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 June 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
[LOGO] 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.
29,853,043 shares of Common Stock, $1.00 par value,
were outstanding on August 3, 2006.
TABLE OF CONTENTS
Page
----
Part I. Financial Information
Item 1. Financial Statements (Unaudited)
Consolidated Statements of Condition
June 30, 2006 and December 31, 2005 ................................ 3
Consolidated Statements of Income
Three and six months ended June 30, 2006 and 2005 .................. 4
Consolidated Statement of Changes in Shareholders' Equity
Six months ended June 30, 2006 ..................................... 5
Consolidated Statements of Comprehensive Income
Three and six months ended June 30, 2006 and 2005 .................. 6
Consolidated Statements of Cash Flows
Six months ended June 30, 2006 and 2005 ............................ 7
Notes to the Consolidated Financial Statements
June 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 ...... 28
Item 4. Controls and Procedures ........................................ 29
Part II. Other Information
Item 1. Legal Proceedings .............................................. 29
Item 1A. Risk Factors ................................................... 29
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds .... 29
Item 3. Defaults Upon Senior Securities ................................ 29
Item 4. Submission of Matters to a Vote of Securities Holders .......... 29
Item 5. Other Information .............................................. 29
Item 6. Exhibits ....................................................... 30
2
Part 1. Financial Information
Item 1. Financial Statements
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF CONDITION (Unaudited)
(In Thousands, Except Share Data)
June 30, December 31,
2006 2005
----------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents $ 124,453 $ 114,605
Available-for-sale investment securities, at fair value 1,110,403 1,160,612
Held-to-maturity investment securities (fair value of $135,767 and $139,512, respectively) 142,799 142,505
----------------------------------------------------------------------------------------------------------------------------
Total investment securities 1,253,202 1,303,117
----------------------------------------------------------------------------------------------------------------------------
Loans 2,444,266 2,411,769
Allowance for loan losses (32,900) (32,581)
----------------------------------------------------------------------------------------------------------------------------
Net loans 2,411,366 2,379,188
----------------------------------------------------------------------------------------------------------------------------
Core deposit intangibles, net 25,346 28,147
Goodwill 195,195 195,195
Other intangibles, net 1,355 1,536
----------------------------------------------------------------------------------------------------------------------------
Intangible assets, net 221,896 224,878
----------------------------------------------------------------------------------------------------------------------------
Premises and equipment, net 63,827 65,175
Accrued interest receivable 24,910 25,216
Other assets 40,070 40,813
----------------------------------------------------------------------------------------------------------------------------
Total assets $ 4,139,724 $ 4,152,992
============================================================================================================================
Liabilities:
Non-interest bearing deposits $ 557,236 $ 601,544
Interest bearing deposits 2,482,346 2,382,425
----------------------------------------------------------------------------------------------------------------------------
Total deposits 3,039,582 2,983,969
Federal funds purchased 6,800 36,300
Borrowings 506,197 536,288
Subordinated debt held by unconsolidated subsidiary trusts 80,530 80,502
Accrued interest and other liabilities 55,039 58,338
----------------------------------------------------------------------------------------------------------------------------
Total liabilities 3,688,148 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; 32,603 32,451
32,603,192 and 32,450,563 shares issued in 2006 and 2005, respectively
Additional paid-in capital 199,610 196,312
Retained earnings 284,801 276,809
Accumulated other comprehensive income (3,638) 8,420
Treasury stock, at cost (2,752,761 and 2,493,711 shares, respectively) (61,608) (56,074)
Employee stock plan - unearned (192) (323)
----------------------------------------------------------------------------------------------------------------------------
Total shareholders' equity 451,576 457,595
----------------------------------------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $ 4,139,724 $ 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 Six Months Ended
June 30, June 30,
-------------------- --------------------
2006 2005 2006 2005
------------------------------------------------------------------------------------------------ --------------------
Interest income:
Interest and fees on loans $ 39,760 $ 36,157 $ 78,088 $ 71,659
Interest and dividends on taxable investments 10,735 12,925 21,205 26,495
Interest and dividends on nontaxable investments 5,883 5,701 11,678 11,852
------------------------------------------------------------------------------------------------ --------------------
Total interest income 56,378 54,783 110,971 110,006
------------------------------------------------------------------------------------------------ --------------------
Interest expense:
Interest on deposits 14,620 10,284 27,641 19,463
Interest on short-term borrowings 1,150 3,852 2,608 6,778
Interest on subordinated debt held by unconsolidated subsidiary trusts 1,872 1,627 3,687 3,196
Interest on long-term borrowings 5,231 2,964 9,910 6,811
------------------------------------------------------------------------------------------------ --------------------
Total interest expense 22,873 18,727 43,846 36,248
------------------------------------------------------------------------------------------------ --------------------
Net interest income 33,505 36,056 67,125 73,758
Less: provision for loan losses 1,725 2,134 3,875 4,009
------------------------------------------------------------------------------------------------ --------------------
Net interest income after provision for loan losses 31,780 33,922 63,250 69,749
------------------------------------------------------------------------------------------------ --------------------
Non-interest income:
Deposit service fees 7,167 6,703 13,841 12,780
Other banking services 361 241 837 766
Benefit plan administration, consulting and actuarial fees 3,155 2,639 6,536 5,489
Trust, investment and asset management fees 1,766 1,859 3,816 3,640
Gain on sales of investment securities -- 5,164 -- 6,890
------------------------------------------------------------------------------------------------ --------------------
Total non-interest income 12,449 16,606 25,030 29,565
------------------------------------------------------------------------------------------------ --------------------
Operating expenses:
Salaries and employee benefits 16,425 16,212 33,207 32,378
Occupancy and equipment 4,448 4,282 9,207 8,872
Data processing and communications 3,333 3,479 6,564 6,785
Amortization of intangible assets 1,489 1,984 2,982 3,968
Legal and professional fees 1,108 1,107 2,391 2,290
Office supplies and postage 1,083 952 2,059 1,890
Business development and marketing 1,084 898 1,814 1,587
Other 2,238 2,286 4,419 4,461
------------------------------------------------------------------------------------------------ --------------------
Total operating expenses 31,208 31,200 62,643 62,231
------------------------------------------------------------------------------------------------ --------------------
Income before income taxes 13,021 19,328 25,637 37,083
Income taxes 3,137 5,047 6,291 9,468
------------------------------------------------------------------------------------------------ --------------------
Net income $ 9,884 $ 14,281 $ 19,346 $ 27,615
================================================================================================ ======== ========
Basic earnings per share $ 0.33 $ 0.47 $ 0.65 $ 0.91
Diluted earnings per share $ 0.33 $ 0.46 $ 0.64 $ 0.89
Dividends declared per share $ 0.19 $ 0.18 $ 0.38 $ 0.36
The accompanying notes are an integral part of the consolidated financial
statements.
