Mark Tryniski - President & CEO Scott Kingsley - EVP & CFO.

John Moran - Macquarie Collyn Gilbert - KBW David Darst - Guggenheim Securities Matthew Breeze - Sterne Agee Julienne Cassarino - Prospector Partners.

Please standby. Welcome to the Community Bank System Second Quarter 2014 Earnings Conference Call.

Please note that this presentation contains forward-looking statements within the provisions of the Private Securities Litigation Reform Act of 1995 that are based on current expectations, estimates and projections about the industry, markets and economic environment in which the company operates.

Such statements involve risks and uncertainties that could cause actual results to differ materially from the results discussed in these statements. These risks are detailed in the company's annual report and Form 10-K filed with the Securities and Exchange Commission.

Today's call presenters are Mark Tryniski, President and Chief Executive Officer; and Scott Kingsley, Executive Vice President and Chief Financial Officer. Gentlemen, please go ahead..

Thank you, Caroline. Good morning everyone and thank you all for joining our second quarter conference call. The operating performance for the quarter was very good and driven by strong execution by our team across the company. The margin is holding up better than our expectation, despite the competitive pressure on spreads.

Growth in non-interest revenues continues to be very additive to operating performance in both our wealth management, and benefits administration businesses running at record levels of revenue, margin and earnings.

Operating expenses were well managed, providing for revenues growing faster than expenses and giving us improved operating leverage and the low level of credit cost continues to be supportive of our results as well. Loan growth in the quarter was modest, but disciplined and consistent with our expectation and our markets as with core deposit growth.

On top of that, we've increased our dividend 7%, which marks the 22nd consecutive year of dividend increase for the company and reflects the strength of our operating performance and our continued confidence in the future. The market environment continues to be very competitive in all credit businesses.

Mortgage originations had slowed to a more historically normalized pace, which we expect to continue into the future. Dodd-Frank regulations have been burdensome and had modestly impacted the efficiency in returns of this business, at least for the near-term.

Market demand in the auto lending business has been very strong, offset by contracting margins. The commercial portfolio was flat for the quarter, but similar to last year. The pipeline is good in the expected improved results in the second half. The spreads are very tight, particularly on quality deals, and we're seeing a relaxation in structure.

With that said, we'll continue to be disciplined in our credit philosophy and has historically been the case, expect lower levels of growth than many of our market peers.

Looking back over the past four quarters, total organic loan growth was 5.3%, an outcome we're quite satisfied with given the lower growth nature of our markets, as well as an outcome that has been supportive of this year's improved operating performance.

Overall, it was a productive quarter, and we believe we're well positioned for the second half of the year and beyond.

Our capital strength provides significant future opportunity, and it will be our focus going forward to utilize that capital in a disciplined manner to continue to grow earnings, grow the dividends and generate above average return to our shareholders.

Scott?.

Thank you, Mark, and good morning everyone. As Mark mentioned the second quarter of 2014 was a very solid operating quarter for us. Also as a reminder, for comparative purposes our acquisition of eight former Bank of America branches in Northeast Pennsylvania was completed in mid December of 2013. I'll first discuss the balance sheet items.

Average earning assets of $6.63 billion for the second quarter, up almost $50 million from the first quarter of 2014, and we're up 6% from the second quarter of 2013.

In addition, the mix change of the earning asset base compared to the second quarter of last year was also very positive in that average loans grew organically $222 million or 5.7% and average investments in cash equivalents grew $152.3 million.

Average deposits were up 5.3% from the second quarter of last year principally from the branch acquisition completed in December. The multi-year trend away from time deposits and into core checking, savings and money market accounts continued in the first half of 2014 resulting in a further decline in overall funding cost.

Outstandings in our business lending portfolio were consistent with the end of the first quarter, and we're 2% higher than the end of the second quarter of last year and very consistent with our market demand characteristics.

Asset quality results in this portfolio continues to be stable and favorable to peers with annual net charge-off of under 25 basis points over the last four, eight and 12 quarters.

Our total consumer real estate portfolios of $1.92 billion comprise of $1.58 billion of consumer mortgages and $339 million of home equity instruments were also consistent with the end of the first quarter, over $45 million higher than the end of last year's second quarter or 2.4% increase.

