Heritage Financial Corp (HFWA) 2015 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Heritage Financial third-quarter earnings release.

(Operator Instructions)

As a reminder, today's call is being recorded. I will turn the conference now over to your host, Mr. Brian Vance, Chief Executive Officer. Please go ahead, sir.

Thank you, John. I'd like to welcome all who called in, and those who may be listening in later in recorded mode. Attended with me here in Olympia this morning is Don Hinson, our Chief Financial Officer, Jeff Deuel, President and Chief Operating Officer, and Bryan McDonald, Chief Lending Officer.

Our earnings press release went out this morning in pre market release, and hopefully you've had an opportunity to review the release prior to the call. And as always, I will refer you to the forward-looking statements as we go through our prepared comments, as well as the Q&A, after our prepared comments this morning.

I'll first start of with the highlights of our third quarter. We had a solid quarter with respects to earnings. Earnings with an EPS of $0.32 for Q3, and return on average assets of 1.06%, and a return an average tangible common equity of 11.2%.

We had another strong quarter of loan growth, with an increase of $56 million or 2.4% for the quarter. Year-to-date loans have increased 6.8%, or 9.1% on an annualized basis.

In addition, we had a strong deposit growth in the third quarter, with an increase of $108 million or 3.7%. Shared loss agreements with the FDIC were terminated during the quarter, resulting in a pre tax gain of $1.7 million.

That covers our highlights, and I'll turn it over to Don to cover some financial statement results for you. Don?

Thanks, Brian. I will start with the balance sheet.

Total assets increased $115 million in Q3, primarily as a result of the $108 million increase in the total deposits during the quarter. The strong deposit growth resulted in a decrease in the loan deposit ratios of 78.0%, from the prior quarter of 78.9%. However, the overall trend is an increased loan deposit ratio, as evidenced by an increase in the ratio from 76.7% for staying at the end of 2014 to the current ratio of 78%.

Significant deposit increased in the third quarter resulted in overnight cash balances increasing to $32.5 million at September 30, from $22.8 million at June 30. Based on the historical performance, we do not expect fourth-quarter deposit growth to be as robust as it was in the third quarter, and therefore we expect overnight deposits to decrease during the fourth quarter.

During the quarter, the percentage of demand deposits to total deposits increased to 25% from 24.7% at the prior quarter end. And total non-maturity deposits to total deposits increased to 85.7% from 84.3% at the prior quarter end.

Moving on to credit quality metrics, we continued to see overall improvement in credit quality metrics for the loan portfolio. Total non-performing assets decreased $1.5 million or 11.5% during Q3. This decrease was due mostly to sales of other real estate owned.

The ratio of our allowance for loan losses on loans to non-performing loans stands at a very healthy 293%. In addition, non-performing -- non-covered assets -- total [non-covered] assets improved to 33 basis points as of September 30, from 39 basis points as of June 30. In addition, included in the carrying value of the loans are $21.6 million of net discounts, which may reduce the need for an allowance for loan losses on those related loans.

Our net interest margin for Q3 was 4.00%. This was a 19 basis point decrease or 4.19% in Q2. The decrease was due partly to an 11 basis point decrease and the impact of incremental [dex account] accretion during the quarter.

Pre-accretion, net interest margin decreased to 3.76% for Q3 from 3.84% in Q2. This decrease was due primarily to a decrease in pre- accretion loan yields of 13 basis points to 4.75% in Q3, as compared to 4.88% in Q2. As new loans are being booked at rates lower than the current portfolio.

In addition to quarter-over-quarter change in the average earning asset mix from investment to overnight deposits effected the net interest margin negatively. Non-interest income increased $2.7 million from the prior quarter. Due mostly to the effects of the $1.7 million gain on the termination of the FDIC shared loss agreements, as well as related to the elimination of the amortization of the FDIC indemnification asset, which was $304,000 in Q2.

In addition, gain on sale of loans increased $129,000 from Q2. Of the gain on the sale of loans in Q3, $857,000 related to mortgage loan sales and $554,000 related to SBA loan sales.

And finally on non-interest expense, non-interest expense for Q3 increased $1.2 million from the prior quarter. The increase was due mostly to increases in compensation expense and data processing expense.

