Columbia Banking System Inc (COLB) 2006 Q2 法說會逐字稿

Welcome to the Columbia Banking Second Quarter 2006 Earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session. Instructions will be given at that time. [OPERATOR INSTRUCTIONS] As a reminder, this conference is being recorded today, Thursday, July 27.

I would now like to turn the call over to your host, Melanie Dressel, President and Chief Executive Officer of Columbia Banking System. Please go ahead, ma'am.

Thank you, Vanessa. Good afternoon everyone and welcome to Columbia's conference call. As Vanessa said, I'm Melanie Dressel, President and CEO of Columbia Banking Systems. I'm going to assume that you've all seen our earnings, which were released this morning, and they are available on our web site. While we typically don't hold a mid-year conference call, we just wanted to give you an update on our year, as well as give you the opportunity to ask questions you might have. Joining me on the call today are Gary Schminkey, our Chief Financial Officer; Mark Nelson, our Chief Banking Officer; and Andy McDonald, Chief Credit Officer. After our discussion, we'll give you the opportunity to ask us questions.

Before we begin, I'd like to remind you that we will be making some forward-looking statements today which are subject to economic and other factors. For a full discussion of the risks and uncertainties associated with the forward-looking statements, please refer to our securities filings and, in particular, our Form 10-K filed with the SEC for the year 2005.

As we mentioned in our release, we reported increased earnings for the second quarter this year due to rising short-term interest rates, along with continued loan growth and the resulting increase in net interest income. Our revenue for both the quarter and the first six months of 2006 increased as well. We were pleased with these results, especially since we had a $1.1 million net-of-tax expense associated with the market value adjustment of our prime rate floor contracts. The prime rate floors will be an important tool for us, to minimize the impact to our earnings if interest rates decline over the next five years. Gary will discuss the floors later in the call, as well as our core numbers that exclude this expense.

Our net income was up 6% for the second quarter of 2005 and up 18% from the first six months of last year. Our revenue rose to $30.6 million for the second quarter 2006 and $60.8 million for the six months ending June 30, 2006. This is up 10% from $55.4 million for the first six months of 2005. Our diluted earnings per share were $0.45 for the quarter, an increase of 5% from the $0.43 a year ago, and diluted earnings per share for the first six months of 2006 were $0.96, compared with $0.83 for the same period last year, an increase of 16%. Excluding the prime rate floor expense, our core earnings were $0.52 per diluted share, an increase of 21% from $0.43 a year ago.

At the end of June, our total assets were $2.54 billion, a 7% increase from $2.38 billion at December 31, 2005. Our total loans were $1.6 billion at June 30, 2006, and we continue to be disciplined in our loan originations in light of rising interest rates and increased competition. Other economic factors, such as increased steel prices, may slow portfolio growth. We believe we are at a point in the credit cycle where competition with both loan structure and interest rates are aggressive and we will not give up quality or sacrifice future earnings to achieve loan growth.

At the end of the second quarter, our total deposits had decreased slightly to $1.96 billion, down 2% from $2 billion at the end of 2005. The banking industry, as a whole, is being a little challenged in maintaining and growing deposits, particularly core deposits. Columbia is facing some of the same challenges now, although we have a strong core deposit base of 73%. Total deposit growth has moderated, putting pressure on our net interest margin, as our reliance on higher cost deposits and borrowings has increased to fund our loan growth.

The net interest margin increased to 4.47% from the second quarter, up from 4.36% for the same period in 2005. This is a decrease, though, from the 4.65% in the first quarter of this year and 4.61% in the third quarter of 2005. However, we continue to reap the benefits of our relationship banking philosophy with continued growth in demand in savings accounts, which is exactly what we wanted to do. We have several different initiatives underway to encourage growth in low cost deposits, such as our new premium plan money market account that is bundled with a lot of extra features.

