COMMUNITY BANK SYSTEM INC - CBU Quarterly Report (10-Q) Item 2. Management's Discussion and Analysis of Financial ...

The following is an excerpt from a 10-Q SEC Filing, filed by COMMUNITY BANK SYSTEM INC on 8/4/2004.

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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Introduction

This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") primarily reviews the financial condition and results of operations of Community Bank System, Inc. ("the Company" or "CBSI") for the three and six months ended June 30, 2004 and 2003, although in some circumstances the first quarter of 2004 is also discussed in order to more fully explain recent trends. The following discussion and analysis should be read in conjunction with the Company's Consolidated Financial Statements and related notes that appear on pages 3 through 13 and the Annual Report on Form 10-K for the year ended December 31, 2003. All references in the discussion to the financial condition and results of operations are to those of the Company and its subsidiaries taken as a whole.

All references to "peer banks", unless otherwise noted, pertain to a group of 78 bank holding companies nationwide having $3 billion to $10 billion in assets and their associated composite financial results for the three months ending March 31, 2004 (the most recently available disclosure) as provided by the Federal Reserve Board in the Bank Holding Company Performance Report. Unless otherwise noted, the term "this year" refers to results in calendar year 2004, "second quarter" refers to the quarter ended June 30, 2004, earnings per share ("EPS") figures refer to diluted EPS, and net interest income and net interest margin are presented on a fully tax-equivalent ("FTE") basis. All common share and common share-based amounts reflect the two-for-one stock split effected as a 100% stock dividend on April 12, 2004.

This MD&A contains certain forward-looking statements with respect to the financial condition, results of operations and business of the Company. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those proposed by such forward-looking statements are set herein under the caption, "Forward-Looking Statements," on page 29.

Critical Accounting Policies

As a result of the complex and dynamic nature of the Company's business, management must exercise judgement in selecting and applying the most appropriate accounting policies for its various areas of operations. The policy decision process not only ensures compliance with the latest generally accepted accounting principles, but also reflects on management's discretion with regard to choosing the most suitable methodology for reporting the Company's financial performance. It is management's opinion that the accounting estimates covering certain aspects of the business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity in the selection process. These estimates affect the reported amounts of assets and liabilities and disclosures of revenues and expenses during the reporting period. Actual results could differ from those estimates. Management believes that critical accounting estimates include:

o Allowance for loan losses - The allowance for loan losses reflects management's best estimate of probable losses inherent in the loan portfolio. Determination of the allowance is subjective in nature and requires significant estimates.

o Actuarial assumptions associated with pension, post-retirement and other employee benefit plans - These assumptions include discount rate, rate of future compensation increases and expected return on plan assets.

o Provision for income taxes - The Company is subject to examinations from various taxing authorities. Such examinations may result in challenges to the tax return treatment applied by the Company to specific transactions. Management believes that the assumptions and judgements used to record tax-related assets or liabilities have been appropriate. Should tax laws change or the taxing authorities determine that management's assumptions were inappropriate, an adjustment may be required which could have a material effect on the Company's results of operations.

o Carrying value of goodwill and other intangible assets - The carrying value of goodwill and other intangible assets is based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires use of a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums, and company-specific risk indicators.

A summary of the accounting policies used by management is disclosed in Note A, "Summary of Significant Accounting Policies" on pages 61 - 67 of the most recent Form 10-K (fiscal year ended December 31, 2003).

Executive Summary

The Company's business philosophy is to operate as a community bank with local decision-making, principally in non-metropolitan markets, providing a broad array of banking and financial services to retail, commercial and municipal customers. The Company's branch network operates in New York as Community Bank, N.A., and in Pennsylvania as First Liberty Bank & Trust. The Company

also operates five financial services businesses, which provide a broad array of wealth management and benefits administration and consulting services to bank and non-bank customers.

The Company's core operating objectives are to: (i) grow the branch network, primarily through a disciplined acquisition and de novo strategy, (ii) build high-quality, profitable loan portfolios using both organic and acquisition strategies, (iii) increase the non-interest income component of total revenues through development of banking-related fee income, growth in existing financial services business units, and the acquisition of additional financial services businesses, and (iv) utilize technology to deliver customer-responsive products and services and to reduce operating costs.

Significant factors management reviews to evaluate achievement of the Company's operating objectives and its operating results and financial condition include, but are not limited to: net income and earnings per share, return on assets and equity, net interest margins, non-interest income, operating expenses, asset quality, loan and deposit growth, capital management, performance of individual banking and financial services business units, liquidity and interest rate sensitivity, enhancements to customer products and services, technology advancements, market share, peer comparisons, and the performance of acquisition and integration activities.

Second quarter and June year-to-date ("YTD") earnings per share were both $0.02 above their respective prior year periods, as higher net interest income and non-interest income and a lower loan loss provision were partially offset by higher operating expenses and a greater number of common shares outstanding. On an operating basis (see Table 1 and related narrative), second quarter and June YTD return on assets were equivalent to the same periods of 2003, while return on equity declined slightly due to higher capital levels. Excluding acquisition activity, revenue generated by the financial services businesses was up for the current quarter and first six months of the year, as a result of strong revenue growth at all of the units. Operating expenses for the quarterly and YTD periods increased primarily due to acquisitions and higher compensation and benefits costs. The efficiency ratio for the second quarter improved as a result of net interest income and recurring non-interest income growing at a faster pace than operating expenses (excluding acquisition costs and intangible amortization). The YTD efficiency ratio was up marginally year-over-year, mostly due to the percentage growth of net interest income being slightly below that of operating expenses.

Asset quality improved over the last year, with reductions in delinquency, net charge-off and non-performing loan ratios. Excluding acquisition activity, the Company experienced strong year-over-year loan growth in consumer mortgage and indirect lending, with slight declines in the business and consumer direct portfolios. On a geographical basis, loan growth in the New York markets mirrored the results for the Company, with the Pennsylvania markets reporting an increase in consumer indirect loans and declines in other portfolios. Excluding acquisitions, total average deposits for the quarter and first six months of 2004 declined slightly from the levels that existed for the same periods last year.

On May 14, 2004, the Company completed its acquisition of First Heritage Bank ("First Heritage"), a $275 million-asset, three-branch commercial bank based in Wilkes-Barre, PA. The Company completed three acquisitions in 2003, including:
(1) Harbridge Consulting Group ("Harbridge"), an actuarial and benefits consulting firm based in Syracuse, NY that was acquired from PricewaterhouseCoopers in July, (2) Peoples Bankcorp Inc. ("Peoples"), a $29 million-asset single branch bank in Ogdensburg, NY acquired in September, and
(3) Grange National Banc Corp. ("Grange"), a $280 million-asset bank with twelve branches in five counties of Northeastern PA, acquired in November.

