Heritage Financial Corp (HFWA) 2006 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Heritage Financial earnings conference call. [OPERATOR INSTRUCTIONS]. I would now like to turn the conference over to our host, Chairman and Chief Executive Officer, Mr. Don Rhodes. Please go ahead.

Thank you, Tom. This is Don Rhodes speaking. I understand that there are about 12 people on the line tuned in, so I want to welcome you. We look forward to discussing our quarter and semi-annual period with you, and I would also like to give an advance welcome to any who may phone in to listen to this broadcast over the next 10 days when it is available.

With me here in the room is Brian Vance, who's President of Heritage Financial Corporation and President and CEO of our primary bank, Heritage Bank, along with Ed Cameron, our Senior Vice President, Chief Financial Officer of our holding company and two subsidiaries. All three of us will be glad to respond to questions you may have. I would like to just offer a few overview comments and then respond to your questions.

But in preparation for that, if you'll bear with me, in just reminding you on the bottom of Page 5 of our press release, of those forward-looking statements that we refer to as the weasel words, but our comments today in this release 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 stated expectations.

Specific factors include, but are not limited to the effect of interest rate changes, risks associated with acquisition of other banks, and opening new branches, both of which we have done in the last few months, 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 the Company's filings with the Securities and Exchange Commission. I'll not force you to listen to this statement in the future during the course of this particular program, but would ask that you incorporate it by reference as we discuss what may come along here.

So, with that, I would just as a background here, would just like to say and remind those of you who were with us a year ago that during our July, 2005 conference call, we outlined our Company's objectives for the five fiscal years ending in December, 2009, and those primary objectives were four in number. First to achieve $14 million annual net profit by fiscal year end, 2009 while maintaining a 15% return on average equity. The second objective was to initiate a more aggressive but orderly growth pattern than in the previous five years which ended in 2005, to include potentially three additional offices during that period of time. Thirdly, to continue our capital management strategies through share repurchases and dividends and other decisions we may make in that particular area. And, fourth, to maintain the high asset quality standards that we have achieved for many, many years.

So my comments this morning would just like to kind of give you a scorecard on where we see ourselves in light of those particular objectives. And, first of all, and probably the subject of -- the main subject of discussion today would be profitability. As noted in our press release, our quarter, we earned $2.5 million dollars. For the full six months about a little over $5 million. Those numbers were consistent with what our earnings were last year for the same quarter and semi-annual period, or you might phrase it our earnings were flat during this period of time.

There were a number of factors that came into play. Certainly a narrowing net interest margin, in part, resulting from the current yield curve situation was certainly a contributor. I think probably the fact that our demand deposits on interest-bearing demand deposits amount to about 14% of our deposits is growing but still is smaller than some commercial banks, is a more noticeable factor today than it was a couple or three years ago when interest rates were lower.

But additionally, we also -- we've had some pretty decent loan growth in terms of new loan originations in the range of 20%, but on a net basis, we've continued to see refinance of commercial real estate loans, a number of competitors are offering ten-year fixed-rate loans at comparatively low rates, either through conduit financing or just some of our local competitors, and we've chosen not to try to maintain -- compete on those particular terms. And as a result, our top line revenue growth has been a little less than what we would like to have seen.

And then on the expense side, certainly investment in our new Sumner branch, which was a first quarter event, but we continue to pay the people and pay the rent and so forth through the second quarter. That certainly had an effect. And included in that was the addition of two new loan officers, and further we added a new loan officer at our Pierce County Business Banking Center. All of this together added up to a flat earnings. But nevertheless, I would point out earnings for the quarter and for the six months. When we -- and resulting from that, we dipped a little bit below the 15% target.

When we developed our five-year plan, one of the things we did was obviously develop a year-over-year plan of where we wanted to be. And the silver lining in this is, despite our flat earnings as we look at our internal financial plan, we still expect this year's earnings to come out pretty much on schedule that we need to meet in order to achieve that $14 million in profit by the end of 2009. So we're not real happy with the flat earnings, but we're happy there are earnings, and we'll be pleased to talk about that a little more in a moment.

