Community Financial System Inc (CBU) 2016 Q3 法說會逐字稿

Good day, and welcome to the Community Bank System third quarter 2016 earnings conference call.

Please note this presentation contains forward-looking statements within the provisions of the Private Security 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 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, Vicki. Good morning, everyone, and thank you all for joining our call this morning. I want to apologize for the last-minute change in the timing. I know this is a busy week for all of you.

We have also been busy and are excited to comment on the quarter, but, more importantly, on our announced merger with Merchants Bancshares.

So Scott and I will make a few comments on the quarter and we'll then discuss the Merchant's transaction.

The third quarter was strong and consistent with our expectations. And, as a reminder, includes the Oneida acquisition that was closed in December, and so is not part of the 2015 quarter.

We had solid loan and deposit growth, with the exception of commercial, which was off in the quarter due to nearly $30 million of unexpected payoffs, most of which was three larger credits.

We continue to manage downward pressure on the margin and an increase state tax rate that cost us almost $0.02 a quarter, but the business is strong and growing. And heading into Q4, we're hopeful to deliver another record year of operating earnings. Scott?

Thank you, Mark, and good morning, everyone.

As Mark mentioned, the third quarter of 2016 was a very solid operating quarter for us, and, again, as a reminder, included the activities Oneida Financial that we completed last December.

Third-quarter operating EPS was $0.59 per share, which excludes $1 million of nonrecurring insurance-related gains in the quarter, bringing year-to-date operating results to $1.73 per share, consistent with the first nine months of 2015.

I'll first cover some updated balance sheet items. Average earning assets of $7.68 billion for the third quarter were up 7.9% from the third quarter of 2015, and $30 million higher than the second quarter of this year.

Ending loans increased $36 million in the third quarter or 0.7% on a linked-quarter basis, as solid organic growth in consumer mortgages and consumer installment products were partially offset by a $30 million net decline in commercial balances, the result of an unusually large level of unscheduled payoffs.

Quarter-end investment securities were down $54 million from the end of June, a result of very modest cash flow reinvestments in the third quarter in the current rate environment.

Period ending deposits were up $120 million in the third quarter of 2016, or 1.7%.

The first nine months of 2016 was a continuation of the favorable overall asset quality results that is part of our credit DNA.

Third-quarter net charge-offs of 12 basis points of average loans were generally consistent with the level reported in both the first half of this year and the third quarter of last year.

Nonperforming loans comprised of both legacy and acquired loans, ended the third quarter at $23.3 million or 0.47% of total loans, slightly improved from the ratio reported at the end of June and 11 basis points improvement from December 2015.

Our September 30th, 2016 reserves for loan losses represent 1.02% of our legacy loans and 0.95% of total loans outstanding.

Based on the most recent trailing four quarter results, our reserves still represent over six years of annualized net charge-offs.

As of September 30th, our investment portfolio stood at $2.87 billion, and was comprised of $235 million of US agency and agency-backed mortgage obligations, or 8% of the total, $623 million of municipal bonds, or 22%, and $1.98 billion of US Treasuries, 68% of the total. The remaining 2% was in corporate debt securities.

The portfolio contained an unrealized gain of $140 million as of quarter end.

Our capital levels in the third quarter of 2016 continue to be very strong. The tier one leverage ratio reached 10.35% at quarter end. Intangible equity to net tangible assets ended September at 9.66%. Tangible book value per share was $18.06 per share at third quarter end, and included $42.5 million of deferred tax liabilities generated from tax deductible goodwill, or $0.96 per share.

Shifting now to the income statement, our reported net interest margin for the third quarter was 3.67%, which was down six basis points from the second quarter and two basis points higher than the third quarter of 2015.

Consistent with historical results, the second and fourth quarters each year include our semiannual dividend from the Federal Reserve Bank of approximately $600,000, which added four basis points of net interest margin to second-quarter results, compared to the linked third and first quarters.

Third quarter results included approximately $500,000 or three basis points of margin improvement, of early termination fees related to the previously mentioned $32 million of unscheduled commercial payoffs.

Proactive and disciplined management of funding costs continued to have a positive effect on margin results, as total deposit costs in the quarter were 10 basis points.

Third quarter noninterest income was up $1.2 million linked quarter, and included the previously mentioned $1 million of nonrecurring insurance-related gain, as well as our annual dividend from certain pooled retail insurance programs of approximately $600,000.

Quarterly revenues from our benefits administration, wealth management, and insurance businesses of $22.2 million were consistent with the second quarter.

