Heartland Financial USA Inc (HTLF) 2008 Q1 法說會逐字稿

Good afternoon, ladies and gentlemen, and thank you for standing by. Welcome to the Heartland Financial USA first-quarter 2008 conference call.

During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (OPERATOR INSTRUCTIONS). This conference is being recorded Monday, April 28, 2008.

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

Thank you. Good afternoon, everyone. Thank you for joining us on Heartland Financial USA's conference call to discuss first-quarter 2008 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 either access it at Heartland's website at www.HTLF.com, or you may call [Hahn Hoy] 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; John Schmidt, Chief Operating Officer and Chief Financial Officer; and Ken Erickson, EVP and Chief Credit Officer. Management will provide a brief summary of the quarter and then we'll open the call up to your questions.

Before I 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 Web site or the SEC's Web site.

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 all of you joining us here today to review Heartland's performance for the first quarter of 2008.

I hope you all have had an opportunity to review Heartland's earnings release that was distributed this morning. For the next few minutes, I will discuss quarterly highlights and the ongoing implementation of our growth strategy. I am joined today by John Schmidt, our Chief Operating Officer and CFO and Ken Erickson, our Executive Vice President and Chief Credit Officer, both of whom will have additional details on Heartland's first-quarter results.

Today, Heartland reported earnings of $6.3 million, a 9% increase compared to last year's first-quarter earnings of $5.8 million. Earnings on a per diluted share basis from continuing operations grew to $0.38, an increase of 12% compared to $0.34 per share for the first quarter of 2007. Also, with respect to balance sheet growth, average earning assets increased $184 million or 7% over the first quarter 2007.

In addition to earnings and asset growth, we maintained our net interest margin at or near 3.88% for three consecutive quarters. I feel we have done a remarkable job maintaining margin in light of the current environment. We have endured a rapid downward movement in rates and intense competition, including irrational pricing of loans and deposits by some competitors, all of which have caused significant margin compression among many of our peers.

For the remainder of the year, margin maintenance will be aided on the deposit side as we continue to benefit from reduced rates on maturing CDs. On average, we're renewing $100 million in CDs per month with as much as a 1% reduction in rates paid. On the loan side, we should be able to maintain returns with the continued discipline for appropriately pricing risk return as well as establishing interest rate floors backed up by prepayments fees. This, combined with improved returns on our investment portfolio and various sound asset liability and hedging strategies, should continue to serve the Company well. In time, we will need to move our margin back up over 4%. However, near term, non-accrual loans will continue to be a drag on our margin.

While we are pleased with the first-quarter results, we recognize there's room for improvement, especially in terms of our non-performing loans. Like most banks of all sizes, we have seen nonperformers grow in recent quarters. As I shared with you last quarter, reduction of non-performing loans is this year's number one priority. You may recall my mentioning in January that we hired a seasoned workout specialist charged with responsibility of assisting our member banks in substantially reducing our problem loans by year end. We have scheduled out by quarter our best estimate of when we will gain control of our collateral, begin liquidation, and return dollars to earning assets. At this time, we anticipate marked improvement in the third and fourth quarter of this year.

Obviously, we are dissatisfied with non-performing loans at this level as they are much higher than our historical levels. However, we believe we are well collateralized in these loans and adequately reserved with reserves at 1.48% of total loans and leases.

Among Heartland's first-quarter highlights, we saw a solid increase of 11% in non-interest income compared to last year. This is an area of ongoing emphasis and annually, each of our member banks are required to review the pricing of every service line to assure a fair return to the Company, while remaining competitively priced in each of their respective markets.

Managing non-interest expense ranks number three in our top corporate objectives for this year. At the beginning of the year, we initiated an internal effort to identify cost savings in every area of our operation. Each subsidiary and corporate departments have identified opportunities, many of which are being implemented right now. Combined with our ongoing efforts to implement workplace lean processes, we expect to see notable improvement in non-interest expense by year end.

