Heritage Financial Corp (HFWA) 2014 Q4 法說會逐字稿

Ladies and gentlemen, good afternoon. Thank you for standing by and welcome to the Heritage Financial Fourth Quarter and Year Ending Earnings Conference Call.

At this time, all lines are in a listen-only mode. Later, there will be an opportunity for your questions and instructions will be given at that time. (Operator Instructions) And as a reminder, today's conference is being recorded.

I would now like turn the conference over to our host, Chief Executive Officer, Mr. Brian Vance. Please go ahead.

Thanks, Tom. I'd like to -- welcome to all who have called in this morning and to those who maybe listening in later in the recorded mode. We are coming to you live from near Seattle, Washington, the home of the defending and contending Seattle -- world champion, Seattle Seahawks. Attending with me this morning is Don Hinson, our CFO; Jeff Deuel, President and COO; and Bryan McDonald, our Chief Lending Officer.

Our earnings press release went out this morning in a pre-market release and hopefully you've got an opportunity to review the release prior to this call. And I would ask as we go through our prepared comments as well as our Q&A later in the session that you would refer to the looking -- forward-looking statements in the recent press release.

I'll first just go over a few highlights of our fourth quarter. Diluted earnings per share were $0.24 for the quarter ended 12/31/14, compared to $0.04 per share for the prior year quarter ended 12/31/13 and $0.23 for the linked quarter ended September 30, 2014. Heritage declared a cash dividend of $0.10 per common share, an increase of 11.1% from the prior quarter regular cash dividend. Non-covered loan receivables, net of allowance for loan losses, increased approximately $61 million or 3% to $2.1 billion at 12/31/14. Non-maturity deposits increased approximately $56 million or 2.4% to $2.38 billion at 12/31/2014. And finally, non-performing non-covered assets [increased] $6.1 million or 38.5% to $9.7 million at 12/31/2014.

Don Hinson will take a few minutes and cover our financial statement results. Don?

Thanks, Brian. I'll start with the balance sheet. Total assets increased only $8.6 million during the quarter, but the percentage of higher earning assets increased materially during the quarter. Total net loans increased [$48.8 million] and investment securities increased $57.8 million during Q4. These increases were funded primarily by a decrease of $101 million in interest earning deposits. The increase in the investment portfolio was driven by purchases of $94 million, partially offset by $33 million in principal pay-downs and maturities and $6 million in sales on securities, which resulted in net gain of $33,000.

Non- maturity deposits continued to show growth as they increased $56.8 million during Q4, and approximately $220 million since the Washington Banking merger on May 1. The increase in non-maturity deposits has been partially offset by decreases in CD account balances. CDs decreased $52.5 million in Q4, and have decreased approximately $114 million since the merger. Net deposit growth since the merger is approximately $106 million.

Moving on to some credit quality metrics. We saw significant improvement in credit quality metrics for the non-covered loan portfolio. Total non-accrual non-covered loans decreased $4.2 million or 35.6% during Q4, and total nonperforming non-covered assets decreased $6.1 million or 38.5% from the prior quarter-end. Non-accrual loans decreased primarily due to $5.6 million of loans that were removed from the non-accrual status as [they have been] worked out and/or paid off during the quarter. The ratio of our allowance for loan losses on non-covered loans to non-covered non-performing loans stands at a very healthy 295%.

Net charge-offs on non-covered loans for Q4 were higher than normal, but most of these loans were taken against previously known problem loans. Non-covered loan charge-offs were offset by an equal amount of provision, which was primarily for Q4 loan growth. Net charge-offs on covered loans were mostly due to one particularly large loan on which we were able to achieve resolution during the quarter. This one loan represents [$1.34 million] of the $2.08 million in covered loan charge-offs for Q4. As a result of this charge-off, the indemnification asset was increased by $703,000 of provision for loan losses in the amount of $792,000 was recorded as a result of this charge-off.

The total FDIC indemnification asset balance was lowered to $1.1 million as of December 31. Of this amount, approximately $300,000 is related to the 10-year single-family loan loss share agreements and approximately $800,000 is related to the five-year non-single family loan agreements, the last of which will be expiring in July of this year. Therefore, by the end of the third quarter, the $800,000 indemnification asset related to non-single family loans will have been either used in loss claims to FDIC or amortized to zero.

