Mark Tryniski - President and Chief Executive Officer Scott Kingsley - Executive Vice President and Chief Financial Officer.

Matthew Breese - Piper Jaffray Chris O'Connell - KBW.

Welcome to the Community Bank System First Quarter 2017 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, 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. Please go ahead gentlemen..

Thank you, Lynnette. Good morning everyone and thank you all for joining our Q1 conference call. It was a very busy quarter for our team beginning with the February close of the Northeast Retirement Services acquisition, as well as final preparations for the Merchants transaction.

We also continue to make excellent progress on our DFAST efforts and our well positioned for a deriver on the stress testing second half of this year. With respect to operating results for the quarter, it was in-line with our expectations. Loan demand was mixed and impacted seasonally to a greater extent this year compared to last year.

Despite that we had modest growth in our mortgage and auto lending portfolios and the declining commercial is related entirely to the early prepayment of the single large credit. Deposit growth was very strong and depository related fee income was up 7% year-over-year, a very good trend.

We also saw revenue growth in our wealth management benefits and insurance businesses. All-in it was a very good start to 2017. The NRS acquisition was completed on February 3 with no integration issues.

As we’ve discussed previously, this business is located outside of Boston and is a nationally recognized provider of plan accounting, transfer agency, fund administration, and trust and retirement plan services.

This business continues to grow at a double digit pace on both the top and bottom lines and we expect we will be $0.04 to $0.06 per share accretive to GAAP earnings in 2017, but more importantly generate $0.16 to $0.18 per share of cash accretion, which is GAAP earnings adjusted for tangible amortization.

That level of cash accretion will be meaningfully additive to our future dividend capacity. Integration efforts with Merchants Banker on full swing and both our teams are working effectively towards the close.

We received approval from the OCC and are awaiting final approval from the Federal Reserve, which we are hopeful comes before month end and which will allow for a mid-May close.

Merchants continues to perform extremely well with Q1 diluted earnings per share excluding acquisition expenses and securities gains growing from $0.55 in 2016 to $0.63 per share in 2017, and total loans growing 8.5% year-over-year.

We continue to expect Merchants will deliver very strong earnings per share accretion in the last half of 2017, exclusive of acquisition expenses. The past 12 months have been very productive for our company and for our shareholders. As you may recall, we discussed frequently in 2015 and 2016 the strategic investment of excess capital.

We could not be more pleased with our partnerships with NRS and merchants. They are very high quality organizations with strong leadership and great teams, and we expect will deliver both growth and high returns on invested capital for our shareholders.

I’m not sure how we could be much better positioned than we are at the moment, and very much look forward to the remainder of 2017.

Scott?.

Thank you Mark, and good morning everyone. As Mark noted, the first quarter of 2017 was another very solid operating quarter for us and as a reminder included a partial quarter of the activities of the NRS acquisition that we completed in early February.

Reported first-quarter earnings were $0.57 per share, which included $0.03 a share of acquisition expenses, but also included over $0.04 a share of impact from the new accounting for share-based transaction. I’ll first cover some updated balance sheet items.

Average earning assets of $7.72 billion for the first quarter were up modestly from the fourth quarter and were 1.5% higher than the first quarter of 2016. Average loans for the quarter increased just $5 million as seasonally expected.

Respectable organic growth in consumer mortgages and consumer installment products were partially offset by net declines in commercial balances; the result again of some unusually large unscheduled payoffs. Quarter-end investment securities were in-line with the year in 2016, a result of very modest portfolio cash flow reinvestment in the quarter.

Average quarterly deposits were up $87 million in the first quarter of 2017 or 1.2% also as seasonally expected. The first quarter of 2017 was again a continuation of the favorable overall asset quality results that we have come to expect.

First-quarter net charge of $2.0 million or 0.16% of total loans were down $0.2 million from the fourth quarter 2016, but up from the 10 basis points of loans we reported in the first quarter of last year.

Non-performing loans comprised of both legacy and acquired loans, ended the first quarter at $22.9 million or 0.46% of total loans 2 basis points lower than the ratio reported at the end of December and our lowest level in 8 years.

Our quarter ended March 2017 reserves for loan losses represent 1.01% of our legacy loans and 0.95% of total outstandings. Based on the most recent trailing four quarters results, our reserves represent over 6.5 years of annualized net charge-offs.