Third-quarter operating expenses of $66.2 million were also consistent with the linked second quarter, despite one additional day of payroll.

We have also continued to invest in improving our infrastructure and systems around the requirements of DFAST, as we embrace the impending $10 billion asset size threshold.

Our effective tax rate in the third quarter of 2016 was 32.8% versus 30.0% in last year's third quarter. Certain legislative changes to state tax rates and structures over the past two years resulted in the majority of the resultant higher rate, including those related to our overall asset size being above $8 [billion] on a consolidated basis.

This higher effective rate was and will continue to be a 2-plus cent per share quarterly headwind compared to the quarterly results of 2015.

Looking forward, we continue to expect the Federal Reserve Bank semiannual dividend in the fourth quarter of this year.

Our third quarter 2016 net charge-off results were again favorable, and, although we don't see signs of asset quality headwinds on the horizon, it would be difficult to expect improvements to current asset quality results.

Our reported net interest margin has remained in a fairly narrow band from 3.65% to 3.73% over the past five quarters, a range we expect to operate in for at least the next couple quarters.

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 sustained low rates.

In addition, as we previously mentioned, near the end of 2015, and then actually experienced in the first nine months of this year, our larger consolidated asset size eliminated certain tax planning opportunities, resulting in the 2.2 percentage points increase in our full-year expected tax rate in 2016.

We believe we remain very well-positioned from both a capital and an operational perspective for the balance of 2016 and into 2017, as we look forward to the incremental opportunities of the recently announced Merchants Bancshares transaction.

Now I'll turn it back over to Mark for some additional comments.

Thank you, Scott. Over the course of the past year or better, we've commented at length on our earnings calls and with our investors on two important strategic themes.

One was deploying our growing and excess capital levels in a disciplined fashion for the benefit of our shareholders, which I would define as growing our earnings and growing our dividend.

And secondly, preparing internally for the eventuality of crossing the $10 billion threshold and doing so in a manner that did not dilute the earnings and dividend returns to our shareholders.

With that as a backdrop, we are thrilled yesterday to have announced the merger with Merchants Bancshares of Vermont. I will make some comments on our thinking around the transaction, and then Scott will review the deal in financial metrics.

So why Merchants? First, this opportunity fully achieves the two strategic themes I just mentioned and that we have been discussing in our boardroom and with our investors for some time.

Namely, it effectively deploys capital and it hurdles the $10 billion threshold in a low-risk manner that is accretive to shareholders.

Number two, Merchants is a very high quality franchise, including its board and governance, its leadership, its people, its markets, its performance, and its balance sheet. This is an exceptionally strong and attractive institution in every respect.

We are very judicious with our capital and very judicious with our business partners, and believe we have both chosen wisely.

Merchants represents a lower risk partner. Of the potential transactions we've evaluated with respect to the $10 billion threshold, nearly all were either noncontiguous, larger, or lesser quality franchises.

Merchants operates in similar markets to our model, which is smaller, non-metropolitan markets with high share. They have a number three market share in the state behind two much larger institutions, a dynamic where we have always enjoyed a competitive advantage.

Their loan book is one of the strongest of any bank in the country. Their cumulative credit losses over the past 10 years, including through the credit crisis, is 27 basis points. That's not an average. That's in total. That's low risk.

And it's funded by an attractive, low-cost core deposit base very similar to ours.

Next, Merchants has tremendous leadership. They're well governed and well led. We're very pleased that Geoffrey Hesslink, Merchants' current President and Chief Executive Officer, will be remaining with the Company and appointed our New England Regional President. Geoffrey is a tremendous leader. And more important to us, he's a tremendous person.

We're also pleased that two Directors from Merchants will be joining the Community Bank System Board of Directors to support our ongoing efforts in these new markets and to provide representation to our significant new shareholders.

An important but frequently ignored element to success in business combinations is culture. The culture of Merchants and Community are identical. We both value humility, work ethic, respect for others, and a commitment to excellence and achievement.

Lastly, we view this merger as a foundation for continued growth and opportunity for both Merchants and Community. Merchants has grown nicely over the past several years at 6% or so a year, and we believe there are significant opportunities for that to continue or expand in many areas, including consumer credit products and, in particular, wealth management services, which we believe are generally underrepresented across the state.

We also like the opportunity to further explore the Springfield market, which is, at present, a small and low-risk investment in a larger market. So we like the dynamic and potential opportunity there as well.

