Financial Institutions - 10-Q quarterly report FY

 

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (585) 786-1100

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).Yes o No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

The registrant had 10,805,319 shares of Common Stock, $0.01 par value, outstanding as of April 30, 2009.

See accompanying notes to the consolidated financial statements.

See accompanying notes to the consolidated financial statements.

See accompanying notes to the consolidated financial statements.

Financial Institutions, Inc., a financial holding company organized under the laws of New York State, and its subsidiaries provide deposit, lending and other financial services to individuals and businesses in Central and Western New York. The Company owns all of the capital stock of Five Star Bank, a New York State-chartered bank, and Five Star Investment Services, Inc., a broker-dealer subsidiary offering noninsured investment products. The Company also owns 100% of FISI Statutory Trust I (the “Trust”), which was formed in February 2001 for the purpose of issuing trust preferred securities. References to “the Company” mean the consolidated reporting entities and references to “the Bank” mean Five Star Bank.

The consolidated financial statements in this Quarterly Report on Form 10-Q include the accounts of the Company and its subsidiaries. The Trust is not included in the consolidated financial statements of the Company. All significant intercompany accounts and transactions have been eliminated in consolidation. The accounting and reporting policies conform to general practices within the banking industry and to U.S. generally accepted accounting principles. Prior years’ consolidated financial statements are re-classified whenever necessary to conform to the current year’s presentation.

These financial statements have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in conformity with U.S. generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. However, in the opinion of management, the accompanying consolidated financial statements reflect all adjustments of a normal and recurring nature necessary to present fairly the consolidated balance sheet, statements of income, stockholders’ equity and cash flows for the periods indicated, and contain adequate disclosure to make the information presented not misleading. These consolidated financial statements should be read in conjunction with the Company’s latest annual report on Form 10-K. The results of operations for any interim periods are not necessarily indicative of the results which may be expected for the entire year.

The preparation of these financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Material estimates relate to the determination of the allowance for loan losses, assumptions used in the defined benefit pension plan accounting, the valuation of goodwill and deferred tax assets, and the valuation and other than temporary impairment considerations related to the securities portfolio.

Earnings Per Share. On January 1, 2009, the Company adopted the provisions of Financial Accounting Standards Board (“FASB”) Staff Position (“FSP”) on Emerging Issues Task Force (“EITF”) Issue 03-6,Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities (“FSP EITF 03-6-1”). FSP EITF 03-6-1 states that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per common share (“EPS”) pursuant to the two-class method. FSP EITF 03-6-1 was effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years. The adoption of FSP EITF 03-6-1 did not have a material impact on the Company’s EPS calculations.

Fair Value Measurements. On January 1, 2008, the Company adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements (“SFAS 157”), for the Company’s financial assets and financial liabilities. In accordance with the provisions of FSP 157-2, Effective Date of FASB Statement No. 157, the Company deferred the effective date of SFAS 157 for the Company’s nonfinancial assets and nonfinancial liabilities, except for those items recognized or disclosed at fair value on an annual or more frequently recurring basis, until January 1, 2009. The adoption of the fair value measurement provisions of SFAS 157 for the Company’s nonfinancial assets and nonfinancial liabilities had no impact on the Company’s statements of income and condition.

Derivative Financial Instruments. On January 1, 2009, the Company adopted the provisions of SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB Statement No. 133 (“SFAS 161”). The statement amended the disclosure requirements for derivative financial instruments and hedging activities. Expanded qualitative disclosures required under SFAS 161 include: (1) how and why an entity uses derivative financial instruments; (2) how derivative financial instruments and related hedged items are accounted for under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and related interpretations; and (3) how derivative financial instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. SFAS 161 also requires several added quantitative disclosures in financial statements. As SFAS 161 amended only the disclosure requirements for derivative financial instruments and hedged items, the adoption had no impact on the Company’s statements of income and condition.

In April 2009, the FASB finalized four FSPs intended to provide additional application guidance and enhance disclosures regarding fair value measurements and impairments of securities.

These FSPs changed the method for determining if OTTI exists and the amount of OTTI to be recorded through an entity’s income statement. The changes brought about by the FSPs provide greater clarity and reflect a more accurate representation of the credit and noncredit components of an OTTI event. The four FSPs are as follows:

These staff positions are effective for financial statements issued for periods ending after June 15, 2009, with early application possible for the first quarter of 2009. The Company elected not to adopt any of the above positions early. The Company has not completed its evaluation of the impact of these standards on its statements of income and condition.