Despite several reports of macro level industry concerns, the first quarter net charge-off ratio in our auto lending portfolio was 42 basis points of average loans, consistent with the last six quarters average of 41 basis points.

As of March 31, our invested portfolio stood at $2.79 billion and was comprised of $245 million of US Agency and agency backed mortgage obligations or 9% of the total, $579 million of municipal bonds or 21%, and $1.91 billion of U.S. Treasury Securities or 68% of the total. The remaining 2% was in corporate debt securities.

The portfolio contained net unrealized gains of $45 million as of quarter-end, compared to a net unrealized gain of $133 million at the end of March 2016, due to the meaningful more up in market interest rates during the last 12 months.

Our capital levels in the first quarter of 2017 continues to be strong, the tier 1 leverage ratio was 10.35% at quarter-end and tangible equity and net tangible assets ended March at 8.91% after the closing of the NRS transaction.

Tangible book value per share was $16.22 per share at March 31, and included $68.2 million of deferred tax liabilities generated from certain acquired intangibles or $1.48 per share.

Shifting to the income statement, our reported net interest margin for the first quarter was 3.65%, which was down 11 basis points from the linked fourth quarter and 2 basis points lower than the first quarter of 2016.

Consistent with historical results, the second and fourth quarters each year include our semiannual dividends from the Federal Reserve Bank of approximately $600,000, which added 3 basis points of net interest margin to fourth-quarter results.

In addition, we recorded the limited partnership dividend of approximately $1.2 million in the fourth quarter of 2016, which also added 6 basis points to quarterly net interest margins.

Proactive and disciplined management of funding costs continue to have a positive effect on margin results as total deposit costs in the quarter remained at 10 basis points. As a reminder, the first quarter of 2016 had one more calendar day in the first quarter of 2017 and the fourth quarter of 2016 had two more.

First quarter basic non-interest income was down $0.5 million on a linked-quarter basis as seasonally expected. Quarterly revenues from our benefits administration, wealth management and insurance businesses of $28.5 million were up 28% from the fourth quarter, principally from the NRS transaction, which closed in February.

First quarter 2017 operating expenses is $71.9 million, which exclude acquisition expenses of $1.7 million or $4.3 million above the linked fourth quarter and included a partial quarter of operating activities from the NRS transaction, including 2 months of significantly higher intangible amortization that resulted from the acquisition.

NRS operating expenses and intangible amortization represented almost 85% of the increase in core operating expenses in the first quarter of 2017, compared to last year's first quarter. Certain occupancy related costs were seemingly higher as we expected, as was first quarter payroll related taxes.

We have continued to invest in improving our infrastructure and systems, including those around the requirements of DFAST as we embrace the pending $10 billion asset size threshold.

Our effective tax rate in the first quarter of 2017 was 27.4% versus 33.4% in last year's fourth quarter and reflected the previously mentioned $2.2 million reduction in net income tax expenses related to the change in accounting for share-based transactions.

Excluding that change, the core effective income tax rate would have been approximately 33.5% for the quarter. Looking forward, we continue to expect Federal Reserve Bank’s semi-annual dividends in the second and fourth quarter of each year.

Our first quarter 2017 net charge-off results were again manageable and although we do not see signs of asset quality headwinds on the horizon, it would be difficult to expect improvements to current asset quality results.

Our core operating net interest margin has remained in a fairly narrow band over past several quarters, a range we would expect to operate in for at least the next few quarters, excluding the impact from the planned Merchants acquisition.

Tax rate management for the foreseeable future will continue to be subject to the successful reinvestment of our cash flows into high quality municipal securities, which has been a challenge at times over the past couple of years.

In summary, we believe we remained very well-positioned from both a capital and an operational perspective for the remainder of 2017 and look forward to the incremental opportunity for the pending Merchants Bancshares transaction. I’ll now turn it back over all to Lynnette to open the line for any questions..

Thank you. [Operator Instructions] We do have one caller in the queue, Matthew Breese from Piper Jaffray. Your line is open..

Good morning everybody..

Hello Matt..

Good morning Matt..

I just wanted to talk about the margin, I mean you guys have a very resilient deposit base, so no surprises there on limited data, but I was a little bit surprised on the loan front.

So could you just talk a little bit about - during the quarter what new loan yields where versus existing and how things have changed since the two most recent fed hikes?.

