Heritage Financial Corp (HFWA) 2017 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the fourth quarter and year-end 2017 earnings call. (Operator Instructions) And as a reminder, this conference is being recorded.

I'd now like to turn the conference over to CEO, Brian Vance. Please go ahead.

Thank you, Linda. Good morning. Welcome to all who have called in and also to those that may listen to this in a recorded mode later. Attending with me this morning is Don Hinson, our CFO; Jeff Deuel, President and Chief Operating Officer; and Bryan McDonald, Chief Lending Officer.

Our earnings press release went out this morning in a premarket release and hopefully you've had an opportunity to review that release prior to this call. And I would ask that you refer to the forward-looking statements in that particular release as we go through our comments this morning, especially during the Q&A session as well.

I'll start off with just some highlights of our fourth quarter and annual 2017 results. Diluted earnings per common share were $0.23 for Q4 '17 compared to $0.33 for Q4 '16 and $0.35 for linked-quarter Q3 '17. Diluted earnings per common share were $1.29 for the year ended December 31, '17, compared to $1.30 for the year ended December 31, '16.

Total loans, net, increased $50.9 million or 1.8% during the quarter. For the year 2017, net loans increased $207 million or about 7.9%.

Yesterday, the Board of Directors declared a regular cash dividend of $0.15, which is an increase of 15% from the $0.13 regular cash dividend declared in Q4 '17.

Don Hinson will now take a few minutes and go over our financial statement results. Don?

Thanks, Brian.

I'll start with the balance sheet. We had total asset growth of $60.2 million in Q4 and assets grew $231 million for all of 2017, which is a 6% increase over prior year-end.

In addition to the strong loan growth mentioned by Brian, total deposits grew $72.2 million in Q4, which outpaced our loan growth for the quarter resulting in slightly lowering our loan-to-deposit ratio to 84.0% from 84.2% at the prior quarter end.

Our credit quality remained stable in Q4. Nonperforming loans decreased to $10.7 million at December 31 from $11.0 million at September 30. The percentage of nonperforming loans to total loans decreased to 0.38% at December 31 from 0.39% at the end of Q3.

The ratio of our allowance for loan losses to nonperforming loans stands at a very healthy 300%.

In addition, included in the carrying value of the loans are $10.1 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 charge-offs of $652,000 in Q4 and $3.2 million for all of 2017. Of the $3.2 million charge-offs for the year, $1.7 million related to the closure of 2 purchased credit-impaired loan pools. These charge-offs were related to losses that had built up in the pools over the last 7 years, but were not recognized as a charge-off until the pool was closed.

Our net interest margin for Q4 was 4.02%. This is a 17 basis point increase from 3.85% in Q3 and was due primarily to an increase in discount accretion quarter-over-quarter. Discount accretion increased primarily due to $1.8 million of accretion related to 2 significant nonperforming purchased loans, which paid in full during Q4.

Pre-accretion net interest margin was 3.74% for Q4, which is unchanged from Q3. Pre-accretion loan yields decreased 2 basis points to 4.55% in Q4 from 4.57% in Q3.

New loans for Q4 were originated at a weighted average rate of 4.58%, an increase from 4.45% in Q3. The increase in rates on originated loans resulted in upward shift in yield curve from the prior quarter.

Cost of funds increased to 37 basis points in Q4 from 36 basis points in Q3. This increase was due primarily to increase in the cost of CDs.

Our cost of total deposits for Q4 was 20 basis points, which is unchanged from Q3.

Service charges increased $704,000 or 18% from Q4 of 2016, primarily due to deposit account restructuring, which we have previously discussed.

Other income increased from the prior quarter due mostly -- due to $682,000 in net gains on sale of former branch buildings.

Our noninterest expense for Q4 was $27.6 million, a decrease of $367,000 from Q3. Included in Q4 noninterest expense was $423,000 of merger-related expenses.

Merger-related expenses for the year 2017 was $810,000.

Total noninterest expense to average assets improved to 2.66% in Q4 from 2.76% in Q3 and from 2.78% in Q4 2016 and improved from 2.84% for the year 2016 to 2.78% for the year 2017, which is the lowest this ratio has been in any year since the company went public in 1998.

