Heritage Financial Corp (HFWA) 2005 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Heritage Financial earnings conference call. At this time, all participants are in a listen-only mode. Later, there will be an opportunity for questions and comments; instructions will be given at that time. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded.

I would now like to turn the conference over to our host, Chairman and Chief Executive Officer of Heritage Financial Corporation, Mr. Don Rhodes. Please go ahead.

Thank you, Tom. This is Don Rhodes speaking. I'd like to welcome all of those of you who are connected to us at this time and also say a welcome to any who may call in during the next ten days when this information is available for rebroadcast.

Also here with me today to also respond to questions you may have later on is Brian Vance, who is President of Heritage Financial Corporation and President and CEO of Heritage Bank, along with Ed Cameron, Senior Vice President and Chief Financial Officer of Heritage Financial and Heritage Bank.

What I'd like to do is just make a few overview comments and then turn to you on the line for questions that you may have. It's been kind of a busy morning with press releases today, so there may be a question or two.

To start it out, I would just like to simply say go Seahawks, beat the Steelers! (LAUGHTER). I hope that I'm not offending any of you who are on the line but you know we like to call them the way we like to see them.

As noted during our July 2005 conference call, a primary objective of our company in recent years has been to achieve a 15% return on average equity. As a result of having accomplished that milestone in 2004, a new five-year plan was developed under Brian Vance's leadership towards the end of 2004, the key components of which we discussed in July, but I would just remind you they included four major items. One was to achieve a net profit of $14 million by fiscal year-end 2009 while maintaining a 15% minimum return on average equity.

The second was a more aggressive but still orderly growth pattern than we've -- (technical difficulty) -- recent years, more aggressive growth pattern, not a more orderly growth pattern we've had in recent years because, in recent years, we've focused on achieving the 15% ROE. This growth pattern that we project over the next little while would include opening of up to three new offices by 2009 in contiguous markets to where we are now with an objective to reach around $1 billion in assets by the end of 2009. This growth could include acquisitions if the right situation developed.

A third component of our objective was to continue our capital management strategies through share repurchases, dividends and -- as appropriate, and fourthly, to maintain our high asset quality standards that we've maintained for many, many years. We've now completed our first full year with these goals in mind and believe that we can report very positive steps toward achieving these objectives. I would just like to comment on those four areas before we turn to your questions.

As to earnings, as noted in the press release, we increased our earnings to $10.4 million from 9.5 in 2004, an increase of over 10% if you exclude the one-time sale of a community bank stock that we had that was sold towards the end of 2004. Also in earnings, as noted, we increased our return on average equity up to 16.13 from 15.8, and our diluted earnings per share increased 10.4% from $1.49 per diluted share to $1.65 per diluted share despite a significant slowdown in the share repurchases under our buyback program. Finally, in earnings, I think another highlight was that our net interest margin remained above 5%.

The second area, as to asset quality, certainly our asset quality we believe remains superior. Nonperforming assets of 16 basis points is well below the national and West Coast averages for publicly traded banks, and we strive to maintain a very superior asset quality.

As to capital management, as indicated, our share repurchase program has slowed considerably. During the past year, we've repurchased just over 73,000 shares during 2005, which is quite a bit less than in previous years when, for example, in 2004, we repurchased 402,000 in '03, 772,000 in '02, 830,000 shares. So significant decrease and as noted a moment ago, despite that, our earnings per share growth increased over 10% and our ROE continued to go up, so it hasn't been all share repurchases, although that was certainly important.

If you read things carefully, you will note that our eighth share repurchase program, which was announced in July of 2004 with a goal of purchasing an additional 5% of our then-outstanding shares or a total of approximately 310,000 shares within 18 months from July, 2004 expired this month. A press release announcing an 18 month extension of that program, which was approved by the Board yesterday, will be issued later today, so you've got the latest information on that. Out of that original 310,000 share repurchase program, we have 223,000 shares remaining. We think it's important to have a continuing share repurchase program available.

