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Community Bank System, Inc. (NYSE:CBU)

Q3 2008 Earnings Call

October 20, 2008 11:00 am ET

Executives

Mark E. Tryniski - President and Chief Executive Officer

Scott A. Kingsley - Executive Vice President and Chief Financial Officer

Analysts

Damon Delmonte - Keefe, Bruyette & Woods

Amanda Larson - Raymond James and Associates

David Darst - Ftn Midwest Securities Corp

Richard Weiss - Janney Montgomery Scott LLC

John Stewart - Sandler O’Neill

Operator

Welcome to the Community Bank Third Quarter Conference Call. (Operator Instructions).

Please note that this presentation contains forward-looking statements within the provisions of the Private Securities Litigation Reform Act of 1995 that are bases on current expectations, estimates, and projections about the industry, markets, and economic environment in which the company operates. Such statements involve risks and uncertainties that could cause actual results to differ materially from the results discussed in this statement. These risks are detailed in the company’s annual report and Form 10-K filed with the Securities and Exchange Commission.

Now I would like to introduce our speakers for today’s call, Mark Tryniski, President and Chief Executive Officer and Scott A. Kingsley, Executive Vice President and Chief Financial Officer of Community Bank System.

Mark Tryniski

I understand that [Vernakey] and Paulsen have an 11:30 public meeting so we will try to be brief here.

Our third quarter operating and financial performance met our objectives with EPS up 7% over 2007 and year-to-date earnings likewise up 11% over 2007. We continue to execute against our objective of achieving structural improvements to our balance sheet; those being, on the asset side, reducing securities and drawing loans and on the liability side reducing time deposits and growing core deposits.

Over the trailing 12 months we have grown loans over $200 million while reducing securities by $125 million. Over that same period we have reduced time deposits by $170 million and grown core deposits nearly $100million.

Asset quality continues to be strong, although net charge-offs were up a bit as a result of a sole commercial lending relationship and Scott may comment on that further. Our non-performing and delinquency metrics are solid and we see not indications of imminent stress in any of our portfolios. Our markets remain stable, including the real estate markets, but we need to be vigilant. The credit crisis has clearly begun to spread more broadly to the consumer and expectations of a recessionary economic environment are looming. Although our markets have held up better than most across the country, we are not immune to a broad based recession and we will continue to be vigilant and disciplined in our credit administration and operating decisions.

With respect to the Citizens Branch acquisition we announced in the second quarter we are making good progress on the conversion and integration of these 18 branches in Northern New York and remain on target to close in early November.

Also, as previously announced, we completed a secondary offering earlier this month raising nearly $50 million of common equity to provide capital support for the Citizens Branch. The offering was significantly over subscribed allowing us to increase the capital rates from two million shares to approximately two and a half million shares. We were very pleased with the outcome of the offering, particularly given these very difficult and challenging times for the capital markets.

Earlier in the quarter we announced an increase in our quarterly dividend from $0.21 per share to $0.22 which is out 14th dividend increase in the past 15 years and, as I said in the press release, underscores our continuing commitment to provide steady, growing, long-term returns to our shareholders.

Overall the third quarter and all of 2008 to date has met our exceeded our operating objectives. We improved our balance sheet, have continued capital strength, very solid asset quality, and strong earnings performance. The fourth quarter will be a busy one for us with the Citizens closing, but we think we are well positioned to finish the year strong.

With that I will ask Scott to give us more commentary on our financial report.

Scott Kingsley

Our third quarter earnings of $11.8 million or $0.39 per share were $0.8 million above the $11.0 million reported in the third quarter of 2007 or a 7% improvement. As Mark mentioned, solid loan and core deposit growth, continued expansion of non-interest income sources, and improved net interest margin and stable asset quality resulted in the improved quarterly operating results.

Cash earnings per share, which excludes the after tax effects of the amortization of intangible assets and acquisition related adjustments were $0.44 per share in the third quarter, a full $0.05 per share above GAAP reported results. Year-to-date earnings of $34.0 million or $1.13 per share were 11% above the $1.02 per share reported in the first nine months of 2007.

I will first discuss the balance sheet.

Our average earnings assets of $4.25 billion were up just $21 million from the third quarter of 2007. Although we produced very solid organic loan growth we have chosen not to fully re-invest investment cash flows over the last 12 months.

