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Edited Transcript of CBU earnings conference call or presentation 22-Jan-18 4:00pm GMT

Thomson Reuters StreetEvents

Q4 2017 Community Bank System Inc Earnings Call

DE WITT Jan 23, 2018 (Thomson StreetEvents) -- Edited Transcript of Community Bank System Inc earnings conference call or presentation Monday, January 22, 2018 at 4:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Mark E. Tryniski

Community Bank System, Inc. - CEO, President & Director

* Scott A. Kingsley

Community Bank System, Inc. - CFO, Executive VP, Treasurer, Executive VP of Community Bank and CFO of Community Bank

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Conference Call Participants

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* Alexander Roberts Huxley Twerdahl

Sandler O'Neill + Partners, L.P., Research Division - MD, Equity Research

* Collyn Bement Gilbert

Keefe, Bruyette, & Woods, Inc., Research Division - MD and Analyst

* Jacob F. Civiello

RBC Capital Markets, LLC, Research Division - Analyst

* Joseph Anthony Fenech

Hovde Group, LLC, Research Division - MD & Head of Research

* Matthew M. Breese

Piper Jaffray Companies, Research Division - Principal & Senior Research Analyst

* Russell Elliott Teasdale Gunther

D.A. Davidson & Co., Research Division - VP & Senior Research Analyst

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Presentation

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Operator [1]

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Good day, and welcome to the Community Bank System Fourth Quarter and Year-End 2017 Earnings Conference Call.

Please note that this presentation contains forward-looking statements within the provision of the Private Securities Litigation Reform Act of 1995 that are based on current expectations, estimates and projections about the industry's market and economic environment in which the Community operates. Such statements involve risks and uncertainties that include -- 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.

At this time, I'd like to turn the conference over to Mark Tryniski, President and Chief Executive Officer. Please go ahead.

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Mark E. Tryniski, Community Bank System, Inc. - CEO, President & Director [2]

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Thank you, Ashley. Good morning, everyone, and thank you all for joining our Q4 and Full Year Conference Call.

We had a strong fourth quarter that was up 10% per share on an operating basis over 2016, but was down $0.01 in Q3 due to a $0.05 per share credit provision related to a single acquired loan that Scott will discuss further. Credit growth remained elusive in the fourth quarter as a result of muted demand in both consumer and business markets as well as a continuation of above-average levels of early payoffs. Despite volume challenges, aggregate margin dollars were at a record level due to new originations at higher yields that contractual and prepayment cash flows for both the consumer and business portfolios. Adding to the margin was a deposit beta in 2017 of 0.

On a full year basis, operating earnings were up 13% over 2016. This performance was attributable to a number of factors, including the accretive benefit of the NRS acquisition in Q1 and the Merchants merger in Q2. In addition, our benefits, wealth management, insurance businesses all delivered double-digit growth on both the top and bottom lines and improved margins. Banking fee income was up double digits as well, and our efficiency ratio improved from 59.5% to 58.3%. We completed our build-out of DFAST, improved our risk management processes and systems and implemented improved customer channel technology. In summary, it was a transformative year for Community Bank System, and I could not be more proud of our 2,600 team members for what they accomplished.

Looking ahead to 2018, we cannot be better positioned. Earnings momentum is at a record level. We will have a significant tax rate benefit going forward that Scott will discuss further. We will accumulate meaningful incremental capital that will be additive to our strategic efforts and have the highest level of dividend capacity we've experienced in many years. We're very optimistic about 2018, and as always, remain mindful of our obligation to deliver exceptional returns to our shareholders. Scott?

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Scott A. Kingsley, Community Bank System, Inc. - CFO, Executive VP, Treasurer, Executive VP of Community Bank and CFO of Community Bank [3]

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Thank you, Mark, and good morning, everyone. As Mark noted, the fourth quarter of 2017 was another very solid operating quarter for us, and as a reminder, included the activities of the Northeast Retirement Services acquisition that we completed in early February of 2017 and the Merchants Bancshares acquisition completed last May.

I'll first cover some updated balance sheet items. Average earning assets of $9.37 billion for the fourth quarter were up 22.0% from the fourth quarter of 2016, reflective of the mid-second quarter acquisition of Merchants. On a year-on-year basis, residential mortgages and home equity instruments grew 1.7% organically, as the company continues to sell most of its longer-term secondary market eligible originations. Consumer indirect loans were down $33 million in 2017 or 3.2%, as we continue to balance growth with our objective of improving returns on capital deployed in this portfolio.

Our net charge-off and delinquency results in this portfolio continue to be very good and consistent with the last several years. As Mark mentioned, business loans were down for the second consecutive quarter, reflective of a number of outside unscheduled payoffs, modest demand characteristics and the continuation of very competitive market dynamics. Quarter-end investment securities were down modestly from the end of the second and third quarters, but up almost $300 million from the end of the fourth quarter of last year, a result of the Merchants acquisition. Average quarterly deposits were up $1.44 billion year-over-year in the fourth quarter 2017, also reflective of the Merchants transaction and continued success in our core deposit gathering.

We ended the quarter with $363 million of borrowings, of which $337 million were collateralized customer repurchase agreements, which act like and are priced much more like deposits than wholesale borrowings. As such, with the exception of our $123 million of highly efficient and regulatory capital added to trust preferred obligations, our December 31 balance sheet has virtually no external debt, a rarity in our peer group.

The fourth quarter and full year of 2017 was a continuation of the favorable overall asset quality results we've experienced for several years, despite a $3.1 million partial charge-off on a single $8.3 million commercial relationship. Including this one large charge-off, full year net charge-offs were $10.6 million or 0.18% of total loans and were up $4.4 million from 2016's results of $6.2 million of net charge-offs or just 0.13% of total loans. Nonperforming loans, comprised of both legacy and acquired loans, ended the fourth quarter of 2017 at $27.4 million or 0.44% of total loans, 7 basis points higher than the ratio reported at the end of September and reflective of the remaining nonaccrual balance on the previously mentioned commercial credit .