Moving on to net interest margin, our net interest margin for Q4 was 4.74%. This is a 42 basis point increase from 4.32% in Q3. The increase is due primarily to a 39 basis point increase in the impact of incremental discount accretion. The increase in incremental discount accretion was due to significant amount of payoffs and loan workouts in Q4, as well as some quarter-end adjustments to prior accretion estimates relating to loans obtained through Washington Banking merger. The carrying value of non-covered acquired portfolios decreased $68 million in Q4 and the carrying value of the covered portfolios decreased $12 million in Q4 for a total decrease in acquired portfolios of $80 million in Q4. We're estimating that the discount accretion in the next couple of quarters will be more in the $2 million to $3 million range. This estimate of course is subject to the speed of loan payoffs within the portfolios.

Pre-accretion net interest margin increased slightly to 3.86% in Q4 from 3.83% in Q3. This increase was due primarily to a 25 basis point increase in yields on taxable securities, partially offset by a 4 basis point decrease in pre-accretion loan yields.

Non-interest income decreased $1.6 million during the quarter, primarily due to the effects of the FDIC indemnification asset. As was mentioned in the earnings release, a combination of claims relating to loan workouts and valuation adjustments affected the balance of the indemnification asset in Q4. Of the gains on sale of loans, $356,000 are related to mortgage loan sales and $187,000 are related to SBA loan sales. The decrease from the prior quarter was due to a decrease of $186,000 in mortgage loan sale gains.

Finally to touch on non-interest expense, as in prior quarters, non-interest expense was impacted by merger-related expenses. These expenses totaled approximately $1.7 million during Q4, up from $1.3 million in Q3. A majority of the expenses in Q4 related to severance payments to transitional employees. We expect to realize a substantial portion of our cost savings related to the Washington Banking merger in Q1 of 2015.

I'll hand this over to Bryan McDonald, who will now have a update on loan production.

Thanks, Don. During the fourth quarter, the commercial lending teams closed $207.6 million of new loans, which is up from $123.5 million in the third quarter, $120 million in the second quarter and $100 million on a combined basis by Heritage and Whidbey commercial teams in the first quarter when they operated as separate banks.

Gross non-covered loan totals increased in the quarter by $59.3 million as a result of the strong level of originations. Commercial team pipelines ended the fourth quarter at $206.5 million, which is down from $281 million at the end of the third quarter. The decline was due to the high level of new loans closed in the fourth quarter and is not a result of changes in loan demand.

SBA 7(a) production in the fourth quarter included 13 loans for $6.2 million and we ended the year with $9 million in the SBA 7(a) pipeline. This compares to third quarter where we closed 16 SBA 7(a) loans for $7.5 million and ended the quarter with $14.8 million in the 7(a) pipeline.

Consumer production remained strong for the fourth quarter with $28 million of new loans closed. The $28 million was comprised of $20 million in dealer volume and $8 million in branch volume. This compares to the third quarter with $26.7 million of new consumer loans and the second quarter with $30.4 million of new consumer loans.

The mortgage department closed $30.4 million in new loans in the fourth quarter compared to $27.1 million in the third quarter, $26 million in the second quarter and $16.9 million for the first quarter. The mortgage pipeline ended the fourth quarter at $21.2 million, down from $26.6 million at the end of the third quarter.

I'll now turn the call to Jeff, who has an update on the conversion and merger activities. Jeff?

Thanks, Bryan. You'll recall that we successfully completed the conversion of legacy Whidbey's operating platform on to the legacy Heritage DNA core system in early October, as originally planned. As a result of that core conversion and continuing efforts to integrate the two banks, you'll notice that we were able to reduce FTE from 809 at June 30, 2014 to 748 as of December 31, 2014, contributing to our overall cost saves. We're pleased with the results of the core conversion and our integration efforts to-date. While the heavy lifting of the conversion is behind us, we are now focused on refining our staffing levels and back-office processes. It is possible that our overall FTE levels may increase slightly over the first half of the year as we adjust staffing metrics from one department to another, but we would expect to see that number trend down again as we approach year end and should come out slightly lower than where it is now.

We also believe we see additional benefits over time as we begin to fully utilize the capabilities of the DNA platform across the combined bank. I think it's important to note that the increased loan production in the fourth quarter mentioned by Bryan McDonald together with the non-maturity deposits growth mentioned by Don are hopefully early indications of the potential at combined organization as we continue to unite the two banks.

And now, I'd like to pass it to Brian, he'd like to finish it up with some comments on capital management.

I'll start with capital management comments and then move into some brief outlook for 2015. Under capital management, we have declared a $0.10 dividend, which is a 25% year-over-year regular dividend increase and is also roughly in line with our previously stated payout ratio of 35% to 40%, assuming merger-related expense adjustments. We continue to believe we have flexibility and opportunity for future regular dividend increases as our profitability continues to improve as a result of continuing growth and efficiencies over recent merger.