Our income tax expense increased in Q4 due primarily to the estimated revaluation of the net deferred tax assets in the amount of $5.6 million, which accrued to $0.19 per share. It should be noted that while we believe that this amount is a reasonable estimate of the impact of the new federal tax legislation, this estimate could be adjusted during the measurement period, which ends in December of 2018.

Bryan McDonald will now have update on loan production.

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

In the fourth quarter, commercial teams closed $161.2 million of new loans, which is down from $216.6 million closed in the third quarter of 2017 and up from $153 million closed in the fourth quarter of 2016.

Commercial team pipelines ended up the fourth quarter at $342.5 million, which is up from $312 million at the end of the third quarter and $296.5 million in the fourth quarter 2016.

Line utilization was 34.4% at the end of the fourth quarter, which is down from 36.1% last quarter and 35.6% at the end of 2016.

The average fourth quarter interest rate from new commercial loans was 4.57% during the fourth quarter. And as Don mentioned, the average fourth quarter interest rates for total loans was 4.58%.

Moving on to our SBA area. 7(a) production in the fourth quarter totaled 7 loans for $2.39 million and the pipeline ended the quarter at $11.1 million. This compares to the third quarter of 2017 when we closed 8 loans for $6.1 million and the pipeline added in $14.4 million.

Consumer production during the fourth quarter was $51 million, down from $60.7 million in the third quarter of 2017, but up from $43.7 million in the fourth quarter of 2016. The decline in volume quarter-over-quarter was due to a HELOC campaign that drove higher volume during the third quarter. For the full year, new consumer volume was up 14.8% compared to 2016.

The mortgage department closed $35.9 million in new loans during the fourth quarter compared to $39.8 million of new loans in the third quarter and $53.9 million in the fourth quarter of 2016. The mortgage pipeline ended the fourth quarter at $27.3 million, down from $29.1 million last quarter and $34.3 million in the fourth quarter of 2016. The current pipeline is comprised of 48% refinanced loans, 17% purchased loans and 35% construction loans. This compares to last quarter's pipeline where refinanced business averaged 43%.

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 Q4 was 56.5%, which is over our guided 35% to 40% payout ratio due the impact of the DTA reevaluation that occurred at year-end. For the year 2017, our regular payout ratio was 39.5 and with $0.10 special dividend we paid in Q4, total payout ratio was 47.3% for 2017.

As we noted earlier, we increased our regular dividend from $0.13 to $0.15, which is a 15% increase.

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

I'll close just with some general observations. We continue to have optimism about the Pacific Northwest economy. We believe our 2018 loan growth will be similar to what it was in 2017.

We are pleased with the pace and the progress of our Puget Sound Bank integration. As a reminder, we closed this transaction on January 16 and plan for conversion in early May.

We are excited to have Jim Mitchell, former CEO, managing our now combined King County growth strategies for Seattle and Bellevue. We also want, again, to welcome our new Puget Sound Bank folks to the team and looking forward to their contributions to our continuing King County successes.

When the issued shares for Puget Sound Bank acquisitions are recorded on Nasdaq soon, our reported market cap should be over $1 billion for the first time in our history.

We are particularly pleased with our expense management in Q4 and for the year, and as Don mentioned earlier, our overhead ratio for Q4 was 2.66%, our lowest performance in recent history. Additionally, our efficiency ratio dropped below 60% at $0.597 also for the first time in recent history.

We are anticipating our overhead ratio will rise in the first half of 2018 due the merger-related and infrastructure expenses, but we also expect to work back to current levels by end of year 2018.

While our loan-to-deposit ratio held steady from Q3 to Q4 at about 84%, we continue to believe the retention and growth of high-quality core deposits will be a critical strategy for us and most banks going forward. We will continue to emphasize and focus on deposit growth strategies to maintain our strong liquidity position.

We continue to expect M&A activity in banks less than $1 billion in assets, and we remain active and interested in additional M&A.

I would welcome any questions you may have and once again refer you to our forward-looking statements in our press release as I answer any of the questions dealing with forward-looking comments. Linda, we'll turn the call back to be opened for questions.

