Heartland Financial USA Inc (HTLF) 2016 Q4 法說會逐字稿

Greetings, and welcome to the Heartland Financial USA, Inc., fourth-quarter 2016 conference call. This afternoon, Heartland distributed its fourth-quarter press release, and hopefully you've had a chance to review the results. If there is anyone on this call who did not receive a copy, you may access it at Heartland's website at www.HTLF.com.

With us today from Management are Lynn Fuller, Chairman and Chief Executive Officer; Bruce Lee, President; Bryan McKeag, Executive Vice President and Chief Financial Officer; and Andrew Townsend, Executive Vice President and Chief Credit Officer.

Management will provide a brief summary of the quarter, and then we will open up the call to questions from analysts. Before we begin the presentation, I would like to remind everyone that some of the information Management we'll 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 concerning the Company's hopes, beliefs, expectations, and 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 may be obtained on the Company's website or the SEC's website.

(Operator Instructions)

As a reminder, this conference is being recorded. At this time, I will now turn the call over to Mr. Lynn Fuller at Heartland. Please go ahead, sir.

Thank you, Darren. Good afternoon.

We appreciate everyone joining us today as we discuss Heartland's performance for 2016. For the next few minutes, I'll touch on the highlights for the year and the fourth quarter. I'll then turn the call over to Heartland's President, Bruce Lee, who will cover progress on our key operating strategies. Then Bryan McKeag, our Executive Vice President and CFO, will provide additional color on Heartland's quarterly results; followed by Drew Townsend, our Executive Vice President and Chief Credit Officer, who will offer insights on credit-related topics.

Well, I'm certainly pleased to begin this afternoon's call with news that Heartland has just completed its best year on record, with net income available to common shareholders of $80.1 million, which represents a 35% increase over 2015. Now on a per-share basis, Heartland earned $3.22 per diluted common share for 2016, and that's a 14% increase over 2015.

For the fourth quarter, net income available to common shareholders of $19.1 million represents a 33% increase over the fourth quarter of 2015. On a per-share basis that's $0.74, compared to $0.67 for the fourth quarter of 2015.

Return on average assets for the quarter and year to date were 0.92% and 0.98%, respectively. Return on average common equity for the quarter and year to date were 10.48% and 11.8% respectively. Finally, return on average tangible common equity for the quarter and year to date were 13.24% and 15.15% respectively. Heartland's tangible common equity ratio, fueled by solid earnings and our recent common stock offering, improved by 43 basis points during the quarter to 7.28%.

Book value and tangible book value per common share continued to increase, ending the quarter at $28.31 and $22.55, respectively. Net interest margin on a fully tax-equivalent basis remained steady for the quarter at 4.14%, benefiting from lower funding cost and improved asset yields. Net interest income in dollars has increased each quarter for over four straight years.

Now looking at the balance sheet. Total assets held steady at $8.2 billion during the quarter, and increased by $552 million for the year, largely the result of the CIC Bancshares acquisition. In a few minutes, Bruce Lee will discuss loans, deposits, and fee income initiatives in more detail.

Heartland's security portfolio currently represents 26% of assets. With our target at 20%, we still have room to convert cash flow from our securities portfolio into loans. Currently our portfolio duration is three and a half to four years, with a portfolio yield approaching 3%.

Overall credit quality remains sound, although we did experience a modest increase in non-performing assets for the quarter. That said, delinquencies decreased, net charge-offs were modest, and provision expense remained low. In a few minutes, Drew Townsend will provide more detail on these and other credit-related topics.

With respect to Heartland's efficiency ratio, we've made significant progress, ending the year at 66.25%. That represents a 291-basis-point improvement year over year. We continue to implement process improvements and build out scalable systems in our ongoing efforts to bring these ratios down further.

We are also taking steps to rationalize under-performing branch locations, with two offices planned for consolidation early this year. As these reductions occur, we continue to invest in Heartland's online banking channels, converting more and more customers to our digital channels. Following Bruce Lee's comments, Bryan McKeag will address non-interest expense in more detail.

Now moving on to M&A, expansion of our banking franchise through mergers and acquisitions remains a high priority for Heartland. Our proposed merger with Founders Bancorp, parent company of Founders Community Bank, headquartered in San Luis Obispo, California, is moving forward with federal regulatory approval in place, and state approval expected any day now. Subject to the Founders' shareholders vote in February, the transaction is expected to close later in the month, with the system conversion planned for March.

