Community Bank System Inc

NYSE:CBU

Earnings Call Transcript 2017-Q4

[Operator]

Good day. And welcome to this Community Bank System Fourth Quarter and Year End 2017 Earnings Conference Call. Please note that this presentation contains forward-looking statements within the provision of the Private Securities Litigation Reform Act of 1995 that are based on current expectations, estimates, and projections about the industry, markets, and economic environment in which the Company operates.

Such statements involve risks and uncertainties that could cause actual results to differ materially from the results discussed in these statements. These risks are detailed in the Company’s Annual Report and Form 10-K filed with the Securities and Exchange Commission.

At this time, I would turn the conference over to Mark Tryniski, President and Chief Executive Officer. Please go ahead.

[Mark Tryniski, President, Chief Executive Officer]

Thank you, Ashley. Good morning, everyone, and thank you all for joining our Q4 and full year conference call. We had a strong fourth quarter, it was up 10% per share on an operating basis over 2016, but was down in Q3 due to $0.05 per share credit provision related to a single acquired loan that Scott will discuss further.

Credit growth remain elusive in the fourth quarter as a result of muted demand in both consumer and business markets, as well as continuation of above average levels of early pay-offs. Despite volume challenges, aggregate margin dollars were at a record level due to new originations and higher yields the contractual and prepayment cash flows for both the consumer and business portfolios, adding to the margin was a deposit made in 2017 of zero.

On a full year basis, operating earnings were up 13% over 2016. This performance was attributable to a number of factors, including the accretive benefit of the NRS acquisition in Q1 and the Merchants merger in Q2. In addition, our benefits, wealth management and insurance businesses all delivered double-digit growth on both the top end bottom line and improved margins. Banking fee income was up double-digit as well and our efficiency ratio improved from 59.5 to 58.3.

We completed our build out of DFAST, improved our risk management processes and systems, and implemented improved customer channel technology. In summary, it was a transformative year for Community Bank System, and I could not be more proud of our 2,600 team members for what they accomplished.

Looking ahead to 2018, we cannot be better positioned. Earnings momentum is at a record level. We will have a significant tax rate benefit going forward that Scott will discuss further. We will accumulate meaningful incremental capital that will be additive to our strategic efforts, again the highest level of dividend capacity we've experienced in many years. We're very optimistic about 2018 and as always, remain mindful of our obligations to deliver exceptional returns to our shareholders. Scott?

[Scott Kingsley]

Thank you, Mark and good morning everyone. As Mark noted the fourth quarter 2017 was noted very solid operating quarter for us; and as a reminder, included the activities of the Northeast Retirement Services acquisition that we completed in early February 2017 and the Merchants Bancshares acquisition completed last May. I'll first cover some updated balance sheet items.

Average earning assets of $9.37 billion for the fourth quarter were up 22% in fourth quarter of 2016, reflective of the mid second quarter acquisition of Merchants. On a year-over-year basis, residential mortgages and home equity instruments grew 1.7% organically as the company continues to sell most of its longer term secondary market eligible originations. Consumer indirect loans were down $33 million in 2017 or 3.2% as we continue to balance growth with our objective of improving returns and capital deployed in this portfolio.

Our net charge off and delinquency results in this portfolio continue to be very good and consistent with the last several years. As Mark mentioned, business loans were down for the second consecutive quarter, reflective of the number of outside unscheduled pay-offs, modest demand characteristics and the continuation of very competitive market dynamics. Quarter-end investment securities were down modestly from the end of second and third quarters, but up almost $300 million from the end of fourth quarter of last year, a result of the Merchants acquisition.

Average quarterly deposits were up $1.44 billion year-over-year in the fourth quarter of 2017, also reflective of the Merchants transaction and continued success in our core deposit gatherer. We ended the quarter with $363 million of borrowings, of which $337 million were collateralized customer repurchase agreements, which act like and are priced much more like deposits than wholesale borrowings. As such, with the exception of our $123 million of highly efficient and regulatory capital additive trust preferred obligations, our December 31st balance sheet has virtually no external debt, a rarity in our peer group.

The fourth quarter and full year of 2017 was a continuation of the favorable overall asset quality results we have experienced for several years, despite $3.1 million partial charge-off on a single $8.3 million commercial relationship. Including this one large charge-off, full year net charge-offs were $10.6 million or 0.18% of total loans and were up $4.4 million from 2016's results of $6.2 million of net charge-offs or just 0.13% of total loans.

Non-performing loans, comprised of both legacy and acquired loans, ended the fourth quarter of 2017 at $27.4 million, or 0.44% of total loans, 7 basis points higher than the ratio reported at the end of September and reflective of the remaining non-accrual balance on the previously mentioned commercial credit.

Our year-end December 2017 reserves below losses represent 0.98% of our legacy loans and 0.76% of total outstanding with the addition of the acquired Merchants' loans earlier in 2017. Based on the most recent trailing four quarters' results, which include the large single charge-off previously mentioned, our reserves still represent 4.5 years of annualized net charge-offs. Despite multiple reports of macro level auto industry concerns, our 2017 net charge-off ratio without our lending portfolio was under 40 basis points of average loans, consistent with the previous eight quarters and still quite productive by longer term historical standards.

