EVANS BANCORP INC - Quarter Report: 2018 March (Form 10-Q)





United States

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

(Mark One)

☒QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934



For quarterly period ended    March 31, 2018



☐TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934



For the transition period from             to ______



Commission file number    001-35021



                   EVANS BANCORP, INC.                  

(Exact name of registrant as specified in its charter)



          New York                            16-1332767

(State or other jurisdiction of         (I.R.S. Employer

incorporation or organization)       Identification No.)



One Grimsby Drive, Hamburg, NY        14075

(Address of principal executive offices)  (Zip Code)



       (716) 926-2000    

(Registrant's telephone number, including area code)



            Not Applicable         

 (Former name, former address and former fiscal year, if changed

 since last report)



Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒  No ☐



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 ☒ No ☐



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





If an emerging growth company, indicate by checkmark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) 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  ☐  No  ☒



Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:

Common Stock, $.50 par value, 4,806,539 shares as of May 1, 2018



 

---

 



INDEX





EVANS BANCORP, INC. AND SUBSIDIARIES











 

---

 









---

 















---

 



















---

 

















---

 





(continued)



---

 









---

 



PART 1 – FINANCIAL INFORMATION

ITEM 1 – FINANCIAL STATEMENTS



EVANS BANCORP, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTH PERIODS ENDED MARCH 31, 2018 AND 2017



1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



The accounting and reporting policies followed by Evans Bancorp, Inc. (the “Company”), a financial holding company, and its two direct, wholly-owned subsidiaries: (i) Evans Bank, National Association (the “Bank”), and the Bank’s subsidiaries, Evans National Leasing, Inc. (“ENL”), Evans National Holding Corp. (“ENHC”) and Suchak Data Systems, LLC (“SDS”); and (ii) Evans National Financial Services, LLC (“ENFS”), and ENFS’s subsidiary, The Evans Agency, LLC (“TEA”), and TEA’s subsidiaries, Frontier Claims Services, Inc. (“FCS”) and ENB Associates Inc. (“ENBA”), in the preparation of the accompanying interim unaudited consolidated financial statements, conform with U.S. generally accepted accounting principles (“GAAP”) and with general practice within the industries in which it operates.  Except as the context otherwise requires, the Company and its direct and indirect subsidiaries are collectively referred to in this report as the “Company.”



The results of operations for the three month period ended March 31, 2018 are not necessarily indicative of the results to be expected for the full year.  The accompanying unaudited consolidated financial statements should be read in conjunction with the Audited Consolidated Financial Statements and the Notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2017 (“10-K”).  The Company’s significant accounting policies are disclosed in Note 1 to the 10-K.



The Company adopted multiple accounting standards as of January 1, 2018 that impacted its consolidated financial statements. The impact on the Company’s equity as depicted in the Statement of Changes in Stockholders’ Equity is as follows:





On January 1, 2018, the Company adopted Accounting Standards Update (“ASU”) 2014-09 Revenue from Contracts with Customers and all subsequent amendments to the ASU (collectively, “ASC 606”), which creates a single framework for recognizing revenue from contracts with customers that fall within its scope.  The Company used the modified retrospective method with a cumulative-effect adjustment to retained earnings.  The Company’s implementation efforts included the identification of revenue within the scope of the guidance, as well as the evaluation of revenue contracts.   The majority of the Company’s revenues come from interest income on loans and securities that are outside the scope of ASC 606.  The Company’s services that fall within the scope of ASC 606 are presented within non-interest income and are recognized as revenue as the Company satisfies its obligation to the customer.  Services within the scope of ASC 606 include insurance services fees, deposit service charges, and interchange income.  Further detail on the Company’s performance obligations and revenue recognition for these revenue streams is provided in Note 10 to these Unaudited Consolidated Financial Statements.



The Company did identify one revenue source, variable profit-sharing revenue for TEA, which will be accounted for differently in 2018 and beyond.  Profit-sharing revenue is variable consideration that TEA earns based on the loss ratio of its customers at insurance companies.  TEA typically receives payment in the year following the year in which the profit-sharing revenue is earned, with most payments received in the first quarter.  Prior to January 1, 2018, the Company recognized profit-sharing revenue when the payment was received.  Beginning with the three-month period ended March 31, 2018, included in these financial statements, the Company will

---

 

estimate this variable consideration based on past performance and loss experience known during the year and make subsequent adjustments to revenue when the uncertainty associated with the variable revenue is resolved.  As of January 1, 2018, the Company recorded accounts receivable of $551 thousand and the tax effect of $142 thousand through a cumulative-effect adjustment to beginning retained earnings, representing the profit sharing revenue earned in 2017 and received in 2018.



The Company adopted ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities and ASU 2018-03 Technical Corrections and Improvements to Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities on January 1, 2018 with a cumulative-effect adjustment to retained earnings.  This ASU requires equity securities to be measured at fair value with changes in the fair value recognized through net income.  As of December 31, 2017, the Company had an investment in the equity securities of another financial institution valued at the historical cost of $0.6 million.  The Company used the cost method of accounting because its ownership of the financial institution was less than 5% of the outstanding shares.  With the adoption of ASU 2016-01, the cost method is no longer an acceptable accounting principle.  On January 1, 2018 the Company recorded an increase in the value of the investment of $1.2 million based on observable prices obtained from orderly transactions between market participants through opening retained earnings.  While the financial institution is not publicly traded on a major stock exchange and is fairly illiquid, there is transaction activity that can be used by the Company to determine the fair value.  The Company recognized an increase in fair value of $147 thousand at March 31, 2018 from the value at January 1, 2018 based on observable prices obtained from the latest orderly transactions in the quarter, with the increase being recorded in earnings.  Given the nature of equity investments and the requirement to record changes in the fair value of the investment through earnings, the adoption of this standard could lead to increased volatility to earnings. 



ASU 2016-01 also contained other provisions impacting the Company’s disclosures, including using the exit price notion when measuring the fair value of financial instruments for disclosure purposes and eliminating the requirement for public business entities to disclose the methods and significant assumptions to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet.  Further details regarding the Company’s fair value measurements and corresponding disclosures are provided in Note 3 to these Unaudited Consolidated Financial Statements.



As of December 31, 2017, the Company had a $171 thousand valuation allowance on the deferred tax asset for the Company’s investments in historic tax credits.  The valuation allowance was due to the nature of the loss to be recognized when the investment is ultimately sold (which for tax purposes will give rise to a capital loss) as the Company did not have any known capital gains in the future to be able to utilize the capital losses from these investments.  With the increase in the value of the equity securities discussed in the preceding paragraph and the corresponding projected capital gains the increased value represents, the Company was able to release the valuation allowance on the deferred tax assets related to the historic tax credits in conjunction with the adoption of ASU 2016-01.



The Company adopted ASU 2017-07 Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost effective January 1, 2018.  The update requires that an employer report the service cost component of net periodic pension cost in the same line item as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net periodic pension cost such as interest cost, expected return on plan assets, gain or loss, and amortization of prior service cost are required to be presented in the income statement separately from the service cost component. If a separate line item is used to present the other components of net benefit cost, that line item must be appropriately described.  Prior to adoption of this update, the Company presented all components of net periodic pension cost in its “salaries and benefits expense” on its income statement.  The Company is presenting its income statement for the three-month periods ended March 31, 2018 and 2017 with service cost as part of the “salaries and benefits expense” and the other components in “other expense.”  Further details regarding the Company’s net periodic pension cost are provided in Note 9 to these Unaudited Consolidated Financial Statements.



ASU 2016-15 Classification of Certain Cash Receipts and Cash Payments: This update addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows under Topic 230, Statement of Cash Flows.  The update had no impact on how the Company was already reporting or presenting its statement of cash flows.



