Heartland Financial USA Inc (HTLF) 2017 Q3 法說會逐字稿

Greetings, and welcome to the Heartland Financial USA, Inc. Third Quarter 2017 Conference Call. This afternoon, Heartland distributed its third 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 Drew 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 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 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 on the SEC's website.

(Operator Instructions) As a reminder, this conference is being recorded.

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

Thank you, Tim, and good afternoon. We appreciate everyone joining us today as we discuss Heartland's performance for the third quarter of 2017.

For the next few minutes, I'll touch on the highlights for the 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 EVP and CFO, will provide additional color on Heartland's quarterly results, followed by Drew Townsend, our EVP and Chief Credit Officer, who will offer insights on credit-related topics.

Well, I'm pleased to open my remarks this afternoon by reporting that Heartland's third quarter performance was very good, albeit somewhat noisy. We accomplished much during the quarter and to summarize, we completed the Citywide Banks acquisition and invested considerable effort in integrating our largest acquisition to date into the Colorado Bank, which at $2.4 billion in assets, is now Heartland's largest charter.

During the quarter, we were delighted to see organic growth in loans and deposits, along with an increased net interest margin, stable credit quality and further improvement in our efficiency ratio. It was a very busy quarter and a lot was accomplished. All in all, we're pleased with the quarter. Now that said, considerable acquisition expenses associated with the Citywide merger were flowing through the income statement and will be substantially reduced next quarter.

Nevertheless, third quarter net income available to common shareholders was $21.6 million, a 7% increase over the third quarter of 2016. On a per-share basis for the quarter, Heartland earned $0.72 per diluted common share. Year-to-date, net income available to common shareholders set a new record of $61.6 million, slightly ahead of $61 million earned in the first 9 months of 2016. Year-to-date diluted earnings per share were $2.21 compared to $2.48 per diluted share last year. The reduction in EPS can be attributed to the increased number of shares we issued in the Founders and Citywide acquisitions this year.

Return on average assets for the quarter and year to date were 0.89% and 0.94% respectively. Return on average common equity for the quarter and year to date were 8.99% and 9.88% respectively, and return on average tangible common equity for the quarter and year to date were 12.41% and 12.9% respectively. Our tangible common equity was 7.46% for the quarter, near the midpoint of our current target range of 7% to 8%. Book value and tangible book value per common share continued to increase, ending the quarter at $32.75 and $23.61, respectively.

Now looking at the balance sheet, total assets ended the quarter at $9.8 billion reflecting $1.5 billion in assets acquired from Citywide. As we inch closer to $10 billion in assets, we will continue to strategically manage the balance sheet to remain under $10 billion throughout the remainder of 2017. Now that said, we are very pleased to report that organic loan growth resumed during the quarter, growing by $63 million or 4.7% annualized. We also experienced solid organic deposit growth of $92 million or 5.2% annualized, and exceptional growth in nontimed deposits.

Our deposit mix continues to improve with noninterest demand deposits now at 37% of total deposits. In a moment, Bruce Lee will discuss loans and deposits in more detail.

Heartland's securities portfolio currently represents 24% of assets. With our target at 20%, we still have room to convert cash flow from our securities portfolio into loans without increasing our asset size. Currently, our available-for-sale portfolio duration is between 4.5 to 5 years, with the portfolio yield now at 3.13%. We've also completed a restructuring of the newly acquired Citywide investment portfolio that will more closely align with our asset liability position and better perform in a wide range of interest rate scenarios.

While credit quality is stable with both nonperforming loans and delinquency ratios moving lower, and in a few minutes Drew Townsend will provide more detail on credit-related topics, we were also very pleased to record a solid increase in net interest margin which increased by 12 basis points to 4.26% from the previous quarter and stands at 4.19% year to date. Incidentally, this is the best margin Heartland has reported in over 10 years.

Finally, another real positive for Heartland's efficiency ratio which improved for the quarter, falling by over 1 percentage point from the previous quarter to 64.54%. I commend the Heartland teams' ongoing efforts to streamline processes, hold the line on headcount, and realize the projected cost saves and efficiencies identified in our newly acquired banks. Following Bruce Lee's comments, Bryan McKeag will address non-interest expense in more detail.