4
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)
Six Months Ended June 30, 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 19,346 19,346
Other comprehensive loss, net of tax (12,058) (12,058)
Dividends declared:
Common, $0.38 per share (11,354) (11,354)
Common stock issued under
employee stock plan,
including tax benefits of $381 152,629 152 2,251 131 2,534
Employee stock options earned 1,047 1,047
Treasury stock purchased (259,050) (5,534) (5,534)
-----------------------------------------------------------------------------------------------------------------------------------
Balance at June 30, 2006 29,850,431 $32,603 $199,610 $284,801 ($3,638) ($61,608) ($192) $451,576
===================================================================================================================================
The accompanying notes are an integral part of the consolidated financial
statements.
5
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
(In Thousands)
Three Months Ended Six Months Ended
June 30, June 30,
--------------------- ---------------------
2006 2005 2006 2005
------------------------------------------------------------------------------------------ ---------------------
Other comprehensive loss, before tax:
Change in minimum pension liability adjustment $0 $0 ($118) $0
Unrealized losses on securities:
Unrealized holding losses arising during period (11,572) 15,551 (19,495) (3,168)
Reclassification adjustment for gains included in net income 0 (5,164) 0 (6,890)
------------------------------------------------------------------------------------------ ---------------------
Other comprehensive loss, before tax: (11,572) 10,387 (19,613) (10,058)
Income tax benefit related to other comprehensive loss 4,439 (4,008) 7,555 3,947
------------------------------------------------------------------------------------------ ---------------------
Other comprehensive loss, net of tax: (7,133) 6,379 (12,058) (6,111)
Net income 9,884 14,281 19,346 27,615
------------------------------------------------------------------------------------------ ---------------------
Comprehensive income $2,751 $20,660 $7,288 $21,504
========================================================================================== =====================
The accompanying notes are an integral part of the consolidated financial
statements.
6
COMMUNITY BANK SYSTEM, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(In Thousands)
Six Months Ended
June 30,
-----------------------
2006 2005
--------------------------------------------------------------------------------------------------------------
Operating activities:
Net income $ 19,346 $ 27,615
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation 4,348 4,144
Amortization of intangible assets 2,982 3,968
Net amortization of premiums and discounts on securities and loans 440 463
Amortization of unearned compensation and discount on subordinated debt 64 154
Provision for loan losses 3,875 4,009
Gain on investment securities and debt extinguishments 0 (6,890)
Gain on sale of loans and other assets (187) (57)
Proceeds from the sale of loans held for sale 9,372 0
Origination of loans held for sale (9,375) 0
Excess tax benefits from share-based payment arrangements (198) 0
Change in other operating assets and liabilities 6,607 6,398
--------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 37,274 39,804
--------------------------------------------------------------------------------------------------------------
Investing Activities:
Proceeds from sales of available-for-sale investment securities 28,409 150,638
Proceeds from maturities of held-to-maturity investment securities 3,299 3,371
Proceeds from maturities of available-for-sale investment securities 56,987 67,054
Purchases of held-to-maturity investment securities (3,682) (7,946)
Purchases of available-for-sale investment securities (55,042) (138,398)
Net increase in loans outstanding (36,044) (23,466)
Capital expenditures (2,810) (5,145)
--------------------------------------------------------------------------------------------------------------
Net cash (used in) provided by investing activities (8,883) 46,108
--------------------------------------------------------------------------------------------------------------
Financing Activities:
Net change in demand deposits, NOW accounts and savings accounts (22,642) 23,878
Net change in time deposits 78,255 23,975
Net change in federal funds purchased (29,500) 20,300
Net change in short-term borrowings (140,000) (243,000)
Change in long-term borrowings (net of payments of $91 and $148) 109,909 99,852
Issuance of common stock 2,150 2,327
Purchase of treasury stock (5,534) (15,297)
Cash dividends paid (11,379) (10,959)
Tax benefits from share-based payment arrangements 198 0
--------------------------------------------------------------------------------------------------------------
Net cash provided by (used in) financing activities (18,543) (98,924)
--------------------------------------------------------------------------------------------------------------
Change in cash and cash equivalents 9,848 13,012
Cash and cash equivalents at beginning of period 114,605 118,405
--------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 124,453 $ 105,393
==============================================================================================================
Supplemental disclosures of cash flow information:
Cash paid for interest $ 41,457 $ 34,458
Cash paid for income taxes 2,082 7,131
Supplemental disclosures of non-cash financing and investing activities:
Dividends declared and unpaid 5,670 5,466
Gross change in unrealized gains on available-for-sale investment securities (19,495) (10,058)
The accompanying notes are an integral part of the consolidated financial
statements.
7
COMMUNITY BANK SYSTEM, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
June 30, 2006
NOTE A: BASIS OF PRESENTATION
The interim financial data as of June 30, 2006 and for the three and six months
ended June 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: OTHER MATTERS
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 June 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.
On April 21, 2006, the Company announced an agreement to acquire ES&L Bancorp,
Inc. (ES&L) in an all-cash transaction valued at approximately $39 million. ES&L
is the parent company of Elmira Savings and Loan, F.A., a federally chartered
thrift operating as a community bank. The company has two branches in the cities
of Elmira and Ithaca, New York, as well as mortgage and title insurance
subsidiaries, all of which combine to total approximately $210 million in
assets, including $190 million in loans. The acquisition is expected to close in
August 2006.
On April 20, 2005, the Company announced a twenty-month authorization to
repurchase up to 1,500,000 of its outstanding shares. Through June 30, 2006, the
Company has repurchased against this authorization 852,761 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.
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.
8
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 prescribes a
recognition threshold and measurement attribute for financial statement
recognition and measurement of a tax position taken or expected to be taken in a
tax return, and 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.
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 (161,793) 13.93 (7,545) 23.09
Forfeited (14,888) 22.72 (4,106) 24.35
--------------------------------------------------------------------- -----------------------------------
Outstanding at June 30, 2006 2,761,220 19.22 9,443 23.59
--------------------------------------------------------------------- -----------------------------------
Exercisable at June 30, 2006 1,864,717 $17.58 -- --
===================================================================== ===================================
The weighted average remaining contractual term of outstanding and exercisable
stock options at June 30, 2006 is 7.0 years and 6.4 years, respectively. The
aggregate intrinsic value of outstanding and exercisable stock options at June
30, 2006 is $8.0 million and $7.3 million, respectively.
9
The Company adopted Statement of Financial Accounting Standards ("SFAS") No.
123(R), Share-Based Payment, 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 No.
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, Accounting for Stock-Based Compensation. 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 six
months ended June 30, 2006, the Company recognized stock-based compensation
expense related to incentive and non-qualified stock options of $421,000 and
$1.0 million, respectively and a related income tax benefit of $53,000 and
$188,000, respectively. Compensation expense related to restricted stock
recognized in the income statement for the three and six months ended June 30,
2006 was $15,000 and $31,000, respectively. Compensation expense related to
restricted stock recognized in the income statement for the three and six months
ended June 30, 2005 was $86,000 and $122,000, respectively.