ASU 2016-18 Restricted Cash: This update requires that a statement of cash flows explains the change during the period in the total cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents.  Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning of period and end of period total amounts shown on the statement of cash flows.  Previous to the update, there had been some diversity in practice.  Given that the Company had already classified restricted cash such as cash reserves at the Federal Reserve as part of cash and cash equivalents on the cash flow statement, the update had no impact on how the Company was already reporting and presenting its statement of cash flows.



---

 

ASU 2017-01 Clarifying the Definition of a Business: This update clarifies the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The definition of a business affects many areas of accounting including acquisitions, disposals, goodwill, and consolidation.  The update did not impact the Company’s financial statements in the three-month period ended March 31, 2018, but will provide the framework in the future should the Company engage in a transaction in which the definition of a business is relevant.

---

 



2. SECURITIES



The amortized cost of securities and their approximate fair value at March 31, 2018 and December 31, 2017 were as follows:









---

 

Available for sale securities with a total fair value of $154 million and $138 million at March 31, 2018 and December 31, 2017, respectively, were pledged as collateral to secure public deposits and for other purposes required or permitted by law.



The scheduled maturities of debt and mortgage-backed securities at March 31, 2018 and December 31, 2017 are summarized below.  All maturity amounts are contractual maturities.  Actual maturities may differ from contractual maturities because certain issuers have the right to call or prepay obligations with or without call premiums.





Contractual maturities of the Company’s mortgage-backed securities generally exceed ten years; however, the effective lives may be significantly shorter due to prepayments of the underlying loans and due to the nature of these securities.



Information regarding unrealized losses within the Company’s available for sale securities at March 31, 2018 and December 31, 2017 is summarized below.  The securities are primarily U.S. government-guaranteed agency securities or municipal securities.  All unrealized losses are considered temporary and are related to market interest rate fluctuations.



---

 

















---

 

Management has assessed the securities available for sale in an unrealized loss position at March 31, 2018 and December 31, 2017 and determined the decline in fair value below amortized cost to be temporary.  In making this determination, management considered the period of time the securities were in a loss position, the percentage decline in comparison to the securities’ amortized cost, and the financial condition of the issuer (primarily government or government-sponsored enterprises).  In addition, management does not intend to sell these securities and it is not more likely than not that the Company will be required to sell these securities before recovery of their amortized cost.  Management believes the decline in fair value is primarily related to market interest rate fluctuations and not to the credit deterioration of the individual issuers.



The Company has not recorded any other-than-temporary impairment (“OTTI”) charges as of March 31, 2018 and did not record any OTTI charges during 2017.  The credit worthiness of the Company’s portfolio is largely reliant on the ability of U.S. government sponsored agencies such as FHLB, Federal National Mortgage Association (“FNMA”), Government National Mortgage Association (“GNMA”), and Federal Home Loan Mortgage Corporation (“FHLMC”), and municipalities throughout New York State to meet their obligations.  In addition, dysfunctional markets could materially alter the liquidity, interest rate, and pricing risk of the portfolio.  The stable past performance is not a guarantee for similar performance of the Company’s securities portfolio in future periods.





3.  FAIR VALUE MEASUREMENTS



Fair value is defined in ASC Topic 820 “Fair Value Measurements” as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

  

There are three levels of inputs to fair value measurements:



Observable market data should be used when available.



FINANCIAL INSTRUMENTS MEASURED AT FAIR VALUE ON A RECURRING BASIS



The following table presents, for each of the fair-value hierarchy levels as defined in this footnote, those financial instruments which are measured at fair value on a recurring basis as of March 31, 2018 and December 31, 2017, respectively:









---

 

Securities available for sale



Fair values for securities available for sale are determined using independent pricing services and market-participating brokers.  The Company’s independent pricing service utilizes evaluated pricing models that vary by asset class and incorporate available trade, bid and other market information for structured securities, cash flow and, when available, loan performance data.  Because many fixed income securities do not trade on a daily basis, the evaluated pricing applications apply information as applicable through processes, such as benchmarking of like securities, sector groupings, and matrix pricing, to prepare evaluations.  In addition, model processes, such as the Option Adjusted Spread model, are used to assess interest rate impact and develop prepayment scenarios.  The models and the process take into account market convention.  For each asset class, a team of evaluators gathers information from market sources and integrates relevant credit information, perceived market movements and sector news into the evaluated pricing applications and models.  The company’s service provider may occasionally determine that it does not have sufficient verifiable information to value a particular security.  In these cases the Company utilizes valuations from another pricing service.



Management believes that it has a sufficient understanding of the third party service’s valuation models, assumptions and inputs used in determining the fair value of securities to enable management to maintain an appropriate system of internal control.  On a quarterly basis, the Company reviews changes in the market value of its security portfolio.  Individual changes in valuations are reviewed for consistency with general interest rate movements and any known credit concerns for specific securities.  Additionally, on an annual basis, the Company has its entire security portfolio priced by a second pricing service to determine consistency with another market evaluator.  If, during the Company’s review or when comparing with another servicer, a material difference between pricing evaluations were to exist, the Company would submit an inquiry to the service provider regarding the data used to value a particular security.  If the Company determines it has market information that would support a different valuation than the initial evaluation it can submit a challenge for a change to that security’s valuation.



Securities available for sale are classified as Level 2 in the fair value hierarchy as the valuation provided by the third-party provider uses observable market data.



Equity securities



The Company holds equity securities in another financial institution.  Since the ownership level is less than 5% of the outstanding shares of the bank, the investment was recorded on the Company’s balance sheet at historical cost, under the cost method of accounting, as of December 31, 2017.  As noted in Note 1 to the Unaudited Consolidated Financial Statements, on January 1, 2018, the Company adopted ASU 2016-01, which resulted in the Company adopting an accounting policy to mark the investment to its fair value with a cumulative-effect adjustment to retained earnings.  As of the end of each reporting period presented, starting with the three-month period ended March 31, 2018, included in these financial statements, equity securities will be presented at fair value, with changes in fair value during the period being recorded in the income statement.



The equity securities are classified as Level 3 in the fair value hierarchy because the primary inputs in measuring the fair value are unobservable to the public.  The shares of the institution are not publicly traded on a major stock exchange, but rather through private sales between shareholders.  Trading in the securities is fairly limited as the institution’s total trading volume for 2017 was approximately 1% of the outstanding common shares.  Trading activity in the first three months of 2018 was at a similar low volume.  The institution tracks the sales and the Company obtains the sales information from the institution to calculate the fair value of the equity securities as of the end of the reporting period.  The fair value recorded in the financial statements is based on observable prices obtained from the latest orderly transactions in the quarter.



Due to the adoption of ASU 2016-01 and the designation of the equity securities as Level 3 on the fair value hierarchy, there was a transfer into Level 3 for the equity securities in the three-month period ended March 31, 2018.  There were no such transfers into or out of Level 3 in the three-month period ended March 31, 2017.    











---

 

Mortgage servicing rights



Mortgage servicing rights (“MSRs”) do not trade in an active, open market with readily observable prices.  Accordingly, the Company obtains the fair value of the MSRs using a third-party pricing provider.  The provider determines the fair value by discounting projected net servicing cash flows of the remaining servicing portfolio.  The valuation model used by the provider considers market loan prepayment predictions and other economic factors which management considers to be significant unobservable inputs.  The fair value of MSRs is mostly affected by changes in mortgage interest rates since rate changes cause the loan prepayment acceleration factors to increase or decrease.  Management has a sufficient understanding of the third party service’s valuation models, assumptions and inputs used in determining the fair value of MSRs to enable management to maintain an appropriate system of internal control.  Mortgage servicing rights are classified within Level 3 of the fair value hierarchy as the valuation is model driven and primarily based on unobservable inputs.



