2,767 9,807 8,256
Trust, investment and asset management fees 1,815 1,823 5,631 5,463
Other banking services 1,113 1,122 1,706 1,779
Mortgage banking 216 289 460 398
------------------------------------------------------ ---------------------- ----------------------
Subtotal 13,744 13,136 38,605 35,740
Gain on sales of investment securities 0 5,305 0 12,195
------------------------------------------------------ ---------------------- ----------------------
Total non-interest income $13,744 $18,441 $38,605 $47,935
====================================================== ====================== ======================
Non-interest income/total income (FTE) 26.8% 32.3% 25.6% 28.6%
As displayed in Table 5, non-interest income (excluding securities gains) was
$13.7 million in the third quarter and $38.6 million for the first nine months
of 2006. This corresponded to increases of $0.6 million (4.6%) for the quarter
and $2.9 million (8.0%) for the YTD period in comparison to one year earlier. A
significant portion of the growth in both time intervals was attributable to the
$0.2 million and $1.2 million increases in recurring bank fees for the quarter
and year-to-date periods, respectively, driven by several revenue enhancement
initiatives put into place during 2005 and core deposit account growth.
Offsetting these increases, was the absence of gains on the sales of investment
securities which equaled $5.3 million and $12.2 million for the third quarter
and first nine months of 2005, respectively, as the Company took advantage of
market conditions to sell certain securities in the first nine months of 2005 in
order to shorten the average length of the portfolio and maximize their expected
total return. Consistent with prior years, other banking revenues for the third
quarter include the annual dividends from creditor insurance programs in which
the Company participates approximating $0.9 million.
Strong performance at BPA-Harbridge generated revenue growth of $0.5 million
(18%) for the quarter and $1.6 million (19%) for the first nine months of 2006,
achieved primarily through enhanced service offerings to both new and existing
clients. In comparison to the third quarter of the prior year, trust, investment
and asset management fees were down due to softer demand for their traditional
investment products. Year-to-date, trust, investment and asset management fees
have increased as compared to the first nine months of 2005, as a result of
development of new client relationships and improved market conditions. During
the third quarter, our wealth management and advisory firm completed its
re-branding efforts to become Nottingham Advisors, to underscore the increased
product and service offerings it has recently developed.
The ratio of non-interest income to total income (FTE basis) was 26.8% for the
quarter and 25.6% for the year-to-date period versus 32.3% and 28.6% for the
comparable periods in 2005. Excluding net security gains, the ratio of
non-interest income to total income (FTE basis) was 26.8% and 25.6% for the
third quarter and YTD periods of 2006, respectively, as compared to 25.4% and
23.0% for the same periods of 2005. This improvement is a function of rising
non-interest banking and financial services income (excluding net security
gains), combined with lower net interest income, attributable to reduced
investment portfolio levels and a decline in the net interest margin.
21
Operating Expenses
Table 6 below sets forth the quarterly results of the major operating expense
categories for the current and prior year, as well as efficiency ratios (defined
below), a standard measure of overhead utilization used in the banking industry.
Table 6: Operating Expenses
Three Months Ended Nine Months Ended
September 30, September 30,
(000's omitted) 2006 2005 2006 2005
---------------------------------------------- ------------------------ ------------------------
Salaries and employee benefits $16,332 $16,458 $48,735 $48,836
Stock option expense 409 0 1,456 0
Occupancy and equipment 4,350 4,483 13,557 13,355
Data processing and communications 3,359 3,467 9,923 10,258
Amortization of intangible assets 1,520 1,553 4,502 5,521
Legal and professional fees 1,119 923 3,267 3,250
Office supplies and postage 1,004 1,024 3,063 2,914
Business development and marketing 1,095 545 2,909 2,132
Other 2,652 2,274 7,071 6,692
---------------------------------------------- ------------------------ ------------------------
Total operating expenses $31,840 $30,727 $94,483 $92,958
============================================== ======================== ========================
Operating expenses/average assets 2.96% 2.88% 3.01% 2.89%
Efficiency ratio 58.8% 56.4% 59.6% 56.2%
As shown in Table 6, third quarter 2006 operating expenses were $31.8 million,
up $1.1 million or 3.6% from the prior year level and year-to-date operating
expenses of $94.5 million rose $1.5 million or 1.6% compared to 2005. Excluding
the effect of adopting SFAS 123(R), Share-Based Payment, operating expenses
increased $0.7 million or 2.3% for the third quarter and were essentially flat
with the first nine months of 2006 as compared to the prior year periods. The
increase was primarily attributable to an increased level of business
development and marketing expenses ($0.6 million for the quarter and $0.8
million YTD) associated with a bank-wide deposit generation program, an
increased level of acquisition related costs ($0.2 million for the quarter and
$0.1 million for the YTD) as well as a month and a half of incremental operating
expense related to the Elmira acquisition ($0.2 million for both the quarter and
YTD), partially offset by a reduction in the amortization of intangible assets
(no impact for the quarter, $1.0 million YTD) and a reduction in data processing
and communication expenses ($0.1 million for the quarter, $0.3 million YTD).
