Chemung Financial Corporation - 10-Q quarterly report FY

CHEMUNG FINANCIAL CORPORATION AND SUBSIDIARIES

INDEX

See accompanying notes to unaudited consolidated financial statements.

CHEMUNG FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME

(UNAUDITED)

The amount of net periodic postretirement benefit cost recognized for the quarter ended September 30, 2004 is as follows:

The composition of the loan portfolio is summarized as follows:

The $10.1 million increase in cash and due from banks was due to a $10.2 million increase in period-end federal transit items.

The available for sale portion of the securities portfolio totaled $239.4 million at September 30, 2005, compared to $249.3 million at the end of 2004, a decrease of approximately $9.9 million or 4.0%. At amortized cost, the available for sale portfolio was down $7.6 million with unrealized appreciation related to the available for sale portfolio down $2.3 million. Federal agency bonds were down $15.0 million because, during the first nine months of 2005, purchases totaling $25.0 million were offset by $40.0 million of federal agency bond calls. This decrease, along with a $1.5 million reduction in the Corporation's stock portfolio, was offset primarily by a $3.7 million increase in the corporate bond portfolio, as well as increases in available for sale municipal bonds and mortgage-backed securities of $3.3 million and $1.8 million, respectively. The held to maturity portion of the portfolio, consisting primarily of local municipal obligations, totaled $8.3 million at amortized cost as of September 30, 2 005, a decrease of approximately $3.9 million since December 31, 2004.

As compared to December 31, 2004, total deposits have increased $31.7 million or 6.1% from $519.6 million to $551.3 million. Non-interest bearing demand deposits were up $7.8 million, principally due to higher period-end personal account balances. A $23.9 million increase in interest bearing deposits was reflected primarily in a $14.0 million increase in Now account balances as well as increases in time deposit and insured money market balances of $7.0 million and $5.2 million, respectively. The increases in Now accounts and time deposits was due primarily to higher period-end public fund balances, while the increase in insured money market accounts reflects higher other non-personal balances. The above increases were somewhat offset by a $2.3 million decrease in savings accounts, reflecting lower period-end personal balances. A $26.0 million decrease in securities sold under agreements to repurchase was due to the maturity during the first nine months of 2005 of $29.0 million in advances from the Federa l Home Loan Bank of New York. These advances had been utilized to leverage the purchase of federal agency bonds which were called during the first nine months of this year.

The following table summarizes the Corporation's non-performing assets:

In addition to non-performing loans, as of September 30, 2005, the Corporation has identified 18 commercial loan relationships totaling $10.785 million in potential problem loans, as compared to $11.367 million (22 commercial loan relationships) at December 31, 2004. Potential problem loans are loans that are currently performing, but where known information about possible credit problems of the related borrowers causes management to have serious doubts as to the ability of such borrowers to comply with the present loan repayment terms, and which may result in the disclosure of such loans as non-performing at some time in the future. At the Corporation, potential problem loans are typically loans that are performing but are classified in the Corporation's loan rating system as "substandard". Management cannot predict the extent to which economic conditions may worsen or other factors may impact borrowers and the potential problem loans. Accordingly, there can be no assurance that other loans will not bec ome 90 days or more past due, be placed on non-accrual, become restructured, or require increased allowance coverage and provisions for loan losses.

Management's evaluation of the adequacy of the allowance for loan losses is performed on a periodic basis and takes into consideration such factors as the historical loan loss experience, review of specific problem loans (including evaluation of the underlying collateral), changes in the composition and volume of the loan portfolio, overall portfolio quality, and current economic conditions that may affect the borrowers' ability to pay. With the level of non-performing relationships having declined, the Corporation has reduced its provision for loan losses during the first nine months of 2005 to $975 thousand as compared to $1.167 million during the first nine months of 2004. At September 30, 2005, the Corporation's allowance for loan losses totaled $9.719 million, resulting in a coverage ratio of allowance to non-performing loans of 103.9%. The allowance for loan losses is an amount that management believes will be adequate to absorb probable loan losses on existing loans. Net loan charge-offs for the f irst nine months of 2005 totaled $1.239 million as compared to $1.246 million during the first nine months of 2004. While net commercial loan and residential mortgage charge-offs increased $64 thousand and $11 thousand, respectively, this was offset by lower net consumer loan charge-offs. The allowance for loan losses to total loans at September 30, 2005 was 2.35% as compared to 2.62% as of December 31, 2004.