The following table summarizes the changes in fair value for mortgage servicing rights during the three month periods ended March 31, 2018 and 2017, respectively:



Quantitative information about the significant unobservable inputs used in the fair value measurement of MSRs at the respective dates is as follows:











FINANCIAL INSTRUMENTS MEASURED AT FAIR VALUE ON A NONRECURRING BASIS



The Company is required, on a nonrecurring basis, to adjust the carrying value of certain assets or provide valuation allowances related to certain assets using fair value measurements.  The following table presents for each of the fair-value hierarchy levels as defined in this footnote, those financial instruments which are measured at fair value on a nonrecurring basis at March 31, 2018 and December 31, 2017:











Collateral dependent impaired loans



The Company evaluates and values impaired loans at the time the loan is identified as impaired, and the fair values of such loans are estimated using Level 3 inputs in the fair value hierarchy.  Each loan’s collateral has a unique appraisal and management’s discount of the value is based on factors unique to each impaired loan.  The significant unobservable input in determining the fair value is management’s subjective discount on appraisals of the collateral securing the loan, which ranges from 10%-50%.  Collateral may consist of real estate and/or business assets including equipment, inventory and/or accounts receivable and the value of these assets is determined based on appraisals by qualified licensed appraisers hired by the Company.  Appraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, estimated costs to sell, and/or management’s expertise and knowledge of the client and the client’s business.

---

 



The Company has an appraisal policy in which appraisals are obtained upon a commercial loan being downgraded on the Company internal loan rating scale to a 5 (special mention) or a 6 (substandard) depending on the amount of the loan, the type of loan and the type of collateral.  All impaired commercial loans are either graded a 6 or 7 on the internal loan rating scale.  For consumer loans, the Company obtains appraisals when a loan becomes 60 days past due or is determined to be impaired, whichever occurs first.  Subsequent to the downgrade or reaching 60 days past due, if the loan remains outstanding and impaired for at least one year more, management may require another follow-up appraisal.  Between receipts of updated appraisals, if necessary, management may perform an internal valuation based on any known changing conditions in the marketplace such as sales of similar properties, a change in the condition of the collateral, or feedback from local appraisers.  Collateral dependent impaired loans had a gross value of $17.2 million, with a valuation allowance of $0.9 million, at March 31, 2018, compared to a gross value for collateral dependent impaired loans of $15.5 million, with a valuation allowance of $1.1 million, at December 31, 2017.



FAIR VALUE OF FINANCIAL INSTRUMENTS



With the adoption of ASU 2016-01, the Company is no longer required to disclose the methods and significant assumptions used in estimating the fair value of financial instruments measured at amortized cost on the balance sheet.  The amendments in the ASU also require the Company to measure the fair value of financial instruments using the exit price notion consistent with ASC Topic 820, Fair Value Measurement.  Prior to adoption on December 31, 2017, loans were calculated using an entry price notion.



The table below depicts the estimated fair values of the Company’s financial instruments, including those that are not measured and reported at fair value on a recurring basis or nonrecurring basis.













---

 

4. LOANS AND THE ALLOWANCE FOR LOAN LOSSES



Loan Portfolio Composition

The following table presents selected information on the composition of the Company’s loan portfolio as of the dates indicated:











The Bank sells certain fixed rate residential mortgages to FNMA while maintaining the servicing rights for those mortgages.  In the three month period ended March 31, 2018, the Bank did not sell any mortgages to FNMA, compared with $2.8 million in the three month period ended March 31, 2017.  At March 31, 2018 and December 31, 2017, the Bank had a loan servicing portfolio principal balance of $76 million and $78 million, respectively, upon which it earned servicing fees.  At each of March 31, 2018 and December 31, 2017, the value of the mortgage servicing rights for that portfolio was $0.6 million.  No loans were held for sale at March 31, 2018 or December 31, 2017.  The Company has never been contacted by FNMA to repurchase any loans due to improper documentation or fraud.

  

Credit Quality Indicators



The Bank monitors the credit risk in its loan portfolio by reviewing certain credit quality indicators (“CQI”).  The primary CQI for its commercial mortgage and commercial and industrial (“C&I”) portfolios is the individual loan’s credit risk rating.  The following list provides a description of the credit risk ratings that are used internally by the Bank when assessing the adequacy of its allowance for loan losses:





The Company’s consumer loans, including residential mortgages and home equities, are not individually risk rated or reviewed in the Company’s loan review process.  Unlike commercial customers, consumer loan customers are not required to provide the Company with updated financial information.  Consumer loans also carry smaller balances.  Given the lack of updated information after the initial underwriting of the loan and small size of individual loans, the Company uses delinquency status as the primary credit quality indicator for consumer loans.  However, once a consumer loan is identified as impaired, it is individually evaluated for impairment.

---

 



The following tables provide data, at the class level, of credit quality indicators of certain loans for the dates specified:















---

 

Past Due Loans

The following tables provide an analysis of the age of the recorded investment in loans that are past due as of the dates indicated:





Note: Loan balances do not include $1.3 million in net deferred loan origination costs as of March 31, 2018.







Note: Loan balances do not include $1.2 million in net deferred loan origination costs as of December 31, 2017.





---

 

Allowance for loan losses



The following tables present the activity in the allowance for loan losses according to portfolio segment for the three month periods ended March 31, 2018 and 2017:















* Includes construction loans



Note: Loan balances do not include $1.3 million in net deferred loan origination costs as of March 31, 2018.



---

 







* Includes construction loans



Note: Loan balances do not include $951 thousand in net deferred loan origination costs as of March 31, 2017.





---

 

Impaired Loans

The following tables provide data, at the class level, for impaired loans as of the dates indicated:













---

 















---

 













---

 

Troubled debt restructurings



The following tables summarize the loans that were classified as troubled debt restructurings as of the dates indicated:









Any TDR that is placed on non-accrual is not reverted back to accruing status until the borrower makes timely payments as contracted for at least six months and future collection under the revised terms is probable.  All of the Company’s restructurings were allowed in an effort to maximize its ability to collect on loans where borrowers were experiencing financial difficulty.



The reserve for a TDR is based upon the present value of the future expected cash flows discounted at the loan’s original effective interest rate or upon the fair value of the collateral less costs to sell, if the loan is deemed collateral dependent.  This reserve methodology is used because all TDR loans are considered impaired.  As of March 31, 2018, there were no commitments to lend additional funds to debtors owing on loans whose terms have been modified in TDRs.



The Company’s TDRs have various agreements that involve deferral of principal payments, or interest-only payments, for a period (usually 12 months or less) to allow the customer time to improve cash flow or sell the property.  Other common concessions leading to the designation of a TDR are lines of credit that are termed-out and/or extensions of maturities at rates that are less than the prevailing market rates given the risk profile of the borrower.

---

 

The following tables show the data for TDR activity by the type of concession granted to the borrower for the three month periods ended March 31, 2018 and 2017:









The general practice of the Bank is to work with borrowers so that they are able to repay their loan in full.  If a borrower continues to be delinquent or cannot meet the terms of a TDR and the loan is determined to be uncollectible, the loan will be charged-off to its collateral value.  A loan is considered in default when the loan is 90 days past due.  The following table presents loans which were classified as TDRs during the preceding twelve months and which subsequently defaulted during the twelve month periods ended March 31, 2018 and 2017.





















---

 

5. EARNINGS PER SHARE DATA



The common stock per share information is based upon the weighted average number of shares outstanding during each period.  For the three month periods ended March 31, 2018 and 2017, the Company had an average of 124,443 and 122,966 dilutive shares outstanding, respectively.



