Bank Ozk (OZK) 2006 Q4 法說會逐字稿

Good morning and welcome to the Bank of the Ozarks fourth quarter earnings release. All lines have been placed on mute to prevent any background noise. For those of you on the Web, please notice the toolbar on the right of your screen. The features on this toolbar allow you to interact with the other show participants and choose show viewing options. To initiate a chat message (OPERATOR INSTRUCTIONS).

At this time, I would like to turn the show over to Susan Blair, Executive Vice President, Director of Investor Relations.

Good morning. The purpose of this call is to discuss the Company's results for the fourth quarter and full year of 2006 and our outlook for upcoming quarters. Our goal is to make this call as useful as possible in understanding our recent operating results and future plans, prospects, goals, and expectations.

To that end, we will make certain forward-looking statements about our plans, goals, expectations, and outlook for the future including statements about economic, competitive, and interest rate conditions, revenue growth including our goal of accelerating our rate of revenue growth in 2007 as compared to 2006, net income, net interest margin including the effects of the relatively flat to inverted yield curve and intense competition, and our goal of stabilizing and possibly improving net interest margin in 2007 as compared to the fourth quarter of 2006, net interest income, non-interest income including service charge, mortgage lending, and trust income, gains on sales of investment securities, noninterest expense including our goal of reducing marketing expense to substantially offset the increased cost of FDIC insurance premiums, and decelerating our rate of growth in noninterest expense in 2007 as compared to 2006, our efficiency ratio, asset quality, interest rate sensitivity including the effects of possible interest rate changes, future growth and expansion including plans for opening new offices, replacing existing offices, chartering a new Oklahoma bank subsidiary and converting loan production offices to banking offices, loan, lease, and deposit growth, and changes in our securities portfolio.

You should understand that our actual results may differ materially from those projected in any forward-looking statements due to a number of risks and uncertainties, some of which we will point out during the course of this call. For a list of certain risks associated with our business, you should also refer to the forward-looking information caption of the management's Discussion and Analysis section of our periodic public reports, the general caption of our most recent earnings release, and the description of certain risk factors contained in our most recent annual report on Form 10-K, all was filed with the SEC.

Forward-looking statements made by the Company and its management are based on estimates, projections, beliefs and assumptions of management at the time of such statements and are not guarantees of future performance. The Company disclaims any obligation to update or revise any forward-looking statements based on the occurrence of future events, the receipt of new information, or otherwise.

Now, let me turn the call over to our Chairman and Chief Executive Officer, George Gleason.

Good morning and thank you for joining this call. During the fourth quarter, we completed our 2006 deposit branching and corporate growth initiatives. I've discussed these three initiatives in each of our conference calls in 2006.

Earlier in 2006, I suggested that these initiatives would collectively result in higher interest and overhead expenses. I also stated our belief that these initiatives were in the best long-term interest of our Company and our shareholders. 2006 was, in many respects, a building year for Bank of the Ozarks with a great deal of effort and expenditures being devoted to laying the foundation for future growth and profitability. Pursuing these initiatives certainly created headwinds to achievement of our 2006 earnings goals. In addition, 2006 brought other challenges.

The yield curve between short-term and long-term interest rates was essentially flat or inverted throughout the year. Competition for both loans and deposits was intense and a slowdown in the housing sector provided headwinds for mortgage lending income. Because of these factors, we didn't make nearly as much money as we wanted to make or as much as we expected to make in 2006.

From a short-term point of view, considering only 2006 growth in net income and earnings per share, this past year will most likely be viewed as disappointing. I was personally disappointed with our 2006 net income.

On the other hand, I am looking at 2006 from a longer-term perspective and I believe that it will ultimately be seen as one of the most important years for our Company, a year in which many strategic steps were taken to position us for the future. In today's conference call, I want to discuss in some detail these two -- or these three 2006 initiatives and why we believe they are so important for our Company's future. As part of this discussion, I also want to discuss our 2006 results and plans and expectations for 2007.

First, let me discuss our 2006 deposit initiative. Regular listeners to our conference calls will recall that throughout most of 2005, we pursued a relatively defensive deposit pricing strategy. However, in 2006, we shifted to a generally more aggressive deposit strategy. For several reasons, we felt that 2006 was the right time to grow and diversify our deposit sources. This shift in deposit strategy included repricing a number of deposit products and increasing marketing expense. These steps were intended to accelerate growth in our number of deposit customers and deposit balances in both existing markets and in the four new markets in which we expanded in 2006.

Additionally, our 2006 deposit initiative included increasing and diversifying our wholesale deposit customers and products in both CD and non-CD accounts to provide an added depth to our funding capabilities. As a result, after growing deposits $212 million or 15.3% in 2005, our deposits grew roughly twice as much, a record $453 million or 28.5% in 2006. We also had record growth in our total number of deposit accounts in 2006 with our number of deposit accounts growing 85% more in 2006 than they grew in 2005.

These new accounts came both in our established and newer markets. These new relationships should provide a multitude of future cross-selling opportunities.

Our 2006 deposit results also helped us reduce our federal home loan bank and Fed funds borrowings, giving us more flexibility in the future management of our balance sheet. All of this is very good, but the price for accomplishing these results was higher interest and marketing expense in 2006.

We were satisfied with the results of our 2006 deposit initiative. Because of these results, we expect to pursue a moderately less aggressive approach to deposit marketing and pricing in many but not all of our markets in 2007. This adjustment in strategy should contribute to achievement of our goal of stabilizing and then improving net interest margin in 2007 as compared to the level achieved in the fourth quarter just ended. It should also help us reduce our marketing cost in 2007 compared to 2006.

