Heritage Financial Corp (HFWA) 2018 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) As a reminder, this conference is being recorded.

I'd now like to turn the conference over to President of Heritage Financial, Jeff Deuel. Please go ahead.

Thanks, David. Good morning, and welcome to all who have called in and those who may listen later. This is Jeff Deuel, President of Heritage Financial and CEO of Heritage Bank. Presenting with me are Brian Vance, CEO of Heritage Financial; Don Hinson, CFO; and Bryan McDonald, Chief Operating Officer.

Our earnings press release went out this morning in a premarket release, and hopefully, you all had an opportunity to review that release prior to this call. Please refer to the forward-looking statements in the recent release.

It has been a good quarter for us, as we continue to make progress with the integration of Puget Sound Bank, and we prepare for the upcoming conversion of Premier Commercial Bank in early November. We are pleased with our core operating metrics. We are pleased that our core operating metrics continue to show nice improvement from prior quarters. We're also pleased to announce we're increasing our regular dividend to $0.17, which is an increase of 13.3% from the 15% (sic) [$0.15] dividend in the prior quarter and that we have declared a special dividend of $0.10 per share.

Don Hinson will now take a few minutes to cover our financial statement results, including color on our core operating metrics.

Thanks, Jeff. We saw a continued improvement in core operating metrics in Q3, for both linked quarter Q2 2018 and from prior year third quarter 2017. Reported earnings per share for Q3 was $0.42, which is an increase of $0.07 from $0.35 for both the prior year Q3 2017 and the linked quarter Q2 2018. Q3 2018 earnings were negatively impacted by $0.07 due to $3.4 million of acquisition-related expenses from the Puget Sound and Premier mergers, which after taxes, had an income impact of $2.7 million.

Adjusting for the net income impact of these expenses would bring our Q3 EPS to $0.49 compared to reported earnings per share of $0.42. In addition, adjusting for the $2.7 million net income impact of these expenses would bring our return on average assets to 1.37% versus a reported 1.17% and our return on average tangible common equity to 14.48% (sic) [14.98%] versus a reported 12.77%.

Moving on to the balance sheet, we had total asset growth of $487 million in Q3. We acquired assets with a fair value of $387 million during the quarter as a result of the Premier merger, which closed on July 2. Net of the $330 million of loans obtained in the Premier merger, loans decreased $9.8 million in Q3. We continue to experience unusually high loan prepayments, and Bryan McDonald will further discuss prepayments and loan production in a few minutes.

Net of the $319 million of deposits obtained in the Premier merger, deposits grew $110 million or 11% on an annualized basis in Q3. Removing the day 1 impact of the Premier merger, noninterest-bearing demand deposits grew $52.9 million or 18.1% on an annualized basis. And overall, non-maturity deposits grew $122 million or 13.9% on an annualized basis. Noninterest-bearing demand deposits increased to 29.8% of total deposits at the end of Q3 compared to 29.2% of total deposits at the end of Q2.

Nonperforming loans decreased to $14.8 million at September 30 from $16.5 million at June 30. The percentage of nonperforming loans to total loans decreased to 0.41% at September 30 from 0.50% at June 30. The decrease in nonperforming loans was due primarily to one agricultural loan relationship that paid off during the quarter.

Our ratio -- the ratio of our allowance for loan losses to total nonperforming loans stands at a very healthy 233%. In addition, included in the carrying value of the loans are $13.4 million of purchase accounting fair value net discounts, which may reduce the needs of an allowance for loan losses on those related purchased loans.

Net charge-offs decreased to $562,000 in Q3 from $1.0 million in Q2. The decrease in net charge-offs compared to the linked quarter was due primarily to lower C&I loan charge-offs. The majority of the charge-offs recorded in Q3 related to smaller charge-off balances.

Potential problem loans increased $4.3 million during Q3, primarily due to the $10.1 million of potential problem loans acquired in the Premier merger. OREO balances increased $1.6 million in Q3 due to the $1.8 million of OREO acquired in the Premier merger.

