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UNITED STATES
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, 2004
Commission file number 001-13695
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[LOGO]
COMMUNITY BANK SYSTEM, INC.
(Exact name of registrant as specified in its charter)
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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,
$1.00 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 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, 2004 determined using the closing price per share on that
date of $22.79, as reported on the New York Stock Exchange was approximately
$636,000,000.
Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of the latest practicable date.
30,312,681 shares of Common Stock, $1.00 par value, were outstanding on
March 9, 2005.
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 11, 2005 (the "Proxy Statement") is incorporated by reference
in Part III of this Annual Report on Form 10-K.
Exhibit Index is located on page 69 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 ................................................ 7
PART II
Item 5. Market for Registrant's Common Stock, Related Shareholders Matters and Issuer
Purchases of Equity Securities .................................................... 8
Item 6. Selected Financial Data ............................................................. 9
Item 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations ........................................................................ 11
Item 7A. Quantitative and Qualitative Disclosures about Market Risk .......................... 35
Item 8. Financial Statements and Supplementary Data:
Consolidated Statements of Condition ........................................... 38
Consolidated Statements of Income .............................................. 39
Consolidated Statements of Changes in Shareholders' Equity ..................... 40
Consolidated Statements of Comprehensive Income ................................ 41
Consolidated Statements of Cash Flows .......................................... 42
Notes to Consolidated Financial Statements ..................................... 43
Management's Report on Internal Control over Financial Reporting ............... 65
Report of Independent Registered Public Accounting Firm ........................ 66
Two Year Selected Quarterly Data .................................................... 67
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 67
Item 9A. Controls and Procedures ............................................................. 67
Item 9B. Other Information ................................................................... 67
PART III
Item 10. Directors and Executive Officers of the Registrant .................................. 68
Item 11. Executive Compensation .............................................................. 68
Item 12. Security Ownership of Certain Beneficial Owners and Management ...................... 68
Item 13. Certain Relationships and Related Transactions ...................................... 68
Item 14. Principal Accounting Fees and Services .............................................. 68
PART IV
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K .................... 69
Signatures .................................................................................... 73
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." The share and
per-share information in this document has been adjusted to give effect to a
two-for-one stock split of the Company's common stock effected as of April 12,
2004.
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 and firstlibertybank.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. ("BPAS"), CFSI Closeout Corp. ("CFSICC"), and
First of Jermyn Realty Co. ("FJRC"). BPAS owns two subsidiaries, Benefit Plans
Administrative Services LLC (BPA) and Harbridge Consulting Group LLC. BPAS
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 125 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 in 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 (1999-2004)
Dansville Branch Acquisition
On December 3, 2004, the Company completed the purchase of a branch office in
Dansville, N.Y. ("Dansville") from HSBC Bank USA, N.A with deposits of $32.6
million.
First Heritage Bank
On May 14, 2004, the Company acquired First Heritage Bank ("First Heritage"), a
closely held bank headquartered in Wilkes-Barre, PA with three branches in
Luzerne County, Pennsylvania. First Heritage's three branches operate as part of
First Liberty Bank & Trust, a division of Community Bank, N.A. Consideration
included 2,592,213 shares of common stock with a fair value of $52 million,
employee stock options with a fair value of $3.0 million, and $7.0 million of
cash (including capitalized acquisition costs of $1.0 million).
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 2,294,000 shares of its
common stock to certain of the former shareholders at a cost of $23.97 per
share. The remaining shareholders received $21.25 per share 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.
3
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.
Harbridge Consulting Group
On July 31, 2003, the Company acquired PricewaterhouseCoopers' Upstate New York
Global Human Resource Solutions consulting group. 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 BPA, 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 1.12 shares of the Company's
common stock, which amounted to approximately 7.2 million shares. The merger
constituted a tax-free reorganization and was accounted for as a pooling of
interests under APB Opinion 16.
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
1,904,000 shares of its common stock to the former shareholders at a cost of
$13.25 per share. All of the 1,296,200 shares then held in the Company's
treasury were issued in this transaction as part of the total 1,904,000 shares.
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,
retail brokerage firms, 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
6/30/2004 Market Has 1st or 2nd
County State (000's) (1) Share Facilities ATM's Towns Market Position
- -----------------------------------------------------------------------------------------------------
Allegany NY $ 193,624 48.6% 10 8 9 9
Lewis NY 80,637 37.7% 4 1 3 3
Yates NY 76,378 32.2% 3 2 2 2
Seneca NY 106,485 30.4% 4 3 4 3
Cattaraugus NY 262,982 30.4% 11 7 7 6
St. Lawrence NY 343,673 26.6% 13 8 11 10
Wyoming PA 76,592 23.5% 3 2 3 2
Franklin NY 83,558 16.9% 5 3 4 4
Chautauqua NY 195,187 13.9% 12 10 10 7
Schuyler NY 18,147 13.8% 1 1 1 0
Jefferson NY 135,393 12.1% 5 5 4 2
Steuben NY 164,712 11.4% 9 6 8 5
Tioga NY 35,724 9.5% 2 2 2 1
Livingston NY 48,106 8.2% 3 3 3 2
Susquehanna PA 38,045 7.3% 3 1 3 3
Lackawanna PA 446,679 6.3% 11 13 8 4
Ontario NY 77,931 5.7% 3 4 3 1
Herkimer NY 30,495 5.5% 1 1 1 1
Wayne NY 47,904 5.3% 2 1 1 0
Luzerne PA 291,214 4.7% 9 8 5 1
Oswego NY 45,446 4.3% 2 2 2 2
Cayuga NY 27,571 3.4% 2 1 2 1
Bradford PA 15,055 1.8% 2 2 2 1
- -----------------------------------------------------------------------------------------------------
Subtotal 2,841,538 10.0% 120 94 98 70
Oneida NY 58,592 1.4% 2 1 1 1
Chemung NY 12,292 1.3% 1 1 1 0
Onondaga NY 10,106 0.1% 1 1 1 0
Erie NY 26,407 0.1% 1 0 1 1
- -----------------------------------------------------------------------------------------------------
27 Total $2,948,935 4.6% 125 97 102 72
=====================================================================================================
(1) Deposit market share data as of June 30, 2004, the most recent information
available, calculated by Sheshunoff Information Services, Inc.
Employees
As of December 31, 2004 and 2003 the Company employed 1,301 and 1,259 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 may engage in a broader range of
activities that are "financial in nature", including insurance underwriting,
securities underwriting and merchant banking. Bank holding companies which are
well capitalized and well managed under regulatory standards may convert to
financial holding companies relatively easily through a notice filing with the
FRB, which acts as the "umbrella regulator" for such entities. The Company may
seek 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 other sources
of funds, the Company may seek borrowings from the Federal Reserve for such
purposes. 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
The Sarbanes Oxley Act of 2002 (the "Sarbanes-Oxley Act") implemented a broad
range of corporate governance, accounting and reporting reforms for companies
that have securities registered under the Exchange Act of 1934. In particular,
the Sarbanes-Oxley Act established, among other things: (i) new requirements for
audit and other key
6
committees involving independence, expertise levels, and specified
responsibilities; (ii) additional responsibilities regarding financial statement
oversight for the Chief Executive Officer and Chief Financial Officer of the
reporting company; (iii) the creation of an independent accounting oversight
board for the accounting industry; (iv) new standards for auditors and
regulation of audits, including independence provisions that restrict non-audit
services that accountants may provide to their audit clients; (v) increased
disclosure and reporting obligations for the reporting company and their
directors and executive officers including accelerated reporting of company
stock transactions; (vi) a prohibition of personal loans to directors and
officers, except certain loans made by insured financial institutions on
nonpreferential terms and in compliance with other bank regulator requirements;
and (vii) a range of new and increased civil and criminal penalties for fraud
and other violation of the securities laws.
