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

Alex Twerdahl - Sandler O'Neill David Darst - Guggenheim Securities Collyn Gilbert - KBW Matthew Breese - Sterne Agee.

Welcome to the Community Bank System's Third 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, you may begin..

Thank you, Jessica. Good morning everyone and thanks for joining in on our third quarter conference call. The operating performance for the quarter was very strong, thanks to solid execution again by our team across the company. Non-interest revenues continues to be a significant driver of results, [indiscernible] 13% over the prior year.

Our wealth management and benefits administrations businesses continue to run at record levels of revenue, margin and earnings, and our deposit fees were 9% over last year. Operating expenses remain well managed and were up less than 2%, excluding litigation charge.

Asset quality remains very good and low priced costs were supportive of results as well. Loan growth in the quarter was very strong for us, with nearly 7% annualized, mostly originating from our consumer businesses. Business lending growth was modest, but up 3% over last year.

On top of that, during the quarter, we 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 continued confidence in the future.

The only disappointment in the quarter was a $2.8 million class action litigation settlement accrual, related to the sufficiency of disclosure around collateral recovery activities.

The settlement has not yet been approved by the court, so I will withhold further commentary, other than to say we achieved the productive outcome for shareholders relative to similar suits. Our overall performance year-to-date has been better than we expected, thanks to exceptional execution by our entire organization, and their focus on two things.

One, growing our businesses; and two, tightly managing operating and credit costs.

We continue to build an already high levels of capital, particularly given the quality of our balance sheet and credit discipline, which creates meaningful future earnings growth capacity for our shareholders in the form of our balance sheet growth, M&A, and share repurchase.

We remain focused on utilizing that capital in a balanced and disciplined manner that best fits our shareholders in the form of growing sustainable earnings and dividends.

Scott?.

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

Average earning assets of $6.67 billion for the third quarter were up $35 million from the second quarter of 2014, and were up 3% from the third quarter of last year. In addition, all of the 3% growth in earning assets was loans, a very positive mixed development, meaning that average loans grew organically $222 million or 4.9%.

Average deposits were up 5.4% from the third quarter of last year, principally from the branch acquisition completed in December. The multiyear trends away from timed deposits and into core checking, savings and money market accounts, continued in the first nine months of 2014, resulting in a further decline in overall funding costs.

Outstandings in our business lending portfolio were slightly higher than the end of the second quarter, and were 3% higher than the end of the third quarter of last year and very consistent with our market demand characteristics.

Asset quality results in this particular area continue to be stable and favorable to peers, with annual net charge-offs of under 20 basis points over the last four, eight and 12 quarters.

Our total consumer real estate portfolio of $1.94 billion comprised of $1.60 billion of consumer mortgages, and $339 million of home equity instruments, were up almost 1% on a linked quarter, and year-over-year basis.

We competition to retain 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 in these portfolios, with total annual net charge-offs over the last four, eight and 12 quarters of under 8 basis points.

Our consumer and direct portfolio of $842 million was up $45 million or 5.6% from the end of the second quarter, consistent with continuing solid regional demand characteristics. Used car valuations, where 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 under 35 basis points, which we consider exceptional. With our continued bias toward A and B paper grades and 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 at just 13 basis points of total loans being of stellar performance. Non-performing loans comprised of both legacy and acquired loans, ended the second quarter at $24.0 million or 0.57% of total loans.

Our reserves for loan losses represent 1.14% of our legacy loans and 1.07% of total outstandings and based on the trailing four quarter's results, represent over six years of annualized net charge-offs. As of September 30th, our investment portfolio stood at $2.51 billion and was comprised of $285 million of U.S.

agency and agency-backed mortgage applications or 11% of the total, $707 million of municipal bonds or 28%, and $1.47 billion of U.S. treasury securities or 59% of the total. The remaining 2% was in corporate debt securities. Our capital levels in the third quarter of 2014 continued to grow.

The tier 1 leverage ratio rose to 9.79% at quarter end, and tangible equity-to-net tangible assets ended September at 8.57%. 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 share, or as Mark mentioned, a 7.1% increase.

