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Community Bank System, Inc. (NYSE:CBU)

Q4 2013 Earnings Conference Call

January 22, 2013 11:00 AM ET

Executives

Mark Tryniski - President and CEO

Scott Kingsley - EVP and CFO

Analysts

David Darst - Guggenheim Securities

Collyn Gilbert - Keefe, Bruyette & Woods

John Moran - Macquarie Capital

Operator

Welcome to the Community Bank System Fourth Quarter and Year End 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 Tryniski

Thank you, Whitney. Good morning everyone and thank you all for joining our fourth quarter conference call. The quarter was busy and productive one for us beginning with the strong operating results. Earnings per share in the quarter were $0.02 higher than 2012, excluding acquisition expenses and the securities and debt transaction this year and litigation charge last year. Highlight of the quarter was loan growth which was seasonally atypical for us, with total loans increasing $84 million or 8% on an annualized basis.

Business lending led the way with $45 million of that growth and our mortgage and auto businesses delivered solid results as well. Second significant element of fourth quarter performance was our benefits administration and wealth management businesses which delivered combined revenue growth of 9% over the prior year. As previously announced, in December we sold our trust preferred CDOs and other securities and also regained our remaining federal home loan bank term borrowings. The series of transactions was done for both qualitative and economic reasons and improve our balance sheet and provide forward earning capacity for our shareholders.

In addition, in December we closed down our previously announced acquisition of eight branches from Bank of America in Northeastern Pennsylvania with approximately $300 million of deposits. This transaction provides very attractive core deposits that effectively replace borrowings and improves the density of our presence and our operating leverage in that market. The integration went very well. We are now focusing our efforts on the growth initiatives particularly around lending opportunities. The whole of 2013 was a very productive year for the company.

Earnings remain strong and consistent with last year on an operating basis although we were hoping to improve performance in other areas we do better than just offset the declining gross interest income. Significant progress was made across the company starting with the balance sheet including organic loan growth of over 6%, organic checking and savings account growth of over 6%, deleveraging of our investment book and wholesale borrowings, growth of our Tier 1 leverage ratio from 8.40 to 9.29, an improvement in asset quality metrics.

From a P&L perspective, the full year margin improved by 3 basis points, banking fee income was up 9%, revenue growth in our benefits administration and wealth management businesses was 11% with pre-tax earnings of around 44% and our efficiency ratio remained below 60%. Beyond financial performance, we closed down two acquisitions the BOfA branches I previously mentioned as well as the small benefits business in Rochester, New York; it will give us a good entry point into the Western New York marketplace. We consolidated four branches over the course of 2013, improving our branch size and reducing operating cost.

We implemented the backroom technology application that allows us to reduce capitalization cost by $500,000. We rebranded our Northeastern Pennsylvania market from First Liberty Bank & Trust to Community Bank which eliminates customer confusion and consolidate our marketing structure. And we increased our cash dividend for the 21st consecutive year. Looking ahead at 2014 we have very good operating net momentum much of which is a result of the progress and the initiatives in the past two years. We also have right now the best balance sheet we have ever had in terms of asset mixed funding, great quality and capital.

We are very well positioned as we entered 2014 and we will be disciplined and work hard to continue to grow earnings and dividends for the benefit of our shareholders. Scott?

Scott Kingsley

Thank you, Mark and good morning everyone. As Mark mentioned 2013 was a very productive year for the company in several areas. As a quick reminder, we completed the acquisition and conversion of 16 former HSBC branches and three First Niagara branches in the third quarter of 2012. So, for comparatives purposes the fourth quarter 2012 was the first quarter with the various operating attributes of those transactions were fully reflected. In addition, as Mark commented our acquisition of eight former Bank of America branches in Northeastern Pennsylvania was completed in mid-December 2013. I will try to provide some additional specifics of the company’s fourth quarter performance.

I will first discuss a couple of balance sheet items. Average earnings assets of $6.58 billion for the fourth quarter were up a $108 million from 1.7% from the third quarter and down 1.3% from the fourth quarter of 2012 averages, reflected on the balance sheet restructuring activity completed in the first half of the year which we have previously described. Compared to the third quarter of 2013 average loans were up $83 million, while average investments including cash equivalents were higher by $25 million. Average deposits were up modestly from the third quarter impressively from the branch acquisition completed in mid-December. The full year trend, away from time deposits and into core checking, savings and money market accounts continued in the fourth quarter.