Net Income and Profitability

As shown in Table 2, second quarter and June YTD earnings per share of $0.40 and $0.77, respectively, were $0.02 higher than the EPS generated in the same periods of last year. Net income for the quarter of $12.1 million was up 21% over second quarter 2003, and net income of $23.3 million for the first six months of 2004 increased 17% from the amount earned in the equivalent period of last year. Net interest income for the second quarter of $41.1 million and $80.4 million for the first half of 2004, were up 17% and 14.0% from their respective prior year periods. Second quarter non-interest income (excluding net gains from investment securities sales and debt prepayment costs) of $10.8 million was up 21% from second quarter 2003, and the YTD amount of $21.3 million rose 20% from the prior year level. Operating expenses of $29.8 million for the quarter and $59.5 million for the first six months of 2004 were up 18% and 20%, respectively, from the equivalent periods of 2003, a portion of which related to acquisition expenses that rose $0.4 million for the quarter and $1.4 million on a YTD basis.

In addition to the earnings results presented above in accordance with generally accepted accounting principles ("GAAP"), the Company provides earnings results on a non-GAAP, or operating basis. The determination of operating earnings excludes the effects of certain items the Company considers to be non-operating, including acquisition expenses, the results of securities transactions and debt restructuring activities. Performance as measured by operating earnings is considered by management to be a useful measure for gauging the underlying performance of the Company by eliminating the volatility caused by voluntary, transaction-based items.

Operating earnings per share for the second quarter were $0.40, up 5.3% from the $0.38 reported in the equivalent period of 2003. On a year-to-date basis, operating EPS of $0.80 increased $0.05 or 6.7% versus the first six months of 2003. As reflected in Table 2, the primary reasons for the improved earnings for both time periods were higher net interest income and non-interest income and a lower

loan loss provision, offset by higher operating expenses and an increased level of weighted average diluted shares. Net interest income increased because of higher earning-asset levels derived from the acquisitions of Peoples, Grange and First Heritage, organic consumer mortgage and indirect loan growth, and investment leverage. The increase in non-interest income for both time frames was mostly attributable to incremental revenue from Harbridge, strong growth at the other financial services units, and additional banking fees generated in the 16 branches added through the three whole-bank acquisitions. A significant decrease in net charge-offs and general improvement in other asset quality metrics were the primary drivers of the decrease in the loan loss provision, despite a significant increase in the size of the total loan portfolio. The quarterly and YTD performance improvements were partially offset by a growth in operating expenses, in most part due to the four acquisitions made in the intervening time period, as well as higher compensation and benefit expenses.

A reconciliation of GAAP-based earnings results to operating-based earnings results and a condensed income statement are as follows:

Table 1: Reconciliation of GAAP Net Income to Operating Net Income

Three Months Ended June 30, Six Months Ended June 30, --------------------------- ------------------------- (000's omitted) 2004 2003 2004 2003 ----------------------------------- -------------------------- ------------------------- Net income $12,141 $10,032 $23,296 $19,981 After-tax operating adjustments: Net securities (gains)/losses (82) 0 (89) 0 Debt prepayment costs 0 0 0 27 Acquisition expenses 252 3 847 3 ----------------------------------- -------------------------- ------------------------- Net income - operating $12,311 $10,035 $24,054 $20,011 =================================== ========================== =========================

Table 2: Summary Income Statements

Three Months Ended June 30, Six Months Ended June 30, --------------------------- --------------------------- (000's omitted, except per share data) 2004 2003 2004 2003 ----------------------------------------------------------- --------------------------- --------------------------- Net interest income (FTE) $41,083 $35,064 $80,372 $70,528 Loan loss provision 2,300 2,673 4,350 6,073 Non-interest income 10,784 8,947 21,304 17,799 Gain (loss) on investment securities & debt extinguishment 135 0 145 (45) Operating expenses 29,364 25,174 58,150 49,621 Acquisition expenses 411 5 1,381 5 ----------------------------------------------------------- --------------------------- --------------------------- Income before taxes (FTE) 19,927 16,159 37,940 32,583 Fully tax-equivalent adjustment 3,626 2,962 6,961 5,942 Income taxes 4,160 3,165 7,683 6,660 ----------------------------------------------------------- --------------------------- --------------------------- Net income $12,141 $10,032 $23,296 $19,981 =========================================================== =========================== ===========================

Diluted earnings per share $0.40 $0.38 $0.77 $0.75 Diluted earnings per share-operating $0.40 $0.38 $0.80 $0.75

Net Interest Income

Net interest income is the amount that interest and fees on earning assets (loans and investments) exceeds the cost of funds, primarily interest paid to the Company's depositors and interest on external borrowings. Net interest margin is the difference between the gross yield on earning assets and the cost of interest-bearing funds as a percentage of earning assets.

As shown in Table 3, net interest income (with non-taxable income converted to a fully tax-equivalent basis) for second quarter 2004 was $41.1 million, up $6.0 million or 17% from the same period last year. A $715 million increase in average earning-assets more than offset $611 million higher interest-bearing liabilities and a 25-basis point decrease in the net interest margin. As reflected in Table 4, the volume changes mentioned above drove net interest income to rise $8.1 million, while the lower net interest margin had a lesser $2.1 million negative impact on net interest income. June 2004 YTD net interest income of $80.4 million was up $9.8 million or 14.0% from the year-earlier period. A $548 million increase in average earning-asset levels had a greater positive effect than a $455 million rise in interest-bearing liabilities and a 19-basis point decline in the net interest margin. Interest-bearing asset and liability volume changes resulted in $12.6 million more net interest income, partially offset by a lower net interest margin that had a negative $2.7 million impact on net interest income.

Higher second quarter and June YTD average loan balances were primarily attributable to the $393 million of loans acquired in the three bank transactions and $96 million of organic loan growth over the past 12 months, driven principally by strong consumer

mortgage demand. Average investments (book value basis) rose $326 million for the second quarter and $202 million for the YTD period in comparison to the same periods of last year. The Company made a substantial amount of security purchases in the third quarter of 2003 and second quarter of 2004 to enhance its interest rate sensitivity and earnings profile. Investments were at below average levels in the first half of 2003 because the Company had instituted a de-leveraging strategy from third quarter 2002 through second quarter 2003, whereby proceeds from the run-off of investment securities were used to pay down borrowings until more favorable investment market conditions arose. Total average deposits were up 13.5% and 10.9% for the quarter and YTD periods in relation to the previous year, respectively, principally due to the deposits added through the Peoples, Grange and First Heritage acquisitions. External borrowings were increased to fund organic loan growth and investment purchases over the last 12 months, resulting in average borrowings that were up $365 million for the quarter and $261 million for the first half of 2004 in comparison to the year-earlier periods.

The 4.49% net interest margin in the second quarter dropped 25 basis points versus the same quarter last year, and the June YTD margin of 4.58% was down 19 basis points from the prior year. These declines were primarily attributable to the reduced level of interest rates over the last 12 months having a greater impact on earning-asset yields (quarter down 66 basis points, YTD down 64 basis points), than on the cost of funds (quarter down 41 basis points, YTD down 44 basis points). The reduction of earning-asset yields was mostly driven by declines in loan yields of 77 basis points for the quarter and 80 basis points for the YTD period. Loan originations over much of the last year were at rates that reflected the record-low rates prevalent in the market at the time, particularly in the mortgage, home equity and auto financing businesses. Investment portfolio yields were comparatively more stable (down 50 basis points for the quarter and 37 basis points YTD), as they benefited from significant call protection and investment purchases that were concentrated in periods of higher long-term rates. The Company's net interest margin for the first three months of 2004 was 70 basis points above the average for peer companies, driven by a very favorable earning-asset yield (+85 basis points), partially offset by a slightly higher ratio of interest expense to average earning assets (+15 basis points).