Our year-end December 2017 reserves for loan losses represents 0.98% of our legacy loans and 0.76% of total outstandings with the addition of the acquired Merchants loans earlier in 2017. Based on the most recent trailing 4 quarters' results, which include the large single charge-offs previously mentioned, our reserves still represent 4.5 years of annualized net charge-offs. Despite multiple reports of macro-level auto industry concerns, our 2017 net charge-off ratio at our auto lending portfolio was under 40 basis points of average loans, consistent with the previous 8 quarters and still quite productive by longer-term historical standards.

As of December 31, our investment portfolio stood at $3.08 billion and was comprised of $590 million of U.S. agency and agency-backed mortgage obligations or 19% of the total, $502 million of municipal bonds or 16% and $1.91 billion of U.S. Treasury securities or 62% of the total. The remaining 3% was in corporate and other debt securities. The portfolio contained net unrealized gains of $23 million as of year-end compared to a net unrealized gain of $42 million at the end of December of 2016 due to the movement of the market interest rates during the last 12 months.

Our capital levels in the fourth quarter of 2017 continued to be very strong. The Tier 1 leverage ratio was 10.00% at year-end. And tangible equity to net tangible assets ended December at 8.61%, despite the meaningful use of capital for both the NRS and Merchants transactions during the year.

As we have consistently discussed and primarily due to our history of acquisitions, the company has been in a net deferred tax liability position for several years. As such, the required revaluation of those net deferred tax liabilities following the late December enacted Tax Cuts and Jobs Act, which will lower the corporate federal tax rate from 35% to 21%, resulted in a onetime gain to the company of $38.0 million, which was reflected in our fourth quarter 2017 GAAP results. Tangible book value per share was $16.94 at year-end and still includes $48.4 million of deferred tax liabilities generated from certain acquired intangible assets or $0.95 per share.

Shifting to the income statement. Our reported net interest margin for the fourth quarter was 3.74%, which was down 2 basis points from the fourth quarter of 2016 and 10 basis points higher than the linked third quarter of 2017. Consistent with historical results, the second and fourth quarters each year include our semiannual dividend from the Federal Reserve Bank of approximately $750,000, which added 3 basis points of net interest margin to fourth quarter results. In addition, we recorded approximately $1.1 million of incremental purchased loan accretion compared to the fourth quarter of 2016, which added an additional 5 basis points to our net interest margin.

Proactive and disciplined management of funding costs continue to have a positive effect on margin results, as total deposit cost in the quarter remained at 10 basis points, including the added deposits from the Merchants transaction. Despite 4 Fed funds rate changes since December of 2016, our deposit beta has remained at 0 over the last 12 months.

Fourth quarter basic noninterest income of $19.3 million was up $2.9 million or 17.8% from the fourth quarter of last year, reflective of the Merchants transaction and several core improvement initiatives. On a linked-quarter basis, banking noninterest income was down $800,000 from the third quarter, which included our annual dividend from certain pooled group insurance programs. Quarterly revenues from our benefits, administration, wealth management and insurance businesses of $34.6 million were up $12.4 million from fourth quarter of last year and included the NRS and Merchants transactions as well as 3 smaller insurance agency acquisitions completed earlier in 2017.

Fourth quarter 2017 operating expenses of $86.1 million, which exclude acquisition expenses of $0.8 million, were $20.9 million above the fourth quarter of 2016 and included the operating activities from both the Merchants and NRS transactions as well as the significantly higher intangible amortization that resulted from the 2 acquisitions. On a linked-quarter basis, operating expenses were up $2.9 million from third quarter and included incremental $650,000 of salaries and benefits costs, primarily performance-based. Occupancy and equipment costs were up $0.5 million and included higher maintenance and utility costs. Other expenses were $1.8 million higher, with more than half of that in higher professional services costs for certain technology and core systems initiatives as well as some additional DFAST-related costs. We also incurred higher marketing and employee training costs in some of our newer markets in the fourth quarter.

Our operating effective tax rate in the fourth quarter of 2017 was 28.6% versus 33.4% in last year's fourth quarter and included a $300,000 reduction in income tax expense related to the change in accounting for share-based transaction. Our quarterly and full year 2017 effective tax rate included the incurrence of almost $26 million of acquisition expenses during 2017.

Looking forward, we continue to expect Federal Reserve Bank's semiannual dividends in the second and fourth quarters this year. But because we expect to be above $10 billion in assets for all of 2018, our dividend rate will be approximately 1/3 of the level we experienced in 2017. Despite the large partial charge-off on the one specific commercial relationship previously mentioned, 2017 net charge-off results were again manageable and we do not see signs of additional asset quality headwinds on the horizon.

Our core operating net interest margin has remained in a fairly narrow band over the last several quarters, a range we would expect to continue to operate in for at least the next few quarters, including the impact of higher purchased loan accretion related to the Merchants transaction. However, the change in the federal tax rate in 2018 will result in lower fully taxable equivalent yield on our municipal investment and loan portfolios. And although the change will not impact reported net interest income, we estimate it will lower 2018 net interest margin by 6 to 8 basis points compared to 2017.

Our full year effective tax rate in 2017 was 29.5%, excluding the onetime gain from the revaluation of deferred tax assets and liabilities. With the lower enacted federal tax rate, we expect our 2018 full year effective rate to decline to between 22% and 23% based on our current mix of income from tax exempt versus fully taxable sources. We continue to expect a net reduction from Durbin-mandated impacts on debit interchange revenues beginning in July of 2018 of approximately $12 million annually or an estimated $6 million in the second half of 2018. In summary, we believe we remain very well positioned from both a capital and an operational perspective for 2018 and beyond, and as Mark mentioned, look forward to continuing to execute on future acquired and organic improvement opportunities.

I'll now turn this call back over to Ashley to open the line for questions.