Now moving onto M&A, we completed the systems integration of Citywide Banks into Centennial Bank & Trust in mid-October and I am pleased to report the largest conversion in our history proceeded smoothly. Our operations teams have finetuned the art and science of systems integrations and I congratulate them for a job well done. We continue to pursue a number of opportunities and see the potential for more announcements yet this year. Through both organic and acquired growth, our goal is to grow assets to $12 billion by mid-2019 to mitigate the adverse impact that crossing $10 billion will have on both revenue and the costs of regulatory compliance.

In concluding my comments today, I am pleased to report at its October meeting, the Heartland Board of Directors authorized a dividend of $0.11 per common share, payable on December 1, 2017. 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. Heartland's 10 community banks turned in a very good third quarter with $63 million of organic loan growth and $92 million of organic deposit growth representing approximately 5% annualized growth across both measures. Collectively, 7 of the 10 Heartland banks increased their loan portfolio balances and 6 of 10 banks grew total deposits. As I spend time in our markets, I continue to hear our bankers and customers express cautious optimism. While they are seeking to ensure stability, they are also looking to enable growth while keeping a watchful eye on the strength of the economy.

The loan portfolio reflects this positive customer sentiment. Last quarter we reported an encouraging trend in new money advanced to new and existing clients in our commercial and agribusiness portfolios. This positive trend accelerated in the third quarter with $238 million in new advances in this quarter, an increase of 11% over last quarter. Also extremely positive is the significant increase in brand new borrowing relationships for the banks with $77 million in new advances this quarter, more than doubling the $34 million in new relationship advances in the second quarter. I will add that organic loan growth remains a high priority. And to that point will mention that our pipeline of loans to be funded is healthy and we are optimistic that we'll produce continued loan growth in the fourth quarter.

Moving to deposits, as we've stated, Heartland had strong deposit growth in the quarter and continues to experience exceptional organic growth in nontimed deposits. The addition of Citywide Banks' high-quality deposit portfolio produced a positive and significant change in mix to our deposit portfolio. Heartland's non-interest-bearing demand deposits now represent 37% of total deposits, up from 32% just one year ago. Nontimed deposits now account for 88% of our total, with timed deposits at 12%. For the third quarter, our total deposit interest expense is 25 basis points, up just 2 basis points from last year's third quarter.

Now moving to residential real estate, Heartland's mortgage loan production slowed in the third quarter, originating nearly $200 million in new loans compared with $324 million in last year's third quarter, producing a significant downward impact on net gains on sale. We are disappointed with this performance and our mortgage unit has put into action plans that focus on delivering consistently profitable results.

You will note a significant reduction from the second quarter of nearly $1 billion in Heartland's mortgage servicing portfolio and a corresponding decrease of over $8 million in servicing rights on the balance sheet. The reduction is largely attributed to the sale of our $774 million Ginnie Mae servicing portfolio and the associated $7 million of servicing rights. As stated in the earnings release, this transaction did not have a significant impact on Heartland's results of operations. As a result of the Ginnie Mae sale, we now show $24 million of MSRs on our books with a fair value of approximately $35 million or $11 million more than book value. In a few minutes, Drew Townsend will discuss the expected impact of this sale on Heartland's impaired loan metrics.

Back to the income statement, we also saw improvement during the quarter from service charges and fees with good increases in treasury management and payments revenue, attributed in part to the acquisition of Citywide Banks solid commercial book of business. Touching on our retail division for a minute, I want to point out that the Heartland Banks are originating new deposit accounts online with good initial results. The new online capability is already accounting for nearly 10% of all consumer new account opening. With strong initial performance, over time we expect to capture 25% of total new consumer checking account openings via the online channel, in line with leading banks offering this capability.

I would also like to mention that we have closed and consolidated 3 branch locations in the Denver market and closed one rural branch this quarter. We are continuously reviewing our physical network to improve effectiveness and efficiency.