We grew average loans by $188 million from last year, including $46 million in business lending, $68 million in consumer mortgages, and $74 million in consumer installment products.

Average investment securities, including cash equivelants, were down $157 million from the third quarter of last year, but do reflect a higher proportion of cash flows being reinvested in tax-exempt securities.

Average deposits were $3.25 billion for the third quarter of 2008 down 2% or $70 million from last years third quarter; however consistent with our focus on expanding core count relationships and reducing higher cost timed deposit levels balances in core product relationships grew $99 million or 5.4% since last years third quarter, while time deposits were allowed to decline $169 million.

Third quarter average borrowings of $926 million increased $57 million from the second quarter of this year in anticipation of the significant additional liquidity we won’t be receiving from the Citizens Branch acquisition.

Loans grew organically $82 million in the third quarter and are up 6.5% or $183 million for the year. This [inaudible] growth was 4.4% from the end of 2007 or 5.9% annualized. Year-to-date consumer mortgages have grown 6.3% and consumer installment products are up 9.0%.

Our capital [inaudible] in the third quarter remains strong. The tier 1 leverage ratio stood at 7.73% at quarter end and our tangible equity ratio was 5.01%. Our third quarter dividend payout ration was 56% of GAAP earnings and just 50% of cash earnings, allowing for continued meaningful capital build.

The carrying value of our level 3 investment assets, which is almost entirely comprised of pool trust preferred securities, declined $11.6 million from the end of the second quarter. The valuation changes reflect market and interest rate volatility as well as the absence of an active market for these types of securities. Our holdings, which are super senior and AAA rated, continue to fully perform.

Checking out the income statement our reported net interest margin for the third quarter was 3.82%, up 26 basis points from the third quarter of 2007 and up 4 basis points from the second quarter. Proactive management of funding costs resulted in the year-over-year improvement as total funding costs declined 63 basis points from last years third quarter and were partially offset by a 37 basis point decline in earning asset yields.

The loan loss provision for the quarter was $2.0 million compared to $1.6 million in the second quarter of 2008 and $0.05 million in last years third quarter. Net charge-offs for the third quarter were $1.7 million up from the $0.9 million reported in the second quarter and up $0.9 million from a very favorable third quarter of last year and did include one $0.5 million charge on a single commercial relationship which was specifically reserved for it in a previous quarter.

Our loan loss allowance to total loans outstanding stood at 1.25% at quarter end versus 1.27% at June 30 and 1.31% a year ago. This small decline in coverage ratio is due to the $82 million of loan growth experienced in the third quarter combined with a stable underwriting credit profile of our balance portfolios. In addition, our coverage ratio of non-performing loans stood at 325% at quarter end compared to 388% at the end of last years third quarter.

Quarter end non-performing assets to total assets outstanding were at 0.25% consistent with the level reported at the end of the second quarter. This favorable and stable asset quality profile is primarily the result of our credit risk management programs and continued emphasis on and adherence to disciplined underwriting standards.

Third quarter non-interest income, excluding securities gains and losses and debt refunding charges was up 10% over the prior year. Our employee benefits administration and consulting business increased revenues by 26% over last years third quarter principally on the strength of acquired growth from the Alliance Benefit Group MidAtlantic transaction completed in early July.

Deposit service fees increased 8% over last year driven by additional account relationships and growing card related revenues. All their banking services revenues, which included nearly $650,000.00 of annual dividends from the creditor license and disability programs in which we participate, were down $338,000.00 from last years third quarter.

Our wealth management businesses posted a 2% year-over-year growth overcoming less than favorable third quarter and full year market conditions through growth in insurance agency revenues and certain other products.

Operating expenses of $39.3 million increased $2.5 million or 7% over the third quarter of 2007, nearly half of which related to the AZG acquisition completed in July. In addition the company recorded higher FDIC insurance premiums, incurred higher volume based processing costs and increased facility based utilities and maintenance costs over last year. Year-to-date operating expenses were up 9.4% from 2007 and include the three acquisitions completed since May of last year.

Our effective tax rate in the third quarter was 22.5% consistent with the first half of 2008 and down from 24.3% reported in the third quarter of 2007, reflecting a higher level of income from tax-exempt sources.