Tangible book value per share increased to $15.04 per share at quarter end, and includes $34.9 million of deferred tax liabilities generated from tax deductible goodwill or $0.86 per share.

Shifting now to the income statement, our reported net interest margin for the third quarter was 3.89%, five basis points lower than both the second quarter of this year and the third quarter of 2013.

Proactive and disciplined management of deposit funding costs continue to have a positive effect on margin results, but have not been able to fully offset declining asset yields. As a reminder, our second quarter net interest income included our semi-annual dividend from the Federal Reserve Bank of just under $0.5 million.

Third quarter net interest income also included approximately $400,000 of incremental purchased loan accretion from certain accelerated paydowns. Third quarter non-interest income was up 12.6% from last year's third quarter.

The company's employee benefits, administration and consulting businesses posted a 14.5% increase in revenues from new customer additions, favorable equity market conditions, and additional service offerings.

Our wealth management group generated a 20.8% revenue improvement from last year, and included solid organic growth and trust in asset advisory services, while also benefiting from favorable market conditions.

Seasonally, our revenues from banking non-interest income sources improved from the first and second quarter and were $1.3 million or 9.2% higher than the third quarter of 2013.

Consistent with prior years, the third quarter included the annual distribution from our participation in certain pools, retail and insurance programs, which approximated $0.015 per share this year. As we mentioned previously, our second quarter results included nearly $400,000 of life insurance-related gains.

Quarterly operating expenses of $56.0 million, excluding the litigation settlement charge, increased to $1.0 million or 1.8% over the third quarter of 2013, and included the operating costs associated with 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 rates. The third quarter of 2014 includes one more payroll day in the second quarter of this year.

Seasonally, as expected, our facilities related costs in the third quarter were almost $0.02 per share lower than the winter-dominated first quarter of the year, and somewhat similar to the second quarter. In addition, we did record approximately $400,000 of incremental expenses in the third quarter related to certain branch efficiency initiatives.

Our effective tax rate in the third quarter of 2014 was 29.9% versus 29.2% in last year's third quarter. We continue to expect net interest margin challenges going forward and into 2015, as most 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 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 the successful reinvestment of cash flows into high quality municipal securities, as it has been for the last several years, and in fact it has become seemingly more difficult each quarter.

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.

We will be hosting our first Investor Day, next Wednesday morning, October 29th, at the New York Stock Exchange. We hope many of you will have the opportunity to join us for a more detailed discussion in person. I'll now turn it back over to Jessica to open the line for questions..

(Operator Instructions). And we will take our first question from Alex Twerdahl with Sandler O'Neill..

Hey good morning..

Hey Alex..

Just wondering, the commercial loan growth that's starting to rematerialize during the third quarter here, is that coming from a specific geography or specific area in the franchise?.

Not particularly, I think it changes quarter-to-quarter, Alex, in terms of the source of that growth. I think we -- our team has done a very good job of executing across our geographies, in all footprints. So I don't think we can chalk it up to any particular geography, it really is subject to variability quarter-by-quarter.

I think we had a good quarter this past quarter. I think Pennsylvania has performed well this past quarter, the kind of Syracuse, Finger Lakes, Western New York markets performed pretty well. I think the North Country markets were a little slower, but that's subject to the change quarter-to-quarter..

Okay, thanks.

And then, on the indirect portfolio, can you just say what the average rates for new production today versus the existing portfolio, and also where the average duration of your loans are today, versus the existing portfolio?.

Alex, on the indirect side, blended portfolio for the third quarter is in like the 360-365 range. New production is probably closer to 350 to 360, so we are still looking to a 10 to 15 basis points below the blended average. Durations, we are still in that 36 to 38 month average window in terms of how long loans are actually staying in place.

Average life for new instruments is probably closer to 48 months. So as you know, people have differences in choices out there to make -- to a new car site or a used car site, the instrument typically never goes to contractual duration..