At closing, Founders Community Bank will be merged into our Premier Valley Bank subsidiary, with the Founders banking offices continuing to operate under the Founders brand. Heartland's presence in the central valley and central coast of California will grow to nine locations, with assets exceeding $800 million. Following the merger, Heartland will grow to 112 full-service banking locations operating across 12 states.

Now looking into 2017, we continue to evaluate several attractive opportunities. Our common stock offering last fall, combined with the surge in Heartland's share price, increases the likelihood of more M&A announcements to come. We remain committed to achieving our goal to reach $1 billion or more in assets in each state where Heartland operates. Building on our M&A experience, Heartland is in a great position for additional accretive acquisitions.

Well, with respect to our dividend, I'm very pleased to report that in December the Heartland Board declared a special dividend of $0.10 per common share, in recognition of the Company's record financial performance for 2016. And at this month's January meeting, the Board approved an increase in the regular quarterly dividend to $0.11 per common share, payable on March 3, 2017.

In closing my portion of today's call, I want to note that Heartland's strong financial performance has not gone unnoticed. We recently learned that Heartland has received recognition from Forbes magazines as we were rated as one of the best banks in America. Based on 10 metrics related to growth, profitability, capital adequacy, and asset quality, Heartland ranked 44th on their list of the 100 largest US banks.

I'll now turn the call over to Bruce Lee, Heartland's President, who will provide an overview of the Company's strategic initiatives. Bruce?

Thank you, Lynn. Good afternoon.

I am pleased to comment today on the collective results at the Heartland banks and our revenue-producing business line, as we pursue profitable and sustainable growth. I will begin my remarks with lending, where on a composite basis, total loans were down in the fourth quarter. At the member bank level, the results varied, as four banks increased loan balances, two were flat, and three experienced decreases.

We continue to see a trend at member banks that have completed recent acquisitions for a decline in balances, as CRE exposure is brought into balance, and challenged credits are resolved, as we de-risk the balance sheet of those banks. Outside of these transitioning markets, loan growth is positive.

On the deposit side, our focus has been on growing non-timed deposits. During 2016, non-timed deposits grew over $700 million, or 13.4%. For the fourth quarter, growth was mixed, with retail non-timed balance -- non-timed deposits growing $80 million. However, commercial and other balances declined a similar amount.

Although balances were flat, we were pleased to see a nice increase in the number of accounts this quarter with all three business lines -- retail, small business, and commercial -- showing positive account growth. With the emphasis and growth in non-timed deposits during 2016, our deposit mix has experienced a favorable shift, with non-timed deposits increasing from 83% to 87% of total deposits. For the fourth quarter, total deposit interest expense improved by 2 basis points to 21 basis points.

Moving now to residential real estate, originations are down 14% from the previous quarter, as interest rates ticked up along with the seasonal slow-down. Compared to the year-ago quarter, however, originations are up over 7%. With the prospect of lower volumes in the short term, we have implemented reductions in our work force and continuing our efforts to improve profitability.

These efforts are meeting with success. Despite a $206 million decrease in loan volume year over year, our pre-tax profit increased by $700,000. Additionally, margin in our mortgage business segment is up 26 basis points this year. With the new Management team in place, and our efforts to improve efficiency, we are optimistic our mortgage unit will have a solid year in 2017, as we focus our efforts on the purchase market, which represents 60% of our volume.

We remain committed to the mortgage business, and to that end, are expanding our presence in current footprint locations in California and Arizona. Heartland's mortgage servicing portfolio continues to grow, exceeding $4.3 billion on December 31. We show $32.1 million of MSRs on our books, which have a fair value of approximately $45 million, or $13 million more than book value. We are also enthusiastic about the progress in some of our fee-producing business lines - namely, commercial card payment solutions, which more than doubled card-related revenue in 2016 over the previous year.

Gross revenues increased from $1.8 million in 2015 to $3.9 million in 2016, an increase of 119%. Given the growth potential of this business line, we are adding additional resources to capture this opportunity. It's another example of how Heartland's size and business model gives us an advantage in this space. We have identified an underserved market, dominated by large regional and national competitors that have overlooked the small and the medium-sized businesses we serve in our community banking niche. Our strategy is to approach these clients with a wholistic solution that streamlines their business payments processes, and adds value beyond reward points and rebates.

Likewise, our Treasury management teams are taking the same strategic approach by offering clients our expertise with process improvements that reduce fraud losses and enhance cash management. We have selectively added experienced staff to our Treasury management teams, especially in our newly acquired banks and expanding markets, bringing enhanced Treasury services to our customers who had limited availability previously. These actions are showing very good results, as commercial deposit account service revenue increased by 35% in 2016.

