Community Financial System Inc (CBU) 2016 Q2 法說會逐字稿

Welcome to the Community Bank System second-quarter 2016 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 risk 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 begin.

Thank you, Matt. Good morning, everyone. Thank you for joining the call.

The second quarter was a good one in nearly every respect and reflects the ongoing core strength and operating trends of our all business lines. Commercial banking, mortgage banking, auto lending, and consumer banking all generated growth, with a total loan portfolio growing at an annualized pace of 7% for the quarter and over $100 million year to date.

Looking back over the trailing 12-month period, organic growth of our entire loan portfolio and core deposits were both 5.8%, which is a highly productive performance in our markets. Operating expenses and asset quality continue to be additive to performance, as has the revenue and margin results of our benefits, wealth management, and insurance businesses. Non-margin revenues now constitute over 35% of total revenues, providing not just diversification but multiple points of opportunity for further growth.

The Oneida Financial transaction, which closed in December, has integrated extremely well, with loans up since year end, deposit retention of 97%, and significant year-over-year pretax earnings growth of OneGroup, our insurance subsidiary. As I commented on last quarter, we continue to implement and build out our DFAST systems and have a road map that provides for a mid-2017 reporting capability, which positions us well with respect to the $10 billion threshold regardless of whether that is near term or beyond.

We are in very good shape heading into the second half of the year. Our capital and liquidity are at record levels. All our businesses have strong operating momentum and our pipelines remain above where they were at this time last year. In summary, we are looking forward to a productive second half of 2016.

Scott?

Thank you, Mark, and good morning, everyone.

As Mark mentioned, the second quarter of 2016 was a very solid operating quarter for us and again included the activities of the Oneida Financial acquisition that we completed last December. Second-quarter operating EPS of $0.58 per share was consistent with last year's results and matches an all-time high for us in the second fiscal quarter of any year, despite absorbing a $0.02 per share year-over-year negative comparison from a higher effective tax rate.

I'll first cover some updated balance sheet items. Average earning assets of $7.65 billion for the second quarter were up 11.5% from second quarter of 2015 and $42 million higher than the first quarter of this year. Average loans increased $655 million year over year, or 15.5%, reflective of the Oneida transaction and a solid last five quarters of organic growth. Ending loans increased $84 million in the second quarter, or 1.7% on a linked-quarter basis. Average investment securities were up 5.2% compared to the second quarter of 2015, entirely related to the Oneida transaction. Average deposits were up $951 million, or 15.6% from the second quarter of 2015, including approximately $700 million from the Oneida transaction, with the remainder from solid core deposit growth over the past four quarters. Total deposits, principally municipal balances, declined $161 million in the second quarter of 2016 as we seasonally expected.

Average borrowings for the quarter were $249 million, down $48 million on a linked-quarter basis. Quarter-end loans in our business lending portfolio of $1.54 billion were $241 million, or 18.6% above the end of June of last year, with approximately $150 million of that increase coming from the Oneida acquisition. Asset quality results in this portfolio continued be very favorable, with net charge-offs of under 10 basis points of average loans over the last nine quarters.

Our total consumer real estate portfolios of $2.18 billion, comprised of $1.78 billion of consumer mortgages and $400 million of home equity instruments, were essentially flat with end of the first quarter. We continue to retain in portfolio most of our short- and mid-duration mortgage production while selling secondary eligible 30-year instruments. Asset quality results continued to be very favorable in these portfolios, with total net charge-offs over the past nine quarters of just seven basis points of average loans.

Our consumer indirect portfolio of $993 million was up $52 million from the end of first quarter, which was seasonally expected. Despite solid new car sales again in 2016, used car valuations, where the largest majority of our lending is concentrated, continued to be generally stable. Net charge-offs in this portfolio were 33 basis points of average loans over the past nine quarters, a level we consider very productive and which has stayed quite consistent.