The Company successfully managed all aspects of its operating expense structure
in the first nine months of 2006, resulting in operating expense, excluding the
effect of adopting SFAS 123(R) and acquisition related expense, decreasing
slightly as compared to the year earlier period. During 2006, the Company
consolidated three of its branch offices into nearby sister branches. This
realignment will reduce market overlap and further strengthen its branch
network, and reflects management's focus on achieving long-term performance
improvements through proactive strategic decision-making.
The Company's efficiency ratio (recurring operating expense excluding intangible
amortization divided by the sum of net interest income (FTE) and recurring
non-interest income) was 58.8% for the third quarter, 2.4 percentage points
above the comparable quarter of 2005. This resulted from operating expenses (as
described above) increasing 3.4% primarily due to stock option expense, while
recurring operating income decreased 0.8% due to $1.0 million lower net interest
income, partially offset by a $0.5 million increase in non-interest income
excluding security gains. The efficiency ratio for the third quarter of 2006,
excluding stock option expense was 58.0%, as compared to 56.4% in the comparable
third quarter of 2005. The efficiency ratio of 59.6% for the first nine months
of 2006 was up 3.4 percentage points from a year earlier due to core operating
expenses increasing 2.8% while recurring operating income decreased 3.1%
primarily as a result of the planned reduction of investment securities and a
lower net interest margin. Operating expenses as a percentage of average assets
increased eight basis points and 12 basis points for the quarter and year to
date periods, respectively, primarily driven by the decrease in the investment
portfolio during the comparable time periods.
Income Taxes
The third quarter effective income tax rate was 24.4%, compared to the 27.4%
effective tax rate in the third quarter of 2005. The year-to-date effective tax
rate was 24.5% as compared to 26.2% for the first nine months of 2005. The lower
effective tax rate for 2006 was principally a result of a higher proportion of
income being generated from tax-exempt securities and loans.
22
Investments
As reflected in Table 7 below, the carrying value of investments (including
unrealized gains on available-for-sale securities) was $1.25 billion at the end
of the third quarter, a decrease of $53 million and $68 million from December
31, 2005 and September 30, 2005, respectively. The book value (excluding
unrealized gains) of investments decreased $45 million from year-end 2005 and
declined $51 million versus September 30, 2005. Over the last twelve months, the
investment portfolio has been allowed to run off in the current flat yield curve
environment. Cash flows have been used to support loan growth and repay
borrowings until more advantageous investment opportunities become available.
The overall mix of securities within the portfolio over the last year has
remained relatively consistent, with a small increase in the proportion of
obligations of state and political subdivisions and mortgage-backed securities,
and a corresponding decrease in the proportion of U.S. Treasury and Agency
securities. The change in the carrying value of investments is impacted by the
amount of net unrealized gains in the available for sale portfolio at a point in
time. At September 30, 2006, the portfolio had a $6.3 million net unrealized
gain, a decrease of $7.4 million and $17.3 million from the unrealized gain at
December 31, 2005 and September 30, 2005, respectively. This fluctuation is
indicative of the interest rate movements during the respective time periods and
the reduction in the size of the portfolio.