Finally, as we begin a new year, we are pleased that all Heartland banks are profitable for each quarter of 2016, and excited by the prospects for each of the banks and the many opportunities to grow our franchises, by adding value to our clients in 2017.

With that, I will now turn the call over to Bryan McKeag for more detail on our quarterly financial results.

Thanks, Bruce, and good afternoon.

I'll begin my comments today with the tangible common equity ratio, which showed good improvement again this quarter, increasing 43 basis points over last quarter to 7.28%. The increase was the result of the $50 million stock issuance in November, which added approximately 57 basis points to the TCE ratio. However, a good portion of that increase was offset by the decline in market value of our investment portfolio, which reduced the ratio by about 30 basis points, with the remaining 16-basis-points increase coming from retained earnings.

Moving to the income statement, net interest income continued to grow, reaching $75.2 million this quarter, up $1.5 million from the prior quarter. Net interest margin on a tax equivalent basis remained strong at 4.14%, which was unchanged from last quarter. Yields on loans and investments increased by 5 basis points and 11 basis points respectively, and interest costs on deposits and borrowings decreased 3 basis points compared to last quarter.

This quarter the net interest margin includes the positive impact of 15 basis points from the amortization of purchase accounting discounts, which is comparable to the prior quarter. Non-interest income totaled $24.5 million for the quarter, down $4 million from last quarter. Gain on sale of securities was relatively unchanged at $1.6 million, and gain on sale of loans for the quarter was down $5.6 million compared to the last quarter, primarily due to lower mortgage loan application activity, which was down 30% from last quarter.

Switching to non-interest expense, total non-interest expense was $69.9 million this quarter, an increase of $1.5 million from the prior quarter. Our largest expense category, salary and benefits, decreased $1.6 million as compared to last quarter, largely due to lower commissions, and reductions in incentive and benefit accruals. Professional fees were up $1.2 million from last-quarter levels, as consulting and other costs related to systems enhancements were higher during the fourth quarter.

Advertising costs were also up $1 million from last quarter, primarily due to a Heartland-wide fourth quarter deposit campaign. Finally, other non-interest expense was also up $2 million over last quarter, as this quarter included $1 million of additional write-downs on partnerships' investments in tax-related -- tax-credit-related projects. In addition, there were several smaller year-end accruals that accounted for the bulk of the remaining increase in the line item.

For the quarter, our efficiency ratio of 66.29%, up from 63.88% last quarter, as core operating revenues decreased $2.4 million, while core operating expenses increased $1 million compared to the prior quarter. For the full year 2016, the efficiency ratio was 66.25%, down almost 3 percentage points from last year.

To wrap up, I want to add a couple comments regarding our 2017 expectations. First, loan and deposits are budgeted to grow on a percentage basis in the mid-single digits. Net interest margin on a tax-equivalent basis is expected to remain fairly stable, but pull back just a bit into the 4.05% to 4.10% range. As the impact from existing purchase accounting diminishes, obviously this could be offset by additional rate increases should they materialize in 2017.

Mortgage production is expected to be down modestly over last year's levels, due to anticipated slowdown in mortgage re-fi volumes. In contrast to the re-fi market, we expect the purchase volumes to increase slightly, as we view the purchase market as more stable, and expect to see increased volumes in our newer and recently expanded markets. Mortgage gain on sale margins are expected to be improved over last year, as we saw our margin expand over 30 basis points during the last half of 2016, and we expect that higher level to carry throughout 2017.

Other fee areas are also expected to show continued improvement, with deposit and service fee-related growth on a percentage basis in the low to mid-teens; and private client services fees -- that's trust, brokerage, and insurance, to grow in the mid-single digits, as we increase the penetration of products and services into our expanding customer bases.

Core expenses in total should remain well controlled, as we work to improve the efficiency in each of our lines of business, and in particular mortgage banking. However, these efficiency gains will be offset by investments in people and technology that are necessary as we continue our growth towards $10 billion. In addition to core expenses, it's also likely that we'll see an increase in professional fees for M&A activities, as we continue to work to find good suitable M&A opportunities during 2017.

Finally, the Founders Bancorp transaction is expected to be closed and converted in first quarter of 2017. As a result, shares outstanding will increase by approximately 450,000; loans will increase by approximately $100 million; and deposits will increase by approximately $180 million next quarter.