We continue to retain in portfolio of most of our short and mid duration mortgage production while selling secondary eligible 30-year instruments. Asset quality results continue to be very favorable on these portfolios with total annual net charge-offs over the last four, eight, and 12 quarters of under eight basis points.

Our consumer indirect portfolio of $797 million was up $41 million or 5.5% from the end of the first quarter consistent with continuing solid regional demand characteristics. Used car valuations were the largest majority of our lending is concentrated continued to be stable and favorable.

Annual net charge-offs for the last four, eight and 12 quarters were also under 30 basis points, which we consider exceptional. With our continued bias toward A and B paper grades and the very competitive market conditions in this asset class, yields have continued to trend lower over the last several quarters.

We have continued to report very favorable net charge-off results with the first six months of 2014 results at just 13 basis points of total loans being a stellar performance. Non-performing loans comprised of both legacy and acquired loans ended the second quarter at $23.9 million or 0.58% of total loans.

Our reserves for loan losses represent 1.15% of our legacy loans and 1.08% of total outstandings, and based on the trailing four quarter's results represent over six years of annualized net charge-offs. As of June 30th, our investment portfolio stood at $2.53 billion and was comprised of $293 million of U.S.

agency and agency-backed mortgage applications or 12% of the total, $707 million of municipal bonds or 28%, and $1.4 billion of U.S. treasury securities or 58% of the total. The remaining 2% was in corporate debt securities. Our capital levels in the second quarter of 2014 continue to grow.

The Tier 1 leverage ratio rose to 9.64% at quarter end, and tangible equity-to-net tangible assets ended June at 8.44%. These higher capital levels and our strong operating income generation allowed us again to raise our quarterly dividend to shareholders, this time to $0.30 per quarter or 7.1% increase.

Tangible book value per share increased to $14.74 per share at quarter end and includes $33.8 million of deferred tax liabilities generated from tax deductible goodwill or $0.83 per share.

Shifting to the income statement, our reported net interest margin for the second quarter was 3.94% consistent with the first quarter of this year and four basis points lower than last year's second quarter. Our net interest margin has been positively impacted by the 2013 balance sheet restructuring activities as previously described.

Proactive management of deposit funding costs continued to have a positive effect on margin results, but have not being able to fully offset declining asset yields. Also, as a remainder, our second quarter net interest income also included our semi-annual dividend from the Federal Reserve Bank of just under half a million dollars.

Second quarter non-interest income was up 9.5% from last year's second quarter. The company's employee benefits, administration and consulting businesses posted 11.2% increase in revenues from new customer additions, favorable equity market conditions, and additional service offerings.

Our wealth management group generated a 9.7% revenue improvement from last year, and also included solid organic growth and trust in asset advisory services while also benefiting from the favorable market conditions.

Seasonally, our revenues from banking non-interest income sources improved from the first quarter and we were $1.4 million or 10.6% higher than the second quarter of 2013. As was mentioned in our release, second quarter results included nearly $400,000 of life insurance-related gains.

Quarterly operating expenses of $55.2 million increased to $0.8 million or 1.5% over the second quarter of 2013 and included the operating cost associated with the eight additional branches acquired in December.

Merit-based personnel cost increases were partially offset by lower retirement planning costs related to the combination of strong plan asset performance and slightly higher pension discount rate in 2014.

Seasonally, as expected, our utilities and maintenance cost in the second quarter were a cent per share lower than the winter-dominated first quarter of the year. Our effective tax rate in the second quarter of 2014 was 29.9% versus 29.2% in last year's second quarter.

We continue to expect net interest margin challenges going forward, as many of our existing assets are still being replaced by new assets with modestly lower yields. Our funding mix and costs are at very favorable levels to-date, from which we do not expect a significant improvement.

Our growth in all sources of non-interest revenues has been very positive, and we believe we're favorably positioned to continue to expand in all areas. While operating expenses will continue to be managed in a disciplined fashion, we do expect to continue to consistently invest in all of our businesses.