We've also invested significantly in television advertising, with five new commercials that promote Columbia's brand, our relationships with our customers and our commitment to providing them with the best customer service possible.

We will continue with the strategies and competitive advantages that have served us well over the last 13 years. At the heart of these strategies is our focus on our customers, enhancing our relationships with them, delivering the best possible customer service, and providing a broad range of products and services that compete effectively with even the largest banks in our markets. We have experienced and dedicated employees, an excellent reputation in the communities we serve, and we have established the infrastructure we need to position us for long-term success.

At this point, I am going to ask Gary Schminkey, our Chief Financial Officer, to review our prime rate floor contracts, our operating results, and some additional financial highlights. Gary?

Thank you, Melanie.

First, I'd like to cover that expense of $1.8 million, due to an adjustment in market value of our prime rate floor contract. We estimate that our balance sheet is asset sensitive over a short-term horizon of three months, which means that interest earning assets, such as loans, reprice more quickly than our interest-bearing liabilities or deposits. As you may remember, about 43% of our loans are tied to the prime rate or other short-term index. During a rising rate environment, our net interest margin is likely to increase, but decrease during a falling rate environment. While no one can predict what interest rates will do, our goal is to position the Company to be indifferent to changing rates, although we may certainly have a bias as to the direction of interest rates.

At the end of the first quarter of this year, we entered into an agreement to purchase $200 million of five-year prime rate floors at a cost of $3.1 million in an effort to reduce the potential impact declining rates would have on our earnings. The floors contain a threshold price ranging from 7.75% to 7.25%. If the prime rate decreases below the threshold price at any time during the five-year term of our agreement, Columbia will receive a monthly payment for the difference between the threshold price and the prime rate. The floors enable a portion of our assets to temporarily take on the attributes of a fixed-rate instrument, assisting us in our efforts to minimize the impact of declining rates on our earnings.

Under a rising rate scenario in which the prime rate never drops below the threshold price of the floors, we will experience an increase in other expense of $3.1 million, which is the cost of the transaction fee. This fee will be recognized over the term of the floors, which is five years. In no event will this cost be greater than $3.1 million over the five-year period. When the floors were purchased, we did not achieve hedge accounting treatment. This would have meant that all adjustments to market value would be an adjustment to equity rather than earnings. Interest rate markups are volatile and the market value of these floors can vary greatly on a quarter-to-quarter basis.

In the second quarter of this year, we recognized all changes in the market value of the floors through income and expense. As you noticed, this accounting methodology may result in a large valuation adjustment to earnings each quarter. We do not view this as desirable, since the market adjustment makes net earnings volatile and has no bearing on operating earnings. Remember that over a five-year period, the total expense will be $3.1 million, so this is simply a timing adjustment.

In July, we will have achieved hedge accounting treatment for these floors on a prospective basis. Changes in market value will be an adjustment to equity, rather than the offset to earnings we saw during the second quarter. We will use mark-to-market accounting up to the effective dates that we achieve hedge accounting. So, you will see what we currently believe will be a positive valuation adjustment in the third quarter. From that point, the remaining market value will be amortized over the remaining life of the floor.

To sum up this discussion, you might ask why we didn't use hedge accounting in the first place. Well, due to the most recent issues experienced by larger banks that utilize hedge accounting and after consulting with our external accountants, the mark-to-market method was deemed the most conservative. We also felt that the amortized costs would approximate market value. As we have learned, the interest rate markets have not followed historical trends and are extremely volatile, resulting in large swings in both directions. Moving forward, we believe that extreme volatility is unacceptable in recording our quarterly operating earnings and, more importantly, Melanie just doesn't have the stomach for it.

As I mentioned, the valuation adjustment for Columbia's interest rate floors resulted in a second quarter pre-tax expense of $1.8 million. If we exclude this expense, our core net income for the second quarter of 2006 was $8.4 million, an increase of 25% from $6.8 million for the second quarter of 2005. Core earnings per share were $0.52 per diluted share, up 23% from $0.43 per diluted share one year ago. For the six months ended June 30, 2006, core net income was $16.6 million, an increase of 27% from $13.1 million a year ago, and core diluted earnings per share was $1.03, compared with $0.83 for the same period in 2005, up 25%.