Item 2. Properties
The Company has 136 properties, 90 are owned and 46 are located in long-term
leased premises. Real property and related banking facilities owned by the
Company at December 31, 2004 had a net book value of $46.5 million and none of
the properties was subject to any material encumbrances. For the year ended
December 31, 2004, rental fees of $2.5 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, 2004.
Item 4A. Executive Officers of the Registrant
The executive officers of the Company and the Bank which are elected by the
Board of Directors are as follows:
Name Age Position
---- --- --------
Sanford A. Belden 62 Director, President and Chief Executive Officer of the Company and the Bank. Mr. Belden has held this
position since he joined the Company in October 1992.
Mark E. Tryniski 44 Executive Vice President and Chief Operating Officer of the Bank. Mr. Tryniski joined the Company in
June 2003 as the Treasurer and Chief Financial Officer. In March 2004 he assumed his current position.
He previously served as a partner in the Syracuse office of PricewaterhouseCoopers LLP, with eighteen
years of experience working with SEC registrants in banking and other industries.
Scott A. Kingsley 40 Treasurer of the Company, and Executive Vice President and Chief Financial Officer of the Bank. Mr.
Kingsley joined the Company in August 2004 in his current position. He served as Vice President and
Chief Financial Officer of Carlisle Engineered Products, Inc., a subsidiary of the Carlisle Companies,
Inc., from 1997 until joining the Company.
Brian D. Donahue 48 Executive Vice President and Chief Banking Officer. Mr. Donahue assumed his current position in August
2004. He served as the Bank's Chief Credit Officer from February 2000 to July 2004 and as the Senior
Lending Officer for the Southern Region of the Bank from 1992 until June 2004.
Michael A. Patton 59 President, Financial Services. Mr. Patton assumed his current position in February 2000 and previously
served as the President of the Southern Region of the Bank from January 1992 to January 2000.
James A. Wears 55 President, New York Banking. Mr. Wears assumed his current position in February 2000 and previously
served as the President of the Northern Region of the Bank from January 1992 to January 2000.
Thomas A. McCullough 58 President, Pennsylvania Banking. Mr. McCullough joined the Company in November 2003 in his current
position. He was previously the President and Chief Executive Officer of Grange National Banc Corp.
from 1989 until they merged with the Company.
Steven R. Tokach 58 Senior Vice President and Chief Credit Administrator. Mr. Tokach assumed the Credit Administrator
position in March 2003. He was previously the President of our Pennsylvania franchise since May 2001,
when the Company acquired First Liberty Bank Corp. He was Executive Vice President of First Liberty
Bank Corp. and First Liberty Bank & Trust from 1998 to 2001.
7
Name Age Position
---- --- --------
Timothy J. Baker 53 Senior Vice President and Director of Special Projects. Mr. Baker assumed his current position in
August 2004. He was previously the Senior Operations Officer of the Bank responsible for bank
operations, special projects and technology innovation since from 1995.
W. Valen McDaniel 58 Senior Vice President and Chief Risk Officer. Mr. McDaniel assumed his current position in January
2004. He served as the Company's corporate auditor and risk manager since joining the Company in 1992.
He is responsible for the audit function, compliance, loan review, facilities, and security of the
bank and all subsidiaries.
Joseph J. Lemchak 43 Senior Vice President and Chief Investment Officer. Mr. Lemchak joined the Company in 1990 and since
May 1991 he has served in the duel capacity of Chief Investment Officer and Asset/Liability Manager
for the Bank.
J. David Clark 50 Senior Vice President and Chief Credit Officer. Mr. Clark assumed his current position in October
2004. He was previously the Commercial Market Manager in the Bank's Corning, New York market since
April 1993.
Robert P. Matley 53 Executive Vice President and Senior Lending Officer, PA Banking. Mr. Matley joined the Company in
2004. He was previously employed by First Heritage Bank, having joined that organization in 1994 as
Executive Vice President and Senior Lending Officer. He was promoted to President and Chief Operating
Officer in 2003 and served in that capacity until the merger with the Company in 2004.
Bernadette R. Barber 43 Senior Vice President and Chief Human Resources Officer. Ms. Barber joined the Company in February
2005 in her current position. She has served since 1997 as Vice President of Human Resources and
Administration for The Penn Traffic Company.
Harold M. Wentworth 40 Senior Vice President and Director of Sales and Marketing. Mr. Wentworth assumed his current position
in January 2005. He was previously a manager in the Bank's treasury department and was responsible for
asset liability management and product development.
J. Michael Wilson 34 Senior Vice President and Chief Technology Officer. Mr. Wilson joined the Company in June 2002 as Vice
President of Information Technology and assumed his current position in October 2004. He previously
held the position of Director of Technology Services for Unizan Bank in Ohio.
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 30,641,591 shares of common stock outstanding
on December 31, 2004, held by approximately 3,760 registered shareholders of
record. 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.
The information below has been adjusted to reflect the two-for-one stock split
of the Company's common stock effected on April 12, 2004.
Closing Price
High Low ------------------ Quarterly
Year / Qtr Price Price Amount % Change Dividend
- -------------------------------------------------------------------------------
2004
4th $28.66 $25.06 $28.25 12.4% $ 0.18
3rd $26.00 $20.87 $25.13 10.3% $ 0.18
2nd $23.85 $18.86 $22.79 (1.5%) $ 0.16
1st $25.39 $21.76 $23.14 (5.6%) $ 0.16
2003
4th $25.48 $21.98 $24.50 11.6% $ 0.16
3rd $23.18 $18.67 $21.96 15.6% $ 0.16
2nd $19.38 $15.51 $19.00 20.9% $ 0.15
1st $17.12 $15.44 $15.72 0.3% $ 0.15
8
The Company has historically paid regular quarterly cash dividends on its common
stock, and declared a cash dividend of $0.18 per share for the first quarter of
2005. 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, 2004 with respect to
shares of common stock that may be issued under the Company's existing equity
compensation plans:
Number of Weighted
Securities to be Average Number of
Issued upon Exercise Price Securities Remaining
Exercise of on Options Available for
Plan Category Outstanding Options (1) Outstanding Future Issuance
- -------------------------------------------------------------------------------------------------------------------------------
Equity compensation plans approved by security holder:
1994 Long Term Incentive Plan 2,409,650 $15.62 0
2004 Long Term Incentive Plan 24,100 $23.24 3,973,900
Equity compensation plans not approved by security holder:
Citizens Advisory Council Plan (2) 2,000 $16.03 6,000
- -------------------------------------------------------------------------------------------------------------------------------
Total 2,435,750 $15.70 3,979,900
===============================================================================================================================
(1) The number of securities includes unvested restricted stock issued of
34,818.
(2) In connection with the acquisition of Citizens National Bank, the Company
formed an advisory council comprised of the former directors of Citizens
National Bank for the purpose of advising the Bank on banking activities in
Citizens National Bank's market area, the transition of business relationships
after the merger, and the continued development of business relationships
throughout Northern New York State. In consideration for serving on this
council, the members have been granted shares of restricted stock that vest over
two years.
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, 2004. The historical information set forth under the captions
"Income Statement Data" and "Balance Sheet Data" is derived from the audited
financial statements while the information under the captions "Average Balance
Sheet Data", "Capital and Related Ratios", "Selected Performance Ratios" and
"Asset Quality Ratios" for all periods is 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.
