Heritage Financial Corp (HFWA) 2008 Q2 法說會逐字稿

Welcome to the Heritage Financial Corporation earnings conference call. All participants are in a listen-only mode at this time. Later we will conduct a question-and-answer session and will give instructions at that time. (OPERATOR INSTRUCTIONS). As a reminder, the conference is being recorded.

And we'd now like to turn the conference over to our host, Mr. Brian Vance. Go ahead, sir.

Good morning. Thanks, Bob. I appreciate hosting this today. I'm Brian Vance, President and CEO of Heritage Financial Corporation, and I would like to welcome all of you that have tuned in this morning. I appreciate your participation in our conference call, and also maybe a future welcome to those that may tune in by recorded processes later. Attending with me today is Don Rhodes, our Board Chairman, and Don Hinson, our Senior Vice President and Chief Financial Officer.

We did release our earnings yesterday after market close. Hopefully you have had an opportunity to read that, and perhaps have it with you today that you might be able to refer to. I will be referring to forward-looking statements, and as a result, I will read you just the short statement, so it is of record. This release includes statements concerning future performance, developments or events. Expectations for growth and market forecast 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 expectations. Specific factors include, but are not limited to the effect of interest rate changes, risks associated with acquisition of other banks, 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 the company's filings with the Securities and Exchange Commission.

With that, I will just jump into a variety of financial highlights and information here this morning with you, and certainly we'll be available to answer questions at the conclusion of my remarks. Highlights of the second quarter and the first six months of the year, our net interest margin improved to 4.56% at the end of the second quarter. Our noninterest income for the first six months of 2008 improved 6.1% over same period last year. And for the first six months of this year, net loans grew at 2.3% or 4.6 annualized, and deposits grew at 3.2% or 6.4% annualized. Net charge-offs for the first six months were only $200,000 in total. Core earnings, or EPS, excluding impairment charge, which I will define in a bit more for you, as -- excuse me, core earnings, or EPS, excluding the impairment charge, was $0.78 for the first six months as compared to $0.75 for the same period last year. Core noninterest expense for the first six months were less than the same period 2007.

Other financial events and metrics. On July 11th, we announced we were recognizing an impairment charge of $1.1 million pretax, and $723,000 after tax as a result of an investment in the AMF ultra short mortgage fund. We also announced we would be exercising our right of redemption in kind and are now finalizing this process. I would like to share with you what our core earnings adjusted for the impairment charge would have been, and this date is contained on page 2 of the earnings release that we sent yesterday. GAAP EPS for the first six months was $0.67, while adjusted core EPS for the impairment charge was $0.78. Our core adjusted EPS of $0.78 compares favorably to the first six months last year EPS of $0.75. GAAP ROE of 10.2% for the first six months compared to a core adjusted ROE of 11.85%. Our core adjusted efficiency ratio of 61.6% for the first six months of this year compares nicely to the 64.5% for the first six months last year, or approximately three points improvement to our efficiency ratio year-over-year on an adjusted basis. Our net interest margin as of June 30 was 4.56%, or a 12 basis point improvement over a linked first quarter 2008 margin of 4.44%, and also a six-basis-point improvement over the same quarter last year, of 4.5%.

Earnings, just speak to earnings, just a little bit. No question our after tax impairment charge of $723,000 was a disappointment, especially after such an otherwise solid second quarter and first six months performance. As indicated earlier, our core earnings on an EPS basis was $0.78 for the first six months, and that compared to $0.75 for the same period last year. Our earnings were primarily driven by modest improvement in net interest margin, continued expense control, and strong relative credit quality. Just a bit more about the impairment charge. As announced earlier, management made a decision to classify our ownership of the Shea fund, which is a mortgage-backed security mutual fund as impaired, and to take a $1.1 million pretax impairment charge resulting in an after tax impairment charge of $723,000. As I indicated earlier, we're in the process of completely the redemption in kind option that was available to us, and we'll have it completed soon. We will also recognize an additional charge to income of approximately $130,000 pretax, or 85,000 after tax in the third quarter of this year, representing the fund's drop in value from June 30th to the date that we exited the fund. Taking a redemption in kind will allow us the opportunity of recovering some of this impairment charge over time as these mortgages repay.

Just a bit about our balance sheet growth, as indicated earlier, for the first six months of 2008 ,we have seen modest loan growth of 4.6% on an annualized basis, and our deposits have grown a bit faster at 6.4% annualized. Our loan growth has been primarily centered in our C & I portfolio, commercial and industrial lending, while our deposit growth has been totally within our transaction accounts. As we look to the balance of 2008, we expect to grow both sides of the balance sheet to roughly mirror what we have accomplished in the first six months.