Core return on average assets and return on average equity for the first six months of 2006 were 1.37% and 14.61%, respectively, compared to 1.17% and 12.68%, respectively, for the period in 2005. Excluding the market value adjustment for the floors, non-interest expense grew from $18.3 million in the first quarter to $19.3 million in the second quarter. In part, this change is due to $300,000 associated with the production and rollout of new television commercials, which we expect to use for up to three years. In addition, we wrote off $177,000 of software licenses, due to the migration to our new residential real estate lending platform.

One other significant item of expense was a $369,000 write-down in one of our Community Reinvestment Act, or CRA, equity investments. However, it is important to note that during the quarter we received $238,000 in tax credits associated with these CRA investments. On a sequential quarter-to-quarter basis, the net interest margin was 4.61% in the fourth quarter of 2005, 4.65% in the first quarter of 2006, and 4.47% for the most recent quarter. This is a result of the increasingly competitive environment for both loans and deposits. As a result, loan rates have moderated in spite of a 50 basis point increase by the Fed in the second quarter, while deposit rates continue to climb, especially money market and CD rates.

Thank you, and now I'd like to turn the conference call back over to Melanie.

Thanks, Gary.

We find it hard to believe that next month we are actually going to celebrate our 13th anniversary. We are pleased with our progress in strengthening our balance sheet, expanding our profitability, and the steps we've taken to protect our margins, should a reduction in short-term rates occur. However, this is a journey and our intent is to make decisions that will enhance our long-term viability.

As many of you know, we expect to open our Lacey Branch during the second quarter of next year. We have completed a thorough analysis of opportunities in our contiguous market areas and have selected strategic new locations that should be a good fit for us, particularly in King County. We believe we are well-positioned for success for the remainder of 2006 and beyond. Our fundamentals simply have not changed. We will remain focused on growth and earnings, increasing market share in every area we serve, and expanding our geographic footprint as we position ourselves as a Pacific Northwest regional community bank.

And now, Vanessa, we'll open the call for questions. And just as a reminder, Mark Nelson, Chief Banking Officer; Andy McDonald, Chief Credit Officer; and Gary Schminkey and I will be here to answer your questions.

[Operator Instructions] Louis Feldman, Hoefer & Arnett

Honestly, Gary, I don't think any of us have the stomach for it. I'll start with a couple of softballs. Mark, can you talk about what your pipeline is like and what the credit line usage is on your C&I lending?

Yes. Actually I'd love to do that, Lou. Our pipeline right now is as strong as we've ever seen it. All of our areas are developing new business, particularly on the C&I side. We've always been a strong C&I lender. On the commercial real estate side, we had an aggressive campaign the first half of the year and we've been watching the CRE guidance from the FDIC, so I think we're pretty well balanced the way that stands. I really think all of our units are functioning very well, so we're really positive about where we are going from here.

You give us great color, but I guess I'm looking for facts and figures here, if you're willing to disclose those.

Well, we generally don't give guidance going forward and a pipeline is a strong estimate of what we expect to do, but clearly I think we will do as well or better in the second half as we have in the first half with growth.

Okay. One quick side question, in terms of, a couple of people have talked about hearing credit unions involved in CRE deals. Have you encountered that?

Yes, we see that intermittently in our marketplace. They have not been a huge competitor, but we do see them doing some various deals now and again.

Okay. And then, Andy, I'll switch over to you. Can you talk about what the classifieds, what your classified assets are looking like and what you see coming down the pipeline, if anything?

