Community Financial System, Inc. Q2 FY2020 Earnings Call

Welcome to Community Bank System Second Quarter 2020 Earnings Conference Call. Please note that this presentation contains forward-looking statements within the provisions of the Private Securities Litigation Reform Act of 1995 that are based on current expectations, estimates and projections about the industry, markets and economic environment in which the company operates. Such statements involve risks and uncertainties that could cause actual results to differ materially from the results discussed in these statements. These risks are detailed in the company's Annual Report and Form 10-K filed with the Securities and Exchange Commission. Today's call presenters are Mark Tryniski, President and Chief Executive Officer; and Joseph Sutaris, Executive Vice President and Chief Financial Officer. They will all be joined by Joseph Serbun, Executive Vice President and Chief Banking Officer for the question-and-answer session. Gentlemen, you may begin.

Thank you, Cole. Good morning everyone and thank you all for joining our Q2 conference call. We hope all of you and your families are well. Like most banks, we had a busy quarter that revolved around PPP, loan deferrals and, for us, an acquisition as well. We provided nearly $500 million of PPP loans for our customers and granted $700 million of deferrals. One of the most significant impacts for the quarter was the change in our balance sheet which grew by over $1.6 billion from a combination of PPP, the Steuben acquisition and significant stimulus-induced deposit growth. Not surprisingly, organic loan growth was negative for the quarter. Despite granting $700 million of loan deferrals over the past two quarters, total active deferrals as of Friday were down to $150 million and requests for a second deferral have been very limited, which we hope is good news for the future. We're certainly starting from a very good point given current credit metrics, but don't expect to necessarily sustain these levels as we move into the second half of the year. Operating earnings were actually pretty good for the quarter as Joe will discuss in further detail with operating PPNR up from both this last quarter and last year's Q2. Encouragingly, our benefits, wealth and insurance businesses are all up year-to-date over last year on both a revenue and earnings basis. The Steuben acquisition closed on June 15, with the conversion and integration going nearly flawlessly. We were excited about this in-market transaction and the further strengthening of our Western New York footprint. Loan and deposit retention have both been almost 100% and we got three consolidations done there already. So, we're off to a very good start. Looking forward to the remainder of the year and into 2021, it's all about three things in my view: credit, the economic environment and interest rates. It's too early to forecast this credit cycle, but we should get more visibility in the second half of the year. We're starting from a position of strength, not just with respect to credit, but also as it relates to earnings, capital and liquidity. The economic environment is equally subject to uncertainty, but we did see significant improvement in consumer activity in the last half of the quarter. The question for me is not just the near-term challenges and severity, but more the longer-term impact on consumer and business behavior and the ultimate demand for financial products and services. And we all know the current interest rate environment has the potential to create continued margin challenges going forward. It's hard to predict whether stimulus or inflation will ultimately prevail, but the current rate environment will make it increasingly more difficult for banks to deliver earnings growth. Despite these forward uncertainties and challenges, I think CBSI is in extremely good stead. As I said last quarter, there is no substitute for earnings, liquidity, capital, asset quality, core deposits and revenue diversification. When I look at the fundamental financial strength of this company, I remain highly confident that we are well prepared to manage the challenges that lie ahead and to capitalize on the opportunities that are created as a result. Joe?

