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Community Bank System, Inc. (NYSE:CBU)

Q3 2013 Earnings Conference Call

October 23, 2013, 11:00 AM, ET

Executives

Mark E. Tryniski – President and Chief Executive Officer

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

Analysts

David W. Darst - Guggenheim Securities LLC

Collyn B. Gilbert - Keefe Bruyette & Woods, Inc.

Operator

Welcome to the Community Bank System Third Quarter 2013 Earnings Conference Call.

Please note that this presentation contains forward-looking statements within the provisions of the Private Securities Litigation Reform Act of 1995, that are based 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 these statements. These risks are detailed in the company’s annual report and Form 10-K filed with the Securities and Exchange Commission.

Today’s call presenters are Mark Tryniski, President and Chief Executive Officer; and Scott Kingsley, Executive Vice President and Chief Financial Officer. Gentlemen, you may now begin.

Mark E. Tryniski

Thank you, George. Good morning and thank you all for taking the time to join our third quarter conference call. We appreciate your interest and engagement.

We are very satisfied with the company’s operating performance of $0.54 per share in the third quarter which is a continuation and modest improvement from the results of the past two quarters. The net interest margin held in better than we expected and was supported by stable yields on our commercial banking business and lower deposit and borrowing costs.

Similar to the second quarter loan growth was strong at 9% annualized and was driven by consumer demand in the mortgage, auto lending and direct consumer businesses. Business lending was down slightly in what is an intensely competitive environment despite what we also see as improving demand and opportunity in the marketplace. Our auto business continues to grow and performed very well thanks to focused execution and market demand with the portfolio up 11% over last year's third quarter.

Our pipelines are ahead of where they typically are as we head into our seasonally softer fourth quarter, particularly the commercial pipeline which is higher than it's ever been. The total loan book is up $20 million already month-to-date so we’ve gotten off to a very productive start for Q4 as well.

Asset quality continues to be stable with only 12 basis points of loss year-to-date. Price discipline has contributed significantly for many years to the strength of our earnings performance and will continue to be a cornerstone of our operating strategy.

Growth in net interest revenues has also been an important element of our operating strategy and has been a significant contributor to operating performance this year. Banking fee income is up 9.5% this year. Wealth management revenues were up 23% and benefits administrations up 8%. Just as important there has been double-digit improvement in the margin of these businesses so we have been growing revenue at much faster pace than expenses benefiting from the greater structural operating leverage capacity as compared to the banking business.

As previously announced we have pending the acquisition of eight branches in Northeast Pennsylvania from Bank of America which we expect to close in mid December. We have already pre-invested $330 million of the proceeds at 2.71% and expect these branches to be 2% to 3% accretive to earnings and meaningfully additive to our market density and operating leverage in that region.

Also as previously announced we increased the quarterly dividend in August by a penny a share, which is our 21st consecutive year of dividend increases and which has been an important contributor to the strength of our total shareholder return for many years.

We believe we are very well positioned for the remainder of the year and beyond. We do expect continued margin pressure and more focused and disciplined growth and execution across the company. Strategically the strength of our earnings capacity and capital levels provides us with the foundation necessary continue to grow earnings, grow our dividend and deliver above average returns for our shareholders. Scott?

Scott A. Kingsley

Thank you, Mark and good morning everyone. As Mark mentioned our operating performance for the third quarter of 2013 remains very favorable. As a reminder we completed the acquisition and conversion of 16 former HSBC branches and three First Niagara branches in the third quarter of last year. So for comparative purposes the fourth quarter of 2012 was the first quarter where various operating attributes of the transactions were fully reflected.

I’ll first discuss some balance sheet items. Average earning assets of $6.47 billion for the third quarter were up $216 million or 3.5% from the second quarter and down 2.4% from the third quarter 2013 averages, reflective of the balance sheet restructuring activities completed in the first half of the year which we have previously described.

Compared to the second quarter 2013 average loans were up $86 million while average investments including cash equivalents were higher by $130 million. Average deposits were up modestly from the second quarter and the trend away from time deposit and into core checking savings and money market accounts continuing.

Average borrowings increased $245 million as we used short term credit facilities to finance the purchase of additional investment securities in anticipation of the December closing of the previously announced branch purchases from Bank of America. This productive pre-investment of acquired liquidity is similar to the strategy we deployed prior to the closing of last year's HSBC First Niagara branch transaction.

Outstandings in our business lending portfolio were down slightly from the second quarter as contractual and other unscheduled principal reductions continue to offset new loan generation. In addition line utilization characteristics remained stubbornly below historically norms. Asset quality results in this portfolio continue to be stable and favorable with net charge-offs of under 20 basis points over the last four quarters.

