Heartland Financial USA Inc (HTLF) 2010 Q2 法說會逐字稿

Good evening, ladies and gentlemen. Thank you for standing by. Welcome to the Heartland Financial USA second quarter 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.). Today's conference is being recorded today, Monday, July 26 of 2010.

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

Thank you. Good afternoon, everyone. Thank you for joining us for the Heartland Financial USA's conference call to discuss second quarter 2010 results.

This afternoon, 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 can call Han Hoi at 312-640-6688, and she will send you a copy immediately.

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

Before we begin the presentation, I'd 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 SEC. 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'd like to turn the call over to Lynn Fuller. Please go ahead.

Thank you, Leslie, and good afternoon, everyone. We certainly appreciate everyone joining us this afternoon as we review Heartland's performance for the second quarter of 2010. For the next few minutes, I'll touch on the highlights for the quarter and will then turn the call over to John Schmidt, our Chief Operating Officer and CFO, who will provide further detail on Heartland's quarterly results. And then Ken Erickson, our EVP and Chief Credit Officer, will offer insights on the status of our nonperforming assets and credit quality issues.

I'm pleased to open my remarks this afternoon on a positive note, with Heartland reporting a profitable second quarter for 2010. Net income for the quarter, at $5.1 million, was slightly ahead of the same quarter last year, and not a lot different from the first quarter of this year.

On a per-share basis, Heartland earned $0.23 per diluted common share, compared to $0.21 per diluted common share in the second quarter of 2009 and $0.24 for Q1 this year. Year-to-date income was also pretty consistent, at $10.4 million, or $0.47 per common share, compared to $10.8 million, or $0.50 per common share, for the first half of 2009.

Our year-to-date pre-provision, pre-tax earnings were exceptional, at $33.4 million for the first six months of 2010, and that's compared to $32.1 million in the first half of 2009. Our results continue to be driven by a strong net interest margin, which was 4.12% on a year-to-date basis. For the quarter, margin was 4.09%, an improvement of 17 basis points over one year ago.

With margin management as one of Heartland's top priorities, I'm pleased to report that our net interest margin has remained above the 4% level over the last four quarters. And with 30% of our assets in high-quality securities, our balance sheet has never been stronger. Year to date, our net interest income was up $7 million over the first six months of last year, offsetting reductions in mortgage banking revenues and security gains and a slight increase in our provision expense.

Another one of Heartland's top priorities over the last two years has been expense control. And as you can see, our non-interest expense is down year to date. So I'd like to commend our staff for the great job that they're doing in this area.

As I've discussed in the past, reduction of nonperforming assets is Heartland's number-one priority. And as much as we continue to believe that we are in a stable to improving credit environment, we did experience a slight uptick in NPAs. That being said, our NPAs to total assets remain below 3%. I can assure you that we are extremely focused on improvement in this area, and we continue to staff up and strengthen our special assets team.

We've increased our allowance to loan losses to 2.03% of total loans and believe that we're well reserved at this point. Needless to say, we continue to closely monitor the loan portfolios of our most economically challenged markets, which are presently Phoenix, Arizona, and Bozeman, Montana. In a few minutes, Ken Erickson will address the specifics related to credit administration topics.

Currently at $4 billion, our total assets have remained relatively unchanged over the last six months. And other than acquisitions, we really don't anticipate significant asset growth in the near term. With our securities portfolio currently representing 30% of our total assets, our balance sheet is extremely liquid. Additionally, with our current loan-to-deposit ratio at 78%, we're eager to make every good loan we can find, converting cash flow out of our securities portfolio into quality loans. Although loan demand continues to be soft, we have experienced some loan growth during the first two quarters.

Our second-highest priority is the continued improvement in deposit mix through the growth of non-time deposits. We're especially delighted with the continued growth in non-interest demand deposits, which are up 23% year over year, and savings deposits, which are also up 23% over the previous year.

We continue to focus on targeting and tracking solid deposit relationships first, and then making every quality loan that comes with that relationship. Remarkably, EDA and savings deposits now represent nearly 70% of total deposits, with time deposits at approximately 30%. Outstanding broker deposits have become insignificant as a result of the robust organic deposit growth which we've experienced over the last year.

In terms of capital, we saw marked improvement in our tangible capital ratio this quarter. The ratio increased to 5.45% from 5.17%, largely as a result of market appreciation in our securities portfolio. Although still within our target range of 5% to 6%, it is our intent to drive this ratio toward the higher end of the range. As a result, we will continue to be very selective in pursuing only the most profitable growth opportunities in the future in an effort to preserve capital and maximize the return on same.