Table 7: Investments
September 30, 2006 December 31, 2005 September 30, 2005
------------------------- ------------------------- -------------------------
Amortized Amortized Amortized
Cost/Book Fair Cost/Book Fair Cost/Book Fair
(000's omitted) Value Value Value Value Value Value
--------------------------------------------------- ------------------------- ------------------------- -------------------------
Held-to-Maturity Portfolio:
U.S. Treasury and Agency securities $ 127,236 $ 122,998 $ 127,345 $ 124,326 $ 127,381 $ 125,114
Obligations of state and political subdivisions 8,495 8,508 5,709 5,735 5,131 5,186
Other securities 9,326 9,326 9,451 9,451 9,461 9,461
--------------------------------------------------- ------------------------- ------------------------- -------------------------
Total held-to-maturity portfolio 145,057 140,832 142,505 139,512 141,973 139,761
--------------------------------------------------- ------------------------- ------------------------- -------------------------
Available-for-Sale Portfolio:
U.S. Treasury and Agency securities 385,424 382,178 420,062 420,808 420,315 423,923
Obligations of state and political subdivisions 507,804 519,697 519,661 532,708 522,955 541,828
Corporate securities 35,639 35,021 35,744 35,559 35,780 35,881
Collateralized mortgage obligations 49,081 48,374 78,708 78,466 76,042 76,019
Mortgage-backed securities 78,247 77,204 53,021 53,365 55,640 56,667
--------------------------------------------------- ------------------------- ------------------------- -------------------------
Subtotal 1,056,195 1,062,474 1,107,196 1,120,906 1,110,732 1,134,318
Equity securities 42,720 42,720 39,706 39,706 41,843 41,843
--------------------------------------------------- ------------------------- ------------------------- -------------------------
Total available-for-sale portfolio 1,098,915 1,105,194 1,146,902 1,160,612 1,152,575 1,176,161
--------------------------------------------------- ------------------------- ------------------------- -------------------------
Net unrealized gain on available-for-sale portfolio 6,279 -- 13,710 -- 23,586 --
--------------------------------------------------- ------------------------- ------------------------- -------------------------
Total $1,250,251 $1,246,026 $1,303,117 $1,300,124 $1,318,134 $1,315,922
=================================================== ========================= ========================= =========================
23
Loans
As shown in Table 8, loans ended the third quarter at $2.66 billion, up $249.8
million (10.4%) year-to-date and up $249.7 (10.4%) versus one year earlier. The
Elmira acquisition added approximately $191 million of loans to the loan
portfolio as of September 30, 2006. Excluding the impact of the Elmira
acquisition, loans increased $59 million or 2.5% from the end of the prior
year-end and third quarter 2005. As compared to the prior quarter and one year
earlier, growth was produced in all three categories. During the third quarter,
excluding the impact of the Elmira acquisition, loans increased $26.7 million
with increases in the consumer installment portfolio ($14.1 million), consumer
mortgage portfolio ($10.2 million) and the business lending portfolio ($2.4
million).
Table 8: Loans
(000's omitted) September 30, 2006 December 31, 2005 September 30, 2005
---------------------- -------------------- -------------------- --------------------
Business lending $ 953,808 35.8% $ 819,605 34.0% $ 816,145 33.8%
Consumer mortgage 890,939 33.5% 815,463 33.8% 813,274 33.7%
Consumer installment 816,815 30.7% 776,701 32.2% 782,419 32.5%
---------------------- -------------------- -------------------- --------------------
Total loans $2,661,562 100.0% $2,411,769 100.0% $2,411,838 100.0%
====================== ==================== ==================== ====================
Business lending increased $134.2 million in the first nine months of 2006 and
increased $137.7 million versus one year ago. Excluding the impact of the Elmira
acquisition, business lending was up $9.8 million over the last three quarters
and $13.3 million over the last year. Growth in commercial mortgage and business
line of credit activity during the first nine months has more than offset a
planned and managed decline in automotive dealer floor plan outstandings. The
Company continues to face competitive conditions in most of its markets and it
maintains its commitment to generating growth in its business portfolio in a
manner that adheres to its twin goals of maintaining strong asset quality and
producing profitable margins.