Second item had to do with a more aggressive growth pattern, and we did, as I mentioned, open our Sumner branch after considerable market research, determined that that was a good location for us. That office has been open since mid-February, and we're very pleased. We're in temporary quarters on the second floor of a rented building while we acquire a permanent site, which we're close to acquiring we think, and so we have the staffing costs and so forth there, but we've seen some deposit growth. One nice thing about that office so far, not getting into the specific numbers, but our non-interest bearing DDA deposits in that office are running higher than our current 14% overall, so we're pleased with that.

And then during the quarter, we closed our Washington State bank acquisition officially on June 1st. That combination of those two offices certainly gives us a much stronger presence in the North Pierce County, South King County area where we've already done quite a bit of business, and we expect both of those offices to contribute to second half -- a stronger second half profitability. The third area had to do with capital management strategies, and we continue our dividend pattern of having increased our dividend to$0.005 each quarter since early in 1998, and in fact we'll be paying a $0.20 per share dividend next Monday.

We certainly -- one of the things we're going to have to be careful about is, now that our capital has worked down from where it was when we did our second step conversion now nearly nine years ago down into the 8% range, we're going to need to manage our capital a little more carefully, and we look at our dividend pattern every quarter. So far we've been able to continue our increases there, but that's something we'll just have to keep our eye on.

Share repurchases, as you noticed, have moderated. More than moderated. They've been nearly nonexistent. I think 367 shares during the last quarter. I like to consider that, as being the case, because our shareholders are happy both with their return and with their share price growth. One, I think, positive note in there is that we do not appear to have seen any real sell-off of shares with the closing of the Washington State bank acquisition. There certainly hasn't been any noticeable -- has not been any noticeable increase in volume, so those shareholders appear to be holding onto their shares, and so we're certainly pleased with that.

The fourth area I'd comment on would be asset quality. It certainly remains comparatively strong, up a little bit from the previous year, primarily in some credits that we knew were there, are related to our acquisition. We're working our way through those. Do not appear to -- or don't feel we have any serious problems there. And, in fact, I'd just note that our loan loss reserve has increased from about 1.3 to 1.35 of total loans outstanding over the last 6 to 12 months, and we feel that reserve is quite adequate for anything that we might experience. So that's just a quick overview of those four key objectives as we look at how we're doing against our December, '09 plan.

Just some other comments before we get to questions. During this quarter, we welcomed back our long-time Chief Financial Officer, Ed Cameron, and we're pleased to have his expertise available to us again on a full-time basis while we determine our longer range course of action in terms of filling that position over a much longer period of time. Ed is with us, is doing the usual fine job that he has done for us for several years, and you'll have a chance to hear from him shortly.

We also, as I mentioned, closed the Washington State bank acquisition. That process seems to have gone very, very well, and in fact I might, just for a moment here, just call on Brian Vance to make some comments on that, but we have completed the acquisition, have converted the data processing, and it seems to be going well, but Brian, your comments on that, please.

Certainly, Don. We did close the transaction May 30, and then the conversion took place on July 10th, where all of their systems were converted to Heritage Bank systems, and signs changed, et cetera, and they're operating today as a Heritage Bank branch in Federal Way, our first entry to King County. That conversion went very well. Little or no issues in that process. And in fact today, we are hosting a ribbon cutting ceremony at Federal Way at noon. As I said, our first entry to King County, and we're excited about the opportunity that brings to us.

Thanks, Bryan.

One of the positive things I think about this is they had approximately 15 employees, and I think all but about three or four are still with us. We're able to place some of their employees with other Pierce County offices, kept most of the familiar faces right there at Federal Way, and I think that's been well received by customers. All in all, that's going to be a very nice fit for us, and we're pleased to have that behind us and have them as part of our team.