In terms of expansion, our plans for 2008 anticipate a somewhat slower pace with one additional office in Albuquerque, New Mexico, and the main office location in Edina, Minnesota for Heartland's newest de novo and 10th bank charter.

Our bank president, Kate Kelly, has assembled a talented team of experienced bankers who will cater to businesses and affluent individuals. We believe now is an excellent time to open a new bank in the Twin Cities market, and we're looking forward to Minnesota Bank & Trust's grand opening on May 22.

Now, with 60 banking offices in Heartland's footprint, and 25% of our locations under three years old, we recognize the near-term negative impact on our efficiency ratio. However, as these offices mature, we appreciate significant opportunity for future earnings growth. As a result, the generation of core non-time deposits is our second-highest priority. And to that end, we're channeling resources into promotional efforts, introducing attractive new products for both business and retail markets and investing in ongoing sales training for our staff. We believe the current stressful banking environment will eventually lead to some attractive acquisition opportunities for Heartland. Our current strategy is to seek out other community banking organizations within our existing markets. We are well positioned for these opportunities with a solid capital base, nominal goodwill, and deep internal experience with M&A.

We will continue our commitment to pursue only those transactions which are additive to our current shareholders' earnings per share.

That concludes my comments. I will now turn the call over to John Schmidt for more detail on our first-quarter and year-to-date financial results. And then John will introduce Ken Erickson, who will share his comments on the credit side. John?

Thanks, Lynn, and good afternoon. My comments will, again, focus on the most substantial changes to Heartland's balance sheet and income statement in the past quarter, in this case, 3/31/08 versus 12/31/2007.

Looking first at the balance sheet, total loan balances decreased by $8.5 million in the first quarter. This decrease was partially attributable to the payoff of a $24 million commercial credit that was refinanced into the secondary market. Saying that, we are seeing reduced loan demand, and at the same time, our first priority for our lenders is to clean up our non-performing loans. For remainder of 2008, with Minnesota Bank & Trust coming online, we would forecast loan production to be in the $100 million range.

Net charge-offs for the quarter totaled $1.1 million. Net charge-offs to date expressed as a percentage of average loans and leases totaled 5 basis points or 19 basis points on an annualized basis.

For the quarter, charge-offs at Citizens Finance, our finance subsidiary, represented 33% of the net losses. At the conclusion of my remarks, Ken Erickson, our Chief Credit Officer, will provide additional detail on our loan portfolio.

Core deposits, in this case excluding brokered CDs, increased by $24.2 million from a quarter-over-quarter perspective. Competition for deposits continues to be keen and as a result, we found the Federal Home Loan Bank to be a lower-cost funding alternative, with balances increasing by $92 million in the past quarter.

At the same time, our expectations of our lenders has always been to develop deposits. And given the slowing loan demand, we have asked them to redouble their efforts in this area.

As Lynn mentioned, net income totaled $0.38 per basic and diluted share in the quarter. The most significant in this is the fact that we were able to maintain our margin at 3.88% for the quarter. By and large, we're able to accomplish this by aggressively moving down rates in light of the federal reserve cuts.

Going forward, 77% of our CD portfolio will be priced in the next year at rates as much as 100 basis points below the average current rate of 4.3%. As a result, we would still model our margin in the lower 3.8% range for the remainder of 2008. Since our balance sheet remains asset sensitive, this will certainly be impacted by additional Fed rate cuts, our ability to grow loans, and the level of non-performing assets.

Non-interest income was up $300,000 on a linked core income basis. This analysis excludes the first-quarter 2008 gain of $246,000 related to the Visa IPO as well as the fourth-quarter 2007 $1 million gain on the sale of our credit card portfolio. It also excludes $838,000 amortization of investments made in limited liability companies that provided offsetting tax credits which were recognized in the fourth quarter.

Total non-interest expense increased by $2.2 million or 9.5% comparing Q4 2007 versus Q1 2008. From a macro perspective, the opening of Minnesota Bank & Trust has had a significant impact in this area, as we incurred $294,000 of expense in 2007, and $444,000 thus far in 2008. As we have indicated in the past, our de novos typically lose between $1 million and $1.5 million on an after-tax basis in the first year of operation.