Thank you, Mark, and good morning, everyone. As Mark noted, the earnings results for the second quarter of 2020 were solid in spite of the challenges related to the COVID-19 pandemic. The company recorded $0.66 in fully diluted GAAP earnings per share for the second quarter, excluding $0.05 per share for acquisition-related expenses, net of tax, and $0.05 per share for acquisition-related provision for credit losses, net of tax, due to the Steuben acquisition. Fully diluted operating earnings per share were $0.76 for the quarter. These results were $0.04 per share lower than the second quarter of 2019 operating earnings per share of $0.80 due largely to the COVID-19 pandemic and its related impacts on the company's operations. The Company recorded $6.6 million in its provision for credit losses, exclusive of acquisition-related provision, in the second quarter of 2020, reflective of expected credit losses due to weak economic conditions. The company's adjusted pretax pre-provision net revenue increased $0.05 per share or 4.9% between comparable annual quarters and $0.03 or 2.9% on a linked quarter basis. I will next touch on the Steuben acquisition and the company's balance sheet before providing additional details on the company's earnings performance for the quarter. On June 12, 2020, the company acquired Steuben Trust Corporation and its banking subsidiary Steuben Trust Company for a combination of stock and cash, representing total consideration valued at approximately $98.6 million. The acquisition extended the company's footprint into two new counties in Western New York State and enhanced the company's presence in four Western New York State counties in which it currently operates. In connection with the acquisition, the company consolidated three former Steuben branch offices into existing Community Bank branch offices, and added 11 additional full-service offices to its current network. The company acquired total deposits of $516.3 million and total loans of $339.7 million in connection with the transaction. The company closed the second quarter of 2020 with total assets of $13.44 billion. This is up $1.64 billion or 13.8% from the end of the linked first quarter and up $2.7 billion or 25.1% from a year earlier. The very large increase in total assets over the last 12 months was driven by the third quarter of 2019 acquisition of Kinderhook Bank Corp., the second quarter of 2020 acquisition of Steuben, large inflows of government stimulus-related funding, PPP originations, and other organic balance sheet growth. Similarly, average interest-earning assets for the second quarter of 2020 of $11.1 billion was up $1.07 billion or 10.6% from the linked quarter of 2020 and up $1.68 billion or 17.8% from one year prior. Ending loans at June 30, 2020 were $7.53 billion. This was up $661.9 million or 9.6% from the end of the first quarter and up $1.24 billion or 19.8% when compared to June 30, 2019. The company acquired $339.7 million of loans in the Steuben acquisition and originated $492.4 million of PPP loans. Exclusive of these activities, the company’s outstanding loan balances decreased $170.2 million or 2.5% during the quarter due largely to a significant slowdown in business activity and the pandemic-related shutdown of non-essential businesses in the company's Northeast markets. At June 30, 2020, the carrying value of the company's available-for-sale investment securities portfolio is $3.29 billion. This includes net unrealized gains of $163.1 million, up from $155.3 million in net unrealized gains at March 31, 2020 and $36.3 million in net unrealized gains a year earlier. The effective duration of the company's investment securities portfolio is 3.3 years at June 30, 2020. The company maintained average cash equivalents during the second quarter of 2020 of $823 million. This is up $708.3 million or 618% over the linked first quarter and $488.7 million or 146% over the second quarter of 2019. The very large increase in cash equivalent balances was due to large inflows of government stimulus funding driving up the company's deposit liabilities, which in turn were invested in overnight fed funds at an average yield of 10 basis points during the quarter. The very large increase in cash equivalents during the quarter placed a significant drag on the company’s net interest margin and return on asset metrics in the second quarter. Average total deposits were up $1.05 billion or 11.6% on a linked quarter basis due to Steuben and stimulus and $1.61 billion or 19% over the same quarter last year due to Steuben, stimulus and Kinderhook. As Mark noted, we believe the company's capital reserves and liquidity along with diversifying revenue streams, a strong credit record and experienced management team leave us well prepared to endure the impacts of the COVID-19 pandemic. The company's net tangible equity to net tangible assets ratio was 10.08% at June 30, 2020. This was down from 10.78% at the end of the first quarter and 10.56% from one year earlier due primarily to a significant increase in assets. The company's Tier 1 leverage ratio was 10.79% at the end of the second quarter, which remains over two times the well capitalized regulatory standard of 5%, while the Tier 1 risk-based capital ratio, total risk-based capital ratio and common equity Tier 1 capital ratios were 17.1%, 18.0% and 16.1%, respectively, reflective of the company's lower risk asset base and high levels of regulatory capital. The company has an abundance of liquidity and resources and is extremely well-positioned to fund future loan growth. The company's funding base is largely comprised of low-cost deposits. At June 30, 2020, checking and savings accounts represented 71.7% of the company's total deposit base. The company's cash and cash equivalents net of float and reserves