We will now take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Damon Delmonte - Keefe, Bruyette & Woods.

Damon Delmonte - Keefe, Bruyette & Woods

Scott, I was wondering if you could quantify for us from a myelin perspective what we should look for, for intangible amortization with the branch acquisition closing this quarter.

Scott Kingsley

Yes we are not quite there yet in terms of the evaluation of that. It certainly depends on the characteristics of what we actually inherit, but I think what we have looked at and we may have talked about this before is we are range modeling the 15% to 20% of the entire intangible or 15% to 20% of the $75 million anticipated intangible would be something we would be amortizing. We will be determining that from a useful life standpoint over the course of the next 45 days or so. My anticipation would be the useful life that would probably be 8 to 10 years that we would be using an accelerated model for that.

Damon Delmonte - Keefe, Bruyette & Woods

Any guidance on how the acquisition will impact the margin?

Scott Kingsley

Probably not at this point; the reason I say that is that consistent with what we said before we do expect to inherit about $400 million of net liquidity. So, I think the margin determination will really be dependent on how fast we are successful at deploying that net $400 million into multiple classes of assets, because as you know, we certainly won’t be deploying them into loans or our expectation wouldn’t be that we would deploy them into loans over the next one year.

I think given some of the market volatility we certainly don’t want to rush into investment decisions, so I think we will be pretty disciplined in how we redeploy that.

Damon Delmonte - Keefe, Bruyette & Woods

Lastly on the branch acquisition any estimated fee income from these deposits? You know like do you have a perspective of what they were generating under Citizens?

Scott Kingsley

I think actually it will be very consistent on sort of a ratio basis to what you see to our existing portfolio.

Damon Delmonte - Keefe, Bruyette & Woods

Any comment on the TARP plan?

Scott Kingsley

Well let’s hope it works.

Damon Delmonte - Keefe, Bruyette & Woods

How about specific to you guys?

Scott Kingsley

We are looking at it. I mean certainly 5% tier 1 capital is advantageous. It is something that we are looking at the opportunity to participate in whether there are opportunities that would be accretive to shareholder value over the next three to five years if we did participate. I do have some concerns about the qualitative implications of smaller banks like us participating in a program that is deemed to be bail our or corporate welfare or whatever words you want to use to describe it. I do have some qualitative concerns with it, but if it is something that we can make use of productively to create shareholder value over the next three to five years. As I said that is something that we’re looking at right now in terms of what those options are.

Damon Delmonte - Keefe, Bruyette & Woods

Scott if I heard you correctly you said the decline in the trust deferreds was about $11.6 million of fair value this quarter?

Scott Kingsley

It was David, you heard that exactly right.

Damon Delmonte - Keefe, Bruyette & Woods

Okay so if I run the numbers through, your amortize class is $73 million so now they are being held at about $50 million so roughly $0.69 on the dollar?

Scott Kingsley

Very close David, right. We are at the 69% of par and about 67% of amortized cost stress.

Operator

Your next question comes from Amanda Larson from Raymond James and Associates.

Amanda Larson - Raymond James and Associates

I wanted to know about the NIM with the branch purchase, but also throw in there the recent Fed action?

Scott Kingsley

Certainly our net interest margin, we expect it to decline in the fourth quarter, because we don’t think we’ll deploy that net $400 million at earning asset yields that are consistent with our $4.25 billion today, but we would certainly think that the net interest margin itself, we expect it to product more net interest income. But, we expect the net interest margin itself to contract some.

Relative to your second question and this is probably consistent with what we said in the first quarter of this year, that the recent Fed actions and the existence probably of one more coming at months end will actually impact near-term results negatively. In other words, we have more assets that will re-price themselves in the short-term so we would expect to have negative results of that. It is not significant, but at the same point in time something we think we would recover from over time.

Again, as the rates continue to come down towards these historic lows in that 1% range for the Fed funds rate, how far one can actually go on the deposits side, at some point in time there is a floor out there certainly at [debt] zero. That being said, our ability to recover that on the deposit side might be a little bit more elongated as the rate structure gets lower.

Operator

Your next question comes from David Darst from Ftn Midwest Securities Corp.

David Darst - Ftn Midwest Securities Corp

Could you give us the revenues that you received from ABG during the period?

