Heritage Financial Corp (HFWA) 2017 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Heritage Financial Second Quarter Earnings Call. (Operator Instructions) As a reminder, the conference is being recorded. I'll now turn the meeting over to our host, CEO, Mr. Brian Vance. Please go ahead, sir.

Thank you, Laurie. I appreciate it. Good morning, everyone, or good afternoon, I guess if you're on the East Coast. I'd like to welcome all who called in and those who may listen in later in the recorded mode. Attending with me 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 earlier this morning in a premarket release and hopefully you've had an opportunity to review the release prior to the call. And please refer to the forward-looking statements in the recent press release, especially as we get into the Q&A session later in the call.

I'll begin with just a few highlights of our second quarter. Diluted earnings per common share were $0.39 for Q2 2017, compared to $0.30 for Q2 '16 and $0.31 for linked-quarter Q1 '17. Return on average assets was 1.21% and return on average equity was 9.54% and return on average tangible common equity was 12.78% for Q2 '17. Total loans increased $84.6 million or 3.2% during Q2. And year-to-date, net loans have increased $107.1 million or an annualized rate of 8.3%.

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

Thanks, Brian. I'll start with the balance sheet. We had total asset growth in Q2 of 2.7% or 10.9% on an annualized basis. As Brian mentioned, we had strong loan growth in Q2, which has increased our year-to-date annualized growth rate to 8.3%. Total deposits grew $47.8 million in Q2, which is 5.9% annualized.

In addition, our noninterest-bearing deposits grew $38.6 million or 17.6% on an annualized basis in Q2.

Moving on to credit quality. Our credit quality remains stable in Q2. Nonperforming loans remain relatively unchanged at $11 million or 0.40% of total loans. The ratio of our allowance for loan losses to nonperforming loans stands at a very healthy 298%.

In addition, included in the carrying value of the loans are $11.2 million of purchase accounting net discounts, which may reduce the need for an allowance for loan losses on those related purchased loans. We had net recoveries of $26,000 in Q2, and year-to-date, our net charge-offs to average loans is 3 basis points, an improvement of 27 basis points from 30 basis points during the same period in 2016.

Our net interest margin for Q2 was 3.92%. This is a 3 basis point increase from 3.89% in Q1. Pre-accretion net interest margin remained at 3.75% for Q2 from the same percentage in Q1. New loans for Q1 were originated at a weighted average rate of 4.60%, an increase from 4.40% in Q1 and from 4.06% Q2 2016. This is the highest quarterly average rate of originated loans since Q2 2014.

Yield on interest-earning assets increased 5 basis points to 4.14% for Q2. This was partially offset by a 3 basis point increase in the cost of funds during Q2. Noninterest income increased $3.3 million from the prior quarter. This increase was due mostly to a $3 million gain on sale of an acquired purchased credit impaired loan.

Service charges increased $213,000 or 5.1% from Q1 and increased $950,000 or 27% from Q2 2016. These increases were due mostly to the impact of the deposit account consolidation process, which we have previously discussed.

Noninterest expense for Q2 was $27.8 million, an increase of $586,000 from Q1. The increase was due partly to the addition of the new Portland team which we announced last week. Total noninterest expense to average assets remained at 2.85% in Q2 from the same percentage in Q1 and a decrease from 2.87% in Q2 2016.

I'll pass the call over to Bryan McDonald, who'll now have an update on loan production.

Thanks, Don. I'm going to provide detail on our second quarter lending results by production areas, starting with our commercial lending group. In the second quarter, commercial teams closed $213 million of new loans, which is up from $121 million closed in the first quarter of 2017 and $211 million in the second quarter of 2016. Commercial team pipelines ended the second quarter at $360 million, which is down slightly from $362.6 million at the end of the first quarter of 2017 but up from $273 million at the end of the second quarter of 2016. Line utilization was 37.8% at the end of the second quarter and is relatively unchanged from 36.4% at the end of the first quarter of 2017. Don mentioned the 4.6% average rate on new loans in the second quarter.