As we discussed last quarter, salaries and employee benefits experienced a $2.4 million decrease in the fourth quarter of 2007 as we reduced our incentive compensation and profit-sharing payouts.

For the purposes of this line item, a more reflective comparison would be with the third quarter of 2007. In this comparison, salaries and employee benefits increased by $492,000 or 3.5%. Consistent with previous years, we expect to see relatively modest increases in this area for the remainder of the year.

Of the remaining categories in non-interest expense, occupancy experienced the largest increase of $383,000 or 20%. This increase is primarily attainable to the opening of branches in Arizona and Colorado. On a go-forward basis, we don't forecast a significant increase in this area, given the moderation and branch openings that Lynn mentioned.

The tax rate for the quarter was 27.86%, reflecting the recognition of tax credits at Dubuque Bank and Trust. On a go forward basis, we still feel that our tax rate will be in the 30% range for the remainder of 2008.

In closing, I would reiterate some of Lynn's comments, in that we're very pleased with the many aspects of the first-quarter performance, including income, margin maintenance, and general cost control. At the same time, we realize that we have a lot of work to do in terms of non-performing loans.

With that, I will turn it over to Ken Erickson, our Chief Credit Officer.

Thanks, John. Good afternoon. As already mentioned, for the quarter ended March 31, our non-performing loans have increased by $7 million. This is almost entirely attributed to one credit in the Arizona market, which is in the process of collection. Foreclosure on this property is anticipated to be completed prior to the end of the year. Our non-performing loans are still concentrated within a small number of credits. Six non-performing credit relationships individually exceed $1 million for an aggregate of $23.7 million or 61% of the nonaccrual loans. Four of these relationships are in housing-related industries, representing $15.9 million with $8.8 million of these in Wisconsin and the remaining $7 million in Arizona. While material losses are not anticipated in any of these credits, we do understand the softness in recent real estate values, especially in Arizona, which may further increase our loss exposure if our estimated collateral values decrease.

Although this quarter still shows an increase in non-performing assets, I'm encouraged by the progress shown on several of these loans. Collection efforts continue and reductions should be seen throughout the balance of this year on the existing non-performing loans. Several of these will be resolved through foreclosure, which will increase other real estate owned. With only $2.7 million currently in ORE, this increase will not put a significant strain on our financial performance, but we will make concerted efforts to liquidate the additions as soon as possible and return these dollars to income-producing assets.

Our retail loans continue to perform quite well. Our bank consumer loan over 30 days delinquency is 1.53%. Approximately one-half of our bank consumer loans are home equity lines of credit. The over 30 days delinquencies of HELOCs is 1.47%.

Our residential real estate loans have a delinquency of 1.05%. Excluding the service loans, the $218 million held in portfolio have a delinquency of 2.05%. Foreclosures also remain relatively low in all of our markets. Only 12 of our residential real estate loans held in portfolio with an addition of 10 more within the service loans are in foreclosure. At the end of March, this represents only 0.35% of the balances and 0.24% of the number of residential real estate loans and 0.75% of the balances of those held in portfolio.

Citizens Finance, our consumer finance company, has also shown solid performance in the first quarter. Delinquency is 4.68% at the end of the quarter, which is down from an average of 5.69% for 2007. Net losses were 3.51% as compared to 4.14% for the year 2007. With that, I will return the call back to Lynn.

Thank you, Ken. Thank you, John, for your comments as well. At this time, we would like to open it up for questions.

(OPERATOR INSTRUCTIONS). Jon Arfstrom, RBC Capital Markets.

A couple of questions for you. The $100 million you talked about in the loan growth target for '08, what markets do you think will drive that growth?

Certainly, we do look, John, to Minneapolis; as I mentioned, that bank comes online; it opened on April 15. So we would anticipate with the staffing that Kate Kelly, our President, has in place at this point. That certainly would be number one on the list. I would add to that then Summit Bank in Denver, Colorado, our second newest de novo, if you will. We still see loan growth to be pretty solid in Dubuque, at Dubuque Bank and Trust.

