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Operator
Before we begin today's call, I'd like to remind you 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, market 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 & Exchange Commission.
And now I would like to introduce today's call leaders, Mr. Mark Tryniski, President and Chief Executive Officer, and Mr. Scott Kingsley, Vice President and Chief Financial Officer of Community Bank System. Gentlemen, you may begin.
Mark Tryniski - President and CEO
Thank you, Betty. And welcome, everyone to Community Bank System, Inc.'s third quarter investor conference call.
Overall, we're very pleased with third quarter results and the earnings trend line YTD. Quarterly earnings met our expectations and are $0.01 above last year's quarter, excluding securities gains, despite a slightly larger decline in margin than we had hoped.
The margin impact was offset by strong growth in loan revenues, the lowest level of loan charge-offs we've recorded in many years, continued growth of our non-interest income line, and core operating expenses that are running below those of 2005.
Organic loan generation in the quarter was acceptable at 4.5% annualized, with both the New York and Pennsylvania markets delivering that growth. Our Pennsylvania markets continue to benefit from strength in business development efforts there during 2006.
I commented in the second quarter call about a significant core deposit generation effort, the objectives of which are to achieve a double-digit increase in its important customer base and their associated balances. We began the program in early April, and for the second quarter increased personal checking accounts from 121,000 accounts to 126,000 accounts, and up to 131,000 for the third quarter, reflecting a growth rate of 17%. Those results have met our expectations to date, and we'll continue to aggressively pursue core deposit relationships in all of our markets.
By way of branch activity, we mentioned previously in our January call that our expense reduction initiatives would include branch consolidations and closures. In the third quarter we consolidated two branches in Pennsylvania and recently consolidated one in New York, reducing recurring annual operating expenses by over $500,000.
We also announced in August our plans to construct a Denovo branch in Springville, New York, which is located just south of the Erie County border, and will position us closer to market opportunities in the southern Buffalo suburbs.
I'd like to comment on our recent acquisition activity. We completed our merger with ES&L Bancorp in mid-August. ES&L is headquartered in Elmira, New York, and also brings us a nice lending presence in the Ithaca market. Integration efforts have been completed, and we've already hit the ground running with their former CEO, Bill McKenzie, who is working hard for us in a senior business development role.
I would also comment on the acquisition of Ontario National Bank, that we've previously announced in August. Ontario is an approximately $100 million bank, headquartered in Clifton Springs in the Northern Finger Lakes Region of New York State. This acquisition nearly doubled our market share in that two-county region, which has been a very productive loan generation market for us over the past two years. We are very pleased with the market opportunities and the valuation multiples associated with both of these partners and anticipate an accretive impact for 2007.
In summary, I would say we had a solid quarter. We have more work to do in the area of loan growth in certain of our markets, and expect that we'll give back a little more margin in the fourth quarter. We also need to continue to be disciplined about expense management across the company, which is going to take some more work, as well. But, overall, we like the trend line of our business and our markets as we head into the fourth quarter.
Scott.
Scott Kingsley - EVP and CFO
Thank you, Mark, and good morning.
Our third quarter earnings of $10.9 million or $0.36 per share were $0.12 or 25% below third quarter of 2005, and included stock option expense of $409,000 or $0.01 per share as a result of the company's adoption of FASBE 123R share based payments beginning in the first quarter of 2006.
In addition, the third quarter of 2005's results included $5.3 million or $0.12 per share of gains on securities sales. Excluding the impact of the securities gains and stock option expense, EPS in this year's third quarter were $0.01 better than the third quarter of 2005. The third quarter results were also $0.03 per share above the second quarter of 2006.
YOY loan and deposit growth of 10% and 5%, respectively, and a 5% increase in non-interest income excluding securities gains, were offset by an increased cost of funds and an 8% decrease in investment income, a result of the company's successful balance sheet repositioning in 2005.
Cash earnings per share, which excludes the after-tax affect of the amortization of intangible assets and acquisition related market value adjustments, were $0.40 pre share in the third quarter and $1.13 for the nine months ended September 30th, a full $0.13 per share above GAAP EPS results.
The results of the quarter also included the acquisition of the ES&L Bancorp in mid-August. At quarter end, loans and deposits from ES&L approximated $191 million and $121 million, respectively.