Finally just back to the earnings situation for a moment, certainly I would tell you that we're not satisfied with flat earnings. That's not going to become our standard. We do expect to do better in the second half of the year, which is traditionally stronger than the first half, but stay tuned on that.

Just an observation. We certainly recognize that some institutions have been reporting not only strong earnings but also strong loan growth, and -- our observation that is a number of those institutions are very heavily into construction lending. We do have around 10% of our loan portfolio in construction lending, but certainly there is a tradeoff there or risk reward tradeoff. We're comfortable with where we are, but we don't feel, as the real estate market cools a bit, that we are going to have any particular unusual exposure in that area. On the other hand, we may not have maximized our profits that could have been out there during this last couple of years, but we're certainly comfortable with where we are in that regard.

Brian or Ed, do either of you have any comments you'd like to add on earnings before we get to any questions there may be?

I do, Don. It's Brian.

Consistent with what Don has already mentioned to you, I think it's important to note that we are executing our plan very consistently with the overall strategic plan, and in doing so, I think we need to understand the effect of that, especially in the margin category. When we set the five-year strategic plan, we didn't contemplate the flat yield curve that we're operating within.

In addition to that, the CNI focused lending that we're doing typically is more variable rate pricing but also carries with it less margin than some of the commercial real estate lending that we were doing at least on an initial basis, but I think gives us more asset sensitivity as we move forward that's important to us. An additional comment on the asset side. Loan production exceeds same period last year and just totaled all new production. Our net growth is not as strong as we would have hoped because of the repayment activity and the commercial real estate area that Don noted earlier.

In addition to that, CNI lending, which is consistent with our strategic plan, typically is lines of credit which do not fully fund, and, in fact, our CNI production, same period this year compared to last year, is up 129%. I think again, that's very consistent with a strategic plan, but that production doesn't always materialize in the form of loan totals day 1, but it does bring with us total relationships, DDA accounts non-interest-bearing, deposits, et cetera which is critical to our overall profitability.

And finally growth initiatives. I think the growth initiatives have upfront expense before the production and the top line revenue begins to come on stream, and the execution of that growth initiative is consistent with our plan as well that I think will position us well into the future.

Ed, any comments that you have? Yes.

You said it all for me.

So with that, Tom, our moderator, I think we can now be pleased to respond to any questions. As we move to that phase of this report, I would just call people's attention to the forward-looking statements (weasel words) that are on the bottom of Page 5 of the press release. With that thought in mind, we'll be pleased to do our best to respond to any questions that might be out there. So Tom, we're ready.

[OPERATOR INSTRUCTIONS]. Our first question comes from the line of Jim Bradshaw representing D.A. Davidson. Please go ahead.

Good morning. Can you talk about -- Ed, were there any direct merger costs in the expense number this quarter?

There were some. About $50,000 worth of just expenses, and then we've got overlapping salaries that are still there in the month of June. Remember there's a June 1 transaction actually.

Right.

So we have a month's worth of overlapping salaries that will sill be there in July, and most of them will be gone. The ones that are going to be gone will be gone in August.

With the mid-July conversion and sign changes and stuff, have you accrued for that, or are there going to be more charges in Q3?

We pretty much completed the purchase accounting. KPMG is reviewing that, and there may be some changes before we're through, but basically it's pretty well complete. Most of it went into goodwill of course.

Sure. Good. Brian, are you getting a lot of pay-off requests still in Q3 on the commercial real estate side? You think that's starting to slow down a bit here?

Jim, I wish I could tell you that it was slowing down, but I don't see it at least so far in the third quarter. As Don mentioned, we're seeing conduit financing which, historically, we saw maybe down to the $5 million level. We're seeing it all the way down sometimes to the $2 million ticket size. But we're also seeing local competitors willing to do ten-year fixed in the commercial real estate sector, and we've just chosen not to compete there. To answer your question, unfortunately I see that continuing in the third quarter. Hopefully at some point we'll get through that round of activity, and that will slow down substantially, but it has not yet.