9
SELECTED CONSOLIDATED FINANCIAL INFORMATION
In thousands except per share data Years Ended December 31,
- --------------------------------------------------------------------------------------------------------------------------------
2004 2003 2002 2001 2000
Income Statement Data:
Interest income $ 212,795 $ 191,129 $ 205,093 $ 198,492 $ 189,665
Interest expense 61,752 59,301 77,243 101,837 99,232
Net interest income 151,043 131,828 127,850 96,655 90,433
Provision for loan losses 8,750 11,195 12,222 7,097 7,722
Net interest income after provision for loan losses 142,293 120,633 115,628 89,558 82,711
Other income 44,373 37,929 30,389 26,252 23,200
Gain (loss) on investment securities & early retirement
of LT borrowings 72 (2,698) 1,673 (113) (159)
Total non-interest income 44,445 35,231 32,062 26,139 23,041
Salaries and employee benefits 61,146 53,164 47,864 40,930 36,743
Occupancy and equipment 18,813 17,125 15,692 12,197 10,308
Amortization of intangible assets 7,414 5,093 5,953 6,679 4,891
Acquisition expenses 1,704 498 700 8,164 400
Other expenses 30,822 26,831 25,077 20,784 18,508
Total operating expense 119,899 102,711 95,286 88,754 70,850
Income before income taxes 66,839 53,153 52,404 26,943 34,902
Provision for income taxes 16,643 12,773 13,887 7,814 10,003
Net income $ 50,196 $ 40,380 $ 38,517 $ 19,129 $ 24,899
Diluted earnings per share (2) $ 1.64 $ 1.49 $ 1.46 $ 0.81 $ 1.16
Diluted earnings per share - cash (1) $ 1.78 $ 1.61 $ 1.60 $ 0.98 $ 1.29
Balance Sheet Data:
Cash and cash equivalents $ 118,345 $ 103,923 $ 113,531 $ 106,554 $ 76,456
Investment securities 1,584,339 1,329,534 1,286,583 1,150,713 930,509
Loans, net of unearned discount 2,358,493 2,128,509 1,806,905 1,732,870 1,515,877
Allowance for loan losses (31,778) (29,095) (26,331) (23,901) (20,035)
Intangible assets 232,500 196,111 134,828 142,342 55,234
Other assets 131,932 126,415 121,731 104,787 93,598
Total assets $4,393,831 $3,855,397 $3,437,247 $3,213,365 $2,651,639
Deposits $2,928,978 $2,725,488 $2,505,356 $2,545,970 $1,948,557
Borrowings 920,511 667,786 543,575 357,931 471,053
Other liabilities 69,714 57,295 63,278 41,484 30,238
Shareholders' equity 474,628 404,828 325,038 267,980 201,791
Total liabilities and shareholders' equity $4,393,831 $3,855,397 $3,437,247 $3,213,365 $2,651,639
Average Balance Sheet Data:
Investment securities $1,454,278 $1,185,487 $1,266,070 $1,042,726 $ 900,250
Loans 2,264,857 1,885,604 1,759,564 1,580,870 1,484,945
Total interest-earning assets 3,719,135 3,071,091 3,025,634 2,623,596 2,385,195
Total assets 4,196,821 3,471,689 3,393,164 2,888,760 2,556,638
Interest-bearing deposits 2,316,696 2,090,749 2,100,960 1,783,938 1,613,918
Borrowings 824,003 508,392 507,893 482,583 447,105
Total interest-earning liabilities 3,140,699 2,599,141 2,608,853 2,266,521 2,061,023
Shareholders' equity $ 440,627 $ 342,679 $ 294,856 $ 239,368 $ 174,498
Capital and Related Ratios:
Tier 1 leverage ratio 6.94% 7.26% 7.05% 6.73% 6.67%
Total risk-based capital to risk-adjusted assets 13.18% 13.01% 13.32% 11.83% 11.70%
Tangible equity to tangible assets 5.82% 5.70% 5.76% 4.09% 5.64%
Cash dividend declared per share (2) $ 0.68 $ 0.61 $ 0.56 $ 0.54 $ 0.52
Dividend payout ratio 40.9% 40.2% 37.7% 65.7% 40.6%
Book value per share (2) $ 15.49 $ 14.29 $ 12.52 $ 10.38 $ 9.55
Tangible book value per share (2) $ 7.90 $ 7.37 $ 7.33 $ 4.87 $ 6.94
Market capitalization (in millions) $ 866 $ 694 $ 407 $ 338 $ 261
Period end common shares outstanding (2) 30,642 28,330 25,957 25,806 21,120
Diluted weighted average shares outstanding (2) 30,670 27,035 26,334 23,650 21,474
Selected Performance Ratios:
Return on assets 1.20% 1.16% 1.14% 0.66% 0.97%
Return on equity 11.39% 11.78% 13.06% 7.99% 14.27%
Net interest margin 4.45% 4.69% 4.62% 3.96% 4.06%
Non-interest income/operating income 21.2% 19.7% 18.6% 20.1% 19.2%
Efficiency ratio 52.8% 53.4% 52.0% 56.8% 54.6%
Asset Quality Ratios:
Allowance for loan loss/loans outstanding 1.35% 1.37% 1.46% 1.38% 1.32%
Non-performing loans/loans outstanding 0.55% 0.62% 0.65% 0.53% 0.50%
Allowance for loan loss/non-performing loans 245% 219% 225% 261% 266%
Net charge-offs/average loans 0.37% 0.54% 0.56% 0.42% 0.42%
Loan loss provision/net charge-offs 104% 109% 125% 108% 124%
Non-performing assets/loans outstanding plus OREO 0.62% 0.67% 0.69% 0.61% 0.58%
(1) Cash earnings exclude the after-tax effect of the amortization of
intangible assets.
(2) All share and share-based amounts reflect the two-for-one stock split
effected as a 100% stock dividend on April 12, 2004.
10
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. ("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 10 and the Company's Consolidated Financial
Statements and related notes that appear on pages 38 through 64. 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 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 2004, "last year" and
equivalent terms refer to calendar year 2003, 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 84 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,
2004 (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. All share and share-based amounts reflect
the two-for-one stock split effected as a 100% stock dividend on April 12, 2004.
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 33.
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 7
on page 20 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 56 through
59.
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 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
11
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 43.
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, and certain selective de
novo expansions, (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 and banking 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 2004, the Company reported record earnings as a result of acquired and
organic growth in earning asset levels, strong growth in non-interest income and
improved asset quality, despite a lower net interest margin. Return on assets
improved slightly over 2003, to 1.20%. Return on equity declined slightly to
11.4%, due to strengthened capital levels. Non-interest income, excluding a loss
on early retirement of debt in 2003, increased 17% over 2003 with strong growth
from banking sources, as well as from the Company's employee benefits and wealth
management businesses. The Company's efficiency ratio improved to 52.8% for the
year.
Asset quality improved in 2004, with reductions in delinquency, charge-off and
non-performing loan ratios versus 2003. Excluding acquisition activity, the
Company experienced loan growth in consumer mortgage and consumer direct and
indirect lending, with declines in the business portfolio. On a geographical
basis, the New York markets reported strong growth in consumer mortgage and
consumer direct and indirect loans, with slight declines in business lending.
Excluding acquisitions, the Pennsylvania markets reported declines in all
portfolios. Excluding acquisition activity, total deposits declined slightly
from 2003.
The Company completed two acquisitions in 2004: (1) First Heritage Bank, a $275
million-asset commercial bank with three branches based in Wilkes-Barre, PA,
acquired in May, and (2) a bank branch in Dansville, NY, from HSBC Bank USA,
N.A., acquired in December with deposits of $32.6 million.
Net Income and Profitability
Net income for 2004 was $50.2 million, up $9.8 million or 24% from the prior
year. Earnings per share of $1.64 in 2004 were 10.1% higher than 2003'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 2.6 million and 2.3 million shares of common stock issued in
conjunction with the acquisition of First Heritage in May 2004 and 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 47 for information regarding the impact of share price on diluted
shares).
