Community Financial System Inc (CBU) 2011 Q3 法說會逐字稿

Welcome to the Community Bank System third quarterly 2011 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 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 in 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.

Thank you Jennifer. Good morning everyone and thank you all for joining our third quarter conference call. We appreciate your participation.

Similar to the first two quarters of the year I believe the strength of our third quarter performance speaks well for itself so I will comment generally on what we see as the highlights.

Earnings per share excluding acquisition costs were up 8% over last year's third quarter and are up 12% year-to-date over 2010. Driving that improvement has been the balance sheet growth, both organic and acquired, non-banking revenue growth, strong asset quality metrics, control of operating expenses, and the accretive impact of the Wilber acquisition closed in the second quarter.

Consumer loan demand was very strong in the quarter with the mortgage and auto portfolios growing in the quarter at an annualized pace of 7% and 11%, respectively. The business lending portfolio was down nearly $30 million for the quarter due in large measure to the acquired Wilber portfolio which Scott will discuss further.

Core deposits grew for the quarter at a double digit pace with virtually all of that growth in low cost and revenue generating demand in savings products.

The Wilber acquisition closed early in the second quarter continues to perform at a high level. Deposits are up significantly as are consumer mortgages and trust assets. The acquisition has been accretive to our second and third quarters and we expect will continue to be additive to earnings and dividend capacity into the future.

As disclosed in the press release we are pleased to announce the acquisition of CAI Benefits, Inc., a New York City based provider of actuarial consulting and retirement planned administration services. This acquisition is an excellent fit with our existing upstate base actuarial investments business which already serves numerous metro New York clients.

We have been searching for some time for the right platform to establish a base in the metro New York area and are excited about the growth opportunity this acquisition presents. Our benefits administration and actuarial business has been a significant revenue and profit grower for many years and remains an important element of our future growth strategy.

Looking forward we expect the strength of our performance this year to continue into the fourth quarter. Our capital continues to grow. Our asset quality is sound. We have significant liquidity and are prepared and well positioned to continue pursuing organic and acquired growth opportunities for the benefit of our shareholders.

Scott?

Thank you Mark and good morning everyone. First as mentioned in our release, third quarter earnings of $0.54 per share included $0.01 per share of acquisition expenses related to the Wilber transaction. On a year-to-date basis, excluding $0.09 of acquisition expenses, operating earnings of $1.59 per share were 12% better than the $1.42 per share of operating earnings reported in the first nine months of 2010 and represent another high water mark for the Company.

I'll first discuss some balance sheet items. Average earning assets of $5.74 billion for the quarter were up $80 million from the second quarter with the vast majority of the increase represented by $63 million of additional invested cash balances from strong core deposit growth in the quarter.

Ending loans were down $1.6 million from the end of the second quarter, comprised of $21.7 million of net organic loan growth, offset by $23.3 million of contractual and other principal reductions in the Wilber portfolio including the disposition of certain impaired loans.

Solid results in consumer mortgage and installment products offset continued soft demand in business lending. The decline in our business lending portfolio in the third quarter was related to the previously mentioned contractual and other principal reductions in the acquired Wilber portfolio as well as the continuation of soft demand conditions for most business lending products.

Asset quality results continued to be stable and favorable in our legacy portfolio with net charge-offs of 21, 26, and 28-basis points over the last four, eight, and 12 quarters, respectively.

Our total consumer real estate portfolios of $1.5 billion, comprised of $1.17 billion of consumer mortgages and $328 million of home equity instruments, was up $17 million from June. Although we continued to sell certain low rate, longer term mortgage assets we were also able to productively add to our portfolio products during the quarter at blended yields of nearly 5%. As a reminder, over the past ten quarters we have sold nearly $325 million of in-market, lower rate consumer mortgage originations. Asset quality results continue to be very favorable in these portfolios with total net charge-offs over the last three quarters of $630,000 or less than 7-basis points of loss.

Our consumer indirect portfolio of nearly $565 million was up 2.7% from the end of the second quarter, capitalizing on solid organic growth opportunities. A byproduct of the improving but still comparatively low new vehicle sales rates has been an improvement in used car valuations where the largest majority of our lending is concentrated.

