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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
|X| FOR ANNUAL AND TRANSITIONAL REPORTS PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
Commission file number 0-11716
[LOGO]
COMMUNITY BANK SYSTEM, INC.
(Exact name of registrant as specified in its charter)
New York Stock Exchange
(Name of Each Exchange on Which Registered)
Delaware 16-1213679
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation)
5790 Widewaters Parkway, DeWitt, New York 13214-1883
(Address of principal executive offices) (Zip Code)
(315) 445-2282
Registrant's telephone number, including area code
Securities registered pursuant to Section 12(b) of the Act: Common Stock,
No Par Value
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during all the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|.
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment of this Form 10-K. |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes |X| No |_|.
The aggregate market value of the voting stock held by non-affiliates of the
Registrant on June 30, 2003 determined using the closing price per share on that
date of $38.00, as reported on the New York Stock Exchange was approximately
$316,000,000.
Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of the latest practicable date.
14,315,773 shares of Common Stock, no par value, were outstanding on
March 10, 2004.
DOCUMENTS INCORPORATED BY REFERENCE.
List hereunder the following documents if incorporated by reference and
the Part of the Form 10-K into which the document is incorporated: (1) any
annual report to security holders; (2) any proxy or information statement; and
(3) any prospectus filed pursuant to Rule 424(b) or (c) under the Securities Act
of 1933.
Portions of Definitive Proxy Statement for Annual Meeting of Shareholders
to be held on May 19, 2004 (the "Proxy Statement") is incorporated by reference
in Part III of this Annual Report on Form 10-K.
Exhibit Index is located on page 71 of 74
TABLE OF CONTENTS
PART I Page
----
Item 1. Business ................................................................................ 3
Item 2. Properties .............................................................................. 7
Item 3. Legal Proceedings ....................................................................... 7
Item 4. Submission of Matters to a Vote of Security Holders ..................................... 7
Item 4a. Executive Officers of the Registrant .................................................... 8
PART II
Item 5. Market for Registrant's Common Stock, Related Shareholders Matters and Issuer
Purchases of Equity Securities ........................................................ 10
Item 6. Selected Financial Data ................................................................. 10
Item 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations ............................................................................ 12
Item 7a. Quantitative and Qualitative Disclosures about Market Risk .............................. 38
Item 8. Financial Statements and Supplementary Data:
Consolidated Statements of Condition ............................................... 40
Consolidated Statements of Income .................................................. 41
Consolidated Statements of Changes in Shareholders' Equity ......................... 42
Consolidated Statements of Comprehensive Income .................................... 43
Consolidated Statements of Cash Flows .............................................. 44
Notes to Consolidated Financial Statements ......................................... 45
Report of Independent Auditors ..................................................... 68
Two Year Selected Quarterly Data ........................................................ 69
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure .... 69
Item 9a. Controls and Procedures ................................................................. 69
PART III
Item 10. Directors and Executive Officers of the Registrant ...................................... 70
Item 11. Executive Compensation .................................................................. 70
Item 12. Security Ownership of Certain Beneficial Owners and Management .......................... 70
Item 13. Certain Relationships and Related Transactions .......................................... 70
Item 14. Principal Accountant Fees and Services .................................................. 70
PART IV
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K ........................ 71
Signatures ......................................................................................... 74
2
Part I
This Annual Report on Form 10-K contains certain forward-looking statements with
respect to the financial condition, results of operations and business of
Community Bank System, Inc. These forward-looking statements involve certain
risks and uncertainties. Factors that may cause actual results to differ
materially from those contemplated by such forward-looking statements are set
forth herein under the caption "Forward-Looking Statements."
Item 1. Business
Community Bank System, Inc. ("the Company") was incorporated on April 15, 1983,
under the Delaware General Corporation Law. Its principal office is located at
5790 Widewaters Parkway, DeWitt, New York 13214. The Company maintains a
web-site at communitybankna.com. Annual reports on Form 10-K, quarterly reports
on Form 10-Q and current reports on Form 8-K, and amendments to those reports,
are available on the Company's web-site free of charge as soon as reasonably
practicable after such reports or amendments are electronically filed with or
furnished to the Securities and Exchange Commission. The information on the
web-site is not part of this filing.
The Company's business philosophy is to operate as a community bank with local
decision-making, principally in non-metropolitan markets, providing a broad
array of banking and financial services to retail, commercial, and municipal
customers.
Community Bank System, Inc. is a single bank holding company which wholly-owns
four subsidiaries: Community Bank, N.A. ("the Bank"), Benefit Plans
Administrative Services, Inc. ("BPA"), CFSI Closeout Corp. ("CFSICC"), and First
of Jermyn Realty Co. ("FJRC"). BPA owns two subsidiaries, Benefit Plans
Administrative LLC and Harbridge Consulting Group LLC. BPA provides
administration, consulting and actuarial services to sponsors of employee
benefit plans. CFSICC and FJRC are inactive companies. The Company also
wholly-owns three unconsolidated subsidiary business trusts formed for the
purpose of issuing mandatorily redeemable preferred securities which are
considered Tier I capital under regulatory capital adequacy guidelines.
The Bank operates 126 customer facilities throughout twenty-two counties of
Upstate New York and five counties of Northeastern Pennsylvania offering a range
of commercial and retail banking services. The Bank owns the following
subsidiaries: Community Investment Services, Inc. ("CISI"), CBNA Treasury
Management Corporation ("TMC"), CBNA Preferred Funding Corporation ("PFC"),
Elias Asset Management, Inc. ("EAM") and First Liberty Service Corp. ("FLSC").
CISI provides broker-dealer and investment advisory services. TMC operates the
cash management, investment, and treasury functions of the Bank. PFC primarily
is an investor of residential real estate loans. EAM provides asset management
services to individuals, corporate pension and profit sharing plans, and
foundations. FLSC provides banking related services to the Pennsylvania branches
of the Bank.
Acquisition History (1999-2003)
First Heritage Bank
On January 6, 2004, the Company announced an agreement to acquire First Heritage
Bank in an all-stock transaction valued at approximately $74 million.
Headquartered in Wilkes-Barre, Pa., First Heritage is a closely held $275
million-asset bank with three branches in Luzerne County. First Heritage's three
branches will operate as part of First Liberty Bank & Trust, a division of
Community Bank, N.A. The acquisition is expected to close during the second
quarter of 2004, pending both customary regulatory and First Heritage
shareholder approval.
Grange National Banc Corp.
On November 24, 2003, the Company acquired Grange National Banc Corp.
("Grange"), a $280 million-asset bank holding company based in Tunkhannock, Pa.
Grange's 12 branches operate as part of First Liberty Bank & Trust, a division
of Community Bank, N.A. The Company issued approximately 1,147,000 shares of its
common stock to certain of the former shareholders at a cost of $47.94 per
share. The remaining shareholders received $42.50 in cash or approximately $20.9
million. In addition, Grange stock options representing $5.4 million of fair
value were exchanged for options of the Company.
Peoples Bankcorp Inc.
On September 5, 2003, the Company acquired Peoples Bankcorp, Inc. ("Peoples"), a
$29-million-asset savings and loan holding company based in Ogdensburg, New
York. Peoples' single branch is being operated as a branch of the Bank's network
of branches in Northern New York. The purchase price of the transaction
approximated $4.0 million in cash.
3
Harbridge Consulting Group
On July 31, 2003, the Company acquired PricewaterhouseCoopers' Upstate New York
Global Human Resource Solutions consulting group for a purchase price of
approximately $7.1 million in cash. This practice has been renamed Harbridge
Consulting Group ("Harbridge") and is a leading provider of retirement and
employee benefits consulting services throughout Upstate New York, and is
complementary to Benefit Plans Administrative Services, Inc., the Company's
defined contribution plan administration subsidiary.
FleetBoston Financial Corporation branches
On November 16, 2001, the Company acquired 36 branches from FleetBoston
Financial Corporation with $470 million in deposits and $177 million in loans.
The branches are located in the Southwestern and Finger Lakes Regions of New
York State.
First Liberty Bank Corp.
On May 11, 2001, the Company completed its acquisition of the $648-million-asset
First Liberty Bank Corp. ("First Liberty"). Pursuant to the terms of the merger,
each share of First Liberty stock was exchanged for .56 shares of the Company's
common stock, which amounted to approximately 3.6 million shares. The merger
constituted a tax-free reorganization and has been accounted for as a pooling of
interests under APB Opinion 16. Accordingly, the consolidated financial
statements for the periods presented have been restated to include the combined
results of operations, financial position and cash flows of the Company and
First Liberty. Certain reclassifications were made to First Liberty's prior year
financial statements to conform to the Company's presentation.
Citizens National Bank of Malone
On January 26, 2001, the Company acquired the $111-million-asset Citizens
National Bank of Malone, a commercial bank with five branches throughout
Franklin and St. Lawrence counties in New York State. The Company issued 952,000
shares of its common stock to the former shareholders at a cost of $26.50 per
share. All of the 648,100 shares held in the Company's treasury were issued in
this transaction.
Elias Asset Management, Inc.
On April 3, 2000, the Company acquired all the stock of Elias Asset Management,
Inc. (EAM) for cash of $6.5 million. Additional consideration of $3.0 million
was recognized in 2001 based upon performance targets set forth within the stock
purchase agreement. EAM, based in Williamsville, NY, is a nationally recognized
firm that manages assets for individuals, corporate pension and profit sharing
plans, and foundations.
Services
The Bank is a community retail bank committed to the philosophy of serving the
financial needs of customers in local communities. The Bank's branches are
generally located in small towns and villages within its geographic market areas
of Upstate New York and Northeastern Pennsylvania. The Company believes that the
local character of business, knowledge of the customer and customer needs, and
comprehensive retail and small business products, together with responsive
decision-making at the branch and regional level, enable the Bank to compete
effectively. The Bank is a member of the Federal Reserve System and the Federal
Home Loan Bank of New York ("FHLB"), and its deposits are insured by the FDIC up
to applicable limits.
Competition
The financial services business is highly competitive. The Company competes
actively with national and state banks, thrift institutions, credit unions,
securities dealers, mortgage bankers, finance companies, insurance companies,
and other regulated and unregulated providers of financial services.
4
The table below summarizes the Bank's deposits and market share by the
twenty-seven counties of New York and Pennsylvania in which it has customer
facilities. Market share is based on deposits of all commercial banks, credit
unions, savings and loan associations, and savings banks.