Our net interest margin for Q3 was 4.41%. This is a 19 basis point increase from Q2 2018 and a 55 basis point increase from Q3 2017. Our pre-accretion net interest margin was 4.18% for Q3, an increase from 4.03% in Q2 and 3.75% in Q3 2017. Pre-accretion loan yield was 5.01% in Q3, a 20 basis point increase from Q2 and a 44 basis point increase from Q3 2017.

New loans for Q3 were originated with a weighted average -- at a weighted average rate of 5.49%, an increase from 5.18% in Q2 and from 4.45% in Q3 2017.

Accretion income was higher in Q3, primarily due to the impact from the Premier merger, which occurred at the beginning of Q3.

Cost of funds for Q3 was 44 basis points, which is an increase from 41 basis points in Q2 and from 36 basis points in Q3 2017. This increase from Q2 was somewhat mitigated by a decrease in the use of higher-costing FHLB advances as a funding source in Q3 as well as strong non-maturity deposit growth.

Our cost of total deposits for Q3 increased to 27 basis points compared to 23 basis points in Q2 and 20 basis points in Q3 2017.

Overall, we are pleased with our continued net interest margin expansion. The combination of our floating rate assets, the higher rates on new loan production and investment purchases and our low-cost deposits has resulted in an increase in our pre-accretion net interest margin of 43 basis points from Q3 2017 to Q3 2018.

Noninterest income increased to $8.1 million in Q3 from $7.6 million in Q2. This increase was due mostly to a $382,000 gain on the sale of a former branch building realized in Q3.

Noninterest expense for Q3 increased to $39.6 million from $35.7 million in Q2. The increase was due to expenses related to the Premier merger, both operating expenses and acquisition-related expenses. As previously mentioned, included in Q3 2018 non-interest expense was $3.4 million of acquisition-related expenses. In addition, due to the recent mergers, the amortization of our core deposit intangible assets has grown to $1.1 million in Q3. Adjusting for the combined $4.5 million impact of acquisition-related expenses and amortization of intangible assets in Q3, noninterest expense to average assets was 2.64% versus a reported 2.98%, and the efficiency ratio was 59.28% versus a reported 66.91%.

Our tangible common equity ratio was a solid 9.6% at September 30, up slightly from 9.5% of the end of Q2. Our regular dividend payout ratio for Q3 was 36%, which is within our guided 35% to 40% payout ratio. However, the payout ratio would have been lower in Q3 without the severance impact from the acquisition-related expenses.

Due to our increased earnings and capital position, as Jeff mentioned, we are increasing our Q4 regular dividend to $0.17 per share from $0.15 in the prior quarter and also declaring a $0.10 special dividend to be paid in November. 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.

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

Thanks, Don. It's Jeff again. I just wanted to interject that Don misspoke earlier when he was presenting the earnings overview, that return on average tangible common equity would adjust to 4.98% (sic) [14.98%] as opposed to the 4 point...

14.

I'm sorry, that's 14.98% as opposed to 14.48% that Don mentioned. And I should say it's usually Don who's correcting me. So thank you. I'll pass it to you now, Don (sic) [Bryan McDonald.]

Okay. Thank you. Again, this is Bryan McDonald. I'm going to give an update on our third quarter lending results by production area, starting with our commercial lending group.

In the third quarter, our commercial teams closed $196 million of new loans, which is down slightly from $199.8 million closed in the second quarter of 2018 and up from $159 million closed in the third quarter of 2017.

Commercial team pipelines ended the third quarter at $335 million, which is down from $430 million last quarter and up from $312 million in the third quarter of 2017. Demand for construction and real estate loans remains oversized in the market relative to other loan categories, and we continue to manage real estate loan levels to stay within our self-imposed concentration limits.

Pricing continues to be very aggressive across all loan types. And during the third quarter, we saw more instances of aggressive loan structures being offered in the market, particularly on commercial credit.

Net loans decreased $9.8 million during the third quarter due to an elevated level of prepayment and payoff activity. Loan payoffs and prepayments during the quarter totaled $167 million, which is $57 million or 52% higher than the prior 6-quarter average. Similar to last quarter, payoff and prepayment activity was elevated by a higher level of business and real estate sales, customers using cash to pay off debt, along with several clients paying off loans after we elected not to offer renewal terms at maturity.

Average third quarter interest rate for new commercial loans was 23 basis points higher, increasing to 5.43% versus 5.20% last quarter. And rates were up 26% from the last year or 113 basis points from 4.3% in the third quarter of 2017. In addition, as Don mentioned, the average third quarter rate for total loans was 5.49%.

SBA 7(a) production in the third quarter included 15 loans for $7.5 million, and the pipeline ended the quarter at $20.6 million. This compares to the third quarter of 2017 when we closed 8 loans for $2.08 million, and the pipeline ended the quarter at $14.8 million.

Consumer production during the second quarter was $49.7 million, down from $55.9 million in the second quarter of 2018 and $60.7 million in the third quarter of 2017. We saw strong direct consumer loan demand, with volumes up 22% quarter-over-quarter, but this was more than offset by a 25% decline in our indirect lending business.

The mortgage department closed $44.4 million of new loans in the third quarter of 2018 compared to $38.1 million of new loans in the second quarter of 2018 and $39.8 million in the third quarter of 2017. The mortgage pipeline ended the quarter at $41 million, down from $47 million last quarter and up from $29.1 million in the third quarter of 2017.

I'll now turn the call back to Jeff.

Thank you, Bryan. I just wanted to cover a few general observations. We continue to be comfortable with the overall Pacific Northwest economy. Valuations are stable for CRE and single family. However, competition continues to be strong in all loan segments.

In spite of the positive economic environment in the region, we continue to be cautious about all loan segments, relying on our robust concentration management process to provide guidance. Currently, our nonowner-occupied CRE concentrations are around 260% compared to regulatory guidance of 300%. This provides us with flexibility while we continue to be disciplined in this area, focusing more on loan quality and yield.

Our overall loan growth in Q3 was buoyed by the addition of Premier. Our organic loan growth was flat quarter-to-quarter due to higher-than-normal payoffs as customers sold businesses, properties and paid off loans with idle cash, which mutes the good work done by our production teams. I think it's important to note that our risk profile also controls our loan growth.

In contrast to the flat loan growth, our ability to manage NIM is contributing to our positive performance overall. And although we have seen a higher-than-normal level of payoffs, the new loans we have originated are booked at higher rates.

Also, now that we've passed -- we are past the distraction of the Puget Sound Bank conversion, which occurred in May, we can see that team contributing in a significant way. The Premier conversion is just around the corner in early November, and we believe we are teed up for another good conversion, thanks to the hard work of our project team. Once that is behind us, we expect to see that team -- the Premier team start to contribute to the pipeline in a bigger way, much like we saw with the Bellevue team. We are happy to see the benefits of our larger scale following the integration of both acquisitions.

We continue to benefit from the flexibility provided by our quality deposit composition. While the cost of deposits is up slightly quarter-over-quarter, the betas are relatively low, and the loan-to-deposit ratio is holding steady in the low 80s range, which provides us with the flexibility to optimize pricing while managing the balance sheet. We continue to focus on maintaining and growing our deposits across the footprint, and we are pleased to see healthy deposit growth from the last quarter, while non-maturity deposits as a percentage of total deposits remained steady quarter-to-quarter. After adjusting for onetime expenses, we are seeing a positive trend in the overhead ratio, and we expect that number to continue to trend down.

During Q3, we increased our total branch count from 59 to 64 locations with the Premier merger, net of closing one legacy Heritage branch. The additional branches from Premier help to enhance our presence in the Portland metro area, where we now have 9 locations on a combined basis and over $800 million of loans and deposits.

As Don noted, credit quality remains quite good. We continue to manage our capital position to support risk in our balance sheet and planned organic growth as well as positioning the bank so we can respond to M&A opportunities when they present themselves.

I'll now turn it over to Brian Vance for some closing comments.

Thanks, Jeff. Just some overall observations from my point of view. I'm happy with the positive progress we have made in the third quarter, and I'm pleased to see here this benefit from the larger scale of the combined organization. We believe the benefit of scale will continue to accelerate after the Premier conversion.

We believe our continuing and historical high prepayment activities signal, in part, a natural occurrence of this economic cycle where folks are selling assets and taking profits. We have considerable evidence of loans paying off as a result of assets and businesses selling. We also have substantial anecdotal evidence from our branches, indicating some deposit growth is attributed to homes, commercial real estate and businesses selling and large deposits being made as a result.

We also believe our NIM expansion, in part, is due to our unwillingness to be a low-cost provider in the form of rate competition. As many banks have recently struggled to get loan growth, we are finding renewed activity of highly competitive rate pricing of new loans.

Our loan growth has also been impacted, in part, by competitive and aggressive underwriting considerations. We believe that, again, at this point in the economic cycle, that underwriting discipline is critically important to future credit quality and financial performance. And as rates continue to increase, the quality of our overall deposit base and relative lack of leverage in our balance sheet will continue to favorably impact our deposit betas. We remain committed to maintaining a liquid balance sheet.

And finally, it is pleasing to see the improving trends in ROA, EPS, ROE and our overhead ratio. These metrics signal to me the leadership team is continuing to effectively manage the bank while we expand our footprint and grow the bank.

David, we'll turn the call back to you and welcome any questions we -- you may have. And once again, we'd refer you to our forward-looking statements in our press release as we answer the questions and dealing with any forward-looking comments.

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

A question on the prepayment front. Just I get sort of the impression that this came on later in the quarter. In discussions, it seemed like payoff activity was sort of at bay relative to 2Q, I guess, through -- midway through the third quarter. Is that -- with the average balances kind of skewed with the deal, is that payoff activity more -- heavier on the back end of the quarter?

Jeff, this is Bryan. No, we had elevated payoff activity in the second quarter, and that continued into the third and all the way through the third. We were hoping it might abate as we got towards the tail end, but didn't see that happen. So it was pretty consistent throughout the quarter. Of course, payoffs are choppy anyway. Just -- obviously, they're a regular occurrence, but the size of the underlying loans do drive some variability. But the activity itself was consistent through the quarter.

And the comments on the kind of the thawing distraction through, I guess, the Puget Sound folks, you saw that immediate ramp throughout 2 to 3 quarters or months after the close. Is that kind of timing consistent with what you're expecting kind of in Q4?

Jeff, it's Jeff Deuel. We've never -- we didn't see the Puget Sound team stop completely. We did see them slow down on their production because they were focused on retaining the customers that we had. But once the conversion occurred, we started to see a more full focus on the production side. I still think they're barely getting to 100%, but they're moving quickly at this point. A fun fact is if you look at the production numbers for the top 20 producers in Heritage Bank, 8 of them are in that office. So we're seeing some really good results there.

And one other one. Just on the -- just looking for some expense detail, and maybe it's for Don or anyone, I guess. Post-conversion, I guess if you look at $39.6 million in expenses less the merger costs, puts you in the low 36 range. Through conversion kind of I don't know if you could broadly walk us through what you expect in Q4 and then in '19.

Well, I think as Jeff mentioned in his comments, and that we continue to -- I'll talk here from the overhead ratio, which is noninterest expense over average assets, that we continue to look to lower that on an ongoing basis. So we -- again, when I talk about backing out the impacts of the merger-related expenses and backing out the CDI amortization, that we were at 2.64%. And so we'll just continue to look to improve upon that. Always, I would say, that's a long-term trend. We always have -- Q1 is always a little bit of a blip up, but the overall year-over-year and ongoing trend to improve upon that. So I guess that's how I'd answer that, is that ratio I expect to continue to improve.

Okay. Obviously, that pulls in another variable on your asset growth, I suppose. But in other words, if you kind of -- if we back into the core this quarter, outside of your comments about Q1 always a step-up, that's a pretty solid figure going forward assuming reasonable growth?

Yes.

And next question will come from the line of Matthew Clark with Piper Jaffray.

Maybe just to pin you down a little bit more, Don, I think last quarter, you spoke about trying to achieve that 2.65% to 2.70% range for the overhead ratio by the end of the year. Clearly in line with that. But I guess as you look out to next years, I think we've talked about in the past maybe sub-2.60% in 2019 and maybe better beyond. I mean, how should we think about that progression? What's your commentary around kind of continued improvement?

