Heritage Financial Corp (HFWA) 2016 Q4 法說會逐字稿

Ladies and gentlemen, thank you for your patience and standing by, and welcome to the Heritage Financial year-end and quarterly earnings conference call.

(Operator Instructions)

As a reminder, today's conference is being recorded. I'd now like to turn the conference over to Chief Executive Officer Brian Vance.

Thank you, Justin. Appreciate it. I'd like to welcome all that called in this morning for our earnings conference call and also to those that may listen in later. Attending with me this morning in Olympia is Don Hinson, our CFO; Jeff Deuel, President and COO; and Bryan McDonald, Chief Lending Officer. Our earnings press release went out early this morning in a pre-market release and hopefully you had an opportunity to review the release prior to the call. As always, I would ask you to refer to the forward-looking statements in that press release both for our prepared remarks this morning and also as we go into a Q&A period following our prepared remarks.

First of all, I'd just like to highlight the fourth-quarter and the annual 2016 results. Diluted earnings per common share were $0.33 for Q4 2016 compared to $0.32 for Q4 of 2015 and $0.37 for Q3 2016. Diluted earnings per common share were $1.30 for the year ended December 31, 2016, compared to $1.25 for the year-end December 31, 2015. Yesterday, we declared a regular cash dividend of $0.12 per common share.

Return on average assets was 1.03% for the year and return on average tangible common equity was 10.84% for Q4 2016. Total loan receivables net increased $60.9 million or 2.4% during Q4 and increased $237.4 million or an even 10% from December 31, 2015. I'll turn the call over to Don Hinson to take a few minutes to cover our financial statements results. Don?

Thanks, Brian. I'll start with the balance sheet. As Brian mentioned, we had another strong quarter of loan growth with net loans growing 9.5% on an annualized basis for Q4, and year-to-date loans grew 10% in 2016. Our loan to deposit ratio increased to 81.2% from 78.9% at the prior-quarter end. This is the highest reported loan to deposit ratio since the merger with Washington Banking Company in 2014. During Q4, the percentage of demand deposits to total deposits increased to 27.3% from 26.7% at the prior-quarter end, and total non-maturity deposits increased to 88.9% from 88.6% at the prior-quarter end. We continue to see a decrease in CD balances due to the continued low rate environment.

The investment portfolio decreased $24.5 million during Q4. This was due primarily to $21 million of net unrelated losses recognized during Q4. These unrealized losses impacted total equity by $13.7 million. This was a major factor in the decrease of tangible book value per share to $11.86 at December 31 from $12.33 at September 30.

Moving on to credit quality metrics, we saw a nice overall improvement in credit quality of the loan portfolio. Potential problem loans decreased $13.2 million or 13.1% during Q4. Non-performing loans decreased $631,000 or 5.5% to 0.41% of total loans from 0.45% at the prior-quarter end. The ratio of our allowance for loan losses to non-performing loans stands at a very healthy 285%. In addition, included in the carrying value of the loans are $13.5 million of purchase accounting net discounts, which may reduce the needs of an allowance roll-off on those related purchase loans.

Net charge-off for the quarter was 0.05% of average loans which lowered the year-to-date charge-off ratio to 0.14%. Two OREO properties totaling $754,000 were added during Q4. However, due to reductions in non-performing loans, our ratio of non-performing assets to total assets remained at 0.3%.

Our net interest margin for Q4 was 3.85%. This is a 10 basis point decrease from 3.95% in Q3. Pre-accretion net interest margin decreased 9 basis points to 3.68% for Q4 or 3.77% in Q3.

The decrease in pre-accretion net interest margin was mostly due to decreases in pre-accretion loan yields as well as decreases in investment portfolio yields. Pre-accretion loan yields decreased partially due to a large loan prepayment penalty realized in Q3 that impacted that quarter's loan yield by 4 basis points.

In addition, new loans for Q4 were originated at a weighted average rate of 4.08%, which is lower than the weighted average rate of the loan portfolio at the end of the prior quarter. As I commented in the earnings release, we continue to increase our floating rate LIBOR-based loan segment. The notional amounts of these loans increased to $102 million at year end from $68 million at prior quarter end and from $21 million at December 31, 2015. These loans should help improve overall portfolio yield performance in an increasing rate environment but they have also contributed toward declining net interest margin in the latter part of 2016.