Scott Kingsley

During the third quarter revenues from ABG were approximately $1.3 million and expenses were approximately $1.2.

David Darst - Ftn Midwest Securities Corp

Then can you give us an idea of what the expense base will be for the 18 branches and the number of FTEs?

Scott Kingsley

I don’t have an annual expense number to give you at this point in time. I think we are inheriting about 100 SGEs, but I think we do know that since we are putting on a growth of 15% to our balance sheet that there is going to need to be some infrastructure invested relative to oversight.

Again, we certainly like our structure as it exists in Northern New York today, but we have already made a couple of internal investments and moved some people around to accommodate some leadership in anticipation of these 18 branches.

David Darst - Ftn Midwest Securities Corp

Then how about giving us the change you made to the balance sheet with liquidity, will there be any changes to your tax rate next year?

Scott Kingsley

Actually I think the anticipation should be that our tax rate in 2009 would be a little bit higher; there are a couple reasons for that. We expect to be generating taxable income from lending and depository activities that will probably be fully taxable and we expect it to be all in the state of New York and we would expect our New York state rate to move up a little bit also.

David Darst - Ftn Midwest Securities Corp

Could you comment on your loan pipeline and then the ability to continue to grow through the winter which might be counter cyclical?

Scott Kingsley

Well it has been David, as you know. Clearly the first quarter of 2008 we performed quite well and the second and third quarters have both been extraordinarily strong, I think about $80 million of growth this quarter. I think it’s close to that the second quarter. The first quarter was strong.

I mean I would tell you that our current growth rate, I would not expect that necessarily to continue. I think we’ve done a good job improving our organic business development capability and execution skills. We hit the markets more aggressively and we’ve made [inaudible] in that business as we talked about in 2007, as far back in 2007 to improve those business development capabilities. They are starting to yield very positive results for sure, but I think that given the markets that we’re in, the nature of those markets, we expect them to hopefully continue to be stable, but I don’t think we’re going to get an above average growth rate.

In terms of modeling I would use less loan growth than what we’ve delivered the last three or four quarters. I think we’ve always said over the winter months if we can grow just a bit in the fourth quarter, break even in the first quarter, we typically really get it done in the second and third quarters. I would probably use that for modeling going forward.

David Darst - Ftn Midwest Securities Corp

Will there be any negative impact from LIBOR spiking through the quarter end?

Scott Kingsley

We do not have a lot in terms of LIBOR based lending assets, if that is where the question was going on the loan side. We do have about $400 million in variable mainly prime based, some of those are LIBOR based, but the majority of them are prime based commercial lending relationships. That includes commercial and non-commercial in home equity, so in total wise in the portfolio about $400 million effective immediately re-price able assets. Not much on the LIROR side. I don’t know what the number is, the dollar wise number, but my guess is it would be under $150 million, maybe under $25 million.

David Darst - Ftn Midwest Securities Corp

And that is probably on the liability side with your trust preferreds?

Scott Kingsley

Actually we are into a fixed swap on the trust preferreds, so it is 643 for the indefinite future.

Operator

Your next question comes from Richard Weiss from Janney.

Richard Weiss - Janney Montgomery Scott LLC

I was wondering with respect to the investment securities or in cash you are picking up for the branches, what are your plans with those. Would they be running down, I suppose, or continue, how is that going to go?

Mark Tryniski

As Scott commented, given the market environment we are going to need to be a bit disciplined in how we deploy that liquidity, which is going to be significant. As much as we have tried hard over the past trailing four quarters, as long as we reduce that securities portfolio, I think it lifted up a little bit this quarter in anticipation of the need to deploy that liquidity.

I think the objective of reducing the securities as a percentage of our overall earning asset is going to be, we are going to have a hill to climb here with the Citizens transaction. I think that is still an objective, we want to have a slightly higher loan to deposit ratio and reduce that, increase the level of loans in core banking relationships and reduce securities levels. It is just given the near term impact of the Citizens acquisition, that is just probably going to move in a different direction for a period of time until we can continue to grow that loan portfolio.

Scott Kingsley

In terms of that ultimate redeployment into the investment portfolio, our expectations today are to look for bullet agency securities, other municipal securities, stuff that we’re good at and understand already. We are not anticipating introducing another asset class to the mix in the investment securities set.