In terms of regulatory capital, our risk-based capital and Tier 1 capital ratios continue at nearly double the required levels. And as I mentioned last quarter, the cost of our preferred stock has been fixed at very low rates of interest, from 4% to 5% for anywhere from three to ten years.

In terms of expansion, we see numerous opportunities in all of our markets. And in terms of how and where our investment of capital will be made, we are taking a very selective posture of pursuing only the most profitable growth opportunities. And outside of acquisitions, organic growth opportunities exist in all of our markets where competitors, both large and small, are struggling, and some have already been taken over by the FDIC. As a result, we are actively pursuing and successfully acquiring high-quality deposit and loan relationships from these troubled competitors.

I'm also pleased to comment on the excellent progress of our consumer finance subsidiary, Citizens Finance Company--year to date, have earnings in excess of $1 million. And at the same time, Citizens is experiencing delinquencies below last year. Recognizing the opportunity, Citizens management is planning to open a ninth branch location later this year.

In concluding my comments today, I'm pleased to report that at its July meeting, the Heartland Board of Directors elected to maintain our dividend at $0.10 per common share, payable on September 10, 2010.

I'll now turn the call over to John Schmidt for more detail on our quarterly results. And then John will introduce Ken Erickson, who will provide commentary on credit quality and real estate exposure. John?

Thanks, Lynn, and good afternoon. This afternoon I'll highlight the most substantial changes to Heartland's balance sheet and income statement in the past quarter, 6/30/2010 versus 3/31/2010.

Again, starting with the income statement, net income totaled $5.1 million for the second quarter, while net income available to common stockholders totaled $3.8 million, or $0.23 per share. As Lynn mentioned, we feel very good about our net interest margin, which is 4.09% for the quarter.

We've started to see the lower reinvestment rate on the cash flow from investment maturities weigh on the margin. This is evident in the 41-basis-point decrease in the tax equivalent yield on investments from Q1 to Q2. At the same time, interest on non-maturity deposits decreased by 13 basis points.

We are certainly closing in on an effective floor on our non-maturity deposits, but we still see repricing opportunity in the $421 million certificates of deposits maturing in the next six months at an average rate of 1.66%. Consistent with the last quarter's call, I would anticipate the margin to decrease to around 4% by year end.

Non-interest income was $10.8 million for the quarter, which reflected a 21% increase in fees for mortgage-related activity. Loan servicing income is a combination of servicing fees received from our Fannie Mae servicing portfolio and the mortgage servicing rights income less amortization. Our mortgage servicing rights asset balance was $9.9 million at 6/30/2010 in comparison with $9.6 million at 3/31/2010 and $8.5 million at 6/30/2009. This asset balance is increased by additional servicing rights and reduced through normal amortization and prepayments on existing serviced loans.

Loan servicing income and gains on sale of loans increased by $478,000 over the prior quarter, or 21%. Given a consistent interest rate environment, we anticipate that these income levels should be at least similar for the third quarter.

Volatility in the bond market has allowed us to continue to recognize bond gains as we reposition the bond portfolio for an increasing rate environment. As a side note, with the recent signing of the Dodd-Frank Act, we would anticipate additional operating costs and potentially disruptive revenue streams. The most immediate cause for concern would be the bill's impact on interchange income on debit transactions, which total $3.2 million for the Company on an annualized basis. Certainly, the industry and Heartland will be looking for ways to offset this potential loss of revenue.

Total non-interest expense for the second quarter increased by $674,000 from the first quarter of 2010. The three categories which experienced larger increases were professional fees, advertising, and other non-interest expenses. Professional fees included a one-time payment of $112,000 associated with the restructuring on $74.5 million of callable FHLB advances. Advertising expenses increased in the second quarter and included expenses related to Dubuque Bank and Trust's 75th anniversary celebration.

We would expect our tax rate to be in the 29% range for the remainder of 2010.

Moving on to the balance sheet, you'll note that our overall balance sheet has remained consistent at $4 billion. We continue to focus our efforts on non-time core deposits, as evidenced by the $48 million increase in demand deposits. This increase was offset by the $19 million decrease in savings account balances and the $50 million decrease in time deposits. We are pleased with the current mix of deposits as demand and savings products comprise 69.93% of total deposits at 6/30/2010, in comparison with 67.9% at 3/30/2010 and 60% at 6/30/09.