totaled $1.25 billion at June 30. Total borrowing availability at the Federal Reserve Bank was $259.8 million and total borrowing capacity at the Federal Home Loan Bank was $1.8 billion. The available-for-sale investment securities portfolio was valued at $3.29 billion, $1.62 billion of which was available for pledging if needed. In total, these sources of immediate liquidity exceeded $4.9 billion. The company recorded total operating revenues of $144.9 million in the second quarter of 2020. This represents a $0.8 million or 0.5% increase over the second quarter of 2019, excluding net gains on securities of $4.9 million. A $3.7 million or 4.1% increase in net interest income between comparable quarters was partially offset by a $2.8 million or 16.5% decrease in banking non-interest revenues and a slight decrease in financial services business revenues. The increase in net interest income was due to a $1.7 billion or 17.8% increase in average earning assets between the periods, offset in part by a 43 basis point decrease in net interest margin. A decrease in market interest rates and a significant change in the composition of earning assets, including a $488.7 million increase in average cash equivalents between the periods, negatively impacted the company's net interest margin. Total revenues were down $3.8 million or 2.5% on a linked quarter basis. The company recorded a $4.3 million or 24.7% decrease in deposit service revenues, and a $1.9 million or 4.8% decrease in financial services business revenues between the linked quarters, offset in part by a $1.9 million or 2.1% increase in net interest income and a $0.5 million or 50% increase in mortgage banking revenues. Interest income and fees on loans was up $4.7 million or 6.3% over the comparable prior year quarter due to a $924.7 million or 14.7% increase in average total loans outstanding and $2.9 million of PPP-related interest and fee income, partially offset by a 33 basis point decrease in the average loan yield. The increase in average outstanding loan balances was due to the Kinderhook acquisition in the third quarter of 2019, pre-COVID organic loan growth, the Steuben acquisition in the second quarter of 2020, as well as a significant increase in business lending due to $492.4 million of PPP loan originations during the quarter. Interest income on investments, including cash equivalents, decreased $1.8 million or 8.9% between the second quarter of 2019 and the second quarter of 2020. The decrease is reflective of lower market interest rates, a significant increase in the proportion of low-yield cash equivalent balances and a $0.8 million decrease in the company's Federal Reserve Bank semi-annual dividend payment, offset in part by a $265.2 million or 9.5% increase in the average book value of investment securities. Interest expense was $0.8 million or 13.4% lower than the previous year second quarter, driven by a nine basis point decrease in the cost on interest-bearing liabilities, partially offset by a $971.9 million or 15% increase in average interest-bearing liabilities. The average cost of deposits was 17 basis points in the second quarter of 2020 as compared to 22 basis points in the second quarter of 2019, reflective of market-driven rate decreases for deposits between the periods and significant increases in non-interest-bearing deposits. By comparison, the average cost of deposits during the linked first quarter of 2020 was 25 basis points. The company recorded $9.8 million in the provision for credit losses during the second quarter of 2020. This was comprised of $3.2 million of acquisition-related provision due to the Steuben transaction and $6.6 million of provision related to expected credit losses largely due to the COVID-19 pandemic. Net charge-offs for the quarter were $0.9 million. This compares to $1.4 million in the provision for credit losses and $1.2 million in net charge-offs recorded during the second quarter of 2019. On a linked quarter basis, the provision for credit losses, exclusive of the acquisition-related provision, increased $1 million due to weaker economic forecasts and the continued financial hardship experienced by certain segments of the company’s loan customers. The company recorded $52.9 million in non-interest revenues in the second quarter of 2020 as compared to $55.8 million in the second quarter of 2019, excluding $4.9 million of investment security gains. This represents a $2.8 million or 5.2% decrease in non-interest revenues between the periods, $2.7 million of which is attributable to a decrease in banking-related non-interest revenues. The significant decrease in banking non-interest revenues was due to a $4 million decrease in deposit service and other banking revenues, offset in part by a $1.2 million increase in mortgage banking revenue. The decrease in deposit service and other banking revenues was driven by a precipitous drop in deposit transaction activity due to mandated shutdowns of non-essential businesses in the company's Northeast markets during the quarter. Employee benefits service revenues for the second quarter of 2020 were $0.3 million or 1.2% higher than the prior year second quarter due to increases in plan administration, record keeping and actuarial services. Insurance services and wealth management revenues were down $0.4 million or 2.4% from the same quarter last year. Total non-interest revenues decreased $5.7 million or 9.7% on a linked quarter basis. This was driven by a $4.3 million or 24.7% decrease in deposit service and other banking revenues, a $1.3 million or 5.1% decrease in employee benefit service revenues and a $0.7 million or 10.8% decrease in wealth management revenues, partially offset by a $0.5 million or 50% increase in mortgage banking revenue and a slight increase in insurance service