Our asset quality has continued to remain a differentiating feature of our business model, and we don't expect that to change going forward. Tax rate management will continue to be subject to successful reinvestment of cash flows into high quality municipal securities as it has been for the last several years.

We have faced similar market characteristics and dynamics over the last few years in this interest rate environment and expect to execute on our business model in a consistent manner in order to create growing and sustainable value for our shareholders. I'll now turn it back over to Caroline to open the line for any questions..

Thank you. (Operator Instructions) We'll go first to John Moran with Macquarie Investment Bank..

Hey, guys..

Good morning, John..

Good morning, John..

How is it going? A quick question on the investment yield there, it was up a little bit, I think a couple of basis points. Scott, I think I caught in those prepared remarks, you said, the semi-annual dividend added just under 500, so kind of two, three basis points there..

It did, John. Yes, they are math. In a matter of fact, I think if you excluded the FRB dividend from the second quarter comparing to the first quarter, it showed three basis points difference..

Okay.

So even sort of pro-forma for that, pretty stable in the book, could you just give us maybe a sense of where things are rolling off and where you are putting them on and what the book or what's changing in the margin there?.

John, that's actually been very consistent. Our second quarter purchases were very, very modest. We just didn't have a lot of expiring cash flows in the portfolio in the second quarter. So we are replacing municipal cash flows with right kinds of municipal instruments.

Your work, we're in the five to seven to eight year duration characteristics for those instruments. We had no new treasury purchases during the quarter, and I think we are just getting natural cash flows off the mortgage back security portfolio. Nothing outside in terms of gains or losses there either..

Okay, thanks. We should shift gears also on yield. I think, Scott, in your prepared remarks you've said, regional demands stays really strong, used car pricing and I am talking to kind of the indirect auto book here, used car pricing really stable, less than 30 basis points on charge offs over the last four quarters if I heard you correctly there..

Yeah, you did hear me that that's actually last -- 130 basis points in the last three years, John..

Three years. And then, I think also you said that yields -- demand is still pretty strong, but yield is under pressure.

Can you give us a sense of maybe size that a little bit where it is today versus maybe where it was 12 months ago?.

Yeah. What we've seen, John is a drop of about 10 to 15 basis points a quarter in our blended portfolio yield. So we are a handful of basis points below 4% as an average yield for the portfolio in the second quarter. We were probably in the mid fours last year at this time.

So I would again say good quality A and B paper grades stuff is going off in the low to mid threes. Again, if you look at that versus certain other asset prices from comparison, what we are seeing is that duration is really not extending there. So, you are still really looking at an instrument that's 34, 35 months in expected duration on average.

Even the most car loans are probably going up at 48 to 60 months today. It's a combination of people leaving their instruments early..

Got it. So despite the fact that that term is changing and I mean we all see that, but the duration and the characteristics at least on the used side is staying pretty much the same..

That's true. John, we are not long duration auto lenders anyways. We are not in the new car world doing 84 months instruments or stuff like that. Anyways, that's not our book..

Got it. I've got one more quick one just on the fee side, the other banking services line ran a little bit high this quarter.

Anything driving that?.

Scott Kingsley:.

:.

Thank you. I missed that one in the prepared remarks. Thanks, guys..

Thanks for the question, John..

Thanks, John..

And next, we will go to Collyn Gilbert with KBW Investments..

Thanks. Good morning, guys..

Good morning, Collyn..

Hi, Collyn..

Just a follow-up back up on the loan yield discussion, and just the outlook for the NIM, it still seems like you guys are holding that loan yield up better maybe even than what you expected, just trying to see that what the expectation is there.

I know that your objective has been to try to keep duration short which I thought maybe would even compress that yield even more.

So, if you could talk a little bit more that overall picture on the blended loan side?.

Sure. I'll break it down this way that -- and you are right about our objective, we are certainly not looking to add duration to the portfolio. Albeit, if you look at competitive market conditions relative to commercial banking right now, longer terms are being offered, no question about that.

But just to back up for us for a second, we reached a point where the portfolio yield versus new production and about first meeting home mortgages has be to be balanced itself. So, the new production that we are seeing going on to the books is in line with where the blended portfolio yield is in the second quarter.