In addition to the earnings results presented above in accordance with GAAP, the
Company provides cash earnings per share, which excludes the after-tax effect of
the amortization of intangible assets. Management believes that this information
helps investors understand the effect of acquisition activity in reported
results. Cash earnings per share for 2004 were $1.78, up 10.6% from $1.61 for
the year ended December 31, 2003.
Net income and earnings per share for 2003 were $40.4 million and $1.49, up 4.8%
and 2.1%, respectively, from 2002 results. The 2003 results were impacted by
$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
12
transaction gains of $1.7 million. In addition, banking services accounted for
$6.5 million of the improvement in 2003, as overdraft volume and the related
fees increased significantly in response to the implementation of the Overdraft
FreedomTM program.
Table 1: Condensed Income Statements
Years Ended December 31,
--------------------------------
(000's omitted, except per share data) 2004 2003 2002
-------------------------------------------------------------------------
Net interest income $151,043 $131,828 $127,850
Loan loss provision 8,750 11,195 12,222
Non-interest income 44,445 35,231 32,062
Operating expenses 119,899 102,711 95,286
-------------------------------------------------------------------------
Income before taxes 66,839 53,153 52,404
Income taxes 16,643 12,773 13,887
-------------------------------------------------------------------------
Net income $ 50,196 $ 40,380 $ 38,517
=========================================================================
Diluted earnings per share $ 1.64 $ 1.49 $ 1.46
Diluted earnings per share-cash (1) $ 1.78 $ 1.61 $ 1.60
(1) Cash earnings exclude the after-tax effect of the amortization
of intangible assets.
The primary factors explaining 2004 performance are discussed in detail in the
remaining sections of this document and are summarized as follows:
o As shown in Table 1 above, net interest income increased 14.6% or $19
million due to a $648 million increase in average earning assets,
partially offset by a 24 basis point decrease in the net interest margin.
Average loans grew $379 million (20%), primarily due to strong consumer
mortgage growth as well as the impact of the acquisitions of First
Heritage in May 2004 and Grange and Peoples in 2003. Average investments
increased $268 million (23%) in 2004 primarily as a result of a leveraging
strategy that began in the third quarter of 2003 and ended during the
second quarter of 2004. The growth in earning assets was funded by $311
million (12.1%) more average deposits and $316 million (62%) higher
average borrowings.
o The loan loss provision of $8.8 million decreased $2.4 million, or 22%,
from the prior year level. Net charge-offs of $8.4 million decreased by
$1.8 million from 2003, reducing the net charge-off ratio (net charge-offs
/ total average loans) to 0.37% for the year. The improved asset quality
position in 2004 was evident in standard metrics such as non-performing
loans as a percentage of total loans (down seven basis points),
non-performing assets as a percentage of loans and other real estate owned
(down five basis points) and delinquent loans (30+ days through
non-accruing) as a percentage of total loans (down 32 basis points).
Additional information on trends and policy related to asset quality is
provided in the asset quality section on pages 25 through 28.
o Non-interest income for 2004 of $44.4 million increased by $9.2 million
(26%) from 2003's level, the eleventh consecutive year of growth. Banking
services accounted for $2.6 million of the improvement, primarily due to
the three whole bank acquisitions over the last 18 months. Financial
services revenue was $3.8 million (30%) higher mostly as a result of the
acquisition of Harbridge at the end of July 2003 and strong growth at the
Company's retirement plan administration business, Benefit Plans
Administrative Services. Gain (loss) on investment securities and debt
prepayment transactions was $72,000 in 2004 as compared to a loss of $2.7
million in 2003. The 2003 loss included $2.6 million of debt restructuring
charges associated with the early retirement of higher-rate, medium-term
borrowings.
o Total operating expenses rose $17.2 million or 17% in 2004 to $119.9
million. Excluding acquisition expenses in both years, 2004 operating
expenses rose $16.0 million or 16%. A majority of the increase was due to
increased personnel expenses associated with the acquisitions in late 2003
and 2004, as well as merit increases, new hires, and higher costs in
employee health and welfare programs. In addition, higher legal and
professional expenses were incurred with a substantial portion of the
increase due to compliance with recently promulgated reporting
requirements. Net occupancy expenses also increased because of a larger
number of facilities due to acquisitions, current and prior year
renovations, and slightly higher property tax and utility rates. In
addition, amortization of intangible assets increased $2.3 million, or 46%
over 2003 due to the amortization of core deposit and customer
relationship intangibles arising from the 2003 and 2004 acquisitions.
13
o The Company's combined effective federal and state tax rate increased 0.9
percentage points in 2004 to 24.9%, primarily as a result of a higher
proportion of income being generated from fully taxable loans and
investments.
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 2: Selected Ratios
2004 2003 2002
-----------------------------------------------------------
Return on average assets 1.20% 1.16% 1.14%
Return on average equity 11.39% 11.78% 13.06%
Dividend payout ratio 40.9% 40.2% 37.7%
Average equity to average assets 10.50% 9.87% 8.69%
As displayed in Table 2 above, the return on average assets improved in 2004 in
comparison to both 2003 and 2002. This was primarily a result of a greater
proportion of earnings generated from non-interest income and improved
operational efficiencies. Reported return on equity in 2004 was down slightly
from 2003'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 acquisitions of First Heritage in May 2004 and Grange in
November 2003. Consequently, average shareholders' equity increased 29% this
year, as compared to a 24% increase in reported net income. For similar reasons
average shareholder's equity increased 16% in 2003 well above the 4.8% increase
in net income for the same period, resulting in a decrease in return on equity
in 2003 as compared to 2002. The strengthening of the Company's equity capital
position over the past two years is reflected in the 63 and 118 basis-point
increases in the average equity to average total assets ratios in 2004 and 2003,
respectively.
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 3, net interest income (with non-taxable income converted
to a fully tax-equivalent basis) totaled $165.6 million in 2004, up $21.6
million or 15% over the prior year. A $648 million increase in average
earning-assets more than offset a $542 million increase in average
interest-bearing liabilities and a 24 basis point decrease in the net interest
margin. As reflected in Table 4, the volume changes mentioned above drove net
interest income to rise $29.1 million, while the lower net interest margin had a
$7.5 million negative impact on net interest income.
The net interest margin declined in each of the quarters of 2004, from 4.67% for
the first quarter, ending with a 4.32% margin for the fourth quarter. This trend
was mostly attributable to the level and changes in market interest rates during
2004. Falling market rates early in the year allowed the Company to reduce or
hold steady rates on deposit interest-bearing accounts in the first three
quarters of 2004. The fourth quarter of 2004 saw interest rates on money market
and time deposit accounts rise slightly in response to increasing market rates.
Similarly, the yield on loans decreased throughout the first three quarters of
the year. The decline in loan yields had a greater negative impact on the margin
in 2004 ($12.1 million) than the benefit derived from deposit rate reductions
($7.2 million). Yields on investments declined 35 basis points during 2004 from
6.53% to 6.18% as investment purchases were at lower rates. Lastly, the average
interest rate paid on borrowings decreased 83 basis points from 4.13% for 2003
to 3.30% for 2004.
The net interest margin for 2003 increased seven basis points from 4.62% in 2002
to 4.69%. Falling market rates prevailed throughout the year. However, the
decline in total average earning asset yields of 56 basis points was less than
the benefit derived from a decline in the cost of funds of 60 basis points,
resulting in the increased net interest margin.
