Welcome to the Community Bank System Second Quarter 2018 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, markets, and economic environment in which the company operates. Such statements involve risks and uncertainties that could cause actual results to differ materially from the results discussed in these statements. These risks are detailed in the company’s annual report and Form 10-K filed with the Securities and Exchange Commission. Today’s call presenters are Mark Tryniski, President and Chief Executive Officer; Scott Kingsley, Executive and Chief Operating Officer; and Joseph Sutaris, Executive Vice President and Chief Financial Officer. Gentlemen, you may begin.

Thank you, Autra. Good morning, everyone, and thank you all for joining our Q2 conference call. Second quarter results were generally quite solid with GAAP EPS of $0.86 and operating earnings of $0.81, excluding the tax benefit related to option exercise activity. The improvement in operating results over 2017 21% is due primarily to last year's acquisitions of NRS and Merchants Bancshares. We also benefited this quarter from low funding costs, modest balance sheet growth and modest improvement in loan yields, credit costs and operating expenses. It was a very well balanced quarter. Total loan book was up slightly due to auto lending, which we expect to be strong in Q2. Business lending was flat excluding the impact of $40 million of municipal credits, which was paid down on June 30 and reloaded in July. Although, we had a record pipeline coming into the quarter and had record new loan originations during the quarter almost double Q1, we absorbed $55 million of early pay downs this quarter, higher than last quarter's $37 million. The mortgage portfolio was flat for the quarter, attributable not to demand, but the low levels of inventory in our markets. Core funding remained solid with end of period balances down $258 million due to timing of municipal activity, but average balances were up over $80 million for the quarter, all related to non-municipal accounts. Total deposit costs moved up from 10 basis points to 11 basis points, a strong performance in this higher rate environment. Our non-banking businesses were off slightly in revenue due to the seasonal strength to Q1, but continued to improve forward revenue and margin outlook. Asset quality metrics are very strong low and stable charge-off in non-performing metrics and delinquencies are at their lowest level in over 12 quarters. We also reported lowest efficiency ratio in over eight quarters. Similar to what I said last quarter, we have significant earnings momentum that we need to support with balance sheet growth asfocus for us for the remainder of the year. We expect our operating and credit costs to be stable, our fee businesses to grow, and our funding costs to increase only modestly. It was a very strong quarter and we're well positioned for the remainder of 2018. Joe?

Thank you, Mark and good morning, everyone. As Mark noted, the second quarter of 2018 was another very solid operating quarter for us. We set a new record for quarterly operating earnings, maintained strong asset quality, and continued to capitalize on our strong core deposit franchise. I'll start off with a few comments about our balance sheet. We closed the second quarter of 2018 with total assets of $10.63 billion. This is down $113.1 million or 1% from the end of the fourth quarter of 2017, and $333.5 million or 3% from the end of the first quarter of 2018. The end of period results are largely reflective of the seasonal characteristics of our balance sheet’s organic funding sources. Deposit and repurchase agreement balances for New England municipal customers increased seasonally in the fourth quarter of 2017. Similarly, our New York based municipal customer deposits increased seasonally in the first quarter of 2018, due primarily to our market areas property tax collection cycle. These seasonal factors resulted in a $257.1 million decrease in deposit balances, a $98 million decrease in borrowings between March 31, 2018 and June 30, 2018. Comparatively, second quarter average deposit liabilities were up $82 million or 1% on a linked quarter, first quarter basis and $56 million or 0.7% when compared to the fourth quarter of 2017. The company's cost of deposits was 11 basis points in the second quarter of 2018, as compared to 10 basis points in both the first quarter of 2018 and fourth quarter of 2017. Average earning assets for the second quarter of 2018 were $9.45 billion, which was up $74.3 million or 1% when compared to the linked quarter of 2018. Although, total earning assets did not change significantly between the linked quarters, we experienced a slight change in the…

Thank you. [Operator Instructions] We’ll go first to Jeffrey Kitsis at Sandler O'Neill.