Quarterly average borrowings increased slightly as we used short-term credit facilities to finance the purchase of additional investment securities in anticipation of the closing of the previously announced branch purchases from Bank of America. This productive pre-investment of acquired liquidity was similar to the strategy and prior to the closing of last year’s HSBC First Niagara branch transactions. Borrowings declined to a $142 million at year end from the receipt of liquidity from the branch transaction and the extinguishment of our remaining federal home loan bank term advances right before year end.

In late December, the company sold its entire portfolio of bank and insurance trust preferred collateralized debt obligation securities or CDOs in response to the uncertainties created by the announcement of the final regulations implementing the Volcker Rule. In conjunction with the liquidation of the trust preferred CDOs, the company extinguish $226 million of FHL fee advances and sold the $418 million of treasury securities previously classified as held to maturity.

The net impact of these transactions was a $6.9 million pretax loss or $0.12 a share recorded in the fourth quarter. The company reinvested the net liquidity created from these transactions of approximately $246 million into treasury securities, which has similar blended duration characteristics as in the treasury and CDO securities sold in order to mitigate the net interest income impact of the securities sales and debt extinguishments.

Despite recent regulatory clarifications on certain securities, which have been determined to be exempt from disposition, including the CDOs we sold, we still believe it was in the best long-term interest of the company and our shareholders to proceed as we did. We clearly recognized the potential for additional regulatory commentary at the time we made the decision to dispose the CDOs but concluded a qualitative improvement to our balance sheet and the elimination of the uncertainties surrounding these types of securities wasn’t prudent. It is worth noting that we could and make use to recover the net loss incurred on these transactions under two years through reinvestment of the additional $225 million of investments sold into similar duration securities.

Outstanding in our business lending portfolio were up to new loan generation and improved line utilization was able to more than offset contractual and other unscheduled principle reductions. Asset quality results in this portfolio continue to be stable and favorable to peers with annual net charge-offs of under 25 basis points over the last four, eight and 12 quarters.

Our total consumer real estate portfolios of $1.93 billion comprise of $1.58 billion of consumer mortgages and $347 million of home equity insurance were up $10 million from September despite the significant slowdown in refinancing activities. We continue to retaining portfolio most of our short and mid duration mortgage production in 2013, selling secondary eligible 30 year instruments, and were able to productively add to our outstanding at blended yields above 4%. Asset quality results continue to be very favorable in these portfolios with total annual net charge-offs over the last four, eight and 12 quarters of under 8 basis points.

Our consumer indirect portfolio of $740 million was up $27 million or 3.7% from the end of the third quarter consistent with seasonal expectations and strong regional demand characteristics. Used car valuations were the largest majority of our lending in concentrated continued to be stable and favorable. Annual net charge-offs for the last four, eight and 12 quarters were under 25 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 2013’s results at just 0.17% of total loans being a stellar performance. Non-performing loans comprised of both legacy and acquired loans ended the third quarter at $22 million or 0.54% of total loans. Our reserves for loan losses represent 1.15% of our legacy loans and 1.08% of total outstanding, and based on the trailing four quarters results represent over six years of annualized net charge-offs.

As of December 31st, our investment portfolio stood at $2.18 billion and was comprised of $307 million of U.S. agency and agency-backed mortgage obligations or 14% of the total; $668 million of municipal bonds or 31%; and $1.18 billion of U.S. treasury securities or 54% of the total. The remaining 1% was in corporate and debt securities.

Our capital levels in 2013 continue to be strong. The tier one leverage ratios rose to 9.29% at quarter end, a meaningful 89 basis points increase over year-end 2012 and tangible equity-to-net tangible assets and to 2013 at 7.68%. Consistent with our second and third quarter discussions, our tangible book value per share of $12.80 is down from the $13.72 per share level at the end of December 2012 and relates entirely to the decline in AOCI over half of which we realized in the balance sheet restructuring activities completed this year. Excluding the effects of changes in AOCI we have actually added noticeably to capital over the past 12 months, with consistently strong earnings result.

