Heartland Financial USA Inc (HTLF) 2006 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen. Welcome to the Heartland Financial USA third-quarter 2006 conference call. At this time, all participants are in a listen-only mode. Following today's presentation, instructions will be given for the question-and-answer session. (OPERATOR INSTRUCTIONS). As a reminder, this conference is being recorded today, Monday the 23rd of October, 2006.

I would now like to turn the conference over to Ms. Leslie Loyet of the Financial Relations Board. Please go ahead.

Thank you. Good afternoon, everyone. Thank you for joining us for Heartland Financial USA's conference call to discuss third-quarter results. This morning, we distributed a copy of the press release, and hopefully you have all had a chance to review the results. If there is anyone online who did not receive a copy, you may access it at Heartland's website at www.htlf.com, or you can call Han Huie at 312-640-6688, and she will send you a copy immediately.

With us today from management are Lynn B. Fuller, President and Chief Executive Officer; and John K. Schmidt, Chief Operating Officer and Chief Financial Officer. Management will provide a brief summary of the quarter, and then we will open the call up to your questions.

But before we begin the presentation, I would like to remind everyone that some of the information that management will be providing today falls under the guidelines of forward-looking statements as defined by the Securities and Exchange Commission. As part of these guidelines, I must point out that statements made during this presentation regarding the company's hopes, beliefs, expectations or predictions of the future are forward-looking statements, and actual results could differ materially from those projected. Additional information on these factors is included from time to time in the Company's 10-K and 10-Q filings, which can be obtained on the company's website or the SEC's website.

At this time, I would like to turn the call over to Lynn Fuller. Please go ahead.

Thank you, Leslie, and good afternoon, everyone. We certainly appreciate everybody joining us this afternoon. I hope you all had an opportunity to review Heartland's third-quarter earnings release. If you did, you saw that we had a great quarter for earnings. Our momentum propelled us to a new milestone of $3 billion in total assets.

Most of my comments will focus on the implementation of our growth strategy and some strategic events which occurred this quarter. John Schmidt, our Chief Operating Officer and CFO, will follow with more detail on Heartland's quarterly and year-to-date financial results.

Starting with earnings, bottom-line income was up 9% for the third quarter 2006 over the same quarter 2005, or $6.9 million compared to $6.3 million, a nice increase. Even more important, earnings per diluted share were up over the same quarter last year, $0.41 versus $0.38 per share, an 8% increase. Our return on average equity for the quarter rose to 13.93% from 13.1% for the previous quarter. Return on average earning assets increased to 0.91% from 0.87% for the previous quarter.

Throughout 2006, we have commented on our strong net interest margin, and the third quarter was no exception at 4.17%. That's 14 basis points above the same quarter last year. Heartland's 2006 year-to-date earnings were $17.6 million, up 4% compared to 2005. However, without the adverse ruling on the court case involving the 2002 sale of our Wisconsin Community Bank Eau Claire branch, year-to-date earnings would have been $1.3 million greater or $18.9 million, an 11% increase.

In our second-quarter conference call, we discussed the possibility of appealing this case, and in fact we did file and appeal. Subsequently, the plaintiff filed a cross-appeal, and we don't expect any resolution on this issue until sometime in 2007. We will keep you updated on the progress.

Year to date, we continue to see reasonably good asset growth, with assets growing by over 8%. So far in 2006, loans have grown at a 9% clip and deposits slightly less at 8%. Our asset quality continues to improve. Non-accruals are down substantially. However, delinquencies were up for the quarter. This is due to one large credit in which workout plans are underway and on target for resolution before the end of this year. Adjusting for this credit, total nonperforming loans to total loans would be at their lowest level this year, or 51 basis points.

Now, I would like to spend a few minutes bringing you up to speed on some recent strategic events, as well as our expansion activities. Perhaps the biggest story of the quarter concerns the anticipated sale of our leasing subsidiary, ULTEA. This proposed sale signals our commitment to focus resources on our core banking and consumer finance businesses. John Schmidt will share more details on this transaction in his comments.