I am pleased to welcome a new member to the Heartland executive team. Laura J. Hughes recently joined us as Executive Vice President and Chief Marketing Officer. She brings 20 years of financial marketing experience including positions at JPMorgan Chase and the Federal Reserve System. We look forward to Laura's leadership on our company's growing and diverse marketing efforts.

In concluding my comments today, I want to acknowledge and thank the large number of Heartland team members who orchestrated a nearly flawless conversion of Citywide Banks two weeks ago in Colorado. I also want to acknowledge the Citywide team led by Kevin Quinn. They demonstrated commitment to their customers and to our company throughout the transition. Kevin and his Colorado team will serve the largest market in the Heartland family with over $2.3 billion in assets and we look forward to celebrating their future successes. I am proud to work with so many talented, engaged and dedicated people who day after day make Heartland the great company that it is by supporting our member banks in delivering excellent products and service to our valued clients.

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

Thanks, Bruce, and good afternoon. As Lynn mentioned, it was a very busy and noisy quarter, so I'll try to bring some clarity to the noise. Starting with the tangible common equity ratio, which declined 51 basis points yet remains strong at 7.46%. The Citywide acquisition reduced the ratio by 76 basis points which was partially offset by a small 3 basis points add from the changes in market value over investments and derivatives and 22 basis points increase from the retained earnings for the quarter.

Lynn and Bruce have already commented on loans and deposits, so I will only comment on a couple other balance sheet items. First, good will and core deposit intangibles increased $95 million and $14 million respectively this quarter as a result of the Citywide transaction. Second, other borrowings increased $20 million as a result of our assumption of Citywide's existing [TROPs].

Moving to the income statement, net interest income totaled $89.8 million this quarter, up $15.3 million from the prior quarter. The primary driver of the increase was a $14.2 million increase attributable to the Citywide acquisition and there was also one additional calendar day this quarter.

Net interest margin on a tax-equivalent basis improved nicely to 4.26%, which is a 12 basis point increase from last quarter. Loan yields increased 14 basis points, and investment yields increased 7 basis points, offset by higher interest costs on deposits and borrowings which climbed 6 basis points compared to last quarter.

This quarter, the net interest margin includes 16 basis points from the amortization of purchase accounting discounts, which compares to 12 basis points in the prior quarter.

Non-interest income totaled $25 million for the quarter, down $600,000 from last quarter. When compared to last quarter, gain on sale of securities was up $300,000, and the gain on sale of loans was down $1.8 million. Service charges and fees increased again this quarter, up almost $400,000 over last quarter, primarily from the addition of Citywide Banks.

Switching to non-interest expense, total non-interest expense was $78.8 million this quarter, an increase of $9.5 million from the prior quarter, with most categories showing increases from the second quarter due to the inclusion of Citywide Banks.

M&A and system conversion-related costs increased from $1 million last quarter to $2.8 million this quarter and are spread across multiple expense categories. Our largest expense category, salary and benefits, increased $4.1 million or 10% compared to last quarter. The primary driver of this increase was a higher fulltime equivalent employee count which increased by 162 or 9%. The increase in employee count includes the addition of Citywide which added 180. So excluding Citywide, the employee count would have been 18 lower than last quarter. Occupancy and FF&E costs combined were up $1.4 million from last quarter due to the inclusion of Citywide run rate costs and also included $400,000 of lease buyouts and equipment rental costs related to the Citywide acquisition.

Professional fees increased $900,000, again, due to Citywide's run rate. M&A and conversion costs in this category were $800,000 this quarter, which is a similar level to last quarter. Gains and losses on the sale or valuation of assets was worse by $1.5 million, particularly from the write-off of assets such as leasehold improvements and old signage that was necessary due to the Citywide acquisition. Other non-interest expenses were up $800,000 over last quarter as this quarter includes both Citywide run rate increases and just over $200,000 of software maintenance write-offs, again, related to the Citywide conversion.

For the quarter, the efficiency ratio was 64.54%, down from 65.61% last quarter. Although improved from last quarter, the ratio was negatively impacted this quarter by the higher level of M&A and system conversion costs and inefficiencies related to the lower mortgage banking revenue.