revenues. Excluding acquisition expenses, operating expenses decreased $2.5 million or 2.7% from $90 million in the second quarter of 2019 to $87.5 million in the second quarter of 2020. The decrease in operating expenses between the periods was largely attributable to decreased levels of business activities due to the COVID-19 pandemic. Business development and marketing expenses decreased $1.6 million or 52.1% between the periods. Other expenses decreased $2.1 million or 33.6%, driven largely by decreases in employee business expenses. Salaries and employee benefits expenses increased $0.7 million or 1.3%, but benefited from a $0.8 million or 21% decrease in employee medical expenses due to reduced provider utilization. On a combined basis, data processing and communications expenses, legal and professional expenses and occupancy and equipment expense increased $0.9 million or 4.2% between the comparable quarterly periods. Intangible asset amortization expense decreased $0.4 million or 9.7% between the periods. On a linked quarter basis, total operating expenses, excluding acquisition expenses, decreased $5.8 million or 6.2%, primarily due to a $3.6 million or 6.1% decrease in salaries and employee benefits, a $1 million or 9.2% decrease in occupancy and equipment expense and a $1 million or 40.2% decrease in business development and marketing expenses. The effective tax rate for the second quarter of 2020 was 20.3%, up from 20.2% in the second quarter of 2019 and 18.8% in the linked first quarter of 2020. From a credit risk and lending perspective, the company has taken actions to identify and assess its COVID-19 related credit exposures based on asset class and borrower type. With respect to the company's lending activities, the company implemented a customer forbearance program to assist both consumer and business borrowers that may be experiencing financial hardship due to COVID-19 related challenges. At June 30, 2020, approximately $700 million or 9.3% of the company's outstanding loan balances were under active COVID-related forbearance. As of last week, the outstanding loan balance under active forbearance dropped below $150 million. The company anticipates at the end of the third quarter the number of active forbearance agreements will decrease further, but the number and amount of delinquent loans will likely rise. At June 30, 2020 non-performing loans decreased to 0.36% of total loans outstanding. This compares to 0.39% of total loans outstanding at the end of the second quarter of 2019 and 0.46% at the end of the linked first quarter of 2020. Total delinquent loans, which includes non-performing loans and loans 30 or more days delinquent to total loans outstanding, were 0.72% at the end of the second quarter of 2020. This compares to 0.87% at the end of the second quarter of 2019 and 1.1% at the end of the linked first quarter of 2020. The delinquency status for loans on payment deferment due to COVID-19 financial hardship reported at June 30, 2020, based on their delinquency status at the end of the first quarter and subsequent to March 31, 2020, indicated the borrower made all required past due payments to bring the loan to current status. The company's allowance for credit losses increased from $55.7 million or 0.81% of total loans outstanding at March 31, 2020 to $64.4 million or 0.86% of total loans outstanding at June 30, 2020. The $8.7 million increase in the allowance for credit losses included $3.6 million in additional reserves due to the Steuben acquisition and $5.1 million primarily due to expected COVID-19 pandemic-related losses. The allowance for credit losses at June 30, 2020 represented approximately 10 times the company's trailing 12 months net charge-offs. Looking forward, operationally, we will continue to adapt to the changing market conditions and remain very focused on asset quality and credit loss mitigation. We anticipate assisting the substantial majority of the company's PPP borrowers with forgiveness requests during the third and fourth quarters of 2020; the eligibility of the borrowers' forgiveness requests and the SBA's ability to provide loan forgiveness in a timely manner is uncertain at this time. For these reasons, it is uncertain as to the timing for which the company's remaining $13.1 million in net deferred PPPs will be recognized through the income statement. It seems likely that the pandemic will continue to negatively impact the level of business activity and employment. These factors will continue to adversely affect certain borrowers' ability to service debt and may increase loan delinquency and credit loss levels for the remaining two quarters of 2020 and potentially beyond. Loan demand may be impaired by weak economic conditions. We're also uncertain as to whether or not the high level of deposit liabilities will be maintained, spent down or increased further by additional stimulus. We do expect the company's deposit service revenues to increase slightly in the third quarter, barring another shutdown of non-essential businesses in the company's market footprint. Although we will remain focused on containing operating expenses, it is likely that they will increase in the third quarter as the company has resumed certain marketing and business development endeavors. The company's dividend capacity remains strong. The company expects to continue to pay a quarterly dividend consistent with past practice. Undoubtedly, the COVID-19 crisis has changed the near-term outlook for society in general, as well as the expectations around economic conditions. With this said, we will continue to support our stakeholders in a thoughtful, disciplined and compassionate manner. I believe the company is well prepared to endure the effects. Thank you. I'll turn it back to our host to open the line for questions.

