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

Joe Fenech - Hovde Group Collyn Gilbert - Keefe Bruyette & Woods William Wallace - Raymond James.

Good day and welcome to the Community Bank System Third Quarter 2016 Earnings Conference Call.

Please note 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, Vicky. Good morning, everyone. And thank you all for joining our call this morning. I wanted to apologize for the last minute change in the timing. I know this is a busy week for all of you. We’ve also been busy and are excited to comment on the quarter, but more importantly on our announced merger with Merchants Bancshares.

So, Scott and I will make a few comments on the quarter and we’ll then discuss the Merchants transaction. The third quarter was strong and consistent with our expectations, and as a reminder, includes the Oneida acquisition that was closed in December and so was not part of the 2015 quarter.

We had solid loan and deposit growth with the exception of commercial, which was off in the quarter due to nearly $30 million of unexpected pay-offs, most of which was three larger credits.

We continued to manage downward pressure on the margin and an increased state tax rate that cost us almost $0.02 a quarter, but the business is strong and growing and heading into Q4, we’re hopeful to deliver another record year of operating earnings.

Scott?.

Thank you, Mark; and good morning everyone. As Mark mentioned, the third quarter of 2016 was a very solid operating quarter for us, and again as a reminder, included the activities of the Oneida Financial that we completed last December.

Third quarter operating EPS was $0.59 per share, which excludes $1 million of non-recurring insurance related gains in the quarter, bringing year-to-date operating results to $1.73 per share consistent with the first nine months of 2015. I’ll first cover some updated balance sheet items.

Average earning assets of $7.68 billion for the third quarter were up 7.9% from the third quarter of 2015, and $30 million higher than the second quarter of this year.

Ending loans increased $36 million in the third quarter or 0.7% on a linked quarter basis, as solid organic growth in consumer mortgages and consumer installment products were partially offset by $30 million net decline in commercial balances, the result of an unusually large level of unscheduled payouts.

Quarter end investment securities were down $54 million from the end of June, a result of very modest cash flow reinvestment in the third quarter, in the current rate environment. Period ending deposits were up $120 million in the third quarter of 2016 or 1.7%.

The first nine months of 2016 was a continuation of the favorable overall asset quality results that is part of our credit DNA. Third quarter net charge-offs of 12 basis points of average loans were generally consistent with the level and reported in both the first half of this year and the third quarter of last year.

Non-performing loans comprised of both legacy and acquired loans ended the third quarter at $23.3 million or 0.47% of total loans slightly improved from the ratio reported at the end of June, an 11 basis points improvement from September 2015.

Our September 30, 2016 reserves for loan losses represent 1.02% of our legacy loans and 0.95% of total loans outstanding. Based on the most recent trailing four-quarter results, our reserves still represent over six years of annualized net charge-offs.

As of September 30th, our investment portfolio stood at $2.87 billion and was comprised of $235 million of U.S. Agency and Agency-backed mortgage obligations or 8% of the total, $643 million of municipal bonds or 22%, and $1.98 billion of U.S. Treasury’s or 68% of the total. The remaining 2% was in corporate debt securities.

The portfolio contained an unrealized gain of $140 million as of quarter-end. Our capital levels in the third quarter of 2016 continue to be very strong. The Tier 1 leverage ratio reached 10.35% at quarter-end and tangible equity to net tangible assets ended September at 9.66%.

Tangible book value per share was $18.06 per share at third quarter end and included $42.5 million of deferred tax liabilities generated from tax deductible goodwill or $0.96 per share.

Shifting out to the income statement, our reported net interest margin for the third quarter was 3.67%, which was down 6 basis points from the second quarter and 2 basis points higher than the third quarter of 2015.

Consistent with historical results, the second and fourth quarters each year include our semi-annual dividend from the Federal Reserve Bank of approximately $600,000, which added 4 basis points of net interest margin to second quarter results, compared to the linked third and first quarters.

Third quarter results included approximately $500,000 or 3 basis points of margin improvement of early termination fees related to the previously mentioned $32 million of unscheduled commercial pay-offs.

Proactive and disciplined management of funding costs continue to have a positive effect on margin results as total deposit comps in the quarter were 10 basis points.

Third quarter non-interest income was up $1.2 million linked quarter and included the previously mentioned $1 million of non-recurring insurance related gains as well as our annual dividend from certain pooled retail insurance programs of approximately $600,000.