And I've forgotten how you guys are positioned on prepayment penalties. Did you do a lot of them or not on that legacy portfolio?

There is a good bit of prepayment penalties. However, most of those -- most of the commercial real estate stuff that we did was on five-year rate repricing schedules, and most of those loans are in the third, fourth, and fifth year of their existence, and the prepayment penalties typically were five, four, three, two, one. So those prepayment penalties have been fairly insignificant as those loans have aged . So that's not been a big tailwind for us.

Okay. Good. Ed or Don, I heard you that you can a little bit about capital ratios, capital maintenance. Could you refresh our memory? You don't have any trust preferred. Is that correct?

That's correct.

Are you thinking about doing some to augment capital ratios?

Well, we have no specific plans at this point to do so. On the other hand, I guess you could say we're in the preliminary stages of thinking what are we going to look like six months, a year, two years from now and what are our capital requirements going to be and what happens if another acquisition opportunity should surface and what are our sources of that capital? So from that standpoint, we certainly are giving thought to our alternatives, but we don't have any immediate plans to go out and do anything.

Both of our banks continue to be well capitalized, the regulatory term "well capitalized" on a risk adjusted basis. So while our capital's down, we're in pretty good shape right now.

Sorry to jump around here. Brian, you talked about low usage still on CNI lines of credit. Do you have a feel for where that is today versus maybe a year ago or a quarter ago, whatever you have at your fingertips?

I don't have any numbers that I could give you. I do know our commercial loan outstandings have increased. But in terms of -- Ed is just pointing to me it's a 17.2% year-over-year growth in that category. That's consistent with our strategic focus.

So you think that it's a growth related to new customers or increased advances on existing lines?

Yeah. Just an intuitive response would be most of it is new customers. This growth is represented by primarily new customers.

Okay, Good. Thanks. Lastly I'll ask Ed to forward look a little bit and give me an idea what the margin looked like post WWB and the numbers. What was margin like in June? Do you know?

Actually margin improved in June a little bit, and the WWB acquisition is going to improve our margin slightly. It's a small transaction.

Right.

So it's not a huge impact, but it brought with it very nice non-interest bearing demand, about 20% of their total deposits non-interest-bearing demand. So much better ratio than we're at today. We're at 14 for the Company. So they're going to be accretive in that respect. However, still margin will continue to be a challenge for us as we put it.

That DDA gets worth more and more as rates go up, doesn't it?

Yes, it does.

Appreciate it, guys. Thanks very much.

Next we'll go to Ross Haberman, representing the Haberman Value Fund. Please go ahead.

I just want to make sure -- I just want to preface by saying I'm sorry that you lost your CFO, but I'm glad Ed is back, and I just wanted to ask you if part of the increased costs were reimbursement for his deposit for that world cruise. Was that part of the increased cost? I hope it was.

Well, I know you're making that comment -- this is Don. Making that comment in jest, but since we don't know who's going to be listening to the call, we should point out that there was no world cruise and that your comment is in jest.

Okay. It is in jest.

Okay.

Sorry. Getting on a more serious note --

Yes.

-- Brian, could you give us a flavor of how you're going to offset the, as you say, challenging margin compression? What do you have to do or how more quickly do you have to grow those loans really to offset that, assuming we continue to see this flat yield curve and pressure on your deposit side?

I wish I had a silver bullet on that, Ross. When we look at the flat yield curve, my guess is -- and I'm no economist by any means. Unfortunately, I think this flat yield curve is going to hang around a little while. With that assumption, I think it's critically important that we continue to look for transaction accounts and especially non-interest-bearing.

And, in fact, we are just announcing and rolling out internally -- and there will be an August 1 effective promo date for a significant campaign for transaction deposit, checking account deposit growth. Probably the single largest campaign and focus in this Company's history. And so we are addressing the value of those. Not that we haven't focused on that in the past but really renewing our efforts with all of our branch folks and all of our lenders the importance of continuing to grow those DDAs.

