Heritage Financial Corp (HFWA) 2012 Q3 法說會逐字稿

Welcome to the Heritage Financial third-quarter earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time.

(Operator Instructions)

As a reminder, this conference is being recorded. I would now like to turn the conference over to our host, President and CEO, Mr. Brian Vance. Please go ahead.

Thanks, Dack. Appreciate that. From the list of participants that Dack shared with you I see that we have a number of our investor friends from the East Coast, and I wish all of you a speedy recovery from the challenges you have had the last several days.

Attending with me here is Don Hinson, our CFO. Our earnings release went out yesterday. Hopefully, you have all had an opportunity to review the release prior to the call. Today, I'm going to spare you from reading the forward-looking statements, but I will ask that you refer to the forward-looking statements in our recent press release, as well as referring to the forward-looking statements as we go into Q&A session a bit later.

I'd like to start off with some highlights of our third quarter. Diluted earnings per share were $0.19 for the quarter ended September 30 compared to $0.12 in the prior year ended September 30, 2011, and $0.21 per share for the quarter ended June 30, 2012. Nonperforming originated loans decreased to 1.5% of total originated loans at September 30. Down from 1.69% at June 30 and 2.94% at September 30, 2011. Originated loan receivables increased $18.3 million, or 2.1% during the quarter ended September 30 and increased $69 million, or 8.6% during the 12 months ended September 30, 2012. Additionally, the Company announced a definitive agreement to acquire Northwest Commercial Bank.

Just a few comments on earnings. We posted -- as I indicated, we posted net income of $2.86 million, $0.19 which was a slight increase over $1.84 million of last year, or $0.12 per share. And then, a slight decrease from Q '12 net income of $3.19 million, or $0.21 per share. Overall, I believe this was a solid earnings quarter with nice improvement in our credit metrics and loan growth.

I would like to turn it over to Don Hinson. He'll take a few minutes to cover our balance sheet, income statements, and comments on acquisition accounting. Don?

Thanks, Brian.

I'll start on the balance sheet. Total assets increased slightly from the prior quarter-end and were $1.37 billion at September 30. Net loans increased $3.6 million during the quarter, mostly due to the increase in originated owner-occupied commercial property loans. Net originated loans increased $18.6 million for the quarter.

Total deposits increased $20.4 million during Q3. Quarter-over-quarter, total non-maturity deposits increased $32.2 million while CDs decreased $11.9 million. Our non-maturity deposit ratio continued to be a very strong 74% of total deposits, and our percentage of non-interest demand deposits to total deposits increased to 22%.

Total equity increased $2.1 million during Q3. The ratio of tangible common equity with tangible assets increased slightly to 13.9% at September 30 from 14.0% at June 30. Our tangible common book value common share increased to $12.40 at September 30 from $12.27 at June 30. The change in these metrics was driven by the net income for the quarter partially offset by cash dividends in the amount of $1.2 million during the quarter.

During Q3, there were no stock repurchases performed in conjunction with our stock repurchase program. This is due to the fact that the price of our stock in Q3 which averaged 117% of tangible book value exceeded our current threshold for buybacks.

Moving on to the effect on acquired loans, in addition to the effects on net interest margin that I'll discuss later, during the quarter, we recorded provision for loan losses on purchased loans in the amount of $592,000 compared to a provision of $419,000 in the prior quarter. The provision in Q3 was due mostly to two acquired loans which defaulted during the quarter.

The change in FDIC indemnification asset was a $492,000 expense in Q3 2012 compared to a $19,000 expense in Q2. As a reminder, the FDIC indemnification asset relates to covered loans obtained in the Cowlitz acquisition. Our net interest margin for Q3 was 5.10%. This is a 15-basis-point decrease from 5.25% in Q2.

The decrease in margin was due to a combination of lower note rates on new originations, reprice of existing loans, and lower effects of incremental discount accretion on loan yields. Partially offsetting the decline in loan yields was a decline in our cost of funds. Our cost of funds for Q3 decreased to 48 basis points compared to 52 basis points for Q2. The cost of all deposits decreased 38 basis points in Q3.

The effect on the net interest margin of incremental discount accretion over stated note rates on the acquired loan portfolios for Q3 was approximately 49 basis points compared to 55 basis points in Q2. Without the effects of incremental discount accretion, net interest margin was 4.61% in Q3, compared to 4.70% in Q2. Due to the lower rate environment in which we see assets repricing at a faster rate than deposits, we expect margins to continue their declining trends.

Non-interest income was $1.5 million for Q3 2012, a decrease from $2.1 million in Q2. This decline was due mostly to the change in the FDIC indemnification asset. Noninterest expense decreased $367,000 to $12.5 million in Q3 compared to $12.9 million in Q2. This decrease occurred even with approximately $180,000 in acquisition-related costs associated with the upcoming pending acquisition.