I'll first discuss the balance sheet. Average earning assets of $3.85 billion were up $72.3 million from the third quarter of 2005 and 2.6% higher than the end of the second quarter, including the ES&L acquisition. Average loans were up $161 million from last year, while investment securities decreased $88 million.
As a reminder, in 2005 the company successfully completed the objective of shortening the average life of its investment portfolio, generating a $0.29 per share after-tax gain through the sale of securities that had optimized their total return and interest rate sensitivity characteristics. The proceeds of these security sales were used to reduce overnight borrowings and overnight and short-term borrowings throughout 2005.
Average deposits of $3.1 million for the quarter were up 3.7% from the third quarter of 2005 and included the expected seasonal reductions associated with several of our municipal customers.
On the YOY basis loans grew $250 million or 10.4%, including the ES&L acquisition. Organically, the company added $26.7 million of consumer installment loans since last year's third quarter end, with success in both home equity and indirect auto products. Although we did sell some new mortgage originations into the secondary market again in the third quarter residential mortgages have increased $19.2 million over the last 12 months, excluding the acquisition.
Business lending has increased organically $13.3 million for the year, despite a $16.9 million planned and managed decline in automotive dealer [floor] plan outstanding, a segment we have actively chosen to underrate in current market conditions.
Average borrowings were up $23.5 million from the second quarter, and included the funding requirements of the ES&L acquisition. We are also currently in the process of reviewing market alternatives for the replacement of our $30 million fixed rate trust preferred obligations. We have estimated the impact of the onetime charge associated with this refinancing to be between $0.04 and $0.05 per share, including an early call premium and the write-off of certain capital financing costs. We expect to complete this evaluation in the fourth quarter.
Our capital levels remain strong despite the completely cash funded ES&L transaction with our tier one leverage ratio standing at 7.26% at quarter end and our tangible equity ratio at 5.44%. In August, we announced a 5.3% increase in our quarterly dividend on common shares to $0.20 per share.
Shifting to the income statement, the net interest margin for the third quarter declined 13 basis points to 3.87% from a 4.0% in the second quarter, and was 19 basis points lower than the 4.06% reported in last year's third quarter. Results included the impact of the ES&L acquisition which has lower net interest margin attributes than our historical averages.
Loan yields improved 17 basis points from the second quarter, but the investment yield declined 23 basis points, reflective of continued scheduled maturities and calls of higher yielding investments. The cost of funds rose 18 basis points to 2.68%, reflecting continued movements into interest bearing instruments, including time deposits, as well as somewhat higher yielding ES&L deposits.
Our loan loss provision for the quarter was $1.3 million, compared to $2.3 million in the third quarter of 2005 and $1.7 million in this year's second quarter. The $1.1 million of net charge-offs in the third quarter was the lowest quarterly level since the second quarter of 2000. Our YTD provision of $5.2 million was 17.6% below the $6.3 million recorded in the first nine months of 2005, but was still a half a million dollars above YTD net charge-offs of $4.7 million.
Our loan loss allowance to total loans outstanding stood at 1.33% at quarter end, and reflected the inclusion of the acquired ES&L loans and reserves, with a coverage ratio of 1.27%. Non-performing loans to total loans outstanding are at .47% compared to .56% at the end of the third quarter of 2005. This favorable and stable asset quality profile is primarily the result of our enhanced credit risk management program and our continued emphasis on and adherence to disciplined underwriting standards.
Third quarter non-interest income excluding securities gains was up 5% over the prior year, and consistent with prior years included the annual dividends from credit or insurance programs in which we participate, approximating $0.02 per share.
Our employee benefits administration and consulting business posted an 18% jump in revenues over the last year's third quarter, thanks to new product offerings and the addition of new clients.
Operating expenses excluding stock option and acquisition expenses increased to 1.8% over the year ago quarter from $30.7 million to $31.3 million, and included a month-and-a-half of ES&L related operating costs. On a YTD basis total operating expenses excluding stock option and acquisition expenses were actually $38,000 lower than the first nine months of 2005.
Our effective tax rate for the quarter was 24.4% compared to 24.1% for the second quarter, and down from 27.4% reported in the third quarter of 2005, which was impacted by income from securities gains. The proportionate tax exempt income to total income continues to be the most significant determinant in our effective tax rate.
I'll now turn it back over to Betty to open the line for questions.
Operator
[OPERATOR INSTRUCTIONS.]
Our first question comes from Rick Weiss. Rick, your line is open.
