Heritage Financial Corp (HFWA) 2003 Q4 法說會逐字稿

Good day and thank you for standing by. Welcome to the Heritage Financial Corp. earnings conference call. At this time all lines are in a listen-only mode. Later there will be an opportunity for your questions; instructions will be given at that time. (OPERATOR INSTRUCTIONS) As a reminder, this conference call is being recorded. I will now turn the conference call over to your host, Chairman, President and CEO, Mr. Don Rhodes. Please go ahead, sir.

Welcome to those of you who are on the line and also an early welcome to any of those who may call in during the next ten days when this recording is available. We welcome you, and we're glad to have you with us. Also here with me to participate in responding to any questions you might have are Brian Vance who is Executive Vice President of Heritage Financial and serves as President and CEO of Heritage Bank, along with Ed Cameron who is senior VP and Chief Financial Officer of both the holding company and the bank.

I would like to just give some overview comments, which hopefully will be fairly brief, and then throw it open to any questions that you may want us to cover. And in so doing I would just like to call your attention to the final paragraph on page 4 of the press release as to forward-looking statements, including the fact that the press release as well as our discussion today may include statements regarding future performance, developments or events, expectations for growth and market forecasts and other guidance on future periods. Forward-looking statements are subject to a number of risks and uncertainties that may cause actual results to differ materially from stated expectations.

Nicely parenthetically in 2002 that actual results deferred very positively from stated expectations, but we'll talk about that in a minute. Specific factors include but are not limited to the effect of interest rates, changes, risks associated with acquisition of other banks and opening new branches, the ability to control costs and expenses and general economic conditions. These factors could affect the Company's financial results. Additional information on these and other factors are included in our filings with the Securities and Exchange Commission.

With your attention called to those weisel (ph) words, if you will, I'd like to call your attention to the fact that we have now completed six years as a public company having started to trade on the NASDAQ national market on January 9, 1998. We're pleased to report continued steady progress toward our previously stated goal of achieving a 15 percent return on average equity by the end of our fiscal year 2005, of course our fiscal year ends at December 31st.

During 2003 our return on equity averaged 13.03 compared to 12.18 in 2002 and, nicely during the fourth quarter 2003, our ROE averaged 13.7. We certainly remain optimistic about achieving our stated goal in the timeframe that we have discussed. During 2003 our actual earnings of 8.9 million were down from 9.4 million in 2002. Normally this would obviously be considered a bad circumstance, but the comparison was more a factor of a record earnings in 2002 than weak earnings in 2003.

I like to look at it from an historical perspective that if you went back and took a look at our earnings beginning in the year 2000 of 5.9 million and in 2001 6.9 million, one would normally have found our earnings in 2002 might have been around 8 million. In fact, they turned out to be 9.4 million for a couple of reasons, one being that was the first full year after showing the effect of our Vision 2001 expense control project, and during that 2002 year interest rates were dropping away very quickly on deposit rates, much more slowly on loans.

So the effect was a year when, while we don't talk about our financial plans as a matter of fact, we have planned earnings in the mid 7 million range and we actually ended up at 9.4. So our earnings of 8.9 this year when taken on that scale show steady progress, and to the extent they're down as we can look at it from an historical perspective I think we could say it's a nice problem to have to explain.

Despite narrowing interest margins, our net interest margin remained a strong 542 for 2003, down only 11 basis points from 553 for 2002. Loan rates dropped a lot faster in 2003, just the opposite of what happened the previous year, causing the margin squeeze. Reduction in loan rates and requests to reduce rates on existing loans has slowed considerably, but we do expect some further narrowing of the margin. Our margin does remain strong compared to many banks, and I think that's a testimony to the work of our pricing committee led by Brian Vance and Ed Cameron.

During the next six months non-public CDs totaling about $47 million with an average rate of 1.61 percent will reprice. That compares to the current average rate of 1.25 for six month CDs today. The problem is that most people aren't renewing for six months, more likely moving into 12 months where the rates are comparable to that 1.61 number. So, we don't see a lot of opportunity to lower deposit rates in the months ahead.

Earnings per share, as mentioned, despite the lower actual earnings our 2003 diluted earnings per share improved to $1.32 from $1.27 in 2002. Certainly our share repurchase program was a key factor. But as we talked about a moment ago about our actual earnings, our earnings per share growth continues strong when taken a look at from an historical perspective and referencing my comment just a moment ago about actual earnings in 2000 -- year 2000 we earned 65 cents a share, 2001 it was 86, last year the record earnings was $1.27 and, despite our actual earnings being a little less this year, we did improve that 5 cents to $1.32 during 2003.