In the area also of capital management, we continued our pattern of increasing our cash dividend by $0.005 each quarter with our next dividends of $0.19 per share to be paid this coming week on Monday, January 30. Also, certainly a highlight of the year was that we declared our first stock dividend in October, a 5% stock dividend. What pleases us even more than the stock dividend itself has been the market reaction. Our shareholders have responded nicely with our stock price increasing from around $22 a share to in excess of over $24 a share since October, an increase in excess of 10%, not counting the 5% stock -- (technical difficulty) -- itself. We will continue to maintain our efforts to continuously improve and grow shareholder value.

Finally, a comment area on asset growth -- while our assets did increase over 7% to approximately $750 million during the year just with normal growth -- (technical difficulty) -- good work of our officers and employees, the real groundwork for future growth took place during the latter part of the year. About the middle of the year, we engaged a market study to determine the best growth opportunities, the best markets for us into which we might expand with those two or three new offices that I mentioned a little while ago, and we found certainly that area south of Pierce County, North/South King County and North Pierce County, Tacoma being in Pierce County, really represented a good opportunity that made a lot of sense to us, contiguous to where we are now. We do a lot of business in those markets already, and so we identified those as growth opportunities. As you may have noticed today, we have issued two press releases, one -- our intent to -- and we have regulatory approval to establish a new branch in Sumner in south Pierce County. We expect to have that open by mid-February and have a very experienced banker who has been with us several years and who knows that market very well to lead our efforts in that market.

Then, today, we also announced the acquisition of Western Washington Ban Corporation in Federal Way; this is a bank that was formed in about 1992, about 57 million in assets, just has a single office in Federal Way and Summer. We are right at the top of the list of market areas that made sense for us to go into. So the timing of these two announcements today was totally coincidental; it just happened to fall that way. But the location of these two markets, Sumner and Federal Way, certainly was not coincidental; it was areas that we have identified, and we think establishing the branch in Sumner and the acquisition of Western Washington Bank Corporation and its single asset, Washington State Bank, really is very much a plus for us, a good way to get into that particular market and to expand our services and our growth in those particular areas.

As mentioned, we expect the Sumner branch to be opened mid-February. The Washington State Bank, which has a (indiscernible) is well located in Federal Way, has a very good customer base -- it will take us, we expect, probably three or four months to get all of the appropriate regulatory approvals, so we anticipate that transaction should close by mid second quarter. We anticipate that, for the approximate seven months that Washington State Bank will be a part of Heritage Bank, Washington State Bank will be absorbed into Heritage and will become a branch of Heritage -- that that office will be slightly accretive during the approximate seven months of 2006 that we expect it to be a part of our organization.

So, in summary, 2005 was a very solid start, I think, to the goals that I mentioned at the beginning of my comments in the major areas that we want to grow.

We would certainly, at this time, be very pleased to respond to any questions that any of you might have, but in so doing, would like to call your attention to Page 4 of the press release and just comment that this release and any statements we've made or are about to make may include statements concerning 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 shared expectations. We would hope the differences might be positive rather than negative. That's not in the press release; that's my comment. Specific factors include but are not limited to the effective interest rate changes; risks associated with acquisition of other banks and opening new branches, both of which we are about to do; the ability to control costs and expenses, which we think we do pretty well; and general economic conditions, which certainly are markedly improved here in the Pacific Northwest over three or four years ago. These factors could affect the Company's financial results. Additional information on these and other factors are included in the Company's filings with the Securities and Exchange Commission. I apologize to all of you for reading those weasel words but you know it's an appropriate legal step to take.

So, with that, Tom, I would be very pleased to respond, as would Brian and Ed, to any questions that our participants may have.

Thank you. (OPERATOR INSTRUCTIONS). Jim Bradshaw, D.A. Davidson.

Good afternoon. Congratulations. I don't know that I've ever seen three press releases from you guys in a day.

That is sort of a new world record for us!

Yes. The first question I had is the loan mix for the quarter -- any appreciable change in the mix and really what was the driver of the growth in the quarter?