Our total consumer real estate portfolios of $1.92 billion comprised of $1.57 billion of consumer mortgages and $348 million of home equity instruments were up 2.4% from June from the continuation of solid organic generation.

We continue to retain in the portfolio most of our short and mid duration mortgage production in the third quarter of 2013 selling all secondary eligible 30 year instruments and were able to productively add to our outstandings at blended yields of 4.5%. Asset quality results continue to be very favorable in these portfolios with total net charge-offs over the last four quarters of $1.6 million or ten basis points of loss.

Our consumer indirect portfolio of $713 million at quarter-end was up $49 million or 7.4% from the end of the second quarter, consistent with seasonal expectations and strong regional demand characteristics. Used car valuations where the largest majority of our lending is concentrated, continued to be stable and favorable.

Net charge-offs for the last four quarters were $1.3 million or 20 basis points which we consider exceptional. With our continued bias toward A and B paper grades and the very competitive market conditions in this asset class, yields have trended lower over the last several quarters. We have continued to report very favorable net charge-off results with the third quarter 2013 results no exception.

Non-performing loans comprised of both legacy and acquired loans ended the third quarter at $24.4 million or 0.61% of total loans. Our reserves for loan losses represent 1.16% of our legacy loans and 1.10% of total outstanding and based on the trailing four quarters results represent seven years of annual net charge-offs.

As of September 30, our investment portfolio stood at $2.52 billion and was comprised of $318 million of U.S. agency and agency-backed mortgage obligations or 14% of the total; $688 million of municipal bonds or 27% and $1.38 billion of U.S. treasury securities or 55% of the total. The remaining 4% was in corporate and another debt securities including our holdings of pool trust preferred instruments, which continue to fully perform.

Our capital levels in 2013 continue to be strong. The tier one leverage ratio rose to 9.39% at quarter end, a meaningful 99 basis points increase over year-end 2012 and tangible equity-to-net tangible assets was 7.38%. Consistent with our second quarter discussion our tangible book value per share of $12.73 is down from the $13.72 per share level at the end of December 2012 and relates entirely to the decline in AOCI, nearly half of which we realized in the balance sheet restructuring activities completed earlier this year.

Excluding the effects of changes in AOCI we’d actually added meaningfully to capital over the past 12 months, primarily through consistently strong earnings results. Also as I’ve mentioned before, consistent with regulatory instructions, our calculation of the company’s tangible equity ratio includes adding back to both the numerator and denominator $31 million of deferred tax liabilities associated with tax deductible goodwill created from several of our asset acquisitions, primarily branch transactions.

Exclusion of this differential would render our comparisons to peers incomplete and since we have recently announced another branch transaction, which will create additional tax deductible goodwill I will keep mentioning it.

Shifting now to the income statement, our reported net interest margin for the third quarter was 3.94%, down four basis points from the second quarter of this year and 15 basis points above the third quarter of 2012. Year-to-date 2013 net interest margin has been positively impacted by the balance sheet restructuring activities previously described. Proactive management of deposit funding costs continues to have a positive effect on margin results, but has not been able to fully offset declining asset yields.

As mentioned in our press release incremental yield depletion from the favorable disposition of an acquired impaired commercial relationship added $0.5 million to third quarter net interest income boosting the quarterly net interest margin by three basis points. Third quarter non-interest income was up 6.7% from last year’s third quarter. The company’s employee benefits administration and consulting businesses posted a 5.4% increase in revenues from new customer additions, favorable equity market conditions and growth from the company’s metro New York actuarial consulting businesses acquired at the end of 2011.

Our wealth management group generated 20% revenue improvement from last year and included solid organic growth in trust and asset advisory services while also benefiting from favorable market conditions.

Compared to last year’s third quarter, the company generated $646,000 increase in deposit service fees or 5.4% driven by the addition of new and acquired deposit relationships and solid growth in debit card related revenues.

Quarterly operating expenses of $55.0 million increased $3.7 million or 7.2% over the third quarter of 2012 excluding acquisition expense in both periods and were reflective of the recurring operating expenses of the branch acquisitions completed in last year’s third quarter. Third quarter operating expenses were 1% above this year’s second quarter and included one additional day of payroll expenses as well as higher business development and marketing cost, including the rebranding initiative of the Pennsylvania portion of our franchise as well as continued technology investments.

Our effective tax rate in the third quarter and the first nine months of 2013 was 29.2% versus 29.1% last year reflective of a consistent level of non-taxable income to total income in the two periods.

I’ll now turn it back over to George to open the line for questions.

Question-and-Answer Section

Operator

(Operator Instructions). Our first question is from David Darst. Your line is live.

David W. Darst - Guggenheim Securities LLC

Hi, good morning.

Mark E. Tryniski

Good morning, David.

Scott A. Kingsley

Good morning, David.