Consumer mortgages increased $77.7 million year over year and $75.5 million in
the first nine months of 2006, despite the Company continuing to sell certain
30-year, fixed-rate new mortgage originations in the secondary market for the
third consecutive quarter. Excluding the impact of the Elmira acquisition,
consumer mortgage lending increased $17.0 million and $19.2 million for the past
nine and twelve month periods, respectively. Consumer mortgage growth has
remained steady over the last few quarters despite interest rates rising above
prior year levels.
Consumer installment loans, including borrowings originated in automobile,
marine and recreational vehicle dealerships, as well as branch originated home
equity and installment loans, rose $40.1 million (5.2%) in the first nine months
of 2006 and increased $34.4 million (4.4%) on a year-over-year basis. Excluding
the impact of the Elmira acquisition, consumer installment lending increased
$32.4 million and $26.7 million for the first nine months and year-over-year
periods, respectively. Continued moderate interest rates (by historical
standards), aggressive dealer and manufacturer incentives on new vehicles, and
enhanced business development efforts have helped drive profitable growth in
this segment in all our markets.
24
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, 2006 and 2005
and December 31, 2005.
Table 9: Non-performing Assets
September 30, December 31, September 30,
(000's omitted) 2006 2005 2005
------------------------------------------------------------- ------------- ------------ -------------
Non-accrual loans $10,114 $10,857 $12,896
Accruing loans 90+ days delinquent 1,133 1,075 672
Restructured loans 1,300 1,375 0
------------------------------------------------------------- ------------- ------------ -------------
Total non-performing loans 12,547 13,307 13,568
Other real estate (OREO) 1,320 1,048 882
------------------------------------------------------------- ------------- ------------ -------------
Total non-performing assets $13,867 $14,355 $14,450
============================================================= ============= ============ =============
Allowance for loan losses to total loans 1.33% 1.35% 1.35%
Allowance for loan losses to non-performing loans 283% 245% 239%
Non-performing loans to total loans 0.47% 0.55% 0.56%
Non-performing assets to total loans and other real estate 0.52% 0.59% 0.60%
Delinquent loans (30 days old to non-accruing) to total loans 1.22% 1.46% 1.46%
Net charge-offs to average loans outstanding (quarterly) 0.17% 0.35% 0.30%
Loan loss provision to net charge-offs (quarterly) 117% 106% 125%
As displayed in Table 9, non-performing assets at September 30, 2006 were $13.9
million, a decrease of $0.5 million versus year-end 2005 and a $0.6 million
decrease as compared to the level at the end of the third quarter of 2005.
Non-performing loans are at the lowest level in over three years, reflective of
disciplined credit management and a steady improvement in economic conditions
over the past few years. Other real estate increased $0.4 million from one-year
ago and increased $0.3 million from year-end 2005, a result of the Company
managing 24 properties at September 30, 2006 as compared to 15 OREO properties
at the end of 2005. No single property has a carrying value in excess of
$350,000.
Non-performing loans were 0.47% of total loans outstanding at the end of the
third quarter, significantly below the 0.56% at September 30, 2005, 0.55% at
year-end 2005 and 0.58% average for the previous eight quarters. The allowance
for loan losses to non-performing loans ratio, a general measure of coverage
adequacy, was 283% at the end of the third quarter compared to 245% at year-end
2005 and 239% at September 30, 2005, reflective of the low level of
non-performing loans.
Delinquent loans (30 days through non-accruing) as a percent of total loans was
1.22% at the end of the third quarter, substantially below the 1.46% at year-end
2005 and at September 30, 2005. Commercial and installment loan delinquency
ratios at the end of the third quarter improved in comparison to both of the
earlier periods. Real estate loan delinquency ratios increased slightly from the
third quarter of 2005, but were improved from December 31, 2005. The delinquency
level at the end of the current quarter was 15 basis points below the Company's
average of 1.37% over the previous eight quarters.