Net charge-offs for the last four quarters were $1.7 million or 33-basis points which we consider exceptional and is an improvement over the 2008 and 2009 levels and consistent with 2010's full year results.

Despite our continued bias towards A and B paper grades, yields have remained very consistent over the last several quarters.

In addition to the continuation of the very favorable net charge-off trends we also reported generally stable delinquency rates in the first nine months of 2011, particularly in our consumer related portfolios. Although our core banking systems conversion in late 2010 and certain changes in customer payment functionality may have played a role in the higher levels experienced near the end of last year we are pleased to be trending back toward a 1.5% average portfolio delinquency rate, consistent with our experience over the six quarters ended June 30, 2010.

Our reserves for loan losses represent 1.38% of our legacy loans including the third quarter's organic growth, consistent with levels reported at the end of last year's third quarter. As of September 30, fair value based loan marks related to the $444 million of outstanding balances required in the Wilber transaction approximated $23 million or 5.2% of the total acquired balances.

As of September 30 our investment portfolio of just over $2 billion was comprised of $736 million of U.S. agency and agency backed mortgage obligations or 35% of the total, $619 million of municipal bonds or 30%, and $649 million of U.S. Treasury securities or 31% of the total. The remaining 4% was in corporate and other debt securities including our holdings of pooled trust preferred instruments which continued to fully perform.

The weighted average life to maturity of the portfolio is approximately 5.6 years with an effective duration of 4.1 years, consistent with the previous ten quarters. Net unrealized gains in our $1.45 billion available-for-sale portfolio were $78 million at September 30. In addition, there was approximately $61 million of unrealized gains in our $600 million held-to-maturity portfolio.

Average deposits in the third quarter of $4.79 billion were $115 million above the second quarter of 2011 and 21% above the third quarter of last year. Core deposits or everything other than CDs for us, now represent 76% of total deposits, a very stable and favorable funding mix.

Our capital levels in the third quarter again improved and remained strong. The tier one leverage ratio stood at 8.17% at quarter end and tangible equity to net tangible assets was 6.79%, a 65-basis point improvement from last September and 35 basis points higher than the end of the second quarter. As a reminder, we did issue an additional 3.4 million shares of common stock or $82 million of equity in conjunction with the Wilber acquisition in April.

Our significant improvements in equity over the past several quarters have been generated from consistently strong operating earnings as opposed to the dilutive capital raising activities deployed at many other institutions. 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 the denominator, $23.5 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.

Shifting to the income statement, our reported net interest margin for the third quarter was 4.04%, down 9-basis points from the second quarter of 2011 and 4-basis points lower than last year's third quarter. The majority of the linked quarter decline and all of the year-over-year decline in net interest margin related to a higher level of invested cash balances in this year's third quarter.

Proactive management of deposit funding costs and productive deployment of net cash flows continued to have a positive effect on margin results.

Third quarter non-interest income was up 1.3% from last year's third quarter. The Company's employee benefits administration and consulting businesses grew revenue 6% over last year and its wealth management group including activities from the Wilber acquisition generated a 21% revenue improvement.

Mortgage banking revenues were down at $900,000 from last year's third quarter, reflective of the very robust demand conditions in the second half of 2010. Compared to last year's third quarter, the Company generated a similar level of deposit service fees despite the addition of Wilber, reflective of the fourth full quarter of activity post-Regulation E which has resulted in net lower product utilization and certain other changes.

Other banking services of $1.2 million for the quarter included $600,000 of revenues derived from the Company's pooled retail life and disability programs consistently recognized in the third quarter annually.

As Mark mentioned, we did sign a definitive agreement to acquire a metro New York based actuarial consulting and retirement planned administration firm, strengthening our participation in a strategically important market. We expect to close the transaction prior to yearend which should add over $4 million of revenues to our service offerings in 2012.