One of our goals for 2007 is to reduce our marketing expense enough to substantially offset the cost of the new FDIC insurance premiums which we expect to start impacting our non-interest expense in the second quarter of 2007. Last week, I was asked by one of our employees if we didn't have a deposit initiative every year. And, of course, every year we expect to grow deposits both in dollar volume and in number of accounts. Gathering new deposits will, once again, be a critical part of our 2007 business plan, but we expect to do that in 2007 without the same intensity of deposit pricing and without the same level of marketing expense as employed in 2006. In 2007, we still expect deposit growth to average from the high teens to the mid-20s in percentage terms.

Secondly, I want to discuss our 2006 branching initiative, which resulted in the addition of a record 11 new banking offices in 2006 plus the relocation of a temporary banking office to a new facility, the replacement of one of our oldest banking offices with a new facility and the establishment of a loan production office in Tulsa, Oklahoma. That's a total of 14 facilities opened in 2006.

Not only did we open a record number of new offices in 2006, but except for one replacement office in Ozark, Arkansas and the Tulsa LPO, all of our new offices were opened in four very important new markets. During 2006, we expanded from one to eight permanent banking offices in Benton and Washington counties in northwest Arkansas, the state's second and third largest counties in terms of bank deposits and among the state's fastest-growing counties.

During the year, we opened our first two banking offices in Hot Springs and Garland County, which is Arkansas' sixth largest county in terms of bank deposits. We expanded from one to three banking offices in the Texarkana market, which includes both Bowie County, Texas and Miller County, Arkansas and we added our first permanent banking office in Frisco, Texas.

Quality is even more important to us than quantity and we believe these four new markets are all high quality markets providing excellent opportunities for future growth and profitability. Of course, these new offices provided more financial burden than in 2000. All new offices require a period of time to generate a sufficient volume of business to cover their overhead.

Opening such a large number of new offices in 2006 contributed to the large increase in our non-interest expense. Because of the challenging yield curve and competitive conditions during the year, the non-interest expense of these offices had an even more significant impact on 2006 net income than originally expected. While some of these new offices will continue to incur operating losses for awhile, we expect each one will grow and ultimately be a contributor to future profitability.

During the fourth quarter of 2006, we also filed an application for a new Oklahoma bank subsidiary to be located in Tulsa. Assuming this application is approved, we expect to combine our Oklahoma loan production office with this new charter and engage in full-service banking operations there during 2007.

Because Oklahoma and North Carolina permit reciprocal interstate branching, we ultimately expect to use this new Oklahoma subsidiary to expand our North Carolina loan production office to a full-service banking operation, most likely during 2008. This new charter is one more example of our spending both management and financial resources during 2006 with a view to future financial benefits.

We expect to continue our growth in de novo branching strategy in 2007, but at a much slower pace. We recently reduced our previous plans for 2007 office additions. We now expect to replace one temporary banking office in Frisco, Texas with a permanent facility and add approximately five new banking offices during 2007. One of these new facilities is expected to replace the current Tulsa, Oklahoma loan production office.

52% of our offices have been added in the last four years. With the substantial capacity of these new offices, we believe we can accomplish our future growth goals while opening a lower number of offices in 2007. Of course, this reduced plan for 2007 office additions should help us achieve our goal of decelerating our rate of growth in non-interest expense in 2007 as compared to 2006.

Third, let me discuss our 2006 corporate growth initiative. This initiative included a broad range of actions intended to build up our staff and our corporate infrastructure to support growth plans for years to come; staff additions and adding more production staff such as loan officers, mortgage loan counselors, and private bankers at existing offices; adding a number of corporate staff members; and giving appropriate salary increases to help retain and develop our next generation of supervisors and managers.

Corporate infrastructure improvements included development and implementation of many new policies, procedures, and processes related to both risk management and other business operations. Because of all these changes, I think we are a better company with far more capabilities and capacities for growth.

While this initiative increased non-interest expense in 2006, it also has given us much greater potential for future growth and profitability. Of course, we are always adding to our production and corporate staff and improving our policies, procedures, and processes, but we do not expect such efforts in 2007 to be as broad-based or costly as those that collectively comprised our 2006 corporate growth initiative.

As I have already stated, one of our goals for 2007 is to decelerate our rate of growth in non-interest expense. Our reduced level of new office additions and our not repeating the level of increases in non-interest expense from our 2006 corporate growth initiative should help us achieve this goal.

Hopefully, this detailed explanation of our 2006 deposit branching and corporate growth initiatives will help you understand our 2006 results and our prospects for 2007 and beyond.

Before we go to questions, I also need to talk about some other major balance sheet and income statement categories which we have not already discussed. Let's start with loans and leases.

Our ability to generate a good volume of quality loans and leases has been one of the hallmarks of our Company. Loans and leases increased 22.4% in 2006, which was right in the middle of our high teens to mid-20s percentage guidance range. We expect continued good loan and lease growth in 2007, and we reiterate our guidance for such growth to average, from the high teens to the mid-20s in percentage terms.

We expect our 2007 growth to come from new lenders in our new markets as a result of our 2006 branching initiative, and from both existing and new lenders in our more established markets. As part of the staff additions pursuant to our 2006 corporate growth initiative, we have hired new lending teams to originate loans to both professional and executive customers and non-real estate loans to commercial and industrial customers. These actions are intended to help us both grow and diversify our loan and lease portfolio in 2007 and beyond.

While we are discussing earning assets, let me also mention our securities portfolio, which we actually reduced by $56 million in the fourth quarter. At year-end, securities accounted for 27% of our earning assets. Historically, our securities portfolio has provided both a good source of earning assets and the collateral necessary to secure our large volume of public funds and trust deposits and customer repurchase agreements.

During the fourth quarter, we were a net seller of securities. Even those such sales reduced earning assets and thus made it harder for us to achieve our goal of growing net interest income. In our opinion, the inverted yield curve between short-term and long-term interest rates, particularly in October and November, provided a compelling sale opportunity.