Richard Weiss - Janney Montgomery Scott LLC

Does it make sense to pay down any borrowings?

Scott Kingsley

We monitor that Rick and in the current environment it does not look like that. Currently in terms of the impact of taking a capital charge to exit some of our term borrowings early, but we will continue to monitor that and certainly this level of liquidity will allow us to be monitoring that on a concurrent basis. Debt refinancing is also one of the options we are looking at with respect to the TARP.

Richard Weiss - Janney Montgomery Scott LLC

Then I was wondering with the plan benefits and consulting expense, it seems like those numbers jump around a bit. What would be a good run rate to use?

Scott Kingsley

On the expense side or?

Richard Weiss - Janney Montgomery Scott LLC

On both, I guess.

Scott Kingsley

Well I think if you looked at the third quarter benefits administration revenue side, I think we made the comment that most of our improvement has been related to the ABG acquisition we completed in July. One of the reasons is there is some proportion of our revenues in that line of business that is attached to market valuation or account balances or the plans for the administrator for and those were clearly down all of this year, but have been down substantially in the third quarter.

On the expense side and I think David had asked this a couple different times, I think the third quarter expense side is fairly representative of what we would expect on a going-forward basis in terms of our expense load, because we basically did have that ABG acquisition for the entire quarter.

I will say this, we certainly know that from a utilities and a maintenance standpoint we are more extensive in the winter than we are in the summer, so there is a little bit of seasonality that bumps around there. Again, the only thing for modeling purposes to remind people from a seasonality standpoint is that the first quarter of every year we tend to be down relative to deposit service fees. I think that’s just utilization of product face up. Other than that there are really not a whole lot of things that are “seasonal”.

Richard Weiss - Janney Montgomery Scott LLC

Is there anything that is going on in relation to asset quality either from quantitative or qualitative point of view that would suggest raising the loss reserves at this time?

Scott Kingsley

Right now, again, we continue to have, if you look at rolling 36-month charge offs in our portfolio the numbers are still actually down, so in other words the third quarter of 2005 as an example, had a higher charge-off level than the third quarter of 2008. I think that is a very important window for us to look at in terms of recent results, is this rolling 36. We certainly look out further than that and try to assess how close are we to some of the dynamics that we may have seen in the 2001, 2002 time frame in terms of general economic conditions, but right now there is really nothing that is out there imminent that supports raising the number.

In fairness, if you were to pull out that specifically reserved loan that we charged off in the third quarter from the reserves at the end of the second quarter, because it was specifically reserved for, you’ll find the coverage ratios 125 for the second quarter also.

Richard Weiss - Janney Montgomery Scott LLC

It definitely looks good now, I was just wondering what you are seeing and like watch list or what loan officers are telling you about your customers, if you are seeing any kinds of more signs of stress.

Scott Kingsley

I think no. As I based in my comments, there are no signs of imminent stress. I think the concern on the part of our folks on the ground is this notion that the consumer is pulling back; that businesses are pulling back; that there is fear of a recession that is looming that is going to be broad based and could actually impact our market. But, I would say that is where the, if there is any sense of concern that is the genesis of it.

Operator

Your last question comes from John Stewart of Sandler O’Neill.

John Stewart - Sandler O’Neill

I wanted to piggyback Rick’s question. If there is not enough evidence out there to suggest that the reserve will be listed is there enough to suggest that it will stop going lower? The reserve has trended kind of from the mid 130s as a percent of loans down to the mid 120s. Is there enough to suggest that you will stop kind of lowering that number from here?

Mark Tryniski

I think what we’re looking at right now would suggest that we are providing for more than charge offs for the last four quarters in terms of that. Despite actually having improved underlying qualitative statistics we are providing more than charge offs to the portfolio. Again I think that we would actually expect to see the lower loan growth volumes in the fourth quarter and in the first quarter of 2009 which also might suggest that some of that “stress” on pushing the coverage ratio down wouldn’t be quite as profound.

Again, I think in terms of the mechanics of how that works, until the qualitative attributes actually suggest that you should lean a different direction, I think we could see that move in that range that is in the 120s or if certain conditions changed it could move back up from 125 to maybe sort of 130. I think that is a fair range.

Operator

There are no further calls.

Mark Tryniski

Thank you all for joining us. We will talk at the end of the year.

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