Good morning

Good morning

If I recall correctly, you guys have been taking down indirect auto production over the last few quarters due to some tweaks that you made to underwriting, but then we saw some good production in 2Q. Does that indicate that the market has rationalized a little bit or is growth in 2Q more attributable to seasonal factors?

Yes, I think a fair question. The tweaks we made to our underwriting was really just in rates, it wasn't related to structure at all, although we have come up a little bit in terms of some of the terms -- the extended terms that were in the market. But obviously, in the second quarter, things are a little stronger than what we expected in the auto portfolio based on a couple things. One, we had increased our rates a bit. And number two, we expect the market wouldn't be as strong as it was. So it was a better outcome for us there than what we would have expected. And right now, the new originations this quarter when added about 405 in the aggregate, and the portfolio yields about 390 something. So we're getting a little bit of lift in terms of the new production versus the cash flows that are coming off at slightly lower yields.

Got it, thank you. And one more question, can you give us an update to the M&A landscape as you see it today? Do you think we could realistically see another deal in 2018?

Second question first, it's always really difficult to predict deals, we tend not to do that. It can be an extended period of time between transactions or they can the sooner than we expect based on market opportunity. Right now, the earnings and the operating performance of the whole industry is pretty strong, and the valuations in the marketplace are pretty strong. So, we're not seeing a lot of compelling reasons currently other than something like liquidity or transition of leadership or something like that. So, it's not -- there is not a lot of robust inbound inquiries, I would say. I mean, we continue to make outbound inquiries and have conversations as we do on an ongoing basis continually. But I will say in terms of the overall environment because of the strength of operating results across the industry and valuation is an excessive degree of market opportunity currently.

Got it. Okay, thank you for taking my questions.

Thank you

We’ll move next to Joe Fenech at Hovde Group.

Morning, guys.

Good morning, Joe.

Good morning, Joe.

Hey, guys. You increased the dividend by 6% year-over-year, but operating earnings were up over 30%. Anything to read into that mismatch, I guess, particularly given the fact that you're already running with a higher level of tangible capital than you really ever had since I've been following the stock. Any reason why you opted not to step up the dividend more materially?

Well, I think we’ve typically evaluated, our Board of Directors has evaluated the dividend in the third quarter, and I suspect that will be on the agenda for our third quarter board consideration, Joe.

Okay. So I'm looking at -- I guess I looked at the commentary and assumed, okay, so it's up, but that reflected kind of the increase from last year, is that fair?

Right.

Okay. My mistake, I apologize. Okay. And then on the M&A front, it's been a while now building on the last question since the last two deals, just want to refresh on the M&A strategy. I know you guys over the years have been contrarian acquires if you will. I remember you doing low-single-digit deposit premium branch deals in the years after the crisis when no one seemed interested in deposit. So kind of in light of this seeming market shift with the embrace of low cost funding where people want to pay up for it. You kind of shifted things as they more at of favor because they're cheaper maybe in markets you wanted to be in but haven't had the opportunity or it is stuff like that really just not factor all that much into your thinking?

Well, we look at certainly in the markets we're in right now and any strategically valuable opportunities within our market we look to adjacent markets, which for us would be New England and the rest of Pennsylvania. We've had conversations in the past and have interest in Ohio as well. So, I mean, I think you’re right at this juncture, things are expensive generally. So what we tend to look for is strategic opportunities that can add particular long-term value to our business model and our shareholders overtime, whether that's in the banking space or the benefit space or the wealth management space or the insurance space. So we continue to think about things more strategically and opportunistically, it’s just a bit more difficult in an environment where asset valuations across the spectrum of assets almost every asset class is very high right now. So I'd say there is fewer opportunistic opportunities but we continue to pursue and evaluate strategic opportunities.