The effective tax rate for the quarter was just under 29%. We believe a normalized tax rate of around 30% is reasonable on a going forward basis.

Lastly, our expectations for Heartland's results for the rest of 2017 would be that the net interest margin on a tax equivalent basis will stay in the 4.20% to 4.25% range. Mortgage production is expected to decline slightly due to the normal seasonal fourth quarter declines. Core fee income, excluding mortgage and security gains, is expected to show continued improvement. We do expect loan servicing fees to be down slightly due to the Ginny Mae servicing sale. However, deposit services and other fee increases will more than offset the decline in loan servicing income.

Core expenses, excluding M&A-related costs, should remain well controlled in the $76 million per quarter range. We anticipate Citywide Banks savings cost to be about $2 million per quarter starting in December, and should be fully phased in by January of 2018.

In addition to core expenses, we also see lower costs for M&A and system conversion activities for Citywide next quarter, which we estimate will be around $500,000. And lastly, loan and deposit growth in fourth quarter, on an annualized percentage basis, is expected to be in the low single digits. And with that, I'll turn the call over to Drew Townsend, our Executive Vice President and Chief Credit Officer.

Thank you, Bryan. This afternoon, I'll begin my credit-related remarks by discussing the changes in Heartland's nonperforming loans. Total nonperforming loans remained relatively unchanged in the third quarter at $65.8 million, however, reduced as a percent of total loans from 1.24% at the end of the second quarter to 1.03% at the end of the third. During the quarter, $5.2 million of nonperforming loans in all categories were resolved. New nonperforming loans identified during the quarter from the legacy portfolios equaled $9.1 million, of which $8 million were originated by Heartland member banks, and $1.1 million came from Citizens Finance, Heartland's consumer finance company. It is noted $1.1 million in nonperforming loans were acquired in the third quarter.

The new bank nonperforming loans by loan type included $4.2 million or 46% attributed to the commercial loan portfolio, $2.3 million or 26% in the ag portfolio, and $2.6 million or 28% from the retail portfolios.

Heartland-wide, there are only 8 nonperforming borrowing relationships with loan outstandings exceeding $1 million. In aggregate, these 8 borrowers total $29.6 million or 45% of total nonperforming loans.

In the retail portfolios, $16.2 million or 25% of all nonperforming loans are repurchased residential real estate loans from our service loans portfolio. This number remained flat between the second and third quarter and it is anticipated this total will trend downward in the future due to the previously mentioned sale of the Ginnie Mae servicing book of business. These loans are government-guaranteed, and our estimated loss exposure is considered to be minimal.

Other real estate owned increased from $9.3 million in the second quarter to $13.2 million in the third. The increase was largely the result of the acquisition of Citywide Banks and their portfolio of other real estate assets in the amount of $6.9 million. In total, nonperforming assets as a percent of total assets, decreased from 0.93% as of June 30 to 0.82% as of September 30. This improvement was anticipated based upon the stable credit quality of the legacy Heartland loan portfolios as well as the very solid credit metrics of the acquired Citywide Bank. When reviewing Heartland's overall loan quality metrics during the third quarter, the company continued to demonstrate a favorable level of total sub-rated loans, those risk-rated watch or substandard. At 5.93%, the non-pass credits as a percent of total loans are at a level which compares very favorably to both recent quarters as well as levels over the past several years.

With respect to total delinquencies, the 30 to 89 days delinquency ratio reduced from 0.38% to 0.33% from the prior quarter to the current quarter. This level of delinquency is somewhat lower than the delinquency percentages reported in the last several quarters.

As we review the allowance for loans, it is noted that provision expense was $5.7 million during the third quarter. Organic loan growth, continued migration of acquired loans from the purchased accounting pool to the allowance pool, and newly identified impairments on one large commercial and one large agribusiness credit relationship all were contributing factors to Heartland's third quarter provision expense being elevated from previous quarters. Total charge offs for the third quarter of 2017 were $5.8 million compared to $3.3 million for the third quarter of 2016. The increase is primary attributable to $3 million of charge offs related to two previously reserved commercial loan relationships at Dubuque Bank & Trust and Arizona Bank & Trust, respectively. It remains noteworthy that $1.7 billion of loans from our most recent acquisitions 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 nonperforming loans was 83.41% in the third quarter, up from 81.78% in the second quarter. The allowance for loan losses as a percent of total loans decreased from 1.02% as of June 30 to 0.86% as of September 30. This is again mainly due to the addition of our largest acquisition to date with almost all of these newly acquired loans being covered by valuation reserves as opposed to the allowance. The valuation reserves total $42.8 million are recorded for the aforementioned loans obtained from the acquisitions. Excluding the $1.7 billion of loans covered by the valuation reserves, would result in allowance to loans ratio of 1.17% as of the end of the third quarter, down slightly from June 30 at 1.20%.

In summary, nonperforming assets as a percent of total assets decreased during the third quarter as previously outlined. Additionally, total sub-rated loan levels as of quarter end continued to show improvement, and trends for various other asset quality metrics, including delinquency levels, continued to demonstrate favorable results. Overall, credit quality for the company is considered very stable.

Finally, providing additional support for this assessment of credit quality at the Heartland member banks were the results of our recently completed regulatory examinations. The exams of the banks were collectively conducted during the third quarter and the results were favorable with no significant issues or material risk rating changes or classifications identified.

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

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

(Operator Instructions) Jeff Rulis, D.A. Davidson.

Kind of tough to pull out the loan growth segmented performance with the Citywide acquisition. Any comment on maybe just where the segmented growth was coming from by loan category and by region if you could?

Yes, Jeff, it was -- came from many of our banks and we were just looking at the data here a little bit ago, it was not nailed down in any specific industry. I think as Bruce may have mentioned, it was 7 of the banks actually showed loan growth. Bruce?

Yeah, Jeff, this is Bruce. The 3 banks that had the most organic loan growth during the quarter were Arizona Bank & Trust, Illinois Bank & Trust and Wisconsin Bank & Trust. New Mexico and Minnesota Bank & Trust also had very nice organic growth and it was spread across many categories including agribusiness, manufacturing, there was some real estate, as well as some healthcare. It was really broad-based.

Appreciate it. Then I think it was maybe Bryan on you talked about the gain on sale outlook to be down sequentially in Q4, some seasonality. But how about the balance of 2018 and your expectations on that line item?

We're working on our budgets right now. I think we're probably looking at 2018, we hope to be slightly better than 2017, but again, don't see any catalysts in the market where the market is going to be up a whole lot. So I think it's going to be, again, a continued fight to grow our market share. Bruce, I don't know if you --

Yeah, Jeff, this is Bruce again. I would say in the residential mortgage business, the only way that we're going to exceed the 2017 performance is to grow our business in both Colorado and California to take advantage of the most recent acquisitions out there. We're disappointed in our performance primarily in both of those markets, haven't gained the traction that we anticipated. So we're really taking a hard look at our entire mortgage business and where the opportunities are in our markets.

Great. Then maybe just one last one, maybe for Drew on the credit quality front. It's been a slow creep in the NPA, I think 9 consecutive quarters up and you talk about the early stage delinquency numbers are trending better. I guess vetting those two on the provision expense, if we're in a kind of return to growth on the portfolio, any thoughts on the provisioning if perhaps charge offs aren't as lumpy as they were in this quarter? Thanks.

Bryan and I have discussed this. I think the conversation we were having is if you kind of put the first three quarters of the year together and kind of average them out, you'd land back at the 3% to 3.5% range I believe quarterly. Obviously the thing that probably causes some pause in truly nailing that down is when you have the $1.7 billion in the valuation reserve, depending on the pace with which deals move through the credit process and move from one space to the other, that's probably a variable that's a little harder to peg. Again, I think we feel well or good about the legacy banks and how we have identified risk in those. So that would be my thoughts. Bryan, I don't know if you have anything else?

I think that's pretty reasonable.

Nathan Race, Piper Jaffray.