Sure. I'm actually pretty pleased with the way the loan portfolios are behaving because we've had a lot of stability in the loan portfolio, and I think you can see that in the numbers in terms of we don't really have any big shakes one way or the other. So, from that perspective, I've been very pleased and I think that the outlook will be that we will continue to enjoy good credit quality.

Are classifieds up, down, sideways? The stuff that we're not seeing just yet but you're putting on your watch list.

Yes, right. No, from our sub-standard and OEM basis, we are fairly flat with the first quarter.

Jeff Rulis, D.A. Davidson

When you strip out the floor expense, its linked quarter non-interest expense is up close to 6%. Do you expect that to slow in the coming quarters?

I would expect that. We had a few items, which I mentioned in the script that were fairly large in the quarter. We had the advertising expense, we had the CRA write-down, and the software license write-down. So I don't see, of course, those same things going forward. So I would hope we would get back to a more normalized expense level.

Got it. Okay. And then in the construction segment of the loan portfolio, it was down quite a bit in the quarter, which is surprising given a lot of the other banks had tacked on some good growth there. Was there a reclassification in there or was that actual runoff?

Andy and I will probably both have a comment on that. A couple of things. One anecdotal bit of information is we saw about $20 million of pay down the last day of the quarter. And those were construction loans that we anticipated it to happen, probably not that particular day. And those are the kinds of things where we are replacing that business as we go forward. That would be part of our pipeline. So, that was pretty much a timing issue and it would have had some impact on that level of construction lending towards the end of, well, the last day of the quarter.

The other thing I'd really like to point out is we've been pretty conservative on the builder banking and construction side all through the cycle and we've looked at really focusing on the strongest people who have staying power through the normal cycles we see in commercial real estate and builder banking. We feel very strongly we've got a strong portfolio and we have not been anxious to go out and be overly aggressive at this point in the cycle. I think that is also a factor that plays into your comment.

Andy, did you want to add anything?

Yes. We basically had about $12 million worth of commercial construction loans that were paid off and ultimately went to conduit lenders, which was exactly as planned. And then we had -- the balance was basically lot loans. We had fortunately for our borrowers, they were able to sell the entire plats out upon completion. So, as a result, we had a dramatic take down there in the residential construction bucket that you're seeing. So, that really explains a big point in time point in time, but the averages, I think, tell a more compelling story.

And then on margins, you had a pretty good string of margin expansion and then a pretty significant decline this quarter. Was there anything special in that margin number or is that all just increasing deposit costs?

We went for quite some time with our core deposit base with very minimal changes. And at this point, I think, going back to the construction lenders, the market is pretty competitive for deposits right now to keep funding those loans with our competitors. So, we did have to make some changes in our deposit pricing over the last several months. Whether that will continue, I don't know. But at this point, we are being very conservative about it and I think the strength of having such a large core deposit base has certainly helped us out in the past and I believe it will continue to do so.

And then, lastly, there were some words in the press release commenting on maybe further compression in the margin. What are your assumptions behind that, as far as, are you seeing another Fed hike here or a flat yield curve? I guess, if you could provide some color on that, that would be great.

It's kind of up in the air right now. If we have another Fed hike in August or September, that certainly would provide a positive impact on our margin. Offsetting that, maybe if the market continues to be very strong on the deposit side, we have to pay up a little bit more to maintain our core deposit base and to fund our current loan bills. What really is impacting the margins in the second quarter is the increased borrowing cost. As you noticed in the balance sheet, we are borrowing roughly $300 million, so that's been bouncing around between $250 and $300 million. We do have some payoffs out of the investment portfolio that would be coming during the second half of the year that would bring that number down. But we're paying for those through the overnight market. So, that has a major impact on the market. Does that answer your question?

That's it, yes. Thanks.

And, Jeff, one other thing, I think that it's important to emphasize that the checking accounts and savings accounts continue to grow and our large balance money market accounts actually are expanding as well. We are actually feeling pretty good about the types of deposits that we're attracting. We'd rather have our deposits, of course, going up as fast as they were several quarters ago, but, to be honest, we felt that during the -- sometime during this year that we would start to see some net interest margin compression because of the competition for deposits.