25
Table 10: Allowance for Loan Losses Activity
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- -----------------------
(000's omitted) 2006 2005 2006 2005
-------------------------------------------------- ----------------------- -----------------------
Allowance for loan losses at beginning of period $32,900 $32,011 $32,581 $31,778
Charge-offs:
Business lending 582 577 3,138 2,138
Consumer mortgage 54 87 156 489
Consumer installment 1,548 2,130 4,410 5,727
-------------------------------------------------- ----------------------- -----------------------
Total charge-offs 2,184 2,794 7,704 8,354
-------------------------------------------------- ----------------------- -----------------------
Recoveries:
Business lending 425 231 664 602
Consumer mortgage 23 3 100 137
Consumer installment 621 734 2,269 2,013
-------------------------------------------------- ----------------------- -----------------------
Total recoveries 1,069 968 3,033 2,752
-------------------------------------------------- ----------------------- -----------------------
Net charge-offs 1,115 1,826 4,671 5,602
Provision for loans losses 1,300 2,275 5,175 6,284
Allowance for acquired loans(1) 2,432 0 2,432 0
-------------------------------------------------- ----------------------- -----------------------
Allowance for loan losses at end of period $35,517 $32,460 $35,517 $32,460
================================================== ======================= =======================
Net charge-offs to average loans outstanding:
Business lending 0.07% 0.17% 0.39% 0.25%
Consumer mortgage 0.01% 0.04% 0.01% 0.06%
Consumer installment 0.46% 0.72% 0.36% 0.67%
Total loans 0.17% 0.30% 0.25% 0.32%
(1) This reserve is attributable to loans purchased from ES&L Bancorp in
August 2006.
As displayed in Table 10, net charge-offs during the third quarter were $1.1
million, $0.7 million lower than the equivalent 2005 period. All portfolios,
consumer mortgage, installment portfolios and business lending, experienced
decreased levels of charge-offs. The net charge-off ratio (net charge-offs as a
percentage of average loans outstanding) for the third quarter was 0.17%,
thirteen basis points lower than the comparable quarter of 2005, and 16 basis
points lower than average charge-off ratio for the previous eight quarters. On a
year to date basis, net charge-offs decreased $0.9 million versus the prior year
period, while average loans were up $97.9 million, resulting in a seven basis
point decline in the net charge-off ratio to 0.25%. Net charge-offs and the
corresponding net charge-off ratios are at their lowest level in years.
The business lending net charge-off ratio for the quarter improved 45 basis
points to 0.07%, the consumer mortgage portfolio experienced a one basis point
improvement in it's net charge-off ratio and the consumer installment net
charge-off ratio increased by 24 basis points to 0.46%. For the year-to-date
period, the business lending net charge-off ratio increased 14 basis points,
while the consumer mortgage and consumer installment charge-off ratios improved
five basis points and 31 basis points, respectively. The increase in business
lending charge-offs was adversely impacted by three commercial relationships in
the auto industry.
A loan loss allowance of $35.5 million was determined as of September 30, 2006,
necessitating a $1.3 million loan loss provision for the quarter, compared to
$2.3 million one year earlier. The third quarter 2006 loan loss provision was
$0.2 million higher than net charge-offs. The allowance for loan losses rose
$3.1 million or 9.4% over the last 12 months, slightly less than the 10.4%
growth in the loan portfolio. Contributing to the changes was the acquired
Elmira loans and reserves, with a coverage ratio of 1.27%. Consequently, the
ratio of allowance for loan loss to loans outstanding decreased two basis points
to 1.33% for the third quarter, as compared to the levels at December 31, 2005
and September 30, 2005. The decrease is attributable to the favorable
charge-off, non-performing and delinquencies trends experienced over the same
time period.
Deposits
As shown in Table 11, average deposits of $3.1 billion in the third quarter were
up $119.1 million compared to fourth quarter 2005 and increased $110.2 million
versus the same quarter of last year. Excluding the impact of the Elmira
acquisition, average deposits increased $51.0 million and $42.1 million as
compared to the fourth and third quarters of the prior year, respectively. The
mix of average deposits changed slightly in the first nine months of 2006. The
weightings of time deposits and interest checking deposits increased from their
fourth quarter levels, while demand, savings and money market deposit weightings
decreased. As interest rates continue to rise, time deposits have continued to
attract more funds, as evidenced by their 7.6% and 9.4% increases, excluding the
impact of the Elmira acquisition, as compared to the fourth and third quarters
of 2005, respectively. Interest checking account
26
balances are above the prior year levels primarily as a result of new product
initiatives that commenced in the second quarter of 2006. This shift in mix,
combined with increasing interest rates on money market and time deposit
accounts increased the quarterly cost of interest-bearing deposits from 2.19% in
the first quarter of 2006 to 2.55% in the most recent quarter, noticeably above
the 1.83% for the quarter ended September 30, 2005.
