COMMUNITY FINANCIAL SYSTEM, INC. quarterly report, Q2 FY2020

Business Context and Reporting Period

Registrant: Community Bank System, Inc. (the filing text identifies the company as Community Bank System, Inc.; this differs from the request metadata naming Community Financial System, Inc.). The unaudited Form 10-Q covers the three and six months ended June 30, 2020, compared with the corresponding 2019 periods.

The company operates banking, employee benefit services, wealth management, and insurance businesses primarily in Upstate New York and surrounding markets. On June 12, 2020, it completed the $98.6 million acquisition of Steuben Trust Corporation, adding approximately $610.1 million of assets, $516.3 million of deposits, $339.7 million of loans, and 11 offices.

Financial Performance and Position

Metric	Three months ended June 30, 2020	Year-over-year change	Six months ended June 30, 2020	Year-over-year change
Net interest income	$92.0 million	Up 4.1%	$182.0 million	Up 3.9%
Provision for credit losses	$9.8 million	Up $8.4 million	$15.4 million	Up $11.5 million
Noninterest revenue	$52.9 million	Down 12.8%	$111.6 million	Down 4.2%
Noninterest expense	$90.9 million	Down 0.3%	$184.6 million	Up 2.6%
Net income	$35.2 million	Down 21.7%	$75.4 million	Down 13.3%
Diluted EPS	$0.66	Down $0.20	$1.43	Down $0.23
Net interest margin	3.37%	Down 43 basis points	3.50%	Down 30 basis points

Second-quarter adjusted net earnings per diluted share, excluding specified acquisition, credit-loss, investment-security, intangible-amortization, and acquired-loan items, were $0.80 versus $0.84 in the prior-year quarter. Adjusted pre-tax, pre-provision net revenue increased 5.9% in the quarter and 3.9% year to date.

Total assets were $13.44 billion at June 30, 2020, up from $11.41 billion at December 31, 2019.
Total loans were $7.53 billion, up 9.3% from year-end 2019 and 19.8% from June 30, 2019. Business lending was $3.46 billion, including $507.2 million of PPP loans.
Total deposits were $10.85 billion, up from $8.99 billion at year-end 2019, driven by acquisitions and government stimulus-related inflows.
Cash and cash equivalents were $1.32 billion. Available-for-sale securities were $3.29 billion, including $1.62 billion unpledged as collateral.
Shareholders’ equity was $2.08 billion. The Tier 1 leverage ratio was 10.79%, compared with the 5.0% well-capitalized regulatory threshold; the net tangible equity-to-assets ratio was 10.08%.
Borrowings excluding securities sold under repurchase agreements were $100.8 million. Securities sold under repurchase agreements were $168.5 million.
Operating cash flow for the first six months was $95.4 million. Investing activities used $201.8 million, while financing activities provided $1.22 billion, primarily from a $1.34 billion increase in deposits.
The allowance for credit losses was $64.4 million, or 0.86% of loans, compared with 0.78% at June 30, 2019 and 0.72% at December 31, 2019.

Material Changes Versus Prior Comparable Period

Net income declined primarily because COVID-19 increased expected credit losses, while noninterest revenue declined and acquisition costs increased.
Net interest income increased because of substantially higher earning-asset balances and lower funding costs, but net interest margin compressed as market rates fell.
Noninterest revenue was reduced by lower deposit service fees, debit interchange and ATM fees, other banking revenue, wealth management revenue, and insurance revenue, as well as the absence of the $4.9 million 2019 gain on investment-security sales.
Loan growth reflected the Steuben and Kinderhook acquisitions and PPP originations. Consumer installment loans declined year over year, reflecting weaker consumer credit demand.
Nonperforming loans were $26.8 million, or 0.36% of total loans, versus 0.35% at June 30, 2019 and 0.39% at December 31, 2019. Nonperforming assets were $29.9 million.
Net charge-offs declined to $0.9 million in the quarter and $2.5 million year to date, despite materially higher provisions.
The company adopted CECL on January 1, 2020, increasing retained earnings by $0.5 million after recording related allowance and liability adjustments.
Accumulated other comprehensive income increased to $90.0 million from a $10.2 million loss at December 31, 2019, primarily due to higher unrealized gains on available-for-sale securities.

Guidance, Outlook, Risks, and Unusual Items

Management expects third-quarter net interest margin to remain depressed because of low short-term rates. PPP forgiveness timing and recognition of the remaining $13.1 million of net deferred PPP origination fees may create earnings-yield volatility.
Management expects most PPP borrowers to seek forgiveness in the third and fourth quarters, but borrower eligibility and the SBA’s timing for forgiveness payments remain uncertain.
Approximately 3,700 borrowers, representing about $700 million, or 9.3% of total loans, were under COVID-19-related forbearance at June 30, 2020. Management expects forbearance levels to decline in the third quarter but warned that delinquencies and provisions may rise after deferrals expire.
Management expects deposit service fees and debit interchange revenue to improve modestly in the third quarter if economic reopening continues without another shutdown. Operating expenses are expected to increase as marketing resumes and the expanded Steuben branch network adds costs.
Liquidity was described as extremely strong: unused FHLB borrowing capacity was $1.80 billion, Federal Reserve discount-window availability was $259.8 million, and the 30-day and 90-day basic surplus ratios were each 19.2%, above the company’s 7.5% internal requirement.
Key risks include the duration and severity of COVID-19, unemployment and economic deterioration, additional credit losses after loan deferrals end, PPP rule changes or delayed forgiveness, prolonged low interest rates, deposit outflows, reduced fee income, market volatility, liquidity access, acquisitions and litigation.
Acquisition-related expenses were $3.4 million in the quarter and $3.7 million year to date. Management expects additional one-time Steuben transaction-related costs during 2020.
Pending litigation is not expected to materially affect financial position; reasonably possible losses beyond recorded liabilities were estimated at $0 to $1 million in aggregate, although effects on a particular future period cannot be ruled out.
The company reported effective disclosure controls and procedures as of June 30, 2020, with no material changes in internal control over financial reporting.

Most Important Facts for Investors to Verify

Whether COVID-19 loan deferrals convert into higher delinquencies, charge-offs, and additional CECL provisions after expiration.
The timing and ultimate amount of PPP loan forgiveness, SBA reimbursement, and recognition of deferred PPP fees.
Whether unusually high stimulus-related deposits persist and how deposit runoff would affect liquidity, funding costs, and net interest margin.
The sustainability of earnings excluding acquisition-related items, investment gains, and other nonrecurring adjustments.
The integration costs, credit marks, goodwill, and revenue contribution associated with the Steuben acquisition.
The effect of prolonged low interest rates on loan yields, securities reinvestment, net interest margin, and capital ratios.
Changes in nonperforming loans, other real estate owned, allowance coverage, and criticized business loans as economic conditions evolve.