I think I'll take a shot. Well generally Matt, in terms of the trend line it has been very consistent. So, if you look at our consumer products what you would find is that new loan origination in the mortgage portfolio is modestly above the blended average of the portfolio yield for the first quarter of 2017.

The same can be said for potentially the consumer installment products where that’s led by indirect auto for us and some direct install loans that we do at the bridge level. Again, new production modestly above where the blended yield of the portfolio was in total.

On the commercial side, we are still seeing a little bit of differential there, in other words new production is still modestly below, modestly below where the blended portfolio is to the tune of about 35 basis points.

So from a practical standpoint, we do not see any list that we might be getting from rate increases in the markets like increases in prime or LIBOR, it is probably getting diminished a little bit by the fact that new production is still going on the books that are a little bit lower than the blended average.

If you remember from a disclosure standpoint for us Matt, the combination of fixed rate securities and a proportionally larger amount of fixed rate assets in our lending portfolio, I think we were pretty clear, pretty transparent that we were not going to get a big list out of the first handful of fed rate adjustments.

In a sense, we had the time when the yield curve was actually flattening, so I think that’s sort of the steady as she goes [indiscernible] for us for probably the next two to three to four quarters, a little bit of color, you know Merchants brings to us a lower net operating margin that's really a function of where they are lending portfolio is concentrated, still very good instruments, but on a net basis with the modestly high cost of funds that we have they are closer to a 3% type outcome.

So, post closing you will see some natural dilution of our net interest margins, but still very productive net interest income generation on a net basis..

Understood, okay.

And then thinking about the loan pipeline just wanted to get some color around that and how you're feeling about loan growth for the full-year based on what you saw this quarter in the pipeline?.

Sure. I will start with the mortgage pipeline. It is actually down a little bit compared to where it was this time last year, a couple of percentage points.

We continue to see activity in our markets, you know it is slow growth, it is 3% kind of growth levels in mortgage which it had been for quite some time given the characteristics of our slower growth markets. So, we expect we will have continued growth, but modest in the mortgage portfolio for the remainder of 2017.

In the auto lending portfolio, we had a pretty good first quarter given the more difficult seasonality this year compared to last year. Still quite positive.

One of the things we are seeing in the auto business is that our penetration rate has gone down, so the percentage of the deal that we get to look at, that we would yes to is declining because of credit. So we are starting to see some credit deterioration in the auto lending business.

I also think if you look at some of the macro national metrics around auto lending sales that are starting to come down and have now for a few months the used auto valuations are starting to soften up, they are still pretty good, but they are starting to soften up a little bit as well.

So, I would expect that we will have - I expect we will have growth in the auto lending portfolio this year also, but likely less growth then we’ve experienced in the last couple of years, which has been very strong.

Lastly on the commercial block, right now the pipeline is bigger than it was last year, it’s - we had as I said a single substantial credit that paid off early in the first quarter, which is actually was the entirety of the decline in the commercial block.

The pipeline is very strong now and so I would expect by year-end we will also have a reasonable growth in our commercial portfolio as well..

Got it. Okay.

And then did you know note that auto just started to see some credit deterioration, was that more broadly for the nation or what you are seeing in your loan portfolio?.

No, that’s what we are seeing flow through our business..

On the application front, so you are seeing some - we [indiscernible] some score or little bit more challenging from among the value standpoint that maybe incurred from most of last year.

I think I made a comment, our losses in the first quarter were very much in-line with the most recent fixed quarters and loss rates in the high 30s, and the low 40s for us in Indirect audio still makes that a very productive asset category.

So, nothing that we are looking at from a delinquency trend in the base of our own portfolio that gives us any cost for concern. Overall, we are very optically aware because of the high proportion of loans that we do on the used size or used car values are. So, we certainly don’t want to, in front ourselves related to longer value characteristics.

So, again remembering that we are in a marketplace that it doesn't deliver any opportunities for public transportation, so the car business kind of stayed steady as she goes..

Right, okay..

And we have made no changes for our underwriting standards at all. It’s just the deterioration request credit quality applications it resulted in slightly more modest growth. We also bumped on our rates a little bit in the first quarter. So, this is another data point..

Okay.