The following table illustrates the effect on net income and earnings per share
if the fair value based method established in FAS No. 123(R) had been applied in
2005:
Three months ended Six months ended
(000's omitted except per share amounts) June 30, 2005 June 30, 2005
-------------------------------------------------------------------------------------------------------
Net income, as reported $14,281 $27,615
Plus: stock-based compensation expense as reported, net of tax 43 78
Less: stock-based compensation expense determined under
fair value method, net of tax (390) (895)
-------------------------------------------------------------------------------------------------------
Pro forma net income $13,934 $26,798
=======================================================================================================
Earnings per share:
As reported:
Basic $ 0.47 $ 0.91
Diluted $ 0.46 $ 0.89
Pro forma:
Basic $ 0.46 $ 0.88
Diluted $ 0.45 $ 0.87
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.
Six months ended June 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 $4.7 million at June 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 1.8 years. The total fair
value of shares vested during the six months ended June 30, 2006 and 2005 were
$1.5 million and $1.7 million, respectively.
During the six months ended June 30, 2006 and 2005, proceeds from stock option
exercises totaled $2.3 million and $2.6 million and the related windfall tax
benefits from exercise were approximately $198,000 and $562,000, respectively.
During the six months ended June 30, 2006 and 2005, 161,793 and 248,927 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 six months ended June 30, 2006
and 2005 were $1.3 million and $3.2 million, respectively.
10
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 1,382,613 anti-dilutive stock options outstanding for
the three and six months ended June 30, 2006 compared to 412,561 anti-dilutive
stock options outstanding for the three and six months ended June 30, 2005. The
following is a reconciliation of basic to diluted earnings per share for the
three and six months ended June 30, 2006 and 2005.
Per Share
(000's omitted, except per share data) Income Shares Amount
-----------------------------------------------------------------------------
Three Months Ended June 30, 2006
Basic EPS $9,884 29,946 $0.33
Stock options 362
----------------------------------------------------------------
Diluted EPS $9,884 30,308 $0.33
================================================================
Three Months Ended June 30, 2005
Basic EPS $14,281 30,401 $0.47
Stock options 539
----------------------------------------------------------------
Diluted EPS $14,281 30,940 $0.46
================================================================
Six Months Ended June 30, 2006
Basic EPS $19,346 29,984 $0.65
Stock options 409
----------------------------------------------------------------
Diluted EPS $19,346 30,393 $0.64
================================================================
Six Months Ended June 30, 2005
Basic EPS $27,615 30,490 $0.91
Stock options 575
----------------------------------------------------------------
Diluted EPS $27,615 31,065 $0.89
================================================================
11
NOTE F: INTANGIBLE ASSETS
The gross carrying amount and accumulated amortization for each type of
intangible asset are as follows:
As of June 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 $63,161 ($37,815) $25,346 $63,161 ($35,014) $28,147
Other intangibles 2,750 (1,395) 1,355 2,750 (1,214) 1,536
------------------------------------ -------------------------------------- -------------------------------------
Total amortizing intangibles 65,911 (39,210) 26,701 65,911 (36,228) 29,683
Non-amortizing intangible assets:
Goodwill 195,195 0 195,195 195,195 0 195,195
------------------------------------ -------------------------------------- -------------------------------------
Total intangible assets, net $261,106 ($39,210) $221,896 $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
-----------------------------
July-Dec 2006 $2,962
2007 5,569
2008 5,262
2009 4,777
2010 2,965
Thereafter 5,166
----------------- --------
Total $26,701
================= ========
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% (8.56%) 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% (8.73%) 7/31/2031 5 year beginning 2006 107.5000% declining
to par in 2011
====================================================================================================================================
12
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 six months ended June 30 is as follows:
Pension Benefits Post-retirement Benefits
------------------------------------------- -------------------------------------------
Three Months Ended Six Months Ended Three Months Ended Six Months Ended
June 30, June 30, June 30, June 30,
------------------- ------------------- ------------------- -------------------
(000's omitted) 2006 2005 2006 2005 2006 2005 2006 2005
------------------------------------------------------------ ------------------- ------------------- -------------------
Service cost $ 748 $ 630 $ 1,496 $ 1,282 $ 127 $ 110 $ 261 $ 220
Interest cost 634 657 1,267 1,302 116 104 237 207
Expected return on plan assets (827) (876) (1,654) (1,754) 0 0 0 0
Net amortization and deferral 315 331 631 635 26 19 54 39
Amortization of prior service cost (42) 29 (84) 59 26 28 55 55
Amortization of transition obligation $ 0 0 0 0 11 10 20 21
------------------------------------------------------------ ------------------- ------------------- -------------------
Net periodic benefit cost $ 828 $ 771 $ 1,656 $ 1,524 $ 306 $ 271 $ 627 $ 542
============================================================ =================== =================== ===================
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:
June 30, December 31,
(000's omitted) 2006 2005
------------------------------------------------------------
Commitments to extend credit $420,000 $434,640
Standby letters of credit 23,157 25,638
------------------------------------------------------------
Total $443,157 $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 six months ended June 30, 2006 and 2005, although in some
circumstances the first 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, "second quarter" refers to the quarter ended June 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 27.
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.
Second quarter and June year-to-date (YTD) earnings per share were $0.33 and
$0.64, respectively, a decrease of $0.13 and $0.25 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 Standard (FAS) 123R, Share-Based Payment, and
the absence of gains on the sale of investment securities recorded in the second
quarter and first half of 2005. These were partially offset by higher loan
interest income, higher non-interest income (excluding gains on sales of
investment securities), and lower recurring operating expenses excluding stock
option expense. Cash earnings per share (which excludes the after-tax effect of
the amortization of intangibles assets and acquisition-related market value
adjustments) were $0.37 versus $0.52 for the prior year's second quarter and
$0.35 for the first quarter of 2006.
Asset quality improved in the second quarter of 2006 in comparison to the first
quarter 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. The size of the investment portfolio was below
that of second 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 second quarter of 2006 as compared to the first
quarter of 2006 and the second quarter of 2005. Borrowings, principally
overnight borrowings and other short-term instruments, decreased during the same
time periods.
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.
As of June 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.
The Company announced in April 2006 it had entered into an agreement to acquire
ES&L Bancorp, Inc. (ES&L), a $210 million asset bank based in Elmira, New York,
in an all-cash transaction valued at approximately $39 million. The transaction
is expected to close in the third quarter.
Net Income and Profitability
As shown in Table 2, earnings per share for the second quarter and June YTD of
$0.33 were $0.64, respectively, were $0.13 and $0.25 lower than the EPS
generated in the same periods of last year. Net income for the quarter of $9.9
million was 31% lower than the second quarter of 2005 and net income of $19.3
million for the first six months of 2006 decreased 30% from the amount earned in
the first six months of 2005. As compared to the first quarter of 2006, net
income increased $0.4 million or 4.5% and earnings per share increased $0.02 or
6.5%.