On the asset side of the balance sheet, the increase in the loan portfolio was funded through cash flow from the investment portfolio. Recent investment purchases have been primarily in short-term Treasuries and agencies versus mortgage-backed securities in an effort to shorten the duration of the portfolio.

As Lynn mentioned, we are starting to see some additional loan activity, primarily in our Midwest markets, where total loans increased by $17 million since 3/31/09, with increases in the commercial portfolio of $30 million, somewhat offset by the decreases in the remainder of the portfolio. Despite the softness in the economy, we still forecast $100 million of loan growth for the entire year. The majority of this growth is expected to occur in the Dubuque, Iowa, Wisconsin, and New Mexico markets.

Net charge-offs for the second quarter totaled $8 million as compared to $4.4 million in the first quarter. The $8.9 million provision taken in the first quarter (inaudible) our allowance by $2 million. End of the quarter allowance is 2.3% of outstanding loans. The majority of the increase occurred at Dubuque Bank and Trust and Arizona Bank and Trust. While the Arizona growth in allowance is driven in large part by market devaluations, the increase at Dubuque Bank and Trust relates primarily to one credit.

The increase in tangible common equity to 5.45% is largely driven by market value appreciation in the bond portfolio. We remain focused on keeping the balance sheet the same size, or even reducing our balance sheet size, and ensuring that it is optimally structured.

In closing, while the uptick in nonperformings is disappointing, the majority of our other metrics remain very strong.

With that, I turn it over to Ken Erickson, our Executive Vice President and Chief Credit Officer. Ken?

Thank you, John, and good afternoon. All of my comments this afternoon, unless otherwise stated, will be exclusive of those assets covered under the loss share agreement. I will begin by discussing the change in nonperforming loans in the second quarter.

As already mentioned, our nonperforming loans increased in the second quarter, increasing by $6.6 million. Eleven credits representing $16 million were removed from nonperforming status during the second quarter, $5.2 million was transferred to other real estate, $604,000 was charged off, while the remainder was resolved through payments, restoration to accrual status, or sale of collateral.

Thirteen new credits exceeding $300,000 on an individual basis were added to nonperforming loans this quarter for a total of $27.6 million. $12.5 million of this was originated by our Montana bank, the Colorado market added $5.3 million of nonperforming loans, while New Mexico added $4.8 million.

The largest of the additions to nonperforming loans is a credit for $8 million. A plan is in place that will most likely liquidate or resolve this problem loan over the next few quarters without litigation.

The second-largest credit added to nonperformings this quarter is a $5.3 million loan secured by nonresidential real estate property. This property has experienced reduced occupancy. Conversations are ongoing with this customer.

I will now turn the discussion to total nonperforming loans. Of the $85 million in nonperforming loans, $55 million resides in 22 credits where individual exposures are greater than $1 million. The majority of these loans were originated, first, by Rocky Mountain Bank, $29.2 million; Summit Bank and Trust in Colorado, $10.5 million; Wisconsin Community Bank, $5.7 million; New Mexico Bank and Trust, $5.5 million; and Arizona Bank and Trust, $3.1 million. These five banks originated $53.9 million of the $55 million.

The industry breakdown for these 22 loans is lot and land development for $15.1 million; lessors of real estate, $12.7 million; construction and development, $7.1 million; other activities related to real estate, $4.2 million; and there are eight other industries that make up the remaining $16.4 million. $3.7 million of our nonperforming loans are covered by government guarantees through Rural Development, SBA, or FSA.

Next I will comment on charge-offs and provision expense. $5.5 million of our losses in the second quarter were from loans originated by Arizona Bank and Trust, and $1 million by New Mexico Bank and Trust. Out of the $7.6 million in losses incurred by our member banks in the second quarter of 2010, the majority was incurred in the three following categories--construction land development and other land loans, $4.2 million; commercial and industrial, $1.2 million; and junior liens on one- to four-family homes, $965,000.

In the second quarter of 2010, Heartland recorded a provision expense of just under $10 million. This net loss is of $8 million, the allowance increased by $2 million. The allowance as a percentage of loans was increased from 1.96% at March 31 to 2.03% as of June 30. The change in this quarter's allowance is attributed to the slight increase in nonperforming loans and the impairment reserve held against some of these loans.

Even with the current quarterly increase in nonperforming loans, the overall portfolio condition appears to be stable to improving. Delinquencies in each of the portfolio segments have been well managed, with no significant adverse trends identified. The trend of 30- to 89-day delinquencies for the last six quarter ends, beginning with March of 2009, is 1.5%, 1.14%, 1.39%, 1.22%, 1.22%, and 0.60%.