Number of
----------------------------------------------
Towns Where
Deposits Company
6/30/2003 Market Has 1st or 2nd
County State (000's) (1) Share Facilities ATM's Towns Market Position
- -----------------------------------------------------------------------------------------------------------
Allegany NY $ 197,975 48.9% 10 8 9 9
Lewis NY 78,786 37.9% 4 1 3 3
Seneca NY 127,261 34.5% 4 3 4 3
Susquehanna PA 170,994 33.7% 2 1 2 2
Yates NY 79,681 29.9% 3 2 2 2
Cattaraugus NY 258,049 28.6% 10 7 7 6
Wyoming PA 99,290 27.1% 4 2 4 3
St. Lawrence NY 341,240 26.2% 15 8 11 10
Franklin NY 82,954 16.5% 5 3 4 4
Chautauqua NY 195,875 14.2% 12 10 10 6
Schuyler NY 16,393 13.1% 1 1 1 0
Jefferson NY 141,765 12.3% 5 5 4 2
Steuben NY 168,020 11.3% 10 6 8 5
Lackawanna PA 440,663 11.0% 11 14 8 4
Tioga NY 36,670 9.8% 2 2 2 1
Livingston NY 48,366 8.2% 3 3 3 2
Ontario NY 82,080 6.2% 3 4 3 1
Wayne NY 51,586 5.9% 2 1 1 0
Herkimer NY 30,006 5.3% 1 1 1 1
Oswego NY 46,094 4.6% 2 2 2 2
Cayuga NY 29,728 3.6% 2 1 2 2
Luzerne PA 95,285 1.6% 8 7 5 2
Bradford PA 13,063 1.6% 2 2 1 0
Oneida NY 59,377 1.5% 2 1 1 1
Chemung NY 16,254 1.3% 1 1 1 0
Onondaga NY 9,690 0.1% 1 1 1 0
Erie NY 24,729 0.1% 1 0 1 1
- -----------------------------------------------------------------------------------------------------------
27 Total $2,941,874 5.1% 126 97 101 72
===========================================================================================================
(1) Deposit market share data as of June 30, 2003, the most recent information
available, calculated by Sheshunoff Information Services, Inc. Includes
all branches acquired from Peoples Bankcorp Inc. and Grange National Banc
Corp. during 2003.
Employees
As of December 31, 2003 and 2002 the Company employed 1,259 and 1,120 full-time
equivalent employees, respectively. The Company offers a variety of employment
benefits and considers its relationship with its employees to be good.
5
Supervision and Regulation
Bank holding companies and national banks are regulated by state and federal
law. The following is a summary of certain laws and regulations that govern the
Company and the Bank. To the extent that the following information describes
statutory or regulatory provisions, it is qualified in its entirety by reference
to the actual statutes and regulations thereunder.
Federal Bank Holding Company Regulation
The Company is registered under, and is subject to, the Bank Holding Company Act
of 1956, as amended. This Act limits the type of companies that Community Bank
System, Inc. may acquire or organize and the activities in which it or they may
engage. In general, the Company and the Bank are prohibited from engaging in or
acquiring direct or indirect control of any corporation engaged in non-banking
activities unless such activities are so closely related to banking as to be a
proper incident thereto. In addition, the Company must obtain the prior approval
of the Board of Governors of the Federal Reserve System ("the FRB") to acquire
control of any bank; to acquire, with certain exceptions, more than five percent
of the outstanding voting stock of any other corporation; or, to merge or
consolidate with another bank holding company. As a result of such laws and
regulation, the Company is restricted as to the types of business activities it
may conduct and the Bank is subject to limitations on, among others, the types
of loans and the amounts of loans it may make to any one borrower. The Financial
Modernization Act of 1999 created, among other things, a new entity, the
"financial holding company". Such entities can engage in a broader range of
activities that are "financial in nature", including insurance underwriting,
securities underwriting and merchant banking. Financial holding companies can be
established relatively easily through a notice filing with the FRB, which acts
as the "umbrella regulator" for such entities. The Company may determine to
become a financial holding company in the future.
Federal Reserve System
The Company is required by the Board of Governors of the Federal Reserve System
to maintain cash reserves against its deposits. After exhausting all other
sources of funds, the Company may request to borrow from the Federal Reserve.
Bank holding companies registered with the FRB are, among other things,
restricted from making direct investments in real estate. Both the Company and
the Bank are subject to extensive supervision and regulation, which focus on,
among other things, the protection of depositors' funds.
The Federal Reserve System also regulates the national supply of bank credit in
order to influence general economic conditions. These policies have a
significant influence on overall growth and distribution of loans, investments
and deposits, and affect the interest rates charged on loans or paid for
deposits.
Fluctuations in interest rates, which may result from government fiscal policies
and the monetary policies of the Federal Reserve System, have a strong impact on
the income derived from loans and securities, and interest paid on deposits.
While the Company and the Bank strive to anticipate changes and adjust their
strategies for such changes, the level of earnings can be materially affected by
economic circumstances beyond their control.
The Bank is subject to minimum capital requirements established, respectively,
by the FRB and the FDIC. For information on these capital requirements and the
Company's and the Bank's capital ratios see "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Capital" and Note P
to the Financial Statements.
Office of Comptroller of the Currency
The Bank is supervised and regularly examined by the Office of the Comptroller
of the Currency ("the OCC"). The various laws and regulations administered by
the OCC affect corporate practices such as payment of dividends, incurring debt,
and acquisition of financial institutions and other companies. It also affects
business practices, such as payment of interest on deposits, the charging of
interest on loans, types of business conducted and location of offices. There
are no regulatory orders or outstanding issues resulting from regulatory
examinations of the Bank.
Sarbanes-Oxley Act of 2002
On July 30, 2002, the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act") was
signed into law. The Sarbanes-Oxley Act represents a comprehensive revision of
laws affecting corporate governance, accounting obligations and corporate
reporting. The Sarbanes-Oxley Act is applicable to all companies with equity or
debt securities registered under the Securities Exchange Act of 1934. In
particular, the Sarbanes-Oxley Act establishes: (i) new requirements for audit
committees, including independence, expertise, and responsibilities; (ii)
additional responsibilities regarding financial
6
statements for the Chief Executive Officer and Chief Financial Officer of the
reporting company; (iii) new standards for auditors and regulation of audits;
(iv) increased disclosure and reporting obligations for the reporting company
and their directors and executive officers; and (v) new and increased civil and
criminal penalties for violation of the securities laws. Sections 302(a) and 906
of Sarbanes-Oxley Act, require the Company's chief executive officer and chief
financial officer to certify that the Company's Quarterly and Annual Reports do
not contain any untrue statement of a material fact or omit to state a material
fact, that the Quarterly and Annual Reports comply with the Securities and
Exchange Act of 1934 and that the information in the Report fairly presents the
financial condition and results of operations of the Company. The rules have
several requirements, including having these officers certify that: they are
responsible for establishing, maintaining and regularly evaluating the
effectiveness of the Company's internal controls; they have made certain
disclosures to the Company's auditors and the audit committee of the Board of
Directors about the Company's internal controls; and they have included
information in the Company's Quarterly and Annual Reports about their evaluation
and whether there have been significant changes in the Company's internal
controls or in other factors that could significantly affect internal controls
subsequent to the evaluation. The Company believes it is in compliance with all
effective sections of the Sarbanes-Oxley Act.
Item 2. Properties
The Company has 131 properties, 88 are owned and 43 are located in long-term
leased premises. Of the 131 properties, 126 are considered customer facilities.
The remaining facilities include its administrative offices at 5790 Widewaters
Parkway, DeWitt, New York, its loan and deposit operation centers located in
Olean and Canton, New York, respectively, its commercial lending center located
in Corning New York, and a training center located in Ogdensburg, New York.
Real property and related banking facilities owned by the Company at December
31, 2003 had a net book value of $44.0 million and none of the properties was
subject to any material encumbrances. For the year ended December 31, 2003,
rental fees of $1.9 million were paid on facilities leased by the Company for
its operations.
Item 3. Legal Proceedings
The Company and its subsidiaries are subject in the normal course of business to
various pending and threatened legal proceedings in which claims for monetary
damages are asserted. Management, after consultation with legal counsel, does
not anticipate that the aggregate liability, if any, arising out of litigation
pending against the Company or its subsidiaries will have a material effect on
the Company's consolidated financial position or results of operations.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of the shareholders during the quarter
ended December 31, 2003. In February 2004, the Company mailed a proxy statement
to shareholders related to the approval of an amendment to the Certificate of
Incorporation of the Company to increase its total authorized shares from 20
million to 50 million. The vote on this amendment will be held at a Special
Meeting of Shareholders on March 26, 2004.
7
Item 4a. Executive Officers of the Registrant
The following table sets forth certain information about the executive officers
of the Company and the Bank, each of whom is elected by the Board of Directors
and each of whom holds office at the discretion of the Board of Directors.
Name and Age Position
------------ --------
Sanford A. Belden Director, President and Chief Executive
Age 61 Officer of the Company and the Bank
Mark E. Tryniski Treasurer of the Company, and Executive
Age 43 Vice President, Chief Operating Officer
and Chief Financial Officer of the Bank
Michael A. Patton President, Financial Services
Age 58
James A. Wears President, New York Banking
Age 54
Thomas A. McCullough President, Pennsylvania Banking
Age 57
Steven R. Tokach Senior Vice President and Chief Credit
Age 57 Administrator
Brian D. Donahue Senior Vice President and Chief Credit
Age 47 Officer
W. Valen McDaniel Senior Vice President and Chief Risk
Age 57 Officer
Timothy J. Baker Senior Vice President and Senior
Age 52 Operations Officer
Sanford A. Belden (Director, President and Chief Executive Officer of the
Company and the Bank). Mr. Belden has been Director, President and Chief
Executive Officer of the Company and the Bank since October 1, 1992. Mr. Belden
was formerly Manager, Eastern Region, Rabobank Nederland, New York, New York
from 1990 to 1992 and prior thereto served as President, Community Banking, for
First Bank System, Minneapolis, Minnesota, a multi-state bank holding company.
Mark E. Tryniski (Treasurer of the Company, Executive Vice President, Chief
Operating Officer and Chief Financial Officer of the Bank). Mr. Tryniski joined
the Company in June 2003. Prior to his position with the Company, Mr. Tryniski
was a partner in the Syracuse office of PricewaterhouseCoopers LLP, with
eighteen years of experience working with SEC registrants in banking and other
industries.
Michael A. Patton (President, Financial Services). Mr. Patton was the President
and Chief Executive Officer of The Exchange National Bank, a former subsidiary
of the Company, from 1984 until January 1992, when, in connection with the
consolidation of the Company's five subsidiary banks into Community Bank, N.A.,
he was named President, Southern Region. He assumed his current position in
February 2000.