The increase in compensation expense was due mostly to personnel additions to the Seattle office, as well as expenses related to performance-based incentive compensation. The data processing expense increased in the prior quarter, primarily due to an incurred fee of $129,000 for the early termination of a data processing contract, sorry, that's $429,000.

Jeff will now have an update on strategic initiatives.

Good morning.

In the latter part of 2014, the management team met to determine our strategic initiatives for 2015. And at that time, we settled on three strategic initiatives, including completing the integration of the two legacy banks, continuing to develop our metro market presence in King, Snohomish and Pierce counties, and growing non-interest income. We remain focused on these initiatives throughout 2015.

At this point in the year, we can see tangible results from our efforts. Early in the year, we achieved the originally planned for merger-related cost saves. You'll recall, that was 10% for each bank or 20% together.

We also continued to identify additional efficiencies throughout the Company, including the renegotiation of a variety of vendor contracts, which will provide us with significant savings over the coming months. The benefits from this effort just started kicking in during the August/September timeframe.

We've also centralized all incoming calls to the customer service center, which provides us with the opportunity for refining branch staffing going forward. We do remain focused on staffing levels in all areas of the bank, and continue to hone our FTE metrics.

Our second initiative for this year focused on developing our metro markets. This initiative has also turned out well, with the opening of our new downtown Seattle location in early August, and the hiring of several highly-experienced lenders on the Seattle team.

At this time, our Seattle office is fully functioning with representation from commercial lending, community development, capital markets and cash management. We are also continuing with selective hiring in Snohomish and Pierce counties to strengthen our lending teams in those locations.

Our third initiative had us focused on growing non-interest income, with a specific focus on referrals to mortgage cash management, SBA and wealth management. Essentially, taking advantage of the ability to offer these services across the combined footprint. To support this initiative, we implemented an internal referral tracking system earlier in the year, which allowed us to monitor referral progress, responses and completions.

The referral process has generated 945 referrals to date, with 381 of those referrals active, and 111 of them closed out or turning into new business. We are seeing very good progress in this area.

Like I said earlier, we're very pleased with the results of our 2015 strategic initiatives, and we're now in the process of gearing up to identify our initiatives for the coming year. I'd like to pass it now to Bryan McDonald, who will give us an update on loan production.

Thanks, Jeff.

During the third quarter, the commercial lending teams closed $210 million of new loans, which is up from $183.6 million closed in the second quarter, and $131.6 million closed in the first quarter. Gross loan totals increased during the quarter by $56.7 million, as a result of the strong level of originations and $201 million over the past 12 months. The majority of the quarter's growth was in commercial and industrial loan balances, which were up $49.5 million.

Commercial team pipelines ended the third quarter at $305.6 million, up from $290.7 million at the end of the second quarter. Loan demand has remained consistent from our customer base, and our calling efforts continue to provide the bank a number of new opportunities. This has been true across the footprint, and in the Seattle market, where we have added five bankers to our production team during 2015.

Line utilization of the end of the quarter was 38.5% versus 38.96% last quarter. This percentage has been very stable over the last couple of years. Average Q3 interest rate for our new commercial loans was 3.75%.

SBA 7(a) production in the third quarter included 11 loans for $14.41 million, and the pipeline ended the quarter at $5.8 million. This compares to the second quarter, when we closed 16 loans for $6.44 million and the pipeline ended at $13.7 million.

The Seattle and Spokane District SBA office recently published third-party lender rankings for their fiscal year ended September 30, 2015. On SBA 7(a) lending, Heritage Bank ranked number ten overall and second-highest versus other community banks. On SBA 504 lending, Heritage Bank, number one overall by a very wide margin.

Consumer production shrank $4.5 million in the third quarter to $35.6 million of new loans closed. The $35.6 million was comprised of $22 million in dealer volume, and $13.6 million in branch volume. This compares to the second quarter with $40.1 million of new consumer loans closed.

The decline in the dealer volume was primarily due to a credit union expanding its geographic presence in August, and taking volume. This expansion only impacted August, with volumes increasing the prior run rates during September.

The mortgage department closed $46 million in new loans during the third quarter, compared to $46.1 million in new loans in the second quarter. The mortgage pipeline ended the third quarter at $35.6 million, down from $46 million at the end of the second quarter.

