Business context and reporting period
This Form 10-K covers the fiscal year ended December 31, 2017, including fourth-quarter results. The filing identifies the registrant as Community Bank System, Inc., a diversified financial holding company with three reportable segments: Banking, Employee Benefit Services, and All Other, which includes wealth management and insurance operations. The company operated 225 branches across Upstate New York, Northeastern Pennsylvania, Vermont and Western Massachusetts.
2017 included the acquisitions of Northeast Retirement Services, Merchants Bancshares, Benefits Advisory Service, Dryfoos Insurance Agency, Northeast Capital Management and Gordon B. Roberts Agency. The Merchants transaction materially expanded the banking footprint and added approximately $2.0 billion of assets, $1.49 billion of loans and $1.45 billion of deposits.
Financial performance and condition
| Metric | 2017 | 2016 | Change |
|---|---|---|---|
| Net interest income | $315.7 million | $273.9 million | +15.3% |
| Noninterest revenue | $202.4 million | $155.6 million | +30.1% |
| Provision for loan losses | $11.0 million | $8.1 million | +36.0% |
| Noninterest expense | $347.1 million | $266.8 million | +30.1% |
| Income before taxes | $160.0 million | $154.6 million | +3.5% |
| Net income | $150.7 million | $103.8 million | +45.2% |
| Diluted EPS | $3.03 | $2.32 | +30.6% |
| Total assets | $10.75 billion | $8.67 billion | +24.0% |
| Gross loans | $6.26 billion | $4.95 billion | +26.4% |
| Total deposits | $8.44 billion | $7.08 billion | +19.3% |
| Shareholders’ equity | $1.64 billion | $1.20 billion | +36.5% |
- Net interest margin was 3.69%, down from 3.71%, as the yield on earning assets declined modestly while funding costs increased.
- Return on average assets was 1.49%, compared with 1.20%; return on average equity was 10.21%, compared with 8.57%.
- The efficiency ratio improved to 58.3% from 59.6%, despite substantial integration and growth-related expenses.
- Employee Benefit Services revenue increased 71.4% to $82.7 million, primarily from the NRS acquisition. Banking noninterest income increased to $73.3 million, and All Other revenue increased to $49.2 million.
- Loan quality remained favorable overall: nonperforming loans were 0.44% of total loans versus 0.48% at year-end 2016, while net charge-offs increased to $10.6 million, or 0.18% of average loans, from 0.13%.
- The allowance for loan losses was $47.6 million, equal to 0.76% of total loans and 173% of nonperforming loans.
Cash flow, funding and liquidity
- Net cash provided by operating activities was $189.7 million, compared with $135.8 million in 2016.
- Investing activities provided $131.4 million, principally because of a net decrease in loans and acquisition-related cash flows; acquisition payments, net of cash acquired, totaled $107.4 million.
- Financing activities used $273.9 million, including a $62.3 million dividend payment and a net reduction in borrowings and deposits.
- Cash and cash equivalents ended the year at $221.0 million, versus $173.9 million in 2016.
- Borrowings increased to $485.9 million from $248.4 million, including $337.0 million of short-term repurchase agreements and $122.8 million of subordinated debt.
- Management reported $1.7 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 liquidity ratios were 13.8% and 13.7%, respectively, above the company’s 7.5% policy minimum.
- The company remained well capitalized. The consolidated Tier 1 leverage ratio was 10.00%, total risk-based capital was 17.45%, and CET1 was 14.65% at year-end.
Material changes versus the prior comparable period
- The Merchants and NRS acquisitions were the principal drivers of balance-sheet expansion, revenue growth, employee additions and higher operating costs. The company issued approximately 6.05 million shares for acquisitions during 2017.
- Acquisition expenses rose to $26.0 million from $1.7 million, including $24.6 million related to Merchants and $1.2 million related to NRS. Intangible assets increased to $825.1 million from $480.8 million, including $734.4 million of goodwill.
- The Tax Cuts and Jobs Act generated a $38.0 million one-time deferred-tax benefit in the fourth quarter. Consequently, the reported effective tax rate was 5.8%, compared with 32.8% in 2016. Management reported adjusted 2017 net income of $138.8 million and adjusted diluted EPS of $2.80, excluding acquisition-related items, intangible amortization, acquired loan accretion and the tax-law impact.
- Gross loans grew $1.31 billion, but loans excluding the Merchants portfolio declined $53.1 million, indicating that most reported loan growth was acquisition-related rather than organic.
- Core deposits increased to 90.5% of average deposits from 89.3%, while time deposits declined as a percentage of funding. The increase in borrowings reflected funding assumed or added through the Merchants transaction.
- The common dividend increased to $1.32 per share from $1.26, marking the company’s 25th consecutive year of dividend increases. A $0.34 per-share dividend was declared for the first quarter of 2018.
Outlook, management commentary, risks and unusual items
The filing does not provide formal earnings or revenue guidance. Management’s stated strategy is to pursue disciplined acquisitions, grow loans and deposits, expand fee-based businesses and use technology to improve efficiency. Management characterized asset quality and liquidity as favorable and reported no goodwill impairment in 2017.
- Interest-rate sensitivity modeling indicated projected first-year net interest income would decrease by approximately $3.7 million under a 200-basis-point increase, decrease by $1.5 million under a 100-basis-point increase, and decrease by $6.9 million under a 100-basis-point decline. These are scenarios, not forecasts.
- Because consolidated assets exceeded $10 billion, the company became subject to heightened regulatory requirements, including direct CFPB supervision, enhanced stress testing, large-institution FDIC assessments and debit-card interchange-fee limits beginning July 1, 2018.
- Key risks include interest-rate and liquidity risk, credit losses, regional economic conditions, acquisition integration, goodwill and intangible-asset impairment, cybersecurity and third-party vendor exposures, regulatory compliance, litigation and competitive pressure.
- Approximately 26% of the loan portfolio was acquired and not originated by the company. Management cautioned that acquired-credit performance may differ from historical experience.
- Off-balance-sheet commitments totaled $1.10 billion, including $1.08 billion of commitments to extend credit and $23.8 million of standby letters of credit.
- Pending litigation was not expected to be material to consolidated financial position; reasonably possible losses beyond recorded liabilities were estimated at $0 to $1 million in aggregate, although period-specific earnings effects cannot be ruled out.
- The company expects future accounting changes, including the expected-credit-loss standard, to affect the allowance for loan losses; the ultimate impact was not yet quantified.
Important facts for investors to verify
- Separate recurring operating performance from the $38.0 million tax benefit and the $26.0 million of acquisition expenses.
- Assess the sustainability of growth after adjusting for the Merchants and NRS acquisitions, particularly organic loan and deposit growth.
- Monitor integration costs, revenue synergies, staffing and operating leverage from the acquired businesses.
- Review credit trends in the commercial portfolio, including the single commercial relationship associated with a $3.1 million partial charge-off and the level of acquired loans.
- Evaluate the effect of higher borrowings, rising funding costs and interest-rate sensitivity on future net interest margin.
- Confirm the effect of the $10 billion asset threshold on regulatory costs, FDIC assessments, interchange revenue and capital planning.
- Track goodwill and other intangible assets, which totaled $825.1 million and represented a significant portion of shareholders’ equity.
- Review cash-flow statements, liquidity capacity and the maturity of $361.0 million of borrowings due within one year.