With that, I'll turn the call over to Drew Townsend, our Executive Vice President and Chief Credit Officer.

Thank you, Bryan. Good afternoon.

This afternoon I'll begin my credit-related remarks by discussing the changes in Heartland's non-performing loans during the fourth quarter. During the quarter, non-performing loans showed a modest net increase of $6.5 million, which resulted in a 14-basis-points change, from 1.06% to 1.2% of total loans. New non-performing loans identified during the fourth quarter equaled $23 million, with $21.5 million generated from the Heartland member banks, and $1.5 million from Citizens Finance, Heartland's consumer finance company.

Within the member bank total, 95% of the $21.5 million increase was originated from the legacy bank portfolios. The new non-performing loans by loan type included $14.1 million, or 66%, attributed to the commercial loan portfolio; and $7.4 million, or 34%, from the retail portfolios. There were no new non-accrual agricultural loans identified during the quarter.

Within the $14.1 million increase in commercial non-accrual loans, it is noted that one large relationship of $10.9 million represents 75% of the total commercial increases. This relationship is Iowa-based, and was originated by our Dubuque bank. This loan was previously deemed impaired during the second quarter of 2016, with total impairment reported for this loan of $1.7 million as of the fourth quarter of 2016.

When reviewing the total non-performing loans in greater detail, it is noted that Heartland-wide, commercial and ag loans equaled $38.6 million, or 61% of the total; and the retail portfolios account for $24.8 million, or 39%. Within the commercial total, there are two large relationships, one agra business and one commercial, which total $20.7 million, and account for 32% of all non-performing loans.

At this time, both loans are adequately reserved, and are in the processes of collection. Given the current complexity of the circumstances with these relationships, it is anticipated it may take several quarters before these credits are brought to resolution.

In the retail portfolios, $14.3 million, or 22%, of the total non-performing loans are repurchased residential real estate loans from our service loans portfolio. These loans are either FHA, VA, or USDA guaranteed, in which our loss exposure is considered minimal. On a more positive note, I'm very pleased to report that $13.7 million of non-performing loans in all categories were resolved during the fourth quarter of 2016.

When reviewing Heartland's overall loan quality metrics, the Company's positive trend with respect to total sub-rated loans, those risk-rated either watch or sub-standard, continued during the fourth quarter, with the combined total decreasing by $29.3 million. These decreases were the result of either risk-rating upgrades, desired pay-downs, or planned exits of credits, with a minimal amount of the decrease attributed to charge-offs.

For the year, Heartland's sub-rated loans were reduced in total by $93.9 million, and as a percent of total loans, equaled 6.9%. This level of non-past credits compares favorably to any quarter at the Company over the past several years. As it relates to delinquency totals, the 30 to 89 days delinquency ratio is down slightly, from 40 basis points to 37 basis points from the third quarter to the fourth.

As a follow-up to comments I've made in prior quarters with respect to Heartland's exposure to the agricultural sector, Heartland Banks have identified only a limited number of borrowers who have been downgraded to a non-pass rating. Due to the elevated risks exhibited by the agricultural industry, Heartland will continue to closely monitor the quality of this portfolio. Other real estate owned totals continued to show improvement during the fourth quarter to $9.7 million, with a limited number of additions of new properties.

In total, non-performing assets as a percent of total assets increased from 0.85% as of September 30 to 0.91% as of December 31. Based on current information, it would be our expectation that some improvement should be realized during the first quarter of 2017, with continued limited credit losses.

With respect to the allowance for losses, it is noted that provision expense was $2.2 million during the fourth quarter, a decrease of $3.1 million from the $5.3 million level reported during the third quarter, and in line with the first two quarters of 2016. Provision expense was positively impacted during the quarter and the year, due to a continued reduction in sub-rated credits, non-performing assets demonstrating limited impairment, very modest net charge-off experience, and a lack of non-acquisition-based loan growth.

It remains noteworthy that $956 million of loans from our acquisitions still reside in the purchased accounting pool, and are covered by the valuation PCI reserves. As credit decisions are made on these loans in future quarters, a provision expense will be necessary to establish the associated allowance for these acquired loans.

As shown in the earnings release, our coverage ratio of allowance for loan losses as a percent of non-performing loans was 84.37% in the fourth quarter, down slightly from 94.39% in the third quarter. The allowance for loan losses as a percent of total loans remained relatively unchanged, increasing only slightly, from 1% to 1.02% this quarter.