The first half of 2016 was a continuation of the favorable overall asset quality results that is part of our credit DNA. Second-quarter net charge-offs of 11 basis points of average loans were generally consistent with the level reported in both the first quarter of this year and the second quarter of last year. Nonperforming loans, comprised of both legacy and acquired loans, ended the second quarter at $24.1 million, or 0.49% of total loans, slightly improved from the ratio reported at the end of March.

Our June 30, 2016, reserves for loan losses represents 1.02% of our legacy loans and 0.95% of total outstandings after the Oneida acquisition. Based on the most recent trailing four quarters results, our reserve still represents over six years of annualized net charge-offs. We also continue to closely monitor our credit relationships influenced by natural gas-related activities in the Marcellus shale region of Northeast Pennsylvania, which experienced only modest changes during the second quarter.

As of June 30, our investment portfolio stood at $2.93 billion and was comprised of $235 million of US agency and agency-backed mortgage obligations, or 8% of the total; $645 million of municipal bonds, or 22%; and $1.99 billion of US Treasury securities, or 68% of the total. The remaining 2% was in corporate debt securities. The portfolio contained net unrealized gains of $164 million as of quarter end, clearly the highest level we have ever reported.

Our capital levels in the second quarter of 2016 continue to be very strong. The Tier 1 leverage ratio stood at 10.14% at quarter end and tangible equity to net tangible assets ended June at 9.58%. Tangible book value per share was $17.99 per share at second quarter end and included $41.5 million of deferred tax liabilities generated from tax deductible goodwill, or $0.94 per share.

Shifting now to the income statement, our reported net interest margin for the second quarter was 3.73%, which was down three basis points from the second quarter of last year and six basis points higher than the first quarter of 2016. Consistent with historical results, the second and fourth quarters of each year include our semiannual dividend from the Federal Reserve Bank of approximately $600,000, which added four basis points of net interest margins to second-quarter results compared to the linked third and first quarters.

Proactive and disciplined management of deposit funding costs continue to have a positive effect on margin results. First-quarter noninterest income was up 30.5% from last year's second quarter -- I'm sorry, second-quarter noninterest income -- and was meaningfully impacted by the Oneida acquisition. The Company's employee benefits administration and consulting businesses posted a 3% increase in revenues, with nearly half of that coming from Oneida activities.

Our wealth management and insurance group revenues were $6.1 million above the second quarter of 2015, with almost 97% of that growth related to the Oneida acquisition, primarily insurance agency revenues. Consistent with Oneida's historical results, the second quarter of the year was not as seasonably strong as the first quarter of the year in the insurance business. We expect third-quarter insurance revenues to be more in line with the second quarter, with another seasonal improvement in the fiscal fourth quarter expected.

Our second-quarter revenues from deposit service fees were seasonally higher than the late first quarter and up from the levels reported in the second quarter of 2015, with other half of that increase coming from the Oneida acquisition as higher card-related revenues were able to more than offset lower utilization of account overdraft protection programs. Mortgage banking and other banking services revenues were up $800,000 from the second quarter of last year and included $400,000 of nonrecurring insurance and other gains.

Second-quarter operating expenses of $66.4 million included a full quarter of the operating activities of the Oneida acquisition and the approximately 275 employees that were added, over half of which worked in and support the insurance and benefits business. As expected, lower payroll taxes expense was the largest contributor to a $1.2 million decline in salaries and employee benefit cost compared to the first quarter. Consistent with the recent historical experience, we did grant merit increases to our employees of approximately 3% in January of this year. We have also continued to invest in improving our infrastructure in systems around the requirements of DFAST as we get closer to the $10 billion asset size threshold.

Our effective tax rate in the second quarter of 2016 was 32.7% versus 30.5% in last year's second quarter. Certain legislative changes to state tax rates and structures over the past two years resulted in the majority of the result in higher rates, including those related to our overall asset size being above $8 billion on a consolidated basis. This higher effective tax rate was and will continue to be a $0.02 per share quarterly headwind compared to the quarterly results of 2015.