Okay. And then on the loan growth Mark, I understand and appreciate the dynamics around the loan pay down activity. But setting it aside for a minute are you guys seeing any noticeable pick up in demand? And then specifically can you talk about production levels and say the business loan portfolio for the first half of this year compared to maybe the first half of last year?

Sure. For the second quarter of this year, our new business originations were about $190 million. Last year, in the second quarter, they were $90 million. Year-to-date, there is $330 million and year-to-date in 2017 they were $170 million. So, the origination levels have clearly ticked up. There is clearly more opportunity. We’re clearly having -- getting more deals doing -- seeing and having the opportunity at the table for more opportunities. It’s pretty clear in the origination numbers. But the pay downs have continued to be higher than what we'd hoped for. In the first quarter I think they were $38 million and we thought that was pretty high. And now in the second quarter they come in at $55 million. So that's a little disappointing. I think it's favorable there is a lot of -- the pipeline continues to be strong. The second quarter, end of quarter pipeline is a little bit lower than it was at the end of the first quarter, but because we booked a lot of those and there was a lot of new origination activities. So there was very little that we can do about early pay downs and pay offs and some of those have been large credit that have been taken out by Berkshire halfway and farm credit and those kinds of things where there is no retention opportunity there. So we continue to fight, our teams are really performing at a high level in terms of sourcing opportunities and getting opportunities across the finish line if we can get some moderation in some of the early pay downs and pay offs that will be helpful, but that doesn't matter. I mean our responsibility is to grow all of our portfolios regardless of the challenges and the headwinds. And our leadership team understands that. So, we'll continue to work hard. I think we’ll continue to have a lot of origination opportunity into the third quarter. And actually the last few years the fourth quarter has been reasonably strong too. So we'll see what the second half of the year brings in terms of early pay downs, but that's not going to -- that's not excuse, that's just the reality of the current environment we're going to continue to execute to the best we can. Our teams are doing a great job as I said, and we'll see what the second half brings.

Great, thank you.

Thanks, Joe.

We'll take our next question from Collyn Gilbert at KBW.

Thanks, good morning guys.

Good morning, Collyn.

Mark, just broadly, in your opening comments you'd indicated significant earnings momentum lays ahead for you guys. And just kind of want to break that down a little bit and also get a little bit more detail on some of the comments that you had made. Maybe starting with I think, if I heard you correctly flat operating expenses for the back half of the year. If you just talk about sort of what’s driving that? Yes that’s part one of the question, I guess.

Sure, I think in terms of significant earnings momentum, the reference there is really to the comparisons to recent quarters, the comparisons to last year certainly much of that is attributable to Merchants and to NRS. As Joe said, we’re going to hit some headwinds in the second half of the year with the impact of Durbin. But I think that if you look at -- and I used the word modest a couple of times in this -- in my comments. Because the things we do generally are modest we’re not going to report 12% loan growth, we’re not going to report significant changes in other operating elements of our balance sheet of our P&L and everything is incremental and it does tend to be modest. So I think the cumulative effect of the levers that we have available to us to pull and I think there are many in loan growth. I know kind of the industry looks at loan growth as that’s the momentum driver. We don’t really look at that way, loan growth is not unimportant, we expect to get it overtime. I think we have historically there are times that are better than others in terms of the operating environment, in terms of loan growth, but it’s not just loan growth it’s focused on core deposit gathering and margin growth and operating expense management. Our business -- our non-banking businesses and the revenues and the margins of those. And so, there are lot of levers that we look at and that we pull and that we manage improve our earnings momentum overtime and we’ll continue to pull those levers. I think we have done that for the last couple of years, I mean, you look back three years our EPS was $2.60 [ph] or something like that $2.30 [ph]. Now it’s running 3 plus, so it’s really about managing in a disciplined way, managing all those levers, paying attention to all those levers, executing on additive M&A opportunities overtime, which is an important or has been historically important part of our business model, in terms of both the banking and non-banking spaces and that will continue as well. So, and that's why I talk about operating momentum it’s continuing to effectively manage all those levers of opportunity that we have across the company. I think Collyn to your second point related to run rate and operating expenses, I’ll let Joe, comment on that.