The Company’s restricted stock awards pay nonforfeitable common stock dividends and meet the criteria of a participating security pursuant to FSP EITF 03-6-1. Accordingly, EPS is calculated using the two-class method, under which earnings are allocated to both common shares and participating securities. This FSP requires retrospective application, thus basic and diluted earnings per share presented for the three months ended March 31, 2008 were calculated in accordance with this FSP. Neither basic nor diluted earnings per share for the three months ended March 31, 2008 changed from the adoption of this FSP.

The computation of basis and diluted EPS is presented in the following table (in thousands, except per share amounts).

All shares of restricted stock are deducted from weighted average shares outstanding for the computation of basic EPS. Shares of restricted stock, stock options, and warrant are included in the calculation of diluted EPS using the treasury stock method.

The amortized cost and fair value of investment securities are summarized below (in thousands):

Included in mortgage-backed securities are collateralized mortgage obligations with an adjusted amortized cost and fair value of $102.5 million and $99.3 million, respectively, at March 31, 2009, and an amortized cost and fair value of $106.3 million and $103.1 million, respectively, at December 31, 2008. The remaining mortgage-backed securities include securities issued by government-sponsored enterprises. Other asset-backed securities include pooled trust preferred securities collateralized by preferred debt issued primarily by financial institutions and, to a lesser extent, insurance companies located throughout the United States.

For the three months ended March 31, 2009, proceeds from sales of securities available for sale were $10.4 million, gross realized gains were $415 thousand and gross realized losses were $361 thousand. The first quarter sales include the Company’s liquidation of its equity securities portfolio, which consisted of auction rate preferred equity securities collateralized by Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“FHLMC”) preferred stock and common equity securities.

The following tables show the investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at March 31, 2009 and December 31, 2008 (in thousands).

The Company reviews investment securities on an ongoing basis for the presence of other-than-temporary-impairment (“OTTI”) with formal reviews performed quarterly. OTTI losses on individual investment securities are recognized as a realized loss through earnings when it is probable that not all of the contractual cash flows will be collected or it is determined that the Company will be unable to hold the securities until a recovery of fair value, which may be maturity.

Based upon these evaluations, the Company recorded impairment charges totaling $50 thousand during the first quarter of 2009 related to a debt security in the available for sale portfolio considered to be other-than-temporarily impaired. Future reviews for OTTI will consider the particular facts and circumstances during the reporting period in review. There were no securities deemed OTTI, and therefore no impairment charges were recorded, during the three months ended March 31, 2008.

As of March 31, 2009, management has concluded that unrealized losses on its investment securities are temporary in nature since they are not related to the underlying credit quality of the issuers, and the Company has both the ability and intent to hold these investments until such time as the value recovers or the securities mature. Further deterioration in credit quality and/or a continuation of the current imbalances in liquidity that exist in the marketplace might adversely affect the fair values of the Company’s investment portfolio and may increase the potential that certain unrealized losses will be designated as other than temporary in future periods and that the Company will incur additional write-downs in the future.

Loans outstanding, including net unearned income and net deferred fees and costs of $13.3 million and $12.3 million as of March 31, 2009 and December 31, 2008, respectively, are summarized as follows (in thousands):

The carrying amount of goodwill totaled $37.4 million as of March 31, 2009 and December 31, 2008. In accordance with SFAS 142, the Company is required to test goodwill annually for impairment or more frequently if events and circumstances warrant. During the first quarter of 2009, the Company concluded that events had occurred and circumstances had changed, which may indicate the existence of potential impairment of goodwill. These indicators included a significant decline in the Company’s stock price and adverse industry conditions. As a result, the Company performed an interim assessment of goodwill for impairment as of March 31, 2009 and determined that no impairment existed.

Declines in the market value of the Company’s publicly traded stock price or declines in the Company’s ability to generate future cash flows may increase the potential that goodwill recorded on the Company’s consolidated statement of financial position be designated as impaired and that the Company may incur a goodwill write-down in the future.