The current pipeline is comprised of 56% refinance loans, 27% purchase loans, and 17% custom construction loans. This compares to last quarter's pipeline, where refinance business averaged about 50%.

Brian Vance will now have an update on capital management, as well as some closing comments. Brian?

Thanks, Brian. I'll start with capital management.

We have continued our $0.11 quarterly dividend, which represents a 34% payout ratio. And is slightly under the range of our previously stated guidance of 35% to 45% payout ratio.

We also announced a special dividend of $0.10. This special dividend is a continuation of at least one special dividend for the past five years including this year. Our special dividend strategies are closely linked to future balance sheet growth, tangible common equity levels and M&A activity.

Our TCE, or tangible common equity, remains at a healthy 9.8%. And our strong TCE level continues to give us flexibility for a variety of growth opportunities, as well as other capital management strategies.

Comments in terms of outlook for the balance of 2015. We continue to be optimistic about the overall economy of the Puget Sound region. Real estate values across all sectors continue to appreciate, and most all economic indicators continue to show measurable improvement.

While commercial real estate construction growth is robust in the region, construction activity seems to match demand at this point. But we are being careful to constantly monitor and limit prudent loan concentration in high activity sectors.

As stated earlier, we continue to be pleased with overall loan growth for the past four quarters, with annualized loan growth for each of the past four quarters in the high single digits or low double-digit range. These growth rates are net of continuing high levels of prepayment activities that continue to persist, as well as the management of failed FDIC asset workouts. The prepayment activities of originated loans are primarily the result of the sale of real estate or the sale of old businesses, both resulting in early payouts.

While our loan growth is coming from all markets we do business in, our Seattle strategy continues to overweight our overall growth. You may have seen our press release of October 16, highlighting three additional lenders to our Seattle location. Along with the addition of one loan support position.

These three additional lenders are a continuation of building out our Seattle team. They all have considerable, embedded and deep knowledge of the entire King County markets, and each has the potential of building nice C&I portfolios. Each of these three lenders is well-known to us, and work directly with current members of our Seattle team.

We continue to be optimistic our net loan growth will be on the upper end of our 6% to 8% guidance for the balance of 2015. Our non- accreted yield for the previous four quarters has been in a fairly tight band between 3.83% and 3.87%, however, it dropped to 3.76% for this quarter. As Don stated earlier, this decrease was due primarily to yields of new loans, but also partially due to increased liquidity.

Our non-accreted margin is likely to continue to deteriorate slightly in the foreseeable future, due to the continuing low rate environment. I also believe it's important to note that our strong C&I growth for the quarter is primarily based in variable-rate loans, which have lower yields, but the value of the variable rates going forward should be noted.

While our efficiency ratio improved this quarter, our overhead ratio went up slightly. Primarily caused by our Seattle initiative, and the early contract termination fee reported by Don earlier. We believe we will continue to improve both metrics over the next several quarters.

We obviously are pleased with our recent successes in expanding our Seattle presence as a result of the recent commercial lending hires. We believe our Seattle expansion strategies will positively affect our results later this year, and more so for the full year of 2016.

I would welcome any questions you may have. And once again, refer to the forward-looking statements in our press release as I answer any of the questions dealing with forward-looking comments. And that completes our prepared remarks, John, and we'll open the lines for any questions that may be.

(Operator Instructions)

Jeff Rulis, D.A. Davidson.

Thanks, hello, guys.

Hello, Jeff.

Really just a couple questions on the Seattle hires. Wanted to try to get a sense for the impact to loan growth that those individuals may have? Kind of a timing thing, did you see any bump already in Q3? Or would you expect one in Q4? Or is it more of just a steady contribution over time?

Hello, Jeff, this is Bryan MacDonald. We did -- the new bankers have closed loans during Q3. We have had a very good pipeline and production out of Seattle going back the last 12 months. And so with this added group, we just see that continuing. So we did have an impact from the team in Q3. We've got a good pipeline overall, and a good share of that coming out of our King County market.

Bryan, while I have you, just a question on overall pay-down activity. How was that sequentially from Q2 to Q3?