Quarterly revenues from our benefits administration, wealth management, and insurance businesses of $22.2 million were consistent with the second quarter. Third quarter operating expenses of $66.2 million were also consistent with the linked second quarter, despite one additional day of payroll.

We have also continued to invest in improving our infrastructure in systems around the requirements of DFAST, as we embrace the impending $10 billion asset size threshold. Our effective tax rate in the third quarter of 2016 was 32.8% versus 30.0% in last year’s third quarter.

Certain legislative changes to state tax rates and structures over the past two years resulted in the majority of the results in higher rate, including those related to our overall asset size being above $8 billion on a consolidated basis.

This higher effective rate was and will continue to be a 2-plus-cent per share quarterly headwind compared to the quarterly results of 2015. Looking forward, we continue to expect the Federal Reserve Bank, semiannual dividend in the fourth quarter of this year. Our third quarter 2016 net charge-off results were again favorable.

And although, we don’t see signs of asset quality headwinds on the horizon, it would be difficult to expect improvements to current asset quality results. Our reported net interest margin has remained in a fairly narrow band from 3.65% to 3.73% over the past five quarters, a range we expect to operate in for at least the next couple of quarters.

Tax rate management will continue to be subject to successful reinvestment of our cash flows into high quality municipal securities, which has been a challenge at times during this period of sustained low rates.

In addition, as we previously mentioned near the end of 2015 and that actually experienced in the first nine months of this year, our larger consolidated asset size eliminated certain tax planning opportunities, resulting in the 2.2 percentage-point increase in our full year expected tax rate in 2016.

We believe we remain very well-positioned from both the capital and operational perspective for the balance of 2016 and into 2017, as we look forward to the incremental opportunities of the recently announced Merchants Bancshares transaction. I’ll now turn it back over to Mark for some additional comments..

Thank you, Scott. Over the course of the past year or about, we’ve commented at length on our earnings call and with our investors on two important strategic themes.

One was deploying or growing in excess capital levels in a disciplined fashion for the benefits of our shareholders, which I would define as growing our earnings and growing our dividend; and secondly preparing internally for the events really crossing the $10 billion threshold and doing so in a matter that did not dilute the earnings and dividend returns to our shareholders.

With that as a backdrop, we were thrilled yesterday to announce the merger with Merchants Bancshares of Vermont. I will make some comments on our thinking around the transaction and then Scott will review the deal and financial metrics.

So, why Merchants? First, this opportunity fully achieves the two strategic things I just mentioned and that we’ve been discussing in our boardroom and with our investors for some time. Mainly, it effectively deploys capital and that hurdles the $10 billion threshold in a low risk manner that is accretive to shareholders.

Number two, Merchants is a very high-quality franchise including its board and governance, its leadership, its people, its markets, its performance, and its balance sheet. This is an exceptionally strong and attractive institution in every respect.

We are judicious with our capital and very judicious with our business partners and believe we have both chosen wisely. Merchants represents a lower risk partner. Of the potential transactions we’ve evaluated with respect to the $10 billion threshold, nearly all were either non-contiguous larger or lesser quality franchises.

Merchants operates in similar markets to our model, which is smaller, non-metropolitan markets with high share. They have a number three market share in the state behind too much larger institutions, a dynamic where we have always enjoyed a competitive advantage. Their loan book is one of the strongest of any bank in the country.

Their cumulative credit losses over the past 10 years including through the credit crisis is 27 basis points. That’s not an average, that’s in total; that’s low risk. And it’s funded by an attractive low cost core deposit base, very similar to ours. Next, Merchants has tremendous leadership. They’re well-governed and well-led.

We’re very pleased Geoffrey Hesslink, Merchants current President and Chief Executive Officer will be remaining with the company and appointed our New England Regional President. Geoffrey is a tremendous leader and more important to us, he is a tremendous person.

We’re also pleased that two directors from Merchants will be joining the Community Bank System Board of Directors to support our ongoing efforts in these new markets and to provide representation to our significant new shareholders. An important but frequently ignored element of success in business combinations is culture.

The culture of Merchants and Community are identical. We both value humility, work assay, respect for others and a commitment to excellence and achievement. Lastly, we view this merger as a foundation for continued growth and opportunity for both Merchants and Community.

Merchants has grown nicely over the past several years at 6% or so a year and we believe there are significant opportunities for that to continue or expand in many areas including consumer credit products and in particular wealth management services, which we believe are generally under-represented across the state.