Shifting now to the income statement our reported net interest margin for the fourth quarter was 3.88% down six basis points from the third quarter of this year and five basis points above the fourth 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 continued to have a positive effect on margin results but have not being able to fully offset declining asset yields.

Excluding gains and losses on security sales and debt repayments fourth quarter non-interest income was up 7.7% from last year’s fourth quarter. The company’s employee benefits administration consulting businesses posted a 6.8% increase in revenues from new customer additions favorable equity market conditions and growth from the company’s metro New York actuarial and consulting business acquired at the end of 2011.

Our wealth management group generated 16% revenue improvement over last year and included sound organic growth and trust in asset advisory services while also benefiting from favorable market conditions. Quarterly operating expenses of $55.2 million increased to $1.3 million or 2.4% over the fourth quarter of 2012 excluding acquisition expenses in both periods and a litigation settlement charge in the fourth quarter of 2012.

Fourth quarter operating expenses again excluding acquisition expenses were $200,000 above this year’s third quarter and included two weeks of additional operating costs associated with the acquired branches in Northeast Pennsylvania. Our effective tax rate in the fourth quarter of 2013 was 28.2% and 29.0% for the full year versus 29.2% in last year’s fourth quarter in full year 2012. We continued to expect net interest margin headwinds in 2014 as most of our existing assets are still being replaced by new assets with modestly lower yields.

Our funding mix costs are at very favorable levels today from which we don’t expect to see improvements. Our growth in all sources of non-interest revenues have been positive and we believe we are favorably positioned going into 2014 to continue to expand in all areas. While operating expenses were continued to be managed in a discipline fashion, we do expect a full quarter of comps associated with the branch acquisition completed in December as well as annual salary adjustments of 2.5% to 3% in January. Our asset quality has continued to remain a differentiating feature of our business model and we don’t expect that to change going forward.

Tax rate management will continue to be subject to the successful reinvestment of cash flows and high quality municipal securities as it has been for the last several years. We have made similar market characteristics and dynamics over the last few years in this low interest rate environment and expect to execute on our business model in a consistent manner in order to create growing and sustainable value for our shareholders.

I will now turn it back over to Whitney to open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions). And we’ll take our first question from David Darst with Guggenheim.

David Darst - Guggenheim Securities

Mark, you outlined where your balance sheet is today as kind of optimal. You have significantly improved your loan-to-earning-asset mix and a number of other ratios. So what would make you -- or what would you look for to be willing to reinvest the $225 million this year, to try and recapture the lost earnings that could be at a lower margin?

Mark Tryniski

I would say most likely David the right market environment to do that, so that is something that we’ll be looking at here in the first quarter I think, we’ll be opportunistic about it, if the opportunity arises we will do it and if the opportunity does not exists we will not do it.

David Darst - Guggenheim Securities

And would you consider maybe doing more of your own residential mortgages or are you specifically looking at like the treasury market and the treasury curve?

Mark Tryniski

Yeah I think we’re talking about just reinvesting just as it relates to that and particularly the particular series of transaction just basically reloading our balance sheet back to where it was before in terms of the securities. So that’s really -- we are disappointed we have some dry powder remaining, David, in terms just the balance sheet and the earning assets from that transaction as it was series of transaction, it was restructured effectively neutralized the ongoing earnings impact of the transactions. But we didn’t reload the balance sheet back to where it was. So the point really that’s happening was just as if we do that it will actually recover the $7 million loss in under three years, actually something like two and a half year or so, and it’s something that we will continue to be aware of in terms of market opportunities.

David Darst - Guggenheim Securities LLC

Okay. And then you've announced a buyback or a reauthorization. Is that something you want to have just for flexibility? Or is there an increasing probability that you might actually use the buyback this year?

Mark Tryniski

I would say, we think it is good quality to have in place on an ongoing basis in the event, an opportunity arises and we haven’t actually bought back shares in six or seven years, I believe. And we bought those back in the lower twenties. So it’s more, at this point, David, it’s a good housekeeping sense of having the policy and the authorization from the board in place to be able to execute on that if we thought that, that was an appropriate opportunity in terms of returning the capital to shareholders and that was a superior alternative to other capital deployment opportunities.