The second quarter cost of funds was down versus the same quarter of 2003 due to a 39-basis point drop in deposit costs and a 155-basis point decline in the average interest rate paid on external borrowings. The decline in the YTD costs of funds was driven by a 41-basis point fall in deposit costs and borrowing rates that were down 130 basis points. The deposit costs for both time periods were impacted to the greatest extent by time deposits rolling-over at lower current rates, but were also favorably affected by an increase in the percentage of deposit funding provided by demand deposits and a decline in the proportion of time deposits. The improvement in borrowing costs for the quarterly and YTD periods was primarily driven by a shift in the mix of external funding from higher-rate, longer-term borrowings to low-rate, short-term debt. A portion of this change was contributed by the prepayment of $25 million of longer-term FHLB obligations in the fourth quarter of 2003, which were replaced with short-term borrowings at much lower rates. The shift in the profile of borrowings not only lowered funding costs, but also serves to reduce the Company's risk exposure to falling interest rates. In addition, a significant amount of intermediate-term borrowings at favorable rates were added in the current quarter to fund investment purchases and organic loan growth, further reducing the overall borrowing rate due to their below-average cost.

Table 3 and 3A below sets forth information relating to average interest-earning assets and interest-bearing liabilities and their associated yields and rates for the periods indicated. Interest income and yields are on a fully tax-equivalent basis using a marginal income tax rate of 38.70% in 2004 and 38.94% in 2003. Average balances are computed by summing the daily ending balances in a period and dividing by the number of days in that period. Loan yields and amounts earned include loan fees. Average loan balances include non-accrual loans.

Table 3: Quarterly Average Balance Sheet

Three Months Ended Three Months Ended (000's omitted except yields and rates) June 30, 2004 June 30, 2003 ---------------------------------------------------------------------------------------------- ----------------------------------- Avg. Avg. Average Yield/Rate Average Yield/Rate Balance Interest Paid Balance Interest Paid ----------------------------------- ----------------------------------- Interest-earning assets: Time deposits in other banks $629 $1 0.64% $219 $1 1.83% Taxable investment securities (2) 948,470 13,526 5.74% 727,936 11,608 6.40% Non-taxable investment securities (2) 506,950 8,881 7.05% 401,535 7,229 7.22% Loans (net of unearned discount)(1) 2,222,827 33,354 6.04% 1,834,610 31,143 6.81% ---------------------- ---------------------- Total interest-earning assets 3,678,876 55,762 6.10% 2,964,300 49,981 6.76% Non-interest earning assets 467,079 395,627 ---------- ---------- Total assets $4,145,955 $3,359,927 ========== ==========

Interest-bearing liabilities: Interest checking, savings and money market deposits $1,122,467 1,512 0.54% $984,553 1,800 0.73% Time deposits 1,197,563 7,009 2.35% 1,088,845 8,133 3.00% Short-term borrowings 416,767 1,277 1.23% 132,775 428 1.29% Long-term borrowings 376,350 4,881 5.22% 295,533 4,556 6.18% ---------------------- ---------------------- Total interest-bearing liabilities 3,113,147 14,679 1.90% 2,501,706 14,917 2.39% Non-interest bearing liabilities: Demand deposits 550,683 456,176 Other liabilities 51,465 59,214 Shareholders' equity 430,660 342,831 ---------- ---------- Total liabilities and shareholders' equity $4,145,955 $3,359,927 ========== ==========

Net interest earnings $41,083 $35,064 ========== ========== Net interest spread 4.20% 4.37% Net interest margin on interest-earnings assets 4.49% 4.74%

Fully tax-equivalent adjustment on investments and loans $3,626 $2,962

(1) The impact of interest not recognized on non-accrual loans was immaterial.

(2) Averages for investment securities are based on historical cost basis and the yields do not give effect to changes in fair value that is reflected as a component of shareholders' equity and deferred taxes.

Table 3A: Year to Date Average Balance Sheet

Six Months Ended Six Months Ended (000's omitted except yields and rates) June 30, 2004 June 30, 2003 ---------------------------------------------------------------------------------------------- ----------------------------------- Avg. Avg. Average Yield/Rate Average Yield/Rate Balance Interest Paid Balance Interest Paid ----------------------------------- ----------------------------------- Interest-earning assets: Time deposits in other banks $716 $2 0.56% $221 $1 0.91% Taxable investment securities (2) 882,585 26,121 5.95% 758,775 24,234 6.44% Non-taxable investment securities (2) 479,943 16,920 7.09% 402,003 14,466 7.26% Loans (net of unearned discount)(1) 2,167,108 65,975 6.12% 1,821,323 62,531 6.92% ---------------------- ---------------------- Total interest-earning assets 3,530,352 109,018 6.21% 2,982,322 101,232 6.85% Non-interest earning assets 463,177 393,366 ---------- ---------- Total assets $3,993,529 $3,375,688 ========== ==========

Interest-bearing liabilities: Interest checking, savings and money market deposits $1,088,502 3,057 0.56% $985,617 3,734 0.76% Time deposits 1,185,501 14,098 2.39% 1,094,934 16,835 3.10% Short-term borrowings 386,465 2,398 1.25% 151,950 990 1.31% Long-term borrowings 323,414 9,093 5.65% 296,653 9,145 6.22% ---------------------- ---------------------- Total interest-bearing liabilities 2,983,882 28,646 1.93% 2,529,154 30,704 2.45% Non-interest bearing liabilities: Demand deposits 535,770 452,717 Other liabilities 53,139 57,613 Shareholders' equity 420,738 336,204 ---------- ---------- Total liabilities and shareholders' equity $3,993,529 $3,375,688 ========== ==========

Net interest earnings $80,372 $70,528 ========== ========== Net interest spread 4.28% 4.40% Net interest margin on interest-earnings assets 4.58% 4.77%

Fully tax-equivalent adjustment $6,961 $5,942

(1) The impact of interest not recognized on non-accrual loans was immaterial.

As discussed above and disclosed in Table 4 below, the year-over-change in quarterly and YTD net interest income (fully tax-equivalent basis) may be analyzed by segregating the volume and rate components of the changes in interest income and interest expense for each underlying category.