We also like the opportunity to further explore the Springfield market, which is at present small and low-risk investment in larger markets, so we like the dynamics and potential opportunities there as well.

In summary, this is a combination of two very-high quality franchises that achieved significant strategic objectives and delivered tremendous value for both sets of shareholders.

Scott?.

Thanks, Mark. Although I’m certain most people on the call have the short investor presentation, which was attached to the transaction announcement released yesterday, I’ll hit on a few of the financial highlights and assumptions.

Merchants shareholders will have the right to receive 0.963 shares of CBU stock for each share of Merchants they own or $40 in cash subject to an overall proration of 70% stock and 30% cash. Assuming that split, the deal value as of the market close last Friday was just over $44 per share or an aggregate value of just under $304 million.

That outcome correlates to 17.5 times Merchants 2017 consensus earnings estimate and 12.6 times with fully baked in cost saves. Subject to approval, we expect the transaction to close in the sector quarter of 2017.

After a very thorough review, we expect to achieve cost saves of 22.7% of Merchants’ non-interest operating expense base by the end of 2017. We have estimated a core deposit and tangibles of $20 million will be created and expect to amortize those over eight years on an accelerated basis, consistent with our historical practices.

Our $0.10 per share projected GAAP accretion in 2018 includes a half year of Durbin impact, which we’ve estimated will be $10.5 million to the combined organization on a full year basis.

Consolidated in bank capital ratios will remain comfortably above well-capitalized regulatory requirements and will continue to provide us with ample flexibility for future organic and acquired growth opportunities. I’ll now turn it back over to Vicky to open the line for questions..

Thank you. [Operator Instructions] And we will take the first question today from Joe Fenech with Hovde Group. Please go ahead..

On a pro forma basis, this deal gives you a bit more of a commercial orientation than you had previously; I think you’ll be pushing 40% in terms of the commercial loan representation.

Was that an important consideration for you in crossing $10 billion with CFPB oversight now or is it more coincidental? And if it’s the former, should we expect in your future deals to see you push even more towards that commercial emphasis?.

I appreciate the comment, Joe. I think it’s a good comment and an important comment, probably one which I should have commented on in terms of improving our balance sheet. But clearly, we will be going from about 29%, which is the current component of our commercial book to our total portfolio to about 37%, so a nice improvement there.

That wasn’t necessarily part of the particular pursuit of any potential partner to take it over $10 billion, but I think certainly a clear advantage to us in terms of the pro forma outcome of the partnership with Merchants..

Okay. And geographically, the deal obviously takes you in the new markets. There are number of ways you guys could have went to expand the franchise being Eastern Ohio, Pennsylvania, maybe down further into the Hudson Valley closer to Metro New York, and you chose New England.

Should we take that to mean that you’ll now love to fill in New England footprint or is it still open season in the sense where you’ll be able willing to go wherever you see the right opportunity, even if that takes you into maybe another new market?.

I think if you think back to the commentary we’ve made in the past, Joe, I’m asked question about M&A expansion. I think we’ve said that our profits would be a move in a contiguous fashion. This is clearly very contiguous; it’s the adjacent state next to New York. Our closest branch to their closest branch is somewhere around 5 or 6 miles.

So, it certainly is our contiguous market. We would be -- we certainly as it relates to the threshold transaction, we’re less interested in a transaction which was not contiguous or in markets; we did look at a handful of those. They were nearly as attractive of franchises as Merchants for a lot of different reasons, which I just talked about.

So, I think at the present time, we have not had further dialogue or analysis around further expansion into New England. I think our objectives are to continue to expand in a contiguous fashion generally in any direction where we can partner with high-quality franchises to create earnings accretion and dividend growth for our shareholders..

Okay, thanks. And last one for me; you’ll be $10.5 billion mark pro forma. So, on the one hand, this is a larger deal for you. So, I’m sure you want to make sure the integration goes well.

But does that outweigh maybe a desire to scale up a little bit more to get to say $12 billion or so and maybe that sends you back into the M&A sooner rather than later?.

As we’ve talked about it lot, Joe, we are not in a hurry to get that; we weren’t necessarily, as you know, in a hurry to do the threshold transaction. We’ve talked about it a lot, because we wanted our investors to understand that we will be prepared when that time does arrive. So, we’ve never pursued growth for the stake of growing.

If we can grow and create earnings growth that’s sustainable and dividend growth capacity for our shareholders, that’s what we’re interested in. We are -- and the idea of having some indiscriminate target around how big we want to be or should be is not really how we think about the Company and its future strategically.