Second quarter net interest income of $33.5 million was down $2.6 million or
7.1% from the prior year comparable period, while net interest income for the
first six months of 2006 decreased $6.6 million or 9.0% over the first half of
2005. The provision for loan losses decreased $0.4 million or 19.2% as compared
to the second quarter of 2005 and decreased $0.1 million for the first six
months of 2006 compared to 2005 as a result of strong asset quality. Second
quarter non-interest income, excluding securities gains was $12.4 million, up
$1.0 million (8.8%) from second quarter 2005 and the YTD amount of $25.0 million
rose $2.4 million or 10.4% from the prior year level. Security gains for the
second quarter and YTD period decreased $5.2 million and $6.9 million,
respectively. Operating expenses of $31.2 million for the quarter and $62.6
million for the first six months of 2006 were up less than one percent from the
comparable prior year periods. Excluding the impact of adopting FASB 123R,
Accounting for Stock Based Compensation, operating expenses for the second
quarter and YTD period decreased 1.3% and 1.0%, respectively, from the prior
year periods.
15
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 second
quarter and the first six months of 2006 were $0.37 and $0.72, respectively,
down 29% and 27% from the $0.52 and $0.99 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 gains 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 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 $5.2 million and $6.9 million of gains on the sale of
securities recognized in the second quarter and first six 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 decreased
primarily due to reductions in the amortization of intangibles and customer
processing costs, partially offset by increased occupancy costs and business
development and marketing expenditures.
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 Six Months Ended
June 30, June 30,
--------------------- ---------------------
(000's omitted) 2006 2005 2006 2005
--------------------------------------- --------------------- ---------------------
Net income $ 9,884 $14,281 $19,346 $27,615
After-tax cash adjustments:
Amortization of premium on net
assets acquired in merger 207 241 412 214
Amortization of intangible assets 1,130 1,465 2,250 2,955
--------------------------------------- --------------------- ---------------------
Net income - cash $11,221 $15,987 $22,008 $30,784
======================================= ===================== =====================
Table 2: Summary Income Statements
Three Months Ended Six Months Ended
June 30, June 30,
---------------------- ----------------------
(000's omitted, except per share data) 2006 2005 2006 2005
---------------------------------------------- ---------------------- ----------------------
Net interest income $33,505 $36,056 $67,125 $73,758
Provision for loan losses 1,725 2,134 3,875 4,009
Non-interest income excluding security gains 12,449 11,442 25,030 22,675
Gains on sales of investment securities 0 5,164 0 6,890
Operating expenses 31,208 31,200 62,643 62,231
---------------------------------------------- ---------------------- ----------------------
Income before taxes 13,021 19,328 25,637 37,083
Income taxes 3,137 5,047 6,291 9,468
---------------------------------------------- ---------------------- ----------------------
Net income $9,884 $14,281 $19,346 $27,615
============================================== ====================== ======================
Diluted earnings per share $ 0.33 $ 0.46 $ 0.64 $ 0.89
Diluted earnings per share - cash (1) $ 0.37 $ 0.52 $ 0.72 $ 0.99
(1) Cash earnings are reconciled to GAAP net income in Table 1.
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.
16
As shown in Table 3, net interest income (with non-taxable income converted to a
fully tax-equivalent basis) for second quarter 2006 was $37.3 million, down $2.3
million or 5.9% from the same period last year. A $77.6 million decrease in
interest earning assets and a 16basis point decrease in the net interest margin
more than offset a $90.1 million decrease in average interest-bearing
liabilities. As reflected in Table 4, the volume and net interest margin changes
mentioned above adversely impacted net interest income by $0.8 million and $1.5
million, respectively, for the second quarter of 2006 as compared to the second
quarter of 2005. June 2006 YTD net interest income of $74.3 million was down
$6.7 million or 8.3% from the year-earlier period. A $122.8 million decrease in
earning assets and a 22 basis point decrease in the net interest margin more
than offset a $152.6 million decrease in interest bearing liabilities. Interest
bearing asset and liability volume changes resulted in $2.5 million less net
interest income, while a lower net interest margin had a negative $4.2 million
impact on net interest income.
Higher second quarter and June YTD average loan balances were attributable to
$73.3 million of organic loan growth since the second quarter of 2005, driven by
growth in all portfolios: consumer installment, consumer mortgage and business
lending. Average investments for the second quarter and YTD periods were $174
million and $201 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
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. Total average
deposits were up $54.7 million or 1.8% and $43.2 million or 1.5% for the quarter
and YTD periods, respectively, as compared to the previous year as a result of
growth in both IPC and public fund balances. Cash flows from the investment
sales were used to pay down external borrowings throughout 2005, resulting in
average quarterly and YTD borrowings being $166 million and $204 million lower
in the second quarter of 2006 and the first six months of 2006, in comparison to
the comparable 2005 periods.
The net interest margin of 4.00% for the second quarter and 4.03% for the year
to date period dropped 16 basis points and 22 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 51 basis points, YTD up 50 basis
points), due principally to the effect of the eight rate hikes (25 basis points
each) by the Federal Reserve since June 2005, while earning assets yields
increased at a slower rate (quarter up 32 basis points, YTD up 25 basis points).
The change in the earning-asset yield was driven by increases in loan yields of
41 basis points for the quarter and 37 basis points for the YTD period, while
investment yields increased 14 basis points for the quarter and two basis points
for the YTD period.
The second quarter cost of funds increased 51 basis points due to a 55 basis
point increase in deposit costs and a 98 basis point increase in the average
interest rate paid on external borrowings. The increase in the YTD cost of funds
was driven by a 53 basis point increase in deposit costs and borrowing rates
that were up 111 basis points. Interest rates on selected categories of deposit
accounts were raised throughout 2005 and the first half of 2006 in response to
the Federal Reserve rate increases. Additionally, customers continued to
transfer funds from low rate and non-interest earning instruments to higher
yielding money market 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 approximately 190 basis
point increase in the 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) June 30, 2006 June 30, 2005
---------------------------------------------------------------------------------------------------------------------------------
Avg. Avg.