James A. Wears (President, New York Banking). Mr. Wears served as Senior Vice
President of the St. Lawrence National Bank, a former subsidiary of the Company,
from 1988 through January 1991 and as President and Chief Executive Officer from
January 1991 until January 1992. Following the January 1992 consolidation of the
Company's five subsidiary banks into Community Bank, N.A., Mr. Wears was named
President, Northern Region. He assumed his current position in February 2000.
Thomas A. McCullough (President, Pennsylvania Banking). Mr. McCullough joined
the Company in November 2003 and serves as President of Banking of First Liberty
Bank & Trust, a division of Community Bank, N.A. He was previously employed by
Grange National Banc Corp., having joined that organization in 1977 as Vice
President and Commercial Loan Officer. He was promoted to President and Chief
Executive Officer in 1989 and served in that capacity until the merger of Grange
with the Company in November 2003.
Steven R. Tokach (Senior Vice President and Chief Credit Administrator). Mr.
Tokach assumed the Credit Administrator position in March 2003. Prior to this,
Mr. Tokach was President of First Liberty Bank & Trust since May
8
2001, when First Liberty Bank Corp. was acquired by the Company. He was
Executive Vice President of First Liberty Bank Corp. and First Liberty Bank &
Trust from 1998-2001, and from 1993-1998, served as Vice President of Guaranty
Bank, N.A. and Executive Vice President of First Eastern Bank, both in
Pennsylvania.
Brian D. Donahue (Senior Vice President and Chief Credit Officer). Mr. Donahue
began his career with Fleet Bank (via its merger with First Trust Union Bank) in
Western New York in early 1980. While there he held various positions which
included Team Leader in the Middle Market Commercial Lending unit as well as
heading up the Small Business Bank division until his departure in 1992 to join
the Company. Mr. Donahue has a diversified background with other areas of
expertise including human resources, branch management, and retail indirect and
mortgage lending.
W. Valen McDaniel (Senior Vice President and Chief Risk Officer). Mr. McDaniel
joined the Company in 1991 as Vice President and Corporate Auditor & Risk
Manager. He assumed his current position in January 2004. Mr. McDaniel was
formerly Vice President & Corporate Auditor for 1st Nationwide Bank, Westfield,
NJ.
Timothy J. Baker (Senior Vice President and Senior Operations Officer). Mr.
Baker joined the St. Lawrence County National Bank (predecessor to Community
Bank, N.A.) in October 1971. Mr. Baker's areas of responsibility have included
head of the Credit Department and Loan Processing from 1973 to 1977; Vice
President, Commercial and Consumer lending group, and Manager of Loan
Application conversions from 1977 to 1983; Merger and Acquisition team leader
for loans from 1983 to 1985; and Chief Financial Officer of the St. Lawrence
National Bank from 1985 to 1992. He assumed his current position in 1992.
9
Part II
Item 5. Market for the Registrant's Common Stock, Related Shareholder Matters
and Issuer Purchases of Equity Securities
The Company's common stock has been trading on the New York Stock Exchange under
the symbol "CBU" since December 31, 1997. Prior to that, the common stock traded
over-the-counter on the NASDAQ National Market under the symbol "CBSI" beginning
on September 16, 1986. There were 14,165,156 shares of common stock outstanding
on December 31, 2003, held by approximately 9,413 registered shareholders of
record and shareholders whose shares are held in nominee name at brokerage firms
and other financial institutions. The following table sets forth the high and
low prices for the common stock, and the cash dividends declared with respect
thereto, for the periods indicated. The prices do not include retail mark-ups,
mark-downs or commissions.
Closing Price
High Low --------------------- Quarterly
Year / Qtr Price Price Amount % Change Dividend
- --------------------------------------------------------------------------------
2003
4th $50.95 $43.95 $49.00 11.6% $ 0.32
3rd $46.35 $37.33 $43.91 15.6% $ 0.32
2nd $38.76 $31.02 $38.00 20.9% $ 0.29
1st $34.23 $30.87 $31.43 0.3% $ 0.29
2002
4th $33.09 $27.20 $31.35 5.8% $ 0.29
3rd $32.55 $26.50 $29.63 -8.1% $ 0.29
2nd $34.21 $29.80 $32.25 7.0% $ 0.27
1st $30.32 $25.93 $30.15 15.1% $ 0.27
The Company has historically paid regular quarterly cash dividends on its common
stock, and declared a cash dividend of $0.32 per share for the first quarter of
2004. The Board of Directors of the Company presently intends to continue the
payment of regular quarterly cash dividends on the common stock, as well as to
make payment of regularly scheduled dividends on the trust preferred stock when
due, subject to the Company's need for those funds. However, because
substantially all of the funds available for the payment of dividends by the
Company are derived from the Bank, future dividends will depend upon the
earnings of the Bank, its financial condition, its need for funds and applicable
governmental policies and regulations.
The following table provides information as of December 31, 2003 with respect to
shares of common stock that may be issued under the Company's existing equity
compensation plans:
Number of Weighted
Securites to be Average Number of
Issued upon Exercise Price Securites Remaining
Exercise of on Shares Available for
Plan category Oustanding Options Outstanding Future Issuance
- ------------------------------------------------------------------------------------------------------------------------------------
Equity compensation plans approved by security holder:
1994 Long Term Incentive Plan 1,216,287 $ 25.56 755,079
Equity compensation plans not approved by security holder:
Citizens Advisory Council Plan 2,000 $ 32.05 3,000
- ------------------------------------------------------------------------------------------------------------------------------------
Total 1,218,287 $ 25.57 758,079
====================================================================================================================================
Item 6. Selected Financial Data
The following table sets forth selected consolidated historical financial data
of the Company as of and for each of the years in the five-year period ended
December 31, 2003. The historical "Income Statement Data" and historical
"Balance Sheet Data" are derived from the audited financial statements. The
"Average Balance Sheet Data", "Capital and Related Ratios", "Selected
Performance Ratios" and "Asset Quality Ratios" for all periods are unaudited.
All financial information in this table should be read in conjunction with the
information contained in "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and with the Consolidated Financial
Statements and the related notes thereto included elsewhere in this Annual
Report on Form 10-K.
10
SELECTED CONSOLIDATED FINANCIAL INFORMATION
Years Ended December 31,
---------------------------------------------------------------------------
In thousands, except per share data 2003 2002 2001 2000 1999
- -------------------------------------------------------------------------------------------------------------------------------
Income Statement Data:
Interest income $ 191,129 $ 205,093 $ 198,492 $ 189,665 $ 166,581
Interest expense 59,301 77,243 101,837 99,232 78,581
Net interest income 131,828 127,850 96,655 90,433 88,000
Provision for loan losses 11,195 12,222 7,097 7,722 5,856
Net interest income after provision for
loan losses 120,633 115,628 89,558 82,711 82,144
Non-interest income before security gains &
debt extinguishment 37,679 30,133 26,092 23,284 18,153
(Loss) gain on investment securities &
debt extinguishment (2,698) 1,673 (113) (159) (413)
Total non-interest income 34,981 31,806 25,979 23,125 17,740
Recurring operating expenses 101,963 94,330 80,430 70,534 66,778
Acquisition and unusual expenses 498 700 8,164 400 0
Total operating expense 102,461 95,030 88,594 70,934 66,778
Income before income taxes 53,153 52,404 26,943 34,902 33,106
Provision for income taxes 12,773 13,887 7,814 10,003 9,444
Net income $ 40,380 $ 38,517 $ 19,129 $ 24,899 $ 23,662
Net income - operating (1) $ 42,332 $ 37,926 $ 24,052 $ 25,230 $ 23,906
Diluted earnings per share $ 2.99 $ 2.93 $ 1.62 $ 2.32 $ 2.18
Diluted earnings per share - operating (1) $ 3.13 $ 2.88 $ 2.03 $ 2.35 $ 2.20
Balance Sheet Data:
Cash and cash equivalents $ 103,923 $ 113,531 $ 106,554 $ 76,456 $ 126,750
Investment securities 1,329,534 1,286,583 1,150,713 930,509 817,524
Loans, net of unearned discount 2,128,509 1,806,905 1,732,870 1,515,877 1,425,773
Allowance for loan losses (29,095) (26,331) (23,901) (20,035) (18,528)
Intangible assets 196,111 134,828 142,342 55,234 54,150
Other assets 126,415 121,731 104,787 93,598 89,274
Total assets $ 3,855,397 $ 3,437,247 $ 3,213,365 $ 2,651,639 $ 2,494,943
Deposits $ 2,725,488 $ 2,505,356 $ 2,545,970 $ 1,948,557 $ 1,844,752
Borrowings 667,786 543,575 357,931 471,053 462,762
Other liabilities 57,295 63,278 41,484 30,238 21,724
Shareholders' equity 404,828 325,038 267,980 201,791 165,705
Total liabilities and shareholders' equity $ 3,855,397 $ 3,437,247 $ 3,213,365 $ 2,651,639 $ 2,494,943
Average Balance Sheet Data:
Investment securities $ 1,185,487 $ 1,266,070 $ 1,042,726 $ 900,250 $ 826,708
Loans 1,885,604 1,759,564 1,580,870 1,484,945 1,343,652
Total interest-earning assets 3,071,091 3,025,634 2,623,596 2,385,195 2,170,360
Total assets 3,471,689 3,393,164 2,888,760 2,556,638 2,356,085
Interest-bearing deposits 2,090,749 2,100,960 1,783,938 1,613,918 1,588,481
Borrowings 508,392 507,893 482,583 447,105 280,806
Total interest-earning liabilities 2,599,141 2,608,853 2,266,521 2,061,023 1,869,287
Shareholders' equity $ 342,679 $ 294,856 $ 239,368 $ 174,498 $ 174,479
Capital and Related Ratios:
Tier I leverage ratio 7.26% 7.05% 6.73% 6.67% 6.76%
Total risk-based capital to risk-adjusted assets 13.01% 13.32% 11.83% 11.70% 12.10%
Tangible equity to tangible assets 5.70% 5.76% 4.09% 5.64% 4.57%
Cash dividends declared per share $ 1.22 $ 1.12 $ 1.08 $ 1.04 $ 0.96
Dividend payout ratio 40.2% 37.7% 65.7% 40.6% 40.4%
Book value per share $ 28.58 $ 25.04 $ 20.77 $ 19.11 $ 15.55
Tangible book value per share $ 14.73 $ 14.66 $ 9.74 $ 13.88 $ 10.47
Market capitalization (in millions) $ 694 $ 407 $ 338 $ 261 $ 247
Period end common shares outstanding 14,165 12,979 12,903 10,560 10,658
Diluted weighted average shares outstanding 13,517 13,167 11,825 10,737 10,861
Selected Performance Ratios:
Return on assets 1.16% 1.14% 0.66% 0.97% 1.00%
Return on assets - operating (1) 1.22% 1.12% 0.83% 0.99% 1.01%
Return on equity 11.78% 13.06% 7.99% 14.27% 13.56%
Return on equity - operating (1) 12.35% 12.86% 10.05% 14.46% 13.70%
Net interest margin 4.69% 4.62% 3.96% 4.06% 4.32%
Non-interest income/operating income 20.7% 17.7% 20.1% 19.4% 16.2%
Efficiency ratio 53.3% 52.0% 56.7% 54.6% 55.5%
Asset Quality Ratios:
Allowance for loan loss/loans outstanding 1.37% 1.46% 1.38% 1.32% 1.30%
Non-performing loans/loans outstanding 0.62% 0.64% 0.53% 0.49% 0.51%
Allowance for loan loss/non-performing loans 220% 226% 263% 271% 253%
Net charge-offs/average loans 0.54% 0.56% 0.42% 0.42% 0.33%
Loan loss provision/net charge-offs 109.1% 124.8% 107.8% 124.2% 133.5%
Non-performing assets/loans outstanding plus OREO 0.67% 0.69% 0.61% 0.58% 0.62%
1) Operating earnings excludes the effects of certain items the Company
considers to be non-operating, including acquisition expenses, the results
of securities transactions, and debt restructuring activities. See Table 1
in "Management's Discussion and Analysis of Financial Condition and
Results of Operations" for a reconciliation of GAAP-based earnings results
to operating-based earnings results.
