Heritage Financial Corp (HFWA) 2017 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the Heritage Financial third quarter earnings call. (Operator Instructions) And as a reminder, this conference is being recorded.

I'll now turn the conference over to your host, CEO, Brian Vance. Please go ahead, sir.

Thank you, Kathy. I'd like to welcome all who called in this morning and also those that may listen later in a recorded mode.

Attending with me in Olympia this morning is Don Hinson, our CFO; Jeff Deuel, our President and COO; and Bryan McDonald, our Chief Lending Officer.

Our earnings press release went out this morning in a premarket release and hopefully you've had the opportunity to review the release prior to this call. And then as we go through the call and especially in the Q&A session later, I would ask you that you refer to the forward-looking statements that is contained in the press release that was sent out earlier today.

I'd like to start with some highlights of our third quarter. Diluted earnings per common share were $0.35 for Q3 compared to $0.37 for Q3 2016 and $0.39 for the linked-quarter Q2 2017.

Return on average assets was 1.05%, return on average equity was 8.34%, and return on average tangible common equity was 11.10% for Q3. Total loans net increase was $49.4 million or 1.8% during the quarter. Year-to-date net loans have increased to $156 million or 6%.

Yesterday, the Board of Directors declared a regular cash dividend of $0.13 and a special cash dividend up $0.10 to be paid in November.

I'll now turn the call over to Don Hinson, who'll take a few moments to cover our financial statement results. Don?

Thanks, Brian. I'll start with the balance sheet. We had total asset growth in Q3 of $59 million and broke the $4 billion asset mark during the quarter.

As Brian mentioned, we have solid loan growth in Q3, and as a result, our year-to-date annualized growth rate is 8% through Q3.

Total deposits grew $29.6 million in Q3 and have increased $91 million year-to-date.

The credit quality remains stable in Q3. Nonperforming loans remain relatively unchanged at $11 million. The percentage of nonperforming loans to total loans decreased to 0.39% at September 30 from 0.40% at the end of Q2. The ratio of our allowance for loan losses to nonperforming loans stands at a very healthy 287%.

In addition, included in the carrying value of the loans are $11.7 million of purchase accounting net discounts, which may reduce the needs of allowance for loan losses on those related purchased loans.

We had net charge-offs of $2.2 million in Q3. This is mainly due to 2 larger charge-offs. First, we recognized a $1.5 million charge-off related to the closure of a purchased credit impaired loan pool. This charge-off was related to the losses that had built up in the pool over the last 7 years but were not recognized as charge-off until the pool was closed.

In addition, we recognized a charge-off of $556,000 related to a write-down of a collateral-dependent land development loan.

Our net interest margin for Q3 was 3.85%. This is a 7 basis point decrease from 3.92% in Q2. Pre-accretion net interest margin decreased slightly to 3.74% for Q3 from 3.75% in Q2. Pre-accretion loan yields increased 4 basis points to 4.57% in Q3 from 4.53% in Q2. This was mostly the result of the increase in the primary in June as well as the impact of higher origination loan rates in Q2 this year.

New loans for Q3 originated at a weighted average rate of 4.45%, a decrease from 4.60% in Q2. The decrease in rates on originated loans is a result of lower market fixed term rates from earlier in the year.

The cost of funds increased to 0.36% in Q3 from 0.31% in Q2. This increase was due primarily to increases in the cost of CDs and overnight borrowings. Our cost of total deposits for Q3 was 0.20% compared to 0.18% in Q2.

Noninterest income was $8.4 million in Q3, a decrease from $10.7 million in Q2. As a reminder, in Q2, we recognized a $3 million gain on sale of a previously classified purchased credit impaired loan.

Service charges increased $343,000 or 7.7% from Q2 and have increased $2.9 million or 28% from Q3 2016. These increases were due mostly to the impacts of the deposit account consolidation process that we have previously discussed.

Noninterest expense for Q3 was $28.0 million, an increase of $146,000 from Q2. The increase was due partly to the cost related to the proposed Puget Sound Bancorp merger. These costs were $383,000 for Q3.