As of December 31st, our investment portfolio stood at $3.08 billion and was comprised of $590 million of U.S. agency and agency backed mortgage obligations, or 19% of the total; $502 million of municipal bonds or [15%] and $1.91 billion of U.S. treasury securities or 62% of the total. The remaining 3% was in corporate and other debt securities. The portfolio contained net unrealized gains of $23 million as of year-end compared to a net unrealized gain of $42 million at the end of December of 2016 due to the movement up in market interest rates during the last 12 months.

Our capital levels in the fourth quarter of 2017 continue to be very strong. The tier one leverage ratio was 10% at year-end and tangible equity to net tangible assets ended December at 8.61% despite the meaningful use of capital for both the NRS and Merchants’ transactions during the year. As we had consistently discussed, and primarily due to our history of acquisitions, the company has vetted a net deferred tax liability position for several years. As such, the required revaluation of those net deferred tax liabilities, following the late December enacted Tax Cuts and Jobs Act, which will lower the corporate federal tax rate from 35% to 21%, resulted in a one-time gain to the Company of $38 million, which was reflected in our fourth quarter 2017 GAAP results. Tangible book value per share was $15.94 at year-end and still includes $48.4 million of deferred tax liabilities generated from certain acquired intangible assets or $0.95 per share.

Shifting to the income statement, our reported net interest margin for the fourth quarter was 3.74%, which was down 2 basis points from the fourth quarter of 2016 and 10 basis points higher than the linked third quarter of 2017, consistent with historical results in the second and fourth quarters each year include our semiannual dividend from the Federal Reserve Bank of approximately $750,000, which added 3 basis points of net interest margin to fourth quarter results.

In addition, we reported approximately $1.1 million of incremental purchase loan accretion compared to the fourth quarter of 2016, which added an additional 5 basis points to our net interest margin. Proactive and disciplined management of funding costs continued our positive effect on margin results as total deposit costs from the quarter remained at 10 basis points, including the added deposits from the Merchants’ transaction. Despite four Fed funds rate changes since December of 2016 our deposit beta has remained at zero over the last 12 months.

Fourth quarter basic non-interest income of $19.3 million was up $2.9 million or 17.8% from the fourth quarter of last year, reflective of the Merchants’ transaction and several core improvement initiatives. On a linked quarter basis, banking non-interest income was down $800,000 from the third quarter, which included our annual dividend from certain pooled group insurance programs.

Quarterly revenues from our benefits administration, wealth management and insurance businesses of $34.6 million, were up $12.4 million from the fourth quarter of last year and included the NRS and Merchants transactions, as well as three smaller insurance agency acquisitions completed earlier in 2017.

Fourth quarter 2017 operating expenses of $86.1 million, which exclude acquisition expenses of $0.8 million or $28.9 million above the fourth quarter of 2016 and included the operating activities from both the Merchants and NRS transaction, as well as the significantly higher intangible amortization that resulted from the two acquisitions.

On a linked quarter basis, operating expenses were up $2.9 million from the third quarter and included incremental 650,000 of salaries and benefits cost, primarily performance based. Occupancy and equipment costs were up $0.5 million and included higher maintenance and utility cost. Other expenses were $1.8 million higher with more than half of that in higher professional services cost for certain technology and core systems initiatives, as well as some additional DFAST related costs. We also incurred higher marketing and employee training costs in some of our newer markets in the fourth quarter.

Our operating effective tax rate in the fourth quarter of 2017 was 28.6% versus 33.4% in last year’s fourth quarter and included $300,000 reduction in income tax expense related to the change in accounting for share-based transaction. Our quarterly and full year 2017 effective tax rate included the incurrence of almost $26 million of acquisition expenses during 2017.

Looking forward, we continue to expect Federal Reserve Bank semiannual dividends in the second and fourth quarters each year, but because we expect to be above $10 billion in assets for all of 2018, our dividend rate will be approximate a third of the level we experienced in 2017. Despite the large partial charge-offs on the one specific commercial relationship previously mentioned, 2017 net charge-offs results were again manageable and we do not keep signs of additional asset quality headwinds on the horizon.

Our core operating net interest margin has remained in a fairly narrow band over the last several quarters, a range we would expect to continue to operate in for, at least, the next few quarters, including the impact of higher purchase loan accretion related to the Merchants transaction. However, the change in the federal tax rate in 2018 will result in lower fully taxable equivalent yields on our municipal investment and loan portfolios. And although, the change will not impact to report that their interest income, we estimate it will lower 2018 net interest margin by 6 basis points to 8 basis points compared to 2017.

Our full year effective tax rate in 2017 was 29.5% excluding the one-time gain from the revaluation of deferred tax assets and liabilities. With the lower and active federal tax rate, we expect our 2018 full year effective rate to decline to between 22% and 23% based on our current mix of income from tax exempts versus fully taxable sources. We continue to expect a net reduction from Durbin mandated impacts on debit interchange revenues beginning in July of 2018 of approximately $12 million annually or estimated $6 million in the second half of 2018.

In summary, we believe we’re very well-position from both the capital and an operational perspective for 2018 and beyond, and as Mark mentioned, look forward to continuing to execute on future required inorganic improvement opportunities.