11
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
This Management's Discussion and Analysis of Financial Condition and Results of
Operations ("MD&A") primarily reviews the financial condition and results of
operations of Community Bank System, Inc., and its subsidiaries ("CBSI" or "the
Company") for the past two years, although in some circumstances a period longer
than two years is covered in order to comply with Securities and Exchange
Commission disclosure requirements or to more fully explain long-term trends.
The following discussion and analysis should be read in conjunction with the
Selected Consolidated Financial Information on page 11and the Company's
Consolidated Financial Statements and related notes that appear on pages 40
through 67. All references in the discussion to the financial condition and
results of operations are to the consolidated position and results of the
Company and its subsidiaries taken as a whole.
All financial results reflect the 2001 acquisition of First Liberty Bank Corp.
("First Liberty") in accordance with the pooling of interests method of
accounting. Unless otherwise noted, all earnings per share ("EPS") figures
disclosed in the MD&A refer to diluted EPS; interest income, net interest income
and net interest margin are presented on a fully tax-equivalent ("FTE") basis.
The term "this year" and equivalent terms refer to results in calendar year
2003, "last year" and equivalent terms refer to calendar year 2002, and all
references to income statement results correspond to full-year activity unless
otherwise noted. Lastly, all references to "peer banks" pertain to a group of 78
bank holding companies nationwide having $3 billion to $10 billion in assets and
their associated composite financial results for the nine months ending
September 30, 2003 (the most recently available disclosure), as provided by the
Federal Reserve Board's Division of Banking Supervision and Regulation in the
Bank Holding Company Performance Report.
This Management's Discussion and Analysis of Financial Condition and Results of
Operations contains certain forward-looking statements with respect to the
financial condition, results of operations and business of Community Bank
System, Inc. These forward-looking statements involve certain risks and
uncertainties. Factors that may cause actual results to differ materially from
those contemplated by such forward-looking statements are set herein under the
caption "Forward-Looking Statements" on page 37.
Critical Accounting Policies
As a result of the complex and dynamic nature of the Company's business,
management must exercise judgement in selecting and applying the most
appropriate accounting policies for its various areas of operations. The policy
decision process not only ensures compliance with the latest generally accepted
accounting principles, but also reflects on management's discretion with regard
to choosing the most suitable methodology for reporting the Company's financial
performance. It is management's opinion that the accounting estimates covering
certain aspects of the business have more significance than others due to the
relative importance of those areas to overall performance, or the level of
subjectivity in the selection process. These estimates affect the reported
amounts of assets and liabilities and disclosures of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
Management believes that the critical accounting estimates include:
o Allowance for loan losses - The allowance for loan losses reflects
management's best estimate of probable loan losses in the Company's loan
portfolio. Determination of the allowance for loan losses is inherently
subjective. It requires significant estimates including the amounts and
timing of expected future cash flows on impaired loans and the amount of
estimated losses on pools of homogeneous loans which is based on
historical loss experience and consideration of current economic trends,
all of which may be susceptible to significant change.
o Actuarial assumptions associated with pension, post-retirement and other
employee benefit plans - These assumptions include discount rate, rate of
future compensation increases and expected return on plan assets. Table 8
on page 23 shows the impact of a one percentage point increase and
decrease of each of these assumptions. Specific discussion of the
assumptions used by management is discussed in Note K on pages 60 through
62.
o Provision for income taxes- The Company is subject to examinations from
various taxing authorities. Such examinations may result in challenges to
the tax return treatment applied by the Company to specific transactions.
Management believes that the assumptions and judgements used to record tax
related assets or liabilities have been appropriate. Should tax laws
change or the taxing authorities determine that management's assumptions
were inappropriate, an adjustment may be required which could have a
material effect on the Company's results of operations.
o Fair value of certain investment securities- Fair values of investment
securities are based on quoted market prices, where available. If quoted
market prices are not available, fair values are based on quoted market
prices of comparable instruments.
12
o Carrying value of goodwill and other intangible assets - The carrying
value of goodwill and other intangible assets is based upon discounted
cash flow modeling techniques that require management to make estimates
regarding the amount and timing of expected future cash flows. It also
requires them to select a discount rate that reflects the current return
requirements of the market in relation to present risk-free interest
rates, required equity market premiums and company-specific risk
indicators.
A summary of the accounting policies used by management is disclosed in Note A
(Summary of Significant Accounting Policies) starting on page 45.
Executive Summary
The Company's business philosophy is to operate as a community bank with local
decision-making, principally in non-metropolitan markets, providing a broad
array of banking and financial services to retail, commercial, and municipal
customers.
The Company's core operating objectives are: (i) grow the branch network,
primarily through a disciplined acquisition strategy, (ii) build high-quality,
profitable loan portfolios using both organic and acquisition strategies, (iii)
increase the non-interest income component of total revenues through development
of banking-related fee income, growth in existing financial services business
units, and the acquisition of additional financial services businesses, and (iv)
utilize technology to deliver customer-responsive products and services and to
reduce operating costs.
Significant factors management reviews to evaluate achievement of the Company's
operating objectives and its operating results and financial condition include,
but are not limited to: net income and earnings per share, return on assets and
equity, net interest margins, non-interest income, operating expenses, asset
quality, loan and deposit growth, capital management, performance of individual
banking and financial services business units, liquidity and interest rate
sensitivity, enhancements to customer products and services, technology
enhancements, market share, peer comparisons, and the performance of acquisition
and integration activities.
In 2003, the Company reported record earnings as a result of strong net interest
margins and significant increases in non-interest income. On an operating basis
(see Table 1 and related narrative), return on assets increased over 2002, while
return on equity declined slightly due to strengthened capital levels. Excluding
acquisition activity, revenues generated by the financial services businesses
declined slightly in 2003, principally as a result of the effects of a
challenging retail investment environment over the past three years. Operating
expenses and the efficiency ratio increased due to acquisition activity as well
as increased benefit costs.
Asset quality improved in 2003, with reductions in delinquency, charge-off and
non-performing loan ratios over 2002. Excluding acquisition activity, the
Company experienced strong loan growth in consumer mortgage and indirect
installment lending, with declines in the commercial and direct installment
portfolios. On a geographical basis, the New York markets reported growth in all
portfolios except consumer indirect. The Pennsylvania markets reported an
increase in consumer indirect, with declines in other portfolios. Excluding
acquisition activity, total deposits declined slightly from 2002.
The Company completed three acquisitions in 2003, including: (1) Harbridge
Consulting Group, an actuarial and benefits consulting firm based in Syracuse,
NY that was acquired from PricewaterhouseCoopers in July, (2) Peoples Bankcorp
Inc., a $29 million-asset single branch bank in Ogdensburg, NY acquired in
September, and (3) Grange National Banc Corp., a $280 million-asset bank with
twelve branches in five counties of Northeastern PA, acquired in November. In
January 2004, the Company announced an agreement to acquire First Heritage Bank,
a $275 million-asset commercial bank based in Wilkes-Barre PA that is expected
to close in May 2004.
Net Income and Profitability
Net income for 2003 was $40.4 million, up $1.9 million or 4.8% from the prior
year. Earnings per share of $2.99 in 2003 were 2.0% higher than 2002's results.
The growth rate of EPS was below that of net income due to higher weighted
average diluted shares outstanding. The increase in diluted shares was primarily
driven by the 1.1 million of common shares issued in conjunction with the
acquisition of Grange National Banc Corp. ("Grange") in November 2003, an
increased level of option grants and exercises, and a higher average common
share price (refer to the "Earnings per Share" section of Note A on page 48 for
information regarding the impact of share price on diluted shares). The 2003
results were impacted by $2.7 million of net losses from debt and security
transactions, including $2.6 million of debt restructuring charges associated
with the early retirement of higher-rate, medium-term borrowings. In contrast,
2002 earning per share benefited from net security and debt transaction gains of
$1.7 million.
13
Net income and earnings per share for 2002 were $38.5 million and $2.93, up 101%
and 81%, respectively, from 2001 results. The improvement in earnings in 2002
was primarily driven by a reduced level of acquisition expenses, which fell from
$8.2 million in 2001 to $0.7 million in 2002. This was due to the fact that two
of the Company's three acquisitions in 2001 were completed in the first half of
the year (see Note B - "Acquisitions"), and consequently the vast majority of
deal-related expenses were incurred during 2001. In addition, the 2002 results
include the benefit of adopting SFAS 147, an accounting standard that eliminates
the regular amortization of goodwill related to the Company's branch
acquisitions, and SFAS 142, which eliminates the requirement to regularly
amortize goodwill related to its whole-company acquisitions. SFAS 142 and SFAS
147 were effective January 1, 2002 and increased 2002 earnings per share by
$0.06 and $0.28, respectively, versus 2001 EPS. Earnings per share for 2002 rose
by a lesser percentage than net income versus 2001 because of 11% higher
weighted average diluted shares outstanding, principally due to 1.3 million
common shares issued in November 2001 to partially fund the acquisition of 36
branches from FleetBoston Financial.