Third quarter operating expenses of $47.7 million excluding acquisition expenses, were $3.4 million or 7.7% above the third quarter of 2010 and reflected the additional operating costs associated with the Wilber acquisition completed in April, offset slightly by decline in FDIC insurance and core system processing costs.

On a linked quarter basis, the increase in salaries and employee benefits reflects a full quarter of lower related costs as well as one additional day of payroll.

Our effective tax rate in the third quarter of 2011 was 30.2%, bringing the full year rate to 28.2%, reflective of a higher level of income from fully taxable sources. The higher third quarter tax rate lowered earnings per share by $0.02 compared to the second quarter of 2011.

On a trailing 12 month basis, our earnings are $2.09 per share excluding $0.11 of acquisition expenses. Our reported return on equity was 10.5% over the last 12 months with the calculated return on tangible equity above 22%. Our ability to generate incremental capital and reward shareholders with a meaningful and growing cash dividend annually stems directly from the commitment to a disciplined and balanced approach to our business regardless of market conditions.

I'll now turn it back over to Jennifer to open the line for questions.

(Operator Instructions) And our first question comes from Damon DelMonte. Your line is live.

Scott, I was wondering if we could talk a little bit about the margin. Could you try to frame out for us your expectation in the coming quarters when you factor in the liquidity position you held on the balance sheet this quarter and then just continual cash flows being generated from the securities portfolio?

Absolutely, Damon. Our expectation is that there is $335 million of investment cash flows coming off the portfolio in the next 15 months of which about one-third of that is expected in this year's fourth quarter, so a little over $100 million.

We would certainly expect to replace those cash flows with investment securities and I think that the securities we're currently buying have an effective yield about 200-basis points lower than what the expiring or the securities coming off the books are.

Your comment on the liquidity is pointed. We don't expect to be carrying $240 million of cash on an average basis every quarter. Our internal targets even for ALCO planning are closer to $100 million so as much as we recognize there should be some natural NIM pressure associated with reinvestment of investment security cash flows, we do think there is some opportunity to score a little better than 25-basis points on all that liquidity as we go into 2012.

Okay so as we look into the fourth quarter, do you think you can maintain the 4% level or do you think you're going to pierce through that and --?

Damon, I think we'll be close to it. I think there is probably a little bit more downward pressure on the margin in the fourth quarter than there is upward opportunity but at the same point in time I don't think it's a gigantic change from the levels we're at today.

Okay, fair enough. And then with regards to the tax rate, that was helpful to clarify why it was what it was this quarter so what do we think about in the fourth quarter?

I think it's fair for going forward to be projecting something in the 28% to 29% range. If there is such a thing as one thing that is quote, a bad outcome from generating such strong operating earnings from fully taxable sources is you do end up paying tax on it.

I think that's all I have for now. I'll get back in the queue after a few more questions are asked, thanks.

And our next question comes from David Darst. Your line is live.

Scott, could you walk through the loan yields and the reason for the increase this quarter and any impact from purchase accounting adjustments that you see from Wilber?

David, there was a little bit of that increase and to your point, loan yields on an average basis were up 4-basis points from the second quarter. I have been through the detail by loan type. It is really, nothing is really moving radically left or right. Our yields on commercial assets were actually a little bit improved which that's where you are likely to see the impact of accretion of activities associated with purchase accounting. In fairness to loan marks and the rest of the portfolio are really modest compared to that.

I think generally across the board we did see a little bit more utilization of some home equity products during the quarter which had yields that were a little bit higher than quote, a [HE] lock instrument as an example. But David, there is really nothing, anything in that mix I would argue that from our perspective, the 577 loan yield from the second quarter is the same as the 581 for third quarter.

Okay, how about consumer -- for indirect loans, where are those yields coming on the books today?

I think new yields are coming out a little bit lower than expiring yields but it is fairly close. Over the last eight quarters the numbers have moved from a 630, 625 to 619, 618-type overall portfolio yield so some of that is a function of paper grade but we still tend to be very biased. Over 85% of our originations are still coming through A and B paper grade.

And they're still coming in above the total portfolio yield as well, right? So if you were to grow that portfolio a bit and improve the mix, you could offset --?