I’ll now turn this back over to Ashley to open the line for any questions.

[Operator]

Thank you [Operator Instructions] First question from Alex Twerdahl with Sandler O’Neill. Please go ahead.

[Alex Twerdahl, Sandler O’Neill]

First off, I think it's remarkable that five rate hikes later your cost to deposits has been unchanged completely at 10 basis points, which is amongst the lowest in industry. How long do you think you can keep that up? I mean, are you getting some pressure from different customers, the different pockets to raise deposit cost?

[Mark Tryniski, President, Chief Executive Officer]

We started to see that in the end of the third quarter, mainly at the higher level of balances customer who have more meaningful balances looking at other alternative. And so we’ve made some modest accommodations to maintain the balances and respond to the competitive market pressure. So I expect that we’ll continue into 2018. So I would suspect our deposit data for 2018 will not be zero. I think if you look at the markets that we operate and we've always had somewhat lower deposit funding cost and would expect that will continue into 2018, I just believe that we will experience some modest break pressure competitively in the market in 2018. But we’ll be very judicious about managing those funding costs as we always try to be. We’ve spent a lot of time understanding the market and understanding how we can optimize our funding cost. So it won’t be zero in 2018 but -- we’d suspect t it may still lag the greater market in terms of betas.

[Alex Twerdahl, Sandler O’Neill]

And then just a modeling question, Scott, the tax rate of 22% to 23% that you project for 2018. Is that include the share based comp adjustment that you expect to see probably the bulk of which in the first quarter?

[Mark Tryniski, President, Chief Executive Officer]

I think it does, Alex. I think it's probably -- as you know, when you establish an effective rate, you establish it in the early near for the full year outcome. So the fact that you may have more activity on the share based side early in the year in theory prognosticate that. As a quick reminder we probably do have more tax exempts income than many of our peers, because of the size of our municipal securities portfolio. In fact, we have decent size of municipal loan portfolio, principally in New England. The other thing to remember is the base in 2017 was a little bit artificially low than 29.5% because we did have $26 million of acquisition expense and we don’t expect to incur in 2018, so you’re starting at a little higher level there. And probably lastly, handful of other small things that came out of the tax code change, one of which does at our size of over $10 billion, FDIC insurance premiums will not be deductable. So a handful of things that play into that region.

[Alex Twerdahl, Sandler O’Neill]

But it would be fair to say the first quarter might be closer to that -- maybe 21% of 22% and then go a little bit higher in the second, third, and fourth, just because of that share based comp adjustment?

[Mark Tryniski, President, Chief Executive Officer]

It could be up. We had some outsized option exercise activity in the first quarter last year when we were trading north of $60. Well, people have the same motivation at our current trading levels? Too early to tell on that. But I would suspect to see a little activity than last year's first quarter. But you're probably not far off by thinking we're at the lower end of blended rate earlier in the year.

[Alex Twerdahl, Sandler O’Neill]

And then just a final question for me with respect to capital deployments. Clearly, with the lower effective tax rate, you'll be accreting capital at a faster pace in 2018 and beyond. Does that change your outlook for how you use capital? Does M&A, for example, become more of a requirement into 2018, 2019, and does that in turn change the criteria of what kind of deals you guys would look at?

[Mark Tryniski, President, Chief Executive Officer]

We will be accreting capital at a more rapid pace in 2018 than we have in the past. I don't think it's going to impact the disciplined and strategic thinking we applied to M&A, which is really around identifying and executing quality merger and acquisition opportunities that can help us model our earnings and our dividends in a sustainable fashion. So I don't think it changes. I think it does allow us to accumulate capital more rapidly and possibly to utilize more capital in the future in terms of cash stock mix. And maybe as you know, we talked for a couple of years about effectively accumulated a fair bit of capital.

We tried to deploy a lot of that with both NRS, which was 50-50 mix and with Merchants, which was a 70-30 mix. But the earnings levels are strong and will even get stronger in 2018 so it just creates that much bigger of a challenge to deploy the capital, which certainly gives us more dividend capacity as well. But I would say that the fact that we’re accumulating capital quicker does not do anything in terms of impacting our strategic thinking, but it would impact our capacity to deploy more capital in terms of mix that creates even stronger earnings accretion at any given transactions, but I think they’ll ultimately be a benefit there.

On the other side, multiples have increased a bit in terms of market multiples, as well as M&A multiples. So we have to be mindful of that ever reaching, but I think this is just -- it creates more of a good profit to have Alex in terms of accumulating that capital more quickly than we can used to effect high value M&A opportunities for the benefit to shareholders, but more effective core strategy.

[Operator]

And we'll take our next question from Collyn Gilbert with KBW. Please go ahead.

[Collyn Gilbert, KBW]

Maybe could you guys talk a little bit about just your growth outlook and what you're seeing in the markets? I know you'd indicated in the opening comments, competitive landscapes as it relates to lending. But just talk a little bit more about that and maybe how you see loan growth shaping out on an organic basis in 2018.