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Questions and Answers

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Operator [1]

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

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Alexander Roberts Huxley Twerdahl, Sandler O'Neill + Partners, L.P., Research Division - MD, Equity Research [2]

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First off, I think it's remarkable that 5 rate hikes later, your cost-to-deposit has been unchanged completely at 10 basis points, which is amongst the lowest in the industry. How long do you think you can keep that up? I mean, are you getting some pressure from different customers or different pockets to raise the deposit costs?

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Mark E. Tryniski, Community Bank System, Inc. - CEO, President & Director [3]

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Yes, Alex, this is Mark. We started to see that in -- at the end of the third quarter mainly at the higher level of balances, customers who have more meaningful balances looking at other alternatives. And so we've made some modest accommodations to maintain the balances and respond to competitive market pressures. So I expect that will continue into 2018. So I would suspect our deposit beta for 2018 will not be 0. I think we -- if you look at the markets that we operate in, we've always had somewhat lower deposits funding costs and I expect that will continue into 2018. I just believe that we will experience some modest rate pressure competitively in the market in 2018. But we'll be very judicious about managing those funding costs as we've always tried to be. We've spent a lot of time understanding the market and understanding how we can optimize our funding costs. So I -- we won't -- it won't be 0 in 2018, but I -- we'd suspect that it may still lag the greater market in terms of betas.

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Alexander Roberts Huxley Twerdahl, Sandler O'Neill + Partners, L.P., Research Division - MD, Equity Research [4]

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Okay. And then just a modeling question, Scott. The tax rate of 22% to 23% that you project for 2018, is -- does that include the share-based comp adjustment that you expect to see, probably the bulk of which in the first quarter?

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Scott A. Kingsley, Community Bank System, Inc. - CFO, Executive VP, Treasurer, Executive VP of Community Bank and CFO of Community Bank [5]

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I think it does, Alex. And I think it's -- as you know, when you establish an effective rate, you establish it in the -- early in the year for the full year outcome. So the fact that you may have more activity on the share-based side early in the year here, as you already prognosticate that. As a quick reminder, we probably do have more tax-exempt income than many of our peers because of the size of our municipal securities portfolio and the fact that we have a decent size municipal loan portfolio principally in New England. The other thing to remember is the base in 2017 was a little bit artificially low, that 29.5%, because we did have $26 million of acquisition expense that we don't expect to incur in 2018, so year you're starting with a little higher level there. And probably lastly, a handful of other sorts of small things that came out of the tax code change, one of which starts at our size and over $10 billion, FDIC insurance premium will not be deductible. So sort of a handful of things that play into that region.

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Alexander Roberts Huxley Twerdahl, Sandler O'Neill + Partners, L.P., Research Division - MD, Equity Research [6]

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Okay. So it'll be fair to say that first quarter might be closer to that maybe 21% or 22% and then go a little bit higher in the second, third and fourth quarter just because of that share-based comp adjustment?

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Scott A. Kingsley, Community Bank System, Inc. - CFO, Executive VP, Treasurer, Executive VP of Community Bank and CFO of Community Bank [7]

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It could be, yes. We had some outsized option exercise activity in the first quarter last year when we were trading north of $60. Well, people have the same kind of motivation at our current trading levels. Too early to tell on that, but I would suspect it'll see a little less activity than last year's first quarter. But you're probably not far off by thinking we're at the lower end of lending rate earlier in the year.

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Alexander Roberts Huxley Twerdahl, Sandler O'Neill + Partners, L.P., Research Division - MD, Equity Research [8]

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Okay. And then just a final question from me with respect to capital deployment. Clearly, with the lower effective tax rate, you'll be accreting capital at a faster pace in 2018 and beyond. Does that change your outlook for how you use capital? Does M&A, for example, become more of a requirement in 2018, 2019? And does that in turn change the criteria of what kind of deals you guys would look at?

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Mark E. Tryniski, Community Bank System, Inc. - CEO, President & Director [9]

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Fair question. We will be accreting capital at a more rapid pace in 2018 than we have in the past. I don't think it's going to impact the discipline and strategic thinking we apply to M&A, which is really around identifying and executing quality merger and acquisition opportunities that can help us grow our earnings and our dividends in a sustainable fashion. So I don't think it changes. I think it does allow us to accumulate capital more rapidly and possibly to utilize more capital in the future in terms of cash-stock mix. And as you know, we talked for a couple of years about the fact that we accumulated a fair bit of capital. We tried to deploy a lot of that with both NRS, which was a 50-50 mix; and with Merchants, which is a 70-30 mix. But the earnings levels are strong and will even get stronger in 2018. So it just creates much bigger of a challenge to deploy the capital. It certainly gives us more dividend capacity, but I would say that the fact that we're accumulating capital quicker does not do anything in terms of impacting our strategic thinking. But it would impact our capacity to deploy more capital in terms of mix that creates even stronger earnings accretion at any given transaction. So I think it'll ultimately be a benefit there. On the other side, multiples have increased a bit in terms of market multiples as well as M&A multiples. So we have to be mindful of that ever reaching, but I think this is just -- it creates more of a good problem to have, Alex, in terms of accumulating that capital more quickly that we can use to effect high-value M&A opportunities for the benefit of shareholders, but won't impact the core strategy.

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Operator [10]

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And we'll take our next question from Collyn Gilbert with KBW.

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Collyn Bement Gilbert, Keefe, Bruyette, & Woods, Inc., Research Division - MD and Analyst [11]

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Maybe could you guys talk about a little bit about just your growth outlook and kind of what you're seeing in the market? I know you had indicated on the opening comments, competitive landscape as it relates to lending. But just talk a little bit more about that and maybe how you see loan growth shaking out on an organic basis in 2018.