That's absolutely correct. It's a productive business to be participating in today and just again as a reminder that again, we are about two-thirds to 70% used versus new so when you are used to seeing all the optics in the market around new rates at 2.9%, 3.9%, that's not the market that we are principally in.

Okay and then within your AFS portfolio I think you have most of the treasuries in your held-to-maturity bucket so you wouldn't have the prepayment risk in that portfolio but in the AFS portfolio, is there a chance that you could use or a probability that you would use some of that $78 million unrealized gain to prepay some of your borrowings and remove some of the higher cost, long day-to-day FHLB advances?

David, probably not right now, no. The quote, the pre-payment penalty in the debt obligations is capital punitive and we don't, as much as we would like to have lower yielding borrowing instruments like I think most people would today, we don't think that that is a productive use of capital from a replacement standpoint today. We're comfortable that for projection purposes, we expected that to be out there through 2012 into '13 and we expect the investment portfolio to be of a similar size as it is today.

I guess in a way, David, it's NPV negative right now so it doesn't make economic sense to do that right now. It is an analysis though that we run several times a year to try to gauge the sensibility of that strategy so it is something that we look at periodically but it's just, with a negative NPV it just doesn't make sense at this point.

How about are there any maturities within the next six months?

No David, really there is not a material maturity composition of that portfolio until late 2014.

Okay, are you seeing any, is there any disruption in the market on the deposit side from customers maybe at HSBC that are uncertain about their future?

Yes. I'll expand. I think there are a lot of things obviously on people's minds today in some of the markets that we're in and certainly that would include markets where we compete head to head with HSBC which is actually a fair number of our markets. In fact, they are one of the competitors that show up most in our market amongst all of the banks that we compete with so we have seen some advantage of that.

In some markets I would characterize it as significant advantage. I think that has probably been motivated as well by a lot of the media reports of you know, throw the big bags overboard and some of those kinds of things but we have certainly been the beneficiary and in some cases in significant ways in some of our markets of the uncertainty surrounding the HSBC branch sale.

How are you thinking about branch acquisitions? What are your hurdle rates for expected earnings per share accretion over a 12 to 18 month horizon after a deal and then also what are you comfortable with as far as expecting any tangible book value dilution in this type of environment?

I think there is -- it is difficult to boil it down to give you a number on IRR or something like that. I mean, I could throw a number out there, David, that would probably satisfy you or not satisfy you. I think the reality is when you start looking at IRR calculations as you know, there are a lot of variables and a lot of complexity to that. You can basically make the answer whatever you want so I can tell you that 20% IRR is the hurdle. I can tell you 10% but those two numbers might not be that far apart based on the assumptions and variables you use in the calculation.

We look at earnings accretion certainly in terms of growth opportunities. It has got to be additive to shareholders. If it doesn't help us grow earnings and grow the dividend over time in a sustainable way, then we won't be interested. I think we probably also take a very focused look at the qualitative factors that go into M&A opportunities in branch as well as whole bank opportunities because when you look back five years at an acquisition you did and you kind of reflect on it, if it went well, it integrated well, it grew a bit, and it was accretive, at the time if it seemed like you paid a lot -- the price is inconsequential to the execution I guess is what I'm saying.

We look at the qualitative issues around our ability to effectively execute and integrate with an acquisition as opposed to just giving the analysts some IRR number that can be effectively contorted to satisfy high expectations. I can't give you a number. We run all those numbers but we look principally at accretion to shareholders, dividend capacity to shareholders, and the sustainability and probability of a successful execution integration. Those are really the standards that we measure opportunities by.

And David, even despite the very low reinvestment rate in the market today from an excess liquidity standpoint, we are still interested in branch transactions and our track record on branch transaction performance is very, very good so I think we believe we've got an integration model that handles the transition of branch transactions quite well, to Mark's point, regardless of price. The challenge in today's market is obviously what to do with reinvestment of significant liquidity with again the underlying presumption that a lot of these branch transactions don't actually come with a lot of assets.

Okay, are you seeing other opportunities in the market for either branch deals or whole bank transactions, putting aside the HSBC related deals?