Well, again, I think that some of the previous comments I've made didn't kind of back out the impact of the amortization. So I think going forward, I'll probably talk more about that because it's kind of one of those costs that aren't really controllable. So I would say, again, this year, I'm looking at Q4, you could do -- that's probably the low 2.60s, and next year, that will bring us for the year probably in the 2.70% range or between 2.65% and 2.70%. And again, each year, the whole idea here is to continue to improve upon every year, whether it's the quarters year-over-year or move forward. But again, there can be blips in a quarter. Like I mentioned, a Q1 can always -- it's always more costly. But overall, there's continued improvement, and yes, hopefully, it will be down to -- by end of next year, down to 2.50s. So that's the progression we're looking at.

And again, that's excluding now amortization?

Correct.

Got it, okay. All right, and then just about the payoff activity, I guess how much did, if at all, prepayment penalty income contribute to the margin this quarter versus last?

Matt, Don's looking, but we follow each one of the payoffs. Anything over $500,000, we get comments back from the banker and actually see the payoffs, and there wasn't significant prepayment impact. Don, I don't know if you have the number on that handy.

I don't think it was really material, Matt, from that.

Okay, just doublechecking. And then just on the full year loan growth guidance or maybe just the 6% to 8% kind of targeted range that you guys look to do, obviously, flattish to down this quarter organically. I guess based on pipeline being down and, I guess, your outlook for kind of the -- Premier stepping up here eventually, I guess, how do you think about that range of growth going forward, whether it's the fourth quarter or into next year?

Matt, we've talked historically about 6% to 8% growth. Obviously, that's not occurring when you look at the whole year. Based on what we've seen in the second quarter and the third quarter with payoffs, we don't see that abating. We would like to hope that it will. It's just -- it's not necessarily something we can control because it's not necessarily related to customer service, for example, or a net need on the part of our customers. They're making these decisions on their own. So that we would -- right now, we're expecting the loan growth to continue to be as it has been the last couple of quarters, relatively flat. So we're probably well below the 6% to 8%. Don, you may want to add to that, in terms of expectations for next year for loan growth.

Yes. I know that the -- we're, at the -- again, we're below that. And so maybe trailing 12 quarters are down around 5% or below that. So it's going to be probably -- for this year, it's going to be tough to hit that.

I think, Matt, to give you guidance for next year, I think we need to see how the rest of the quarter goes.

Next question comes from the line of Jackie Bohlen with KBW.

Don, do you have the breakout between call it comp, professional fees and then data processing in terms of the acquisition expenses in the quarter? I'm just trying to see the core run rates of those.

Yes. The -- most of it was in compensation. And so we didn't have that much -- well, actually we did. We did have about $1 million of professional fees in Q3 was part of that. So the rest of it was comp and data processing.

Okay, that's helpful. And were any cost savings realized in the quarter? Or are most of those waiting until the conversion?

For Premier, most of that will happen after Q4.

Okay, okay. And then just lastly, and I mean, I guess the special dividend kind of almost answers this question. But just how you're thinking about capital management. I know you have an authorization now for buybacks, and there's market volatility and everything and potential M&A. If we could just have an update on how you think about dividend versus buyback versus M&A.

Jackie, this is Brian. I think that when we -- if you look back to the start of the year, and we've done 2 acquisitions, and we've grown the bank over the -- on a year-to-year basis by some billion dollars in assets combined, I think I would have told you that I would be surprised that our capital has actually grown now as a result of working through that growth and those acquisitions. Now obviously, we were issuing stock as a part of that. But my point is that I think that we're beginning to generate some pretty nice internally generated capital, and that's showing with -- that's showing through the actual TCA -- TCE growth. So I think that as we continue to look to 2019, and I think at this point, we like the progression of most all of our operating metrics, whether they're ROA, ROE, expense control, et cetera, that we -- I think we believe that there's a good chance that internally generated capital is going to continue to grow, which I think will fuel not only organic growth but future M&A growth. So I think our overall capital position is strong, and we hold it at that level, probably intentionally for both the organic growth and M&A growth. M&A growth is hard to predict. We've been successful the last year. We continue to be active in that arena going forward in terms of just discussions, et cetera, but it's hard to predict when. But we believe that we've got sufficient capital to support not only growth in regular dividends but, as I said a moment ago, organic growth and M&A growth.