What we think around is really again growing in a way where we can partner in a low-risk fashion with high quality partners to create above average returns for our shareholders and do that in a lower risk fashion..

And, Joe, I would even add to Mark’s comments that as you know it was up, because we have significant non-interest income businesses. We have the opportunity to evaluate not only transactions, but organic growth opportunities on that front. And you don’t necessarily add to the balance sheet in the same framing that a bank transaction might..

[Operator Instructions] We’ll now go to Collyn Gilbert with Keefe Bruyette & Woods. Please go ahead..

Scott, if you could -- I think it seems like a few folks, perhaps including myself maybe a little surprised that the $10.8 billion threshold will do it in terms of absorption of cost and lost revenues tied to Durbin.

Can you walk through -- you did a little bit on the Durbin side, but can you just walk through some of the math a little bit more specifically on how you’re looking at kind of the cost needs you already have in your run rate versus what you’re going to incur and why you feel comfortable that you can get it all done at this modestly low asset level?.

I’ll start with the enterprises that are coming together first, because I do think there is a general perception from an industry standpoint that the one half to larger and maybe quite frankly that’s true for most transactions.

But I think when you’re combining two high-quality institutions who both have return on asset characteristics, north of 90 basis points; in our case, 120 basis points, the earnings capacity of the two enterprises you bring together really chop [ph] the asset size.

Now that’s not to say that asset size isn’t important and we reach over the long term adding to earning assets, when you’re essentially a capital controlled-enterprise, it’s definitely important. But I think we started off with two very good sets of hands here relative to earnings capacity to get started.

I think from there, Collyn, I think you work back through the scenario that says we are going to have a large Durbin charge. We have a very granular base of high-quality, low-cost core deposits, namely checking account.

And our people much like the Merchants people are very used to convincing their customers the utilization of card-based revenues, an important attribute to build relationship. So, I would actually probably guess that we’ve had one of the largest Durbin impact of any institution getting close to the threshold.

But to that point, the mix of revenues within the two institutions that are coming together, especially somebody like us with a higher profile of non-interest income and non-interest income growth, I think actually makes up for some of that “perception of the asset needed to be a little bit bigger”.

I think that’s our general thought around that process. Not every combination that we’ve even modeled; looks exactly like that, Collyn. You’ve been right that certain institutions with lower earnings capacity today do take more assets to get you to the same outcome..

And then, just -- and maybe it’s more -- so, Durbin hit, and I know Scott I think you said this in the past, the loss on the USSB [ph] to be what once full phased in?.

Yes. So, we are modeling $10.5 million on a consolidated basis. So, essentially $9 million for us and about another $1.5 million for Merchants, because again, high volume of core checking accounts that have card utilization attached to them. The premise that we’re going under from a modeling standpoint is that starts on July 1, 2018.

So, 2018 results absorb a half of year of that impact, 2019 a full year impact but clearly, we expect to be slightly larger institution in 2019 than we are on October 25, 2016.

Your question relative to the costs surrounding the rest of the stuff associated with DFAST, as we’ve said, we’re underway; we’re in the middle of systems implementations relative to expanding our capabilities to do some of that.

We are clearly using some outside resources who are very capable to get us to a best -- sort of a best in breeder, best practice type of an outcome.

Our plans are to continue forward with an internal drive run per se for 2017 than have another driver in 2018 that we would actually plan to submit for the regulatory body and then 2019 would be on the box. So that’s how we’ve read relative to complying with that.

Your question around incremental costs, there will be some in 2017 and 2018, no question about it. We’ll keep improving our infrastructure as we get better at the evaluation of the characteristics of completing the task. But I don’t think -- we think it’s so incremental that we don’t observe it in the normal course of our business..

And then, is it safe to assume in this regulatory world that you kind of discuss with your regulators, the prospect of this deal before you guys went ahead and signed an agreement with Merchants?.

I will not comment specifically on discussions with our regulators other than we have a very good relationship with our potential regulator and have frequent dialogue of any potential matters of significance..

And then just now back to the bank, the quarter. U.S.

had a great mortgage banking quarter, what is your outlook there in terms of is it seasonally driven or do you see a change in kind of borrower behavior that would suggest that that line can kind of run at a higher level?.