Bryan, maybe starting with you on the core margin, I appreciate the guidance you provided for the core margin of between 4.20% and 4.25% going forward. But kind of excluding purchase accounting, can you give us a sense of where the core margin goes from here? Obviously it's up nicely quarter-over-quarter here, but any color you can provide in terms of where new loan pricing is relative to the core portfolio yield around 5%? And also, any comments on deposit pricing after these last couple of rate hikes?

Well, there's a couple of questions in there. I would say, and Lynn and Bruce, you guys can jump in, I think our loan pricing has probably been in the upper 4s to mid 4s maybe at the low range, depending upon the type of products. So I think that's hanging in here in terms of maintaining our margin. Deposit pricing to this point has been pretty good. We've got a small 3% to 5% of our book is variable, so that moves with the market. But the rest of it, as we price it has been pretty slow to move upward with no big moves from competitors in our market. So the next move, that's a little bit harder to judge given that we've had 2 or 3 moves here where deposit prices haven't moved. So how much pent up pricing change is there, I don't know. So those are the things we're struggling with there. The core, as I looked at it, going from the 4.14% to the 4.26% this quarter, we had about I think 6 basis points or so that came from the fed move. We've been getting about 5 or 6 the last couple of moves in terms of basis points, so that next move I wouldn't think would be more than that because we may get a little bit of deposit pressure along with it. So that's why I think we have a hard time basing what the amortization is going to be. It was 16 basis points this quarter, I don't think it's going to go higher now with Citywide in, so that's why we hedge a little bit and say I think between 4.20% and 4.25% is probably a reasonable number for the margin.

What I've seen Nathan is we're getting and have historically been able to get better pricing out west than we get in the Midwest. That said, we see tight pricing on large, high quality credits. So credits in that $15 million to $25 million that are very high quality, are getting priced a lot tighter than smaller credits. And on the deposit side, we've been very fortunate not to have a lot of pressure to increase interest rates on deposits. And again, you can see that we continue to improve our deposit mix. So we'll, if we get another rate hike, which we'd like to see in December if the fed chooses to hike another quarter, that will help us, but it may create a little more pressure for us to increase rates on deposits.

Got it, that's very helpful and I appreciate that color. Just changing gears and going back to Bruce on the growth outlook going forward, it doesn't sound like Colorado contributed too much to the growth you guys had here in 3Q. So just curious kind of what the early indications are in terms of loan growth out of that footprint and what if any kind of one-off expectations you guys have for some credits that may not fit your credit box going forward?

I would say that the Citywide Banks, their credit policy and credit appetite is very similar to ours. There is nothing in their portfolio that we do not want to continue to attract that type of relationship. And actually, we're pretty pleased that for the quarter, we would consider their organic growth, the new Citywide combined with Centennial, was basically flat for the quarter. So we're pretty pleased given everything going on with the conversion of our Centennial staff and the new Citywide coming in with that. So we expect them to be in the mid-single digit growth in the fourth quarter and going forward.

And Nathan, from a deposit side on Citywide, I just saw a report today that since the announcement, we've been able to retain I think it was very close to 99.5%, I think it was 99.8% of the deposits. So we've been very good at retaining the business of that bank and once we get through the conversion expense, they're going to be a great contributor to our earnings.

And they did have organic deposit growth in the third quarter, so we're very pleased with their financial contribution even in the short, roughly 3 months, just a little less than 3 months that they've been part of the Heartland family

That's great to hear. I appreciate that as well. Just going back to the credit conversation, Drew, I was wondering if you could just help us kind of understand how credit size classified migration occurred within the ag portfolio this quarter. I know we're still in the early process of going through credit renewals for 4Q and 1Q, but just kind of any early indication in terms of what you guys expect in terms of credit size migrations in 4Q into 1Q as well as how that may impact growth within ag going forward as well.

