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Community Bank System Inc  (NYSE:CBU)
Q1 2019 Earnings Call
April 22, 2019, 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Welcome to the Community Bank System First Quarter 2019 Earnings Conference Call.

Please note that this presentation contains forward-looking statements within the provisions of the Private Securities Litigation Reform Act of 1995 that are based on current expectations, estimates and projections about the industry, markets and economic environment, in which the Company operates. Such statements involve risks and uncertainties that could cause actual results to differ materially from the results discussed in these statements. These risks are detailed in the Company's Annual Report and Form 10-K filed with the Securities and Exchange Commission.

Today's call presenters are Mark Tryniski, President and Chief Executive Officer and Joseph Sutaris, Executive Vice President and Chief Financial Officer.

Gentlemen, you may begin.

Mark E. Tryniski -- President and Chief Executive Officer

Thank you, Jenny. Good morning and thank you all for joining our Q1 conference call. We hope everyone had a joyous Easter holiday and start to pass over. We're very satisfied with the quarter that was about as expected. Our earnings up a little, loan flat, deposits up. The high point takeaway for me for the quarter was that we more than offset $0.05 per share Durbin hit compared to last year's Q1. Our margin was up a couple of bps, operating expenses were a bit better than we expected, non-banking revenues grew 3% and asset quality metrics were very good.

Loan growth was flat, given the seasonal runoff of the auto book, but both the commercial and mortgage portfolios were up slightly, which is a good outcome for the first quarter. Deposit inflows were strong due mainly to municipal seasonality and core checking and savings balances were also up in the quarter. All-in-all, a very good start to 2019.

The integration and transition efforts of the Kinderhook merger are going extremely well and we have received all regulatory approvals. The Kinderhook shareholder meeting is tomorrow and we are confident that their shareholders will approve the transaction. Our existing commercial lending business in the Capital District continues to perform at a very high level and we're excited about the future opportunity when we close the Kinderhook transaction in the first half of July.

Looking ahead, we have strong earnings and operating momentum across the business, which should position us well for the remainder of 2019. We continue to accrue capital at a pace greater than what we need for organic growth, which provides tremendous dividend capacity and strategic flexibility upon which to build further value for our shareholders.

Joe?

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Thank you, Mark and good morning everyone. As Mark noted, we are generally pleased with the Company's first quarter 2019 earnings results. The Company recorded GAAP net income of $41.9 million and earnings per share of $0.80 during the first quarter of 2019. This compares to net income of $40.1 million and $0.78 in earnings per share for the first quarter of 2018. The $1.8 million improvement in net income and $0.02 improvement in earnings per share were achieved in spite of absorbing over a $3 million or $0.05 per share reduction in non-interest revenues due to Durbin related debit interchange price restrictions imposed on the Company between the periods.

Operating earnings per share, which excludes acquisition expenses net of tax effect, increased $0.03 per share from $0.78 in the first quarter of 2018 at $0.81 in the first quarter of 2019. The return on assets and return on tangible equity for the quarter were 1.59% and 17.61% respectively.

I'll now make a few comments about our balance sheet before providing additional details on the quarterly earnings results. We closed the first quarter of 2019 with total assets of $10.92 billion, this is up $309.2 million or 2.9% from the end of the fourth quarter of 2018 and down $50.1 million or 0.5% from the end of the first quarter of 2018. Average earning assets for the first quarter of 2019 of $9.37 billion were up $67 million or 0.7%, when compared to the linked fourth quarter and consistent with first quarter of 2018 average earning assets of $9.3 billion. The growth in the Company's balance sheet during the quarter was largely attributable to the seasonal inflow of municipal deposits.

Average loan balances for the first quarter of 2019 were essentially flat to the linked fourth quarter of 2019, but up $36 million or 0.6% over the first quarter of 2018. As Mark mentioned, although the Company's total loan balances were essentially flat in the first quarter, due to decreases in the indirect auto portfolio as seasonally expected, both the business lending and consumer mortgage portfolios grew slightly. Total deposits increased $297.3 million or 3.6% on a linked quarter basis, due largely to an inflow of municipal deposits as seasonally anticipated and consistent with prior year's annual cycles.

Checking and savings accounts represented 68.4% of total deposits at March 31st, 2019, a solid increase from 66.6% one year prior. Our total cost of deposits for the first quarter of 2019 was 20 basis points, reflective of ours very solid base of core deposits. At March 31st, the Company's investment portfolio stood at $2.97 billion. The portfolio is largely comprised of treasury securities, agency mortgage-backed securities and high-quality municipal securities. The effective duration of the portfolio was three years.

At March 31st, 2019, the Company also held seasonally high cash and cash equivalents of $508.4 million at the end of the first quarter. The first quarter 2019 tax equivalent yield on the investment portfolio including cash equivalents was 2.58%. Principal cash flows from existing investment securities portfolio are expected to total approximately $160 million for the balance of 2019 and $790 million in 2020. We anticipate reinvesting and potentially pre-investing a portion of these anticipated cash flows in similar types of securities prior to the maturity as investment opportunities present themselves over the coming quarters.

As mentioned in my opening comments, operating earnings per share were up $0.03 as compared to the same quarter in the prior year. The improvement in operating earnings per share was driven by an increase in net interest income and decreases in the provision for loan losses and income taxes, offset in part by lower non-interest revenues, higher operating expenses, and an increase in fully diluted weighted average shares outstanding.