We felt the conditions for sale of municipal bonds were particularly favorable. As a result, we realized gains of $1.3 million on securities in the fourth quarter. These securities gains were partially offset by $145,000 in losses on disposition of other assets, which was due principally to the write-off of the undepreciated value of our old bank facility in Ozark, Arkansas. Of course, as I've already mentioned, that facility was replaced with a new banking office in the quarter.

Our practice has been to maintain securities of approximately 25% to 30% of earning assets. We will continue to actively monitor our securities portfolio with a goal of finding relative value among the various investment products available from time to time. When we believe that available securities provide attractive spreads or favorable pricing, we will be a buyer, and when we believe it is more advantageous to sell particular securities, we will be a seller.

Given the inverted yield curve and the very low spreads between securities yields and our marginal cost of funds, we do not see a compelling reason to buy many securities at this time.

That provides me an excellent segueway to net interest margin. Obviously, we were in a very tough margin environment all year. We attribute this primarily to three factors -- the first two being external, the relatively flat yield curve or inverted yield curve between short-term and long-term rates and the very challenging competitive environment for pricing both loans and deposits during 2006.

These two factors, combined with our decision to more aggressively price a number of deposit products in 2006, put considerable pressure on our net interest margin. While 2006's margin environment was far more challenging than we expected at the beginning of the year, we are cautiously optimistic that this challenging margin environment will improve in 2007. We can't predict whether the Federal Reserve's next Fed funds rate change will be up or down, but it seems likely to us that we may be at or near current interest rate levels for quite a while.

Also, we're not excited about the flatter inverted yield curve and we can't predict when that will improve. However, despite these challenging conditions, we are making adjustments for the current environment and we are cautiously optimistic that in 2007, our net interest margin will stabilize at or near the level achieved in the fourth quarter of 2006 and may improve as 2007 progresses.

Of course, any improvement will depend on stabilizing our cost of funds and achieving more favorable yields on earning assets, in competitive conditions, changes in the shape of the yield curve, Fed monetary policy, among other factors will significantly affect our actual results.

As I've already mentioned, one of the strengths of our Company has been our ability to generate good growth in earning assets primarily in the form of loans and leases. One of our goals for 2007 is to improve net interest income by growing earning assets and stabilizing and ultimately improving our net interest margin.

Let's turn our attention to non-interest income. Service charges on deposit accounts are our largest source of non-interest income and we were pleased to report record income in this category in the fourth quarter.

In the last conference call, I noted that we were reviewing this area and developing plans intended to help us achieve better growth in deposit account service charge income in 2007. In December, we implemented some changes in our processes affecting deposit account service charges. These changes, among other factors, contributed to the record fourth quarter results in this income category, and accordingly, we believe that 2007 deposit accounts service charge income will improve nicely as compared with 2006.

Continued growth in our number of non-CD accounts should also have a positive effect. Mortgage lending income has traditionally been our second largest source of non-interest income, and in 2006, it declined 3.8% compared to 2005. Our goal in 2006 was to improve mortgage lending income despite the expected tough housing market conditions by gaining market share in existing markets and capturing share in newer markets. While we had some success in both respects, we were not able to generate enough market share gains to fully offset the headwinds from a generally slower mortgage market.

I should note that in 2006, we expanded our team of mortgage originators as part of our 2006 corporate growth initiative, and some of these new recruits seem to be gaining traction later in the year. We will continue to focus on gaining market share in 2007 and whether or not that will translate into increases in mortgage lending income will, to a great extent, depend on market conditions.

Trust is another important source of non-interest income. We've said for some time that this is an area of opportunity for us to grow non-interest income, so we were pleased to see trust income grow by 16.4% in 2006 as compared to 2005. We were also particularly pleased to see trust income hit a record level in the fourth quarter. We believe trust income will continue to be a good contributor to growth in noninterest income.

Suffice it to say that during 2006, we continued to benefit from our strong credit culture and the resulting favorable asset quality. Non-performing loans and leases as a percent of total loans and leases were 34 basis points at year-end. Non-performing assets as a percent of total assets were 24 basis points, and our ratio of loans and leases past due 30 days or more, including past due non-accrual loans and leases, was 60 basis points. Our net charge-off ratio for 2006 was a favorable 12 basis points.

Our strategy for getting back on a record earnings pace as 2007 progresses is very simple. We believe that we will continue to achieve meaningful growth in earning assets, primarily loans and leases, and we also believe that in 2007, we will see our net interest margin stabilize and then hopefully improve.

We also expect good growth and income from service charges on deposit accounts and trust in 2007. If these combinations -- in combination, these factors should result in accelerating revenue growth in 2007 as compared to 2006.

Following our substantial expense growth related to 2006's initiatives, we expect that we will be less aggressive in pricing deposits in 2007, that we will add fewer offices than we added in 2006, and that we will not incur the same level of expense growth related to corporate staff in infrastructure as in 2006.

If these things happen as expected, we should see a decelerating rate of expense growth. And frankly, that's what we're seeking -- accelerating revenue growth and decelerating expense growth.

For a variety of reasons, the first quarter has always been a challenging earnings quarter, and we expect it would be so again in 2007. We are cautiously optimistic that we will achieve positive operating trends in the subsequent quarters of 2007. One of our goals is to once again be achieving record quarterly earnings by some time in the second half of 2007.

At this time, we will entertain questions. Let me ask our operator to once again remind our listeners how to queue in for questions.

(OPERATOR INSTRUCTIONS). Barry McCarver, Stephens Inc.

First off, on the sale of securities and non-taxable securities there in the quarter, is that going to have an effect on the tax rate going forward?

Yes, it is and I can't quantify that for you. The securities that we sold were principally non-Arkansas securities. There were a few Arkansas securities but a very few in there, so they were typically securities that were exempt from federal income tax but not exempt from Arkansas income tax. But I cannot quantify that, but that will have some effect on the tax rate going forward.