However, consistent with this strategic focus, HTLF Capital Corp., Heartland's investment banking subsidiary, closed its operations this quarter. Given their historical performance, the impact to Heartland's bottom line will be negligible. Both divestitures are steps to maximize shareholder value, freeing up capital and management time which can be redirected toward our core franchise opportunities.

We were also very pleased during the third quarter to receive approval from the FDIC and the Colorado Banking Department to open Heartland's newest de novo bank, Summit Bank & Trust, in the Denver suburb of Broomfield, Colorado. Summit is scheduled to open on November 1st, with over $15 million in loan commitments originated while operating as a loan production office. This is the ninth bank to join the Heartland family of community banks, and increases our number of banking locations to 55. Additionally, the Broomfield office represents Heartland's 30th office in the western United States.

Our expansion plans for the Denver market also include the opening of a second branch office in the community of Thornton, just north of the Denver International Airport, sometime in the second quarter of 2007. Within three years, we anticipate at least three offices serving the northern front range of the greater Denver Metro area.

Now, in New Mexico, we're in the process of expanding our presence in Santa Fe with our third branch office. This location is scheduled to open in the second quarter of 2007. With this branch, our footprint in New Mexico will grow to 16 locations.

At Arizona Bank & Trust, we will soon begin construction of a new office to serve the community of Gilbert. This office is also planned for opening in the second quarter next year, and will be our sixth office in the Metro Phoenix area.

Also, at Rocky Mountain Bank in Montana, we have finalized our plans for a new office to serve the fast-growing West Side of Billings. This office is scheduled to open late next summer, and will be our 10th location in Montana.

In Madison, Wisconsin, our Wisconsin Community Bank subsidiary is in the process of building a new office on Madison's rapidly expanding Southwest Side. The branch is located on one of the busiest intersections in the state, at Mineral Point Road and Junction Road. This new branch is scheduled to open in the first quarter of 2007, and will increase our Madison area presence to five locations.

Summarizing Heartland's expansion activities in 2006, we will have opened four new offices, purchased one and have five additional locations at various stages planned for opening in 2007. As always, we will continue to seek strategic acquisition opportunities with the focus on fill-in acquisitions that both enhance our market position and immediately contribute to earnings.

As you have heard us state many times, we have position Heartland financial as having the big bank punch with the little bank touch. A fitting example of this fact is the recent introduction of our remote deposit capture service, which we call E-Deposit. This new desktop service for our business customers converts checks to electronic images and transmits the images directly to the bank for deposit to their business account. We are one of a small number of innovative banks that is making this technology affordable and easy to operate for our customers. We see this new product as providing us an opportunity to attract new business demand deposits and, at the same time, provide our existing customers with greater convenience and immediate cost savings.

Finally, our consumer finance company, Citizens Finance, continues to roll out its growth plan with the opening of a new office in Cedar Rapids, Iowa, last week. Our next expansion target for Citizens Finance is in Davenport, Iowa, where we anticipate opening in November. This will be Citizens' eighth location overall.

That concludes my comments on our ambitious expansion activities. I will now turn the call over to John Schmidt for more detail on our third-quarter and year-to-date financial results.

Thanks, Lynn, and good afternoon. The third quarter of 2006 was a very good quarter for Heartland, not only in terms of the 10% improvement in bottom line Q3 2006 versus Q2 2006, but also in terms of growth in margin dollars, the increase in non-interest income and the virtual stabilization on non-interest expense.

I will again focus my comments on the most significant things which have impacted the balance sheet and income statement in the past quarter. In conjunction with this discussion, I will also identify the more significant components of the financials, which have been impacted by the identification of ULTEA as assets of discontinued operations held for sale. We would expect an agreement to sell ULTEA will be signed in the next several days, with the closing anticipated in the fourth quarter.

Looking first at the balance sheet, securities grew $66 million during the third quarter of 2006. Of this increase, $50 million represents securities purchased as part of a structured repurchase agreement transaction put in place to further reduce the Company's exposure to a reduction in interest rates. At inception, this transaction was effectuated on a no-cost, no-spread basis.

Loan growth totaled $45 million or a 9% increase on an annualized basis for the quarter. Not included in this total was $7 million of loans reclassed as part of the ULTEA presentation. Much of the growth occurred at New Mexico Bank & Trust and Rocky Mountain Bank.

While this production compares favorably to the second-quarter organic growth of $36 million, we continue to see some week weakness in overall loan demand. Additionally, the Company's effort to reduce the amount of nonperforming loans tends to further constrain growth. Saying that, we still believe we can reach the 2006 goal of $175 million inorganic, i.e., without the Bank of the Southwest acquisition and loan production we previously projected at the end of the second quarter.

Lynn also mentioned that, aside from the one large delinquent credit, we were very pleased to see the continued reduction in nonperforming loans. Again, it is important to note that the resolution of these problem credits did not significantly impact the allowance or provisions. Additionally, we maintained the allowance at 1.45%, driven in part by the reduction in the coverage ratio. If we continue to reduce the nonperforming loans, there should be opportunity to reduce the allowance on a go-forward basis.

Deposits grew by $38 million in the second quarter. Excluding the $7.4 million reduction in brokered CDs, deposits actually grew by $45 million or 9% on an annualized basis. The funding for the structured repurchase transaction I mentioned earlier is reflected in other borrowings. The impact for this transaction on the overall balance was mitigated by the Company's reduced reliance on FHLB borrowings.

Looking at the margin, the Company's net interest margin decreased from 4.27% to 4.17%. The 10 basis point reduction in the third quarter is consistent with our expectations, as the repricing of the liability side of the balance sheet continued to catch up with the timing of the repricing on the asset side. This ratio reflects the positive implications of the ULTEA reclassification, as the margin in the second quarter as previously reported was 4.19% compared to the 4.27% mentioned above.

Looking forward, with continued pressure on the liability side, we see some difficulty in maintaining the margin at the current level. This concern is in part driven by the previously mentioned liability side repricing, with about 65% of our CD portfolio return in the next year. We continue to feel, however, that our margin is sustainable around the 4% level.

Non-interest income reflects a 5% increase comparing the results for the quarters ended 9/30/06 and 6/30/06. The most notable increase this quarter was reflected in service charge income, which increased by 14%. The largest contributor to this increase was a $253,000 increase in fees from HTLF Capital, as one large transaction was originated prior to the close of the entity. Additionally, the area benefited from the Company's broad-based efforts to generate the demand deposit accounts.

This growth in revenue occurred despite our disappointment with the results of the checking account initiative we announced in January. We have subsequently discontinued this initiative.

We were pleased to see the moderation in growth of non-interest expense for the quarter ended 9/30/06, which increased by less than 1% from the 6/30/06 total. Outside services experienced the largest drop, decreasing by $292,000 or 11%, comparing the third quarter of 2006 with the second quarter of 2006. The most significant portion of this decrease is associated with the nonreoccurrence of costs related to the Bank of the Southwest acquisition and conversion of their data processing system.

In closing, while we would like to have seen a stronger balance sheet growth, particularly in light of our goal of doubling assets every five to seven years, it was a good quarter in terms of income, margin, non-accrual loan reductions and expense control.

As Lynn mentioned, the potential sale of ULTEA is probably the most significant event for the company in the third quarter. In addition to those benefits already mentioned, you will note the nearly 300 basis point reduction in our efficiency ratio compared to previously reported results. Additionally, we would anticipate paying down the Company's credit line by $25 million

With that, I would open it up for questions.

(OPERATOR INSTRUCTIONS). Matthew Clark, KBW.

Can you just talk about the loan yields this quarter? They were up 24 basis points, I guess, despite no Fed rate increases. Can you just talk about whether or not there's any prepayment penalties in there, or anything that would have juiced that up a little bit?

I really don't think there's anything extraordinary in there, quarter over quarter. Obviously, we see some catch-up in the fixed-rate loan maturities. But aside from that, I don't believe is any substantial increase in, again, nonrecurring fees, other prepayment fees, et cetera. There may be some. I guess the only thing that would come to mind would be some loans being brought back on accrual in Montana. I would suggest that amount would be maybe $100,000 at the outside.

So, as we brought these loans back on accrual from off accrual and brought those -- either moved them out of the system or actually brought them back under our loan portfolio, we may have been able to recognize as much as $100,000 of interest income. But that would be really the only extraordinary item that I can think of.

But you would expect some further repricing on some of your ARMs, I guess (multiple speakers)?

ARMs and also our other fixed-rate loans as they come due for repricing, et cetera.

Can you just clarify again -- I didn't hear it all -- about the securities purchase?

Yes. We put in place a structured repurchase transaction or a structured repurchase agreement transaction. In essence, we have bought $50 million of securities on the asset side, and funded that with a similar amount on the liabilities side. All that, again, focused on trying to reduce our exposure to a downward rate environment.

I guess Arizona and New Mexico, the linked-quarter asset growth was a little bit more modest, I guess, mid single digit. Is that something we should get used to? I know that you mentioned that demand has weakened some.

I would suggest -- and, Lynn, you can also entertain some of this. But I would suggest some of the slowdown in Arizona is certainly the integration of the acquisition of the Bank of the Southwest. Certainly, there has been some -- again, just bringing those portfolios together and those two entities together have shifted their focus, at least for the last quarter. I think the market has probably softened a little bit in Arizona at the same time. On a go-forward basis, I think we still are confident that we have the right people in place and the market is still very viable.

I don't really have anything to add to that. I would concur that we were pretty focused on integration of the Bank of the Southwest with Arizona Bank & Trust, to make sure that we preserved the business we paid for. We have historically, and in this case as well, have just not lost much business when we have acquired, different from some of our competitors who expect to lose 20% to 25% of the book. We were very pleased with holding onto the majority of the deposits as well as the loans in Arizona.

I would say in New Mexico, it was a little softer on the growth side, but their economy seems to be holding up reasonably well. I think in all our markets, we are seeing more competitive pressure than we saw maybe a year ago. But we have been pretty focused on getting paid for the loans we book, so we are not trying to buy the business at low rates, and we are not overpaying for deposits in the Southwest.

Are you now comfortable with your business mix? Is there anything else where you might want to rationalize a lower-performing affiliate bank, for example? Is there anything else left to do here, other than, obviously, grow your new Colorado franchise?

I think we constantly reassess that, Matthew. There isn't anything that we can disclose to you at this point. But we are constantly reassessing that, and taking our capital to the areas where we can get the best return for our shareholders.

I think that's well said. You look at our tangible capital assets ratio right now, at 5.18%. I think we would like to see that higher. In order to do that, we need to continue to look at the overall mix of assets on our balance sheet, and that's something we do on an ongoing basis.

Did you buy back stock this quarter?

I don't think anything real substantial this quarter.

John Rowan, Sidoti & Company.

John, do you have the income from discontinued operations for the first and second quarter of 2005?

It would probably run pretty true to form. We are looking at -- on a go-forward basis, the impact would be about $0.02 per share on an annualized basis. So, their income is fairly consistent. Off the top of my head -- and I can certainly get back to you, but I think as a proxy, if you will, that $0.02 on an annualized basis would reflect pretty well for 2005 at the same time, if that answers your question.

Oh, that's fine.

Their income has been fairly consistent year over year. They had a little bigger year last year than they are this year. I think that's still a reasonable estimate.

Lynn, in your prepared remarks, you mentioned there was one large credit that moved into non-accrual. Can you discuss the collateral that's securing the loan, give us a little bit more color on it?

It's an income-producing real estate. I don't want to get into the specific type. We've had the credit on our books for some time. The credit actually has payments current, and the taxes are current on the real estate. It's just that we have been asking the ownership to sell the property; we think that somebody else can probably do a better job of managing it. So we were past due on our forbearance agreement, but they've continue to maintain their payments and taxes.

So, it's kind of an oddball deal. But in any case, the customer is agreeing with our position now, and we expect that property to be sold prior to year end.

Just refresh my memory -- do you guys have any option ARMs in your portfolio?

I don't think -- nothing material to our overall balance sheet.

Nothing that's negatively amortizing, right?

No, there aren't.

You guys discussed a little bit potentially reducing your allowance if you did see continued improvements in your asset quality. What kind of timeframe are we looking for, if you were going to reduce your allowance, which is fairly large at this point? How much could we expect that you would release from that?

We have talked about improving our position on our nonperformers and cleaning up the portfolio. I think, since late last year, we have had that as part of our conference calls and our releases. We really had all of our banks focused very hard on this as a priority. There are a good number of loans that either had been off accrual or were downgraded that are being cleaned up.

We really feel good about the progress made to date. We have got some pretty substantial recoveries coming back in. I really don't want to comment on the dollar amount at this point in time, but I think you will be pleased when we report fourth-quarter earnings, and you can see the improvement that continues to occur in that area.

One additional part of that, obviously. We assess the overall allowance each quarter. We will be doing that again at 12/31 and see if I made the requisite improvements such that we can take a look at reduction.

So you would release the allowance as your asset quality improves. There wouldn't be some kind of lag that we would look at. So, we could see some kind of reduction in the fourth quarter, is what I'm getting an?

We're expecting that. Some of it is still coming out of Montana, but we also have some credits than I mentioned that are coming from other banks. The case of the one I mentioned was out of Wisconsin Community Bank's charter.

I think, all that being said, again, I think we are going to remain true to the methodology we have been operating under for a solid five years, and we won't deviate from that. If that yields a decrease in the overall allowance, certainly, we will take it at that point.

(OPERATOR INSTRUCTIONS). Jeff Davis, FTN Midwest Securities.

The CDs that reprice over the next year -- do you have the average rate, John?

I think about 75 basis points.

Versus current market rates? John?

Yes, I'm sorry. Yes. I'm sorry.

That's okay. I wanted to make sure I understood.

Then, ULTEA is the -- do you expect to book a gain from the transaction?

We do.

Significant? Or I'm sure you don't want to be too specific, but -- and don't say, if you don't need to. That's okay. (Multiple speakers).

Just to make it clear, I would assume that we would be signing this transaction within the next couple days. We will be, then, closing it hopefully very shortly thereafter, at which time we will obviously announce the gain.

Then, on the structured securities repo program put on, what happens, John? I assume it's just as simple as -- maybe it's not, but you have added bonds that are funded short, so if the Fed cuts, you have got bullets that can't be called, that the margin there widens out?

Yes.

If rates were to surprise and go up next year, what happens to the margin in that scenario?

It would be negatively impacted, under that scenario.

But the overall margin would -- you have trended up as the Fed has raised rates, with (multiple speakers).

Yes, and what we have thought about, in that scenario, is that we would be giving up some of our upside.

But not all of it?

Certainly not.

The transaction on the upside, Jeff, is a one for one. We go negative one for one. But on the downside, if rates drop 200, our spread goes up by 400, or very close to that.

Let me just give you -- everybody on the phone a little more background on the detail and how it's actually structured. The funding is at three-month LIBOR. There's a premium protection against falling rates through an embedded double floor. The double floor starts at three-month LIBOR at 4.40%. On the asset side, then we have Fannie Mae eight years at 5.72%; it provides a lockout during the protection period.

Brad Milsaps, Sandler O'Neill.

John, just kind of a clarification question. Did you mention prior to you closing the investment bank there was a large fee (multiple speakers)?

Yes, there was a fee of $253,000 that actually -- the fee was slightly more than that, but $253,000 net increase quarter over quarter.

What line item did that come through? I'm sorry, just trying to --?

That was in the service charge area.

Brian Martin, Howe Barnes Financial.

Just wanted to touch base on these expenses being flat kind of linked quarter, with this deposits initiative no longer in place and the closing of HTLF Capital. When we look at the run rate, does that change with these two out of the equation? Or is it not enough to move the needle?

I don't think either one is enough to move the needle. Sorry, Brian. We saw HTLF effectively -- they were gone for most of the third quarter, and we will see a decrease in Q4 as a result of some reduced advertising costs, which may be offset, by the way, as we bring on other initiatives to replace this initiative. As I said in my comments, we are very focused on growing demand deposit accounts. If it's not this initiative, it will be something else in order to continue to propel that.

The only thing I would add to that is that we really believe that we can acquire demand deposit accounts at a lesser cost per account than what we had under the old marketing program. So, we will be continuing to pursue that initiative of building non-interest-bearing demand. But we believe we can do it at a lesser cost.

One thing you might want to think about, though -- Lynn mentioned in his comments that we will open up Summit Bank & Trust at 11/1. Obviously, with the operation now fully open versus the loan production office, we're going to incur some additional costs there.

Saying that, though, again, we have had really almost a full complement of staffing for, certainly, the last quarter. So, it will be incremental. It won't be huge, but there will be some additional costs there.

Just a little bit of color on the loan portfolio. You said you're kind of seeing a little bit of slowing. Given that at least in the press release, you talked about Dubuque Bank and New Mexico being pretty strong. The loan growth that you are seeing the slowing -- can you give us, I guess, geographically where you are seeing more pressure than elsewhere?

I think you see the strengths in Montana, as I mentioned, New Mexico picking up speed. Montana saw some growth despite the fact that we're working some of these loans out of our system there. So, that has been kind of a bright spot in the third quarter.

Arizona -- I think, again, the economy has softened a little bit there. What I would suggest, maybe the reason we saw reduced growth and there wasn't as much due to the economy, but more that we were integrating this entity into -- combining the two entities.

The credits that you're talking about in the fourth quarter maybe cleaning up -- how much could you potentially look to push out of the bank at this point? That's kind of what it seems like you are referring to in kind of cleaning things up. Can you give any idea of what kind of --?

The one credit we talked about -- if you look at the increase in delinquencies, it's about $6 million.

$6.5 million, yes.

That's one credit.

Almost the entire line item in the release is related to this credit that Lynn had mentioned in his comments.

Just to continue a little bit on the Summit, just to give you an overall feel for that, year to date, we have $980,000 of costs incurred actually bottom-line impact to us to date, before tax.

One of the positives you should expect to see in the fourth quarter, though, although it's going to be a short quarter with them opening, with Summit Bank opening November 1st, you're going to see some pretty decent deposit growth out of them. They have not been able to obtain deposits as they were just a loan production office. But we should see a nice pickup in deposits when they get open.

There are no further questions at this time. Mr. Full, please continue with any closing comments.

I would like to thank everyone for joining us today. In summary, we were very pleased with our third quarter, and especially pleased with maintaining our margin at 4% plus. That, combined with a 10% increase in average earning assets over the third quarter of 2005, and total assets reaching a new milestone of $3 billion, made for a great quarter.

We will continue to stay focused on our expansion of our core business and our master strategy of balanced profit and growth to maximize shareholder value. I hope that you can all join us again next quarter. Our conference call is scheduled for January 29th of next year, 2007. Have a good evening, everybody.

Ladies and gentlemen, this does conclude the Heartland Financial USA third-quarter 2006 conference call. You may now disconnect. Thank you for using AT&T Conferencing. Have a very pleasant day.