Noninterest income decreased $1.7 million from the prior quarter due mostly to a $2.1 million gain recognized on the sale of a loan during Q3. Of the $1.6 million in loan sale gains recognized in Q4, $1.2 million related to mortgage loan sale gains, $239,000 related to SBA loan sale gains, and $192,000 related to other note sales.

Noninterest expense for Q4 was $26.8 million, which is basically unchanged from Q3 2016 and Q4 2015. In addition, noninterest expense for year-to-date 2016 increased only $265,000 or 0.2% from the 2015 amount. The ratio of noninterest expense to average assets continues to improve. This ratio was 2.78% for Q4 compared to 2.81% for Q3 and 2.92% for Q4 2015. Bryan McDonald will now have an update on loan production.

Thanks, Don. I'm going to provide detail in our fourth-quarter lending results by production area starting with our commercial lending group. In the fourth quarter, the commercial teams closed $153 million of new loans, which is down slightly from $159 million closed in the third quarter. For all of 2016, the commercial teams closed $682 million versus $660 million in 2015.

Line utilization was 35.6% at the end of the fourth quarter and is relatively unchanged from 35.9% last quarter and 35.7% in the fourth quarter of 2015. Commercial team pipelines ended the fourth quarter at $296.5 million, up from $248.3 million last quarter, but down from $336 million in the fourth quarter of 2015.

Moving on to interest rates, the average fourth-quarter interest rate for new commercial loans was 4.01%. For reference, last quarter was 3.66% and in Q2, it was 3.93%. And as Don mentioned, the fourth-quarter rate for total loans was 4.08%.

SBA 7(a) production in the fourth quarter included 17 loans for $14.8 million and the pipeline ended the quarter at $14 million. This compares with the third quarter of 2016 when we closed eight loans for $2 million and the pipeline ended at $14.8 million. Consumer production during the quarter was $43.7 million, which is in line with each of the prior three quarters. Consumer production for all of 2016 was $171 million, which is a 14% increase over 2015.

The mortgage department closed $53.9 million in new loans during the fourth quarter, compared to $50.5 million in the third quarter, $43.6 million in the second quarter, and $29.6 million in the first quarter of 2016. The mortgage pipeline ended the third quarter at $34.3 million, down from $53.3 million at the end of the third quarter but up from $29.4 million at the end of 2015. The current pipeline is comprised of 59% refinanced loans, 28% purchased loans, and 13% construction loans. This compares to last quarter's pipeline where refinanced business averaged 54%.

We continue to place additional emphasis on expanding our customer base in Bellevue and Seattle as part of the King County growth initiative, which we started in the middle of last year. At the end of the fourth quarter, our commercial teams in King County have 18 FTE, including 9 commercial bankers. Commercial loan balances associated with the King County commercial team have grown from $145 million at the end of 2014 to $275 million at the end of 2015 to just over $439 million at the end of 2016. And the commercial loan pipeline in King County ended 2016 at $70 million.

Deposit relationships managed by the King County commercial team have grown from $66 million at the end of 2015 to $93 million at the end of 2016. In total, loans and deposits managed by our King County commercial team were $533 million at the end of 2016, which is a 56% increase over 2015. The King County market continues to show strong growth prospects, and we will look to selectively add additional bankers as talent becomes available. I will now turn the call back to Brian for an update on capital management as well as some closing comments.

Thanks, Bryan. I'll start with the capital management. We have continued our regular quarterly dividend of $0.12, which equates to dividend payout ratio for the quarter of approximately 36%, comfortably within our guided 35% to 40% payout ratio. As Don noted earlier, our TCE level dropped from 9.9% in Q3 to 9.5% in Q4, primarily due to the changes in our net unrealized losses in our securities portfolio.