As noted in our press release, we have for now repurchased 47 percent of the shares that were outstanding in 1999 after our last acquisition, and the average price of all those shares repurchased has been $12.01. Continue to evaluate our share repurchase program and its impact on our earnings per share as well as its impact on our book value. And the primary criteria we've been looking at is does it help us continue to be accretive to earnings.

Another thing we'd like to call your attention to is our nonperforming assets. There aren't many of them. That's one reason we like to call your attention to them. Only $686,000 at December 31, '03, which is only 11 basis points of total assets, well below the average of publicly traded commercial banks on the West Coast as of September 30, '03 data as put together by D.A. Davidson & Co. Although we underwrite loans carefully, we still experienced solid net loan growth during the year, again despite a runoff in residential one to four family loans that ran down some approximate $40 million during the year due to refinance activity and sail into the secondary market.

Our dividend program, we continue to increase -- we continued to increase the dividend by half a cent quarterly. Most recently paid 15 cents a share last Friday, January 30th, and that's up from 13 cents a share of the same period a year ago. We continue to evaluate both our dividend policy and our share repurchase program on an ongoing basis as to their affecting us in meeting our objective of continually improving shareholder value.

In summary we feel we've had a solid year despite declining interest rates and a soft Pacific Northwest economy, and are confident of meeting our 15 percent ROE objective. Ad this time we'd be pleased to respond to any questions, comments that you may have, and in so doing again call your attention to those statements regarding future performance and so forth as found in the last paragraph of the press release. So at this point in time we'd be pleased to take any questions that you might have.

(OPERATOR INSTRUCTIONS) Jim Bradshaw from D.A. Davidson.

Wondered if you could talk about -- you or Brian I guess -- could talk about the pace of loan activity over the course of the quarter and are you starting to see things brighten up a little bit as we head into the new year?

We, as you may recall from information in -- from the past press release and previous ones, we again had a fairly substantial increase in our discounting lending area, added a couple of new lenders to that marketplace, leased an office and consolidated several lenders that were already in the marketplace in one location. That was done in the second quarter of last year. And as you would anticipate, that growth takes a little bit of time coming in, and that began really third quarter and substantial increases in the fourth quarter.

So if we look just an that particular growth, we look to Pierce County to continue to grow in '04 as a result of those new lenders and just the increased activity. Our net loans grew last year at an almost 11 percent clip. If you adjust for the single-family numbers that Don mentioned earlier, that loan growth would've been in the neighborhood of 19 percent had that single-family portfolio not runoff, but of course it did. So I think that the loan growth we experienced in the fourth quarter may not continue at that same pace. But -- as we move into early '04 -- but I think we can expect loans to continue to grow.

And just one more, if I may. Are there any events that you've got planned for '04 regarding branch, remodeling or technology platform improvements, things of that nature?

Yes, actually we -- interesting that you would ask -- we have -- we're doing some extensive studies, have been the last few months, toward upgrading our technology. We found ourselves to be very competitive with the bigger banks in products for our business customers such as cash management and all of those types of programs. But at the same time, as you may know, we use the BISYS system, we outsource our technology. And in several cases we don't have their latest versions of their particular product, although what we have is working well. So during this year we will be moving into those applications which represent the latest versions of the products that they may offer.

The other thing is that we have continued to have Central Valley Bank continue as a separate entity, which will continue. However, they have also been on their own original VP system, which was FISERV. So one of the projects this year, which probably won't get accomplished until the end of the year -- not probably, won't -- but is scheduled by the end of the year, is to get both banks on the same system, which has not particularly hurt us not to be, but it will just make it far more efficient and enable us to introduce some of the more sophisticated cash management products to our customers over in the Eastern Washington area that heretofore we haven't had. So we do have some activity planned in the technology area this year.

Appreciate that. Just one more, if I may. Is there -- maybe, Don, you could give me a feeling for what the board's attitude is regarding buybacks versus dividends. You sort of balanced the two over the last few years dividend growth and a lot of buyback. Just wondered if anything has changed in the thinking with tax changes and the price of the stock and things like that?

It's something, as I mentioned, we continue to evaluate really on a monthly basis or -- and, of course, when we do announce a buyback we need to get through the end of that before we might look at the next one and we evaluate dividends on a quarterly basis. But certainly I think the feedback we've gotten is that our customers like what has happened, the dividends. We've established a very steady, predictable pattern. And as long as our earnings remain, our payout ratio is in the range of -- in the low 40s. And we anticipate as earnings continue to grow it won't increase above that. So we're comfortable with that.