Although we actually reported improved net interest margins in the second quarter of 2016, we continue to expect more net interest margin challenges than opportunities in this persistent lower-for-longer rate environment. Although the majority of our new loan originations in our consumer lender portfolios are at yields consistent with those of the existing instruments, yields on new commercial originations remain modestly below our blended portfolio yields. Our funding mix and costs remain at very favorable levels today, which we do not expect significant improvement.

Our growth in all sources of recurring noninterest revenues has been positive and we believe we are positioned to continue to expand in all areas. While operating expenses will continue to be managed in a disciplined fashion, we do expect to consistently invest in all of our businesses. We continue to expect Federal Reserve Bank semiannual dividends in the second and the fourth quarter each year, as well as our annual dividend from certain pooled retail insurance programs in the fiscal third quarter.

Our second-quarter 2016 net charge-off results were again favorable, and although we do not see signs of asset quality headwinds on the horizon, it would be difficult to expect improvements to current asset quality results. Tax rate management will continue to be subject to successful reinvestment of our cash flows into high-quality municipal securities, which has been a challenge at times during this period of slow and low -- sustained low rates.

In addition, as we previously mentioned near the end of 2015 and then actually experienced in the first half of this year, our larger consolidated asset size eliminated certain tax planning opportunities, resulting in the 1.6 percentage point increase in our full-year expected tax rate in 2016. However, despite some of these apparent challenges, we believe we remain very well-positioned from both a capital and an operational perspective for the balance of 2016 and beyond.

With that, I will now turn it back over to Matt to open the line for questions.

(Operator Instructions)

Alex Twerdahl, Sandler O'Neill.

Good morning, guys.

Morning, Alex.

I wanted to ask first about M&A outlook. I am sure that it was going to be tackled at some point in this call, so might as well ask it first. It's been about 1.5 years since you guys announced the Oneida deal and I think that's probably the last deal that we have seen in your market. You think there is anything on the horizon that could come down that could look attractive, could fit your parameters as an opportunity for you guys in the next quarter or two?

It's tough to predict the near-term future, Alex, as you know. I think if you looked historically at our business model, we made an effort to be disciplined in partnering with high-value institutions, either within our footprint or adjacent to our footprint, so that strategy will continue. It's, again, difficult to predict what might happen in the near term.

I wouldn't even venture a guess in terms of that prediction other than to say we continue to have dialogue and to seek opportunities to partner with high-value acquisition partners in a constructive way to create value for combined shareholders. That is not going to change. I think overall the environment seems to be pretty open, relatively open, in terms of announced M&A, including a fairly significant transaction this morning.

Our strategy will continue. We're disciplined. We are not rushing to do things. We are not frantic. Right now, as I said the core momentums of all our business lines is really good. Trailing 12-month growth of almost 6% on both sides of the balance sheet. Our non-banking businesses are doing extremely well. We aren't going to push to do anything just to grow, but continue to seek out those opportunities that can help us grow shareholder value.

Okay. And then, just sort of a second part and a follow-up to that question. As you referenced, all of your business lines are chugging along and you are creating a lot of excess capital, and certainly have way too much capital as it is but limited things to do with it up in your market. So, if it's not M&A, are there any other opportunities or options you have for deploying excess capital, whether it be through special dividend or just increasing the regular dividend or do you think still the best use of it is to keep it and save it for potential M&A in the future?

I think your point about capital is good. I made that comment a couple times over the last four to six calls, which is that one of the burdens of surplus capital is deploying it effectively for the benefit of shareholders. Historically, we have done that through M&A. We haven't historically done a lot of buybacks.

I think it's preferable to invest in the business in a way that grows earnings and grows the dividends and grows total shareholder return over time. That's been our historical preference. If you look at the $10 billion level and where we are at right now and the surplus capital that we have on the balance sheet, we certainly have the capacity to do something a little bit larger. I'm not trying to foreshadow anything, I'm just saying that we have the capacity do that, not just in terms of capital but also relative to the Durbin challenge in $10 billion.