Even with the slight increase in nonperforming loans, the total delinquencies were reduced from 4.56% to 4.28% during the second quarter, which is the lowest delinquency recorded in any of the past six quarters. And the 0.6% delinquency, exclusive of nonperforming loans, is the lowest we have recorded for some time.

Regarding expected resolution of the nonperforming loans, I can state that our collection efforts in the third quarter of 2010 are expected to result in a reduction of $13 million of the nonperforming loans recorded at June 30. Of this amount, $11 million is expected to be moved to other real estate.

Relative to other real estate, it increased by $4.3 million to a total of $32.6 million in the second quarter. Total owned residential real estate is $5.4 million, while owned commercial ag real estate is $27.1 million. During the second quarter, $10.5 million was moved into other real estate, while sales resulted in the reduction of $5.4 million, and reduction in other real estate balances of $829,000 was recorded upon the receipt of new appraisals or the sale of the properties.

Liquidation strategies have been put in place for all of the assets held in other real estate. We continue to carry and market these properties in an orderly liquidation manner. It remains our opinion that the current market for quick liquidation requires a discounted value that exceeds the projected carrying costs of these properties.

Regarding portfolio diversification, we do remain well diversified in our portfolio. $1.8 billion, or 73% of our loans, are either fully or partially secured by real estate. Of the $811 million of loans categorized as non-farm, non-residential, 58%, or $474 million, is owner-occupied. A review of the $337 million non-owner-occupied portfolio at June 30 shows that only $11.7 million of that portfolio is classified as nonperforming. Only two accounts are 30 to 89 days past due, for a total of $175,000. $91 million, or 26.9% of this portfolio segment, is in our hotel and motel portfolio segment. Only 2.3% of these hospitality credits are nonperforming. This segment is well diversified, with loans to 49 different relationships.

My final comments will be directed at our retail portfolio. Our retail portfolio continues to perform quite well. Losses in the second quarter for residential real estate loans were 1.12% of outstanding, increasing the year-to-date losses for the first six months to 0.65%. Foreclosures on six residential properties for $801,000 were completed in the second quarter; 33 foreclosures on $3 million of loans are currently in process. Historically, several of these get resolved prior to final action.

And, as Lynn mentioned, Citizens Finance, our consumer finance company, performed well in the second quarter. Net loan outstandings are now at $48.1 million, net charge-offs were $294,000, or 2.5% on an annualized basis and at 2.35% for the first six months. Delinquencies held at 4.54% at June 30.

With that, I'll turn the call back to you, Lynn, and remain available for questions.

Thank you, Ken. And now we'll open the phone lines for questions.

Thank you, sir. (OPERATOR INSTRUCTIONS.) Our first question comes from the line of Jon Arfstrom with RBC Capital Markets. Please go ahead.

Thanks. Good afternoon, guys.

Hi, Jon.

A couple of questions for you, maybe for you, John. You talk about your approach on Reg E. You had mentioned Dodd-Frank, but maybe you have a few thoughts on Reg E and what you've done and how big that exposure might be?

Yes, I think the overall exposure we put on Reg E was about $1.3 million. If everything, with no response on that, Jon, we've had a very aggressive campaign. I think our results at this point, as far as response rate on the letters we've sent in on the Op 10 has been north of 90%. So thus far, it looks to be very positive. Again, I think the jury's still out to some extent, but the maximum exposure is about $1.3 million, and we're certainly working very hard to narrow that down.

Okay, good. And then, Ken, a couple of questions. It looks like you did a nice job in Wisconsin at First Community in bringing the NPLs down, but I was a little surprised by the Rocky Mountain increase and just the overall level of the nonperformers there. Just remind us of what's there and how long do you think it will take you to work some of those balances down? It's clearly an outlier, but just give us an idea of what's there and how long it might take to get those back down.

The largest loan that I commented that went nonperforming this quarter, $8 million, it's a combination of three different related relationships. And as I mentioned, we have had significant conversations with the parties involved. It does appear that this will remain in nonperforming for the next few quarters, but we're reaching an agreement with the borrower where they have come up with a way to liquidate certain of the properties. Today it appears that, as that will be in nonperforming for the next few quarters, it will be a self-liquidation and no identified loss in that as of today.

Another one that went into that portfolio is a project that we do have a potential loss. We did identify an impairment on that this past quarter. I've already identified that. That loan is slightly north of $4 million. We're having discussions with the borrower there, but as of today, if I were a betting man, I'd say that that is going to turn into litigation for us to obtain that property.