David Darst - Guggenheim Securities LLC

Okay. And then how about -- you announced a small acquisition in your benefits business, and you gave us some guidance on what the incremental revenues would be. Is that still a focus for future M&A, and continued through -- to expect the same rates we've seen there going forward?

Mark Tryniski

It is, I think we have grown historically over a number of years in that benefits administration business very strongly, both organically and through M&A opportunities. I think we will continue to focus our efforts on growing that business through that both means; both organic and acquired, as well as our wealth management businesses. Those businesses continue to perform extremely well. They are growing rapidly. They had an extremely good year in 2013. Some of it organic, some of it market tailwinds but continues to be very productive for us. As you know there is not a lot of balance sheet in those businesses so the return on equity -- the accretion to the return on equity is substantial. We like those businesses. We think we have a very good leadership in those businesses and we will continue to work to opportunities to invest in those businesses, obviously we have right now, a lot of capital. And so we certainly are not capital challenges in terms of investing in any of our businesses, but we'll be mindful of ultimately the need to buy high-quality businesses where we can integrate and create incremental, and sustainable earnings growth and dividend capacity for our shareholders itself. We will look to continue to grow all those businesses through both organic and acquired means David.

Operator

And we will take our next question from Collyn Gilbert with KBW.

Collyn Gilbert - Keefe, Bruyette & Woods

Thanks. Good morning, guys. Scott, just a follow-up on your comment about the buyback. What would need to happen -- or can maybe frame sort of a scenario for us that would cause you to buyback the stock at this level, or think that that was a good use of capital. I am just kind of want to better understand how you think about that?

Mark Tryniski

Collyn, this is Mark. I think as I said in response to David's question, I think it's just good to have an authorization outstanding and it’s good to have as many opportunities and alternatives in terms of productive capital deployment available to you at any time as you can, and I think -- we think and our Board thinks that the stock buyback is just one of those. Frankly, the challenge with the stock buyback is it's pretty diluted to both value metrics, and we don’t necessarily manage the organization in terms of growth in shareholder value along both value metrics. It's earnings growth per share and dividend growth per share. But with that said, I think if the variety of alternatives of opportunities brought in terms of capital deployment were such that a buyback was in the best interest of our shareholders in terms of its relative value compared with that alternative, that it’s unlikely in our present trading valuation multiple that that is something that we would do relative to other alternative, then the yield curve is low over the yield curve is reasonably steep. And we think there is M&A opportunities and variety of other opportunities that have dividend growth to create returns for our shareholders. But we just think that having the buyback as one of those alternatives is productive for us.

Collyn Gilbert - Keefe, Bruyette & Woods

Okay. And then just a question a loan growth. Usually the fourth quarter is a seasonably lower or slower quarter, but you guys put up some good numbers this quarter. Was there anything specific that you could attribute that to? Is that reflective of increased momentum as you guys go into this year? Or just maybe talk a little bit about that. And then just one other follow-up, on the indirect side, you said you've been seeing some good business there. I'm just curious if you have a sense of who you might be taking share from.

Mark Tryniski

Well, I think in terms of the growth, we had organic growth in all of our lending businesses, I think with the exception of home equity which was flat or down I think by 1 million or 2 million but very strong business flowing growth, very productive still consumer mortgage growth all that slowed a lot in the fourth quarter direct loans to consumers to the branches actually have pretty good outcome in the fourth quarter and the auto lending business was, I would say seasonally strong which grew almost 4% in the quarter.

So, business loans grew by 4% and mortgages grew little bit and the auto business grew about 4%. So the ratio was seasonally strong for us, the business lending growth, I think I maybe have in our third quarter call that the business lending pipeline was very strong and some of that was related to projects and transactions and deals that were actually related to or approved in prior quarters and just ended up getting closed in the fourth quarter. So, it really from the business lending side and is really just a timing but with a lot of really good transactions and really good opportunities in the fourth quarter so we were very pleased with the fourth quarter performance which for us is usually little bit better than the flat but is not up the way it was $84 million in the quarters we were very pleased with the performance of all the prior businesses in the fourth quarter.