While the 2005 third quarter net interest margin of 3.77% was 7 basis points higher than the third quarter of 2004 net interest margin, net interest income compared to the third quarter of 2004 was down $100 thousand or 1.6%, primarily impacted by a $26.6 million or 3.9% decrease in average earning assets. The decrease in average earning assets was due to a $47.8 million decrease in the average securities portfolio, partially offset by a $17.6 million increase in average loans and a $3.6 million increase in federal funds sold and interest-bearing deposits. The decrease in the average securities portfolio as compared to the third quarter of 2004 was impacted by the continuing low mid to long-term rate environment throughout much of the past twelve months, and the Corporation's reluctance to increase its investments in bonds during this time given the expectation for higher rates going forward. The average loan growth was primarily due to an $11.4 million increase in average business loans, as well as incre ases in average mortgage and consumer loans of $3.7 million and $2.4 million, respectively. While average earning assets declined 3.9%, total interest income rose $68 thousand or 0.7%, as the average yield increased 23 basis points to 5.49%, reflecting a greater proportion of earning assets in higher yielding loans.

Total average funding liabilities decreased $25.9 million or 4.0% when compared to the third quarter of 2004, impacted by a $5.4 million decrease in average deposits and a $24.4 million decrease in average securities sold under agreements to repurchase funded through the Federal Home Loan Bank of New York. The decrease in average deposits was primarily related to lower insured money market and time deposit average balances of $8.4 million and $4.4 million, respectively, offset primarily by a $6.7 million increase in average demand deposits. The decrease in average insured money market balances is due primarily to lower average public fund and personal account averages, with the decrease in average time deposits related primarily to lower personal certificate and IRA averages, these decreases offset by higher average personal and non-personal demand deposit average balances. The decrease in average securities sold under agreements to repurchase reflects the fact that during 2005, $29.0 million of advances from the Federal Home Loan Bank of New York matured. These advances had been utilized to leverage the purchase of investment securities. However, with a flattening yield curve, available spreads have narrowed significantly, thus impacting the ability of the Corporation to obtain sufficient spread to offset the future interest rate risk associated with these transactions. While average interest bearing liabilities decreased $32.6 million or 6.2% compared to third quarter 2004 averages, interest expense increased $168 thousand or 6.2%, as the cost of funds, including the impact of non-interest bearing funding sources (such as demand deposits), was up 17 basis points to 1.82%.

Non-interest income during the third quarter of 2005 compared to the third quarter of 2004 increased $298 thousand or 9.6%. This increase was impacted primarily by a $154 thousand increase in trust and investment services fee income as well as a $75 thousand increase in revenue from the Corporation's equity investment in Cephas Capital Partners, LP ("Cephas"), a small business investment company (SBIC) which provides capital through loans and equity positions to businesses which may not qualify for traditional bank financing. The increase in trust and investment services income was primarily related to higher fee income from personal trust and agency accounts, retirement services and investment management accounts. The increase in revenue from Cephas was due to higher levels of interest income on loans receivable held by Cephas, impacted by the receipt of previously non-accrued interest during the quarter. Other factors impacting the increase in non-interest income included increases in credit card merchant earnings and checkcard interchange income of $45 thousand and $31 thousand, respectively, as well as the recognition of $26 thousand of deferred gains on the 2004 sale of the Corporation's consumer credit card portfolio. The above increases were somewhat offset primarily by a $43 thousand decrease in service charges on deposit accounts, impacted by a decrease in business checking analysis charges.

Third quarter 2005 operating expenses were $374 thousand or 6.0% higher than the comparable period last year. Areas having the greatest impact on this increase include a $167 thousand increase in salaries and wages, a $78 thousand increase in marketing and advertising costs and a $68 thousand increase in net occupancy costs. The increase in salaries and wages was due primarily to merit compensation increases effective in January of 2005. Marketing and advertising expenses were impacted primarily by higher costs related to radio and TV advertising, promotions, production and direct mail. A $40 thousand increase in pension and other employee benefits was due primarily to a $61 thousand increase in post-retirement medical benefits, as during the third quarter of 2004 the Corporation recognized a $49 thousand reduction in these costs related to Medicare Part D coverage.

A $76 thousand decrease in income tax expense is primarily a function of the lower level of pre-tax income.

Nine-Month Period Ended September 30, 2005 vs. Nine-Month Period Ended September 30, 2004

Net income for the nine-month period ended September 30, 2005 totaled $5.283 million, a decrease of $939 thousand or 15.1% as compared to results for the nine-month period ended September 30, 2004. Earnings per share were down 12.8% from $1.64 per share to $1.43 per share on 86,428 fewer average shares outstanding. This decrease in income was impacted by lower levels of net interest income and non-interest income, as well as higher operating expenses, partially offset by a lower provision for loan losses.