In addition to the earnings results presented above in accordance with GAAP, the
Company provides earnings results on a non-GAAP, or operating basis. The
determination of operating earnings excludes the effects of certain items the
Company considers to be non-operating, including acquisition expenses, the
results of securities transactions, and debt restructuring activities.
Performance as measured by operating earnings is considered by management to be
a useful measure for gauging the underlying performance of the Company by
eliminating the volatility caused by voluntary, transaction-based items. Diluted
operating earnings per share for 2003 were $3.13, up 8.7% from the $2.88
reported in 2002. The growth in earnings in 2003 was principally due to
increased deposit service fee income, consumer mortgage growth, a higher net
interest margin and a lower effective income tax rate. These improvements to
earnings were partially offset by higher personnel, occupancy and volume-driven
expenses and a planned reduction of investment portfolio balances. A
reconciliation of GAAP-based earnings results to operating-based earnings
results is as follows:
Table 1: Reconciliation of GAAP EPS to Operating EPS
Years Ended December 31,
-----------------------------------------------------------
(000's omitted) 2003 2002 2001 2000 1999
-----------------------------------------------------------------------------------------------
Net income $40,380 $ 38,517 $ 19,129 $24,899 $23,662
Eliminate after-tax impact of:
Net securities losses/(gains) 33 (1,575) (1,514) 94 244
Loss on debt restructuring 1,615 559 1,581 0 0
Acquisition expenses 304 425 4,856 237 0
-----------------------------------------------------------------------------------------------
Net income - operating $42,332 $ 37,926 $ 24,052 $25,230 $23,906
===============================================================================================
Excluding the aforementioned benefits from adopting SFAS 142 and 147 in 2002,
operating earnings per share of $2.54 last year were 25% higher than the
operating EPS generated in 2001. The resulting $0.51 improvement largely
reflects the full-year impact of the FleetBoston branch acquisition, an improved
net interest margin, a larger securities portfolio and a lower effective income
tax rate.
Table 2: Summary Income Statements
Years Ended December 31,
-------------------------------------
(000's omitted, except per share data) 2003 2002 2001
----------------------------------------------------------------------------------------------------
Net interest income (FTE) $ 143,918 $139,921 $ 103,985
Provision for loan losses 11,195 12,222 7,097
Non-interest income 37,679 30,133 26,092
(Loss) gain on investment securities & debt extinguishment (2,698) 1,673 (113)
Operating expenses 101,963 94,330 80,430
Acquisition and unusual expenses 498 700 8,164
----------------------------------------------------------------------------------------------------
Income before taxes (FTE) 65,243 64,475 34,273
Fully tax-equivalent adjustment 12,090 12,071 7,330
Income taxes 12,773 13,887 7,814
----------------------------------------------------------------------------------------------------
Net income $ 40,380 $ 38,517 $ 19,129
====================================================================================================
Diluted earnings per share $ 2.99 $ 2.93 $ 1.62
Diluted earnings per share-operating $ 3.13 $ 2.88 $ 2.03
The primary factors explaining 2003 performance are discussed in detail in the
remaining sections of this document and are summarized as follows:
14
o As shown in Table 2 above, net interest income increased 2.9% or $4.0
million due to a $45 million increase in average earning assets and a
seven-basis point improvement in the net interest margin. The relative
contribution of changing balances and better margins were relatively
balanced at 53% and 47%, respectively (see Table 5 on page 19). The net
interest margin benefited from the rates on deposits and borrowings
declining more than the yields earned on investments in the low interest
rate environment. Average loans grew $126 million (7.2%), primarily due to
a record year for consumer mortgage volume as well as the impact of the
acquisitions of Grange and Peoples Bankcorp Inc. ("Peoples"). Average
investments declined $81 million (6.4%) in 2003 as a result of a
de-leveraging strategy undertaken in the first half of the year. The
growth in earning assets was funded by $22 million (0.8%) more average
deposits and slightly higher average borrowings (up $499,000 or 0.1%).
o The loan loss provision decreased $1.0 million or 8.4% from the prior year
level. Net charge-offs increased by $0.5 million primarily as a result of
a larger loan portfolio, as evidenced by a two-basis point decrease in the
net charge-off ratio (net charge-offs / total average loans) to 0.54%. The
loan loss provision decreased despite the higher net charge-offs because
the overall risk profile of the loan portfolio improved, in part due to a
higher proportion of relatively low-risk consumer mortgages being added
through organic growth and acquisitions. The improved asset quality
position in 2003 was evident in standard metrics such as non-performing
loans as a percentage of total loans (down two basis points),
non-performing assets as a percentage of loans and other real estate owned
(down two basis points) and delinquent loans (30+ days through
non-accruing) as a percentage of total loans (down 12 basis points).
Additional information on trends and policy related to asset quality is
provided in the asset quality section on pages 28 through 31.
o Non-interest income (excluding net gains and losses on investment security
transactions and debt prepayment) for 2003 of $37.7 million increased by
$7.5 million (25%) from 2002's level, the tenth consecutive year of
growth. Banking services accounted for $6.5 million of the improvement, as
overdraft volume increased significantly and income related to secondary
market mortgage activity rose. Overdraft fee income benefited from the
implementation of the Overdraft Freedom(TM) program (described in
non-interest income section on pages 20 through 22) in December 2002, an
increase of the fee charged for overdrafts in mid-2002 and a larger number
of customer accounts due primarily to the two bank acquisitions. Financial
services revenue was $1.0 million higher mostly as a result of the
acquisition of PricewaterhouseCoopers' Upstate New York Global Human
Resource Solutions consulting group (renamed Harbridge Consulting Group)
at the end of July 2003 and strong growth at the Company's retirement plan
administration business, Benefits Plans Administrative Services. As
previously noted, 2003 included $2.6 million of debt prepayment charges
and $0.1 million of net losses on investment security sales versus $2.6
million of gains on the sale of securities and a $925,000 charge for the
early retirement of debt in 2002. The $4.4 million negative variance from
security and debt transactions caused total non-interest income of $35.0
million in 2003 to rise by a lesser $3.2 million amount.
o Total operating expenses rose $7.4 million or 7.8% in 2003 to $102.5
million. Excluding acquisition expenses in both years, 2003 operating
expenses rose $7.6 million or 8.1%. A majority of the increase was due to
increased personnel expenses, as merit increases, new hires, higher
pension and medical expense rates and employees added through the three
acquisitions drove these expenses higher. In addition, volume-related
expenses such as checking charges (write-off of overdraft balances and
fees) and customer processing expenses for the consumer mortgage business
rose significantly in 2003 due to record levels of activity. Net occupancy
expenses also increased because of a larger number of facilities due to
acquisitions, current and prior year renovations, higher property tax and
utility rates and a rise in various weather-related costs.
o The Company's combined effective federal and state tax rate decreased 2.5
percentage points in 2003 to 24.0%, primarily as a result of an increased
proportion of pre-tax income from tax-exempt investments and loans.
Selected Profitability and Other Measures
Return on average assets, return on average equity, dividend payout and equity
to asset ratios for the years indicated are as follows:
Table 3: Selected Ratios
2003 2002 2001
-----------------------------------------------------------------------
Return on assets 1.16% 1.14% 0.66%
Return on assets - operating 1.22% 1.12% 0.83%
Return on equity 11.78% 13.06% 7.99%
Return on equity - operating 12.35% 12.86% 10.05%
Dividend payout ratio 40.2% 37.7% 65.7%
Average equity to average assets 9.87% 8.69% 8.29%
15
As displayed in Table 3 above, the return on average assets improved in 2003 in
comparison to both 2002 and 2001. This was primarily a result of higher net
interest margins, a greater proportion of earnings generated from non-interest
income and improved operational efficiencies. Based on operating earnings, the
return on assets was up 10 basis points in 2003. Reported return on equity in
2003 was down from 2002's level. This was mainly a result of the build-up of
equity capital this year from the retention of net profits and the common shares
issued in conjunction with the acquisition of Grange National Banc Corp., and
the $4.4 million swing in net gains and losses from security and debt
transactions. Consequently, average shareholders' equity increased 16.2% this
year, well above the 4.8% increase in reported (GAAP) net income. Based on
operating earnings, the return on equity in 2003 fell by a lesser 51 basis
points. The return on equity improved in 2002 versus 2001 despite significantly
higher equity levels (stock issuance and market value appreciation in the
investment portfolio) because of much higher profits. The strengthening of the
Company's equity capital position over the past two years is reflected in the 40
and 118 basis-point increases in the average equity to average total assets
ratios in 2002 and 2003, respectively.
The dividend payout ratio for 2003 was above 2002's level based on reported net
income mostly due to the security and debt transactions previously mentioned. On
an operating basis, the dividend payout ratio for 2003 was essentially equal to
the prior year (38.4% vs. 38.2%), as operating net income grew at approximately
the same rate (11.6%) as dividends declared (11.9%). The dividend payout ratio
spiked temporarily in 2001 due to a short-term drop in earnings as the Company
worked through the integration of three major acquisitions, and the related 2.3
million increase in the number of shares outstanding that caused the dollar
amount of declared dividends to rise significantly.
Net Interest Income
Net interest income is the amount that interest and fees on earning assets
(loans and investments) exceeds the cost of funds, primarily interest paid to
the Company's depositors and interest on external borrowings. Net interest
margin is the difference between the gross yield on earning assets and the cost
of interest bearing funds as a percentage of earning assets.
As disclosed in Table 4, net interest income (with non-taxable income converted
to a fully tax-equivalent basis) totaled $143.9 million in 2003, up $4.0 million
or 2.9% over the prior year. The increase was due to a favorable shift in the
mix of interest-earning assets and interest-bearing balances and improved
margins, which had positive impacts of $2.1 million and $1.9 million on net
interest income, respectively (see Table 5 on page 19).
CBSI's net interest margin increased seven basis points from 4.62% in 2002 to
4.69% this year. The 68-basis point decrease in the rate on average
interest-bearing funds and a greater proportion of funding from
non-interest-bearing deposits had a greater impact than the 56-basis point
decline in the yield on interest-earning assets. Downward re-pricing of the
Company's interest-bearing deposits, a shift in deposit mix from higher-rate
accounts to low and non-interest bearing accounts and greater utilization of
low-rate, short-term borrowings, combined with a relatively stable yield on the
investment portfolio led to the improvement in the margin. The Company's net
interest margin ranked in the very favorable 86th peer bank percentile for the
nine months ending September 30, 2003.