Collyn Gilbert - Keefe Bruyette & Woods

Okay. Okay, that's helpful. And just one housekeeping item for modeling purposes. Given the movement of some of the balance sheet moves this quarter, what was the -- can you give us what the asset yield and the cost of interest-bearing liabilities were at December 31?

Mark Tryniski

I can give that, Collyn, I’ve got that in front of me, just give me couple of minutes to get back through that but I will say that it was not from the asset side, not radically different than the fourth quarter average. From the liability side, two days from the end of the year and we have the extinguishment of $225 million of liabilities in the mid 3s, you know, 350, 360 type of rate on those term advances. So, those are gone and the $140 million of short-term mortgage that we have on books is probably at 40 basis points.

So, otherwise on deposit side endings and averages are probably pretty close to the same things. We really think from a balance sheet perspective in terms of this very efficient looking balance sheet at the end of the year. If you think about $7.1 billion in the right side of the balance sheet funding, 70% of that is core deposits or $5 billion of money market and checking and savings account at 7 basis points. The pretty good head start when you have an expectation that rates might go up over the course of the next two or three years.

Collyn Gilbert - Keefe Bruyette & Woods

Yes, good point. Okay. Alright, thanks guys.

Mark Tryniski

Thanks Collyn.

Operator

(Operator Instructions). And we’ll take our next question from John Moran with Macquarie Capital.

John Moran - Macquarie Capital

Hi guys, how’s it going?

Mark Tryniski

Hi, John.

Scott Kingsley

Hi, John.

John Moran - Macquarie Capital

I just wanted to follow up on that last one. With a couple of moving pieces that I know you've got -- a full quarter of Bank of America costs coming in, some wholesale funding gone, some liabilities gone. If I'm doing the math properly -- and I think I might be -- I get basically kind of a push; and then, Scott, it sounds like from your commentary, some additional core margin compression expected here in 2014, with funding costs about as low as they're going to ,go and some continued declines in the asset yield. Am I thinking about that right? And is 4Q's core margin likely to carry into first quarter here?

Mark Tryniski

Couple of different answers to that, John. But I think you’re on the right track. I think in terms of a push on net interest income generation is certainly what we’ve been saying, in other words we reinvested in lot of the net liquidity from those transactions at the end of the year to create the push into the first quarter.

Now, if you can appreciate, you know there are some seasonable issues associated with net interest income generation you compare fourth quarter to the first quarter the largest of which being there is two last days in the quarter which is adding significant, we tend to get Federal Reserve Bank dividends only in the second quarter and fourth quarter so that three quarters of percent per share that you won’t see in the first quarter.

But I think generally you said it right, I think we have looked at this sort of three to four basis points of core margin compression per quarter going forward which is not dissimilar to what the core outcome of 2013 looks like.

So, growing the balance sheet enough to be able to offset that in terms of natural core margin erosion, again, it’s a task for 2013 but one could argue that was the task for 2011 and 2012 as well.

John Moran - Macquarie Capital

Got it. Okay, that's helpful. And then I think you alluded to it in the prepared remarks, you exit the year in a pretty good position in terms of the balance sheet. Outside of possibly reinvesting or redeploying the $225 million, there'd be no other big structural things considered at this point, right?

Scott Kingsley

No, John. Really, I think, we ultimately, to say it in short order accomplished where we like to balance sheet to get to with the expectation that you’re modeling an ALCO environment that’s expecting long-term interest rate changes on way up over the course of the next several years. To Mark’s point, do we think short-term interest rates are going to move in the near term, we probably don’t, but I think that’s consensus amongst most people. So does that create some yield curve opportunities in the near terms when you’re carrying 200 basis points of Tier 1 capital leverage above what we’re used to carrying.

John Moran - Macquarie Capital

All right, thanks very much for taking the questions.

Operator

At this time, we have no further questions in the queue.

Mark Tryniski

Great, thank you, Whitney. Thank you all for joining. Please stay warm. I want you to know we have branches in the North Country of our franchise -- it was almost 40 below this morning, they open that time so everybody stay warm. Thanks, we’ll talk to you again in the second quarter. Thank you.

Operator

This now concludes the conference. Thank you for your participation.

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