Good morning, Collyn. Just to add a couple of comments regarding operating expenses. So, it’s typical that in the first quarter and even trailing slightly into the second quarter we had some occupancy related expenses that are a little higher than we would see in the third quarter. So, in terms of the occupancy and equipment expenses we would expect those effectively to be down a little bit in third quarter, we don’t have any major initiatives on the horizon that are going to drive up those costs. And from our salaries and employee benefits line item perspective, we had some incentive related costs in the second quarter that we do not expect to incur in the third quarter. So they are really the factors driving that expectation around operating expenses, we were $86.3 million versus an $86.1 million the last two quarters and our expectation is that those levels are reasonable for the next two quarters.

Okay, that’s helpful. And then just on the margin, your betas have held up just amazingly well, and I know you had indicated that you don’t expect that necessarily to stay. I know that that’s also been the commentary you guys have offered for the last couple of quarters and they seem to stay low. Is there something that you are seeing definitively in your market or in your deposit base that would suggest that you think the betas are going to go higher, or is that just more of a logical defensive conservative comment that you’re making?

I think it’s a little of both Collyn, I mean, if you look at the -- you look at other banks in our market, if you look at what their funding costs are, and look at the expectation of customers generally, you start and see and have for the last couple of quarters larger customers after more we expect that trend will continue, we expect there’s going to be more Fed hikes. So, I mean, it’s a little bit of what we've seen, as well as -- what we've seen ourselves, what we've seen in the marketplace and what we expect going forward. I think we tend to be conservative by nature, and we'll do our best to hold deposit costs in there. Again, I think, the word modest is probably the right word to use, in terms of what you are going to see for the remainder of the year, in terms of funding costs 10 to 11, I guess as it goes in the third quarter 11 to something else it's a bigger number, it's not going to be 11 to 13, might be 11 to 12, or 11 to 15, or whatever the number is, but it's -- so we do expect to see increased deposit costs over time. And I think, we probably didn't expect that we're going to come in at 11 this quarter and we did, and I think sitting here, we don't actually next quarter is going to be 11, but it might be 12 or 13 or something like that. So I think any increase in deposits funding costs is also going to be incremental and modest. We expect that -- you just think directly that's the environment right now in terms of both our customer base, the markets we're in and the expectation for higher market rates.

Okay. Okay, that's helpful. And then just finally, on the mortgage side, both from a mortgage banking sale -- gain on sale perspective as well as portfolio perspective. I know that -- I think that you had indicated maybe last quarter or so that application volume was up and then I know, you had said that inventory is low, but can you just kind of tie some of those comments together and give us a sense of what your outlook is for mortgage both from a sales perspective as well as a portfolio perspective?

Sure, I think it was -- the mortgage business was flat, which is a little disappointing in this quarter for us in our markets. Because the growth in that portfolio has never been very robust other than when we were in the refi markets and you get more opportunity there. But, it's been -- in the second quarter was pretty good. We booked $89 million worth of mortgage loans in the second quarter compared to $74 million in the first quarter. So, the fact that there wasn't much growth to kind of show for that it was a little bit disappointing for this quarter, I will say, we are turning around our mortgages in record time. So, we made some improvements in our processing in terms of the mortgage origination process and that’s how -- but also I think we expected a little bit more on volume for this time of year and our understanding from talking to our originators is that it's not a demand issue, it's a supply issue, there is enough inventory in the markets. So hopefully the third quarter will open up a little bit further off the top of my head I am not really exactly sure where the pipeline is, I think it's up a little bit from the last quarter, but I'm not exactly sure. It doesn't really change that much over time. It's always been that kind of little over $100 million range to kind of ebbs and flows seasonally. But, we would hope to see a little bit of growth in that market -- in that portfolio in the third quarter, which is pretty seasonally typical for us. But that may, again, be a function of supply of inventory in the market.