On the commercial side, where it's actually fairly close with the blended yield in the mid to upper 4s for us on the commercial side that is kind of blended new production yield, but as Mark pointed out, spreads are tightening there, so the better quality the A sort of A deals are being priced at ranges that are spread lower than that today.

We are still getting a little bit of protection from the fact that we are at floors in a lot of our commercial loan in our variable commercial loan portfolio. Again, we wouldn't expect to see a lot of movement up when and if there is a rate change.

On the consumer side we are definitely seeing so lower new apps that yields then what exists in the blended portfolio and that's both on the indirect side and our bridge based direct lending tend to be very small loans. I think that that is just a -- and that result of the improvement on the auto lending side.

Again, I think some better consumer confidence characteristics and in our marketplace these people are buying ATVs and snow mobiles and motor cycles, other things for outdoor activities. The rates on those instruments have been lower than they were, say, 12 months ago or even 24 months ago, that's for sure..

Okay, all right. That's helpful. Then just on the spending side. I know that a lot of the growth this quarter looks like it's funded by borrowings.

Can you just talk through again your strategy there and how you are thinking about that going forward?.

We look it at this way, Collyn, what happens with us is that we get a natural first quarter write off in municipal deposits. We don't have a real robust municipal banking business that it's constantly chasing in that market. But we are in so many markets as the market leader that we actually have a nice base of municipal customers.

They tend to actually -- their deposit balances tend to balloon going into the end of the first quarter because their collectors, they tend to spend some of that in the second quarter. Our strategy on the deposit side is still to lead with the core checking account.

From a practical standpoint if we have time deposit customers only with the instruments that are expiring, we are probably not retaining those customers unless we can convert them into a core account.

I think that out strategy is the 69% to 70% loan to deposit ratio is not at all to chase any kinds of balance improvements if we have to give up any kind of pricing at all. And our marketplaces have been pretty stable and pretty constant. In other words there hasn't been a lot of people who are for mispricing deposits in our marketplaces today.

I think our strategy has been, let's continue to retain the good solid core accounts. If we have time deposit customers only and they want to go somewhere else, well, let them. By giving the finite amount of customers we have in a lot of our markets, we are retaining most of our customers..

Okay. That's super helpful. Then just one last question on expenses, I think after the first quarter we are kind of talking about $56 million run rate, and I think inside of making any -- and you said that in your opening remarks, investments in the business.

Is that $56 million run rate is something we should expect over the next several quarters or there have been things that have gone on internally that you are going to be able to maintain it lower than that?.

Yeah. It's a really good question. We are constantly looking at our expense base relative to the opportunities to efficiently keep that in check. When we came out of the first quarter which was obviously maintenance and utilities challenge relative to the nature of the winter we had.

We usually see a modest takedown in the second quarter, but expect that as we do investments in technology projects, in certain buildings or occupancy improvements and extend any of those are necessary. We will be usually seeing that.

I think what we've found in the second quarter is that we didn't quite have a lot of those projects underway and at full capacity. So we are implementing some stuff that we are likely to see a little bit higher cost in the third and the fourth quarter attached to those initiatives.

Again, I think generally attention to the detail relative to our vendor-related purchase costs and just how we are fulfilling some of our people obligations. We don't have a large branch initiative relative to right sizing the franchise, Collyn.

But on an annual basis you will see us look at five or six or seven branch consolidations or branch right sizings on the annual basis in this year is now different than that..

Okay. That's great. That's Helpful. Thanks, guys..

Thank you..

Thanks, Collyn..

Next, we will go to David Darst with Guggenheim Securities..

Hi, good morning..

Good morning, David..

Just following up on the expense topic, have you had a significant reduction in FTEs over the past year that even now the branch acquisition?.

Well, I think the netting, David, is probably -- you probably active with the netting that we are actually up about 15 FTEs from where we were at the same time last year.

Remember, we brought on 40 something folks in December, so some of our other processing initiatives and just service capacity as it relates to branch staffing have allowed for some neutralization of that..

Okay. And then with the indirect close this quarter, does it feels like you are trying to shorten the duration of the balance sheet.