It is also important to note our Tier 1 leverage ratio, which is unaffected by any unrealized losses, decreased only 0.2% to 10.3% for Q4, due to increases in average assets and the effect of our special dividend of $0.25 also paid in Q4. We continue to believe our strong capital position sufficiently supports our balance sheet risk, our internal growth, and potential future growth, both organic and M&A.

I'll close this morning by just giving you some of my thoughts for our outlook for 2017. As I reported to you on our Q3 call, we continue to be optimistic about the overall economy of the Puget Sound region for 2017 and for our continuing growth. Commercial real estate construction continues to be robust and remained disciplined in monitoring our commercial real estate loan production concentration risk.

While we remain comfortably under regulatory CRE concentration guidelines at approximately 250% of capital, we are mindful that a higher percentage of our growth this past year has come from CRE and we need to be careful that we maintain discipline over appropriate CRE growth going forward. We are guiding loan growth for 2017 once again at 6% to 8%. Upside potential will result from lower-than-expected loan prepayments, and downside risk may stem from even more robust commercial real estate concentration risk management disciplines.

We will continue to focus on growing core deposits and specifically noninterest bearing deposits but with a slightly changed emphasis to maintain current CD balances during 2017. This philosophy stems from our ability to have largely managed out the rate-sensitive single-service CDs that we acquired through four FDIC transactions.

While year-over-year deposits have grown at a modest 3.9%, our noninterest bearing deposits grew year over year at 14.4% and now stands at about 27% of total deposits. We expect noninterest deposits to again grow in the double-digit range in 2017 while our overall deposits should grow in the 4% to 6% range.

Due to several large one-off noninterest income gains in 2016, such as the $2.1 million gain on a sale of a troubled loan, noninterest income is likely to be flat at best for 2017 over 2016. However, due to some substantial account plan consolidation and account fee structure changes that took place in late 2016, we are anticipating a substantial improvement in service charge account fee income in 2017.

Expense management continues to remain a primary focus of the Company. We are pleased that our overhead ratio has improved again this quarter to 2.78%. As I mentioned in my comments in the release, this quarter marks the fifth consecutive quarter in a row that our overhead ratio has improved.

You will continue to see some ongoing branch consolidation activities in 2017. As a result of ongoing expense management, we expect to end 2017 a few basis points lower in our overhead ratio than it currently is. We expect M&A activity in the smaller less than $1 billion range to increase this year, and we expect to be active in that arena.

That concludes our prepared remarks. I would welcome any questions you may have, and once again refer you to our forward-looking statements in our press release, as we answer any of these questions dealing with the forward-looking comments. So Justin, we will open the call to any questions that may be.

(Operator Instructions)

Matthew Clark, Piper Jaffray.

Hello, guys.

Good morning, Matthew.

Maybe just on the expense guidance, I know you have talked about in the past about keeping that run rate relatively flat at least. Thought you might be able to keep the growth flat this year. I haven't recast the numbers just yet but some incremental improvement upon that overhead ratio. Does that still get you flattish expense growth?

I'll give you some big picture comments, and Don can give the more detail. I think that we have been pretty consistent with wanting to get our overall overhead ratio into that low 2.7% range, and I think what we would like to see is on a run rate basis to be into that 2.70% range at year end. Realizing that the overhead ratio is a function of two calculations. One is your expense level, two is your asset growth. If you look back at our balance sheet and you look at our loan growth this past year, we increased our leverage, as we pointed out, through the loan growth deposits because again, we are continuing to manage out some of our higher rate CDs, higher rate single service CDs.

It wasn't as strong as you might have anticipated but what we really focused on is that noninterest-bearing deposit growth of double digits. My whole point here is that a lot of the loan growth is coming through increased leverage and not necessarily balance sheet asset growth. If we would have those stronger asset growth, of course that overhead ratio would have improved somewhat. So we need to keep in mind that the relationship of those two numbers but generally we would like to be in that 2.70% on a run rate basis by the end of the year. Don?

And how that works out with the math, I think there's going to be a little bit of increase in expenses year over year but we still would like to keep it under a 2% increase overall and under that some if we can't. But we did have some initiatives. We are growing in some markets that are generating income and some initiatives we have going on that are going to probably lead to some additional expenses year over year, but again I think that run rate will continue to improve as we get through the year. But I think the total noninterest expense for the year will increase some.