And also, Jeff, as another point, a couple of years ago, or maybe a little more than that, we had a large inflow of deposits into our money market accounts and other core deposit accounts. And at the time, we always wondered how long it would last and how long that would keep growing and so on. Well, maybe we know now, I don't know. But there are several things that could be the reason for that. As loan rates have increased, people tend not to want keep funds sitting in their money market accounts. They probably really want to pay off loan balances or they go back into the stock market or go into higher-rate CDs. It's hard to say, but I think this is something that we've all thought about over the last few years of when something like that might happen.

Joe Morford, RBC Capital Markets

It's nice to listen in on everyone. I guess first, just a follow up to your last comment, Gary. What should we expect in terms of the securities portfolio going forward? It actually grew a little bit since March, but it sounded like from your last comments you are going to see some payoffs and should we be expecting that to be used to fund loan growth going forward?

That's correct. We do not anticipate growing the securities portfolio at all. In fact, any cash flow generated from that we will use to pay down borrowing.

What are you seeing in terms of cash flows on either a monthly or quarterly basis?

Well, we have a pretty good chunk coming in August, roughly $40 million. And then the remaining portions throughout the rest of the year could be another $10 to $20.

Through year end?

Yes.

Okay. And then on the loan side, it seems, historically, you sometimes had a bit of a slowdown in the third quarter, but it sounded like the pipeline was pretty strong. Might that kind of overrule that this quarter or this year in terms of the seasonal trend?

Well, yes, particularly the last couple of years, we've seen -- I attribute that to vacations and that kind of thing. Yes, it's quite possible and quite probable in the next 30 days we are going to see a pickup in closings of loans. How much impact that will have in the third quarter, I don't know. But we always seem to have that impact us greatly in the fourth quarter and we saw the same thing last year.

Joe, you might note a little bit of caution in our voices. And it isn't that we believe that there is anything wrong fundamentally with the economy, it's just in talking with business owners, they are thinking a little bit more cautiously again, in light of the rising interest rates and fuel costs and other economic factors. And they're using more of their money first instead of -- we are not seeing the line of credit usage coming back as quickly as we had hoped during the good economy, so it's so unpredictable right now.

A lot of anecdotal discussion with clients about paying down debt today.

I wondered about that. I saw that line in the release and I was -- but then when I heard the pipeline comments, it was a little inconsistent, so I wasn't quite sure what to expect for the --

Yes, and it is confusing out there. We just have a tendency to be more cautious, I guess.

Right. I guess then, lastly, Gary, could you quantify what the total tax benefits were this quarter and, again, just confirm what a more normalized tax rate should be going forward?

Yes. In terms of quantifying, I don't have the actual dollar amount here in front of me, but as far as a tax rate going forward, we did have a cushion adjustment in the second quarter, so the tax rate for the second quarter is fairly low. And we also have the tax credit associated with the CRA investment. But on a go-forward basis, I would assume that we would be back into our normalized percentage in the 28% range, 28 to 29%.

Okay. That's great. Thanks very much.

Sara Hasan, McAdams, Wright, Ragen

I just have a couple of questions. I'm sorry if you've already gone over them. I've been in and out. The compensation expense was down on the linked-quarter basis. What is behind that?

We are all trying to remember this link basis. The first quarter of last year, of 2005, we brought in some additional new lenders. Gary, what else was there?

On a quarterly basis, Sara, there are many times that we have to true up our calculations for incentive compensation. That is, so when you look from quarter to quarter, we look at certain incentive programs and we try to true it up on a quarterly basis. And we had a fairly robust first quarter, which kind of backed off a little bit in the second quarter. So I think what you see is a true-up of the incentive accruals that we make for year end.

Okay. What was the stock-based compensation expense in the quarter?