Is there much C&I demand in your market and is there an opportunity for you to put on more variable rate C&I?.

I think, David, the demand that we've seen at least year-to-date in the markets is, I'd say, at the small business end, there has been less demand than there is kind of mid market. The opportunities below, let's say, a million dollars are -- there is less demand in that space than there is for some of those larger opportunities.

So, we are saying more significant opportunities at the middle to upper end and been up to lower end, and also seeing different demand by geographies. It has been a little bit softer in our northern region and a little bit more robust in our finger lays western New York market and in our Pennsylvania market.

So it depends on the segment of the market and also a little bit on geography..

Okay. Scott, just looking at your AOCI in the growth in tangible book value, was that all this quarter, it's in a year-to-date from rates going down and changing the AFS values or is it -- some of this is relates to the pension such as that you had earlier in the year as well..

Well, pension is not what you'd have saw in the first quarter that benefit the pension just so you do have got it December of 2013. So you know which one you've re-run the impact of discount rates against your pension liabilities, net pension liabilities, pension assets, you get that impact at December 31st.

All of the change in 2014 is coming through at AFS securities. Really, you remember you are obligated to use the quarter end date, given some of the fluctuations that you have seen over a week or two week timeframe and the 10-year treasure using that as an object.

I think well, March 31st and June 31st ended a fairly low 10-year quote compared to treasury rates or seven year treasury rates if you want to use that as comparison. Most of the pick up in the AOCI side, David, has been on the AFS security..

Okay.

Are you inclined to take any gains or to reposition our portfolio than the correct order?.

We think probably it's pretty unlikely. We continue to look at that and we are certainly in the even that there is some kind of outside market activity that takes the 10-year as it going -- those are optic from the 240s to 210, 215. Then, would we think about repositioning it.

Again, for us stated with our low loan to deposit ratio, you are going to have to redeploy that someway she perform given the capital that we have today. At some juncture that there is a point where you could say I should harvest some gains of that portfolio. And we don't think we add that point today, but we are certainly aware of it.

You need to follow for us because you have so few securities in that treasury portfolio that we are talking about..

Okay.

And then, Mark, do you have any broad thoughts on the M&A for the remainder of this year and the propensity to a bank account, a holdback deal?.

Sure. Well, it appears that the market is getting more receptive to opportunities, you are seeing an improvement in transactions, volumes, particularly at kind of the smallish bank level, let's say under a billion.

As I said in my commentary, the continued accumulation of capital in our capital levels right now are extremely strong and our focus prospectively is going to be a disciplined evaluation of the optimal use of that capital, which maybe loan growth. It may be share buy backs.

It may be securities activities and it may in fact also the acquisitions strategy. So, I think we will continue to evaluate all those opportunities. We certainly continue to remain active in our interest across our footprint and continuous to our footprint and trying to evaluate those opportunities and continue to have dialogs.

So that's under we do on a continued basis in any of that. But I do think that the market seems more receptive or at least that receptivity is growing. I think given the capital strength we have right now, I think, a very productive deployment of that capital could be in a high value holdback transaction..

That would be under a being dollars in assets, is that your target?.

I think the billion range give or take is a good starting point. I think for the right strategic opportunity we look at things smaller than that for the right strategic opportunities. We may look at things slightly larger than that..

Okay, but it all keeps you under 10 billion, right?.

Well, I guess that would depend on the size of the opportunity. We've been fairly somewhat focused at understanding what the $10 billion threshold means particularly as it relates to regulation incompliance and capital and some of the operating impacts that results from Durbin.

So that's something that we understand reasonably well and had been mindful of in trying to manage and prepare for us. So, I think we're in pretty good shape in terms of understanding the impact in that. And also understanding internally what our strategy is around that..

Okay, great. Thank you. Nice quarter..

Thank you, David..

And next, we will go to Matthew Breeze with Sterne Agee..

Good morning, guys..

Hey, Matt..

Good morning, Matt..

One quick question on the deposit service fee item, quite a bit higher than last quarter, but given the branch acquisitions, I just want to get some insight into what's driving that number, and is this a good run rate?.