We've got another one that, in total, is north of $5 million. That's been in the foreclosure process for the last several months. That appears that it will take into the first quarter for that to come to a final resolution there. As of today, that still appears to be fairly well collateralized, close to our loan balance at worst in today's environment. So we don't anticipate any losses, just taking time to move through that one.

We have certainly looked hard at all of our lot and land development loans. We don't see a significant amount of future problems in those, either in the Montana, Bozeman area, or in the Southwest. But part of that hinges on if the economy does start to rebound and show some building in the upcoming quarters.

Okay. And then you've been pretty consistent in your approach on the OREO properties and some mixed signals from various banks about how the OREO markets could be firming somewhat. I'm just wondering what kind of experience you have with some of the debt that you're seeing?

It depends on the market that you're in. We had one in Dubuque that we were able to take title to it and turn within a matter of days and realized full value from that. Our largest loss this quarter was right at $4 million, and that is because of the deteriorating values in properties we still see on some land and lot developments in the Arizona market. When we see how quickly the values have gone down there--and again, it depends on which market that you're in to see how stable and how much demand for some of these properties are.

Okay, thanks a lot.

And just to clarify that, that $4 million, you asked the question on ORE. I've led to property evaluations in markets. That did run through the allowance. That was a charge-off that's still a loan remaining on our books net of the charge-off. That was not a write-down in ORE.

Okay. Okay, thank you.

Thank you. And our next question comes from the line of Jonathan Elmi with Macquarie Group. Please go ahead.

Hi, good afternoon, guys. Thanks for taking my questions. I just wanted to get some more color on the loan growth. Nice to see that kick up again this quarter. Maybe you could give a little more color on the types of industries where you're making the loans, and then maybe what gives you the confidence that you're going to continue to see this growth potentially accelerate a little, based on your guidance into the second half?

This is John. We've had a couple of larger transactions that we've booked within the first half of the year. The most recent one was a hospital transaction in the Midwest that contributed to several of the banks' loan growth. Dubuque Bank and Trust showed a good portion of that. As being the largest bank in the holding company, they shared, I think, $10 million or $11 million of that. We've had some smaller manufacturers, some of our customers are seeing some growth in the manufacturing side beginning to occur. So there's been some small increases there, but nothing that really jumps out at this time.

Jonathan, this is Lynn. What we're targeting specifically are operating companies that either provide or produce essential type products and services. And the institutions that we're specifically targeting are those troubled institutions that their highest quality clients are uncomfortable continuing the relationships with those institutions, and we're specifically targeting those.

Okay, great, thanks. And then just maybe in terms of the competition for loans out there, what are you guys seeing, and how about pricing?

Again, for the very highest quality clients, the pricing is tighter, obviously. But I would say, in our niche, which I would say our sweet spot is between $1 million and $5 million in credit size, I think the pricing is reasonable. We're not overly challenged. We tend to be able to get prepayment fees, floors on our loans, and a reasonable margin over the index, whether that be prime, for the most part, or LIBOR. So clearly, we're willing, on the very highest quality of credits, to price aggressively. But we just haven't run into a lot of issues on getting pricing on our credits.

And I would just add to that, we have not had any significant pressure on the floors that we've established for the new businesses that we're addressing to push those floors lower than those that we've been working with for the last year to two years.

Okay, great. Thanks very much, guys. Appreciate your time.

Thanks, Jonathan.

Thank you. (OPERATOR INSTRUCTIONS.) Our next question comes from the line of Stephen Geyen with Stifel Nicolaus. Please go ahead.

Yes, good morning, or good afternoon, guys. Just curious, it's really a follow-up to Jon's question. I'm wondering where you are with appraised values on those loans that are, I guess, more mature loans that have been in the nonperforming loan bucket for a while. Do you feel fairly hopeful with the appraised values that you have on those?

I think we do. We update those on a quarterly basis. For our approach to look at those valuations, if we're seeing significant market changes, we are going out and updating additional knowledge that may be a new appraisal at that time, or it may be just other market analysis. But we're doing the best that we can to stay in front of those, and if values continue to deteriorate in some of those markets, we accept the impairments that we're carrying on those loans.

This is Lynn. The greatest devaluation, Stephen, has obviously been out West. The Midwest values have declined, but not nearly to the extent that we've seen out West. And I would say specifically in the Bozeman area, much more so than Billings and the rest of Montana. We've seen pretty good reductions in the Denver area and in Arizona.