Rick Weiss - Analyst
Good morning.
Scott Kingsley - EVP and CFO
Good morning, Rick.
Mark Tryniski - President and CEO
Good morning, Rick.
Rick Weiss - Analyst
I guess this is more of a question for Mark. If you could just talk a little bit about the M&A market, what you see coming in the next 12 months?
Mark Tryniski - President and CEO
Well, you know, from our announcements we've been pretty active so far this year, and I think that's from our perspective consistent and reflective of what we expect to see into the future. It's a difficult operating environment, as everyone understands. I think a lot of times that falls disproportionately on some of the smaller community institutions that do not have the resources to invest in product and people and technology and compliance.
So I think it's a tough environment because of the yield curve, the competitive environment, and I think all of that combined will probably make for an opportunistic marketplace out over the next year or so, Rick.
Rick Weiss - Analyst
Would you expect the deal pricing to kind of stay where it has been, Mark, or coming in a little bit? Like, what's your feeling on that?
Mark Tryniski - President and CEO
Well, we hope it comes in a bit. I think it, you know, it frankly depends on the opportunity and the expectations. From our point of view, we like to partner with institutions where the valuation multiples are appropriate. For example, at ES&L Bancorp, that was 1.74 times book value and 13.7 times earnings. Ontario, that we announced in August, is 1.68 times book value and 21 times earnings. So we think at that those kind of reasonable multiples we can deliver accretive growth that's required.
I think if you get a whole lot beyond that you need to have an environment where you can really, you know, cut costs and justify the investment, but we don't like to look at it solely from that point of view. It's also a question about the markets, themselves, and the market opportunities, not just for growth but for kind of synergies with our product line and customer base, as well, so that's what we look for.
I can't predict, I mean I have no predictions, Rick, about, you know, what the future is going to be for sure. I will say this, we will not do transactions that are overpriced from our point of view, in terms of our ability to make those accretive in the near term and indefinitely into the future. So we've said, no, to a handful of recent opportunities that we felt were just priced too high relative to the future opportunities and would, you know, continue to do that.
I suspect as the market heats up a little bit, which I think it may, that might bring the pricing in a little bit, but I don't know, that may be hopeful thinking. But I think it's going to be, my suspicion is it's an active market over the course of the next couple of years.
Rick Weiss - Analyst
Okay. Thank you very much.
Mark Tryniski - President and CEO
Thank you, Rick.
Operator
Thank you. Our next question comes from Kevin Timmons. Kevin, your line is open.
Kevin Timmons - Analyst
Hi, guys. A couple of questions related to the margin. Can you quantify this client in this quarter versus Q2, can you quantify about how much was due to ES&L?
Scott Kingsley - EVP and CFO
Kevin, I think it's fair for modeling purpose to use that, the ES&L defined as 4 or 5 basis points. So we probably use the scenario that we went from 4 to say 3.92 or 3.93 on our own, and then the additional decline coming from the ES&L. We're likely to see, Kevin, a little bit more erosion of that number in the fourth quarter, just based on the fact that we really only have ES&L asset and liabilities in our results for half a quarter.
Mark Tryniski - President and CEO
Okay? So we took another 4 or 5 off for the ES&L affect.
Kevin Timmons - Analyst
Any sense of what the remaining compression is in Q4 for you guys? Is it going to be somewhat the same?
Scott Kingsley - EVP and CFO
I think if you ultimately drive down into the low 3.80s I think you'd be in line with what our expectations were.
Kevin Timmons - Analyst
And is that total, Scott, is that just for – is that including the ES&L affect?
Scott Kingsley - EVP and CFO
That's total, Kevin.
Kevin Timmons - Analyst
Okay. And then you mentioned in the release about the trust preferred refinancing opportunities. Do you have any sense at this point for what the range of alternatives may be and what the range of pricing may be on those?
Scott Kingsley - EVP and CFO
Well, Kevin, the current outstandings that we have out there, are the fixed rate is at 9.75, so I think our expectations are that the pure interest rate savings, by itself, is approaching 300 basis points.
Kevin Timmons - Analyst
Okay, great. Thank you.
Operator
Thank you. Our next question comes from Damon Delmonte. Damon, your line is open.
Damon Delmonte - Analyst
Hi, good morning, guys. How are you?
Scott Kingsley - EVP and CFO
Morning, Damon.