The net interest margin declined in each of the quarters of 2003, ending with a
4.59% margin for the fourth quarter. This trend was mostly attributable to the
level and changes in market interest rates during 2003. Falling market rates
early in the year allowed the Company to reduce rates on non-time deposit
interest-bearing accounts in the first two quarters that were not reproduced in
the second half of 2003. The overall low level of interest rates resulted in
loan yields and time deposit rates declining throughout the year. However, due
to the larger size and substantial growth of the loan portfolio in 2003 (versus
a decline in average time deposit balances), the decline in loan yields had a
greater negative impact on the margin in 2003 ($15.0 million) than the benefit
derived from time deposit rate reductions ($9.5 million). Another reason the net
interest margin declined later in the year was that the de-leveraging of the
investment portfolio in the first half of 2003 allowed the Company to avoid
adding low-yielding securities during that time period. However, investment
purchases were made in the second half of 2003 that will provide incremental net
interest income in the coming years and help protect the Company from falling
interest rates, but also contributed somewhat to the contraction of the net
interest margin later in 2003.
As shown in Table 4, total interest income decreased by $13.9 million or 6.4% in
2003. Table 5 shows that lower rates contributed a negative variance of $17.2
million, partially offset by a positive impact of $3.2 million from $45.5
million higher average earning assets and changes in the mix of funding sources.
Average loans grew a total of $126.0 million in 2003, with the vast majority
coming from organic consumer mortgage and consumer indirect loan growth. The
addition of $15.1 million of loans through the acquisition of Peoples in early
September 2003 and $171.1 million from the late-November 2003 acquisition of
Grange had a positive, but less substantial impact on average loan growth due to
the timing of the transactions. Interest and fees on loans decreased $5.9
million or 4.5%. An 82-basis point drop in loan yields due to falling capital
market rates had more of an impact (negative $15.0 million) than growth in
average loans (positive $9.0 million).
16
In early fourth quarter 2002, management instituted an investment de-leveraging
strategy, allowing the portfolio to run down and using the proceeds to pay down
borrowings due to the lack of investment opportunities offering acceptable
yields. This approach was in effect through June 2003, when it was decided that
investment purchases should be reinitiated to take advantage of more attractive
medium and long-term rates and a steep yield curve, as well as protect the
Company from its interest rate exposure to falling rates. Due to the
de-leveraging strategy being in place for approximately half of 2003 versus less
than a quarter of 2002, average investment balances for 2003 were down $80.6
million versus the year-earlier period, primarily in the mortgage-backed
securities ("MBS") and collateralized mortgage obligations ("CMOs") segments of
the portfolio (refer to the "Investments" section of the MD&A on pages 34
through 36 for further information).
Investment interest income in 2003 of $77.4 million was $8.0 million or 9.4%
lower than the prior year as a result of the smaller portfolio (negative $4.5
million impact) and a decrease in the average investment yield from 6.74% to
6.53% (negative $3.5 million impact). The decrease in the yield was principally
driven by significant declines in market interest rates from early 2001 through
mid-2003. Consequently, the Company was unable to replace the run-off of
longer-held, higher-yielding securities with equivalent-rate investments, and
the purchase of securities in the relatively low-interest rate conditions in the
second half of 2003 led to yield declines. However, the net spread on these
medium-term investment purchases were comparable because they were funded by
very low-rate, short-term borrowings. In addition, the performance of the
investment portfolio in 2003 was strong given the interest rate environment. The
Company was able to maintain its yields to a great extent primarily because of
two important strategies: the addition of a substantial amount of call-protected
securities in 2001 and first half of 2002 when rates were higher, and foregoing
security purchases in the late-2002 to mid-2003 period as rates were falling
significantly. The success of these actions was evident in CBSI's exceptional
97th percentile ranking within its peer group for tax-equivalent investment
yield for the nine months ended September 2003.
The average earning asset yield fell 56 basis points to 6.62% in 2003 because of
the previously mentioned decrease in investment and loan yields and the fact
that the yields on the overall loan portfolio have converged with those of the
investment portfolio. In 2002 the yield on the loan portfolio was 75 basis
points higher than the yield on investments. Loan yields were only 14 basis
points above those produced by investments in 2003. Consequently, the shift in
the mix of average earning assets towards a higher proportion of loans in 2003
(61.4% vs. 58.2%) due to significant consumer mortgage growth, acquired loans
and the reduced size of the investment portfolio, did not provide the usual
yield advantage it would have under more normalized interest rate conditions.
Total average fundings (deposits and borrowings) grew by $22.1 million in 2003,
with $21.6 million of the increase coming from deposits, mostly attributable to
the acquisitions of Grange and Peoples, and $0.5 million from additional
external borrowings. All of the increase in external funding came from
short-term borrowings. Long-term debt was reduced through normal pay-downs and
the pre-payment of $25 million of medium-term FHLB borrowings in the fourth
quarter of 2003, which was replaced with much lower-rate, short-term funding
from the Federal Home Loan Bank.
Total interest expense decreased by $17.9 million to $59.3 million in 2003. As
shown in Table 5, lower rates on deposits and external borrowings accounted for
$17.7 million, or almost all of the decrease. Interest expense as a percentage
of earning assets fell by 62 basis points to 1.93%. The rate on interest bearing
deposits fell 73 basis points to 1.83%, due largely to steady declines in time
deposit rates throughout 2003 and periodic reduction of rates on other
interest-bearing deposit products. The rate on external borrowings declined 47
basis points to 4.13% because of substantially lower market rates and the
previously mentioned shift in funding mix towards short-term borrowings.
As shown in Table 4, net interest income for 2003 was $39.9 million higher than
2001's level due to a number of factors. Interest-earning assets have grown by
$447 million (17%) through a combination of acquired loans, organic loan growth
and effective management of a larger investment portfolio. The net interest
margin in 2003 was 73 basis points higher than two years ago in most part due to
earning-asset yields declining 123 basis points versus a 221 basis-point decline
in interest-bearing liabilities and an 197-basis point decrease in the cost of
funds (includes demand deposits). The yield on earning-assets benefited greatly
over the last two years by the relative stability of the investment portfolio
yield, which declined only 48 basis points over this period despite a
significant drop in market interest rates. The cost of funding was aided by the
change in the make-up of both the deposit base and external borrowings. The fall
of market interest rates over the last two years not only enabled a significant
reduction of interest-bearing deposit rates, but also caused many customers to
shift their funds from time deposits to less restrictive accounts such as
savings and demand deposits due to the greatly diminished rate spread between
the two groups of accounts. This is demonstrated by the percentage of average
deposits that were in time deposit accounts dropping from 52% in 2001 to 43% in
2003, accounting for a portion of the reduced funding costs beyond the absolute
drop in rates. The Company also changed the proportion of long-term funding in
average external borrowings from 71% in 2001 to 58% in 2003 to take advantage of
historically low short-term rates, providing further funding cost savings.
17
The following table sets forth certain information concerning average
interest-earning assets and interest-bearing liabilities and the yields and
rates thereon for the years ended December 31, 2003, 2002 and 2001. Interest
income and resultant yield information in the tables are on a fully
tax-equivalent basis using marginal income tax rates of 38.9% in 2003, 39.3% in
2002 and 40.5% in 2001. Averages are computed on daily average balances for each
month in the period divided by the number of days in the period. Yields and
amounts earned include loan fees. Nonaccrual loans have been included in
interest-earning assets for purposes of these computations.
Table 4: Average Balance Sheet
(000's omitted, except yields and rates) Year Ended December 31, 2003 Year Ended December 31, 2002
- ---------------------------------------- ------------------------------------------ ------------------------------------------
Avg. Avg.
Average Yield/Rate Average Yield/Rate
Balance Interest Paid Balance Interest Paid
- ---------------------------------------- ------------------------------------------ ------------------------------------------
Assets
Interest-earning assets:
Time deposits in other banks $ 346 $ 4 1.16% $ 525 $ 6 1.14%
Taxable investment securities (2) 779,107 48,212 6.19% 906,902 58,458 6.45%
Non-taxable investment securities (2) 406,034 29,148 7.18% 358,643 26,899 7.50%
Loans (net of unearned discount)(1) 1,885,604 125,855 6.67% 1,759,564 131,801 7.49%
-------------------------- --------------------------
Total interest-earning assets 3,071,091 203,219 6.62% 3,025,634 217,164 7.18%
Non-interest earning assets 400,598 367,530
---------- ----------
Total assets $3,471,689 $3,393,164
========== ==========
Liabilities and Shareholders' Equity
Interest-bearing liabilities:
Interest checking, savings and
money market deposits $1,000,238 6,769 0.68% $ 969,664 11,416 1.18%
Time deposits 1,090,511 31,519 2.89% 1,131,296 42,462 3.75%
Short-term borrowings 212,512 2,685 1.26% 141,024 2,586 1.83%
Long-term borrowings 295,880 18,328 6.19% 366,869 20,779 5.66%
Total interest-bearing liabilities 2,599,141 59,301 2.28% 2,608,853 77,243 2.96%
Non-interest bearing liabilities:
Demand deposits 473,568 441,800
Other liabilities 56,301 47,655
Shareholders' equity 342,679 294,856
---------- ----------
Total liabilities and
shareholders' equity $3,471,689 $3,393,164
========== ==========
Net interest earnings $143,918 $139,921
======== ========
Net interest spread 4.34% 4.22%
Net interest margin on
interest-earnings assets 4.69% 4.62%
Fully tax-equivalent adjustment on $ 12,090 $ 12,071
Investments and loans
(000's omitted, except yields and rates) Year Ended December 31, 2001
- ---------------------------------------- ------------------------------------------
Avg.
Average Yield/Rate
Balance Interest Paid
- ---------------------------------------- ------------------------------------------
Assets
Interest-earning assets:
Time deposits in other banks $ 4,874 $ 549 11.26%
Taxable investment securities (2) 822,285 56,808 6.91%
Non-taxable investment securities (2) 215,567 15,759 7.31%
Loans (net of unearned discount)(1) 1,580,870 132,706 8.39%
--------------------------
Total interest-earning assets 2,623,596 205,822 7.85%
Non-interest earning assets 265,164
----------
Total assets $2,888,760
==========
Liabilities and Shareholders' Equity
Interest-bearing liabilities:
Interest checking, savings and
money market deposits $ 683,088 12,783 1.87%
Time deposits 1,100,850 60,380 5.48%
Short-term borrowings 141,772 6,738 4.75%
Long-term borrowings 340,811 21,936 6.44%
---------- -------- -----
Total interest-bearing liabilities 2,266,521 101,837 4.49%
Non-interest bearing liabilities:
Demand deposits 343,173
Other liabilities 39,698
Shareholders' equity 239,368
----------
Total liabilities and
shareholders' equity $2,888,760
==========
Net interest earnings $103,985
========
Net interest spread 3.36%
Net interest margin on
interest-earnings assets 3.96%
Fully tax-equivalent adjustment on $ 7,330
Investments and loans
(1) The impact of interest not recognized on non-accrual loans and interest
income that would have been recorded if the restructured loans had been
current in accordance with their original terms was immaterial.