No change in the loan mix, meaning that we still have slightly over 50% of the loans our balance sheet are loans to businesses. We expect that to probably stay in that mode or grow. Brian, I just call upon you here to just comment on the loan growth that we -- (technical difficulty).

You know, we will continue, as we have in the past and consistent with our strategic plan, to focus on the C&I, the commercial and industrial loans. I think that has been a big part of our growth last year.

From a percentage point of view, the concentration of commercial real estate loans that has been sometimes reported now by FDIC has been lessening, and that is certainly a strategic focus. That does not mean that we are not seeking that type of lending; that is certainly a big part of what we do. But we do see an increasing focus, and I think it would be safe to assume that the growth in the fourth quarter -- there was a higher percentage of C&I growth versus commercial real estate growth than has been in the past. Not an appreciable difference, but yet a move in that direction, and I think you will continue to see that focus going forward.

Okay, I appreciate it. A couple of others if I may? Ed, on the buyback front, which you have been kind of like with the deal in the works, you probably couldn't buy back stock. I just wondered if you would have, had you been able to in the fourth quarter, I should say.

Yes, we would have. It has been difficult, though, to get stock. Then, of course, when we started working on the deal, we had to go quiet.

Do you have to stay quiet now until the proxy statement gets filed or are you technically free a couple of days after this call is over?

We should be technically free a couple of days after the call is over.

Okay, good. A couple of questions about the merger also -- I think they have 14 or 15 employees. I just wonder what your thoughts are, whether anybody within that organization is likely to take a significant management role within your company.

I will respond to that. We enter into ticklish ground here, of course, but [Tony Tibo], who was kind of the founding President and somebody I worked with many years in the last century as a matter of fact at National Bank of Washington in Tacoma, will actually be retiring. We do not anticipate that -- or there are not any other senior executives of that firm who would move into directly-like levels of responsibilities with us. At the same time, a couple of key people that they have heading up their lending and their operations are very good employees, and we anticipate are going to do our best to find a spot where we think they could make a significant contribution here.

Certainly, as this goes from their -- Federal Way being their world headquarters and having administrative people there to operating as a branch, the staffing requirements will change somewhat, particularly at the senior levels, so that's something that we need to go through. We just met with their staff this morning, as a matter of fact had a chance to discuss with them what's going to take place and how we operate. We will be doubling back and spending quite a bit of time, but they have a number of good employees who know their customers; they take a lot of pride in the customers they have there, and we certainly told them we want them to continue that. So, we will kind of work our way through that one.

Don, it's been a while since I looked at Tony's bank, but I recall they had some asset quality problems maybe a couple years ago now but I just wondered what the state of credit quality is like over there.

Yes. Well, we think -- you're right; they had been asset-quality challenged, I guess we could say, going back a couple or three years, but we think we are catching them at a very nice time. They have done -- made a considerable amount of progress. They did have some substantial asset-quality problems. They had several of those loans that they were able to manage out of the bank last year; they've also cleaned up and collateralized a number. They do have a few assets that are substandard but nothing that, as we absorb them, that is going to knock us off the radar charts here at all. Actually, as of the end of the year, they did not have any nonperforming loans in their portfolio, so we -- and the same time, they've gone a couple or three years because of additional loan loss reserve requirements of basically not having any profitability. Last year, they had a nice earnings pattern, so we think we are catching them kind of at the best they've been in several years' asset quality and the best they've been profit-wise. So we want to build on that.

Good. The last one for me was what tech platform they operate on and when you plan to convert them to yours?

They operate -- their main provider is Fiserv; we are on Bisys. One of the things we will get busy on now, since the Board has just approved all of this yesterday, is to determine, first of all, when we can expect the transaction to close. We will be laying that groundwork with our provider to try and schedule a conversion date as soon as possible after that closure. Certainly, if we could accomplish, say, a closing by the end of April, I would hope that we could get them converted in the next 30 to 60 days, if not sooner after that. But it's going to depend a little bit on our preparation, their preparation and our provider, Bisys, availability. But we've had -- we've had some experience in converting North Pacific bank that we acquired. As you know, this will be our third acquisition of Pacific bank, and then last year, although Central Valley Bank operates as a wholly-owned subsidiary separately, we did convert them off of Fiserv to Bisys last year. That's working nicely, so we think we can do a conversion with minimal disruption.