Net interest income increased due to widening of the net interest margin in the most recent quarter to 3.80%, as compared to net interest margin of 3.71% reported in the first quarter of 2018. The tax equivalent yield on the Company's loan portfolio increased 25 basis points between the comparable quarters from 4.53% from the first quarter of 2018 to 4.78% in the first quarter of 2019. Although the first quarter 2019 loan yield was favorably impacted by 6 basis points due to certain loan prepayment fees, the Company's total yield on loans continue to trend upward.

Comparatively, the total loan yield in the linked fourth quarter was 4.65%. During the first quarter of 2019, the average yield on new loans was exceeding current book yields by an average of 50 basis points. Over the same comparable quarters, Company's total cost of funds increased 10 basis points from 17 basis points in the first quarter of 2018 to 27 basis points in the first quarter of 2019. The yield on the investment portfolio inclusive of cash equivalents increased 2 basis points from 2.56% in the first quarter of '18 to 2.58% in the first quarter of 2019.

Non-interest revenues in the non-banking businesses were up $1.2 million or 3.2% or were offset by a $3 million or 14.8% decrease in banking related non-interest revenues due to a decrease in debit interchange fees in connection with the Company being subject to the Durbin amendment in the third quarter of '18. Despite the Durbin reduction, non-interest revenues contributed 39.1% of the Company's total operating revenues during the first quarter of 2019, consistent with full year 2018 results. Compared to the prior first quarter, total operating expenses excluding acquisition expenses were up $1.8 million or 2.1%. Increases in salaries, employee benefits of $1.5 million or 2.9% and other expenses of $1.2 million or 6.1% were offset in part by $0.2 million or 2.3% decrease in occupancy and equipment expenses, a $0.7 million or 13.9% decrease in the amortization of intangible assets.

We reported $2.4 million in the provision for loan losses during the first quarter of 2019. This compares to $3.7 million reported in the provision for loan losses in the first quarter of 2018, a $1.3 million decrease between the comparable periods. The decrease in the provision for loan losses was reflective of an improvement in the Company's asset quality metrics between the periods.

The effective tax rate for the first quarter 2019 was 18.5% down from 23% in the first quarter of 2018. The Company had significantly higher levels of income tax benefits related to stock-based compensation activity in the first quarter of 2019 as compared to the first quarter of 2018. Exclusive of the stock-based compensation tax benefits, the company's effective tax rate was 21.8% in the first quarter of 2019. The income tax benefit related to the company's stock-based compensation activity contributed $0.03 of operating earnings per share for the first quarter of 2019.

Our asset quality remained strong. At the end of the first quarter of 2019, non-performing loans comprised both legacy and acquired loans totaled $24.2 million or 0.39% of total loans. This is 1 basis point lower than the ratio reported the end of the linked fourth quarter and 9 basis points lower than the ratio reported at the end of the first quarter of 2018.

Our reserve for loan losses represented 0.78% of total loans outstanding and 0.94% legacy loans outstanding. Our reserves remain adequate and exceed the most trailing four quarters of charge-offs by multiple of 5. The allowance for loan losses to non-performing loans was 202% at March 31st, 2019. This compares to 197% at the end of the linked fourth quarter and 162% at the end of the first quarter of 2018.

We reported net charge-offs of $2.6 million or 17 basis points annualized in loan portfolio during the first quarter of 2019. This compares to net charge-offs of $3.2 million or 21 basis points starting in the first quarter of 2018. We do not currently have any commercial OREO properties and the internal loan risk ratings portends stable asset quality.

Shareholder's equity increased to $125.7 million or 7.7% between the end of the first quarter of 2019 and the end of the first quarter of 2018 to due largely to an increase in retained earnings. Our capital ratios also remained strong in the first quarter. The company's Tier 1 leverage ratio was 11.27% at the end of the quarter, over 2 times to well capitalized regulatory standard. Tangible equity and the net tangible assets ended the quarter at a solid 9.83%, this is up from 9.68% at the end of the linked fourth quarter of 2018 and 8.42% at the end of the first quarter of 2018. Both the Tier 1 leverage ratio and a tangible equity to net tangible asset ratios are expected to decrease by approximately 100 basis points as a result of the pending Kinderhook transaction.

Looking ahead, we do not anticipate any significant deviations from recent trends around the company's net interest margin results, operating expenses and asset quality exclusive of the pending Kinderhook transaction. In addition, the seasonal characteristics of the business are unlikely to change significantly. Although, we anticipate continued improvement in the loan yield, we also expect to see some continued pricing pressure on the funding base. The persistence of our flat yield curve likely remains a headwind for the banking industry, it potentially portend to setback in the economy, it could begin impact margin results that are persist several more quarters.

We remain cautiously optimistic about the commercial loan pipeline and potential opportunities for continued revenue growth in our non-banking businesses. Since the Durbin restrictions do not become effective until the second half of 2018, we also expect that the second quarter 2019 earnings will also be unfavorably impacted by $0.05 to $0.06 per share as compared to the second quarter of 2018 results.

In summary, we believe the company remains very well positioned to effectively integrate the Kinderhook bank merger early in the third quarter of 2019 and anticipate a smooth integration. We also continue to expect that Kinderhook will be $0.07 to $0.08 accretive in the company's operating results on a full year basis.

Thank you. Now I'll turn it back to Jenny to open the line for questions.

Questions and Answers:

Operator

Thank you. (Operator Instructions) And we will hear first from Austin Nicholas of Stephens.

Austin Nicholas -- Stephens Inc. -- Analyst

Hey guys, good morning.

Mark E. Tryniski -- President and Chief Executive Officer

Good morning, Austin.

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Good morning, Austin.