In summary, this is a combination of two very high quality franchises that achieve significant strategic objectives and delivers tremendous value for both sets of shareholders. Scott?

Thanks, Mark. Although I'm certain most people on the call have the short investor presentation which was attached to the transaction announcement released yesterday, I'll hit on a few of the financial highlights and assumptions.

Merchants' shareholders will have the right to receive 0.963 shares of CBU stock for each share of Merchants they own, or $40 in cash, subject to an overall proration of 70% stock and 30% cash.

Assuming that split, the deal value as of the market close last Friday was just over $44 per share or an aggregate value of just under $304 million.

That outcome correlates to 17.5 times Merchants' 2017 consensus earnings estimates and 12.6 times with (inaudible) and cost [saves].

Subject to approvals, we expect the transaction to close in the second quarter of 2017.

After a very thorough review, we expect to achieve cost saves of 22.7% of Merchants' noninterest operating expense base by the end of 2017.

We have estimated that core deposit intangibles of $20 million will be created, and expect to amortize those over eight years on an accelerated basis, consistent with our historical practices.

Our $0.10-per-share projected GAAP accretion in 2018 includes a half year of Durbin impact, which we've estimated will be $10.5 million to the combined organization on a full-year basis.

Consolidated and bank capital ratios will remain comfortably above well capitalized regulatory requirements and will continue to provide us with ample flexibility for future organic and acquired growth opportunities.

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

Thank you. (Operator Instructions) Joe Fenech with Hovde Group.

On a pro forma basis, this deal gives you a bit more of a commercial orientation than you had previously. I think you'll be pushing 40% in terms of the commercial loan representation.

Was that an important consideration for you in crossing $10 billion with CFPB oversight now, or was it more coincidental?

And if it's the former, should we expect in your future deals to see you push even more towards that commercial emphasis?

No, I appreciate the comment, Joe. I think it's a good comment, an important comment, probably one which I should have commented on in terms of improving our balance sheet.

But clearly, we will be going from about 29%, which is the current component of our commercial book to our total portfolio, to about 37%. So a nice improvement there.

That wasn't necessarily part of the particular pursuit of any potential partner to take us over $10 billion. But I think certainly a clear advantage to us in terms of the pro forma outcome of the partnership with Merchants.

Okay. And geographically, the deal obviously takes you into new markets. There are a number of ways you guys could have went to expand the franchise, being eastern Ohio, Pennsylvania, maybe down further into the Hudson Valley closer to Metro New York, and you chose New England.

Should we take that to mean that you'll now look to fill in that New England footprint or is it still open season in the sense where you'll be willing to go wherever you see the right opportunity even if that takes you into maybe another new market?

Yes. I think if you think back to the commentary we've made in the past, Joe, on that question about M&A expansion, I think we've said that our preference would be to move in a contiguous fashion.

This is clearly very contiguous. It's the adjacent state next to New York. Our closest branch to their closest branch is somewhere around five or six miles. So it certainly are contiguous markets.

We certainly, as it relates to the threshold transaction, we're less interested in a transaction which was not contiguous or in market. We did look at a handful of those. They weren't nearly as attractive of franchises as Merchants for a lot of different reasons, which I just talked about.

So I think we, at the present time, have not had further dialogue or analysis around further expansion into New England. I think our objectives are to continue to expand in a contiguous fashion generally and in any direction where we can partner with high-quality franchises to create earnings accretion and dividend growth for our shareholders.

Okay. Thanks. And last one for me, you'll be at $10.5 billion mark pro forma. So on the one hand this is a larger deal for you, so I'm sure you'll want to make sure the integration goes well.

But does that outweigh maybe a desire to scale up a little bit more to get to, say $12 billion or so, and maybe that sends you back into the M&A arena sooner rather than later?

As we've talked about a lot, Joe, we are not in a hurry to get big. We weren't necessarily, as you know, in a hurry to do the threshold transaction. We talked about it a lot because we wanted our investors to understand that we will be prepared when that time does arrive.

So we've never pursued growth for the sake of growing. If we can grow and create earnings growth that's sustainable and dividend growth capacity for our shareholders, that's what we're interested in.

We aren't in the idea of having some indiscriminate target around how big we want to be or should be is not really how we think about the Company and its future strategically.

What we think around is really, again, growing in a way where we can partner in a low-risk fashion with high-quality partners to create above-average returns for our shareholders and do that in a lower risk fashion.