Secondly, in thinking about the deposit pricing, you mentioned kind of your stance going into 2007 on deposit pricing, I was wondering if you could talk a little bit about the marketplace and what you might have saw during the fourth quarter?

As expected, after the Fed discontinued their campaign of rate increases after the 17th increase, we saw the marginal cost of various deposits begin to come down a little bit and I'm particularly talking about CD's, and I think we suggested a quarter ago that we expected that to happen because the cost at which we were booking new CD's in October and it continued in November and December was at a lower cost than the cost at which we were booking new CD's in June and July.

The market typically tends to overshoot and when it becomes or seems apparent that the Fed is not going to increase more, folks begin to ratchet back down toward that Fed funds target level. We have seen that and we've seen it in local deposits in a number of markets. We've seen it in wholesale funds such as broker deposits that are 25 to 50 basis points, in many cases cheaper than they were.

Now, we are still -- throughout the fourth quarter and this will continue to a lesser extent in the first quarter -- I think we're seeing the CD's that we're putting on today may be at a slightly higher rate than the CD's that are rolling off; at rate of difference was ratcheting down lower and lower in the quarter. We will reach a point out here where the rate of CD's that we are putting on, if rates stay at the current levels, will actually be less than the rates on CD's that are rolling off. That may be a quarter or two away, but the rate of a cent of our CD cost is slowing every month, and we think that will continue to be the case. As a result, our loans reprice with a little bit more of a lag than our deposits.

For example, 64% of our loan portfolio will now reprice in one year, 78% in two years, and 88% in three years, and those numbers are fairly consistent with the numbers we've had recently. So what that means is in 2007, we're going to be pricing some loans that were put on the books in 2004 and 2005 as well as 2006, and a few even before that. If rates stay stable, our premise is that our asset repricing will begin to catch up with the CD's which have already substantially fully repriced, or mostly reprised, and we'll begin to get a little positive movement in the margin as 2007 progresses from that. So that's our thought on all that.

That certainly sounds much more encouraging.

It does to me too, and this has been a terribly challenging year on margin. The challenges were more profound on the competitive side and yield curve side than we envisioned at the beginning of the year, and thus we had a lot more damage to our margin. Honestly, there was -- that created a great deal of temptation on our part to pull off some of the strategies that we set in place for 2006, but as we look at those strategies, we deeply believe that they are the right thing to do from our Company in the long-term perspective, and we stuck to our guns even though it did more damage to our margin than we anticipated and did more damage to our net income and EPS than we had expected.

We did that because we believe it's the right thing to do in the long run and that it was worth sacrificing some short-term earnings to accomplish that. I'll give you one factor, and I alluded to this in percentage terms, but raw data is perhaps even more telling. In 2005, we added 6,683 net new deposit accounts. That's accounts added over and above accounts that ran off. In 2006, that number was 85% higher. We added 12,385 net new deposit accounts, and we think that that addition among many other changes that we made in the year will be a growth in our business, a growth in our franchise that over time, we can translate into meaningful improvements in net income and EPS.

So, it was a year in which we were very focused on the future. We realized that we live as a public company in a world where there's a lot of emphasis on the short-term and sometimes not as much on the long-term, and for us, this was a year where we were very focused on our long-term objectives.

Very good. Then just lastly, George, on the branch openings for 2007, is the reduced number that you're going to be targeting for this year, is that a factor of some of the markets that you're going to be moving into? Or what's caused the slowdown in de novo?

It's simply a reflection of the fact that we have done more damage to our margin than we expected to do. Our earnings are starting 2007 at a lower base than we expected to be starting at, and with the substantial infrastructure that we've put in place this year, we've concluded that the best strategy is to slow down that number of branches that we're opening, concentrate on maximizing growth and capitalizing on opportunities in the new markets.

So, that's what we are doing. It's just a moderation in our strategy. We have, as part of our ongoing review of number of branches, we have downgraded further the ultimate number of branches that we expect to open in Arkansas, and that is a reflection of continuing highly competitive conditions in some of those markets. The total number of Arkansas branches that we expect to open by 2010 -- and I can say also by 2009 because we don't plan to open any Arkansas branches in 2010 -- is 74 branches, and we are currently at 62 branches open. So, we plan only 12 more Arkansas branches which would be built in 2007, 2008 and 2009, and then we're done in Arkansas.

So that is a further downgrade. I don't remember what the last number that we publicly commented on is, but we have continued to whittle that number down. The reason for that is we look at the opportunities and the competitive conditions in Arkansas and we look at the opportunities in markets such as metro Dallas, Charlotte, and Tulsa, we believe that there are relatively more favorable opportunities there. We want to spend our branch opening resources developing those markets more substantially in the future than putting additional markets -- additional offices in Arkansas.

That's very helpful, George. Thanks a lot.

Andy Stapp, Cowen & Co.

I was wondering if you could give us some order of magnitude guidance, how much you expect non-interest expenses to rise in 2007.

I'm not going to be able to quantify that for you. Certainly, we have a projection, but our practice has not been to give that specific -- you know, to really quantify that. What I would tell you is, is that we expect that level of increase to be a lower percentage level of increase than we incurred in 2006. I'll give you some pieces to the puzzle and that is we're basically looking at five new offices and a replacement office as opposed to 11 new offices, two replacement offices and an LPO last year.

We do expect that we will incur about $850,000 of FDIC insurance premium cost in 2007 that we didn't incur in 2006. You all know that the FDIC has reinstituted premiums with credit for institutions and that it paid certain assessments in the past. We've got enough credits to offset the expected deposit premiums in the first quarter and part of the second quarter.