(2) Averages for investment securities are based on historical cost basis and
the yields do not give effect to changes in fair value that is reflected
as a component of shareholders' equity and deferred taxes.
18
As discussed above, the change in 2003 net interest income (fully tax-equivalent
basis) may be analyzed by segregating the volume and rate components of the
changes in interest income and interest expense for each underlying category.
Table 5: Rate/Volume
2003 Compared to 2002 2002 Compared to 2001
Increase (Decrease) Due to Change in (1) Increase (Decrease) Due to Change in (1)
---------------------------------------- ----------------------------------------
Net Net
(000's omitted) Volume Rate Change Volume Rate Change
- --------------------------------------- ---------------------------------------- ----------------------------------------
Interest earned on:
Time deposits in other banks ($2) $0 ($2) ($271) ($272) ($543)
Taxable investment securities (7,981) (2,265) (10,246) 5,609 (3,959) 1,650
Nontaxable investment securities 3,439 (1,190) 2,249 10,721 419 11,140
Loans (net of unearned discount) 9,033 (14,979) (5,946) 14,173 (15,078) (905)
Total interest-earning assets (2) $3,222 ($17,167) ($13,945) $29,814 ($18,472) $11,342
Interest paid on:
Interest checking, savings and $349 ($4,996) ($4,647) $4,307 ($5,674) ($1,367)
money market deposits
Time deposits (1,483) (9,460) (10,943) 1,627 (19,545) (17,918)
Short-term borrowings 1,058 (959) 99 (35) (4,117) (4,152)
Long-term borrowings (4,274) 1,823 (2,451) 1,599 (2,756) (1,157)
Total interest-bearing liabilities (2) ($286) ($17,656) ($17,942) $13,771 ($38,365) ($24,594)
Net interest earnings (2) $2,117 $1,880 $3,997 $17,207 $18,729 $35,936
(1) The change in interest due to both rate and volume has been allocated to
volume and rate changes in proportion to the relationship of the absolute
dollar amounts of change in each.
(2) Changes due to volume and rate are computed from the respective changes in
average balances and rates of the totals; they are not a summation of the
changes of the components.
19
Non-interest Income
The Company's sources of non-interest income are of three primary types: general
banking services related to loans, deposits and other core customer activities
typically provided through the branch network; financial services, comprised of
retirement plan administration and employee benefit trusts (Benefit Plans
Administrative Services or BPA), employee benefit actuarial and consulting
services (Harbridge Consulting Group or Harbridge), personal trust, investment
and insurance products (Community Investment Services, Inc. or CISI) and
investment management (Elias Asset Management or EAM); and periodic
transactions, most often net gains (losses) from the sale of investments and
prepayment of term debt.
Table 6: Non-interest Income
Years Ended December 31,
------------------------------------
(000's omitted) 2003 2002 2001
---------------------------------------------------------------------------------------------------
Banking services:
Electronic banking $ 2,604 $ 2,375 $ 1,469
Mortgage banking 518 175 653
Deposit service charges 5,374 5,310 4,183
Overdraft fees 13,476 6,937 5,183
Credit life and disability insurance 856 1,082 835
Commissions and other fees 2,042 2,243 2,259
Miscellaneous (93) 163 89
---------------------------------------------------------------------------------------------------
Total banking services 24,777 18,285 14,671
Financial services:
Retirement plan administration and trust fees 4,668 3,845 3,585
Benefit plan actuarial and consulting fees 1,552 0 0
Asset advisory and management fees 1,890 2,606 3,643
Investment and insurance product commissions 3,339 3,715 2,372
Personal trust 1,453 1,682 1,821
---------------------------------------------------------------------------------------------------
Total financial services 12,902 11,848 11,421
---------------------------------------------------------------------------------------------------
Sub-total 37,679 30,133 26,092
(Loss) gain on investment securities & debt extinguishment (2,698) 1,673 (113)
---------------------------------------------------------------------------------------------------
Total non-interest income $ 34,981 $31,806 $ 25,979
===================================================================================================
Non-interest income/operating income (FTE) 20.7% 17.7% 20.1%
As displayed in Table 6, total non-interest income in 2003 increased by 10.0% to
$35.0 million, largely as a result of significantly higher overdraft volume, the
acquisition of Harbridge and growth at BPA. These improvements were offset by
substantially higher losses on the early retirement of long-term borrowings, the
absence of gains on the sale of securities and weakness in the other financial
services group businesses. Non-interest income, excluding transactions related
to investment securities and debt obligations, rose for the tenth consecutive
year to $37.7 million in 2003, a $7.5 million or 25% improvement over 2002.
Non-interest income, excluding net gains (losses) from the sale of securities
and early retirement of debt, as a percent of operating income (FTE basis) was
20.7% in 2003, up 3.0 percentage points from the prior year, and an all-time
high for the Company. This increase was primarily driven by the aforementioned
strong growth in overdraft fees and BPA revenue, as well as the acquisition of
Harbridge. This ratio is considered an important measure for determining the
progress the Company is making on one of its primary long-term strategies,
expansion of non-interest income in order to diversify its revenue sources and
reduce reliance on net interest margins that may be strongly impacted by general
interest rate and other market conditions.
The largest segment of the Company's recurring non-interest income is the wide
variety of fees earned from general banking services, which reached $24.8
million in 2003, up 36% from the prior year. This segment contributed 66% of
2003 non-interest income, excluding net gains and losses from security sales and
debt extinguishment. A large portion of the income growth was attributable to
overdraft fees, up $6.5 million (94%) over 2002's level, which benefited from
the implementation of the Company's Overdraft Freedom(TM) program in December
2002, additional accounts added through acquisitions and the full-year impact of
a fee increase implemented in June 2002. Overdraft Freedom(TM) is a program
currently offered to retail customers whereby the Company may pay overdrawn
amounts for qualified customers up to a
20
certain predetermined limit, for which they are charged a standard overdraft
fee. This program is a courtesy service to customers in good standing that may
allow them to avoid late and non-payment penalties from creditors and vendors
and help them in their effort to avoid the negative consequences of returned
checks. This type of deposit account service has become prevalent throughout
much of the banking industry.
Income derived from activity associated with the secondary market mortgage
portfolio rose to $518,000 in 2003, up $343,000 from the prior year. One of the
main reasons for the increase was that $67 million of consumer mortgages were
sold on the secondary market in 2003 versus $9 million in 2002. The selling of
secondary mortgages was resumed in October 2002 after a one-year suspension, and
continued through September 2003. The combination of increased sales and
fluctuations in interest rates was the primary driver of gains of $627,000 on
loans sold and $372,000 from the establishment of and valuation of mortgage
servicing rights. This compares to $64,000 of gains on loans sold and a $163,000
write-down of mortgage servicing rights in 2002. These income improvements were
offset by a $795,000 unrealized loss on mortgage loan commitments. Certain loan
commitments that had been categorized as held-for-sale were reclassified as
portfolio loans commitments after the decision was made to discontinue the sale
of twenty-year and longer mortgages. Market loss on these commitments was
recognized in earnings concurrent with the reclassification. Higher secondary
sales partially offset by increased levels of mortgage prepayments resulted in
the loan-servicing portfolio rising from $103.7 million at the end of 2002 to
$126.3 million at year-end 2003. This growth was the primary reason why a fourth
component of secondary market activity, loan-servicing fees, rose 14.5% to
$313,000 in 2003.
As disclosed in Table 6, non-interest income from the financial services segment
rose $1.0 million or 8.9% in 2003 to $12.9 million. Financial services revenue
now comprises 34% of total non-interest income, excluding net gains (losses) on
the sale of investment securities and retirement of debt. This compares to 39%
in 2002, with the decline primarily due to the tremendous success of the
Company's new overdraft program this year. The acquisition of Harbridge at the
end of July 2003 resulted in $1.6 million of incremental revenue for the
financial services group in the current year. Another impressive year of revenue
growth at BPA (up $823,000 or 21%) was driven by a significant number of new
plans and growth in the market value of client assets. These two businesses are
part of the Company's Benefits Plan Administrative Services, Inc. ("BPAS")
subsidiary, and operate collaboratively to offer clients a full array of
employee benefits, recordkeeping and consulting services throughout much of the
country. BPAS revenue of $6.2 million was $2.4 million higher than prior year
results.
The other financial services businesses, CISI, Elias Asset Management and
personal trust were all negatively impacted by the challenging retail investment
market conditions of the past few years. A significant drop in interest rates
this year resulted in much lower annuity volume and commission rates for CISI,
accounting for most of the $376,000 decline in their revenue to $3.3 million. An
extended period of weak performance by US equities from late-2000 through early
2003 had an adverse impact on EAM's assets under management, as lower valuations
and the loss of assets reduced their main driver of revenue generation.
Consequently, EAM's revenue was down $716,000 to $1.9 million in 2003. However,
significantly improved market conditions and investor confidence in the latter
part of 2003 directly benefited EAM's performance, as higher equity valuations
and new client acquisition resulted in 15% higher revenues in the second half of
the year versus the first half. Lastly, the personal trust business experienced
a $229,000 decline in revenue to $1.5 million, primarily due to the timing of
estate settlements.
Assets under management from the Company's financial services businesses rose
considerably to $1.807 billion at the end of 2003 compared to $1.364 billion at
year-end 2002. Market-driven gains in equity-based assets were augmented by
attraction of new client assets. BPA in particular was very successful at
growing its asset base, as demonstrated by the $312 million or 69% increase in
its assets under administration.
The total financial services group contributed $1.6 million (excluding
allocation of indirect corporate expense) or 2.9% of the Company's pretax income
this year, reflecting nearly a 12% margin. In 2002, financial services'
contribution was $2.2 million or 4.2% of total pretax income, with a margin of
18%. The lower earnings and margin were the result of up-front,
transaction-related expenses absorbed by Harbridge and cost-cutting efforts at
EAM and CISI not keeping pace with revenue shortfalls. In addition, most of the
expenses for the personal trust unit are fixed in nature and therefore its
margins and pre-tax contribution tend to fluctuate to a large degree with
variability of their traditionally uneven revenue stream. The decline in
percentage contribution was primarily due to the banking business's success at
growing net interest income, non-interest income and reducing the loan loss
provision in 2003. In addition, the near-term profitability challenges faced by
the financial services group due to market conditions, amortization of
intangible assets and unusual expenses are expected to diminish over time and be
more than offset by top-line growth.