[Mark Tryniski, President, Chief Executive Officer]

I think as you know when you operate in lower growth markets we've never had double digit market opportunities. In fact, it’s mid single digits, which sometimes we've been at and other times, we haven't depending on market demand. Right now, I would -- if you look at the three main portfolios in the commercial, we had record originations in 2017, excluding Merchants. But we also had an incredible level of unexpected pay-offs. So despite the fact that we have otherwise great year in terms of business lending, get over $100 million, those are the larger ones in unexpected pay-off. So that certainly impacted what would otherwise have been a very solid year.

Right now, we're sitting at a record pipeline in our commercial business, but we also expect and we had some poor visibility in the past and we expect more and some larger pay-offs to happen in the first half of 2018. So hopefully, we can offset that. As I said, we do have a record pipeline right now. And you've got a more competitive environment. The insurance companies and the kind have gotten back into the commercial lending, they're doing 30 year non- recourse financing. And you have our commercial customer with a nice project that cash flows well, and we're not going to compete with that. I think the competitiveness in the market is probably more around rate and turn than anything else. So we're seeing really low spreads and we do not manage the volume. We run our business based on profitability and return on equity characteristics, but not on volume. So when spreads get too thin, we don't participate. And I think we believe there’s better ways to deploy our capital.

So I think as the spreads have gotten lower and the terms have gotten longer, that's what from our perspective, is the principal competitive dynamics of the commercial market. It’s not really so much demand as much as it is other participants taking out credit relationships, not other banks by enlarge, but non-bank participants in the markets. And I think I said this last quarter, but prices are high right now. Cap rates are low and there’s a lot of transactions going on in terms of asset sales. But if you put all those together, it’s probably less about average demand than it is about the competitive environment and the early pay-offs because of asset prices.

In the mortgage business, I think our mortgage and home equity business year-over-year was up about 2%, that's not a typical for us, pretty consistent low single digit market growth in mortgages. I think we expect that to continue into 2018. And we talked about the auto book a little bit last quarter, year-over-year it was down I think 3%, it's actually down less than what we thought it was going to be, because we did make some strategic moves in that business to trade off volume for returns. In fact, the portfolio yield in the auto book is actually up 24 basis points over the last two quarters, so a pretty significant move in the yield and the market in that business, but we traded off some volume.

So I hope that helps at all, Collyn, the auto book will probably, in 2018, be off a little bit in terms of volume as well but I would expect the yields to remain higher. Mortgage and home equity will move forward as usual, 3% give or take and then commercial we’ll see what happens with the early pay-offs. In fact, we don’t have the same level of early pay-offs in '18 as we have in '17. I would expect it’ll be up next year, because there is some activity in the market. It's just really a function of those unscheduled pay-offs, which are difficult to predict. But right now, as I said, the pipeline is really good and we had record originations last year. And so I would expect we’ll have a good origination here in 2018 as well. It will really be a function in terms of both actionable growth in the portfolio, it will be a function of level of those unscheduled pay-offs.

[Collyn Gilbert, KBW]

And I guess that ties to the next question just on the margin, which could have been margin came in better than what we were looking for. I recognize the FRB dividend and obviously the accretion income. But in total, and I understand your comments on that deposit data is likely to go -- move higher in '18. But how are you thinking about the margin? I mean if there is increased discipline around profitability, do we see maybe better NIM results in '18 than perhaps what we saw in '17, or are you trying to just control compression? Or how should we think about the margin?

[Scott Kingsley]

Collyn, I’ll take that one. This is Scott. I think generally, we would certainly welcome the outcome we've got in the fourth quarter, which was a combination of slightly higher asset yields based on new originations in virtually all of our three major portfolios, and not being up at all by funding cost. As a matter of fact, we actually had a very, very efficient balance sheet in the fourth quarter in terms of very, very much levels of overnight borrowings on a net basis. And part to that prefaces to [indiscernible] part of that was, if you look at our deposit balances from the end of June to the end of the year and it looks like we dropped deposits from about $180 million, $115 million of those will be placed or put into commercial and municipal repurchase agreements, which as I mentioned, price more like the deposit, a little higher than deposit, but generally closer to a deposit than an overnight institutional wholesale rate, so very efficient outcome from that.

To come back to your question, I think we still will get asset yield acceleration into 2018. The question is, are we going to be forced from a market dynamic to match up with the piece of that on the rate side. I like our starting point as well as anybody’s in the industry in terms of the absolute. But that being said, there is another rate change late in the first quarter, does that generate a little bit more market activity from competitive standpoint in our markets probably. But to Mark's point, you’re probably not going to see it in our markets; first, as you know, our markets tend to be sort of a six to 12 month lag from the rest of the broader market. So I think you’ll hear more from folks in Northern New Jersey or Boston or the Carolina's from the standpoint and the demographic than you will from us early. Would we be satisfied with a flat margin in 2018, probably, but at the same point in time, we love the benefit modestly from a little bit of pick up.

[Collyn Gilbert, KBW]

And then just to frame some of that the FRB dividend. So can you remind us what it was for the full year 2017? I know you had said that you expect '18 to be a third of that level.

[Scott Kingsley]

So we were about $600,000 for the second quarter and then up through about $750,000 in the fourth quarter, because so we were larger banks for FRB purposes. Now that we're over 10, we fall into the big bank dividend characteristics. So instead of a roughly 6% dividend yield from the Federal Reserve, we got closer to 2%. So I would take instead of $1.3 million or probably looking at $455,000 we expect in dividends for 2018.