As shown in Table 3, total interest income increased by $24.1 million or 11.9%
in 2004. Table 4 shows that higher average earning assets contributed a positive
$40.5 million variance, partially offset by lower yields with a negative impact
of $16.4 million. Average loans grew a total of $379 million in 2004, the
majority being the result of the $207 million loans acquired in the First
Heritage acquisition in May of 2004 and the $186 million of loans acquired in
the Peoples and Grange acquisitions in late 2003. Interest and fees on loans
increased $11.6 million or 9.2%. The increase was attributable to higher average
loan balances (positive $23.7 million), partially offset by a 60-basis point
drop in loan yields (negative $12.1 million) due to falling capital market
rates. Average loans grew $126 million in 2003, with the vast majority coming
14
from organic consumer mortgage and consumer indirect loan growth. Interest and
fees on loans decreased $5.9 million or 4.5% in 2003 as compared to 2002. An
82-basis point drop in loan yields due to falling interest rates had more of an
impact (negative $15.0 million) than growth in average loans (positive $9.0
million).
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 a
leveraging strategy for most of 2004, average investment balances for 2004 were
up $268.3 million versus the year-earlier period, primarily in the U.S. treasury
and agency securities and obligations of state and political subdivision
segments of the portfolio (refer to the "Investments" section of the MD&A on
pages 31 through 33 for further information).
Investment interest income in 2004 of $89.8 million was $12.5 million or 16%
higher than the prior year as a result of a larger portfolio (positive $16.9
million impact) partially offset by a decrease in the average investment yield
from 6.53% to 6.18% (negative $4.5 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-term, higher-yielding securities with equivalent-rate
investments, and the purchase of securities in the relatively low-interest rate
environment in the second half of 2003 and 2004 led to yield declines. However,
the net spread on these medium-term investment purchases were comparable because
they were funded with a mixture of short to medium term low-rate, borrowings. In
addition, the performance of the investment portfolio in 2004 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 the Company's exceptional 98th percentile ranking within
its peer group for tax-equivalent investment yield for the nine months ended
September 2004. 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 average earning asset yield fell 51 basis points to 6.11% in 2004 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 and in 2004 the yield on the
investment portfolio was 11 basis points higher than the yield on the loan
portfolio.
Total average funding (deposits and borrowings) grew by $626.5 million in 2004,
with $310.9 million of the increase coming from deposits, mostly attributable to
the acquisitions of First Heritage, Grange and Peoples. External borrowings were
increased to fund organic loan growth and investment purchases over the last 18
months resulting in average borrowings that were up $315.6 million for 2004 as
compared to the previous year.
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 45% in 2002 to 41% in 2004, accounting for a portion of the
reduced funding costs beyond the absolute drop in rates. The Company also
changed the proportion of short-term funding in average external borrowings from
28% in 2002 to 54% in 2004 to take advantage of historically low short-term
rates, providing further funding cost savings.
Total interest expense increased by $2.5 million to $61.8 million in 2004. As
shown in Table 4, higher levels of deposits and borrowings accounted for an
$11.3 million increase in interest expense, offset by an $8.9 million decrease
as a result of lower rates on deposits and external borrowings. Interest expense
as a percentage of earning assets fell by 27 basis points to 1.66%. The rate on
interest bearing deposits fell 34 basis points to 1.49%, due largely to declines
in time deposit rates for the first three quarters of 2004. The rate on external
borrowings declined 83 basis points to 3.30% because of substantially lower
market rates and the previously mentioned shift in funding mix towards
short-term borrowings. Total interest expense decreased by $17.9 million to
$59.3 million in 2003 as compared to 2002. Lower rates on deposits and external
borrowings accounted for the majority of the decrease. The rate on interest
bearing deposits fell 73 basis points to 1.83% and the rate on external
borrowings declined 47 basis points to 4.13%.
15
The following table sets forth information related to average interest-earning
assets and interest-bearing liabilities and their associated yields and rates
for the years ended December 31, 2004, 2003 and 2002. Interest income and yields
are on a fully tax-equivalent basis using marginal income tax rates of 38.7% in
2004, 38.9% in 2003, and 39.3% in 2002. Average balances are computed by summing
the daily ending balances in a period and dividing by the number of days in that
period. Loan yields and amounts earned include loan fees. Average loan balances
include non-accrual loans.
Table 3: Average Balance Sheet
(000's omitted except yields and rates) Year Ended December 31, 2004 Year Ended December 31, 2003
------------------------------------- -------------------------------------
Avg. Avg.
Average Yield/Rate Average Yield/Rate
Balance Interest Paid Balance Interest Paid
- ------------------------------------------------------------------------------- -------------------------------------
Interest-earning assets:
Time deposits in other banks $ 868 $ 22 2.53% $ 346 $ 4 1.16%
Taxable investment securities (2) 940,744 54,205 5.76% 779,107 48,212 6.19%
Non-taxable investment securities (2) 512,666 35,626 6.95% 406,034 29,149 7.18%
Loans (net of unearned discount)(1) 2,264,857 137,450 6.07% 1,885,604 125,855 6.67%
----------------------- -----------------------
Total interest-earning assets 3,719,135 227,303 6.11% 3,071,091 203,220 6.62%
Non-interest earning assets 477,686 400,598
---------- ----------
Total assets $4,196,821 $3,471,689
========== ==========
Interest-bearing liabilities:
Interest checking, savings and
money market deposits $1,128,071 6,368 0.56% $1,000,238 6,769 0.68%
Time deposits 1,188,625 28,219 2.37% 1,090,511 31,519 2.89%
Short-term borrowings 442,287 7,242 1.64% 212,512 2,685 1.26%
Long-term borrowings 381,716 19,923 5.22% 295,880 18,328 6.19%
----------------------- -----------------------
Total interest-bearing liabilities 3,140,699 61,752 1.97% 2,599,141 59,301 2.28%
Non-interest bearing liabilities:
Demand deposits 558,552 473,568
Other liabilities 56,943 56,301
Shareholders' equity 440,627 342,679
---------- ----------
Total liabilities and
shareholders' equity $4,196,821 $3,471,689
========== ==========
Net interest earnings $ 165,551 $ 143,919
========== ==========
Net interest spread 4.14% 4.34%
Net interest margin on interest-
earnings assets 4.45% 4.69%
Fully tax-equivalent adjustment $ 14,508 $ 12,091
(000's omitted except yields and rates) Year Ended December 31, 2002
-------------------------------------
Avg.
Average Yield/Rate
Balance Interest Paid
- -------------------------------------------------------------------------------
Interest-earning assets:
Time deposits in other banks $ 525 $ 6 1.14%
Taxable investment securities (2) 906,902 58,458 6.45%
Non-taxable investment securities (2) 358,643 26,899 7.50%
Loans (net of unearned discount)(1) 1,759,564 131,801 7.49%
-----------------------
Total interest-earning assets 3,025,634 217,164 7.18%
Non-interest earning assets 367,530
----------
Total assets $3,393,164
==========
Interest-bearing liabilities:
Interest checking, savings and
money market deposits $ 969,664 11,416 1.18%
Time deposits 1,131,296 42,462 3.75%
Short-term borrowings 141,024 2,586 1.83%
Long-term borrowings 366,869 20,779 5.66%
-----------------------
Total interest-bearing liabilities 2,608,853 77,243 2.96%
Non-interest bearing liabilities:
Demand deposits 441,800
Other liabilities 47,655
Shareholders' equity 294,856
----------
Total liabilities and
shareholders' equity $3,393,164
==========
Net interest earnings $ 139,921
==========
Net interest spread 4.22%
Net interest margin on interest-
earnings assets 4.62%
Fully tax-equivalent adjustment $ 12,071
(1) The impact of interest and fees not recognized on non-accrual loans was
immaterial.
(2) Averages for investment securities are based on historical cost and the
yields do not give effect to changes in fair value that is reflected as a
component of shareholders' equity and deferred taxes.