Differently said, I think any growth in noninterest expense are going to be related to growth opportunities in the balance sheet.

Great. Got it. Okay. And then on the core margin, 3.68%, I know that you guys mentioned the increase in LIBOR floaters contributing to some of that pressure on the loan yield, but was there anything else in there, the linked quarter, whether it be lower prepayment fees or anything else that put some downward pressure on the yields there?

Well we did -- I mentioned that we had that one large prepayment penalty, I think Q3 that was about 4 basis points on the loan yield so I think that was part of it of the decrease. In addition to again, we are putting loans on at an average of 4.08%. At the beginning of the quarter they were at 4.50% or so, so that's where we're getting some downward pressure, just again the math of putting on loans lower than they started at. That's a culmination.

I will say, Matthew, that obviously with the growth numbers that you see in our LIBOR-based loans year over year represent a very conscious effort on our part to layer in more interest-rate sensitive assets I think will bode well for us going well. So it's a very focused strategy and a conscious strategy on our part giving us a little bit of a headwind today on the NIM side, but I think will pay dividends as we move forward.

Okay, and then just on your comments around M&A and the expansion opportunities you see, can you just talk about the geography and the types of targets you might want to consider in terms of -- you mentioned size being less than $1 billion but just any update in terms of activity and criteria of what you might consider.

Sure. When I step back and take a little bigger picture look at this, let's not forget in the last probably 120 days, two potential M&A competitors of ours, Cascade in Bend and Pacific Continental out of Eugene, have both been acquired and they were banks that were active in the Pacific Northwest M&A arena. And I think that the removal of those two competitors, not that there aren't other competitors but it's just when you look at competition whether it's organic growth and we are competing against those folks on a day-to-day basis with just organic growth in the marketplace or the potential of M&A, I think that bodes well for us.

We are seeing more activity in the M&A markets in discussions. That activity tends to be focused and centered with banks in the less than $500 million in assets. I don't know that there is any specific reasoning for that other than that you can just look at the numbers. There are more banks under $500 million than there are from $500 million to $1 billion, so the population opportunities are greater. But we do see increased activity and potential discussions in that realm, and I'm more optimistic than I have been in a while that we will be active in the M&A game in 2017.

Okay, and then just housekeeping. On the tax rate a little bit lighter this quarter, and I'm curious what your thoughts are for an assumption there in 2017?

I think that going forward, I think the tax rate will be probably around what it was for Q4. it will be between the 26% and 27% I'm guessing throughout the year but in the Q4, it was 26.2%. I think that's probably a decent guide for going forward in 2017.

Okay. Thanks.

Thanks, Matthew.

Jeff Rulis, D.A. Davidson.

Thanks. Hello, guys.

Good morning, Jeff.

Question on the -- a couple follow-ups. On the margin, the detail on the floating rate impact but on a core basis, as you look into 2017 just netting out some of the discussion you had, since for the quarter firming up. I know that you had talked about new loans coming on at just above 4% and that's still a drag but the balance of the year and what you guys are expecting on the core margin direction?

I think the core margin direction will, if the rate forecasts are accurate as far as what's going to happen in the overall rate environment, I would expect our core margin to flatten out this year. And by the end of the year, and that's again, I think we might still feel some little bit of downward pressure the beginning of the year but if we have another one or two bumps in the increases as people are predicting, I think we will flatten out by the end of the year.

And then a little follow-up to the deal activity with those institutions, the announcements on Pacific Continental and Cascade. I know it's a little early but are you hearing any inbound calls from the talent at those institutions and/or anticipating or looking to get or recruit any fallout from those acquisitions?

Jeff, on the big picture point of view, any time that there is merger activity in any given market, there is the potential for dislocation in the market. It's way too early to predict or to comment on that. I think most banks would tell you that they are anxious and would love to see that dislocation.

I would point back to our Seattle growth, our King County growth. It really hasn't been a dislocation-based focus. I think what we do in terms of growing that organic base and lender base is just through constant contact and discussions with lenders in the marketplace for a variety of reasons. I won't discount dislocation as an opportunity for us. But it's not our primary focus as we move forward and continuing to grow the organic side.