For Q3 2012, our efficiency ratio was 71.5% compared to 70.4% in Q2. This increase was due mostly to lower net interest margin as well as lower noninterest income. Overhead expenses are expected to increase in Q4, due to additional costs associated with the pending acquisition which is expected to close in Q4.

Brian will now have an update on overall loan growth and loan quality changes as well as some closing comments.

Thanks, Don. I'll start with loan growth.

During Q3 2012, we booked a total of $56 million in new loans compared to Q3 2011 of $49 million. These totals represent new loans to new borrowers and new loans to existing borrowers. As we typically have been doing, we analyzed all of the new loans for the quarter over $300,000 which represented a total of $36 million. The average loan size for the new loan production over $300,000 was $969,000. Average note rate for the new loans in Q3 was 4.81% compared to 5.25% in Q2.

Some comments on loan quality. Nonaccrual originated loans decreased $1 million from the prior quarter. The decrease during Q3 was due to $1.2 million in paydowns, $228,000 in transfers to OREO, and $276,000 in charge-offs offsets by $648,000 additions to nonaccrual loans. Of the $588,000 in Q3 charge-offs, $376,000 were previously provided for through specific reserves. Additionally, other charge-offs taken in Q3 would have had general reserve allowances.

Our Q3 provision of $215,000 for the originated loan portfolio was essentially for the new loan growth experienced during the quarter. OREO decreased $1.3 million during Q3 to $7.3 million. OREO totals remained abnormally high from a historical perspective for our Bank, though we believe through our ongoing marketing efforts, these totals will be lower at year-end. The ratio of the allowance for loan losses to nonperforming originated loans increased to 150% from 145% at the prior quarter-end. Generally, I believe the total nonperforming assets will continue to improve, not only through the balance of the year, but through 2013 as well.

I'd like to speak to capital management for a moment. In the past nine months, we have declared two special dividends. In December of 2011, we paid a $0.25 per share special dividend, and in June of this year, we declared a $0.20 per share special dividend which was paid July 24. As we have communicated several times, the overarching strategy of the Company is to leverage our strong capital position through a variety of organic growth strategies, coupled with continuing acquisition strategies. Our dividend strategy in 2011 was to pay out essentially 100% of our profits through regular and special dividends, so as not to grow our already strong capital position.

As we have previously communicated, we will consider, but not commit, to a similar dividend strategy in 2012 as we did for 2011. Considering all previously paid dividends year-to-date, both regular and special, and including the $0.08 just declared on October 30, we will have paid out a total of $0.50 per share versus year-to-date EPS of $0.67 for a payout ratio of 75%.

As previously mentioned, we announced the acquisition of Northwest Commercial Bank which is scheduled to close before year-end. When closed, this acquisition is expected to decrease our tangible common equity by a range of 70 to 80 basis points.

I would like to just speak to some key performance highlights for Q3. Return on average assets for the quarter was 0.84%. I have been discussing the importance of achieving a return on average assets of greater than 1% at this point in the recovery cycle, and, while we fell short of 1% ROA in Q3, our 2012 year-to-date return on average assets average is 1%.

Our efficiency ratio increased to 71.5% in Q3 from 70.4% in Q2, which was caused by declining revenue as our quarter-to-quarter noninterest expense decreased slightly. And, as Don previously mentioned, Q3 also contained approximately $180,000 in merger-related expenses. We continue to be mindful of the potential of top line revenue shrinkage due to the likely margin compression which means we need to continue to focus on overall expense management. As to the overall balance sheet growth, we were able to post encouraging growth on both sides of the balance sheet this past quarter.

I'll close with some general outlook for the balance of 2012. We have been pleased to see relatively strong real estate valuation recovery with most real estate sectors in King County, or Seattle, but less so in surrounding counties. There are still some areas in the outlying counties of Puget Sound region where real estate valuation recovery is sporadic, but it is slowly improving. The loan growth we experienced in Q3 and Q -- I'm sorry, in Q2 and Q3 is not likely to occur in Q4. This is due to the cyclical nature of our balance sheet primarily with ag loans paying down as well as other scheduled loan payoffs we are aware of that are likely to happen in Q4.

As we have consistently reported, M&A activity is a significant part of our growth strategy, and we are pleased to announce the acquisition of Northwest Commercial Bank during the third quarter. We are beginning to see more normal bank acquisition activity in the Pacific Northwest and expect the pace to continue to increase as we move through 2013. I would welcome any questions you may have, and once again, would refer you back to the forward-looking statements in our press release.