Expand just a little bit on our net interest margin. As I indicated, on a linked quarter basis, our net interest margin improved by 12 basis points. We are very pleased with the overall margin performance. Our strong performance in this area really began last year when we strategically began to go short on our CD maturities, which allowed us to reprice our total CD buckets in the first six months of this year. We are largely through this repricing opportunity, and we hope to maintain our net interest margin level at its -- roughly at its current state through the balance of this year. Another strong contributor to our margin performance is our liquidity.

Quite frankly, our strong liquidity position has allowed us to be more selective in our CD pricing strategies, choosing not to compete with some of the aggressive rates being offered by other banks in our area, which may not enjoy the same strong liquidity position that we do. We have been strongly moving to a longer CD pricing strategy for the last several months, that we believe will help us in the longer term. Again, our strong liquidity position allows us to avoid some of the aggressive pricing strategies that we still see present in our market area. During the implementation of these strategies over the past years, we have found that our transaction accounts have grown nicely, and while our CD balances have actually contracted a bit, while overall deposits have continued to grow. Most of all of our margin improvement to date has come from liability strategies, and we are hoping as we work through this credit cycle that we can also begin to benefit from some better risk-based pricing on the asset side.

Talk just a little bit about noninterest expense. As I indicated earlier, our total core adjusted noninterest expense decreased by approximately $218,000 for the first six months as compared to the same period last year. Linked quarter noninterest expense has declined in 5 out of the last 6 reporting quarters. While this decrease is not dramatic, it is steady. This will be our continued focus moving forward.

Efficiency ratio. Our efficiency ratio continues to focus on being below 60%. That's been a long stated goal of this company, and on a core adjusted basis for the second quarter, our efficiency ratio improved to 61.6%, down from 63.3% the same quarter last year. On a core adjusted basis for the first six months, our efficiency ratio improved to 61.6 from 64.5 from the first six months of last year. We believe this to be a substantial improvement. I have said several times that I believe that many of our peers' efficiency ratio was from the result of a construction-driven margin, resulting in a construction-driven efficiency ratio. Our efficiency ratio, while higher than peer norms in the recent past, will hopefully continue to improve, and be below peer norms, if not already.

I'd like to expand with you just a little bit more about loan quality and give you a little bit more granularity of some of the loan reports or within our loan totals as a whole. Our overall loan quality remains very good. No question, our nonperforming assets is, or NPAs, have increased as a result of adding two single family residential builders, but I have been consistent in previous earnings calls and widely disseminated investor conferences, that while we have a relative low exposure to single family construction lending, we will not be immune from the troubles of this sector. Our NPAs increased to $8.5 million, or about 0.94% of total assets. To put this in perspective, at 0.94%, we are still well under our peer group performance in this category for Q1, which averaged 2.6% within a 20-bank Northwest peer group. I expect the peer group number for Q2 to increase from its present level of 2.6%, again, while our Q2 number is 0.94%. We believe, as a result of continuing weakness in the local and national housing sectors, we will continue to see weaknesses develop in our construction portfolio.

Our construction portfolio as of the end of the second quarter is broken down as follows. Total construction loans, $118 million, or 14.8% of total loans. Total single-family construction is $72 million, the or 9% of total loans, and total commercial construction is $46 million, or 5.8%. Differently said, our total construction portfolio of $118 million is comprised of $72 million in single-family construction and $46 million in commercial construction.

Our single-family construction loan outstanding as of the end of the second quarter, are as follows: and this is the $72 million total that I'm breaking down for you. A and D is roughly $36 million, single family specs, roughly $20 million. Land only, about $6 million. And an "other" category which includes lines of credits, et cetera, which are typically secured by other assets other than the construction assets, amount to $9.7 million, roughly $10 million. The combination of our non-performing assets of $8.5 million, plus potential problem loans of $18.7 million as of the end of June 30 totaled $28 million, and that compares almost identically to the same number in the first of this year of $28 million. We were able to manage some of the credits out in terms of problem assets, while a few new credits were added. Of the total criticized assets of $27 million, construction comprises about $20 million of that number. Or differently said, about $7 million of our criticized loans are represented by non-construction-related credit.

Our CRE portfolio is not showing any signs of deterioration or weakness. Our total second Deed of Trust home equity lines and loans consist-- of all of those loans there is only one current delinquency in that total home equity portfolio. Our well-seasoned single-family portfolio of approximately $55 million has zero current past dues, and I believe the above information accurately reflects a well balanced strong community bank portfolio.

Just a few comments about our general market economy. We are certainly seeing standing inventory in this market, but it is beginning to slowly decrease, but standing inventory levels are at least nine months out in terms of a backlog of inventory in our markets areas. Home values are continuing to generally show less than 5% price decline when compared to year-ago sales values. The most active new home market is entry level homes, which in our area is generally below $275,000 in sales price, and as I indicated earlier, commercial real estate continues to show stability in all sectors. Unemployment numbers are increasing slightly in our market areas, but are still below norms that we see for the balance of the country.