Fantastic. Thanks and congratulations on a really productive day.

David Rochester, FBR.

Good afternoon. I just want to get a sense of any change in the competitive landscape on the loan side and the deposit side. Is there any pressure coming from anywhere? Who is being aggressive? And trying to get a sense for whether pricing, at least on the loan side, is holding and what kind of spreads you're getting now.

I will ask Brian to comment on that.

Yes, you know, just the general economic landscape of the Puget Sound is certainly increasing and improving I think over the last year. I think, as we look through '06, I think we could see continued strengthening in the economy. So, I think that we have a pretty good feeling about that.

In terms of the competitive nature, a couple of -- we do still have some local lenders that are interested in doing commercial real estate lending for ten-year fixed; we simply do not to that. We also see a lot of conduit refinancing. We really had pretty strong loan production in '05 that didn't really show up in our net outstandings as a result of conduit financing for commercial real estate lending, which is typically nonrecourse loans, ten-year fixed at very attractive rates. We saw some prepayment flight out of our portfolio as a result of that. I think a little bit of that will continue as we move to '06 as well.

In terms of just other competitive issues, I don't see an appreciable change. It's a highly competitive market, but I'm not sure there are very many that are. I think we've got our lenders -- are well seasoned and well positioned in the marketplace, and I think that we will get our fair share.

Okay, thanks. Just touching on the buybacks again, I know you had commented on last quarter. I wasn't sure about the outlook. I guess are you returning to levels we've seen in prior quarters, excluding the fourth quarter?

Well, time will tell. There's good news and there's bad news, depending on how you look at it. I guess the good news is we have primarily a retail shareholder base. As you know, our institutional holders are kind of in the 14 to 15% range, not particularly high. We have a pretty strong retail shareholder base and I think, with our dividends and so forth, there just haven't been a lot of people wanting to sell their stock. As a result of that, the opportunities for buybacks have also slowed considerably.

The question is do we expect to see any change in that pattern? I guess, at this point in time, I don't, but we certainly want to be prepared to repurchase, as long as we think repurchasing can be accretive for us in the long run, even though, at these levels, it kind of gives book value a black eye if we got back to the 4, 5 and 600,000 a share range. But I don't expect -- or year range. But I don't expect to see that level of buyback. But Ed, comments you might have?

No, I would basically agree. We will be opportunistic as we go along this year, and that's going to be about it. We will continue to buy some stock, but I don't see us returning to the levels we were at.

As noted in the press release, we will be issuing about 210,000 shares to the Federal Way shareholders. They obviously are a typical community bank, large retail shareholder base. Their shareholders really haven't received any dividends, as typical of newer community banks, so I don't anticipate that we're going to see many of those shares come on the market. You know, there could be some, certainly, but I don't think that is -- (technical difficulty) -- to create much greater turnover in shares, but you never know. But out of the 6 million or so shares we have outstanding, another 210,000 isn't going to really be a big addition.

Okay. Just looking out over the year -- and I understand if you don't want to make any specific comments about this -- but in terms of loan growth, should we be thinking about, say, a level of 10% being too conservative, or would you say that's kind of in the range of what you're targeting as you are ramping up growth this year?

Well, as I indicated earlier, we had really pretty good production last year, and we had net loan growth of somewhere almost 9%, 8.9%. If we hadn't had some of the prepayment activities, of course it would've been a little stronger. We were able to hire a couple of new lenders last year, one mid year, one late year -- late in the year. I think, as their production comes online, I think we could look to a little stronger growth in '06, provided that we don't get a lot of conduit refinancing again. So assuming that, I think you can look for slightly stronger growth as we move through '06.