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Mark E. Tryniski, Community Bank System, Inc. - CEO, President & Director [12]

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Sure. I think as you know, we operate in lower growth markets. We've never had double-digit market opportunities. The best is mid-single digits, which sometimes we've been at and other times we haven't depending on market demand. Right now, I think I would -- I mean, if you look at the 3 main portfolios, in commercial, we had record originations in 2017, excluding Merchants, but we also had an incredible level of unexpected payoffs. So despite the fact that we have otherwise a great year in terms of business lending, yet over $100 million, those are the larger ones, in unexpected payoffs. So that certainly impacted what would otherwise have been a very, very solid year. Right now, we're sitting on a record pipeline in our commercial business. But we also expect, and we have some poor visibility in the payoffs, and we expect more and some larger payoffs to happen in the first half of 2018. So hopefully, we can offset that. As I said, we do have a record pipeline right now. And you've got a more competitive environment. The insurance companies and the conduits have gotten back into commercial lending. They're doing 30-year nonrecourse financing. And you have a commercial customer with a nice project, the cash flow as well, and we're not going to compete with that. I think the competitiveness in the market is probably more around rate and term than anything else that we're seeing that really low spreads, and we do not manage the volume. We run our business based on profitability and return on equity characteristics, not on volume. So when spreads got too thin, we don't participate. And I think we believe there's better ways to deploy our capital. So I think that the spreads have gotten lower and the terms have gotten longer. And that's what, from our perspective, is the principal competitive dynamics of the commercial market. It's not really so much demand as much as it is other participants taking out credit relationships. Not other banks, by and large, but nonbank participants in the markets. And I think I had said this last quarter, but asset prices are higher right now, cap rates are low. And there's a lot of transactions going on in terms of asset sales. So I think if you put all those together, it's probably less about aggregate demand than it is about the competitive environment and the early payoffs because of asset prices. In the mortgage business, I think mortgage and home equity business year-over-year was up about 2%. That's not atypical for us. Pretty consistent low single-digit market growth in mortgages. I think we expect that to continue into 2018. And we talked about the auto book a little bit last quarter. Year-over-year, it was down, I think, 3%. It was actually down less than what we thought it was going to be, because we did make some strategic moves in that business to trade off volume for returns. In fact, the portfolio yield in the auto book is actually up 24 basis points over the last 2 quarters. So a pretty significant move in the yield in the market in that business, but we traded off some volume. So I don't know if that helps at all, Collyn. I think the auto book will probably in 2018 be off a little bit in terms of volume as well, but I would expect the yields to remain higher. Mortgage and home equity will move forward as usual, 3% give or take. And then commercial, we'll see what happens with the early payoffs. I can tell we don't have the same level of early payoffs in '18 as we had in '17. I would expect we'll be up next year, because there is some activity in the market. It's just really a function of those unscheduled payoffs, which are difficult to predict. But right now, as I said, the pipeline is really good, record originations last year. And so I would expect we'll have a good origination year in 2018 as well. It would really be a function in terms of absolute growth in the portfolio, it will be a function of a level of those unscheduled payoffs.

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Collyn Bement Gilbert, Keefe, Bruyette, & Woods, Inc., Research Division - MD and Analyst [13]

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Okay. That's really -- that's very helpful. And I guess, that ties to the next question just on margin, which could have been -- margin came in better than what we were looking for. I recognize the FRB dividend and obviously the accretion income. But in total -- and I understand your comments on the deposit beta is likely to go -- move higher in '18. But how are you thinking about the margin? I mean, if there is increased discipline around profitability, do we see maybe better NIM results in '18 than perhaps what we saw in '17, or are you trying to just control compression? Or how should we think about the margin?

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Scott A. Kingsley, Community Bank System, Inc. - CFO, Executive VP, Treasurer, Executive VP of Community Bank and CFO of Community Bank [14]

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Collyn, I'll take that one. This is Scott. I think generally, we would certainly walk on the outcome we got in the fourth quarter, which was a combination of slightly higher asset yields based on new originations in virtually all of our 3 major portfolios and not being offset at all by funding costs. Matter of fact, we actually had a very, very efficient balance sheet in the fourth quarter in terms of very, very modest levels of overnight borrowings on a net basis. And part of that, matter of fact, just to give a little more color than that. Part of that was if you look at our deposit balances through the end of June to the end of the year, and it looks like we dropped deposits of about $180 million, $150 million of those were replaced or put into commercial and municipal repurchase agreements. As I mentioned, priced more like deposit a, a little higher than the deposit, but generally closer to a deposit than an overnight institutional wholesale rate. So a very efficient outcome for that. To come back to your question, I think we still will get some asset yield acceleration into 2018. The question is, are we going to be forced from a market dynamic to match up with the piece of that on the rate side. I like our starting point as well as anybody in the industry in terms of the absolute. But that being said, if there's another rate change late in the third -- late in the first quarter, does that generate a little bit more market activity from a competitive standpoint in our market? Probably. But to Mark's point, you're probably not going to see that in our markets first. As you know, our markets tend to be sort of a 6- to 12-month lag from the rest of the broader market. So I think you'll hear more from folks in Northern New Jersey or Boston or the Carolinas from the standpoint of the demographics than you will from us early. Would we be satisfied with a flat margin in 2018? Probably, but at the same point in time, we'd love to benefit modestly from a little bit of a tick up.

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Collyn Bement Gilbert, Keefe, Bruyette, & Woods, Inc., Research Division - MD and Analyst [15]

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Okay. Okay. That's helpful. And then just to frame some of the FRB dividend, so can you remind us what it was for the full year 2017? I know you had said that you expect '18 to be 1/3 of that level?

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Scott A. Kingsley, Community Bank System, Inc. - CFO, Executive VP, Treasurer, Executive VP of Community Bank and CFO of Community Bank [16]

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Sure. So we were about $600,000 for the second quarter and up to $750,000 in the fourth quarter, because we were a larger bank for FRB purposes. Now that we're over $10 billion, we fall into the big bank dividend characteristics. So instead of a roughly 6% dividend yield from the Federal Reserve, we come closer to 2%. So I would think, instead of $1.3 million, you're probably looking at $450,000, $500,000 of expected dividends for 2018.

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Collyn Bement Gilbert, Keefe, Bruyette, & Woods, Inc., Research Division - MD and Analyst [17]

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Okay. And the payment schedule is still the same, that doesn't change?