The other -- and the share repurchase, the main criteria there that we are looking at is is it accretive to earnings. And of course, even at today's prices it continues to be accretive to earnings. But the other side of that is its impact on book value, which it is decretive to book value. And so that's something we need to continually look at as well. But we continue to think both of those activities dividends and the share repurchase have been beneficial.

The other major factor, we are beginning to approach the period where we no longer are as strongly capitalized as we were. We are still by definition well capitalized, but our capital has gotten downright right in the 10 percent or slightly below range, so it's not like when we were out there with 12, 15 or 20 percent capital. So the share repurchases at this level of capital obviously take a big chunk of it. It has benefit to earnings per share, but the capital position of the company is now emerging as something that we also take a look at. We're in great shape, still right on the border of double-digit capital so there aren't any problems -- but I'm just saying it's something that we also are keeping our eye on.

Nice problem to have. Thanks a lot. Appreciate it.

Thanks, Jim. Appreciate you being on the line. Thanks for your questions.

Ross Haberman from Haberman Brothers.

Just had a couple quick questions. You know I'm just a stickler for the efficiency ratio. What's your prognostication regarding that, and was the pickup basically related to the couple of new lenders which you brought on the past -- what was it -- two or three quarters ago?

We did have an uptick in the efficiency ratio, certainly from the previous year. But to a large extent the increase in the efficiency ratio had to do with the addition of actually five people, three lenders up in the Pierce County market, as well as leasing some additional space there in which they were housed. And frankly, also -- following up on Jim's earlier question just a moment ago, we spent some money during the course of the year visiting some sites in connection with our technology upgrade that we're going to be going through, visited some BISYS sites and some FISERV sites to make sure we were seeing the products in action and making sure we were comfortable with them, so we spent a dollar or two in that area as well.

But we're very mindful of our efficiency ratio, that it has drifted up a bit. Certainly our plan, in addition to the 15 percent ROE, our plan looking forward is to get that efficiency ratio down into the mid '50s and over time even lower than that. But we're not ignoring that. Point well taken.

Given the money should be spent on I guess the systems for the coming year, do you see much progress at least in calendar '04 with that efficiency? And the new lenders you brought on -- net net, given the upfront money you've spent, will they be contributing to the bottom line do you think in the coming year?

We saw some -- with the lenders that came on we saw some nice loan growth during the latter part of the year, not only there but here in Thurston County as well. But I think as far as the efficiency ratio, I think we'll hang right around that 60 percent number this coming year, just based on what we see coming now. Our revenues will be going up. Of course, there are two sides to that ratio. One is the expense, the other is a revenue. If we saw some increased interest rates and that led to some increased loan revenue, that could have a positive affect as well. But on the expense side, we should be holding during '04 about the same rate we did in '03.

One final question, if I may. You have a decent currency, I know you've historically looked at acquisitions. One, are you looking? And I won't ask specifically what you're finding, but do you think an acquisition is in the cards over the next year or two?

We, as we've previously indicated, we -- I guess we're looking on an ongoing basis, evaluating what's out there. And we, over the last four years or so, really have look that four different situations with varying degrees of seriousness, none of which seem to be the right fit at the right price for us at that particular time. And we continue to look ahead. There's a sense that maybe M&A activity out in the Northwest will pick up a little bit. We certainly remain in our intentions of remaining independent ourselves. So one way for us to grow would be to find the right acquisition opportunity.

Our strategy has been, as it was -- as we talked a few minutes ago, our strategy has been more than -- rather than opening branches or making an acquisition while still continuing to look, but not being desperate to do one. But our strategy has been to grow through hiring additional loan officers in the markets we serve whether that's here in Thurston County, last year it was most noticeable up in Pierce County, but that doesn't mean that's the only place that that type of growth will take place. And as we look at the dollars spent to add to our lending staffs, wherever it might be, compared to the cost of opening branches, we think that gives us a pretty good return.

The problem with acquisitions, we see kind of -- to the extent there are any banks that are interested in talking about selling, we seem to be going back to a little bit of seller euphoria in terms of prices and sometimes those don't always really pencil out. And again, our goal is to get us to that 15 percent ROE as soon as possible, recognizing that probably the market wouldn't penalize us particularly if we found the right acquisition as long as it really was truly accretive to earnings and didn't just say it was going to be but in fact turned out to be.