Just in round numbers, we are expecting about $213,000 in Q2, $310,000 in Q3, $325,000 in Q4 of 2007. Those are very rough estimates based on our assessment rate and some projections of our deposit growth next year. So, zero in Q1, $213,000 in Q2, $310,000 in Q3, and $325,000 in Q4. We do expect to substantially offset that as I've already alluded to with a reduction in marketing expense. Our marketing expense and ad expense this year was at a record high level as we opened a lot of offices and very aggressively pursued this deposit campaign. We'll be dialing that back to a more normal level next year and the dial back there ought to substantially offset these FDIC insurance premiums.

That's very helpful. Thank you. And could you also talk -- give us a little color on asset quality? In particular, the late quarter increase in the provision for loan losses?

Yes, I could. A couple of things there I would tell you is one, obviously, our non-performing assets and non-performing loans were up in the fourth quarter and, as compared to the third quarter, level, but they were, nonetheless, within a range that is not unusual by our historical standards. If you go back to the year end 2004 and the first quarter of 2005, just going back seven and eight quarters, we were at non-performing asset and non-performing loan levels that were actually higher than the levels at year-end.

We view this as really indicative of the normal ebb and flow in asset quality issues and not a source of particular concern that there is a downtrend. There were really about four credit relationships that contributed to that increase, and there's always a lot of changes in the composition of that; non-performing assets come and go constantly. So, there's a constant evolution of that, but there were about four credit relationships that contributed to that, and all of them were housing-related. When you look at that, you'd say, oh, a slower housing market is creating the problems, but that's not necessarily the case.

One of the customers had a severe debilitating stroke and is unable to continue to manage his business. One of the customers that is in there that we've got a rental property in there, it turns out had a prior criminal record and got arrested on a parole violation. So there's a story on each of these things and certainly we've seen a little slower housing market conditions and since they're, I think, eight housing-related construction or rental property loans in there, one could say, well, gosh, that's the reason. But that may have been a contributing factor, but we're not really seeing a significant impact from that.

So our view on that is that the increase at this point, to us, just appears to be kind of the normal random ebb and flow of the loan collection and problem asset resolution process and we don't see that as indicative of a significant trend. The higher provision was a result of the fact that we did have an increase in our non-performers, and also a result of the fact that that reserve percentage has dwindled down somewhat lower over the course of the year; all consistent with our formula for calculation of that reserve, but you read certain levels that seem to one that you're approaching levels that are a minimum sort of level. I know there actually are no minimums in the accounting guidelines for calculating reserves, but we bankers sort of have different points that we think, gosh, you know, that's as low as it ought to get. That's not actually in keeping with GAAP, but nonetheless, you run into those things.

As we looked at that and applied the mathematical formula as a result of putting additional loans on nonaccrual status and subjectively looked at it, we felt like that that $900,000 quarterly provision which was higher than it had been in awhile, seemed to be the appropriate provision for us. So we filled the reserves adequate and we're comfortable with that. We'll continue to monitor that on a quarter-to-quarter basis and go where the numbers by and large dictate we go.

Okay.

Is that what you were looking for?

Yes, that's perfect. You also mentioned that working on your net interest margin, to stabilize it and making some changes for the current environment that you are operating in, could you elaborate on that a little bit, please?

Well, yes. I will be happy to try. Again, after a period of being extremely aggressive in our deposit pricing, particularly by virtue of the fact that we've entered four new markets last year and we typically tend to be more aggressive when we're entering a lot of new markets than when we're not, and in those markets particularly, we feel like we will be able to dial back to a little more normal level of competitive fervor as we go forward next year.

Another thing that created some considerable pressure on our margin this last year and I will tell you, deposits did about what we thought they would do. Deposit cost did about what we thought it would do, but what was the great disappointment to us in regard to net interest margin in 2006 was that we could not achieve the kind of yields on earning assets that we expected to achieve. We thought with the increases in deposit costs that would come from the Feds' action, that loans would move in tandem and we found ourselves all year repricing loans that we had priced a year or two or three years earlier at a disproportionately lower level of increase than our deposits had increased.

And, we had to reprice a lot of loans, so we were faced a number of times in the course of the year on large numbers of loan relationships with the decision of either reprice that to meet a competitor's ultra aggressive pricing on that asset or lose that relationship. So we found ourselves throughout the year sliding down that slippery slope. We made the decision to keep relationships that we thought were good, valuable long-term relationships even if we had to get very aggressive on the pricing. We did that and we see that pressure as pretty much through.

There will be an isolated case here and there where we will still have to address that sort of issue, but we think most of the hammering that we're going to take on that has already occurred and we're at a point where we can start working back up. Certainly, there is a sense that there is a slowing occurring in the real estate sector and particularly the housing sector, and we believe that a little bit more rational pricing in regard to those sort of loans will be able to occur in 2007 as a result of 2006.

We hope that some of our competitive lenders that have been assuming that there's no risk any where and not in our view adequately pricing in credit quality issues, will begin to look at the world and say there are risks out there and we need to price that into our pricing decision and we'll see a little bit more of what we think is rational pricing in loan pricing as 2007 progresses. So we think that's a source for hope on the margin as well.

Okay. Thank you very much. That's all I had.

Dave Bishop, Stifel Nicolaus.

Just a follow-up to Andy's question and just to sort of ducktail on your last comment there. I know you said you hoped that the competition will begin to price that seemingly absence of credit risk. Have you seen any anecdotal evidence that that's beginning to happen in any of your markets as of yet?

We have seen some examples of situations where we were able to price loans up at a better rate than we might have priced those at six months or a year ago. It is limited and spotty at this time, but after the beating we've taken on net interest margin, we're glad to have even a few good signs even if they're limited and spotty. But we've gotten a few deals at pricing that I thought we would not have gotten them at recently and we are drawing some encouragement from that.

Certainly, we've not seen the kind of return to rationality and pricing that I want to see, but we are seeing a few spotty hopeful signs here and there, and that's been going on now for several months. So I'm hopeful that that will take hold and become a little more widespread.