Okay, great. And then just last question; Scott, you mentioned that there were some branch efficiency initiatives during the third quarter. I think you said it was $400,000.

Has that changed the run rate for expenses going forward or is that something that will come out, or is that something that will come out, or can you just go into a little more detail surrounding that?.

Sure.

So I would look at the $400,000 of the third quarter and be incremental, something we do not expect to have recur in the fourth quarter, and we would expect the modest savings against that $400,000; most of those from the accrual standpoint Alex, were based on just the belief that we either combine and/or exited that has some residual lease costs or residual facility related costs.

I think we did announce in the quarter, five different branch consolidations. Two of them actually happened, one happened very early in October, and the next two are within the next three weeks. But generally speaking, probably in our situation, moves the needle a little bit, but not a lot for five of 190 spots..

Great. Thanks for taking my questions..

Thank you, Alex..

Thanks Alex..

Thank you. (Operator Instructions). We will take our next question from David Darst - Guggenheim Securities. Go ahead sir..

Good morning..

Good morning David..

Scott, just following up on the indirect, what's the optimal balance sheet allocation that you'd like to have in residential versus indirect?.

Well it’s a decent question; I think in our marketplace David, we said we need to be the source that delivers credit products across the board. I think like anybody in an expected rising rate environment over some time to be determined, but we'd like to have more variable rate credit, and that tends to be more in the commercial portfolio for sure.

I would say that I think when you mix a solid high performing residential portfolio that tends to have maybe eight or nine or 10 year contractual duration -- expected duration, with a 36 to 38 month indirect portfolio; that's a nice mix and it tends to be consumers coming from the daily walks of life across our franchise.

So I think we are happy with our mix today David. I think like a lot of people, I think we'd like to lean a little bit more, I hope they do business lending side of our market, picks up in terms of demand. But we are very satisfied and happy with the mix that we currently have..

That sounds to me, probably the more -- most valuable our business is just in terms of market demand. In West Allis, I think the third year, fourth year of double digits relative to the auto industry overall; and our experience has not been different than that.

We have grown 10% to 15% for the last several years, the [indiscernible] were up about $120 million over the last 12 trailing months, that's because the market opportunity is there. That's a very viable business.

If you look back historically, our indirect auto lending business and there are times when it declined by $100 million over a period of time. So it’s a viable business right now. Its growing substantially, if that continues, that's okay.

We will take as much of that paper, generally focused on A&B paper grades as the markets will provide to us, but we don't expect that demand level that we are currently experiencing in that business to continue in perpetuity..

Okay, got it.

And then if you look at the $1.5 billion of treasuries that you have, I know you have purchased of that in various allocations of pools, as you have done at your branch fields, and so if we look out over the next 24 to 36 months, are there any big maturity walls that you have, that could create an inflow of cash and an opportunity to redeploy it?.

No it's not David, especially not on the treasury side. Our expected capitals on the portfolio are heavily dominated by municipal cash flows over the -- some of these in excess of 15 months, but probably the same pattern for the next 27. In terms of -- through 2016, early 2017 before you have any kind of meaningful treasury cash flows.

Remember, we buy mostly bullet [ph] securities..

Okay.

And it will b e 2016 or 2017 before you get the cash flows?.

Yes..

Okay, and so what's the average duration of the overall portfolio?.

Just a touch over five years right now David..

Okay.

And Mark, any comments on your outlook for M&A and your appetite to do more deals?.

Well I think the outlook would be productive. I think there continues to be more dialog, more activity, more opportunity evolving over time. I think that will probably continue, David, is my observation.

I think if you look at, as it relates to our appetite, right now pushing to 10% tier one leverage ratio, we arguably have more capital than we need to properly and sufficiently capitalize our balance sheet.

So I think that we have the tenacity in terms of M&A and deploying into that surplus capital in a predominant fashion into an environment where we expect there will be more opportunity.

We will be strategic, we will be disciplined, but sitting on that much of surplus capital, I would expect our shareholders would expect that as management team, we will deploy that capital, and if you think about it, we have got a fairly reasonable level of tier one leverage capital for our shareholders, its earning returns there.