Table 4: Rate/Volume

2nd Quarter 2004 versus 2nd Six Months Ended June 30, Quarter 2003 2004 versus 2003 Increase (Decrease) Due to Increase (Decrease) Due to Change in (1) Change in (1) ------------------------------- ------------------------------- Net Net (000's omitted) Volume Rate Change Volume Rate Change ---------------------------------------------------------------------------------------- ------------------------------- Interest earned on: Time deposits in other banks $1 ($1) $0 $2 ($1) $1 Taxable investment securities 3,241 (1,323) 1,918 3,754 (1,867) 1,887 Non-taxable investment securities 1,851 (199) 1,652 2,753 (299) 2,454 Loans (net of unearned discount) 6,096 (3,885) 2,211 11,030 (7,586) 3,444 Total interest-earning assets (2) $11,191 ($5,410) $5,781 $17,476 ($9,690) $7,786

Interest paid on: Interest checking, savings and money market deposits $229 ($517) ($288) $365 ($1,042) ($677) Time deposits 757 (1,881) (1,124) 1,308 (4,045) (2,737) Short-term borrowings 871 (22) 849 1,457 (49) 1,408 Long-term borrowings 1,121 (796) 325 788 (840) (52) Total interest-bearing liabilities (2) $3,235 ($3,473) ($238) $4,987 ($7,045) ($2,058)

Net interest earnings (2) $8,069 ($2,050) $6,019 $12,558 ($2,714) $9,844

(1) The change in interest due to both rate and volume has been allocated in proportion to the relationship of the absolute dollar amounts of change in each.

(2) Changes due to volume and rate are computed from the respective changes in average balances and rates and are not a summation of the changes of the components.

Non-interest Income

The Company's sources of non-interest income are of three primary types: banking services related to loans, deposits and other core customer activities typically provided through the branch network; financial services, comprised of retirement plan administration and employee benefit trusts (Benefit Plans Administrative Services or BPA), actuarial and employee benefit consulting services (Harbridge Consulting Group or Harbridge), personal trust, investment and insurance products (Community Investment Services, Inc. or CISI) and investment management (Elias Asset Management or EAM); and periodic transactions, most often net gains (losses) from the sale of investments and prepayment of term debt.

Table 5: Non-interest Income

Three Months Ended June 30, Six Months Ended June 30, --------------------------- ------------------------- (000's omitted) 2004 2003 2004 2003 -------------------------------------------------------- --------------------------- ------------------------- Banking services: Electronic banking $626 $617 $1,155 $1,163 Mortgage banking 4 268 261 957 Deposit service charges 1,355 1,345 2,692 2,641 Overdraft fees 3,682 3,391 7,134 6,301 Credit life and disability insurance 86 65 141 126 Commissions and other fees 611 459 1,197 1,005 Miscellaneous 83 70 301 96 -------------------------------------------------------- --------------------------- ------------------------- Total banking services 6,447 6,215 12,881 12,289 -------------------------------------------------------- --------------------------- -------------------------

Financial services: Retirement plan administration and trustee fees 1,422 1,202 2,866 2,303 Actuarial and benefit plan consulting fees 853 0 1,793 0 Asset advisory and management fees 593 369 1,092 878 Investment and insurance product commissions 1,072 808 1,827 1,601 Personal trust 397 353 845 728 -------------------------------------------------------- --------------------------- ------------------------- Total financial services 4,337 2,732 8,423 5,510 -------------------------------------------------------- --------------------------- -------------------------

Sub-total 10,784 8,947 21,304 17,799 Gain (loss) on investment securities & debt prepayment 135 0 145 (45) -------------------------------------------------------- --------------------------- ------------------------- Total non-interest income $10,919 $8,947 $21,449 $17,754 ======================================================== ========================== =========================

Non-interest income/operating income (FTE) 20.8% 20.3% 21.0% 20.2%

As displayed in Table 5, non-interest income (excluding net securities gains and debt prepayment costs) was $10.8 million in the second quarter and $21.3 million for the first half of 2004. This corresponded to increases of $1.8 million (21%) for the quarter and $3.5 million (20%) for the YTD period in comparison to one-year earlier. A majority of the growth in both time intervals was attributable to the $1.6 million and $2.9 million increases in financial services revenue for the quarterly and YTD periods, respectively. Recurring banking fees were up 3.7% for the current quarter and 4.8% for the first six months of 2004 versus year-earlier levels.

A majority of the growth in banking non-interest income for both periods was due to the three whole-bank acquisitions completed over the last nine months, with a majority of the increase derived from higher overdraft fees. The $291,000 and $833,000 rise in overdraft income for the quarter and first half of 2004, respectively, was further enhanced by the conversion of a majority of the acquired retail accounts to the Company's successful Overdraft FreedomTM program. In addition, the $205,000 increase in miscellaneous non-interest income for the first half of 2004 benefited from higher cash surrender values derived from acquired life insurance policies. These improvements were offset by a year-over-year decline in mortgage banking income for the quarter (down $264,000) and first six months of 2004 (down $696,000), which was primarily attributable to the discontinuation of the sale of longer-term mortgages in the secondary market in the fourth quarter of 2003. A material amount of gains on the sale of mortgages were earned in the first half of 2003 as declining long-term rates increased the market value of mortgages that had been held for sale.

More than half of the increase in financial services revenue for the second quarter and first six months of the year was driven by the acquisition of Harbridge, which accounted for $853,000 and $1,793,000 of the quarterly and YTD variances, respectively. Strong growth at each of the other financial services units for both periods also contributed significantly to the year-over-year increases. BPA generated revenue growth of $220,000 (18%) for the quarter and $563,000 (24%) for first half of 2004, primarily achieved through obtaining a significant number of new client relationships and their associated investment assets. Essentially all of the year-over-year growth at CISI and EAM was achieved in the current quarter. CISI was up $264,000 for the quarter and was positively impacted by an

increased volume of annuity sales in response to higher interest rates and additional client relationships developed in the new markets opened up by the Company's banking acquisitions. Second quarter revenue for EAM increased $224,000 over the prior year quarter as appreciation in the U.S. equity markets and the attraction of net new client assets over the past 12 months drove significant growth (61%). Second quarter and June YTD revenue for the personal trust business was up 13% and 16% versus the prior year, respectively, as the unit benefited from increased fees attributable to higher equity asset valuations and new business generation.

The ratio of non-interest income to operating income (FTE basis, excluding net security gains and debt prepayment costs) was 20.8% for the second quarter and 21.0% for the first half of the year, 0.5 and 0.8 percentage points higher than the same periods of last year. The significant growth of the financial services group was the primary reason non-interest income outpaced net interest income growth.

There was $145,000 of net security gains in the first half of 2004 from the sale of securities that were inherited through acquisitions. This compared to $45,000 of debt prepayment costs in the first six months of 2003 associated with the retirement of $500,000 of the Company's 9.75% fixed-rate subordinated debentures.

Operating Expenses

Table 6 below sets forth the quarterly and YTD results of the major operating expense categories for the current and prior year, as well as the efficiency ratio (defined below), a standard measure of overhead utilization used in the banking industry.