Thank you. We will now begin the question-and-answer session. And our first question today will come from Alex Twerdahl with Piper Sandler. Please go ahead.

Hey, good morning guys.

Good morning, Alex.

Good morning, Alex.

First question, just on the additional reserve build this quarter. Was that mostly driven by just a change in the economic scenario inputs to the model? Or was there any portion of it that was actually related to any loan downgrades in the second quarter?

Alex, that's a good question. Most of the reserve build was really due to changing economic conditions and continued challenges with the economic forecast as we look ahead. But we also tried to estimate what would happen to delinquency given the level of deferrals, which is a non-economic qualitative factor. We have seen some modest migration in risk ratings, but not significant yet. We expect that in the third and fourth quarters we'll continue to see some migration downward relative to risk ratings and probably higher levels of delinquency. We'll continue to monitor that and monitor our customers to determine any additional provision requirements in the third and fourth quarters.

Okay. Thanks. And then I appreciate all the additional color that you guys provided in this accompanying slide presentation on some of the more at-risk portfolios. But I was wondering if you can just kind of help us all on the line understand where your economies are in Upstate New York in terms of reopening. And then as you look at some of the higher categories on that list of risk, the retail and the lodging, if you have any sense for the utilization of some of these properties right now so we can get a better sense for where the risks or the things we should be focusing on in terms of credit will be?

Alex, it's Mark. I would say broadly, and I'll ask Joe Serbun to comment with more detail, that our markets have generally had lower infection rates across almost all our markets, which has been a help for us because they're less metropolitan. Most of our markets are open for business, except for certain high-risk businesses still like gyms and bowling alleys and some other things. But most are open, which has been good. Clearly, the trend in activity is directly tied to economic activity, such as debit swipes. We can pretty clearly see when we had the lockdown across most of our markets, which was in April, the debit activity took an enormous hit, as did overdrafts. But then it recovered pretty nicely when things started to open back up. It's hard to predict right now. Everything looks pretty good. The credit metrics are good. The fact that our deferrals went from $700 million to $150 million and that we've had very few requests for second deferrals was surprising and encouraging; we'll address second deferral requests on a case-by-case basis. When you look at some of the at-risk portfolios, like retail, a lot of it is essential businesses that have reopened, so I'm cautiously optimistic about some of the credit. The lodging portfolio is probably one that is a little more at risk for us. It's one of the larger sub-sectors where we've seen a higher percentage of deferral requests. However, if you look at our lending structure in terms of equity and the fact that occupancy rates in the hotel industry have been coming back, that helps. Joe, can you comment on the lodging portfolio and what we're seeing on deferral requests?