Total noninterest expense to average assets improved to 2.76% in Q3 from 2.85% in Q2. Bryan McDonald will now have an update on loan production.

Thanks, Don. I'm going to provide detail on our third quarter lending results by production areas starting with our commercial lending group.

In the third quarter, commercial teams closed $216.6 million of new loans, which is up from $213 million closed in the second quarter of 2017 and $158.8 million closed in the third quarter of 2016.

Line utilization was 36.1% at the end of the third quarter and is relatively unchanged from 37.8% at the end of the second quarter of 2017.

Moving on to interest rates. Average third quarter interest rate for new commercial loans was 4.3%. And as Don mentioned, the average second quarter rate for total loans was 4.45%.

SBA 7(a) production in the third quarter totaled 8 loans for $6.1 million, and the pipeline ended the quarter at $14.4 million. This compares to the second quarter of 2017 when we closed 10 loans for $6.2 million, and the pipeline ended the quarter at $15.9 million.

Consumer production during the third quarter was $60.7 million, up from $53.3 million in the second quarter of 2017 and $35.5 million in the first quarter of 2017. Third quarter branch retail loan volume comprised $27.9 million of the total, up slightly from $27.2 million last quarter, and indirect loan volume was $32.8 million, which is up $6.7 million from the [second quarter].

The growth in retail branch volume over the last 2 quarters is 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 portfolio during 2017.

The mortgage department closed $39.8 million in new loans during the third quarter compared to $33.7 million of new loans in the second quarter and $50.5 million in the third quarter of 2016. The mortgage pipeline ended the third quarter at $29.1 million, very similar to the $29.7 million at the end of the second quarter of 2017 but down from $53.3 million at the end of the third quarter of 2016.

The current mortgage pipeline is comprised of 46% refinanced loans, 37% purchased loans and 17% construction loans. This compares to last quarter's pipeline, where refinanced business averaged 43%.

I will now turn the call to Jeff for an update on the Puget Sound Bank merger.

Thank you, Bryan. I just want to jump in and let you know that the Puget Sound Bank transaction is progressing as planned. We spent the last 90 days working with the Puget Sound leadership team and their employees to develop a plan for the integration. We've gotten to know the team better in the process of working together. We're impressed with their capabilities as well as their business model, and we've already identified several practices that we will probably bring to the Heritage Bank platform.

Our system conversion projects are underway, and we expect conversion to occur in the second quarter of 2018. We're still trending towards the change in control in the first quarter of 2018.

Also you may have noticed my comments in the earnings release about increased expense relating to senior staffing. In the last 18 months, we've continued to strengthen our enterprise risk management team.

Additionally, you may have noticed in the recent press release that we also added a Chief Technology Officer in the last month. Many of these new members of the team come from larger banks, which is part of our plan to continue to enhance the existing capacity and experience of our team to support our growth plans. We believe this effort is key to our future success.

And now, I'll turn it back to Brian Vance for an update on capital management as well as some closing comments.

Thanks, Jeff. I'll start with capital management. Our regular dividend payout ratio for Q3 was 37.1%. And for the first 9 months of 2017, it was 35.8% and comfortably within our suggested 35% to 40% payout ratio.

As I previously mentioned in addition to the regular dividend of $0.13, we have also declared a special dividend of $0.10. This will be the seventh consecutive year in which we have paid a special dividend to our shareholders.

We continue to believe our capital position sufficiently supports our balance sheet risk, our internal growth and potential future growth, both organic and M&A.

Now some comments for the -- just outlook for the balance of 2017. We continue to be optimistic about the overall economy of the Puget Sound region for the balance of 2017 and for our continuing growth. Competitive pressures, however, are still present. We continue to see aggressive pricing from all fronts as well as a few aggressively structured deals. Competitive pricing, along with a slight increase in cost of deposits, primarily drove nonaccretive NIM lower by 1 basis point.

We remain committed to our core focus on credit quality despite these competitive pressures, which is what continues to fundamentally drive our loan growth strategies and performance.