Presented below is a reconciliation of net income to comprehensive income including the components of other comprehensive income for the periods indicated (in thousands):

The components of accumulated other comprehensive loss, net of tax, for the periods indicated were as follows (in thousands):

The Company has a Management Stock Incentive Plan and a Director’s Stock Incentive Plan (the “Plans”). Under the Plans, the Company may grant stock options to purchase shares of common stock, shares of restricted stock or stock appreciation rights to its directors and key employees. Grants under the plans may be made up to 10% of the number of shares of common stock issued, including treasury shares. The exercise price of each option equals the market price of the Company’s stock on the date of the grant. All options have a 10-year term and become fully exercisable over a period of 3 to 5 years from the grant date. When option recipients exercise their options, the Company issues shares from treasury stock and record the proceeds as additions to capital.

The share-based compensation expense associated with the amortization of unvested stock compensation included in the consolidated statements of income (unaudited) for the periods indicated (in thousands):

The restricted stock award expense for 2009 includes $1 thousand of dividends for unearned shares in the restricted stock plan which is accounted for as compensation expense.

The Company awarded grants of 48,500 restricted shares to certain key officers during the three months ended March 31, 2009. The market price of the restricted shares on the date of grant was $13.21. Both a performance requirement and a service requirement must be satisfied before the participant becomes vested in the shares. The performance period for the awards is the Company’s fiscal year ending on December 31, 2009. As a result of not satisfying certain performance requirements, 41,200 restricted shares granted in the first quarter of 2008 were forfeited during the first quarter of 2009. There was no reversal of restricted stock award expense required during the three months ended March 31, 2009, as the Company reduced share-based compensation expense related to the forfeited shares during 2008.

The Company participates in The New York State Bankers Retirement System (the “System”), which is a defined benefit pension plan covering substantially all employees, subject to the limitations related to the plan closure effective December 31, 2006. The benefits are based on years of service and the employee’s highest average compensation during five consecutive years of employment. The defined benefit plan was closed to new participants effective December 31, 2006. Only employees hired on or before December 31, 2006 and who met participation requirements on or before January 1, 2008 are eligible to receive benefits.

The components of the Company’s net periodic benefit expense for its pension plan were as follows (in thousands):

The Company’s funding policy is to contribute, at a minimum, an actuarially determined amount that will satisfy the minimum funding requirements determined under the appropriate sections of Internal Revenue Code. In April 2009 the Company made the minimum required contribution for fiscal year 2009 of $1.6 million to the pension plan. The Company may make additional contributions to its pension plan in fiscal year 2009.

Employees that meet certain age and service requirements are eligible to participate in the Company sponsored 401(k) plan. Under the plan, participants may make contributions, in the form of salary deferrals, up to the maximum Internal Revenue Code limit. The Company matches a participant’s contributions up to 4.5% of compensation, calculated as 100% of the first 3% of compensation and 50% of the next 3% of compensation deferred by the participant. The Company may also make additional discretionary matching contributions, although no such additional discretionary contributions were made in 2009 or 2008. The expense included in salaries and employee benefits in the consolidated statements of income for this plan amounted to $234 thousand and $300 thousand for the three months ended March 31, 2009 and March 31, 2008, respectively.

During the third quarter of 2008 the Company established non-qualified supplemental executive retirement plans (“SERPs”) for two active executives. The Company has accrued a liability, all of which is unfunded, of $549 thousand as of March 31, 2009, and recorded expense of $240 thousand for the three months ended March 31, 2009. There were no amounts recorded for these SERPs prior to the third quarter of 2008.

SFAS 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. For SFAS 157 disclosures, SFAS 157 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three levels.

Investment Securities. Fair values of equity securities are determined using public quotations, when available. Where quoted market prices are not available, fair values may be estimated based on dealer quotes, pricing models, discounted cash flow methodologies, or similar techniques for which the determination of fair value may require significant judgment or estimation. Fair values of public bonds and those private securities that are actively traded in the secondary market have been determined through the use of third-party pricing services using market observable inputs. Private placement securities and other securities where the Company does not receive a public quotation are valued by discounting the expected cash flows. Market rates used are applicable to the yield, credit quality and average maturity of each security. Private equity securities may also utilize internal valuation methodologies appropriate for the specific asset. Fair values might also be determined using broker quotes or through the use of internal models or analysis.

The following table summarizes financial assets measured and recorded at fair value on a recurring basis as of March 31, 2009, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value (in thousands):

The following table presents changes in Level 3 available for sale securities measured at fair value on a recurring basis during the three months ended March 31, 2009 (in thousands):

Certain financial assets and financial liabilities are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). Examples of these nonrecurring uses of fair value include: loans held for sale, mortgage servicing assets and collateral dependent impaired loans. As of March 31, 2009, the Company had no liabilities measured at fair value on a nonrecurring basis.