Collyn, we’d love to take credit for great mortgage banking quarter, we had a good mortgage banking quarter. That line in our financial presentation includes things like insurance related [Multiple Speakers] our full number and as I mentioned, one-time non-recurring related item that if you would hope; that’s okay.

But we did have a good quarter aided and it is -- we are seasonally better in the summer time just given our market, the closing activity from a whole lending standpoint is more active in the summer time. So, you’ve been correct with that assertion..

And then just finally on the loan growth.

Are you guys seeing any changes in borrower behavior in either your various lending buckets or geographies this quarter? I know you obviously had those unexpected pay downs, but just sort of how you’re seeing demand evolve as we move into next year?.

I would say kind of I think overall, it’s reasonably good; it’s probably right now the run rate on the consumer businesses are a bit better than they are on commercial. The consumer pipelines are pretty good, so the mortgage pipeline is good; the activity has been reasonably strong.

The auto business has also been very strong, certainly this year and the last handful of years. There is some discussions that we’ve hit peak. [Ph] But that business continues to perform very well and demand has been very strong. I think more recently, the weakness has been on the commercial side.

I think in terms of customer behavior, I would just suggest that it’s become more competitive. So, there is a greater downward pressure on margins and greater pressure on term and structure.

So, I think it’s a nature of the competitive environment, particularly on commercial and then, I think most banks are working hard to put assets on the books to overcome the headwinds of downward margin compression..

And to that, point, Mark, is the three that paid down this quarter, anything consistent? Is it one bank that came in and is just being more aggressive in your market or was it just unusual circumstances for each of those three borrowers?.

No, in every situation, I believe they were projects for businesses that were sold..

Okay..

I would tell you in one case though we had a prepayment penalty on $11 million credit that was around $0.5 million. So, we did get paid for the assets, but nevertheless it does represent a decline on the balance sheet..

[Operator Instructions] And we will now take a question from William Wallace with Raymond James. Please go ahead..

Maybe as a follow-on to Collyn’s questions around loan growth.

Historically, you guys have talked about 3% to 4% annual, does the Merchants deal change that at all?.

Well, we are hoping. They I think historically run at somewhat higher rate than we have in terms of loan growth, certainly on the commercial side. So, I think the opportunities I commented on to expand some of the consumer credit options in their market is something that we hope can kind of help accelerate growth.

I would like to hope that we can continue to stand the level of performance in those markets as it relates to commercial.

Potentially even thinking about the idea that it is a bigger combined institution will have a greater credit capacity and maybe able to leverage that into the marketplace, not just in Vermont but also in the Springfield to our benefit. So, in our markets, if you look at the demographics, higher population growth, HHI and HHI growth.

So, we would hope that we can continue to grow in those markets and hope to continue to grow in our markets as well. And we’ll think about these opportunities that I commented on to try to accelerate growth in certain lending businesses..

I wanted to ask a follow-up on Durbin. You said $10.5 million annual impact.

Does that -- is that based off of looking at the current quarters, putting the two together or do you have some assumption that you’re going to grow your deposit customer base, between now and then?.

Yes. Well, we’ve got some modest growth because of the deposits were baked that and the assumption is you continue to little bit better at card utilization characteristics each year. So, yes, it’s not radically above the current run rate, but it’s some..

And then last question is a follow-up about the expense associated with preparing to go over $10 billion.

Is there going to be -- you guys were already preparing for this; are you going to have to accelerate any costs whether it’s personnel or for systems investments between now and when the deal closes to prepare faster?.

I think between now and the time the deal closes, probably not, I would think soon after the deal closes, there is any risk of accelerating or the need to accelerate, it will be right there. I think our plans relative to how we’re going to drive around 2016, during the 2017 calendar year from a prep standpoint, will stay pretty much in step.

But again, we’re not at what we think is ultimate full stepping for that outcome and we know there will continue to be system enhancement as one goes through data integrity type characteristics over time.

Again, I think we’ve introduced those costs on a relative basis currently and I don’t think that we think that there will be something that’s picked out becomes something -- this is something you look at from the financials going forward and say wow, that cost is completely associated with that build out. So we will take it in the normal course..

And that does conclude our question-and-answer session for today. I’d like to turn it back to Mark Tryniski for any additional or closing remarks..

Thank you, Vicky. Thanks to everyone for joining this morning. And thanks to those from Merchants Bancshares who joined as well. And we will talk to you again in January. Thank you all..

Thank you very much. And that does conclude our call for today. I’d like to thank everyone for your participation and have a great day..