Valuation reserves totaling $25.3 million are recorded for the aforementioned loans obtained from acquisitions. Excluding those loans covered by the valuation reserves would result in an allowance-to-loan ratio of 1.22%, which compares to 1.23% at September 30.

In summary, although non-performing assets increased modestly during the fourth quarter, the cause, as previously stated, is primarily attributed to one large commercial credit, and an increase in repurchased government guaranteed residential mortgages. Beyond those specific items, the trends for various other asset quality metrics, including delinquency levels, net charge-offs, total sub-rated loans, and total other real estate owned, either remained stable or are demonstrating improvement.

That concludes my remarks. I'll turn the call back to Lynn and remain available for questions.

Thank you, Drew. We can now open the phone lines for questions from our analysts.

Thank you. We will now be conducting a question-and-answer session for the Heartland investment analysts.

(Operator Instructions)

Our first question comes from Andrew Leash with Sandler O'Neill. Please proceed with your question.

Hi, good afternoon, guys. It's actually Aaron Deer on for Andrew.

Hi, Aaron.

Hi, Aaron.

Hi, Aaron.

First, congratulations on a very solid year. I'd like to start with a question for Lynn or Bruce. As you look out over the year ahead, particularly in light of some of the slight decline in some of the loan books heading into year end, where do you see the best growth opportunities, both by category as well as by geography?

Yes. This is Bruce, Aaron. First of all, we think that most of the decreases, particularly in real estate in a couple of our newly acquired markets, that's behind us. We would expect that the markets out West in particular will show the best opportunity for growth. The Midwest is still a little muted, particularly the manufacturing space, and I'll let Drew maybe address where he thinks ag is going to go. But we do expect, as Bryan mentioned, mid-single-digit growth going forward. But I would say most of the growth opportunity we believe is in our Western franchises.

This is Drew. Relative to the ag, I think we're going to see another pretty flat year, probably I think we all recognize we have some additional headwinds, at least in the Midwest with respect to commodities prices. If we would grow in that area, it would be taking quality credit away from other banks. Our Western portfolios tend to be a little less -- a little more specialized in terms of commodity, and there's a little more up side in those portfolios. But overall, I would think ag will be a hold-your-own type of year.

Okay, that's great. Drew, maybe continuing with you. Generally speaking, I know the credit trends are pretty favorable. Just curious though on the two larger NPLs that you highlighted, are those both to two separate borrowers? Where -- I want to confirm that, and also if there's any industry correlation between the two? Then also, can you give us what the specific reserve is against those credits?

The first answer is it is two separate borrowers. One is an agra business. One is an assisted-living industry. The reserve for the one with the impairment is $1.7 million. The other one we feel very good about our collateral position, so at this point there's no reserve attached to that one.

Okay, and then one last question for Bryan on the expense side. I know you gave the number, but I missed it. Can you give what the tax credits accrual amount was for the fourth quarter, as well as maybe what it was in the third quarter, just to see what the variance was, and then what the other one-off items were in the fourth quarter?

In terms of tax write-offs, we had about $1 million write-off in the third quarter. I don't believe there were any in the third quarter, so the fourth quarter's $1 million, none in the third quarter. That would be running through other expenses.

The rest, we had at the end of the year a lot of accrual adjustments in the salary and related areas. I think when you put it all together and maybe where your question is going, is what's our run rate going forward? Quite frankly, I've looked at that a couple different ways. I think we're probably going to see the expense run rate hang in there at about this level, plus or minus maybe a given quarter $1 million. I think we're working to keep those expenses relatively flat to maybe slightly down as we're working on the efficiency within the Company.

Okay, that's great. Thank you for taking my questions.

Our next question comes from Jeff Rulis with D.A. Davidson. Please proceed with your question.

Thanks, good afternoon. A question on the mortgage side, particularly on the gain on sale, maybe for Bryan. Obviously that's a number that was almost half the previous quarter, and you discussed the outlook, specific to the gain on sale for the full year. What is that expectation at quarterly? We've got a pretty wide range in the quarterly basis, but for the bulk of 2017, what are your thoughts on that line item?

Yes, I think it's going to have its same seasonality. Most of our business in 2017 is going to be purchased-related, so that has a seasonality to it. You'll see the first and fourth quarters will be the lowest, and then the middle of the year should show a pretty good tick-up.

The reason the fourth quarter was low is we actually came into the third quarter with a pretty good size pipeline. We had a mark adjustment that catches up right at the end of the year when the pipeline shrinks and the loans get sold in the secondary market. I think that accounting tends to cause things to shift a little bit quarter to quarter.