Okay.

You might add -- this is Lynn. You might add New Mexico, Jon, to that, and possibly Montana. We have some credits that we're moving out in both of those markets, but they still could show us some pretty positive growth.

I would say the strongest market from an economic standpoint that we are in is probably New Mexico and Iowa, believe it or not. So I think the economies are pretty stable in the Madison area, although things are slow in Wisconsin. Denver seems to be stable, and Minnesota seems to be stable. Arizona is by far the weakest market that we are in at present.

Okay. And just a question on the agriculture portfolio. I know you've seen a lot of variation in commodity prices through the years, but it looks like you've had a pretty good quarter in that business and obviously one of the stronger sectors of the economy. I'm just curious how you balance some of the risks and opportunities in that business and what kind of an appetite you have for expanding that business further.

We're probably one of the premier ag lenders in the state as far as a bank. Dubuque Bank and Trust has a very solid portfolio of ag loans; and our historical losses in that portfolio have been very, very low.

We tend to deal with the large ag relationships, the larger operations, where you have -- the young people have come back from graduating from ag school at Ames or the likes. They clearly are running the family farm like a business. These are larger operations that are well-managed. They hedge their inputs and their outputs. So we've always been very careful not to lend at two high of levels of loan to value, where you see land values escalating from $5000 an acre to $6000 an acre for productive land. So we're pretty careful not to get caught up in loaning out at too high of loan to values with land at these levels.

John, it's Ken. I would just add to that. We certainly look, especially when some ag land has shot up in value significantly in the last 12 months, we do keep in mind the production value versus the recent sales price when we're underwriting any credit.

And then within our ag portfolio, we do have a fair amount of diversification in there, between those in the livestock industry between cattle, hogs, and dairy, as well as those in row crop production. So behind the numbers of ag loans, there's a fairly good diversification within the ag sector.

And as far as the states that we're in, the biggest portfolios would be Iowa out of Dubuque Bank and Trust followed by probably Wisconsin, Monroe, Wisconsin and the surrounding area south of Madison. We have a small amount, a very small amount, of ag in Illinois. But we do have ag in Montana, as well as down in Clovis and Portales, New Mexico, which is on the border of Texas and New Mexico.

Okay. That's helpful. And then John, just one question. Do you have the dollar amount of your floating-rate loans that are at floors?

Jon, I don't have that in front of me right now.

Okay. I'll just follow up later on that.

All right, if you would.

Thanks, guys.

(OPERATOR INSTRUCTIONS). Brad Milsaps, Sandler O'Neill.

Just curious, any charges this quarter related to the large Arizona loan? Did you write that down at all? Was that part of the $1.1 million in net charge-offs this quarter?

There was no direct charge-off on that credit yet. We do have a specific reserve against that as well as many other credits within our portfolio. But none of the $1.1 million charge-off was related to that credit.

I believe we did have some real estate though in Arizona that we had written down we're bringing into Oriole; is that correct, Ken? Okay, that's in the following, okay.

Okay, so did I understand correctly that you expect some resolution to that $7 million credit this quarter?

No, it will happen this year. We have begun a legal process. It will most likely go through foreclosure, and that will be completed prior to year end.

Okay. And then, guys, just maybe a little bit more color on the $24 million loan that paid off this quarter. Just curious, did that relationship have any significance, deposits attached to it? Sort of which bank did that come out of? And then, would you consider that one of your larger loans on the books? And any others that might fit in that category?

Brad, that is one of the larger loans we do have on our books. It was really participated out throughout all of our banks as -- the originating bank was Galena State Bank. Saying that all the deposit balances did remain with us and will remain with us on a go forward basis.

Okay. And then final question. John, can you just talk a little bit about maybe the margin and kind of what you're doing on the balance sheet in terms of maybe the duration of some of the wholesale borrowings that you're using at this point? And then maybe what else you are buying in the investment portfolio?