Austin Nicholas -- Stephens Inc. -- Analyst

You obviously had a nice quarter for the core NIM when you back out some of the noise and I guess as you look out from here, can you maybe provide some thoughts on kind of where maybe your incremental margin was coming on at the end of the quarter as you looked at your loan yields and your deposit costs and then kind of any guidance on how you would see that trajectory through the course of the year given where the yield curve is and kind of no further rate hikes on the horizon?

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Yeah, Austin. We witnessed kind of new loans going on at above 50 basis points higher than the current book yields, which was actually similar to the fourth quarter outcome. So we've seen a bit of -- I'll call it leveling on the new loan rate yields. Obviously, if the yield curve stays flat, we expect that competitors would certainly put a cap or potentially start to lower some of those rates, but that yield curve we have to persist for an extended period of time for us to see that. From a cost of funds perspective, we were up 4 basis points in the first quarter over the fourth quarter and I would expect that we're going to continue to see that pressure, perhaps able to continue to maintain a deposit beta that's similar to say the fourth and the first quarter, fourth quarter 2018, first quarter 2019. As we look ahead to the rest of the balance of the year, we have not seen very large market competitors play out extremely aggressive rates on the deposit side, but with that said, we're also -- we need to maintain our current deposit base and certainly those defend those deposits.

Austin Nicholas -- Stephens Inc. -- Analyst

Sure. That's helpful. And then maybe just on the deposit topic. Could you maybe give us or remind us of the kind of duration or I guess how long does municipal deposits stay on the balance sheet and kind of what the outflow could be expected to be in the second quarter and the third quarter. Just maybe kind of any commentary on the variability that you generally see in that and if there's been any changes in that?

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Yeah. We typically hit our high point in the first quarter, as -- in New York state, the tax collection cycle is early or actually in late January. So we tend to see a increase in those deposit side, typically a couple of hundred million dollars in the quarter, we then tend to see those drift down a bit in the second quarter and then sort of hit the low point in the third quarter. We start to see some of those come back in the fourth as the school districts collect their taxes in New York State and usually the delta is a couple of hundred million dollars between the high points and low points.

Austin Nicholas -- Stephens Inc. -- Analyst

Understood. That's helpful. And then maybe just one last one on M&A. Can you remind us of your outlook for M&A on the whole bank front after Kinderhook is closed and then on the kind of non-bank side, any changes in what you're seeing in the market from opportunities in the employee benefits business or also on the investment management or the kind of insurance side of the businesses?

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Sure. I think it's our -- Austin, our strategy really hasn't changed much, it's pretty consistent, which is trying to identify high opportunity, high value acquisition targets whether it's banking or non-banking that we think can be additive to our franchise and our capacity to generate long-term growth in earnings and cash flow. So the strategy hasn't changed much, I mean, we continue to be actively engaged and opportunities across that spectrum and I think I would say that, may be recently has been more of an uptick, a slight modest uptick in potential opportunities and activity just based on kind of the flow and conversations and all of that, that we have on an ongoing basis with potential merger partners as well as with investment bankers. So I think that it's probably a good news.

I think on the non-banking business side, we've done a number of, I would say kind of smaller insurance add-ons to our existing insurance business. We haven't done historically many significant wealth management acquisitions, although, we did do a small one over the course of last six months or so. And with respect to the benefits business, we're always looking for good opportunities there. We have a significant benefits business, it's national and scope, I think we're in the leadership are pretty plugged into the opportunities that are above there. The interesting development I think I've come in and unless in the past relative to the benefits related businesses, there is a lot of venture capital money and private equity money going into that space, which changes the economics in valuation characteristics for a strategic buyer like us. So we continue to be active, Austin and continue to see opportunities. I would say not really any significant change in the market really, maybe marginally better than a year-ago, I guess how to characterize it.

Austin Nicholas -- Stephens Inc. -- Analyst

Okay. Got it. That's helpful. And then maybe just on the organic growth in that business. Is it still fair to think about it in the kind of mid-single-digit fee income growth range, barring any kind of major market downturn that could impact kind of asset values?

Mark E. Tryniski -- President and Chief Executive Officer

Yeah, I think you nailed it. I think mid-single-digits. But some of those businesses are growing at twice that pace and some of them are growing at less than that. So overtime, I think together, I would say mid-single-digits is a good number.

Austin Nicholas -- Stephens Inc. -- Analyst

Okay, great. Thanks for taking my questions.

Mark E. Tryniski -- President and Chief Executive Officer

Thank you, Austin.

Operator

And we will hear next from Alex Twerdahl of Sandler O'Neill.

Alexander Twerdahl -- Sandler O'Neill & Partners LP -- Analyst

Hi good morning guys.

Mark E. Tryniski -- President and Chief Executive Officer

Good morning Alex.

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Good morning Alex.

Alexander Twerdahl -- Sandler O'Neill & Partners LP -- Analyst

First off, just wanted to drill in a little bit on some of the loan growth trends that we saw during the quarter. I assume from the large level of prepaid fees that there were some significant commercial paydowns during the quarter that may be hindered that overall loan growth number?

Mark E. Tryniski -- President and Chief Executive Officer

No. Actually, interestingly enough, we had a better quarter as it relates to prepayments, which was good to see. It was in a -- it was $25 million range or somewhere around there, which is less than kind of what we've seen here trending historically. The big prepayment fee was really related to one significant credit that paid down in the quarter. So the experience on the prepayments overall was actually OK for the quarter.

Alexander Twerdahl -- Sandler O'Neill & Partners LP -- Analyst

Okay. And then just maybe elaborate a little bit on the outlook for some of the different portfolios as the year progresses?