Our tangible common equity remains at a healthy 9.7% and our strong TCE level continues to give us flexibility for a variety of growth opportunities as well as other capital management strategies.

Now for a few comments and just in terms of an outlook for 2015. We believe our core Puget Sound, [Counties of Kings], Snohomish and Pierce economics will continue to improve and we believe this improvement is likely to be sustainable throughout 2015. While we're pleased with the overall loan growth in Q4, we continue to see very competitive local lending markets. And with the recent drop in general rate environment, we are experiencing a very competitive commercial lending environment, resulting in a much higher commercial real estate refinancing activity.

We hope to achieve non-covered loan growth for 2015 in the 6% to 8% range. We will continue to focus on quality loan growth. We were also focused more on growing non-interest income through growth than maintaining our current margins. In doing so, we will concentrate our loan growth in short to medium maturity duration so as not to take undue future interest rate risk.

We believe we have achieved the announced cost saves with our Washington Banking Company merger and we'll continue to focus on improving our various efficiency metrics such as assets per employee, efficiency ratio and overhead ratio.

As Jeff has mentioned, we are pleased with the positive results from our conversion from the legacy Whidbey Island Bank customers and we continue to be pleased with the overall integration of the two organizations.

That completes our prepared remarks. Tom, we'll open the lines for any Q&A that we may have.

(Operator Instructions) Jeff Rulis, D.A. Davidson.

Question on sort of the late loan growth that you alluded to. First, was that -- do you get the sense was from a competitor, some of those loans or kind of new demand of current customers or how would you characterize it?

It was really across the board. There was no particular competitor situation that drove significant volume. And particularly on the construction side, where we had some growth, a portion of that was related to closings going back to the second and third quarter where we closed a number of larger construction loans. And of course, in many cases, it takes months for those to fund through the borrower equity before they get into the bank debt.

So, no specific place and really a combination of factors going back to the second quarter driving that loan growth.

And as far as late growth obviously impacted the pipeline, do you think that that cannibalizes Q1 growth or has that pipeline rebuilt so far in Q1?

We've continued to see a very nice level of lending activity and in the first couple weeks of January, we already saw the pipeline replenishing itself, certainly it's starting at a lower rate. And I'd also add that Q1 typically is not our strongest quarter for loan growth historically.

But I guess the general comment would be, we still see strong loan demand although the market is competitive.

And then maybe a last one on kind of the late growth. The average -- I don't know if there is a average kind of rate of that production, but how does that -- do you think that could translate to some tailwinds on margins into Q1, assuming it was as a higher rate or maybe loosely comment on the rate impact you'd expect from that late growth.

We're going to -- I think the rates going on are somewhat lower, but again I think that we're more leveraged outside, I think that the leverage is going to help our margin. In fact the leverage is going to happen late in the quarter. And so I think that's going to offset some of the lower rates on the loans and sales.

Some of the loans were actually some tax-exempt loans also. So they were at lower rates, but you also get the benefit on the tax side.

That maybe net neutral to margin?

I think it might be, yes.

Okay. And then just a question or two on the costs side. So are the merger costs would you anticipate finished here for WBCO?

Yes, I believe. So there may be a little carry over, but I think it will be significantly -- it will not be significant. It will be very little.

And then as we pointed kind of the run rate on expenses then, I think Don mentioned we would substantially get the cost savings in Q1. So I guess, absent the merger costs, is that a decent run rate on non-interest expense?

I think it's going to be -- our run rate is looking to be less, because we have more employees, the employees were -- levels were lowered throughout the quarter. So I don't think just taking the quarter and then reducing it by the merger cost is actually going to be a low enough expense level. It should be lower than that, because of the lower amount of employees by year-end.

Okay and so if I heard Jeff right then, if you're refining those staff levels throughout the year, I mean you might carry some a little higher than possibly, if we step down in Q1 we might even see some lower cost towards the back half of the year?

From an FTE standpoint, Jeff, I think what we're looking at it is if we -- as we refine and we're reassessing that 90 days after or 120 days after the conversion, we may see FTE go up maybe 5 or 10. It's not and when I say slightly, I mean slightly through the first half and then I think as the first half rolls around, we'll start reassessing and start working towards a slightly lower number than where we are now.

Don, did you have a tax rate you'd expect for 2015?

I think obviously it's very -- it's been very volatile. I think it's going to, probably, be in the 29% to 30% range.

[Jacque Chimura], KBW.