There is always activity and opportunity in the marketplace, David. We don't stand on the shore with our pole in the water waiting for a fish to head. We get in the boat and go find the fish so we are always active in terms of searching out those high value opportunities that we think would be additive to shareholder value and that activity and exercise is ongoing. I think right now if you look at the business cycle is at a lower point. The confidence cycle is at a lower point. Even the valuation cycle, you look at banks and a lot of even very high quality institutions trading at multiples that are significantly less than book value. We think it's a very exceptional time in the cycle to be out in the boat fishing. We continue to be active in that respect and as you know, it has historically been an important element of our growth strategy because we're not in markets that go through these boom and bust cycles where you have tremendous opportunities to grow. They're very low growth but stable and I think we've developed a business and growth strategy which really capitalizes on our ability to create value for shareholders in that environment.

And then David to your last question at the very end, as you know we have a very pointed perspective relative to tangible equity ratios. We have lived through a cycle where we've been told by virtually everybody that we had lower than our peer level of tangible equity. We continue to equate the necessity of tangible equity to two points. One is risk attributes on the balance sheet. The second is regulatory constraints, if any, and we currently obviously don't have any of those so for the right transaction, we could see our tangible equity ratio go back into the fives easily and we would not be uncomfortable with that again if it met that same criteria which is creates earnings and creates dividend paying capacity. And as you know, we have never run away from the amortization of intangible. That is not a problem for us. That creates capital from day one forward. Our perspective is that's not necessarily a bad thing.

Okay, got it, thank you.

Our next question comes from Rick Wise. Your line is live.

Hi guys, this is Dave Peppard filling in for Rick. I'm just curious if you can give us a little color as to what you're seeing in the deposit portfolios and how you are managing levels quarter to quarter and what kind of opportunities you have there to lower your overall cost of funds through that side?

I think strategically for many years we've been pursuing core deposits even when the interest rate market was higher and they had more value. We continue to pursue core deposits because I think that longer term there is very little you can do in the world of community banking that creates as much value as creating a strong core deposit base. We continue to pursue core deposits. Core deposits as a percent of total funding has grown dramatically. I think Scott gave some data points on that. We will continue to focus on that. Those core deposits also create the income opportunities in many respects despite the headwinds on that. They still for us continue to be highly profitable mechanisms and stable in terms of their retention characteristics.

We will continue to focus on core deposits. If you look at our release in the data sheets you can see the time deposit book has come down. It will continue to come down. Honestly, we didn't get as much decline in CD funding costs this quarter as maybe we could have. We have room to move that down further and I think you're going to see in the future the cost of the CD, the CD funding costs will come down.

I think we have room to lower other deposit rates as well and expect to move in that direction as we have really over the past eight quarters or so as the general interest rate environment has come down but we think we have the capacity to continue to do that particularly given the excessive liquidity that we have of a couple hundred million dollars plus so we think we have opportunity to continue to drive down the funding costs on the deposit side.

And David I'll even add this sort of one little obscure fact that as much as we grew core deposits and to Mark's point, I don't think we'll ever stop trying to grow core deposits because of the other stable funding base that that creates that allows you to do other things from an ALCO planning standpoint but even in the quarter with the predominant amount of the new funding rates in the quarter being in demand instruments checking and savings, even though that was only redeployed at 25-basis points we actually made money on it. Now it destroyed the margin from a characteristic standpoint but we made money on that outcome, hard to believe.

And our last question comes from John Stewart. Your line is live.

Just curious if you could maybe give a little more detail around the disposition of the Wilber assets, the $23.3 million that you referenced. Can you just talk about I guess specifically with regard to the impaired loans, what price or the disposition price relative to the acquired mark?

Sure. John, it's really not a big piece of that. We didn't do some kind of a wholesale loan sale or anything like that. Probably half of that $23 million is actually scheduled principle cash contractual obligations for borrowers that are servicing. The remainder is really what I would call normal course of business but remember we've had such a small portfolio of impaired loans historically. Normal course of business for us is probably accelerated course of business for many so to your point, we're actually, quote, disposing of certain of these assets very, very close to fair value par so we're not seeing large additional needs for losses associated with disposition nor are we running a situation where we're achieving significant gains from what we booked it at.