All right. I did a quick look back here over the last 7 quarters. Our growth has been relatively nominal, we concluded 2015 at $472 million, we concluded the third quarter here at $513 million. So you can see the pace of growth of the aggregate portfolio has not been high. We have experienced, it had been largely flat so far in the year 2016. Watch and sub-rated $65 million at the end of 2016, $66 million right now. But that is up. It was about 8% of the total portfolio at the end of 2015 and it's been hanging at 13% of the total portfolio in 2017. So I think the outlook will be that crops, yields are good. I was just speaking with one of our dairy farmers, I think our lenders, I think overall production is good, prices are still challenged though. The good news in the sub-rated, we are I think very good about using FSA guarantees. We typically have solid land equities in our portfolio. So even though the portfolio is showing a bit more stress, I don't think the level of loss exposure is elevating to any significant degree.

I would just add to that that we are seeing milk prices go up, so that's improving, livestock prices, cattle and hogs, are improving. And even though we're seeing lower prices on corn and beans which is most of what of our guys are raising to feed to their livestock, the production is here and the area we're lending into is very good. We're getting more bushels per acre, so even if your prices are a bit lower, they still are coming out okay. So I don't see things getting much worse. I would hope that, I think 2018 is going to be a little tough because we've got so much more supply than we have demand. They're carrying supply of beans and corn over plus we've got bumper crops in our area again. So I think it's going to be an issue in 2018 where we just are going to see low prices on crops because of the heavy supply and less demand.

Stephen Moss, FBR.

Circling back to the loan pipeline, I'm just wondering the detail as to where you're seeing the demand for loans these days.

The pipeline is very similar to what we originated here in the third quarter. We're seeing it across our footprint. Most of our markets are seeing the demand and it's mixed. We're seeing some manufacturing demand, some medical, we're also seeing some real estate. And then there is some demand in ag. I would say those are sort of the 4 areas that we're seeing the demand in right now.

Okay, that's helpful. Then Drew, I heard your comments about the reserves trending higher as the acquired loans are renewed or run off. Wondering how we should think about the loan loss reserve by yearend 2018 excluding acquisitions.

Drew and I are looking at each other, Steve, this is Bryan.

I guess it really depends is the way I'd answer the question. I mean Citywide I would say does have a bit more pace to its portfolio. And what I mean by that is, in their larger relationships, take construction deals, oftentimes they may source, provide the construction financing with the end financing to be handled outside of the bank. And so unlike maybe some of the other more recent acquisitions that may have had longer tenured loans, I would think that will potentially weigh in in a little greater pace in terms of movement out of the purchase reserve and into the regular allowance. But with that said, and a CNI, I guess that would be the other component, is they do have a sizable CNI portfolio as well and those will be working their way through the end of the year and the annual renewal. So I doubt we see a whole lot of impact over the next 90 days, but I would expect as we move through the first half of 2018, we'll start to see some more, a larger number in that transfer. That would be my take.

I'll add to that, Drew. Steve, the impact in 2018 to a great extent should be offset by additional acquisitions. I mentioned in my comments that you can expect some additional announcements this year. We won't close additional deals this year because we're going to stay under the $10 billion asset size. But as the Citywide loans start to roll off, we'll have additional loans from additionally acquired banks coming onboard. So I would hope to see that somewhat offset.

Right. Which on M&A, I was just wondering here, in terms of acquisitions going forward, is it more likely to be one or two large deals or are you thinking a couple of smaller deals?

It would be a mix of larger and smaller ones. As I said in my comments, our goal is to get to $12 billion in total assets through both organic and acquired growth by mid-2019. So we're going to have to have a good number of those boarded in 2018.

Damon DelMonte, KBW.

First question, Bryan, could you just walk us through again some of the details on the merger charges? I got down some of them, but if you could just run through that again, that would be helpful.

Just a second here, let me get my sheet here. So in my comments, total this quarter was $2.8 million. We had -- there was about $400,000 that went through occupancy. There's another $800,000 or so that went through professional fees. I think about $1 million of that $1.5 million was related to, on the gain or loss on sale of other assets, was related to the acquisition. There's another $200,000 that went through other. And I think then the balance would have gone through a very small component in salaries and benefits. I don't know if that all added up to $2.8 million. I kind of read them off here, I didn't do all the math, but those are the pieces I had written down.

That would be pretty close. Okay, that's helpful. Thanks. And then with regards to the outlook for Durbin, whenever that comes in, which I think you guys are saying like mid-2019 you'd be impacted by that, is that correct?

Yeah, we figured it was going to be $5 million pretax at $10 billion. So when we get to $12 billion, if we're there when we cross, it probably should be about $6 million pretax.

Then with the banks that you acquired in California, has there been any impacts with the wildfires that we've seen?

No, they were not impacted at all during the quarter. We did not go up into, none of our operations are up into Wine Country. We had no customers or employees that were impacted.

We did have to close a Yosemite branch, but this was not the latest fire, that was an earlier fire around midyear that we had to close the branch for I think it was 3 days, but we didn't have any damage to the bank or homes in the near vicinity of Yosemite.

Okay, great. That's all I had. All my other questions have been asked already. Thank you.

Andrew Liesch, Sandler O'Neill.

One follow-up question for me, Bryan. Just the expenses, I think you said $76 million here in the fourth quarter with $2 million of cost saves coming in in December. So just to clarify, is that a $74 million run rate to start next year?

We should be close to that ballpark. I would say the only thing that would go against that is we continue to add some expenses for crossing $10 billion. So there might be a little add to that, but I would say the first quarter we should enter -- now we get, the one other thing that tends to happen is we get some resets on some of our accruals that we do for the year. So we should be, I would say $74 million to $74.5 million probably is where we should see our run rate as we go into next year.

That's great. You covered everything else. Thanks so much.

Daniel Cardenas, Raymond James.

Just one quick question. In terms of your M&A outlook, are you seeing more opportunities in the western part of your franchise or is it more of a Midwest? Or is that a good mix as well?

It's a mix of Midwest and west. We don't see an awful lot in Iowa or Wisconsin or Illinois at this time. But we are seeing opportunities in Minnesota and then out west we're seeing opportunities. There's not a lot left, Dan, to buy in Arizona. So that's pretty quiet there. And nothing currently at New Mexico. But there are opportunities elsewhere out west.

And would you consider kind of going outside your current footprint right now or is the goal really just kind of to build up each state to $1 billion plus in assets?

Yeah, that's a good question. In the past we've always said that our first priority is in our current states to get each of the charters to $1 billion plus. We've got 4 of them now and I would hope in 2018 we'd have 6 to 7 of the banks over $1 billion. But we would look at very strategic opportunities if they were in neighboring states to where we're already located and it made a great deal of sense. We're going to be very, very picky if we go into a new state that they're going to have to have a great management team, we're going to have to see a bank that has great quality of earnings and very high-quality loan assets. So as you know, there's a lot more risk when you go outside of your footprint, so we'd be very, very picky if we end up going outside of the footprint.

Nathan Race.

I appreciate you taking the follow-up. Bryan, just on the tax rate, I think in the past you've guided 30% to 31%. Is that still a good range to use going forward?

Yeah, I would say 30% probably maybe for the fourth quarter, then you might bump it to 31% with hopefully some better earnings next year.

There are no further questions over the audio portion of the conference. I would now like to turn the conference back over to management for closing remarks.

Great. Thanks, Tim. In closing, we were very happy with the quarterly results as well as our year to date performance. Just to recap real quickly, Heartland's organic, and I want to emphasize organic, loan and deposit growth rate was 5% annualized. So that was good to see the organic loan growth pick up again. We maintained solid credit quality and improvement in nonperformers and delinquencies. Our company continues to maintain its net interest margin at an enviable 4.26% level and that is the best we've seen in 10 years, it's pretty remarkable. Our efficiency ratio at 64.5% is improving as we realize efficiencies in our operations and cost take outs in our acquisitions. And we are strategically managing our balance sheet to remain under the $10 billion total asset level for the remainder of 2017, while advancing a number of additional M&A prospects which will eventually mitigate the adverse impact that we talked about for reduced revenue as a result of Durbin and the increased cost of regulatory compliance. So in closing, as we assimilate Citywide and other acquisitions into the Heartland organization, we'll continue to see improvement in our earnings. 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 scheduled for January 29, 2018. So with that, everyone have a good evening.

This concludes today's conference. Thank you for your participation. You may disconnect your lines at this time. Have a wonderful rest of your night.