Potential common shares that would have the effect of increasing diluted earnings per share are considered to be anti-dilutive and not included in calculating diluted earnings per share.  For the three month periods ended March 31, 2018 and 2017, there was an average of 28,660 and 24,990 potentially anti-dilutive shares outstanding, respectively, that were not included in calculating diluted earnings per share because their effect was anti-dilutive.









6. OTHER COMPREHENSIVE INCOME

The following tables summarize the changes in the components of accumulated other comprehensive income (loss) during the three month periods ended March 31, 2018 and 2017:





---

 









from 34% to 35%.



---

 

7. SEGMENT INFORMATION



The Company is comprised of two primary business segments, banking and insurance agency activities.  The following tables set forth information regarding these segments for the three month periods ended March 31, 2018 and 2017.

















---

 

8. CONTINGENT LIABILITIES AND COMMITMENTS



The unaudited consolidated financial statements do not reflect various commitments and contingent liabilities, which arise in the normal course of business, and which involve elements of credit risk, interest rate risk and liquidity risk.  These commitments and contingent liabilities consist of commitments to extend credit and standby letters of credit.  A summary of the Bank’s commitments and contingent liabilities is as follows:









Commitments to extend credit and standby letters of credit include some exposure to credit loss in the event of nonperformance by the customer.  The Bank’s credit policies and procedures for credit commitments and financial guarantees are the same as those for extensions of credit that are recorded on the Company’s unaudited consolidated balance sheets.  Because these instruments have fixed maturity dates, and because they may expire without being drawn upon, they do not necessarily represent cash requirements of the Bank.  The Bank did not incur any losses on its commitments and did not record a reserve for its commitments during the first three months of 2018 or during 2017.



Certain lending commitments for construction residential mortgage loans are considered derivative instruments under the guidelines of GAAP.  The changes in the fair value of these commitments, due to interest rate risk, are not recorded on the consolidated balance sheets as the fair value of these derivatives is not considered to be material.



---

 

9. NET PERIODIC BENEFIT COSTS



On January 31, 2008, the Bank froze its defined benefit pension plan.  The plan covered substantially all Bank employees.  The plan provides benefits that are based on the employees’ compensation and years of service.  Under the freeze, eligible employees will receive, at retirement, the benefits already earned through January 31, 2008, but have not accrued any additional benefits since then.  As a result, service cost is no longer incurred.



The Bank uses an actuarial method of amortizing prior service cost and unrecognized net gains or losses which result from actual expense and assumptions being different than those that are projected.  The amortization method the Bank used recognized the prior service cost and net gains or losses over the average remaining service period of active employees.



The Bank also maintains a nonqualified supplemental executive retirement plan covering certain members of the Company’s senior management.  The Bank uses an actuarial method of amortizing unrecognized net gains or losses which result from actual expense and assumptions being different than those that are projected.  The amortization method the Bank uses recognizes the net gains or losses over the average remaining service period of active employees.



The Bank did not make a contribution to the defined benefit pension plan during the first three months of 2018.



The following table presents the net periodic cost for the Bank’s defined benefit pension plan and supplemental executive retirement plan for the three month periods ended March 31, 2018 and 2017:









The components of net periodic benefit cost other than the service cost component are included in the line item “other expense” in the income statement.

---

 



10.  REVENUE RECOGNITION OF NON-INTEREST INCOME



A description of the Company’s material revenue streams in non-interest income accounted for under ASC 606 follows:



Insurance Service and Fees: Insurance services revenue relates to various revenue streams from services provided by TEA and the Bank:





TEA has agreements with various insurance companies to sell policies to customers on behalf of the carriers. The performance obligation for TEA is to sell annual P&C policies to commercial customers and consumers. This performance obligation is met when a new policy is sold or when an existing policy renews. The policies are generally one year terms. In the agreements with the respective companies, a commission rate is agreed upon.  The commission is recognized at the time of the sale of the policy or when a policy renews.



TEA has signed contracts with insurance carriers that enable TEA to sell benefit plans to commercial customers on behalf of the insurance carriers. The performance obligation for TEA is to sell the plans to commercial customers. After the initial sale when the customer signs an agreement to purchase the offered benefit plan, the performance obligation is met each month when a customer continues utilizing benefit plans from the carrier. The customer does not commit to a specific length of time with the carrier. In the agreements with the respective insurance companies, a commission rate is agreed upon. Revenue is recognized each month when the customer continues with the benefit plan sold by TEA.





TEA has signed written agreements with insurance carriers that document payouts to TEA based on the loss ratios of its customers. The performance obligation for TEA is to maintain a customer base with loss ratios below the agreed upon thresholds. In the contracts with the insurance companies, payout rates based on loss ratios are documented. The consideration is variable as loss ratios vary based on customer experience.  TEA’s performance obligation is over the course of the year as its customers’ performance with insurance carriers is measured throughout the year as losses occur. Due to variable nature of contingent profit sharing revenue, TEA will accrue contingent profit sharing revenue throughout the year based on recent historical results. As loss events occur and overall performance becomes known to TEA, accrual adjustments will be made until the cash is ultimately received.





The Company earns wealth management fees from its contracts with customers for certain financial services.  Fees that are transaction-based are recognized at the point in time that the transaction is executed.  Other related services provided include financial planning services and the fees the Bank earns are recognized when the services are rendered.





FCS has signed agreements with insurance companies to perform claims services including investigative and adjustment services related to residential and commercial lines. The performance obligation is for FCS to investigate the insurance claims and inspecting the damage to determine the extent of the insurance company’s liability. FCS is paid based on time and materials expended to investigate the claim. The rates paid are determined in the agreement between FCS and the respective insurance companies. Upon completion of its claims inspection work, FCS bills the insurance company for services rendered and recognizes the revenue earned.

---

 

A disaggregation of the total insurance service and other fees is provided in the table below:





Service Charges on Deposit Accounts: The Company earns fees from its deposit customers for transaction-based, account maintenance, and overdraft services.  Transaction-based fees, which include services such as ATM fees, stop payment charges, statement rendering, and ACH fees, are recognized at the time the transaction is executed as that is the point in time the Company fulfills the customer’s request.  Account maintenance fees, which primarily relate to monthly maintenance, are earned over the course of a month, representing the period over which the Company satisfies the performance obligation.  Overdraft fees are recognized at the point in time that the overdraft occurs.  Service charges on deposits are withdrawn from the customer’s account balance.



Interchange Income: The Company earns interchange fees from debit cardholder transactions conducted through the MasterCard payment network.  Interchange fees from cardholder transactions represent a percentage of the underlying transaction value and are recognized daily, concurrently with the transaction processing services provided to the cardholder.



11.  RECENT ACCOUNTING PRONOUNCEMENTS



Note 1 contains details on the impact of accounting pronouncements adopted in the three-month period ended March 31, 2018.  The following proposed standards will be adopted in future periods:

  

ASU 2016-02, Leases.  The objective of this ASU is to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements to meet that objective.  The main difference between previous GAAP and this ASU is the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous GAAP.  Under this new guidance, a lessee should recognize in the statement of financial position a liability to make lease payments and a right-of-use asset representing its right to use the underlying asset for the lease term.  The recognition, measurement, and presentation of expenses and cash flows arising from a lease by a lessee have not significantly changed from previous GAAP.  Information about the Company’s operating lease obligations is disclosed in Note 16 to the Company’s Consolidated Financial Statements included in Item 8 of the Annual Report on Form 10-K for the year ended December 31, 2016.  The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.  The Company is currently evaluating the impact of the standard on its financial reporting.