Additionally, commercial real estate construction continues to be robust in our markets due to the economic growth we are seeing, but we continue to remain disciplined in managing our concentration risks, which also impacts our growth.

We remain comfortably under regulatory CRE concentration guidelines at approximately 253% of capital.

By design and strategy, our loan-to-deposit ratio has increased from 79.5% a year ago to 84.2% today -- or at the end of Q3. However, as we approach the 85% range, our strategies were gradually moved to maintain a loan-to-deposit range in the mid- to high-80% range through a more concentrated deposit gathering strategy.

This deposit-focused strategy has been developing for the past year or so as we have been anticipating an inflection point in deposit outflows for our industry, coupled with increased competitive pressures in deposit pricing. Our Portland strategy was primarily built around a deposit growth focus.

As Don mentioned previously, our overhead ratio improved quarter-over-quarter from 2.85% in Q2 to 2.76% in Q3 despite our increased expenses related to our Portland, Oregon expansion as well as merger-related expenses of Puget Sound bank.

We continue to expect M&A activity in the smaller, less than $1 billion range, and we expect that we will remain active in this area.

That completes our prepared remarks today. And I would welcome any questions you may have. And once again, we'd refer you to our forward-looking statements in our press release as we answer any questions that you may have.

Kathy, if you'd like to open the call for questions, I'd appreciate it.

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

A question for you on the account consolidation, those benefits and the growth rates are pretty impressive. I guess, could you capture if that's more of a near-term pop in growth? Or it has -- that had some carry for several quarters? Maybe talk about kind of the growth rates you'd expect on the fees.

Jeff, it's Jeff Deuel. We've been very happy to see that play out. As you remember, we managed through the consumer product rationalization process towards the end of last year, and then we did the business accounts mid this year. I think we're probably at the right run rate now. There may be still a little bit more left to come, but I think generally, we're done. The other thing that I would add to that is that we also fully implemented our treasury services platform. We had acquired a new one. And I think that, that's contributing to it as well. That platform gives us more insights into how our commercial accounts are priced and how we monitor and manage that. So the 3 pieces together are what's generating that fee income.

And Jeff, this is Brian. I would just add to that. As Jeff indicated, I think we're comfortable in that the run rates today are sustainable as we move forward. So we're really pleased with the efforts and the results in that particular area.

One quick one back for Jeff. Just on the deal closing in Q1, kind of refine that. Is it looking more earlier in the quarter? Or is there a timing that you'd throw out there?

At this point, we would be delighted to close end of January, that would be ideal for us. We just don't have full control over the timing at this point.

And maybe last one, just on -- Brian, you talked about -- it's a dynamic situation, obviously, you've got some pressure on the loan side or loan competition, and you talked about your deposit strategy. I guess, expectations on core margin, not specifically, but just kind of your -- the balance of '18, how you look at that core margin number.

I'd invite Don to offer his comments as well. I guess that as indicated, I think these our industry issues that as we look to pressures in deposit growth areas, pressure on deposit rates, I think the industry is experiencing this. And we're starting to see just the beginnings of that as well. And as I said in my prepared remarks, we've anticipated this for the last year or so. And we've really been focusing on building our deposit growth piece. And as I said, that was a primary focus of our Portland team. But we're also taking that strategy across the footprint. We've got a very comfortable liquidity position, our overall liquidity position, where we are with the loan-to-deposit ratio and the ability to fund future growth. And while I'm very comfortable with that, I think the industry is faced with some pressures there that if -- that -- I think we need to pay attention to. It's real. And while we're seeing a little bit of increase on the deposit funding side, I feel very comfortable about our ability to manage deposit costs. And hopefully, we can start seeing a little bit of lift on the loan yields side. It's a little hard to predict because of the competitive pressures, but I feel pretty good about where we are on NIM going forward. And Don, you probably got some comments as well.

Sure. I'll reiterate some of what Brian said, is that we are seeing some pressures competitively. I think especially from smaller banks that are -- have high loan-to-deposit ratio. So we're seeing that, but we are doing what we can to keep the deposits and making some pricing exceptions, that's causing part of it. We're -- again, we're looking for our deposit growth to improve over the next few quarters. And as a result, if that happens, then we will also need less borrowings, and borrowings are more expensive than our deposits. So that would also help the margin. At this time though, the yield curve, it actually kind of sagged a little bit kind of midyear and that kind of affected some of our midyear, I think, loan pricing for the last quarter. That picks up a little bit. It has over the last week or so. That can also help especially if we get the yield curve up in the 5-year term range, that can help, too. So obviously, some various dynamics going on there. But we're looking to either hold it or improve it as we get further into the year.

Our next question is from Matthew Clark with Piper Jaffray.

Just on the loan growth front, I know you had talked about 6% to 8% as your goal, probably coming in toward the high end of that range. But curious how the pipeline looks right now. And given all the kind of competitive dynamics, is that 6% to 8% still doable next year ex-Puget Sound, do you think?

Matt, it's Bryan McDonald. The pipeline at the -- commercial pipeline at the end of the third quarter was $312 million. That's down from $360 million at the end of the second quarter but up from $248 million this time last year. $312 million is a healthy pipeline going into the fourth quarter.

And I guess -- it's Brian Vance. I guess, maybe, Matthew, in terms of your comments about '18. As I said, we still feel very comfortable with the economic growth in the region. Nothing has changed in that regard. As I mentioned -- and this -- we're sounding like a broken record here, but it's reality. Our concentration management is a bit of a self-imposed regulator to our growth. We feel that's important from just fundamentally managing the risk in the portfolio. But I think that as we look to '18, I think we're still comfortable with the historical loan growth that we've been experiencing. You asked ex-Puget Sound, that would be my comment on ex-Puget Sound. But I think adding Puget Sound to the mix, I think gives us a bit of encouragement that we can develop some synergies there as we meld the 2 teams together and have what I believe will be a very strong platform in King County. And I think that could give us a bit of a tailwind in '18 as well. So overall, yes, I think we're still quite positive about the future growth opportunities.

Great. And then any update on the Portland initiative and attraction there so far?

Yes. Go ahead, Bryan.

Sure, Matt. It's Bryan McDonald, again. We have 8 FTE, new FTE that have joined since mid-May, and we've got another commercial banker who has accepted an employment offer, will start -- had given a notice and we'll start at the beginning of November, first part of November, and then we're continuing to recruit for a few additional positions in 2017 in terms of our milestones, in terms of loans and deposits. For competitive reasons, we're not sharing the details on that, similar to when we launched Seattle. But I will say, similar to Seattle, we are ahead of where we had hoped to be at this point. And again, we'll be adding to the extend we continue to hit our production goals.

Great. And then on -- you mentioned some additional expenses in the release. I guess, how do we feel about the run rate going to the fourth quarter on noninterest expense?

Matt, this is Don. I think the run rate is, if you take out the Puget Sound Bank merger cost that we've stated in the release, I think the run rate is probably pretty good, it's probably pretty close to that. So we feel pretty good about that. That may pop up a little bit, but I think the run rate overall is pretty good.

We'll go next to Jackie Bohlen with KBW.

Brian, I'm curious as to why you may consider Portland a deposit strategy and why lending wouldn't -- I mean, obviously, you'll be doing some lending in there, but why lending isn't part of that description?

Well, again, I'll give you a big picture, and Bryan can add in some more detail. It is not just exclusive, the deposit focus. We are -- have hired and will continue to hire lenders. But I think the team that we hired have several very accomplished deposit gatherers with, I think, proven capabilities in that market area of managing fairly complex deposit relationships over -- across a variety of industries. It was an opportunity that when we looked at, I will tell you that, that has not been a design focus on our organization to have specifically -- specific deposit gatherers. But as we look at the model, we really saw a lot of benefit there, not only with their proven ability in the Portland market, but taking that strength across the footprint. And not necessarily across the footprint, but I'll say in major economic areas that we do business in. And you couple that with what our belief has been on just general deposit flows and the need to continue to grow deposits. And my belief that a community bank's primary valuation premise is built on the deposit funding side. And so we will continue to strengthen that. So Bryan, you may have some additional thoughts as well.