Mark E. Tryniski -- President and Chief Executive Officer

Sure. Obviously, the first quarter is always really difficult in the auto book, the cash flow on that portfolio in short duration average of 30 something months, so it throws up about $30 million plus a month in cash flow. In our market, there's not a lot of activity in January, February and March. So we had some runoff in that portfolio, actually not that bad all things considered, maybe less than historical. So I'd expect the auto book to grow in the second and third quarters as well. The mortgage business is good. The pipeline is up. We're turning them around faster as well, which is good. We're starting to see a lot -- a bit greater mix of purchased mortgages as opposed to refis, which is also good. So I mean the fact that we actually were up in the mortgage book in the first quarter is also pretty good, because there is also not that much real estate activity in the first quarter leased residential, so that was good. And we would hope that the second and third quarters are good in that business as well. I think, we're doing a good job in that business in terms of some of the marketing efforts that we're undertaking across the business. So I'd expect that will be additive. So I look forward to a productive outcome in the mortgage business in the second quarter.

Now commercial, the pipeline is really good right now. The couple of things in there are much larger credits that could go either way. So I'm cautiously optimistic I guess there on the commercial side. I'm hoping that the trend of lower prepayments continues into the second quarter, that would be good. So I would also expect that -- we've got -- the pipeline is really strong in some parts of our franchise. Pennsylvania is really good, the Central and Western New York is good, Capital District is really good. So I hope that we have a continuation of the lower prepayments and given more kind of a more seasonally advantageous period of the year that the second quarter is also for productive for the commercial lending business.

Alexander Twerdahl -- Sandler O'Neill & Partners LP -- Analyst

Okay. And then switching gears to kind of drill down a little bit more into some of the moving parts of the margin. Joe, over the last couple of quarters, you've kind of alluded to some of these -- the possibility of reinvesting or pre-investing some of the securities portfolio. We haven't really seen you guys do much there and you're sitting on a pretty good chunk of cash at the end of the second quarter. What are you specifically looking for in terms of opportunities to actually put some of that cash to work faster and then would it primarily be funded with the cash on hand or would you go out and borrow to fund some of the pre-investments?

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

At this point, well, let me back-up in bit. So in the third and fourth quarter, we had a little bit more opportunity in the yield curve to go out a little bit, certainly on the treasury curve, the mortgage-backed securities were -- again, we had decent returns there, that's backed up a little bit. So that opportunity hasn't been there and it wasn't there in the first quarter. But with that said, we do have $160 million expected to run-off in the investment securities portfolio for the balance of the year. So we're just looking forward and after you pick a couple of spots, let me get a little inflected in the curve throughout the -- to get little bit of steepness throughout the year and we can pick our spots, but we also have some plans in the work for just at least reinvesting those cash flows. So we're not anticipating, leveraging necessarily at this point, unless we get a significant change in the yield curve.

Mark E. Tryniski -- President and Chief Executive Officer

Yeah, I would just add Alex, I think if the tenure gets to three, that's probably trigger point to start looking at what opportunities might be. We also are investing a little bit in the spot securities market right now, the curves are better there and the spreads are a little bit better. So that's just really not what you kind of refill the bucket from the $160 million that's going to mature otherwise in 2019. And the other thing is that we're set -- from an interest rate risk perspective, we have more risk to falling rates than rising rates. So we just want to make sure that our balance sheet is properly positioned, we're not going to put ourselves in a position to -- if there is a significant reduction in the rate environment like we saw a couple of years ago that we're well positioned in terms of managing the risk to a lower rate environment. So just I guess follow-up comments.

Alexander Twerdahl -- Sandler O'Neill & Partners LP -- Analyst

Okay. And then perhaps you can give us a little bit more color and outlook on how you're kind of envisioning the expenses to run over the next couple of quarters. Just given some of the seasonality that maybe you can remind us of in the first quarter and then in terms of cost saves for Kinderhook, I'm not sure you ever gave a formal number, but kind of how should we be thinking about overall expenses for the year?

Mark E. Tryniski -- President and Chief Executive Officer

Okay. Relative to the operating expenses excluding Kinderhook, we were up by just under 3% in operating expenses this quarter versus the first quarter of 2018. I think that the first quarter is a reasonable expectation for the future quarters for 2019 exclusive of Kinderhook. Kinderhook has had an operating expense run rate of about $16.5 million in 2018, but we had modeled 30% reduction in the operating expenses, which right now we're anticipating that to hold barring some sort of unforeseen circumstance. So I think that's kind of the expectation on operating expenses looking forward.

Alexander Twerdahl -- Sandler O'Neill & Partners LP -- Analyst

Great. Thanks for taking all my questions.

Mark E. Tryniski -- President and Chief Executive Officer

Thanks Alex.

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Thank you.

Operator

And moving on, we have a question from Russell Gunther of D.A. Davidson.

Russell Gunther -- D.A. Davidson & Co. -- Analyst

Hey, good morning guys.

Mark E. Tryniski -- President and Chief Executive Officer

Good morning, Russell.

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Good morning, Russell.

Russell Gunther -- D.A. Davidson & Co. -- Analyst

I just want to follow-up on the comments about the commercial pipeline pulling through here. If you could characterize it, is it more of an expectation for originations to pick-up and increased activity or paydown headwinds to ease or if it's some combination of the two, how would you weigh that?

Mark E. Tryniski -- President and Chief Executive Officer

I'm hoping for both.

Russell Gunther -- D.A. Davidson & Co. -- Analyst

Got it. And then any color you could provide. I'm just trying to get a sense, if you think there is more of a lift going on from a loan growth perspective that could drive that where paydown is less than that's kind of a nice extra tailwind to you there or is it really more you'd expect paydowns to ease and let things kind of flow through?

Mark E. Tryniski -- President and Chief Executive Officer

Yeah. I would hope paydowns out with ease, I mean one quarter doesn't constitute a trend, but it was good that it was down and set them up. So hopefully we'll get that. We obviously have less control over prepayments than we do originations. I think in our markets, we got to work pretty hard to grow at 3% or 4%, that's tough, so I don't want to put too much pressure on our commercial team. We're also one; we're in lower growth markets; and number two, we're very conscious of credit quality. So we're never going to -- it's very unlikely that we're ever going to deliver commercial loan growth of 10% or 8% or 9%. So if we could -- if we can get even 2%, 3%, 4% organic growth in our markets after payoffs and cash flow, that's a pretty good outcome for us. So that's what I would I guess hoped for second and third quarters.

Russell Gunther -- D.A. Davidson & Co. -- Analyst

That's very helpful, and I appreciate clarifying that. And then any granularity you guys could share with regard to the larger credits you're hoping pull through whether it's type alone or a particular region, any trends to take away from that expectation?

Mark E. Tryniski -- President and Chief Executive Officer

No, there's just a couple of large, I would say high-quality transactions that we probably syndicate anyway in terms of purchase of that syndication for participations. So they tend to be high quality credits, they tend to be lesser spreads and very high quality customer in business relationship opportunities. So that we put our best foot forward, hope for the best, but if you look at and I wont't give you the numbers, but the absolute dollar value of the pipeline is $100 million more than last year and I would just say that that $100 million constitutes two or three larger credits.

Russell Gunther -- D.A. Davidson & Co. -- Analyst

Very helpful. Thanks guys. That's it from me.

Mark E. Tryniski -- President and Chief Executive Officer

Thanks Russ.

Operator

And we'll go to our next question from Erik Zwick of Boenning & Scattergood.

Erik Zwick -- Boenning & Scattergood, Inc. -- Analyst

Good morning, guys.

Mark E. Tryniski -- President and Chief Executive Officer

Good morning, Erik.

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Good morning, Erik.

Erik Zwick -- Boenning & Scattergood, Inc. -- Analyst

First, maybe just a follow-up on the deposit pricing conversation. Are you guys currently running any deposit specials in your markets. And if so, what products and at what rates and maturities?

Mark E. Tryniski -- President and Chief Executive Officer

Yeah. We are kind of looking at our customer base and looking at the competition and on the retail side, we have a couple of products that we're offering to our retail customer base and we've been successful holding those in. Relative to the rates, our cost of funds was up 4 basis points. So we're trying to put rates out here that are basically in the market. We don't necessarily haven't typically been at the absolute high of the market. Across all markets, we have a very broad geography. So we're putting out competitive rates out into the market right now. I think, we're doing pretty good job of maintaining that deposit base.

The other thing, just as a reminder Derek, about two-thirds of our total deposit base is checking and savings account that have a positive fund around zero. So we start from a pretty strong base of core deposits in terms of managing that and it's really, not that some of that is in interest rate sensitive, because sometimes it is, but it's not like we need to an aggressive full scale retail basis that compete on rates to hold in the majority of our deposit funding. We don't need to do that. So that's I guess a benefit in, an advantage and what we've typically done with kind of the -- some of the special products that Joe referred to was use them on a selective basis with customers in the market, whether they come to us or in many cases, we've gone to them to help position them better to ensure that we are in at risk with those deposit relationships. So we're not in the market broad basis with higher rates. We're doing it selectively, but starting from a strong position, the two-thirds of our deposits are checking and savings accounts.

Erik Zwick -- Boenning & Scattergood, Inc. -- Analyst

Understood. And then just kind of a record-keeping one. The amount of purchase accounting accretion in the first quarter step down from -- the average level of recorded quarterly last year, what's the expected scheduled accretion for 2Q?

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Yeah. I would expect 2Q to be not similar from Q1. The slowing in the prepayments on that portfolio certainly create a little bit of a decrease in any accretion and we like the level of prepayments knowledge slowed a bit, but that will also negatively impact the accretion.

Erik Zwick -- Boenning & Scattergood, Inc. -- Analyst

And then just one more from me. With regard to Kinderhook, I appreciate the updates on the regulatory and shareholder approvals. Could you provide any commentary on your expectations for deposit retention as well as any -- maybe some color on the efforts you've made to reach out to their larger relationships both on the loan and deposit side?

Mark E. Tryniski -- President and Chief Executive Officer

Sure. Every transaction is little bit different in terms of the market and the risks in that market. I would expect that the performance here will be pretty good. They have a really good relationship with their customers, they have a good reputation in the market. We have spent a lot of time, our people, our team, our leadership in that market, getting to know people, getting to meet people, their customers on the ground with their customers. So I think we're off to a pretty good start there. I would be surprised if there was a typical level of run-off in either the deposit franchise or the loan book.

Erik Zwick -- Boenning & Scattergood, Inc. -- Analyst

Great. I appreciate the color. Thanks for taking my questions.

Mark E. Tryniski -- President and Chief Executive Officer

Thanks Erik.

Operator

And we'll hear next from Collyn Gilbert of KBW.

Collyn Gilbert -- Keefe, Bruyette & Woods, Inc. -- Analyst

Thanks, good morning guys.

Mark E. Tryniski -- President and Chief Executive Officer

Good morning Collyn.

Collyn Gilbert -- Keefe, Bruyette & Woods, Inc. -- Analyst

Just wanted to start off on the growth discussion. You gave the growth or some of the commentary around the commercial pipeline and kind of commercial outlook, but just curious as to what you think you can do in terms of overall organic loan growth given the dynamics that continue to happen on kind of the consumer and direct side, but what your growth outlook is for the year and on total loan growth?

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Well, the first quarter, if we can be flat in the first quarter, I think you look historically generally we're kind of flat, sometimes we are down. Actually there's been years where we've been up a little bit, but I think this year at flat, is pretty typically historically. Given where the pipelines are and kind of what I see is the trajectory in the business in our markets, I would hope that we get that lower-single digit growth in the organic loan performance for the year. If we can get all in 4% per year, that's pretty good year for us. 2% to 3%, it doesn't sound like much compared to lot of banks in other markets, but we're pulling a lot of other levers in terms of earnings performance, and not just the balance sheet because we don't have it in our market. So if we can grow the loan book 2%, 3% and get operating leverage in other pull through and that with other relationships, then that's kind of model. So I would hope that we get to that in 2019. I think the start we're off to is fair to get there, but it's hard to predict, particularly on the commercial side with some of the prepayments. I think we had such I would say above average prepayments last year, then it would seem to me that it almost have to revert to the mean, but that's not prediction because I can't predict that, but the first quarter was good, hopefully, we get a continuation of that into the second and third quarters where we usually grow the mortgage portfolio, where we grow the auto portfolio and where we draw the commercial portfolio. So if we can end the year at -- if you start flat after the first quarter, you've got to grow little more to get to 3% or 4%, I would take that if I could right now, but that's the goal.

Collyn Gilbert -- Keefe, Bruyette & Woods, Inc. -- Analyst

Okay, that's helpful. And then, as you look at your -- the overall markets, where are you seeing some of the best opportunities for household formation or new customer acquisition opportunities. You'd mentioned some of the markets that were doing well on the commercial side, but just curious from -- on a sort of consumer retail side where you're seeing some opportunities for growth?

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Consumer retail, so I'm assuming here, it is more mortgage, right? The indirect auto book is -- it depends on the market. We don't usually outperform the market there, we try not to because that means you are over competing on rates. I think from the mortgage standpoint, we've always had a very strong mortgage business in the north of New York, in Central New York, in Western New York. I would say last year we had a really good year in Pennsylvania, probably our best year ever in mortgage originations in Pennsylvania. I think I expect to actually do better than that this year even in Pennsylvania. There is a lot of opportunity in Vermont also and we had a slightly different go-to-market model in mortgage lending than merchants did. So it's actually taken us a little while to get some traction there. Last year the Vermont, New England region, mortgage run-off was something like $40 million. So we're hoping that that will not be the case this year. So we've done some work to inject some resources and try to reposition our resources and market strategy in Vermont and actually it's already starting to improve. So I would say that's kind of -- I don't know your question column was beyond the mortgage business, but --

Collyn Gilbert -- Keefe, Bruyette & Woods, Inc. -- Analyst

Well, that's helpful. And I know on the indirect side, of course, mindfulness to risk and credit, I get it. I just didn't know if there are any markets where there is an opportunity for you to take share if the competitive landscape is changing or yeah, just thinking more structurally where you can go with some of your businesses from a geographic perspective?

Mark E. Tryniski -- President and Chief Executive Officer

Yeah, I think we have more opportunity in Pennsylvania and I think will continue to do better there. I don't -- I mean the market isn't growing rapidly, in fact, it's kind of a low single-digit growth market, but I think we are executing better in Pennsylvania, so we're getting more share, I think that's good. I think we have the opportunity in Vermont to execute better and I expect we will this year and as I said, we're already starting to do that and I think the Capital District in Albany, in that market place. We have tremendous opportunity there as well. So I think there is pockets of opportunity for us across that footprint as it relates to mortgage lending and honestly we've upped our game in terms of executing across all our markets in that business. So I am hopeful that we will have a productive year in mortgage lending in 2019.

Collyn Gilbert -- Keefe, Bruyette & Woods, Inc. -- Analyst

Okay. That's really helpful. And then Joe, just in terms of the NIM outlook. So I just, I want to make sure, I kind of understand some of the moving parts here. So this quarter, you had said if I heard you correctly, you guys had 6 basis points of prepayment income?

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Yes, correct. There was a one-time fee associated with a particular borrower that was about $1 million, which was 6 basis point effect on loan yields.

Collyn Gilbert -- Keefe, Bruyette & Woods, Inc. -- Analyst

Okay. And then, if we kind of think about the NIM trajectory kind of for the full-year, bringing on Kinderhook, I think they were operating close to like 3.50% NIM or a little bit lower of a NIM, certainly than what you guys had. And then I think that when you had given guidance last quarter on the mid 3.70% NIM, that assumed two rate hikes. So just wanted to kind of get all the blendedness here of some of these moving parts and where you're thinking the NIM will shake out for the full-year?

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Yeah. I mean the mid 3.70% is prior to the Kinderhook transaction I think is still a reasonable expectation. We did OK on the deposit side of the equation with a 4 basis point increase. We did loose if you will the expectation, although it's not off the table yet relative to rate hikes and the impact that we had on the variable portfolio, but we have offset some of that with better than expected results on the deposit side. So prior to the Kinderhook transaction, that mid 3.70%s range, you're right, Kinderhook's current margins, most recent margins are bit lower than ours. It would add so, about 5% or 6% to our earning asset base. So there is some potentially net reduction in core margin relative to the inclusion of Kinderhook. So I think that's a fair expectation, but it's also 6% of our earning assets.

Collyn Gilbert -- Keefe, Bruyette & Woods, Inc. -- Analyst

Yeah. Okay, that's helpful. And then just finally, Mark, just back to you on kind of tying into the growth outlook and obviously your capital has been building little bit post Kinderhook, but then rebuild pretty quickly thereafter. You had indicated giving you a lot of capital flexibility, you also outlaid thoughts on M&A. What kind of -- is there a trigger or how -- is there a sense of urgency or how are you thinking about that capital deployment? And is there a near-term targeted TCE ratio you want to get to or just I guess kind of asking for a little bit more detail on capital usage, given how much you guys are building capital?

Mark E. Tryniski -- President and Chief Executive Officer

Sure. Well, I think if you go back a few years, we were at a similar situation where we were building capital rapidly. We said at that point in time, that's one of our kind of strategic focuses was affected deployment of that what I would consider excess capital relative to the quality of our balance sheet, but we were not going to be in a hurry to do something with it, that we would be patient and disciplined and along came the opportunity for Merchants and NRS where we deployed $150 million or so of that surplus capital. I would give the same answer a couple of years ago that we're well positioned, but we got to be patient and we got to be disciplined and we're not going to squander the opportunity that we have, because we're in the fortunate position of having surplus capital that continues to accrete and generate every day and every quarter, but we'll be disciplined. So that could be an opportunity that arises next week and it could be an opportunity that arises next year. I think it gives us lots of dividend capacity as well. I mean if you look at our payout ratio right now, despite the fact that we've grown the dividend every year for 26 years, our payout ratio still is not that high relative to the organic growth part of our strategic model. So between dividend capacity and M&A capacity, if you notice last three transactions in -- the Kinderhook was all cash, just a great utilization capital. Merchants was 30% cash by the $100 million and NRS was about $70 million in cash. So even with all that said if you look at the current capital ratios in metrics, we're still and remain beyond well capitalized, but I would say, beyond well capitalized even relative to our balance sheet. So we'll continue to -- as we do and have for -- and need to do frankly, because it really is all about that above average return to shareholders if we're not deploying that capital productively, it is not about the timeliness of it, it's about the productivity of it.

So you have to use it for purposes that will generate growing and sustainable cash flows for shareholders. So that could be this year and it could be next year, it could be the year after. But I think, if you look back in our history, we've been sufficiently active over time in terms of high-value M&A opportunities that I think we have the model and the ability to execute and identify and effectuate those high-value transactions over time. We get and I've said this in the past, we get a lot of looks in a lot of things, almost everything that comes up within a couple of states of us, we kind of know about and get a look at and those opportunities continue even right now. There's also those where we understand our very high value opportunities for us as an institution. So we're more active in our outreach efforts to have that dialog with others. So that will continue. We're not going to be undisciplined in terms of how we deploy that capital and again it's difficult to predict, but the one thing I will say is, we will be disciplined in to deploy that capital in the way that we believe will help further our strategic effort to create growing and sustainable cash flows per share for our shareholders.

Collyn Gilbert -- Keefe, Bruyette & Woods, Inc. -- Analyst

Okay, that's great. That's all I had. Thank you.

Mark E. Tryniski -- President and Chief Executive Officer

Thanks Collyn.

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Thank you.

Operator

And we'll hear next from Matthew Breese from Piper Jaffray.

Matthew Breese -- Piper Jaffray Companies -- Analyst

Good morning, everybody.

Mark E. Tryniski -- President and Chief Executive Officer

Good morning, Matt.

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Good morning.

Matthew Breese -- Piper Jaffray Companies -- Analyst

Good morning. I just wanted to follow up on the NIM discussion, just I know the outlook is for the mid 3.70%s ex the loan fee, but just thinking about the moving parts there, I mean a 4 basis point increase in the cost of deposits are still relatively modest and your new loans that are coming on board are 50 basis points better. So I would just think that with that kind of math that the natural trajectory is higher for the NIM as we think about the next 12 to 18 months leased organically, is that the right way to think about it?

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Yeah. Well, the one comment I would add to that Matt is, we book about $300 million to $350 million of new loans in a quarter if you look at kind of historical average. So yes, it's nice to pick up that 50 basis points we have in last two quarters or so whereas with $8 billion in deposits, 4 basis points is a bit more meaningful. So I think we have -- you look at the ratio of total deposits versus just the opportunity on new loans, that's why we're sort of in that range of mid 3.70%s.

Matthew Breese -- Piper Jaffray Companies -- Analyst

Right, OK. So you think the 3.70% range is there to hold all else equal, at least for the next few quarters?

Mark E. Tryniski -- President and Chief Executive Officer

Yeah, I mean obviously the changes or we have a yield curve, it's kind of static and stays where it is, that gets more and more difficult in future quarters, but right now we've had some momentum on the loan side of the equation and we can maintain pricing relative to our competitors where our expectations are that we'll continue to see loan yields stripped-off a bit.

Matthew Breese -- Piper Jaffray Companies -- Analyst

Okay. Understood. And if we do get a rate cut by the end of the year, what is the impact of the NIM over the ensuing two or three quarters do you think at this point?

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Well, we have in variable rate loans, assets just around $1 billion. So the impact of -- it's a 25 basis point decrease, we would see pretty significant immediate impact to that portfolio. Obviously, we have to sharpen the pencil around the entire pricing for loans and deposits, but immediately there would be no negative impact of those variable rate loans.

Matthew Breese -- Piper Jaffray Companies -- Analyst

Okay. And then just thinking about your deposit base, Mark, I think you mentioned, two-thirds are checking and savings. And if we're at the end of the Fed hike cycle, I think you guys have done quite well from deposit beta standpoint. Just thinking about what's new technology-wise this cycle than in past ones, one would think that the rule deposits might be more at risk, but you guys have clearly demonstrated that you can perform very well. So I guess the question is, why might there be more of a mode around your deposit base versus some of the technological advances over the years? And with that in mind, might we see just a slower creep higher post the Fed cycle stopping?

Mark E. Tryniski -- President and Chief Executive Officer

So I guess that's a broad question that in terms of the impact of technology and I would start by saying, if you look at the things that JPMorgan can do and Bank of America and the big Wells Fargo and some of the big retail banks, the biggest retail banks in the country to get service before that, there's -- if you look at our platform for online and mobile and cash management, there is very few things that the big banks can do for customers that we know that we can do. Peer-to-peer payments and all that kind of thing, we can do all of that as well, so can a lot of other small banks. I think there's a lot of noise, let's call it that, excitement and venture capital funding around kind of Fintech, let's call it. To-date what that is involved is creating an online product in paying 235 (ph) , so ultimately you're at risk maybe because over time of the rates, of those platforms, but I still think that certainly in our markets and I would argue in other markets as well that branches are still matter. If you look at JPMorgan and what they're doing, they are building branches all over the country. Yes, they're in select markets where they want exposure, but if the biggest and presumably best bank in the country is building branches all over, what does that tell you about the -- ultimately the direction of these platforms. And I'm not suggesting that, I'm not trying to be a lug eye or suggesting the technology doesn't matter, but I think there is a balance between chasing technology that isn't going to be helpful to your franchise and understanding that technology is going to change your franchise. So for us what that's meant is, ensuring that we are investing in those technology platforms that actually could ultimately be detrimental to us if we're not participating in some of those kinds of platform. So I think this is going to have to play-out.

We will see how it plays out over an extended period of time. I remember I think it was in the early '90s when we bought some branches from Chase and Chase was getting out of the bricks and mortar business, because the online banking, which I think they were the first to come out with, was going to take over the world and so that was 30 years ago. And it's clear that the number of branches in the United States has been declining for -- I don't know maybe eight years or something like that, it will probably continue to decline, but there is still a very strong business model associated with branch banking, just thinking how to be over time, more prudent around what your branch strategy is and where you invest in bricks and mortar versus divest in bricks and mortar. So I think we tried to be mindful of the playing field. We don't want to be first mover in some of these platforms. I don't think they're going to -- the impact of our business over time I think is going to be more marginal and we just need to be smart and prudent about how we manage our retail banking business relative to our branch part of our business and also relative to the technology part of our business.

We introduced I think it was last year a pure kind of online deposit account opening platform as part of our website and just seeing really good uptick on that, pure online deposit account opening. So we're about to rollout this year a pure online lending platform, again as part of our kind of website not a separate platform or separate branded platform. So our strategy has been to kind of invest in things that are core to our existing platform to be sure that, yes, you can open a deposit account in Community Banking in your pajamas, yes, you can apply for loan at Community Banking sitting in your pajamas at home. But also mindful of what does this mean overtime for our branch business and what are the prudent steps we need to make to continue to either invest or consolidate over time our branch network as well. So that's the way we think about it from here.

Matthew Breese -- Piper Jaffray Companies -- Analyst

Understood. I know it's broad-based, but it's kind of fascinating that we are now at the end or perhaps at the end of a Fed hiking cycle and your cost of deposits is 20 basis points. The last question that I really had was just around CECL, any updates, where you are in the process and what we might see for that day one reserve especially considering your loss history over the past 10 years has been very solid.

Mark E. Tryniski -- President and Chief Executive Officer

Yeah. And at this point, we are in the process of still sort of building and confirming and validating our models. So we're not in a position yet to put out a number, but I think you did point out that our reserves are pretty strong at this point relative to our historical losses. So at this point, yes, we are really going to put out, we need to get through our continuation of confirming the models and building out the models and validating it before we post the number.

Matthew Breese -- Piper Jaffray Companies -- Analyst

Understood. Is it possible that the given your loss history, we could see a reserve release?

Mark E. Tryniski -- President and Chief Executive Officer

I guess there are possibilities at this point in our analysis, but we have to get through that process really before we commit in either amount or direction.

Matthew Breese -- Piper Jaffray Companies -- Analyst

That's all I had. Thank you.

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

The only thing I would add to that is that, if you look at our reserve, it represents about five years of net charge-offs. So I would expect that whatever adjustment we have for CECL either way it goes that, it would be probably less than the average in the industry in terms of the reserve adjustment.

Matthew Breese -- Piper Jaffray Companies -- Analyst

Understood. Okay. Thanks for taking my questions.

Mark E. Tryniski -- President and Chief Executive Officer

Thanks, Matt.

Operator

And with no other questions in the queue, I would now like to turn the call back to Mark Tryniski for any additional or closing remarks.

Mark E. Tryniski -- President and Chief Executive Officer

Thank you Jenny. I think that's it from all of us here. So I thank you all again for joining and we will talk to you again in July. Thank you.

Operator

Okay. And that does conclude the call. We would like to thank everyone for your participation. You may now disconnect.

Duration: 64 minutes

Call participants:

Mark E. Tryniski -- President and Chief Executive Officer

Joseph E. Sutaris -- Executive Vice President and Chief Financial Officer

Austin Nicholas -- Stephens Inc. -- Analyst

Alexander Twerdahl -- Sandler O'Neill & Partners LP -- Analyst

Russell Gunther -- D.A. Davidson & Co. -- Analyst

Erik Zwick -- Boenning & Scattergood, Inc. -- Analyst

Collyn Gilbert -- Keefe, Bruyette & Woods, Inc. -- Analyst

Matthew Breese -- Piper Jaffray Companies -- Analyst

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