So that's kind of a long answer. I guess we continue to look. There are probably some institutions in the market areas around us that would make a nice fit for us. But it seems to me most of the time -- the timing on those things has to work right. A board has to be willing to sell, the CEO has to be willing to sell. It has to be desirable and it has to be a good match. Although, as you say, we've got some currency and it's another one of those things that I think falls in the category of a nice problem to have.

Thank you. The best of luck. We'll call you back about my plans to be out there.

James Abbott from FBR.

I wondered if you could touch briefly on your -- the interest rate floors that may be on the loans and what percentage of the portfolio that may be, and basically how a rising interest rate environment would impact your company at this point?

Sure. I didn't catch the first part of your question there on the interest rate what? I didn't -- it was a little bit garbled what you asked there.

I'm sorry, as to whether there were interest rate floors on the loans.

All right. On going to ask Brian Vance to comment on that and Ed Cameron just to speak generally about the profile of the portfolio at this point.

First of all, I would comment that during the year '03 that there was an incredible downward pressure on refinance activity inside our commercial portfolio as well. And we obviously, in order to keep some of those very strong quality assets, adjusted rates. I bring that up only to say that almost in every instance when we did adjust a rate downwards we put a floor in the deal going forward. So while we gave up a little bit in terms of earning asset yield, we did get a floor.

We're attempting to get floors in deals going forward as competitive issues would allow. We don't get them in every deal. It depends on the type of project, the structure, etc. But it is something that we do focus on in our negotiation process.

What percentage of the portfolio would you say is below there in the indexed -- or below the floor rate?

Below, I would say half or below the floor rate -- most of the deals that have floors would be at that rate, or at the floor or below. The primary reason again, most of the floors were established within the last year and rates really haven't moved much since then. So most of them would be at about the floor now.

Okay. So then in a rising rate environment you may see some modest pressure on the margin within -- for the first 50 basis points up perhaps, but after that you're not going to see too much of a problem?

Yes. Of course, that would be true in fixed rate deals. There are -- of course, we have a good number of floating-rate deals that we have negotiated floors as well. And that those would float up with the rates as the rates change.

Ed, any comment on that?

The problem with floors, if you do have them they come in and renegotiate them, so that was part of the renegotiation process we went through in the past year. And we will get squeezed a little bit when rates go back up because of those loans that are below -- or the floors that are above current interest rates. So we'll have a little bit of squeeze there. Central Valley Bank, almost all of their portfolio floats to prime without a floor being a big problem. So, on a corporate wide basis we're relatively close to neutral. I think our bigger problem will come with liabilities not -- liabilities repricing on the way up as opposed to getting really squeezed on the loan side these days.

Okay, good.

Adding -- those comments certainly true, I guess the other thing I would say is that we still expect to see -- we don't see, to -- we don't see any devastating impact on our margin, meaning we think compared to most banks we're going to still be showing a very strong margin. And even though it might drift down a little bit depending on what happens with interest rates, but we certainly don't see anything that's going to cause the floor to drop out -- the bottom to drop out of it and suddenly get to a point where our margin is much weaker than most.

Most banks across the country would kill to have margins like yours.

Another one of those nice problems to have.

Exactly. The other question -- I guess two other quick questions, one is on the mortgage banking volume. Obviously income declined. I wonder if you could give a little color or a little breakdown on the volume of loans that were sold from the third quarter to the fourth-quarter? We sort of know what happened nationally, and I just wondered if we could get a sense from you guys? And then also, the gain on sale of margins.

Okay, we're just -- in order to get you the exact numbers, Ed, do you have those in front of you?

I don't have them in front of me, but I can say that the third quarter's linked volumes really went into a decline, and in the fourth-quarter they were very low. But the actual volume, I think we -- I'll do it this way, I think we peaked around August at $13 to $14 million, and we probably only closed -- what did we close last month? Less than 5 million close last month, so it was that kind of a decline. And almost all of that change was just when the refi wall was hit by everybody it seemed to dry up everything for a brief period.

I'm sorry, you mentioned 13 million in August and then 5 million in December?

Less than 5 (inaudible).

He's taking a look at a -- an historical look at it. In the year 2001 we closed 103 million in residential loans. And basically 95 percent of that was sold into the secondary market. In 2002 we closed 91 million, and in 2003 125 million. So 2003 was our record year, the previous real high mark had been in 1998 when we closed 118 million. But certainly things tailed off during the fourth-quarter, which is still kind of -- which is interesting to me because there is the market perception that it's no longer advantageous to refinance.