Okay, that's very helpful. I will leave it there. Thank you, guys.

Thanks, Collyn.

We'll go next to Russell Gunther at D.A. Davidson.

Hey, good morning, guys.

Good morning.

Good morning, Russell.

Just appreciate all the comments on the loan growth and pipeline and including in the release on some of the geographic puts and takes. Can we just kind of hone in though on the New England footprint for a bit. Could you just share with us what you're seeing on the commercial outlook and what you think that's going to contribute results going forward in the back half of the year?

Sure. The pipeline is actually improving in New England, which is good. If you look at the pay offs and pay down, including the two larger ones that I had mentioned, those were both in the New England region. So if you look at across the footprint, I mean, we're getting early pay offs in all of our markets. It's probably a little bit more concentrated in New England. Certainly, those two larger ones I mentioned attributed a lot to that. We're again, we're seeing it across the footprints, it's proportionally more has been in the first half of the year proportionally more in New England, but the pipeline is getting bigger there as well, which is also very good. We got a great team there, we’ve got a great customer base there, is a great market. We love the markets, we love the teams we have there. We need to keep growing the pipeline there, and hopefully we'll get better luck on some of those early pay offs there.

Okay, great. And then last question for me is on the employee benefits line and fee income. Just kind a share with us what you're seeing with the revenue growth outlook might look like there?

It continues to grow organically. It has for a number of years probably 10 years or more. Certain elements of that business that are growing at a faster pace than others, the business we bought last year NRS in Boston is growing faster than the other elements of that business. The 401k administration record keeping business is also growing organically at a slightly slower pace. So, I mean, it's actually a little bit difficult to predict, Russell. There were times when that business -- there were years where that business grew at double-digits. I don’t know if that's going to be the pace for this year. And I don't even know where we're at year-to-date, I know it's up. But we almost overtime always grown that portfolio organically anywhere from 5% to 10%. I mean Scott sitting in, so I don't know, Scott, if you want to comment. I think it's -- in terms of some color around that, the standard record keeping 401k business it has lower growth trajectory today. Those combined businesses now are between $90 million $92 million. So the years of 8% to 10% organic revenue growth are pretty tough hurdle for us or kind of log that back in down to the mid-single-digits. And lot of times what you'll see is that this new customer transitioned is a first quarter transition of that's in a lot of these in other words the timing of coming on to our platform versus somebody else's or the formation of new plans tend to be calendar specific in the first quarter of the year. So last time what you'll see is a nice spike on a year-over-year comparison in every quarter, but not a lot of movement quarter-to-quarter in that business with the exceptions to some small seasonal factors. So I think it's better to frame it on a year-over-year basis, Russell. Because quite frankly not a lot of people convert and transition their plan to mid-year.

That's very helpful, guys. I appreciate the color there. That's it for me.

Thanks, Russell.

We'll take our next question from Matthew Breese of Piper Jaffray.

Good morning, everybody.

Good morning, Matt.

Wanted to touch on the margin guidance for the remainder of the year, I think you said in the 370s was the forecast. I just wanted to get a sense for your assumption no accredible yield, assumptions for the Fed dividends. I think there is one more in the fourth quarter. And then the last part of that is what is the core margin guide from here?