I think we will also look at non-banking businesses. We have done some of that over the last handful of years. Those businesses have grown nicely, both organically and, if you look back at the businesses that we acquired -- and those are, as you know, that's a national business, we have offices all over the country -- those businesses continue to grow. The margins continue to grow. We have very strong leadership in those non-banking business lines and we will continue to invest in those. We think that is a good place to deploy capital.

Beyond the initial capital deployment, there is no capital required on the subsequent growth of those businesses, which is -- so the return characteristics for shareholders are quite substantial. We will look to high-value bank opportunities. We will look to high-value non-bank opportunities. We do have a record of -- I think it's 23 years consecutively -- of raising our dividend. That's probably not a history that we would like to see tarnished. But the pressure remains on us as the leadership team to grow earnings so that we can keep that payout ratio within an appropriate and reasonable range.

We need -- the capital generation -- we generate a fair bit more capital than we need to capitalize organic growth, so it is our responsibility to deploy that capital in a way that can create growing and sustainable earnings and dividends for the benefit of our shareholders. We've got a record of doing that. I think we can continue to accomplish that, but we are also not in a hurry to deploy it in a way that doesn't benefit our shareholders.

Okay. That's great. One final question regarding expenses. You talked about the investments you made to get your DFAST ready by middle of 2017. Will there be any change in expenses, either leading up until that middle of 2017 mark or after that middle of 2017 mark based on the investments that you've made or will be making?

Right now it has been principally internal, though some of it has been external. Systems consulting resources needed I know at some juncture and this is built into our work plan. We are going to need to add resources that have specific financial and other kind of technology and mathematical-related skill sets. I would suggest to you that it won't be anything that even sticks out in terms of our run rate on expenses. They will get layered in over a period of time. Scott, you might have further comment --

I would go along with that, Alex. I think that we expect that will be on a ramped up basis but given where we are today, we are really happy with our progress that we have made to date. To Mark's point, we don't see an extraordinary or unusual event where there is a huge increase in that. It will probably start to blend into our numbers and just become something that we do on a recurring basis.

Great. That's all my questions for now. Thanks.

Thank you, Alex.

Joe Fenech, Hovde Group.

Good morning. On M&A, can you just update us on your thinking as you guys fine-tune your expectations, call it working through the DFAST preparation process. Has anything emerged through that process that has led you to say, okay, in an ideal world it would be great if we could pass through $10 billion at around this date and get to a specific size? I know the world doesn't necessarily work that way, but just wanted to get a little bit of insight into your thinking as you sort of fine-tune that process.

I think the thinking behind our process is really to be prepared. It is not -- we started down this path of DFAST compliance last year, have made good progress. The thinking behind this strategically was more to be fully prepared when that point came. It wasn't as much around having a strategy that speaks specifically to we want to be a certain size at a certain date. We try to be really opportunistic in terms of the quality of the franchises we partner with and the capacity we have jointly to create value for both sets of shareholders. That model has worked really good.

This isn't about getting to a certain size. I think our inertial momentum is really good right now. We understand that at some juncture we are going to need to face the $10 billion in the Durbin and maybe some higher expectations around risk management compliance and the like. We are going to be fully prepared for that.

The timing truly is not an issue. Even if we were to announce the transaction tomorrow that took us over $10 billion and it closed in, let's say, April or the second quarter of 2017, our DFAST submission would not actually be due until 2019. So we will be -- we're plenty ahead of the curve in terms of the timing. The timing in DFAST doesn't have really anything to do with any strategy around growth, other than we do expect to continue to grow over time in a disciplined and measured way that will create value for our shareholders.

That might be tomorrow, and that might be several years from now. We need to continue to operate organically to create value, and we need to continue to deploy that surplus capital in a fashion that also creates capital. Right now I think we have tremendous momentum on the operating side, not just momentum but also opportunity, particularly as it relates to our non-banking businesses. On the other side, we also have capital that will allow us to be flexible and hopefully opportunistic in terms of future growth potential for the benefit of shareholders.