Excuse me?

What was the stock-based comp expense for the quarter?

That's something I'm going to have to pull out and I can get -- pull that out for you.

Okay.

It usually runs in the neighborhood of $40,000 to $50,000.

Okay, that's great. Then, the increase in the securities portfolio, is that just trying to bring you into a more asset neutral position, or balance sheet neutral position, going forward?

Yes, in the first quarter we really looked at how we wanted to position the bank going forward, should rates start to decline. What we did is we essentially knew that we had a certain amount of cash flow from the security portfolio for the year and we wanted to lock in with some securities that will perform well as rates decrease, and they won't disappear and get paid off and so on. So, we actually did that in the first quarter. Then we paid that off with the cash flow during the year. That was also part of our initiative to add the floors too, to give us a more stable environment from an asset liability management directive.

Louis Feldman, Hoefer and Arnett

Gary, can you comment on the cash build, also, during the quarter, cash due to receivables? And did that have any meaningful impact on the margin for the quarter?

Say that again, Lou. I'm sorry.

Your cash build. Cash in due from other institutions went from $88 to $107.

Right.

Can you give us a little color on that, on what your thinking was there, and did that have any impact on the margin?

No, it shouldn't have -- not a large impact on the margin. It's just more of a timing issue of when we collect the balances. The cash that's sitting in the branches and so on, that really hasn't changed and may have actually gone down a little bit, but mostly it's due from other banks. So this number of -- the amount of time or number of days really isn't that great. So, there is quite a turnover in that balance. That's more of an end of the quarter type thing.

So that's more of an end of period and late inflow or something like that?

Yes, we had, as Andy was saying, we had some big payoffs on loans at the end of the quarter. So, those typically come in and they are usually a due from at the end of the quarter, since they are probably uncollected at that point.

Okay. Going back to Sara's question, to what extent was the -- also reduction in comp due to the variable compensation on the mortgage side, which was down?

Basically, we've cut down our back office staff dramatically on the residential real estate side and we have, in essence, five production employees that we had previously. So, part of that is driven by the reduction in back office staff. I don't have specific dollar amounts for you, Lou, but we're probably down somewhere around 14 or 15 people, net.

Okay. Then the hardball question. Mel, on the merchant card business, revenues, on a linked-quarter basis, were up 6%, but your costs were up 13%. Comments? Objectives? Goals for that business?

I'll comment on part of that and then ask Mark to talk more specifically about it. One of the issues, when you look at 2005 compared to this quarter, there was a change in our fee structure, everybody's fee structure, with Visa and MasterCard, during the -- it actually went into effect, I believe, July 31st of last year, so it's a little bit hard to compare apples to apples.

I'm looking at 1Q '06.

Oh, I'm sorry. On a linked-quarter basis. Mark, would you like to --

Well, a couple of things. One, we continue to see our volumes increase. We have people rolling in and out of that account. We do a lot of correspondent business there. Banks are acquiring. We may lose that business. There is a little bit of that towards the end of the first quarter, but, in general, we are replacing all of that business with -- continuing to grow our internal merchant services business with our clients and credit card business. And so most of what we've got in there is volume-related and continuing to perform based on our expectations for the year. Actually, outperform our expectations.

Okay. One last question. Given your C&I [bents], where are you on remote capture?

We are working on a product as we speak.

Rollout time?

I would say fourth quarter this year would be our target objective. Late fourth quarter, maybe first part of first quarter next year.

We wanted to get through our data processing conversions before we introduced that product. We're actually glad that we did. You've probably been reading a lot about some of the legal challenges that have arisen with this new product and they should be resolved by the time we jump in.

[Operator Instructions] At this time, there are no further questions.

Well, we thank you all for joining us here today. We really appreciate it. And feel free, if you have any follow-up questions over the next few days, to give us a call. Thank you.

This concludes today's Columbia Bank conference call. You may now disconnect.