Okay. Just one last one, a quick one on the acquisition -- were there any other interested parties that you know about that were involved in negotiations?

We have reason to believe that there may have been three or four other potential interested parties. I think Federal Way is a pretty attractive market. I think the Bank originally -- (technical difficulty) -- thought about selling the bank maybe a year and a half or two years ago, but kind of had to face the fact that, with the asset-quality challenges they faced at that particular time, they were not quite as attractive a product, despite their attractive geographical location, than what they might be. At that time, they had an investment banking firm that I think sent out a number of prospectus to a number of banks. This go-around, we were told, without being told who they were, that there were three or four, obviously including ourselves. But they didn't really just put it out for wholesale bidding.

Okay, very good. Thanks for the color, guys. I appreciate it.

Okay. Will we see you in Phoenix?

Potentially. We will see.

Ross Haberman, Haberman Funds.

So Don, I see you finally got your elusive bride! (LAUGHTER)

Might elusive bride?

Yes. You finally closed the deal you've been searching for for a number of years now!

Yes, I like that phraseology better -- my bride! (LAUGHTER). You are right.

I think, as you might find, the search might be better than living with her, but I guess (LAUGHTER) you'll see!

Well, I hope you're wrong on that one! One thing, we know that if that proves to be right, at least we will have a great location.

You're right; well done. That brings me to my questioning. Are you getting -- tell me about the lenders you're picking up. Are you picking up any additional lenders or will they be leaving, or really, as you said, are you strictly buying a good location?

Well, I think we are buying a good location very definitely, a good location in a very good market. We are also, I think, buying a customer base that we're going to need to continue to work hard to maintain, and we will -- as I mentioned, their CEO, [Tony Tibo], will be leaving. We are not particularly acquainted with their lenders at the moment, but we know they've done a pretty good job of cleaning up a number of problem loans.

I would have to say that probably Washington State Bank has underachieved in its marketplace, having been in that marketplace since 1992, you might expect -- the opportunities were certainly there to grow it bigger than what it was. Part of that had to do that they seemed to be characterized by somewhat of a turnover over the years in lenders, and there are probably a number of reasons for that. But the net result of that is that the three lenders who are there now for the most part are pretty new to the company in the last couple of years, not necessarily the ones who originated the problems that existed there. So what we need to do is to get acquainted with them, see what their capabilities are, see what their wishes are, and then we will kind of take it from there.

But their lenders who are there now seem to have a pretty good repoire with their customers that exist there, as near as we can tell. But I think the thing we can bring to the party here, if you will, or to the alter, if we can keep it in your phraseology, is that we've got some technology-driven products, our cash-management products, that they've not had in the past. We also have a much larger lending authority, so we will be able to reach out to customers that they haven't had and reach out with more sophisticated products. I think just our size will bring confidence to lenders in that market.

It's not an area that is under-banked to buy any matter or means. Most all of the big kids are there and a couple of other independents. So the idea of being able to move into that market through acquisition rather than just tacking up another branch, in addition to everybody else there, and to start out with a good customer base was I think important to us. But I think we can move forward with their people and any that we might bring into that market as well.

Could you just tell us a little bit about their depositor mix or deposit mix, their average cost of funds vis-à-vis yours, as well as their mix of loans vis-à-vis yours? Similar, just similar or what?

Sure. I'm going to ask Ed to specifically comment on this, but just a couple of thoughts -- one, their net interest margin has been well over 5%, so they've done a pretty good job of pricing. I think they have -- they've probably not done a real good job of penetrating the market there, in terms of core deposits, as we would like to see. They may be a little more heavily dependent on CDs, but we think we can turn that around.

But Ed, any other comments you might?

I think that is right. It's just the deposit mix is just a little more heavily oriented to certificates that you would expect to find in a commercial bank, so they haven't had a great deal of success at getting the good old-fashioned DDA that we value so highly. But their loan mix is actually quite similar to ours with business loans comprising more than half and obviously their pricing has been pretty good because they do have a good margin there. They do sell a few excess funds, so relatively liquid.