16
As discussed above, the change in 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 4: Rate/Volume
------------------------------ ------------------------------
2004 Compared to 2003 2003 Compared to 2002
------------------------------ ------------------------------
Increase (Decrease) Due to Increase (Decrease) Due to
Change in (1) Change in (1)
------------------------------ ------------------------------
Net Net
(000's omitted) Volume Rate Change Volume Rate Change
------------------------------ ------------------------------
Interest earned on:
Time deposits in other banks $10 $8 $18 ($2) $0 ($2)
Taxable investment securities 9,485 (3,492) 5,993 (7,981) (2,265) (10,246)
Non-taxable investment securities 7,437 (960) 6,477 3,439 (1,189) 2,250
Loans (net of unearned discount) 23,730 (12,135) 11,595 9,033 (14,979) (5,946)
Total interest-earning assets (2) $40,477 ($16,394) $24,083 $3,222 ($17,166) ($13,944)
Interest paid on:
Interest checking, savings
and money market deposits $803 ($1,204) ($401) $349 ($4,996) ($4,647)
Time deposits 2,666 (5,966) (3,300) (1,483) (9,460) (10,943)
Short-term borrowings 3,578 979 4,557 1,058 (959) 99
Long-term borrowings 4,774 (3,179) 1,595 (4,274) 1,823 (2,451)
Total interest-bearing liabilities (2) $11,329 ($8,878) $2,451 ($286) ($17,656) ($17,942)
Net interest earnings (2) $29,139 ($7,507) $21,632 $2,117 $1,881 $3,998
(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.
17
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 5: Non-interest Income
Years Ended December 31,
--------------------------------
(000's omitted) 2004 2003 2002
- ------------------------------------------------------------------------------------------
Banking services:
Electronic banking $ 2,585 $ 2,604 $ 2,375
Mortgage banking 525 518 175
Deposit service charges 5,475 5,374 5,310
Overdraft fees 14,867 13,476 6,937
Credit life and disability insurance 1,206 856 1,082
Commissions and other 2,974 2,199 2,662
- ------------------------------------------------------------------------------------------
Total banking services 27,632 25,027 18,541
Financial services:
Retirement plan administration and trustee fees 5,820 4,668 3,845
Actuarial and benefit plan consulting fees 3,478 1,552 0
Asset advisory and management fees 1,832 1,890 2,606
Investment and insurance product commissions 3,907 3,339 3,715
Personal trust 1,704 1,453 1,682
- ------------------------------------------------------------------------------------------
Total financial services 16,741 12,902 11,848
Gain (loss) on investment securities & debt prepayment 72 (2,698) 1,673
- ------------------------------------------------------------------------------------------
Total non-interest income $44,445 $35,231 $32,062
==========================================================================================
Non-interest income/operating income (FTE) 21.2% 19.7% 18.6%
As displayed in Table 5, total non-interest income in 2004 increased by 26.2% to
$44 million, largely as a result of higher overdraft volume, the acquisition of
Harbridge, growth at BPA and the absence of losses on the early retirement of
long-term borrowings. Total non-interest income for 2003 was up $3.2 million or
9.9% from 2002's level, driven by significantly higher overdraft volume, the
acquisition of Harbridge and the 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 decreases in the other
financial services group businesses.
Non-interest income as a percent of operating income (FTE basis) was 21.2% in
2004, up 1.5 percentage points from the prior year, 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 portion of the Company's recurring non-interest income is the wide
variety of fees earned from general banking services, which reached $27.6
million in 2004, up 10.4% from the prior year. Total banking services
contributed 62% of 2004 non-interest income. A large portion of the income
growth was attributable to overdraft fees, up $1.4 million (10.3%) over 2003's
level, due in large part to the incremental transaction volume generated from
the accounts added through the First Heritage, Grange and Peoples acquisitions.
In addition, commissions and other increased $0.8 million, due to higher
commissions and cash surrender values derived from life insurance policies
acquired in the 2003 and 2004 acquisitions. Fees from the general banking
services was $25.0 million in 2003, up $6.5 million or 35% from 2002 primarily
driven by the success of the Company's Overdraft FreedomTM program implemented
in December 2002.
18
As disclosed in Table 5, non-interest income from financial services rose $3.8
million or 30% in 2004 to $16.7 million. Financial services revenue now
comprises 38% of total non-interest income, excluding net gains (losses) on the
sale of investment securities and retirement of debt. This compares to 34% in
2003, with the increase primarily due to seven more months of revenue from
Harbridge, which was acquired at the end of July 2003, resulting in $1.9 million
of incremental revenue for the financial services group in the current year.
Another impressive year of revenue growth at BPA (up $1.2 million or 25%) was
driven by a significant number of new plans under administration and growth in
the market value of client assets. These two businesses are part of the 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 $9.3 million in 2004 was $3.1 million higher than prior
year results. BPAS revenue for 2003 was $6.2 million, up $2.4 million from 2002
primarily due to the acquisition of Harbridge in July of 2003 as well as strong
organic growth at BPA.
CISI and personal trust had positive growth of $568,000 (17%) and $251,000
(17%), respectively, as improving market conditions have positively impacted
both businesses. Increased volume of annuity sales in response to higher
interest rates and additional client relationships developed in the new markets
opened up by the Company's acquisitions has had a positive impact. Additionally,
CISI has obtained a large number of higher net-worth investors caused by recent
retirees rolling over their 401(k) plans and/or receiving inheritances. In 2003,
CISI, Elias and personal trust were all negatively impacted by the challenging
retail investment market conditions of the past few years. Non-interest income
for 2003 was down $376 million (10%), $716 million (27%) and $229 million (14%)
at CISI, Elias and personal trust, respectively as compared to 2002.
Assets under management from the Company's financial services businesses rose
considerably over the last two years reaching $2.102 billion at the end of 2004,
compared to $1.807 billion at year-end 2003 and $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 $259 million or 34% increase in its assets under
administration.
The total financial services group contributed $2.1 million (excluding
allocation of indirect corporate expense) or 3.1% of the Company's pre-tax
income this year, reflecting nearly a 12% margin. In 2003, financial services'
contribution was $1.6 million or 2.9% of total pre-tax income, with a margin of
12%. The higher earnings were the result of new client business at BPA, CISI and
personal trust as well as a full year of Harbridge as compared to only five
months in 2003. The increase in percentage contribution was primarily due to
higher growth in the financial services businesses than the banking business's
increase in net interest income and decline of the provision for loan losses.
There was a total net gain on security and debt transactions of $72,000 this
year compared to a net loss of $2.7 million in 2003. 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 are expected to provide a long-term
earnings benefit as well as reduce interest rate risk. The $1.7 million 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. The security and debt gains and losses
taken over the last three 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.
Operating Expenses
As shown in Table 6, operating expenses rose $17.2 million or 17% in 2004 to
$119.9 million. Excluding acquisition expenses, operating expenses were up $16.0
million or 15.6% in 2004, reflective mostly of incremental operating expenses
associated with the acquisitions of First Heritage in 2004 and Harbridge, Grange
and Peoples in 2003. This year's operating expenses as a percent of average
assets were 2.86%, down from 2.96% in 2003 and higher than the 2.81% in 2002.
The decrease in this ratio for 2004 was principally due to the acquisitions in
late 2003 and the first half of 2004 (Grange and First Heritage), whereby
average assets increased significantly (21%), while operating expenses only
increased 17%. 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.
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 2004 the
efficiency ratio decreased 0.6 percentage points to 52.8% due in part to the
investment leverage strategy in effect during the first half of 2004. The
efficiency ratio for 2003 was 1.4 percentage points higher than the 52.0% ratio
for 2002. This was primarily a result of net interest income being tempered for
much of the year due to the
19
investment de-leveraging strategy, rising pension and medical expenses and the
impact from reduced pre-tax margins in the financial services businesses in
2003, as discussed earlier.