Okay. And was there any specific driver of the special dividend this quarter? Or was it just you had really strong capital levels and wanted to reward shareholders?

I think that's probably a fair statement, Jackie. I think, Don, correct me, we've done a special dividend each of the last 6 years now?

Yes, 7 actually.

Seven years now. So I think there's been a pretty consistent special dividend payment -- payout on our part. It's varied from year-to-year, and I think the last few years, it's been at $0.10. And I think that we've used that special dividend to kind of manage that -- the TCE, to keep it at least steady and not to grow it beyond where it is. And so it will continue to be variable for -- because it's not always easy to predict exactly what growth, et cetera, where it will be. But yes, I think your general statement is true.

(Operator Instructions) We have a question from the line of Tim O'Brien with Sandler O'Neill.

Two questions for me. Don, do you have a budgeted number for conversion costs or, I don't know, remaining residual deal-related costs that you expect to book in the fourth quarter?

Yes. Tim, I'm expecting somewhere between $500,000 and $1 million.

Okay, great. And then secondarily, tax rate, 16.3% effective this quarter. Is that -- that's pretty close to what you guys were guiding on a run rate basis. Any adjustments or -- in thinking around what your tax rate might be here going forward on a sustainable basis?

I think it's going to increase a little bit over time as we are not -- no longer really use -- buying of municipal bonds anymore due to the tax rate and their prices. So I think some of our tax-exempt securities will fall off over time, in addition to the whole -- because we're not adding to it also, the percentage of cash exempt assets will go down compared to other assets. And so I think it will be creeping up over time. So the 16.3% is -- will probably go up little by little for every quarter.

Great. And then last question, kind of a banker's question, existential question. Given all the color that we've heard from you guys about the challenging lending environment and, I guess, excessive risk taking and underwriting and loss of deals, prepayments, that sort of stuff on the lending side, would you characterize this market in terms of what your bankers face as being more challenging in terms of gathering good high-quality loans or deposits at this point?

I don't think it's necessarily any more challenging than it has been, Tim. I think that what you're doing is -- or what you're seeing is that we're continuing to just be disciplined about how we approach the market. There's lots of opportunities for us to do CRE business but -- or nonowner-occupied CRE. We're trying to focus on the owner-occupied, which comes with the relationships, and saving our firepower for the relationships that are related to nonowner-occupied. Bryan, you might want to add some color as well.

Yes, I'd agree. I guess I'd start, Tim, just by saying, just when I look at the sales force that we have today, it's by far the best group that I've been involved with in my career. And look at the distribution in the markets we operate in, it's just terrific. The customer base, the distribution that were all very strong. So I feel really well positioned. And then when we look at the new production activity in the second and third quarter, it was good. It was really quite good. And so really, it's this payoff activity, and it's not related to losing clients. It's just clients making decisions to sell an asset or sell a business. So if we were losing clients, I'd be -- I'd feel differently about it, but that isn't the case. These folks are going to come back and continue to do business with the bank. The competitive side is -- and the pipeline activity and competing in the market for business, it's, as Jeff said, always a competitive marketplace. We've seen that tick up a level on the pricing side and the structure side, and that's having an impact. But in spite of that, our production is strong. So we see the payoff requests, and we'll hear a customer selling a piece of property and netting a nice profit on it. And Jeff and I say, well, that seems like a good business decision, and we'll get the chance to do other business with them down the road. We are keenly focused on deposits as well all across the platform, and we're seeing good results from that. So overall, I wouldn't say I'm comfortable with where we sit.

Tim, Bryan just made the comment about how we -- probably one of the best production teams that we've ever had, and they're placed in the right spots. When you hear about the business origination that we do have, both the loans and deposits, it's coming from the parts of our footprint that you would expect. It's coming from that Seattle-Bellevue metro area, the Portland market, as well as in some of the legacy Heritage markets like Pierce County where Tacoma is and even in Thurston County, where we've been for 91 years.

And at this time, there are no further questions in the queue.

Okay. Thank you, David, and thank you, everyone, for calling in. And I'm sure we'll be crossing paths over the next quarter. Thank you.

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