ASU 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments.  Current GAAP requires an “incurred loss” methodology for recognizing credit losses that delays recognition until it is probable a loss has been incurred. Both financial institutions and users of their financial statements expressed concern that current GAAP restricts the ability to record credit losses that are expected, but do not yet meet the “probable” threshold.  The main objective of this ASU (commonly known as the Current Expected Credit Loss Impairment Model, or CECL, in the industry) is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date.  To achieve this objective, the amendments in CECL replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates.  The amendments in CECL are effective for the Company for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.  The FASB expects that an entity will be able to leverage its current systems and methods for recording the allowance for credit losses.  However, many financial institutions, particularly community banks similar in size to the Company and industry groups like the American Bankers Association, have expressed concern about the impact of CECL.  The life of loan loss concept presents complexities that can decrease capital, and add both volatility to the allowance for loan losses (“ALLL”) estimates and additional costs.  CECL may increase the ALLL, though many factors will determine the impact for each bank.  Changes in expectations of future economic conditions play a large role in CECL and can significantly affect the credit loss estimate.  A challenge for the Company could be the operational impact.  Costly new systems and processes to track loan performance may need to be purchased or developed.  Significant procedural challenges may be faced both in implementation and on an ongoing basis.  The total impact of CECL to the Company’s

---

 

financial statements is unknown but may be material.  Implementation of CECL will be a significant project for the Company through the projected implementation date of January 1, 2020.



ASU 2017-04, Simplifying the Test for Goodwill Impairment.  The objective of this ASU is to simplify how an entity is required to test goodwill impairment by eliminating Step 2 from the goodwill impairment test.  Step 2 measures a goodwill impairment loss by comparing the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill.  Under the amendments in this ASU, an entity will perform its annual goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount.  An entity would recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value.  The amendments in this ASU are effective for annual reporting periods beginning after December 15, 2019, including interim periods within those fiscal years.  The Company does not expect the standard to have a material impact on the Company’s financial reporting.



ASU 2017-08, Premium Amortization on Purchased Callable Debt Securities.  The objective of this ASU is to amend the amortization period for certain purchased callable debt securities held at a premium.  The FASB is shortening the amortization period for the premium to the earliest call date.  Under current GAAP, entities generally amortize the premium as an adjustment of yield over the contractual life of the investment.  Current GAAP excludes certain callable debt securities from consideration of early repayment of principal even if the holder is certain that the call will be exercised.  As a result, upon the exercise of a call on a callable debt security held at a premium, the unamortized premium is recorded as a loss in earnings.  The amendments do no not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity.  The amendments in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018.  The Company does hold callable debt securities that were purchased at a premium and is currently evaluating the impact of the standard on its financial reporting.

---

 

ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



This Quarterly Report on Form 10-Q may contain certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that involve substantial risks and uncertainties.  When used in this report, or in the documents incorporated by reference herein, the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “plan,” “seek,” and similar expressions identify such forward-looking statements.  These forward-looking statements include statements regarding the Company’s business plans, prospects, growth and operating strategies, statements regarding the asset quality of the Company’s loan and investment portfolios, and estimates of the Company’s risks and future costs and benefits.



These forward-looking statements are based largely on the expectations of the Company’s management and are subject to a number of risks and uncertainties, including but not limited to: general economic conditions, either nationally or in the Company’s market areas, that are worse than expected; increased competition among depository or other financial institutions; inflation and changes in the interest rate environment that reduce the Company’s margins or reduce the fair value of financial instruments; changes in laws or government regulations affecting financial institutions, including changes in regulatory fees, monetary policy, and capital requirements; the Company’s ability to enter new markets successfully and capitalize on growth opportunities; the Company’s ability to successfully integrate acquired entities; loan losses in excess of the Company’s allowance for loan losses; changes in accounting pronouncements and practices, as adopted by financial institution regulatory agencies, the Financial Accounting Standards Board and the Public Company Accounting Oversight Board; the impact of such changes in accounting pronouncements and practices being greater than anticipated; the ability to realize the benefit of deferred tax assets; changes in tax policies, rates and regulations of federal, state and local tax authorities; changes in consumer spending, borrowing and saving habits; changes in the Company’s organization, compensation and benefit plans; and other factors discussed elsewhere in this Quarterly Report on Form 10-Q, as well as in the Company’s periodic reports filed with the SEC, in particular the “Risk Factors” discussed in Item 1A of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2017.  Many of these factors are beyond the Company’s control and are difficult to predict.



Because of these and other uncertainties, the Company’s actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements contained herein.  Forward-looking statements speak only as of the date they are made.  The Company undertakes no obligation to publicly update or revise forward-looking information, whether as a result of new, updated information, future events or otherwise, except to the extent required by law.





APPLICATION OF CRITICAL ACCOUNTING ESTIMATES



The Company’s Unaudited Consolidated Financial Statements included in this Quarterly Report on Form 10-Q are prepared in accordance with U.S. GAAP and follow general practices within the industries in which it operates.  Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the Company’s Unaudited Consolidated Financial Statements and Notes.  These estimates, assumptions, and judgments are based on information available as of the date of the Unaudited Consolidated Financial Statements.  Accordingly, as this information changes, the Unaudited Consolidated Financial Statements could reflect different estimates, assumptions, and judgments.  Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments, and as such, have a greater possibility of producing results that could be materially different than originally reported.  Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event.  Carrying assets and liabilities at fair value inherently results in more financial statement volatility.  The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available.  When third-party information is not available, valuation adjustments are estimated in good faith by management primarily through the use of internal cash flow modeling techniques.  Refer to Note 3 – “Fair Value Measurements” to the Company’s Unaudited Consolidated Financial Statements included in Item 1 of this Quarterly Report on Form 10-Q for further detail on fair value measurement.



Significant accounting policies followed by the Company are presented in Note 1 – “Organization and Summary of Significant Accounting Policies” to the Audited Consolidated Financial Statements included in Item 8 in its Annual Report on Form 10-K for the year ended December 31, 2017.  These policies, along with the disclosures presented in the other Notes to the Company's Audited Consolidated Financial Statements contained in its Annual Report on Form 10-K and in this financial review, provide information on how significant assets and liabilities are presented in the Company’s Unaudited Consolidated Financial Statements and how those values are determined.



---

 

Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses and valuation of goodwill to be the accounting areas that require the most subjective or complex judgments, and, as such, could be most subject to revision as new information becomes available.



Allowance for Loan Losses



The allowance for loan losses represents management’s estimate of probable losses in the Company’s loan portfolio.  Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment on the part of management and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change.  The loan portfolio also represents the largest asset type on the Company’s Unaudited Consolidated Balance Sheets.  Note 1 to the Audited Consolidated Financial Statements included in Item 8 in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 describes the methodology used to determine the allowance for loan losses.



Goodwill



The amount of goodwill reflected in the Company’s Unaudited Consolidated Financial Statements is required to be tested by management for impairment on at least an annual basis.  The test for impairment of goodwill on the identified reporting unit is considered a critical accounting estimate because it requires judgment on the part of management and the use of estimates related to the growth assumptions and market multiples used in the valuation model.  The goodwill impairment testing is performed annually as of December 31st.  No impairment charges were incurred in the most recent test and the fair value of the tested reporting unit substantially exceeded its fair value.  There were no triggering events in the three month period ended March  31, 2018 that resulted in an interim impairment test.



ANALYSIS OF FINANCIAL CONDITION



Loan Activity

Total loans grew to $1.11 billion at March 31, 2018, a $45 million or 4% increase from total loans of $1.07 billion at December 31, 2017 and a  $164 million or 17% increase from $946 million at March 31, 2017.