And Brian, that was a little bit where I was headed then, so is there anything strategic in 2017 that as you had built out in Seattle, is there another market or the potential for an investment substantially in a region that you could foresee in 2017?

We have been sharing with you our King County results. We have been pleased with those results. As I've said several times, the King County results have exceeded our internal expectation. We've been very pleased with that.

I think we can look at that success story and say can we replicate that elsewhere. That's a possibility. I think we need to be careful from a competitive point of view that we don't signal too many things as to what we are intending to do other than I would just say we've been successful at that, and I will say that we are looking at other opportunities. I may have not have given you the detail you were looking for, Jeff, but I hope you appreciate the sensitivity of that.

I got it. That helps. I appreciate the comments.

Jacque Bohlen, KBW.

Hi. Good morning, everyone.

Good morning, Jacque.

Brian, can you provide a little bit of color what you are anticipating in service charges? What's changing there, what's driving your guidance that there could be a meaningful increase next year?

Yes. I'd be happy to. I'm going to ask Jeff to give you a little bit. And I think the big picture here, Jacque, is we want through a very big comprehensive account consolidation process starting third quarter last year, culminating late fourth quarter. Jeff, you want to give a little color on that?

Yes. Jacque, to put it in perspective after all the banks coming together, we found ourselves with something like 20-plus consumer deposit accounts, too many for our people to stay on top of and confusing for customers in some cases. So we have called it the consumer deposit rationalization project, and as Brian said, it was put in play in the fourth quarter reducing our consumer accounts down to six and embedded in those account makeups there are minimum balances.

Mostly to drive a conversation -- fees for minimum balances, and it was mostly to drive a discussion with the customers because we had a lot of grandfathered accounts that are not necessarily active, and as Brian pointed to the substantial fee income we expect to get, we are just seeing the beginning of that late in December. It's hard for us to frame up exactly what that's going to be because it is tied to customer choices and behaviors, and I think after the first quarter, we'll have a lot better feel for what that is going to look like for us but we do believe it's going to have a beneficial impact.

Okay, and are there expense efficiencies tied to this as well given the decrease in account numbers?

To a degree, yes. I think that's less notable than the fee income that we will generate from the new accounts.

Okay. And then next question would be on deposit growth. As you look out and you commented on double-digit expectations for noninterest-bearing balances. Given that we're in a rising-rate environment, is a lot of that coming from just the growth in King County as deposits catch up to some of the long trajectory that you've seen and just other new account expectations?

I wouldn't advise Brian's comments to this, but my sense is, is that's really coming across total footprint certainly aided by King County. I think that all of our folks, our retail bankers, our commercial bankers, have really focused and have been for a long time, Jacque, on the total relationship. I think that's focused on -- you'd look back. I don't have the data in front of me, but I think we've been doing this for the last two or three years so I think it's a bit more across footprint but, Bryan, additional thoughts?

I agree with Brian. It is really broad based and has been going on for several years, just a number of enhancements, the consumer migration Jeff mentioned had a lot of favorable enhancements to the customers associated with it. There's been a lot of improvement in terms of the banks cash management offering. The sales force, and then Cindy Huntley and the retail staff along with the commercial staff have just been focused on additional partnering just as time has gone on just looking for more opportunities to work together and bring in the full relationships. So really a broad base of different areas of the bank focused on that, and we are going to continue to do that as we go into 2017.

Okay. And as you think about those growth levels, are you also incorporating the potential for additional rate increases into that?

Yes. Yes, we are.

Okay. Great. Thanks, guys. That's helpful.

Thanks, Jacque.

Tim O'Brien, Sandler O'Neill.

Good morning, Tim.

Good morning, Brian. Good morning, guys. Just baseline here, again, can you tell me what percentage of your loans are true floating rate loans?

Don is looking through some data here, Tim, for you so hang on for just a moment.

I got some information. For the amount of floating rate like we said within one year is probably between $600 million and $700 million, and of that about $540 million will just reset just based off the 25 basis point increase, so some of the rest of it needs larger increases but hope that helps you. We have about $300 million tied to prime.