And yet at the same time, if you take a look at our posted rates, or for anybody else's for that matter, rates are still certainly at a very, very low picture (ph) compared to going back 15-20 years ago and really aren't that much different than they were earlier in the year. And I think the information I see, there's still a lot of people out there who would benefit by refinancing. But whether after the first of the year we'll see a little pickup in refinancing or not remains to be seen. But if your neighbor hasn't refinances it's still a good time to do so.

It still is, that's absolutely true. Rates are still a great -- people haggling over 25 basis points or so when they're as low as they are is not --. And the final question, or I guess on the gain on sale margin, some other mortgage banks across the country did experience some really tight sale spreads. Did you see anything less than 25 basis points or (indiscernible) in that range at all on the conforming?

No, but it is getting to be more and more of a commodity business every day, and the gimmicks are coming out of the woodwork this year it looks like to try to get business because of the commodity nature, but we were never that (inaudible).

Okay. And then I guess on the final question, and this is on the provision methodology that you used -- maybe if you can give us a little color or give me a little bit of color on what you -- how might we model that a little bit, is it a reserve to loan ratio? I know there's a lot of shifting going on in the industry right now as to how to calculate that provision -- more of a science debate than it used to be.

I read one glorious announcement this morning that probably came in Friday when I wasn't here, that the AICPA has dropped their loan loss reserve project. So what happens going forward I don't know. But what we do is we assess the overall marketplace here and our loan concentrations, our loss history, what be the economy, trends that are going on in our own portfolio in terms of volume and terms, (inaudible) already said concentrations, state of the real estate market -- community banks are traditionally real estate lenders in one form or another, we specifically look at that, we rate them and then assign a level of basis points to our unclassified portfolio, and then we look at our classified portfolio and assign 5, 15 and 50 basis points depending on where we got it classified. Add all those up and say that's the level of loan loss reserves that we should have in an ideal situation, project our loan growth forward for a quarter, and applied the basis points to that and come up with a monthly recommendation to our board, and then the board approves our provisions. That's kind of a 25 words or less version. Does that answer the question?

Yes, I think so. I mean --.

I would just add this. We, and of course, we -- it's actually the board approves it but it's actually the audit committee that meets with our accountants. And we -- our general target has been to have the loan loss reserve at about 1.5 percent of loans. That's fairly normal in the industry. If some big dramatic change takes place in what -- FASB allows that to be done or the SEC does or whatever, we'll have to deal with it. But over the years I would say our balance sheet right now is no longer just trying to get it to be commercial bank like, I'd say that it is bank like.

And so as we have growth in our business loans and in our commercial real estate totals to a certain extent and in our construction lending, certainly that's higher risk than the good old days when the portfolio was one to four single-family residents in terms of 70 percent of the loan portfolio. So we try to be realistic, stay within the appropriate accounting guidelines. But if you were looking for a number, the one that we would normally be shooting for, unless we just blatantly can't justify it, would be about a 1 percent -- 1.5 percent reserve on total loans.

Thank you very much. Those are both good insights. And then finally, on the securities portfolio, any thoughts on increasing that as a percentage of total assets or do you expect to keep that relatively stable, about 20 percent or a little less than 20 percent of total asset?

We're projected that to be relatively stable this year. As a matter of fact, it'll probably shrink a little bit as a percentage of total assets.

Okay, thanks very much for your time.

(OPERATOR INSTRUCTIONS) There are no question in queue, please continue.

No further questions then? If not, I want to thank those of you who have been on the line listening and those who raised questions. Again, we'd like to welcome people who weren't on the line during the live teleconference but may choose to listen in over the next ten days, so I hope you find the information helpful. We're pleased to hear from our shareholders at any time with your suggestions and comments and questions. So we look forward to you. It's been our practice to hold a conference call every six months. So it would be our intention to be with you again in this format following release of our six-month earnings in late July of 2004. So thank you very much for being with us. Thanks, Barbara, for coordinating this for us. And we'll sign off at this time.

Thank you. Ladies and gentlemen, this does conclude your conference for today. And as a reminder it is available for replay beginning today at 2:15 PM Pacific Time through February 12th at midnight. And to access the AT&T Executive Replay Service dial 1-800-475-6701 and the access code 715-749. We thank you for your participation and using AT&T Executive Teleconference. And you may now disconnect.