Average Yield/Rate Average Yield/Rate
Balance Interest Paid Balance Interest Paid
---------------------------------------------------------------------------------------------------------------------------------
Interest-earning assets:
Time deposits in other banks $ 24,084 $ 299 4.98% $ 803 $ 10 4.87%
Taxable investment securities (1) 770,614 10,843 5.64% 943,212 13,289 5.65%
Non-taxable investment securities (1) 518,309 9,093 7.04% 519,873 8,741 6.75%
Loans (net of unearned discount) 2,425,763 39,890 6.60% 2,352,473 36,276 6.19%
--------------------- ---------------------
Total interest-earning assets 3,738,770 60,125 6.45% 3,816,361 58,316 6.13%
------- -------
Non-interest earning assets 429,125 490,483
---------- ----------
Total assets $4,167,895 $4,306,844
========== ==========
Interest-bearing liabilities:
Interest checking, savings and money market deposits $1,130,655 $ 2,775 0.98% $1,183,283 $ 2,189 0.74%
Time deposits 1,330,126 11,845 3.57% 1,202,087 8,095 2.70%
Short-term borrowings 127,208 1,150 3.63% 462,913 3,852 3.34%
Long-term borrowings 509,102 7,103 5.60% 338,957 4,591 5.43%
--------------------- ---------------------
Total interest-bearing liabilities 3,097,091 22,873 2.96% 3,187,240 18,727 2.36%
------- ------- -------
Non-interest bearing liabilities:
Demand deposits 566,143 586,812
Other liabilities 52,253 64,440
Shareholders' equity 452,408 468,352
---------- ----------
Total liabilities and shareholders' equity $4,167,895 $4,306,844
========== ==========
Net interest earnings $37,252 $39,589
======= =======
Net interest spread 3.49% 3.77%
Net interest margin on interest-earnings assets 4.00% 4.16%
Fully tax-equivalent adjustment $ 3,747 $ 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
Six Months Ended Six Months Ended
(000's omitted except yields and rates) June 30, 2006 June 30, 2005
-----------------------------------------------------------------------------------------------------------------------------------
Avg. Avg.
Average Yield/Rate Average Yield/Rate
Balance Interest Paid Balance Interest Paid
-----------------------------------------------------------------------------------------------------------------------------------
Interest-earning assets:
Time deposits in other banks $ 12,652 $ 310 4.94% $ 858 $ 14 3.30%
Taxable investment securities (1) 775,477 21,685 5.64% 957,550 27,200 5.73%
Non-taxable investment securities (1) 520,200 17,867 6.93% 538,633 18,235 6.83%
Loans (net of unearned discount) 2,413,414 78,322 6.54% 2,347,465 71,867 6.17%
---------------------- ----------------------
Total interest-earning assets 3,721,743 118,184 6.40% 3,844,506 117,316 6.15%
-------- --------
Non-interest earning assets 434,689 498,707
---------- ----------
Total assets $4,156,432 $4,343,213
========== ==========
Interest-bearing liabilities:
Interest checking, savings and money market deposits $1,128,696 $ 5,289 0.94% $1,183,840 $ 4,141 0.71%
Time deposits 1,307,007 22,352 3.45% 1,200,589 15,322 2.57%
Short-term borrowings 145,473 2,608 3.62% 449,620 6,778 3.04%
Long-term borrowings 489,104 13,597 5.61% 388,824 10,007 5.19%
---------------------- ----------------------
Total interest-bearing liabilities 3,070,280 43,846 2.88% 3,222,873 36,248 2.27%
-------- --------
Non-interest bearing liabilities:
Demand deposits 577,711 585,747
Other liabilities 53,171 64,638
Shareholders' equity 455,270 469,955
---------- ----------
Total liabilities and shareholders' equity $4,156,432 $4,343,213
========== ==========
Net interest earnings $ 74,338 $ 81,068
======== ========
Net interest spread 3.52% 3.88%
Net interest margin on interest-earnings assets 4.03% 4.25%
Fully tax-equivalent adjustment $ 7,213 $ 7,310
(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
Six Months Ended June 30, 2006 versus
2nd Quarter 2006 versus 2nd Quarter 2005 June 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 $ 289 $ 0 $ 289 $ 286 $ 10 $ 296
Taxable investment securities (2,430) (16) (2,446) (5,096) (419) (5,515)
Non-taxable investment securities (26) 378 352 (630) 262 (368)
Loans (net of unearned discount) 1,154 2,460 3,614 2,058 4,397 6,455
Total interest-earning assets (2) (1,203) 3,012 1,809 (3,812) 4,680 868
Interest paid on:
Interest checking, savings and money
market deposits (101) 687 586 (201) 1,349 1,148
Time deposits 931 2,819 3,750 815 6,215 7,030
Short-term borrowings (3,009) 307 (2,702) (4,327) 157 (4,170)
Long-term borrowings 2,370 142 2,512 2,219 1,371 3,590
Total interest-bearing liabilities (2) (543) 4,689 4,146 (970) 8,568 7,598
Net interest earnings (2) $ (794) $(1,543) $(2,337) $(2,536) $(4,194) $(6,730)
(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 (Elias Asset Management or EAM); and periodic
transactions, most often net gains (losses) from the sale of investment
securities and prepayment of term debt.
Table 5: Non-interest Income
Three Months Ended Six Months Ended
June 30, June 30,
(000's omitted) 2006 2005 2006 2005
--------------------------------------------- ---------------------- ----------------------
Deposit service charges and fees $ 7,167 $ 6,703 $13,841 $12,780
Benefit plan administration, consulting
and actuarial fees 3,155 2,639 6,536 5,489
Trust, investment and asset management fees 1,766 1,859 3,816 3,640
Other banking services 303 297 593 657
Mortgage banking 58 (56) 244 109
--------------------------------------------- ---------------------- ----------------------
Subtotal 12,449 11,442 25,030 22,675
Gain on sales of investment securities 0 5,164 0 6,890
--------------------------------------------- ---------------------- ----------------------
Total non-interest income $12,449 $16,606 $25,030 $29,565
============================================= ====================== ======================
Non-interest income/total income (FTE) 25.0% 29.6% 25.2% 26.7%
As displayed in Table 5, non-interest income (excluding securities gains) was
$12.4 million in the second quarter and $25.0 million for the first half of
2006. This corresponded to increases of $1.0 million (8.8%) for the quarter and
$2.4 million (10.4%) for the YTD period in comparison to one year earlier. A
significant portion of the growth in both time intervals was attributable to the
$0.5 million and $1.1 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 higher utilization of deposit service
products. Offsetting these increases, was the absence of gains on the sales of
investment securities which equaled $5.2 million and $6.9 million for the second
quarter and first six months of 2005, as the Company took advantage of market
conditions to sell certain securities in the first half of 2005 in order to
shorten the average length of the portfolio and maximize their expected total
return.
Strong performance at BPA-Harbridge generated revenue growth of $0.5 million
(20%) for the quarter and $1.0 million (19%) for the first six months of 2006,
achieved primarily through enhanced service offerings to both new and existing
clients. Trust service revenue was up $0.1 million or 17% for the quarter and
$0.3 million or 30% for the first six months of 2006 as compared to the prior
year periods, primarily as a result of the generation of estate settlement fees.
In comparison to the second quarter of the prior year, EAM and CISI revenues
were down due to softer demand for their traditional investment products.
Year-to-date, CISI revenue has increased as compared to the first half of 2005,
while EAM was down for the same period.