Do you know if that's endemic of any certain market that concentrate maybe in Texas or Arkansas or is it sort of sporadic?

Well, as I say, it's been sort of sporadic and spotty and no, I wouldn't say it's been typical of any particular market.

Also, any shift in terms of customer demand in terms of fixed versus floating type loans?

Yes, that's a good question and our total variable rate loans at year end, 43.7% of our loan portfolio was variable. That compares to 43.1% at the end of the third quarter, so actually, we went a little more variable in Q4 compared to Q3, but that number is down from 44.0% at the end of the last year.

So basically, we've been knocking around within about a percent there plus or minus all year long in regard to variable rate loans. So there is a demand on the part of a lot of customers to fix rates at this point, which at least the pundits that think we're at the end of Fed timing and rates next move's going to be down instead of up, would disagree with that. But a lot of customers who have ridden the prime rate cycle or LIBOR rate cycle, their projects would stress test easily in a plus 300 or 400 or 500 environment when rates were very low and now, the dead surface coverage capabilities of their project at these higher rate levels are not near as good. Those guys are looking at it and a lot of those guys are saying, gosh, if rates went up another 100 basis points, my project might not cash flow. I've got to get a fixed-rate and make sure it will work.

So there is a greater pressure that direction from some customers, and frankly, after 425 basis points of Fed rate increases, my lenders are not fighting that tendency as aggressively and vigorously as they resisted that when we were much, much lower in the rate cycle. Now, we don't know whether the next move's up or down, but we don't feel as compelled to fight a battle with the customer and risk losing a piece of business over the decision to fix a rate if it's, we think, an appropriate rate.

So we are a little more willing to do that than we were a year or two years ago, and there seems to be a little bit more demand from a lot of customers for that, so yes, I think it's going to be hard to continue to get the loan portfolio any more variable than we have.

Two quick questions then for you. In terms of 2007, in terms of balance sheet growth and the funding of that, I guess the fourth quarter looked like you used obviously the securities runoff and I don't think you reported the cash [equity] from banks, I don't know if you used that short-term liquidity to fund the majority of loan growth. How should we think about that in 2007? Is it going to be more matched [fund] in terms of deposits, one for one funding loan growth or are you going to use some of that liquidity as well and maybe let that security portfolio (indiscernible) down assuming -- (multiple speakers)

As I said in the call, we're going to be opportunistic about the securities portfolio. If we had a tremendous selloff in the bond market and rates went substantially higher, I wouldn't hesitate to add securities and replace comparable securities to a lot of what sold if I could buy them back at the same rates that I originally bought them at.

On the other hand, if rates went substantially lower and bond prices went up a bunch, I would sell some more securities. So, what happens to that securities portfolio as far as either increasing or decreasing in size is going to be very dependent upon what happens in the bond market. But our guidance is that we expect loans and leases to grow in the high teens to mid-20s range. We expect deposits to grow similarly in a high teens to mid-20s sort of range, and certainly, with the tremendous deposit growth that we had in 2006, we have much more flexibility with Fed funds and federal home loan bank borrowings and other secondary sources of funding to manage any adjustments in our balance sheet that that would require. But our assumption is that we'll predominantly fund that growth with deposit growth next year.

Finally, it's back to credit quality in terms of the increased provision, I think you noted that internally, reserves have sort of approached the bottom or near the end of a comfort level. Their (indiscernible) reserve coverage of (indiscernible) and reserved loans and specific metric we should use to think about how that could potentially limit share growth next year?

That is a very hard question to give you good guidance on because it is going to very much depend on what happens. If our asset quality holds up as well as we hope it will and if our charge-offs continue to be in that same sort of range that they've been in recently and you look over the last three years, they've been 10, 11, and 12 basis points a year. The reserve provision of $900,000 a quarter would be a heavy provision probably, and even with growth that we would achieve.

On the other hand, if economic conditions are more challenging and the nonperformers picked up a little bit or charge-offs picked up a little bit, then that number would need to rise. It's going to be purely driven by the numbers as to what happens in the economy and what happens in our portfolio. So, we felt comfortable with the $900,000 being an appropriate provision in the fourth quarter.

We're going to look hard at the end of the first quarter and make a decision on what we believe based on the mathematics of our portfolio as an appropriate provision at that time. I will tell you that if you look back over the last several years, in most months we've had about a $500,000 provision and typically, that's provided about a -- oh, I think, about a two to one coverage of our losses or a one and one-half to one coverage of our losses.

We've had a couple of quarters, for example, in the third quarter of 2005 we had $800,000; in the third quarter of this year we had $550,000, and then of course, in the quarter just ended, $900,000.

There is some sense as we look at the portfolio that we should have a somewhat higher provision, something more like the fourth quarter than, say, the second quarter of this year simply because we are in a slower economic environment and the reserve now is one point -- what (indiscernible) are we? 1.06? 1.06% of outstanding loans and leases and obviously, that's lower than we've been in a considerable period of time.

So, with the growth that we expect, high teens to mid-20s sort of growth, we're going to add a lot of loans and there's a sense just given a relative level of the reserve and where we seem to be just nationally in the economic cycle and the growth that we expect, to think that the provision will be higher next year, more akin to the fourth quarter level, say, than the second quarter level of this year.

On the other hand, if we continue to generate 10, 11 or 12 basis point sort of charge-offs consistently, then that performance to some extent may trump the relative level of the reserve and the concerns about macroeconomic conditions and just mathematically say you just can't put more in the reserve because you've got a big reserve relative to a 10 or 11 or 12 basis point loss ratio.

So, there is a lot of evaluation that is ongoing all the time here looking at that, a lot of discussion in our Board level about it. We're just trying to look at the numbers and do the right thing quarter to quarter on what that reserve needs to be. So, I realize that is not much guidance, but at least I've sort of outlined to you two countervailing points of view on that that we're looking at and debating all the time here.