Despite a 7 basis point increase in the net interest margin from 3.67% to 3.74%, net interest income before the provision for loan losses was down $628 thousand or 3.3%, principally due to a $34.6 million or 5.0% decrease in average earning assets. For reasons noted in the above discussion of third quarter results, this decrease resulted primarily from a $45.3 million decrease in the average securities portfolio, offset somewhat by a $10.9 million increase in average year-to-date loans. As compared to the first nine months of 2004, average commercial loans increased $6.0 million, average mortgages increased $2.2 million, and average consumer loans were up $2.7 million despite a $4.9 million decrease in average consumer credit card balances resulting from the sale of this portfolio during the fourth quarter of 2004. While average earning assets declined 5.0%, total interest and dividend income was down $705 thousand or 2.6%, with the average yield increasing 14 basis points from 5.25% to 5.39% compared to the first nine months of 2004.

Total average funding liabilities for the nine-month period ended September 30, 2005 declined $34.4 million or 5.2% when compared to the first nine months of last year, the result of an $18.2 million decrease in average deposits and a $19.7 million decrease in average securities sold under agreements to repurchase funded through the Federal Home Loan Bank of New York. The decrease in average deposits was primarily related to lower average insured money market and time deposit balances of $16.4 million and $10.8 million, respectively, partially offset primarily by an $8.1 million increase in average demand deposits. The above decreases in average insured money market and time balances reflects the fact that absent loan growth during 2004, and given the continuing low yields on investments, we had not been aggressive in the pricing of these products. As loans have grown during 2005, we have become more aggressive in pricing strategy, particularly in the pricing of time deposit products. The decrease in ave rage securities sold under agreements to repurchase again reflects the fact that during 2005, $29.0 million of advances matured. In total, average interest bearing liabilities decreased $42.5 million or 7.9% compared to the first nine months 2004 averages, and interest expense decreased $78 thousand or 0.9% with the cost of funds, including the impact of non-interest bearing funding sources (such as demand deposits), up 8 basis points to 1.74%.

As discussed more fully under the Asset Quality section of this report, with the level of non-performing loans having stabilized, and given the adequacy of the Corporation's allowance for loan losses, the provision for loan losses during the first nine months of this year totaled $975 thousand as compared to $1.167 million during the first nine months of 2004, a decrease of $192 thousand.

Non-interest income for the first nine months of 2005 was down $221 thousand or 2.3% when compared to the comparable period of 2004. The major factors impacting this decline included a $366 thousand decrease in service charges on deposit accounts and a $213 thousand decrease in net gains on securities transactions. The decrease in service charges reflects a reduced level of fees for insufficient funds and business checking fees, as well as the Corporation's introduction of free checking accounts during the first quarter of 2005. The decrease in net gains on securities transactions is due to the fact that during the first quarter of 2004, the Corporation sold a $3.0 million federal agency bond at a gain of $219 thousand. A nominal gain on municipal bonds was realized during the second quarter of 2005. The above reductions in non-interest income were partially offset primarily by year-to-date increases in trust and investment services fee income of $114 thousand, credit card merchant earnings of $99 thousa nd and checkcard interchange income of $89 thousand. Additionally, accretion of deferred gains on the fourth quarter 2004 sale of our consumer credit card portfolio totaled $78 thousand.

Operating expenses were $823 thousand or 4.4% higher than a year ago. The areas having the greatest impact on this increase include a $505 thousand increase in salaries and wages, as well as increases in marketing and advertising costs and net occupancy costs of $177 thousand and $166 thousand, respectively. The increase in salaries and wages was due primarily to merit increases effective in January of this year. The increase in marketing and advertising costs have been impacted primarily by increases in radio and television advertising, production costs, printing and direct mail. An increase in net occupancy expense is due primarily to higher depreciation, maintenance, utilities and rent. In addition to the above, furniture and equipment expenses were up $44 thousand, impacted by increases in depreciation and automobile expenses. The above increases were partially offset primarily by a $152 thousand decrease in professional services fees due to lower consulting costs related to compliance with Section 404 of the Sarbanes Oxley Act of 2002.

The $540 thousand reduction in income tax expense is primarily related to the decrease in pre-tax income during the first nine months of 2005.

Average Consolidated Balance Sheet and Interest Analysis

For the purpose of these computations, non-accruing loans are included in the daily average loan amounts outstanding. Daily balances were used for average balance computations. Investment securities are stated at amortized cost. No tax equivalent adjustments have been made in calculating yields on obligations of states and political subdivisions.