And, we would open the calls up for any questions that may be out there.

(Operator Instructions)

Jeff Rulis, D.A. Davidson

Hello, Brian and John. On the construction loan growth, could you provide a little color as to where that is coming from geographically in your footprint? Is it pretty broad, or is it a specific region, perhaps?

I think it is probably pretty broad. I do know that we have picked up a couple of construction loans the Vancouver, Portland markets, but we have also done construction loans -- new construction loans here in the Puget Sound region. I think it is a fairly broad experience, and it's typically in the commercial -- the construction increases is coming out of the commercial sector.

Your sort of seasonal comments about loan growth expected to taper off a bit, that would apply to this segment seasonally?

Yes. And, just to clarify, Jeff, a little bit more, I mentioned the ag loans, which primarily -- almost exclusively, come out of our Central Valley Bank affiliate. As you would expect, there are significant agricultural pay-down's on operating lines of credit that happen in late Q3 and Q4. So, that is one reason for that comment. The other expected pay-down's we have that is a construction loan previously, but that we are anticipating will pay off through permanent financing which was part of our knowledge going into the credit. So, it's that sort of cyclical-type activity is why we don't believe net loan growth is likely to happen during Q4.

And, maybe a couple of questions on the acquisition. Any update on the loan deposited asset totals as of 9-30? Are they pretty similar to the announcement date?

Yes, we continue as I think you would expect and as is fairly typical in any acquisition once the definitive agreement is signed, we are a part of their monthly Board meetings. And, we have access to financial information, and we're confident and feel good about asset values remaining pretty static as we move through the early stages of the announcement.

Close date most likely very late in the quarter? Mid-quarter? Any idea there?

I am guessing that we are looking at mid-month of December.

Okay.

That is most of our -- that's our best guess at this point.

Sounds good. Last one for Don, just on the merger expenses. Any additional guidance as far as what you expect in Q4 on that -- within the merger expenses?

I would expect probably another $300,000 -- between $300,000 and $400,000 in Q4.

Okay. And then, outside of the merger expenses, a pretty clean quarter cost-wise. Is that still expected? Or, are you still trying to drive some efficiencies on the flat cost line item?

You know as my comments indicated, I think as all of us face the prospects of declining margins, expense management becomes even more of a focus, I think, in most institutions, and certainly, that is the case with us. We continue to evaluate efficiencies all levels in the Company. And, I think that while Q4 is not likely to contain marked expense improvement, I think that we are hopeful that we can continue the downward movement, exclusive of merger costs, et cetera.

Okay, that's it for me. Thanks.

Thanks Jeff.

Tim O'Brien, Sandler O'Neill

Hello. This is Andrew on for Tim.

You can give our congratulations to Tim and his Giants for winning the Series.

He's quite excited.

I'm sure he is.

Couple of questions from us. I'm curious if you have the balance of 30- to 89-day past due loans at September 30.

Can you repeat your question, please?

The balance of 30- to 89-day past due -- early stage delinquencies?

The percentage?

Yes, sure.

I'm guessing it is about 30 basis points. Kind of looking at an average here. So, I'm thinking it is probably 30 basis points.

Great, thanks. And then, it sounds like you will have the ag loans pay down which is pretty normal. But, what does the pipeline look like just for traditional commercial business loans and owner-occupied CRE?

Let me comment to the year as a whole, and then I'll comment more currently. I think we have seen, as we compare the pipeline -- commercial loan pipeline in 2012 to 2011 as we have moved through the year -- it has been lighter generally this year than last. On the other hand, we are seeing a little bit of a tick-up just the last month or two in the pipeline. So, we are encouraged with the potential of production remaining fairly strong during the quarter. I think it is going to be offset by the cyclical nature that we have been talking about -- ag loans paid off and a couple of other scheduled pay-down's. So, that should give you a little more color in general.

Thank you. Those are all of our questions.

Okay, good. Thank you.

(Operator Instructions)

Jacque Chimera, KBW.

Good morning. Quick question -- just a clarification on the loan growth that you were talking about in the quarter, Brian? When you say the payoffs and everything and the net loan growth might be a little bit compressed, does that take the covered portfolio into consideration? Or, is that just purely on the originated portfolio?

My comments go more to the originated portfolio. Obviously, ag loans and scheduled pay-down's are all overall originated activity. And then, you balance that against what I'm hoping to be a fairly typical production of new loans in the quarter. That is generally where my comments are focused. Little hard to predict what runoff might be on the acquired portfolios. It is certainly going to be there. My guess -- it is probably going to be similar to what it has been the last couple of quarters. Not aware of any abnormal payoff activity in the acquired portfolio for the quarter.