What we keep close track of is the larger payoffs, the payoffs over $1 million. And those were just over $36 million during Q3, versus something closer to $24 million for Q2. So they were up.

And Q2, Q2 was higher than what our typical run rate would be. In Q2, we had a number of SBA 504 debentures fund that took it higher than what we would typically expect. But, it was higher. And if you looked at the loan composition in terms of the owner and non-owner occupied real estate quarter over quarter, that was the primary reason for the decline in those sectors.

Maybe going back to the Seattle hires, Don, you mentioned that non-interest expense. So similar question, any lumpiness in their hires? Obviously, it picked up in Q3. Is there anything extending into Q4 that we should be aware of, or maybe fall off from that level?

Well I think that as we mentioned before that we're expecting additional expenses. Some of the hires -- we didn't move into the facility until August, and so I think the full -- we're actually going have increased expenses associated with that initiative in Q4 compared to Q3.

Jeff, to that, this is Brian Vance. To that point, I think in Q2's earnings conference call, we had given some guidance that the balance of the year, in other words, the last six months of the year impact for the Seattle initiative that could be around $750,000. And could increase maybe to as much as $1 million if there were additional hires, and we still feel that guidance is appropriate.

Thanks, guys.

Thank you, Jeff.

Matthew Clark, Piper Jaffray.

Hey, guys. How are you doing?

Hello, Matthew. We're doing well, thank you.

Good. On the core margin, excluding the accretion, with your expectation for deposits to come down, obviously that excess cash coming down. I assume -- is it enough to allow that core margin to maybe bounce back a little bit, even with the ongoing pressure on loan yields or no?

Matthew, it's Brian. Let me give you a big picture, and I'll let Don fill in some more color. As I mentioned in my comments earlier, I think it's important to note that a good bit of our growth in Q3 came from C&I volumes. That's important to know for a couple of reasons. We have always felt that the Seattle strategy was and will be focused on C&I loan growth. We're beginning to see that borne out in our numbers. I think that's good.

Secondly, as the C&I loans are variable-rate and variable-rates typically carry lower yields. And I think that certainly has impacted our loan yields, both from what the yield of the new loans are being booked as well as the NIM. There are certainly other nuances in the net interest margin, and Don, you might want to comment to that as well?

Building on what Brian said, again, our origination -- originated loans this quarter was down quite a bit, the new loans, what the rates were put on at. But again, a lot of it's due to the C&I. C&I drove that down some, the average C&I loan I think was like [3.65%] compared to overall [3.94%] for the quarter.

In prior quarters, we haven't had as much of that product on there, and that's why it's been in the low [4%]s in previous quarters for new origination, so that's a big part of it. Part of it will be is as we leverage more of the cash, that that will bring --that will help the margin some. It won't have a significant impact, but it will help bring it back up some.

Okay. And I guess on the non-C&I stuff in terms of pricing, just incrementally relative to last quarter, in terms of new business are you seeing a step down on those rates based on what market rates have done? Or even here in the fourth quarter, or is the non-C&I stuff still remained around where it's been?

I would say it has, Matt. It continues to be a pretty competitive marketplace, particularly for the quality loans. But yes, I think the majority of the impact to this quarter was more in the mix, the higher mix of C&I than a significant decrease in the lending rates.

Overall rates have continued to come down since last quarter. So that has an impact in the overall repricing of the portfolio, which is tied to the Federal Home Loan Bank Index. So as the overall market rates decline, our pricing rates come down. So that's a pretty big driver of the overall yields in the portfolio.

Okay. And just last one, just thinking about the opportunity to pick off more seasoned lenders with all the dislocation that's going on in and around you relative to M&A opportunities. Can you just help us think through those too?

Sure. Since we put the announcement out last week on the commercial banker additions there in Seattle, we have hired one additional person, a credit analyst, to that team. And that fills out our first phase of hiring in Seattle. We are targeting some additional adds for some specific areas, and we continue to be out actively recruiting for that. And we continue to be recruiting in all of our markets. And we have had good reception, continue to have very good reception interest from bankers at other banks in terms of talking to Heritage.

So that's been an active strategy, really something we do all the time. But I can tell you that, really over the last year, it's really been very favorable. We've had a lot of people interested in talking to us, and we feel quite fortunate to have hired the folks that we have being able to bring aboard. And that we continue to have a good reputation in the market.

