Community Bank System, Inc. — FY2018 Form 10-K Summary
Business context and reporting period
The filing covers the fiscal year ended December 31, 2018, with comparative results for 2017 and 2016. Community Bank System, Inc. is a diversified financial holding company operating through Community Bank, N.A., BPAS and related subsidiaries. Reportable segments are Banking, Employee Benefit Services, and All Other, which includes wealth management and insurance. At year-end, the Bank operated 224 branches across Upstate New York, Northeastern Pennsylvania, Vermont and Western Massachusetts and employed 2,933 full-time, part-time and temporary employees.
Financial performance and condition
| Metric | 2018 | 2017 | Change |
|---|---|---|---|
| Net interest income | $345.1 million | $315.7 million | +9.3% |
| Noninterest revenue | $224.1 million | $202.4 million | +10.7% |
| Income before taxes | $213.0 million | $160.0 million | +33.1% |
| Net income | $168.6 million | $150.7 million | +11.9% |
| Diluted EPS | $3.24 | $3.03 | +6.9% |
| Net interest margin | 3.73% | 3.69% | +4 basis points |
| Return on average assets | 1.58% | 1.49% | +9 basis points |
| Return on average equity | 10.20% | 10.21% | Essentially stable |
| Efficiency ratio | 58.0% | 58.3% | Improved 30 basis points |
At December 31, 2018, total assets were $10.61 billion, loans were $6.28 billion, investment securities were $2.98 billion, deposits were $8.32 billion, borrowings were $413.7 million and shareholders’ equity was $1.71 billion. Cash and cash equivalents totaled $211.8 million. The loan portfolio was broadly diversified, with approximately 62% of loans to consumers and the remainder primarily business lending.
Credit quality remained favorable. Nonperforming loans were $25.0 million, or 0.40% of total loans, compared with 0.44% in 2017. Net charge-offs were $9.1 million, or 0.15% of average loans, compared with 0.18% in 2017. The allowance for loan losses was $49.3 million, or 0.78% of loans, and covered 197% of nonperforming loans.
Operating cash flow was $221.4 million, compared with $189.7 million in 2017. Investing activities provided $17.5 million, while financing activities used $248.1 million, primarily reflecting decreases in deposits and borrowings, repayment of $25.2 million of subordinated debt, and $71.5 million of cash dividends. Ending cash and cash equivalents declined by $9.2 million from 2017.
Liquidity was reported as sufficient. The Bank had $1.6 billion of unused FHLB borrowing capacity, $1.6 billion of unencumbered securities and $25.0 million of unsecured correspondent-bank lines. The 30-day and 90-day basic surplus ratios were 14.2% and 14.4%, respectively, above the 7.5% internal policy minimum.
Capital levels were well above regulatory requirements. The Company reported an 11.08% Tier 1 leverage ratio, 16.65% common equity Tier 1 ratio and 19.06% total risk-based capital ratio. The Bank was categorized as well capitalized. The Company declared $1.44 per share of dividends, a 9.1% increase from 2017, and reported a 43.8% payout ratio.
Material changes versus the prior comparable period
- Net income increased primarily because 2018 included a full year of earnings from the 2017 Merchants Bancshares and Northeast Retirement Services acquisitions.
- Adjusted net income increased 26.7% to $175.9 million, and adjusted EPS increased 21.1% to $3.39; these are non-GAAP measures that exclude specified acquisition, tax, amortization and other items.
- Banking net interest income increased $29.6 million, driven by higher average earning assets, loan growth and higher loan yields. Average loans increased $445.5 million, largely from Merchants.
- Employee Benefit Services revenue increased 14.1% to $94.4 million, primarily from a full year of NRS operations and organic growth.
- All Other revenue increased $8.0 million to $57.2 million, reflecting acquired and organic growth in wealth management and insurance.
- Noninterest expenses decreased 0.5% to $345.3 million because 2017 included $26.0 million of acquisition expenses; 2018 included a $0.8 million recovery of certain acquisition-related charges.
- Debit-card revenue declined approximately $7.1 million after the Company became subject to the Durbin interchange-fee cap beginning July 1, 2018.
- The effective tax rate increased to 20.8% from 5.8% in 2017. The 2017 rate benefited from a $38.0 million one-time deferred-tax benefit related to the Tax Cuts and Jobs Act.
- Accumulated other comprehensive loss increased substantially, primarily from lower unrealized values on available-for-sale securities and pension-related items. The investment portfolio moved from a $23.9 million unrealized gain at year-end 2017 to a $15.3 million unrealized loss at year-end 2018.
Outlook, commentary, risks and unusual items
Management’s strategy emphasizes disciplined acquisitions, organic loan and deposit growth, expansion of fee-based businesses, technology investment and maintenance of strong capital and liquidity. The filing does not provide formal earnings guidance. Interest-rate sensitivity modeling indicated that projected first-year net interest income could decline by $2.5 million under a 200-basis-point rate increase and by $8.5 million under a 200-basis-point decline, although management cautioned that the analysis is not a forecast.
- On January 22, 2019, the Company announced a pending approximately $93.4 million cash acquisition of Kinderhook Bank Corp., expected to close in the third quarter of 2019 subject to regulatory and shareholder approvals. The transaction is expected to add 11 branches, approximately $640 million of assets and $560 million of deposits, and to generate one-time 2019 transaction costs.
- On January 2, 2019, the Company acquired certain Wealth Resources Network assets for $1.2 million and recorded a corresponding customer-list intangible asset.
- Adoption of revenue-recognition guidance and other accounting standards in 2018 did not materially affect reported results. Lease accounting adopted January 1, 2019 added approximately $33.5 million of lease liabilities and right-of-use assets.
- The Current Expected Credit Loss standard becomes effective for the Company after December 15, 2019. Management expects the allowance for credit losses to change, but the filing does not provide a clear estimate of the amount.
- Principal risks include interest-rate and funding risk, regional economic weakness, credit losses, the acquired portion of the loan portfolio, regulatory and compliance costs, cybersecurity and vendor failures, competition, market-related declines in assets under management, acquisition integration, goodwill or intangible impairment, and litigation.
- Legal proceedings are considered immaterial to consolidated financial position; the disclosed range of reasonably possible losses beyond recorded liabilities was $0 to $1 million in aggregate, although losses could affect a particular future period.
Most important facts for investors to verify
- Confirm the legal registrant name: the supplied filing is for Community Bank System, Inc., although the request metadata identifies Community Financial System, Inc.
- Reconcile GAAP net income and EPS with management’s non-GAAP adjusted net income of $175.9 million and adjusted EPS of $3.39.
- Assess the sustainability of earnings growth after excluding the 2017 tax benefit and acquisition-related comparisons.
- Monitor deposit pricing, borrowing costs and net interest margin as rates and funding costs change.
- Evaluate credit performance, particularly the 20% of loans acquired and not originated by the Company, allowance coverage and future CECL effects.
- Review the Kinderhook transaction’s approval status, purchase accounting, funding, integration risk and expected 2019 costs.
- Consider the $733.5 million goodwill balance and $73.8 million of amortizing intangible assets relative to tangible equity.
- Verify liquidity capacity, short-term borrowings and the concentration of contractual obligations and off-balance-sheet commitments, including $1.13 billion of commitments to extend credit and $33.2 million of standby letters of credit.
- Review the effect of the Durbin interchange-fee cap, regulatory requirements applicable to institutions above $10 billion in assets, and the Company’s cybersecurity and third-party vendor exposures.