Table 6: Operating Expenses

Three Months Ended June 30, Six Months Ended June 30, --------------------------- ---------------------------- (000's omitted) 2004 2003 2004 2003 ----------------------------------- --------------------------- ---------------------------- Salaries and employee benefits $15,392 $12,318 $30,559 $25,018 Occupancy 2,500 2,328 5,130 4,749 Equipment and furniture 2,150 1,977 4,302 3,881 Legal and professional fees 970 859 1,967 1,578 Data processing 1,924 1,740 3,804 3,359 Amortization of intangible assets 1,759 1,251 3,398 2,532 Office supplies 577 466 1,098 1,052 Foreclosed property 212 (9) 443 158 Other 3,880 4,244 7,449 7,294 ----------------------------------- --------------------------- ---------------------------- Total recurring expenses 29,364 25,174 58,150 49,621 Acquisition expenses 411 5 1,381 5 ----------------------------------- --------------------------- ---------------------------- Total operating expenses $29,775 $25,179 $59,531 $49,626 =================================== =========================== ============================

Operating expenses/average assets 2.85% 3.01% 2.93% 2.96% Efficiency ratio 53.2% 54.4% 53.8% 53.3%

As shown in Table 6, second quarter operating expenses were $29.8 million, up $4.6 million (18%) from the prior year level, and year-to-date operating expenses of $59.5 million rose $9.9 million or 20% compared to 2003. The increases for both periods were primarily attributable to the incremental recurring operating expenses associated with the acquisitions of Peoples, Grange, Harbridge and First Heritage during the intervening time period. In addition, $1.4 million of acquisition expenses were incurred in the first six months of 2004 versus an immaterial amount in the previous year (no acquisitions were completed in 2002 and the first half of 2003). A large portion of the acquisition expenses were associated with $0.9 million of deferred compensation costs that were recorded in first quarter 2004 but should have been recognized in 1996 by a bank that was acquired by First Liberty Bank & Trust, prior to its acquisition by the Company in 2001. The balance of the acquisition expenses was primarily attributable to professional fees and system conversion costs that arose due to the acquisitions of First Heritage and Grange.

Recurring operating expenses (excludes acquisition expenses) of $29.4 million for the quarter and $58.2 million for the first half of 2004 were both up 17% versus the equivalent prior year periods. As previously mentioned, these increases were mainly driven by the four acquisitions completed since the end of June 2003, which affected virtually all expense categories, and amortization of intangible assets in particular. The year-over-year rise in personnel expenses, $3.1 million for the second quarter and $5.5 million for the June YTD period, was also impacted by merit increases, hiring activity and higher pension and medical costs. Year-to-date legal and professional fees increased versus prior year in most part due to the increased responsibilities associated with complying with new governance and regulatory requirements. Lastly, other expenses in the second quarter were down versus the same period last year primarily because of costs associated with the retirement of a senior executive in the second quarter of 2003.

The Company's efficiency ratio (recurring operating expenses excluding intangible amortization divided by the sum of net interest income (FTE) and recurring non-interest income) was 53.2% for the second quarter, 1.2 percentage points below the comparable period of 2003. Recurring operating income grew 18% versus the 15% increase in core operating expenses (as defined above). Organic income expansion generated principally through loan growth, investment leverage and increased revenue from the financial services segment resulted in higher margins due to the significant proportion of fixed costs inherent in the Company's expense structure. The efficiency ratio of 53.8% for the first half of 2004 was up 0.5 percentage points from a year-earlier due to core operating expenses increasing 16%, while recurring operating income grew at a lesser, 15% pace. First quarter 2004 year-over-year net interest income growth lagged the percentage increase in operating expenses primarily due to a lower net interest margin and the escalation of certain employee benefit costs.

Income Taxes

The June YTD effective income tax rate was raised 0.8 percentage points to 24.8% in the second quarter of 2004 principally as a result of a higher proportion of income being generated from fully taxable loans and investments. The YTD effective tax rate was only slightly below (0.2 percentage points) the rate for the first half of 2003. The full six-month impact of the tax rate increase was incurred in the current quarter, and therefore the rate of 25.5% was above the YTD and projected full year rate. The quarterly tax rate was 1.5 percentage points above the tax rate for second quarter 2003, when the YTD rate lowered from 26.0% to 25.0%.

Investments

As reflected in Table 7 below, the book value (excludes unrealized gains) of investments at the end of the quarter increased $287 million from year-end 2003 and was up $473 million versus June 30, 2003. As previously mentioned, the year-over-year and quarterly growth in the book value of the investment portfolio was driven by strategic security purchases made over the last four quarters to enhance the Company's interest rate sensitivity profile and take advantage of improved investment market conditions. In addition, the strong capital positions and excess deposits held by the three banks the Company acquired over the past nine months provided further support for investment purchases. The investment portfolio at the end of second quarter 2003 was at a reduced level due to the de-leveraging strategy that had been in place for more than three quarters. During that time frame the Company used cash flow from the run-off of investments to support loan growth and repay borrowings until reinvestment opportunities became more attractive.

The carrying value of investments (includes unrealized gains on available-for-sale securities) was $1.6 billion at the end of the second quarter, up $255 million from December 31, 2003 and $414 million higher than the end of second quarter 2003. The increases in carrying value were well below that of the book value changes for the equivalent six and twelve-month periods because of the decline in the value of unrealized gains (market value adjustment or "MVA"), caused primarily by the significant rise in interest rates during second quarter 2004. The MVA at June 30, 2004 of $26.6 million was down $32 million (-55%) from year-end 2003 and was $59 million (-69%) lower than its level at the end of second quarter 2003, despite the increased size of the underlying portfolio.

Table 7: Investments

June 30, 2004 December 31, 2003 June 30, 2003 ------------------------ ------------------------ ------------------------ Amortized Amortized Amortized Cost/Book Market Cost/Book Market Cost/Book Market (000's omitted) Value Value Value Value Value Value ------------------------------------------------------------------------------- ------------------------ ------------------------ Held-to-Maturity Portfolio: U.S. Treasury securities and obligations of U.S. government corporations and agencies $127,563 $121,957 $127,635 $125,003 $0 $0 Obligations of state and political subdivisions 7,653 7,773 7,459 7,677 6,818 7,108 Other securities 3,577 3,577 3,558 3,558 3,559 3,559 ------------------------------------------------------------------------------- ------------------------ ------------------------ Total held-to-maturity portfolio 138,793 133,307 138,652 136,238 10,377 10,667 ------------------------------------------------------------------------------- ------------------------ ------------------------

Available-for-Sale Portfolio: U.S. Treasury securities and obligations of U.S. government corporations and agencies 637,166 646,271 456,913 479,454 356,392 389,910 Obligations of state and political subdivisions 543,574 555,393 443,930 470,210 403,837 440,359 Corporate securities 42,177 43,552 27,712 30,251 27,646 31,451 Collateralized mortgage obligations (CMO's) 82,003 84,205 89,566 93,552 163,951 170,819 Mortgage-backed securities 60,182 62,257 76,628 80,177 100,092 105,256 ------------------------------------------------------------------------------- ------------------------ ------------------------ Sub-total 1,365,102 1,391,678 1,094,749 1,153,644 1,051,918 1,137,795 Equity securities (1) 44,026 44,026 29,185 29,185 16,543 16,543 Federal Reserve Bank common stock 9,856 9,856 8,053 8,053 5,656 5,656 ------------------------------------------------------------------------------- ------------------------ ------------------------ Total available-for-sale portfolio 1,418,984 1,445,560 1,131,987 1,190,882 1,074,117 1,159,994 Net unrealized gain on available-for-sale portfolio 26,576 0 58,895 0 85,877 0 ------------------------------------------------------------------------------- ------------------------ ------------------------ Total carrying value $1,584,353 $1,578,867 $1,329,534 $1,327,120 $1,170,371 $1,170,661 ======================== ======================== ========================

Loans

As shown in Table 8, loans ended the first quarter at $2.3 billion, up $218 million (10.3%) year-to-date and $489 million (26%) higher than one year earlier. Most of the YTD and year-over-year increases in loan balances was attributable to acquisitions, which added $206 million to the loan portfolio in 2004 and $393 million over the last 12 months. Excluding the impact of acquisitions, total loans grew $12 million or 0.5% in the first half of 2004 and $96 million or 5.2% over the past year. All of the loan growth for both periods was produced in the consumer mortgage and consumer indirect lines of business. The organic loan growth for the six and 12-month intervals was generated in the New York markets, with declines in Pennsylvania. Over the last year the mix of loans has become more weighted towards consumer mortgages because of the strong growth in that segment, and business lending due to the high proportion of commercial loans in First Heritage's portfolio.