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Scott A. Kingsley, Community Bank System, Inc. - CFO, Executive VP, Treasurer, Executive VP of Community Bank and CFO of Community Bank [18]

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Yes.

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Collyn Bement Gilbert, Keefe, Bruyette, & Woods, Inc., Research Division - MD and Analyst [19]

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Okay. Okay. And then just finally, Scott, on operating expenses, and I apologize if you said this in your opening comments, but just trying to reconcile some of the moving parts there in terms of what will be recurring and what was sort of onetime in nature, I mean, what the run rate is going to look like from here on the OpEx side?

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Scott A. Kingsley, Community Bank System, Inc. - CFO, Executive VP, Treasurer, Executive VP of Community Bank and CFO of Community Bank [20]

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Yes. So I will start with this comment. If the fourth quarter was roughly $3 million higher than the third quarter, I would argue that a little bit more than half of that variable for variation from the quarter was actually something that we don't have in our recurring run rate. We had a handful of costs associated with some competitive needs for some technology and system related initiatives. We had a little bit higher cost on the DFAST side. We have a little bit higher cost in the repair and maintenance side of our physical infrastructure. Because we were so busy with the Merchants integration in the second and third quarter, we had a little bit of latent demand there that we probably took care of in the fourth quarter from a facility standpoint. So I would take the third quarter run rate and add about half of that variation that we had in the fourth quarter as the trend rate going into the first quarter of 2018. We're modeling about 3% to 4% growth in salaries and benefits costs going into 2018, principally merit in nature. But I think there are certain positions, like I think most of the people in the free world are seeing. There is a little bit of wage pressure in certain skilled level positions. So we were trying to leave ourselves the opportunity to react to that. And again, just for you, Collyn, for the rest of the group as a reminder, first quarter is our one quarter of the year where we have some seasonality. We typically have $0.01 to $0.015 more in payroll tax expenses, because you're still early in the payroll year; $0.01 to $0.0125 more in utility and maintenance costs for winter-related activity. And then we typically are $0.01 to $0.0125 lower on banking noninterest income from lower account utilization characteristics. And we're doing our best through a bunch of initiatives trying to offset some of that in preparation for the Durbin. But no guarantee that we'll deliver on that in the first fiscal quarter of '18. So hopefully that helps you a little bit with run rate.

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Collyn Bement Gilbert, Keefe, Bruyette, & Woods, Inc., Research Division - MD and Analyst [21]

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Yes, that is very helpful. That's great. And then just final question back, Mark, you had mentioned in the discussion about capital usage as you guys accrete capital in more '18 that -- I'm trying to find exactly what you -- how you worded it. Deploying more capital in terms of mix maybe in the deal, can you just talk about what did you mean by that?

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Mark E. Tryniski, Community Bank System, Inc. - CEO, President & Director [22]

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Well, if you want to -- if you -- we -- in terms of capital, we really managed Tier 1 leverage, which is where -- for us, all the risk-based ratios were 2x, the requirements of -- the one that's kind of closest to us, if you will, for us, is the Tier 1 leverage ratio. And right now we're at 10% and the minimum is 6%. But we probably wouldn't run that. We have a fair bit of surplus capital that we can deploy. In M&A, if you do a 100% stock deal, you're not really using that capital. The way you use the capital and effectively reduce your Tier 1 leverage ratio is to use a cash-stock mix. So the more cash you use, the lower you're going to -- the more of your Tier 1 surplus you're going to utilize. So that's what really I meant by that. It's more of a mix, because when you issue 100% stock, you're really -- you're financing all -- the entire premium and goodwill and intangibles. So you get -- I mean, it affects your tangible differently than your Tier 1. But our focus is not as much on tangible as it is over time gap in cash returns per share and the way you manage that -- the way we manage it in terms of M&A is try and use the appropriate mix of cash and stock in our transactions.

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Operator [23]

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And we'll take our next question from Russell Gunther with D.A. Davidson.

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Russell Elliott Teasdale Gunther, D.A. Davidson & Co., Research Division - VP & Senior Research Analyst [24]

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I just appreciate the comments on the loan growth outlook. I will be curious, though, for an update on the Merchants footprint. What are some of the dynamics going on in that market and your loan growth expectations there?

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Mark E. Tryniski, Community Bank System, Inc. - CEO, President & Director [25]

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Sure. As you know, we effected the transaction in May, in the second quarter. We just had some of that runoff in the Merchants portfolio for a couple of reasons. One is that, and I can't remember if we talked about this last quarter, and I thought I'll repeat it. Before the May merger, they had essentially pushed through the -- almost the entire [using our] pipeline to the closing process before we closed to avoid any disruptions to customers during the transition. So they had almost no pipeline in May. Now that brought with it a higher balance sheet from us, which -- with our advantage, of course, but it left them with almost no pipeline. So they spent the last 7 months rebuilding that pipeline, which they have in 2 large groups. So we had not run off at Merchants, which we expected, frankly, over the -- in soon 6 or 7 months. I would say at this point, most of that is working for us. But those markets are on average more active than ours in terms of economic demand and wealth characteristics. So we're looking forward to resumption of net growth in the Merchants portfolio in 2018. We did get some runoff that we expected in the third and fourth quarters of the Merchants' portfolio.

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Russell Elliott Teasdale Gunther, D.A. Davidson & Co., Research Division - VP & Senior Research Analyst [26]

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Okay. I appreciate the color there. And then just last one from me, Mark, a little bit more of a big picture. But you expressed a great degree of optimism for 2018. And I'd just be curious as to what part of your business do you think you're most optimistic about? What are the kind of the dynamics going on there?