And, Joe, I would just even add at to Mark's comments that, as you know, with us, because we have significant noninterest income businesses, we have the opportunity to evaluate not only transactions, but organic growth opportunities on that front, and they don't necessarily add to the balance sheet in the same framing that a bank transaction might.

Got it. Thanks, guys.

(Operator Instructions) Collyn Gilbert with Keefe, Bruyette, and Woods.

Scott, if you could, I think it seems like a few folks perhaps, including myself, may be a little surprised that the $10.8 billion threshold will do it in terms of absorption of cost [and] lost revenue tied to Durbin.

Can you walk through -- I know you did a little bit on the Durbin side. But can you just walk through some of the math a little bit more specifically on how you're looking at kind of the cost needs that you already have in your run rate versus what you're going to incur and why you feel comfortable that you can get it all done at this modestly low asset level?

Well, Collyn, I'll start with the enterprises that are coming together first, because I do think there's a general perception from an industry standpoint that one has to get larger. And maybe, quite frankly, that's true for most transactions.

But I think when you're combining two high-quality institutions who both have return on asset characteristics north of 90 basis points, and in our case 120 basis points, the earnings capacity of the two enterprises you're bringing together really trump the asset size.

Now, that's not to say that asset size isn't important. And as we've said, over the long term, adding to earning assets when you are essentially a capital-controlled enterprise is definitely important. But I think we start off with two very good sets of hands here relative to earnings capacity to get started.

I think from there, Collyn, I think you work back through the scenario that says we are going to have a large Durbin charge. We have a very granular base of high-quality, low-cost core deposits, namely checking accounts. And our people, much like the Merchants people, are very used to convincing their customers that utilization of card-based revenues is an important attribute of their relationship.

So I would actually probably guess that we have one of the largest Durbin impacts of any institution getting close to the threshold.

But to that point, the mix of revenues within the two institutions that are coming together, especially somebody like us with a higher profile of noninterest income and noninterest income growth, I think actually makes up for some of that, quote, perception of the assets needed to be a little bit bigger.

So I think that's our general thought around that process. Not every combination that we've even modeled looks exactly like that, Collyn. You'd have been right that certain institutions with lower earnings capacity today do take, quote, more assets to get you to the same outcome.

Okay, that's helpful. And then just maybe it's more -- so the Durbin hit -- and I know, Scott, I think you've said this in the past, the loss on the fees you anticipate to be what once fully phased in?

Yes, so we're modeling $10.5 million on a consolidated basis, so essentially $9 million for us and about another $1.5 million for Merchants. Again, high volume of core checking accounts that have card utilization attached to them. The premise that we're going under from a modeling standpoint is that starts on July 1, 2018. So the 2018 results absorb a half year of that impact, 2019 a full-year impact. But clearly we expect to be a slightly larger institution in 2019 than we are on October 25, 2016.

Your question relative to the costs surrounding the rest of the stuff associated with DFAST, as we've said, we're underway. We're in the middle of some systems implementations relative to expanding our capabilities to do some of that. We are clearly using some outside resources who are very capable to get us to a sort of best in breed or best practice type of an outcome.

Our plans are to continue forward with an internal dry run per se for 2017, then have another dry run in 2018 that we would actually plan to submit to the regulatory body, and then 2019 would be on the clock. So that's how we've read relative to complying with that.

Your question on incremental costs, there will be some in 2017 and 2018, no question about it. We'll keep improving our infrastructure as we get better at the evaluation of the characteristics of completing the tasks. But I don't think we think it's so incremental that we don't absorb it in the normal course of our business.

Okay. That's really helpful. Okay. And then, is it safe to assume in this regulatory world that you kind of discussed with your regulators the prospect of this deal before you guys went ahead and signed an agreement with merchants?

I will not comment specifically on discussions with our regulators other than we have a very good relationship with our prudential regulator and have frequent dialog of any potential matters of significance.

Okay, great. And now back to the bank, the quarter. You guys had a great mortgage banking quarter. Kind of what is your outlook there in terms of is it seasonally driven or do you see a change in kind of borrower behavior that would suggest that that line can kind of run at a higher level?

You know, Collyn, we would love take credit for a great mortgage banking quarter. We had a good mortgage banking quarter. That line in our financial presentation includes things like insurance-related --

Oh, yes, yes, yes.

-- (multiple speakers). And as I mentioned, the one-time nonrecurring [noise item] that we would hope that --

I apologize.