David W. Darst - Guggenheim Securities LLC

I guess if we look back over the past year your deposit growth has been pretty limited following the acquisition, while your loan growth is accelerating. Could you maybe give us the contribution to loan growth that you’ve received in these new acquired branches and are you able to -- do you actually expect to continue to see some pull through as you bring up more of the loan relationships of those deposits?

Mark E. Tryniski

Yeah, I think we can probably get that point, David, I don’t know if we have in front of us. I think what we’ve historically seen and one of the attractive elements of the branch acquisition is the capacity that you have to bring over additional lending relationships. And we’ve experienced that now in almost all of the branch acquisitions we have done, we’ve done historically. So I don’t know that we have that data in front of us, I don’t think we do. But I can tell you that based on that historical transaction that’s clearly been the case.

The other thing is that we, as our business model we acquire branches from larger banks, our business model is very much defined by the Community Bank model. We push our lending authority to our branch managers and other of our staff in the branch and when we acquire branches in particular from the larger institutions which were the last, I think three transactions we've done, from larger institutions because we don’t have that lending experience or lending authority so there is a trade-off period that’s required in order to train those folks and develop the skills necessary to lend.

But our experience historically has been in fact we've typically gotten double-digit loan growth in these markets but it takes couple of years to get the staff trained up to accomplish that. We are in the process of doing that right now. In fact were highly successful in additive, in the systems branch transaction we did in the North country. We are underway right now with the staff, folks in fact many of them have lending authority already from the branch transaction last year from HSBC and First Niagara. So I expect we will do the same thing with the Bank of America folks when we bring them online in mid-December.

David W. Darst - Guggenheim Securities LLC

And should we expect to see most of this growth in residential mortgages or also in some home equity or other consumer categories?

Mark E. Tryniski

Well I think we tend to play in all, in our markets which are generally non-investment and in many cases where we need to be a provider of all assets classes in our markets. So it's consumer mortgage, consumer installment, it's auto lending, it's small and mid-sized business lending which we also do small business lending out of our branches. So we expect that we play in every asset class in our market. We test the demand in these smaller non-metropolitan markets.

David W. Darst - Guggenheim Securities LLC

Okay. Scott could you maybe just the timing of the pre-investment and how that would impact our expected deal for the fourth quarter and maybe could you quantify just from an earnings perspective what you may have brought forward relative to expected accretion?

Scott A. Kingsley

Sure, David. I do think that most of our pre-investment we have little bit of pre-investment in the month of June. We did most of the rest of it in mid-July to early August. So the lion's share of the benefit is already there in the third quarter, from an accretion standpoint and that's certainly something we will acknowledge.

We are talking a little bit of net interest income generation in the fourth quarter that would come through as a result of the pre-investment but we know what will also come through in the second half of December because we expect to close mid month in December would be the operating cost associated with those branches and the fee income attached to the huge group of [court files] that we are acquiring from Bank of America.

My guess is we won't see much impact of the acquisition for the last two weeks of the year but that's the opportunity you should think about for first quarter of 2014.

In terms David, of other sort of investment type dialogue we think we've got about $180 million of natural cash flows coming out of our portfolio over the course of next 15 months. So fourth quarter this year and all of next year one of the concentrated spots of investment that do come due or come to maturity levels are some tax free instruments, some municipal instruments, that are little bit hard to replace in the markets today and they be some of the fully taxable securities in terms of just the inventory stuff that we are comfortable looking that.

So there is a little bit of a play as the affected tax rate it would not adjust for redeploying of capital into a similar tax free instrument.

David W. Darst - Guggenheim Securities LLC

Okay. And how you think about the margin going into the fourth quarter?

Scott A. Kingsley

I think we believe this David, and I think we pointed this out that we went from 398 to 391, we posted 394 because we got some benefits from some acquired and inherited accretion but kind of think about as seven basis point drop it has in this quarter. We did a little bit of that to our ourselves because we deployed assets in the 270 range, it involves the money at 35 or 40 basis points to fund it. So we put ourselves in the margin characteristics but quickly generated incremental net interest income.

So I think we're thinking about as five to six basis points of margin headwind for the fourth quarter and kind of going into 2014. That's the cash growing balance sheet, improving the fees to offset what is probably a little bit of margin headwind that continues for us, understanding that you've got a little bit of higher average asset yields than lot of our peers.

David W. Darst - Guggenheim Securities LLC

Sure, okay, great. Thank you.

Scott A. Kingsley

Thank you.

Operator

Thank you. (Operator Instructions). Our next question is from Collyn Gilbert. Your line is live.

Collyn B. Gilbert - Keefe Bruyette & Woods, Inc.

Thanks. Good morning guys.

Scott A. Kingsley

Good morning, Collyn

Collyn B. Gilbert - Keefe Bruyette & Woods, Inc.