[Collyn Gilbert, KBW]

And the payment schedule is still the same, that doesn’t change?

[Scott Kingsley]

Yes.

[Collyn Gilbert, KBW]

And then just finally, Scott, on operating expenses and I apologize if you said this in your opening comments. But just trying to reconcile some of the moving parts there in terms of what will be recurring and what were one time in nature and may be what the run rate is going to look like from here on the OpEx side.

[Scott Kingsley]

So I will start with this comment, as the fourth quarter was roughly $3 million higher than the third quarter. I would argue that’s a little bit more than half of net variable or variation from the quarter was actually something that we don’t have in our recurring run rate. We have handful of costs associated with some competitive needs for some technology and system related initiatives. It's little bit higher cost on the DFAST side. We had a little bit higher cost in the repair and maintenance side of our physical infrastructure, because we were so busy with the Merchants’ integration in the second and third quarter, we get a little bit of latent demand there, that we probably took care of in the fourth quarter from a facility standpoint.

So I would take the third quarter run rate and add about half of that and variation we had in the fourth quarter as the trend rate going into the first quarter of 2018. We're modeling about 3% to 4% growth in salaries and benefit cost going into 2018, principally merit in nature. But I think there are certain positions like I think most of the people and in free world are seeing. Again, there’s a little bit of wage pressure in certain skilled level positions. So we were trying to leave ourselves the opportunity to react to that.

Again, just for you Collyn and the rest of the group as a reminder, the first quarter is our low quarter of the year where we have some seasonality. We typically have a cent to a cent and half more in payroll tax expenses, because we're so early in the payroll a year, a cent to a cent and a quarter more in utility and maintenance cost for petrol related activity. And as we typically are a cent to a cent and a quarter lower on making non-interest income from lower account utilization characteristics. Now we’re doing our best and a bunch of initiatives trying to offset some of that in preparation for the Durbin, but no guarantees that we’ll deliver on that in the first fiscal quarter of ‘18. So hope it helps you little bit with run rate.

[Collyn Gilbert, KBW]

And then just final question back, Mark, you had mentioned in the discussion about capital usage as you guys accrete capital more in ’18. And I'm trying to find exactly how you worded it. Deploying more capital in terms of mix may be in a deal. Can you just talk about what did you mean by that?

[Mark Tryniski, President, Chief Executive Officer]

Well, if you -- in terms of capital, we really managed tier one leverage, which is where for us all the other risk based ratios were 2x, the requirements. The one that’s closest to us, if you will, for us is the tier 1 leverage ratio right now at 10% and the minimum is 6%, but we probably would have run that. We have a fair bit of certain amount of capital that we can deploy. And M&A, if you do 100% stock deal, you're not really using that capital the way you use the capital and effectively reduce your tier 1 leverage ratio is to use a cash stock mix. So the more cash you use, the lower you're going to -- the more of your tier 1 surplus you're going to utilize.

So that's what really I meant by that, more of a managed, because when you issue 100% stock you’re really -- you're financing all -- the entire premium and goodwill and intangibles. So you get -- I mean it affects your tangible differently than your tier 1 but our focus is not as much as intangible as it is over time, gap in cash returns per share in the way you manage that, the way we mange it in terms of M&A and try to use an appropriate mix of cash and stock in our transactions.

[Operator]

And we'll take our next question from Russell Gunther with D.A. Davidson. Please go ahead.

[Russell Gunther, D.A. Davidson]

Just appreciate the comments on the loan growth outlook. I would be curious though for an update on the Merchants’ footprints. What are some of the dynamics going on in that market and your loan growth expectations there?

[Mark Tryniski, President, Chief Executive Officer]

As you know, we effected the transaction in May, in the second quarter. We have had sum that run off in the Merchants’ portfolio for couple of reasons. One is that and I can't remember if we talked about this last quarter, and I'll repeat it. Before the May merger, they had essentially pushed through almost the entirety of their pipeline to the closing process before we closed to avoid any disruptions to customers during the transition. So they had almost no pipelines in May. Now, that brought with it a higher balance sheet from us, which was our advantage of course but it left them with almost no pipeline. So they spent the last seven months rebuilding that pipeline, which they have to a large degree. So we had net run off at Merchants, which we expected frankly over the six or seven months. I would say at this point, most of that is for us. But those markets are on average more active than ours in terms of economic demand and growth characteristics. So we're looking forward to resumption of net growth in the Merchants portfolio in 2018. But we did get some run off that we expected in the third and fourth quarters of the Merchants portfolio.

[Russell Gunther, D.A. Davidson]

And then just last one for me, Mark, a little bit more of a big picture. But you expressed a great degree of optimism for 2018. And I'd just be curious as to what part of your business do you think you're most optimistic about, what are the dynamics going on there.

[Mark Tryniski, President, Chief Executive Officer]

I am pretty optimistic about all of it, frankly. I think we will have a good year in commercial in 2018, regardless the impact of the early pay-offs. And as I said, we were aware of the plans with larger ones in the first half. I’ll expect our originations in 2018 to be very strong in the commercial business. So it's really a function of what happens with those early pay-offs. The mortgage business will continue to move forward. The mortgage business will be fine as it always has been. The auto business will probably decline a bit further in terms of outstanding volumes. I think as everyone knows, the auto business is in like year ten of the cycle and that's a very cyclical business. So that it goes a number of different ways. With that said, the margin on that business will be higher in 2018 than it will be in 2017.