If you want, [indiscernible] 7 or 7.5 rate, whatever the number is. Anything above that is earning zero. So that's the way we look at it, and we need to be disciplined about how we deploy there.

I think we have opportunities such as M&A, organic growth, stock repurchase, I think we have a lot of opportunity, securities leveraged, although clearly the environment is not conducive to that right now, in any way, shape or form.

I think we have some good optionality around that deployment of capital and other than strategically, it will be a significant focus for us here into 2015..

Okay great. Thank you. See you next week..

Thank you, David..

Thank you. Up next, we will have Collyn Gilbert with KBW..

Thanks. Good morning guys..

Good morning Collyn..

Mark, just to follow-up first on the capital build discussion, can you just go into that in a little more detail, sort of how you prioritize? I mean, you have build a lot of capital, as you said, you have got excess capital.

Number one, I guess, what's the metric that you kind of feel comfortable managing to? Second, do you anticipate anything that would ramp up your organic growth rate over the next couple of years? And then thirdly, just remind us again of sort of your threshold and parameters of returns on buybacks? And then I have other question as opposed to the capital one?.

Sure. I did worry about the 10%. You can look at some of the other capital metrics that you need to manage by the tier one leverages as probably the most consequential, and that 9.8% U.S. above the threshold. I would think 7, 7.5 would not be inconsistent with our balance sheet and credit discipline.

So that leaves a reasonably significant amount of capital both above and beyond that. We prefer frankly to use it for organic growth, that's always -- you're going to get a better return for shareholders growing organically than you will with other capital deployments, back in the -- other than to do that which is direct dollars or dollar returns.

So I would prefer, for organic growth, as you know, generally our geographies. If you have outside growth, you need to be careful about your credit quality. So I don't expect we are going to invest that capital in outside growth.

I mean, if you look across the industry, anybody who is really outperforming their markets in a meaningful way in terms of growth, is not infrequently faced with credit issues in the future. So we won't be ramping up organic growth in a way that's inconsistent with our credit discipline philosophy. M&A is, we have some experience.

We have been disciplined. I think it was good, given the volume emerging opportunities that the M&A environment seems to be more active, I think that's an area where we have and will continue to spend a bit more time in terms of deploying that capital. We haven't discounted share repurchases.

We do -- if you look at the build of shares over the last two or three years, it has been, I don't know, about 1.5 million shares or so, almost fully just because of the performance of the share price in the exercise of options and the likes.

So I think, doing a clean-up, if you will, of some of the share related to the equity plans would be sensible as well.

So I think we will have options, we continue to accrete capital fairly quickly, more than what we need to capitalize organic growth, and I think one of our more significant strategic objectives, we will view, evaluate and execute on opportunities to deploy that capital.

As I said, the way we look at it is, anything above that 7% to 7.5% is earning a return zero for our shareholders. But with that said, you need to balance that against the need to be disciplined to deploy that capital, in a way that does create kind of not just growing earnings, but sustainably growing earnings for shareholders.

So we've got that as a principle focus here strategically going forward Collyn..

Okay. That's helpful.

And then Scott, just back to the discussion on the cash flows within the securities portfolio, what are your current quarterly cash flows?.

We are in the neighborhood of about $40 million a quarter coming off, and it really tends to be the -- because we are a bullet [ph] security purchasers generally. It generally is a contractual maturity date. So pretty easy for us to look at.

We have such a small portion of our investment portfolio in mortgage-backed securities and collateralized mortgage obligations. Any kind of a change in the acceleration of cash flows or a deceleration there, really doesn't move the needle much for us, and so it is fairly straight-forward for us to predict contractual cash flows..

Okay.

So that asset yield should hold in then -- that investment security yield should hold in pretty well then, you would anticipate, until you said, maybe late in 2016 and 2017?.

Yeah I would say certainly through 2015 Collyn they'd be similar. I would say, since I mentioned this in my prepared remarks, it is getting harder to find a high quality municipal security that we'd like to include in our portfolio.