Yeah.

Let me touch on both portfolios. On the retail portfolio, particularly the non-owner occupied CRE, to put some context around it: the top 10 clients make up approximately $60 million or 41% of the total $900 million non-owner occupied portfolio. Much of that has national or regional tenants. These are not malls; these are large properties with multiple stores and their own entrances. LTVs for the top 10 range from about 40% on the low end to 79% at the high end, with an average around the low 70s — so there's nice diversification from a loan-to-value perspective. What we don't know is the long-term impact of online shopping and whether that will continue to reduce physical store traffic. On hospitality, as Mark said, it is our largest impacted category: lodging represents 53% of the total impacted dollars and retail represents 25% of the impacted dollars. So, about 75% of the impacted dollars are those two portfolios. The number of loans impacted is 23% for lodging and 21% for retail. We're keenly focused on those two portfolios. The deferrals that came in first and the requests for second deferrals are primarily hospitality properties. We're handling them one at a time. For the second round deferrals, about 50% received a principal-and-interest deferral, almost 10% will be making a modified principal-and-interest payment, and the remaining roughly 40% will be making interest-only payments. So a good percentage — 50% — will be making some level of payment, whether interest or modified principal and interest, and the other ~50% are in full P&I deferral. Regarding credit quality, in the first round if a borrower wasn't a past credit issue, we did not downgrade them and we didn't move many credits on that first go-around. We're looking harder in the second round and are moving the risk ratings on credits where appropriate.

And to add, if you look at the lodging portfolio, the current loan-to-value on that portfolio is about 55%. These are, for the most part, good developers with solid brands. I don't lose any sleep over where we'll end up in our lodging portfolio.

Great. That was a very helpful answer. And then just a final question for me. Can you remind us what your dividend policy is? Obviously, you've got plenty of coverage today. But remind us where the policy is and your willingness to continue increasing it on an annual basis, especially if the revenue environment continues to be challenged.

Sure. We think the dividend is important, and it's important to be balanced in that dividend. We don't want to upset the balance between return to shareholders and capital retention to use in the business. It's important that earnings grow over time so that you can grow the dividend, because you can't just raise the dividend without growing earnings. We've raised the dividend every year for about 27 or 28 years. We're biased toward growing the dividend, but also mindful of the balance between capital retention and return to shareholders.

But I guess said another way, would you be willing to raise the dividend for a year or two even in an environment where revenues and earnings could be going down given how comfortable you are with your capital position today? Is that a fair way to think about it?

It may be a fair way to look at it. It's difficult to predict because it depends on where credit results end up, what happens with margin and the interest rate environment, and potential changes to tax rates. We'll take all of those things into consideration before the Board makes judgments on the dividend. Ideally we'd like the payout ratio to be in the 40% to 60% range, with a bias toward the middle of that range. Over time, various events — tax changes, M&A, or other operating things — could impact earnings. Our preference is to continue to raise the dividend when sensible, but if we saw severe storm clouds on the horizon we would consider adjustments in the short term. So 40% to 60% is a reasonable range with a bias toward growing it if we can do so prudently.

Thank you for taking my questions.

Thank you, Alex.

Thanks, Alex.

And our next question comes from Erik Zwick with Boenning & Scattergood. Please go ahead.

Good morning, guys.

Good morning, Erik.

Good morning, Erik.

First, I wanted to start with a couple follow-ups on the lodging portfolio, and I appreciate the detail you gave there. Curious, can you give us a sense of the distribution of primary uses, either business or recreation, for that portfolio and any insight into current occupancy rates across the portfolio?