Matthew, this is Brian. I would add to Bryan's comments in that we've had a very, I'll say, comprehensive, targeted approach for lender recruiting in King County for the last year or so. And that's resulted in the new hires that we've announced.

I think the other thing that it's done as we've brought what I strongly believe are very high-quality lenders to the organization, is it's raised the awareness of Heritage Bank in that market of which we were hoping and wanting to do as well. Which is also creating a nice side benefit of some inbound calls from the standpoint of folks that are taking notice and seeing what we are doing.

It's fun to see. I think it's important to say that we're very selective in terms of fit. We're looking for fit on a culture side, we're looking for fit on a credit quality side, and we believe we're getting that. We believe that the strategy is being executed to our desire, and I think that as we go forward into 2016 I think there will be some additional opportunities.

Jacque Chimera, KBW.

Hello, good afternoon, guys.

Hello, Jacque. How are you?

Good. How are you, Brian?

Doing well, thank you.

There was, and this excludes the $1.7 million in the loss share benefit that you got the quarter. But what else caused that pop up in other income this quarter?

Well again, we had some loan sale gains which was part of that. We also had some, I will say, miscellaneous loan income on some loans we were able to get some resolution on that were one of those loans we've mentioned before.

That were never really on our -- never had a balance on our books because they were through an FDIC deal that came across as zero. So there was no charge-off related, so therefore it came into other income. So that was part of the other income increase for the quarter.

So some of that will be a nice bump in the quarter, but non-recurring the future?

Right. It does happen, and we've seemed to have experienced it, I don't think we did a lot in Q2, but we have seen that quite a bit over the last few quarters, that those type of recoveries come across.

Do you have a lot left of those, Don?

Sorry?

Do you have many left of those? Any of those potential recoveries?

They're kind of hard to predict, because again, we constantly work those credits to see what we can get. And sometimes they come through, and sometimes they don't. So again, it's hard to predict that. I would say as you get further away from the events of the acquisition, but yes, they're probably fewer and fewer apart.

Jacque, this is Brian. I would add some additional color on that, and just reminding everybody that there were four failed institutions now in this balance sheet too from legacy Heritage too, from legacy Whidbey. Now that the loss share agreements have been canceled, some of these recoveries going forward are a 100% gain to the bank.

Some of that gain will be through [allowance], some of the gain is done, just indicated, will be through non-interest income depending on how the asset was rigorously carried. But I think because there are four troubled -- actually four failed institutions in the balance sheet, is very difficult to predict. But I think that there could be and will likely be some of that continuing activity as we move through the next year or two.

And then I wondered, probably a question for Bryan McDonald. If you could just update on where the floors are at, and how that number shifts as you continue to book more and more C&I growth? And how much you think rates would have to rise before you start to see an impact on that?

Jacque, I am going to ask Don to answer that one for you.

Okay.

I think -- I don't think it's really changed much from where we had. I think we've, again, we've got floors in various areas. I think it might be best again to look at the overall interest rate position of the Company, and I think we're pretty neutral overall.

I think that even with our assumptions of being pretty conservative, that we are maybe slightly liability sensitive, I think we've continued with the C&I loans and so additional liquidity we're probably asset sensitive. And we feel pretty confident that if rates do go up that we're going to be adding to our bottom line going forward. So I'll answer it that way.

Okay. And do you have just a round range that you're willing to discuss in terms of how much rates need to go up before you'll trigger some of those floors?

Well, I don't at this point, no.

Jacque, it's Brian. I think probably as -- and who knows what rates are going to do going forward. I think that as Don indicated, we're pretty even today. I think rather than the importance of getting through floors is just a when rates do increase, I believe that we're going to see a benefit from that in an overall sense. I don't think that the floor issue is as great of an issue as it was once before.

But I think that -- I don't know that we've positioned the balance sheet necessarily. But at a fairly balanced portfolio today in this interest-rate environment is really not a bad thing to have. But on the other hand, we would look forward to interest-rate increases going forward.

Great. Thanks for the color, guys. I'll step back now.

Thanks, Jacque.

(Operator Instructions)

Tim O'Brien, Sandler O'Neill.