Average third quarter IPC (individuals and businesses) deposits increased $88.6
million or 3.2% versus the fourth quarter of 2005, and were up $73.3 million or
2.6% compared to the year earlier period. Excluding the impact of the Elmira
acquisition, average third quarter IPC deposits increased $20.5 million and $5.3
million from the fourth and third quarters of the prior years, respectively.
Average public funds have increased $30.5 million or 15.8% and $36.8 million or
19.7% over the same periods. The increase in core deposits is the result of
ongoing enhanced marketing efforts and new product offerings introduced
throughout 2006.
Table 11: Quarterly Average Deposits
September 30, December 31, September 30,
(000's omitted) 2006 2005 2005
---------------------------- ------------- ------------ -------------
Demand deposits $ 558,060 $ 596,508 $ 601,702
Interest checking deposits 364,762 307,738 308,297
Savings deposits 464,037 484,908 506,408
Money market deposits 332,277 351,029 353,342
Time deposits 1,379,074 1,238,945 1,218,291
---------------------------- ------------- ------------ -------------
Total deposits $3,098,210 $2,979,128 $2,988,040
============================ ============= ============ =============
IPC deposits $2,874,584 $2,785,967 $2,801,255
Public fund deposits 223,626 193,161 186,785
---------------------------- ------------- ------------ -------------
Total deposits $3,098,210 $2,979,128 $2,988,040
============================ ============= ============ =============
Borrowings
At the end of the third quarter, borrowings of $709 million were up $55.9
million from December 31, 2005 and up $2.3 million versus the end of the third
quarter of 2005. Excluding the borrowings related to the Elmira acquisition,
external borrowings have declined approximately $33 million and $87 million from
the fourth quarter and third quarter of 2005. The reduction in borrowings was
principally the result of the decision to use a portion of the cash flows from
the maturities of investments to reduce debt levels in the current flat or
inverted yield curve environment.
The Company is currently in the process of reviewing market alternatives for the
replacement of its $30 million, fixed-rate trust preferred obligations, which
include a premium call provision currently at 4.54%, starting in February 2007.
The Company estimates the impact of the one-time charge associated with this
refinancing to be between $0.04 and $0.05 per share, and expects to conclude its
evaluation in the fourth quarter.
Shareholders' Equity
On April 20, 2005, the Company announced that its Board of Directors had
authorized a stock repurchase program to acquire up to 1.5 million of its
shares, or approximately 5% of its outstanding common stock. The shares may be
repurchased from time to time, in open market or privately negotiated
transactions through December 31, 2006. All reacquired shares will become
treasury shares and will be used for general corporate purposes. Through
September 30, 2006, the Company had repurchased 853,161 shares at an aggregate
cost of $19.5 million.
Total shareholders' equity of $465 million at the end of the third quarter
increased $7.0 million from the balance at December 31, 2005. This change
consisted of net income of $30.2 million, $2.8 million from shares issued under
the employee stock plan and $1.5 million from employee stock options earned,
partially offset by a decrease in the after-tax market value adjustment on the
available-for-sale investment portfolio of $4.6 million, dividends declared of
$17.3 million and treasury stock purchases of $5.5 million. Over the past 12
months total shareholders' equity increased by $4.1 million, as net income and
positive contributions from shares issued under the employee stock plan more
than offset dividends declared, treasury stock purchases, and a lower market
value adjustment.