Erik, occupancy rates are improving but still not where they need to be. By and large, they are in the mid-30% to 40% range. Whether that's driven by business or leisure travel varies property by property. Anecdotally, destination-type properties are seeing a pickup over the last couple of weeks as people get more comfortable with the pandemic and wear masks. Properties that keep their properties clean and sanitized are seeing better results. Destination markets are seeing a larger pickup than more business-focused properties, where business travel remains depressed due to many employers limiting travel.

Thanks for the color. On the smaller piece, the rooming and boarding houses and student housing: what's your sense for that portfolio if universities and colleges reopen in the fall and how that portfolio might trend?

As of today there's a lot of talk about bringing students back to campus. That would certainly help student housing. In that portfolio, we focus on solid sponsors with alternative cash flows and liquidity, and this portfolio is no different. Bringing students back would be beneficial.

Switching gears to net interest margin: in the third quarter there are variables like earning a full quarter impact of Steuben, excess liquidity, PPP loans and related deposits. What's your view for where NIM might move relative to 2Q?

Erik, you've identified the key variables. If you peel back the excess cash and cash equivalents we had on the balance sheet in Q2 and call that a push, the core margin was down about six or seven basis points; the high 3.50%s excluding that excess liquidity — roughly 3.57%. For the third quarter, if we recognize some of the net deferred PPP income — we noted $13 million remaining — the reported margin could go up a bit in Q3. Peeling that back and rolling in the Steuben transaction, I would characterize the third quarter NIM as roughly flat with Q2. The flat, very low yield curve presents challenges as we move forward into Q4 and into next year. We'd like to see a little slope in the curve; without it, it will be difficult to grow net interest margin even with modest loan growth in the second half of the year.

Thanks, Joe. And one last one on M&A: you've closed Kinderhook and Steuben recently. The M&A environment changed; the number of deals slowed. You're in an advantaged position with strong currency. How are you thinking about M&A today and the pace of discussions versus past quarters? How do you evaluate targets today given the unknowns and economic outlook?

We view M&A as an important element of our strategy given the low-growth markets where we operate. The formula for delivering double-digit returns has been roughly 3%–4% organic growth plus 3%–4% from M&A over time, and a sensible dividend payout. We continue to pursue high-value opportunities for shareholders across bank and non-bank financial services. Conversation activity slowed over the last few months but green shoots are appearing. Banks that don't start from a position of strength may be at a disadvantage and could present greater opportunities in the future. I think you'll see greater M&A opportunity at some juncture because some banks may conclude they have a difficult path to create incremental shareholder value over the next year or two. Our currency is in a relative advantage now, perhaps even greater post-COVID, so we're positioned well if opportunities arise. We continue to evaluate opportunities and remain active in dialogues.

Thanks so much for taking my questions.

Thanks, Erik.

And the next question comes from Russell Gunther with D.A. Davidson. Please go ahead.

Hey, good morning guys.

Good morning, Russell.

Good morning, Russell.

Just a quick follow-up: on the roughly $150 million of pro forma deferrals, could you give us a sense for how that breaks down? What types of loans or exposures does that primarily consist of?

I'll take that, Russell. I'll break it down by line of business: business loans account for about $130 million of the active deferrals. Consumer mortgage, home equity, consumer direct and indirect make up the difference — roughly $13 million to $15 million. Keep in mind our approach: on consumer products we were willing to participate in providing relief in the first round, but in the second round we will grant very few consumer deferrals and will use other loss mitigation approaches. So today it's about $130 million in business and the remainder in the consumer portfolio.

Okay. And then of the $130 million in business, thinking about the COVID-sensitive sectors you identified on the slides, how would that breakdown?

Sure. Of that, lodging represents about 53% and retail about 25% of the impacted dollars. Manufacturing is just under 7.5%, and the rest are smaller amounts across other sectors. So lodging and retail are the two primary areas of concentration.

Got it. That's helpful. In terms of how you view this exposure, are these credits that you believe are at risk simply because they are in forbearance and therefore captured in your current reserve? Or is this more of a potential risk migration over the next couple of quarters that would impact future provisioning?