I wonder if you could touch a little bit on the great consumer growth that you had in the quarter and just what I'm curious about is that I know that with more of the consumer lender historically and I'm wondering how much of that growth is from those legacy branches versus how much of it is the successful application to Heritage?

The bulk of the growth is, it's on the indirect side and we've just -- that market has just been very strong for us this year. The production levels up significantly all year, first quarter pre-merger and then it's just carried on for the residual of the year. So, it's primarily in the indirect consumer lending that's driven the growth.

I would add to that, Jackie. I do think that -- now that the conversion is behind us, I like Whidbey's -- legacy Whidbey consumer loan origination platform, whether it be on the indirect side or the direct side. I think that was something that we didn't really have perfected well on the legacy Heritage side. I would anticipate that we could see some increased growth on the direct side across the legacy Heritage footprint as we move through 2015.

So, I think we can look for some strong consumer lending growth in total 2015. It may not equal that of 2014 because I think the indirect side driven by a very high level of auto sales, not only just locally but nationally whether or not that continues in 2015 is, it remains to be seen. But overall, I think that you'll continue to see strong consumer loan growth as we move through 2015.

And then, I've been expecting a seasonal decline in the C&I portfolio and that actually bumped up a little bit. Was there anything unique that happened in the fourth quarter?

No, we continue to add new relationships. We did have about $10 million seasonal decline related to our operation in Central Washington for the Ag business in the fourth quarter, but that was more than made up with new origination volume. The usage percentage is actually maintained -- has not changed. So, that wasn't a driver around the growth. So it just has been added commercial business in the fourth quarter.

And how is interest, just given recent movements in rates and I think you'd mentioned that CRE refinancings could become an issue. How is that impacting demand just across portfolios?

I think as we've gone through 2014, we've seen our customers doing more borrowing, which is obviously our preference versus going out trying to take a customer from one of our competitors and so that percentage of business coming out of the customer base versus requiring us to take a loan from a competitor, we've continued to see our customers doing more business. And there has been a fair amount of new construction loans for owner-occupied as well as a few non-owner occupied projects, equipment purchases and other fixed asset purchases. So we are seeing loan demand continue to return to the customer base.

Just a comment a little bit more on the CRE growth. I made that comment in my opening remarks about the refinancing activity, and I think that we could expand that to just prepayment activity. I think we saw that in Q3. We certainly saw it in Q4. I think other banks are seeing this as well.

I think what's going on out there is that the lower interest rate is driving some refinancing activity in the CRE space. I see that continuing. And of course, if it's one of our loans already, we will be very competitive to retain the loan, but sometimes when folks are out there with [sub 4% fix for ten], it's a hard one to agree to keep it with that interest rate duration.

The flip side of that -- I think we see some real estate properties moving, I think folks are taking money off the table, I think the real estate valuations have come back and they've got some nice equities and they are taking money off the table and selling real estate. So I think it's a combination of a lot of things for the last couple of quarters and it's likely to continue in 2015 just from the standpoint of interest rates have gone down more and prospects for lower rates longer certainly appears to be the case.

Okay. And then just one last quick one, Bryan. On the topic of usage within the commercial portfolio, most of your -- not most, a lot of the economies that your footprint touches, I read more and more articles about how well the economy is doing. So what do you think is needed to see those usage rates move up?

I think it's just going to take time. I mean the usage rate I was just booking here was just under 40% in December, actually 39.7%, up from 39.5%. I think the proportion of the customer base is mature with very good equity positions and working capital after the last downturn. They are still approaching things with less leverage and more liquidity. And so, I think the answer is just time. We do have a strong economy and people are borrowing. But it's still more on a term basis, perhaps than just more usage of [of lines].

I would add anecdotally, I think also what we see going on is that the improvement we've seen in the local markets is more real estate driven than it is just commercial business driven. I think the commercial business owners are -- have not seen that lift. They certainly have seen some improvement, don't get me wrong, but I don't think they've seen the lift that we've seen on the real estate side. And so I think our smaller businesses are probably been a little more careful, because they're not seeing that top line revenue line grow a lot yet. Hopefully that will change and when and if it does, I think we could see higher utilization rates.

(Operator Instructions). Tim O'Brien, Sandler.

Most of my questions have been answered, I'd just ask Bryan, utilization -- did you guys, can you tell me what unfunded commitments are for construction at year end versus at the start of the third quarter or at the start of the fourth quarter?

I don't have that with me here, Tim, but we can give you a call back with that.