Loans secured by real estate were $862 million at March 31, 2018, reflecting a $32 million or 4% increase from $830 million at December 31, 2017 and a $111 million or 15% increase from $751 million at March 31, 2017.  The largest component of the growth in loans secured by real estate is commercial and multi-family real estate loans, which grew $30 million or 6% during the quarter, and $86 million or 19% over the past twelve months.  Commercial construction loans decreased $6 million during the quarter but at $101 million on March 31, 2018 they were $6 million higher than the balance at the conclusion of the prior year’s first quarter.  Commercial real estate is the largest part of the Company’s loan portfolio and has historically been the highest growth segment of the portfolio.  The market for commercial real estate in the Company’s footprint in Western New York was particularly strong over the past year.



In the first quarter of 2018, residential mortgage originations were  $12 million compared with $11 million in each of the fourth quarter and first quarter of 2017.  The Company did not sell any residential mortgages in the first three months of 2018, compared with the sale of 17% of residential mortgages originated in the fourth quarter of 2017 and 25% of originations in last year’s first quarter.  Management decides to keep or sell residential mortgage loans that are originated in conformance with FNMA underwriting standards at the time of origination based on interest rate risk management and the risk-adjusted return of alternative investment sources such as mortgage-backed securities.



The Company has also focused on growth opportunities in commercial and industrial (“C&I”) lending as a way to diversify its overall loan portfolio.  The C&I portfolio increased 6% to $245 million at March 31, 2018 from $232 million at December 31, 2017, and 28%  from $192 million at March 31, 2017.  Strong commercial loan demand and an increase in the number of C&I relationship managers has contributed to the elevated loan growth.



Credit Quality of Loan Portfolio

Total non-performing loans, defined as accruing loans greater than 90 days past due and nonaccrual loans, totaled $15 million, or 1.33% of total loans outstanding at March 31, 2018, compared with $14 million, or 1.29% of total loans outstanding, as of December 31, 2017 and $12 million, or 1.30% of total loans outstanding, as of March 31, 2017.  In the first quarter of 2018, the increase in non-performing loans reflected higher C&I and commercial construction nonaccrual loans.



---

 

Commercial credits graded as “special mention” and “substandard,” or the criticized loan portfolio, were $38 million at March 31, 2018, an $8 million increase from $30 million at December 31, 2017 and $4 million higher than the $34 million in criticized loans at March 31, 2017.  The increase in criticized loans in the first quarter of 2018 was in the commercial real estate portfolio as one large loan relationship for $8 million was downgraded to special mention.  The level of criticized loans can fluctuate as new information is received on the Company’s borrowers and their financial circumstances change over time.  As noted in Note 4 to the Company’s Unaudited Financial Statements included in Part I of this Quarterly Report on Form 10-Q, internal risk ratings are the credit quality indicators used by the Company’s management to determine the appropriate allowance for loan losses for commercial credits.  “Special mention” and “substandard” loans are weaker credits with a higher risk of loss categorized as “criticized” credits rather than “pass” or “watch” credits.



The Company maintains an allowance for loan losses that in management’s judgment appropriately reflects losses inherent in the loan portfolio.  The allowance for loan losses totaled $14.7 million or 1.32% of total loans outstanding at March 31, 2018, compared with $14.0 million or 1.32% of total loans outstanding as of December 31, 2017 and $13.6 million or 1.44% of total loans outstanding at March 31, 2017.  The Company recorded a $0.8 million provision for loan losses and $0.1 million in net charge-offs in the first quarter of 2018.  The net charge-off (recovery) ratio for the first quarter of 2018 was 0.03% of average net loans, compared with a ratio of 0.30% and (0.04) % in the fourth quarter of 2017 and first quarter of 2017, respectively.  A single C&I loan charge-off in the amount of $0.7 million caused the elevated charge-off ratio in the fourth quarter of 2017.



Investing Activities

Total investment securities were $163 million at March 31, 2018, compared with $149 million at December 31, 2017 and $116 million at March 31, 2017.  Interest-bearing deposits at other banks, which consist of overnight funds kept at correspondent banks and the Federal Reserve, increased to $9 million at March 31, 2018 from $8 million at December 31, 2017, but decreased from $19 million at March 31, 2017.  After the Company raised $14 million in equity in the first quarter of 2017, management increased the size of the investment portfolio to leverage and generate immediate returns on the capital.  The Company also purchased short-term securities in the first quarter of 2018 to collateralize seasonal municipal deposit inflows from tax receipts.  Securities and interest-bearing deposits at correspondent banks made up 13% of the Bank’s total average interest earning assets in the first quarter of 2018, compared with 14% in the fourth quarter of 2017 and 11% in last year’s first quarter.



The Company’s highest concentration in its securities portfolio was in available for sale U.S. government sponsored mortgage-backed securities at 53% of total investment securities at March 31, 2018, compared with 58% at December 31, 2017 and 55% at March 31,

2017.  The concentration in tax-advantaged debt securities issued by state and political subdivisions and U.S. government-sponsored agency bonds was 19% and 22%, respectively, of the total securities portfolio at March 31, 2018, compared with 23% and 19% at December 31, 2017 and 31% and 14% at March 31, 2017.  The Company also held a short-term U.S. Treasury bond for $10 million, or 6% of total outstanding investment securities, as of March 31, 2018 for purposes of collateralizing seasonal municipal deposits.



Management believes that the credit quality of the securities portfolio as a whole is strong.  The securities in an unrealized loss position at the end of the quarter reflect the increase in market interest rates rather than any credit concerns.  The total net unrealized loss of the available-for-sale investment portfolio was $3.3 million at March 31, 2018, compared with $1.4 million at December 31, 2017. 



The Company monitors extension and prepayment risk in the securities portfolio to limit potential exposures.  The Company has no exposure to subprime mortgages, nor does the Company hold private-label mortgage-backed securities, credit default swaps, or FNMA or FHLMC preferred stock investments in its investment portfolio.



Funding Activities

Total deposits at March 31, 2018 were $1.13 billion, an $83 million or 8% increase from $1.05 billion at December 31, 2017 and a $156 million or 16% increase from $978 million at March 31, 2017.  The growth in the first quarter of 2018 reflected growth of $19 million in demand deposits, $16 million in NOW deposits, $31 million in savings deposits, and $18 million in time deposits.  The largest contributor to the overall deposit growth was seasonal municipal deposit growth as municipalities collect annual property tax receipts in the first quarter. The Company also experienced organic growth in its government banking portfolio through the acquisition of new customers.  Municipal deposits grew $62 million in the first three months of 2018, including $9 million in demand deposits, $15 million in NOW deposits, and $38 million in savings deposits.  The Company also garnered commercial deposit growth in the first quarter of 2018, with an increase of $8 million in commercial demand deposits and $12 million in commercial savings deposits.



Consumer savings deposit growth has been challenging as consumer preferences move toward term products with higher rates and local market competition has stiffened.  Consumer savings deposits declined $20 million during the first quarter of 2018.  The growth product for consumer deposits continues to be time deposits, which grew $18 million during the first quarter of 2018 and increased $56 million from March 31, 2017.



---

 

Due to the transactional nature of demand deposits, average balances are a useful metric to meaningfully measure sustained growth rates.  Average demand deposits were $223 million in the first quarter of 2018, a $4 million increase from $219 million in the fourth quarter of 2017, but 14% higher than the $196 million average balance in the first quarter of 2017.  Most of the Company’s demand deposit growth over the past twelve months was with municipal and commercial customers. 



The Company had $62 million in other borrowings at March 31, 2018, which consisted of a  $10 million advance with the Federal Home Loan Bank of New York (“FHLBNY”) scheduled to mature in 2020 and $52 million in overnight borrowings with the FHLBNY.  Other borrowings were $88 million at December 31, 2017 and $10 million at March 31, 2017.  The Company relied less on its overnight line of credit with FHLBNY in the first quarter of 2018 due to the inflow of seasonal municipal deposits.  The Company’s strong loan growth over the past twelve months coupled with the challenging environment for growing core deposits in a rising rate environment resulted in an increase in the Company’s usage of its overnight borrowings since March 31, 2017.



---

 

ANALYSIS OF RESULTS OF OPERATIONS



Average Balance Sheet

The following tables present the significant categories of the assets and liabilities of the Company, interest income and interest expense, and the corresponding yields earned and rates paid for the periods indicated.  The assets and liabilities are presented as daily averages.  The average loan balances include both performing and non-performing loans.  Investments are included at book value.   Yields are presented on a non-tax-equivalent basis.







---

 

Net Income



Net income was $3.3 million, or $0.68 per diluted share, in the first quarter of 2018, compared with $1.0 million, or $0.20 per diluted share, in the fourth quarter of 2017 and $3.1 million, or $0.66 per diluted share, in last year’s first quarter.  The fourth quarter of 2017 included a one-time $2.1 million deferred income tax expense related to the signing of the Tax Cuts and Jobs Act (the “TCJA”).  The increase over both comparative periods primarily reflects higher net interest income due to loan growth and a lower income tax expense related to the enactment of the TCJA.  Return on average equity was 11.15% for the first quarter of 2018 compared with 3.32% in the fourth quarter of 2017 and 11.59% in the first quarter of 2017.



Other Results of Operations – Quarterly Comparison



Net interest income increased $0.3 million, or 3%, from the fourth quarter of 2017 and $1.8 million, or 19%, from the prior-year first quarter to $11.5 million in the first quarter of 2018.  The increase was driven by growth in average interest-earning assets, particularly loans.  Loan growth was driven by continued success in commercial lending.  Average commercial loans, including commercial real estate and commercial and industrial loans, were $872 million in the first quarter of 2018, 6% higher than $822 million in the fourth quarter of 2017 and 17% higher than $747 million in the 2017 first quarter.   

First quarter net interest margin of 3.77% decreased 2 basis points from the 2017 fourth quarter, but was flat compared with the first quarter of 2017.  Loan yields benefited from variable loan re-pricing due to an increase in the prime rate as the Federal Reserve increased its target rate by 100 basis points since March 2017, including an increase of 25 basis points at its March 2018 meeting.  Loan yields were 4.70% in the first quarter of 2018, compared with 4.65% in the fourth quarter of 2017 and 4.49% in last year’s first quarter.  The benefit of higher loan yields was offset by an increase in funding costs, reflecting a rise in both core deposit and wholesale borrowing rates due to the increase in short-term interest rates.  The cost of interest-bearing liabilities was 0.81% in the first quarter of 2018 compared with 0.73% in the fourth quarter of 2017 and 0.66% in the first quarter of 2017.

The $0.8 million provision for loan losses for the first quarter of 2018 reflects strong loan growth and an increase in criticized loans in the quarter.  By comparison, each of the fourth quarter and first quarter of 2017 experienced a decrease in criticized loans, resulting in lower provision for loan loss.  The level of criticized loans, or those loans that have potential or well-defined weaknesses that warrant management’s close attention, is a key variable in management’s determination of the allowance for loan losses.  Additionally, the first quarter of 2017 had only marginal loan growth, contributing to the release of allowance for loan losses of $0.4 million during that quarter.

Total non-interest income was $3.8 million in the first quarter of 2018, an increase of $0.8 million from the fourth quarter of 2017 and $0.3 million from the first quarter of 2017.

The increase in deposit service charges from $0.4 million in last year’s first quarter to $0.5 million in this year’s first quarter is a result of higher overdraft fees as the Company introduced a new product to commercial clients that provides overdraft protection lines of credit. 

The year-over-year decrease in insurance revenue from $2.2 million in the first quarter of 2017 to $2.0 million in the first quarter of 2018 was a result of a change in the revenue recognition policy for contingent profit sharing revenue discussed in Note 1 and Note 10 to the Unaudited Consolidated Financial Statements.  The decrease in profit-sharing revenue recognized in the 2018 first quarter from last year’s first quarter was $0.4 million.  This decrease was partially offset by an increase in employee benefits revenue of $0.2 million. The increase in insurance revenue from $1.6 million in the fourth quarter of 2017 was seasonal in nature as the final quarter of the year is a low point in policy renewals for institutional clients, including businesses and municipalities. 

Other income of $0.6 million in the first quarter of 2018 included a $147 thousand increase in the Company’s investment in the equity securities of another financial institution.  This recognition of the increase in the fair value of this investment reflects the Company’s 2018 adoption of ASU 2016-01, as detailed in Note 1 to these Unaudited Consolidated Financial Statements.  Changes in the fair value of this investment will be reflected in the Company’s earnings going forward.

There were no new historic tax credit investments in the first quarter of 2018 or 2017.  Historic tax credit investment activity resulted in a net loss of $0.5 million being recorded in non-interest income in the fourth quarter of 2017.    

First quarter 2018 non-interest expenses increased 12% from the prior-year period to $10.2 million, but decreased 2% from the fourth quarter of 2017.  The most significant component of the year over year increase was higher salaries and benefits costs.  The increase in salaries and benefits of $1.0 million to $6.7 million in the first quarter of 2018 reflects strategic personnel hires to support the Company’s continued growth, as well as an increase in incentive compensation and benefits costs.  The first quarter of 2018 also included approximately $250,000 in total cost related to the previously announced one-time $1,000 bonus paid to non-senior associates after the TCJA was signed into law in late 2017.

---

 

Advertising expenses decreased in the first quarter of 2018 to $0.1 million from $0.4 million in the fourth quarter of 2017 and $0.2 million in the first quarter of 2017 mostly due to seasonality with larger campaigns planned for the spring and summer.  Technology and communications expenses increased to $0.8 million in the first quarter of 2018 from $0.6 million in the prior-year period due to a new online banking platform that was implemented in the second quarter of 2017.   

Other expenses in the fourth quarter of 2017 included the impact of a $300,000 contribution to the Evans Bank Foundation Fund (“the Foundation”).  The Foundation contributes to community organizations reflecting the Company’s values and impacting the Western New York region in a positive and meaningful way.

The Company’s efficiency ratio in the first quarter of 2018 improved to 66.6% from 70.4% in the fourth quarter of 2017 and 68.6% in last year’s first quarter.  The reduction reflects the Company’s significant net interest income growth.

Income tax expense was $1.0 million, or an effective tax rate of 22.8%, for the first quarter of 2018 compared with $2.2 million, or 69.0%, in the fourth quarter of 2017 and $1.4 million, or 30.8%, in last year’s first quarter.  The effective tax rate for the fourth quarter of 2017 reflects the benefit of the previously noted historic tax credit investment transactions as well as a $2.1 million deferred tax expense related to the TCJA.  The decrease in the effective rate in the first quarter of 2018 reflects the benefit of federal tax reform, which decreased the Company’s marginal federal income tax rate from 35% to 21%.



CAPITAL



The Company consistently maintains regulatory capital ratios significantly above the federal “well capitalized” standard, including a  Tier 1 leverage ratio of 9.81% at March 31, 2018, compared with 10.06% and 10.76% at December 31, 2017  and March 31, 2017, respectively.  The decrease reflects the growth in average assets used in the leverage ratio calculation.  Book value per share increased to $24.96 at March 31, 2018, compared with $24.74 at December 31, 2017 and $23.64 at March 31, 2017. 