Russell, regarding future provisions, we'd like to have more visibility as we come through this first round of deferrals and see what the second round looks like. As we get toward the end of the third quarter we'll have a better sense of true delinquency once some of the deferral activity is unmasked. If higher levels of delinquency or further risk migration occur in Q3, we'll provision appropriately. We're trying to capture all expected losses at this point, but the lack of visibility — because of significant stimulus injected into depositors' accounts — makes it difficult to project future provisions. There may be some pent-up repayment capacity; a second round of stimulus would affect that. The credit metrics at the end of Q2 looked pretty good from an NPA and net charge-off perspective, which is encouraging.

Great. Last question: around run-rate expenses — you mentioned you'd expect them to move a bit higher next quarter. Could you give a sense for where that might shake out, considering normalized migration and any cost saves from Steuben? How might 3Q non-interest expense look?

Good question. Our operating OpEx run-rate prior to COVID we were calling in the $93 million to $94 million range per quarter, exclusive of Steuben. The world changed quickly and we recognized significant savings in Q2, particularly payroll-related and medical plan utilization, travel and business development costs. We were at $87.5 million in Q2, which was well below our prior full-tilt expectation. In the third quarter we expect payroll and medical costs to increase — higher utilization and an extra payroll day — and we are resuming business development activities. Travel will likely come back more slowly. Our full-tilt run rate including Steuben was expected to be $95 million to $96 million. I don't think we'll be fully back to that level in Q3, but over the coming quarters we would expect to ramp back up toward that range assuming a return to normal activity levels.

Thank you, Joe. That's very helpful. That's it from me.

Thanks, Russell.

And our next question comes from Matthew Breese with Stephens, Inc. Please go ahead.

Good morning.

Good morning, Matt.

On the deferrals down to about $150 million, the cure rate is solid. Is the decrease attributable entirely to resumption of payment, or any transfer to non-accrual or TDR categories?

All of the decrease is due to the resumption of payments. The initial deferral periods have ended and borrowers have resumed payments.

Understood. Joe, you mentioned for 3Q NIM you might be able to hold roughly flat. Were you referring to the reported NIM of 3.37% being roughly flat, or the liquidity-adjusted core NIM in the high 3.50%s?

Good question. If liquidity stays where it was in Q2, the reported NIM at 3.37% is expected to stay about there in Q3. The core margin, which was closer to the high 3.50%s — about 3.57% — would also hold up similarly in Q3. So both should be roughly stable in Q3, all things considered.

Does that also imply net interest income expectations around $92 million can hold for a while? And longer term, what's your view on ultimately deploying that liquidity? How long will that take?

The liquidity question is uncertain. Some of the cash on deposit accounts may runoff as consumer spending picks up and debt gets paid down. Conversely, a second round of stimulus could reload deposit balances. Opportunities to deploy that liquidity are limited today because the yield curve is flat and the long end doesn't present attractive trades. Absent another round of stimulus, I would expect some of that liquidity to trickle out over the coming quarters as consumers spend and pay down debt. The political landscape will influence that — there's ongoing negotiation around stimulus that will affect the liquidity profile.

Last question: the employee benefits services line held up well fee-wise. Is that business AUA-driven, or are fees more contractual versus AUA? Is the $24 million to $25 million quarterly run rate a reasonable baseline going forward?

Yes. The employee benefits business is much less dependent on market performance than our wealth management business. We expect the business to continue to grow modestly over time as it has, and it's less sensitive to equity markets. We continue to win opportunities and grow these businesses organically in our markets. We also have some deferred wins that didn't close in the first half due to COVID that we expect to close in the second half, so there may be some pent-up revenue. We would expect these businesses to continue to do okay regardless of equity market conditions.

Got it. That's all I had. Thanks for taking my questions.

Sure. Thanks, Matt.

Thanks, Matt.

This concludes our question-and-answer session. I'd like to turn the conference back over to Mr. Tryniski for any closing remarks.

No — nothing further. Thank you, Cole. Thank you everyone for joining, and we will talk to you again in October. Enjoy the rest of your summer. Thank you.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect your lines.