New commercial loan rates were also 4.6%, which was an increase from 4.25% in the first quarter of 2017. SBA 7(a) production in the second quarter totaled 10 loans for $6.2 million, and the pipeline ended the quarter at $15.9 million. This compares to the first quarter of 2017 when we closed 11 loans for $5.4 million and the pipeline ended at $14.8 million.

Consumer production during the quarter was $53.3 million, which is up from $35.5 million in the first quarter of 2017. Branch retail loan volume comprised $27.2 million of the total, which is up $16.5 million from last quarter. And the indirect loan volume was $26.1 million, which is up $1.3 million from the first quarter. The growth in retail branch volume was due to an increased emphasis on direct consumer lending, primarily home equity lines of credit, as we look to offset a planned lower growth rate in our indirect loan portfolio.

The mortgage department closed $33.7 million in new loans during the second quarter compared to $33.3 million of new loans during the first quarter and $43.6 million in the second quarter of 2016. The mortgage pipeline ended the second quarter at $29.7 million, up from $22.6 million at the end of the first quarter of 2017 and down from $38.6 million at the end of the second quarter of 2016. Current pipeline is comprised of 43% of refinanced loans, 37% purchased loans and 20% construction loans. This compares to last quarter's pipeline, where refinanced business averaged 42%.

I'll 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 capital management. Our regular dividend payout ratio for Q2 was 33.3%, and for the first 6 months of '17 was 35.7%, comfortably within our guided 35% to 40% payout ratio. We continue to believe our capital position sufficiently supports our balance sheet risk, our internal growth and potential future growth for both organic and M&A.

I'd like to just close with a few comments in terms of our -- on our outlook for the balance of 2017. I know I'm sounding like a broken record with these comments, but we continue to be optimistic about the overall economy of the Puget Sound region for the balance of '17 and for our continuing growth. And I'd like to cite just a few economic data points for you. Many of you probably saw this but last week, CNBC announced their annual top states for business and Washington State was named America's Top State for Business in 2017. Additionally, they indicated that Washington State has the country's largest concentration of STEM workers, science, technology, education and math. And then there's one other statistic by the -- from the Bureau of Economic Analysis, Seattle ranks -- the Seattle economy ranks 12th largest in the country by GDP, which has increased 5.2% since 2014. So there is reason for us to be optimistic. Seattle and the Puget Sound region continues to enjoy some very nice growth and recognition.

We are particularly pleased with our loan growth for Q2. While we are fairly confident loan growth would be stronger in Q2 than Q1, it was gratifying to see the pull-through rates perform consistently with our increased pipeline numbers, giving us even more confidence in the validity of our pipeline management process and the ability of our lenders to close the deal. You all may have noticed a press release last week announcing the addition of a team of seasoned bankers in Portland, Oregon. We are pleased to be able to attract this team of talented bankers, and we're encouraged by the recent successes of this team.

Commercial real estate construction continues to be robust, and we remain disciplined in our monitoring of our commercial real estate loan production concentration risks. As we have mentioned in the past, our robust CRE concentration management processes are likely to continue to impact future loan growth. We remain comfortably under the regulatory CRE concentration guidelines at approximately 250% of capital. We are pleased to note the 3 basis points increase in our NIM quarter-over-quarter as well as seeing our nonaccretive NIM holding steady in Q2. This is the second quarter in a row that our nonaccretive NIM has held steady, giving us a degree of confidence we are marking the bottom of future NIM compression.

While our overhead ratio remained flat quarter-to-quarter, please keep in mind the added expenses of our Portland team referred to earlier that occurred also in Q2. We continue to expect M&A activity in the smaller less than $1 billion range to increase this year, and we hope to be active in that arena.

That completes our prepared comments. And Laurie, we would open the call for any questions that may be out there.

(Operator Instructions) And our first question, from Jeff Rulis with D.A. Davidson.

Brian, on your last comment on the sort of the -- I just want to confirm on the expense in the Portland team, that was a lot of the comp add linked-quarter. Is that correct?

I believe it was. Don, do you want to?

Yes, that'd be correct.

Okay. And then I guess the outlook then -- well, one other specific on the expenses, the branch consolidation that you had in April, did that add to any costs in the quarter? Or is there any expected benefit in the second half?

Yes, I think with our branch closure expenses, the one time we closed them, I think we were pretty break even. I think we'll see a little bit of benefit from that in Q3. But again, it will be offset somewhat by the addition of the Portland team.

As they're on for a full quarter?

Yes.

Okay. So sort of a flattish expense, you add a little bump with the team. But from here, there's some offsetting that you think the run rate is modest growth from here? Or just kind of holding the line?

I think when you're looking at -- yes, expenses in the comp expense, I think, it's -- the run rate is probably pretty good at this point when you're netting them out.

Great. And then again, Brian, you touched on -- kind of, you guys have been cautious on CRE and talked about the multifamily segments. I guess is that a little more specific to the growth that you saw, I guess, above maybe the long-term or the year guidance that you've given? How do you see that play out in the back half of the year? You said it could restrict growth in CRE, but this quarter seemed a little above that level.

Well, I'll invite Bryan to add some comments to this as well. Let's remember to keep in mind that Q1 was a cyclically slow quarter. I think that my comments about the pipeline integrity as we -- when we combined the company a few years ago, that was something that took us a little while to really dial in to where we had some confidence in the pipeline and process. And you'll recall from Q1 that even though the growth was cyclically lower, we still had a very strong pipeline going into -- from Q1 into Q2, and that certainly did bear out in the Q2 performance. And pipeline numbers remain strong. So I guess my big picture on this is that -- I mean what I say when concentration risks are somewhat of an impact on loan growth because we are turning away some CRE opportunities because of that. But on the other hand, we're seeing growth in other sectors that is nice to see. So Bryan, I'm sure you have comments as well.

Yes, I would just add on to what Brian said, that the growth we saw in Q2 was really balanced. We had good growth in C&I owner-occupied, nonowner, a little bit in construction and a little bit in consumer. A lot of the consumer volume we closed was home equity. So as those lines fund between now and as we go through the rest of the year and into the future, I think that'll give us some additional volume. But the key is just to keep it in balance. There's a lot of commercial real estate opportunities. I won't say an unlimited amount, but many, many construction and nonowner-occupied. So our challenge is keeping all the categories in balance as we go forward. But pretty pleased with the teams in Q2. It's a real balanced result.

And we'll go next to Matthew Clark with Piper Jaffray.

Curious about the team you picked up in Portland, how large of a portfolio they may have been managing prior to you acquiring them?

Matthew, this is Bryan. We're not going to go into details just for competitive reasons. And today, we've got 17 members down there and came from 3 different banks. And so over time, we've got additional postings out, we hope to have a blended team. But we're very -- as Brian mentioned in his opening comments, we're very pleased with the results so far. We're obviously early yet, but good reception of the market and the team has a nice reputation and experience in the market. So we're optimistic.

Okay. And does this, Brian, maybe make it -- is there less of a need to find an M&A deal in the Portland market as a result of this? Or do you feel like it would be helpful to kind of build around them?

Well, just to remind folks that are on the call, we've had a Portland presence since 2007, I believe, very small presence. We -- from a strategy point of view, we decided a couple of years ago really to focus on Seattle, Bellevue and building that presence out. And I think we've been fairly successful at that. And I think that we'll continue to focus on growing the Seattle, Bellevue. But it was time to turn our attention to Portland. And as Bryan indicated, we believe we picked up a nice team from actually a couple of organizations that had some consolidation in that market. In terms of I think future growth, we're looking to continue to -- for that team to engage and get some real traction in that market. We believe that'll happen. As to whether there's M&A opportunity in that market, we would love to add on from an M&A perspective. But as I keep saying, banks are sold, they're not bought. So folks need to come to that conclusion. And when and if they do, we would be very interested to have discussions because we would love to build out a much stronger, I'll say Portland metro market presence.

Okay, great. And then just on gain on sale, obviously, a big number this quarter. I suspect we'd see that normalize going forward unless you think there's some resilience there, more resilience?

No, we actually broke out at a table in the earnings release this time about -- broke out the mortgage from the other. And it was about $3 million again. It was considered more of a one-off. We did this once last year. It happened in a similar situation where we found a buyer for a note that we liked the price and so we -- I think it was third quarter of last year, I think, it was worth like $2.1 million. This was, again, a purchased credit impaired loan that was a hotel, had been written down quite a bit, and we ended up having -- finding a buyer that was -- with a very attractive price and so we ended up selling a note for a $3 million gain.

And I will add that this was an asset that was picked up in an FDIC-assisted transaction several years ago.

Great. And then just the last one for me. Obviously, credit, very good and benign, but just curious if you guys have done a deep dive on the retail CRE to try to isolate the piece that might be -- not only the big box stuff but also the stuff that might be at risk of kind of the Amazon effect.

That's an area that continues to cause us some concern internally. We talk a lot about it. And when I talk about CRE concentrations, that's one of the specific areas that I'm referring to in terms of very limited growth in that space going forward. Because -- and we've been talking about this for probably the last year in terms of the risks in that space. And when you think about it, it's just not -- even though the Amazon effect, et cetera, you tend to think, well, it's only going to impact the bigger space. But we all know that real estate values are based on comps. And if there are difficulties in the larger space, it's going to filter down to the smaller note size, too. So we're looking at this across the footprint and across all loan sizes and types as it pertains to retail space. As it pertains to what's in our existing portfolio, we're evaluating that. We don't see any weakness currently. And we don't believe we have concentrations in that space. But at the same time, I know it's got the attention of our credit folks, and this is something that we're managing closely. And I think the fact that we've been on this focus for at least the last year, I think there's going to be issues in this space for all banks in the future. But we don't see any concern within the portfolio currently.

We'll go to Jackie Bohlen with KBW.

Touching on deposits now, Brian. The movement between the money market and the now accounts that took place in the quarter, was that related to rate movements? Or was it more of an internal focus?

Jackie, this is Don. This had to do with our sweep accounts, how they were classified. And we kind of -- again, we were kind of moving some deposit accounts around. And so between now and money market, mostly due to the sweep accounts and how they got classified.

Okay, so it was more of a classification issue than anything else?

Correct. Correct.

Okay. Okay. And how have customers been reacting to the rise in rates? I know deposit costs were up just a little bit in the quarter. Just any color you have there and kind of conversations you may be having since the June rate increase.

I think there's more sensitivity to rates than there have been in the past. We're getting more calls about that. We actually haven't really increased our rates much, if any, overall. I think we probably did a lot more exception pricing than we've done in the past. But overall, we've been able to hold it. But I can see where -- as the rates continue to increase, that the customers are noticing. And over time that we will need to increase our rates some.

Okay. So the movement in account rates that happened in the quarter, that was more proactive customers just reaching out to you?

Yes. And we have some accounts that we have kind of had an agreement with that were moving -- some of them may be tied to the Fed funds rate or something like that. But those aren't the majority, obviously, but there are a few accounts like that, individual accounts.

Okay. And have you -- outside of the sweep movements in the quarter, have you seen any change in deposit or behavior in the types of accounts that they might be moving their money around in between?

No, we really haven't. I think -- we continue to get good noninterest bearing demand deposit growth. So I think that that's positive, and that's a nice anchor on the NIM because, obviously, there are no rates on that. So I haven't really noticed anything unusual in customer behavior as far as the type of deposit accounts.

Okay. And the growth in noninterest bearing that you had in the quarter, was that related to new loan relationships or just increasing balances from existing customers?

I think we get -- at the end of the first quarter, in that timeframe, March, April, we tend to have a lot of various types of payments going out. And although I would say that some tax payments were postponed until April, still, we tend to start dropping in March and April and start building back up. So I think we were down a little bit. We didn't have much growth. If you look at year-end to March, we didn't have much growth at all. In fact, it was down a little bit in the demand deposits. I think it's just kind of cyclical. I think it's -- we're starting to build it back up.

Okay. And then just one last one, probably for Jeff. I know in the past we've talked about some of the new fees that you're able to charge just as you've reevaluated some of the products that you offer. Are we at a good run rate, given the growth that you saw in service charges in 2Q? Or is there still more room for improvement there?

I think there's actually more room, Jackie, because if you recall, we did our consumer deposit rationalization in December, and we knew it was going to take several months to fully impact us, which I think is the majority of what you'd see. But we've also -- we're in the process of doing a similar rationalization of our business line or our business products. So I think there's more to come on that front. We're pretty pleased with the results so far, though.

Okay. And do you have a general timeline of when you might complete the evaluation of the business deposits?

Probably closer to the end of the year would be -- maybe beginning of the fourth quarter, around that timeframe, maybe. It should be fully implemented and all of the communication and responses from customers or changes that they might make as a result of them seeing the way things are working will probably flow through in the next 3 or 4 months.

And our next question is from Tim O'Brien with Sandler O'Neill + Partners.

I don't know if you guys touched on this. I didn't capture it if you did. But the lower housing listings in the Pacific Northwest, is that impacting mortgage production for you guys?

I'll ask Bryan to maybe comment on that. I -- also one of the statistics, economic statistics, factors in our Seattle paper this morning is that home prices increased 12.7% '16 -- '17 over '16 June-to-June, the highest increase of any market in the U.S. So obviously, the single-family market is -- you can say it's hot from a valuation point of view, and -- but that really is driven by 2 things. One, demand, people moving to the area, and two is a slowdown in or a lack of inventory. And so when you see the lack of inventory, that translates a bit in slower mortgage volumes because there are just not enough homes. So kind of big picture, that's where we are. And Bryan has probably got some more specifics.

Yes. For sure, there are many customers coming in and getting prequalified and then bidding on multiple houses and having trouble actually acquiring a home. So there's a lot of additional time and work spent on that phase without immediate conversion into a home purchase. So yes, for sure, it's holding down mortgage volume because inventory is low.

Great color. And then I saw you guys had a nice uptick in swap, interest rate swap fees this quarter. Is that going to bounce around from here? I mean, prior quarters you've done better still. How should we look at that number?

Yes, it is up over first quarter, second quarter last year. It does bounce around, Tim. We had a really strong finish in the fourth quarter last year as well and in '16. Back to some of Brian's comments on commercial real estate, as we are careful in terms of keeping our mix the same, that does have an impact on the swap volume because much of it is tied to the commercial real estate bucket. But this is a long way of saying, yes, I think it'll bounce up and down, but we still have a pipeline of swap activity pending.

And then last question. So looking at total noninterest expense, were there I guess nonrecurring initiative-related cost around your deposit rationalization initiative? Or were there residual costs with branch consolidation this quarter? That's gone, but probably that was fully captured in 1Q. Or were there any initiative-related costs that are nonrecurring that you guys showed this quarter?

Tim, no, I think it's -- there's nothing really outstanding during the quarter except, again, we did again close some branches. That actually happened I think in April. So there were some costs associated with that, but they were kind of offset by the -- because they happened in April, they kind of were somewhat breakeven for the quarter. And then, of course, the hiring of the Portland team, which occurred after April, kind of -- were kind offsetting. So I think this is -- the run rate, it can fluctuate some, but it's not going to, I don't think, fluctuate a lot from what we have here.

And what was the date of the start of that team?

The first 5 started mid-May.

And we'll go next to Tim Coffey with FIG Partners.

I got on a little bit late on the call and so I hope I didn't miss this, you may have mentioned it already. But the loan growth that occurred in the back half of the quarter, I think you said about 2/3 of it occurred in June. I'm wondering what the incremental pickup was in net interest income from that?