On the other hand, New Mexico, values have held up reasonably well. It looks more like the Midwest markets in New Mexico, and part of that, maybe it's the kind of credits that we had on our books were maybe of better quality. But I told our guys, I said, we've written this stuff down in some cases to $0.20 on the dollar. There's just not a whole lot more room to go down. We were lending at 60% to 70% of cost, and in many cases, the OREO that we received back, we've written it down so far, there's just not a whole lot more room to go. I think the bigger issue is, are there going to be buyers that will eventually come in and see this as an opportunity to pick up property extremely cheap?

Okay, and a question for Ken. Just curious--the reserving that you have for this quarter, the provision, the extra provisions that you put up, just wondering what was the impact, or what contribution came from the reserving model that you used? Or was it mostly specific reserves?

The majority of it came from specific reserves, new impairments that we identified. The (inaudible) five portion of it remained relatively stable quarter over quarter, but we did see an increase in the amount that we carried under the past 1.14% impairment counts.

Okay, on near-term concerns do you still see C&D or the fifth as really the big issue, or have your thoughts migrated to (inaudible)?

For future deterioration or continued problems, you're asking?

Yes.

I think the big one is still in the construction development, seeing the balance of our lot and land loans come through. I've looked at those hard. As I mentioned, I looked at our non-owner-occupied real estate, and as of now, I do not see, did not six months ago, still don't see significant problems in that portfolio. We were never a lender to do a lot of dollars expended in high-cost hotels in large metropolitan areas or larger office complexes. So we just don't have exposure to that type of property. Our nonperforming in those categories are less than what we are overall. We're still working through our decreasing balances in our land and lot development projects.

Okay, and the last question, just trying to reconcile the more modest balance sheet that you might be expecting over the next couple of quarters. Is that really going to be the security portfolio, that's what's going to take it this far?

What we would hope to accomplish over the next six months is take the cash flow out of securities and put that into quality loans. So yes, we would--more typically, we'd be at 20% of our assets in securities versus 30%. So we really don't see a huge growth in the balance sheet, but we see a continued shift in mix, to the extent we can be successful in growing quality loans by getting those relationships from the struggling banks in the markets that we operate in.

Got it. Okay, thank you.

The added benefit of that, Stephen, obviously, is we shift out of that bond portfolio into loans. We were able to preserve and realize the gains, certainly there. So we have a lot of motivation to do exactly as Lynn indicated.

Okay, thank you.

Thank you, and our next question comes from the line of Brad Milsaps with Sandler O'Neill and Partners. Please go ahead.

Hey, good afternoon.

Good afternoon, Brad.

I just wanted to see if you guys could maybe add some color to some of your subsidiary banking that you provide. I know Dubuque continued to be your flagship subsidiary bank. But I did notice that you bumped the allowance there a couple million bucks, where as Rocky Mountain's was maybe down $1 million, and you have NPAs going opposite directions--Dubuque coming down and Rocky Mountain going up. Just curious if that has more to do with maybe how you have loans participating around the system or if you're seeing some trends that you don't like in certain markets? I'd just be interested to hear what you have to say in regards to some of the subsidiary bank data.

I'll comment first, and then I'll let John or Lynn follow there. One of them did mention that Dubuque, we had one credit where we took a significant impairment charge in this quarter. I think all of us around this table have questioned whether or not there would be any loss exposure in that. But we did need to recognize our current collateral position as we move into working through that credit. And hopefully, within the third quarter, if not the fourth, we'll see that problem resolve itself.

In regards to what appears to be an increase there with limited nonperforming loans and Rocky having several more, but limited dollars, I think we've commented on previous calls that Rocky has had a history, well before our acquisition of them, of doing a very good job of capturing collateral in doing the loans, as best of any of our banks of structuring those with all available collateral on those. So even though we've had some increases in individual loans, like I mentioned, the $8 million one that just came this quarter, it doesn't appear today that there will be a loss to that. So the impairment assessed against that one individual loan is very small, if any, at the end of this quarter. And John, if you wish to add any comments to that.

Maybe more direct to your point, too, is granted, I don't think we see anything systemic in Dubuque's portfolio at this point at all. I think we saw the allowance, as Ken indicated, that was an increase in allowance. That was driven in large part by the one credit. I think Montana, Ken did a nice job of characterizing Montana's loan. The values are holding up reasonably well. I think the problem we're still identifying there is the fact that it just takes a long time to work though the courts, et cetera, in Montana. So we don't see any additional losses. It's just represent itself in nonperforming loans for a while here as we work through the process there.