Table 6: Operating Expenses
Years Ended December 31,
----------------------------------
(000's omitted) 2004 2003 2002
----------------------------------------------------------------------
Salaries and employee benefits $ 61,146 $ 53,164 $ 47,864
Occupancy 10,177 9,297 8,154
Equipment and furniture 8,636 7,828 7,538
Legal and professional fees 4,578 3,183 3,272
Data processing 7,737 6,800 6,574
Amortization of intangible assets 7,414 5,093 5,953
Office supplies 2,232 1,996 2,321
Foreclosed property 994 561 902
Acquisition expenses 1,704 498 700
Other 15,281 14,291 12,008
----------------------------------------------------------------------
Total operating expenses $119,899 $102,711 $ 95,286
======================================================================
Operating expenses/average assets 2.86% 2.96% 2.81%
Efficiency ratio 52.8% 53.4% 52.0%
Higher personnel expenses accounted for 46% of 2004's increase in operating
costs, primarily the result of three acquisitions in 2003 and the First Heritage
acquisition in 2004. The remainder of the increases in personnel expense reflect
higher benefit costs, merit increases and new hiring activity. Total full-time
equivalent staff at the end of 2004 was 1,301 compared to 1,259 at year-end 2003
and 1,120 at year-end 2002.
Medical expenses were up in 2004 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 decreased slightly in
2004 principally due to a change in the Company's defined benefit pension plan
from a standard annuity paid benefit, to a cash balance design, offset by a
reduction of the discount rate applied to future payments to 5.9% from 6.1%
(increases current expenses in present value terms) and additional obligations
for employees added through acquisition and organic growth. 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 7
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 7: Pension Plan Sensitivity Analysis
One Percentage Point
--------------------
(000's omitted) Increase Decrease
----------------------------------------------------
Discount rate ($611) $ 707
Rate of compensation increase $ 324 ($289)
Expected return on plan assets ($402) $ 402
Total non-personnel expenses increased $9.2 million or 19% in 2004. Excluding
acquisition-related expenses, non-personnel expenses were up $8.0 million or 16%
from 2003's level. As displayed in Table 6, this was largely caused by higher
occupancy expense (up $.9 million), equipment and furniture expense ($.8
million), legal and professional fees ($1.4 million), data processing expense
($.9 million), amortization of intangible assets ($2.3 million) and other
expenses ($1.0 million). The increase in occupancy expense and equipment and
furniture expense in 2004 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 locations we do business in.
The increase in legal and professional fees over the prior year was caused, in
most part, by the additional responsibilities associated with complying with new
governance and regulatory requirements. Data processing and other expenses were
up primarily due to incremental recurring operating expense associated with the
five acquisitions completed during the last eighteen months. Intangible
amortization in 2004 was up versus the prior year due to the amortization of
core deposit and customer relationship intangibles arising from the 2003 and
2004 acquisitions.
20
Total non-personnel expenses increased $2.1 million or 4.5% in 2003 as compared
to 2002, 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). The increase in occupancy expense in 2003 was mainly due to
incremental costs from recently acquired facilities. Other expenses include two
volume-driven expense items that were up considerably due to record levels of
business activity. Intangible amortization in 2003 was down versus the prior
year because the drop in accelerated amortization of core deposit intangibles
from the FleetBoston branch acquisitions had a greater impact than the
amortization of intangibles added as a result of the three acquisitions
completed in 2003.
Acquisition expenses totaled $1.7 million in 2004, up from $498,000 in 2003.
These expenditures were primarily comprised of severance and employee benefits
of $1.0 million, legal and consulting fees of $491,000, and system conversion
costs of $130,000 and $39,000 of other general administrative expenses.
Acquisition 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 were incurred in conjunction with the
Company's largest acquisition of 2003, Grange National Banc Corp., in November
2003.
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 55. 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 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 2004 increased by 0.9 percentage points to 24.9%.
This increase was primarily due to a larger proportion of income from fully
taxable sources in 2004, in comparison to 2003.
The effective tax rate for 2003 of 24.0% was down from the 26.5% rate in 2002.
This decline was primarily due to the benefits realized on a larger proportion
of income from tax-exempt investment securities in 2003, versus 2002.
Capital
Shareholders' equity ended 2004 at $474.6 million, up $69.8 million or 17% from
one year earlier. This increase reflects $54.7 million of common stock issued in
conjunction with the acquisition of First Heritage, net income of $50.2 million
and $8.9 million from the issuance of shares through employee stock plans. These
increases were partially offset by common dividends declared of $20.5 million,
treasury share purchases of $21.7 million and a $1.8 million decline in the
market value adjustment ("MVA", represents the after-tax, unrealized change in
value of available-for-sale securities in the Company's investment portfolio).
Excluding accumulated other comprehensive income in both 2004 and 2003, capital
rose by $71.6 million or 19%. Shares outstanding rose by 2,311,000 during the
year, comprised of 2,592,000 issued to First Heritage shareholders and 703,000
added through employee stock plans, offset by the purchase of 984,000 treasury
shares.
The Company's ratio of tier I capital to assets (or tier I leverage ratio), the
basic measure for which regulators have established a 5% minimum to be
considered "well-capitalized," decreased 32 basis points in 2004 to 6.94%. This
was due to the net issuance of common stock and the capital-building
contribution from retained earnings (net income less dividends declared) offset
by the proportionately higher organic and acquired growth of the investment and
loan portfolios. The tangible equity/tangible assets ratio was 5.82% at the end
of 2004 versus 5.70% one year earlier. The Company manages organic and acquired
growth in a manner that enables it to continue to build upon its strong capital
base, and maintain the Company's ability to take advantage of future strategic
growth opportunities.
Cash dividends declared on common stock in 2004 of $20.5 million represented an
increase of 26% over the prior year. This growth was mostly a result of
dividends per share of $0.68 for 2004 increasing from $0.61 in 2003 due to
quarterly dividends per share being raised from $0.16 to $0.18 (+12.5%) in the
third quarter of 2004 and from $0.145 to $0.16 (+10.3%) in the third quarter of
2003. The increase in dollar amount of dividends declared also reflects an
increase in the number of shares outstanding at the end of this year, primarily
a result of the 2.6 million shares issued in May 2004 to First Heritage
shareholders.
21
The dividend payout ratio for this year was 40.9% compared to 40.2% in 2003, and
37.7% in 2002, and near the top of the Company's targeted payout range for
dividends on common stock of 30 to 40%.
Liquidity
Liquidity risk is measured by the Company's ability to raise cash when needed at
a reasonable cost and with a minimum of loss. The Company must be capable of
meeting all obligations to its customers at any time and, therefore, the active
management of its liquidity position is critical. Given the uncertain nature of
our customers' demands as well as the Company's desire to take advantage of
earnings enhancement opportunities, the Company must have available adequate
sources of on and off balance sheet funds that can be acquired in time of need.
Accordingly, in addition to the liquidity provided by balance sheet cashflows,
liquidity must be supplemented with additional sources such as credit lines from
correspondent banks, Federal Home Loan Bank, and Federal Reserve Bank. Other
funding alternatives may also be appropriate from time to time, including
wholesale and retail repurchase agreements, large certificates of deposit, and
brokered CD relationships.
The Company's primary approach to measuring liquidity is known as the Basic
Surplus/Deficit model. It is used to calculate liquidity over two time periods:
first, the amount of cash that could be made available within 30 days
(calculated as liquid assets less short-term liabilities as a percentage of
total assets); and second, a projection of subsequent cash availability over an
additional 60 days. As of December 31, 2004, this ratio was 15.4% and 17.5% for
the respective time periods, excluding the Company's capacity to borrow
additional funds from the Federal Home Loan Bank and other sources. There is
currently $134 million in additional Federal Home Loan Bank borrowing capacity
based on the Company's year-end collateral levels. Additionally, the Company has
$11 million in unused capacity at the Federal Reserve Bank and $47 million in
unused capacity from an unsecured line of credit with other correspondent banks.