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

Wanted to talk about the deposit success a little bit and hoping to get a little color on the Portland market and the team that you have there. And I think it was indicated that there you've got maybe a better -- or not a better, but certainly a deposit focus with that team. What was the makeup of the -- if you have the deposit increase by geography, if possible?

Yes, and then -- and I'll just provide a few overview comments and ask Bryan to maybe fill in a little detail. We've talked about our Portland team the last few calls and this is both a loan- and deposit-generating team. But I think one of the particular highlights of this team is their focused on high-quality core deposits and they've certainly been successful in that regard. We're a little hesitant to give a lot of specific color, Jeff, for competitive reasons. I will tell you that it continues to exceed our expectations. And I think you can see some of that reflected in our overall deposit growth during the quarter. But maybe ask Bryan to provide some additional comments.

Sure. Jeff, we did see broad-based success with deposits and very strong deposit growth in Portland included in that. Maybe just a few comments on the Portland team. We did add an additional 4 production folks since the end of the third quarter. A couple of those joined the first couple days of 2018, but we're now up to 11 on the production team including 2 support positions. And in general, for Portland, we set a plan out in the middle of 2018 (sic) [2017] when we launched that effort and we're exceeding our original expectations when we put that plan in place.

Jeff, sorry, we can't give you additional specific color on that and hope you appreciate the competitive issues there.

Sure. No, that's good color. And then just on the loan side, on the C&I balances being down, it sounds like lower line utilization. But any thoughts on -- is there some seasonality or anything going -- I mean, the overall growth is solid and I think you entered the quarter with a lower pipeline than you had the previous quarter and put up a decent number. But maybe just a comment on the C&I outlook maybe for the balance of the year.

Sure, Jeff. This is Bryan, again. We did look closely at that. It was about $20 million drop in outstanding balances. And of that total, about $12 million was ag related and then the residual was paydowns on lines and we continue to have some customers that have significant liquidity and are just using that additional working capital to reduce debt. So we did study that. Just -- again, didn't see anything out of the ordinary there, just higher liquidity driving that. The pipeline was up quarter-over-quarter. I mentioned the $342 million coming into 2018, that's up over where we ended last quarter so we had some growth there. And on top of what we reported, if you add the Puget Sound Bank team's pipeline in there, then you would add another $40 million. It takes it over $380 million, so we're entering Q1 with a really strong pipeline.

And maybe one last one. Don, just the tax rate expected in '18 effective?

Yes, so as I have previously mentioned, the total rate cuts, corporate tax rate cut, went from 35.21% that the management went forward because we were already at around 26% before that. It wasn't going to drop the all 14 basis points. We're expecting it to drop probably about 11 basis points going forward. So it'd be more the 15% effective tax rate going forward.

Next, we'll go to the line of Jackie Bohlen with KBW.

Brian, looking to the dividend increase that took place in the quarter, would you categorize that more as based on the strength you had in 2017? Or is it a reflection of the lower tax rate you expect going forward?

Jackie, I think it's probably both. Certainly reflecting on what I believe was a good solid quarter, and I would say even a good solid year, that was reflected in that increase. But I think also a nod towards the tax decrease as well.

Okay. And would the board potentially, as you get into 2018 and you see the impacts of the tax rate, would you potentially look to increase that dividend once again just as you manage your payout ratio?

We look at that, as you would suspect, Jackie, every quarter. And we have a pretty active capital plan process at the board level and considering, I think a variety of things, certainly ongoing profitability growth in the company, I think our capital levels as it pertains to supporting growth, whether it be organic or M&A, so there's a lot of things that fit into it. I think the short answer is, yes, we would consider it, but we would consider a lot of other things. So there's opposing forces here that we've got to factor into it. But I guess, rest assured that there's pretty active capital management process at the board level on a quarterly basis.

Okay. Definitely understood. And then a question on CD cost, just having watched them move up this year and understanding that they've had a very limited impact on your overall deposit costs, which have remained quite low. Is that increase that you've been receiving? Or have you been proactively trying to lock in some money at those rates?

Jackie, this is Don. So we had -- we went through some CD specials just to kind of -- in the past few years, we've seen our CD balances decline some. And so we did have some more specials this year as far as just holding on to kind of the balances, as they were, on the CD side. In addition, periodically, we do make rate exceptions as we feel needed. But again, it's a -- we've seen that. I don't know if it'll happen again this year, we'll see quite the increase in '18 we saw in '17, but we did make a more concerted effort in 2017 to maintain our CD balances.

Okay. And what kind of -- I guess, are you receiving an influx of inquiries? Or has been any change with the depositor behaviors since the December rate increase?

I don't think we've noticed a whole lot on the deposit side as far as a lot -- nothing more than we have before the rate increase really. But it's been-- hasn't been that long also. It's only been about a month. So we haven't received that much more than we were seeing before the rate increase.

Okay. So at this point in time, just given where we are, we haven't really hit that tipping point where people are taking notice of rate increases from a deposit standpoint?

And I'd invite the team to give their color to this as well. I think depositors are seeing interest rates increase -- rise. I think they're taking note of that. I don't think that we're seeing a lot of pressure yet. I think that part of this is going to be on the competitive side in terms of what we see, the competitive landscape in this particular region. From my perspective, I don't see -- there's a few one-offs out there, but I think it's pretty limited and I just don't see much happening there. Does the team see anything different there?

I think that's true, Jackie. Most of the regional players remain pretty consistent on the deposit pricing, and we haven't seen much change there. As Brian said, there's a few outliers that maybe have a more of a funding need and are being more aggressive. But that's kind of a onesie-twosie rather than the overall market shifting.

Next, we move to the line of Tim O'Brien with Sandler O'Neill Partners.

One question I have is it's been quite some time since you guys published or gave color on sensitivity profile of your balance sheet. Could you give a little -- could you share a little bit of color here at the year-end maybe to reflect on what changes you've tried to make or accomplish to prepare yourself for potential rising rates here over the course of this past year?

Tim, I'll give a little overview and Don can give you additional color. I guess, we can look at the overall sensitivity of the balance sheet. I know there are lots of discussions in the banking world about deposit betas, and that's real. I think the reality of it is we've seen -- is it 3 or 4 increases in the last 12 months now? 3? I can't recall now. But our cost of funds has stayed pretty steady. And I think that if you look at models, that might suggest that maybe a cost of funds would move a little more than they have because of the rate increases. So I think it gets to competitive pressures. I think it gets to a lot of different things. But I think that we've demonstrated the ability to manage interest rate sensitivity maybe on an organic basis as opposed to what the actual models might suggest on sensitivity if that makes any sense, but I'd ask Don to add to that as well.

Yes. Tim, I think that we continue to show, again, I think more asset-sensitive than we were maybe a year ago when we probably published this in the last K. By the way, it will be out -- we will publish it -- the information in our 10-K, which would be out now by the end of February. So it's not too far off you'll have that information. But I think we are -- if you look at last year's, think we're more asset-sensitive than when we were last year and I think we are positively asset-sensitive, but not -- again, we've always kept kind of a neutral balance sheet in that way, but I would say that we're going to improve -- I expect our margin to improve this year as rates improve or increase. So that's, I guess, what I can give you on that.

I guess, one other question for you -- just a follow-up on to that, Don, then is over the course of the past year, has the proportion of your funded loan that are variable rate tied to prime, say, has that increased? Have you guys been able to grow that relative to fixed-rate loans or loans that have a fixed rate component in the past year?

I don't think we've increased it a lot this past year. I think more of it was done in 2016. I think that Puget Sound Bank coming on will help our asset sensitivity, and in fact, they have, I think, more prime-based loans than we had although, it can be obviously, have much smaller percentage of our overall loan portfolio. But I think that merger will also help us be more asset-sensitive. But overall, I think we're maintaining that piece of it. We are always looking out and saying even more, maybe more so on the investment portfolio, in the last year we probably added more variable rate than before. We continue to add to our notional amounts of our swap product that is LIBOR. But I think, again, the increases were more in '16 than they were in '17, but we do continue to add to that.

And then last question for you, Don. I thought I caught -- you'd mentioned to Jeff that effective tax rate by your calculation coming out of this, the new tax law, with the DTA adjustment and everything, 15%, did you say?

For 2018, I'm estimating it to be around 15%.

And that -- and the reason that's below the federal rate is because of tax strategies that you guys have in place?

Correct. Just like we were -- the federal tax rate was 35% and our effective tax rate was 26% before so...

So the way the law was written, those strategies are still somewhat effective?

Correct.

Meaningfully effective.

Yes.

Next, we'll go to the line of Matthew Clark with Piper Jaffray.

On the overhead ratio, the outlook you provided sounds like that includes merger charges. Can you maybe quantify what the merger charges -- or maybe you can speak to what that ratio might look like if you striped out the kind of nonrecurring stuff?

Well, I think -- this is Don, Matthew. I think that we've mentioned a couple of things here. We have merger charges, we also have talked about some infrastructure at Puget. I would say merger charges over the next couple of quarters mostly loaded in Q1 will be around $5 million to the Puget Sound Bank merger. So I guess I'll let you maybe back into the overhead ratio, but we have some things we're working on. But again, as Brian mentioned, that we expected to be back down to Q4 levels by the end of Q4 of '18.

Got it. Okay, great. And then just on the margin, obviously a little volatility in the accretion this quarter. I assume that would normalize going forward. But also thinking about PCBK coming online with that related accretion and their margin profile relative to yours. Also thinking about the impact on taxable-equivalent investments with the lower tax rate and what that does to reset your margin. Can you just maybe kind of walk through some of those issues on the core and reported margins?

Yes, again, we don't show tax-equivalent margins, so we won't -- what we show won't be affected by the -- any taxes that are tied to loans or securities. Talking about the Puget Sound Bank, I think you mentioned, I think, again, they're a little more asset-sensitive. And I'm sorry, Matthew, I can't remember what the first...

Yes, sorry. The Puget Sound deal -- excuse me. And also the -- on the -- just on the core, it sounded like you expect a little lift in the core with being a little bit maybe asset-sensitive and the benefit from rising rates here. I guess, that's still a fair assumption for some gradual improvement?

Yes, I would expect that.

Next, we'll go to the line of Tim Coffey with FIG Partners.

Brian, can you talk a little bit about the success that Puget's been having? Because I think the pipeline looks strong. Obviously, the loan balance you supplied in the press release were much bigger than the balances at announcement. So can you kind of talk about what's going on there? And have your thoughts changed on that performance of the company here?

Yes. Tim, this is Bryan McDonald. The bank has continued to take an offensive approach and been active in the market. You can see that in their pipeline going into the first quarter. I don't have their numbers in front of me here, but they certainly continue to perform well through the rest of 2017. So we're very optimistic the combination of Puget Sound and our teams in Bellevue and Seattle who had an excellent year last year as well. So again, we're optimistic based on the quality of the people and where we sit today going into '18.

Tim, this is Jeff. I think I would add to what Bryan was -- is saying is that now that we've gotten past the change of control date, a lot of the planning process around that is done and there's a full focus on the market now. So we're optimistic that the teams are going to work well together under Jim's leadership.

And perhaps could I read into it that your expectations for loan growth for '18 to be somewhat similar to '17 is a bit conservative?

Well, there's a lot of factors, I guess, that go into that comment. We have previously or historically guided 6% to 8%, and what was our growth, 7.9? Yes, 7.9%. So it's -- I guess, you could read into that, that's conservative. I'll let you read into that what you would like. At the same time, Tim, I think that the synergies that we believe that we would create as a result of putting the 2 banks together, we continue to see those synergies, we continue to be very positive about it. It's kind of hard to predict, I think, actual market forces as we get into this, but from our point of view, we are not any less optimistic about the opportunities today than when we put the 2 banks together.

Okay. And what other items need to be done or completed to integrate the banks?

So we have conversion schedules for May. That's the primary focus right now for the entire combined bank to make sure that we do that in an orderly fashion. But that's the next big step.

There are no further questions at this time.

Well, I appreciate everyone joining in on our call. Look forward to seeing many of you with investor conferences that are coming up soon and as we move through the year. Thanks for joining us today.

Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may now disconnect.