Fair enough. And then, Mark, as you creep closer to $9 billion, though, organically here, does it make it less likely that you would be willing to do another deal like Oneida that might put you right at $10 billion? In other words, do you maybe skip over now the smaller deal as you creep closer to go over $9 billion and then try to do the larger deal first to leapfrog, or that wouldn't factor too much into your thinking?

Well, it probably wouldn't. I think if it was a high-value opportunity, a high-quality franchise that we had confidence in our capacity to create growing returns for shareholders -- earnings growth, sustainable growing earnings growth, cash flow for dividend purposes -- I think we would do it. Our responsibility is to create growing returns to shareholders. I think, despite the fact that it might be something that was a smaller transaction that got us up to the edge of $10 billion, I think we would evaluate that, Joe.

Clearly, it creates a little bit more -- at that point, you are at $9.8 billion or something, it does create a little bit of timing pressure in terms of the next transaction because I know some banks have grown over the $10 billion mark. We are not going to do that, because we are not in markets that are growing at a rate that allows us to do that in a way that doesn't impair value for shareholders.

I do think there could ultimately be, down the road, more timing pressure. But we -- our focus is, how do we ensure that three years from now, four years from now, five years from now we have considerably greater earnings per share, cash flow per share, dividend per share for our shareholders? If that means partnering with an institution that's a little bit smaller, that gets us up to the edge, we're not going to forgo that opportunity if we think it's highly additive to that three- to five-year future timeframe. That said, it would create a bit more pressure on the next transaction.

Sorry to beat this to death, but just one more. Would that include -- would that commentary, Mark, include an out-of-market deal where you wouldn't necessarily get the cost saves to offset Durbin? Or would that commentary be restricted to in-market where you can get those cost saves and make that more attractive with the Durbin hit?

Yes, I would say that we would be agnostic to that. We're not likely to go way out of market. We're not going to jump four states to go into a market that we are unfamiliar with. We're unlikely to do that. I think we'll continue to have plenty of high-quality opportunities to partner with great franchises in a either in-market or contiguous market opportunity so we wouldn't be likely to jump.

But in the event we went to a market where we didn't have a presence currently, and maybe you couldn't get the same degree of cost saves, if it is a high-quality franchise with opportunity to grow earnings and dividends for shareholders, we would certainly do it.

Okay. Thanks, guys.

Collyn Gilbert, KBW.

Thanks. Good morning, guys. Just to follow up on the comment about the capital accumulation, do you have plans, or how do you see yourselves managing that, what did you say, Scott, the $160-some odd million of unrealized gains in the securities book? Do you intend to take those? Are you going to restructure the portfolio at all? How should we think about that unfolding?

We have not really spent a lot of time talking about taking the gains because, in fairness, we really don't have use for the sources. We have so much capital today to naturally fund something without giving up the earnings stream associated with those superior yields today that we really haven't spent a lot of time talking about that.

I think in terms of managing the unrealized gains and losses, I would argue that, unless there is episodic events that lead us to say a restructuring is appropriate, that's not in our foreseeable future. Again, if something else showed up where we said, hey, listen, we need to fund something that is a bit larger than where we think our capital levels are, but again looking at that and saying, what am I going to do to the trend line relative to your earnings continuation, we are really comfortable with the portfolio attributes.

In the big scheme of things, I think there was a period of time not that long ago where we were critiqued for being a little bit longer than the average bank. I think we are in a spot now that we are extremely comfortable with, and I think we have stayed in that spot and enjoyed a better yield outcome than maybe many of our peers. Not that we were prognosticators of lower for longer but, quite frankly, that certainly has been in our best benefit over the course of the last several quarters.