27
The Company's Tier I leverage ratio, a primary measure of regulatory capital for
which 5% is the requirement to be "well-capitalized," was 7.26% at the end of
the third quarter, down 31 basis points from year-end 2005 and eight basis
points lower than its level one year ago. The decrease in the Tier I leverage
ratio compared to December 31, 2005 is primarily the result of a 1.1% decrease
in shareholders equity excluding intangibles and market value adjustment, with a
3.1% increase in average assets excluding intangibles and market value
adjustment, primarily as a result of the Elmira acquisition. The decrease in
Tier I as compared to the prior year third quarter is the result of a 0.5%
increase in shareholders equity excluding intangibles and market value
adjustment combined with a 1.7 % increase in average assets excluding
intangibles and market value adjustment. The tangible equity-to-assets ratio of
5.44% decreased 48 basis points versus December 31, 2005 and 42 basis points
versus September 30, 2005 due to the acquisition of Elmira, treasury share
purchases and a decline in the market value adjustment.
The dividend payout ratio (dividends declared divided by net income) for the
first nine months of 2006 was 57.3%, up from 39.1% for the first nine months of
2005. Excluding securities gains, the dividend payout ratio for 2005 was 49.6%.
The ratio increased because dividends declared increased 4.4%, while net income
including securities gains decreased 28.8% and net income excluding securities
gains decreased 9.7%. The expansion of dividends declared was caused by the
dividend per share being raised 5.3% in August 2006, from $0.19 to $0.20 and
5.6% in August 2005 from $0.18 to $0.19, partially offset by a reduction in the
number of shares outstanding.
Liquidity
Management of the Company's liquidity is critical due to the potential for
unexpected fluctuations in deposits and loans. Adequate sources of both on and
off-balance sheet funding are in place to effectively respond to such unexpected
fluctuations.
The Company's primary approach to measuring liquidity is known as the Basic
Surplus/Deficit model. It is used to calculate liquidity over two time periods:
first, the amount of cash that could be made available within 30 days
(calculated as liquid assets less short-term liabilities); and second, a
projection of subsequent cash availability over an additional 60 days. The
minimum policy level of liquidity under the Basic Surplus/Deficit approach is
7.5% of total assets for both the 30 and 90-day time horizons. As of September
30, 2006, this ratio was 13.8% for 30 days and 13.7% for 90 days, 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.
Forward-Looking Statements
This document contains comments or information that constitute forward-looking
statements (within the meaning of the Private Securities Litigation Reform Act
of 1995), which involve significant risks and uncertainties. Actual results may
differ materially from the results discussed in the forward-looking statements.
Moreover, the Company's plans, objectives and intentions are subject to change
based on various factors (some of which are beyond the Company's control).
Factors that could cause actual results to differ from those discussed in the
forward-looking statements include: (1) risks related to credit quality,
interest rate sensitivity and liquidity; (2) the strength of the U.S. economy in
general and the strength of the local economies where the Company conducts its
business; (3) the effect of, and changes in, monetary and fiscal policies and
laws, including interest rate policies of the Board of Governors of the Federal
Reserve System; (4) inflation, interest rate, market and monetary fluctuations;
(5) the timely development of new products and services and customer perception
of the overall value thereof (including features, pricing and quality) compared
to competing products and services; (6) changes in consumer spending, borrowing
and savings habits; (7) technological changes; (8) any acquisitions or mergers
that might be considered or consummated by the Company and the costs and factors
associated therewith; (9) the ability to maintain and increase market share and
control expenses; (10) the effect of changes in laws and regulations (including
laws and regulations concerning taxes, banking, securities and insurance) and
accounting principles generally accepted in the United States; (11) changes in
the Company's organization, compensation and benefit plans and in the
availability of, and compensation levels for, employees in its geographic
markets; (12) the costs and effects of litigation and of any adverse outcome in
such litigation; (13) other risk factors outlined in the Company's filings with
the Securities and Exchange Commission from time to time; and (14) the success
of the Company at managing the risks of the foregoing.
The foregoing list of important factors is not all-inclusive. Such
forward-looking statements speak only as of the date on which they are made and
the Company does not undertake any obligation to update any forward-looking
statement, whether written or oral, to reflect events or circumstances after the
date on which such statement is made. If the Company does update or correct one
or more forward-looking statements, investors and others should not conclude
that the Company would make additional updates or corrections with respect
thereto or with respect to other forward-looking statements.