So at some level of spread, it no longer makes sense for us to "taking the kind of duration risk to get a lower base spread in the municipal side," as you know from our income statement, it is our primary tax planning characteristic.

So if cash flows don't end up in municipal security, the taxable security, these or they just pay down some short term borrowings, that will be where you get some [indiscernible]..

Okay. And then just on the comment about the indirect auto.

You price it off of prime correct?.

Some of it is priced off prime, but some of it is priced off your expected duration, so it could be spread above a three year treasury. The market pricing for indirect tends to drive more than index pricing, in terms of where that is; and there are [indiscernible] out there based on paper class.

There is super prime, FICO, there is prime and FICO and then there is the position of [indiscernible], which should be subprime FICO, things below the six-seven year, 660. I would argue that the market conditions tend to drive the dealer decision, based on where the paper actually goes.

We think we have a great historical position with our core group of dealers across the footprint, that allows us to be there suggest it, or their preferred source for AEB paper grade, and not have to actually demonstrate live participation into these and the no scores..

Okay. I guess it just seems like that's a pretty good yield, and to your point, totally Mark, in terms of the geography driving or Scott, driving that. The difference is there, but it just seems like that's a pretty healthy yield relative to what we are hearing, actually like from other indirect lenders, even in your geography, so I just was curious..

All of it, Collyn, is driven by the mix. We like to see the used car financing business much better. The yields are higher, the residual risk is lower. So we do more than half of our auto underwriting is used vehicles. A lot like that, because its -- I don't know why they don't like it, but the dollar values are smaller.

So you are just kind of [indiscernible] exercise, and we like to guess [ph], because the margins are better. So some of it is mix too, it is not just geography..

Right, that's a good point. Okay.

And then just one quick final question, the pooled retail insurance revenue that you guys saw this quarter, what line did that flow through?.

That comes through on the P&L, other banking services. So you should look historically, you could see that our third quarter always looks like it is meaningfully above the quarters around it, because the [indiscernible] declare their annual dividend once a year.

Of course, that dividend is sort of a proxy for the underwriting commission that we would get for soliciting customers and putting their instrument into the pool..

Okay, great. All right, that's all I had. Thanks guys..

Thanks Collyn..

At this time we have one question remaining in the queue. (Operator Instructions). We will take our next question from Matthew Breese with Sterne Agee..

Good morning guys..

Good morning Matt..

Most of my questions have been answered, but I just had one quick one on non-interest income trends, and Scott, you had mentioned that you expect to see the business lines there continue to grow nicely, and I was hoping you could just provide a little bit more color, and specifically talk about deposit service fees, which are up nicely this year, and talk about your ability to maintain and grow the current level?.

Good question Matt, and actually a [indiscernible] for us. Deposit service fee for us dominated by either changed outcomes with our footage [ph] programs, and in general, being attached to customers' checking accounts. In terms of utilization, I think we continue to have creative ways to see that growth for our talent bases.

But generally, we really benefited from our focus on core checking account origination. In other words, adding new accounts and hopefully having a longer duration or longer tenure of both accounts we had than many of our peers. There's no question we benefited from the customer proclivity to go into electronic transactions.

So car utilization for us is up. We have a focus on that in our bridge network to get cars actually activated and used on a recurring basis, because that does tend to be the customer's preference today, and we get that, so we are trying to foster that sense amongst our people.

I think in terms of going -- the other thing we [indiscernible] right now is, we benefited from the fact that in our greatest transactions, where we have not got a lot of assets on the first day in terms of lone assets, what we have picked up is a lot of retail accounts, priced very favorably from an overall cost of funds and created the opportunity for deposit service fees against those accounts..

Got it. That's all I had, thank you guys..

Thanks Matt..

Thanks Matt..

And it appears, there are no further questions at this time. I'd like to turn the conference back to you for any additional or closing remarks..

Great. Closing remarks; again, we just thank everyone for joining in on the call, and hope to talk to you in January..

Thank you..

This concludes today's conference. Thank you for your participation. You may now disconnect..