On the retail banking side, deposit growth is in average. We took out a fair bit more municipal business with the Merchants transaction and that tends to be a little bit more volatile just in terms of quarter-to-quarter swing. So it's little bit more difficult to assess quarter-to-quarter. But we've always had low single digit deposit growth in our market. So I expect that will continue. We actually had really good -- despite the fact that we had negative commercial growth, our deposit growth in the commercial portfolio, I don't remember exactly, Scott, if it’s 4%, 5% or 6%, something like that, deposit growth for business customers. So with the function of -- with the customers, it was a function of the pay downs that really worked the debt side.

So I think the retail business will perform well. I think overall despite the fact that approximately $6 million we're going to hit next year. There're some things we're going to try to do that will offset a part of that. So I think we've gotten some plans in terms of the retail business. The real [indiscernible] it's really done to non-banking businesses. I mean if you look at -- I don't know how many times I've gotten end of the year and said we had double digit growth in the top and bottom lines in our non-banking businesses. But our benefits business tremendous year, same with wealth and benefits, double digits top line, double digits bottom line. The margins of every one of those businesses went up, so they've been highly additive to overall operating results over the last few years, and I expect that to continue. I expect 2018 is going to again be a really very strong year for all three of our non-banking businesses.

So I think that we're pretty well positioned here, the capital accumulation is going to help. We improved our operating efficiency from last year over this year. And with the lower tax rate in higher earnings and higher capital accumulation, I think we have a lot of options the earnings momentum is great, the margin and maintenance, I think we've got that pretty well enhanced, our non-banking businesses continue to just excel in terms of their performance. So I think we’re pretty well position going into 2018.

[Operator]

And we’ll take our next question from Jake Civiello with RBC Capital Markets.

[Jake Civiello, RBC Capital Markets]

Do you anticipate that you will continue to place the emphasis on munis in the investment portfolio in the new tax environment? Or do you think there could be other types of securities that become more investible from both the risk and tax adjusted yield standpoint?

[Mark Tryniski, President, Chief Executive Officer]

Yes, I think you hit it right on the head. I think there will be other instruments that will become more attractive any time it gets 40% drop in the moving tax equivalent adjustment. It will probably take some market a little bit of time to react to that. And so I definitely agree -- we’re probably likely to see net cash flows of our municipal portfolio and certainly co-filling hoping that shape of the curve will allow us some productive reinvestments. But actually for us in mortgage back securities, something we really has not invested in in a significant way in number of years. But really on point question, Jake, I think that will give you the result.

[Jake Civiello, RBC Capital Markets]

And then what's the normal or typical run-off that you see in the muni book on a quarterly basis?

[Mark Tryniski, President, Chief Executive Officer]

Yes, for the whole year next year, Jake, we're expecting about $125 million of cash flows up our investment portfolio, and over two thirds of that is municipal. So probably in the $80 million to $90 million range in terms of cash flow expectation. Our municipal portfolio is very, very diverse. Hundreds, literally several hundreds of CUSIPs in that portfolio, probably not that big of a surprise given the market that we participate in, as well as what we buy for things out of the market. But generally speaking, we think that's a pretty productive outcome. In 2017, we did not redeployed our investment capital on a full basis but in fact most of our investment purchases in 2017 work for CRA related activities. And most of those are agency backed mortgage back securities or flow with some type. Early in 2018 is probably still going to be the answer. And then the jury is out and we actually have a couple of more rate increases. And get a little bit of upward inflection on yield curve that would be highly productive for us.

[Scott Kingsley]

I suspect Jake we would also evaluate a sale all or part of that municipal portfolio, as Scott said, the benefit to us is a lot less. But the market prices haven't really declined, because that market really is not made up of corporate buyers, is made up of individual buyers who are still in the 37% tax bracket. So the pricing is still recently good in that market, yet the benefit to us upholding those is deteriorated somewhat. So I would suspect we will keep our eye on that market and there is a potential for a repositioning there, I would suspect.

[Jake Civiello, RBC Capital Markets]

And then does the potential for a higher interest rate environment in 2018 change how you think about M&A and the value of core deposits as potential acquisition targets?

[Scott Kingsley]

No. I mean, I think we have particular discipline around what we focus on with M&A, has to be qualitatively high value, it's got to be economically high value, it's got to fit in our expected geographic footprint and future expansion potential for that footprint. Our focus is really less around core deposits. And certainly that’s an element that’s not unimportant. We understand and very much value core deposits. I would argue that that’s the most high value thing you can do with bank is attract core deposits.

So that’s certainly part of it, but the overall strategy is not necessarily as much around interest rates or solely core deposit quality, it's really a function of the entire qualitative and economic aspect of a potential opportunity, ultimately focusing on what's the accretion on both a GAAP and cash per share basis over time, and is that sustainable or is it a quality expense in our organization. So I mean all those things certainly play a role, but they’re not just positive in terms of the ultimate judgments we make around M&A.