Loans held for sale were $2.3 million as of March 31, 2009. These loans are carried at the lower of cost or fair value and are adjusted to fair value on a nonrecurring basis. Fair value is based on observable market rates for comparable loan products which is considered a level 2 fair value measurement.

Mortgage servicing rights were $749 thousand as of March 31, 2009. This asset is carried at the lower of cost or fair value and is adjusted to fair value on a nonrecurring basis. The mortgage servicing rights are a Level 3 fair value measurement, as fair value is determined by calculating the present value of the future servicing cash flows from the underlying mortgage loans.

During the first quarter of 2009, certain impaired loans were remeasured and reported at fair value through a specific valuation allowance allocation of the allowance for loan losses based upon the fair value of the underlying collateral. Impaired loans with a carrying value of $1.3 million were reduced by specific valuation allowance allocations totaling $410 thousand to a total reported fair value of $849 thousand. The collateral dependent impaired loans are a Level 2 fair measurement, as fair value is determined based upon estimates of the fair value of the collateral underlying the impaired loans typically using appraisals of comparable property or valuation guides.

Certain nonfinancial assets measured at fair value on a non-recurring basis include nonfinancial assets and nonfinancial liabilities measured at fair value in the second step of a goodwill impairment test, and intangible assets and other nonfinancial long-lived assets measured at fair value for impairment assessment. There were no nonfinancial assets or nonfinancial liabilities measured at fair value during the three months ended March 31, 2009.

Statements in this Quarterly Report on Form 10-Q that are based on other than historical data are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements provide current expectations or forecasts of future events and include, among others:

These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management’s views as of any subsequent date. Forward-looking statements involve significant risks and uncertainties and actual results may differ materially from those presented, either expressed or implied, in this Quarterly Report on Form 10-Q, including, but not limited to, those presented in the Management’s Discussion and Analysis. Factors that might cause such differences include, but are not limited to:

The Company cautions readers not to place undue reliance on any forward-looking statements, which speak only as of the date made, and advises readers that various factors, including those described above, could affect the Company’s financial performance and could cause the Company’s actual results or circumstances for future periods to differ materially from those anticipated or projected.

Except as required by law, the Company does not undertake, and specifically disclaims any obligation to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

The Company’s consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles and are consistent with predominant practices in the banking industry. Application of critical accounting policies, which are those policies that management believes are the most important to the Company’s financial position and results, requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes and are based on information available as of the date of the financial statements. Future changes in information may affect these estimates, assumptions and judgments, which, in turn, may affect amounts reported in the financial statements.

The Company has numerous accounting policies, of which the most significant are presented in Note 1, Summary of Significant Accounting Policies, of the notes to consolidated financial statements included in the Company’s most recently filed Form 10-K. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets, liabilities, revenues and expenses are reported in the consolidated financial statements and how those reported amounts are determined. Based on the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has determined that the accounting policies with respect to the allowance for loan losses, valuation of goodwill and deferred tax assets, the valuation of securities and determination of OTTI, and accounting for defined benefit plans require particularly subjective or complex judgments important to the Company’s financial position and results of operations, and, as such, are considered to be critical accounting policies. These estimates and assumptions are based on management’s best estimates and judgment and are evaluated on an ongoing basis using historical experience and other factors, including the current economic environment. The Company adjusts these estimates and assumptions when facts and circumstances dictate. Illiquid credit markets and volatile equity have combined with declines in consumer spending to increase the uncertainty inherent in these estimates and assumptions. As future events cannot be determined with precision, actual results could differ significantly from the Company’s estimates.

For additional information regarding critical accounting policies, refer to Note 1, Summary of Significant Accounting Policies, of the notes to consolidated financial statements and the section captioned “Critical Accounting Estimates” in Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the 2008 Form 10-K. There have been no material changes in the Company’s application of critical accounting policies related to the allowance for loan losses, valuation of goodwill and deferred tax assets, the valuation of securities and determination of OTTI, and accounting for defined benefit plans since December 31, 2008.

The principal objective of this discussion is to provide an overview of the financial condition and results of operations of the Company for the periods covered in this quarterly report. This discussion and tabular presentations should be read in conjunction with the accompanying consolidated financial statements and accompanying notes.