Table 8: Loans

(000's omitted) June 30, 2004 December 31, 2003 June 30, 2003 --------------------- -------------------- -------------------- ------------------- Consumer mortgage $780,550 33% $739,593 35% $545,828 29% Business lending 853,034 36% 689,436 32% 637,985 34% Consumer indirect 340,868 15% 325,241 15% 305,549 17% Consumer direct 372,283 16% 374,239 18% 368,653 20% --------------------- ------------------- ------------------- ------------------- Total loans $2,346,735 100% $2,128,509 100% $1,858,015 100% ===================== =================== =================== ===================

Total consumer mortgages increased $41 million in the first six months of 2004 and $235 million year-over year. Excluding the impact of acquisitions, consumer mortgages were up $20 million (2.7%) over the last two quarters and $112 million (21%) over the last year. The year-over-year growth rate would have been even higher had $14 million of longer-term mortgages not been sold in the secondary market in the third quarter of 2003. Volumes have slowed in the past six months as the record levels of refinancing activity that were driven by 40-year low mortgage rates in 2003 have diminished in a rising interest rate environment. The growth for both the six and 12-month time frames was derived principally from activity in the New York markets.

Business loans rose $164 million over the latest six months and were up $215 million from one year ago. All of the growth for both periods came from the loans acquired in the First Heritage transaction in May 2004. Excluding those loans, business lending was down $6 million or 0.9% from December 2003's level. Excluding the impact of all three bank acquisitions, business loans fell $23 million or 3.5% over the last 12 months. The New York markets were down year-over-year but increased over the past six months, while the Pennsylvania markets experienced declines over both periods. A relatively slow economic recovery in our primary markets, restricted capital spending by companies, competitive conditions and the desire to maintain solid asset quality standards have limited growth in certain of our markets. However, business loans continue to grow on an organic basis, as the sequential increase produced in the second quarter of 2004 was the highest it has been in two and a half years.

Consumer indirect loans, largely borrowings originated in automobile, marine and recreational vehicle dealerships, rose $16 million (4.8%) in the last six months and $35 million (11.6%) on a year-over-year basis. Only an immaterial amount of consumer indirect loans was added in the three bank acquisitions. Historically low interest rates, aggressive dealer and manufacturer incentives on new vehicles, and very competitive pricing on used vehicles have helped maintain solid growth in auto, boat and recreational vehicle sales over the last year. These market factors as well as the Company's addition of new originating dealers, strong relationships with current dealers and ability to offer competitive rates have contributed to 10 straight quarters of consumer indirect lending growth. Consumer indirect loans increased in both the New York and Pennsylvania markets during the six and 12-month time frames.

Consumer direct loans are comprised of installment loans, personal loans, student loans (which are sold once principal repayment begins) and variable and fixed rate home equity loans and lines of credit. This segment declined by $2 million in the first half of 2004 and was up $4 million from one year ago. Excluding loans added through acquisition, consumer direct loans were down $18 million (-4.8%) from year-end 2003 and declined $29 million (-7.9%) versus June 30, 2003. A certain amount of consumer installment and home equity loans continue to be paid off through conventional mortgage refinancings. Promotional rates, the reduction of rates on larger loans and marketing campaigns were initiated in the current quarter to promote new home equity volume, but extremely competitive conditions in this segment has made it difficult to grow this part of the loan portfolio at profitable yield levels. Total consumer direct loans were down for both periods in the New York and Pennsylvania markets.

Asset Quality

Table 9 below exhibits the major components of non-performing loans and assets and key asset quality metrics for the periods ending June 30, 2004 and 2003 and December 31, 2003.

Table 9: Non-performing Assets

(000's omitted) June 30, 2004 December 31, 2003 June 30, 2003 ------------------------------------------------------------ -------------- ------------------ -------------- Non-accrual loans $11,142 $11,940 $12,678 Accruing loans 90+ days delinquent 1,234 1,307 2,457 Restructured loans 856 28 30 ------------------------------------------------------------ -------------- ------------------ -------------- Total non-performing loans 13,232 13,275 15,165 Other real estate 1,044 1,077 943 ------------------------------------------------------------ -------------- ------------------ -------------- Total non-performing assets $14,276 $14,352 $16,108 ============================================================ ============== ================== ==============

Allowance for loan losses to total loans 1.37% 1.37% 1.48% Allowance for loan losses to non-performing loans 242% 219% 181% Non-performing loans to total loans 0.56% 0.62% 0.82% Non-performing assets to total loans and other real estate 0.61% 0.67% 0.87% Delinquent loans (30 days + to non-accruing) to total loans 1.50% 1.77% 1.79% Net charge-offs to average loans outstanding (quarterly) 0.26% 0.54% 0.57% Loan loss provision to net charge-offs (quarterly) 160% 113% 103%

As displayed in Table 9, non-performing assets at June 30, 2004 were $14.3 million, a decrease of $0.1 million versus year-end 2003 and $1.8 million below the level at the end of second quarter 2003. The improvement over the last six months was due to a reduction in installment 90+ day delinquencies and commercial non-accrual levels despite the addition of First Heritage's portfolio, contributing to a six-basis point drop in the ratio of non-performing assets to total loans. The decline in non-performing assets over the last year was primarily attributable to non-performing commercial loans falling by $2.0 million. This improvement combined with the substantial increase in the size of the loan portfolio resulted in the ratio of non-performing assets to total loans plus OREO to decline 26 basis points versus June 30, 2003 to 0.61%, reflecting an overall improvement in asset quality.

Non-performing loans were 0.56% of total loans outstanding at the end of the second quarter versus 0.62% at year-end 2003 and 0.82% at June 30, 2003. This ratio improved in comparison to year-end 2003 and one year ago due to the aforementioned positive developments in the commercial and installment portfolios over the last year. The Company's non-performing loan ratios for the second and first (0.66%) quarters of 2004 compared very favorably to the peer bank mean of 0.78% at the end of first quarter 2004. The allowance for loan loss to non-performing loans ratio, a general measure of coverage adequacy, was 242% at the end of the second quarter, up from the coverage ratios of 219% at year-end 2003 and 181% at June 30, 2003.