The ratio of non-interest income to total income (FTE basis) was 25.0% for the
quarter and 25.2% for the year-to-date period versus 29.6% and 26.7% for the
comparable periods in 2005. Excluding net security gains, the ratio of
non-interest income to total income (FTE basis) was 25.0% and 25.2% for the
second quarter and YTD periods of 2006, respectively, as compared to 22.4% and
21.9% 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 Six Months Ended
June 30, June 30,
(000's omitted) 2006 2005 2006 2005
-------------------------------------- ---------------------- ----------------------
Salaries and employee benefits $16,004 $16,212 $32,402 $32,378
Stock option expense 421 0 1,047 0
Occupancy and equipment 4,448 4,282 9,207 8,872
Data processing and communications 3,333 3,479 6,564 6,785
Amortization of intangible assets 1,489 1,984 2,982 3,968
Legal and professional fees 1,108 1,107 2,149 2,290
Office supplies and postage 1,083 952 2,059 1,890
Business development and marketing 1,084 898 1,814 1,587
Other 2,238 2,286 4,419 4,461
-------------------------------------- ---------------------- ----------------------
Total operating expenses $31,208 $31,200 $62,643 $62,231
====================================== ====================== ======================
Operating expenses/average assets 3.00% 2.91% 3.04% 2.89%
Efficiency ratio 59.8% 57.2% 60.0% 56.1%
As shown in Table 6, second quarter 2006 operating expenses were $31.2 million,
consistent with the prior year level and $0.2 million below the first quarter of
2006. Year-to-date operating expenses of $62.6 rose $0.4 million or 0.7%
compared to 2005. Excluding the effect of adopting FASB 123R, Share-Based
Payment, operating expenses decreased $0.4 million or 1.3% for the second
quarter and $0.6 million or 1.0% for the first six months of 2006 as compared to
the prior year periods. The decrease was primarily attributable to a reduction
in the amortization of intangible assets ($0.5 million for the quarter, $1.0
million YTD) and a reduction in data processing and communication expenses ($0.1
million for the quarter, $0.2 million YTD), partially offset by an increased
level of business development and marketing expenses ($0.2 million for both the
quarter and YTD) associated with a bankwide deposit generation program and an
increase in occupancy-related costs ($0.2 million for the quarter and $0.3
million YTD). Additionally, the second quarter of 2006 included $0.2 million of
costs associated with two branch consolidations.
The Company continued to manage all aspects of its operating expense structure
in the first half of 2006, resulting in operating expense, excluding the effect
of adopting FASB 123R, reductions as compared to the year earlier period. The
Company recently announced that it will consolidate 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 59.8% for the second quarter, 2.6 percentage points
above the comparable quarter of 2005. This resulted from operating expenses (as
described above) increasing 1.7% primarily due to stock option expense, while
recurring operating income decreased 2.6% due to $2.4 million lower net interest
income, partially offset by a $1.0 million increase in non-interest income
excluding security gains. The efficiency ratio for the second quarter of 2006,
excluding stock option expense was 59.0%, as compared to 57.2% in the comparable
second quarter of 2005. The efficiency ratio of 60.0% for the first half of 2006
was up 3.9 percentage points from a year earlier due to core operating expenses
increasing 2.5% while recurring operating income decreased 4.2%. Operating
expenses as a percentage of average assets increased nine basis points and 15
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 second quarter effective income tax rate was 24.1%, compared to the 26.1%
effective tax rate in the second quarter of 2005. The year-to-date effective tax
rate was 24.5% as compared to 25.5% for the first half 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 second quarter, a decrease of $50 million and $253 million from December
31, 2005 and June 30, 2005, respectively. The book value (excluding unrealized
gains) of investments decreased $30 million from year-end 2005 and declined $202
million versus June 30, 2005. The decrease in the portfolio from the second
quarter of the prior year was the result of the decision to sell certain
securities and not fully reinvest cash flows from these sales and from
contractual maturities to take advantage of market conditions to shorten the
average life of the portfolio and maximize the expected total return. 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 June
30, 2006, the portfolio had a $5.8 million net unrealized loss, a decrease of
$19.5 million and $51.5 million from the unrealized gains at December 31, 2005
and June 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. In addition, the decrease in net unrealized gains from one
year ago was impacted by the sale of $122 million of securities over the last 12
months, which generated pre-tax gains of $5.3 million.
Table 7: Investments
June 30, 2006 December 31, 2005 June 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 $ 127,273 $ 120,240 $ 127,345 $ 124,326 $ 127,418 $ 127,899
Obligations of state and political subdivisions 6,052 6,053 5,709 5,735 5,257 5,301
Other securities 9,474 9,474 9,451 9,451 9,471 9,471
--------------------------------------------------------- ----------------------- ---------------------- ----------------------
Total held-to-maturity portfolio 142,799 135,767 142,505 139,512 142,146 142,671
--------------------------------------------------------- ----------------------- ---------------------- ----------------------
Available-for-Sale Portfolio:
U.S. Treasury and Agency securities 399,555 390,970 420,062 420,808 577,103 597,548
Obligations of state and political subdivisions 510,831 517,673 519,661 532,708 525,463 547,373
Corporate securities 35,674 34,193 35,744 35,559 35,815 36,941
Collateralized mortgage obligations 57,934 56,827 78,708 78,466 82,301 82,893
Mortgage-backed securities 75,086 73,632 53,021 53,365 51,483 53,144
--------------------------------------------------------- ----------------------- ---------------------- ----------------------
Sub-total 1,079,080 1,073,295 1,107,196 1,120,906 1,272,165 1,317,899
Equity securities 37,108 37,108 39,706 39,706 46,228 46,228
--------------------------------------------------------- ----------------------- ---------------------- ----------------------
Total available-for-sale portfolio 1,116,188 1,110,403 1,146,902 1,160,612 1,318,393 1,364,127
Net unrealized gain(loss) on available-for-sale portfolio (5,785) 0 13,710 0 45,734 0
--------------------------------------------------------- ----------------------- ---------------------- ----------------------
Total $1,253,202 $1,246,170 $1,303,117 $1,300,124 $1,506,273 $1,506,798
========================================================= ======================= ====================== ======================
23
Loans
As shown in Table 8, loans ended the second quarter at $2.44 billion, up $32.5
million (1.3%) year-to-date and up $65.4 (2.8%) versus one year earlier. As
compared to the prior quarter and one year earlier, growth was produced in all
three categories. Consistent with prior years, the Company experienced softness
within our lending portfolio in the first quarter, due principally to seasonal
(weather-related) trends and demands. In the second quarter, loans increased
$36.0 million with increases in the consumer installment portfolio ($22.4
million), consumer mortgage portfolio ($7.4 million) and the business lending
portfolio ($6.3 million).