Well, I think it was -- well, again, our new loans came in at 4.60% this quarter compared to 4.40%. And again, most of that, I don't know the incremental income pickup from just those loans. But I can also tell you that our weighted average kind of -- or you might say weighted average rate within the portfolio at the end of the quarter was, I think, about 9 basis points higher than the weighted average rate from the end of the prior quarter. So if that gives you any hint there. In addition, that's a combination of, obviously, we had another -- we had some resets during the quarter in addition to the new loans coming on at 4.60%. So I think the combination of that, we're -- I'm pretty optimistic about our pre-accretion loan yields going forward.

Okay, great. That's good color. And then just kind of, I know the utilization rates in the lines of credit are relatively flat quarter-over-quarter. But are you seeing any change in those dynamics or has your outlook for potential for utilization rates to drop or increase changed in the last couple of months or so?

This is Bryan. We haven't seen a significant change there in the last couple of years. We are seeing an increase in commercial loan demand or kind of what I'll call the C&I side. Equipment or expansion continues to increase. And so I don't know if that'll translate into a higher utilization rate because a lot of the borrowers, they try to manage for significant line capacity when they're looking at new projects. But overall, we are continuing to see improving commercial loan demand here in our market.

(Operator Instructions) We'll go next to Louis Feldman with Wells Capital Management.

I apologize if you touched on this because I had to step away in the middle of the call for a second. Did you -- can you -- did you give some granularity on what you're seeing in the indirect auto markets and what concerns are starting to arise for it?

Lou, this is Bryan. We're not seeing any deterioration in payment performance or quality. Obviously, we're in a very strong employment market here in the northwest, and that's our primary driver of credit quality in that business. And we've been moderating our growth somewhat in 2017. We're targeting somewhere around a 10% target there in that business just because we've had such strong growth over the last 2 years. Not a concern over credit quality, just more of keeping portfolio balance. At this point, the job market is strong and our quality is strong.

Okay. So you're not seeing credit deterioration within your portfolio at this point?

No. It's actually very strong. It's improved over the last year, and it was very strong a year ago. But again, it all ties back to employment primarily because of the grades that we're targeting in the portfolio are on the higher end of the spectrum. So it's typically somebody losing their job or some sort of a similar change that's causing the deterioration.

Lou, it's Brian. I'll just comment, kind of give a big picture again on indirect. Those that have followed us for some time will remember that the indirect product came to us as a result of the merger from Whidbey Island Bank. And as I've said to many of you previously, this was a portfolio that I had a high degree of skepticism over just because that's kind of my background through the years, that indirect portfolio is going to be a problem. And I know that this was an issue nationally that's getting a lot of attention, so I appreciate the nature of your question. However, because of my concern when we brought the companies together, we've done a substantial deep dive into that portfolio in terms of underwriting rationale. Just incidentally, this is all indirect within our footprint with dealers we've done business with for many years. And this is a portfolio that has performed very well. During the downturn and since the downturn, we continue to follow a variety of metrics. And while I'm not predicting that this portfolio won't experience increased difficulties, I really feel good about the quality of the paper that goes into this portfolio. And you also may know from previous conversations, we've ramped back our growth. I mean, it's still growing but much smaller. So I think the consumer growth that you're going to see in our balance sheet over the next several quarters is likely to be direct consumer-oriented in the form of home equity as opposed to dealer. It's not that we're getting out of the dealer business, it's just we got to a point -- again, when I talk about concentration management, it's very critical in all of our portfolios. We got to a point that we were comfortable with the concentrations but we didn't want to grow it much -- beyond where it is. So the volume today is really a maintained volume and future consumer totals will -- growth is likely to come from the direct side of the house, just to give you a bit more color.

And I'll turn it back to our speakers for closing remarks.

Well, Laurie, thank you for hosting. You've done a great job. Appreciate all that's called in and had interest in our company. We will see many of our investors next week in New York at the KBW Conference. So I look forward to chatting with you then. That concludes our call today. Thank you.

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