Delinquent loans (30 days through non-accruing and restructured loans) as a percent of total loans was 1.50% at the end of the second quarter, its lowest level since first quarter 2001. This ratio improved 27 basis points in comparison to year-end 2003 and 29 basis points versus June 30, 2003. The reduction of the delinquency ratio from its level six months ago was driven by the non-performing loan improvements discussed above as well as significant declines in installment and real estate loans 30 to 89 days past due. The decrease in the delinquency ratio in comparison to one-year earlier was again attributable to commercial loans, which experienced a decline in loans 30 to 89 days delinquent in addition to the improved non-performing metrics. As of March 31, 2004, the median peer bank delinquency ratio of 1.57% was seven basis points above the Company's second quarter ratio and eight basis points lower than its ratio at that time.

Table 10: Allowance for Loan Loss Activity

Three Months Ended June 30, Six Months Ended June 30, ---------------------------- ---------------------------- (000's omitted) 2004 2003 2004 2003 ---------------------------------------------------------- ---------------------------- ---------------------------- Amount of loans outstanding at end of period $2,346,735 $1,858,015 $2,346,735 $1,858,015 Daily average amount of loans (net of unearned discount) $2,222,827 $1,834,610 $2,167,108 $1,821,323

Allowance for loan losses at beginning of period $28,821 $27,350 $29,095 $26,331 Charge-offs: Business lending 613 1,522 1,732 2,702 Consumer mortgage 34 46 130 87 Consumer direct 686 701 1,444 1,388 Consumer indirect 1,154 980 2,205 2,054 ---------------------------------------------------------- ---------------------------- ---------------------------- Total charge-offs 2,487 3,249 5,511 6,231 Recoveries: Business lending 437 56 579 122 Consumer mortgage 10 4 22 8 Consumer direct 187 189 371 405 Consumer indirect 415 394 777 709 ---------------------------------------------------------- ---------------------------- ---------------------------- Total recoveries 1,049 643 1,749 1,244 ---------------------------------------------------------- ---------------------------- ---------------------------- Net charge-offs 1,438 2,606 3,762 4,987 Provision for loan losses 2,300 2,673 4,350 6,073 Allowance on acquired loans 2,357 0 2,357 0 ---------------------------------------------------------- ---------------------------- ---------------------------- Allowance for loan losses at end of period $32,040 $27,417 $32,040 $27,417 ========================================================== ============================ ============================

Net charge-offs to average loans outstanding 0.26% 0.57% 0.35% 0.55%

As displayed in Table 10, net charge-offs during the second quarter were $1.4 million, $1.2 million less than the equivalent 2003 period, driven by significant declines in the business lending segment. This decrease occurred despite a $388 million increase in average loan balances, and resulted in a 31-basis point drop in the net charge-off ratio (net charge-offs as a percentage of average loans outstanding) to 0.26%, its lowest quarter-end level in more than four years. On a year-to-date basis net charge-offs were down $1.2 million versus the prior year period, while average loans were up $346 million for the same period, resulting in a 20-basis point decline in the YTD net charge-off ratio to 0.35%. Lower business loan net charge-offs were again the main contributor to this substantial improvement, reflecting strengthening economic conditions and the effectiveness of increased credit risk management resources. The increased proportion of comparatively low-risk consumer mortgages in the loan portfolio (35% of total average loans in first half of 2004 versus 29% one year earlier) also helped reduce the overall level of charge-offs in relation to total average loan balances.

The business lending net charge-off ratio for the quarter declined 84 basis points versus prior year to 0.09%, and on a year-to-date basis was down 50 basis points to 0.32% of average business loans. The second quarter consumer indirect net charge-off ratio was up 11 basis points versus the same quarter of 2003 to 0.90%, but the June YTD ratio of 0.88% improved by five basis points in comparison to prior year. The consumer direct net charge-off ratio of 0.55% for the quarter was equal to the year earlier period and the ratio of 0.59% for the first half of 2004 was up six basis points versus the same time interval last year. The net charge-off ratio for consumer mortgages was 0.01% and 0.03% for the second quarter and first six months of 2004, respectively, in line with the equivalent periods of 2003. This ratio has averaged only 0.04% of average consumer mortgage balances over the last eight quarters.

A required loan loss allowance of $32.0 million was determined as of June 30, 2004, resulting in a $2.3 million loan loss provision for the quarter compared to $2.7 million one year earlier. The second quarter loan loss provision was $0.9 million higher than net charge-offs mainly due to the additional allowance needed to cover the $35 million of organic loan growth in the quarter, the downgrade of risk ratings on certain business loans, and an increase in the historical loss factors for installment loans. The loan loss provision for the first half of 2004 of $4.4 million was down $1.7 million or 28% versus the prior year, driven by the overall improvement in asset quality. The allowance for loan losses rose $4.6 million or 17% over the last 12 months, versus a 26% increase in loans outstanding. Consequently, the ratio of allowance for loan loss to loans outstanding declined 11 basis points to 1.37%. The reduction in this ratio reflects a higher proportion of high-credit quality consumer mortgages in the loan portfolio and improving trends in net charge-off, non-performing and delinquency ratios.

Deposits

As shown in Table 11, average deposits of $2.9 billion in the second quarter were up $224 million compared to fourth quarter 2003 and increased $341 million versus the same quarter of last year. Deposits of $212 million were added in the second quarter as a result of the acquisition of First Heritage, and approximately $249 million of deposits were acquired in conjunction with the Peoples and Grange transactions in the second half of 2003. Excluding the impact of these acquisitions, average deposits for the quarter were down approximately 1% from their level in the second and fourth quarters of 2003.

Over the past year the deposit mix continued to shift towards demand deposits and more liquid interest-bearing deposits (interest checking and savings accounts). This shift in deposit mix may have reflected customers' unwillingness to be locked into CD rates for extended periods of time and hold money in accounts with higher minimum balance requirements at low interest rates, especially given the diminished interest rate spread between these accounts and shorter-term or less restrictive interest-bearing accounts. The greatly reduced opportunity cost of holding money in non-interest and low-interest bearing accounts contributed to the average balances for demand deposit, interest checking and savings accounts increasing to 48% of total deposits in second quarter 2004 versus 45% in the same quarter last year. This shift in mix, combined with CDs being rolled over at lower interest rates and periodic reductions of other interest-bearing deposit rates, helped drive down the second quarter cost of deposits by 39 basis points on a year-over-year basis.

Excluding the impact of acquisitions, average IPC (individuals and businesses) deposits in the current quarter decreased 1.8% from fourth quarter 2004's level and 1.7% from one year ago. This mostly reflects the competitive conditions in our primary markets and the relative attractiveness of alternative funding sources. Average second quarter public funds deposits were up 9.1% and 15% and from the second and fourth quarters of 2003, respectively, excluding acquired deposits. On a total deposit basis, however, this funding source only accounted for 6.7% of average deposits in second quarter 2004, comparable to the ratio one year earlier, in part due to the minimal amount of public funds held by the three banks acquired by the Company over the last year.