Appreciate the color.

Joe Fenech, Sandler O'Neill.

George, most of my questions are answered, but just a few things here. First, can you tell us if any of the four credits that moved to nonperformer, were any of those in newer markets for you, specifically in northwest Arkansas, North Carolina or in Texas? In other words, were there any geographic concentrations that you can pinpoint?

They were all in northwest Arkansas. And again, you would look at that and say oh, there were -- I think it was eight different residential loans and they're in northwest Arkansas and low, that market is slower and they're housing-related credits and there's the problem. But that's really not the right interpretation of that story. I mentioned two of the guys, you know another guy is a guy that had been a long-term, successful customer of ours in another market and he made the decision to -- he's a builder and he made the decision to relocate his family to northwest Arkansas to take advantage of that market, got up there and started building, didn't have the subcontractor connections that he had in his established market, spent a lot of personal funds in relocating his family up there, and I think we've got three houses with him now that we're in foreclosure on. The problem is, is he spent a lot more than our loan amount to build them and has got a bunch of mechanics and material (indiscernible) liens that are inferior to our mortgage and the houses are readily sellable. They just can't sell them at a price to come out on them because he lost control of his cost on the project -- or projects.

So, yes, they are housing-related and yes, they are in northwest Arkansas, but the bottom line is there are only about eight of them. We think we're in good value. I don't think we've actually got any principal loss in any of them, and when they're liquidated, I think we'll actually recover some, if not all, of our interest on them, which, of course, we've got them on nonaccrual, obviously.

So I don't see them as particularly related to the housing market in northwest Arkansas or particularly related to housing market in general. They're just -- there are some anomalies on each of them that have led to them being in problem loan status.

Also, George, your loans are up about 11% on the average basis. End of period, you're up about 20% annualize. Can you just reconcile that for us? Was it just a timing issue? And then can you maybe also give us some color on where the growth came from in terms of the individual categories and maybe by geography?

We had a considerable number of loans that closed in literally the last week of the month, including several fairly substantial credits that because of the borrower's timetables on closing, their purchase contracts for the assets had to close on the last or by the last day of the month of the year. So, it was a -- as it often is in December, a rush to the finish to get all of our customers' needs for closings and transactions taken care of and you're exactly right. The average growth in loans from quarter to quarter on an annualized basis was about 11%. The point in time, 930 to 1231 number was north of 20% somewhere -- 20 something percent.

None of that's unusual. It's just the way these things happen. You don't have a nice, level flow of business. We did have a couple of large credits that did contribute to the growth and to give you a little color on those, the two largest credits that we closed in December was a large, large land loan on like 50 something hundred acres of land I believe, and we made a $24 million loan. The customer put in, I think, $28 million of cash equity in the transaction. And we've got first mortgage, of course.

And then we helped a customer that's an established customer that we had a relationship with, buying an apartment complex and we loaned $10 million on a $16 million purchase price and he put in $6 million cash equity. So, and the land loan was in Texas and the apartment loan was in Ohio. So, that's sort of some of the very detailed color on some of those transactions that occurred really late in the year.

Okay, so no real -- in terms of the pipeline heading into first quarter relative to where you were heading into fourth quarter? And also, just by geography, if you can talk about where -- maybe a better way to ask it is, how much of the loan growth was in those three markets that I mentioned earlier, in northwest Arkansas, North Carolina and Texas, relative to your older, more legacy markets?

Well, I can give you some point in time numbers here. Hold on just a second, let me see if I can -- our Texas loans at year-end, in total Texas loans were 7.5% of our loan portfolio or actually, if you want to carry it out, 7.54%, and that compares with a year ago and I don't have the last quarter numbers, but a year ago, Texas loans were 5.61%, so, Texas increased in 2006 as a percent of which our loans, 1.9%, and North Carolina went 3.6% at year-end 2005 to 4.3%. So, 7/10 of a percent there, and Arkansas went from at year-end 2005, 90.8% of the portfolio to 88.1%.

Certainly, our Texas offices, we would expect to contribute a higher percentage of our (technical difficulty) going forward, and North Carolina as well. We expect growth in Arkansas, but we expect that the relative growth in Texas and North Carolina will outstrip the growth in Arkansas and we've given this guidance for some period of time, that our non-Arkansas loans will be a higher (technical difficulty) portfolio going forward (technical difficulty) percentage, although we expect growth in all markets. We didn't see much growth in northwest Arkansas in the fourth quarter just because that market has slowed somewhat and we're being appropriately cautious in that market.

That's helpful, George. And then just last question, and I wanted to jump back to an earlier comment you made about specifically the first quarter here that's typically a tougher quarter for you. Just generally speaking here, if your margin is stabilizing, you're seeing good loan growth, asset quality is stable, fee income picking up, the rate of expense growth slowing. You're saying you're not going to see that increase in the FDIC insurance premium cost until the second quarter. Where do you see the challenges specifically here in the first quarter that would lead you to make that comment? I'm just wondering if I'm missing something here just in general terms.

Well, first quarter is always a challenging quarter, and there a lot of reasons for it. One, there are just 90 days in the quarter as opposed to 91 or 92 in other quarters, so you lose one or two days of interest income. Consumers put their credit cards and debit cards and checkbooks up considerably more in the first quarter than they do later quarters of the year because most folks have overspent on Christmas and they're trying to heal up their personal balance sheet. NSFOD fee income typically takes a dip in the first quarter because so many consumers, particularly in a more moderate income market such as Arkansas, elect to get their tax refunds electronically, so a lot of guys who typically are regular users of NSFOD fee income are not using that as much because they get a rapid refund or electronic refund of their tax refund and that typically puts them in a good cash position for a month or two.