I would almost say common fare and I would expect that we would have that sort of orderly march of some other assets over the course of the next three to nine months that move off the books in a similar fashion.

Okay but so the dispositions you're saying are pretty close to fair value par but there are some -- I guess what I'm trying to understand is is there some acceleration of the accretable yield given that you've disposed of these assets maybe quicker than you maybe otherwise would have expected?

For us those impaired loans are kind of a pooled activity so no upside recognition at all.

Okay, thank you.

And our next question comes from John Moran. Your line is live.

Just real quick, you had talked a couple quarters back I think about the possibility of sort of leveraging Wilber's wholesale banking across the CVU footprint and I'm just wondering if you had any kind of update or sort of extended thoughts on that?

Sure. I will say that, I think I said in my comments that one of the growth characteristics of Wilber since the acquisition has been the growth in consumer mortgage itself. That business is actually doing quite well. As to the opportunity to leverage it up by doing more than what we're doing right now in terms of additional offices opening or additional sales and origination folks, we haven't done that at this point yet. Strategically, I think we're still evaluating our alternative to that respect. I'm not sure which direction we're going to go but I will tell you that the origination volume is very strong right now.

Terrific, that's helpful. And then just in terms of demand, you guys had mentioned that it's still pretty tepid out there. Would you characterize it as stronger in certain markets, weaker in others and kind of if you could give us the lay of the land, sort of sub-footprint if you will, that would be helpful.

Yes, as I said, the consumer businesses are actually doing quite well. I think we commented on that. Scott gave some detail around the mortgage business which continues to perform extremely well and the auto business which also is performing extremely well. In fact, that's on a double digit growth pace and we think the opportunity for that to continue will be present just given the dynamics of the auto market.

So the consumer side, with the exception of home equities which are down a bit but barely, the consumer business has been very good and very strong and very productive for us.

The commercial business side has been softer. It has been, and I think that decline in demand in market opportunities has created a more competitive environment as well so you're seeing more competition. You're seeing spreads narrow. You're actually -- at this point what we've seen is structure in some cases has started to deteriorate. The ability to get floors is now much more difficult.

Clearly, the demand is soft on the commercial banking side. Market by market it kind of changes quarter to quarter so in the north country four quarters ago it was very strong and it has slowed down a little bit now. In Pennsylvania four quarters ago it was slow and now it has heated up a bit so it really can change over the course of the movement of quarters from one region to the next but I would just say overall that commercial demand has remained somewhat soft. That is certainly true in terms of the main street. I can't speak to the big corporate borrowers but that is not really our target market but the main street kind of small to midsized businesses, the demand is relatively soft.

One of the things we've seen as well, if you look at the data on commercial real estate transactions, they're up a lot so we've actually had some unexpected or unscheduled payoffs on commercial real estate transactions that we had financed that now have been sold with no opportunity to refinance so we have experienced some of that as well.

I just think it's a tough environment right now in our market for small and midsized commercial lending. The competitive environment is much more difficult but we're working hard to get our share and I expect we will get our share.

But it's not as if one piece of the footprint is really lagging. Geographically speaking, it's not as if upstate is really lagging while downstate is kind of hanging in there. It's sort of just soft everywhere then?

Yes, I would say generally that is true. It changes quarter to quarter but I would say there is not a significant distinction right now between our northern New York market, our kind of Finger Lakes and western New York market and our northeast Pennsylvania market. We are seeing some incremental opportunity in northeast Pennsylvania relative to the shale gas activity and that has been a bright spot in a lot of different respects in terms of deposit growth, wealth management opportunities, credit opportunities but beyond that, I would say that it is generally soft across all of our markets.

Okay, thanks very much.

And there are no more questions in the queue right now.

Very good. Thank you Jennifer. Thanks everyone for joining the call and we will talk to you again in January.

That concludes today's conference. Thank you for your participation and you may now disconnect.