28
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, 2006 as a starting point.
o There are assumed to be conservative levels of balance sheet growth--low
to mid single digit growth in loans and deposits, while using the
cashflows from investment contractual maturities and prepayments to repay
short-term capital market borrowings.
o The prime rate and federal funds rates are assumed to move up 200 basis
points and down 100 basis points over a 12-month period while moving the
long end of the treasury curve to spreads over federal funds that are more
consistent with historical norms. Deposit rates are assumed to move in a
manner that reflects the historical relationship between deposit rate
movement and changes in the federal funds rate.
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, 2006
-----------------------------------------------------
+ 200 basis points (0.8%)
- 100 basis points (0.3%)
The modeled net interest income remains neutral to changes in interest rates
over a 12-month period. Over a longer time period, however, the growth in net
interest income improves in a rising rate environment as a result of lower
yielding earning assets running off and being replaced at increased rates.
The analysis does not represent a Company forecast and should not be relied upon
as being indicative of expected operating results. These hypothetical estimates
are based upon numerous assumptions: the nature and timing of interest rate
levels (including yield curve shape), prepayments on loans and securities,
deposit decay rates, pricing decisions on loans and deposits,
reinvestment/replacement of asset and liability cash flows, and other factors.
While the assumptions are developed based upon current economic and local market
conditions, the Company cannot make any assurances as to the predictive nature
of these assumptions, including how customer preferences or competitor
influences might change. Furthermore, the sensitivity analysis does not reflect
actions that ALCO might take in responding to or anticipating changes in
interest rates.
29
Item 4. Controls and Procedures
The Company maintains disclosure controls and procedures, as defined in Rule 13a
- 15(e) under the Securities Exchange Act of 1934, designed to ensure that it is
able to collect the information it is required to disclose in the reports that
are filed with the Securities and Exchange Commission, (SEC), and to process,
summarize and disclose this information within the time periods specified in the
rules of the SEC. Based on management's evaluation of the Company's disclosure
controls and procedures, with the participation of the Chief Executive Officer
and the Chief Financial Officer, it has concluded that, as of the end of the
period covered by this Quarterly Report on Form 10-Q, these disclosure controls
and procedures were effective as of September 30, 2006.
There have been no changes in the Company's internal controls over financial
reporting in connection with the evaluation referenced in the paragraph above
that occurred during the Company's last fiscal quarter that has materially
affected, or is reasonably likely to materially affect, the Company's internal
control over financial reporting.
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 1A. Risk Factors
There has not been any material change in the risk factors disclosure from that
contained in the Company's 2005 Form 10-K for the fiscal year ended December 31,
2005.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
On April 20, 2005, the Company announced a twenty-month authorization to
repurchase up to 1,500,000 of its outstanding shares in open market or privately
negotiated transactions. These repurchases will be for general corporate
purposes, including those related to stock plan activities. The following table
shows treasury stock purchases during the third quarter 2006.
Number of Average Price Total Number of Shares Maximum Number of Shares
Shares Paid Purchased as Part of Publicly That May Yet Be Purchased
Purchased Per share Announced Plans or Programs Under the Plans or Programs
-----------------------------------------------------------------------------------------------------------------------------
July 2006 -- $ -- 852,761 647,239
August 2006 400 20.17 853,161 646,839
September 2006 -- -- 853,161 646,839
-----------------------------------------------------------------------------------------------------------------------------
Total 400 $ 20.17 853,161 646,839
=============================================================================================================================
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, 2006.
Item 5. Other Information.
Not applicable
30
Item 6. Exhibits
Exhibit No. Description
----------- -----------
2.2 Agreement and Plan of Merger, dated August 2, 2006, by and among
Community Bank System, Inc., Seneca Acquisition Corp. and ONB
Corporation.
31.1 Certification of Mark E. Tryniski, 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 Kingsley, Treasurer and Chief Financial
Officer of the Registrant, pursuant to Rule 13a-15(e) or Rule
15d-15(e) under the Securities Exchange Act of 1934, as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Mark E. Tryniski, 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 Kingsley, Treasurer and Chief Financial
Officer of the Registrant, pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002
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 8, 2006 /s/ Mark E. Tryniski
--------------------
Mark E. Tryniski, President, Chief
Executive Officer and Director
Date: November 8, 2006 /s/ Scott Kingsley
------------------
Scott Kingsley, Treasurer and Chief
Financial Officer
32