So you guys were making amends on your end, I'm just curious though I mean, nonperforming assets have never been an issue for you, do you expect to see some upward migration in MPAs and if so would it be a meaningful amount over the next year or so?.

Well it is interesting Matt. As you know in the auto portfolio nothing is ever a nonperforming asset because they never make it the best way. So by the time something is and 90 days past June, we had an actionable outcome. So, the amount of auto-related loans that are in an MPA category is very de minimis.

So I would come back to say, for us, when you are thinking about nonperforming loans you are trying to focus on residential mortgage activity in commercial activity and I think I said in my comment, on the commercial activity, our nonperforming loan balances or assets like eight-year low levels.

Residential mortgage is still manageable for us, it is still the majority of our nonperforming assets and we certainly think we are in good protected collateral positions in our market rates for the price of housing really has not accelerated much, but again it is better than it was a couple of years ago, but it still takes some long time to work through, you know how mortgage work out, whether it is a foreclosure or some other type of remediation activity.

So you do find yourself kind of accumulating multiple properties and you don't see some moment through the system very quickly. That being said, we don't think we have got really value erosion in any great form. I would expect that number to move up a lot, but it is such a low number Matt; you know small changes move the number..

Right. I guess I asked the wrong question then in terms of the audio portion.

Given what you are seeing on the residual values and then maybe some deterioration, would you expect charge-offs then over the next year or so to pick up?.

I don’t think it is logical to say it is really difficult to go below the levels we are at now because I do think that is the big concern, certain types of products are not demanding the same robust outcomes they were at the auction two years ago or one year ago, but are really, for us, it really becomes as a side, you know it is not like we have a national business where the national trend tends to dominate, it tends to be more of a regional local trend that dominates that outcome.

Honestly as new car sales start to go down a little bit, our dealer network actually starts to see some more activity on the youth side. So no necessarily a bad thing; again with our portion of all the most that two-thirds of our activity being on the used side..

Got it. Okay.

And then maybe just switching gears to the expense side of things, first just wanted to get broad terms, what the right operating expense number on a core basis through Merchants will be for the next couple of quarters, just to get a sense of where it'll stand and then secondly, I know with NRS there is a game plan to accelerate the amortization of the intangible asset quite a bit, so I wanted to get a sense for what that was this quarter and what is the annual decline, which we should be baking in on that piece?.

All right let me take a shot at that. Let us start with the NRS activity, which is, in the first two months that we owned it; we recorded $1.5 million or $750,000 a month of amortization. So we are using an accelerated amortization to essentially amortize about $61 million core customer list intangible.

So, I think in the first year, you would essentially see kind of $9 million run rate, year two that backs of about $800,000 Matt. So, year two of a, I think we're going to continue life. Year two backs off to say $8.2 million; year three backs off to see $7.5 million. Then you reach a point where essentially it becomes in and around $5 million a year.

Maybe four or five years into it, and that stays for the balance of the 10-year period of time can potentially reach back in kind of the straight line outcome. So, $1.5 million in the two months that we owned it is kind of for a quarterly run rate of $2.25 million for the next three quarters on a minimum with a modest reduction going into early 2018.

In terms of core operating expenses ex-Merchants, we will get one more month of NRS revenue and one more month of NRS expenses in the second quarter that we didn’t have in the first quarter and that is a positive outcome. This is a very productive yielding business for us. So, it is a net benefit of, even net of the - even net of the amortization.

Core operating expense for the first quarter was actually very, very good in terms of expense control, but I would add that if you're working up the base of core first quarter expenses, making the adjustment for NRS remind to use it, we did have winter in 2017 and I know this sounds pretty hokey, but clearly it’s more expensive for us to probably driveway meet [ph] the buildings that it is too cut the grass and turn on the air conditioning.

So it [indiscernible] per share, it is probably close to that. The first quarter also absorbs a lot of payroll tax expense because you have reset all of your withholding lines that’s closing in on for us, a million dollar differential between first fiscal quarter and a fourth fiscal quarter.

That tappers down into the second quarter, but honestly the first quarter is really the robust one. Generally for us, the first quarter is the lowest quarter of the year in terms of activity level for deposit service fees. Our customers tend to use their debit cards less.

They tend to have less transactions that allow us to have service fees attached to that. They typically build back up to the tune of 3% to 5% more in the second, third, and fourth quarter. That all seems to be in line with what we’re seeing.