Right, Matthew this is Joe, I'll take that question. So with respect to the accredible yield, we've been running about $2 million a quarter. We don't expect that to change very much in the quarters looking forward. So I think that's a reasonable expectation we have. As far as the Federal Reserve Bank dividend, we booked $450,000 this quarter. We expected to book about the same in the fourth quarter. With regard to the forward-looking margin, we're estimating in the ballpark of 370 at current levels. We have a variable rate loan portfolio above $900 million. So we will likely see some lift in the third and the fourth quarter of around that portfolio. Also on some of our shorter amortization portfolios as Mark mentioned, the indirect loan portfolio, we're starting to see new volume go on at a rate higher than the volume that's running off. So we do expect some modest lift on the pure rate around our loan portfolio. Obviously the challenge is we’re sitting on above $8.1 billion of immediately repriseable deposits and borrowings. And we are beginning to see some request around increasing rates from customers, we’re starting to accommodate that, we moved up a couple of our core deposit rates a few basis points. So we expect that that $8.1 billion will limit some of the positive impact that we’ve had on the earning asset side.

Got it, okay. And when you make that move, will you make that accommodation, given the absolute low level of your deposit costs. If for say it’s a 20 basis point money market account, where is that incremental move to given where your competitors are?

Well it depends on -- we do have competitive conditions that are different in each of the markets. And so it depends on sort of the product type whether it’s a municipal account, whether it’s an individual account, a business account as well as the market dynamics of each region. So, we have been very measured in those increases, at least in the second quarter we expect to continue to be measured. So some of our core accounts we have raised the core rate 2 to 5 basis points across the board. So those kinds of rate increases will hit us in the third quarter, but we’re not making significant wholesale changes to the core deposit pricing structures.

Our strategy Matt, right now is really to play defense, I mean, there are others who need to offense. When your loans are growing at double-digits, you need to play offense on deposit gathering to fund your loan growth. We’re not in that position so we can be -- we can play more defense and that’s really been our game plan right now is to play defense. We have, as Joe said made some modest moves on some of our accounts in terms of moving up the rates. We have opportunities in terms of high balance customers, there is a multitude opportunities we have in off balance sheet money market product, we have wealth management products, we have let’s call a defensive special deposit account that have higher rates that we can use on defensive basis. So there is a multitude of opportunities there.

Understood, okay. And then just following up on the capital question, might we see you increase the size of the securities portfolio as you wait for M&A opportunities or should that stay about the same?

I think right now we’re just watching what the market is, we haven’t really been in the market in terms of the securities portfolio for a long time. We kind of like the portfolio we have, the yield is pretty good, it did flip to a net underlying loss position recently. But it’s been -- I think the timing has been good in terms of when you look at when we put those securities on mostly 10 years, we did it something like eight years ago. Right now it’s a -- we just -- we aren’t compelled to do it right now for a number of different reasons we don’t have less surplus liquidity, but we have lots of liquidity because the portfolio in terms of cash liquidity. The yield curve right now is pretty flat in the middle. I think we’re in a kind of period of what everyone expect is going to be rising rate, so you don’t want to jump in before you see where this the rate increases are going to go in terms of where they moderate again. And how long is that take is it a year, or is it two years. So, I mean we’re not really looking right now at the particularly it’s flat out -- it’s pretty flat at the end we would be interest in looking at which is usually historically has been the 7 to 10 year, I mean, the five year right now and 10 year almost the same yield. So, it’s too flat, rates are going up, we don’t need to do it. If there is a spikes in the 10 year for some reasons or a spike in the part of the curve that was attractive to us in terms of our asset liability management overall, we’d probably look at doing something at that point. So we’re just watching it right now and we’ll see what the yield curve does.

Okay, last one is just on seasonal, any incremental thoughts or color anything you can provide for us in terms of what the allowance to provision might look like once that’s implemented?

We’re in a process of evaluating implementation in models, we’re not at a point where we have any expectations around what seasonal reserves will be effective on January 1, 2020. But we certainly have started the process and we’ll be evaluating the model for the balance of this year and then throughout 2019. But at this point it’s a little too early to certainly put a number out.

Okay, understood. That’s all I had. Thank you.

Thanks, Matt.

And that does conclude the question-and-answer session. At this time I’ll turn the conference back over to management, for any closing remarks.

Thank you and thank you all for joining our Q2 call, we look forward to reconvening at the end of the third quarter. Thank you.