So the rest is tied to LIBOR ostensibly, Don?

Or FHLB rates, those type of things.

And you added LIBOR-based loans during the quarter. Did you already have a small book there or is that a new product?

We started -- this is related to the -- you will see the interest rate swap fee income on the noninterest income. We started that in right about I think September of 2015 and again at the end of last year, I think we had $28 million of these loans, and by the end of this year was $102 million so and we added close to $30 million-something just in Q4.

And can we assume that is going to continue? You guys are going to be actively pursuing that business and trying to book those loans?

Tim, this is Bryan. We are. It's really a tool and particularly as we went into last summer, the yield curve was flat and we were in a really competitive environment. We much preferred to take the variable side versus maybe only 100 basis points more for the 10-year fixed so that was really the strategic approach we were taking. And when we ended last year, as Don just noted, we started the program in late 2015 and had a really good start in the fourth quarter but not much of a pipeline heading into 2016.

2016 was a strong year, particularly the second half the year. We are entering 2017 with a good pipeline. So yes, expect to continue to have this business continue through 2017 and on.

I think that assuming that rates continue to increase a bit as we go through the year or even if there is a perception on the borrower's behalf that rates are going to increase, I think that bodes well for that activity to continue during 2017.

This is a dumb question for you, Bryan. Are those operating lines or are they tied to something else?

The majority of them are commercial real estate loans.

So they automatically have a full -- they are fully funded?

The majority are fully funded at closing, and the bank is taking the variable side of that swap transaction, so we have a LIBOR-based loan on our books and that's facilitating a swap for the borrower to achieve an effective fixed rate, long term but a fixed rate.

Great. And then last question for Don. Don, can you share any rate sensitivity analysis? I know beta -- deposit beta can swing a model around but up 100 basis points for the Fed. Can you give us a sense of what benefit that might have on interest income?

I'll say this that I think in the past we've said we were modeled out slightly liability sensitive or basically flat. I think we're still basically flat. I think we're with these LIBOR-based loans, and even on the security side, we have been adding more floating-rate securities in the security portfolio. So I think that we're I would say slightly asset sensitive. Hard to say, again, with the curve and everything else what might happen but I would categorize this as being slightly asset sensitive, so I would bet we will improve in an up-rate environment going forward.

I would also say that, Tim, I think as we look at our beta rate assumptions as we work with our interest rate risk consultants, I think they tend to look at our betas on our deposits and say we're pretty aggressive on the betas, so if that in fact is true, we could be a bit more asset sensitive than maybe we are thinking we are.

A lot of assumptions as I think if everyone can appreciate when you get into an interest rate risk model and the sensitivities and you get to the instrument level and you start trying to predict the behavior of the customer and then where rates are going, there's just a zillion assumptions that go into that. I think as our nature is we are pretty conservative on a lot of things, so I'm pretty comfortable with our balance sheet is more sensitive than we believe it has been, and I think it's probably growing more asset sensitive as we move forward.

Any chance any of that discussion could make it into your K, Don?

In the K, we do put rate sensitivity information in there.

Great, all right. Thanks a lot.

Thanks, Tim.

Matthew Clark, Piper Jaffray.

Go ahead, Matthew

Yes, just on again on sales, the line item there. It steadily increased the last few quarters but looking back to the first quarter of last year, we did see a drop. Just thinking about the contribution of refi this past quarter, how should we think about maybe that line item going into first quarter knowing that the activity would likely pick up in the spring?

The pipeline is coming into 2017 stronger than it was at the beginning of last year, so I think the first quarter will be definitely higher than last year when we hit that Q4 average, that will depend on how the pipeline does through January and into early February. We still have good purchase activity in the markets. Of course, rates have gone up and some of the refi volume has declined but we are in a stronger position going into 2017 than we were last year.

Okay. Great. Thank you.

At this point, we have no further questions here in queue.

Okay, Justin. I appreciate everyone that called in today. I appreciate your continued interest in our Company, and this concludes our call today. Thanks again.

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