That was great color that you've just offered. So just a couple of quick things. You had mentioned that the commercial pipeline was higher than it's ever been kind of going into the fourth quarter I guess at the end of the third quarter. What do you think is driving that and how do that impact your outlook for commercial growth?

Scott A. Kingsley

Very good question. I think we're very satisfied and pleased with where the commercial pipeline is going. I think I said the same thing as I recall in July after the second quarter call and despite the size of the pipeline was actually pretty significant last quarter as well. But what we are seeing is we encountered a more intense operating environment in commercial. So as much as we believe that there is growing demand and opportunity in the business lending market place the competitive nature is resulting in more movement.

So as much as we continue to fill the bucket and the top end we are seeing things run out the door on the bottom end. So it's just a function of trying to replace, but I think that typically the fourth quarter is not is robust for us is it relates to all of our loan portfolios. I think we are hopeful that the fourth quarter will be productive in terms of the commercial opportunities that we have in the pipeline.

The challenge is really trying to predict and understand what it is that’s going to run off that you didn’t expect.

Collyn B. Gilbert - Keefe Bruyette & Woods, Inc.

All right okay.

Scott A. Kingsley

And that’s really, that’s the challenge. I am not trying to tee us up for some big large growth in the commercial portfolio in the fourth quarter, because as much as the pipeline is very strong what we’ve been seeing is I think growing demand, growing opportunity and growing success on the front end but also greater levels of pre-payments and pay downs on the back end.

So just trying to net all those together, I think the point is going into the fourth quarter we’re pretty satisfied at where the commercial pipeline is which is historically stronger than where it is at the current time heading into what is a more seasonally softer fourth quarter for us.

Collyn B. Gilbert - Keefe Bruyette & Woods, Inc.

Okay, that’s helpful. And then just on the indirect auto side I know you guys have spoken to sort of the increased competition there. Does that, the competitive landscape is that changing your appetite for future growth or you feel just as comfortable continuing to build out that portfolio?

Mark E. Tryniski

We are pretty comfortable with that account. We’ve been in that business a long time and there are lot of new entrants in the business now, there's a lot of institutions and lenders they get in that business and get out of this much more powerful based on market demand and opportunity and the like, leasing has come back in a significant way as well. So that’s a competitive element to the business right now.

We will continue to invest in and grow that business in a pretty disciplined fashion. I think if you look at that portfolio and you trend it over the last five years, you will see pretty stable consistent growth in that portfolio in that 5% to 6% range over time. it's fairly stabilized it's a function of the management slightly [avoiding] that business, the focus that we have on execution the fact that we’ve never got out of that business, the relationships that we have with our dealer network which are almost all footprints have been very strong for a number of years.

So it's a business we’ll continue to, I think the growth in that business is going to ebb and flow overtime with demand, it's more of a demand centric influence, I would say than competition. I think competition drives the yield environment. But in terms of demand we have a pretty established business in that portfolio. It's mostly A and B paper, the average paper size is seven twenty, the net charge-offs have run consistently, I think in the 20s for the last couple of years.

It been a very productive business for us, we’ll continue to invest in it. We are not going to grow it wildly and we are not going to abandon it. So we just -- it's pretty much steady as she goes in that business and the performance the last couple of years has been very strong as a result of focused on execution and also improving market demand.

Collyn B. Gilbert - Keefe Bruyette & Woods, Inc.

Okay that’s great. And then just a question on the wealth decline, the linked quarter decline from second to third quarter. Was there a timing of a certain issue in there or...?

Mark E. Tryniski

No I wouldn’t say it's timing, I would say it's more along the lines of a decent portion of our wealth management business is for our market base or our bridge-based broker dealer and some in certain quarters you may have more some transaction that close the results and book the revenue one way or the other.

The trust side is very predictable and very steady. So it really comes from the activities of our investment management folks in the market and the customer appetite for new assets.

Collyn B. Gilbert - Keefe Bruyette & Woods, Inc.

Okay, that’s helpful. And then just one final thing the comment on the margin guidance and is that off of the 3.91 or the 3.94?

Mark E. Tryniski

Well we would love to repeat the $500,000, they got up to 3.94, but I think 3.91 is a safe number to use.

Collyn B. Gilbert - Keefe Bruyette & Woods, Inc.

Okay, all right that was all I had, thanks guys.

Mark E. Tryniski

Thank you.

Operator

Thank you. (Operator Instructions). And at this time I have no further questions, thank you.

Mark E. Tryniski

Great very good. Thank you George. Thank you all for joining us. We will talk to after the end of the year.

Scott A. Kingsley

Thank you.

Operator

That concludes today’s conference. Thank you for your participation everybody may disconnect.

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