The following table sets forth for the periods indicated, a summary of the changes in interest and dividends earned and interest paid resulting from changes in volume and changes in rates (in thousands of dollars):

Cash generated during the first nine months of 2005 was used primarily to fund the purchase of securities totaling $61.3 million, a net increase in loans of $34.4 million, and to reduce securities sold under agreements to repurchase by $26.0 million. Other significant uses of cash during this period included the payment of cash dividends ($2.6 million), the purchase of treasury shares ($2.3 million) and the purchase of premises and equipment ($2.1 million). During the first nine months of 2004, cash generated was used primarily to fund the purchase of securities and a net decrease in deposits of $70.2 million and $23.8 million, respectively. Other significant uses of cash during the first nine months of 2004 included the payment of cash dividends ($2.6 million), the purchase of treasury shares ($1.7 million) and a net increase in loans ($2.0 million).

Since year-end 2004, the Corporation's total shareholders' equity has decreased approximately $847 thousand to $81.3 million. This decrease is reflected in the $2.0 million increase in treasury shares, a $1.4 million decrease in accumulated other comprehensive income and a $156 thousand decrease in capital surplus, partially offset by a $2.7 million increase in retained earnings.

As of September 30, 2005, the Corporation's consolidated leverage ratio was 10.61%. The Tier I and Total Risk Adjusted Capital ratios were 15.87% and 17.92%, respectively. All of the above ratios are in excess of the requirements for being considered "well capitalized" by the FDIC, the Federal Reserve and the New York State Banking Department.

When shares of the Corporation become available in the market, we may purchase them after careful consideration of our capital position. On November 17, 2004, the Corporation announced that its Board of Directors authorized the repurchase of up to 180,000 shares, or approximately 5% of its outstanding common shares, either through open market or privately negotiated transactions over a two-year period. During the first nine months of 2005, the Corporation purchased 70,865 shares at an average price of $32.20 per share. As of September 30, 2005, a total of 79,665 shares had been purchased since the inception of the announced repurchase program. Additionally during the first nine months of 2005, 13,245 shares were re-issued from treasury to fund distributions under the Corporation's directors' deferred stock plan.

Interest Rate Risk

As intermediaries between borrowers and savers, commercial banks incur both interest rate risk and liquidity risk. The Corporation's Asset/Liability Committee ("ALCO") has the strategic responsibility for setting the policy guidelines on acceptable exposure to these areas. These guidelines contain specific measures and limits regarding these risks, which are monitored on a regular basis. The ALCO is made up of the president, two executive vice presidents, chief financial officer, asset liability management officer, senior marketing officer, and others representing key functions.

The ALCO is also responsible for supervising the preparation and annual revisions of the financial portions of the annual budget, which is built upon the committee's economic and interest-rate assumptions. It is the responsibility of the ALCO to modify prudently the Corporation's asset/liability policies.

Interest rate risk is the risk that net interest income will fluctuate as a result of a change in interest rates. It is the assumption of interest rate risk, along with credit risk, that drives the net interest margin of a financial institution. For that reason, the ALCO has established tolerance limits based upon a 200-basis point change in interest rates. At September 30, 2005, it is estimated that an immediate 200-basis point decrease in interest rates would negatively impact the next 12 months net interest income by 8.57% and an immediate 200-basis point increase would negatively impact the next 12 months net interest income by 2.01%. Both are within the Corporation's policy guideline of 15% established by ALCO.

A related component of interest rate risk is the expectation that the market value of our capital account will fluctuate with changes in interest rates. This component is a direct corollary to the earnings-impact component: an institution exposed to earnings erosion is also exposed to shrinkage in market value. At September 30, 2005, it is estimated that an immediate 200-basis point decrease in interest rates would negatively impact the market value of our capital account by 9.15% and an immediate 200-basis point increase in interest rates would negatively impact the market value by 3.55%. Both are within the established tolerance limit of 15.0%.

Management does recognize the need for certain hedging strategies during periods of anticipated higher fluctuations in interest rates and the Board-approved Funds Management Policy provides for limited use of certain derivatives in asset liability management. These strategies have not been employed during the first nine months of 2005.

Item 3: Quantitative and Qualitative Disclosures about Market Risk

Information required by this Item is set forth herein in Management's Discussion and Analysis of Financial Condition and Results of Operations under the heading "Interest Rate Risk".

Item 4: Controls and Procedures

The Corporation's management, under the supervision and with the participation of our President and Chief Executive Officer, who is the Corporation's principal executive officer, and our Treasurer and Chief Financial Officer, who is the Corporation's principal financial officer, has evaluated the effectiveness of the Corporation's disclosure controls and procedures as of September 30, 2005. Based upon that evaluation, the President and Chief Executive Officer and the Treasurer and Chief Financial Officer have concluded that the Corporation's disclosure controls and procedures are effective as of September 30, 2005.

There were no significant changes in the Corporation's internal control over financial reporting that occurred during the Corporation's most recent fiscal quarter that have materially affected, or that are reasonably likely to materially affect, the Corporation's internal control over financial reporting.