The Company’s revenues are dependent primarily on net interest income, which is the difference between the income earned on loans and investment securities and the interest paid on deposits and borrowings. Revenues are also affected by service charges on deposits, ATM and debit card income, broker-dealer fees and commissions, loan servicing income, company owned life insurance, gain or loss on the sale or call of investment securities, gain or loss on sale of loans held for sale, gain or loss on the sale of other assets and other miscellaneous noninterest income.

The Company’s expenses primarily consist of the provision for loan losses, salaries and employee benefits, occupancy and equipment, supplies and postage, amortization of other intangible assets, computer and data processing, professional services, advertising and promotions, other miscellaneous noninterest expense and income tax expense.

Results of operations are also affected by the general economic and competitive conditions, particularly changes in interest rates, government policies and the actions of regulatory authorities.

Net income for the first quarter of 2009 was $3.0 million compared to $3.8 million for the first quarter of 2008. Net income available to common shareholders was $2.0 million, or $0.19 per diluted share, for the first quarter of 2009 compared to $3.4 million, or $0.31 per diluted share, for the first quarter of 2008. Return on average equity was 6.29% and return on average assets was 0.61% for the first quarter of 2009, compared to 7.69% and 0.80%, respectively, for the first quarter of 2008.

Net income and net income available to common shareholders decreased $812 thousand, or 21%, and $1.4 million, or 40%, respectively, for the three months ended March 31, 2009 compared to the same period in 2008. The decrease in net income during the three months ended March 31, 2009 was primarily the result of a $1.2 million increase in the provision for loan losses and a $1.8 million increase in noninterest expense offset by a $2.2 million increase in net interest income. An increase in preferred dividends relating to the TARP preferred stock resulted in the additional $547 thousand, or $0.05 per diluted share, decrease in net income available to common shareholders.

Details of the changes in the various components of net income are further discussed below.

For the first three months of 2009 net interest income was $17.3 million compared to $15.1 million for the same period in 2008. The increase in net interest income was due to an increase in net interest margin for the three month period ended March 31, 2009 to 4.09%, compared to the corresponding period in the prior year of 3.73%. The reason for the increase has been due to a combination of factors, including the following:

Interest on investment securities and interest-earning deposits was $6.0 million for the three month period ended March 31, 2009, compared to $8.5 million for the same period in 2008. The average balance of investment securities was $601.2 million with an average tax equivalent yield of 4.54% for the three month period ended March 31, 2009 compared to an average balance of $753.8 million with an average yield of 5.04% for the same period in 2008. The decrease in yield is primarily due to lower market interest rates and less tax-exempt and tax-preferred interest income. Tax-preferred interest income for the three months ended March 31, 2008 was primarily dividend income from auction rate preferred equity securities collateralized by FNMA and FHLMC stock, which were sold during the first quarter of 2009. There were no dividends recognized on the auction rate securities during 2009.

Interest on loans was $17.1 million for the three month period ended March 31, 2009, compared to $16.7 million for the three month period in 2008. The average balance of loans was $1.140 billion with an average yield of 6.04% for the three month period ended March 31, 2009 compared to an average balance of $964.4 million with an average yield of 6.97% for the same period in 2008. Average balances of commercial loans in 2009 increased $46.2 million, as compared to 2008 primarily due to strong organic growth in our commercial loan portfolio. The average balance of consumer indirect loans, comprised almost entirely of automobile loans, increased $129.6 million for the first quarter of 2009 over the corresponding quarter last year. This 94.1% increase in volume was responsible for the $2.2 million increase in interest income on consumer indirect loans when comparing the first quarter of 2009 to that of 2008.

Interest on deposits was $5.0 million for the three month period ended March 31, 2009, compared to $9.2 million for the same period in 2008. The average balance of interest-bearing deposits was $1.400 billion with an average cost of 1.45% for the three month period ended March 31, 2009 compared to an average balance of $1.340 billion with an average cost of 2.77% for the same period in 2008. The average balance of noninterest-bearing deposits increased to $281.7 million or 5% during the first quarter of this year compared to the same quarter last year. The increase in the balance of total deposits is due to an increase in public fund deposits, while the decrease in average cost is due primarily to the beneficial repricing of certificates of deposits, and to a lesser extent savings and money market accounts, at lower interest rates.

The declines in interest and average cost on borrowed funds from last year’s first quarter to this year’s first quarter are due to reductions in short-term interest rates.

The following table sets forth certain information relating to the consolidated balance sheets and reflects the average yields earned on interest-earning assets, as well as the average rates paid on interest-bearing liabilities for the periods indicated (in thousands).