Yes. I would just add that as Brian said, it's kind of a combination of the types of business that they're going after, tend to be deposit-rich, and then just a resource allocation in terms of hiring specific individuals to go after deposits. And in Portland, we're a little bit more balanced on our commercial team than how we are in some of our other offices. So certainly, we're going after full relationships. It's just with the niches and the mix of clients, a number of these are very, very deposit-rich.

Jackie, this is Jeff. The other thing that's very positive for us is not only is this new team a great cultural fit for us, they've been in that market for a long time, and they're helping us understand how that market works. And I think as a result of that, our supporting them has been able to enable them to do some really nice business pretty quickly.

Okay. And do you see that being additive to fees as well, Jeff?

Yes. Actually, yes, we do.

Okay. And probably slowly as it ramps up there?

Yes.

Okay. That's really great color. And then just one last one. The comments in the prepared remarks about switching the focus from indirect auto to HELOC, if you could just provide a few details as to any promotions you might be offering to achieve that if there are any and then also part of the thought process behind deciding to make that switch.

Yes, Jackie, we -- last year, 2016, we were kind of running a mid-20% growth rate in the indirect, and just in terms of managing the overall bank concentrations, no specific concern with indirect, just wanting to maintain balance between the different loan categories. So as we look to pull that back somewhat in 2017, we still wanted to grow the consumer mix, so we increased the focus on home equity, looking at that as a good option for us to balance out the overall growth. And we did run a campaign that started in the second quarter of 2017 and ran well into the third quarter. And as a result of that, had significant growth in our home equity business. It will be interesting to -- we've been watching the funding rate on that, on those lines that we closed through the summer, and are hoping for some additional dry activity through the fourth quarter.

You might speak to the general concessions, what we offered in that.

It's really a discount on the appraisal as the primary valuations, they're not always appraisals, but it's a discount of upfront costs, which is similar to what a number of our competitors do just to entice folks to move their home equity or to open a home equity with Heritage.

And next, we have a question from Tim Coffey with FIG Partners.

As the transaction with Puget Sound moves along, do you still maintain the same amount of deal cost that you -- I think we talked about when the deal's announced?

Yes, I think we would. Yes, I think we're comfortable with both the deal cost and the cost savings that were suggested when we announced the deal.

Okay. And then Brian, your comments on competition in the marketplace. Is that having any negative impact on the fallout ratio within the pipeline?

Tim, this is Bryan. I would say, the pipeline numbers that we're quoting are what we view as our 90-day pipeline. It ends up being extended longer than that in reality. And so most of those competitive deals often won't make the pipeline, so it impacts the calling activity outside the pipeline. I'll say mostly we do run into scenarios where we get close to closing and then get competitive pressure from whoever the incumbent bank is that the business is coming from. But that's always there, and I would say we've seen a material change on that front. But the market is competitive. There's lots of activity in the market, but it's also continued to be quite competitive.

Tim, I guess, I would just add to that. My comments -- in my prepared comments, I talked about aggressive competition. And I think that when we're talking about the aggressive competition on a deal, whether it'd be pricing, whether it'd be structure, those deals, as Bryan just indicated, typically, we don't even make it to our pipeline because we just quickly see that it just does not fit our parameters, and the deal is killed before it gets to the pipeline. I think once it gets to the pipeline, I think our pull-through rates are probably fairly consistent over the last several quarters. So it's not without competitive pressures, but I think we do a pretty good job of managing what goes in the pipeline and not putting deals in there that are not realistic either to fit in our credit culture or pricing or whatever the case might be.

Okay, that's helpful. And then just to kind of follow back up on the indirect portfolio. I understand that you are sort of balancing out the different components of the loan book. Has the credit quality that you've seen from the indirect portfolio held up to kind of what you expecting coming into the year?