Share with you just a little bit about capital management strategies. We recognize that our second quarter dividend payout ratio is higher than our peer group, and considerably higher than it has been due to the impairment charge. We will continue to carefully evaluate our cash dividends quarterly, and our primary strategy for managing our future dividend payouts will be to preserve capital for economic uncertainty, as well as growth opportunities that we believe will exist on the other side of this volatility. We will continue to focus on maintaining a well capitalized banking company that currently sets at 10.8% risk-based capital ratio. We believe that one of the keys to our strength today in having flexibility to manage in all areas of our balance sheet is our overall bank liquidity. We believe we have one of the strongest overall liquidity positions among our peer group. As of quarter end, our $900 million balance sheet has a total borrowings of only $7 million, including federal home loan advances, no brokered CDs, no trust-preferred debt, and the total company loan to deposit ratio is under 100% with approximately 57% of total deposits funded through transaction accounts.

We also think and believe we have a strong earnings stream integrity, we believe we have a solid net interest margin that does not have an overbalanced construction-driven margin that is susceptible to margin compression due to a slowdown in construction loan originations. We have worked hard to build a C&I portfolio of business that is still showing relative strength that has a greater likelihood of go forward earnings stream integrity. We have continuing noninterest income growth, and our modest balance sheet growth is not likely to create undue credit risk during this economic cycle. I would like to close with the following important points that I believe give a good summary of our overall company today. We have strong liquidity, as I have indicated, we have approximately $200 million available to us from a variety of in place and available sources of liquidity. We have a well capitalized company with a risk-weighted capital of 10.8%, we have strong, stable earnings, and our current single-family construction exposure stands below 9% of total assets.

That concludes my prepared remarks, but before I forget I would like to remind everybody, and it was a part of the press release, that I am presenting at the Keefe Bruyette Woods Investor Conference in New York City next Wednesday, July 30, at 4:30 eastern daylight time, or 1:30 pacific daylight time. Bob, at that time that concludes my remarks, and I'd be happy to entertain any questions from our audience.

Thank you, Mr. Vance. (OPERATOR INSTRUCTIONS). And we do after question from the line of Jeff Rulis with DA Davidson. Please go ahead.

Good morning.

Good morning, Jeff. How are you?

Good, thanks. A couple data points I missed on the call, Brian. The Q3 charge for the AMF fund was, you said 130 pretax? What was that?

It was $1.1 million pretax and $723 million.

But for Q 3.

I'm sorry, Q3. Q3 was $130,000 pretax and $85,000 after tax.

Got it. Okay. And then the total criticized loans, $27 million? Is that correct?

Let me refer to my notes. 28 million.

28. Okay. And that was equal to last quarter's as well?

Yes. There were some shifts, Jeff, that took place in the portfolio obviously the nonperforming assets increase', and some of those loans would have gone from substandard to non accrual but the total overall criticized total stayed the same from quarter to quarter.

Got it. Okay. And then you mentioned, some pretty good success on the core expenses. Anything that you would characterize what's driving that number down or -- is there a policy in place that's sort of moving that down? If you could give me some color on what's sending that number lower.

Sure. I would love to be able to tell you, point to one or two things, but at the same time, I think it is a -- it's everything. I think that we've done a nice job throughout the company at all levels of managing all expenses. I don't know that I could specifically point the a specific area, Jeff. As I indicated, this has not been a recent phenomenon. It hasn't been spectacular decreases but it's been steady, it's been focused, and I think that continues to be the focus in our company at a grass roots level from top to bottom.

Then on the margin, nice expansion there. I wanted to know if there was any offsetting margin decline on a basis point standpoint from loans that were placed on non accrual, if you have that number handy.

I don't have that number, Jeff. Certainly there was interest accrual back out that was netted into your margin numbers that we gave you. It's not going to be a huge number. We can get that back to you later. But there was a small amount in non material amount. I'm going say probably less than $50,000 of backed out interest in Q2. More like $150,000.

Thank you for the correction. And then lastly, have you had a safety and soundness exam recently or have one scheduled?

We did have one in December, and are scheduled for another one probably this December or January.

Got it. Okay. Thank you very much.

Thank you, Jeff.

Okay. (OPERATOR INSTRUCTIONS). And there are no other questions in queue. Please continue.

I don't have anything additional to add. I appreciate your interest in tuning in today, and unless there are any further questions, invite you to tune in to the Keefe Bruyette conference later next week, and appreciate your interest.

Thank you. And ladies and gentlemen, that does conclude your conference for today. Thanks for your participation, and you can now disconnect.