[Operator]

And we’ll take our next question from Matthew Breese with Piper Jaffray. Please go ahead.

[Matthew Breese, Piper Jaffray]

Mark, just building on some of your very positive commentary on the non-banking front, also very strong 2017. What do you think the growth outlook for 2018 is for those items?

[Mark Tryniski, President, Chief Executive Officer]

Those businesses all report to Scott directly actually. So I'm going ask Scott to respond.

[Scott Kingsley]

And I think that’s expecting double-digits in our revenue and margin improvements or earnings improvement, it's probably not the target at this current time, look we’d like to see that. I think in those businesses we’re thinking about mid single digit growth rate with continued operating leverage performance. The path for us has been relatively simple for all of our businesses but grow revenues faster than you grow expenses using, if this happened. I mean you have -- we will pick up one conditional month of revenues from the NRS transaction, remember we acquired that February of last year. So we get little bit of a lift on the wealth management side, because the Merchants’ trust business came to us in May of last year.

So probably from an organic standpoint, Matt, mid single digits would maybe a little bit of a pick-up higher because we're getting full year impact in a couple of those spots. But again, those are businesses that we really like right now. And I think we said this before, because we’ve got to a critical mass size in each and every one of them, we now have good operating leverage characteristics in terms of our growth. As a post to somebody who is brand new in one of those non-banking business lines, sometimes you have to suffer through and so you get to a certain level of critical mass, you don’t improve your outcome. But both in terms of business developments, distribution underlying operation, very, very sound and strong business for us at this point in time, all of which we believe are investible on both organic and an acquired basis.

[Matthew Breese, Piper Jaffray]

Is there any way we could may be measure that in terms of efficiency. What is the employee benefits business do in terms of efficiency? What's the wealth and insurance business doing in terms of efficiency? And what is that -- the improvement year-over-year?

[Scott Kingsley]

Again, it’s a little hard to find these in the segment disclosures that we do, but you can get close. I would argue if you blended those businesses together, you get to a margin outcome of roughly 30%, maybe you touch higher in 2017, which means the inverse of that is the efficiency ratio, so you're in the high 60s in terms of efficiency ratio. Clearly, the transactions that we have completed on the benefit side improvement in those businesses from an operational standpoint, it has led to an outcome that is not hurting our blended effective efficiency ratio.

You're not quite as I say deliverable on the insurance and the wealth management side, but still very, very acceptable. Internally, we do look at the core efficiency ratio of the core bank differently than we look at the efficiency ratio of the non-banking businesses. And remembering that the non-banking businesses, with the exception of what you're acquiring, you don't use a lot of incremental capital to add growth in those businesses, because they essentially don't have a balance sheet.

Now 2017 was the year where we used a bunch of capital in the NRS transaction to really jumpstart that business, and essentially to buy business that we had not participated in core in terms of product and service mix. But outside of that, with a little bit of operating improvement, you are capital returning enterprise from that point forward, even if your growth rate is in mid single digits.

[Matthew Breese, Piper Jaffray]

And then given the shape of the yield curve and some of the changes between September and now we've seen a lot of upward momentum on the yields. Where is that translated into higher asset yield on your side? And then conversely, where is some of that being competed away more heavily?

[Scott Kingsley]

Matt, if you look at the detail for us, I would tell you that there is some positive improvement in yields associated with auto lending for sure. And I think as we mentioned, we took a little bit of a step back in certain lines of business or in certain asset classes within indirect auto, principally and interestingly enough, new car lending where the rates and the balance of the risk and return did not make a lot of sense. So we intended to return to our very entrench groups, which would be a really good used auto lender. And in our marketplace since you have a severe absence of public transportation that tends to work pretty well.

Mortgage side, still rates are better than they were a year ago and better than they were a year before that in terms of composite rates. We're portfolio-ing 15 year products and below that may or may not be characteristics of secondary eligible. But we think that the average life of those products in our marketplace is in that eight to nine year total outcome, and we're happy with that on the balance sheet; so selling most of our longer term originations, because that's probably still the right thing to do in this interest rate environment in terms of durations and tenure. And I think -- and back to your question, in the commercial side, some of that opportunity to price things up is probably being competed away there. So as much as you may see a little bit higher asset yields on the business lending side, spread don’t look like they have widened through the end of 2017.

And that’s more than an episodic conclusion on our behalf, and it probably represents in some cases as Mark mentioned, prices were rigid not participatory. If somebody is getting funding from the outside on 25 or 30 years basis at fixed rate outcomes, that's probably not going to be our sweet spot. On the investment portfolio side, Matt, nothing much yet but again, we've had really modest reinvestment in cash flows. So I don’t know that we could pick it up on that anyway.

[Matthew Breese, Piper Jaffray]

And then my last question is really in terms of capital deployment. Obviously, the tax rate helps dividend capacity and then we are amortizing quite a bit of an intangible. So I just wanted to get a sense for if there is a targeted payout ratio, what it is and is it more or less based on cash earnings or GAAP earnings? Just help me frame where that could be heading.