As far as the duration of the balance sheet, we're still keeping that relatively short overall. The funding sources, again, as I indicated in my comments, Brad, you are seeing the FHLB, and although they've spiked up a little bit recently, we saw that has a tremendous opportunity in the first quarter. And we did seize that opportunity. That's not to say that we departed any of the local markets. But certainly that was one of our key funding sources throughout the quarter. So we drove down our costs there. We drove it down in terms of repurchase agreements as well, most of which are tied to Fed funds. I think all that was very positive from our perspective -- obviously from the margin perspective.

Relative to the investment side, we are shifting more of our portfolio to mortgage backs now. We're moving out of agencies into mortgage backs. We feel there's tremendous value there versus historical spreads. So that's been our focus really for the last probably six to seven months.

We are buying mortgage backs, Brad, that perform better in the rates-up environment. Our concern is that in the next 12 to 18 months, we could start to see rates move up the other direction. So even if we get some short-term drop by the Fed, we're repositioning some of the investment dollars to help us out as rates increase.

The other thing with FHLB, we bought a number of maturities that we could lock in very low cost of funding. These were five, seven, and ten-year total maturities with no call for two, three and four years. So we got a lock on those dollars for the next two, three and four years. And it was much cheaper than what we could actually buy two, three and four-year money in our local markets in CDs.

Okay, great. Thank you very much.

John Rowan, Sidoti & Company.

Good afternoon. John, can you just discuss kind of the, again, on the margin issue, can you just discuss your deposits and kind of where you are going to get some compression on the liability side of what you see for the rate cuts?

Certainly on the savings product, we're going to see some impact there. Both in regular savings and IBCA, we are reaching the effective floor in those.

Maybe I will set in that a little bit. We introduced a product which we call Cash Rewards Checking that we've been paying 6% on, the cost of which is offset by debits that are required -- that customer is required to put through each month in order to obtain that rate. It's a $20,000 maximum balance that we'll pay that 6% on. We do see an opportunity ultimately to push that down. We have in one bank committed to, out through, I believe, the end of '09. But the remaining balance within that account, we can start to look at reducing that cost probably after year end in that account.

I think total balances in that right now are approximately $7 million. So it's not huge right now, but we do see an opportunity to grow that. So that's one way we can actually start to reduce our cost at the same time.

John, this isn't your question, but it was a question asked before about the floors, and I don't have the dollar amount either. But most of the floors that we're implementing on our floating-rate loans are between 5% and 6%. So many of those have started to kick in.

Okay, thank you very much.

Does that address your question, John?

Sure.

(OPERATOR INSTRUCTIONS). Brian Martin, Howe Barnes.

I just wanted -- you talked about some of the resolution and the liquidation of the credit issues. Ken, can you just give a little bit more color as far as what your expectations are in that area or --? As you talked about the second half of the year?

Like Lynn mentioned it too, we have scheduled those out -- the existing non-performings. And I'm looking at the sheet here. With the existing non-performings we have, I expect those to be a third of what they are today. Now that bars any new non-performings sliding into that group, which certainly could occur. But from the ones that we see today, we see those down to approximately a third of what we have.

As I mentioned, a good part of those will go through foreclosure and will end up in other real estate. But then, we will be through the process of the problem loan and be in control of the underlying asset that we can liquidate.

Okay. And you talked about just some of the loss content being pretty minimal. And I guess, have you done -- I guess what have you done reappraisals on these properties or what are the current timing of those reappraisals? Have they been done or are you in the process of that?

The most recent one that I mentioned, the $7 million in Arizona, we have an appraisal ordered on that. It will be several months before we get to conclusion of a foreclosure process. But we have an appraisal that has been ordered, so we can begin assessment of that at this time.

Okay.

Brian, there are other credits beyond that though that we do have current appraisals, within the last 90 days.

Okay.

Ken was just referring to that individual credit.

Right, exactly, okay. And, I think that's all I've got. Thanks, guys.

Stephen Geyen, Stifel Nicolaus.

I was wondering if you could quantify the improvement in non-interest expenses that you expect by year end.