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Mark E. Tryniski, Community Bank System, Inc. - CEO, President & Director [27]

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Yes, I'm pretty optimistic about almost all of it, frankly. I think we will have a good year in commercial in 2018 regardless of the impact the scheduled early payoffs. As I said, we have -- we're aware of a handful of larger ones in the first half. I expect our originations in 2018 will be very strong in the commercial business. So it's really a function of what happens with those early payoffs. The mortgage business will continue to move forward. That -- the mortgage business will be fine, as it always has been. The auto business will probably decline a bit further in terms of outstanding volumes. I think as everyone knows, the auto business is in, like, year 10 of cycle, and that's a very cyclical business. So that could go a number of different ways. With that said, the margin on that business will be higher in 2018 than it will be in 2017. On the retail banking side, deposit growth is average. We took out a fair bit more municipal business with the Merchants transaction, that tends to be a little bit more volatile just in terms of quarter-to-quarter swings. So it's a little bit more difficult to assess quarter-to-quarter. But we've always had low single-digit deposit growth in our markets, and I expect that would continue. In fact, last year, we actually had really good -- despite the fact that we had negative commercial growth, our deposit growth in the commercial portfolio, and I don't remember exactly, Scott, but 4%, 5% or 6% or something like that deposit growth for business customer. So with the function of the customers, it was a function of the pay down that really worked for us (inaudible). So I think the retail business will perform well. I think overall (inaudible) approximately $6 million Durbin hit next year. There's some things we're going to try to do that will offset part of that. So I think we've got some plans in terms of the retail business. The real (inaudible) has really been the nonbanking businesses. I mean, if you look at the -- I don't know how many times I've gotten to the end of the year and said we had double-digit growth in the top and bottom line in our nonbanking businesses. But our benefits business, tremendous year. Same with wealth and benefits, double-digits top line, double-digits bottom line. The margins of every one of those businesses went up. So they've been highly additive to overall operating results over the last 2 years. And I expect that's going to continue. I expect 2018 is going to again be a really very strong year for all 3 of our nonbanking businesses. So I think we're very well positioned here. The capital accumulation is going to help. We improved our operating efficiency from last year to this year. And with the lower tax rate and higher earnings and higher capital accumulation, I think we have a lot of options. The earnings momentum is great. The margin maintenance, I think, we've got that pretty well in hand. Our nonbanking businesses continue to just excel in terms of their performance. So I think we're pretty well positioned going into 2018.

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Operator [28]

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And we'll take our next question from Jake Civiello with RBC Capital Markets.

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Jacob F. Civiello, RBC Capital Markets, LLC, Research Division - Analyst [29]

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Do you anticipate that you'll continue to place the same emphasis on munis and the investment portfolio in the new tax environment? Or do you think there could be other types of securities that become more investable from both risk and tax-adjusted yield standpoint?

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Scott A. Kingsley, Community Bank System, Inc. - CFO, Executive VP, Treasurer, Executive VP of Community Bank and CFO of Community Bank [30]

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Yes, I think, you hit right on the head. I think there will be other instruments that will become more attractive any time you get sort of a 40% drop in the fully taxable equivalent adjustment. It'll probably take the market a little bit of time to react to that. And so I definitely agree. We're probably like to see net cash flows off our municipal portfolio and certainly hoping that the shape of the curve will allow us for some productive reinvestments. Now potentially for us in mortgage-backed securities, something we really have not invested in, in a significant way in a number of years, so -- but really on point question, Jake, I think that would absolutely be the result.

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Jacob F. Civiello, RBC Capital Markets, LLC, Research Division - Analyst [31]

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Then what's the normal or typical runoff that you see in the muni book on a quarterly basis?

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Scott A. Kingsley, Community Bank System, Inc. - CFO, Executive VP, Treasurer, Executive VP of Community Bank and CFO of Community Bank [32]

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Yes. So the whole year next year, Jake, we're expecting about $125 million of cash flows off our investment portfolio, and over 2/3 of that is municipal. So probably in the $80 million to $90 million range in terms of cash flow expectations. Our municipal portfolio is very, very diverse. Hundreds, literally several hundreds of CUSIPs in that portfolio. Probably not that big of a surprise, given the markets that we participate in as well as what we buy for things out of the market. But generally speaking, we think that's a pretty productive outcome. In 2017, we did not redeploy our investment capital on a full basis. Matter of fact, most of our investment purchases in 2017 were for CRA-related activities. And most of those are agency-backed mortgage-backed securities or pools of some type. Early in 2018 is probably still going to be the answer. And then the jury is out if you actually have a couple of more rate increases, can get a little bit of upward inflection on the yield curve. That would be highly productive for us.

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Mark E. Tryniski, Community Bank System, Inc. - CEO, President & Director [33]

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I suspect, Jake, we would also evaluate the sale of all or part of that municipal portfolio, as Scott said, the benefit to us is a lot less. But the market prices haven't really declined, because that market really is not made up of corporate buyers. It's made up of individual buyers who are still in the 37% tax bracket. So the pricing is still reasonably good in that market, yet the benefit to us to holding those has deteriorated somewhat. So I would suspect we will keep our eye on that market and there's a potential for repositioning there, I would suspect.

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Jacob F. Civiello, RBC Capital Markets, LLC, Research Division - Analyst [34]

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Okay. That makes sense. And does the potential for a higher interest rate environment in 2018 change how you think about M&A and the value of core deposits of potential acquisition targets?

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Mark E. Tryniski, Community Bank System, Inc. - CEO, President & Director [35]

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No. I mean, I think we have a particular discipline around what we focus on with M&A. It has to be qualitatively high value. It's got to be economically high value. It's got to fit in our expected geographic footprint and future expansion potential for that footprint. Our focus is really less around core deposit. Certainly, that's an element that's not unimportant. We understand and very much value core deposits. I would argue that, that's the most high value thing you can do at a bank is attract core deposits. So that's certainly part of it. But the overall strategy is not necessarily as much around interest rates or solely core deposit quality. It's really a function of the entire qualitative and economic aspect of a potential opportunity, ultimately focusing on what's the accretion on both a GAAP and cash per share basis over time and is that sustainable, is it a quality fit within our organization. So I mean, all those things certainly play a role, but they're not dispositive in terms of the ultimate judgments we make around M&A.