Table 11: Average Deposits

Three Months Ended
June 30, December 31, June 30, (000's omitted) 2004 2003 2003
Demand deposits $550,683 $505,015 $456,176 Interest checking deposits 301,509 283,752 269,110 Savings deposits 516,507 448,064 425,580 Money market deposits 304,451 300,558 289,863 Time deposits 1,197,563 1,109,350 1,088,845
Total deposits $2,870,713 $2,646,739 $2,529,574

IPC deposits $2,678,002 $2,485,165 $2,362,357 Public fund deposits 192,711 161,574 167,217
Total deposits $2,870,713 $2,646,739 $2,529,574

Borrowings

At the end of the first quarter, borrowings of $933 million increased $265 million from December 31, 2003 and were up $533 million from the June 30, 2003 level. The increases over both the six and 12-month periods were dictated by organic loan growth, investment security purchases and organic deposit declines. In the first half of 2004 short-term borrowings increased $96 million and long-term borrowings were up $169 million. Over the last 12 months, short-term borrowings increased $389 million and long-term borrowings rose by $144 million. A higher proportion of short-term borrowings has been utilized in comparison to one year ago due to the significant amount of longer-term, core deposits added through acquisitions, to take advantage of an unusually steep yield curve, to reduce the Company's sensitivity to falling interest rates and to provide more flexibility with regard to altering future debt levels. The percentage of long-term borrowings increased in the current quarter due to the addition of a substantial amount of eighteen month FHLB borrowings that were used to fund securities purchases. These borrowings still carry relatively short maturities and help provide funding cost stability for a period of time that is complementary to our asset/liability profile.

Shareholders' Equity

At a special meeting of the shareholders held on March 26, 2004, the shareholders approved an amendment to the certificate of incorporation of the Company to increase the number of authorized shares of common stock from 20 million to 50 million shares. This amendment was adopted in connection with the previously announced two-for-one stock split of the Company's common stock. The split was effected in the form of a 100% stock dividend that was paid on April 12, 2004 to shareholders of record as of March 17, 2004.

The Company announced on May 21, 2004 that its Board of Directors had approved the continuation of a stock repurchase program previously announced on June 9, 2003. The program provides for the purchase of up to 1,400,000 of its shares, which may be repurchased from time to time, in open market or privately negotiated transactions over the course of the subsequent 12 months. All reacquired shares will become treasury shares and will be used for general corporate purposes. As of the end of the second quarter, 1,119,287 shares had been repurchased through this program at an aggregate cost of $23.9 million and an average price per share of $21.31.

Total common shares of 30.6 million were outstanding as of June 30, 2004, up 2.3 million from year-end 2003 and 4.6 million higher than the level at the end of second quarter 2003. The increase over the last twelve months was comprised of 4.9 million shares issued in conjunction with the Grange and First Heritage acquisitions and 0.7 million shares issued through the employee stock plan, partially offset by 1.0 million of treasury stock purchases.

Total shareholders' equity equaled $441 million at the end of the second quarter, $37 million higher than the balance at December 31, 2003. This increase consisted of $55 million of common stock and options issued in the First Heritage acquisition, net income of $23 million and $3 million from shares issued under the employee stock plan, partially offset by a $20 million decline in the after-tax investment market value adjustment (a component of other comprehensive income), treasury stock purchases of $15 million and dividends declared of $9 million. Over the past 12 months total shareholders' equity increased by $90 million as shares issued in the Grange and First Heritage acquisitions and employee stock plan and capital growth from net income more than offset declines caused by a drop in the market value adjustment, dividends declared and treasury stock purchases.

The Company's Tier I leverage ratio, a primary measure of regulatory capital for which 5% is the requirement to be "well-capitalized," was 6.98% at the end of the second quarter, down 28 basis points from year-end 2003 and 79 basis points lower than its level one year ago. These declines were primarily caused by the treasury share purchases made over the last 12 months and increased investment levels prompted by a more favorable interest rate environment. The tangible equity-to-assets ratio declined 60 basis points versus year-end 2003 and was down 1.7 percentage points in comparison to June 30, 2003. A decline in the market value adjustment due to a significant rise in interest rates in the current quarter was the primary driver of the drop in this ratio in addition to the factors discussed above. The decline in the tangible equity-to-assets ratio was more pronounced than that of the Tier I leverage ratio primarily because the market value adjustment component of equity is excluded from that regulatory ratio.

The dividend payout ratio (dividends declared divided by net income) for the first half of 2004 was 40.8%, up 3.0 percentage points from one year ago. The ratio rose because dividends declared increased 26%, higher than the 17% growth in net income. The rise in dividends declared was caused by shares outstanding increasing 18%, mostly attributable to the Grange and First Heritage acquisitions, and dividends per share being raised 10.3% in third quarter 2003, from $0.145 to $0.160.

Liquidity

Management of the Company's liquidity is critical due to the potential for unexpected fluctuations in deposits and loans. Adequate sources of both on and off-balance sheet funding are in place to effectively respond to such unexpected fluctuations.

The Bank's primary approach to measuring liquidity is known as the Basic Surplus/Deficit model. It is used to calculate liquidity over two time periods:
first, the amount of cash that could be made available within 30 days (calculated as liquid assets less short-term liabilities); and second, a projection of subsequent cash availability over an additional 60 days. The minimum policy level of liquidity under the Basic Surplus/Deficit approach is 7.5% of total assets for both the 30 and 90-day time horizons. As of June 30, 2004, this ratio was 14.6% for both time periods, excluding the Company's capacity to borrow additional funds from the Federal Home Loan Bank.

To measure longer-term liquidity, a baseline projection of loan and deposit growth for five years is made to reflect how current liquidity levels could change over time. This five-year measure reflects adequate liquidity to fund loan and other asset growth over the next five years.

Forward-Looking Statements

This document contains comments or information that constitute forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995), which involve significant risks and uncertainties. Actual results may differ materially from the results discussed in the forward-looking statements. Moreover, the Company's plans, objectives and intentions are subject to change based on various factors (some of which are beyond the Company's control). Factors that could cause actual results to differ from those discussed in the forward-looking statements include: (1) risks related to credit quality, interest rate sensitivity and liquidity; (2) the strength of the U.S. economy in general and the strength of the local economies where the Company conducts its business; (3) the effect of, and changes in, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System; (4) inflation, interest rate, market and monetary fluctuations;
(5) the timely development of new products and services and customer perception of the overall value thereof (including features, pricing and quality) compared to competing

products and services; (6) changes in consumer spending, borrowing and savings habits; (7) technological changes; (8) any acquisitions or mergers that might be considered or consummated by the Company and the costs and factors associated therewith; (9) the ability to maintain and increase market share and control expenses; (10) the effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) and accounting principles generally accepted in the United States; (11) changes in the Company's organization, compensation and benefit plans and in the availability of, and compensation levels for, employees in its geographic markets; (12) the costs and effects of litigation and of any adverse outcome in such litigation;
(13) other risk factors outlined in the Company's filings with the Securities and Exchange Commission from time to time; and (14) the success of the Company at managing the risks of the foregoing.

The foregoing list of important factors is not exclusive. Such forward-looking statements speak only as of the date on which they are made and the Company does not undertake any obligation to update any forward-looking statement, whether written or oral, to reflect events or circumstances after the date on which such statement is made. If the Company does update or correct one or more forward-looking statements, investors and others should not conclude that the Company would make additional updates or corrections with respect thereto or with respect to other forward-looking statements.