Mark Tryniski - President and CEO
Hi, Damon.
Damon Delmonte - Analyst
Most of my questions have been answered, but just one question regarding the provision, it was a little bit lower than last quarter, and given the positive trend in asset quality do you have a targeted range for that going forward?
Scott Kingsley - EVP and CFO
Well, Kevin, we would like it to be as low as it was in the third quarter, or, Damon, as low as it was in the third quarter. I think for practical purposes, as we pointed out, that was the lowest in about six years.
And but to your point, we do get some pretty good visibility on what's happening in the portfolio, which we suspect would go back more toward what we've reported in the second quarter. You know, we would love to be able to show another record provision, again, but I think for modeling purposes we probably have [to] build in a repeat of that for now.
Damon Delmonte - Analyst
Okay, great. And that's all I have. Thanks a lot.
Scott Kingsley - EVP and CFO
Thank you.
Mark Tryniski - President and CEO
Thanks, Damon.
Operator
Thank you. [OPERATOR INSTRUCTIONS.]
Our next question comes from David Darst. David, your line is open.
David Darst - Analyst
Good morning.
Scott Kingsley - EVP and CFO
Good morning, David.
Mark Tryniski - President and CEO
Hello, David.
David Darst - Analyst
Could you give us the amount of the write-down for the franchise you consolidated in Pennsylvania?
Scott Kingsley - EVP and CFO
Sure, David. In terms of when you refer to that, let me make sure I understand your question?
David Darst - Analyst
In the press release you note that you had certain write-downs associated with two bank consolidations in Pennsylvania?
Scott Kingsley - EVP and CFO
David, I think what I would probably use is something just under a couple hundred thousand dollars for the third quarter, and we also had some charge in the second quarter related to the same activity. So I think probably all in, maybe $400,000. And what that would have included is, you know, early lease termination costs, as well as some severance. And then in the third quarter we actually have the write-down of some residual fixed assets and the final, you know, and the final consolidation of what was left in some of those branches.
David Darst - Analyst
Okay. And did you reverse any bonus accruals that resulted in lower personal expenses?
Scott Kingsley - EVP and CFO
No, we did not, David.
David Darst - Analyst
Okay. What drove your lower salary expense for the quarter?
Scott Kingsley - EVP and CFO
For this quarter, actually, David, it was actually up from the second quarter. We were actually showing about a 16.3 million salaries and employee benefits for the quarter versus 16 in the second quarter, 16.0. And, again, we're purists relative to the days, so we have a few more – we had a couple more business days in third quarter, and then we had 50 days of the ES&L operating costs.
David Darst - Analyst
Okay. And then how about from a balance sheet standpoint, you know, what might be the cash flows that you would see in the securities portfolio in the fourth quarter relative to what you're gaining through the acquisitions?
Mark Tryniski - President and CEO
Let me take a shot at that, David. I think we're using for our purposes, say $40 to $50 million of expected cash flows, the portfolio in the fourth quarter. You know, we'll pick-up sort of the second half of the ES&L loans, because from an average standpoint we only picked up half in the quarter. And our expectation is we're going to be picking up about $55 million of loans from Ontario National Bank with probably an early December close. And we also expect to pick-up $35 million of securities and $80 million of deposits. The securities we will probably liquidate because we do have some short-term borrowings that are coming due early in 2007 and we would expect to use those proceeds against that.
David Darst - Analyst
Okay. So you would just hold those in cash until you repaid them in '07?
Mark Tryniski - President and CEO
Or, again, David, given the fact that there's probably some smaller denominational stuff, the liquidation of that stuff is probably not going to happen in an [hour].
David Darst - Analyst
Okay. Any additional branches that you're looking at, as far as consolidations for next year?
Mark Tryniski - President and CEO
You know, David, I think it's an ongoing activity for us, but we're certainly today not at the point where we're expecting to take any other actions in the near term. But, again, as we've talked to you about before, our branch profitability model is pretty robust, and we certainly ask how do we improve before we ask how do we close, so in the current timeframe we don't have plans for other closures but that's certainly not going to valuation.
David Darst - Analyst
Okay, thanks a lot.
Operator
[OPERATOR INSTRUCTIONS.]
It appears we have no other questions.
Mark Tryniski - President and CEO
Very good. Thank you, all. Thank you, Betty.
Operator
You're welcome. That concludes today's conference. Thank you for participating. You may now disconnect.