I think on a full-year basis, probably flat in total to slightly down. Volume might be down a little bit. We're hoping to make up some of that volume difference in better margins that we saw towards the end of the year as we worked on margin management. We'll see. It really depends on the volumes that the purchased market gives to us.

Sure, okay. That's helpful, thank you. Then the tax rate going forward is 31.5%, in the range of your expectations?

I would say, if you were to ask, I would say between 31% and 32%, so I think 31.5% is right smack in the middle.

Okay. Then maybe one last one, maybe for Butch, just on -- you talked about M&A, and it sounds like there's additional opportunities out there. Given the capital level -- well, two part. One, would you go back and consider additional stock offerings? Two, just a little more detail on those conversations on the M&A side, if you could? Thanks.

Yes. As you know, in the past for acquisitions of any size, we've done a good portion of those in stock. It's not uncommon to do 20% cash, 80% stock, or 30% cash, 70% stock. The deals that we've been working on would have a good portion of stock to be issued. We really haven't looked at anything at this point as far as new issuances, other than for the acquisitions.

I really thought we'd have another announcement yet in 2016, but what we've been working on got pushed out into 2017. You can expect that we'll be coming in with some announcements. We'll just have to see.

Our earnings have been strong. That $50 million really helped push our rate up as far as our TCE. We know that as we approach $10 billion, we need to start operating in that closer to 8%, but we really have no intention of going over $10 billion in 2017. We thought that could happen potentially in 2018, so we'll just have to play it by ear.

Okay, thank you.

(Operator Instructions)

Our next question comes from Steve Moss with FBR. Please proceed with your question.

Good afternoon.

Hi, Steve.

Hi. I was wondering if there's been any pick-up in the loan pipeline here over the past couple months post the election?

I'm not sure if it was related to the election or not, but we have seen a pick-up in the loan pipeline as we head into the first quarter of this year over the fourth quarter. Typically the first quarter is a little softer, so we feel optimistic about the level of the pipeline right now.

Okay. Then with regard to the net interest margin guidance, what are the rate expectations built into that?

As we budget, we typically don't build in a rising rate scenario. We budget a flat scenario. We would not have picked up, because it was so late in the year, the last 25 basis points. There may be 25 basis points of opportunity that we don't have in our budget that wouldn't be in that guidance of the 4.05 to 4.10 that I gave you. I think a 25 basis point move, though, is probably 4 to 6 basis points, depending upon what happens with deposit pricing, when that moves. It will move it a little bit, but not materially.

Okay, thank you. That's helpful. Then one more thing. With regard to just on the expense side on the deposit campaign, is that going to carry over into the new year, or is that completed?

I think there could be a -- I think most of it's done. There could be just a little bleed-over, but most of that should be done.

Okay, thank you very much.

Our next question comes from Damon DelMonte with KBW. Please proceed with your question.

Hi, good afternoon, guys. How's it going today?

Hello, Damon. Very good.

Great. My first question, just want to talk a little about the Wisconsin Bank and Trust subsidiary. I think loans have steadily declined since -- if you look on a year-over-year basis, they went from around $800 million down to $650 million. Could you talk about some of the de-risking that's going on there? Do you think that it's reached an inflection point, or would you expect additional run-off from that portfolio?

Damon, this is Bruce. I'll take the beginning of that, and then I'll let Drew maybe follow up. Most of that run-off, especially what occurred in the last half of this year, was directly related to de-risking that portfolio. It had a significant portion of its portfolio was sub-standard. We knew it, and we worked very hard at working those relationships out.

We also did have one significant relationship where we were paid off, which was unexpected. It was a little over $20 million. I think Drew has the numbers that -- where we decreased the sub-standard portfolio year over year. Do you want to mention those?

Yes, just as a follow-up to Bruce's comments there, at the end of 2015, the total of sub-rated credit at WBT was $161 million. As we concluded the 2016, we're down to $92 million, so that's about a -- what is it, $60 million --

Almost $70 million of the decrease was associated with sub-standard credits that we worked down.

Got you, okay.

Maybe to finish, our numbers coming into the acquisition now are very much in line, but the portfolio's considerably bigger, so I think to Bruce's point we should be reaching the inflection point.

That portfolio is now to the point where it should turn. We're not -- clearly we'd like to work out some more of the sub-standards, however that is not the focus that the team in Wisconsin has, which they did have in 2016.