The overall improvements, Stephen, in non-interest expense, did you say?

Yes, please.

I think the biggest thing we saw is really the plateauing of sellers and employee benefits. As I indicated, we were up modestly in that line item when you compare 9/30 versus 3/31.

The other items, by and large, look to be fairly stable across the board with the exception of occupancy, as I indicated, which really we're starting to see some of the costs associated with branches coming online impact us there. Other than that, again, I see it relatively stable almost across the board quarter over quarter.

Okay. And Lynn, you had mentioned the acquisitions or the interest in acquisitions. Could you talk a little bit about location size, asset types that you might be interested in?

We're starting to hear of more community banks that are interested in looking at having Heartland as a partner, and we've heard of that in Minnesota. We've heard of it in Arizona, in Phoenix, in Denver. So I would say those are probably the ones that we have the most knowledge of at this point. We don't have any in Iowa, none at this point in Wisconsin or Illinois. But we do have some interest in both Minnesota, Arizona and, oh, one in Montana. Montana, Minnesota, Denver, and Arizona. Those four states. The size, anywhere from $100 million to $300 million in size would be probably the most probable prospects, $100 million to $300 million would be the range.

Okay, thank you.

Jeff Davis, FTN Financial.

Good afternoon. John, if you said it, I completely missed it, or Lynn, if you said it, or Ken for that matter. In terms of loss rates then for the quarter, 19 bips annualized, a third or so for Citizens. Is it fair to say then expectations for charge-offs this year will be somewhere between the call it 20 bips and the 30 or so you have had the last year or two?

That's a good question, Jeff. I think ken framed it pretty well in his comments, that based on what we're seeing right now, yes, it is. It should hopefully be in that 20 basis point area. But we also understand that there is a softness in that Arizona market, and so as we take these properties in other real estate, that's going to be the swing factor at this juncture.

Okay, but nothing dramatic? At least as of today?

I would turn that question over to Ken.

As of today, I don't see any major surprises that would show us losses that would be anywhere close to where we were last year.

And -- go ahead. I'm sorry.

No, I just -- we still have to work through these issues. We've always been good at taking collateral, and we're faced with -- in some markets where we have had some significant decline in collateral value. We still feel we are relatively well protected, but we need to get through the softness, especially in Arizona.

And Ken, you made a reference to I guess problem or potential problem loans declining by a third, if I heard that right. Could you restate that again in the context?

Yes. Lynn started by making the comment that we have chartered out the non-performing assets, looking at those quarter by quarter on resolutions that we expect will come to fruition. And by the end of the year, by the end of the fourth quarter, I expect the existing non-performing portfolio will be a third of the size that it is today.

I'm sorry I'm not listening well, sorry. So Ken, is it -- then, in terms of your watchlist or just from a grading of your credits, has the migration of deterioration plateaued and now we're starting to see 7's become 6's and more 6's become 5's?

I would say we are seeing 7's becoming worked out and moving those to other real estate. And as I had mentioned before, non-accrual loans I anticipate will be reduced by a third from our existing portfolio. I wish I could see into the future well enough to know if we have any more that are going to tip over. Today, I feel fairly comfortable with our portfolio. And I expect those non-accrual loans to be a third of what they are today. But with that said, we will have a significant pickup in other real estate, which then we'll have to market those properties and reduce -- and return those into income-producing assets.

Understood. Thank you.

At this time, I'm showing no further questions. I would like to turn the call back over to Mr. Fuller for any concluding remarks.

Great. Thank you and thank you all for joining us today. Heartland continues to navigate through some very challenging times, but with a solid first quarter, an increase in earnings and increase in earnings per share and continued growth in non-interest income, as well as continued growth in our earning assets.

I would like to thank you all again for joining us and hope you can join us at our next quarterly conference call, which is scheduled for July 28, 2008. Have a good evening, everybody.

Ladies and gentlemen, this concludes the Heartland Financial USA first-quarter 2008 conference call. You may now disconnect and ACT would like to thank you for your participation. Have a pleasant day.