Yes, or email that'd be great. And then Brian are there any markets -- real estate markets that you think either from an industrial standpoint or retailer or such in that I'll say Seattle proper, King County or maybe Pierce are getting pretty hot with valuations now or perhaps in Portland, can you characterize any markets you are avoiding?

Sure. I think I can I continue to talk about the core Puget Sound markets, which I define as Snohomish, Everett, Seattle and Pierce, Tacoma. Those three counties are certainly the strongest counties within our entire footprint. And I think everything is centered around Seattle and the ripple effect of Boeing's activities, Amazon all of the high-tech industries, and so we certainly have seen real estate values rebound nicely.

I always -- I've been thinking for the last 6 or 12 months that we may be seeing a bubble at some point in time, especially in the multi-family side. There's a lot of multifamily activity, but there's a lot of folks, I think just changing lifestyles, not wanting to be tied to mortgages and homes when they can qualify. But there's a tremendous amount of, I'll say, high-rise apartment condo complexes being built in Seattle for folks -- downtown Seattle, for folks who want to live downtown.

So I don't see that necessarily as a concern at this point and when I look at other sectors whether to be, let's say the commercial sector, warehouse sector, I don't know that we've seen anything that concerns us from a valuation perspective. I think that we've got to keep our eyes to the cap rates and watch those cap rates as where as we move forward.

As in my remark earlier, we're going to maintain our loan quality and we're going to watch for bubbles, unreasonable cap rates, et cetera. But in our footprint, I don't really see anything that would necessarily concerns me. You mentioned Portland, and then I candidly say that that's not a big part of our operating footprint today. So it's not something that we're focused on. I think we will continue to focus future loan growth in this three county core market that we're operating in.

And then last question for Don. Don, obviously data processing costs are pretty elevated in the conversion quarter in such. Can you give any sort of sense of kind of a range of how they might [save a lot here], it's a pretty important piece of it. You must have some decent sense of how that's going to play out. You're starting in the first quarter or even in the second quarter?

It's going to be lower, but again there are some costs in that. I think if I go back to our -- I mean, look quick while we're talking here on the -- how much we had 212,000. So there's not a lot. I would say, there is -- maybe a little bit more savings than what's in those merger-related costs, but for the most part, we are on one system for the quarter. So that's.

Maybe like third quarter number of $1.7 million or something like $1.75 million or something it might settle to, is that what you're saying or is it going to be a little higher than that even?

I think if you look at the fourth quarter, we were actually on pretty much for the whole quarter our combined system. And then obviously we had some one-time expenses we listed in there. I don't think it's going to materially change from that a lot I think it might be somewhat less, because of some items we're clearing up, it wasn't a lot. If we had merger related items, they would have been shown in that table. So I don't think there is a lot of less than what that run rate would give you.

Yes, to add to that. Tim, I think really if you're looking at run rates, the bulk of the improvement is obviously going to come out of the total comp and benefits. And remember that quarter, there were a number of folks that left employment as we work through the quarter even in the December. And then there were, as we've noted, there was some severance cost et cetera. So I think the bulk of the improvement is going to come out of compensation, employee benefits. I think a little bit will come out of maybe other expense. But I think data process and some of those others are likely to remain fairly flat.

Okay. And then I guess just to follow-up then on that. I mean looking back at, where you guys, how you thought cost savings might play out with the combined companies when the deals were announced? How is that [ceding] with what you're actually seeing, how would you compare those remarks back then and that view back then with where we are today on the overall deals?

Sure. To remind everybody we announced 20% cost saves of the Whidbey non-interest expense or 10% combined because the two companies were identical in size and identical in non-interest expense. So just using a 10% combined cost saves and looking at what we've accomplished, we're going to exceed that 10%. It's not going to be by a wide margin, but we believe that it will be a few points over that 10%, as it stands now.

And I think that's important to remember because as we move through 2015, there is still some more expense reduction that we're going to get. It's not going to be a big number, but the expense saves we've already built into the process is likely to grow as we move through 2015.

Jeff Rulis, D.A. Davidson.

Sorry, one more expense question but different angle. On the merchant card sale, you mentioned you'd expect revenues to cut in half. Is there a related expense drop expected?

No. There's not. It's on the revenue side. It's just that how we're doing. It is a process, it's not necessarily any really expenses related to it.

And Mr. Vance, there are no other questions queuing up at this time.

If there are no further questions, I appreciate everybody's continued interest in our Company, and I know that few of us are going to be making the rounds at conference, earnings -- investor conferences over the next few weeks. I'm sure we may run into some of you and appreciate your interest today and Go Hawks.

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