There was a total net loss on security and debt transactions of $2.7 million
this year compared to $1.7 million of net gains in 2002. The loss in 2003 was
primarily composed of $2.6 million of charges associated with the early
retirement of $25 million of longer-term FHLB borrowings that were replaced with
lower rate, short-term borrowings, which is expected to provide a long-term
earnings benefit as well as reduce interest rate risk. Current year results also
included $0.1 million of
21
losses from a variety of smaller security and debt transactions. The net gain in
2002 included $2.6 million of gains on $80 million of investment sales, and a
$0.9 million prepayment penalty on the retirement of approximately $11 million
of intermediate-term FHLB borrowings in the fourth quarter. The security and
debt gains and losses taken over the last two years are illustrative of the
Company's active management of its investment portfolio and external borrowings
to achieve a desirable total return through the combination of net interest
income, transaction gains/losses and changes in market value across financial
market cycles.
Excluding gains and losses from security sales and debt retirement, non-interest
income for 2003 was up $11.6 million or 44% from 2001's level, driven by strong
growth of 15% and 25% in 2002 and 2003, respectively. The increase in 2002 came
from both the banking and financial services segments. The acquisition of 36
FleetBoston branches in November 2001 contributed a significant amount of
incremental banking fees in 2002. Prior year non-interest income also benefited
greatly from substantial business expansion at BPA, which has provided
consistent revenue growth since it was acquired in July 1996, and CISI which
successfully shifted it focus to annuity sales in 2002 to provide growth in a
very difficult year for equity-based products. As previously noted, the
impressive increase in recurring non-interest income in 2003 was driven by
deposit service fees, income related to the secondary mortgage market, the
acquisition of Harbridge and another year of robust growth at BPA. Total
non-interest income for 2003 was up a lesser $9.0 million from 2001's level, due
primarily to debt repayment penalties that will provide future benefits and very
limited security sales in comparison to the earlier periods.
Operating Expenses
As shown in Table 7, operating expenses rose $7.4 million or 7.8% in 2003 to
$102.5 million. Excluding acquisition expenses related to Harbridge, Peoples and
Grange in 2003 and the FleetBoston branches in 2002, operating expenses were up
$7.6 million or 8.1% in 2003, reflective mostly of incremental expenses from the
operations of the acquired businesses listed above, as well as increases in
pension, medical and volume-driven costs. This year's operating expenses as a
percent of average assets were 2.95%, up from 2.80% in 2002 and lower than the
3.07% in 2001. The increase in this ratio for 2003 was principally due to the
acquisition of a financial services unit whose revenue is not driven by earning
assets (Harbridge), and the charge-offs resulting from higher overdraft volume,
another significant revenue generating tool with a limited underlying asset
base. This ratio was elevated in 2001 primarily as a result of the high level of
acquisition expenses in that year. CBSI's operating expenses to average asset
ratio of 2.94% (annualized) for the nine months ended September 2003 was
slightly below the median of 2.95% for peer banks.
The efficiency ratio, a performance measurement tool widely used by banks, is
defined by the Company as operating expenses (excluding acquisition expenses and
intangible amortization) divided by operating income (fully tax-equivalent net
interest income plus non-interest income, excluding net securities and debt
gains and losses). Lower ratios correspond to higher efficiency. In 2003 the
efficiency ratio increased by 1.3 percentage points to 53.3%. This was primarily
a result of net interest income being tempered for much of the year due to the
investment de-leveraging strategy, rising pension and medical expenses and the
impact from reduced pre-tax margins in the financial services segment in 2003,
as discussed earlier. The efficiency ratio for 2003 was significantly lower than
the ratio of 56.7% for 2001, as initiatives undertaken in 2001, such as the
consolidation of the Company's loan and deposit operations centers and cost
take-outs at First Liberty, have provided ongoing efficiency improvements.
Table 7: Operating Expenses
Years Ended December,
----------------------------------
(000's omitted) 2003 2002 2001
------------------------------------------------------------------------
Salaries and employee benefits $ 53,164 $47,864 $40,930
Occupancy 9,297 8,154 6,122
Equipment and furniture 7,828 7,538 6,075
Legal and professional fees 3,183 3,272 2,789
Data processing 6,800 6,574 4,727
Amortization of intangible assets 5,093 5,953 6,679
Office supplies 1,996 2,321 1,995
Foreclosed property 561 902 1,059
Deposit insurance premiums 388 440 346
Other 13,653 11,312 9,708
------------------------------------------------------------------------
Total recurring expenses 101,963 94,330 80,430
Acquisition and unusual expenses 498 700 8,164
------------------------------------------------------------------------
Total operating expenses $102,461 $95,030 $88,594
========================================================================
Operating expenses/average assets 2.95% 2.80% 3.07%
Efficiency ratio 53.3% 52.0% 56.7%
22
Higher personnel expenses accounted for 69% of 2003's increase in operating
costs, excluding acquisition expenses, as they increased 11.1%, mostly as a
result of the three acquisitions. The remainder of the increases in personnel
expense reflect higher pension (discussed in further detail below) and medical
rates, merit increases and new hiring activity. Total full-time equivalent staff
at the end of 2003 was 1,259 compared to 1,120 at year-end 2002.
Medical expenses were up in 2003 due to a general rise in the cost of medical
care, administration and insurance, as well as a greater number of insured
employees. Qualified and non-qualified pension expenses increased significantly
in 2003 principally due to a reduction of the discount rate applied to future
payments to 6.10% from 6.75% (increases current expenses in present value terms)
and additional obligations for employees added through acquisition and organic
growth. In addition, a $1.2 million adjustment was recorded in the fourth
quarter of 2003 to reflect the proper actuarial impact of indexing salary levels
associated with certain benefits frozen in 1988. The three assumptions that have
the largest impact on the calculation of annual pension expense are the
aforementioned discount rate, the rate applied to future compensation increases
and the expected rate of return on plan assets. Table 8 contains the results of
a sensitivity analysis conducted to determine what the impact of a 1.0
percentage point increase and decrease in these three assumptions would have on
the annual pension expense for the two plans. Also, see Note K to the financial
statements for further information concerning the pension plan.
Table 8: Pension Plan Sensitivity Analysis
One Percentage Point
----------------------
(000's omitted) Increase Decrease
-----------------------------------------------------------
Discount rate ($834) $ 949
Rate of compensation increase $451 ($430)
Expected return on plan assets ($360) $ 360
Total non-personnel expenses increased $2.1 million or 4.5% in 2003. Excluding
acquisition-related expenses, non-personnel expenses were up $2.3 million or
5.0% from 2002's level. As displayed in Table 7, this was largely caused by
higher occupancy expense (up $1.1 million) and other expenses (up $2.3 million),
and partially offset by lower intangible amortization (down $0.9 million),
office supplies (down $0.3 million) and foreclosed property expenses (down $0.3
million). The increase in occupancy expense in 2003 was mainly due to
incremental costs from recently acquired facilities, expenses arising from
renovations and repairs, the effect of higher rates and severe weather on
maintenance and utilities expenses and the general increase in property taxes in
many of the municipalities we do business in. Other expenses include two
volume-driven expense items that were up considerably due to record levels of
business activity, mortgage processing expenses and checking charges related to
overdraft activity. In 2003 non-recurring expenses associated with the
retirement of a senior executive also impacted other expenses. Intangible
amortization in 2003 was down versus the prior year because the drop in
accelerated amortization of core deposit intangibles from the FleetBoston branch
acquisition had a greater impact than the amortization of intangibles added as a
result of the three acquisitions completed this year. Office supply expenses
declined primarily because of improved purchasing cost controls in 2003 and
escalated expense levels in early 2002 arising from the integration of the
acquired FleetBoston branches.
Acquisition and unusual expenses totaled $498,000 in 2003, down from $700,000 in
2002. These expenditures were primarily comprised of legal and consulting fees
of $213,000, $191,000 of system conversion costs and $94,000 of other general
administrative expenses. The majority of these expenses was incurred in
conjunction with the Company's largest acquisition of 2003, Grange National Banc
Corp., in November 2003.
As displayed in Table 7 above, recurring operating expenses in 2002 increased
$13.9 million or 17% in comparison to 2001. As was the case in 2003, the rise in
2002 was predominately caused by incremental expenses from acquired operations.
The increase in 2002 was substantially higher than the 8.1% rise this year
primarily due to 2002 including ten and a half months of additional expenses
from a large scale acquisition (FleetBoston branches), versus 2003 having only
one and half months of incremental expenses from a relatively large acquisition,
Grange. In addition, the two acquisitions made under the purchase method of
accounting in 2002 (Citizens and the FleetBoston branches) were larger than the
three acquisitions made this year ($949 million of assets and deposits vs. $600
million). The cumulative effect of these six acquisitions was the major
contributor to the $21.5 million of increased recurring operating expenses in
2003 in comparison to 2001, a modest increase in light of the $51.5 million
growth in recurring operating income over the same time period.
Income Taxes
The Company estimates its tax expense based on the amount it expects to owe the
respective tax authorities, plus the impact of deferred tax items. Taxes are
discussed in more detail in Note I of the Consolidated Financial Statements on
page 58. Accrued taxes represent the net estimated amount due or to be received
from taxing authorities. In estimating accrued taxes, management assesses the
relative merits and risks of the appropriate tax treatment of transactions
taking into account
23
statutory, judicial and regulatory guidance in the context of the Company's tax
position. If the final resolution of taxes payable differs from our estimates
due to regulatory determination or legislative or judicial actions, adjustments
to tax expense may be required.
The effective tax rate for 2003 declined by 2.5 percentage points to 24.0%. This
decline was primarily due to the benefits realized on a larger proportion of
income from tax-exempt investment securities. In addition, the amount of
nondeductible merger expenses declined in 2003.
The effective tax rate for 2002 of 26.5% was down from the 29.0% rate in 2001.
This decline was primarily due to the benefits realized on a larger proportion
of income from tax exempt investment securities, which mitigated the effect of
the near doubling of income before tax. In addition, the adoption of SFAS 142
and 147, the reduced level of nondeductible merger expenses in 2002 compared
with 2001, and a federal low-income housing tax credit claimed in 2002, all
contributed to the decline in the effective tax rate last year.
Capital
Shareholders' equity ended 2003 at $405 million, up $79.8 million or 25% from
one year earlier. This increase reflects $60.4 of common stock issued in