[Mark Tryniski, President, Chief Executive Officer]

I'll start with the fact that we've increased the dividend every year for the past 25 years, which is a dynamic I like, because it puts pressure on us to continue to grow earnings. So I kind of like that dynamic and that pressure. I suspect we will, as board does every, I think third quarter of the year, we will evaluate the dividend again in the third quarter. We certainly have significant capacity right now to continue to raise the dividend. Ultimately, that's the board's judgment.

As far as a targeted payout ratio, we don't really have one that’s formal. I think we like to keep it in between the 50% to 60% range. As you know, our organic growth is at best a low to mid single digit number that does not require an enormous amount of our capital to provide organic growth. So we are going to be accumulating capital regardless of the tax rate change as we have historically. I think we like to keep it in the 50% to 60% range somewhere.

There're times where the earnings are a little higher, a little lower for some reason and it moves around from 45 to 65 somewhere. But I would say Matt anywhere from 50% to 60% range is ultimately where we would like to maintain our focus in terms of that dividend payout ratio.

[Scott Kingsley]

And Matt to your question, we are essentially expecting $0.06 to $0.07 of GAAP expense on amortization intangible assets, which is likely to be very close to the same number for quarter in 2018 as it was in '17, just given the timing of our last two transactions, last two major transactions. And we will look at both. So to Mark's point is that whole 50% to 60% both general policy guidelines for us, we'll do that both on a cash earnings as well as the GAAP earnings. And then at the same point, I'm always trying to look out what else could you use that incremental capital for, if you didn't put it into dividend capacity.

[Operator]

And we'll take our last question from Joe Fenech with Hovde Group. Please go ahead.

[Joe Fenech, Hovde Group]

We’re a few years now into this initiative by New York State, as you know though, to invest substantial dollars across the region. Seems like there's been a substantial benefit, certainly more activity, appreciate you guys aren't quite as active in some of the larger metro markets as some of your peers. Were you seeing some stretching, would you say, at the margins in terms of underwriting maybe some peers doing some things that make you raise an eyebrow or have the standards held for the most part from what you're seeing?

[Mark Tryniski, President, Chief Executive Officer]

I would say the standards have held reasonably well, Joe. I’d say better than the last big up cycle where you saw lot of the structure deterioration. I think what we're seeing now is other market participants like the insurance companies and the kind of the way that they come in, they're going to do 30 year non-recourse financing for a established project with cash flow, and we’re not going to do that. And I don’t see a lot of banks doing that as well. I think the things that we see where there is anything, if you want to call stretching going on, is some of the [AMs] have stretched a little bit where you normally do something on a 10 year basis, somebody is wanting to go 20, and the spreads [effect].

I think the spreads have gotten -- I mean the events than for sometime but they've gotten there but those are the only two areas. And I don’t think you’re seeing a lot of wholesale deterioration in credit structure that really speaks to safety and soundness necessarily in terms of credit. I would -- from my advantage point it's mainly term extension and thinner spreads.

[Joe Fenech, Hovde Group]

And then obviously limited activity in terms of M&A across upstate in New York for a variety of reasons. Guys, for the targets of size that are still out there, does the pick-up in the activity economically these last two years. Do you think that extends the time line even further in terms of when some of these smaller targets decide to partner up? And if so, do you think that means we’re increasingly likely to see you guys pursue deals like merchants outside of what's been your core markets historically?

[Mark Tryniski, President, Chief Executive Officer]

I think that's a fair question, Joe. I think, as you know, there is only so many things left in upstate New York is that really over the banks in terms of concentration. We have our presence in New England, which I would arguably not a big stretch for us. I mean our closest branch to their closest branch was six miles and other than Lake Champlain, which is in the middle where there is actually contiguous markets, which is I think really along the lines of what we would look to continue to do in the future, we clearly can't go north.

So I think if you look at an extension further into New England that's a possibility, I think further opportunities in Pennsylvania is an opportunity and I think Ohio remains an opportunity for us. So I do think M&A activity I think I'm not mistaken the volume was off in '17 compared to '16, not for us I mean industry wide. I think as long as there is a lot of economic growth and earnings are growing for these banks that might be thinking about the strategic transaction, I think they hold off. So I think the fact that the strong economy creates growing earnings and operating performance, I think there is no reason necessarily to think about a strategic transaction.

So I think as you know banks aren't really bought as much as they are sold. And so I think the current market we’re in, if it continues to be strong economically, strong multiples in the marketplace, strong operating performance, I think that will put somewhat of a damper on any acceleration of M&A. I mean it's not going to prevent us from understanding and identifying those high value targets and then having dialogues with them. But certainly the multiples have gone up, not just in the market but in the M&A space as well, that can make a difference in terms of whether a transacting can get done or not relative to the sellers’ expectation. So that could be another challenge or hurdle that we need to face in this environment.

But the markets and the multiples that goes up then it goes down and over time, it doesn’t really change our strategic thinking around acquiring high value partners that can help us sustainably grow our earnings per share and our cash flow per share.

[Operator]

And that concludes our question-and-answer session for today. I would like to turn the conference back over to Mark for any additional or closing remarks.

[Mark Tryniski, President, Chief Executive Officer]

Thank you, Ashley. Nothing further to say, other than thank you all for joining the call and we look forward to talking again in April. Thank you.

[Operator]

And once again that concludes today’s presentation. We thank you all for your participation and you may now disconnect.