That's okay. But we did have a good quarter. And we are seasonally better in the summertime, just given our markets. The closing activity from a home lending standpoint is more active in the summertime. So you'd have been correct with that assertion.

Okay, that's right. Sorry about that. And then just finally on the loan growth, are you guys seeing any changes in borrower behavior in either your various lending buckets or geographies either this quarter -- I know you obviously had those unexpected pay-downs, but just sort of how you're seeing demand evolve as we move into next year?

Yes, I would say, Collyn, I think overall it's reasonably good. It's probably right now the run rate at our consumer businesses are a bit better than they are on commercial. The consumer pipelines are pretty good, so the mortgage pipeline is good. The activity has been pretty -- has been reasonably strong.

The auto business has also been very strong certainly this year and the last handful of years. There's some discussions that we've hit peak auto, but that business continues to perform very well and demand has been very strong.

I think more recently the weakness has been on the commercial side. I think in terms of customer behavior I would just suggest that it's become more competitive. So there's a greater downward pressure on margins and there's greater pressure on term and structure. So I think it's the nature of the competitive environment, particularly on commercial. And then I think most banks are working hard to put assets on the books to overcome the headwinds of downward margin compression.

Okay, that's helpful. And to that point, Mark, is the three that paid down this quarter, anything consistent? Is it one bank that came in and it's just being more aggressive in your market? Or was it just unusual circumstances for each of those three borrowers?

No, in every situation I believe they were projects for businesses that were sold.

Oh, okay.

I would tell you in one case, though, we had a prepayment penalty on a, I think it was, $11 million credit that was around $0.5 million. So we did get paid for the excess but, nevertheless, it does represent a decline on the balance sheet.

Got it. Okay. All right. That's really great color. Thanks, guys.

(Operator Instructions) William Wallace; Raymond James

Maybe as a follow-on to Collyn's questions around loan growth, historically you guys have kind of talked about 3% to 4% annual. Does the Merchants deal change that at all?

Well, we're hoping. They've I think historically run at a somewhat higher rate than we have in terms of loan growth, certainly on the commercial side. So I think the opportunity, as I commented on, to expand some of the consumer credit options in their markets is something that we hope can kind of help accelerate growth. Would like to hope that we can continue the same level of performance in those markets as it relates to commercial, potentially even thinking about the idea that as a bigger combined institution we'll have greater credit capacity and may be able to leverage that into the marketplace, not just in Vermont but also into Springfield to our benefit.

So in their markets, if you look at the demographics, higher population growth, better HHI and HHI growth. So we would hope that we can continue to grow in those markets and hope to continue to grow in our markets as well. And we'll think about these opportunities that I commented on to try to accelerate growth in certain lending businesses.

Okay, thanks. I wanted to ask a follow-up on Durbin. You said $10.5 million annual impact. Is that based off of looking at the current quarters, putting the two together? Or do you have some assumption that you're going to grow your deposit customer base between now and then?

Yes, Wally. It's got some modest growth of the deposit customer based in that. And the assumption is you continue to get a little bit better at card utilization characteristics each year. So, yes, it's not radically above the current run rates, but it's some.

Okay. And then, my last question is a follow-up about the expense associated with preparing to go over $10 billion. Is there going to be -- you guys were already preparing for this. Are you going to have to accelerate any costs, whether it's personnel or systems investments between now and when the deal closes to prepare even faster?

I think between now and the time the deal closes, probably not. I would think soon after the deal closes, if there's any risk of accelerating, or the need to accelerate, it will be right then. I think our plans relative to how we're going to dry run 2016 during the 2017 calendar year from a prep standpoint will stay pretty much in step. But, again, we're not -- we're at what we think is ultimate full staffing for that outcome. And we know that there will continue to be system enhancements as one goes through data integrity type characteristics over time, Wally.

But, again, I think we've introduced those costs on a relative basis currently. And I don't think that we think that they'll be something that sticks out and becomes something you'll look at from the financials going forward and say -- wow, that cost is completely associated with that build-out. So think we'll take them in the normal course.

Okay. That's helpful. Thanks, Scott. Thanks, Mark. That's all I have.

And that does conclude our question-and-answer session for today, so I'd like to turn it back to Mark Tryniski for any additional or closing remarks.

Thank you, Ricky. Thanks to everyone for joining this morning. And thanks to those from Merchant Bancshares who joined as well. And we will talk to you again in January. Thank you all.

Thank you very much. And that does conclude our call for today. I'd like to thank everyone for your participation, and have a great day.