Yes, really well, through 2016 and into '17, credit quality has been very good.

And very consistent. And I know that's an area that analysts are watching across the U.S., and we watch that very carefully as well. It's just the performance of the indirect portfolio, I'll go back even to the beginning of the merger, has performed consistently and substantially better than what I see portfolios across the U.S. performing.

And for us, Tim, it's always been highly employment-related. So strong employment, has a job, they're making the payments. If you have something that impacts employment, it usually shows up really quick in the past dues on that portfolio.

(Operator Instructions) And we'll go next to Tim O'Brien with Sandler O'Neill and Partners.

First question, just a follow-up. The comments you made about the close out of the pool and it was a $1.7 million in charge-offs that came that were kind of tied to that. Are there additional pools that are nearing, I guess, that same kind of accounting treatment? And do you see something like that or more of that occurring here, I don't know, in the fourth quarter or 2018?

Tim, this is Don. We don't necessarily see anything on the horizon. It doesn't mean it's not going to happen. I think we have 2 more pools where we have this potential situation, but one of the pools has numerous loans in it, so we don't see that happening. There is another one that has one loan in it, but the maturity isn't for a while, and so we're not expecting anything to happen there. So it doesn't mean that it won't prepay. I don't think they're quite as large as what we went through this time, but it is always something that kind of hits us all at once when that pool closes. But I think we just have a couple potential situations, but we don't foresee anything happening in the near future on those.

So do you have a pretty good sense of -- given the pool that has one loan remaining and has a longer maturity, do you have a pretty good sense also, say, that loan prepay here in the fourth quarter, of what the impact would be? Or is that an adjustment that you guys aren't capable of making just because of how arcane the accounting is around that at this point? Can you forward look on that a little, Don? Or is that -- are you -- whether or not you disclose those, but is that something that you're able to do?

Well, yes, we know the balance of the allowance within each of these pools, and I can't tell you off the top of my head the exact amount, but we are monitoring that internally. Yes, we are doing that. And so we're aware of what those amounts are. But there'll be allowances that could possibly reverse at least estimate at this point.

Is that something that would be worthwhile to disclose in your 10-K maybe for '17, to give an indication of remaining allowances and remaining pools or something like that just so investors can have a heads-up on where there might be some noise?

Well, Tim, I'll look into that. We'll consider that.

And then the other question is, is it always going to be an adjustment to -- was it an anomaly that the adjustment hit net charge-offs? Or based on the treatment that occurred for that one pool?

No, Tim. This happened once last year, I don't know if you remember that. I think we had $1.2 million charge-off last year related to -- in one quarter, I think it was Q2 of last year related to this. Like I said, some pools don't have an allowance related to them, so when the pool closes, there's no impact. But like I said, I think we have 2 pools left that do have some allowance on that, that we may -- this may impact it in the future.

And then shifting gears real quickly. What was the ending quarter balance of HELOCs? And how much growth did you put on in the quarter?

I don't think we have the balances. Don, do you have the balances for -- it's in the consumer number in the release. But the -- during the quarter, the total direct business was $27.9 million. And actually, if you compare it to 2016, our total direct lending is a little over $80 million year-to-date versus $51 million last year. Don is just pulling the number here, it's $90 million -- just over $94 million in outstanding HELOC balances as of the end of September.

And the rest is indirect auto by extension predominantly.

Yes. There is some other types of consumer loans in that number, but it would be predominantly indirect.

And so the HELOC production that you put on, do you happen to have a weighted average rate, that you guys, that, that's generating or throwing off right out of the gate?

We don't have that here with us.

Could you estimate it by the...

Yes. The rates run from kind of the prime plus a quarter range up to the prime plus 2 range. So it's a prime plus product.

And gentlemen, we have no one else in queue. Please go ahead with any closing remarks.

Well, I appreciate everyone calling in today, appreciate your interest in our company. And we may be seeing you down the road with investor conferences that may be coming up. But thanks for calling in today.

Thank you. And ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and for using AT&T Executive TeleConference. You may now disconnect.