Damon, this is Lynn Fuller. The only thing I would add is that when we modeled that transaction, we had a very large mark on the loans. We knew going in that they tended to be a bit of a lender-of-last-resort, so it was modeled appropriately. We knew that this was coming.

Got you, okay, so this was all planned and anticipated on your end, then?

Yes.

Okay, great. Maybe for Bryan, on the other non-interest income line, I think it was $2.6 million this quarter. I missed if you said it before, but what were some of the components of that? That was up from $1 million last quarter, and call it $750,000 the quarter before?

This quarter in the fourth quarter there were two items. One, we had a recovery on a credit out in California. That charge-off was actually taken before we acquired the bank out there. That ran through other income because we couldn't run it through a normal -- as a normal recovery. That was about $0.5 million. Then our tax partnerships, we did actually have a distribution from those that was income; did not run through taxes, it ran through just to other income. That was about $1 million.

About $1 million, okay.

That's the $1.5 million change.

Okay, great. Lastly, as we look at the provision, I know you guys touched on this a little bit, but third quarter was abnormally high versus the other three quarters from this year. Look back to the other first-, second-, and fourth-quarter levels. Is that a reasonable expectation going forward?

Yes, I would -- I thought a lot about this. I think when you look at this year in total, Damon, I would say we probably will be -- it's reasonable to expect that we'll be slightly higher than what we ran through this year.

This year was a pretty good year in total in terms of, as Drew mentioned, our underlying credit quality actually got better. Didn't have a lot of loan growth. We didn't have a lot of charge-offs. And I think with some loan growth and everything else still remaining in pretty good shape, which we expect, I think you could see that go up to maybe a run rate of somewhere in the $3.5 million per quarter, something like that.

Okay. All right, that's helpful. Thanks a lot, guys, appreciate it.

Thanks.

Our next question comes from Nathan Race with Piper Jaffray. Please proceed with your question.

Hi, guys. Good evening.

Hi, Nate.

Question on the securities portfolio at this point. Given the up-tick in rates that we've seen over the last couple months, update us on your strategy deploying some excess liquidity going forward.

Well, we've got -- as I mentioned, we've got a lot of cash flow coming off of the investment portfolio. We've got close to $200 million in principal alone coming off of the investment portfolio in 2017. What we'd like to see happen, obviously, is that $200 million go out of the portfolio into loans, pick up the increase in return. That's the plan. We'll see if we can get the loan growth.

The portfolio structure hasn't really changed a lot. On the short end, it's SBA floaters and very short mortgage backs. Some of those actually increase in yield if rates increase. On the long end, it's munis. Now we're not really buying more munis now. Not knowing what's going to happen with the federal tax rate, we stayed away from any additions in that long end of the portfolio.

The average yield on those munis is somewhere in the range of 5%, so it's a good return. But obviously if the federal tax rate goes down to 20%, that taxable equivalent yield is going to come off. We're staying pretty short with the investment portfolio, and we think we can hold in that 3% return range with a short duration.

I think, Nate, as rates go up, if we can't reinvest those -- if we have more cash flow than what can go into loans, we're going to be reinvesting those at higher rates, so we'll get a little up-tick on that as well, if we don't get the loans.

Then heading into 2016, organic deposit growth was the top priority. Obviously the success there is fairly evident. Just curious what the top priorities are as we head into 2017.

Well, we still have deposit growth, specifically non-timed deposits, so non-interest bearing DDA and low-cost savings still is a very high priority. You'd have to put loan growth right up with that. Those are still the two highest priorities. I follow that with continual improvement in our efficiency ratio, and integration of M&A transactions, because we expect this year to be a busy year for M&A integration.

Nate, this is Bruce. I might, just to follow up on Lynn's comments, one of the major focuses for us on both the deposit and loan side and even our fee businesses is all about new-customer acquisition. That's what really will drive us forward in 2017. It's bringing new relationships into the Bank. That's why we were so pleased on the deposit front in the fourth quarter.

We brought in 3,000 new relationships to the Bank during the fourth quarter. That will continue to be our focus in 2017, which should result in increased fees, increased loans, and increased non-timed deposits.

Got it. I appreciate all that color. Just going back to your previous point about M&A, and expecting some acceleration this year. Can you remind us where your comfort level is in terms of bringing on additional assets, and what that would do on a pro forma basis for your capital levels, in terms of where you guys would be operating if you were able to do some larger acquisitions this year?