Ross, it's Brian. I would also add to that that I think, as a Don alluded to, the turnover in the lenders ranks over the last several years has I think hurt their ability to really focus on the relationships as we do and I think many successful community banks do. I think, as we create some stability to that lending group, I think we will start to penetrate the relationship deposit side of things that maybe they haven't done as well as they could have.

Just one final question about that -- what's your guesstimate in terms of deposit run-off there or range?

Well, I think there's two pieces to that. One, I don't expect we will see much deposit run-off just as far as their core deposits are concerned, or their customers. They take a lot of pride in their customer base. I think there's -- we met with their staff this morning, found a lot of enthusiasm, a lot of pride. As one employee said, they mother their customers. We like to do the same things. They give out good quality dog bones to their people who come through the drive -- (technical difficulty) -- like we do, and some of that high-touch kind of stuff. So I think they will be able to maintain their customer base very well.

As to some of the CDs, maybe that but if there's any deposit run off, if we can replace those CDs with demand deposits and lower-interest deposits just through growing the customer base and through growing the customer business base, that's probably where we would see any run-off. You know what you do with this kind of a deal? I think it's unrealistic not to expect there's going to be some run-off, maybe on the -- (technical difficulty) -- side, other side. But I think we are probably well enough known in that marketplace and we can bring enough experience and enthusiasm and any a similar culture, albeit different asset-quality culture but a different or a similar culture to that organization, that the runoff should be minimized.

Certainly do not expect any of their loan officers that would be leaving and taking a bunch of loans with them. I just don't think that situation exists there. The first place, as we mentioned, that most of their loan officers do just -- some turnover they've had has been -- they haven't been there that long. I think that we spent a lot of time emphasizing this morning with their people, with their lenders, that the products -- what we can bring, both for the employees and for their customers, in addition to what they're doing it now, and if they can deliver that in their same mothering style, if I can use that term, why, I think we will see pretty minimal run-off there.

Just the final question for Ed -- Ed, your margin dropped, what, year-to-year around 9 basis points?

Yes -- (multiple speakers).

You threw out a statement in the verbage you expect a continued margin pressure in '06. Would you expect a similar type of margin loss in '06, assuming they raise the rates another, I don't know, 25 to 50 basis points? Is that a reasonable guess?

Similar -- maybe a little bit less, but yes, we expect that flat yield curve out there is going to damage us a little bit. And the competitive environment -- the question was asked earlier, the competitive environment for deposits amongst community banks in our market has definitely heeded up in the last few months, whereas I would say even 12 months ago, it wasn't so bad. But the people are starting to shop for more income on their money these days, so we think it will continue.

Okay, thanks again.

Ross?

Yes?

I think you've asked us that same question each year for the last several years, and I think our answer is always about the same -- a little bit guarded as to what the future is going to bring, but still we wouldn't trade our margin with many of the other institutions, and we expect that will remain to be true.

Okay, the best of luck. Hopefully, you've got a beautiful new bride and it's just not a short trist! Thanks again.

We hope the honeymoon lasts a long time!

(OPERATOR INSTRUCTIONS). Gentlemen, there is nobody else queuing up. Please continue.

Okay, well, thank you, Tom. If any of you who phoned in are still on the line, thank you for your interest; we appreciate it. We are overall pleased with what '05 -- we were able to accomplish in '05, and we look forward to continuously improving in '06.

Thank you very much for your interest and we hope to see all of you personally soon. Tom, I think that concludes our call.

Thank you. Ladies and gentlemen, this conference will be available for replay after 4:30 this afternoon until February 6 at midnight. You may access the AT&T Executive Playback service at any time by dialing 1-800-475-6701 and entering the access code of 812620. International participants may dial 1-320-365-3844. (Operator repeats numbers). That does conclude our conference for today. Thank you for your participation and for using the AT&T Executive Teleconference service. You may now disconnect.