On February 20, 2018, the Company declared a cash dividend of $0.46 per share on the Company’s outstanding common stock.  The dividend was paid on April 3, 2018.    This semi-annual dividend represents a $0.06, or 15%, increase from the previous semi-annual dividend paid in October 2017.





LIQUIDITY



The Bank utilizes cash flows from the investment portfolio and federal funds sold balances to manage the liquidity requirements related to loan demand and deposit fluctuations.  The Bank also has many borrowing options.  The Company uses the FHLBNY as its primary source of overnight funds and also has one long-term advance with FHLBNY.  The Company had $62 million and $88 million in borrowed funds at FHLBNY at March 31, 2018 and December 31, 2017, respectively.  The Company has pledged sufficient collateral in the form of residential and commercial real estate loans at FHLBNY that meets FHLB collateral requirements.    As a member of the FHLB, the Bank is able to borrow funds at competitive rates.  Advances of up to $167 million can be drawn on the FHLB via an Overnight Line of Credit Agreement between the Bank and the FHLB.  An amount equal to 25% of the Bank’s total assets could be borrowed through the advance programs under certain qualifying circumstances.  The Bank also has the ability to purchase up to $18 million in federal funds from its correspondent banks.  By placing sufficient collateral in safekeeping at the Federal Reserve Bank, the Bank could borrow at the discount window.  The Bank’s liquidity needs also can be met by more aggressively pursuing time deposits, or accessing the brokered time deposit market, including the Certificate of Deposit Account Registry Service (“CDARS”) network.



Cash flows from the Bank’s investment portfolio are laddered, so that securities mature at regular intervals, to provide funds from principal and interest payments at various times as liquidity needs may arise.  Contractual maturities are also laddered, with consideration as to the volatility of market prices.  At March 31, 2018, approximately 13% of the Bank’s securities had contractual maturity dates of one year or less and approximately 28% had maturity dates of five years or less.  Additionally, mortgage-backed securities, which comprise 53% of the investment portfolio at March 31, 2018, provide consistent cash flows for the Bank.



The Company’s primary source of liquidity is dividends from the Bank.  Additionally, the Company has access to capital markets as a funding source.



Management, on an ongoing basis, closely monitors the Company’s liquidity position for compliance with internal policies and believes that available sources of liquidity are adequate to meet funding needs in the normal course of business.  As part of that monitoring process, management calculates the 90-day liquidity each month by analyzing the cash needs of the Bank.  Included in the calculation are liquid assets and potential liabilities.  Management stresses the potential liabilities calculation to ensure a strong liquidity position.  Included in the calculation are assumptions of some significant deposit run-off as well as funds needed for loan closings and investment purchases.  In the Company’s internal stress test at  March 31, 2018 the Company had net short-term liquidity of $145 million as compared with $237 million at December 31, 2017.  Available assets of $170 million, divided by public and purchased funds of $299 million, resulted in a long-term liquidity ratio of 57% at March 31, 2018, compared with 49% at December 31, 2017.

---

 



Management does not anticipate engaging in any activities, either currently or in the long term, for which adequate funding would not be available and which would therefore result in significant pressure on liquidity.



The Company believes that the Bank maintains a sufficient level of U.S. government and government agency securities and New York State municipal bonds that can be pledged as collateral for municipal deposits.





ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



Additional information responsive to this Item is contained in the Liquidity section of Management’s Discussion and Analysis of Financial Condition and Results of Operations, which information is incorporated herein by reference.



Market risk is the risk of loss from adverse changes in market prices and/or interest rates of the Bank’s financial instruments.  The primary market risk that the Company is exposed to is interest rate risk.  The core banking activities of lending and deposit-taking expose the Bank to interest rate risk, which occurs when assets and liabilities reprice at different times and by different amounts as interest rates change.  As a result, net interest income earned by the Bank is subject to the effects of changing interest rates.  The Bank measures interest rate risk by calculating the variability of net interest income in future periods under various interest rate scenarios using projected balances for interest-earning assets and interest-bearing liabilities.  Management’s philosophy toward interest rate risk management is to limit the variability of net interest income to changes in net interest rates.  The balances of financial instruments used in the projections are based on expected growth from forecasted business opportunities, anticipated prepayments of loans, and expected maturities of investment securities, loans, and deposits.  Management supplements the modeling technique described above with analysis of market values of the Bank’s financial instruments and changes to such market values given changes in the interest rates.



The Bank’s Asset-Liability Committee, which includes members of senior management, monitors the Bank’s interest rate sensitivity with the aid of a model that considers the impact of ongoing lending and deposit taking activities, as well as interrelationships in the magnitude and timing of the repricing of financial instruments, including the effect of changing interest rates on expected prepayments and maturities.  When deemed prudent, management has taken actions, and intends to do so in the future, to mitigate exposure to interest rate risk through the use of on- or off-balance sheet financial instruments.  Possible actions include, but are not limited to, changing the pricing of loan and deposit products, and modifying the composition of interest-earning assets and interest-bearing liabilities, and reliance on other financial instruments used for interest rate risk management purposes.



---

 

The following table demonstrates the possible impact of changes in interest rates on the Bank’s net interest income over a 12-month period of time:



SENSITIVITY OF NET INTEREST INCOME TO CHANGES IN INTEREST RATES









Many assumptions were utilized by management to calculate the impact that changes in interest rates may have on the Bank’s net interest income.  The more significant assumptions related to the rate of prepayments of mortgage-related assets, loan and deposit volumes and pricing, and deposit maturities.  The Bank assumed immediate changes in rates including 200 basis point rate changes.



In each of the 100 and 200 basis point rate reduction scenarios, the applicable rate changes are limited to lesser amounts such that interest rates are not less than zero.  These assumptions are inherently uncertain and, as a result, the Bank cannot precisely predict the impact of changes in interest rates on net interest income.  Actual results may differ significantly due to the timing, magnitude, and frequency of interest rate changes in market conditions and interest rate differentials (spreads) between maturity/repricing categories, as well as any actions such as those previously described, which management may take to counter such changes.  In light of the uncertainties and assumptions associated with the process, the amounts presented in the table and changes in such amounts are not considered significant to the Bank’s projected net interest income.





ITEM 4 - CONTROLS AND PROCEDURES



DISCLOSURE CONTROLS AND PROCEDURES



The Company’s management, with the participation of the Company’s principal executive officer and principal financial officer, evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of March 31, 2018 (the end of the period covered by this Report).  Based on that evaluation, the Company’s principal executive and principal financial officers concluded that as of March 31, 2018 the Company’s disclosure controls and procedures were effective.



CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING



No changes in the Company’s internal control over financial reporting were identified in connection with the evaluation required by paragraph (d) of Rule 13a-15 or Rule 15d-15 under the Exchange Act that occurred during the fiscal quarter ended March  31, 2018 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.





---

 

PART II - OTHER INFORMATION



ITEM 1 – LEGAL PROCEEDINGS



The nature of the Company’s business generates a certain amount of litigation involving matters arising in the ordinary course of business.



In the opinion of management, there are no proceedings pending to which the Company is a party or to which its property is subject, which, if determined adversely, would have a material effect on the Company’s results of operations or financial condition.



ITEM 2 – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS



In the first quarter of 2018, the Company purchased shares of its common stock as follows:



Issuer Purchases of Equity Securities











































---

 

ITEM 6 – EXHIBITS



The following exhibits are filed as a part of this report.







---

 



SIGNATURES







Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.





                                                                             Evans Bancorp, Inc.









DATE

May 2, 2018







DATE

May 2, 2018

















---