You are going to really start to see some lending of those numbers though bringing on merchants in the middle of the second quarter. So hopefully we will do a decent job at the end of the second quarter kind of giving you the Merchants characteristics.

If you looked at the Merchants results that were published earlier in the week, they are off to a great start. They really had a nice first quarter.

If you pull out their acquisition expenses as Mark said, you know they are kind of running a core early, mid-60s type earnings per share outcome and from that perspective, again they have some seasonal expenses for themselves that are higher in the first quarter.

When we put out the modeling for Merchants we said we would get to a low 20% type of a cost save outcome because we had no bridge overlap with them.

Some of that cost saves has already been realized in Merchants numbers because they’ve had some people that are no longer with them, already even before the transaction has closed and they have grown a little faster than maybe we would have expected. So, their results are good.

So, I think from a perspective growth, it is an operating expense line, that’s a safe way to start that from a modeling standpoint, and I am certainly happy to provide more color off line, of you feel it is necessary..

That was very helpful. I appreciate it. I think that's all I had guys. Thanks for the color..

Great. [Indiscernible] Matt..

[Operator Instructions] We will hear from Chris O'Connell from KBW..

Hi guys flown in for Collyn Gilbert.

I was and just wondering if, you know it looks like you had some liquidity buildup in the cash balances in the first quarter, is that just the result of little bit weaker loan growth, a little bit strong deposits and how you guys see that going forward?.

It was Chris. So seasonally, it was not huge [indiscernible] loan growth in the first quarter.

Actually for the last seven years we haven’t been able to produce net loan growth in the first quarter, and we certainly had accessible full-year outcome as Mark was mentioning, but to answer your question directly, good deposit growth, - actually good deposit growth both on the core OCC side, retail side, as well as on the municipal side, which cannot be expected in the first quarter, because of where we are in the rate cycle Chris we have chosen not to have heavy reinvestment certainly through investment securities in the first quarter.

Also understanding that we will be expecting to close on Merchants in the second quarter, we clearly have much lower loan deposit ratio than the Merchants people and they have certainly generated more loan growth on a proportional basis in their balance sheet than we have.

So we didn’t think it was, yeah it probably costs us a little bit on the margin line in the net interest income generation to not be fully invested, but we think that will probably pay some longer term results.

With the rates a little bit higher, we will have the opportunity for a full reinvestment, as well as using some of our lower cost funds on the Merchants - deposits of the Merchants grow. So, yes it did influence the outcome, it might have actually moved the margin one or two basis points Chris, but generally I wouldn't put that in there as a trend.

We typically have been a none borrower of the overnight size, overnight month size in the first fiscal quarter, and by the end of the second quarter we tend to be neutral of a slight overnight rollover. With the Merchants transaction, I kind of expect that to actually grow our system as well.

I would see that as a modest borrower post the transaction..

Okay.

And then I know you guys spoke about the margin a little bit in the prepared comments, but combined with the liquidity, maybe later in the year and into securities or better loan growth and then with the Merchants transaction coming in next quarter, do you see the margin performing little bit down year-over-year from 2016 or got neutral, or just a little bit more color there?.

I think neutral [indiscernible] I would say, I was handicapped with the neutral because I do think we will be challenged to replace expiring investment cash flows with the amounts of equivalent to where it is coming off. So, I think the challenge will be more on the security side.

I think you are right, I think whether it is the next one or two Fed rate increases on the lending side, we will get a little bit less than that. We feel confident that we can manage our deposit costs, treat them conservatively, just giving our loan to deposit ratio on the markets that we participate in.

So, I think neutral is a good way to think about it. Merchants has about a 3% operating net interest margin. We’ve just reported 365. So the blended combined will actually come down, kind of normally around that from a mass endpoint, but I don't think that we think that the Merchants margin is under attack either.

I think it is at a level that is probably pretty sustainable for them. And they probably actually have more positive inflection given in more proportion of commercial lending instruments then we do on a proportional basis..

All right great. That's all I got guys. Thanks..

Thank you, Chris..

With no additional callers on the queue, I would like to turn the conference back over to our host for any additional or closing comments..

I think that’s it for us. Thank you all for joining our Q1 conference call. We will talk again next quarter. Thank you..

That does conclude today's teleconference. We thank you all for your participation..