Yes. It's a good question that it's certainly much higher than last quarter. But, again, we find it as very transactional utilization-based across our year from a seasonal standpoint. So, the first quarter is always a bit challenged, and the second quarter is a return to full utilization of accounts by our customers. It is led by debit interchange.

So, in other words, more utilization of debits wise and our revenue opportunity is such that is the single largest driver of that. But what we've seen in sort of stabilization overdraft protection programs. So when you're adding accounts, one can actually expect to have a proportional ad relative to the fees coming of that.

And that's definitely been the case if we just used the portfolio of accounts that we acquired from Bank of America. In fairness, Bank of America was actually had trained their customers and their people for debit interchange, for debit utilization, probably even a little bit more robust than us.

So, we're probably picking up and net positive with that.

But I think in terms of run rate, it's always really hard for us to predict transactional outcomes, but I think generally we're in line with the pattern that would suggest you get a natural run up in the second quarter, and that flattens out in the third and the fourth quarter, but stays closer to the second quarter levels than it does in the first quarter.

And then in the first quarter, you get a natural 8% to 9% drop-off in just sheer utilization of the activity..

Okay. And then, related to that, if you were to cross the $10 billion threshold that collects $50 million line item for the year? How much of that would be at risk for the ….

I think we still sign that, Matt, in the $7 million to $8 million range. In other words, that amount of exposure. You always have to continue to keep updating your math on this, because there is the perspective that the under $10 billion banks are getting paid twice as much as the bigger banks. That is not a true statement.

And we've actually seen our portion of debit interchange proportionally by transaction come down annually, but the number of transactions is just growing much faster than that reduction.

But I'd still sight that as when we put our -- go back to David's question, when we put our math together relative to what would we lose, we still think it's about $7 million to $8 million item for exposure..

Okay.

And then, switching gears a little bit, on the C&I side, the business lending side, how utilization rates acted over the past three months? Have you seen any uptick in the lines being drawn there?.

We always get a little bit of uptick coming into the second, third quarters, just because of seasonality. I wouldn't characterize if there is anything that I'd say is a structural improvement necessarily in the trend line map. So, I'd say nothing is not unusual, it sticks out that might be a predictor of the future.

I think there is still a lot of caution and discipline being exercised by the small business community in particular. And as I said, the demand there has been a little bit light.

I think on the larger customer and the middle market level, there has been somewhat better demand and better opportunity and maybe better utilization, particularly in the second and possibly third quarter as well, utilization of those credit life.

But we're not seeing anything that's really atypical for us seasonally or that would suggest a significant trend either way..

Just to reference, what is that average utilization rate?.

I actually -- I don't know what that number is. I don't ….

I think the last time I saw it, it was -- we were really in the high 30's to low 40's on utilization..

Okay. Thank you very much..

Thank you..

And next, we'll go to Julienne Cassarino with Prospector Partners..

Hi. My question is about the AOCI as well.

Was it around 26 million this quarter?.

Let me look real quick on the updated numbers, Julienne. Yes, pretty close. Pretty close, between 25 and 30, because I'm looking at some average numbers as opposed to just the end. We're pretty close to that..

Okay.

Do you have 15 plus millions swings in AOCI in the last couple of quarters?.

Mark Tryniski:.

:.

[End of that ahead] in the first quarter, because it was the first ….

That actually comes through the December numbers. So that part of it came through the December numbers. And that's why we're probably in a modest unrealized loss position on the AFS portfolio in December. And that definitely has swung through June..

Okay. So, the majority of it's been simply interest rates. Can you say it's really the seven or the 10-year interest rate ….

Yes, exactly. We don't historically spend a lot of time with that subject line, because as you know, those dollars don't spend, and they're part of regulatory capital. So, they don't tend to be the first thing we focus on relative to capital management..

Right. Okay, got it. Thank you..

Thank you..

Thank you..

(Operator Instructions) And it appears we have no further questions..

Very good. Thank you, Caroline. Thank you all for joining the call. We'll talk again at the end of the third quarter..

Thank you..

And that will conclude today's conference call. Thank you everyone for your participation..