I think other than that, we have an authorization relative to share buyback. I think we try to be obviously efficient with doing that. If you will notice our numbers, it's easy to say we've have some share creep over the last 12 months. To a certain -- as our share price has gone up (technical difficulty) of equity instruments from our folks that (technical difficulty). Over time we like to try to be neutral with that but I think you have to balance that with evaluation and potential other opportunities for the use of that capital before you rush into the large buyback or the large special dividend consideration. That's kind of where we think about it right now.

Okay. Given the rate environment where the 10-year is and everything like that, do you feel like you can kind of hold that securities yield in the 3% range?

It's challenging, I will say that. Where we find it is we've been so adept historically at finding opportunities in the municipal space. That's very difficult today. We are not having a lot of success replacing expiring cash flows on the muni side with new instruments that are close to the yields and the same risk or duration attributes that came off. That is a challenge for us.

We've been largely a buyer of bullet securities on the treasury and the agency side, so that is not necessarily a near-term focus. Our cash flows for 2016 and into 2017 are in the $150 million range off the portfolio, so it's not like we have got to track down $500 million of new assets in securities [times], so feel good about that for today. But probably if there was margin pressure that we felt going forward, it's probably more pronounced on the securities side today than it is on the lending side.

Okay. That's helpful. Just actually, on the lending side, you had indicated obviously the consumer yields are sort of finding an inflection point but the commercial yields are still coming under pressure. What is the spread differential on what you're originating on the commercial side versus what is rolling off?

It depends. I would say right now the commercial real estate spreads and cap rates in our markets are still pretty good. They're not like they are in a lot of other markets. The C&I stuff is where the spreads have come down quite a bit, so it really depends. If you look at the commercial yields the last few quarters, they were actually pretty flat for the last couple quarters.

This quarter, I think, held up better than we thought but I think, to Scott's point, generally speaking, the aggregate yield of the instruments that are going into the portfolio are a little bit lower than what the overall portfolio yield is right now. I think Scott said (inaudible). On the consumer side we've about washed out. Most of the consumer books, the new origination yield is about the same as what the portfolio yield is.

Okay. Taking all of this in totality, you guys have done a pretty good job keeping the NIM, or having NIM come on higher certainly than what I was thinking, but just kind of holding that NIM given all the variabilities. What do you think the trajectory is for the NIM as we look out over the next 6 to 12 to 18 months?

I would think we'd come back to this discussion that says I've got asset yield concerns in the 2 to 3 basis points a quarter that, as we found in the second quarter, sometimes there's ways to fight that off. Sometimes the mix change allows for a positive net spread change when it comes to that. I'll use the second quarter as an example. Growing in the commercial side and in the indirect auto side actually allowed us to probably make up basis points relative to our original projections just in terms of the mix change.

I think as we look forward, Collyn, the other thing that we're paying a lot of attention to is, where does essentially the large mortgage buyers go relative to the rate structure? Since the big drop in the 10-year over the last three weeks, some of which has come back, there really hasn't been the in-step drop in mortgage rates on a secondary side. Whether that's just a delay or whether that's, hey, we just are not going through to the next level of mortgage rate changes, that could potentially influence our outcome.

We have been preparing ourselves for whether it was going to be necessary to do anything on the funding side and we kind of thought about that in the second half of 2016. We would like our ability to really hold in our funding characteristics longer than the average bank, just because of where we are and where our concentration is. We really aren't having (technical difficulty) conversation today and don't think that conversation comes up for a while now, so feel good about the funding side.

Again, I think we would be comfortable with the difference being there are some things relative to the Federal Reserve Bank and the home loan bank that influence our quarter-over-quarter changes. I think we're in that and the concerning side for us is, do asset yields have a 2-or-3-basis-point type of a risk of drop going forward for the next three to four quarters?

Okay. That's helpful. I will leave it there. Thank you.

Thanks, Collyn.

(Operator Instructions)

It appears there are no further questions at this time. Mr. Tryniski, I'd like to turn the conference back to you for any additional or closing remarks.

No further commentary. It was a great quarter. Thank you, Matt. Thank you all for joining. We will talk to you again next quarter.

Thank you.

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