In addition to the 30 and 90-day basic surplus/deficit model, longer-term
liquidity over a minimum of five years is measured and a liquidity worksheet
projecting sources and uses of funds is prepared. To measure longer-term
liquidity, a baseline projection of loan and deposit growth for five years is
made to reflect how liquidity levels could change over time. This five-year
measure reflects ample liquidity for loan growth over the next five years.
Though remote, the possibility of a funding crisis exists at all financial
institutions and therefore must be planned for. Management has addressed this
issue by formulating a Liquidity Contingency Plan, which has been reviewed and
approved by both the Board of Directors and the Company's Asset/Liability
Management Committee. The plan addresses those actions the Company would take in
response to both a short-term and long-term funding crisis.
A short-term funding crisis would most likely result from a shock to the
financial system, either internal or external, which disrupts orderly short-term
funding operations. Such a crisis should be temporary in nature and would not
involve a change in credit ratings. A long-term funding crisis would most likely
be the result of drastic credit deterioration at the Company. Management
believes that both circumstances have been fully addressed, backed up with
detailed action plans and trigger points for monitoring such events.
Intangible Assets
Intangible assets at the end of 2004 of $232.5 million were up $36.4 million
from the prior year-end due to $43.4 million of additional intangible assets
arising from the acquisitions of First Heritage Bank and a branch located in
Dansville, as well as $0.4 million of goodwill adjustments related primarily to
fair value adjustments associated with the 2003 acquisitions, offset by $7.4
million of amortization during the year.
Intangible assets consist of goodwill, core deposit value and customer
relationships arising from acquisitions. Goodwill represents the excess cost of
an acquisition over the fair value of the net assets acquired. Goodwill at
December 31, 2004 equaled $195 million, comprised of $184 million related to
banking acquisitions and $11 million arising from the acquisition of financial
services businesses. Goodwill is subjected to an annual impairment analysis to
determine whether the carrying value of the acquired net assets exceeds their
fair value, which would necessitate a write-down of the goodwill. The Company
completed its goodwill impairment analyses during 2004 and 2003 and no
adjustments were necessary. The impairment analysis was 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. Management believes that
there is a low probability of future impairment with regard to the goodwill
associated with whole-bank acquisitions. The performance of Elias Asset
Management weakened subsequent to its acquisition in 2000 as a result of adverse
market conditions, however, its performance stabilized in 2004
22
as market conditions improved. Additional declines in EAM's operating results
may result in impairment to its recorded goodwill of $7.3 million.
Core deposit intangibles represent the premium the Company has paid for deposits
acquired in excess of the cost incurred had the funds been purchased in the
capital markets. Core deposit intangibles are amortized on either an accelerated
or straight-line basis over periods ranging from seven to twenty years. The
recognition of a customer relationship intangible arose due to the acquisition
of Harbridge. This asset was determined based on a methodology that calculates
the present value of the projected future revenue derived from the acquired
customer base. This asset is being amortized over eleven years on an accelerated
basis.
Loans
The Company's loans outstanding, by type, as of December 31 are as follows:
Table 8: Loans Outstanding
(000's omitted) 2004 2003 2002 2001 2000
- -------------------------------------------------------------------------------------------------------------
Consumer mortgage $ 801,412 $ 739,593 $ 510,309 $ 443,767 $ 416,160
Business lending 831,244 689,436 629,874 643,834 576,887
Consumer direct and indirect 725,885 699,562 666,838 645,487 523,832
- -------------------------------------------------------------------------------------------------------------
Gross loans 2,358,541 2,128,591 1,807,021 1,733,088 1,516,879
Less: unearned discount 48 82 116 218 1,002
- -------------------------------------------------------------------------------------------------------------
Net loans 2,358,493 2,128,509 1,806,905 1,732,870 1,515,877
Allowance for loan loss 31,778 29,095 26,331 23,901 20,035
- -------------------------------------------------------------------------------------------------------------
Loans, net of allowance for loan losses $2,326,715 $2,099,414 $1,780,574 $1,708,969 $1,495,842
=============================================================================================================
As disclosed in Table 8 above, gross loans outstanding, reached a record level
of $2.359 billion as of year-end 2004, up $230 million or 10.8% compared to
twelve months earlier. The acquisitions of First Heritage and Dansville
accounted for $212 million of that growth. Excluding the impact of these
acquisitions (at time of completion), total loans rose $18 million or 1% from
the prior year. All of the organic loan growth was produced in the consumer
mortgage and installment lines of business, with declines experienced in
business lending. The organic loan growth was attributable to the New York
market, with the Pennsylvania market experiencing a net decline in loans
outstanding.
The compounded annual growth rate ("CAGR") for the Company's total loan
portfolio between 2000 and 2003 was 8.3% with approximately 7% of the growth
coming from whole bank and branch acquisitions and the balance from organic
growth. The greatest overall expansion occurred in the consumer mortgage
segment, which grew at a 14% CAGR (including the impact of acquisitions) over
that time frame. The consumer mortgage growth was primarily driven by record
mortgage refinancing volumes over the last three years, as well as the
acquisition of consumer-oriented banks in the intervening period. The other loan
categories grew at compounded annual growth rates of between 5% and 7% from 2000
to 2004. As a consequence, the consumer mortgages segment accounted for 34% of
the total loan portfolio at year-end 2004 versus 27% at the end of 2000.
The weighting of retail lending in the Company's loan portfolio enables it to be
highly diversified. Approximately 65% of loans outstanding at the end of 2004
were made to consumers borrowing on an installment and residential mortgage loan
basis. The commercial portfolio is also broadly diversified by industry type as
demonstrated by the following distributions at year-end 2004: real estate
development (16%), healthcare (11%), general services (11%), motor vehicle and
parts dealers (9%), construction (7%), agriculture (6%), restaurant & lodging
(6%), retail trade (6%), manufacturing (5%) and wholesale trade (5%). A variety
of other industries with less than a 3% share of the total portfolio comprise
the remaining 18%. Over the last year, the mix of loans has become more weighted
towards business lending due to the high proportion of commercial loans in First
Heritage's portfolio.
The consumer mortgage segment of the Company's loan portfolio is comprised of
fixed (94%) and adjustable rate (6%) residential lending. Approximately $21
million of the $62 million growth in consumer mortgages was attributable to the
acquisition of First Heritage. Excluding the impact of this acquisition, this
segment was up $41 million or 5.6% in 2004 due to continued strong mortgage
volumes in the historically low interest rate environment. All of the organic
growth was generated in the New York market, as Pennsylvania experienced a net
decline in 2004 despite a significant volume of new originations.
The combined total of general-purpose business lending, dealer floor plans,
mortgages on commercial property, and farm loans is characterized as the
Company's business lending activity. Approximately $170 million in business
loans added
23
through the First Heritage acquisition offset the $28 million (4.1%) decrease
from ongoing operations in 2004. The majority of this decrease was attributable
to the Pennsylvania market, with the New York market experiencing a slight
decrease. Lending efforts in First Liberty's traditional markets continue to be
challenged by a modest economic recovery, diminished capital spending levels in
the commercial sector, an extremely competitive pricing environment and the
Company's dedication to maintaining strong credit quality standards. Management
has worked aggressively to address the loan generation challenges in
Pennsylvania by adding enhanced management, lending and credit administration
resources, and strong business relationships via the acquisition of First
Heritage in 2004 and Grange in 2003. The enhanced scale and coverage of the
Pennsylvania business combined with the new management team's continued
commitment to business development efforts, positions them to fully take
advantage of growth opportunities in this key market as economic conditions
continue to improve and increased capital spending leads to expanded borrowing
activity in the commercial sector.
Consumer installment loans, bot