Well, you can put a cap on it by just saying that we're not going to go over $10 billion in 2017. That will give you an idea on how many dollars of acquisitions we can do. If you have a larger acquisition, that of course takes more work. We're probably going to be limited to one or two for 2017.

If they're smaller -- we've done as many as four a year. That pushes the envelope pretty hard. We're really more comfortable with a maximum of three. But again, we would be looking at acquisitions where we can do a large portion of the purchase price in Heartland stock. It makes sense for us to use our currency, given where it's trading.

Right, I was just curious if you had a target capital level that you wouldn't go below on either a TCE or regulatory basis?

Well, we're not going to go below $7 billion, and we want to continue to move toward $8 billion.

Got it. I appreciate all the color. Thanks, guys.

Yes, thanks, Damon.

Your next question comes from Daniel Cardenas with Raymond James. Please proceed with your question.

Good afternoon, guys.

Hi, Dan.

Just a couple quick questions. I apologize if you guys went through this on the call already; I've been jumping in and out. But the sequential quarter loan decline, what was that attributable to?

Dan, this is Bruce. Majority of that was attributable to derisking in three of our member banks, reducing CRE exposure, as well as challenged credits. I think we gave a fair amount of color on Wisconsin Bank and Trust, which was when you look both quarter over quarter as well as year over year, the largest decline of balances. That was, again, planned as we worked through sub-standard credit.

Except for the one bigger credit that left, that was unplanned, $20-some million.

Has all the de-risking been completed, or is there still some additional de-risking that we can see in 2017?

We feel on the real estate side we're very comfortable with all of our member bank commercial real estate portfolios. I think we're done with that. We feel pretty comfortable that Wisconsin has done a great job of cleaning up their loan portfolio, and now it's time for them to turn the corner.

Daniel, this is Drew. Just to follow up to Bruce's CRE comment, I did see for the first time today our 100/300 report. As far as commercial real estate concentration, we have all the banks that are well within the 300% level now, so there is room.

Okay, good. All right. Then just a quick question on the ag portfolio. I imagine you're going through renewal season right now. Are there any trends? Didn't sound like it in the earlier comments, but are there any trends emerging that are giving pause for concern right now?

There's obviously some stress on the commodity of the Midwest here, but our borrowers tend to come into these situations with good balance sheets. We've tended to keep ourselves pretty restrained about loaning into higher land values, and so they have capacity to work their way through. To answer your question specifically, no, not yet. We haven't seen anything.

Obviously another difficult year in 2017 will put further stress, but I think we're going to see our way through this year in pretty good shape. Dairy is an example that's actually going the right direction for the most part. There's some bright spots.

I think I said this in the past, Dan, that most of our ag would be with clients that take their crops and feed it through their livestock. We're not like you would see down in Central and Southern Illinois, where they're just plain crop farmers and dependent on the price of corn and beans.

I think we tend to do a little better. As Drew said, our ag credits tend to be the larger credits and they're low leverage. They're not making a lot of money. That's pretty clear. But ag has always been a cyclical business. As long as you keep the leverage low on these guys and you don't get them levered up on expensive land, they'll have years where they don't make any money but they're not going bust.

Okay, good. Then one last question on the margin, Bryan. Have you built in any additional rate increases for 2017?

We have not.

Okay, perfect. All right, great. Thanks, guys.

Thanks, Dan.

There are no further questions at this time. I would like to turn the floor back over to Mr. Fuller for closing comments.

Thank you, Darren. In closing, we're obviously very pleased with our excellent performance for 2016 and the fourth quarter, and I'll recap very quickly.

Heartland completed its best year on record in 2016, with net income available to common shareholders of $80.1 million, representing a 35% increase over 2015. Over the past three years -- now just over the past three years, Heartland's net income has more than doubled, growing by 118%, and assets have increased by nearly 40%. Heartland's net interest margin on a fully tax-equivalent basis remains at an enviable level of 4.14%, and as a result, our earnings are strong, with full-year earnings per share at $3.22. That's a 14% increase over last year.

The Company continues to produce double-digit returns on average common equity and average-common-tangible equity. Our efficiency ratio has improved by 291 basis points this year, with ongoing efforts for further reductions.

Finally, our pipeline of acquisition opportunities remains strong. Through both organic and acquired growth, we're moving closer to our goal of $1 billion of assets in each state where we operate.

In summary, we begin the new year poised for strong financial performance as we work toward another record year. I'd like to thank everyone for joining us today, and hope you can join us again for our next quarterly conference call, which is on April 24, 2017. Have a good evening, everyone.

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.