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Operator [36]

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And we'll take our next question from Matthew Breese with Piper Jaffray.

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Matthew M. Breese, Piper Jaffray Companies, Research Division - Principal & Senior Research Analyst [37]

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Mark, just building on some of your very positive commentary on the nonbanking front, off a very strong 2017. What do you think the growth outlook for 2018 is for those items?

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Mark E. Tryniski, Community Bank System, Inc. - CEO, President & Director [38]

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Matt, those businesses all report to Scott directly actually. So I'm going to ask Scott to respond.

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Scott A. Kingsley, Community Bank System, Inc. - CFO, Executive VP, Treasurer, Executive VP of Community Bank and CFO of Community Bank [39]

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Thanks, Mark. And I think that expecting double-digit revenue and margin improvement to our earnings improvement is probably not the target at this current time. Lord knows, we would like to see that. I think we -- in those businesses, we're thinking about mid-single-digit growth rates with continued operating leverage performance. The path for us has been relatively simple for all of our businesses, but grow revenues faster than you grow expenses using if this happened. We do have -- we'll pick up 1 additional month of revenues from the NRS transaction. Remember, we acquired that in February of last year. And we get a little bit of lift on the wealth management side, because the Merchants trust business came to us in May of last year. So probably from an organic standpoint, Matt, mid-single digits with maybe a little bit of a tick-up higher, because we're getting a full year impact in a couple of those spots. But again, those are businesses that we really like right now. And I think we've said this before, because we've gotten to critical mass size in each and every one of them, we now have good operating leverage characteristics in terms of our growth as opposed to somebody who is brand new in one of those nonbanking business lines. Sometimes you sort of have to suffer through, until you get to a certain level of critical mass, you don't improve your outcome. But both in terms of business development, distribution, underlying operation, very, very sound and strong business for us at this point in time, all of which we believe are investable on both an organic and an acquired basis.

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Matthew M. Breese, Piper Jaffray Companies, Research Division - Principal & Senior Research Analyst [40]

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Is there any way we can, I mean, maybe measure it in terms of efficiency? What is the employee benefits business do in terms of efficiency? What's the wealth and insurance business doing in terms of efficiency? And what is that kind of the improvement year-over-year?

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Scott A. Kingsley, Community Bank System, Inc. - CFO, Executive VP, Treasurer, Executive VP of Community Bank and CFO of Community Bank [41]

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Sure, Matt. And again, it's a little hard to find these in the segment disclosures that we do, but you can get close. I would argue, if you blended those businesses together, you get to a margin outcome of roughly 30%, maybe a touch higher in 2017, which means the inverse of that is the efficiency ratio. So you're in the high 60s in terms of efficiency ratio. Clearly, the transactions that we have completed on the benefits side, an improvement in those businesses from an operational standpoint has led to an outcome that is not hurting our blended effective efficiency ratio. Not quite as I say deliverable on the insurance and the wealth management side, but still very, very acceptable. Internally, we do look at the "efficiency ratio" of the core bank differently than we look at the efficiency ratio of the nonbanking businesses. And remembering that the nonbanking businesses, with the exception of when you're acquiring, you don't use a lot of incremental capital to add growth in those businesses, because they essentially don't have a balance sheet. Now 2017 was a year where we used a bunch of capital in the NRS transaction to really jump start that business and essentially to buy a business that we had not participated in terms of product and service mix. But outside of that, with a little bit of operating improvement, you are a capital returning enterprise from that point forward even if your growth rate is mid-single digits.

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Matthew M. Breese, Piper Jaffray Companies, Research Division - Principal & Senior Research Analyst [42]

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Got it. Okay. It's very helpful. And then given the shape of the yield curve and some of the changes between September and now, we've seen a lot of upward momentum on the yields. Where has that translated into higher asset yield on your side? And then, conversely, where is some of that being competed away most heavily?

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Scott A. Kingsley, Community Bank System, Inc. - CFO, Executive VP, Treasurer, Executive VP of Community Bank and CFO of Community Bank [43]

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Matt, if you look at the detail for us, I would tell you that there is some positive improvement in yields associated with auto lending for sure. And I think as we mentioned, we took a little bit of a step back in certain lines of business or in certain asset classes within indirect auto, principally and interestingly enough new car lending where the rates and the balance of the risk and return does not make a lot of sense. So we intended to "return" to our very entrenched roots, which must be a really good used auto lender. And in our marketplaces that have a severe absence of public transportation, that tends to work pretty well. Mortgage side, still rates are better than they were a year ago and better than they were a year before that in terms of composite rates. We're portfolio-ing 15 year products and below that may or may not meet characteristics of secondary eligible. But we think that the average life of those products in our marketplace is in that sort of 8- to 9-year total outcome. And we're happy with that on the balance sheet. So selling most of our longer-term originations, because that's probably still the right thing to do in this interest rate environment in terms of duration and tenure. And I think back to your question, in the commercial side, some of that opportunity to price things up is probably being competed away there. So as much as you may see a little bit higher asset yields in -- on the business lending side, spreads don't look like they have widened through the end of 2017. And that's more than an episodic conclusion on our behalf. And it probably represents, in some cases, as Mark mentioned, places were not participatory. If somebody is getting funding from the outside on a 25- or 30-year basis at fixed rate outcomes, then it's just probably not going to be our sweet spot. On the investment portfolio side, Matt, not seeing much yet. But again, we've had very modest reinvestment in cash flows. So I don't know that we could pick that up on that anyways.

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Matthew M. Breese, Piper Jaffray Companies, Research Division - Principal & Senior Research Analyst [44]

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Okay. And then my last question is really in terms of capital deployment. Obviously, the tax rate helps dividend capacity, and then we are amortizing quite a little bit of intangibles. So I just wanted to get a sense for, if there was a targeted payout ratio, what it is and is it more or less based on cash earnings or GAAP earnings? Just help me kind of frame where that could be heading.