The only thing I would add, Brad, is that I think we've got most of the issues behind us in Colorado. There just aren't that many problem credits in our portfolio out there, and those that we have, I think we've got a pretty good handle on at this point.

And as far as Arizona goes--probably the most troubled market from a devaluation standpoint--I think we're approaching the end of that, and we've got a hell of a lot of dollars reserved because you just--our experience there has been every time we get a new valuation, it's lower than the one before. But that's what I was commenting before, that once we get these things written down to about 20% of the original value, there's just not a whole lot more to go. So I think the worst of it's behind us down in Arizona.

Okay, great, and maybe one final question. It looks like this is the first quarter that you turned a profit at the Colorado subsidiary. Do you think you're getting closer in Minnesota to getting to profitability? Still, it's going to need a little bit more growth there, to achieve that level?

We don't have enough mass to generate positive earnings in Minnesota yet. Our overall size is just too small. And we deviated from our original plan up there to advance and provide greater exposure and visibility for that entity, because we really believe that somewhere in the next 12 months, it's going to be so much cheaper to buy than it is to try to branch that thing and de novo it. So the reason we backed off and have not expanded their footprint and their visibility is because we're just waiting for the right opportunity.

And I can tell you, we've looked at a number of options but just haven't been able to put together the right deal. We're being very cautious that we make the right deal, and we think there's a lot of opportunity to come. So I told our people that patience is important right in here.

And just relative to Summit, Brad, where we certainly like the trends, there was some reserve release there--a little bit, as you saw. So we're certainly headed in the right direction there, but it's not where we want it to be relative to profitability at this point.

And that reserve release came from a loan that had been problematic a year or so ago. We had charged off a portion of that, had taken part of it in sale of a nonperforming loan. We got paid in full on that, so we got paid off our loan balance plus the portion that was charged off.

Okay, great. Thanks for the additional color.

Thanks, Brad.

Thank you. And our next question comes from the line of Chris McGratty with Keefe, Bruyette & Woods. Please go ahead.

Yes. On the capital front, 5.50% is right in the middle of your range. Maybe you could talk about getting to 6%, maintaining the dividend in the context of continuing to grow the balance sheet and pursuing deals. I'm wondering if you think you can do it organically or if the right opportunity presents itself, would you raise for some growth?

I think what we've been fairly consistent on in all our communications is that an acquisition of size would certainly require a follow-on offering, Chris. So I think that sits out there. Relative to the overall operating metrics at 5.45 to 5.50, I think we're in reasonable shape.

I think that we're in good shape, actually, relative to the earning stream that we're currently sitting on. We can start to see the trend in nonperformings and in turn the provisions start to go in the right direction. I think that adds a lot of horsepower to the ultimate build in the equity of this Company. So that's what we're really focusing on. Understand that if an acquisition of any size--and again, we've probably identified anything over $100 million to be of size--that we'd certainly have to do a follow-on offering.

Organic growth, Chris, we don't see the asset size of the Company growing a lot. As I said, we're planning to convert securities cash flow into loans. So that's not going to increase our overall asset size. Our asset size has been pretty flat now for six months, and I wouldn't anticipate a whole lot of organic growth. If we find the right transaction, the right acquisition, certainly. If capital's required, unless we do a stock deal that provides us more capital, we'd have to look at a follow-on, as John suggested. But we're going to be pretty careful about what transaction we pursue.

What's the duration on the securities book? Where does it stand? I guess, how quickly can you turn around the securities book into loans?

We're sitting on a lot of appreciation in the bond portfolios right now, and we've looked at our rates in that three-year--.

Probably about three years is a fair assessment.

So it's pretty short. We've, over the last year, have continued to look to shorten that duration. We actually thought interest rates would be rising on a sooner, and it doesn't look like that's going to happen any time real soon right now, but we still want to keep that duration short.

Okay, and then last, on TARP. How are you viewing ultimate repayment? You're one of the few banks that continues to make money, and I'm wondering what your thoughts are on an alternate resolution?

That's why we think our pre-tax, pre-provision earnings are still important, because if what we believe happens, and the provisioning starts to slow down, the earnings will start to hit bottom line, and we believe, by our projections, we should be able to earn our way out of that. But again, the variable that looms out there is if we have a significant M&A transaction that really is additive for our shareholders and would require an issuance of stock, that changes the game a bit.