Okay. Just going off of past quarters' data, the runoff in the covered portfolio might drive overall grow to be flat or maybe slightly down?

I think that is possible. Again, early in the quarter. Tough to predict a variety of things. But, I think that is a fairly decent generalization.

Okay, thank you. That's good color. And then, maybe a question on the deposit service charges? Was there any sort of a restatement there that happened in the quarter? I noticed that there was a shift in past quarters as well.

We did a little bit of a reclassification to kind of sync up with our regulatory reporting there.

Okay. So, just sort of a numbers thing, not anything meaningful?

Correct. It didn't change the total net interest income. We just did a little bit of reclass to kind of match up some of our regulatory reporting.

Okay, that's helpful. Then, my last question -- I apologize if you can hear all of the background noise. I have got a parade going on behind me. Brian, I wondered if you could touch on how conversations have changed over the past three months? Just given -- I know you can't go into too many details, but just given the recent announcements that we have had coming out of your footprint, inclusive of your announcement?

The parade would not be the World Series Giants winning parade, would it?

It would be. And, I have front row seats out my window. (laughter)

Okay. One of these days maybe the Mariners can have a similar parade. We can only hope.

I certainly referred to the M&A activity picking up in the Pacific Northwest. We have seen several acquisition announcements in the last couple of months. My take on that, as I indicated -- I think that we're going to see increased activity for 2013. I don't think it is going to be a landslide of activity. I think it is just going to be a generally building activity for any variety of reasons. I think that as margins continue to compress for all institutions, and especially those that may be starting from a lower net interest margin to begin with -- that only exacerbates profitability issues. I think you add on continuing regulatory costs. I just think it's going to continue to put pressure on folks to begin to have some serious discussions in that regard.

So, I continue to be optimistic. We were able to do a deal in Q3. I realize it was a small deal. As I have said several times, you -- I would characterize it as kind of a bunt single, but we put together a few of those, and it begins to be meaningful. I am encouraged that as we finish out '12 and move more specifically into '13 that there will be more activity in that regard.

Okay, thank you. That's helpful, Brian. Those were all my questions.

Okay, thanks. Enjoy your parade.

Tim Coffey, FIG Partners.

Morning, gentlemen. Brian, how would you classify the production that we saw in the third quarter on the loan side? The $50 million-some-odd in new loans. Is that kind of standard? Or, was that more of an outlier?

I think it was pretty standard. Might have been a little stronger than previous quarters. But, as I said, I think it was probably -- well, compared to Q2 was $49 million. So, $56 million was a little stronger. I don't have Q1's number. But, it was certainly stronger than I had anticipated going into the quarter which was a pleasant surprise. But, I think probably a bit stronger.

Okay. I saw in the text that you booked a small gain on sale of the OREO. We are seeing improving property prices across the Pacific Northwest, mostly in the Puget Sound, exclusively. Do you anticipate there to be a possibility for additional gain on sale of OREO going forward?

I think so. We do a pretty good job of marking OREO assets to value before we move them in. And, I think you look back historically, we've -- our OREO costs have not been relatively high compared to others. But, as I look at what is left in the OREO bucket and see what properties are selling for -- I would agree with you. I think that we're certainly seeing activity. OREO numbers are going down. And, we have booked a little bit of gain. I would not be surprised if that may happen again in Q4.

Thanks. The rest of my questions have been answered.

Okay. Thanks, Tim.

Ross Haberman.

Quick question on if we do see a premature rise in rates, how are you positioned for that? And, will you possibly get squeezed initially because deposits would go up a little faster than your asset side?

Yes. I think Don wants to take a shot at that.

I think we are in good shape. We are asset-sensitive. Some of the floors of things we're repricing have become less of a factor in some ways. And, in addition, our investment portfolio is short. We have quite a bit of that rolling off in the next year or two. So, I think that we are in good shape if we see a premature before 2015. In fact, I would welcome that, if we did.

Just one final question on the reinvestment's. When your mortgage-backs are rolling off presently, how are you reinvesting that cash today?

I'm reinvesting it in additional -- my two main areas I'm investing in are further mortgage-backs and municipal's.

Even at these very low rates, the mortgage-backs still make sense?

Yes, they do.

Okay. Thank you.

Ross, I hope all as well in downtown Manhattan?

It is a little wet, but we have our electricity. So, it's okay.

So, things are beginning to get back to normal?

Yes. A couple more days, and then we will get the subways back.

Thank you, Ross.

Thank you for the concern.

Okay. Take care now.

(Operator Instructions)

At this time, there are no further questions from the phone.

Deck, I appreciate hosting the call, and I appreciate all of you that have called in today for the earnings conference call. We'll see you next time around. Thank you.

That does conclude our conference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect.