Heartland Financial USA Inc (HTLF) 2007 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Heartland Financial USA fourth-quarter 2007 conference call. During today's presentation, all participants will be in a listen-only mode. Following the presentation, the conference will be open for questions. (OPERATOR INSTRUCTIONS). This conference is being recorded today, Monday, January 28, 2008.

I would now like to turn the conference over to Leslie Loyet, Financial Relations Board. Please go ahead, ma'am.

Thank you. Good afternoon, everyone. Thank you for joining us for Heartland Financial USA's conference call to discuss fourth-quarter and year-end 2007 results. This morning we distributed a copy of the press release and hopefully you've 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 may call [Hon Hoi] 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 open the call up to your questions.

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 any 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. I appreciate everybody joining us today to review Heartland's performance for 2007. I hope you all have had an opportunity to review Heartland's earnings release that was issued this morning.

For the next few minutes, I will discuss highlights of our performance and the ongoing implementation of our growth strategy. I'm joined today by John Schmidt; John is our Chief Operating Officer and CFO; as well as Ken Erickson, our Executive Vice President and Chief Credit Officer. Both will provide additional detail on Heartland's financial results for the year, as well as the fourth quarter.

In today's earnings release, Heartland reported an increase in net income for 2007 to $25.6 million or 2.1% over the previous year. Total assets ended the year at $3.26 billion and just sort of $3.3 billion if you add back the assets from the sale of the Broadus, Montana branch.

Diluted earnings per share for 2007 were $1.54 compared to $1.50 last year and $0.41 for the fourth quarter. Diluted earnings from continuing operations for 2007 were $1.44 compared to $1.45 last year.

Since I know all of you are more interested in learning about where we are going than where we've been, I think there's more good news to report today than bad. That being said, let me begin by addressing nonperforming loans, which certainly had our full attention during the second half of 2007, and is our number one priority for 2008.

To date, we have moved out and collected out a number of problem credits and have been aggressively downgrading others. As a result, our non-performing loans remain in the $30 million range, which is much higher than our historic levels. For the year, our provision expense was $10 million, net charge-offs were $7 million and reserves reached 1.45% of total loans and leases at year end. In the fourth quarter of 2007, we hired a seasoned workout specialist as Vice President of Special Assets. This individual is charged with responsibility of working with our member banks to substantially reduce non-performing loans from their current levels to compare more favorably with our historic levels. We believe we can unlock sizable earnings potential in 2008 through the successful achievement of this goal.

Though we are navigating in turbulent times, several areas of our performance truly stand out as positive. For 2007, our number one priority was margin maintenance, and I was very pleased with our efforts in this area. For the fourth quarter, we maintained our net interest margin at 3.87%, equal to the third quarter of 2007. For the year, we fared much better than many of our peers, averaging 3.95%. Though we will be challenged to maintain this level going forward, we are proactively managing our pricing in concert with the decline in market rates.

Second, we continue to show pretty good growth given intense competition and the current economic environment. Total loans increased to $2.3 billion and deposits increased $2.4 billion. Profitable growth is key to ramping up the contribution from our new branch investments. And we continue to channel resources toward increasing same-store sales year-over-year. Our benchmark for de novo offices is $10 million in net new deposits each year.

For the year ahead, we're anticipating loan growth to be similar to the growth we experienced in 2007. We are expecting our de novo banks in both Denver and Minneapolis to make meaningful contribution to this year's goal.

The third area where we are particularly pleased is in noninterest income. For the year, this grew by $2.5 million or 9% over 2006. We saw our Wealth Management Group revenue increased by 11%, and brokerage revenue increased by 66%, in part due to the purchase of a book of business in the Denver market.

Additionally, with respect to non-interest income, $1 million came from a onetime gain on sale of our credit card portfolio during the fourth quarter. We now have a much improved and competitive credit card product to offer our customers. And given where we are in the credit cycle, our timing could not have been better. We were also able to retain an income sharing arrangement with the purchaser of the portfolio.

I'm sure you also noticed the year-over-year decrease in human resource expense in the fourth quarter. As the year ended, we acknowledge that our performance in 2007 fell short of expectations and behind our plan to double earnings per share and assets every five to seven years. As a result, bonus payments at both the corporate and member bank level were reduced based on performance. And additionally, the 2007 profit-sharing contributions were adjusted downward, to bring them also in line with the Company's performance.

In terms of expansion, 2007 was a very active year, in which we opened five new branch offices, relocated one office and initiated the organization of our newest de novo bank charter, Minnesota Bank & Trust. Looking forward, we view our de novo expansion as a cost-effective way to plant the seeds for future earnings power. In 2008, we anticipate opening four new branch offices with new locations planned for Albuquerque, New Mexico; Mesa, new Arizona; and one new office in addition to the main location in Edina, Minnesota.

Our application for the Minnesota charter has been filed, and all approvals are expected within the next few weeks. Our President, Kate Kelly, is assembling an outstanding team of experienced bankers from the Twin Cities who are eager to get rolling with Heartland's 10th charter. We anticipate our grand opening in the second quarter of this year.

Continuing our forward-look into 2008, we've identified six top corporate objectives for the year. And these are -- number one, and most important, achieving a substantial reduction in non-performing loans. Number two, generation of core, non-time deposits. Number three, overhead reduction with the goal of trimming another 5% out of our current 2008 budget. Number four, maintenance of our net interest margin near its current level. Five, continued emphasis on training, especially in the areas of sales and supervisory training. And last, number six, disciplined and accountable leadership to stay on track with our plan and budget.

In closing, I still believe we have a shot at our stated strategic goal of doubling EPS and assets every five to seven years, which will end 12/31/2010. We realize this is an aggressive goal and that factors beyond our control, such as the economy, will have an impact on our future success.

Well that concludes my comments. I will now turn the call over to John Schmidt for more detail on our fourth-quarter and full-year financial results and then John will introduce Ken Erickson, who will provide additional commentary on the credit side. John?

Thanks, Lynn, and good afternoon. It's my pleasure to provide additional details on this morning's press release.

Consistent with previous calls, I will focus my comments on the most substantial changes to our balance sheet and income statement of the past quarter, 12/31/07 versus 9/30/07.

From a macro perspective, at this juncture, I would suggest that Heartland has weathered the storm fairly well in terms of earnings and limiting the increases of non-performing loans. Looking first at the balance sheet, total loans increased by $2.5 million in the fourth quarter. This quarter's performance was negatively impacted by efforts to clean up our loan portfolio. Representative of that, we successfully moved $24 million in sub-rated credit out of our banks in the fourth quarter. The majority of these credits were still on accrual.

Finally, in the fourth quarter, we closed on the sale of our credit card portfolio, which had $6 million in outstandings at the time of sale.

Even considering these sales, loan production for the year totaled $94.6 million. When the sale of the credit card portfolio, and those loans sold at the Broadus, Montana location are included, total loan growth would be $121.5 million.

Looking ahead to 2008, we would forecast loan production to be in the $125 million to $150 million range.

Net charge-offs for the quarter totaled $1.7 million, and $6.9 million from a year-to-date perspective. Net charge-offs for the fourth quarter expressed as a percentage of average loans and leases totaled 8 basis points. Citizens Finance, our finance subsidiary, represented approximately 40% of this total.

Finally, while our allowance for loan and lease loss methodology remains consistent, we continue to explore ways to refine the process, including the purchase of software which should be fully operational by the third quarter of 2008.

At the conclusion of my remarks, Ken Erickson, Our Chief Credit Officer, will provide additional detail on our loan portfolios.

Core deposits, meaning excluding broker deposits, increased by $2.1 million from a quarter-over-quarter perspective. We continue to see significant competition for deposits, and recently have found alternative funding sources to be more attractive from a rate perspective. Core deposit growth for the year totaled $96 million or 4.35% and $126 million or 5.72% when those deposits sold with our branch in Broadus, Montana are considered.

As Lynn mentioned, net income totaled $0.41 per basic and diluted share. Fourth-quarter results were positively impacted by the previously mentioned sale of the credit card portfolio, which reflected a $1 million net gain. Lynn also mentioned that we were able to maintain our net interest margin at 3.87% for the quarter. By and large, we were able to accomplish this by aggressively moving funding rates down, consistent with the Federal Reserve cuts. Going forward, with the opportunity to reprice 77% of our CD portfolio into next year, at rates at least 50 basis points lower than the current 4.87% rate, we see a continued relative stabilization of the margin in 2008. However, given the asset sensitive nature of the balance sheet, the margin remains exposed to additional Fed rate cuts. The sustainability of the margin is also a function of our ability to grow loans.

While noninterest income reflected an increase in the fourth quarter compared to the third, most of this is attributable to $1 million gain on the sale of the credit card portfolio. Balancing that was the amortization of the investments made in limited liability companies, which served to reduce the other noninterest income line item by $838,000. The offset to this charge is reflected in lower tax expense for the quarter.

Other areas of significant improvement included loan servicing income in addition to brokerage revenue. Going forward, I would anticipate that we will be able to increase noninterest income at a level at least consistent with the current year's growth of 8.5%.

Aside from the provision, the most obvious issue impacting our financial statements in the fourth quarter was a reduction in noninterest expense. Included in this total is the salaries and employee benefits line item, which decreased by $2.4 million or 17% for the third-quarter total. This reduction was due in large part to reduced incentive compensation and profit-sharing payouts as it became evident that we would not hit our performance targets for 2007. Additionally, relative to profit-sharing, the decision on the level of contribution is made at our December meeting. As such, the entire reduction flowed into the fourth quarter.

For modeling purposes, given the majority of our salary increases go into effect in January, I would suggest that the third quarter run rate plus 6% would provide a reasonable baseline. We are again pleased to see a relative stabilization of the remaining categories in the noninterest expense area.

Looking forward to 2008, we anticipate at least a 10% increase in outside services, primarily associated with FDIC insurance costs. This increase is driven in part by the fact that our credit is nearly fully utilized at our largest bank.

Finally, the tax rate for the quarter was 22.9%, reflecting the recognition of tax credits associated with the Dubuque Bank and Trust ownership in two limited liability companies that own certified historic structures. For 2008, a reasonable estimate would be in the 30% range.

This concludes my remarks. I would now like to introduce Ken Erickson, Heartland's Executive Vice President and Chief Credit Officer. Ken is a CPA and has been in the banking industry for the past 32 years, all at Heartland. Given where we are in the credit cycle, we thought it would be helpful to bring Ken's expertise and perspective into this conference call. Ken?

Thank you, John. Good afternoon. As John said, I am Ken Erickson, Executive Vice President and Chief Credit Officer for Heartland. I do appreciate this opportunity to speak today regarding Heartland's loan portfolios.

This past year, was certainly atypical when you compare 2007's results to prior years. I will not speak to the specifics behind individual credit losses, but in my opinion, they are not reflective of a new level of expected losses of the Company. Underwriting remains strong and collection efforts appropriate for each individual credit. Only five non-performing credits exceeded $1 million as of December 31st. These five credits totaled $16.7 million. Two of these represent 39% or $12.3 million of the total non-performing loans as of December 31st.

As mentioned in the past, we have several loans with government guarantees. $2.5 million of our non-performing loans represents the guaranteed portion of those loans.

Uncertainties still exist regarding a few larger credits in our portfolios. Material losses are not foreseen in any one of those credits, but the timing to resolve the issues are uncertain, depending on whether we can return the loans to a performing status or if legal action will become necessary.

Most of our markets appear to be relatively strong with minimal declines in real estate collateral values. The exception to this would be the Phoenix market, where we have seen a greater decline in real estate values. Although 76% of our loan portfolios are secured by real estate, the risk in these portfolios is most likely less than that number may suggest. It has been the practice of this organization to seek out complete customer relationships versus financing individual transactions or purchasing loans through brokers or other participating banks. This has led to the majority of our loans being within the primary trade areas of our member banks as well as to a high percentage of our commercial real estate loans being owner occupied. Whenever possible, we also structure our loans so that they are cross collateralized. Our goal in 2008 is to significantly reduce the net losses from the levels seen in 2007.

Citizens Finance Company, our consumer finance subsidiary, has $40 million in net loans as of December 31st, an increase of 11% in 2007. Their primary business is to provide secured, closed-end credit to customers that represent a higher credit risk than those within the bank consumer portfolio. Most of this credit is secured with personal vehicles. Although they represent only 1.2% of the assets of Heartland, they do have a significant impact on certain numbers within the consolidated financial statement.

Citizens' yield on loans was 21.3% in 2007, an appropriate yield to offset their net losses of 4.3%. Their losses of $1.7 million translates into 7 basis points of net loan losses, while the banks contributed the remaining 23 basis points towards the 30 basis points shown in the consolidated financials of Heartland. I do not anticipate significantly different performance within this entity in 2008.

Consumer loans represent 7% of the overall bank's portfolio, with home equity lines of credit representing approximately half of that amount. A potential softening in consumer spending should not have any significant impact on our overall credit quality.

As John commented, we have been busy implementing a new software system acquired from Inmatrix. With this system, we will transform to a dual risk rating system and have the opportunity to perform stress testing and migration analysis on various portfolio segments. It should be fully operational in the third quarter of 2008. This adds a significant tool to our risk management program and will assist us in fine-tuning our allowance methodologies. With that, I will return the call back to Lynn.

Thank you, Ken. And at this time, Leslie, I think we can open up the call for questions.

(OPERATOR INSTRUCTIONS). George Richmond, Richmond Corporate Services.

Thank you. You people have had a lot of experience in starting new banks and I think that will help you. You now have one in Denver and a second on the way in Minneapolis. Can you give us some guidelines for this year as to how much of your time on the top level will be devoted on these new entities?

And then, how do you see the progress by quarter turning red ink to black ink as these banks get up and running?

Maybe I can start out on that, George, and just say that the new de novos do take a bit more of our attention in the first year. Once the local president and the board have pulled together their management team, they become pretty self-sufficient. But -- as in any acquisition or de novo startup, there is a period of time of adjustment, where they are getting accustomed to our culture and our way of doing business. Typically, the banks will lose $1 million in the first year. We like to see that second year drop down to somewhere in the $0.5 million to $750,000. But that will depend on how quickly we expand their branching network. We have had a philosophy of trying to anchor a group of branches strategically off main arterials in these big markets close to magnets, magnets being either grocery stores or shopping centers, where we have good locations that are easy to access and right off major thoroughfares, especially where we see heavy concentrations of small, medium-sized businesses and a lack of saturation of competing banks.

In the third year, we like to see the banks be profitable. And fourth and fifth year, more so. I can't tell you that that's always happened, but it has happened with some of our banks.

Okay. That's great because what that tells me is that you will be facing somewhat higher costs this year from the new banks opening, but '09 and '10 should be really very good years for you then.

And that would be our hope, George. The only thing that I would give you caution on is the reason we have been very active in de novo startups is because the acquisition price for banks that we would be interested in, in those markets that we're interested in expanding in, have been very pricey. We've seen multiples book up to 3 times. We've seen multiples of earnings up to 28 times. And quite honestly, at those levels, we've never been able to make sense out of them and ensure that they would be accretive to our earnings.

Our M&A strategy continues to be focused on those markets where we have already established a presence. In those types of markets, we can better consolidate into current operations and get more economies of scale. If we venture into a new market paying those historical multiples just have never made sense to us.

So we've been a pretty cautious acquirer. We are still looking to acquire, but we would have to see the pricing at a level where it could be accretive to earnings.

I think your point is excellent though, too, George, in the fact that it does in fact retard your earnings on the front end, if you will. But certainly going forward, and you alluded to '09 and '10, we do start to reap the benefits, and we don't have that goodwill that we would otherwise have if we did an acquisition. So there needs to be some patience I think exhibited. But long-term it really does serve the shareholder better in our minds.

Very good. Thank you.

(OPERATOR INSTRUCTIONS). John Rowan, Sidoti & Company.

Good afternoon. Can you just go over the margin again? It seems like you are saying that your maintenance of the margin is going to be a priority, but there could be some pressure in the near-term. I guess just to get to where I think it will kind of all fall out later this year, can you just go over how much exactly of your liabilities are repricing again?

I guess the biggest issuer or option we have, John, as I mentioned, is that 77% of our CD portfolio does mature in the next year. As we look at it, we should be able to drop the rate on that portion of our CD portfolio by at least 50 bips.

Our savings we have -- we been able to drive down our savings rates I think pretty effectively. Do we feel there's some additional room there? Yes, there is.

All of that -- again, to reiterate my broader comment was that we look at the margin that -- we should be able to sustain our margin near that 387. Again, it becomes a function of how fast the Fed does cut rates. Our counterbalance still remains the CD portfolio and probably to a slightly lesser extent, our savings portfolio. But there's still some room there.

And when do you get into a compression issue, in terms of the Fed us cutting rates you can't lower your funding costs any further?

Well, you know, quite honestly, there's certainly a portion of our savings portfolio right now that we have effectively hit a floor on. I would say that's maybe 20% of our savings total.

The balance of that though -- and remember that we have been effective in putting floors into our commercial loans. I don't have that figure on the top of my head, but call it 30% of our loans, variable-rate commercial loans, would have floors on them. So that starts to counteract some of this decrease at the same time.

Again, there is going to be some compression potential. But I think we've still -- depending on how low the rates go, if there is another 100 basis points out there, yes, we're going to see more compression than where we are at right now.

I would just add that we are using this as an opportunity to lock in very affordable financing rates. We put caps on some of our floating-rate [trops]. So I think this is an area of opportunity as much as an area of risk. But certainly, we're not totally immune to compression if interest rates drop another 150, 200 basis points.

Thank you. That's it.

John, one last point too. We have I think been very effective at the same time, putting prepayment penalties in our fixed-rate loans. So again, we have tried to balance a lot of this liability exposure on the asset side. That is something that we've been very cognizant of throughout this rate cycle.

Actually just one more question. You said you're looking for fee growth of 8% this year; correct?

Correct.

Okay, thank you.

Jon Arfstrom, RBC Capital Markets.

Lynn, can you talk a little bit more about the expense management initiatives? Kind of where and what you're thinking about there?

Well, as we go through our budgeting process every year, we are very, very strict on the expense side. And the reason is obviously because we know we've got quite a bit of expense coming out of these de novo initiatives and our branch expansion. But it's those expansions that we look to, to provide profits to us in future years without adding a lot of goodwill.

We went through our budget process. We felt we did a good job. But we think there's an opportunity -- and we've gone back to our bank presidents and to our holding company -- we think there's an opportunity to get another 5% of expense reduction out. And so we're turning over every rock we can to address that end of the income statement, because, as you know, if it gets very challenging to grow top line through '08, we've got to get it out of the expense side. So, that's been an initiative that's been put in play right after we finished the budget in December. And our member banks and the holding company are coming back with their ideas on the specific dollars and where they are going to get them.

Also, we have started the beginning of '07 on a project called Six Sigma Workplace Lean. And we have a number of initiatives under Workplace Lean that we're looking at our processes, to see if there is a way that we can improve those and become more efficient. We look at productivity at all of our production levels of our sales people both in the retail and the commercial platform. And where we don't see the levels of productivity that we expect, we move people out and get somebody in that can give us the productivity. So we're looking at it at all levels, John.

Okay. A couple more questions. Maybe, John, for you on the loan loss provision for the quarter -- was a little higher than we had anticipated, not terribly higher. But I guess when you think about your loan growth numbers and you're also giving us some comfort on asset quality, I guess the question is, is there the opportunity for that loan loss provision number to come down a bit in '08, given some of the outlook that you've given?

Let me just say we certainly would hope so. We, at this juncture, I only thing that we've really been fairly consistent or very consistent on the use of our -- the formula, John. And we need to be. So some of it certainly was driven by losses. Certainly some of it was driven by the growth and some was just making sure we maintain some consistency with the formula we've exhibited over the years.

So when Ken spoke to the new methodology, does that ultimately provide relief? It's probably yet to be seen. But we certainly would hope that, ultimately, given everything we are seeing and saying as far as the credit culture and credit environment we're working in right now, going forward, if we can clean up some of these nonperformings, certainly hopefully we can see some reduction in the overall amount of the loans.

And I might add one more thing, John. As our comp committee works with our outside independent compensation consultants, what they have told us and what we have seen when compared to our peer group is that we focus an awful lot more of our compensation programs on performance so that it's variable based upon how well the Company does. And we've committed to our shareholders that we're going to continue to give them increases in earnings per share and work toward our strategic goal of doubling earnings and EPS specifically and assets every five to seven years. So if we were successful in accomplishing that, we've got a fair amount of discretionary dollars that get adjusted.

Okay, good. Just one question on loan growth. I appreciate the number that you gave us for your expectations for '08. And I'm just curious how the near-term pipeline looks -- should we think about this, where maybe when the Minnesota bank is open, we might see a bit of an acceleration in growth? Or does the near-term pipeline look pretty strong?

I would say based on what we're seeing right now, our pipeline right now is about 70% of what we saw in 2007. So we are -- we aren't at the same pace, if you will, John. We had a strong first quarter last year. But even saying that 70% of a strong quarter I think is fairly representative of hopefully what we can do.

And the pipeline right now doesn't include a whole lot for Minnesota Bank & Trust. And we really need to see Denver and Minnesota step up and make a fair contribution. If that happens, then that will make up for what we think might be a bit slower production in our more mature banks.

Okay, great thank you.

But you know, saying that, Dubuque too has been one of those strong providers and we still look to Dubuque as being a capable production bank this year.

All right, thanks.

Brian Martin, Howe Barnes.

Just maybe a question for Ken, but the non-performings in the quarter were pretty stable, I guess, or up a little bit. And I guess I'm just wondering if you could talk a little bit about -- you talked about aggressively downgrading some credits; and I know that John you talked about moving some out that were still on accrual. Can you just talk about -- that number was relatively flat. Could you just talk a little bit about the migration of maybe what was coming in and what was going out or was it kind of was it as flat as it looked or I guess any large movements that you could talk a little bit about?

Sure, Brian. Thanks. There was movement in there. Unfortunately, some moved in that replaced the dollars the did move out. We had a couple of properties that were in our Heartland Business Bank that we were able to resolve. We had one $1.5 million loan that did fully pay out. We had another $1 million nonaccrual loan that came back to a performing status.

In one of our banks, we had a loan just slightly under $1 million that is on some spec buildings. Well collateralized, but did fall past 90 days; it came off accrual.

And then, in our Arizona market, we had an aggregate of about four or five credits that brought up a couple of million dollars of non-performings on some various residential real estate lots, spec loans, in that market, that has created some additional non-performings. So we did see some come out of there, but unfortunately, the same number of dollars or close to it came back in.

Okay. And I guess you're just talking about maybe your goals for kind of the resolution; you seem pretty optimistic as far as getting some resolution here in '08 on some of these that came aboard. And I guess can you give any thoughts as far as what expectations appear realistic at this point given kind of what you looked at and -- whatever color you can offer there as far as your expectations.

I would probably state first that the goal that both Lynn and I have discussed internally is we feel that we need to return -- strong desire to return to approximately a 3 to 1 coverage of allowance for non-performings. We think that is the level that should be held within our Company. When we look at these specific dollars, the specific loans in there, some of those are under foreclosure activity and will take a couple of quarters at a minimum to move through. But barring any new significant dollars going in there, it is realistic to see a significant reduction in non-performings in 2008.

Brian, I think I mentioned this last quarter in our earnings release that I have asked credit and loan review to be very aggressive in downgrading loans so that we get these credits in front of us so we can address them and try to resolve them early. I'm not sure that all of our peers are as aggressive in this area as we are. We believe that the quicker that we can get these in front of us and bring them to a head the lower our losses are going to be. And historically, we have done a pretty darn good job of taking collateral. So I'm pretty hopeful, as I mentioned in my comments, that we will see some real improvement in that area in '08.

Okay. And I guess, Lynn, you talked about the 24 that came out this quarter that were mostly still accruing, when you talk about your loan goals for '08, I guess what are your -- do you guys feel like you've looked at the portfolio close enough at this point that you don't expect any type of movement along the lines of what we saw this quarter moving out? Or do you still expect to see quite a bit moving out or have you gotten most of that, you feel, at this point?

I think it depends on how bad the economy gets. If we fall into a deep recession, we are not immune to, as a banking company, we're not immune to problems that a recession would cause. But at least at this point in time, I think we feel pretty comfortable we have identified most things. We had credits that were still performing credits that we were a bit uneasy with that we asked to move and there are still plenty of banks out there willing to finance them. So I think we've been pretty diligent on reviewing the entire portfolio and trying to mitigate the risk to the greatest extent possible.

Okay. And just lastly, the past due 30 days or kind of the watch of those type of credits, can you just talk a little bit about the 9/30 to 12/31 change as far as -- has that been pretty stable or have you seen that number move up?

I think, John -- this is Ken. I think John hit on that. We are saying that we saw a significant reduction in that number. In those that I would call significant over $0.5 million on the relationship, substandard credits, those reduced by 16 to $18 million. And the majority of that came with those two large credits that were still performing credits, but we're showing somewhere in the best resolution of those were to move out of our portfolio. So there was some significant dollar reduction in those categories of sub-rated credits.

Okay. I appreciate the color, guys. Thanks very much.

Brad Milsaps, Sandler O'Neill.

John, I was trying to run or trying to quickly jot down your comments on some of the income statement items this quarter. I didn't quite catch some of your color on the other expense category. I guess it was up about $1 million on a linked quarter basis. Any additional color there? And I apologize if I missed it.

The other expense category?

Yes, sir.

I don't know if there's anything real significant that jumps out at us in that category, Brad. I think there were some telephone charges that went into that line item. There were really -- it was nothing that would jump out at you as one single event because I did look at that, quite honestly, and there was probably six items that contributed about $700,000. So a variety of things, but nothing that substantial. Maybe your question goes to what is it on a go-forward basis. I would probably see it going back down to a little more closer to the Q3 level.

Right. Your guidance, the 6% guidance strictly relates to personnel expense?

Yes, that was 6% overall. You are correct. That was just personnel expense. The big thing -- I'm sorry, but the one thing that I was looking at was outside services. In that outside services line item was the FDIC cost. And that is the one that has our attention given the fact that there has been obviously an increase in overall FDIC premiums, and the fact that the credit that we have at Dubuque Bank and Trust is running out. So that was my largest concern. And the other expense, there wasn't really anything that jumped out at us. You are talking about the $4.1 million?

That's correct.

Yes, there wasn't anything real substantial there. What I was referring to is the outside services, which contain the FDIC costs.

Okay.

And if you look at other outside, other noninterest expense rather, model Q3 level versus that Q4 level.

Okay. And then final question. Collectively, you guys don't have a lot of construction development exposure, which seems to be giving everyone the most trouble at this point. But you do have a fair number of loans in that C&D bucket I guess at the Arizona bank and also in Albuquerque. Can you, Lynn, or Ken, can you comment a little bit on just kind of the health of those markets as you view them at this point? Thanks.

I'll comment first -- being Ken. And Arizona certainly has shrunk back in the values that we've seen in real estate and the turn time on some of the projects down there. It's certainly going to extend the absorption time for some of the land developments that are underway down there. Fortunately, the market is still growing at such a rapid pace, that slowing it down may go from six months to nine months of absorption period in some of the areas.

Now we certainly do see that there is a lengthening of time of absorption when you get farther away from the core populace area. So we have seen some of the development projects in the market that are significantly a distance from the main Phoenix Metropolitan area are slowing down significantly. And Lynn, I ask you if you wish to go further with that comment?

We have a little bit of that type of business in Madison, Wisconsin; a little bit in Phoenix; a little bit in Bozeman, Montana and Billings; and as well in Albuquerque. And I would have to say I'm just amazed at how well the Albuquerque market has held up -- that we've consciously been pulling back a bit from that end of our business in Albuquerque, but we just don't see a real slowing down. It's certainly not at its absolute peak. But I think the builders down there have been quite cautious. They have known that things are going to slow a bit and they've adjusted real well.

In Montana, still, incredibly good growth in Billings and Bozeman in those growth markets. I think in the case of Bozeman, I think some of the land development got a little ahead of itself, so as Ken suggested, maybe a little more time for absorption of that inventory. Madison has had a little bit of a pullback, but that market over the years has been so stable through any recession that I think you are definitely seeing a slowing in Madison, Wisconsin, but not anywhere near what we see in Phoenix.

Phoenix clearly is the market that we're in that's seen the greatest adjustment, and it's in the outlying suburbs. One exception of that my be Casa Grande because it's right on Highway 10 in route down to Tucson. But some of the other more westerly suburbs that were later to develop and that are farther out, fortunately, we haven't had any investment in those markets, but they have really seen a slowdown.

(OPERATOR INSTRUCTIONS). There are no further questions in the queue, and I'll turn it back over to Mr. Fuller.

Thank you. In summary, I would just say that Heartland's financial performance remains solid with continued EPS growth; certainly a reasonable balance sheet growth; solid noninterest income growth; and a leveling off of our noninterest expense, and I would expect that to continue through this year.

I would like to thank everyone for joining us today and hope that you can join us again for our next quarterly conference call. That's scheduled for April 28th. So I wish everybody a nice evening. Thanks, again.

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