I think, on the asset side -- I think, unfortunately it's just continue to do what we're doing. I think the CNI focus is where we need to be. I think that continues to give us asset sensitivity that we need. But we find a very competitive environment out there that a lot of those loans are prime plus zero and in today's flat yield curve, funding it as we typically do, the margin is fairly narrow, and in fact, is probably dilutive to current margin, but I think that's probably the right thing to do in the long run.

I wish I could tell you that we see margin issues improving going forward, but I just don't think they will. But I think institutionally we're really focused on a variety of initiatives to help offset those challenges.

Okay. Sorry. Is there sort of one or two of the shops, the bigger shops or the smaller shops who are being extra aggressive on the deposit side, the credit unions or really across the board? And just a follow-up question. How do you see the competition in Federal Road, I guess, where you bought that little bank.

Deposit competition first, we're seeing strong competition especially on the time side, the CD side. While we need CDs as a part of our deposit growth, that's not where we're focusing. So I think we're continuing again to focus more on the transaction account side and tier pricing on money markets, bringing in larger money market accounts because of the efficiencies of those as opposed to smaller dollar-sized accounts. That's a strategy. But the CD competition is certainly out there.

Federal Way, we have seen -- and this is very preliminary, but when we put our signs up and begin to operate as Heritage Bank, a nice influx of account growth. Federal Way is, I think, going to be a good market for us. We have a great location. I think a community bank presence in that market will help us substantially going forward. So I'm cautiously optimistic for the account growth and the type of account growth that we need will come from Federal Way as well.

I just mentioned -- I think I saw -- was it Rainier Pacific or someone just opened up an additional office there, and I know it was competitive to start off with. It just doesn't make life any less with all these additional entrants there.

Ross, Don here. I'd just say we don't lack competition in any of the markets we're in, and I think all the same folks that we compete against in Tacoma, Pierce County, here in Olympia are also up in Federal Way. The larger banks, the credit unions, a community bank or two -- I'm not sure what you saw in terms of announcement, but there's a company called Mt. Rainier Bank that has six or eight offices up in that general market area east of Federal Way have a loan production office and are planning on opening a branch there in Federal Way you may have seen. That may be what you're referring to.

Rainier Pacific --

Correct.

-- has an office there. Columbia Bank has an office there as well as I mentioned, the big B of A and Wells and so forth. So I think the competition in that market is pretty consistent with those we're competing against in other markets we serve.

Just one final question for Ed. The heightened expenses, I know you had some again with the additional branches, will that come down and get your efficiency back to under 60 or your endeavor to open additional branches will sort of keep it in the 63 or 64% range for the time being?

I don't think it will stay in the 63 or 64% range. We need to generate more revenue from the lenders that we've hired and do anticipate we will get that as part of the expense increase. Sumner, that'll go on for the rest of the year in terms of expenses. Federal Way, we will eliminate some costs there in the month of August, and that will improve our efficiency ratio. But I think right now we need as much as anything to see our top line revenue growth. And we anticipate that, and so I think we'll be back down towards 60. I don't think we'll stay in 63, 64.

Thank you, and we'll stay in touch.

Thanks, Ross. We'll see you next week?

Yes.

[OPERATOR INSTRUCTIONS]. Gentlemen, there are no other participants queueing up at this time.

All right. Well, thank you, Tom, for moderating this for us and to any of you who phoned in who are still on the line, we appreciate your interest. We'd point out, as our press release indicated, that we will be presenting next Wednesday at Keefe, Bruyette & Woods conference in New York, and we look forward to seeing some of you there at that time.

And again, to those who may phone in during the next 10 days when this is available for rebroadcast, welcome. We appreciate the interest of our investors and shareholders, and we continue to be confident that we have a bright future. We have a great staff of people. We're in a good market. And we look forward to hopefully stronger earnings here in the second half of this year and beyond. So thanks again for listening in.

And, Tom, I think that concludes our comments.

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