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Mark E. Tryniski, Community Bank System, Inc. - CEO, President & Director [45]

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Sure. Well, I'll start with the fact we've increased the dividend every year for the past 25 years, which is a dynamic I like, because it puts pressure on us to continue to grow earnings. So I kind of like that dynamic and that pressure. I suspect we will -- as our board does every, I think, third quarter of the year, we will evaluate the dividend again in the third quarter. We certainly have significant capacity right now to continue to raise the dividend. Ultimately, that's the board's judgment. As far as a targeted payout ratio, we don't really have one. That's formal. I think we like to keep it in between kind of the 50% to 60% range. As you know, our organic growth is at best a low to mid-single-digit number. That does not require an enormous amount of our capital to provide for organic growth. So we are going to be accumulating capital regardless of the tax rate change as we have historically. I think we like to keep it in the 50% to 60% range, somewhere. There are times where the earnings are a little higher or a little lower for some reason, and it moves around from 45% to 65%, somewhere. But I would say that anywhere from 50% to 60% range is ultimately where we would like to maintain our focus in terms of that dividend payout ratio.

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Scott A. Kingsley, Community Bank System, Inc. - CFO, Executive VP, Treasurer, Executive VP of Community Bank and CFO of Community Bank [46]

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And Matt, to your question, we are essentially expensing $0.06 to $0.07 of GAAP expense on the amortization of intangible assets, which is likely to be very close to the same number per quarter in 2018 as it was in '17, just given the timing of our last 2 transactions -- last 2 major transactions. And we'll look at both. So to Mark's point, yes, that whole 50% to 60% type of general policy guideline for us, we'll do that both on a cash earnings as well as the GAAP earnings. And then at the same point, I always kind of look at what else could you use that incremental capital for if you just put it into dividend capacity.

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Operator [47]

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And we'll take our last question from Joe Fenech with Hovde Group.

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Joseph Anthony Fenech, Hovde Group, LLC, Research Division - MD & Head of Research [48]

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We're a few years now into this initiative by New York state, as you know, to invest substantial dollars across the region. It seems like there has been a substantial benefit, certainly more activity. Appreciate you guys aren't quite as active in some of the larger metro markets of some of your peers. But are you seeing some stretching, would you say, at the margins in terms of underwriting, maybe some peers doing some things to make you raise an eyebrow? Or have the standards held for the most part from what you're seeing?

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Mark E. Tryniski, Community Bank System, Inc. - CEO, President & Director [49]

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I would say the standards have held reasonably well, Joe, I'd say, better than the last big upcycle where you saw a lot of structure deterioration. I think what we're seeing now is out-of-market participants like the insurance companies and the conduits that come in, they're going to do 30-year nonrecourse financing for a established project with good cash flow. And we're not going to do that, and I don't see a lot of banks doing that as well. I think the thing that we see where there's – if there's anything, if you want to call it stretching going on is some of the [AMs] are -- have stretched a little bit. Where you normally do something on a 10-year basis, someone's wanting to go 20 and the spreads are thin. I mean, I think that the spreads have gotten – I mean that's been for some time, but they've gotten thinner. But those are the only 2 areas. And I don't think you're seeing a lot of wholesale deterioration in credit structure that really speaks to safety and soundness necessarily in terms of credit. I would -- my vantage point is mainly term extension and thinner spreads.

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Joseph Anthony Fenech, Hovde Group, LLC, Research Division - MD & Head of Research [50]

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Okay. And then obviously, limited activity in terms of M&A across upstate New York for a variety of reasons. Guys, for the few targets the size that are still out there, does the pickup in activity economically these last few years, do you think that extends the timeline even further in terms of when some of these smaller targets decide to partner up? And if so, do you think that means we're increasingly likely to see you guys pursue deals like Merchants outside of what's been your core markets historically?

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Mark E. Tryniski, Community Bank System, Inc. - CEO, President & Director [51]

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I think that's a fair question, Joe. I mean, I think as you know, there's only so many things left in upstate New York, it's not really overly based in terms of concentration. We have now a presence in New England, which I would arguably not a big stretch for us. I mean, our closest branch to their closest branch was 6 miles. And other than Lake Champlain, which is in the middle there, there is actually continuous -- contiguous markets, which is, I think, really along the lines of what we look to continue to do in the future. We clearly can't go north. So I think if you look at an extension further into New England, that's a possibility. I think further opportunities in Pennsylvania is an opportunity. And I think Ohio remains an opportunity for us. So I do think M&A activity, I think if I'm not mistaken, the volume was off in '17 compared to '16, not for us, I mean, industry-wide. I think as long as there's a lot of economic growth and earnings are growing for these banks that might be thinking about the strategic transaction, I think they'll hold off. So I think the fact that the strong economy creates growing earnings and operating performance, I think there's no reason necessarily to think about a strategic transaction. So and I think as you know, banks aren't really bought as much as they're sold. And so I think the current market we're in, if it continues to be strong economically, strong multiples in the marketplace, strong operating performance, I think that will put somewhat of a damper on any acceleration of M&A. I mean, it's not going to prevent us from understanding and identifying those high-value targets and then having dialogues with them. But certainly, multiples have gone up, not just in the market, but in the M&A space as well. That can make a difference in terms of whether a transaction can get done or not relative to the seller's expectations. So that can be another challenge or hurdle that we need to face in this environment. But the market and the multiples, it goes up and it goes down, and over time, it doesn't really change our strategic thinking around acquiring high-value partners that can help us sustainably grow our earnings per share and our cash flow per share.

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Operator [52]

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And that concludes our question-and-answer session for today. I'd like to turn the conference back to Mark for any additional or closing remarks.

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Mark E. Tryniski, Community Bank System, Inc. - CEO, President & Director [53]

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Thank you, Ashley. Nothing further to say other than thank you all for joining the call and we look forward to talking again in April. Thank you.

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Operator [54]

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And once again, that concludes today's presentation. We thank you all for your participation. And you may now disconnect.