Table 8: Loans
(000's omitted) June 30, 2006 December 31, 2005 June 30, 2005
------------------------ -------------------- -------------------- --------------------
Business lending $ 827,021 33.8% $ 819,605 34.0% $ 824,007 34.6%
Consumer mortgage 822,235 33.7% 815,463 33.8% 802,787 33.8%
Consumer installment 795,010 32.5% 776,701 32.2% 752,043 31.6%
------------------------ -------------------- -------------------- --------------------
Total loans $2,444,266 100.0% $2,411,769 100.0% $2,378,837 100.0%
======================== ==================== ==================== ====================
Business lending increased $7.4 million in the first six months of 2006 and
increased $3.0 million versus one year ago. Strong commercial line of credit
activity during the first six months has more than offset a reduction in the
dealer floor plan portfolio. 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. Total
consumer mortgages increased $19.4 million year over year and $6.8 million in
the first six months of 2006, despite the Company continuing to sell certain 30
year fixed rate new mortgage originations into the secondary market for the
third consecutive quarter. Consumer mortgage growth has remained steady over the
last few quarters despite rising interest rates. Consumer installment loans,
including borrowings originated in automobile, marine and recreational vehicle
dealerships as well as branch originated home equity and installment loans, rose
$43.0 million (5.7%) on a year-over-year basis and increased $18.3 million
(2.4%) in the first six months of 2006. 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.
Asset Quality
Table 9 below exhibits the major components of non-performing loans and assets
and key asset quality metrics for the periods ending June 30, 2006 and 2005 and
December 31, 2005.
Table 9: Non-performing Assets
June 30, December 31, June 30,
(000's omitted) 2006 2005 2005
-------------------------------------------------------------- ------------ ------------ ------------
Non-accrual loans $ 9,002 $10,857 $12,455
Accruing loans 90+ days delinquent 765 1,075 898
Restructured loans 1,325 1,375 0
-------------------------------------------------------------- ------------ ------------ ------------
Total non-performing loans 11,092 13,307 13,353
Other real estate (OREO) 1,353 1,048 684
-------------------------------------------------------------- ------------ ------------ ------------
Total non-performing assets $12,445 $14,355 $14,037
============================================================== ============ ============ ============
Allowance for loan losses to total loans 1.35% 1.35% 1.35%
Allowance for loan losses to non-performing loans 297% 245% 240%
Non-performing loans to total loans 0.45% 0.55% 0.56%
Non-performing assets to total loans and other real estate 0.51% 0.59% 0.59%
Delinquent loans (30 days old to non-accruing) to total loans 1.15% 1.46% 1.32%
Net charge-offs to average loans outstanding (quarterly) 0.26% 0.35% 0.34%
Loan loss provision to net charge-offs (quarterly) 112% 106% 106%
As displayed in Table 9, non-performing assets at June 30, 2006 were $11.1
million, a decrease of $2.2 million versus year-end 2005 and a $2.3 million
decrease as compared to the level at the end of the second quarter 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 $0.7 million from one-year
ago and increased $0.3 million from year-end 2005, a result of the Company
managing 22 properties at June 30, 2006 as compared to 15 OREO properties at the
end of 2005. No one property has a carrying value in excess of $350,000.
24
Non-performing loans were 0.45% of total loans outstanding at the end of the
second quarter, significantly below the 0.56% at June 30, 2005 and the 0.55% at
year-end 2005. The allowance for loan losses to non-performing loans ratio, a
general measure of coverage adequacy, was 297% at the end of the second quarter
compared to 245% at year-end 2005 and 240% at June 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
1.15% at the end of the second quarter, substantially below the 1.46% at
year-end 2005 and 17 basis points below the 1.32% delinquency ratio at June 30,
2005. Commercial and installment loan delinquency ratios at the end of the
second quarter improved in comparison to both of the earlier periods. Real
estate loan delinquency ratios increased slightly from the second quarter of
2005, but were improved from December 31, 2005. The delinquency level at the end
of the current quarter was 26 basis points below the Company's average of 1.41%
over the previous eight quarters.
Table 10: Allowance for Loan Losses Activity
Three Months Ended Six Months Ended
June 30, June 30,
---------------------- ----------------------
(000's omitted) 2006 2005 2006 2005
-------------------------------------------------- ---------------------- ----------------------
Allowance for loan losses at beginning of period $32,720 $31,898 $32,581 $31,778
Charge-offs:
Business lending 1,201 854 2,556 1,561
Consumer mortgage 67 379 102 402
Consumer installment 1,237 1,882 2,862 3,597
-------------------------------------------------- ---------------------- ----------------------
Total charge-offs 2,505 3,115 5,520 5,560
-------------------------------------------------- ---------------------- ----------------------
Recoveries:
Business lending 125 330 239 371
Consumer mortgage 19 127 77 134
Consumer installment 816 637 1,648 1,279
-------------------------------------------------- ---------------------- ----------------------
Total recoveries 960 1,094 1,964 1,784
-------------------------------------------------- ---------------------- ----------------------
Net charge-offs 1,545 2,021 3,556 3,776
Provision for loan losses 1,725 2,134 3,875 4,009
-------------------------------------------------- ---------------------- ----------------------
Allowance for loan losses at end of period $32,900 $32,011 $32,900 $32,011
================================================== ====================== ======================
Net charge-offs to average loans outstanding:
Business lending 0.52% 0.26% 0.57% 0.29%
Consumer mortgage 0.02% 0.13% 0.01% 0.07%
Consumer installment 0.22% 0.68% 0.31% 0.64%
Total loans 0.26% 0.34% 0.30% 0.32%
As displayed in Table 10, net charge-offs during the second quarter were $1.5
million, $0.5 million lower than the equivalent 2005 period. The consumer
mortgage and installment portfolios experienced decreased levels of charge-offs,
while business lending charge-offs increased. The net charge-off ratio (net
charge-offs as a percentage of average loans outstanding) for the second quarter
was 0.26%, eight basis points lower than the comparable quarter of 2005, and
seven basis points lower than average charge-off ratio for the previous eight
quarters. On a year to date basis, net charge-offs decreased $0.2 million versus
the prior year period, while average loans were up $65.9 million, resulting in a
two basis point decline in the net charge-off ratio to 0.30%. Net charge-offs
and the corresponding net charge-off ratios are at their lowest level in two
years.
The business lending net charge-off ratio for the quarter increased 26 basis
points to 0.52%, the consumer installment net charge-off ratio improved by 46
basis points to 0.22%, and the consumer mortgage portfolio experienced an 11
basis point improvement in it's net charge-off ratio. The increase in business
lending charge-offs was adversely impacted by three commercial relationships in
the auto industry.
A required loan loss allowance of $32.9 million was determined as of June 30,
2006, necessitating a $1.7 million loan loss provision for the quarter, compared
to $2.1 million one year earlier. The second quarter 2006 loan loss provision
was $0.2 million higher than net charge-offs. The allowance for loan losses rose
$0.9 million or 2.7% over the last 12 months, consistent with the 2.8% growth in
the loan portfolio. Consequently, the ratio of allowance for loan loss to loans
outstanding remained at 1.35% for the second quarter, consistent with the levels
at December 31, 2005 and June 30, 2005.