The other thing that I think is important to remember is our preferred stock is at very low cost to us, in that 4% to 5% range fixed for three to ten years. That's very attractive capital and at very low cost to us. So I understand the focus on PCE, but I also think you need to look at the structure of our other capital.

And maybe just try to bring that all under one picture. As we look at, certainly, the earnings capability of the Company will be a large portion of it. There will be some debt aspects. Hopefully, the markets will free back up here a little bit and there will be some debt aspect. Internally, some capital release at the member banks, if they reduced the amount of nonperforming assets at that level. So a combination of those three, I think, really puts us in a very good position to repay that TARP. At this juncture, we don't identify capital as a component of that TARP repayment.

All right, great. Thanks.

A follow-on offering price at a put.

Thank you. (OPERATOR INSTRUCTIONS.) Our next question comes from the line of John Rodis with Howe Barnes Hoefer & Arnett. Please go ahead.

Good afternoon, guys.

Hi, John.

Ken, maybe a question for you. Do you know what the balance of the restructured loans were at the end of the quarter?

Give me one second.

I showed they were like $21 million to $21.5 million at the end of March? Any maybe just along those lines, while you're looking at it, maybe you guys can talk a little bit about how you decide to proceed with a restructured loan versus various other alternatives, I guess.

They stayed flat from March to June. They're at $30.5 million, went to $30.8 million in the month of, from March to June.

But how much of that was not in nonaccrual or anything else, I guess, or nonperforming?

How much of that was nonaccrual?

Yes.

As he looks for that, John, your other question were?

I was just saying, John, I guess, how do you guys determine when you look at one credit to the next as far as to use the TDR status versus not, just all things equal, on a credit-by-credit basis?

I think there's a material change in terms, and we'll certainly look at the TDR. If it's not going to be paid back in accordance with the original parameters of the agreement, then we're looking very seriously at a TDR.

That's why we end up with a TDR, but I would add to that, that unless we are extremely comfortable that the customer is going to be able to service the debt and repay the loan, we're not just going to go through the motions of a TDR. We'd go through foreclosure, regain the collateral, and liquidate it. We're not really interested in pursuing a TDR where the probability of repayment is low.

And I think that's good color on it. Now looking, trying to add these in my head, I think we're under $5 million of that $30 million that had a nonaccrual status. And some of those, we've remained in nonaccrual after the restructuring until we got to performing.

But echoing what Lynn and John have both said, we will look at a TDR when we feel the customer has a known and measurable cash flow that can service the debt going forward, where we're not quick to just try to restructure it and say, "Well, let's see what happens." If it really looks like that is the best structure rather than us having to go through foreclosure and ownership and ultimate sale of property, then we want to look at that resolution, but only if we're quite satisfied that it will become a performing loan and stay a performing loan on a go-forward basis.

Okay, so, Ken, just to make sure, so you said TDRs in total were about $30 million, back out about $5 million that were already nonaccrual, so roughly $25 million were performing TDRs?

That's on my internal report. I hate to quote that number. It may fall differently on the Q, but yes, the number remained relatively flat from quarter over quarter on TDRs. And the large part of those are performing loans.

Okay. And then, John, just one other question on the balance sheet. What was OCI within equity at the end of June?

Let me grab that. It was still a little north of $13 million, John.

Okay. Thanks, guys.

All right, thanks much.

Thank you. There are no further questions in the queue. I would like to turn the call back to Mr. Fuller for any closing comments at this time.

Very good. Thank you. In closing, I would like to describe the second quarter as a reasonably good quarter as we continue to see favorable trends on our balance sheet and on our income statement. We have a superb net interest margin that's producing exceptional pre-tax and pre-provision earnings, and our non-interest expense remains flat.

We continue to improve the composition of our balance sheet with high-quality securities and an excellent mix of core deposits. So finally, we're well positioned and eager to pursue profitable acquisitions that meet our criteria.

So in short, I feel fairly good about the earnings power of the Company and continue to see excellent opportunities ahead for Heartland.

I'd like to thank everybody for joining us today and hope that you can all join us again next quarter on our conference call, which is scheduled for October 25, 2010. Have a good evening, everybody.

Thank you. Ladies and gentlemen, this concludes the Heartland Financial USA second quarter conference call. This conference will be available for replay after seven p.m. Eastern Time today through October 25, 2010 at midnight Eastern Time. You may access the replay at any time by dialing 303-590-3030 or 1-800-406-7325 and entering the access code of 4329088, followed by the pound sign. Thank you for your participation. You may now disconnect.