It typically is a slower month mortgage-wise because of the weather and the fact that people are busy starting the new year and recovering from the holidays, there's not as much mortgage activity. There are just a lot of things that make Q1 always a challenge, and we -- I dislike it every year, but I'll be honest with you. This year, I'm glad to get into Q1 just to get out of 2006.

Okay, but nothing besides the normal seasonal factors that you just talked about?

It's just normal seasonal factors. That's it.

Andy Stapp, Cowen & Co.

Yes, just wondered if you could talk about the economy, I know the housing market is slowing down, but in general, if you could talk about how the economy is faring in the markets you serve outside of housing.

Our sense is that the economy is in very good shape in the markets we serve and even in northwest Arkansas, which is the market that probably has received the most attention of the markets that we're in regarding potential overbilling and overdevelopment of lots and overbilling of houses. Certainly there is an element of that there, but even in that market, we've got a lot of builders who are very active up there and they're continuing to sell houses. We've got developers that have developed lots and generally they're continuing to see good sale of lots.

It's not as much of a slowdown up there in our view as you might get from reading the press. And of course, the metro Little Rock market continues to be in very good shape as does Charlotte and Dallas. The majority of our small rural markets are behaving in the same sort of normal slow growth conditions that exist in those markets. So, we are -- you know, I think generally, we're pretty comfortable with the economic conditions and the implications of that for our asset quality.

The only challenge that I think really of that nature that is evident is in northwest Arkansas where there is some overbuilding of housing and considerable overdevelopment of lots, but they're creating lots of jobs up there, you've got very positive population growth. There's a lot of commercial development construction and nonresidential things that are happening that will continue to create jobs and economic vigor in that market, so, I don't think that's a particular source of concern either. So we feel pretty good about economic conditions.

Brian Martin, Howe Barnes.

One housekeeping question and one other question. Housekeeping one -- you talked about the expenses and kind of marketing expense the FDIC -- the incentive comp for 2006 and for 4Q, can you give a little color on what that was? And then how to look at that for 2007 at this point?

Yes, obviously, we didn't achieve our earnings objectives that would have triggered a payment of our general cash bonuses. We didn't even get any place close. And we've got our thresholds for that set at a level for 2007 that I think it's very unlikely that we will pay those in 2007. I assure you if we do, you nor anyone else will have any problem with it.

Our desire as a Company is to grow earnings in a meaningful way each year and this year was a disappointment and essentially flat on a GAAP basis to last year, up less than 1% on a GAAP basis. Certainly, we've got to get back on a substantially positive track before our general cash bonus program is going to kick back in. While we're cautiously optimistic that we will get things turned around and going the right direction in 2007, we're going to be starting out -- obviously if you look at fourth quarter numbers, we're going to be starting out from a low base on which to build in Q1 and subsequent quarters of 2007.

So I don't think you're going to see any difference in our incentive comp next year. Now, with that said, we have a general cash bonus program and then we have targeted incentives for various people in the Company. All of our mortgage folks are commission based, our trust guys drive a substantial amount of their income from commission. We have various referral programs and various specific incentive programs for private bankers and others, and those things were paid per the contracts with those folks. We would expect similar levels of payout on those, but I assume your question related to our general cash bonus program. We didn't pay it in 2006 and honestly, unless we have an extraordinarily robust upsurge in earnings that gets us back onto what we think should be the earnings track that we should be on long-term, even ignoring the flat year this year, I don't think we'll pay it in 2007.

How about -- just one other question and that was regarding branch profitability. Just wondering if you can give a little bit of color, I mean, with the slowdown here or at least what you're looking at for 2007 [and talk to me] about the 52% of your branches that have come online over the last four years. Can you give a little bit of color on the timing to get those branches profitable? How many will cross that profitability barrier in 2007 of the branches that are out there?

Well, our typical rule of thumb in the past has been that it takes about a year plus or minus to hit a breakeven level of operations in a branch. Obviously, that was predicated upon our sort of historical margin numbers. It's not rocket science to realize if you've got a three something margin instead of a four something margin, if you've got 100 basis points or 125 basis points less margin, it's going to take 20% to 25% more assets to get that office to a breakeven level of operations than if you had the higher relative level of margin. We've certainly seen that over the last year as margins have gotten crushed, you've just got to build more customers and put on more loans and deposits to get the same net income or margin net interest income that would offset your overhead and get you to a breakeven.

So, it is taking longer in this more challenging margin environment to hit a breakeven level of operations. That was one of the factors that was taken into account in our decision to slow the rate of offices next year. What we really realized we need to do is we've got to focus more time and energy and attention on the offices we built in 2006 and try to help those guys get their balance sheets built faster than normal so that we can get all those offices to a breakeven and then profitable level of operation in 2007. That's certainly one of our goals.

Will we get them all to profitability? Probably not, particularly given the fact that we opened four of them in the last quarter of the year, but we're going to try real hard to get everyone we can as profitable as we can next year and we think that that will translate through into some positive earnings leverage.

Can you comment on how many branches at this point are not profitable? That is, if you've got 60 -- 67 or 70 branches, I'm not sure the exact number, but if 52% were opened in the last four years, of those 30 or so that were opened -- 30 plus or whatever the number is, how many of them are not profitable at this point?

I don't have that data and -- but I can give you a general comment. You'll have to take this as an off the top of the head comment that I didn't prepare to answer that question. I think we've got some of our offices that were opened in 2006 that are profitable. We've certainly got -- and I don't mean they were profitable for the whole year, but they've reached a profitable level of operation. So I think we've got some of those offices that are profitable. I think the vast majority -- and there may be a couple of isolated exceptions -- of offices that were open prior to 2006 are profitable, but the number that would be unprofitable opened prior to calendar year 2006, it would be a handful.

(OPERATOR INSTRUCTIONS). At this time there are no further questions.

Let me thank you for joining our call today. We will look forward to talking with you in about 90 days. Thank you very much.

This concludes today's conference call. You may now disconnect.