25
Deposits
As shown in Table 11, average deposits of $3.0 billion in the second quarter
were up $47.8 million compared to fourth quarter 2005 and increased $54.7
million versus the same quarter of last year. The mix of average deposits
changed slightly in the first half 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 7.4% and 10.7% increases as compared to the fourth and second
quarters of 2005, respectively. Interest checking account 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 2.38% in the most recent quarter, noticeably above the 1.73% for the
quarter ended June 30, 2005.
Average second quarter IPC (individuals and businesses) deposits increased $16.2
million or 0.6% versus the first quarter of 2006, and were up $9.4 million or
0.3% compared to the year earlier period. Average public funds have increased
$11.0 million or 4.6% and $45.3 million or 22% over the same periods. A decrease
in IPC deposits and an inflow of public fund deposits in the first quarter is a
typical seasonal fluctuation in our markets, as payment of local property taxes
tends to shift funds from one category to the other.
Table 11: Quarterly Average Deposits
June 30, December 31, June 30,
(000's omitted) 2006 2005 2005
------------------------------ ------------ -------------- -------------
Demand deposits $ 566,143 $ 596,508 $ 586,812
Interest checking deposits 331,554 307,738 311,932
Savings deposits 462,110 484,908 521,969
Money market deposits 336,991 351,029 349,382
Time deposits 1,330,126 1,238,945 1,202,087
------------------------------ ------------ -------------- -------------
Total deposits $3,026,924 $2,979,128 $2,972,182
============================== ============= ============== =============
IPC deposits $2,775,319 $2,785,967 $2,765,920
Public fund deposits 251,605 193,161 206,262
------------------------------ ------------ -------------- -------------
Total deposits $3,026,924 $2,979,128 $2,972,182
============================== ============= ============== =============
Borrowings
At the end of the second quarter, borrowings of $594 million were down $59.6
million from December 31, 2005 and down $205 million versus the end of the
second quarter of 2005. The reduction in borrowings over the last twelve months
was principally the result of the decision to use a portion of the cash flows
from the sales and maturities of investments to reduce debt levels in the
current flat yield curve environment.
Shareholders' Equity
On April 20, 2005, the Company announced that its Board of Directors had
authorized a stock repurchase program to acquire up to 1.5 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 June
30, 2006, the Company had repurchased 852,761 shares at an aggregate cost of
$19.5 million.
Total shareholders' equity of $452 million at the end of the second quarter
decreased $6.0 million from the balance at December 31, 2005. This change
consisted of a decrease in the after-tax market value adjustment on the
available-for-sale investment portfolio of $12.0 million, dividends declared of
$11.3 million and treasury stock purchases of $5.5 million, partially offset by
net income of $19.4 million, $2.3 million from shares issued under the employee
stock plan and $1.1 from employee stock options earned. Over the past 12 months
total shareholders' equity decreased by $21.5 million, as dividends declared,
treasury stock purchases, and a lower market value adjustment more than offset
net income and positive contributions from shares issued under the employee
stock plan.
26
The Company's Tier I leverage ratio, a primary measure of regulatory capital for
which 5% is the requirement to be "well-capitalized," was 7.73% at the end of
the second quarter, up 16 basis points from year-end 2005 and 59 basis points
higher than its level one year ago. The increase in the Tier I leverage ratio
compared to December 31, 2005 is primarily the result of a 3.0% increase in
shareholders equity excluding intangibles and market value adjustment, with a
smaller 0.8% increase in average assets excluding intangibles and market value
adjustment. The increase in Tier I as compared to the prior year second quarter
is the result of a 5.8% increase in shareholders equity excluding intangibles
and market value adjustment combined with a 2.2 % decrease in average assets
excluding intangibles and market value adjustment, primarily due to the sale of
investments. The tangible equity-to-assets ratio of 5.86% decreased six basis
points versus December 31, 2005 and 13 basis points versus June 30, 2005 due to
treasury share purchases and a decline in the market value adjustment having a
greater impact on this ratio than lower asset levels.
The dividend payout ratio (dividends declared divided by net income) for the
first half of 2006 was 58.7%, up from 39.5% for the first half of 2005. The
ratio increased because dividends declared increased 4.1%, while net income
including securities gains decreased 29.9%. The expansion of dividends declared
was caused by the dividend per share being raised 5.6% in August 2005, from
$0.18 to $0.19, offset by a 1.3% decrease 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 June 30,
2006, this ratio was 13.6% for 30 days and 13.4% 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.
27
Item 3. Quantitative and Qualitative Disclosure about Market Risk
Market risk is the risk of loss in a financial instrument arising from adverse
changes in market rates, prices or credit risk. Credit risk associated with the
Company's loan portfolio has been previously discussed in the asset quality
section of Management's Discussion and Analysis of Financial Condition and
Results of Operations. Management believes that the tax risk of the Company's
municipal investments associated with potential future changes in statutory,
judicial and regulatory actions is minimal. The Company has an insignificant
amount of credit risk in its investment portfolio because essentially all of the
fixed-income securities in the portfolio are AAA-rated (highest possible
rating). Therefore, almost all the market risk in the investment portfolio is
related to interest rates.
The ongoing monitoring and management of both interest rate risk and liquidity,
in the short and long term time horizons is an important component of the
Company's asset/liability management process, which is governed by limits
established in the policies reviewed and approved annually by the Board of
Directors. The Board of Directors delegates responsibility for carrying out the
policies to the Asset/Liability Committee (ALCO) which meets each month and is
made up of the Company's senior management as well as regional and
line-of-business managers who oversee specific earning asset classes and various
funding sources. As the Company does not believe it is possible to reliably
predict future interest rate movements, it has maintained an appropriate process
and set of measurement tools, which enable it to identify and quantify sources
of interest rate risk in varying rate environments. The primary tool used by the
Company in managing interest rate risk is income simulation.
While a wide variety of strategic balance sheet and treasury yield curve
scenarios are tested on an ongoing basis, the following reflects the Company's
one-year net interest income sensitivity based on:
o Asset and liability levels using June 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
projected net interest
Change in interest rates income at June 30, 2006
------------------------------------------------------
+ 200 basis points (0.9%)
- 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
28
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 June 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 second 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
--------------------------------------------------------------------------------------------------------------
April 2006 -- $ -- 751,836 748,164
May 2006 100,925 19.96 852,761 647,239
June 2006 -- -- 852,761 647,239
--------------------------------------------------------------------------------------------------------------
Total 100,925 $ 19.96 852,761 647,239
==============================================================================================================
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 June 30, 2006.
Item 5. Other Information.
Not applicable
29
Item 6. Exhibits
Exhibit No. Description
----------- -----------
3.2 Bylaws of Community Bank System, Inc., amended March 15, 2006.
Incorporated by reference to Exhibit 3.2 to the Form 8-K filed
on June 30, 2006.
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
30
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Community Bank System, Inc.
Date: August 8, 2006
/s/ Mark E. Tryniski
--------------------
Mark E. Tryniski, President, Chief
Executive Officer and Director
Date: August 8, 2006 /s/ Scott Kingsley
------------------
Scott A. Kingsley, Treasurer and Chief
Financial Officer
31