Don, a quick question for you. Did you say that there's $21.6 million in discount remaining on acquired loans?

Yes, I did, Tim, I think that's what I said. I'm looking it up real quick. I did. That's $21.6 million.

What was that number at the end of the second quarter, just remind me?

I believe it was $23.4 million.

And is that credit a combination of credit and interest rate discount?

It is, but there's not a whole lot of interest rate piece to that.

So, majority predominantly credit?

Correct.

Okay, great. And then another question, are you guys in -- have you met the performance thresholds on your sold merchant card book that are going to allow you to capture that $0.5 million incentive in 4Q?

I believe we're on track to do that. Yes, Tim.

Tim, you have a good memory.

Okay, great. Well that's what writing notes is for, Brian, at my age. And then another question, did -- can you give a little color on the deposit? The deposit growth was phenomenal this quarter, and, Don, you alluded to some guidance saying that there might be -- balances could come down a little bit, you could see some deposits move out in the fourth quarter. Did I catch that right? And can you give a little bit of color on what happened this quarter?

While I looked historically at our deposit growth, and the third quarter is always our strongest deposit growth quarter.

So seasonal?

It seasonal. There's no real events, like in the first and second quarters you have some tax type stuff going on. In the fourth quarter, you have tax events, like there's property taxes, there's some final individual taxes happening. And plus some of the holiday type stuff happening.

So the third-quarter is a quarter where there's really no events, and the positive balances just tend to accumulate over time. So historically, it's always been our strongest quarter.

I would remind you, Tim, that really the last half of last year and the first quarter or couple of quarters this year, we were still running off old CD balances of, again, acquired -- failed acquired institutions that had five-year CDs out there. So that impacted the net deposit growth for the first half of the year at least.

One other question tied to that. The Seattle banking team and the Seattle strategy, can you talk a little bit about how you anticipate deposit gathering being part of that, the goals of that unit and the effort up there?

Sure, Tim, this is Bryan. We have our caps management lead in our Seattle office, and also a cash management sales officer. And then here, beginning part of next year, we have the retail staff that is going to join the new location downtown.

But we have some very specific strategies set out around deposit gathering and deposit growth from an office space setting versus the traditional branch setting. So we do have specific deposit strategies to go along with the overall Seattle and King County really land because it certainly impacts our Bellevue office.

Will you fund C&I loans up there without capturing deposit accounts of some sort?

Is our objective to bring in full relationships, and that has been what we have been successful in doing the last year. And the new relationships that some of the new folks have brought aboard, we have been getting full relationships.

So the strategy is both to do that, but also to go after some of the larger deposit relationships that exist in the downtown core. We think we've got an opportunity to pick up some business there, that isn't centered around a lending relationship necessarily.

So some of the deposit growth this quarter was tied to Seattle. Those guys brought it in?

Yes, it was. But I wouldn't say that it was new relationships in Seattle that drove the bump. But along with the lending activity, they've picked up deposit relationships right along with that.

Thanks for answer my questions.

Yes, Tim, Brian Vance here. Just to add a little additional comments to that. And I've been pleased at, as we've looked at the C&I credits out of King County, that it does -- they do bring with them some very nice deposit relationships. And our relationship managers there have done a great job in really acquiring the total relationship, and I anticipate that to continue.

Bryan also referred to the addition of the retail team to our downtown Seattle location. To clarify that point that is our current West Seattle branch location that will be closed following the first part of the year. And a couple of staff members there will transfer downtown Seattle, just to clarify that point. That is why you will see in our release where -- why branch counts went from 66 to 67. That will fall back to 66 after the first of the year.

Thanks, Brian. Thanks for the color. Talk to you guys later.

Okay thanks, Tim.

And Mr. Vance, we have no further questions in queue.

Well once again, I appreciate everybody's interest that has joined our call today. Appreciate your continued interest in the Company, and we will chat with you after Q4 results. Thanks, everybody.

Ladies and gentlemen, this conference is available for replay. It starts today at 1:00 PM Pacific time until November 5 at midnight. You may access the replay at any time by dialing 800-475-6701. The access code is 370446. That number again, 800-475-6701, and the access code 370446. That does conclude your conference for today, we thank you for your participation. You may now disconnect.